Chapter 8 Unit 1. IET 350 Engineering Economics. Learning Objectives Chapter 8. Learning Objectives Unit 1. Breakeven Analysis

Transcription

1 Chapter 8 Unit 1 Breakeven Analysis IET 350 Engineering Economics Learning Objectives Chapter 8 Upon completion of this chapter you should understand: Calculating linear breakeven points. Calculating nonlinear breakeven points. Effect of changes in costs and revenue. Strategies associated with capacity limits, expansion and profits. Isocosts and breakeven between products. Legislation and public policy as it related to breakeven. 2 Learning Objectives Unit 1 Upon completion of this unit you should understand: Calculating linear breakeven points. Calculating nonlinear breakeven points. Effect of changes in costs and revenue. Strategies associated with capacity limits, expansion and profits. Isocosts and breakeven between products. Legislation and public policy as it related to breakeven. 3 1

2 Introduction Breakeven analysis is a tool that can be used to: Determine the volume of a product or service that must be produced to cover all costs and generate a profit. Choose between two or more alternatives. Determine make vs. buy decisions. Assist in managing asset intensive and labor intensive organizations. Breakeven analysis is also know as cost volume profit analysis. 4 Linear Breakeven Linear breakeven can be illustrated on the breakeven graph. Quantity is plotted on the independent (horizontal) axis. Cash flow ($) is plotted on the dependent (vertical) axis. 5 Linear Breakeven Linear breakeven assumes that total revenue, variable cost and fixed cost can be approximated by straight lines. Total revenue = constant $/unit. Fixed cost = single cost amount. Variable cost = constant $/unit. Total cost = fixed + variable cost 6 2

3 Fixed Costs Fixed costs (FC) do not change with change in output. We assume that even if quantity = 0, fixed costs will occur. Since fixed costs are independent of quantity, they are plotted as a horizontal line. Examples of fixed costs: Rent Management salaries Depreciation Property taxes Building maintenance Advertising Engineering salaries 7 Variable Costs Variable costs (VC) change proportionally with change in output. Variable costs are plotted as a line beginning at the origin with slope = $VC/unit. Examples of variable costs: Direct material Direct labor Production utilities Shipping cost Equipment maintenance 8 Total Costs Total costs (TC) = Fixed costs (FC) + Variable costs (VC) For linear costs, the total cost line is parallel to the variable cost line with an origin equal to the fixed cost. 9 3

4 Total Revenue Total revenue (TR) is the selling price of the product or service times the quantity. Total revenue is plotted as a line beginning at the origin with slope = $price/unit. 10 Total Revenue and Demand Demand curves illustrate the relationship between product or service selling price ($/unit) and the demand (units/year). Total revenue (TR) is the area under the demand curve for a given quantity and resulting price. 11 Breakeven Quantity Breakeven quantity (Q BE ) occurs at the intersection of the total revenue (TR) and total cost (TC) lines. Breakeven occurs when total cost = total revenue. 12 4

5 Breakeven Quantity Output quantity < breakeven quantity (Q BE ) results in a loss. Output quantity > breakeven quantity (Q BE ) results in a profit. Profit Area TR > TC Loss Area TC > TR Profit is maximized in this situation by increasing output to the limit of capacity. 13 Breakeven Quantity Breakeven quantity (Q BE ) can be determined mathematically by setting total revenue (TR) equal to total cost (TC) and solving for the quantity: Q TR = TC TR = FC + VC Q price BE unit = FC + QBE BE ( cost ) FC = price cost unit unit unit 14 Unit Costs and Revenues Unit costs and unit revenues are useful measures for many benchmarking and analysis needs. Variable costs is already a unit value ($VC/unit). Revenue is already a unit value ($selling price/unit). Fixed costs can be converted into a unit value by dividing the fixed cost by various quantities. Total cost/unit can be determined by adding fixed cost/unit and the variable cost. TC FC unit = unit + VC 15 5

6 Unit Costs and Revenues Unit costs and can be plotted against quantity: Variable cost and selling price are now horizontal lines. Fixed cost/unit and total cost/unit now become curves. 16 Unit Costs and Revenues The unit cost graph shows the important concept As the quantity of output increases, the total cost per unit decreases. 17 Example Problem 8.1 Example Problem 8.1 Solution 18 6

7 End Unit 1 Material Go to Unit 2 Nonlinear Breakeven 19 Chapter 8 Unit 2 Nonlinear Breakeven IET 350 Engineering Economics Learning Objectives Unit 2 Upon completion of this unit you should understand: Calculating linear breakeven points. Calculating nonlinear breakeven points. Effect of changes in costs and revenue. Strategies associated with capacity limits, expansion and profits. Isocosts and breakeven between products. Legislation and public policy as it related to breakeven. 21 7

8 Non Linear Breakeven Linear breakeven assumes revenue and costs can be approximated by straight lines. This assumptions simplifies the analysis but does not match real world situations. Production situations have a maximum capacity that cannot be exceeded in the short term. Fixed costs change at some point due to the need for additional resources. Example hiring an additional supervisor. Variable costs may not be proportional over all quantities. Example volume discounts for direct materials. Total revenue may not be proportional over all quantities. Example volume discounts for increased order quantities. 22 Non Linear Breakeven Non linear breakeven is illustrated in text figure 8 6. Note that: Maximum capacity is represented by the vertical dashed line. Fixed costs and variable costs approach vertical line as output quantity approaches maximum capacity. More than one breakeven quantity (Q BE ) may occur as costs and revenue change. 23 Non Linear Breakeven Generally, in linear breakeven analysis profit is maximized by increasing output to the limit of capacity. With non linear costs and revenues, maximum profit may occur at some quantity and decrease with greater output as illustrated in figure 8 6. Higher non linear costs can result in a loss at higher output quantities. 24 8

9 Non Linear Breakeven Another category of costs are partially fixed and partially variable. These are also known as semi fixed and semi variable. Partially fixed costs may be linear over an output range, then incrementally increase to another linear level. Example another supervisor (fixed cost) is hired due to the increase in production volume. Partially variable costs may be linear over an output range, then the cost/unit may change resulting is a change in slope of the line. Example direct material cost per unit decreases due to volume purchase discounts. 25 Non Linear Breakeven Partially fixed cost is illustrated on the following graph. Note that the horizontal line incrementally shifts when additional fixed cost is added. While profit occurs at quantities greater than breakeven, the level of profit changes when the fixed cost changes. If the incremental change in fixed cost had been greater, the profit may have turned to loss. 26 Example Problem 8.2 Example Problem 8.2 Solution 27 9

10 End Unit 2 Material Go to Unit 3 Analysis of Breakeven 28 Chapter 8 Unit 3 Analysis of Breakeven IET 350 Engineering Economics Learning Objectives Unit 3 Upon completion of this unit you should understand: Calculating linear breakeven points. Calculating nonlinear breakeven points. Effect of changes in costs and revenue. Strategies associated with capacity limits, expansion and profits. Isocosts and breakeven between products. Legislation and public policy as it related to breakeven

11 How Changes Effect Q BE We can isolate and change one component in breakeven analysis and determine how it will effect the breakeven point. Example: Fixed cost (FC) can be changed while holding total revenue (TR) and variable cost (VC) constant. Total cost (TC) will change since TC = FC + VC. Since total cost changes, the intersection between total cost and total revenue will change resulting in a change in the breakeven point (Q BE ). Over the next few slides we will look at each component. 31 How Changes Effect Q BE Increasing fixed costs (FC) will cause the breakeven to increase since the total cost (TC) line is shifted upward. Figure 8 7 Changes in Costs and Selling Price Affect the Breakeven Point (Bowman text page 308) 32 How Changes Effect Q BE Decreasing fixed costs (FC) will cause the breakeven to decrease since the total cost (TC) line is shifted downward. Figure 8 7 Changes in Costs and Selling Price Affect the Breakeven Point (Bowman text page 308) 33 11

12 How Changes Effect Q BE Increasing variable costs (VC) will cause the breakeven to increase since the total cost (TC) line s slope increases. Figure 8 7 Changes in Costs and Selling Price Affect the Breakeven Point (Bowman text page 308) 34 How Changes Effect Q BE Decreasing variable costs (VC) will cause the breakeven to decrease since the total cost (TC) line s slope decreases. Figure 8 7 Changes in Costs and Selling Price Affect the Breakeven Point (Bowman text page 308) 35 How Changes Effect Q BE Increasing the selling price will cause the breakeven to decrease since the total revenue (TR) line s slope increases. Figure 8 7 Changes in Costs and Selling Price Affect the Breakeven Point (Bowman text page 308) 36 12

13 How Changes Effect Q BE Decreasing the selling price will cause the breakeven to increase since the total revenue (TR) line s slope decreases. Figure 8 7 Changes in Costs and Selling Price Affect the Breakeven Point (Bowman text page 308) 37 Area Graphs Area graphs display breakeven information in a different format to provide another view of breakeven, profit and capacity. An area graph is plotted for a specific output level and shows: Variable cost Fixed cost Profit Maximum capacity Unused capacity 38 Area Graphs Potential capacity is illustrated by the unused capacity falling between current output and maximum capacity. If output is increased to utilize unused capacity, only variable costs will increase. Additional output utilizing the unused capacity results in a higher profit/unit since the fixed costs do not increase. Therefore, a firm can sell product at a discount since only variable costs must be covered

14 Private Label Strategy Sears sells a vast variety of products under the Sears, DieHard, Kenmore and Craftsman brand names. Many of these products are produced by manufacturers who also retail the same or similar products to consumers. Examples: Craftsman tools have been made by Stanley in the past who also markets tools under the Stanley name. Kenmore appliances are manufactured by Whirlpool Corp. Manufacturers of the products sell to Sears at a lower price than they market the product under their own trademark. This approach is profitable to the manufacturer if they utilize their unused capacity to produce the product. 40 Strategy Limitations Generally, increasing output through strategies such as private label marketing yield increased profits. However, there are limitations: Market limitations if the additional output cannot be sold the current output is more efficient. Profit limitations if increasing output causes the fixed cost, variable cost rate, and/or revenue rate to change, the current output may be a better alternative. Capacity limitations physical capacity of the facilities and organization may limit expansion in the short term. 41 Capacity Limitations Capacity is based not only on physical facilities, but also on the organizational capacity. Capacity include: Building resources space for production and warehousing raw materials and finished product. Equipment resources available time on all production related equipment required to produce the product. Human resources staffing of production, management, sales, engineering, support and technical areas. Financial resources the firm must provide additional cash outlays when increasing output

15 Balancing Capacity Capacity limitations may result from the manufacturing process. Product typically moves through multiple production areas (departments) which may not have equal capacity or efficiency. Product may be held as in process inventory before processes that limit capacity. In process inventory has a holding cost associated with it that will affect overall product cost. 43 Balancing Capacity Balancing capacity involves removing the bottleneck resulting in increased capacity. Strategies can include: Operate the capacity limiting process/equipment more hours by working additional shifts or overtime. Purchase additional capacity/equipment for the limiting process to match the capacity of the remaining processes. Increase the efficiency and productivity of the limiting process/equipment through process changes or replacement with more efficient equipment. Limit the production rate of the remaining processes to match the limiting process. 44 Breakeven and TVM Breakeven and time value of money are not mutually exclusive analysis techniques. Breakeven should incorporate time value of money methods whenever costs and revenues do not occur in the same time period. Example: Acquisition of equipment occurs at one point in time, but the fixed cost associated with purchasing the equipment would be included as an annual cost in breakeven. Anticipated future cost for periodic equipment rehabilitation are an operating expense would be included as an annual fixed cost in breakeven

16 End Unit 3 Material Go to Unit 4 Isocosts 46 Chapter 8 Unit 4 Isocosts IET 350 Engineering Economics Learning Objectives Unit 4 Upon completion of this unit you should understand: Calculating linear breakeven points. Calculating nonlinear breakeven points. Effect of changes in costs and revenue. Strategies associated with capacity limits, expansion and profits. Isocosts and breakeven between products. Legislation and public policy as it related to breakeven

17 Breakeven Between Processes Breakeven so far has been based on setting revenue = cost. Breakeven can also be used to analysis when two costs are equal to each other such as the cost associated with two production processes: Cost A = Cost B. Isocost point is the equal cost point or the point at which two cost are equal. Isocost analysis is commonly used to: Select between alternative manufacturing methods. Determine whether product should be made or purchased. 49 Isocost Point Graphically, the variable and fixed costs for each alternative are used to determine the total cost curves. Isocost point occurs where the two total cost curves intersect. Isocost points are also known as indifference points. 50 Isocost Point Quantities other than the isocost point quantity indicate the best alternative based on lowest total cost. For figure 8 17: Output quantity < 1,400 units/year select alternative B. Output quantity > 1,400 units/year select alternative A. Select B TC A > TC B Select A TC A < TC B 51 17

18 Isocost Quantity Isocost quantity (Q IC ) can be determined mathematically by setting total cost for alternative A (TC A ) equal to total cost for alternative B (TC B ) and solving for the quantity: FC + Q A IC Q IC A TC = TC A FC + VC = FC + VC A ( cost unit) = FC + Q ( cost unit) = A A ( cost unit) B ( cost unit) A B B B FC FC B B IC B 52 Example Problem 8.3 Example Problem 8.3 Solution 53 Make/Buy Analysis Decisions whether to purchase a product or service from an outside vendor or whether to produce the product or service in house is known as make or buy. Make or buy analysis is a special case of isocost analysis. Make option includes fixed and variable costs as before. Buy option includes only variable cost which is the purchase price of the product or service. Therefore, the isocost is determined by: VC make + FC make = VC buy 54 18

19 Isocost Point Quantities other than the isocost point quantity indicate the best alternative based on lowest total cost. For figure 8 20 Output quantity < Q IC units/year select buy option. Output quantity > Q IC units/year select make option. Select Buy TC make > TC buy Select Make TC make < TC buy 55 Isocost Points More than two alternatives result in multiple isocost points. Each alternative generates an isocost point with each other alternative. However, not all isocost points are meaningful. Isocost between Auto and Buy does not enter into the decision. Select Auto TC auto < TC exist TC auto < TC buy Select Buy TC buy < TC exist TC buy < TC auto Select Exit TC exist < TC buy TC exist < TC auto 56 Example Problem 8.4 Example Problem 8.4 Solution 57 19

20 Public Policy History shows that pubic policy in the United States addresses monopolies and competition. Monopolies occur when there is a single provider or when one dominate supplier sets the price for the service/product. Through legislation, monopolies are illegal except where federal, state and local governments grant exclusive rights. Examples utilities (power, water, gas), first class mail service, telecommunications (cable, land telephone), etc. Traditionally, monopolies were allowed to exist in asset intensive organizations with profits regulated by government agencies. 58 Public Policy Asset intensive firms such as utilities have high fixed costs and a relatively low variable cost rate. Therefore, changes in quantity result in large increases in revenue. Labor intensive firms have low fixed costs and a relatively high variable cost rate (direct labor). Therefore, changes in quantity result in small increases in revenue. 59 Public Policy Asset intensive firms were and are allowed to operate as monopolies with government regulation to insure the service or product is provided as necessary. Example providing electricity to remote locations where the fixed cost of installing the power lines would not be recovered through revenue. Deregulation has and is changing the justification for monopolies. The text gives the example of the airline industry which was deregulated in the s. Telecommunications is the latest industry to be subject to deregulation discussions and actions

21 End Chapter 8 Material Student Study Guide Chapter 8 Homework Assignment Problem Set