4/28/2023

Chapter 13

Breakeven and
Payback Analysis

April, 2023 Dr. Mansour Abou Gamila 1

LEARNING OBJECTIVES

The purpose of this chapter is to enable you to:

• Determine the breakeven value for a single project.

• Calculate the breakeven value between two alternatives and
use it to select one alternative.
• Use a spreadsheet to perform breakeven analysis.

April, 2023 Dr. Mansour Abou Gamila 2

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13.1 Breakeven Analysis for a Single Project

 The breakeven analysis was used to find out one of the

engineering economy symbols P,F,A,i, or n by setting an
equivalence relation for PW or AW equal to zero.

 Here we concentrate on the determination of the

breakeven quantity. (E.g. What is the number of units to
produce to cover my investment)

April, 2023 Dr. Mansour Abou Gamila 3

Process Selection With Breakeven Analysis

• Breakeven analysis is a technique for selecting a process based on
the cost tradeoffs associated with demand volume. The components
of breakeven analysis are volume, cost, revenue, and profit.

• Volume is the level of production, usually expressed as the number

of units produced and sold.

• Cost is divided into fixed and variable costs.

• Revenue is the price at which an item is sold. The total revenue is
price times volume sold.

• Profit is the difference between total revenue and total cost.

• The breakeven (BE) point QBE is the point where the revenue equals
the total cost.

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13.1 Breakeven Analysis for a Single Project

• Fixed costs (FC) - Costs are independent of the volume of units
produced. costs that do not vary with production or activity levels.
• They include costs such as: Machines, Building, Depreciation, taxes,
debt, mortgage payments, Insurance cost, etc.

• Variable cost (VC) - Costs that vary with the volume of units
produced.
• They include costs such as: Labor, materials, portion of utilities.

• When FC and VC are added they form total cost TC.

Total Cost = Fixed Costs + Variable Costs
TC = FC + VC

April, 2023 Dr. Mansour Abou Gamila 5

13.1 Breakeven Analysis for a Single Project

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Q1 Output/Sales

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13.1 Breakeven Analysis for a Single Project

Costs/Revenue TR (p = £3) TR (p = £2) TC If the firm chose

to set price higher
VC than £2 (say £3)
the TR curve
would be steeper
– they would not
have to sell as
many units to
break even

FC

Q2 Q1 Output/Sales

April, 2023 Dr. Mansour Abou Gamila 7

13.1 Breakeven Analysis for a Single Project

TR (p = £1)
Costs/Revenue If the firm chose
TR (p = £2) TC to set prices lower
VC (say £1) it would
need to sell more
units before
covering its costs

FC

Q1 Q3 Output/Sales

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13.1 Breakeven Analysis for a Single Project

TR (p = £2) TC
Costs/Revenue
Profit VC

Loss
FC

Q1 Output/Sales

April, 2023 Dr. Mansour Abou Gamila 9

13.1 Breakeven Analysis for a Single

Project
• Cost – Revenue Relationships
Basic Linear Cost Relationship Basic Non-linear Cost Relationship
Total
Total Cost
Cost
Variable
Cost
Variable
Cost
Cost

Cost

Fixed Cost ( level) Fixed Cost ( level)

Quantity Quantity

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13.1 Breakeven Analysis for a Single

Project
Break-even Chart
Total revenue line
Dinars
Profit

Total cost line

Variable cost

Loss Fixed cost

Volume (units/period)
Breakeven point
Total cost = Total revenue
April, 2023 Dr. Mansour Abou Gamila 11

13.1 Breakeven Analysis for a Single Project

• The breakeven (BE) point QBE changes when the VC is

lowered.

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13.1 Breakeven Analysis for a Single Project

E.g. The market requires only 1000 units so every
unit you produce extra you will have to reduce its
selling price to sell it. (i.e. selling price reduces)

• For non-linear relations, it is possible to have more than

one QBE point.

Therefore, I can determine

the Breakeven points and
the Maximum Profit.

April, 2023 Dr. Mansour Abou Gamila 13

13.1 Breakeven Analysis for a Single

Project
Importance of Price Elasticity of Demand:
Higher prices might mean fewer sales to break-
even but those sales may take a longer time to
achieve.

Lower prices might encourage more customers but

higher volume needed before sufficient revenue
generated to break-even

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13.1 Breakeven Analysis for a Single Project

 Profit Relationships
Profit = Revenue – Total Cost
P = R – TC
= R – (FC + VC)
 Therefore, the QBE point is derived when revenue and total
cost are equal to each other, indicating a profit of zero
R = TC
rQ = FC + VC = FC + VQ

where r = revenue per unit

V = variable cost per unit

 The breakeven quantity

FC
Q BE 
r-v
April, 2023 15
Dr. Mansour Abou Gamila

Example 13.1, Page 344

Indira Industries is a major producer of diverter dampers used in the gas
turbine power industry to divert gas exhausts from the turbine to a side
stack, thus reducing the noise to acceptable levels for human
environments. Normal production level is 60 diverter systems per month,
but due to significantly improved economic conditions in Asia,
production is at 72 per month. The following information is available.
• Fixed costs FC = $2.4 million per month
• Variable cost per unit v = $35,000
• Revenue per unit r = $75,000
(a) How does the increased production level of 72 units per month compare
with the current breakeven point?
(b) What is the current profit level per month for the facility?
(c) What is the difference between the revenue and variable cost per damper
that is necessary to break even at a significantly reduced monthly
production level of 45 units, if fixed costs remain constant?
April, 2023 Dr. Mansour Abou Gamila 16
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Example 13.1, Page 344

• Fixed cost =FC=$2.4 million per month
• Variable cost =V=$35,000 per unit
• Revenue=r=$75,000 per unit

FC 2400
Q BE    60 units per month
r - v 75  35

Dollars

Total cost line

$2400
$2000
Total
$1000 revenue
line
QBE=60 Units
April, 2023 Breakeven point Dr. Mansour Abou Gamila 17

Example 13.1, Page 344 CON.

(b) AT Q=72 units per month

Profit = R-TC=(r-v)Q-FC = (75-35)72-2400=$480
There is a profit of $480,000 per month.

(c ) To determine the required difference revenue and variable

cost to breakeven.
0=(r-v)(45)-2400
r-v = 2400/45 = $53.55per unit
If v stays as $35,000, the revenue per unit must increase from
$75,000 to $88,330 just to beak even at a production level of Q =
45 /moth

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Break-even Example 2
A firm produces radios with a fixed cost of LE7,000 per
month and a variable cost of LE5 per radio. If radios sell
for LE8 each:
1a) What is the break-even point?
TR = TC 8Q = 7000 + 5Q
Q = 7000/3 = 2,333.333 radios per month

1b) What output is needed to produce a profit of D2,000/month?

Profit = 2000/month
TR - TC = 8Q - (7000 + 5Q) = 2000
Q = 9000/3 = 3,000 radios per month

April, 2023 Dr. Mansour Abou Gamila 19

Break-even Example 2- continued

1c) What is the profit or loss if 500 radios are produced each
week?
First, get monthly production:
50052/12 = 2,166.6667 radios per month

Then calculate profit or loss

TR - TC = 82166.6667 - (7000 + 52166.6667)
= LE-500 per month
(LE500 loss per month)

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Break-even Example 3
A firm produces radios with a fixed cost of LE7,000 per month
and a variable cost of LE5 per radio for the first 3,000 radios
produced per month. For all radios produced each month after
the first 3,000 the variable cost is LE10 per radio (for added
overtime and maintenance costs). If radios sell for LE8 each:
2a) What are the break-even point(s)?
Now TC has two parts depending on the level of production:
For Q  3000/month: TC = 7000 + 5Q
For Q > 3000/month: TC = 7000 + 5(3000) + 10(Q-3000)
= -8000 + 10Q
For any Q: TR = 8Q

April, 2023 Dr. Mansour Abou Gamila 21

Break-even Example 3- continued

For Q  3000/month: TC = 7000 + 5Q
For Q > 3000/month: TC = -8000 + 10Q
For any Q: TR = 8Q

For Q  3000/month: 7000 + 5Q = 8Q Q= 2,333.33/month

This is < 3000/month, so it is a valid break-even point.

For Q > 3000/month: -8000 + 10Q = 8Q Q= 4000/month

This is > 3000/month, so it is also a valid break-even point.

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Break-even Example 3

Dinar (Thousands) 40
Total revenue line
32

24
Total cost line

16

Break-even
8 points

1000 2000 3000 4000

Volume (units/month)
7-23 2023
April, Dr. Mansour Abou Gamila

Break-even Example 4
An automobile company is investigating the advisability of converting a plant
that manufactures economy cars into one that will make retro sports cars.
The initial cost for equipment conversion will be $200 million with a 20%
salvage value anytime within a 5-year period. The cost of producing a car
will be $21,000, but it is expected to have a selling price of $33,000 (to
dealers). The production capacity for the first year will be 4000 units. At
an interest rate of 12% per year, by what uniform amount will production
have to increase each year in order for the company to recover its
investment in 3 years?

Let x = gradient increase per year. Set revenue = cost.

[4000 + x(A/G,12%,3)](33,000 – 21,000) + (0.20)(200,000,000)(A/F,12%,3)
=200,000,000(A/P,12%,3)
[4000 + x (0.9246)](12,000) + 40,000,000(0.29635) =200,000,000(0.41635)
11,095.2X = 23,416,000
x = 2110 cars/year increase
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13.2 Breakeven Analysis Between Two

Alternatives
 The breakeven point is calculated using either the PW or
AW at the MARR. The AW is preferred to be used as it is
simpler in calculation for alternatives with unequal lives.

 The following steps may be used to find the breakeven

point:

◦ Define the common variable and its dimensional units.

◦ Use AW or PW analysis to express the total cost of each
alternative as a function of the common variable.
◦ Equate the two relations and solve for the breakeven value
of the variable.
◦ If the anticipated level is below the breakeven point, select
the alternative with the higher variable cost (larger slope). If
the anticipated level is above the breakeven value, select
the alternative with the lower variable cost (smaller slope).
April, 2023 Dr. Mansour Abou Gamila 25

13.2 Breakeven Analysis Between Two

Alternatives
E.g. Shall I buy semi-manual machine or fully
automated drilling machine?
AL 1-TC
$ (Machine cost + Labor cost)

AL 2-TC
(Machine cost + Labor cost)

Select AL 1 Select AL 2
Semi- manual Fully automated
Q
QBE

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• The same type of analysis can be performed for three or

more alternatives. To do so you have to compare the
alternatives in pairs to find the respective breakeven points.

April, 2023 Dr. Mansour Abou Gamila 27

13.2 Breakeven Analysis Between Two

Alternatives

• Method I : TC1 = FC1 + V1 * Q

• Method II : TC2 = FC2 +V2 *Q
• At break-even point:
FC1 + (V1 * Q) = FC2 + (V2 * Q)

(V1 * Q) – (V2 * Q) = FC2 – FC1

Q* (V1 – V2) =FC2 – FC1

Q = (FC2 – FC1)/(V1 – V2)

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Breakeven for Three Alternatives

 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

April, 2023 29
Dr. Mansour Abou Gamila

13.2 Breakeven Analysis Between Two Alternatives

Process A Process B
Example 5 $2000 + $5Q = $10,000 + $3Q
$2Q = $8,000
Q = 4000 units
$40000 Total cost of
process A
$35,000

$30,000 Total cost of

process B
$25,000

$20,000
$15,000 Choose
Process B
$10,000
Choose
$5000 Process A
$0 4,000
2,000 $6,000 $8,000
April, 2023 Point of Indifference = 4000 units 30
Dr. Mansour Abou Gamila
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13.2 Breakeven Analysis Between Two Alternatives

Example 6
Should You Sell Your Old Car?
Your old car is quite functional, but it only averages 20
miles per gallon (mpg). You have found a somewhat newer
vehicle (roughly the same functionality) that averages 26
mpg. You can sell your current car for $2800 and purchase
the newer vehicle for $4,000. Assume a cost of gasoline
$4.00 per gallon. How many miles per year must You drive
if You want to recover your investment in three years?
Assume an interest rate of 6%, zero salvage value for either
vehicle after three years, and identical maintenance cost.

April, 2023 Dr. Mansour Abou Gamila 31

13.2 Breakeven Analysis Between Two

Alternatives
Old Car

New vehicle

Equating these, and solving for x, we find

Equating these, and solving for x, we find
2,800+(X/20)(4)(2.673) = 4,000 + (X/26)(4)(2.673)
0.123368 X = 1,200

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13.2 Breakeven Analysis Between Two Alternatives

We use sensitivity analysis to see what
happens to project profitability when the
estimated value of study factors are changed.

• What if expenses are 10% higher than expected—

is the project profitable?
• What if sales revenue is 15% lower than expected?
• What change in either expenses or revenues will
cause the project to be unprofitable (decision
reversal)?

April, 2023 Dr. Mansour Abou Gamila 33

13.2 Breakeven Analysis Between Two

Alternatives
Reconsidering Your car:
Considering that You drive about 10,000 miles per year,
our previous analysis would indicate that you should
purchase the vehicle that gets better mileage. However,
what if gas prices drop by 10%? Should you still sell
your old car?

So, if gas prices drop by 10%, You should keep your old car

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13.2 Breakeven Analysis Between Two Alternatives

Example 13.2, Page 346
A small aerospace is evaluating two alternatives: the first
alternative has an initial cost of $23000, an estimated salvage
value of $4000, and a predicted life of 10 years. One person will
operate it at a rate of $12 per hour. The expected output is 8 tons
per hour. Annual maintenance and operating cost is expected to
be $3500.

The second alternative has a first cost of $8000, no expected

salvage value, a 5 year life, and an output of 6 tons per hour.
However, three workers will be required at $8 per hour each. The
alternative will have an annual maintenance and operations cost
of $1500. All projects are expected to generate a return of 10%
per year. how many tons per year must be finished in order to
justify the higher purchase cost of the a first alternative?
April, 2023 Dr. Mansour Abou Gamila 35

13.2 Breakeven Analysis Between Two Alternatives

Example 13.2, Page 346
Let X represent the number of ton per year
For alternative 1:
$12 1hour X tons
Annual VC  1.5 X
hour 8 ton year

the VC is developed in dollars per year

AWFIRST  23000( A / P ,10%,10)  4000( A / F ,10%,10)  3500  1.5 X

AWFIRST  $  6992  1.5 X

For alternative 2 :
$8 1 hour X tons
Annual VC  ( 3 operators) 4X
hour 6 ton year

AWsec ond  8000( A / P,10%,5) 1500  4 X  $  3610  4 X

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13.2 Breakeven Analysis Between Two Alternatives

Example 13.2, Page 346

Equate the two cos t relations and solve for X

AWFIRST  AWSECOND
 6992  1.5 X   3610  4 X
X 1353 ton per year

The output is exp ected to exceed 1353 tons per year ,

purchase the first alternative, sin ce its VC slope of 1.5 is smaller than the alternative "2"
VC slope of 4

April, 2023 Dr. Mansour Abou Gamila 37

13.2 Breakeven Analysis Between Two Alternatives

Example 13.3, Page 347
Guardian is a national manufacturing company of home health care appliances. It
is faced with a make-or-buy decision. A newly engineered lift can be installed in a
car trunk to raise and lower a wheelchair. The steel arm of the lift can be
purchased internationally for $3.50 per unit or made in-house. If manufactured on
site, two machines will be required. Machine A is estimated to cost $18,000, have
a life of 6 years, and have a $2000 salvage value; machine B will cost $12,000,
have a life of 4 years, and have a $—500 salvage value (carry-away cost).
Machine A will require an overhaul after 3 years costing $3000. The annual
operating cost for machine A is expected to be $6000 per year and for machine B
is $5000 per year. A total of four operators will be required for the two machines
at a rate of $12.50 per hour per operator. In a normal 8-hour period, the operators
and two machines can produce parts sufficient to manufacture 1000 units. Use a
MARR of 15% per year to determine the following.
a. Number of units to manufacture each year to justify the in-house (make)
option.
b. The maximum capital expense justifiable to purchase machine A, assuming all
other estimates for machines A and B are as stated. The company expects to
produce 10,000 units per year.
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13.2 Breakeven Analysis Between Two

Alternatives
Example 13.3, Page 347
Let X= the number of lifts produced per year.
There are variable costs for the operators and fixed
costs for the two machines for the make option
Annual VC= (cost per unit)(units per year)

4 operators $ 12 .5
Annual VC  (8 hour ) X  0 .4 X
1000 units hour
The annual fixed costs for machines A and B are the AW amounts
AWA= -18,000(A/P,15%,6)+ 2000(A/F,15%,6)-6000-3000(P/F,15%,3)(A/P,15%,6)
AWB= -12,000(A/P,15%,4) -500(A/F,15%,4) – 5000
The total cost= AWA +AWB +VC

April, 2023 Dr. Mansour Abou Gamila 39

13.2 Breakeven Analysis Between Two Alternatives

Example 13.3, Page 347
Equating the annual cost of the buy option (3.5 X) and the make option
-3.5 X = AWA +AWB –VC
-3.5X = -18,000(A/P,15%,6)+2000(A/F,15%,6)-6000-
3000(P/F,15%,3)(A/P,15%,6)-12,000(A/P,15%,4)-
500(A/F,15%,4)-5000-0.4X
-3.1 X = -20,352
X = 6,565 units per year
A minimum of 6,565 lifts must be produced each year to justify the make
option, which has the lower variable cost of 0.40x.
(b) -3.5(10,000) = -PA(A/P,15%,6)+2000(A/F,15%,6)-6000-
3000(P/F,15%,3)(A/P,15%,6)-12,000(A/P,15%,4)-500(A/F,15%,4)-
5000-0.4(125,000)
PA=$58,295
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13.3 Payback Period Analysis

• Payback analysis (also called payout analysis) is another
extension of the present worth method. The payback
period is the estimated time, usually in years, it will take
for the estimated revenues and other economic benefits to
recover the initial investment and as stated rate of return.
The payback period measure how fast the initial
investment is recovered.

Note: The payback period “np” should never be used as the

primary measure of worth to select an alternative. It should be
used to provide initial screening or supplement information.

April, 2023 Dr. Mansour Abou Gamila 41

13.3 Payback Period Analysis

Payback period: Estimated amount of time (np) for cash inflows to recover an
initial investment (P) plus a stated return of return (i%)

Types of payback analysis: No-return and discounted payback

1. No-return payback means rate of return is ZERO (i = 0%)

2. Discounted payback considers time value of money (i > 0%)

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13.3 Payback Period Analysis

Formula to determine payback period (np)

varies with type of analysis.

NCF = Net Cash Flow per period t

April, 2019 Dr. Mansour Abou Gamila 43

Example 13.4, Page 349

The board of directors of Halliburton International has
just approved an $18 million worldwide engineering
construction design contract. The services are expected to
generate new annual net cash flows of $3 million. The
contract has a potentially lucrative repayment clause to
Halliburton of $3 million at any time that the contract is
canceled by either party during the 10 years of the
contract period, (a) If i = 15%, compute the payback
period. (b) Determine the no-return payback period and
compare it with the answer for i = 15%. This is an initial
check to determine if the board made a good economic
decision.

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Example 13.4, Page 349

P=$-18 million
Annual net cash flow NCF=$ 3 million
The single $ 3 million payment “CV” for cancellation.
a. i= 15%
0=-P+NCF(P/A,i,n)+CV (P/F, i,n)
In $1,000,000 units:
0=-18+3(P/A,15%,n)+3(P/F,15%,n)
The 15% payback period is np =15.3 years. During the period of
10 years, the contract will not deliver the required return.
b. No return on its $18 million investment
0=-18+np (3)+3
np=5 years
There is a very significant difference in np for 15% and 0%. At
15% this contract would have to be in force for 15.3 years,
while the no-return payback period requires only 5 years.
April, 2023 Dr. Mansour Abou Gamila 45

Example: Payback Analysis

System 1 System 2

First cost, $ 12,000 8,000

NCF, $ per year 3,000 1,000 (year 1-5)
3,000 (year 6-14)
Maximum life, years 7 14

Problem: Use (a) no-return payback,

(b) discounted payback at15%, and
(c) PW analysis at 15% to select a system.

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Example: Payback Analysis

System 1 System 2

First cost, $ 12,000 8,000

NCF, $ per year 3,000 1,000 (year 1-5)
3,000 (year 6-14)
Maximum life, years 7 14

(a) Use Eqns. 1 and 2

System 1:
np1 = 12,000 / 3,000 = 4 years

System 2:
0 = -8,000 + 5(1,000) + (np2 -5)(3,000)
(np2 -5)= 1
np2 =6 years
Select system 1

April, 2023 Dr. Mansour Abou Gamila 47

Example: Payback Analysis

System 1 System 2

First cost, $ 12,000 8,000

NCF, $ per year 3,000 1,000 (year 1-5)
3,000 (year 6-14)
Maximum life, years 7 14

(b) Use Eqns. 3 and 4

System 1: 0 = -12,000 + 3,000(P/A,15%,np1)

np1 = 6.6 years

System 2: 0 = -8,000 + 1,000(P/A,15%,5)

+ 3,000(P/A,15%,np2 - 5)(P/F,15%,5)
np1 = 9.5 years

Select system 1

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Example: Payback Analysis

System 1 System 2
First cost, $ 12,000 8,000
NCF, $ per year 3,000 1,000 (year 1-5)
3,000 (year 6-14)
Maximum life, years 7 14

(c) Find PW over LCM of 14 years

PW1 = -12,000-12,000(P/F,15%,7)+3000(P/A,15%,14)=$663
PW2 = -8,000 +1000(P/A,15%,5)+3,000(P/A,15%,9)(P/F,15%,5) =$2470
Select system 2

Comment: PW method considers cash flows after payback period.

Selection changes from system 1 to 2

April, 2023 Dr. Mansour Abou Gamila 49

Example: Payback Analysis

Solve the relation AWlease - AWbuy = 0 for N = number of months

Monthly i = 1.25%.
-800 + 8500(A/P,1.25%,N) + 75 = 0
N = 12.8 months

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Example: Payback Analysis

How long will you have to sell a product that has an income of
$5000 per month and expenses of $1500 per month if your
initial investment is $28,000 and your MARR is (a) 0% and (b)
3% per month?

(a) np = 28,000/(5000-1500) = 8 months

(b) 0 = -28,000 + (5000 – 1500)(P/A,3%,np)

(P/A,3%, np) = 8
np = 9.284 months

April, 2023 Dr. Mansour Abou Gamila 51

Example: Payback Analysis

Set PW = 0 at given interest rates and solve for np

0 = -3,150,000 + 500,000(P/A,i%,np) + 400,000(P/F,i%,np)

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XYZ company is planning to purchase a fabricating machine, where

two models are available. The manual model will cost LE 35,000 to
buy with a 7-year life. Its annual income will be LE 25,000 and
annual operating cost will be LE 15,000 for labor and LE 1,000 for
maintenance. A computer controlled model will cost LE 80,000 to
buy with a 10-year life. The annual income for the computer
controlled model will be LE 30,000 and annual operating cost will
be LE 7,500 for labor and LE 2,500 for maintenance. Determine the
following:
a. Payback period for both models at an interest rate of 10% per
year?
b. Rate of return for both models?
c. Which model would you recommend to choose? Why?

April, 2023 Dr. Mansour Abou Gamila 53

April, 2023 Dr. Mansour Abou Gamila 54

 4/28/2023

Quiz 4

P&G sold its prescription drug business to

Wamer-Chilcott, Ltd. for $3.1 billion. If income
from product sales is $2 billion per year and
net profit is 20% of sales, what rate of return
will the company make over a 10-year planning
horizon?

P&G sold its prescription drug business to Wamer-

Chilcott, Ltd. for $3.1 billion. If income from
product sales is $2 billion per year and net profit is
20% of sales, what rate of return will the company
make over a 10-year planning horizon?

0 = -3.1 + (2)(0.2)(P/A,i,10)
(P/A,i,10) = 7.7500
Find which interest table has 7.7500 in P/A column at n
= 10
i is between 4% and 5%
i = 4.9% (spreadsheet, equation, or table interpolation