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Dilla University
School of Business and Economics
MBA program
Managerial Economics assignment of Break-even analysis, and national income and welfare
Prepared by Tesfaye Hailu ID No. 009/11
Submitted to Dr. Richards
July, 2012
Dilla, Ethiopia
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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 break-
even 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.
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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
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- 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.
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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 thecurrent 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 servicesproduced 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
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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 netexport 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 incomesearned 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 offactors 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
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7. Gross National Product at Market Prices: Refers to the gross value of final goods andservice 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 servicesvalued 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 bythe 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 non-
economic 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
brought directly or indirectly into relation with the measuring rod of money."1
On the contrary,
non-economic welfare is that part of social, welfare which cannot be measured in money, for
instance moral welfare.
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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
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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
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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:
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1. National Income estimate considers only those transactions which are carried throughmoney. 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 thecommunity. 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 acountry.
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.