02 - basic of economics

PRODUCTION

BASIC OF ECONOMICS & INVESTMENTS EVALUATION

Alessandro Chiaraviglio

Introduction to break-even analysis Break-even analysis is a technique widely used by

production management and management accountants. It is based on categorising production costs between those which are "variable" (costs that change when the production output changes) and those that are "fixed" (costs not directly related to the volume of production).

Total variable and fixed costs are compared with sales revenue in order to determine the level of sales volume, sales value or production at which the business makes neither a profit nor a loss (the "break-even point").

INDUSTRIAL PLANT & SAFETY BASIC OF ECONOMICS

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 newfactory unit) or through the growth in overheads required to support a larger, more complex business.

Examples of fixed costs: - Rent and rates - Depreciation - 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 Semi-variable cost is an expense which contains both a fixed-cost

component and a variable-cost component. The fixed cost element shall be a part of the cost that needs to be paid irrespective of the level of activity achieved by the entity. On the other hand the variable component of the cost is payable proportionate to the level of activity.

Cost of energy, such as electricity, is a good example as it is integral to production of goods and services. This component straddles both the fixed and variable universe because electrical power is essential for the basic operation of the business in lighting and heating this portion is a sunk cost that is foregone regardless of production. As demand ramps up, more energy is required to ramp up the production process in the use of machinery or large banks of computers for instance. Cost of electrical energy will then riseaccordingly as production activities increase. Therefore, the cost of electricity can be viewed as semi-variable.


Break-even analysis In its simplest form, the break-even chart is a graphical

representation of costs at various levels of activity shown on the same chart as the variation of income (or sales, revenue) with the 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:

RT=CTP x Q = CF + Cvu x Q

Q(BEP) = CF / (P Cvu)

LegendaRT = total revenueCT = total costQ = salesP = unit priceCvu = unit variable costCF = total fixed cost


Break-even analysis


Introduction to investment evaluation Investment appraisal is the planning process used to determine

whether an organization's long term investments such as new machinery, replacement machinery, new plants, new products, and research development projects are worth pursuing. It is budget for major capital, or investment, expenditures.

Many formal methods are used in capital budgeting, including thetechniques such as Net present value Payback period Internal rate of return Economic value added

INDUSTRIAL PLANT & SAFETY INVESTMENT EVALUATION

Financial Markets

Financial MarketsOperations

OperationsFinancialManager

FinancialManager

InvestmentDecision

FinancingDecision

How much to invest and in what assets?

Where is the $ going to

come from?

Mirror MaskNoteInvestment appraisal : Techniques for determining whether an investment is likely to be profitable

Net present value (NPV) NPV is the value of an investment calculated as the sum of its initial

cost and the present value of expected future cash flows. A positive NPV indicates that the project should be profitable,

assuming that the estimated cash flows are reasonably accurate. A negative NPV indicates that the project will probably be unprofitable and therefore should be adjusted, if not abandoned altogether.

NPV enables management to consider the time-value of money it will invest. This concept holds that the value of money increases with time because it can always earn interest in a savings account. When the time-value-of-money concept is incorporated in the calculation of NPV, the value of a project's future net cash receipts in "today's money" can be determined. This enables proper comparisons between different projects.


Net present value (NPV)

Legenda: Ft = net cash flow i.e. cash inflow cash outflow, at time t k = discount rate i.e. opportunity cost of capital or WACC F0 = investment


06

6

5

5

4

4

3

3

2

21

)1()1()1()1()1()1(F

k

F

k

F

k

F

k

F

k

F

k

FNPV

++

++

++

++

++

+=

=

+=

n

tt

t Fk

FNPV

1

0)1(

Payback period Payback period in capital budgeting refers to the period of time required for

the return on an investment to "repay" the sum of the original investment. All else being equal, shorter payback periods are preferable to longer

payback periods. Payback period is widely used because of its ease of use despite the recognized limitations described below.

The payback period is considered a method of analysis with serious limitations, because it does not account for the time value of money, risk, financing or other important considerations.

The discounted payback period is the amount of time that it takes to cover the cost of a project, by adding positive discounted cash flow coming from the profits of the project.


Legenda: Ft = net cash flow i.e.

cash inflow cash outflow, at time t

k = discount rate F0 = investment

==

PBP

tt FF

10 0

=+=

PBP

tt

t Fk

F

10 0

)1(

Internal rate of return (IRR) In a discounted cash flow calculation, the rate of interest that

reduces future income streams to the cost of the investment; practically speaking, the rate that indicates whether or not an investment is worth pursuing.

Typically, managements require an IRR equal to or higher than the cost of capital, depending on relative risk and other factors.


=

=

+

n

tt

t FIRR

F

1

0 0)1(

REA

k*

10%

20%

864

2514

k

NPV

IRR

Legenda: Ft = net cash flow i.e.

cash inflow cash outflow, at time t

k = discount rate F0 = investment

Economic value added (EVA) Economic Value Added or EVA, is an estimate of a firm's economic

profit being the value created in excess of the required return of the company's investors (being shareholders and debt holders).

Quite simply, EVA is the profit earned by the firm less the cost of financing the firm's capital. The idea is that value is created when the return on the firm's economic capital employed is greater than the cost of that capital.


CIWACCCI

NOPATEVA

=

NOPAT (net operating profit after taxes) is profits derived from a companys operations after cash taxes but before financing costs. It is the total pool of profits available to provide a cash return to those who provide capital to the firm.

CI (economic capital employed) is the amount of cash invested in the business, net of depreciation. It can be calculated as the sum of interest-bearing debt and equity or as the sum of net assets less non-interest-bearing current liabilities.

WACC (weighted average cost of capital) is the minimum rate of return on capital required to compensate investors (debt and equity) for bearing risk, their opportunity cost.

02 - basic of economics

Documents