Discuss about the Venture Project Economics and Finance.
In modern business environment there are various factors that impacts business decisions of management and managers at veracious levels. Business organization is has to deal with various unpredictable factors that together impacts business operations. Financial management and management accounting in modern business environment has been growing at tremendous rate. These manage financial resources as well as cost components of business organization. Managerial decision making process has been changed to great extend for management of business operations. With the advent of growing competition and consideration of various external environmental factors, two important analyses becomes mandatory for management. Breakeven analysis and sensitivity analysis are two concepts that together provide decision making information to management or managers at various levels. Both the analysis use different input or data to process and generate some decision making information for management. We will be discussing both the analysis in detail in this literature review.
Breakeven analysis is an economic concept which is used to generate some information related to indifference point in cost of commodity and benefit from commodity. Breakeven analysis examines that point (i.e. indifference point) in business operations where cost of product is fully recovered. Breakeven analysis or point is that point of business operations where all cost related to commodity has been recovered. Beyond breakeven point there will be real profit for the business organization. From management prospective it is necessary for management or managers to change price of commodity according to competition and market conditions to stay in competition. Breakeven analysis is used in this situation for measuring cost and profitability after certain level of business operation (Badiru, 2016). Breakeven analysis supports profitability decisions of management along with cost control capabilities after certain level of business operations. Breakeven analysis uses relationship between costs incurred, profit per unit, selling price per unit and other managerial concepts.
Breakeven analysis has three main components that altogether support decision making process. Fixed cost can be defined as the cost which remains constant throughout the production process. Total fixed cost will be used in this method as base for calculating breakeven point in the production and selling process. Variable cost is the cost which changes with the change in level of business operations or production. Variable cost is incurred on per unit basis and varies in total. Selling price per unit is the per unit price of commodity at which it is exchanges between buyer and seller (Miranowski and Rosburg, 2010).
Breakeven point can be calculated in units and in monetary terms also. Breakeven analysis or point is that point at which all cost related to production is recovered and beyond that level there will be only profit. This analysis also helps business organization to take decisions related to selling price of product or commodity.
Breakeven analysis has been used by management or management accountant of the business organization in term of decision making process. Since breakeven analysis establishes relationship between cost, profit and volume (units), therefore this relationship is widely use by management in terms of deciding appropriate level of production (Yang and Meziani, 2012). Following are some other advantages of breakeven analysis:
Make or buy decision making: Breakeven analysis analyses relationship between production units and cost recovery point of operation. Then management can decide at breakeven point, if buying price of commodity is lower than variable cost then management shall opt for buy decision (Cipollini and Canty, 2013). Make or buy decision is not possible without analysis and interpretation of breakeven analysis results.
Production planning: Another advantage of breakeven analysis is production planning that can be taken on the basis of breakeven analysis results. Products recovering cost early shall be produced first and process shall goes on and this ultimately reaches to optimum production process with maximum profitability.
Optimum output: Breakeven analysis also reflected or analysis optimum level of output in the business organization. Since breakeven analysis results in calculation of profit or loss at different level of output therefore optimum level of out can be measured (Meena et al., 2013).
From the above graph it can be analyze that there are different point of time or different level of production under which cost is incurred. Indifference point or breakeven point is that point where income line cross or intercepts total cost (fixed cost and variable cost) line. On x axis of above graph, output or production units has been reflected. On Y axis, fixed cost and variable cost has been reflected. As and when output or production increases then there will be increase in variable cost and fixed cost at the same time (Lemons, 2012).
Line A shows income in above graph and before recovery of variable and fixed cost there is loss for the business organization. On the other hand, after line of inception or after breakeven line there will be profit for the business organization. Management can use such graph of breakeven analysis in decision making process. Once output or production or sales reaches Q point in above graph, then at that point of output all cost has been recovered (Sadrani, 2014). Beyond that point there will be only profit for the business organization and this area is known as margin of safety sales.
Business decision making is one of the most difficult and useful management accounting tool that can be employed by top management of business organization. In terms of decision making process managers or top management use what if analysis that analysis results under different situation. What-if analysis examines likely or probable outcome uncertain event. It is well known fact that business operates in uncertain and unpredictable external environment that management has be control and analyze in its decision making process. Sensitivity analysis comes into play when defined parameters and assumption are subject to errors or any uncertain changes while or after results. Sensitivity analysis also measures impact of changes or errors on end result or outcome of any process or model (Bris, 2015). Sensitivity analysis is the managerial tool that examines or measures change in result when input or data has been changed from its actual position or actual value. Sensitivity analysis explores changes in end result or defined output when source or input data is changed within specified limit. Therefore sensitivity analysis can be used as risk assessment tool for managerial decisions of business organization.
Sensitivity analysis has broader usage for the management or decision makers of the business organization in terms of various sections of business operations. Sensitivity analysis is majorly used for capital budgeting decisions because of long term nature of decisions and involvement of huge financial resources. Sensitivity analysis tends to measure accuracy in net present value of capital project that is undertaken. It is not used to measure risk or works net present value of capital project. As net present value of capital project is future oriented measure and requires prediction in terms of cash flows. Therefore risk of wrong estimation or wrong prediction is there that can lead to wrong decision making. Presence of sensitivity analysis can lower the risk by measuring end result under different net present value of undertaken capital project (Dimi and Liliana, 2014). Sensitivity analysis measures change in outcome or end result of capital project with the change in net present value. This is measures by analyzing ratio of change in net present value and change in outcome. Another use of sensitivity analysis is to establish relationship between input and output of system or decision making case. It is used define understanding and estimating relationship between input of case or system and output. This helps in assessing level of risk included in the undertaken case or system. This risk assessment capability will enhance understanding of risk involve in decision making and degree of change in output when there is change in level of input (Hirst and Murphy, 2015). Therefore sensitivity analysis is mainly used in decision making and case making situations by top management.
Planning tool: Sensitivity analysis is used to analyze and measure risk involve in undertaken project or future course of action. This capability serves useful information to management in terms of risk involved and level of changes required. Therefore management can plan for future course of actions and plan for safety stock in terms of different resources.
Problem identification: Sensitivity analysis measures risk involved in project and marks input points where risk is identified in overall system or undertaken project. This analysis identifies problem areas in achieving organizational objectives and goals by successfully completing different projects. Therefore this analysis provides direction to management at different level of business operation regarding crucial activities (Ferretti and Tarantola, 2016). Therefore management will be able to focus on identified crucial success activities or factors having high degree of risk.
Optimum solution of problems: Sensitivity analysis is used to identify optimum solution of the problem and provide less risky solution to the management. Sensitivity analysis provide base for change management in the undertaken project. Those areas in the project are highly sensitive then it can be replaced with alternate course of action or quality of those activities can be placed (Joshi and Zhu, 2016). This capability of sensitivity analysis serves base for decision making process to management in terms of successfully achieving objective of project.
References
Badiru, A. (2016). Equity Breakeven Point: A Graphical and Tabulation Tool for Engineering Managers. Engineering Management Journal, 28(4), 249-255.
Bris, M. (2015). Sensitivity Analysis as a managerial decision making tool. Faculty of Economics in Osijek, 291-294.
Cipollini, A., & Canty, P. (2013). Inflation breakeven in the Jarrow and Yildirim model and resulting pricing formulas. Quantitative Finance, 13(2), 205.
Dimi Ofilean, Dan Ioan Topor, & Liliana Paschia. (2014). Profit Sensitivity In The Decision – Making Process. Studia Universitatis Vasile Goldis Arad, Seria Stiinte Economice, 24(1), 199-213.
Ferretti, Saltelli, & Tarantola. (2016). Trends in sensitivity analysis practice in the last decade. Science of the Total Environment, 568, 666-670.
Hirst, Guy, & Murphy. (2015). PRM122 – Sensitivity Analysis: How Much Impact Does It Have on The Nice Decision Making Process? Value in Health, 18(7), A704.
Joshi, & Zhu. (2016). An exact method for the sensitivity analysis of systems simulated by rejection techniques. European Journal of Operational Research, 254(3), 875-888.
Lemons, D. (2012). When to Start Collecting Social Security Benefits: A Break-Even Analysis. Journal of Financial Planning, 25(1), 52-54,56-60.
Lokesh Kumar Meena, Chandra Sen, Shoji Lal Bairwa, Arun Jhajharia, & N. K. Raghuwanshi. (2013). Economics of Garlic Production in Baran District of Rajasthan; Break Even Analysis. Asian Journal of Agriculture and Rural Development, 3(10), 697-701.
Miranowski, J., & Rosburg, A. (2010). An Economic Breakeven Model of Cellulosic Feedstock Production and Ethanol Conversion with Implied Carbon Pricing. Department of Economics, 4-8.
Sadrani, Y. (2014). Breakeven Analysis. Business Technology, 5-15.
Yang, J., & Meziani, A. (2012). Break-Even Point Between Short-Term and Long-Term Capital Gain (Loss) Strategies. Journal of Investing, 21(4), 115-126.
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