APPENDIX D

PRODUCTION COST VARIATIONS AND BREAK.EVEN ANALYSIS

D.1 Fixed and Variable Costs

Project costs for production activities generally vary with the level of pro-
duction activity of the project. The costs of labor and material are typical
operating costs that tend tb vary directly with the number of units produced
and hence are called variable cosfs. Some costs tend to remain relatively
constant regardless of the level of production activity and are called fixed
cosrs. Fixed costs tend to be constant for a given period of time and inde-
pendent ofthe number ofunits produced. Fixed costs frequently are referred
to as "overhead costs" and include such costs as supervisory and manage-
ment salaries, other administrative expenses, insurance, property taxes,
license fees, heat, light, rent, supplies, repayment of investment principal,
research and development, and certain maintenance and repair charges. This
list of fixed costs is not intended to be all-inclusive, but it gives an indica-
tion of the type of expenses that can fall into this category. However, it must
be noted that it is not uncommon for many of the expenses listed as fixed
costs to become variable costs under widely varying business conditions.
For example, administrative expenses and research and development costs
may be increased or decreased by hiring or firing personnel if business war-
rants the changes, so these costs become variable under these conditions.
Analysis of fixed and variable costs must be made relative to conditions that
exist at the time of the analysis and for the projected period of future time
for which the analysis is expected to be valid.
Unit costs are input costs divided by the number of units produced in the
period of time being evaluated. Unit costs may be based on the total cost or
on individual fixed and variabie costs. Illustration of the use of variable,
fixed, and unit costs is provided in the following example, which assumes
 AppenCix D: Production Cost Variations and Break-even Anaiysis

that rariable costs, and thereibre total costs, vary linearly with production
rate instead of non-Iinearly as illustrated in the generai schematic shown in
Figurc D-1.'fhe linear approxirnarion case often is found to be a useful sim-
piification ot the general nonlinear cost situation.

rotat a/
C,tstS -/
Total
Cost
?r
Income

Production Rate----->
Figure D-l General Graph of Income and costs vs. production Rate

EXAtulPLE D-I lllustration of Linear Variation in Costs

The total cost of producing 1000 lb of a chemical product per
nronth is $5000. The total cost of producing 1s00 lb of the chemical
cer month is $6000. Assuming that variable ccsts vary direcily vrith
production rate (that is, assuming they vary linearly with produciion
rate), determine the following:
a) What is the variable cost per unit?
b) What is the total fixed cost?
c) what is the fixed cost per unit for the first 1000 units/month?
d) what is the total cost per unit for the first 1000 units/month?
e) lf the chemical product is sold for 910 per lb, what production
rate is required for costs to break-even with income? what rs
the profit or loss to produce and sell 200 lb/month of the chemi-
cal? 1000 lb/month?
Solution:
Figure D-1a graphically illustrates this problem. However, the graph
is not developed with sufficient accuracy to give good numerical results
for the questions asked so the mathematical solutions are presented.
698 Economic Evaluation and lnvestment Decision Methods

10,000

8,000
Incomes
6.000
OT LOSTS,
Dollars 4,000
Cp
2,000

0
500 1000 1s00 2000
Production, lb/month
Figure D-la Linear Approximation of Figure D-1

a) Variable Cost per lb, Cv is the slope of the total cost curve.
Therefore,

6000 - 5000
$2:00 per [b.
1500 - 1000 =

C, also is the variable, marginal, or incremental cosVunit.

b) The total fixed cost can be calculated either graphically or
mathematically. Graphically we see in Figure D-1a the total cost
curve intersects the zero production rate axis where fixed cost, Cp. =
$3000. Mathematically, Cp can be calculated by writing the equation
for the straight line that represents the total cost curve.
Cost = C, (Production Rate) + Cp D-1
Substituting the numbers into Equation D-1 for the two points
given yields:

$5000 = Cv (1000) + C5 D-2

and
$6000 = Cv (1500) + Cp D-3

lf we had not already calculated C, from the slope of the total cost
curve, we could subtract Equation D-2 from D-3 and obtain C, =
$2.00/lb. Knowing Cy, w€ can substitute C, = 2.00 into either Equa-
tion D-2 or D-3 and calculate Cp = $3000.
Anpendr;< D: Production Cost Variations and Br€ak-even Analysis 699

c) Knowing Cp = $3000 gives a $3.00 fixed cost per lb for the first
1u00 units.
d) The total cost per unit for the first 1000 lb/month is $5000/1000
cr" = $5.00/lb. lt could also be found from C, + Cpl1000 = $2.00 +
$-r.iO = 55 C0/lb.
e) The break-even point can be found graphicaily to equal 375
lbirnonth. Mathematically, it is the intersection of the total cost equa-
ticn and the income equation. Let X represent production rate per
n:clih.
Total Cost = ($2.OOfln)(X lb/month) + 3000 D-4
lncome = ($10/lbxx lb/month) + 0 D-5

Solving Equations D-4 and D-5 for the production rate, X, that will
make Total Cost equal lncome gives the break-even production rate.
2X + 3000 = 10 X or X = 375 lb/month to break-even.

Production rates below 375 lb/month yield a loss and production

rates greater than 375 lb/month yield a profit.
The loss at a production rate of 200 lb/month is
lncome - Total Cost = ($10nbx200 lb/month) - ($2/1b)(200 lb/mo
- 3000 = -$1400/month or a $t400/month loss.
At a production rate of 1000 lb/month
lncome - Total Cost = 10(1000) - 2(1000) - 3000
= +$5000/month profit.

It is worth mentioning at this point that in numerous places in jour-

nal literature and textbooks you will find the following equation given
to calculate the break-even production rate:
Break-even
Fixed Cost
Production =
Units Selling Price/U nit-Variable Cost/Unit

Note that this equation is based on assuming linear variation in

costs and income and that it can be obtained directly from setting
lncome = Total Cost in generalized Equations D-4 and D-5 as follows:
700 Economic Evaluation and lnvestment Decision Methods

Total Cost = (Variable CosVUnit) (X Units) + Fixed Cost

lncome = (Seiling Price/Unit) (X Units) + 0
setting lncome = Total cost gives the break-even production units, X.

D.2 Specify Break-even Assumptions

The term "break-even" has been used in Example D- I to describe the
production ievel of operation at which income exactly equals total cost.
There are many other possible break-even criteria. The investor must be
careful to understand break-even analysis assumptions. The following
example illustrates break-even price analysis to break-even with an existing
Ioss and with no lcss.

EXAMPLE D-2 Break-even with Existing Loss lllustration

60 tons of rice hulls per day must be disposed of by a rice bom-
pany. Pollution problems concerning incinerating or burying the hulls
have forced the company to accelerate efforts to convert the waste
rice hulls into a usable product. The cost of disposing of the rice hulls
is $4 per ton for the 60 tons per day, 300 days per year operation. A
proposed process estimated to have a fixed capital cost of 9200,000
can be installed to convert the waste rice hulls into 60 tons per day
cjf usable product. Operating costs are expected to be g200 per day
of operation. lf the $200,000 first cost of the process is recovered in
3 years, what selling price per ton must be recovered for the product
to break-even with the present loss of $240 per day? Assume the
minimum RoR is 15% before taxes. what selling price will com-
pletely eliminate the present loss of $240 per day? Use before-tax
analysis.

Solution:
Disposal Annual Cost = (60 tonsidayX$a/ton)(S00 days/year)

= 972,000
.4380
Process Annual Cost = 200,000(A/P1S,3) + 60,000 = 147,600
Annual Sales = (60 tons/day)(300 days/y0(g)Vton) = 918,000 X.
Appendix D: Production Cost Variations and Break-even Analysis 701

To break-even with present loss and realize a 15o/o ROR on new

i:,vestmeflt:

$18,0CiC X = 147,600 - 72,OOO= g7S,O00

X = $4.20lton
To break even with no loss and realize a 15o/o ROR on new invest-
fi,giris:
518,000 X = 147,600
X = 99.20/ton
Uihen people talk about a break-even parameter, be very careful to
pin down the meaning of "break-even".

L).3 Increnrental Ana!ysis Applied to Production Situations \l/ith

Non-L,inear Cost !'ariations
l'he incremental cost concept is very important to evaluate optimum lev-
els of production activities and to determine pricing to yield satisflctcry
profit margins. Marginal cost per unit and differential cost per unit are other
corlln-lon naffles used interchangably tbr inclemental cost in the literatu:e.
Different production levels are mutuallv exciusive, so the incremental cost
c()ncept is applicabie to titis type of prohlem. !
Incremental operating costs can be calculated either from total cost r,..-
sus prs6lxglion rate dara or variable cost ','ersus production rate data. Since
the total cost curve is forind b1 adding the constant fixed cost to the variable
cost, change in total cost ior a given change in production level is identical
to the change in'variable cost. That is, incremental total cost equals incre-
mental variable cost. The following example illustrates the use of incremen-
tal operating costs for the economic evaluation of a manufacturing process.

EXAMPLE D-3 Optimization of l-4anufactLrring Prcfit

The costs per period at ditferent levels of output for a manufactur-
ing process to make small pumps are given in the foilowing table.
The sales price of the pumps is $20 each. The manufacturing plant
is operating at 100% of rated capacity when a purchase order from a
company is received for an extra 1000 pumps at a reduced sales
price of $14.00/pump.
 702 Economic Evaluation and lnvestment Decision Methods

Rated Vari-
Capacity, Pumps Fixed able Total Total lncremental
% Manufactured Cost Cost Cost Clg{Pump CosVpump
00 $10,000 o $10,000 $
2s% 1000 10,000 15,000 2s,000 25.00 $15'00
50% 2000 10,000 20,000 30,000 15.00 5'00
75% 3000 10,000 23,000 33,000 11.00 3'00
100% 4000 't0,000 29,000 38,000 9.50 5'00
125% 5000 10,000 43,000 53,000 10.60 15'00
'19'00
150% 6000 10,000 62,000 72,OOO 12.00
175/o 7000 10,000 85,000 95,000 13.57 23'00

The pumps would be retailed in a foreign market and should not

affect other domestic sales. should the s-ales manager accept the
order if the decision is based on whether accepting[the order
will
increase the period profit? where is the break-even
"ular $20 per pump price? [oint at the reg-
Graph the break-even.chait. At what rated
capacity should the plant be operated to maximize total profit if
sales
at $20 per pump are unlimited? Solution:
Evaluation of the Total cost/pump data shows that the cost of
making 5000 pumps is 910.60 per pump, which is ress than
the pro-
posed selling price of $14.00 per pump. However, it was
shown in
chapter 4 that evaluation of total cost data does not answer the
question of what an investor receives or pays for each
extra incre-
mental investment between mutually excluslve choices. The incre-
mental unit costs given in the last column of the table show that
it
would actually cost 915.00 per pump for the 1000 pumps
needed to
increase production from the 1oo% capacity to 12s/" capacity
level.
Selling the units for 914.00 per pump would leave the company
with
a $'1 per pump loss for each of tne iooo increment of pumps. obvi-
ously, total profitability for the cornpany will be greater at the
end of
the period if the sales manager rejects the order.
Note that the minimum incremental cosVpump equals
$g.OO al7S"/"
of rated capacity while the minimum total cosVpump of
$g.50 occurs
at 100% of rated capacity. As incremental costs decrease, total
cosvpump must decrease, because total cost per pump at each
level
of operation is made up of a weighted average of tne total cost per
pump at the next lower level plus the incremental cost per pump
between the levels. As long as the incremental cost per pump
is lower
Appendix D: Production Cost Variations and Break-even Analysis 703

than the total cost per pump at the last level, the new total cost per
pump must be lower than the previous one. Thus, minimum incre-
mental cost per unit and minimum total cost per unit usually do not
occur at the same production level. lt is only coincidence if they do.
The break-even poini for cost to equal income at the reguiar $20
per pump price may be seen to be about 1300 pumps on the break-
even clrart shown in Figure D-2. Mathematicali), the break-even
point ri^,ay be foun,J ;:,;ie s;iactly as foliows:
Evaluate the data given in the problenr statement and find that the
break-even point occurs between 25"/" and 50% of rated capacity.
Assume the total cost curve is a straight line in this range with slope
= (30,000 - 25,000)i(1000) = 5.0. The equation for the cost curue in
the break-even range is
Tctat Cost = 5.0(X) + K D-6
where X equals production rate for 1000 < X < 2000 and K is the
pseudc fixed cost where the total cost line intercepts the cost axis at
zero production rate. Since Total Cost = 25,000 when X = 1000, we
see that K = 20,000. Obviously this K value is a pseudo fixed cost
because we know the actual fixed cost is $10,000,
Tctai Cost = 5.0 X + 2C,000 D-7

Tire equation for the income line is

income = 20 X D-8

The point where Total Cost equals lncome is

5.0 X + 20,000 = 20 X or X = 1333 pumps.

At this break-even production rate, Iotal Cost = lncome = $26,666.

Note on the break-even chart that the slope of the total cost curve
between operating levels equals the increment cost between those
levels. For $20 per pump sold, maximum profit occurs at 6000 units
sold. To maximize total profit, increase sales until the slope of the
total cost curve equals the slope of the income curve. At that point,
selling price per unit equals incremental cost per unit. Further
increase in sales would erode profits.
704 Economic Evaluation and lnvestment Decision Methods

Cost or
lncome,
Dollars

'100,000

80.000

60,000
Breakeven 6ot'
40,000 Variable
Cost
20,000
CF
Fixed Cost

0 1000 2000 3000 4000 5000 6000 7000

Production Rate, pumps/period, X
Figure D-2 GraphicalAnalysis of Example D-g

D.4 Incremental Analysis Applied to product Make or Buy Decisions

Management and managerial accounting literature is full of the so-called
"classic textbook cases" illustrating how numerous companies over the
years have made incorrect management decisions because of improper or
non-use of incremental economic analysis. This covers decisions such as
those illustrated in the last example concerning whether to accept or reject
new orders at a given,selling price per unit or where to operate an existing
facilitl to maximize the profit that it can generate. Another very important
decision-making area that requires incremental analysis as well as toial cort
analysis concerns whether it is economically best to produce a product
internally or to purchase it from an outside supplier. Th"r" are mutually
exclusive alternative choices, you must select one or the other, not both, and
mutually exclusive alternative decisions always require incremental analysis
no matter what method of analysis you are using. For example, whether you
are using rate of return analysis or cost per unit analysis, with mutually
exclusive alternatives you must look at incremental rate of return or incre-

l,
_^t
Apprendix D. ,ri'cduction Cost Variations and Break-even Analysis 705

nlental co:jt per unit rcsults to be sure that they are satisfactory. One of the
nlr)st corllr-lon causesC)[ incorrect management decisron maliing concerning
mutuallv exclusive alternative decisions is to base a decision on total invest-
nreri anrl).sis or total cost per unit analysis instead of properly evaluating
i; rcrcir--r,';:ill analr si.r rr.sLrlts.
In nrairy' rnake or bu1, decision situations, it is desirable to keep an exist-
r jrg n1a!rLrt:rctr.rring/prodLrction facility in operahle condition even if part or
rrii of prr\ent production is eliminated to buy product from an outside
si:)lllcc. in this colnmon make or bu1.,situation the lixed costs of the facilitv
ol opcration are eoirrg to be incnrred whether the product is purchased
cxternally or produced internally. Proper incremental analysis will show
clearly that only the variable costs are relevant to make or buy decisions for
iire situ;tior-l described. The following example illustrates analysis of this
t,r pe o1'mal:e or buy decision.

EXAMFLE D-4 Make or Buy Decision ttlustration

A manufacturing operation has the capacity to produce 1,0OO,OO0
product units per year. The present production rate is 75"/" of capac-
ity, where the firms annual income is $750,000. Annual fixed costs
are $200,000 and variable pt:oduction costs are constant at $0.50
per unit of product .

a) $/hat is the profit or loss at present capacity?

b) At urnat volume of sales does the cperailon break-even?
c) At what purchase price would it be better to buy the product
frorn a competitor for resale rather than to produce internally if it
is assumed the plant will be maintained in operating condition?
Solution: Costs and lncome in Thousands of Dollars,
Price in Dollars
a) lncome = 750 Variable O,C. = 375
-Total OC = 575 +Fixed O.C. = 200
Profit = 175 Total O.C. = 575
b) lnconre = ($1/unit) (X units) + O
Cost = (0.50) (X units) + 200,000
For break-even, X = 0.5 X + 200,000 so 0.5 X = 200,000
.'. X - 400,000 units to break-even
At break-even, lncoms = $400,000 = Cost
 Economic Evaluation and Investment Decision Methods

c) Variable cosVunit = 90.50

+Fixed cosVunit = $200/750 = $0.2
Total cosUunit = $0.77 at 750,000 units
of production

At first glance these calculations often lead people to the incorrect con-
clusion that it is economically desirable to purchase externally for any pur-
chase price less than $0.77lunit. Actually, if it costs more than the $0.50
variable cost/unit to purchase externally, the economics favor producing
internally because the difference between the external cost/ unit and the
$0.50/unit out-of-pocket variable cost/unit can be applied to pay part of the
fixed costs,. which will be incurred whether we buy or produce. The incre-
mental difference between the total costs at any two levels of operation
leaves the incremental variable cost which in this problem is $0.50 per unit
at all levels of operation.