Break-even analysis is a graphical representation of the
relationships among volume of output, costs, and revenues. As the volume of
output from a facility increases, costs and revenues also increase. Costs can
generally be divided into two categories: fixed and variable. Fixed costs are
those incurred regardless of output volume. They include heating, lighting, and
administrative expenses that are the same whether one or one thousand units of
output are produced. Variable costs are those that fluctuate directly with
volume of output: higher output results in higher total variable cost; lower
output results in lower variable costs. Typically, they are the costs of direct
labor and material. In Figure total costs are shown as linear.
Function
of output volume. Costs exceed revenues in the initial stages of output up to
point VBE. Point VBE is the break-even point:
the level of volume for which total costs equal total revenues. Thereafter,
revenues exceed costs of operation.
Break-even analysis identifies the
level of output that must be reached in order to recover through revenues all
the costs of operation. The break-even point depends on the selling price of
the product and the operating cost structure. Some conversion processes require
high fixed costs-that is, large capital outlays and high overhead expenses –
but low unit variable costs. They require a large volume of output to reach
break-even, but once they have attained it, profitability increases rapidly.
Other conversion processes have low fixed costs and high unit variable costs.
Figure shows both kinds of cost structures.
Break-even
with Discontinuous Revenues and Costs Revenues and/or costs may be nonlinear
rather than linear functions(with constant slop) of output volume, or the
function may increase in jumps rather than smoothly. Indeed, a major purpose of
break-even analysis into reveals how the organization’s costs and revenues
change with volume of output.
Consider the situation in figure.
The organization has two facilities, A and B, which may be operated during the
coming year. Facility A, working a single shift, has a break-even volume of VBE(A) units. Thereafter,
profitability increases up to the output Vmax(A).
If greater profit is desired, facility B must be opened and additional fixed
costs incurred. The overall operation (facilities A and B ) will not be
profitable until a volume of VBE(A,B)is
reached. To achieve outputs above Vmax(A,B)
a second shift is necessary, and variable costs increase accordingly. Beyond Vmax (A,B), profits continue
to increase, but at a slower rate as shower rate as shown in profit region 3.
Information from the break-even
chart can now be used for managerial decisions. Once the desired level of
profitability for the year has been stated, we can show the volume of output
required to achieve it. We can also identify how many facilities and shifts
will be needed, and we can estimate operating costs and working capital
requirements.
Revenues: In some industries, revenues depend on having
the facility near potential customers. For example, for manufacturing firms
that supply customers who are themselves manufacturers and assemblers, delivery
time can be a crucial component of the strategic mission.
For service industries, the
situation is somewhat different. Location is not so important for stored
services, those not directly consumed. Federal Reserve banks, automotive repair
shops, and manufactures who repair appliances are often quasi- manufacturers
and they don’t necessarily have to be located near consumers. On the other
hand, for firms that offer directly consumed services, location can be critical.
Movie theaters, restaurants, banks, apartments, dry cleaning stores, and even
public recreation areas obviously must be located conveniently to the public.
Otherwise, consumers will go elsewhere, and revenues will decline.
Fixes Costs:
New or additional facilities entail fixed initial costs,
usually incurred only once, which must be recovered out of revenues if the
investment is to be profitable. Acquiring new or additional facilities involves
costs for new construction, purchase and renovation of other existing plants,
or rental. And once they’re acquired, more money must be spent on equipment and
fixtures. The magnitude of these costs may well depend on the site on equipment
and fixtures. The magnitude of these costs may well depend on the site that is
selected. A choice merchandising, corner location in downtown Washington, D.C.,
requires a totally different capital outlay from one in Greencastle, Indiana.
Construction costs also vary greatly from one place to another.
Variable Costs: Once
built, the new facility must be staffed and operated, and these costs, too,
depend on location. For labor-intensive conversion processes, the availability
of labor and local expectations for wages are major concerns. Management must
also consider proximity to sources of raw materials (inputs) and to markets for
finished goods (outputs), which can vary transportation and shipping costs.
Seldom does an organization find a
single site that is best in terms of all revenue and cost considerations. The
location offering the highest revenue potential may also incur higher costs.
Tradeoffs must be made among fixed costs, variable costs, and revenue
potential; the final choice of location should be the one that offers the best
overall balance towards achieving the organization’s mission. Staples stores,
in Operations Management.
In evaluating any potential site,
then, we might consider all these revenue and cost factors using a break-even
analysis. For locate A, fixed costs are high and variable costs are low. The
lower fixed costs of location B are offset by its higher variable costs.
