Dilla University

School of Business and Economics

MBA program

Managerial Economics assignment of Breakeven analysis, and national income and welfare
Prepared by Tesfaye Hailu Submitted to Dr. Richards ID No. 009/11

July, 2012 Dilla, Ethiopia

Breakeven point in production and cost analysis

Introduction
One of the most common tools used in evaluating the economic feasibility of a new enterprise or product is the break-even analysis. The break-even point is the point at which revenue is exactly equal to costs. At this point, no profit is made and no losses are incurred. The breakeven point can be expressed in terms of unit sales or dollar sales. That is, the break-even units indicate the level of sales that are required to cover costs. Sales above that number result in profit and sales below that number result in a loss. The break-even sale indicates the dollars of gross sales required to break-even. It is important to realize that a company will not necessarily produce a product just because it is expected to breakeven. Many times, a certain level of profitability or return on investment is desired. If this objective cannot be reached, which may mean selling a substantial number of units above break-even, the product may not be produced. However, the break-even is an excellent tool to help quantify the level of production needed for a new business or a new product. Break-even analysis is based on two types of costs: fixed costs and variable costs. Fixed costs are overhead-type expenses that are constant and do not change as the level of output changes. Variable expenses are not constant and do change with the level of output. Because of this, variable expenses are often stated on a per unit basis. Once the break-even point is met, assuming no change in selling price, fixed and variable cost, a profit in the amount of the difference in the selling price and the variable costs will be recognized. One important aspect of break-even analysis is that it is normally not this simple. In many instances, the selling price, fixed costs or variable costs will not remain constant resulting in a change in the break-even. And these changes will change the break-even. So, a break-even cannot be calculated only once. It should be calculated on a regular basis to reflect changes in costs and prices and in order to maintain profitability or make adjustments in the product line.

Breakeven analysis estimates the minimum level of performance (breakeven point) needed to cover all relevant costs. Real world examples would include: a restaurant manager knowing how many customers he needs to serve per day to cover his total costs a veterinarian knowing the she needs to pregnancy check at least 100 cows per week to cover her costs a greenhouse manager knowing that she needs to sell at least 85% of her poinsettias during December to cover the costs a cattleman knowing that he needs to get at least $95/cwt for his feeder calves a dairyman knowing that he needs to get 200 cwts of milk per cow a landscaper knowing that she needs to do 75 jobs per year to justify buying a tractor versus leasing one.

Break-even analysis is a technique widely used by production management and management accountants. It is based on categorising production costs between those which are "variable" (costs that change when the production output changes) and those that are "fixed" (costs not directly related to the volume of production). Total variable and fixed costs are compared with sales revenue in order to determine the level of sales volume, sales value or production at which the business makes neither a profit nor a loss (the "break-even point"). The Break-Even Chart In its simplest form, the break-even chart is a graphical representation of costs at various levels of activity shown on the same chart as the variation of income (or sales, revenue) with the

same variation in activity. The point at which neither profit nor loss is made is known as the "break-even point" and is represented on the chart below by the intersection of the two lines:

In the diagram above, the line OA represents the variation of income at varying levels of production activity ("output"). OB represents the total fixed costs in the business. As output increases, variable costs are incurred, meaning that total costs (fixed + variable) also increase. At low levels of output, Costs are greater than Income. At the point of intersection, P, costs are exactly equal to income, and hence neither profit nor loss is made. Fixed Costs Fixed costs are those business costs that are not directly related to the level of production or output. In other words, even if the business has a zero output or high output, the level of fixed costs will remain broadly the same. In the long term fixed costs can alter - perhaps as a result of investment in production capacity (e.g. adding a new factory unit) or through the growth in overheads required to support a larger, more complex business. Examples of fixed costs: - Rent and rates - Depreciation

- Research and development - Marketing costs (non- revenue related) - Administration costs Variable Costs Variable costs are those costs which vary directly with the level of output. They represent payment output-related inputs such as raw materials, direct labour, fuel and revenue-related costs such as commission. A distinction is often made between "Direct" variable costs and "Indirect" variable costs. Direct variable costs are those which can be directly attributable to the production of a particular product or service and allocated to a particular cost centre. Raw materials and the wages those working on the production line are good examples. Indirect variable costs cannot be directly attributable to production but they do vary with output. These include depreciation (where it is calculated related to output - e.g. machine hours), maintenance and certain labour costs. Semi-Variable Costs Whilst the distinction between fixed and variable costs is a convenient way of categorising business costs, in reality there are some costs which are fixed in nature but which increase when output reaches certain levels. These are largely related to the overall "scale" and/or complexity of the business. For example, when a business has relatively low levels of output or sales, it may not require costs associated with functions such as human resource management or a fully-resourced finance department. However, as the scale of the business grows (e.g. output, number people employed, number and complexity of transactions) then more resources are required. If production rises suddenly then some short-term increase in warehousing and/or transport may be required. In these circumstances, we say that part of the cost is variable and part fixed.

NATIONAL INCOME
Definition: According to Alfred Marshall, National Income is the labour and Capital of a country, acting on its natural resources, produced annually a certain net aggregate of commodities and in materials including services of all kinds. This is the net annual income or revenue of the country or the true national dividend. According to A.C.Pigou The national income dividend is that part of the objective income of the community, including, the income derived from aboard which can be measured in Money.

Different concepts of National Income

1. Gross National Product (GNP): According to W.C. Peterson GNP may be defined as the current market value of all goods & services produced by the economy during an economic period. GNP is the aggregate money value or market value of the final goods and services produced by a country in a year before deducting the wear & tear or depreciation charges required to be provided for the replacement of worn out capital assets. 2. Net National Product (NNP): It is the agreegate market value of final goods and services produced in a country in a year after deducting depreciation charges provided for the replacement of worn out capital assets.

It should be noted that, in the competitive of the net national product depreciation charges should be deducted from the gross national product. This is necessary, because, in the process of production some capital assets are used up a part of final goods

services produced has to be set apart as depreciation charges to the replacement of warm-out capital assets.

3. Gross Domestic Product (GOP): It refers to the monetary value of all the final products & services produced within the country. It can also be defined as the GNP of the country excluding the net export earning That is: The GNP Income from abroad 4. Net Domestic Product (NOP): It is the net national product of the country excluding net export earnings. In other words, it is the net market value of all final goods & services produced within the country without taking into account the net export earnings. 5. Gross National Product at Factor Cost: It is the sum of the money value of incomes earned by & accruing to various factor of production in a country. It excludes indirect taxes on goods, but includes subsides. Gross national product at factor cost= Gross national product at market prices Indirect taxes + Subsidies 6. National Income at Factor Cost: Net National Income at factor cost is the sum total of factors rewards, such as wages, rent, interest and profit earned by the suppliers of various factors of production for their contribution of land, labour, capital & organization in a year. To obtain national income at cost, Indirect taxes levied on goods should be deducted from net national product because these taxes do not go to the supplies of factors.

Subsides should be added to the net national product, because they form part of the payment for factors of production. National income at factor cost = Net national product Indirect taxes + subsidies

7. Gross National Product at Market Prices: Refers to the gross value of final goods and service produced annually in a country + net income from abroad. 8. Net National Product at Market prices: It is the net value of final goods and services valued at market prices. Net national product at market prices = Gross national product at market prices depreciation. 9. Net Domestic Product or Factor Cost: It means that national product which is made by the domestic factors of production of the country during the period of a year. It can be obtained by deducting the net Income received from abroad. NDP at factor or Cost= NN pat factor cost Net income from abroad.

National welfare
What is Economic Welfare?
Before knowing the relation between economic welfare and national income, it is essential to define economic welfare. Welfare is a state of the mind which reflects human happiness and satisfaction. In actuality, welfare is a happy state of human mind. Pigou regards individual welfare as the sum total of all satisfactions experienced by an individual; and social welfare as the sum total of individual welfares. He divides welfare into economic welfare and noneconomic welfare. Economic welfare is that part of social welfare which can directly or indirectly be measured in money. Pigou attaches great importance to, economic welfare because welfare is a very wide term. In his, words: "The range of our enquiry becomes restricted to that part of social (general) welfare that can be
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brought directly or indirectly into relation with the measuring rod of money." On the contrary, non-economic welfare is that part of social, welfare which cannot be measured in money, for instance moral welfare.

But it is not proper to differentiate between economic and non-economic welfare on the basis of money. Pigou also accepts it. According to him, non-economic welfare can be improved upon in two ways. First, by the income-earning method longer hours of working and unfavorable conditions will affect economic welfare, adversely. Second, by the income spending method. In economic welfare it is assumed that expenditures incurred on different consumption goods provide the same amount of satisfaction, but in actuality it is not so, because when the utility of purchased goods starts diminishing the non-economic welfare declines which results in reducing the total welfare. But Pigou is of the view that it is not possible to calculate such effects, because non-economic welfare cannot be measured in terms of money. The economist should, therefore, proceed with the assumption that the effect of economic causes on economic welfare applies also to total welfare. Hence, Pigou arrives at the conclusion that the increase in economic welfare results in the increase of total welfare 'and vice versa. But it is not possible always, because the causes welfare lead to an increase in economic welfare may also reduce the non-economic welfare. The increase in total welfare may, therefore, be Jess than anticipated. For instance, with the increase in income, both the economic, welfare and total welfare increase and vice versa. But economic welfare depends not only on the amount of income but also on the methods of earning and spending it. When the workers earn more by working in factories but reside in slums and vitiated atmosphere, the total welfare cannot be said to have increased, even though the economic welfare might have increased. Similarly, as a result of increase in their expenditure proportionately to, income, the total welfare cannot be presumed to have increased, if they spend their increased income, on harmful commodities like wine, cigarettes etc. Hence, economic welfare is not an indicator of total welfare.

National Income and National Welfare

Relation between Economic Welfare and National Income

Pigou establishes a close relationship between economic welfare and national income, because both of them are measured. in terms of money. When national income increases, total welfare also increases and vice-versa. The effect of national income on economic welfare can be studied in two ways:. I. Changes in size of national income and economic welfare II. Change in the composition of national income and economic welfare III. Changes in the distribution of national income and economic welfare. (i) The change in the size of national income and economic welfare: There is direct relationship between size of national income and economic welfare. The changes in the size of national income and economic welfare may be positive or negative. The positive change in the national income increases its volume, as a result people consume more of goods and services, which. leads in increase in the economic welfare. Whereas the negative change in national income results in reduction of its volume; People get lesser goods and services for consumption which leads to decrease in economic welfare. But this relationship depends on a number of factors. (ii) Changes in the composition of national income and economic welfare: composition of national income refers to the kind of the goods and services produced in the country. Change in the composition of national income may sometimes increase economic welfare and may at another time decrease it. (iii). Changes in the distribution of national income and economic welfare: Changes in the distribution of national income and economic welfare take place in two ways: First, by transfer of wealth from the poor to the rich, and

Second, from the rich to the poor. When as a result of increase in national income, the transfer of wealth takes place in the former manner, the economic welfare decreases. This happens when the government gives more privileges to the richer sections and imposes regressive taxes on the poor. The actual relation between the distribution of national income and economic welfare concerns the latter form of transfer when wealth flows from the rich to the poor. The redistribution of wealth in favor of the poor is brought about by reducing the wealth of the rich and increasing the income of the poor. The income of the richer sections can be reduced by adopting a number of measures, e.g., by progressive taxation on income, property etc., by imposing checks on monopoly by nationalizing social services, by levying duties on costly and foreign goods which are used by the rich and so on. On the other hand, the income of the poor can ,also be raised in a number of ways, e.g., by fixing a minimum wage rate, by increasing the production of goods used by the poor, and by fixing the prices of such goods. By granting financial assistance to the producers of these goods, by the distribution of goods through cooperative stores, and by providing free education, social security and low rent accommodation to the poor. When through these methods the distribution of income takes, place ill favor of the poor, the economic welfare increases.

Limitations of National Income as a measure of National Welfare:

1. National Income estimate considers only those transactions which are carried through money. It does not take into A/c the portion of output especially the farm output. If the portion of output kept for self consumption is also brought to the market, the national Income will increase, though the total output in the country has not really increased. So, increase in income does not result in increase in economic welfare. 2. The N.I. at current prices cannot be a proper indicator of the economic welfare of the community. This is because if the prices changes, the N.I. also charges. But the actual production of the economy does not change. So, if the income alone increases without an increase in production, economic welfare cannot increase. 3. The per capita Income is a better index that the N.I. to measure economic welfare of a country. 4. The per capita Income also is not a foolproof index of economic welfare. This is because, if the growth of population in the country is at a higher rate than the increase it the real national income of the country, the per capita income and the economic welfare of the people will decrease.