4f.
Estimate profitability
• Economic analysis is the determination of
relationship of income and expenses to the material
welfare of the company.
• The problem is now to establish…..
• What the income from sales will be, subtract the
total product cost, and obtain a gross income.
• By subtracting income taxes, new earnings are
obtained which must be linked to total capital
investment to determine the attractiveness of the
venture.
• These conclusions must be conveyed to management
in one or more ways so that a sound decision can be
rendered.
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Economic Analysis
• There are a wide variety of problems which
will come up for economic analysis.
1. Sales price already established by competition
and plant capacity set by the marketing and sales
group. Determine the profitability.
2. Sales price already established by competition.
Determine profitability as a function of plant
capacity.
3. A new venture sales price to be established in
forms of profitability.
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Economic Analysis
• Methods of profitability
• Economic analysis methods are given below
– Percentage Return on investment,
– Pay-out time,
– Project present worth
• To proceed with the economic analysis net or
new earning must first be determined from
selling price less costs.
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4.10 Profitability analysis
Net and gross earnings
• The terms gross income or gross revenue used
by accountants refer to the total amount of
capital received as a result of the sale of goods
or service.
• The total income minus the total production
cost gives the gross earnings made by the
particular production operation, which can
then be treated mathematically by any of
several methods to measure the profitably of
the proposed venture or project.
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Net and gross earnings
• Net income or net revenue is the total profit
remaining after deducting all costs, including
taxes.
• Because of income-tax demands, the final net
profit is often much less than the gross
earnings. Income-tax rates are based on the
gross earnings received from all the company
interests. Consequently, the magnitude of
these costs varies widely from one company
to another.
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Methods of Profitability
• The word profitability is used as the general term
for the measure of the amount of profit that can be
obtained from a given situation.
• The most commonly used methods for profitability
analysis, can be categorized under the following
headings:
1. Rate of return on investment or percentage return on
investment
2. Discounted cash flow based on full-life performance
3. Net present worth
4. Capitalized costs
5. Payout period
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Percent return on investment
• Rate of return on investment is ordinarily expressed
on an annual percentage basis.
• The yearly profit divided by the total initial
investment necessary represents the fractional
return, and this fraction times 100 is the standard
percent return on investment.
• Profit is a function of the quantity of goods or
services produced and the selling price.
• The amount of profit is also affected by the economic
efficiency of the operation, and increased profits can
be obtained by use of effective methods which
reduce operating expenses.
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Percent return on investment
• According to formula it is given by.
rb = P x 100 / I
ra = E x 100 / I = P x m x 100 / I
Where,
rb = annual percent return on investment before taxes
ra = annual percent retur`n on investment after taxes
P = annual gross profit before taxes
E = annual new earnings = P.m,
where m = [1 - fraction for income tax ]
I = investment, fixed or total, with r specified accordingly
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Percent return on investment
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Percent return on investment
• An accepted rate of anticipated return will vary with the
degree of risk from obsolescence or competition.
• Low risk figures should apply only to those processes which
have been well established commercially with firm sales
markets.
• The high risk values are applicable to pioneering ventures
where scale-up and market conditions are uncertain.
PIYUSH M. GADHIYA 219
Pay-out time period
• In making economic studies involving the purchase of
new plants or equipment, it is frequently found
desirable to estimate the so-called “pay-out period”.
• The number of years n that will elapse before the
investments has been completely recovered through
savings or added earnings.
• Pay out time before taxes, nb is most commonly
expressed, using a fixed investment If, as follows:
• nb = If/P
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Pay-out time period
• The effect of both taxes and interest can be included in a pay
out calculation by means of a stepwise calculation, which will
determine, for each year, the net amount of capital recovered.
• This computation must be continued by years, until the entire
investment is shown as recovered. Given by following
equation
ni = log Z – log (Z - iIf)/log X – log Y
Where,
X = 1 + i/2, Y = 1 – i/2, Z = P(1 – t ) + t D = E + t D
i = effective fractional rate of interest
t = fractional tax rate applicable to earnings
D = deprecation allowed for tax purposes
P = annual profit of the plant before taxes and interest
PIYUSH M. GADHIYA 221
Present worth
• This method recognizes the time value of money.
• The time value of money depends on the earning rate at
which money is reinvested.
• Reinvestment at high earning rates requires recovery of the
initial investment as soon as possible.
• In the preceding treatment of discounted cash flow, the
procedure has involved the determination of an index or
interest rate which discounts the annual cash flows to a zero
present value when properly compared to the initial
investment.
• This index gives the rate of return which includes the profit on
the project, payoff of the investment, and normal interest on
the investment. A related approach, known as the method of
net present worth
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Present worth
• Capital to the company is at an interest rate of
15 percent. Under these conditions, the
present value of the cash flows is Rs.127,000
and the initial investment is Rs.110,000. Thus,
the net present worth of the project is
• Rs.127,000 - Rs.110,000 = Rs.17,000
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