## FYBCOM Economics Sem 1 Chapter 8 Notes

(Extension of Cost Analysis)

**Q.1) Select the correct answer from the alternatives given and rewrite the sentences: **

1) At the break-even point, the price is equal to _______ cost.

a) Total

b) Marginal **c) Average **d) Variable

2) At the shutdown point, price is equal to average _______ cost.

a) Fixed **b) Variable**c) Above

d) Below

3) When the fixed cost level of output.

a) Falls **b) Rises **c) Remains constant

d) Shfits down

4) The shutdown and break-even points are the break-even point _____.

a) Same **b) Different **c) Irrelevant

d) Equal

5) Break-even point is reached when a firm .**a) earns zero profit **b) covers fixed cost

c) covers variable cost

6) A firm is at break even point when

a) TR > TC

b) TR < TC **c) TR = TC . **

7) A break-even point changes whenever there is change in

a) Price

b) Fixed cost

c) Variable cost **d) AIl three factors **

8) Break-even point is easily worked out in case of a

a) Joint-product firm

b) Multiple-products firm **c) Single product**

9) A firm earns Supernormal profit when its

a) TR = TC **b) TR > TC **c) TR < TC

**Q.2) Answer the Following Questions **

### 1) Explain the concept of break-even point with the help of diagram.

**Answer: **Break-even analysis studies the **relationship **between total cost, total revenue, total profits and losses over a** range** of **output**.

Break-even point is a point where the **total revenue **of the firm is equal to total cost.

Therefore, at **break-even point** there is no profit, no loss.

**Break-even analysis** technique is used in the business to determine the level of production or sales volume which is necessary for the business to cover its cost of doing a business.

In **financial analysis** the concept of **break-even point** is most commonly used.

The concept of break-even point can be explained with the help of following.

Output | TR | TC | Profit/ Loss |

0 | 0 | 1200 | -1200 |

1 | 1000 | 1500 | -500 |

2 | 1400 | 1800 | -400 |

3 | 2000 | 2000 | 0 |

4 | 2600 | 2200 | 400 |

5 | 3500 | 3000 | 500 |

Above table shows that break-even level of output is 3 units because, firms **TR **and **TC **are equal at 3 units of output and therefore there is no profit, no loss.

Break-even point can also be explained with the help of following diagram

Above diagram is drawn on the basis of the **assumption **that **TR** and **TC** curves are linear i.e. **TR** and **TC **increases at a constant rate with an increase in the level of output. Therefore, **TR** and **TC** curves are straight lines.

For initial levels of output total cost is greater than total revenue therefore the firm is making loss. At output **OQ**, firm stops making loss, **TR=TC **therefore there is no profit no loss. Thus, **OQ**

is the break-even output and B1 is the break-even point. After **OQ** level of output total revenue is greater than total cost and thus firm starts making profit.

When **TR** and **TC** curves are linear, there is only **one break-even point**. According to above diagram entire output after break-even output gives profit. However, this may not be true because of changes in **price** and cost.

If we do not consider constant change in **TR **and** TC, TR and TC** curves are non-linear.

In this case we have more than one break-even point as shown in the following diagram-

In the above diagram on the** Y axis** we measure **cost **and **revenue **and on the **X axis **

we measure output.

In case of **non-linear TR **and **TC curves **there two break-even points **P **and **Q**, indicating lower level of output **OM **and higher level of output **ON **respectively.

For any output less than **OM** and greater than **ON**, firm makes losses because **TC>TR**.

Between the range of output **M **and **N**, **TR>TC **and thus firm makes profit.

### 2) Discuss with the help of diagram how break-even point changes due to change in price and fixed cost.

**Answer:** **Any change in price **will have an effect on **total revenue** and therefore also on break-even point. If we consider the same example 1 and consider an increase in price to** Rs.17,** and keep fixed cost and average variable cost constant, break-even quantity is-

QB = FC/ P-AVC

= 4000/17-7

= 4000/10

= 400 units.

If we consider fall in price to Rs. 12, keeping fixed cost and average variable cost constant, break-even quantity is-**QB** = FC/P-AVC

= 4000/12-7

= 4000/5

= 800 units.

This shows that with an increase in price, break-even quantity falls and with a fall in price, break-even quantity increases.

Effect of changes in price on break-even point and break-even quantity can be explained with the help of following diagram.

In the above diagram X axis measures output and Y axis measures cost and revenue. With an initial TR and TC curves A is the break-even point, where TR and TC curves intersects.

If price increases, TR curve shifts upward from TR to TR1. This will bring down the break-even point from A to A1.

Similarly, with a fall in price, TR curve shifts downward to TR2 and thus break-even point also shifts to A2.

- Changes in fixed cost

For the same mathematical example 1 if we change the fixed cost and keep price and average variable cost constant, we have changes in breakeven quantity.

Suppose fixed cost increases to Rs. 5000, break-even quantity is-**QB **= FC/P-AVC

= 5000/15-7

= 5000/8

= 625 units.

If fixed cost falls to Rs. 3600, break-even quantity is-**QB **= FC/P-AVC

= 3600/15-7

= 3600/8

= 450 units.

This shows that with an increase in fixed cost, break-even quantity increases and with a fall in fixed cost, break-even quantity falls.

Changes in break-even point due to changes in fixed cost can be explained with the help of following diagram-

On the **X axis **we measure output and on the **Y axis **we measure cost and revenue. With an initial **TR **and **TC **curves initial break-even point is **B **initial break even quantity is **OQ **if fixed cost increases, **TFC curve **shifts upward to **TFC1**. As total cost is the **addition **of **TFC **and **TVC**, TC curve will also shift upward to **TC1**.

This shifts the break-even point at higher level to **B1**. Break even quantity has also increased from **OQ **to **OQ1**.

On the other hand, if **TFC falls**, **TFC curve **will shift downward to **TFC2**. This will shift the **TC **curve down to **TC2**.

Therefore, new break-even point is **B2** & new break even quantity falls from **OQ** to **OQ2**.

### 3) Explain changes in break-even point due to change in total variable cost.

**Answer:** if TFC falls, **TFC** curve will shift downward to **TFC2**. This will shift the **TC** curve down to **TC2**.

Therefore, new break-even point is **B2** & new break even quantity falls from **OQ** to **OQ2**.

- Changes in variable cost per unit

Using the same **mathematical** problem if we keep **price** and **fixed cost constant** and change the variable cost per unit, we have a change in break-even quantity.

Suppose the average variable cost per unit increases to Rs. 10, break-even quantity is**QB** = FC/P-AVC

= 4000/15-10

= 4000/5

= 800 units.

If variable cost per unit falls to Rs. 5, break-even quantity is**QB **= FC/P-AVC

= 4000/15-5

= 4000/10

= 400 units.

This shows that with an increase in per unit variable cost, break-even quantity increases and with a fall in average variable cost, break-even quantity falls.

**This can be discussed with the help of following diagram-**

In the above diagram **X axis **measures output and **Y axis **measures cost and revenue. Initial break-even point is **C** where **TR **and **TC **curves intersect. Initial break even quantity is **OQ**. With an increase in **TVC**, **TVC **curve shifts to **TVC1**.

This also shifts **TC **curve to **TC1**. **TVC1 **and **TC **are parallel to each other. Thus, the

new break-even point shifts upward to **C1 **& break even quantity increases from **OQ **to **OQ1**.

With a fall in **TVC**, **TVC **curve shifts to **TVC2**, shifting down **TC **curve to **TC2**. Thus, the new break-even point also shifts down to **C2**. Again, **TVC2 **and **TC2 **are parallel to each other. New break even quantity falls from **OQ **to **OQ2**.

### 4) Discuss the implications and limitations of break-even analysis.

**Answer:** Linear **TR **and **TC **curves gives wrong impression that the entire output after break-even point is profitable. But this is not always **true**.

In case of single product unit, break-even analysis can be applied. But in case of **multiple **or joint **products **it is difficult to apply break-even analysis as long as cost cannot be determined

for each of the product.

The **data **required for break-even analysis including costs, price etc. is generally historical.

If historical data is not proper for estimating **future costs** and **prices**, break-even analysis cannot be usefully applied.

If it is possible to clearly classify costs as **fixed **and **variable costs**, break-even analysis is more useful. But sometimes it is not possible to have such classification of costs.

Even though there are various limitations of break-even analysis, it is useful in production planning if proper data is obtained.

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