Engineering Economics: Inflation

• Engineering Economics module 2

Inflation

• Prices of goods and services fluctuate due to factors like population growth, government spending, and industrial decline.
• Inflation is the increase in prices of goods and services over a period, measured by:
  • Consumer Price Index (CPI): Tracks price changes of select goods/services, affecting consumer buying power and reflecting price inflation or cost of living.
  • Wholesale Price Index (WPI): Tracks monthly average price changes of wholesale goods sold in large quantities.
• Inflation rate calculation:
  • Formula: Inflation Rate = ((CPI or WPI of current period – CPI or WPI of previous period) / CPI or WPI of previous period) × 100
  • In India, inflation is primarily measured using WPI
• Continued inflation reduces people's buying capacity due to increased prices.
• Inflation can slow down a country's economic growth.
• Controlling inflation:
  • Stop printing money.
  • Increase credit policy rates.
  • Invest money in firms instead of holding it.

Inflation and Deflation

• Inflation and deflation are macroeconomic terms experienced worldwide.
• Inflation:
  • Rising price levels of goods/services leads to decreased purchasing power.
  • Always a steady or sustained rise in prices, not seasonal
  • Impacts most sectors of the economy.
• Deflation:
  • Opposite of inflation
  • Exponential decrease in the price level of goods and services which results in increased purchasing power.
  • People can buy more with less money.
• Inflation vs. Deflation:
  • Inflation: Increase in price levels of goods/services.
  • Deflation: Decrease in price levels of goods/services.
  • Inflation: Demand for products/services increases.
  • Deflation: Demand for products/services decreases.
  • Inflation: No impact on national income.
  • Deflation: National income declines.
  • Inflation: Unequal income distribution.
  • Deflation: Rise in unemployment.
  • Inflation at a moderate level is good for the economy.
  • Calculated based on amount availed.
  • Inflation decreases purchasing power.
  • Deflation increases purchasing power.

Causes of Inflation

• Growing economy creates economic vibrancy and more spending.
• Increased demand + decreased supply raises prices.
• Hoarding.
• Lack of competition and advanced technology.
• Growing population.
• High household spending.
• Less savings by citizens.
• Genuine shortage.
• Price increases in international markets.
• Deficit financing by the government.

Money Supply and National Debt

• Money Supply:
  • Excess currency in an economy can cause inflation.
  • Money supply/circulation growing above economic growth reduces currency value.
  • Modern money valuation is determined by the amount of currency in circulation and its perceived value.
• National Debt:
  • Influenced by borrowing and spending.
  • Options when debt increases:
    • Raise taxes.
    • Print more money to pay off the debt.

Causes of Deflation

• Decreased aggregate demand:
  • Fall in money supply and decline in confidence
• Structural changes in capital markets:
  • Competition among companies selling similar goods/services lowers prices.
• Increased productivity:
  • Innovation/technology increases production efficiency and lowers prices.
• Increased aggregate supply:
  • Lower production costs + technological advances
• Decreased supply of currency makes goods/services more affordable.

Types of Inflation

• Demand-Pull Effect:
  • Growing economy leads to higher wages and increased spending.
  • Increased demand causes companies to raise prices to balance supply and demand.
• Cost-Push Effect:
  • Higher input costs (raw materials and wages) for manufacturing cause companies to preserve profitability.
  • Pass the increased production cost to consumers.
• Exchange Rates:
  • Economies with foreign market exposure function based on the dollar value.
  • Exchange rates are important in global trade when determining inflation rates.

Break-Even Analysis

• Objective: To find the production volume where a firm will start making a profit.
  • s = selling price per unit
  • v = variable cost per unit
  • FC = fixed cost per period
  • Q = volume of production
• Total Sales Revenue (S): S = s × Q
• Total Cost (TC): TC = (v × Q) + FC
• Break-Even Point: Intersection of total sales revenue and total cost lines also known as no-loss/no-gain situation.
  • Below break-even quantity = Loss
  • Above break-even quantity = Profit
  • Profit = Sales – (Fixed Cost + Variable Cost) = s × Q – (FC + v × Q)
• Break-Even Quantity Formula:
  • Break even quantity = Fixed Cost / (Selling price – Variable cost) = FC / (s - v) (in Units)
• Break-Even Sales (Revenue) :
  • Break – even sales (Revenue) = Fixed Cost / (Selling price – Variable cost) × Selling price = FC / (s - v) × s (In Rupees)
• Contribution: Contribution = Sales – Variable Cost is the difference between the Contribution and the variable costs.
• Margin of Safety: Margin of Safety = Actual sales – Break-even sales is the sales over and above the break-even sales. The formulae to compute these values are:
  • Margin of Safety = Profit/Contribution x Sales
  • Margin of Safety (% of Sales) = (Margin of Safety / Sales) x 100
• Profit/Volume (P/V) Ratio:
  • A ratio useful for further analysis
  • P/V ratio = Contribution/Sales = (Sales – Variable Cost)/Sales
  • BEP = Fixed Cost / (P/V Ratio)
  • MS = Profit / (P/V Ratio)

Problem Statement 1

• Karan Associates:
  • Fixed cost = Rs. 20,00,000
  • Variable cost/unit = Rs. 100
  • Selling price/unit = Rs. 200
• Break-even sales quantity:
  • Break – even quantity = Fixed Cost / (Selling price – Variable cost) = 2000000 / (200 - 100) = 20,000 units
• Break-even sales (Revenue):
  • Break – even sales (Revenue) = (Fixed Cost / (Selling price – Variable cost)) × Selling price = (2000000 / (200 - 100)) × 200 = Rs. 40,00,000
• Given:
  • Actual production quantity is 60,000.
• Contribution:
  • Contribution = Sales – Variable Cost
  • = (200×60000) – (100×60000) = Rs. 60,00,000
• Margin of Safety:
  • = Actual sales – Break-even sales =
  • =(60000×200) – 4000000
  • = Rs. 80,00,000
• Margin of Safety (% of sales):
  • = (Margin of Safety / Sales) × 100 = (8000000/12000000) × 100 =67%

Problem Statement 2 for 2001

• Sales = Rs. 1,20,000
• Fixed cost = Rs. 25000
• Variable cost = Rs. 45000
• Contribution
  • Contribution = Sales – Variable Cost
  • = 120000 – 45000
  • = Rs. 75,000
• Profit
  • Profit = Sales – (Fixed Cost + Variable Cost)
  • = 120000 – (25000 + 45000)
  • = Rs. 50,000
• P/V ratio
  • P/V ratio = Contribution / Sales = 75000/120000 = 0.625MS = Profit / (P/(V Ratio) = Rs. 80,000BEP = Fixed Cost/ (P/V Ratio) = Rs,40,000
• BEP
  • BEP = Fixed Cost / (P/V Ratio) = Rs.40,000
• MS
  • MS = Profit / (P/V Ratio) = Rs. 80,000

Problem Statement 3 for 2005

• Sales = 80,000
• Fixed Cost = 15,000
• Variable Cost = 35,000
• Contribution = Rs. 45,000
• Profit = Rs. 30,000
• BEP = Rs. 26,667
• MS = Rs. 53,333