Engineering Economics

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Engineering Economics

• Breakeven Analysis

Lecture 6 31 August, 2007
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Lecture Topics

• Introduction
• Cost Price
• Fixed and variable costs
• Breakeven point
• Comparing alternatives

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Introduction

• Breakeven analysis, in general, is an important
  step in the business planning process.
• It is the transition point between negative and
  positive total cash flow.
• It is used in comparing two or more alternatives.
• It is helpful in the decision making process on
  such issues like make-or-buy.

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Cost Price

• Cost and Price do not mean the same thing.
• The price charged by a manufacturer for an item
  is cost markup.
• The manufacturer pays a price for raw materials,
  it is part of the cost of manufacturing an item.
• Produce an item at a cost and sell it for a
  price.

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Total Costs (TC)

• Fixed Costs (FC)
• Buildings (rent, depreciation, outgoings, etc.)
• Insurance
• Fixed overhead
• Equipment (lease, depreciation, etc.)
• Indirect labour (salaries)
• Variable Costs (VC)
• Materials
• Direct labour
• Contractors
• etc.

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Fixed Costs (FC)

• Essentially constant for all values of the
  variable in question
• Not affected by level of (business) activity
• Fixed costs may be optimised for an efficient
  operation
• Fixed costs are optimal for maximum utilisation
  of plant capacity

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Typical Characteristics of FC

FC 3
FC 2
FC 1
Quantity
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Variable Costs (VC)

• Variable costs change with the level of activity
• More activity - greater variable costs
• Less activity - lower variable costs
• Variable costs are impacted by efficiency of
  operation, improved design, quality, safety, and
  higher sales volume
• Variable costs should be correlated to revenue
  and profit

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Total Costs

• Total Cost Fixed Costs Variable Costs
• TC FC VC
• Profit Relationship
• Profit Revenue - Total Cost
• P R - TC
• P R - (FC VC)

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Profit
Revenue
Variable Costs

Fixed Costs
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Linear Cost Relationship
TC FC VC
Total Costs
Cost per year
Variable Costs
Fixed Costs ( level)
Q units per year
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Non-linear Cost Relationship
TC FC VC
Total Costs
Cost per year
Variable Costs
Fixed Costs ( level)
Q units per year
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Revenue
Linear
nonlinear-increasing
nonlinear-decreasing
Revenue / year R
Q units per year
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Breakeven Point

• The breakeven point is the intersection of the
  two functions Revenue (R) and Total Cost (TC)
• Profit Revenue - Total Cost
• P R - TC
• Now let Profit 0
• 0 R - TC R TC

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Breakeven Point
TC

R
QBE
Q units per year
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Variable Costs and QBE
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Maximum Profit
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Two Alternative Analysis

• Given two alternatives (mutually exclusive)
• Determine a common variable or an economic
  parameter common to both alternatives
• It could be
• Interest rate,
• First cost (investment),
• Annual operating cost,
• Etc.

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Breakeven for two alternatives

• Common analysis considers
• Revenue or
• Costs
• Common to both options.
• Assume a linear revenue-cost relationship

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Two Alternatives
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Two Alternative Analysis

• The preferred approach is to define either
• Present worth relationships or,
• Annual worth relationships and,
• Set the two expressions equal and solve for the
  parameter or variable of interest.

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Three Alternative Analysis

• If three alternatives are present
• Compare the alternatives pair-wise or,
• Use a spreadsheet model to plot the present
  worth or annual worth over a specified range of
  values.
• A typical three alternative plot might look like
  .

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Three Alternatives
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Self-Study Task
In the textbook, go through examples 13.3 and
13.4 which illustrate the Annual Worth approach
to evaluating alternatives in terms of breakeven
analysis. Refer photocopy with notes.
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Example AW/Breakeven

• Refer 2004 assignment Part 2, Q4
• Question and solution are on the website.

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Example AW/Breakeven 2004 assignment Part 2,
Q4 refer web
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Solution AW/Breakeven 2004 assignment Part 2,
Q4 refer web
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References

• Blank, L., Tarquin, A., Engineering Economy,
  McGraw-Hill, 5/e - Chapter 13

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Thanks for your attention