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COURSE: MBA-
1
SUBJECT: ME
UNIT:4Profit Management & Risk
Analysis
COURSE CONTENT
Nature, Scope, Theories of profit,
Measurement policies, Cost –
Volume- Profit Analysis.
Risk analysis; investment and
capital replacement decisions
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MEANING AND NATURE OF PROFIT
The term "profit" means all excess of income over
costs.
In economics, profit is regarded as a reward for the
entrepreneurial functions of final decision making
and ultimate uncertainty bearing.
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PROFITS CAN BE EXPRESSED IN THE FOLLOWING
DIFFERENT
WAYS
Gross Profit and Net Profit
It is the excess of revenue receipt over explicit payment
and charges.
Gross profit = Total Revenue – Explicit costs
Normal Profit and Supernormal Profit
Normal profit refers to that portion of profit which is
absolutely necessary for the business to remain in
operation
Super normal profit or abnormal profit could be treated
as any return above the normal profit. It is the residual
surplus after paying for explicit costs, implicit costs and
normal profit.
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THEORIES OF PROFIT
Risk and Uncertainty Theory of Profits
Dynamic Theory of Profit
Innovation Theory of Profits
Profit as a Reward for Organizing other Factors of
Production
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RISK AND UNCERTAINTY THEORY OF PROFITS
Prof. Hawley's Theory
Profit is a reward paid to the organization for undertaking risks
According to Hawley-enterprise is the only real productive factor – land, labour, and capital are subordinate factors and mere means of production
According to Prof. F H Knight risks are an inherent factor in any business and they are of two kinds, insurable risks and non-insurable risks
Prof. Knight advanced the theory that pure economic profit is related to uncertainty
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DYNAMIC THEORY OF PROFIT
Prof. J. B. Clark Theory
In a static economy neither demand nor supply
changes
In a dynamic economy all factors that influence
demand and supply change continuously resulting
in profit or loss
According to Prof. Clark, profits belong essentially
to economic dynamics and not to economic statics
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INNOVATION THEORY OF PROFITS
Prof. J A Schumpeter's theory
Attributes profits to dynamic changes in the
productive process due to the introduction of
modern science and technology of production
techniques
Risk plays no part in this theory and profits are
solely attributed to dynamic development
According to Schumpeter, profit is both the cause
as well as the effect of innovations and thus it is the
cause and effect of economic progress also
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PROFIT AS A REWARD FOR ORGANIZING
OTHER FACTORS OF PRODUCTION
A proportionate combination of the various
infrastructures, men, material, money, machinery,
marketing is quite indispensable to produce the
desired output.
Entrepreneur takes this responsibility to coordinate
these infrastructures to produce products.
A disproportionate combination of factors only
increases cost of production and reduces profits.
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PROFIT MEASUREMENT
The most practical measure of whether firms are
making adequate profits or not
It is called as rate of return on capital
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COST - VOLUME - PROFIT (CVP)
ANALYSIS
Helps management in finding out the relationship
of costs and revenues to profit
Cost is the result of the operation of a number of
varying factors such as:
Volume of production,
Product mix,
Internal efficiency,
Methods of production,
Size of plant, etc.
Of all these, volume is perhaps the largest single
factor which influences costs which can basically be
divided into fixed costs and variable costs
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COST - VOLUME - PROFIT (CVP)
ANALYSIS
What is volume?
Volume is usually expressed in terms of sales
capacity
Expressed as a percentage of maximum sales,
volume of sales, unit of sales, etc.
What is production capacity?
Production capacity is expressed as a
percentage of maximum production, production
in revenue of physical terms, direct labour hours
or machine hours.
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COST - VOLUME - PROFIT (CVP)
ANALYSIS
Analysis of cost-volume-profit involves
consideration of the interplay of the following
factors:
Volume of sales
Selling price
Product mix of sales
Variable cost per unit
Total fixed costs
The relationship between two or more of these
factors may be
presented in the form of reports and statements or
shown in charts or graphs, or
established in the form of mathematical deduction
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OBJECTIVES OF COST-VOLUME
PROFIT ANALYSIS
To forecast profit accurately
Useful in setting up flexible budgets which indicate
costs at various levels of activity.
Assistance in performance evaluation for the
purpose of control
Assist in formulating price
To know the amount of overhead costs which could
be charged to product costs at various levels of
operation
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PROFIT-VOLUME (P/V) RATIO
The ratio or percentage of contribution margin to
sales is known as P/V ratio.
Also known as
Marginal income ratio or
Contribution to sales ratio or
Variable profit ratio
Usually expressed as a percentage
Is the rate at which profits increase with the
increase in volume
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BREAK EVEN ANALYSIS
It examines the relationship between the total
revenue, total costs and total profits of the firm at
various levels of output
Break even point is that volume of sales where the
firm breaks even i.e., the total costs equal total
revenue
A point where losses cease to occur while profits
have not yet begun. That is, it is the point of zero
profit
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ASSUMPTIONS OF BREAK EVEN ANALYSIS
All costs are either perfectly variable or absolutely
fixed over the entire period of production
The volume of production and the volume of sales
are equal
All revenue is perfectly variable with the physical
volume of production
The assumption of stable product mix
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METHODS OF BREAKS EVEN ANALYSIS
The Break even Charts
The Algebraic Method. Pre
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THE BREAK EVEN CHARTS
The difference between price and average variable
cost (P-AVC) is defined as 'profit contribution‘
After fixed costs are covered, the firm will be
earning a profit
A manager may want to know the output rate
necessary to cover all fixed costs and to earn a
"required" profit
Here, P= ProfitTR= Total Revenue
TC=Total Cost
P = TR – TC
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BREAK EVEN ANALYSIS CHART
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EXAMPLES
1. Calculate break even point from following details.
Sales Rs. 42000
Variable Costs 28000
Fixed costs 3000
BEP (Rs)= Fixed Costs
Sales- Variable Costs
= 3000
14000
= 0.21
In Rs. =0.21*42000
=8820 Rs
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Calculate break even point from following details.
Sales Rs. 42000
Variable Costs 28000
Fixed costs 3000
No. of Units 4200
BEP (Units)= Fixed Costs
Selling Price- Variable Cost per Unit
= 3000
10-6.67
= 900
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TRY YOURSELF
Calculate Break Even point (in Rs and Units) for
following
Sales Rs. 90000
Variable Costs 45000
Fixed costs 3000
No. of Units 10000
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RISK ANALYSIS
What is Risk?
The probability that a particular threat will exploit a particular vulnerability
Need to systematically understand risks to a system and decide how to control them.
What is Risk Analysis?
The process of identifying, assessing, and reducing risks to an acceptable level Defines and controls threats and vulnerabilities
Implements risk reduction measures
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BENEFITS OF RISK ANALYSIS
Assurance that greatest risks have been identified
and addressed
Increased understanding of risks
Mechanism for reaching consensus
Support for needed controls
Means for communicating results
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BASIC RISK ANALYSIS STRUCTURE
Evaluate
Value of computing and information assets
Vulnerabilities of the system
Threats from inside and outside
Risk priorities
Examine
Availability of security countermeasures
Effectiveness of countermeasures
Costs (installation, operation, etc.) of countermeasures
Implement and Monitor
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DECISION TREE ANALYSIS- A TOOL FOR RISK
ANALYSIS
A graphical tool for describing
(1) the actions available to the decision-maker,
(2) the events that can occur, and
(3) the relationship between the actions and events.
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INVESTMENT DECISIONS
A determination made
by directors and/or management as to how, when,
where and how much capital will be spent
on investment opportunities.
The decision often follows research to
determine costs and returns for each option.
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TECHNIQUES OR METHODS OF INVESTMENT
EVALUATION
The Payback Period Method
The Average Rate of Return on Investment
The Net Present Value (NPV) Method
The Internal Rate of Return (IRR) Criterion
The Profitability Index Criterion
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CAPITAL REPLACEMENT DECISIONS
Decision on replacing the Machines, Equipments
etc.
Problem is to decided whether to replace the
machine at present or in future
Replacement would be
Whether new machine gives higher receipts or
Reduces the cost of capital
Returns from replacing the machine now rather
than later must be calculated by reference to the
period for which replacement could really be
postponed
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PHASES OF THE BUSINESS CYCLE
BUSINESS CYCLE
Definition: alternating increases and decreases in
the level of business activity of varying amplitude
and length
How do we measure “increases and decreases in
business activity?”
Percent change in real GDP!
Expansion ExpansionRecession
THE PHASES OF THE BUSINESS
CYCLE
Secular growth trend
Trough
Peak
0Jan.-Mar
Tota
l O
utp
ut
Apr.-June
July-Sept.
Oct.-Dec.
Jan.-Mar
Apr.-June
July-Sept.
Oct.-Dec.
Jan.-Mar
Apr.-June
McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
LONG-RUN ECONOMIC GROWTH
Secular long-run growth, or long-run growth, is the sustained upward trend in aggregate output per person over several decades.
A country can achieve a permanent increase in the standard of living of its citizens only through long-run growth. So a central concern of macroeconomics is what determines long-run growth.
RECESSION
What is a recession?
Generally, 2 or more quarters of declining real GDP
Implication: it’s not officially a called a recession until the
economy has already been declining for 6 months!
Who decides when we’re in a recession?
National Bureau of Economic Research traditionally
declares recessions
Private research organization, not a federal agency
Recession dates from peak of business
Innovation
Political events
Random events
Wars
Level of consumer spending
Seasonal fluctuations
Cyclical Impacts — durable and non
durable
Causes of Fluctuations
Source:
Manquee book managerial economics.
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