Matakuliah: D0762 – Ekonomi Teknik Tahun: 2009 Break Even Point and Payback Period Course Outline 11

Outline 2 Break Even Analysis Payback Period Case Study References : -Engineering Economy – Leland T. Blank, Anthoy J. Tarquin p Engineering Economic Analysis, Donald G. Newman, p Engineering Economy, William G. Sulivan, p.21-35, p Next

Break Even Analysis Determine the quantity of a variable at which revenues and costs are equal in order to estimate the amount of profit or loss The quantity called the breakeven point 3

Type of Cost considered for Break Even Analysis Fixed Costs (FC) : include cost such as buildings, insurance, fixed overhead or indirect costs, some minimum level of labor, and capital recovery usually constant for all values of the variable. Variable Cost (VC) : Include costs such as direct labor, materials, indirect and support labor, contractors, marketing, advertisement, and warranty Change with production level, workforce size, and other variables. 4

Break-Even Analysis Costs/Revenue Output/Sales Initially a firm will incur fixed costs, these do not depend on output or sales. FC As output is generated, the firm will incur variable costs – these vary directly with the amount produced VC The total costs therefore (assuming accurate forecasts!) is the sum of FC+VC TC Total revenue is determined by the price charged and the quantity sold – again this will be determined by expected forecast sales initially. TR The lower the price, the less steep the total revenue curve. TR Q1 The Break-even point occurs where total revenue equals total costs – the firm, in this example would have to sell Q1 to generate sufficient revenue to cover its costs.

Break-Even Analysis Costs/Revenue Output/Sales FC VC TC TR (p = £2) Q1 If the firm chose to set price higher than £2 (say £3) the TR curve would be steeper – they would not have to sell as many units to break even TR (p = £3) Q2

Break-Even Analysis Costs/Revenue Output/Sales FC VC TC TR (p = £2) Q1 If the firm chose to set prices lower (say £1) it would need to sell more units before covering its costs TR (p = £1) Q3

Break-Even Analysis Costs/Revenue Output/Sales FC VC TC TR (p = £2) Q1 Loss Profit

Break-Even Analysis Costs/Revenue Output/Sales FC VC TC TR (p = £2) Q1 Q2 Assume current sales at Q2 Margin of Safety Margin of safety shows how far sales can fall before losses made. If Q1 = 1000 and Q2 = 1800, sales could fall by 800 units before a loss would be made TR (p = £3) Q3 A higher price would lower the break even point and the margin of safety would widen

Costs/Revenue Output/Sales FC VC TR Eurotunnel’s problem High initial FC. Interest on debt rises each year – FC rise therefore FC 1 Losses get bigger!

Break-Even Analysis Remember: A higher price or lower price does not mean that break even will never be reached! The BE point depends on the number of sales needed to generate revenue to cover costs – the BE chart is NOT time related!

Break-Even Analysis 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

Break-Even Analysis Links of BE to pricing strategies and elasticity Penetration pricing – ‘high’ volume, ‘low’ price – more sales to break even Market Skimming – ‘high’ price ‘low’ volumes – fewer sales to break even Elasticity – what is likely to happen to sales when prices are increased or decreased?

Payback Period Payback Period, often called the simply payout method Mainly indicates a project’s liquidity rather its profitability. Calculates the number of years required for cash inflows to just equal outflows. Define as the period of time required for the profit or other benefits of an investment to equal cost of the investment 14

Basic Concepts Answer : the period of time required for the profit or other benefits of an investment to equal cost of the investment  Method: Based on cumulative cash flow (accounting profit) Weakness: Ignores the time value of money Payback period is used because  the concept can be readily understood,  the calculations can be readily made and understood by people unfamiliar with the use of the time value of money. It’s “better than nothing.” Use it as a last resort to communicate. 15

16 A firm is buying production equipment for a new plant. Two alternative machines are being considered. Payback Period: Example YearTempo machine Dura machine 0-$30,000-$35, ,0001,000 29,0004,000 36,0007,000 43,00010, , , , ,000 Totals057,000 PBP analysis would choose Tempo (PBP = 4 yrs.) instead of Dura (PBP = 5 yrs.). However, with IRR analysis we can see that Tempo is not a very attractive investment. Although, Tempo does return its investment more quickly than Dura.

17 Lesson from Example: liquidity and profitability can be very different criteria. Final Conclusions about PBP Analysis This analysis provides a measure of the speed of the return of the investment. If a company is short of working capital, or experiences a rapidly changing technology, the speed of return can be important. PBP analysis should not be confused with careful economic analysis. PBP analysis does not always mean the investment is economically desirable. Payback Period: Summary 1.Payback period is an approximate, rather than an exact, analysis calculation. 2. All costs and all profits, or savings of the investment prior to payback, are included without considering differences in their timing. 3. All the economic consequences beyond the payback period are completely ignored. 4. Payback period may or may not select the same alternative as an exact economic analysis method. 5. Payback period is used because the concept can be readily understood, the calculations can be readily made and understood by people unfamiliar with the use of the time value of money. 6. PBP analysis is “better than nothing.” Use it as a last resort to communicate.