Break-Even Analysis and the Payback Period

Recognize the weaknesses of the payback period method

Arbitrary Does not consider: capital, timing of cash flows during payback period, cash flows after payback period, return on alternative investments

Recognize the strengths of the payback period method.

Based on cash flows, not earnings. Provides liquidity measure Easy to compute

What information is needed to compute the break-even level of sales?

Break-Even Quantity (Q) = total fixed cost/ (Price per unit - variable cost per unit)

Under what circumstances can fixed costs change?

Can increase with significant change in sales volume.

Be able to compute an investment's payback period. Use the payback period to evaluate projects.

Compare totals of investments for amount of years until it reaches the total. The best project is the shortest payback period.

Use break-even analysis to evaluate a project.

Consider: sales are likely to exceed break-even level Reject: sales are likely to fall below break-even level

What are fixed costs? Recognize examples?

Fixed Costs- costs that vary only indirectly with sales. Ex. salaries, rent, insurance premiums

What happens to the break-even level of sales when fixed costs increase? When price per unit declines?

Increases Increases

Define Payback Period.

Payback Period- time to recoup an investment's cost, cost of the investment is a cash outflow at time 0, cash inflows are generated in subsequent time periods, useful when liquidity is a problem for the firm.

Define break-even levels of sales.

Provides the minimum number of units that must be sold in order to make a profit; reject the project if you think the firm might sell fewer units.

What does a linear variable cost function imply?

The cost of producing each unit is constant regardless of the number produced.

What does a linear total revenue function imply?

The price of the product is constant regardless of the number sold.

Calculate total revenue, total variable costs, total costs, and profit given the level of sales, price per unit, variable cost per unit, and fixed costs.

Total Revenue = Price X Quantity Variable Cost = cost per unit X Quantity

What are variable costs? Recognize examples.

Variable Costs- costs that vary directly with sales. Ex. costs of goods sold, sales commissions, credit card fees, royalties paid to franchise