Engineering Economics

Dr. Karim

Chapter 5: Breakeven & Payback

Analysis

Introduction
Breakeven analysis is performed to determine the value
of a variable or parameter of a project or alternative that
makes two elements equal, for example, the sales
volume (Q) that will equate revenues and costs.
A breakeven study is performed for two alternatives to
determine when either alternative is equally acceptable.
The breakeven analysis approach is commonly used for
make-or-buy decisions. This means the company
contracts to buy the product from the outside , or
makes it within the company. The alternative to buy
usually has no xed cost and a larger variable cost than
the option to make. Where the two cost relations cross is
the make-buy decision quantity. Amounts above this
indicate that the item should be made, not purchased
from outside.

Terminology and Symbol

P

= value or amount of money at a time designated as the present or

time 0. Also P is referred to as present worth (PW), present value
(PV), net present value (NPV), discounted cash ow (DCF), and
capitalized cost (CC); monetary units, such as dollars

= value or amount of money at some future time. Also F is called

future worth (FW) and future value (FV); dollars

= series of consecutive, equal, end-of-period amounts of money. Also

A

is called the annual worth (AW) and equivalent uniform annual

worth (EUAW); equivalent uniform annual cost (EUAC) dollars per year,
euros per month
n = number of interest periods; years, months, days
i = interest rate per time period; percent per year, percent per month
t = time, stated in periods; years, months, days

Breakeven Point
Value of a parameter that makes two elements equal
The parameter (or variable) can be an amount of
revenue, cost, supply, demand, etc. for one project or
between two alternatives

One project - Breakeven Quantity is identied as

QBE. Determined using linear or non-linear math
relations for revenue and cost.
Between two alternatives - Determine one of the
parameters P, A, F, i, or n with others constant

Cost-Revenue Model One Project

Quantity, Q An amount of the variable in
question, e.g., units/year, hours/month
Breakeven value is QBE
Fixed cost, FC Costs not directly dependent on the variable, e.g.,
buildings, fixed overhead, insurance, minimum workforce cost
Variable cost, VC Costs that change with parameters such as
production level and workforce size. These are labor, material
and marketing costs. Variable cost per unit is v
Total cost, TC Sum of fixed and variable costs, TC = FC + VC
Revenue, R Amount is
dependent on quantity sold
Revenue per unit is r

Profit, P Amount of
revenue remaining after costs
P = R TC = R (FC+VC)

Breakeven for linear R and TC

Set R = TC and solve
for Q = QBE
R = TC
rQ = FC + vQ
QBE
=

FC
rv

When variable cost,

v, is lowered, QBE
decreases (moves to
left)

Example: One Project Breakeven Point

A plant produces 15,000 units/month. Find breakeven
level if FC = $75,000 /month, revenue is $8/unit and
variable cost is $2.50/unit. Determine expected monthly
profit or loss.

Solution: Find QBE and compare to 15,000; calculate

Prot
QBE = 75,000 / (8.00-2.50) = 13,636 units/month
Production level is above breakeven
Profit = R (FC + VC)
= rQ (FC + vQ) = (r-v)Q FC
= (8.00 2.50)(15,000) 75,000
= $ 7500/month

Profit

Often

Breakeven Between Two

Alternatives
breakeven analysis involves revenue or cost variables

common to both alternatives, such as price per unit, operating

cost, cost of materials, or labor cost. The next slide illustrates
the breakeven concept for two alternatives with linear cost
relations. The fixed cost of alternative 2 is greater than
that of alternative 1. However, alternative 2 has a
smaller variable cost, as indicated by its lower slope.
The intersection of the total cost lines locates the breakeven
point, and the variable cost establishes the slope. Thus, if the
number of units of the common variable is greater than the
breakeven amount, alternative 2 is selected, since the total
cost will be lower. Conversely, an anticipated level of operation
below the breakeven point favors alternative 1.

Breakeven Between Two Alternatives With

Linear Cost Relations
Selection between alternatives is based on this guideline:
- If the anticipated level of the common variable is below
the breakeven value, select the alternative with the
higher variable cost (alternative 1). - I f the anticipated
level of the common variable is above the breakeven
point, select the alternative with the lower variable cost
(alternative 2).
Selection of alternative is based
on anticipated value of common
variable:
Value BELOW breakeven;
select higher variable
cost
Value ABOVE breakeven;
select lower variable
cost

Breakeven Between Two

Alternatives
Instead of plotting the total costs of each alternative and
estimating the breakeven point graphically, it may be
easier to calculate the breakeven point numerically
using engineering economy expressions for the PW
(present worth ), or AW (annual worth).
The AW is preferred when the variable units are
expressed on a yearly basis, and AW calculations
are simpler for alternatives with unequal lives.

Example #1
Investment (A) costs $10,000 today and pays back $11,500 two years from
now. Investment (B) costs $8,000 today and pays back $4500 each year
for two years. If the interest rate of 5% is used for comparison, which
investment is superior?
Solution:

Since the two alternatives do the same job and have the
same lifetimes, we will compare them by converting each
to its cash value today. The superior alternative will have the
highest present worth.
P(A)= $10,000 + ($11,500)(P/F,5%,2) = $10,000 + ($11,500)(0.9070) =
$431
P(B) = $8,000 + ($4500)(P/A,5%,2)

= $8,000 + ($4,500)(1.8594) =

$367
$431 > $367, so Alternative (A) is superior.

Example #2
Alternative A (Make):
First Cost = 18000
Salvage Value = 2000
Per Unit Cost = 0.4
Alternative B (Buy):
Per Unit Cost = 1.5
Minimum Attractive Rate of Return (MARR) = 15%
Life = 6 Years

Example # 2 (con)
Perform a make/buy analysis where the
common variable is X, the number of
units produced each year. AW (the
annual worth is chosen because the
two alternatives have unequal lives) AW,
relations are:
1000
$/year
8
AWmake = -18,000(A/P,15%,6)
+2,000(A/F,15%,6) 0.4X
7
AWbuy = -1.5X

Solution: Equate AW relations, solve for X

-1.5X = -4528 - 0.4X

X = 4116 per
year
If anticipated production > 4116,
select make alternative (lower
variable cost)

Breakeven
value of X
AWbuy
AWmake

4
3
2
1
0

1
4

2
5

X, 1000 units per

year

The following steps determine the breakeven point

of the common variable and the slope of a linear
total cost relation.
1. Dene the common variable and its dimensional units.

2. Develop the PW or AW or EUAC or EUAW relation for

each alternative as a function of the common variable.
3. Equate the two relations and solve for the breakeven
value of the variable.

Example #3

How many kilometers must be driven per year for leasing and buying to
cost the same? Use 10% interest and year-end cost. Leasing: $0.15 per
kilometer Buying: $5000 purchase cost, 3-year life, salvage $1200, $0.04
per kilometer for gas and oil, $500 per year for insurance.
Let (x) be the common variable = number of kilometers driven
EUAC (leasing) = $0.15x
EUAC (buying) = $0.04x + $500 + ($5 k)(A/P,10%,3) ($1.2 k)(A/F,10%,3)
= $0.04x + $500 + ($5 k)(0.4021) ($1.2 k)(0.3021) = $0.04x +
$2148
Setting EUAC (leasing) = EUAC (buying) and solving for x
$0.15x = $0.04x + $2148
x = 19,527 km that must be driven to break even

Payback Analysis
Payback analysis is used to determine
the amount of time (Payback Period np) , usually expressed in years,
required to recover the first cost of a
project.
The
investment decision criteria for
this technique suggests that if the
calculated payback period is less than
some maximum value acceptable to

Types of Payback Analysis

There are two types of payback analysis as determined
by the required return:
1- No Return Payback; i= 0%: Also called simple payback,
this is the recovery of only the initial investment. So
no return is expected for the investment made.
2- Discounted Payback; i > 0%: The time value of money
is considered in that some return, for example, 10%
per year, must be realized in addition to recovering the
initial investment.

It is

Caution!!

important to

understand that payback analysis

neglects all cash flows after the payback period of (np)

years. Consequently, it is preferable to use payback as
an initial screening method or supplemental tool rather
than as the primary means to select an alternative. The
reasons for this caution are:
No-return payback neglects the time value of money,
since no return on an investment is required.
Either type of payback (No Return Payback & Discounted
Payback) disregards all cash flows occurring after the
payback period. These cash flows may increase the
return on the initial investment A different alternative
may be selected using payback.

Computation of Payback Period (np)

The equations used to determine the payback period (np) differ for each type of payback
analysis (No Return Payback & Discounted Payback). For both types, the terminology is
(P) for the initial investment in the asset, project, contract, etc., and NCF for the estimated
annual net cash flow.
NCF = cash inflows - cash outflows
To calculate the payback period for i = 0% or i > 0%, determine the pattern of the NCF
series. Note that n p is usually not an integer. For t _ 1, 2, . . . , (np) ,

Eqn.
1
Eqn.
2
Eqn.

Example: Payback Analysis

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

System #2
8,000
1,000 (year 1-5)
7

14

Problem: Use (a) no-return payback, and (b) discounted payback at

15% to select a system.
(a)Solution:

= 4 years

np1 = 12,000 / 3,000

0 = -8,000 + 5(1,000) + 1(3,000) np2 = 6 years (found by

trial and error)
4 < 6 Select system # 1

Example: Payback Analysis (con)

System #1
First cost, $
NCF, $ per year

12,000

Maximum life, years

System #2

8,000
3,000
1,000 (year 1-5)
3,000 (year 6-14)
7
14

(b) Solution:
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)]
np2 = 9.5 years

6.6 < 9.5 Select system #1

Summary of Important Points

Breakeven amount is a point of indifference to
accept or reject a project

One project breakeven: accept if quantity is > Q

Two alternative breakeven: if level > breakeven

select lower variable cost alternative (smaller

Payback estimates time to recover investment.

Return can be i = 0% or i > 0%

Use payback as supplemental to PW or other an

because np neglects cash flows after payback,
and if i = 0%, it neglects time value of money
Payback is useful to sense the economic risk in