DAYANANDA SAGAR COLLEGE

OF ENGINEERING

DEPARTMENT OF INFORMATION
SCIENCE AND ENGINEERING
 ENGINEERING ECONOMICS
(18HS6ICEEM )

Faculty in charge:

Bindu Bhargavi S M
Asst. Professor, Dept. of ISE, DSCE
 SYLLABUS
• Depreciation: Meaning of depreciation, Causes of Depreciation,
methods of computing depreciation, Straight line method of
depreciation, Declining balance method, Sum of year’s digits method
and Sinking fund method.
• Breakeven analysis: Introduction to breakeven analysis, calculation of
BEQ, BEP, Numerical Exercises.
 DEPRICIATION
• Depreciation is an accounting method of allocating the cost of a tangible or
physical asset over its useful life or life expectancy.

• Depreciation represents how much of an asset's value has been used up.

• Depreciating assets helps companies earn revenue from an asset while expensing
a portion of its cost each year the asset is in use.

• Depreciation allows a portion of the cost of a fixed asset to the revenue

generated by the fixed asset

• Book Value
• Inputs required:
• Useful life
• Salvage value
• Cost of the asset
• Importance of depreciation
• Depreciation allows for companies to recover the cost of an asset when it was
purchased.
• The process allows for companies to cover the total cost of an asset over it's lifespan
instead of immediately recovering the purchase cost
• This allows companies to replace future assets using the appropriate amount of
revenue.
• Causes
• Internal
• External
 CAUSES OF DEPRECIATION
• Internal causes
• Wear and tear
• Depletion
• External causes
• Obsolescence
• Efflux of Time
• Accident
• Other causes
• Physical depreciation
• Functional depreciation
• Technological depreciation
• Sudden failure
• Depletion
• Monetary depreciation
 METHODS OF DEPRECIATION
• Straight line method of depreciation
• Declining balance method of depreciation
• Sum of the years—digits method of depreciation
• Sinking-fund method of depreciation
• Service output method of depreciation
 STRAIGHT LINE METHOD OF
DEPRECIATION
• Straight line depreciation - common, simplest, method of calculating
depreciation expense.
• Here the expense amount is the same every year over the useful life of the
asset.
• A fixed sum is charged as the depreciation amount throughout the lifetime
of an asset such that the accumulated sum at the end of the life of the
asset is exactly equal to the purchase value of the asset.
• P = first cost of the asset,
• F = salvage value of the asset,
• n = life of the asset,
• Bt = book value of the asset at the end of the period t,
• Dt = depreciation amount for the period t.
• Dt = (P – F)/n
• Bt = Bt–1– Dt = P – t [(P – F)/n]
A company has purchased an equipment whose first cost is Rs.
1,00,000 with an estimated life of eight years. The estimated
salvage value of the equipment at the end of its lifetime is Rs.
20,000. Determine the depreciation charge and book value at the
end of various years using the straight line method of depreciation.

• P = Rs. 1,00,000
• F = Rs. 20,000
• n = 8 years
• Dt = (P – F)/n
• = (1,00,000 – 20,000)/8
• = Rs. 10,000
• Here the value of Dt is the same for all the years.
 DECLINING BALANCE METHOD OF
DEPRECIATION
• A constant percentage of the book value of the previous period of the
asset will be charged as the depreciation amount for the current period.
• The book value at the end of the life of the asset may not be exactly
equal to the salvage value of the asset
• P = first cost of the asset,
• F = salvage value of the asset,
• n = life of the asset,
• Bt = book value of the asset at the end of the period t,
• Dt = depreciation amount for the period t.
• K = a fixed percentage
• K = 1 – (S/P)^(1/N)
 SUM-OF-THE-YEARS-DIGITS METHOD OF
DEPRECIATION
• It is assumed that the book value of the asset decreases at a decreasing
rate.
• The rate of depreciation charge for the first year is assumed as the highest
and then it decreases
• Dt = Rate* (P – F)
• Bt= Bt–1 – Dt
P = Rs. 1,00,000
F = Rs. 20,000
n = 8 years

Sum = n(n + 1)/2 = 8 9/2 = 36

The rates for years 1–8, are respectively 8/36, 7/36, 6/36, 5/36, 4/36,
3/36, 2/36 and 1/36.
 SINKING FUND METHOD OF
DEPRECIATION
• The book value decreases at increasing rates with respect to the life of
the asset.
P = first cost of the asset,
F = salvage value of the asset
n = life of the asset,
i = rate of return compounded annually,
A = the annual equivalent amount,
Bt = the book value of the asset at the end of the period t, and
Dt = the depreciation amount at the end of the period t.
• The loss in value of the asset (P – F) is made available an the form of
cumulative depreciation amount at the end of the life of the asset by
setting up an equal depreciation amount (A) at the end of each period
during the lifetime of the asset.
• A = (P – F) * [A/F, i, n]
• The fixed sum depreciated at the end of every time period earns an interest
at the rate of i% compounded annually, and hence the actual depreciation
amount will be in the increasing manner with respect to the time period
P = Rs. 1,00,000
F = Rs. 20,000
n = 8 years
i = 12%

A = (P – F) * [A/F, 12%, 8]
= (1,00,000 – 20,000) 0.0813
= Rs. 6,504

Depreciation at the end of year 1 (D1) = Rs. 6,504.

Depreciation at the end of year 2 (D2) = 6,504 + 6,504 * 0.12
= Rs. 7,284.48
Depreciation at the end of the year 3 (D3)
= 6,504 + (6,504 + 7,284.48) * .12
= Rs. 8,158.62
Depreciation at the end of year 4 (D4)
= 6,504 + (6,504 + 7,284.48 + 8,158.62) * 0.12
= Rs. 9,137.65
 BREAK EVEN ANALYSIS
• A break-even analysis is a financial tool which helps a company to determine the
stage at which the company, or a new service or a product, will be profitable.

• It is the financial calculation for determining the number of products or services a

company should sell or provide to cover its costs – fixed assets

• Break-even analysis is useful in studying the relation between the variable cost,
fixed cost and revenue

• Analyzing different price levels relating to various levels of demand, the break-
even analysis determines what level of sales are necessary to cover the
company's total fixed costs

• Break-Even Quantity = Fixed Costs / (Sales Price Per Unit – Variable Costs Per
Unit)
 IMPORTANCE OF BREAKEVEN ANALYSIS
• Manages the size of units to be sold

• Budgeting and setting targets

• Manage the margin of safety

• Monitors and controls cost

• Helps to design pricing strategy

 COMPONENTS OF BREAK-EVEN
ANALYSIS
• Fixed costs
• Also called as overhead costs
• Includes interest, taxes, salaries, rent, depreciation costs, labour costs, energy
costs.

• Variable costs
• Increases or decreases in direct relation with the production volume
• Includes cost of raw materials, packaging cost, fuel and other costs
 ASSUMPTIONS OF BREAK EVEN ANALYSIS
• The total costs may be classified into fixed and variable costs. It ignores
semi-variable cost.
• The cost and revenue functions remain linear
• The price of the product is assumed to be constant.
• The volume of sales and volume of production are equal
• The fixed costs remain constant over the volume under consideration.
• It assumes constant rate of increase in variable cost.
• It assumes constant technology and no improvement in labour efficiency
• The price of the product is assumed to be constant
• Changes in input prices are ruled out
 LIMITATIONS OF BREAK EVEN ANALYSIS
• Everything is considered constant.
• Projecting the future with the help of past functions.
• assumption that the cost-revenue-output relationship is linear - over a
small range of output – not useful for long range use
• Profits are a function of not only output, but also of other factors like
technological change, improvement in the art of management
• Selling costs are specially difficult to handle break-even analysis.
• The simple form of a break-even chart makes no provisions for taxes,
particularly corporate income tax
• Because of so many restrictive assumptions underlying the technique,
computation of a breakeven point is considered an approximation rather
than a reality
 APPLICATIONS OF BREAK EVEN ANALYSIS

• Starting a new business

• Creating a new product

• Changing the business model

 ADVANTAGES OF BREAKEVEN ANALYSIS
• It helps to determine remaining/unused capacity of the company
once the breakeven is reached

• It helps to determine the impact on profit on changing to automation

from manual

• It helps to determine the change in profits if the price of a product is

altered.

• It helps to determine the amount of losses that could be sustained if

there is a sales downturn.
 BENEFITS OF BREAKEVEN ANALYSIS
• Catch missing expenses

• Set revenue targets

• Make smarter decisions

• Fund your business

• Better pricing

• Cover fixed costs

 BREAKEVEN POINT (BEP)
• The breakeven point is the level of production at which the costs of
production equal the revenues for a product
• In investing, the breakeven point is said to be achieved when the
market price of an asset is the same as its original cost
• Breakeven point is the production level at which total revenues for a
product equal total expenses.
• the breakeven point is calculated by dividing the fixed costs of
production by the price per unit minus the variable costs of
production.
Let
s = selling price per unit
v = variable cost per unit
FC = fixed cost per period
Q = volume of production

The total sales revenue (S) of the firm is given by

S=s*Q
The total cost of the firm for a given production volume is given as
TC = Total variable cost + Fixed cost
= v * Q + FC
Profit = Sales – (Fixed cost + Variable costs)
= s * Q – (FC + v * Q)
The formulae to find the break-even quantity and break-even sales
quantity
The contribution is the difference between the sales and the variable
costs. The margin of safety (M.S.) is the sales over and above the
break-even sales. The formulae to compute these values are
• Alpha Associates has the following details:
Fixed cost = Rs. 20,00,000
Variable cost per unit = Rs. 100
Selling price per unit = Rs. 200

Find
(a) The break-even sales quantity,
(b) The break-even sales
(c) If the actual production quantity is 60,000, find (i) contribution; and
(ii) margin of safety by all methods.
• Solution
Fixed cost (FC) = Rs. 20,00,000
Variable cost per unit (v) = Rs. 100
Selling price per unit (s) = Rs. 200
Calculate Break-Even Point from the following particulars.
Fixed expenses Rs.1, 50,000
Variable cost per unit Rs.10
Selling price per unit Rs.15
Calculate Break-even point:

Rs.
Sales 6, 00,000
Fixed expenses 1, 50,000
Variable costs:
Direct Material 2, 00,000
Direct Labour 1, 20,000
Other Variable expenses 80,000
From the following particulars find out the B.E.P. What will be the
selling price per unit if B.E.P. is to be brought down to 9,000 units?
Rs.
Variable cost per unit 75
Fixed expenses 2, 70,000
Selling price per unit 100
Krishna Company Ltd. has the following details:
Fixed cost = Rs. 40,00,000
Variable cost per unit = Rs. 300
Selling price per unit = Rs. 500

Find
(a) The break-even sales quantity
(b) The break-even sales
(c) If the actual production quantity is 1,20,000, find the following:
(i) Contribution
(ii) Margin of safety by all methods
Consider the following data of a company for the year 1998

Sales = Rs. 2,40,000

Fixed cost = Rs. 50,000
Variable cost = Rs. 75,000

Find the following:

(a) Contribution
(b) Profit
(c) BEP
(d) Margin of safety
Consider the following data of a company for the year 1997
Sales = Rs. 1,20,000
Fixed cost = Rs. 25,000
Variable cost = Rs. 45,000
Find the following:
(a) Contribution
(b) Profit
(c) BEP
(d) M.S.
From the following information relating to Quick Standard Ltd., you are
required to find out
(a) P.V. ratio
(b) Break even point
(c) Profit
(d) Margin of safety
Total Fixed Costs Rs. 4,500
Total Variable cost Rs7,500
Total sales Rs15,000
(e) Also Calculate the Volume of sales to earn profit of Rs.6, 000.
BREAK-EVEN ANALYSIS

The main objective of break-even analysis is to find the cut-off production

volume from where a firm will make profit. Let
s = selling price per unit
v = variable cost per unit
FC = fixed cost per period
Q = volume of production
The total sales revenue (S) of the firm is given by the following formula:
S=s´Q
The total cost of the firm for a given production volume is given as
TC = Total variable cost + Fixed cost
= v ´ Q + FC
The linear plots of the above two equations are shown in Fig. 1.3. The
intersection point of the total sales revenue line and the total cost line is called
Sales (S)

Profit
Total cost (TC)

Break-even
sales Fixed cost (FC)

Loss

BEP(Q*)
Production quantity
Fig. 1.3 Break-even chart.
the break-even point. The corresponding volume of production on the X-axis is
known as the break-even sales quantity. At the intersection point, the total cost
is equal to the total revenue. This point is also called the no-loss or no-gain
situation. For any production quantity which is less than the break-even quantity,
the total cost is more than the total revenue. Hence, the firm will be making loss.
For any production quantity which is more than the break-even quantity, the
total revenue will be more than the total cost. Hence, the firm will be making
profit.
Profit = Sales – (Fixed cost + Variable costs)
= s ´ Q – (FC + v ´ Q)
The formulae to find the break-even quantity and break-even sales quantity

Fixed cost
Break-even quantity =
Selling price/unit − Variable cost/unit

FC
= (in units)
s−v

Fixed cost
Break-even sales = × Selling price/unit
Selling price/unit − Variable cost/unit

FC
= × s (Rs.)
s−v
The contribution is the difference between the sales and the variable costs. The
margin of safety (M.S.) is the sales over and above the break-even sales. The
formulae to compute these values are
Contribution = Sales – Variable costs
Contribution/unit = Selling price/unit – Variable cost/unit
M.S. = Actual sales – Break-even sales
Profit
= × sales
Contribution
M.S. as a per cent of sales = (M.S./Sales) ´ 100

EXAMPLE 1.1 Alpha Associates has the following details:

Fixed cost = Rs. 20,00,000
Variable cost per unit = Rs. 100
Selling price per unit = Rs. 200
Find
(a) The break-even sales quantity,
(b) The break-even sales
(c) If the actual production quantity is 60,000, find (i) contribution; and
(ii) margin of safety by all methods.

Solution
Fixed cost (FC) = Rs. 20,00,000
Variable cost per unit (v) = Rs. 100
Selling price per unit (s) = Rs. 200
(a) Break-even quantity = FC = 20,00,000
s − v 200 − 100
= 20,00,000/100 = 20,000 units

FC
(b) Break-even sales = ´ s (Rs.)
s−v
20,00,000
= ´ 200
200 − 100
20,00,000
= ´ 200 = Rs. 40,00,000
100
(c) (i) Contribution = Sales – Variable cost
=s´Q–v´Q
= 200 ´ 60,000 – 100 ´ 60,000
= 1,20,00,000 – 60,00,000
= Rs. 60,00,000
(ii) Margin of safety

METHOD I
M.S. = Sales – Break-even sales
= 60,000 ´ 200 – 40,00,000
= 1,20,00,000 – 40,00,000 = Rs. 80,00,000
METHOD II

Profit
M.S. = ´ Sales
Contribution
Profit = Sales – (FC + v ´ Q)

= 60,000 ´ 200 – (20,00,000 + 100 ´ 60,000)

= 1,20,00,000 – 80,00,000

= Rs. 40,00,000

40,00,000
M.S. = ´ 1,20,00,000 = Rs. 80,00,000
60,00,000

80,00,000
M.S. as a per cent of sales = ´ 100 = 67%
1,20,00,000
 PROFIT/VOLUME RATIO (P/V RATIO)

P/V ratio is a valid ratio which is useful for further analysis. The different
formulae for the P/V ratio are as follows:

Contribution Sales − Variable costs

P/V ratio = =
Sales Sales
The relationship between BEP and P/V ratio is as follows:

Fixed cost
BEP =
P /V ratio
The following formula helps us find the M.S. using the P/V ratio:

Profit
M.S. =
P /V ratio

EXAMPLE 1.2 Consider the following data of a company for the year 1997:
Sales = Rs. 1,20,000
Fixed cost = Rs. 25,000
Variable cost = Rs. 45,000
Find the following:
(a) Contribution
(b) Profit
(c) BEP
(d) M.S.

Solution
(a) Contribution = Sales – Variable costs
= Rs. 1,20,000 – Rs. 45,000
= Rs. 75,000
(b) Profit = Contribution – Fixed cost
= Rs. 75,000 – Rs. 25,000
= Rs. 50,000
(c) BEP
Contribution
P/V ratio =
Sales

75,000
= ´ 100 = 62.50%
1,20,000
 Fixed cost 25,000
BEP = = ´ 100 = Rs. 40,000
P /V ratio 62.50
Profit 50,000
M.S. = = ´ 100 = Rs. 80,000
P / V ratio 62.50

EXAMPLE 1.3 Consider the following data of a company for the year 1998:
Sales = Rs. 80,000
Fixed cost = Rs. 15,000
Variable cost = 35,000
Find the following:
(a) Contribution
(b) Profit
(c) BEP
(d) M.S.
Solution
(a) Contribution = Sales – Variable costs
= Rs. 80,000 – Rs. 35,000
= Rs. 45,000
(b) Profit = Contribution – Fixed cost
= Rs. 45,000 – Rs. 15,000
= Rs. 30,000
(c) BEP
Contribution 45,000
P/V ratio = = ´ 100 = 56.25%
Sales 80,000
Fixed cost 15,000
BEP = = ´ 100 = Rs. 26,667
P / V ratio 56.25
Profit 30,000
(d) M.S. = = ´ 100 = Rs. 53,333.33
P /V ratio 56 .25
1. Krishna Company Ltd. has the following details:
Fixed cost = Rs. 40,00,000
Variable cost per unit = Rs. 300
Selling price per unit = Rs. 500
Find
(a) The break-even sales quantity
(b) The break-even sales
(c) If the actual production quantity is 1,20,000, find the following:
(i) Contribution
(ii) Margin of safety by all methods
2. Consider the following data of a company for the year 1998.
Sales = Rs. 2,40,000
Fixed cost = Rs. 50,000
Variable cost = Rs. 75,000
Find the following:
(a) Contribution
(b) Profit
(c) BEP
(d) Margin of safety