Break Even Analysis

Break-Even Method
of Investment Analysis
Fact Sheet No. 3.759 Farm and Ranch Series| Economics
by P.H. Gutierrez and N.L. Dalsted*

Break-even analysis is a useful tool to The total cost line is the sum of the total Quick Facts
study the relationship between fixed costs, fixed costs and total variable costs. The total
variable costs and returns. A break-even cost line parallels the total variable cost line, • A break-even point defines
point defines when an investment will gener- but it begins at the level of the total fixed when an investment will
ate a positive return and can be determined cost line. generate a positive return.
graphically or with simple mathematics. The total income line is the gross value
Break-even analysis computes the volume of of the output. This is shown as a dotted • Fixed costs are not directly
production at a given price necessary to cover line, starting at the lower left of the graph related to the level of
all costs. and slanting upward. At any point, the total production.
Break-even price analysis computes the income line is equivalent to the number
• Variable costs change in
price necessary at a given level of production of units produced multiplied by the price
direct relation to volume of
to cover all costs. To explain how break-even per unit.
output.
analysis works, it is necessary to define the The key point (break-even point) is the
cost items. intersection of the total cost line and the total • Total fixed costs do not
Fixed costs, incurred after the decision income line (Point P). A vertical line down change as the level of produc
to enter into a business activity is made, are from this point shows the level of production increases.
not directly related to the level of production. tion necessary to cover all costs. Production
Fixed costs include, but are not limited to, de- greater than this level generates positive
preciation on equipment, interest costs, taxes revenue; losses are incurred at lower levels
and general overhead expenses. Total fixed of production.
costs are the sum of the fixed costs.
Variable costs change in direct relation
to volume of output. They may include cost Mathematical Explanation
of goods sold or production expenses such as The graphic method of analysis helps the
labor and power costs, feed, fuel, veterinary, reader understand the concept of the break-
irrigation and other expenses directly related even point. However, graphing the cost and
to the production of a commodity or invest- income lines is laborious. The break-even
ment in a capital asset. Total
variable costs (TVC) are the
sum of the variable costs for the
specified level of production or
output. Average variable costs
are the variable costs per unit
of output or of TVC divided by
units of output.
Total fixed costs are shown
in Figure 1 by the broken
horizontal line. Total fixed
costs do not change as the level
of production increases. Total
variable costs of production
are indicated by the broken © Colorado State University
line sloping upward, which il- Extension. 9/92. Revised 3/12.
lustrates that total variable costs Figure 1: Graph form of break-even analysis.
www.ext.colostate.edu
increase directly as production increases.
P.H. Gutierrez, former Colorado State University Extension farm/ranch management economist and associate professor;
*
N.L. Dalsted, Extension farm/ranch management specialist and professor; agricultural and resource economics. 3/2012
point is found faster and more accurately Additional income = $4/bu * 2 bu/A = $8/A Solutions
with the following formula: B-E = $21,270 / ($16/A + $8/A - $1.75/A) = Fixed costs = $12,000
B-E = F / (S - V) $21,270 / $22.25/A = 956 Acres Savings = $16/A
Variable costs = $7/hr / 4 A/hr = $1.75/A
where:
Example 3 Problem 1:
B-E = break-even point (units of produc-
tion), A farmer raising 1,200 acres of wheat B-E = $12,000 / ($16/A - $1.75/A) =
F = total fixed costs, per year considers purchasing a combine. $12,000 / $14.25/A = 842 Acres
V = variable costs per unit of production, How much additional return (to land, Problem 2:
S = savings or additional returns per unit capital labor, management and risk) would Additional profit = ($16/A x 900 A) -
of production, and the mathematical ap- result? [$12,000 + ($7/hr / 4 A/hr x 900 A =
proach is best presented using examples. Additional return = (savings or additional $14,000 - $13,575 = $825 increase
income) - (fixed costs + variable costs)
Example 1 Additional profit = [ $16/A + ($4/bu * 2 Appraisal of Break-
A farmer wants to buy a new combine bu/A) ] x 1200 A = $21,270 + [ ($8.75/hr
rather than hire a custom harvester. The / 5 A/hr) x 1200 A] = $28,800-$23,370 = Even Analysis
total fixed costs for the desired combine are $5,430 The main advantage of break-even
$21,270 per year. The variable costs (not analysis is that it points out the relation-
Thus, the farmer would generate anoth-
counting the operator’s labor) are $8.75 per ship between cost, production volume and
er $5,430 in additional return by purchas-
hour. The farmer can harvest 5 acres per returns. It can be extended to show how
ing the combine. A farmer harvesting only
hour. The custom harvester charges $16.00 changes in fixed cost-variable cost relation-
900 acres would probably choose not to buy
per acre. How many acres must be harvest- ships, in commodity prices, or in revenues,
the combine because the acreage is below
ed per year to break-even? will affect profit levels and break-even
the break-even point of 956 acres. The
points. Limitations of break-even analysis
Fixed costs (F) = $21,270 farmer may want to evaluate the purchase
include:
Savings (S) = $16/A of a smaller or used combine.
• It is best suited to the analysis of one
Variable costs (V) = $8.75/hr / 5 A/hr =
product at a time;
$1.75/A Additional Situations
• It may be difficult to classify a cost as all
B-E = $21,270 / ($16/A - $1.75/A) = Two additional situations are presented variable or all fixed; and
$21,270 / $14.25/A = 1,493 Acres as follows: • There may be a tendency to continue to
Problem 1. If the fixed costs for the use a break-even analysis after the cost
Example 2 combine are $12,000 per year, no additional and income functions have changed.
Break-even analysis can be easily yield is expected, variable costs are $7 per Break-even analysis is most useful
extended to consider other changes. If hour and the farmer can combine 4 acres when used with partial budgeting or capital
the farm operator can save two addition per hour, what is the new break-even point? budgeting techniques. The major benefit to
al bushels of wheat per acre more than the Problem 2. If 900 acres are harvested, using break-even analysis is that it indi-
custom harvester, what would be the break- what is the effect on the farmer’s profits? cates the lowest amount of business activity
even point if wheat is worth $4/bushel? necessary to prevent losses.
Colorado State University, U.S. Department of

Agriculture and Colorado counties cooperating.
CSU Extension programs are available to all without
discrimination. No endorsement of products mentioned
is intended nor is criticism implied of products not
mentioned.

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Break-Even Method

by P.H. Gutierrez and N.L. Dalsted*

Colorado State University, U.S. Department of

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