Chapter 8 -Extension of Cost Analysis PDF

Chapter 8 -EXTENSION OF COST ANALYSIS Objectives Concept of break- even point Changes in break- even point due to price, fixed cost and variable cost Application of break- even analysis Limitations CONCEPT OF BREAK-EVEN POINT Q. Explain the concept of...

Chapter 8 -EXTENSION OF COST ANALYSIS Objectives Concept of break- even point Changes in break- even point due to price, fixed cost and variable cost Application of break- even analysis Limitations CONCEPT OF BREAK-EVEN POINT Q. Explain the concept of break-even point with the help of diagram ? Break-even analysis studies the relationship between total cost, total revenue, total profits and losses over a range of output. Break-even point is a point where the total revenue of the firm is equal to total cost. Therefore, at break-even point there is NO PROFIT, NO LOSS. Break-even analysis technique is used in the business to determine the level of production or sales volume which is necessary for the business to cover its cost of doing a business. In financial analysis the concept of break-even point is most commonly used. …continue with table and graph OUTPUT TR TC PROFIT/LOSS 0 0 1200 -1200 1 1000 1500 -500 2 1400 1800 -400 3 2000 2000 0 4 2600 2200 400 5 3500 3000 500 The break-even level of output is 3 units because, firms TR and TC are equal at 3 units of output and therefore there is no profit, no loss. ….continue Above diagram is drawn on the basis of the assumption that TR and TC curves are linear i.e. TR and TC increases at a constant rate with an increase in the level of output. Therefore, TR and TC curves are straight lines. For initial levels of output total cost is greater than total revenue. TFC is constant ,hence parallel to the X axis Thus, OQ is the break-even output and B1 is the break-even point. If we do not consider constant change in TR and TC, TR and TC curves are non-linear. In this case we have more than one break-even point as shown in the following In case of non-linear TR and TC curves there two break even points P and Q, indicating lower level of output OM and higher level of output ON respectively. For any output less than OM and greater than ON, firm makes losses because TC>TR. Between the range of output M and N, TR>TC and thus firm makes profit. CHANGES IN BREAK- EVEN POINT DUE TO PRICE, FIXED COST AND VARIABLE COST Q. How break-even point changes due to change in price and fixed cost and variable cost? Break-even point or break-even quantity changes due to change in following factors: Changes in price Changes in fixed cost Changes in variable cost Any change in price will have an effect on total revenue and therefore also on break-even point This shows that with an increase in price, break-even quantity falls and with a fall in price, break-even quantity increases. An increase in fixed cost, break-even quantity increases and with a fall in fixed cost, break-even quantity falls. This shows that with an increase in per unit variable cost, break-even quantity increases and with a fall in average variable cost, break-even quantity falls APPLICATION OF BREAK-EVEN ANALYSIS Q. Discuss the implications of break-even analysis? Business firms are interested in understanding break-even analysis because it helps to determine that level of output which will help the firm to cover its entire cost and thus to make profit. Break even point is the point where the firm starts making profit. Break even analysis is used in the business for following purposes. Targeting profits- Firm has to target the level of profit for short run and long run. Break-even point gives the level of output where the firm starts making profit. For setting profit targets, it is important. Recovery of cost- At break-even point firm covers its entire cost of production (including fixed and variable cost). Helps in deciding techniques of production- Each technique differs in efficiency and cost. Break-even analysis helps in deciding a proper technique of production. …continue  Effects of changes- In order to be competitive, firm needs to make changes in their pricing, marketing and other policies. Any change in this policy will have an effect on revenue and cost of the firm and thereby on break-even point. Deciding sales and marketing policies- It is possible for the firm to lower break-even point by using new marketing strategies. But an increase in marketing cost will increase the cost of production and break even. It is necessary for the firm to find proper sales and marketing policies to achieve its break-even point. Utilization of capacity- It is possible for the firm to reduce its average cost when it uses its full capacity and thereby reduces wastages Capital raising capacity- once the break-even point is reached, it is possible for the firm to raise capital for its future expansion. The financial institutions are also ready to give loans to these firms. LIMITATIONS OF BREAK-EVEN ANALYSIS Q.Discuss the limitations of break-even analysis Various limitations of break-even are as follows Linear TR and TC curves gives wrong impression that the entire output after break-even point is profitable. But this is not always true. In case of single product unit, break-even analysis can be applied. But in case of multiple or joint products it is difficult to apply break-even analysis as long as cost cannot be determined for each of the product. The data required for break-even analysis including costs, price etc. is generally historical. If historical data is not proper for estimating future costs and prices, break-even analysis cannot be usefully applied. If it is possible to clearly classify costs as fixed and variable costs, break-even analysis is more useful. But sometimes it is not possible to have such classification of costs.  Formulas Fixed cost per month Variable cost per unit Sales cost per unit BEQ=FC / SP-VC BSE= BQ×P BEQ= Break even quantity BEP= Break even point BSE= Break even sales volume FC= Fixed Cost VC= Variable Cost SP= Sales per unit (price)  Q. Suppose the TFC of the firm is ₹5000.AVC is ₹25 and price per unit is ₹40.Calculate Break even quantity and Break even sales volume. FC=5000 SP=40. VC=25 Calulate BEQ=? And BES=? BEQ= FC / SP- VC = 5000 / 40-25 = 5000 / 15 BEQ= 333.33 BSE= BQ×P = 333×40 BSE= 13333.2  Q. If TFC increases to ₹6000 ,what will happen to Break even quantity and sales volume ? FC = 6000 SP = 40 VC = 25 Calculate BEQ=? and BSE=? BEQ = FC / SP-VC = 6000 / 40-25 = 6000 / 15 BEQ = 400 BSE = BQ×P = 400×40 BSE = 16000  Q. If price per unit reduces to ₹35 ,what will happen to Break even quantity and sales volume ? FC = 6000. SP = 35 VC = 25 Calculate BEQ=? and BSE=? BEQ = FC / SP-VC = 6000 / 35-25 = 6000 / 10 BEQ = 600 BSE = BQ×P = 600×35 BSE = 21000  Q. With the help of following data find out lower and upper level of Break even quantity OUTPUT TR TC 0 2500 3500 1 2200 3000 2 2000 2000 3 1800 1500 4 1500 1300 5 1000 1000  Answer* OUTPUT TR TC Profit & Loss 0 2500 3500 -1000 1 2200 3000 -800 2 2000 2000 0 3 1800 1500 300 4 1500 1300 200 5 1000 1000 0