Foundations of Entrepreneurship
Managerial Economics
Demand Analysis & Forecasting
Profit Management
Capital Management
Background
• The future sales of all major products or services
(except some essential items such as life-saving drugs)
will fully depend on the
micro (related to small entities such as individuals, consumers, firms
including buyers and vendors) and the
macro (related to larger geographies – say a country, economies, the
world in general)
economic conditions of the nation (the market or the
entire economy).
• The objective of managerial economics is to help firms
to make the best decisions (most suitable actions) to
maximize value creation under changing macro and
microeconomic situations by optimizing the factors of
production (land, labor, and capital {including IP}).
Definition: Managerial Economics
• Managerial economics deals with the decision
making process by mangers and entrepreneurs
in response to changing macro and micro
economic conditions.
• Managerial Economics provides the process of
applying economic theories & methods and
the tools of analysis of decision science in
management decision process for appropriate
actions under changing economic conditions.
Managerial Economics – three key components
• Demand Analysis & Forecasting (helps to plan production, price,
promotion and logistics)
• Profit Management (costs and price management)
• Capital Management (selection of alternative business models,
capital investment decisions, hiring decisions, and
advertisements)
• Define problems, determine objectives (long-term vs. short-term
cash flow, profit maximization, turnover maximization, etc.),
discover alternatives, forecast possible consequences, check
sensitivities of various parameters to possible outcomes, and
make the best possible choice for maximizing objective functions.
• Cost object: Object for which costs are accumulated and
measured.
For example: a car is the cost object for all components that go into
making the car.
Other examples of cost object may be transmission, car, plant,
division
• Cost behaviour, with respect to output volume (Cost can be
classified into):
– Variable,
– Fixed,
– Mixed,
– Step.
A cost object is often a product or department
for which costs are accumulated or measured.
For example, a product is the cost object for
direct materials, direct labour and
manufacturing overhead.
The factory maintenance department is a cost
object for the cost of the maintenance,
employees and the maintenance supplies.
Marginal Revenue and Marginal Cost
Approach
Marginal cost is the cost of producing one extra
unit beyond some number or quantity
produced.
Average cost is the total (fixed plus variable cost)
unit cost of production and is determined by
dividing the total cost by the number of unit
produced.
Marginal Revenue and Marginal Cost
Approach
P
Marginal cost
Marginal revenue
Maximum profit
Q
Cost
Variable Cost
Fixed Cost
Quantity
Cost
Variable Cost
Fixed Cost
Quantity
Total variable Cost
Cost
Total Cost per unit
Fixed Cost per unit
Total Fixed Cost
Quantity
Variable Cost per unit
Cost
Total Cost per unit
Fixed Cost per unit
Variable Cost per unit
Quantity
COST-VOLUME-PROFIT
RELATIONSHIPS
Foundations of Entrepreneurship
COST AND COST DRIVER
• Cost is the price that one must pay, a sacrifice or
resource given up for an item or service.
• When an item or service is procured and used up
immediately, the cost is easy to allocate. But when it is
used for a long period, the cost is difficult to allocate.
• Cost driver is any output measure that causes cost
(i.e., causes the use of resources).
Value Chain Function & Examples of Cost Examples of Cost Driver
R&D
• Cost of feasibility study Man-hours
• Prototyping, testing Material, interest, chemicals
Design of products, services, and processes Number of parts per product
• Cost to develop and test prototype Testing hours, machine hours
Production
• Labour wages Number of labour-hours
• Material cost Quantity of material used
• Cost of machining Machine hours
Marketing Number of advertisements
• Cost of advertisement Time of display
Cost of contents
Distribution
• Transportation cost Weights of items
Distance
Customer service
• Cost of supplies, travel Number of service calls
Cost Classification
Two ways of classifying costs
Product specific Company specific
• Direct cost – directly • Fixed cost – Cost that is not
traceable on each product such as related to activity level - a
raw-materials, direct labor costs. company has to bear it even if
there is no activity.
• Indirect cost – difficult to
estimate exact cost on each • Variable cost – proportional
product. to level of operation.
FIXED AND VARIABLE COSTS
Fixed costs are defined as expenses that do not change as a function of
the activity of a business, within the relevant period. For example, a
manufacturer must pay rent of factory premises, utility bills, depreciation,
salary to administrative staff, interest on term loan, etc. irrespective of
level of activities and sales.
While in practice, all costs vary over time and no cost is a purely fixed cost,
the concept of fixed costs is necessary in short term cost accounting.
Organizations with high fixed costs are significantly different from those
with high variable costs. The entire fixed cost is divided by the amount
produced during a period and therefore the unit fixed cost reduces as
production increases.
Variable cost is one that changes in direct proportion to the change in its
cost driver activity level. A cost that varies in step with the output or the
sales revenue of a company is called variable cost. Cost of raw material,
energy usage, labor, distribution costs, etc. are examples of variable costs.
As the production volume changes, the material cost changes, but the
machine cost per hour does not change.
Material Cost: Variable cost; Machine cost: Fixed cost
COST-VOLUME-PROFIT ANALYSIS
The analysis that helps in assessing the effect of output
volume on revenue (sales), expenses (cost), net income (net
profit). It is used to estimate Break Even Point and Factor of
Safety.
The major assumptions are the following:
1. Costs can be classified as fixed or variable with respect
to a single measure of volume of output activity.
2. Sales and variable costs vary proportionately with the
output level.
3. All items produced are sold, with no inventory built up.
4. Productivity is unchanged.
5. Sales mix is constant.
COST-VOLUME-PROFIT ANALYSIS
Let
p: Unit sales price (Rs/unit)
v: Unit variable cost of manufacturing (Rs/unit)
F: Fixed cost (Rs/week)
Q: Quantity produced and sold (unit/week)
Total variable cost (Rs/week) = (v)(Q)
Total fixed cost (Rs/week) = F
Total cost of production (Rs/week) = F + vQ
Total sales revenue (Rs/week) = (p)(Q)
Net income = I = pQ – (F + vQ)
BREAK-EVEN POINT
Break-even point is the level of sales Q* at which
revenue equals expenses and net income equals zero:
F + vQ* = p*Q*
Example:
Fixed cost: 5,00,000
or Unit price: 500
Unit variable cost: 400
pQ* - (F + vQ*) = 0
F Fixed Cos t 500000
Q
*
5000
p v Contribution 500 400
CONTRIBUTION
Contribution
= Unit sales price – Unit variable cost
=p–v
Say the unit price is Rs. 100 and unit variable cost is Rs.
60, the Contribution is Rs. 40.
Break-even point is thus given by
F Totalfixed cost
Q
*
p v contribution perunit
Q* is the amount of sales at which the total contribution
margin equals the fixed cost; i.e., it is the total amount
at which the fixed cost is fully recovered.
GRAPHICAL SOLUTION
Profit
Total Revenue = (p)(Q)
(Rs/week) Break-even Point
Total Cost = (F + v*Q)
v
Variable Cost = v*Q
p
Fixed Cost = F
v
Loss
Q* Q
(unit/week)
p – UNIT price, v – UNIT variable cost, F – TOTAL fixed cost
Example
A factory has the following fixed and variable costs. Note that
repair and maintenance cost is a semi-variable cost and here it is
part of fixed cost. The unit price of the item is Rs 30.
Fixed Cost Variable Cost
(Rs/year) (Rs/unit)
Depreciation 20,000
Insurance 5,000
Repair & Maintenance 5,000 0.50
Material 9.50
Labour and Power 10.00
Total 30,000 20.00
a. Find the breakeven quantity to be produced.
b. If the production plan is 2,000 units annually, what is the
profit/loss?
Solution:
a. Given
F = ₹ 30,000 per year, v = ₹ 20 per unit, p = ₹ 30 per unit
The breakeven production quantity is given by
F 30, 000
Q
*
3, 000 units/year
p v 30 20
b. p – unit price, v – unit variable cost, F – total fixed cost
The production plan is Qp = 2,000 units/year.
Total revenue = (2,000)(30) = 60,000 Rs/year
Total cost = 30,000 + (2,000)(20) = 70,000 Rs/year
Loss = 10,000 Rs/year
How many units need to be produced to make profit of Rs.
10,000/-?
Estimating Costs: High-Low
• Previous data assumed FC and VC were easily
obtained, but what if costs are “mixed”—
elements of both fixed and variable costs
combined?
• Linear regression—most accurate method to
break out costs
• High-Low: quick method to estimate variable
and fixed cost portions
High-Low: Illustration (1)
Month Quantity Total Cost ₹
January 4,000 244,000
There is a
February 3,600 231,600 clear
March 3,800 241,600 relationship
April 3,400 222,000
May 4,200 246,000 between
June 4,300 244,700 quantity and
July 4,400 252,000 cost, but it is
August 4,600 262,600
September 4,700 270,400 not yet
October 4,900 262,100 specified
November 5,200 276,000
December 5,400 282,000
Totals 48,500 2,791,000
High-Low: Illustration (2)
Cost Quantity Per unit
High December 282,000.00 5,400
Low April -222,000.00 -3,400
difference 60,000.00 2,000 30.00
divide by VC
or slope
High Low
Total cost 282,000.00 222,000.00
less VC= slope x qty -162,000.00 -102,000.00
FC 120,000.00 120,000.00
Thus VC estimated = ₹30 per unit and FC estimate = ₹
120000 for the period
or Total costs = ₹30q + ₹120,000
MARGIN OF SAFETY
Margin of safety = Planned sales – Break-even sales
It helps to assess the possible risk.
It shows how far sales can fall below the planned
level before loss occurs.
MARGIN OF SAFETY
Profit
Total Revenue = (p)(Q)
(Rs/week) Total Cost = (F + vQ)
v
p Margin of
F Safety
Loss
Planned Production
Q* Qp Q
(unit/week)
CHANGE IN FIXED COSTS
Total Revenue = (p)(Q)
(Rs/week) Total Cost = (F2 + vQ)
Total Cost = (F1 + vQ)
F2
F1
Q1* Q2* Q
(unit/week)
CHANGE IN VARIABLE COST
Total Revenue = (p)(Q)
Total Cost = (F + v2Q)
(Rs/week) v2 Total Cost = (F + v1Q)
v1
F
Q1* Q2* Q
(unit/week)
Example – Automation
Automation usually involves substantial fixed cost and reduced
variable cost. Normally, high volume of production breaks even
the cost. But it may not be always the case.
F1 < F2 , v > v , Q1* > Q2*
1 2
(Rs/week)
v1 v2
F2
F1
Q1* Q Q2* Q
(unit/week) (unit/week)
Without Automation With Automation
Operating Leverage
Operating leverage refers to the percentage of fixed
costs that a company has compared to variable cost.
Stated another way, operating leverage is the ratio of
fixed costs to variable costs.
Financial leverage refers to the amount of debt in the
capital structure of the business firm. If you can envision
a balance sheet, financial leverage refers to the right-
hand side of the balance sheet.
Combined, or total, leverage is the total amount of risk
facing a business firm.
• High operating leverage means that the fixed
cost of a company is high compared to the
variable cost. In this case, the firm, after break-
even, earns a large profit on each incremental
sale. But the break-even point of the company is
at a high level indicating that the company must
attain sufficient sales volume to cover its high
fixed costs.
• Low operating leverage means the major part of
the cost is variable in nature. In this case, the
firm achieve break-even with small sales, but
earns a small profit on each incremental sale.
Examples
• Consider a car company, ABC, with capacity to produce 5
lakh cars.
• Investment in fixed assets (does not outsource much):
10,000 cr.
• Fixed cost per annum: 2,500 cr. [high depreciation,
interest, and salary]
• Variable cost per unit: 0.04 cr.
• Price per car: 0.05 cr.
• Contribution margin per car = 0.05 – 0.04 = 0.01 cr.
• Minimum number of cars to be sold to beak even=
2500/0.01 = 2,50,000
Example … contd
• Assume that another car company XYZ outsources major components
and invest less in fixed asset have the same capacity to produce 5 lakh
cars.
• Investment in fixed assets (does not outsource much): 500 cr.
• Fixed cost per annum: 250 cr. [low depreciation, interest and salary]
• Variable cost per unit: 0.045 cr.
• Price per car: 0.05 cr.
• Contribution margin per car = 0.05 – 0.045 = 0.005 cr.
• Minimum number of cars to be sold to beak even= 250/0.005 = 50,000
• Operating leverage of the ABC company is much higher compared to
XYZ as indicative from high break-even point. Whereas, the operating
leverage of company XYZ is lower.
Operating Leverage
Contribution _ m arg in
Operating _ leverage
Net _ operating _ income
Unit _ sold (Pr ice Variable _ cos t )
Operating _ leverage
[(unit _ sold (Pr ice Variable _ cos t ) Fixed _ cos t
Operating leverage example … contd
• Operating leverage of company ABC
300000 (0.05 0.04)
Operating _ leverage
[(300000 (0.05 0.04) 2500]
= 6.
This means that if at this point, sales increases by 10%, operating profit would
increase by (6X10%) 60%. Notice that the break-even point is high.
• Operating leverage of company XYZ
300000 (0.05 0.045)
Operating _ leverage
[(300000 (0.05 0.045) 250]
= 1.2.
This means that if at this point, sales increases by 10%, operating profit would
increase by (1.2X10%) 12%. But notice that the break-even point is low.
• High operating leverage is associated with high
break-even point and vice versa.
• Operating leverage is high when unit variable
cost is small compared to unit fixed cost.
• Operating leverage is high when the ratio of total
fixed cost to unit variable cost (F/v) is high.
• When F/v is low (meaning a low fixed cost
scenario), operating leverage is low and the risk
of the business is low.
It is not so important to go deeper into
operating leverage (OL). But it would look like
the following if one plots the OL over quantity
Op
er
ati
ng
lev
er
ag
e
Number of unit sold Break even (quantity) point
You may neglect this slide for examination purpose. It is included only for those who
may have questions.
Classification of some regular cost items
Item Type Comment
Depreciation 1500 Fixed
Consider as variable for now. (in reality it
Insurance 100 Variable may have two components)
Interest on long-term loan 250 Fixed
Interest on short-term loan 450 Variable
Audit fee 50 Fixed
RoC registration fee 20 Fixed
Rent 120 Fixed
Salaries 3000 Fixed
Wages 2100 Variable
Advertisement 100 Variable
Maintenance 50 Variable
Electricity cost 40 Variable
Fuel cost 35 Variable
Transportation 150 Variable
Stationery 10 Variable
Dividend Not a cost
Printing cost 20 Variable
Internet and data plan cost 12 Fixed
Income tax Not a cost
Web-hosting cost 22 Fixed
Cost of maintaining security around the factory 25 Fixed
u ra nce
Rent 120 Fixed
er ins nce as
Production bonus (related to higher production) 120 Variable sid na
Traveling expense 25 Variable Con mainte ts.
Telephone bill payment 10 Variable and ble cos
a
Sales promotion cost
Annual renewal of export license
50 Variable
30 Fixed
vari
Insurance for vehicle 40 Fixed Ignore for now
Insurance for inventory and other assets of the factory 30 Variable Ignore for now
Sales 5000
Number of unit sold 500
Example
A factory has the following fixed and variable costs. Note that
repair and maintenance cost is a semi-variable cost and here it is
part of fixed cost. The unit price of the item is Rs 30.
Fixed Cost Variable Cost
(Rs/year) (Rs/unit)
Depreciation 20,000
Insurance 5,000
Repair & Maintenance 5,000 0.50
Material 9.50
Labour and Power 10.00
Total 30,000 20.00
a. Find the breakeven quantity to be produced.
b. If the production plan is 2,000 units annually, what is the
profit/loss?
RISKINESS OF LEVERAGED COMPANIES
Total Revenue
(Rs/week) TC2
TC1
F2
F1
Q1* Q2*
(unit/week)
SALES-MIX ANALYSIS
Two products:
Product 1: p1, v1, and F1
Product 2: p2, v2, and F2
We assume a constant mix of c units of product 2 for every one unit
of product 1.
Thus if the breakeven point for product 1 is Q1*, then the breakeven
point for product 2 is Q2* = cQ1*.
Hence,
[(P1)(Q1*) + (P2)(cQ1*)] – [(v1)(Q1*) + (v2)(cQ1*)] – [F1 + F2] = 0
Q1*, and hence Q2* = cQ1*, can be determined.
These values are conditional on the constant sales mix of 1:c.
VARIOUS COST-BEHAVIOUR PATTERNS
Labour Cost (Workers Material Cost Wage Cost
Learning with (Price Rising with (Guaranteed Wage)
Experience) Usage)
Material Cost Machine Cost
(Unit Price (Machines Are
Discounting) Added)
Some representative questions
• Define break-even point. Explain with graphical representation.
• How is operating leverage related to fixed cost and variable
cost?
• Show the total fixed cost, total variable cost, unit fixed cost, and
unit total cost on a graph with respect to number of units.
• What is margin of safety? Explain it with graphical
representation.
• Explain ‘operating leverage’ and ‘financial leverage’ giving
hypothetical data.
• Expect numerical sums.
