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").

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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 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

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BASIC OF ECONOMICS

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.

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BASIC OF ECONOMICS

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 rise
accordingly as production activities increase. Therefore, the cost of
electricity can be viewed as semi-variable.

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BASIC OF ECONOMICS

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=CT
P x Q = CF + Cvu x Q
Q(BEP) = CF / (P Cvu)
Legenda
RT = total revenue
CT = total cost
Q = sales
P = unit price
Cvu = unit variable cost
CF = total fixed cost

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BASIC OF ECONOMICS

Break-even analysis

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BASIC OF ECONOMICS

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 the
techniques such as

Net present value

Payback period
Internal rate of return
Economic value added

Operations
Operations

Investment
Decision

Financial
Financial
Manager
Manager

How much to
invest and in
what assets?

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Financing
Decision

Financial
Financial
Markets
Markets

Where is the
$ going to
come from?

INVESTMENT EVALUATION

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.

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INVESTMENT EVALUATION

Net present value (NPV)

NPV =

F3
F5
F6
F1
F2
F4
+
+
+
+
+
F0
2
3
4
5
6
(1 + k ) (1 + k ) (1 + k ) (1 + k ) (1 + k ) (1 + k )

Ft
F0
t
t =1 (1 + k )

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
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INVESTMENT EVALUATION

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.
PBP

Ft F 0 = 0

Legenda:
Ft = net cash flow i.e.
cash inflow cash
outflow, at time t
k = discount rate
F0 = investment

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t =1

Ft
F0 = 0

t
t =1 (1 + k )

PBP

INVESTMENT EVALUATION

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

Ft
F0 = 0

t
t =1 (1 + IRR )

Legenda:
Ft = net cash flow i.e.
cash inflow cash
outflow, at time t
k = discount rate
F0 = investment

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REA
NPV

2514

k*
864

20%

10%

IRR

INVESTMENT EVALUATION

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.

NOPAT

EVA =
WACC CI
CI

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.

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