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Managerial Economics
Price elasticity of demand:
.

PED is derived from the percentage change in quantity (%Qd) and percentage change in price (%P). Price elasticity of demand (PED or Ed) is a measure used in economics to show the responsiveness, or elasticity, of the quantity demanded of a good or service to a change in its price. More precisely, it gives the percentage change in quantity demanded in response to a one percent change in price (holding constant all the other determinants of demand, such as income). It was devised by Alfred Marshall. Price elasticities are almost always negative, although analysts tend to ignore the sign even though this can lead to ambiguity. Only goods which do not conform to the law of demand, such as Veblen and Giffen goods, have a positive PED. In general, the demand for a good is said to be inelastic (or relatively inelastic) when the PED is less than one (in absolute value): that is, changes in price have a relatively small effect on the quantity of the good demanded. The demand for a good is said to be elastic (or relatively elastic) when its PED is greater than one (in absolute value): that is, changes in price have a relatively large effect on the quantity of a good demanded. Revenue is maximised when price is set so that the PED is exactly one. The PED of a good can also be used to predict the incidence (or "burden") of a tax on that good. Various research methods are used to determine price elasticity, including test markets, analysis of historical sales data and conjoint analysis. Definition PED is a measure of responsiveness of the quantity of a good or service demanded to changes in its price. The formula for the coefficient of price elasticity of demand for a good is:

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The above formula usually yields a negative value, due to the inverse nature of the relationship between price and quantity demanded, as described by the "law of demand".For example, if the price increases by 5% and quantity demanded decreases by 5%, then the elasticity at the initial price and quantity = 5%/5% = 1. The only classes of goods which have a PED of greater than 0 are Veblen and Giffen goods. Because the PED is negative for the vast majority of goods and services, however, economists often refer to price elasticity of demand as a positive value (i.e., in absolute value terms). This measure of elasticity is sometimes referred to as the own-price elasticity of demand for a good, i.e., the elasticity of demand with respect to the good's own price, in order to distinguish it from the elasticity of demand for that good with respect to the change in the price of some other good, i.e., a complementary or substitute good. The latter type of elasticity measure is called a cross-price elasticity of demand. As the difference between the two prices or quantities increases, the accuracy of the PED given by the formula above decreases for a combination of two reasons. First, the PED for a good is not necessarily constant; as explained below, PED can vary at different points along the demand curve, due to its percentage nature. Elasticity is not the same thing as the slope of the demand curve, which is dependent on the units used for both price and quantity. Second, percentage changes are not symmetric; instead, the percentage change between any two values depends on which one is chosen as the starting value and which as the ending value. For example, if quantity demanded increases from 10 units to 15 units, the percentage change is 50%, i.e., (15 10) 10 (converted to a percentage). But if quantity demanded decreases from 15 units to 10 units, the percentage change is 33.3%, i.e., (15 10) 15. Two alternative elasticity measures avoid or minimise these shortcomings of the basic elasticity formula: point-price elasticity and arc elasticity.

Point-price elasticity:
One way to avoid the accuracy problem described above is to minimise the difference between the starting and ending prices and quantities. This is the approach taken in the definition of point-price elasticity, which uses differential calculus to calculate the elasticity for an infinitesimal change in price and quantity at any given point on the demand curve:

In other words, it is equal to the absolute value of the first derivative of quantity with respect to price (dQd/dP) multiplied by the point's price (P) divided by its quantity (Qd). In terms of partial-differential calculus, point-price elasticity of demand can be defined as follows: let be the demand of goods as a function of parameters price and wealth,

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and let be the demand for good . The elasticity of demand for good respect to price pk is

with

However, the point-price elasticity can be computed only if the formula for the demand function, Qd = f(P), is known so its derivative with respect to price, dQd / dP, can be determined. Arc elasticity A second solution to the asymmetry problem of having a PED dependent on which of the two given points on a demand curve is chosen as the "original" point and which as the "new" one is to compute the percentage change in P and Q relative to the average of the two prices and the average of the two quantities, rather than just the change relative to one point or the other. Loosely speaking, this gives an "average" elasticity for the section of the actual demand curve i.e., the arc of the curvebetween the two points. As a result, this measure is known as the arc elasticity, in this case with respect to the price of the good. The arc elasticity is defined mathematically as:

This method for computing the price elasticity is also known as the "midpoints formula", because the average price and average quantity are the coordinates of the midpoint of the straight line between the two given points. However, because this formula implicitly assumes the section of the demand curve between those points is linear, the greater the curvature of the actual demand curve is over that range, the worse this approximation of its elasticity will be. History

The illustration that accompanied Marshall's original definition of PED, the ratio of PT to Pt Together with the concept of an economic "elasticity" coefficient, Alfred Marshall is credited with defining PED ("elasticity of demand") in his book Principles of Economics,
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published in 1890. He described it thus: "And we may say generally: the elasticity (or responsiveness) of demand in a market is great or small according as the amount demanded increases much or little for a given fall in price, and diminishes much or little for a given rise in price". He reasons this since "the only universal law as to a person's desire for a commodity is that it diminishes... but this diminution may be slow or rapid. If it is slow... a small fall in price will cause a comparatively large increase in his purchases. But if it is rapid, a small fall in price will cause only a very small increase in his purchases. In the former case... the elasticity of his wants, we may say, is great. In the latter case... the elasticity of his demand is small. Mathematically, the Marshallian PED was based on a point-price definition, using differential calculus to calculate elasticities. Determinants: The overriding factor in determining PED is the willingness and ability of consumers after a price change to postpone immediate consumption decisions concerning the good and to search for substitutes ("wait and look").A number of factors can thus affect the elasticity of demand for a good: Availability of substitute goods: the more and closer the substitutes available, the higher the elasticity is likely to be, as people can easily switch from one good to another if an even minor price change is made; There is a strong substitution effect. If no close substitutes are available the substitution of effect will be small and the demand inelastic.

Breadth of definition of a good: the broader the definition of a good (or service), the lower the elasticity. For example, Company X's fish and chips would tend to have a relatively high elasticity of demand if a significant number of substitutes are available, whereas food in general would have an extremely low elasticity of demand because no substitutes exist. Percentage of income: the higher the percentage of the consumer's income that the product's price represents, the higher the elasticity tends to be, as people will pay more attention when purchasing the good because of its cost; the income effect is substantial. When the goods represent only a negligible portion of the budget the income effect will be insignificant and demand inelastic, Necessity: the more necessary a good is, the lower the elasticity, as people will attempt to buy it no matter the price, such as the case of insulin for those that need it. Duration: for most goods, the longer a price change holds, the higher the elasticity is likely to be, as more and more consumers find they have the time and inclination to search for substitutes. When fuel prices increase suddenly, for instance, consumers may still fill up their empty tanks in the short run, but when prices remain high over several years, more consumers will reduce their demand for fuel by switching to carpooling or public transportation, investing in vehicles with greater fuel economy or taking other measures. This does not hold for consumer durables such as the cars themselves, however; eventually, it may become necessary for consumers to replace their present cars, so one would expect demand to be less elastic.

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Brand loyalty: an attachment to a certain brandeither out of tradition or because of proprietary barrierscan override sensitivity to price changes, resulting in more inelastic demand. Who pays: where the purchaser does not directly pay for the good they consume, such as with corporate expense accounts, demand is likely to be more inelastic. Interpreting values of price elasticity coefficients:

Perfectly inelastic demand

Perfectly elastic demand Elasticities of demand are interpreted as follows: Value Descriptive Terms Ed = 0 Perfectly inelastic demand - 1 < Ed < 0 Inelastic or relatively inelastic demand Ed = - 1 Unit elastic, unit elasticity, unitary elasticity, or unitarily elastic demand - < Ed < - 1 Elastic or relatively elastic demand Ed = - Perfectly elastic demand A decrease in the price of a good normally results in an increase in the quantity demanded by consumers because of the law of demand, and conversely, quantity demanded decreases when
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price rises. As summarized in the table above, the PED for a good or service is referred to by different descriptive terms depending on whether the elasticity coefficient is greater than, equal to, or less than 1. That is, the demand for a good is called:

relatively inelastic when the percentage change in quantity demanded is less than the percentage change in price (so that Ed > - 1); unit elastic, unit elasticity, unitary elasticity, or unitarily elastic demand when the percentage change in quantity demanded is equal to the percentage change in price (so that Ed = - 1); and relatively elastic when the percentage change in quantity demanded is greater than the percentage change in price (so that Ed < - 1). As the two accompanying diagrams show, perfectly elastic demand is represented graphically as a horizontal line, and perfectly inelastic demand as a vertical line. These are the only cases in which the PED and the slope of the demand curve (P/Q) are both constant, as well as the only cases in which the PED is determined solely by the slope of the demand curve (or more precisely, by the inverse of that slope).

Effect on total revenue:

A set of graphs shows the relationship between demand and total revenue (TR) for a linear demand curve. As price decreases in the elastic range, TR increases, but in the inelastic range, TR decreases. TR is maximised at the quantity where PED = 1. A firm considering a price change must know what effect the change in price will have on total revenue. Generally any change in price will have two effects: the price effect: an increase in unit price will tend to increase revenue, while a decrease in price will tend to decrease revenue.

the quantity effect : an increase in unit price will tend to lead to fewer units sold, while a decrease in unit price will tend to lead to more units sold.

Because of the inverse nature of the relationship between price and quantity demanded (i.e., the law of demand), the two effects affect total revenue in opposite directions. But in

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determining whether to increase or decrease prices, a firm needs to know what the net effect will be. Elasticity provides the answer: The percentage change in total revenue is equal to the percentage change in quantity demanded plus the percentage change in price. (One change will be positive, the other negative.) As a result, the relationship between PED and total revenue can be described for any good: When the price elasticity of demand for a good is perfectly inelastic (Ed = 0), changes in the price do not affect the quantity demanded for the good; raising prices will cause total revenue to increase.

When the price elasticity of demand for a good is relatively inelastic (- 1 < Ed < 0), the percentage change in quantity demanded is smaller than that in price. Hence, when the price is raised, the total revenue rises, and vice versa. When the price elasticity of demand for a good is unit (or unitary) elastic (Ed = -1), the percentage change in quantity is equal to that in price, so a change in price will not affect total revenue. When the price elasticity of demand for a good is relatively elastic (- < Ed < - 1), the percentage change in quantity demanded is greater than that in price. Hence, when the price is raised, the total revenue falls, and vice versa. When the price elasticity of demand for a good is perfectly elastic (Ed is ), any increase in the price, no matter how small, will cause demand for the good to drop to zero. Hence, when the price is raised, the total revenue falls to zero.

Hence, as the accompanying diagram shows, total revenue is maximised at the combination of price and quantity demanded where the elasticity of demand is unitary. It is important to realise that price-elasticity of demand is not necessarily constant over all price ranges. The linear demand curve in the accompanying diagram illustrates that changes in price also change the elasticity: the price elasticity is different at every point on the curve. Effect on tax incidence:

When demand is more elastic than supply, producers will bear a greater proportion of the tax burden than consumers will. Main article: tax incidence PEDs, in combination with price elasticity of supply (PES), can be used to assess where the incidence (or "burden") of a per-unit tax is falling or to predict where it will fall if the tax is imposed. For example, when demand is perfectly inelastic, by definition consumers have no alternative to purchasing the good or service if the price increases, so the quantity demanded
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would remain constant. Hence, suppliers can increase the price by the full amount of the tax, and the consumer would end up paying the entirety. In the opposite case, when demand is perfectly elastic, by definition consumers have an infinite ability to switch to alternatives if the price increases, so they would stop buying the good or service in question completelyquantity demanded would fall to zero. As a result, firms cannot pass on any part of the tax by raising prices, so they would be forced to pay all of it themselves. In practice, demand is likely to be only relatively elastic or relatively inelastic, that is, somewhere between the extreme cases of perfect elasticity or inelasticity. More generally, then, the higher the elasticity of demand compared to PES, the heavier the burden on producers; conversely, the more inelastic the demand compared to PES, the heavier the burden on consumers. The general principle is that the party (i.e., consumers or producers) that has fewer opportunities to avoid the tax by switching to alternatives will bear the greater proportion of the tax burden. Selected price elasticities: Various research methods are used to calculate price elasticities in real life, including analysis of historic sales data, both public and private, and use of present-day surveys of customers' preferences to build up test markets capable of modeling such changes. Alternatively, conjoint analysis (a ranking of users' preferences which can then be statistically analysed) may be used. Though PEDs for most demand schedules vary depending on price, they can be modeled assuming constant elasticity. Using this method, the PEDs for various goodsintended to act as examples of the theory described aboveare as follows. For suggestions on why these goods and services may have the PED shown, see the above section on determinants of price elasticity.

Cigarettes (US) o 0.3 to 0.6 (General) o 0.6 to 0.7 (Youth) Alcoholic beverages (US) o 0.3 or 0.7 to 0.9 as of 1972 (Beer) o 1.0 (Wine) o 1.5 (Spirits) o Airline travel (US) o 0.3 (First Class) o 0.9 (Discount) o 1.5 (for Pleasure Travelers) Livestock o 0.5 to 0.6 (Broiler Chickens) Oil (World) o 0.4 o Car fuel o 0.25 (Short run) o 0.64 (Long run) Medicine (US) o 0.31 (Medical insurance)

Rice 0.47 (Austria) 0.80 (Bangladesh) 0.80 (China) 0.25 (Japan) 0.55 (US) Cinema visits (US) o 0.87 (General) Live Performing Arts (Theater, etc.) 0.4 to 0.9 Transport 0.20 (Bus travel US) 2.80 (Ford compact automobile) Soft drinks o 0.8 to 1.0 (general) o 3.8 (Coca-Cola) o 4.4 (Mountain Dew) Steel 0.2 to 0.3 Eggs o 0.1 (US: Household only) o 0.35 (Canada) 0.55 (South
o o o o o

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o

.03 to .06 (Pediatric Visits)

Africa)

Income elasticity of demand:

In economics, income elasticity of demand measures the responsiveness of the demand for a good to a change in the income of the people demanding the good, holding all prices constant under the concept of ceteris paribus. It is calculated as the ratio of the percentage change in demand to the percentage change in income. For example, if, in response to a 10% increase in income, the demand for a good increased by 20%, the income elasticity of demand would be 20%/10% = 2.

Interpretation:

Inferior goods' demand falls as consumer income increases.

A negative income elasticity of demand is associated with inferior goods; an increase in income will lead to a fall in the demand and may lead to changes to more luxurious substitutes. A positive income elasticity of demand is associated with normal goods; an increase in income will lead to a rise in demand. If income elasticity of demand of a commodity is less than 1, it is a necessity good. If the elasticity of demand is greater than 1, it is a luxury good or a superior good. A zero income elasticity (or inelastic) demand occurs when an increase in income is not associated with a change in the demand of a good. These would be sticky goods.

Income elasticity of demand can be used as an indicator of industry health, future consumption patterns and as a guide to firms investment decisions. For example, the "selected income elasticities" below suggest that an increasing portion of consumer's budgets will be devoted to purchasing automobiles and restaurant meals and a smaller share to tobacco and margarine.[1] Income elasticitites are closely related to the population income distribution and the fraction of a the product's sales attributable to buyers from different income brackets. Specifically when a buyer in a certain income bracket experiences an income increase, their purchase of a product changes to match that of individuals in their new income bracket. If the income share elasticity is defined as the negative percentage change in individuals given a

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percentage increase in income bracket, then the income-elasticity, after some computation, becomes the expected value of the income-share elasticity with respect to the income distribution of purchasers of the product. When the income distribution is described by a gamma distribution, the income elasticity is proportional to the percentage difference between the average income of the product's buyers and the average income of the population. (Bordley and McDonald, "Estimating Income Elasticitities from the Average Income of a Product's Buyers and the Population Income Distribution. Journal of Business and Economic Statistics.

Mathematical definition:

More formally, the income elasticity of demand, for a good is

, for a given Marshallian demand function

or alternatively:

This can be rewritten in the form:

With income I, and vector of prices . Many necessities have an income elasticity of demand between zero and one: expenditure on these goods may increase with income, but not as fast as income does, so the proportion of expenditure on these goods falls as income rises. This observation for food is known as Engel's law. Income elasticity of demand Introduction Income elasticity of demand measures the relationship between a change in quantity demanded and a change in income. The basic formula for calculating the coefficient of income elasticity is: Percentage change in quantity demanded of good X divided by the percentage change in real consumers' income

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Normal Goods Normal goods have a positive income elasticity of demand so as income rise more is demand at each price level. We make a distinction between normal necessities and normal luxuries (both have a positive coefficient of income elasticity). Necessities have an income elasticity of demand of between 0 and +1. Demand rises with income, but less than proportionately. Often this is because we have a limited need to consume additional quantities of necessary goods as our real living standards rise. The class examples of this would be the demand for fresh vegetables, toothpaste and newspapers. Demand is not very sensitive at all to fluctuations in income in this sense total market demand is relatively stable following changes in the wider economic (business) cycle. Luxuries on the other hand are said to have an income elasticity of demand > +1. (Demand rises more than proportionate to a change in income). Luxuries are items we can (and often do) manage to do without during periods of below average income and falling consumer confidence. When incomes are rising strongly and consumers have the confidence to go ahead with big-ticket items of spending, so the demand for luxury goods will grow. Conversely in a recession or economic slowdown, these items of discretionary spending might be the first victims of decisions by consumers to rein in their spending and rebuild savings and household financial balance sheets. Many luxury goods also deserve the sobriquet of positional goods. These are products where the consumer derives satisfaction (and utility) not just from consuming the good or service itself, but also from being seen to be a consumer by others. Inferior Goods: Inferior goods have a negative income elasticity of demand. Demand falls as income rises. In a recession the demand for inferior products might actually grow (depending on the severity of any change in income and also the absolute co-efficient of income elasticity of demand). For example if we find that the income elasticity of demand for cigarettes is -0.3, then a 5% fall in the average real incomes of consumers might lead to a 1.5% fall in the total demand for cigarettes (ceteris paribus).

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Within a given market, the income elasticity of demand for various products can vary and of course the perception of a product must differ from consumer to consumer. The hugely important market for overseas holidays is a great example to develop further in this respect. What to some people is a necessity might be a luxury to others. For many products, the final income elasticity of demand might be close to zero, in other words there is a very weak link at best between fluctuations in income and spending decisions. In this case the real income effect arising from a fall in prices is likely to be relatively small. Most of the impact on demand following a change in price will be due to changes in the relative prices of substitute goods and services.

The income elasticity of demand for a product will also change over time the vast majority of products have a finite life-cycle. Consumer perceptions of the value and desirability of a good or service will be influenced not just by their own experiences of consuming it (and the feedback from other purchasers) but also the appearance of new products onto the market. Consider the income elasticity of demand for flat-screen colour televisions as the market for plasma screens develops and the income elasticity of demand for TV services provided through

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satellite dishes set against the growing availability and falling cost (in nominal and real terms) and integrated digital televisions.

Advertising elasticity of demand:

Advertising elasticity of demand (or simply advertising elasticity, often shortened to AED) is an elasticity measuring the effect of an increase or decrease in advertising on a market. Although traditionally considered as being positively related, demand for the good that is subject of the advertising campaign can be inversely related to the amount spent if the advertising is negative.

Definition:
Good advertising will result in a positive shift in demand for a good. AED is used to measure the effectiveness of this strategy in increasing demand versus its cost. Mathematically, then, AED measures the percentage change in the quantity of a good demanded induced by a given percentage change in spending on advertising in that sector:

In other words, the percentage by which sales will increase after a 1% increase in advertising expenditure assuming all other factors remain equal (ceteris paribus). AED is usually positive. Negative advertising may, however, result in a negative AED.

Applications
AED can be used to make sure advertising expenses are in line, though an increase in demand may not be the only desired outcome of advertising.[3] The rule of thumb combines the AED with a known price elasticity of demand (PED) for the same good. The optimal relationship is denoted by:

In words, "to maximize profit, the firm's advertising to sales ratio should be equal to minus the ratio of the advertising and price elasticities of demand. As noted by Pindyck and Rubinfeld, firms should advertise heavily if their AED is high (they get a lot of bang for their advertising buck) or if their PED is low (since for every added sale there is significant profit). Thus, a comparison of PED and AED can also be used to determine whether more advertising is the correct strategy to maximise profits (e.g. for Heinz in the market for baked beans), or changing prices (as with supermarket own brands).

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Examples:
The following are for industry-wide AEDs, researched in the United States:[2]

Beer: 0.0 Wine: 0.08 Cigarettes: 0.04 Recreation: 0.08

The elasticity figures are surprisingly low. Both the beer and cigarette industries advertised heavily. The answer is that the coefficients are for industry-wide demand not firm demand; the AED for individual brands would be substantially higher.[2] Promotional elasticity of demand (eA): This is a concept which J.R. Hicks has popularized. It has reference to the percentage change in the level of future price (Pi+1) expected as a result of a change in the level of current prices (P1). It may be stated as: ee = dpt+1/dPt . Pt/Pt+1 Thus ex co-efficient measures the ratio of the per cent rise in expected future prices, the ee = 1. If a rise in Pt it believed to cause a larger than proportionate change in Pt+1 then ee > 1. If a rise in Pt is expected to cause a less than proportionate rise in Pt+1 , then ee <1. The expectation that the rise in current prices will lead to a further rise in prices in future mean ee > 0 while a rise in price leading to expectation that prices will fall in future will give in ee < 0. As we have talked of elasticity of price expectations, so we can talk of elasticity of demand or sales expectations to consider expected future demand as a function of current demand.

Email Based, Online Homework Assignment Help inpromotional elasticity of demand: Transtutors is the best place to get answers to all your doubts regarding promotional elasticity of demand. Transtutors has a vast panel of experienced in promotional elasticity of demand managerial economics tutorswho can explain the different concepts to you effectively. You can submit your school, college or university level homework or assignment to us and we will make sure that you get the answers related to promotional elasticity of demand

Cross elasticity of demand:

Proportionate change in the demand for one item in response to a change in the price of another item. It is 'positive' where the two items are mutual substitutes, and any increase in the price of one (say butter) will increase the demand for the other (say margarine). It is 'negative'

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when the items are complementary and any increase in the price of one (say cars) will decrease the demand for the other (say tires). See also elasticity. Also called cross price elasticity. In economics, the cross elasticity of demand or cross-price elasticity of demand measures the responsiveness of the demand for a good to a change in the price of another good. It is measured as the percentage change in demand for the first good that occurs in response to a percentage change in price of the second good. For example, if, in response to a 10% increase in the price of fuel, the demand of new cars that are fuel inefficient decreased by 20%, the cross elasticity of demand would be: .

Formula:The formula used to calculate the coefficient cross elasticity of demand is

(OR)

Results for main types of goods:

In the example above, the two goods, fuel and cars (consists of fuel consumption), are complements; that is, one is used with the other. In these cases the cross elasticity of demand will be negative, as shown by the decrease in demand for cars when the price of fuel increased. Where the two goods are substitutes the cross elasticity of demand will be positive, so that as the price of one goes up the demand of the other will increase. For example, in response to an increase in the price of carbonated soft drinks, the demand for non-carbonated soft drinks will rise. In the case of perfect substitutes, the cross elasticity of demand is equal to positive infinity. Where the two goods are independent, or, as described in consumer theory, if a good is independent in demand then the demand of that good is independent of the quantity consumed of all other goods available to the consumer, the cross elasticity of demand will be zero: as the price of one good changes, there will be no change in demand for the other good.

Two goods that complement each other show a negative

Two goods that are independent Two goods that are substitutes have a zero cross elasticity of have a positive cross elasticity demand: as the price of good Y

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cross elasticity of demand: as the price of good Y rises, the demand for good X falls

of demand: as the price of good rises, the demand for good X Y rises, the demand for good X stays constant rises

When goods are substitutable, the diversion ratio, which quantifies how much of the displaced demand for product j switches to product i, is measured by the ratio of the cross-elasticity to the own-elasticity multiplied by the ratio of product i's demand to product j's demand. In the discrete case, the diversion ratio is naturally interpreted as the fraction of product j demand which treats product i as a second choice,[1] measuring how much of the demand diverting from product j because of a price increase is diverted to product i can be written as the product of the ratio of the cross-elasticity to the own-elasticity and the ratio of the demand for product i to the demand for product j. In some cases, it has a natural interpretation as the proportion of people buying product j who would consider product i their "second choice".

Selected cross price elastic ties of demand

Below are some examples of the cross-price elasticity of demand (XED) for various goods: Good Good with Price Change XED Butter Margarine +0.81 Beef Pork +0.28 Entertainment Food -0.72

Break-even (economics):
.

The Break-Even Point is where Total Costs equal Sales. In the Cost-Volume-Profit Analysis model, Total Costs are linear in volume. In economics & business, specifically cost accounting, the break-even point (BEP) is the point at which cost or expenses and revenue are equal: there is no net loss or gain, and one has "broken even". A profit or a loss has not been made, although opportunity costs have been paid, and capital has received the risk-adjusted, expected return.

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For example, if a business sells fewer than 200 tables each month, it will make a loss, if it sells more, it will be a profit. With this information, the business managers will then need to see if they expect to be able to make and sell 200 tables per month. If they think they cannot sell that many, to ensure viability they could: 1. Try to reduce the fixed costs (by renegotiating rent for example, or keeping better control of telephone bills or other costs) 2. Try to reduce variable costs (the price it pays for the tables by finding a new supplier) 3. Increase the selling price of their tables. Any of these would reduce the breakeven point. In other words, the business would not need to sell so many tables to make sure it could pay its fixed costs.

Computation:
In the linear Cost-Volume-Profit Analysis model, the break-even point (in terms of Unit Sales (X)) can be directly computed in terms of Total Revenue (TR) and Total Costs (TC) as:

where:

TFC is Total Fixed Costs, P is Unit Sale Price, and V is Unit Variable Cost.

The Break-Even Point can alternatively be computed as the point where Contribution equals Fixed Costs.

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The quantity is of interest in its own right, and is called the Unit Contribution Margin (C): it is the marginal profit per unit, or alternatively the portion of each sale that contributes to Fixed Costs. Thus the break-even point can be more simply computed as the point where Total Contribution = Total Fixed Cost:

In currency units (sales proceeds) to reach break-even, one can use the above calculation and multiply by Price, or equivalently use the Contribution Margin Ratio (Unit Contribution Margin over Price) to compute it as: R=C Where R is revenue generated C is cost incurred i.e. Fixed costs + Variable Costs or Q X P(Price per unit)=FCT + Q X VC(Price per unit) Q X P - Q X VC=FC Q (P-VC)=FC or Break Even Analysis Q=FC/c/s ratio=Break Even

Margin of Safety:
Margin of safety represents the strength of the business. It enables a business to know what the exact amount it has gained or lost is and whether they are over or below the breakeven point. margin of safety = (current output - breakeven output) margin of safety% = (current output - breakeven output)/current output x 100 When dealing with budgets you would instead replace "Current output" with "Budgeted output". If P/V ratio is given then profit/ PV ratio == In unit Break Even = FC

/ (SP VC)

where FC is Fixed Cost, SP is Selling Price and VC is Variable Cost

Break Even Analysis:

By inserting different prices into the formula, you will obtain a number of break even points, one for each possible price charged. If the firm changes the selling price for its product, from $2 to $2.30, in the example above, then it would have to sell only (1000/(2.3 - 0.6))= 589 units to break even, rather than 715.

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To make the results clearer, they can be graphed. To do this, you draw the total cost curve (TC in the diagram) which shows the total cost associated with each possible level of output, the fixed cost curve (FC) which shows the costs that do not vary with output level, and finally the various total revenue lines (R1, R2, and R3) which show the total amount of revenue received at each output level, given the price you will be charging. The break even points (A,B,C) are the points of intersection between the total cost curve (TC) and a total revenue curve (R1, R2, or R3). The break even quantity at each selling price can be read off the horizontal axis and the breakeven price at each selling price can be read off the vertical axis. The total cost, total revenue, and fixed cost curves can each be constructed with simple formulae. For example, the total revenue curve is simply the product of selling price times quantity for each output quantity. The data used in these formulae come either from accounting records or from various estimation techniques such as regression analysis.

Application:
The break-even point is one of the simplest yet least used analytical tools in management. It helps to provide a dynamic view of the relationships between sales, costs and profits. A better understanding of break-even, for example, is expressing break-even sales as a percentage of actual salescan give managers a chance to understand when to expect to break even (by linking the percent to when in the week/month this percent of sales might occur). The break-even point is a special case of Target Income Sales, where Target Income is 0 (breaking even). This is very important for financial analysis.

Limitations:

Break-even analysis is only a supply side (i.e. costs only) analysis, as it tells you nothing about what sales are actually likely to be for the product at these various prices. It assumes that fixed costs (FC) are constant. Although, this is true in the short run, an increase in the scale of production is likely to cause fixed costs to rise. It assumes average variable costs are constant per unit of output, at least in the range of likely quantities of sales. (i.e. linearity)

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It assumes that the quantity of goods produced is equal to the quantity of goods sold (i.e., there is no change in the quantity of goods held in inventory at the beginning of the period and the quantity of goods held in inventory at the end of the period).
In multi-product companies, it assumes that the relative proportions of each product sold and produced are constant (i.e., the sales mix is constant).

Introduction to Break Even Analysis:

Break-even analysis is a technique widely used by production management and management accountants. It is based on categorizing 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").

The Break-Even Chart:

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:

In the diagram above, the line OA represents the variation of income at varying levels of production activity ("output"). OB represents the total fixed costs in the business. As output increases, variable costs are incurred, meaning that total costs (fixed + variable) also increase. At low levels of output, Costs are greater than Income. At the point of intersection, P, costs are exactly equal to income, and hence neither profit nor loss is made.

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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 new factory 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:
Whilst the distinction between fixed and variable costs is a convenient way of categorising business costs, in reality there are some costs which are fixed in nature but which increase when output reaches certain levels. These are largely related to the overall "scale" and/or complexity of the business. For example, when a business has relatively low levels of output or sales, it may not require costs associated with functions such as human resource management or a fully-resourced finance department. However, as the scale of the business grows (e.g. output, number people employed, number and complexity of transactions) then more resources are required. If production rises suddenly then some short-term increase in warehousing and/or transport may be required. In these circumstances, we say that part of the cost is variable and part fixed.

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Break-Even Analysis by Tim Berry Summary: When you're starting a new business, the last thing you want to focus on is failure. But if you address the common reasons for failure up front, you'll be much less likely to fall victim to them yourself. Here are the top 7 reasons why businesses fail and tips for avoiding them. The Break-even Analysis lets you determine what you need to sell, monthly or annually, to cover your costs of doing business--your break-even point. Illustration 1 shows the Breakeven Analysis table from Business Plan Pro. The Break-even Analysis table calculates a break-even point based on fixed costs, variable costs per unit of sales, and revenue per unit of sales.

UnderstandingBreak-even The break-even analysis is not our favorite analysis because:

It is frequently mistaken for the payback period, the time it takes to recover an investment. There are variations on break-even that make some people think we have it wrong. The one we do use is the most common, the most universally accepted, but not the only one possible. It depends on the concept of fixed costs, a hard idea to swallow. Technically, a break-even analysis defines fixed costs as those costs that would continue even if you went broke. Instead, you may want to use your regular running fixed costs, including payroll and normal expenses. This will give you a better insight on financial realities. We call that burn rate these postInternet days.

It depends on averaging your per-unit variable cost and per-unit revenue over the whole business. However, whether we like it or not, this table is a mainstay of financial analysis. You may choose to leave it out, but really, a business plan would not be complete without it. And, although there are some other ways to do a Break-even Analysis, this is the most standard. The Break-even Analysis depends on three key assumptions:

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1. Averageper-unitsalesprice(per-unitrevenue): This is the price that you receive per unit of sales. Take into account sales discounts and special offers. Get this number from your Sales Forecast. For non-unit based businesses, make the per-unit revenue $1 and enter your costs as a percent of a dollar. The most common questions about this input relate to averaging many different products into a single estimate. The analysis requires a single number, and if you build your Sales Forecast first, then you will have this number. You are not alone in this, the vast majority of businesses sell more than one item,andhave to average for their Break-even Analysis. 2. Averageper-unitcost: This is the incremental cost, or variable cost, of each unit of sales. If you buy goods for resale, this is what you paid, on average, for the goods you sell. If you sell a service, this is what it costs you, per dollar of revenue or unit of service delivered, to deliver that service. If you are using a Units-Based Sales Forecast table (for manufacturing and mixed business types), you can project unit costs from the Sales Forecast table. If you are using the basic Sales Forecast table for retail, service and distribution businesses, use a percentage estimate, e.g., a retail store running a 50% margin would have a per-unit cost of .5, and a per-unit revenue of 1. 3. Monthlyfixedcosts: Technically, a break-even analysis defines fixed costs as costs that would continue even if you went broke. Instead, we recommend that you use your regular running fixed costs, including payroll and normal expenses (total monthly Operating Expenses). This will give you a better insight on financial realities. If averaging and estimating is difficult, use your Profit and Loss table to calculate a working fixed cost estimateit will be a rough estimate, but it will provide a useful input for a conservative Break-even Analysis. Illustration 2 shows a Break-even chart. As sales increase, the profit line passes through the zero or break-even line at the break-even point.

The illustration shows that the company needs to sell approximately 1,222 units in order to cross the break-even line. This is a classic business chart that helps you consider your bottomline financial realities. Can you sell enough to make your break-even volume?

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The break-even analysis depends on assumptions made for average per-unit revenue, average per-unit cost, and fixed costs. These are rarely exact. We recommend that you do the break-even table twice: first, with educated guesses for assumptions, as part of the initial assessment, and later on, using your detailed Sales Forecast and Profit and Loss numbers. Both are valid uses.

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