VTU MBA Sem 1 Notes on Economics for Managers

1. Module 3
Profit and Break Even Analysis (BEA)
Determinants of short term and long term profits
Introduction: ‘Profit means different meaning to different people – Businessmen, Accountants, Tax
Collector, Worker and Economists’.
For an Economist, Profit would be ‘Pure Profit’ also called ‘Economic Profit’ or Just Profit’, Pure Profit is
the return over and above the ‘Opportunity Cost’ that is the income a businessmen might expect from
the second best alternative use of his resources.
Determinants of short term and long term profits
There are 2 basic concepts that figure in business decisions are ‘Economic Profit’.
“Accounting Profit and Economic Profit”
ACCOUNTING PROFIT can be arrived as follows:
AP = TR (W+R+I+M)
Where AP refers to Accounting Profit, TR refers to Wages and Salaries, R refers to Rent, I refers for
interest and M refers to Cost of Materials.
Here the cost is calculated only on the explicit costs or book cost recorded on books of accounts are
considered
Determinants of short term and long term profits
2. ECONOMIC PROFIT: Economic Profit not only includes the ‘Book Cost or Explicit Cost’ also the ‘Implicit
Cost’ or un authorized costs incurred – Ex: Bribe. (Implicit cost is the opportunity cost [also called as
transfer cost] as the businessmen employs for best or most remunerative alternative employment, it can
be renting his own house for business, or forgoes his salary for his business and so on). Also, Economic
or Pure Profit Cost makes provision of a) Insurable risks, b) Depreciation and Necessary minimum
payments to shareholders to prevent them from withdrawing their capital. Hence “Pure Profit is the
residual left after all contractual costs have been met”.
Determinants of short term and long term profits
Economic Profit or Pure Profit equals Total revenue minus explicit costs and implicit costs
‘Pure Profit = Total Revenue – (Explicit Costs + Implicit Costs)
Or
‘Pure Profit = Accounting Profit – (Opportunity Cost + Unauthorized Payments, Eg Bribe etc)’
Determinants of short term and long term profits
Importance of profit:
Profit gives incentives to shareholders.
Profit ensures compensation to employees and owners.
Profit impacts stock price.
Profit measures the Growth and Efficiency.
Profit for ‘Cash Flow’ and future development.
Determinants of short term and long term profits
Short Run: The short run would refer to a period of time in which the supply of certain inputs such as
plant, building, machinery is FIXED. Hence production can be increased by increasing the other
VARIABLE inputs like labor and raw materials.
Determinants of short term and long term profits
On the other hand, Long Run: The long run refers to a period of time in which the supply of all inputs are
VARIABLE, as production can be increased by employing more of both variable and fixed inputs.
Determinants of short term and long term profits
Economist use another term, Very Long Run, which refer to a period, where the technology of
production is also subject to change or can be improved. In a very long run the production function also

2. changes. The technological advances results in a larger output from a given quantity of inputs per unit of
time.
Determinants of short term and long term profits
Determinants of profit in short and long run:
The objective of a firm is maximization of profit. In short run profits can be maximized by avoiding
maintenance costs, discretionary costs, investments required for the on-going competitiveness as they
experiment with free business game.
1. The ‘profit maximization’ can be done by using the model of monopoly and comparing the two
policies: 1) Extremely High Prices, and 2) A price set from a mark-up of 15% on costs.
2. The other determinants of profits can be 1) rising prices of competitors, 2) better sales conditions and
skills, 3) A higher overall price level allow for higher prices of the considered firm’s products, thus these
increase profits to the extent that costs are inelastic, that is they rise less than the proportionally to
revenue.
Determinants of short term and long term profits
Profit Analysis: Profit analysis is a part, where total revenue and total costs are equal at this break even
point the firm do not experience any income or any loss.
The key components involved in profit analysis include:
Selling price per unit,
Level or Volume of Activity,
Total Fixed Costs,
Per Unit Variable Costs and
Sales Mix.
Determinants of short term and long term profits
Assumptions in profit analysis:
Consistent sales prices,
Unvarying variable cost per unit,
Identical Total Fixed Cost,
Unvarying sales mix,
Units sold equal units produced.
Determinants of short term and long term profits
Approaches to measuring profits:
1. Operating Profit Approach: This Approach is a periodic profit, where profit is measured and reported
as income from operations less expenses from operations.
2. All inclusive Approach: The periodic Profit is measured and reported as the result of ordinary
operations plus adjustments relating to prior period and items of an extraordinary nature and the
effects of some accounting policy changes. This approach is broader than the ‘Operating Profit
Approach’.
3. Comprehensive Income Approach: Under this approach, profit for the period includes all income and
expenses as defined in the framework. In other words, all changes in net assets (that is all recognized
changes in the carrying amount of assets and liabilities), other than transactions with owners are
included in the measurement of profit.
Break Even Point
Break Even Point represents the level of activity where the total cost equals total revenue. It’s the point
of ‘No Profit, No Loss’ and at this level, the firm is said to, ‘Break Even’.
Break even point can be determined with the help of the following formula:
BEP (UNITS)
BEP (Units) = Fixed Cost/ Contribution per unit.
Break Even Point

3. BEP (Value)
1. BEP (Value) = Fixed Cost/ Profit Volume ratio,
Or
2. BEP (Value) = (Fixed Cost/ Contribution) x Sales.
(Graphical representation can be done practically, on LINEAR AND NON-LINEAR BEP)
Break Even Point
Assumptions of Break Even Analysis:
Average per unit sales price (per unit revenue),
Average per unit cost,
Monthly fixed costs,
Break Even Point
Determinants of Break Even Analysis:
Determine the per unit selling price,
Calculate the contribution margin in ‘Rupees per unit’,
Calculate the overhead costs,
Determine the break even point,
Determine BEA on a regular basis
Break Even Point
Uses of Break Even Analysis:
Measure profit and loss at different levels of production and sales,
Predicting the effect of changes in prices of sales,
Analysis the relationship between the fixed and variable cost,
Predicting the effect of profitability if changes in cost and efficiency.
Break Even Point
Advantages:
1. BEA helps the firm to find out the selling price, which proves most profitable for the firm.
2. BEA helps the firm on decisions on start payments of dividends to its shareholders,
3. BEA helps to determine the optimum level of output, which is not profitable,
4. BEA helps to determine the target capacity for a firm to get the benefit of minimum unit cost of
production.
5. BEA can determine minimum cost at a given level of output.
6. BEA helps the firm to decide which product to be produced.
7. BEA helps for decisions on contraction and expansion of the perceived situation.
8. BEA helps to analyze on change in prices and costs on profit of the firm.