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

Pre

pa

red B

y: M

itika M

ah

aja

n

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.

Pre

pa

red B

y: M

itika M

ah

aja

n

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.

Pre

pa

red B

y: M

itika M

ah

aja

n

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

Pre

pa

red B

y: M

itika M

ah

aja

n

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

Pre

pa

red B

y: M

itika M

ah

aja

n

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

Pre

pa

red B

y: M

itika M

ah

aja

n

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

Pre

pa

red B

y: M

itika M

ah

aja

n

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.

Pre

pa

red B

y: M

itika M

ah

aja

n

PROFIT MEASUREMENT

The most practical measure of whether firms are

making adequate profits or not

It is called as rate of return on capital

Pre

pa

red B

y: M

itika M

ah

aja

n

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

Pre

pa

red B

y: M

itika M

ah

aja

n

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.

Pre

pa

red B

y: M

itika M

ah

aja

n

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

Pre

pa

red B

y: M

itika M

ah

aja

n

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

Pre

pa

red B

y: M

itika M

ah

aja

n

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

Pre

pa

red B

y: M

itika M

ah

aja

n

Pre

pa

red B

y: M

itika M

ah

aja

n

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

Pre

pa

red B

y: M

itika M

ah

aja

n

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

Pre

pa

red B

y: M

itika M

ah

aja

n

METHODS OF BREAKS EVEN ANALYSIS

The Break even Charts

The Algebraic Method. Pre

pa

red B

y: M

itika M

ah

aja

n

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

Pre

pa

red B

y: M

itika M

ah

aja

n

BREAK EVEN ANALYSIS CHART

Pre

pa

red B

y: M

itika M

ah

aja

n

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

Pre

pa

red B

y: M

itika M

ah

aja

n

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

Pre

pa

red B

y: M

itika M

ah

aja

n

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

Pre

pa

red B

y: M

itika M

ah

aja

n

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

Pre

pa

red B

y: M

itika M

ah

aja

n

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

Pre

pa

red B

y: M

itika M

ah

aja

n

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

Pre

pa

red B

y: M

itika M

ah

aja

n

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.

Pre

pa

red B

y: M

itika M

ah

aja

n

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.

Pre

pa

red B

y: M

itika M

ah

aja

n

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

Pre

pa

red B

y: M

itika M

ah

aja

n

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

Pre

pa

red B

y: M

itika M

ah

aja

n

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.

www.Slideshare.com

www.Wikipedia.com

www.Google.com