Question

In: Economics

Below is how we calculate the breakeven quality: Q = FC / (P - MC) Here,...

Below is how we calculate the breakeven quality: Q = FC / (P - MC)
Here,
Q is the Breakeven Quality,
FC is the Fixed Cost
MC is the Marginal Cost
(P – MC) is the contribution margin
If I implement the Breakeven Quality formula in my example. Say for example,
Fixed cost was 40 million dollar’s
Price per customer is $20 million dollar’s Marginal Cost is 10 million dollar’s
i.e.
Price per customer - Marginal Cost
  
20 million dollar’s – 10 million dollar’s MC = 10 Million Dollar’s
Hence,
Q for the product = $40M / ($20M - $10M) Q = $40M / $10M
Q= 4
To reach the breakeven point I need to sell my software product at least to 4 customers. Once I sell product to 4 customers, I can say that I have done the Return on Investment and I am in profit.

Question:
the average fixes cost is $40/4=$10. The markup on each unit (P - MC) is $10. So, the price that you receive for a unit of production covers marginal cost (additional cost of producing that unit) and the fixes cost per unit (average fixed cost). Do you think your investors will like these numbers?

How would you apply the break-even analysis for the software you are working on? What is the goal of the break-even analysis? What are the limitations?

Solutions

Expert Solution

Break even analysis actually gives the idea that how much output you need to produce so that you do not face any loss. It gives the idea how much time or how much output you need to produce to cover up your fixed cost. (P - MC) is the contribution margin i.e price per unit how much higher than marginal cost and how long or how much output it needs to produce to cover up the fixed cost. If fixed cost is higher then breakeven output will be also higher.

The goal of break even analysis is how you do feasibility of any project. Through break even analysis one can easily calculate that how much sales it needs to make the profit. The level of output and optimum minimum level of output through which investor can not make loss. It is a output which actually helps to cover fixed cost and after this output level price per unit is higher than average variable cost the investor will start to make profit.

The main limitation of breakeven analysis is that it assumes price is fixed for every unit it solds but it is very unrealistic assumption that every unit will be sold at same price. There is another thing that variable cost can also vary with more output and less output. It is also kind of unrealistic that variable cost per unit will be same. There is another side that thorough breakeven we can do only the no profit no loss situation but if we decide any target profit level then it is difficult to calculate. If software company also makes some other product with this final software product then also it is difficult to breakeven output because more than one kind of output it is producing.


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