MCom I Semester Profit Policy & Profit Forecasting Break Even Analysis Study Material Notes

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MCom I Semester Profit Policy & Profit Forecasting Break-Even Analysis Study Material Notes

MCom I Semester Profit Policy & Profit Forecasting Break-Even Analysis Study Material Notes: Aooriages of Profit Foeacsing Calculation of Break-Even Point Meaning of Break-Even Analysis Meaning of Break-Even Point Assumption of Break-Even Analysis Uses or Application or Break-Even AnalysisMeaning of Break Even Chart Methods of Construction of Break Even Chart Meaning of profit Volume Ration Uses of Profit Volume Ratio Practical Problems :

MCom I Semester Profit Policy & Profit Forecasting Break Even Analysis Study Material Notes
MCom I Semester Profit Policy & Profit Forecasting Break-Even Analysis Study Material Notes

MCom I Semester Managerial Economics Equilibrium Price Study Material Notes

PROFIT POLICY AND PROFIT FORECASTING [BREAK-EVEN ANALYSIS]

PROBLEMS INVOLVED IN DETERMINATION OF PROFIT POLICY

Main aim of every business enterprises is to earn maximum profit. It is important to note in this regard that earning maximum profit does not mean exploitation of society and the factors of production. It means to earn maximum profit from consumers through maximising the demand of product, maximing sales, minimising costs and controlling normal and abnormal wastages. A business enterprise can be successful in earning maximum profit only when it has some defined policies, plans and programmes and it implements these policies, plans and programmes sincerely and strictly. There are some practical problems in the Determination of Profit Policy. These problems are as under—

1 Problem of Determination of Selling Price. Selling Price of the product or products of an enterprise bears a direct relationship with its profit. If selling price is high, enterprise will be successful in earing more profit and if the selling price is low, enterprise will earn less profit. Though, selling price is determined by the enterprise itself but it is not completely free in determining selling price for its product or products. An enterprise can fix selling price ofits product or products only after considering the price policies of its competitors.

2. Problem of Controlling Cost of Production. Success of an enterprise depends to a large extent upon its ability to control its cost of production. It should have an effective control over the cost of production so that it may be minimised and all the normal and abnormal wastages may be checked.

3. Problem of Determination of Amount of Depreciation. Important problem in the determination of Profit Policy is the determination of amount of depreciation which should be provided on fixed assets. There are many methods of determining depreciation and it is very difficult to select a particular method of depreciation.

4. Problem of Valuation of Stock. Another important problem in the determination of Profit Policy is the valuation of stock. Valuation of stock bears direct relationship with the amount of profit of an enterprise. If the value of stock is high, profit of the enterprise will be more. Valuation of stock is not so easy because it is very difficult to select a particular method of valuation of stock.

5. Problem of Writing off of Intangible Assets. Every business enterprise has some intagible assets on its balance sheet such as-patent. preliminary expenses, discount on issue of shares and debentures, expenses on issue of shares and debentures, trade mark, goodwill etc. Writing off these assets is a direct charge against profit of an enterprise but it is not very easy to determine the amount which should be written off of these assets every year.

6. Problem of Getting the knowledge of Solvency Position of Debtors. Every business and industrial enterprise has some debtors on its balance sheet from whom it has to collect the money. It has been a practical experience that no business enterprise collects full amount of debtors. Therefore, a certain amount is provided as provision for bad and doubtful debts every year. This provision is a charge against profit of the enterprise.

Conclusion. Main aim of every enterprise is to earn maximum profit through maximing sales, miniming costs and controlling all the wastages. There are many practical problems in the determination of Profit Policy. These problems relate to the valuation of stock, determination of the amount of depreciation, writting off of intangible assets, getting knowledge of solvency position of debtors, controlling cost of production and determining selling price etc. These problems should be solved rationally so that a suitable Profit Policy may be determined for the enterprise.

APPROACHES OF PROFIT FORECASTING

All the firms have to work in an atmosphere of competition. There is cut-throat competition in almost all the fields or activities of business and industrial enterprise. In such an atmosphere, it is necessary for all the firms to forecast their profit because main aim of all the firms is to earn maximum profit through maximum sales and maximum satisfaction of consumers. Though it is very difficult to prepare forecasts of profit, yet there are three methods which can be used for this purpose. These methods are as under

1 Preparation of Profit and Loss Account. Under this method of forecasting profit, a projected profit and loss account is prepared for the period for which forecasts are to be prepared. In this account, all the items of estimated income and expenditure are shown and the balance of this account is taken to be the forecasted profit or loss of the firm.

2. Break-Even Analysis. Under this method of forecasting profit, total sales and total cost are estimated at different levels of activity. Difference between total sales and total cost is the profit at a particular level of activity. Thus, with the help of this approach, profit or loss can be calculated at different levels of activity.

3. Environmental Analysis. Under this method, profit is forecasted on the basis of analysis of circumstances in which a firm has to work. Profit of a firm-is affected by general economic conditions of the country, general economic conditions of the industry, trend of sales and profit of the industry. trend of sales and profit of a particular firm, general price level, trade cycles, Government policies and regulations etc. Therefore, under this method, all these factors are estimated for the period of forecasting and forcasts of profit are prepared on the basis of such analysis.

Conclusion. There are three approach of profit forecasting-preparation of profit and loss account, break-even analysis and environmental analysis. Though any of these methods can be used for forecasting profit, yet it is advisable to adopt a combination of all the three methods.

MEANING OF BREAK-EVEN ANALYSIS

Under Break-Even Analysis, total cost and sales of an enterprise are analysed. This analysis explains the level of activity at which total cost and total sales revenue of the enterprise will be equal. Thus, it may be concluded that break-even analysis determines the level of activity (either the volume of sales or the value of sales) at which total cost and total revenue of an enterprise will be equal (TR = TC).

MEANING OF BREAK-EVEN POINT

Break-Even Point is that point of production and sale at which the total cost and total revenue are equal. If the enterprise operates at this point, there will be no profit no loss. For this reason, this point is known as no profit, no losss point also. The term ‘Break-Even Point’ has earn defined as under

Matz, Curry and Frank, “A Break-Even Analysis indicates at what level, cost and revenue are in equilibruim.”

Keller and Ferrara, “The Break-Even Point of a unit of a company is the level of sales income which will equal the sum of its fixed cost and its variable costs.”

Charies T. Horngren, “The Break-Even Point of activity (sales volume) where total revenue and total expenses are equal. It is the point of zero profit and zero loss.”

ASSUMPTIONS OF BREAK-EVEN ANALYSIS

Like every law of economics, Break-Even Analysis is also based upon certain assumptions. Some important assumptions of break-even analysis are as under

1 Behaviour of costs is linear. In other words, if costs are presented on a graph paper, we will get a straight line.

2. There are two types of costs-Fixed Costs and Variable Costs. Fixed Costs are the Costs which change with a change in production.

3. All the Cost of enterprise can be divided into two parts only-Fixed Cost and Variable Costs. There is no third type of Costs.

4. There is no change in the prices of materials, labour etc. Similarly, there is no change in factory overheads, office and administration overheads, selling and distribution overheads.

5. There is no change in the efficiency of workers and machines. There is no change in production technique also.

6. Cost control remains unchanged in the enterprise.

7. Selling Price of the product remains equal at all the levels of sales.

8. There is no change in the level of stock. In other words, entire production is sold.

9. Quantity of production and sales is the only factor affecting costs.

10. Enterprise produces a single product. If an enterprise produces more than one products, there is no change in the ratio of sales-mix of these products.

11Total Costs and Total Revenue of an enterprise can be compared on the basis of volume of sales or value of sales.

CALCULATION OF BREAK-EVEN POINT

Before discussing the method of Calculation of Break-Even Point, it is necessary that the meaning of the terms which are used for this purpose should be clearly understood. Important Terms used in the Calculation of Break-Even Point are as under

MC = Marginal Cost

C = Contribution

F = Total Fixed Cost

V = Total Variable Cost

VC = Variable Cost Per Unit

S = Total Sales

SP = Selling Price Per Unit

Pt. = Total Profit

MP= Marginal Profit

MS= Margin of Safety

Marginal Cost (MC). Marginal Cost is the cost of producing an additional unit. It is measured by studying the change in total cost of production as a result of an increase or decrease of one unit in the quantity of production of enterprise. Mathematically, it can be presented as follows

MC = [(TC of ‘X’ +1) – (TC of ‘X’)]

Marginal Cost is known as Variable Cost per unit also.

Contribution. Contribution is the difference between Selling Price and Variable Cost of a product. Mathematically, it can be presented as follows

CP = SP – VC Or,

C=S-V

Fixed Costs is the part of total cost which does not change in the level of prodcution. It includes- Rent of Building, ce Premium, Depreciation, Salary of Permanent Staff, Interest on Loan etc. It is important to note in this regard that Per Unit Fixed reducing with an increase in production.

Variable Cost. Variable Cost is the part of total cost which changes with change in the quantity of production. If the quantity of prodcution increases, ariable Cost will also incrase and if the quantity of production decreases, Variable Cost will also decrease. Variable Cost includes the cost of raw materials, the cost of labour and other direct expenses. It is important to note in this regard that Per Unit Variable Cost remains constant.

Marginal Profit. Marginal Profit is the difference between Selling Price and Marginal Cost. In other words, contribution is the Marginal Profit.

Margin of Safety. Margin of Safety is the difference between Total Sales and the Sales of B.E.P. It may be calculated either in terms of units of in terms of rupees. Mathematically, it can be presented as follows

Margin of Safety = Sales – B.E.P.

Break-Even Point is calculated as follows

1 Calculation of Break-Even Point in Units. Break-even point can be calculated in terms of units only when Selling Price Per Unit and Variable Cost Per Unit are given or can be calculated. Following formula is used to calculate B.E.P. in terms of unitsB.E.P. (In Units) =

Profit Policy & Profit Forecasting
Profit Policy & Profit Forecasting

2. Calculation of Break-Even Point in Value. Break-even point can be calculated in value also. It can be calculated in both the conditions-(i) When Total Fixed Cost, Total Sales and Total Variable Cost are given, (ii) When Total Fixed Cost Selling Price per Unit and Variable Cost Per Unit are given. Formula in both the conditions are as follows

Profit Policy & Profit Forecasting
Profit Policy & Profit Forecasting
Profit Policy & Profit Forecasting
Profit Policy & Profit Forecasting
Profit Policy & Profit Forecasting
Profit Policy & Profit Forecasting
Profit Policy & Profit Forecasting
Profit Policy & Profit Forecasting
Profit Policy & Profit Forecasting
Profit Policy & Profit Forecasting
Profit Policy & Profit Forecasting
Profit Policy & Profit Forecasting

Above calculations make it clear that if sales mix is changes break-even point will be lower by Rs. 3,125. As a result margin of safety will increase. This situation is more profitable for the enterprise. Therefore, sales mix should be changed.

13. For Decision-Making on the Change in production Capacity. If the demand of the product of an enterprise increases, an important problem before the management is to decide whether to expand the production capacity of the enterprise or not? The management should carefully and cautiously analyse all the relevant factors of problem. Break-even analysis helps in taking a decision in this respect also. If profit to the enterprise are expected to increase on an increase in production capacity, it should be increased, otherwise not.

14. Make Or Buy Decisions. Sometimes, management has to decide whether to produce a particular component in the enterprise or to purchase it from market. Such problem arises when an enterprises to use a particular component for its product and the component is readily available in market also. If the enterprise decides to produce it, fixed costs and variable costs of the enterprise are bound to increase. Break-even analysis helps in deciding the level beyond which it will be profitable for the enterprise to produce the component and below which it will be profitable for the enterprise to purchase it from market. Following formula is used for this for purpose

Fixed Costs B.E.P. =

Purchase Price Per Unit – Variable Cost Per Unit

Problem 13. A manufacturer buys a certain component of its product from the market at Rs. 10 each. In case he makes it himself, his fixed cost and variable cost would be Rs. 20,000 and Rs. 6 per unit respectively. Should the manufacturer make or buy?

Fixed Costs B.E.P. =

Purchase Price Per Unit – Variable Cost Per Unit

20,000 – 5.000 Units

10-6

Thus, if the manufacturer needs 5,000 units or more per year, it will be profitable for him to produce it, otherwise, it will be profitable for him to purchase it from market.

15. Dropping Or Adding Decisions. Sometimes, the management has to decide whether to drop or to add a particular product to their product line. Break-even analysis helps management in taking the decision in this respect also.

Conclusion. Break-even analysis helps in analysing the profitability of an enterprise in different situations. It helps in taking several managerial decisions. It directs and controls the profit position of an enterprise.

MEANING OF BREAK-EVEN CHART

Diagramatic presentation of break-even analysis is called break-even chart. Break-ever chart helps management in analysing the position of Costs, Revenues, Break-even Point, Profit/Loss and Margin of Safety etc.

In the words of Matz Curry and Frank, “A break-even chart can be defined as an analysis in graphic form of the relationship of production and sales to profit.”

METHODS OF CONSTRUCTION OF BREAK-EVEN CHART

Break-even chart is constructed as urder :

(1) Sales Or Production is presented on OX axis Or X axis on horizontalline of Break-Even Chart. A suitable scale is decided for this purpose.

(2) Costs and Revenues are presented on OY axis Or Y axis on vertical

line of Break-Even Chart. A suitable scale is decided for this purposealso.

(3) Fixed Costs Line is drawn parallel to OX axis.

(4) Total Costs Line is drawn on OY axis. It starts from the point of

Fixed Costs Line and moves upwards. It is important to remember in this regard that no specific Line is drawn in Break-Even Chart for Variable Costs. A Total Costs Line is drawn which represents Variable Costs also indirectly because the difference between Total Costs and Fixed Costs is equal to Variable Costs. Due to this reason, Total Costs Line starts from the point of Fixed Costs Line and not from the point of origin.

(5) Total Sales Line Or Total Revenue Line is drawn on OY axis. It starts from the point of Origin and moves upwards.

(6) The point at which Total Sales Line Or Total Revenue Line and total

Costs Line intersect each other, is called Break-Even Point (BEP). A perpendicular is drawn from this point on OX axis and Break-Even Point is calculated in terms of Units Or Rupees, as the case may be. Another perpendicular is drawn from this point on OY axis and Sales are calculated in terms of Rupees and Total Costs are calculated at Break-Even Point. Space between Total Sales Line and Total Costs Line on left hand side from Break-Even Point is called the area of Loss and the space between Total Sales Line and Total Costs Line on right hand side from Break-Even Point is called the area of Profit

Break-Even Chart can be prepared in two ways-(i) In terms Units, and (ii) In terms of Rupees. Which particular Chart is to be prepared, depends upon the information given for the Solution of a Problem? It can be discussed as follow

(i) When Production/Sales Volume is Given. In this situation, volume of Sales/Production is presented on OX axis in terms of Units and Costs of Sales/Production and Sales Revenue are presented on OY axis in terms of Rupees. An analytical table is prepared before preparing Break-Even Chart. There are five columns in this table. In first column of this table. Arbitrary Units of Production Sales level such as-Zero, Units of Break-Even Point (if break-even point is in decimal, these units may be little more or less break-even point), Double Units of Break-Even Point or the Units of maximum production capacity are entered. In second column, Fixed Costs are entered. These Costs will remain constant at all the levels of production. In third column, Variable Costs are entered. For this purpose, variable cost per unit is multiplied with the number of units entered in first column. In fourth column, Total Costs are entered. For this purpose, Fixed Cost and Variable Costs enterred in second and third column respectively are added. In fifth column, Total Sales Revenue is entered. For this purpose, Selling Price per unit is multiplied with the number of units entered in first column. Break-Even Chart can now be prepared with the help of this analytical table.

(ii) When Production/Sales Volume is Given in Terms of Rupees. In this situation, Production/Sales Volume is presented on OX axis and Costs and Sales is presented on OY axis, both in terms of Rupees scale for both the OX axis and OY axis is identical. An analytical table is prepared before preparing Break-Even Chart. There are five columns, in this table also. In the first column of this table, Sales Volume is entered in terms of Rupees such as-Zero, Break-Even Point (if break-even point is in decimal it may be little more or less than break-even point) and Double Amount of Break-Even Point or maximum production capacity. In rest four columns, the amounts of Fixed Costs, Variable Costs, Total Costs and Sales Revenue are entered respectively keeping in view the sales volume entered in first column. Now Break-Even Chart can be prepared with the help of this analytical table.

Process of preparing Break-Even Chart can be explained with the help of following illustration

Illustration. The following data relates to a business concern

Fixed costs (F)                  Rs. 50,000

Variable Costs (VC)          Rs. 10 Per

Unit Selling Price              Rs. 20 Per

Unit Total Production Capacity 10,000

Units Draw a Break-Even Chart with the help of above information and verify the Break-Even Point by formula

 

 

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