Break-even Analysis Part 1
Slide One:
This is a 2-part series on break-even analysis. You will learn how to use this tool to help make important operations management decisions based on cost.
Slide Two:
In part 1 of this 2-part series, we will revisit the implications of a cost-based competitive priority and how operations can help support such a strategy. Next we will study how to use break-even analysis as a decision making tool to achieve a cost-based strategy in part 2.
Slide Three:
When a company chooses to compete on low cost, it should focus on waste elimination, process efficiency, high volume standardized product, and may invest in automation to bring about the desired productivity and efficiency.
Slide Four:
How do operations support a cost-based strategy? We can examine three typical yet critical operations management (OM) decisions that help bring about a company’s low cost competitive edge. They are new product screening, production process selection, and make-or-buy decision.
Slide Five:
In new product screening, a low-cost focus company can evaluate a new product idea’s likelihood of success by ascertaining how easy or difficult it is to sell enough of the new product to cover its costs and make a profit. The amount of a product that a company needs to sell to cover its costs is called the break-even quantity. A new product with a break-even quantity that is too high to reach may not be a good product choice. We will learn a decision making tool called break-even analysis to help determine this break-even quantity in part 2.
Slide Six:
After a new product idea is approved, the next operations decision is to choose the right process to produce that product. The above diagram illustrates the best process strategies relative to product volume and product standardization. Continuous operations that encompass line and continuous processes are best suited for the production of a single product (or high product standardization) in large quantity (or high product volume). On the other hand, an intermittent operations that include project and batch processes are best suited for the production of a single unit (or low product volume) of a one-of-kind (or low product standardization) product. In general, continuous operations are more cost competitive than intermittent operations. It is because with continuous operations, cost savings brought on by mass production of a single product can help spread the production costs over a large volume. This enables the company to offer that product at a comparatively lower price.
Slide Seven:
A cost analysis, which we will discuss in detail in part-2, can be used to screen alternative processes. This involves solving for the indifference quantity. The same total costs are incurred by alternative processes that are producing at the indifference quantity. The most cost competitive process can be identified by comparing the indifference quantity with the desired production quantity.
Slide Eight:
After the production process is selected, the next operations decision is to decide to what extent the activities involved in obtaining raw materials to delivering the finished product (i.e., the supply chain) is performed within the company. This decision is called make-or-buy, also known as insourcing versus outsourcing. A related concept is called vertical integration. A company decides to go with a low level of outsourcing (or a high level of insourcing) is said to have a high degree of vertical integration.
Slide Nine:
A company’s level of vertical integration is indicative of the extent to which its supply chain is under its control. To acquire control of its raw materials supplier is called backward integration. To acquire control of its distributor is called forward integration. A high level of vertical integration often goes hand in hand with producing a high-volume low-variety product in-house, as is the case with continuous operations. This allows for task specialization and economy of scales that bring about a low cost strategy.
Slide Ten:
Once again, a cost analysis involving a comparison of the indifference quantity with the desired production quantity can be used to solve the make-or-buy decision. We will discuss this cost analysis in detail in part-2.