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8/8/2019 Ch 5 Profit Analysiss
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Profit Analysis
By
Kanchana Iyer
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Introduction
Reward to the entrepreneur
It may be negative
It can be expressed in different ways
according to the rationale.
It is the residual income and not the
contractual income Highly fluctuating
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Types of Profit
Gross Profit and Net Profit:
GP: Excess of revenue over all explicit payments.(wages, taxes, depreciation)
NP: Its is also known as pure profit. Implicit Costs hasto be deducted from Gross Profit to arrive for NetProfits.
Normal and Super Normal Profit:
NP: Profits necessary to remain in the operation (Min) SNP: It is the residual surplus over explicit costs,
implicit costs and normal profits.
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Types of Profit
Accounting Profit and Economic Profit:
AP: It is the revenue obtained during the
period minus the cost and expenses incurred toproduce the goods responsible for getting the
revenue.
EP: It take into account both explicit and
implicit costs. It reflects true profitabilityposition of the business enterprise.
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Theories of Profit
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RiskTheory of Profit
Given by Prof Hawley
Profit as a reward for venturing into
something risky. Higher the risk, higher the reward.
Businesses are speculative in nature andtherefore reward is necessary for the riskbearer.
Profit is the risk premium
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Uncertainty Theory of Profit
Given by Prof F H Knight
Risks are inherent factors of business but can bedivided into insurable and non insurable risks.
The insurable risks are predictable and can beinsured and the insurance premium becomes apart of the price / costs
Only the non insurable risks become responsiblefor emergence of profits.
Uncertainty bearing rather than risk bearingimportant
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Dynamic Theory of Profit
Given By Prof Clark
Dynamic economy leads to constant changes indemand and supply force and leads to constant
change in the profit / loss conditions. The dynamics leads to the profits which is again
a temporary phenomena.
Dynamic changes can be introduced by the firm
also, in the form of mew technology, product,process, ad, salesmanship etc and this can lead tochange in the level.
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Innovation Theory of Profits
Prof Schumpeter:
Profit is both cause and effect of
innovation Innovation brings change in consumers
tastes and preferences
When innovation becomes obsolete, profitsdisappear.
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Profit for organizing other
factors of Production An entrepreneur is responsible for
coordinating infrastructures, men ,machine
etc and the profit is reward for his skill inmanaging all the resources.
It is a payment for the efficient and
effective utilization to the optimum pointof the resources in order to reach the target
or goal
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Objectives of a firm
Profit maximization
Sales maximization
Revenue Maximization Industry leadership
Cost control
Maintain liquidity
Consumer goodwill
Fight competition
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Profit Measurement
Rate of return on capital:
Net profit * 100
Fixed capitalLow returns do not always indicate low profits
but sometimes indicate the high overheads
among which the profits get distributed
Graph:
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Equilibrium of the firm
Profit = TR TC
Condition of maximization: First order derivative
should be 0 dr - dc = 0
dq dq
dr = dc
dq dq
MR = MC
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Cost Volume Profit Analysis
Profit Sales Volume ofCosts Production
The revenue generated depends on market
conditions, competitors, taste of consumerswhich are external therefore not alwayscontrollable.
On the other hand, the profits can be controlled
by controlling the costs which is related to thevolume of production. (that is why the analysis isknown as CVP relations
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Cost Volume Profit Analysis
CVP Analysis gives a picture profit levelsof activity.
Volume is usually expressed in terms ofsales capacity expressed as a percentage ofmaximum sales, volume of sales, unit ofsales etc
It will involve volume of sales. Price,product mix of sales, variable costs,overhead costs
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Objectives of CVP analysis
To know the relationship bet profits and
costs as well bet profit and volume.
To know and set costs (budgets) at variouslevel of activity.
To evaluate performance for control
To formulate price policies.
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Profit- Volume Ratio
P/V ratio = Marginal Contribution /Sales
or
Sales value Variable CostsSales value
Sales value Variable Costs
Sales value
Fixed Cost + Profit
Sales Value
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Break Even Analysis
It relates revenue, costs and total profits ofthe firm at various levels of output
BEP point is that volume of sales wherethe firm the total costs will be equal to totalrevenue.
It is the point of 0 profit
BEP = Fixed Costs
Selling Price Variable Costs
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Assumptions
Perfect distinction of costs into fixed and
variable costs
Whatever is produced is sold (Production =Sales)
Revenue is perfectly variable with
production (Straight Line) Stable Product Mix
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Utility
Effect of Pricing Policy
Product Method and its impact on costs/rev
To adjust cost and revenue to achieve thetargeted profits
Better margin of profit betweenalternatives.
Level of production to be maintained toearn quick profits.
http://wwwbizedacuk
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BE Chart
http://www.bized.ac.uk
Break-Even AnalysisCosts/Revenue
Output/Sales
FC
VCTCTR TR
Q1
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Implications
Both cost and revenue curve are linear
curve. (Constant variable costs and
constant MR) Effect of change in Price
Effect of change in VC
Effect of change in FC In a non linear function
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Contribution Margin
Total Contribution Profit : Difference
between total revenues and total variable
costs. On a per unit basis , it is equal to
difference between the price and average
variable costs.
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Advantages
To determine optimum level of output
To decide the ideal production level (capacity)
To choose projects from alternatives To know the impact of changes in price and costs
on profits.
To know the pricing policy
Situations like hire or purchase, add or drop,
expand or divert.