UNIT-V

Nature of Profit
Profit, in business usage, the excess of total revenue over total cost during a specific
period of time. In economics, profit is the excess over the returns to capital, land,
and labour (interest, rent, and wages). In economic terms profit is defined as a reward
received by an entrepreneur by combining all the factors of production to serve the need
of individuals in the economy faced with uncertainties.

Theories of Profit or Different Views on Profit

The following points highlight the top seven theories of profit. The theories are: 1. Rent
Theory of Profit 2. Wage Theory of Profit 3. Risk Theory of Profit 4. The Dynamic Theory
of Profit 5. Schumpeter’s Innovation Theory 6. Uncertainty Bearing Theory of
Profit 7. Marginal Productivity Theory of Profit.

Theory # 1. Rent Theory of Profit:

This theory was first propounded by the American Economist Walker. It is based on the
ideas of Senior and J.S. Mill. According to Mill, “the extra gains which any producer obtains
through superior talents for business or superior business arrangements are very much of
a kind similar to rent. Walker says that “Profits are of the same genus as rent”. His theory
of profits states that profit is the rent of superior entrepreneur over marginal of less
efficient entrepreneur.

According to these economists, there was a good deal of similarity between rent and profit.
Rent was the reward for the use of land while a profit was the reward for the ability of the
entrepreneur. Just as land differs from one another in fertility, entrepreneurs differ from
one another in ability. Rent of superior land is determined by the difference in productivity
of the marginal and super marginal land; similarly the profits of the marginal and super
marginal entrepreneurs.

In short it is the intra-marginal lands that earn a surplus over marginal lands. So also intra
marginal entrepreneurs earn a surplus over marginal entrepreneur. Just as there is the
marginal land, there is the marginal entrepreneur. The marginal land yields no rent; so
also marginal entrepreneur is a no profit entrepreneur.

The marginal entrepreneur sells his produce at cost price and gets no profit. He secures
only the wages of management not profit. Thus profit does not enter into cost of
production. Like rent, profit also does not enter into price. Profit is thus a surplus.

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Criticism:

1. According to critics there cannot be perfect similarity between rent and profit. Rent is
generally positive and in rare cases it may be zero. But rent can never be negative. When
entrepreneur suffers losses profit can be negative.

2. The theory explains profit as the differential surplus rather than a reward for an
entrepreneur.

3. Profit is not always the reward for business ability. Profit can be due to monopoly or it
can arise due to favourable chance to the entrepreneur.

4. This theory maintains that there is no profit entrepreneur just as no rent land. But in
practical life there is no such entrepreneur because whether the entrepreneur has ability
or not be gets profit as his reward.

5. The system of joint stock enterprise has become more important in the modern
economy. The manner in which dividends are distributed among the shareholders is not
at all related to latter’s ability. Both dull and intelligent shareholders enjoy the same
dividends. In fact, the less able may secure more dividends if they possess more shares.

6. This theory assumes that profit does not enter into price. But this is unrealistic because
profit as a part of the cost of production does enter into price.

7. Rent is a known and expected surplus. It is also a contractual payment. Profit is

unknown.

8. Walker has analysed only surplus profit. But profit can be several other types.’

9. Walker failed to understand the true nature of profit. According to Walker, profit arose
on account of the ability of the entrepreneur to undertake risk. Critics point out that profit
is not the reward for undertaking risk but it is the reward for the avoidance of risk.

Theory # 2. Wage Theory of Profit:

This theory was propounded by Taussig, the American economist. According to this theory,
profit is also a type of wage which is given to the entrepreneur for the services rendered
by him. In the words of Taussig, “profit is the wage of the entrepreneur which accrues to
him on account of his ability”.

Just as a labourer receives wages for his services, the entrepreneur works hard gets profit
for the part played by him in the production. The only difference is that while labourer
renders physical services, entrepreneur puts in mental work. Thus an entrepreneur is not
different from a doctor, lawyer, teacher, etc., who do mental work. Profit is thus a form of
wage.

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Criticism:

1. The main defect of this theory is that it does not make a distinction between wage and
profit. Wages are fixed and certain, but profits are uncertain income.

2. The entrepreneurs undergo risk in production; but the labourer undertakes no such risk.

3. Entrepreneur bears the entire responsibility to organize the business, but labourer need
not do so.

4. Profits tend to vary with price but wages do not vary so.

5. The labourer get his wages if he has put in the required amount of labour, but the
entrepreneur may not get profit even if he works hard.

6. Profit may include chance gain while wages do not include such an element.

Theory # 3. Risk Theory of Profit:

This theory is associated with American economist Hawley. According to him profit is the
reward for risk-taking in business. Risk-taking is supposed to be the most important
function of an entrepreneur. Every production that is undertaken in anticipation of demand
involves risk. According to Drucker there are four kinds of risk. They are replacement,
obsolescence, risk proper and uncertainty.

The first two are calculated and therefore they are insured. But the other two are unknown
and unforeseen risks. It is for bearing such risk profit is paid to entrepreneur. No
entrepreneur will be willing to undertake risks if he gets only the normal return.

Therefore, the reward for risk-taking must be higher than the actual value of the risk. If
the entrepreneur does not receive the reward, he will not be prepared to undertake the
risk. Thus higher the risk greater is the possibility of profit.

According to Hawley the entrepreneur can avoid certain risks for a fixed payment to the
insurance company. But he cannot get rid of all risks by means of insurance. If he does so
he is not an entrepreneur and would earn only wages of management and not profit.

Criticism:

1. Risk-taking is not the only entrepreneurial function which leads to emergence of profits.
Profits are also due to the organizational and coordinating ability of the entrepreneur. It is
also reward for innovation.

2. According to Carver profit is paid to an entrepreneur not for beaming the risk but for
minimizing and avoiding risk.

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3. This theory assumes that profit is proportional to risk undertaken by entrepreneurs. But
this is not true in practical life because even entrepreneurs who do not take any risk are
paid profit.

4. Knight says that it is not every risk that gives profit. It is unforeseen and non-insured
risks that account for profit. According to Knight risks are of two types viz., foreseeable
risk and unforeseeable risk. The risk of fire in a factory is a foreseeable risk and can be
covered through insurance. The premium paid for the fire insurance can be included in the
cost of production. The entrepreneur can foresee such a risk and insures it. An insurable
risk in reality is no risk and profit cannot arise due to insurable risk.

5. There is little empirical evidence to prove that entrepreneurs earn more in risky
enterprises. In a way all enterprises are risky, for an element of uncertainty is present in
them and every entrepreneur aims at making large profits.

Theory # 4. The Dynamic Theory of Profit:

Prof. J.B. Clark propounded the dynamic theory of profit in the year 1900. To him profit is
the difference between the price and the cost of production of the commodity. Profit is the
result of progressive change in an organized society.

The progressive change is possible only in a dynamic state. According to Clark the whole
economic society is divided into organized and unorganized society. The organized society
is further divided into static and dynamic state. Only in dynamic state profit arises.

In a static state, the five generic changes such as the size of the population, technical
knowledge, the amount of capital, method of production of the firms and the size of the
industry and the wants of the people do not take place; everything is stagnant and there
is no change at all. The element of time is non-existent and there is no uncertainty. The
same economic features are repeated year after year.

Therefore there is not risk of any kind to the entrepreneur. The price of the good will be
equal to the cost of production. Hence profit does not arise at all. The entrepreneur would
get wages for his labour and interest on his capital. If the price of the commodity is higher
than the cost of production, competition would reduce the price again to the level of the
cost of production so that profit is eliminated.

The presence of perfect competition makes the price equal to the cost of production which
eliminates the super normal profit. Thus Knight observes, “Since costs and selling prices
are always equal, there can be no profit beyond wages for the routine work of supervision”.

It is well known that the society has always been dynamic. Several changes are taking
place in a dynamic societ

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According to Clark five major changes are constantly taking place in a society. They are:

(1) Changes in the size of the population,

(2) Changes in the supply of capital,

(3) Changes in production techniques,

(4) Changes in the forms of industrial organisation, and

(5) Changes in human wants.

These dynamic changes affect the demand and supply of commodities which leads to
emergence of profit. Sometimes individual firms may introduce dynamic changes. For
example, a firm may improve its production technique, reduce its cost and thereby
increase its profit. The typical dynamic change is an invention. This enables the
entrepreneur to produce more and reduce costs, leading to emergence of profit.

Criticism:

1. It is wrong to say that there is no profit in static state because every entrepreneur is
paid profit irrespective of the state of an economy.

2. This theory does not fully appreciate the nature of the entrepreneurial function. If there
are no profits in a static state, it means there is no entrepreneur. But without an
entrepreneur it is not possible to imagine how different factors of production would be
employed.

3. Mere change in an economy would not give rise to profits if those changes are
predictable. It is only the unpredictable, provision can be made for such changes and the
expenditure can be included in the cost of production.

4. This theory assumes the existence of perfect competition and static state. But they are
far from reality.

5. This theory states that profit arises because of dynamic changes. But Knight says that
it is only unforeseen changes that give rise to profit.

6. This theory associates’ profit for imitating progressive changes in the economy. But in
reality, profit is paid to entrepreneur for other important functions like risk taking and
uncertainty bearing.

7. According to Taussig, “dynamic theory has created unnecessary and artificial distinction
between “profits” and wage of management”.

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Theory # 5. Schumpeter’s Innovation Theory:

This theory was propounded by Schumpeter. This theory is more or less similar to that of
Clark’s theory. Instead of five changes mentioned by Clark, Schumpeter explains the
change caused by innovations in the production process. According to this theory profit is
the reward for innovations. He uses the term innovation in a sense wider than that of the
changes mentioned by Clark.

Innovation refers to all those changes, in the production process with an objective of
reducing the cost of commodity so as to create gap between the existing price of the
commodity and its new cost. Innovation may take any shape like introduction of a new
technique or a new plant, a change in the internal structure or organizational set up of the
firm or change in the quality of raw material, a new form of energy, better method of
salesmanship, etc.

Schumpeter makes a distinction between invention and innovation. Innovation is brought

about mainly for reducing the cost of production and it is cost reducing agent. Profit is the
reward for this strategic role, Innovations are not possible by all entrepreneurs. Only
exceptional entrepreneurs can innovate. They are capable of tapping new resources,
technical knowledge and reduce the cost of production. Thus the main motive for
introducing innovation is the desire to earn profit. Profit is therefore the cause of
innovation.

Profits are of temporary nature. The pioneer who innovates earns abnormal profit for a
short period. Soon other entrepreneurs, “swarm in clusters”, compete for profit in the
same manner. The pioneer will make another innovation. In a dynamic world innovation
in one field may induce other innovations in related fields.

The emergence of motor car industry may in turn stimulate new investments in the
construction of highways, rubber, tyresm and petroleum products. Profits are thus causes
and effects of innovation. The interest of profit leads entrepreneur to innovate and
innovation leads to profit. Thus, profit has a tendency to appear, disappear and reappear.

Profits are caused by innovation and disappear by imitation. Innovational profit is thus,
never permanent, in the opinion of Schumpeter. Therefore, it is different from other
incomes, such as rent, wages and interest. These are regular and permanent incomes
arising under all circumstances. Profit on the other hand is a temporary surplus resulting
from innovation.

Prof. Schumpeter also explained his views on the functions of the entrepreneur. The
entrepreneur organizes the business and combines the various factors of production. But
this is not his real function and this will not yield him profit. The real function of the

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entrepreneur is to introduce innovations in business. It is innovations which yield him
profit.

Criticisms:

1. This theory concentrates only on innovation, which is only one of the many functions of
the entrepreneur and not the only factor.

2. This theory does not consider profit as the reward for risk-taking. According to
Schumpeter it is the capitalist not the entrepreneur who undertakes risk.

3. This theory has ignored the importance of uncertainty bearing which is one of the factors
that determines profit.

4. This theory attributes profit only to innovation ignoring other functions of entrepreneur.

5. Monopoly profits are permanent in nature while Schumpeter says that innovate profits
occur temporarily.

6. This theory has presented a very narrow view of the function of the entrepreneur. He
not only introduces innovation but he is equally responsible for proper organisation of the
business. As such profit is not merely due to innovation. It is also due to organizational
work performed by the entrepreneur. As it is well known, every entrepreneur does not
innovate and yet he must earn profit if he is to stay in business.

7. It is an incomplete theory because it has failed to explain all the factors that influence
profit.

Theory # 6. Uncertainty Bearing Theory of Profit:

This theory was propounded by an American economist Prof. Frank H. Knight. This theory,
starts on the foundation of Hawley’s risk bearing theory. Knight agrees with Hawley that
profit is a reward for risk-taking. There are two types of risks viz. foreseeable risk and
unforeseeable risk. According to Knight unforeseeable risk is called uncertainty beaming.

Knight, regards profit as the reward for bearing non-insurable risks and uncertainties. He
distinguishes between insurable and non-insurable risks. Certain risks are measurable, the
probability of their occurrence can be statistically calculated. The risks of fire, theft, flood
and death by accident are insurable. These risks are borne by the insurance company.

The premium paid for insurance is included in the cost of production. According to Knight
these foreseen risks are not genuine economic risks eligible for any remuneration of profit.
In other words insurable risk does not give rise to profit.

According to Knight profit is due to non-insurable risk or unforeseeable risk.

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Some of the non- insurable risks which arise in modern business are as follows:

(a) Competitive risk:

Some new firms enter into the market unexpectedly. The existing firms may have to face
serious competition from them. This will inevitably lower down the profit of the firms.

(b) Technical risk:

This risk arises from the possibility of machinery becoming obsolete due to the discovery
of new processes. The existing firm may not be in a position to adopt these changes into
its organization, and hence suffer losses.

(c) Risk of government intervention:

The government, in course of time, interferes into the affairs of the industry such as price
control, tax policy, import and export restrictions, etc., which might reduce the profits of
the firm.

(d) Cyclical risk:

This risk emerges from business cycles. Due to business recession or depression,
consumer’s purchasing power is reduced, consequently demand for the product of the firm
also falls.

(e) Risk of demand:

This is generated by a shift or change of demand in the market.

Prof. Knight calls these risks as ‘uncertainties’ and ‘it is uncertainties in this sense which
explains profit in the proper use of the term’. These risks cannot be foreseen and
measured, they become non- insurable and the uncertainties have to be borne by the
entrepreneur. According to this theory there is a direct relationship between profit and
uncertainty bearing.

Greater the uncertainty bearing the higher the level of profit. Uncertainty beaming has
become so important in business enterprise in modern days, it has come to be considered
as a separate factor of production. Like other factors it has a supply price and
entrepreneurs undertake uncertainty bearing in the expectation of earning certain level of
profit. Profit is thus the reward for assuming uncertainty.

In the modern days production has to take place In advance of consumption. The
producers have to face their rival producers and the future is uncertain and unknown.
These are uncertainties. Some entrepreneurs are able to see it more clearly than others
and therefore able to earn profit.

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Criticism:

1. According to this theory, profit is the reward for uncertainty bearing. But critics point
out that sometimes an entrepreneur earns no profit in spite of uncertainty bearing.

2. Uncertainty bearing is one of the determinants of profit and it is not the only
determinant. Profit is also a reward for many other activities performed by entrepreneur
like initiating, coordinating and bargaining, etc.

3. It is not possible to measure uncertainty in quantitative terms as depicted in this theory.

4. In modern business corporations ownership is separate from control. Decision-making

is done by the salaried managers who control and organise the corporation. Ownership
rests with the shareholders who ultimately bear uncertainties of business. Knight does not
separate ownership and control and this theory becomes unrealistic.

5. Uncertainty bearing cannot be looked upon as a separate factor of production like land,
labour or capital. It is a psychological concept which forms part of the real cost of
production.

6. Monopoly firms earn much larger profits than competitive firms and they are not due to
the presence of uncertainty. This theory throws no light on monopoly profit.

Knight’s theory of profit is more elaborate than other theories, because it combines the
conception of risk, of economic change and of the role of business ability.

Theory # 7. Marginal Productivity Theory of Profit:

The general theory of distribution is also applied to the factor, entrepreneur. According to
Prof. Chapman, profits are equal to the marginal worth of the entrepreneur and are
determined by the marginal productivity of the entrepreneur. When the marginal
productivity is high, profits will be high.

Just as marginal revenue productivity of any factor represents the demand curve of a
factor the marginal revenue productivity curve of entrepreneur is the demand curve of an
entrepreneur. As more and more firms enter into the industry, the marginal revenue
productivity (MRP) of entrepreneurship decreases. The slope of the MRP curve will be
negative. The supply curve of entrepreneur will be perfectly elastic under perfect
competition.

Criticism:

1. This theory is not a satisfactory theory of profit because it is very difficult to calculate
the marginal productivity of entrepreneurship.

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2. Like land, labour, or capital the marginal revenue productivity of entrepreneurship is a
meaningless concept in the case of a firm because unlike other factors, there can be only
one entrepreneur in a firm.

3. This theory is based on the homogeneity of entrepreneur, in an industry. Entrepreneurs

differ in efficiency. It is therefore, not possible to have one marginal revenue productivity
curve for all entrepreneurs. This theory thus fails to determine profit accurately.

4. This theory fails to explain why entrepreneurs sometimes earn windfall or chance gains
and even monopoly profits.

5. It is one-sided theory which takes into account only the demand for entrepreneurs and
neglects supply of entrepreneurs.

6. It is a static theory according to which all entrepreneurs earn only normal profits in the
long- run. In the real world entrepreneurs earn more than normal profit due to its dynamic
nature.

In conclusion it can be stated that there are essentially three kinds of profit theories which
have been developed during last two centuries. The functional theory of profit regards
profit as a reward for a factor of production. Secondly the rent theory of profit regards
profit as a residual income or as excess of price over costs. The institutional theory
emphasises unearned nature of profit as monopoly profit.

None of the theories is satisfactory. Each theory explains profit in terms of one function
rather than in terms of all the functions. Economists are of the opinion that it is very
difficult to state an adequate theory of profit.

Profit Functions

Functions of Profit:

Profit is the primary objective of all business organizations. The expectation of earning
higher profits of business organizations induces them to invest money in new ventures.
This results in large employment opportunities in the economy which further raises the
level of income. Consequently, there is a rise in the demand for goods and services in the
economy. In this way, profit generated by business organizations play a significant role in
the economy.

According to Peter Ducker, there are three main purposes of profit, which are explained
as follows:

i. Tool for measuring performance:

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Refers to the fact that profit generated by an organization helps in estimating the
effectiveness of its business efforts. If the profits earned by an organization are high, it
indicates the efficient management of its business. However, profit is not the most efficient
measure of estimating the business efficiency of an organization, but is useful to measure
the general efficiency of the organization.

ii. Source of covering costs:

Helps organizations to cover various costs, such as replacement costs, technical costs, and
costs related to other risks and uncertainties. An organization needs to earn sufficient
profit to cover its various costs and survive in the business.

iii. Aid to ensure future capital:

Assures the availability of capital in future for various purposes, such as innovation and
expansion. For example, if the retained profits of an organization are high, it may invest
in various projects. This would help in the business expansion and success of the
organization.

Apart from aforementioned functions, following are the positive results of high profits:

i. Investment in research and development:

Leads to better technology and dynamic efficiency. An organization invests in research and
development activities for its further expansion, if it earns high profit. The organization
would lose its competitiveness, if it does not invest in research and development activities.

ii. Reward for shareholders:

Includes dividends for shareholders. If an organization earns high profits, it would provide
high dividends to shareholders. As a result, the organization would attract more investors,
which are crucial for the growth of the organization.

iii. Aid for economies:

Implies that profits are helpful for economies. If organizations generate high profits, they
would be able to cope with adverse economic situations, such as recession and inflation.
This results in stability of economies even in adverse situations.

iv. Tool to stimulate government finances:

Implies that if the profits generated by organizations are high, they are liable for paying
high taxes. This helps government to earn high revenue and spend for social welfare.

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Measurement of Profit

The problem of profit measurement has always been a difficult affair. In the present
business world, the tendency is to discard the word ‘profit’ and use a neutral expression
as “business income”. In the accounting sense, profit is an ex-post concept. Accountants
follow conventions and define their terms by enumeration.

Conventional accounting is largely concerned with historical profits rather than anticipated
profits. Economists disagree with conventional techniques and they define their terms
functionally. For an economist, profit is an ex-ante concept.

It is a surplus in excess of all opportunity costs or the difference between the cash value
of an enterprise at the beginning and end of a period. From the management point of view,
economic profits are a better reflection of profitability of business. The economist is
basically interested in the theoretical analysis of profit.

The most important points of difference between the economist’s and

accountant’s approaches centre around:

(i) Inclusiveness of Costs:

To determine profits, economists include in costs, wages, rent and interest for all the
services employed in the business, including both those actually paid for in the market
and virtual wage or interest or rent for services rendered by the owner himself.

To determine profits, accountants only deduct explicit or paid out costs from the income.
The non-cost items as the entrepreneurial wages, rental income on land and the interest
that the capital could earn elsewhere do not appear in the books of accounts.

The economist s costs of production are a payment which is necessary to keep resources
out of the next best alternative employment. The economist does not agree with the
accountant’s approach. The accountant would only deduct actual costs from the revenues,
the economist points out that in addition to the deduction of actual cost imputed cost
should also be deducted.

(ii) Depreciation:

The treatment of depreciation has an important bearing on the measurement of profit. To

the economist, depreciation is capital consumption cost. The cost of capital consumption
is the replacement cost of the equipment. It has various meanings. In the accounting
sense, it refers to the writing off the unamortised cost over the useful life of an asset. In
the value sense, it may be defined as the lessening in the value of a physical asset caused
by deterioration.

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Economists recognise only two kinds of depreciation charges and they are:

(a) The opportunity cost of the equipment, and

(b) The exhaustion of a year’s worth of limited valuable life.

The former includes the most profitable alternative use of it that is forgone by putting it
into its present use, while the latter aims at preserving enough capital so that the
equipment may be replaced without causing any loss. Both these concepts are useful to
the management.

(iii) Inventory valuation

In managerial Economics we should consider inventory value. Inventory depends on the

methods like FIFO, LIFO, average stock and base stock.

Policies of Profit Maximisation

It is generally held that the main motive of a firm is to make profits. The volume of profit
made by it is regarded as a primary measure of its success. Economic theory advocates
profit maximisation as the chief policy of a firm. Modem business enterprises do not accept
this view and relegate the profit maximisation theory to the back ground. This does not
mean that modem firms do not aim at profits. They do aim at maximum profits but aim
at other goals as well. All these constitute the profit policy.

(i) Industry Leadership:

Industry leadership may involve either the achievement of the maximum sales volume or
the manufacture of the maximum product lines. For the attainment of leadership in the
industry, there has to be a satisfactory level of profit consistent with capital invested,
labour force employed and volume of output produced.

(ii) Restricting the Entry:

If a firm follows a policy of restricting its profit, no competitors are likely to enter the
market. Reasonable profits which guarantee its survival and growth are essential.
According to Joel Dean, “Competitors can invade the market as soon as they discover its
profitability and find ways to shift the patents and make necessary changes in design,
technique, and production plant and market penetration.”

(iii) Political Impact:

High profits are considered to be suicidal for a firm. If the government comes to know that
the firms are earning huge returns, it may resort to high taxation or to nationalisation.

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High profits are often considered as an index of monopoly power and to prevent the
government may introduce price control and profit regulation policies.

(iv) Consumer Goodwill:

Consumer is the foundation of any business. For maintaining consumer goodwill, firms
have to restrict the profit. By maintaining low profit, the firms may seek the goodwill of
the consumers. Consumer goodwill is valued so much these days that firms often make
organised efforts through advertisements.

(v) Wage Consideration:

Higher profits may be taken as an evidence of the ability to pay higher wages. If the labour
associations come to know that the firms are declaring higher dividends to the
shareholders, naturally they demand higher wages, bonus, etc. Under these circumstances
in the interest of harmonious relations with employees, firms keep the profit margin at a
reasonable level.

(vi) Liquidity Preference:

Many concerns give greater importance to capital soundness of a firm and hence prefer
liquidity to profit maximisation. Liquidity preference means the preference to hold cash to
meet the day to day transactions. The first item that attracts one’s attention in the balance
sheet is the ratio of current assets to current liabilities. In order to give capital soundness,
the business concerns keep less profit and maintain high cash.

(vii) Avoid Risk:

Avoiding risk is another objective of the modem business for which the firms have to
restrict the profit. Risk element is high under profit maximisation. Managerial decision
involving the setting up of a new venture has to face a number of uncertainties. Very often
experienced managements avoid the possibility of such risks. When there is oligopolistic
uncertainty, firms may focus attention at minimising losses. The guiding principle of
business economics is not maximisation of profit but the avoidance of loss.

(viii) Market Share :

Company sales do not reveal how well the company is performing. If the company’s market
share goes up, the company is gaining as a competitor, if it goes down the company is
losing relative to competitors.

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Profit Planning

Profit planning deals with management accounting techniques such as Break-even

analysis, also known as cost-volume-profit (CVP) analysis.It is used by management to
help understand the relationships between cost, sales volume and profit. This technique
focuses on how selling prices, sales volume, variable costs, fixed costs and the mix of
product sold affects profit. Understanding some of the basic tenets of CVP analysis can
help you analyse these factors in your business and make better business decisions.
Break-even point is the level of sales activity at which the business makes zero profit (no
gain, no loss).

Assumptions of BEA
✓ The cost function and revenue function are linear
✓ Total cost is divided into fixed cost and variable cost
✓ The selling price is constant
✓ The volume of sales and volume of production are identical
✓ Average and marginal productivity of factors are constant
✓ Product mix is stable for multi-product firm
✓ Factor price is constant
Limitations of BEA
✓ It is static
✓ It is unrealistic
✓ In case of multi products we have to calculate break even points for each one.
✓ Its scope is limited to the short run only

Uses of Break- Even Analysis

The following points highlight the top ten managerial uses of break-even analysis. the
managerial uses are: 1. Safety Margin 2. Target Profit 3. Change in Price 4. Change in
Costs 5. Decision on Choice of Technique of Production 6. Make or Buy Decision 7. Plant
Expansion Decisions 8. Plant Shut Down Decisions 9. Advertising and Promotion Mix
Decisions 10. Decision Regarding Addition or Deletion of Product Line.

Use # 1. Safety Margin:

The break-even chart helps the management to know at a glance the profits generated at
the various levels of sales. The safety margin refers to the extent to which the firm can
afford a decline before it starts incurring losses.

Use # 2. Target Profit:

The break-even analysis can be utilised for the purpose of calculating the volume of sales
necessary to achieve a target profit.

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When a firm has some target profit, this analysis will help in finding out the
extent of increase in sales by using the following formula:

Target Sales Volume = Fixed Cost + Target Profit/Contribution Margin Per Unit.

Use # 3. Change in Price:

The management is often faced with a problem of whether to reduce prices or not. Before
taking a decision on this question, the management will have to consider a profit. A
reduction in price leads to a reduction in the contribution margin.

This means that the volume of sales will have to be increased even to maintain the
previous level of profit. The higher the reduction in the contribution margin, the higher is
the increase in sales needed to ensure the previous profit.

The formula for determining the new volume of sales to maintain the same profit, given a
reduction in price, will be

New Sales Volume = Total Fixed Cost + Total Profit/New Selling Price – Average Variable
Cost

Use # 4. Change in Costs:

When costs undergo change, the selling price and the quantity produced and sold also
undergo changes.

Changes in cost can be in two ways:

(i) Change in variable cost, and

(ii) Change in fixed cost.

(i) Variable Cost Change:

An increase in variable costs leads to a reduction in the contribution margin. This reduction
in the contribution margin will shift the break-even point downward. Conversely, with the
fall in the proportion of variable costs, contribution margins increase and break-even point
moves upwards.

Under conditions of changing variable costs, the formula to determine the new
quantity or the new selling price are:

(a) New Quantity or Sales Volume = Contribution to Margin/Present Selling Price – New
Variable Cost Per Unit

(b) New Selling Price = Present Sale Price + New Variable Cost-Present Variable Cost

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(ii) Fixed Cost Change:

An increase in fixed cost of a firm may be caused either due to a tax on assets or due to
an increase in remuneration of management, etc. It will increase the contribution margin
and thus push the break-even point upwards. Again, to maintain the earlier level of profits,
a new level of sales volume or new price has to be found out.

New Sales Volume = Present Sale Volume + (New Fixed Cost + Present Fixed Costs)/
(Present Selling Price-Present Variable Cost)

New Sale Price = Present Sale Price + (New Fixed Costs – Present Fixed Costs)/Present
Sale Volume

Use # 5. Decision on Choice of Technique of Production:

A firm has to decide about the most economical production process both at the planning
and expansion stages. There are many techniques available to produce a product. These
techniques will differ in terms of capacity and costs.

The breakeven analysis is the most simple and helpful in the case of decision on a choice
of technique of production. For example, for low levels of output, some conventional
methods may be most probable as they require minimum fixed cost.

For high levels of output, only automatic machines may be most profitable. By showing
the cost of different alternative techniques at different levels of output, the break-even
analysis helps the decision of the choice among these techniques.

Use # 6. Make or Buy Decision:

Firms often have the option of making certain components or for purchasing them from
outside the concern. Break-even analysis can enable the firm to decide whether to make
or buy.

Use # 7. Plant Expansion Decisions:

The break-even analysis may be adopted to reveal the effect of an actual or proposed
change in operation condition. This may be illustrated by showing the impact of a proposed
plant on expansion on costs, volume and profits. Through the break-even analysis, it would
be possible to examine the various implications of this proposal.

Use # 8. Plant Shut Down Decisions:

In the shut-down decisions, a distinction should be made between out of pocket and sunk
costs. Out of pocket costs include all the variable costs plus the fixed cost which do not

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vary with output. Sunk fixed costs are the expenditures previously made but from which
benefits still remain to be obtained e.g., depreciation.

Use # 9. Advertising and Promotion Mix Decisions:

The main objective of advertisement is to stimulate or increase sales to all customers—

former, present and future. If there is keen competition, the firm has to undertake
vigorous campaign of advertisement. The management has to examine those marketing
activities that stimulate consumer purchasing and dealer effectiveness.

The break-even point concept helps the management to know about the circumstances. It
enables him not only to take appropriate decision but by showing how these additional
fixed costs would influence BEPs. The advertisement cost pushes up the total cost curve
by the amount of advertisement expenditure.

Use # 10. Decision Regarding Addition or Deletion of Product Line:

If a product has outlived its utility in the market immediately, the production must be
abandoned by the management and examined what would be its consequent effect on
revenue and cost. Alternatively, the management may like to add a product to its existing
product line because it expects the product as a potential profit spinner. The break-even
analysis helps in such a decision.

Breakeven Chart

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