CHA PT ER 11

BREAKEVEN AND
SENSITIVITY ANALYSIS

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INTRODUCTION
In the previous chapter, the estimates of revenues,
costs, other quantities for the eng eco analysis were
assumed with high degree of confidence.
It is called assumed certainty.
The decisions based on this sometimes called
decisions under certainty.

However, it is very rare care whereby the estimates

of quantities can be assumed as certain. The element
of doubt exists as to the economic results that will be
obtained from an engineering project.

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 RISK
 Risk and uncertainty are similar in that they
both present the problem of not knowing
what future conditions will be
 Risk offers estimates of probabilities for
possible outcomes
 Uncertainty does not provide estimates of
probabilities for possible outcomes
 This book treats them as interchangeable

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PRINCIPLE 6: Make Uncertainty
Explicit (recognize and make known)
We need to determine to what degree, changes in
an estimates would effect a capital investment
decision.
In other words:
To determine how sensitive a given investment is to
changes in particular factors (ex: annual revenues,
project life, MV, annual costs) that are not known
with certainty.
If a small changes in the relative magnitude of a
factor will reverse an investment decision, the
decision is said to be highly sensitive to that factor.

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 FOUR MAJOR SOURCES OF
UNCERTAINTY
• Possible inaccuracy of cash-flow
estimates used in the study
• Type of business relative to the
future health of the economy
• Type of physical plant and
equipment involved
• Length of study period

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 POSSIBLE INACCURACY OF
CASH-FLOW ESTIMATES
 How much source information is
available
 How dependable is the source

information
 Uncertainty in capital investment

requirements is often reflected as a

contingency above actual cost of
plant and equipment (commonly used)

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 TYPE OF BUSINESS
INVOLVED RELATIVE TO
HEALTH OF ECONOMY

Some businesses will typically be

more at risk of declining when there
is a general decline in the economy
--- when the economy has gone into
recession

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 TYPE OF PHYSICAL PLANT
AND EQUIPMENT INVOLVED

 Some types of structures and equipment

have definite economic lives and market
values – they may be used in a multitude
of settings.
 Other dwellings and equipment, being
made for very specific and singular
functions, may have little or no resale
value

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LENGTH OF STUDY PERIOD

The longer the study period, the

greater the level of uncertainty of a
capital investment

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 SENSITIVITY ANALYSIS
 Sensitivity – The degree to which a
measure of merit (i.e., PW, IRR, etc…)
will change as a result of changes in
one or more of the study factor values.

Sensitivity Analysis Techniques

4. Breakeven Analysis √
5. Sensitivity Graph (spider plot) √
6. Combination of factors

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 BREAKEVEN ANALYSIS
 Technique commonly used when an uncertain
single factor (EG: capacity utilization) determines
the selection of an alternative or acceptability of an
engineering project
 For given alternative, if best estimate of actual
outcome of common factor is higher or lower than
the breakeven point, and assumed certain, the best
alternative becomes apparent
– Indifference between alternatives (EWA = f1(y); EWB = f2(y)
EWA = EWB; f1(y) = f2(y) : Solve for y (a common factor of
interest)
3. Economic acceptability of engineering project
EWp = f(z) = 0
The value of ‘z’ is the value at which we would be
indifferent between accepting or rejecting the project
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 BREAKEVEN PROBLEM
INVOLVING TWO ALTERNATIVES
Most easily approached
mathematically by equating an
equivalent worth of the two
alternatives expressed as a
function of the factor of interest

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 BREAKEVEN ANALYSIS FOR
ECONOMIC ACCEPTABILITY OF
AN ENGINEERING PROJECT
Most easily approached by equating an
equivalent worth of the project to zero
as a function of the factor of concern
Because of the potential difference in
project lives, care should be taken to
determine whether the coterminated or
the repeatability assumption best fits the
situation
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 EXAMPLE APPLICATIONS OF
BREAKEVEN ANALYSIS
 Annual revenue and expenses
Solve for annual revenue required to equal annual
expenses.
 Rate of return
Solve for the rate of return on the increment of
invested capital at which two given alternatives are
equally desirable.
 Market (or salvage) value
Solve for the future resale value that would result in
indifference as to preference for an alternative.

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 EXAMPLE APPLICATIONS OF
BREAKEVEN ANALYSIS
 Equipment Life
Solve for the useful life required for an engineering
project to be economically justified.
 Capacity utilization
Solve for the hour utilisation per year at which an
alternative is justified or at which two alternatives
are equally desirable.

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 Example 10-1: Breakeven Analysis

AC MOTOR, 100Hp
Alpha Beta
$ $
Investment 12,000 16,000
Operating expenses/year 5.04X 4.05X
Maintenance expenses/year 500 250
Taxes and insurance/year 187 240
MARR = 15%, useful life 10 yrs
X = number of hours of operation per year
AW(15%)Alpha = 12,000(A/P, 15%, 10) + 5.04X + 500 + 187
AW(15%)Beta = 16,000(A/P, 15%, 10) + 4.05X + 250 + 240

At breakeven point, AWα = AWβ.

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Equating AWα = AWβ
2,490 + 5.04X + 500 + 187 = 3,190 + 4.05X + 250 + 240
5.04X + 3,177 = 4.05X + 3,680
AW (15%) X = 508 hrs/year
9,000
α
7,000
β

5,000

3,000 Select β
Select α
1,000
Hours of operation per year, X

100 200 300 400 500 600 700 800 900 1,000 1,200 1,300
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 SENSITIVITY GRAPH
(SPIDERPLOT)
An analysis tool applicable when the breakeven
analysis does not fit the project situation.

Makes explicit the impact of uncertainty in the

estimates of each factor of concern on the
economic measure of merit (PW, AW, FW).

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EXAMPLE 10-4: Sensitivity Graph
The cash-flow estimates of a piece of new equipment
with useful life of 6 years are as follows:
Capital investment, I $11,500
Revenues/year $ 5,000
Expenses/year $ 2,000
Salvage value, SV $ 1,000
Investigate PW over a range of + 40% changes in
estimates for
a. Capital investment
b. Annual net cash flow
c. Salvage value
d. Useful Life

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 The basic equation using PW:

This equation is termed “the best estimate”:

PW(10%) = -$11,500 + $3,000 (P / A, 10%, 6) +

$1,000 (P / F,10)
= $2,130
This value occurs at the intersection point of the
spider plot.

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 Revenues/year = $5,000

SV = $1,000

Expenses/year = $2,000
I = $5,000

• When the capital investment, I varies by ± p% the PW is

PW(10%) = -(1 ± p% / 100)($11,500) + $5,000(P/A, 10%, 6)
- $2,000(P/A, 10%, 6) + $1,000(P/F, 10%, 6)

(P/A, 10%, 6) = 4.3553

(P/F, 10%, 6) = 0.5645
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 SENSITIVITY GRAPH (SPIDERPLOT)
OF FOUR FACTORS
PW (10%)
Ca
pi 7000
ta
lI ,A
nv o w
es 6000 Fl
tm s h , N
e
en
t
5000 $2130 t Ca l L if
lN
e efu
4000 Us
n ua
n
3000 A alu e, SV
Salvage V
2000
-% Deviation
Changes in 1000
Factor Estimate

0 +10 +20 +30 +40

- 40 -30 -20 -10
-1000
+%Deviation
-2000 Changes in
-3000 Factor Estimate
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REVELATIONS OF SPIDERPLOT
 Shows the sensitivity of the present worth to percent
deviation changes in each factor’s best estimate
 Other factors are assumed to remain at their best
estimate values
 The relative degree of sensitivity of the present worth
to each factor is indicated by the slope of the curves
(the “steeper” the slope of a curve the more sensitive
the present worth is to the factor)
 The intersection of each curve with the abscissa
shows the percent change in each factor’s best
estimate at which the present worth is zero

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REVELATIONS OF SPIDERPLOT
In this example
 Present worth is insensitive to SV
 Present worth is sensitive to I, A, and N

From the spiderplot it is obvious that the investment, I , can

be increased by 18.5% without causing the project’s PW
(10%) to become negative.

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 PITFALLS OF RISK-ADJUSTED
MARR
 A widely used industrial practice for
including some consideration of uncertainty
is to increase the MARR
 Even though intent of risk-adjusted MARR
is to make more uncertain projects appear
less economically attractive, opposite may
appear to be true
 Cost-only projects are made to appear
more desirable as the interest rate is
adjusted upward to account for uncertainty
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REDUCTION OF USEFUL LIFE

 By excluding those revenues (savings) and

expenses that may occur after a reduced
study period, heavy emphasis is placed on
rapid recovery of capital in early years of a
project’s life
 This method is closely related to the
discounted payback technique and suffers
from most of the same deficiencies (ignore the
cash flows after the payback period)

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