ICA 2: Using break-even analysis to evaluate alternative prices

Break-even analysis can be a very useful tool for evaluating alternative prices--especially when the prices being considered are fairly realistic from a demand point of view. Break-even analysis shows how many units would have to be sold to just cover the firm's costs at alternative prices. The text shows how to compute the break-even point in units; sometimes it's also useful to know the break-even point in dollars (sales). The easiest way is to compute the BEP in units and then multiply by the assumed per-unit price. A realistic appraisal of the likelihood of achieving the break-even point associated with each alternative price might show that some prices are clearly unacceptable--that is, there would be no way that the firm could even reach the break-even point, let alone make a profit.

The mechanics of break-even analysis are relatively simple--once you understand the concepts and assumptions. This exercise reviews these ideas and then has you apply them to a fairly common decision-making situation.

Assignment

Read each of the following problems carefully--and fill in the blanks as you come to them. Where calculations are required, make them in the space provided--and show your calculations to aid review.

1. a) Suppose you were considering going into the car-washing business and investing in a new kind of car-washing unit which is more mechanized than the usual ones--but also has higher fixed costs. Calculate the break-even point in dollars and units if the usual price of $4.00 per car were charged. The variable cost per car is estimated at $2.00. The total fixed cost per year (including depreciation, interest, taxes, fixed labor costs, and other fixed costs) is estimated at $320,000.

BEP in $ BEP in units

b) There is some possibility that there will be increased price cutting in your proposed market in the near future. Calculate the BEPs for the situation in (a) if the retail price drops to $3.50 per car.

BEP in $ BEP in units

c. There is also a possibility that the new washing unit will deliver a better job for which some people will be willing to pay more. Calculate the new BEPs if it were possible to raise the retail price to $4.50.

BEP in $ BEP in units

Should you go into the car-washing business in any of the above situations? Explain.

Question for Discussion

What does break-even analysis assume about the nature of demand and about the competitive environment? Is break-even analysis relevant for monopolistic competition?