Final answer:
The break-even equation is modified to account for desired profit by adding the profit to the fixed costs before dividing by the contribution margin. A firm decides on production based on minimizing losses. An example shows economic profits when operating above the break-even point.
Step-by-step explanation:
The break-even equation is modified to take into consideration the sales required to earn a desired profit by adding the target profit to total fixed costs before dividing by the contribution margin per unit. The modified break-even formula becomes:
Break-Even Point in Units (for Target Profit) = (Fixed Costs + Desired Profit) / (Price per Unit - Variable Cost per Unit)
If a firm is operating below the break-even point, where price equals average cost, it is operating at a loss. The firm then needs to decide whether to continue to produce and lose money or shutdown. Preferably, it would choose the option that minimizes losses.
An example of this can be seen where a firm has set a price and determined its quantity. Assuming the firm's total revenue at a quantity of 40 is $640 and its total costs are $580, the profits would be $60. This economic profit is the shaded area above the average cost curve in the graph, indicating the firm is operating above the break-even point.