Mba 1 me u 4 profit management & risk analysis

COURSE: MBA-
1
SUBJECT: ME
UNIT:4
Profit Management & Risk
Analysis

COURSE CONTENT
Nature, Scope, Theories of profit,
Measurement policies, Cost –
Volume- Profit Analysis.
Risk analysis; investment and
capital replacement decisions
PreparedBy:MitikaMahajan

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.

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.

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

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

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

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

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.

PROFIT MEASUREMENT
 The most practical measure of whether firms are
making adequate profits or not
 It is called as rate of return on capital

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

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.

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

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

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

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

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

METHODS OF BREAKS EVEN ANALYSIS
 The Break even Charts
 The Algebraic Method.

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= Profit
TR= Total Revenue
TC=Total Cost
P = TR – TC

BREAK EVEN ANALYSIS CHART

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

Calculate break even point from following details.
Sales Rs. 42000
Fixed costs 3000
No. of Units 4200
BEP (Units)= Fixed Costs
Selling Price- Variable Cost per Unit
= 3000
10-6.67
= 900

TRY YOURSELF
 Calculate Break Even point (in Rs and Units) for
following
Sales Rs. 90000
Fixed costs 3000
No. of Units 10000

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

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

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

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.

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.

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

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

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
0
Jan.-
Mar
TotalOutput
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
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Mba 1 me u 4 profit management & risk analysis

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