Decision Making

Supplement A

Break-Even Analysis
 Break-even analysis is used to compare
processes by finding the volume at which two
different processes have equal total costs.
 Break-even point is the volume at which total
revenues equal total costs.
 Variable costs (c) are costs that vary directly
with the volume of output.
 Fixed costs (F) are those costs that remain
constant with changes in output level.

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Break-Even Analysis can tell you…

 Whether forecast sales volume is sufficient to
break even (no profit or no loss)
 How low variable cost per unit must be to break
even given current prices and sales forecast.
 How low the fixed cost need to be to break
even.
 How price levels affect the break-even volume.

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 Break-Even Analysis
 “Q” is the volume of customers or units, “c” is the
unit variable cost, F is fixed cost and p is the
revenue per unit
 cQ is the total variable cost.

 Total cost = F + cQ

 Total revenue = pQ

 Break-even is where pQ = F + cQ

(Total revenue = Total cost)

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Break-Even Analysis
 Compare costs of different processes.
 Make decisions about process and capacity.
 Break-Even Point: costs equal revenues.
Cost
Total revenue Assumptions:
Total cost • All costs are linear.
BEP
• All units produced
are sold.
Fixed cost • Price does not
change.

Volume

Calculation of Break-Even Point

TC = F + cQ
TC = total cost
F = fixed cost
c = variable cost
Q = quantity produced and sold
TR = pQ
TR = total revenue
p = price per unit

To find BEP in units , find Q where TC=TR:

pQ = F + cQ
F
Solve for Q: Q=
p-c
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 Finding the Break-Even Quantity
A hospital is considering a new procedure to be offered at
$200 per patient. The fixed cost per year would be $100,000,
with total variable costs of $100 per patient. What is the break-
even quantity for this service? Use both algebraic and graphic
approaches to get the answer.

SOLUTION
The formula for the break-even quantity yields

F 100,000
Q= = = 1,000 patients
p-c 200 – 100

Left-click with your mouse to see the answers on this and subsequent slides.
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Finding the Break-Even Quantity

 To solve graphically we plot two lines: one for costs and one for
revenues
 Begin by calculating costs and revenues for two different output
levels
 The following table shows the results for Q = 0 and Q = 2,000

Quantity Total Annual Cost ($) Total Annual Revenue ($)

(patients) (Q) (100,000 + 100Q) (200Q)

0 100,000 0

2,000 300,000 400,000

 Draw the cost line through points (0, 100,000) and (2,000,
300,000)
 Draw the revenue line through (0, 0) and (2,000, 400,000)
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The two lines intersect

at 1,000 patients, the
break-even quantity

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 Sensitivity Analysis
 “A technique for systematically changing parameters in a
model to determine the effects of such changes.” (page
31)
 For example, demand forecasts are uncertain, so it’s
important to check how the solution would be affected if
demand were more or less
 What would be the contribution to profit if demand were
1,500 patients?
 First notice that 1,500 is above the break-even point of
1,000
 Next, use the break-even point formula and/or the graph to
determine total contribution at this demand level.

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Another example of break-even analysis

The Denver Zoo must decide whether to move twin polar bears to
Sea World or build a special exhibit for them and the zoo. The
expected increase in attendance is 200,000 patrons. The data are:
Revenues per Patron for Exhibit
Gate receipts $4
Concessions $5
Licensed apparel $15 Is the
predicted
Estimated Fixed Costs increase in
Exhibit construction $2,400,000 attendance
Salaries $220,000 sufficient to
Food $30,000 break even?

Estimated Variable Costs per Person

Concessions $2
Licensed apparel $9
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 Revenue and Cost at Two Demand Points

Where
p = 4 + 5 + 15 = $24
F = 2,400,000 + 220,000 + 30,000
= $2,650,000
c = 2 + 9 = $11

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Algebraic solution of Denver Zoo problem

p = 4 + 5 + 15 = $24 So the zoo needs an

F = 2,400,000 + 220,000 + 30,000 increase of at least
= $2,650,000 203,846 patrons to
c = 2 + 9 = $11 justify building the
special exhibit.

p = F + cQ
Should they do it??
24Q = 2,650,000 + 11Q
13Q = 2,650,000
Q = 203,846

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 Evaluating Processes and
Make-or-Buy Decisions

 Break-even analysis can be used to choose between

two processes or between an internal process and
buying those services or materials.
 The solution finds the point at which the total
costs of each of the two alternatives are equal.
 The forecast volume is then applied to see which
alternative has the lowest cost for that volume.

Note that the textbook uses the term “Break-even Point”

for this value, too. In order to distinguish between the
two, I use the term “Indifference Point” on the following
slides.

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Evaluating Processes: Indifference Point

 Let Fb equal the fixed cost (per year) of the buy option,
Fm equal the fixed cost of the make option, cb equal the
variable cost (per unit) of the buy option, and cm equal
the variable cost of the make option
 The total cost to buy is Fb + cbQ and the total cost to
make is Fm + cmQ
 To find the break-even quantity (indifference point), we
set the two cost functions equal and solve for Q:

Fb + cbQ = Fm + cmQ
Note that the “make”
option is the one with Fm – Fb
the higher fixed cost. Q=
cb – cm
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Break-Even Point Example

Your firm manufactures office accessories.
For 20 years you have made them out of metal. Now
you need to buy some new machinery, and are
considering switching over to plastic for one type of
file holder.
Metal Plastic
Fixed Cost ($) 50,000 170,000
Variable Cost ($/unit) 5 2
Price ($/unit) 10 10

METAL : 50,000
= 10,000 units
10-5
170,000
PLASTIC : = 21,250 units
10-2
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 Break-Even Point Example
If volume > 21,250, what do we do?
Cost

170 K indifference point

plastic

50 K
metal
Volume
(1,000’s)
TCmetal= 50,000 + 5Q
TCplastic= 170,000 + 2Q

Example, continued
What is the volume at the point of indifference?

50,000 + 5Q = 170,000 + 2Q = > Q=40,000

Fplastic - Fmetal 170,000 – 50,000

Q= =
cmetal - cplastic 5-2

= 40,000

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Break-Even Point: Make or Buy

General Formula:

Fm - Fb Note that the “m”

Q= option is the one with
cb - cm the higher fixed cost.

In general:

-- Below indifference point, choose lower fixed cost.

-- Above indifference point, choose lower variable cost.

PROFIT = (price-variable cost)*volume - fixed cost

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 Break-Even Point: Make or Buy
Metal Plastic Subcontract
Fixed Cost ($) 50,000 170,000 0
Variable Cost 5 2 8
($/unit)
Price ($/unit) 10 10 10

Metal vs. Subcontracting:

50,000 + 5Q = 8Q => Q = 16,666

Plastic vs. Subcontracting:

170,000 + 2Q = 8Q => Q = 28,333

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Break-Even Point: Make-or-Buy Example

Cost

28,333
170 K 40,000
plastic

16,666
50 K
metal
0 Volume
subcontract (1,000’s)

What do we do?
• Decide on payback period

• Q < 16,666 then subcontract

• 16,666 < Q < 40,000 keep metal

• 40,000 < Q switch to plastic

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 Make or Buy: Other Factors

– Available capacity
– Expertise
– Quality considerations
– The nature of demand
– Cost
– Other considerations?

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Make-or-Buy Decision:
Another Example

 Fast-food restaurant is adding salads

 Forecast: 25,000 salads annually

 Two options:

 Salad bar: F=$12,000, cm=$1.50

 Preassembled: F=$2,400, cb=$2.00

 What is break-even quantity (indifference point)?

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Restaurant Example: Graphical Solution

FIGURE A.2 – Break-Even Analysis

Solver of OM Explorer for Example A.3

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 Algebraic Solution
The formula for the break-even quantity yields:

Fm – Fb
Q= c –c
b m

12,000 – 2,400
= = 19,200 salads
2.0 – 1.5

What should the restaurant do?

The 25,000-salad sales forecast

exceeds this amount, so the make
option is preferred. Only if the
restaurant expected to sell fewer than
19,200 salads would the buy option
be better.
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Denver Zoo Example: Make or Buy

Fm – Fb $300,000 – $0
Q = = = 150,000
cb – cm $9 – $7

So the sweatshirts should be bought from a supplier if

demand is less than 150,000. Otherwise they should
be made by zoo employees.
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Preference Matrix

 How to make decision with multiple criteria?

 New product, plant location, etc.

 Common sense approach:

 Decide how important each criterion is
 Use weighted sum to evaluated options
 Compare options, or choose threshold value

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 Preference Matrix

 Preference Matrix: table that allows the rating of

alternatives according to multiple performance criteria.
The criteria can be scored on any scale as long as the
same scale is applied to all the alternatives being
compared.
Each score is weighted according to its perceived
importance, with the total weights typically equaling 100.
The total score is the sum of the weighted scores
(weight × score) for all the criteria. You then compare
the scores for alternatives with one another, or with a
predetermined threshold.
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