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PART 3 LESSON 7

DECISION MAKING PROCESS

LESSON -7
DECISION MAKING PROCESS

Before going through various stages of decision making process, we must essentially
understand the word ‘decision.’ This word has been derived from Latin word ‘decide re
‘and this mean ‘a cutting off ‘. This decision involves a cut of alternation between these that
are desirable.

The decision making is a process to arrive at a decision. “Shell et al” have defined decision
making as follows:
“Decision Making is a conscious human process is involving both individual and social
phenomenon based upon factual and value premises which includes with a choice of
behavioral activity from among one more alternatives with the intention of moving towards
some desired state is affairs”.

Thus decision-making is an act of one’s own mind upon an opinion or cause of action.
Decision making May takes places with or without recognizing that an opportunity for
decision making exists. The recognizing of such situation (problems) is the first element of
a decision making process.

There must be at least two alternations available to have a decision making situation. There
will be no decision making if only one course of action is available because there is nothing
to decide.

There are eight main steps to decision making

1) Define specific goal.


2) Recognition of a problem
3) Collect all relevant data
4) Search for feasible alternative.
5) Criteria for judging alternation
6) Modeling the inter relationships
7) Predictions of out comes of alternatives.
8) Choose the best alternative

• Recognizing a problem:
Recognizing a problem is a real beginning of decision making process. Only when a problem
is recognized can the work toward its solution begin in a logical manner. The decision making
process begin with the recognition of a problem and the rush was on to determine what should
be done. A problem exist for a long time, it will be a problem only if it is recognized. In
typical situation like an overdrawn check, or exhausted supply of raw materials in a
manufacturing process, recognition of problem is obvious and immediate. Once we are aware
of the problem, we can solve it immediately

As we have already discussed, from the information external from the problem statement, the
objective function and constraints are formulated. A checklist may be useful for eliminating
error in problem formulation. Following is a sample checklist.

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1) Initial conditions should be considered eg: staff at the beginning.


2) Ensure that any non- negativity constraints are listed.
3) Confirm all variable in the objective function is listed.
4) Binary variables are restricted to 0 or 1.
5) Every problem in the problem statement should be implemented or restricted eg;
sunk cost.

• Define specific goal


Defining the goal or objective is an act of exactly deciding the task. The goal need not be
grand. It may be narrow and specific. It may be personal or in business situation. Personal
goal is to lead a meaningful life. In a business situation, objective is to operate profitably; in
both the cases, a situation, which would prevent the attainment of goal, is viewed as a
problem. Therefore the problems should be clearly defined. In fact, setting of specific
objective itself is an outcome of an earlier decision. This may not be considered truly as the
first step of decision process. It provides framework for further decision.

• Identification of alternation for further analysis:


We can usually derive a variety of ways of achieving an objective after some thought. There
must be alternative courses of action available for decision making. Since many alternatives
are available, we may overlook the best alternative of all. But there is no way to ensure that
the best alternative among the alternatives, the concept of limiting factors should be applied. If
the limiting factors are identified, they will confirm their search for alternative to those which
will overcome limiting factors.

We may find lot of alternation to a problem but they may be practical or impractical
alternations. An alternative may be infeasible for a variety of reasons such as violation of
fundamental law of science or require resources etc. After elimination only feasible
alternatives remain, and these became an input for further analysis.

• Criterion for judging alternatives.


We want to choose the best alternatives while making a decision. This can be done, if we
define what we mean by “best”. We recognize that the best is a relative adjective. Since we
are dealing with relative terms, the selection will be the alternative that is relatively the most
desirable. On absolute criterion, neither alternative is desirable. There will be unlimited
numbers of ways in which one may judge the results of decision- making. Following are the
examples of the possible criteria;

1. Use money in economically efficient ways.


2. Minimize the expenditure.
3. Minimize the time to reach goal or object
4. Minimize unemployment
5. Least disturbance to ecology.

It is very easy to select the criteria for choosing the best alternative. If the above five criteria
to a situation in which there were a number of alternation. It seems likely that the different
criteria would result in different decision. It may not the possible to minimize
unemployment without increasing expenditure of money at the same time. The

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disagreement between labor and management is collective bargaining wages and conditions
of employment reflect o disagreement over the criterion for selecting the best alternative.
After listing possible alternatives we have to weigh them without prejudice, no matte how it
is appealing or distasteful. While a suitable solution may solve the problem, it may not work
if resources are not available, if people won’t accept or if it causes new problem.

• Modeling the Interrelationship.


In the decision making process, the various elements like objective, relevant data, the feasible
alternatives and selection criterion must be brought together and merged. The relationships
may be obscure and complex as in trying to measure the impact of a domestic decision on
hold peace. They may not be possible to define on paper in a meaningful way. But if one were
considering barrowing money to buy an automobile. In this there is a readily defined
mathematical relationship between the variables like amount of loan, rate of interest, duration
of loan etc. the formation of interrelationship between the decision making elements is called
while solving the best alternation, we have to keep in mind the following important points;
 Consider your intuition or inner feeling in decision on a course of action.
 Consider compromise when you have a full grasp of the problem and your
alternatives. Comparing solution may yield a hybrid solution.
 Don’t consider any alternatives as perfect solution.

• Outcome for each alternative;


Each alternative produces a number of outcomes. A model is used to predict the outcome for
each of the feasible alternatives. To avoid unnecessary complications we assume that decision
making is based on a single criterion for measuring the relative attractiveness of the various
alternatives. The other outcomes are ignored. This single criterion is used to judge the
alternatives. Using the model, the magnitude of the selected criteria is computed and recorded
for each alternative.

• Select the best alternatives.


The final step is choosing the best alternative, after completion of all other elements of the
rational decision making process. If the other elements of decision making have been carefully
done, the choice of the best alternative is simply construction of model or model building.

Modeling an engineer may be of two forms


A physical representation of a real thing or system or a mathematical equation or equation is
that which describes the desired interrelationships. For a decision maker, the model is
mathematical. In modeling it is usual only the part of the real system that is important to the
problem at hand. Thus a mathematical model of a audience capacity of an auditorium might
be capacity = lw/k where l= length of the auditorium in meters w= width of auditorium in
meters and k= auditorium arrangement factor, accomplished by selecting the alternatives
which best meets the chosen criterion.

Decision making tools:

The following are some of the technologies used in decision making process.
1. Brain storming process
2. Linear programming.

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Brain storing process:


Brain storming process is a Group decision making technique for problem- solving, team
building and creative process. Brain Storming process because it involves members of a
team in important management issues. This makes the team to work together. The brain
storing needs to be structured to get excellent results.

1. Objectives: Define objectives.


2. Problem: the problem on which decision is required is given to the group.
3. Generate ideas: Each member is required to give their own ideas to solve the
problem. Emphasis will be given to quantity, rather than quality first This is to generate
maximum number of ideas.
4. Applying to problem solution: The group members have to put their ideas for
problems solution without considering any limiting factors, like financial, legal,
organizational factors etc.
5. This is because the limiting factor will act as different to free flow of ideas of
members.
6. Time scale: brain storm ideas and suggestion having agreed a time limit.
7. Evaluate ideas: In the last stage, the ideas have to be evaluated. The members are
required to be away from any criticism, judgment or comment.

Linear Programming
Linear programming is a mathematical technique used in economics. This is to find
optimum objective function, subject to a set of constraints. The function must be linear in
order, for LP technique to use. This is to achieve the best allocation of its limited resources
such as money, materials, machines, spaces, time etc in a typical organization.

The features of linear programming are:


a. Objective functions:
The goal which is to be achieved by the application of LP in solving a problem is called as
objective function. In the problem, there must be clearly defined objectives and should be
expressed quantitatively.
b. Non negative condition:
The values of each variable can either practice or zero in LP model. In no case it can be
negative. If it is negative then the whole technique will be rendered useless.
c. Constraints/ restriction:
These are restriction imposed on variable. The variable may be in the form of labor,
machine or raw material etc. these constraints must be capable of arithmetical expression.
d. The linear relation ship:
The relationship is expressed in the form of expression or in equalities. They must be
linear. Linear programming (LP) problem can be solved by the graphical method.

Sensitivity Analysis

The problem may be modeled using objective function. In reality there will be variation.
Suppose that you don’t know the value of a variable, but you have an idea of lowest
possible value and the highest possible value that it can take. A sensitivity analysis can be
performed to determine the sensitivity of the solution to change the parameters. Therefore

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sensitivity analysis is a technique by which to find whether a particular utility or


possibility is important in determining the performed option.
Sensitivity analysis requires a lot of computation when you allow the value of an uncertain
parameter to take on every value in the range in order to graph the relationship between
value of the parameter and the expected outcome. Therefore, Microsoft excel can be used
to generate a sensitivity report which may be in two parts. One is changing cells report and
the other is constraint report.

Report on changing cells;

Cell Particulars Value Cost Objective Increased Decreased


no (2) (3) reduced coefficien allowance Allowance
(1) (4) t (6) (7)
(5)

1. The allowance increase or decrease refers to how much the objective function
decision variable coefficient can change without changing the values of any of the decision
variable.
2. The objective function value will change. If a coefficient changes, the
corresponding decision variable does not change.
3. 100% rule can be used to determine if a change in multiple objectives function
coefficients will change the value of the decision variable. Any combination of changes can
occur without a change in the solution, up to the total percentage, deviation does not exceed
100%
4. The decision variable coefficient is the effective numbers that is multiplied by
decision variable when the objective function is simplified, so that each decision variable
appears once.
5. How much reduced cost is more attractive the variable’s coefficient in the
objective functions, must be before the variable is worth using.

Cell Particulars Final Shadow Cons- Increase Decrease


no value price traint allowance allowance
RHS

The shadow price in business applications is the maximum price that management is
willing to pay for an extra unit of a given limited source. The amount that the change in
objective function value is obtained by a change in constraint by one unit.

The shadow price is valid up to the allowance increase or decrease in the constraint. To
determine if a constraint is binding, compare final value with the constraint RHS. If the
constraint is non binding its shadow price is zero.

Simulation:

Simulation is a linear programming technique which assumes certainty and do not deal
with randomness by themselves. Procedure for maximizing or minimizing some objective
function, that contains random variables as follows;

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1. Objective function should be defined in terms of the decision variable.


2. Clearly mention a search range and incremental search value for the decision
variable. Possibly using problem information to reduce the search range.
3. Run a simulation for each incremental value of the decision variable using Monte
Carlo simulation such as crystal ball.
4. Compare the mean expected value of the objective function and their confidence
intervals, possibly using statistical hypothesis testing to identity the best solution.

Investment decision making;


The investment decisions are made by investors. They perform investment analysis by
using from broad approaches in the stock market
1. Fundamental approaches
2. Psychological approaches
3. Academic approaches

Fundamental approaches:
Fundamental approach is perhaps most commonly advocated by investment professionals.
The basic principle of fundamental is as follows
• There is an intrinsic value of security, which depend upon under lying economic
function.
• The intrinsic value can be established by analysis of fundamental factors of
company or industry.
• Prevailing market price will differ from intrinsic value.
• Sooner or later the market price may come in line with intrinsic value.
• Buying undervalued securities and selling overvalued securities, the investor get
superior return.

Psychological approaches:
This approach is based on the premise that stock price are guided by emotion rather than
reason.

Relevant data concepts:


Decision analysis in business is the discipline of evaluating complex alternatives in terms
of values and uncertainty. Values are generally expressed monetarily. At a first step,
collect all information relevant to the decision process. In business the information are
relevant cost and relevant revenues. Eliminate all non relevant data from the decision
calculation.

Relevant cost and relevant revenues:


It is very important to recognize the cost and revenue that are relevant to the decision.
Therefore no relevant data is to be excluded in decision process. Relevant cost may be
defined clearly. These costs are appropriate to help in making specific decision. This
means those cost which change as a result of the decision.
a. The relevant cost is expected future cost.
b. Relevant revenue future revenue.
c. Historical cost or revenue may be helpful as a basis but historical cost themselves
are irrelevant when making decisions.

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d. There are items which influence a decision but can not be accurately measuring in
monetary terms. There factors are called a qualitative factors. While making decision,
appropriate weight age must be given to the factor.
e. There are qualitative factors, which are non- financial, must be considered
carefully and must given appropriate weight age.
f. The cost and revenues will remain unaffected during the decision process, which
are called as irrelevant cost. Therefore relevant cost and relevant revenues differ among the
alternative course of action.
g. Relevant range is another concept in decision making. The fixed cost remains
fixed over a range of activity. This leads to cost behaviors e.g. fixed cost, variable cost,
semi variable cost. The cost behavior does not necessary to determine the relevant of cost.
h. In any business decision, the earnings must consider the effect of income taxes.

COST CATEGORIES.

1. Actual cost: Actual cost refers to real transactions.


2. Discretionary cost: Discretionary cost is corresponding to strategic goals (e.g. by
improving the firm’s image through advertisement) but not strictly for current production.
3. Production cost: Production cost is usually classified according to their
responsiveness to different levels of production.
4. Fixed cost: Fixed cost represent a cost which remains constant in total cost without
responsive to production level. This concept of fixed cost remains valid within the specific
range of output or turnover. But the incidence of fixed cost on unit cost decreases as
production increases. E.g. rent of building, depreciation, legal fee. If there are only fixed
cost the total cost follow this rule . For instance the rent is a fixed cost, because this constant
fixes it for a certain period of time (say one year), without reference to the income produced
by the operations that takes place in the same office.
5. Variable cost: Variable cost is a cost which varies with the change in the volume of
activity. Variable cost grow with high levels of production. It varies total but in incidence
on unit cost remains constant. Example; material cost, labor cost, power and fuel etc. the
behavior of variable cost is placed on graph
6. Semi variable cost: Semi variable cost is a cost which is partly fixed and partly
variable. This semi variable may remain constant within a certain line activity but if the
specified levels of activity exceeds they vary without having direct relations ship to volume.
Example: fixed sum of salary per month i.e. $ 3000 paid per month; if he exceeds specified
production of 1000 units he will be getting incentive of $ 0.50 per unit. If he produces 1000
units he is eligible for $3000 as salary. It produces 1500- his salary is 3000+ (500*0.5) i.e.
3250$. Diagram. In cost analysis, semi variable cost present lot of problems, because there
is no readily ascertainable relationship between cost and volume. Here the cost must be
separated into fixed and variable elements.
7. Avoidable Cost : Avoidable cost is cost that can be avoided or saved by not
following specific activity or sector of a business. The avoidable cost is relevant for
decision making purpose. In general that those alternatives which generate revenue in
excess of avoidable cost should be selected for. The unavoidable cost is the one that cannot
be avoided if we follow ss specific action. For example the rent is an unavoidable cost.
8. Sunk cost: The concept of sunk cost is very important in decision making. Because
sunk costs are irrelevant cost for decision making. Sunk cost is investment cost incurred
before a certain activity takes place. This cost cannot be recovered. The sunk cost remains
unaffected by choice between various alternations. For examples; R&D a highly specific

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irrelevant are usually sunk cost. Following important points with regard to should be kept
in varies while making decision.
a. Sunk cost cannot be recovered.
b. These irrelevant. But all irrelevant cost is not sunk cost.
c. Suck cost represents behavior to exit. A firm incurred heavy expenses on R&D, but
it will be difficult to decide to exit market even if it sees good opportunities our side.
d. Sunk cost may be useful for analyzing the market, as in the case of exports.
e. Sunk cost is distinct from economic loss.
9. Opportunity cost: Opportunity cost is the measure of benefits forgone for adopting a
specific course of action. This is the most important factor to be considered in decision
making. This cost is relevant in a situation where the resource is scarce. The opportunity
cost of something in terms of an opportunity forgone. The opportunity cost need not be
assessed in monetary terms. Opportunity cost is not incorporated into formal financial
accounting records.

Cost-Volume-Profit relationship:
The relationship of analysis can be presented in the following ways:
1. Formulae
2. Reports or statements.
3. Charts- such as breakeven chart. Etc.

Formulae: This method involves finding out different values by the use of marginal cost
equalize.
(i.e) = sales – (fixed cost +variable cost) = profit,
Sales – variable cost = fixed cost +profit.
S – v = f+p.
Or p/v ratio = (sales- marginal cost of sales) / sales.

1. Statements or reports show how the relationship of CVP is presented.


2. Graphic presentation of CVP relationship: This is an effective means of
presenting CVP relationships. This is in the form graphic charts. Following important charts
to depict the CVP relationship.
– Break-even chart.
– P/V. chart.
– Sequential profit

Break even analysis:


Break even analysis is a technique used by management accountants and production
management. This is based on classifying the production cost into variable and fixed cost.
The variable cost are cost that change where production changes and fixed cost are cost
that can not directly related to volume of production. These variable and fixed costs are
compared with sales revenue in order to determine the level of sale volume or production
volume at which the business makes neither profit nor loss. This is the Break-even point.

That means the point where operating income equals zero. Or at a point where total
revenue is equal to total cost.
BEP units = F.Cost/Contribution per unit.
The break even points in dollars can be found by using the formula:
Fixed cost /contribution margin percentage.

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$1500 * 100/30 = 15000$.


Break even chart
This is the graphical representation of cost of variable of various levels of activities, as a
sale or revenue varies with the same variation in activity. The point at which no loss or no
profit is made is known as Break even point.

Cost / Volume / Profit Analysis:


“Profit” is a goal of the business and a matter of concern to the management. The
capability to make right prediction about the future profit shows the efficiency of the
management. For this purpose, the correct relationship is required for cost, volume, and
profit. All the three will never remain constant. Sales / volume may go up or go down. The
profit will change correspondingly. The profit analysis warrants the knowledge of
relationship existing among factors like cost, volume and profit.

The main uses of analysis of cost, volume, profit are :


 Prediction of future profit.
 Pricing products during lean season
 Evaluating profit performance.
 Profit planning – for a specific contact or project..
 Pricing issues
 Decision making process.

It is necessary to know the following costing terminologies before taking up the detailed
study of CVP analysis.

Marginal costing:
CIMA defines the marginal costing “as the accounting system in which variable cost are
charged to cost units and fixed cost of the period are written off in full against the
aggregate contribution. Its special value is in decision making”. The marginal costing is a
technique which uses data to reveal the true relationship of costs- volume – profit. This is
not a method of costing like process costing or standard costing.

Under this system, the cost is analyzed into two categories; one is fixed cost and the other
is variable cost. Fixed cost will be written off against contribution. The Excess of
contribution over fixed cost is profit or net margin. Emphasis will be given only to
increase total contribution.

Fixed cost:
This cost remains constant for a period of time or over a range of volume of sales of
production. For examples rent is a fixed expense. The expenses will be increased for a
period of time irrespective of volume of production.

Variable cost:
The variable cost changes directly in proportion with volume. Variable cost per unit of
production remains constant irrespective of change in out put. Total variable cost changes
with the changes in volume of output.

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Variable cost includes Cost of direct material, direct labors and direct overhead expenses.
Variable cost per unit can be arrived at either by deciding total variable cost by number of
units produced or by dividing change in cost by change in volume.

i.e. = total variable cost______ = unit variable cost.


number of units produced
or

change in cost__________ = unit variable cost.


Change in volume of output

Marginal cost:
CIMA defines marginal cost as “the cost of one unit of product or service which would be
avoided if that unit were not produced or provided”.

Following terms are very essential to understand Cost Volume Profit relationship

Sales mix:
This is the total sales revenue of various products, i.e, the percentage of each product
added to from total revenue. The same will be maintained for all volume changes. This is
also called as revenue mix.

Unit contribution margin:


This is a unit selling price minus unit variable cost i.e, the contribution available by selling
one unit. It is the contribution from sale of one unit which is available to cover fixed cost.
This is expressed in amount or in percentage of selling price.

Operating income:
Operating income = sales – variable cost – fixed cost. This operating income is zero at
break even point.

Semi variable cost:


Since the cost includes both fixed and variable elements. The semi variable cost is known
as mixed cost.

P/V Ratio:
The profit / volume ratio expressed the relationship between contribution and sales. This is
expressed as a percentage of sales value. The statement that P/V ratio is 40% means the
contribution is 40$; if the size of the sale is 100$. P/V ratio remains same as all levels of
output. P/V ratio is also called a marginal income ratio or contribution of sale or variable
profit ratio. This is my be expressed as

P/V ratio = (sale – marginal cost of sales) / sales

The same may also be expressed as follows


= contribution / sales or
= change in contribution / change in sale or
= change in profit / change in sale.

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Change in product mix which increases the contribution

This will lead to improvement of margin of safety. This will increase the gap of sale at
specified level of activity and sales at BEP.

Lowering fixed cost:


The lowering of fixed cost, make the increase in contribution. Therefore it increases the
margin of safety.

Lowering of variable indirect expenses:


As a result of lowering the indirect expenses the P/V ratio improves. This leads to improve
in margin of safety.

Breakeven chart:
Breakeven chart is the pictorial expression of relationship of cost-volume-profit.
Breakeven chart demonstrates importance of fixed cost in the operation of an organization.

Soundness of business can be measured by M.O.S. This is very helpful to take decision to
reduce price, to face competition.

The profit is the concern of the management. Margin of safety indicates how much present
output is able to keep the business away from the breakeven point. Therefore management
is always giving importance to improve the margin of safety. The margin of safety can be
improved by following the steps.

Increase in selling price; in certain cases, it is not possible to increase the sale volume. The
sale price can be increased to improve the margin of safety

Increase in sale volume: If the sale volume increases the sale at BEP and present sale
increase. The margin of safety also increases.

Beak even point


Breakeven point is the level of output or sale made at which the company makes no profit
or loss, that is total revenue is equal to total expenses. In marginal costing, difference
between sales and variable expenses is .Contribution includes fixed cost and profit. At a
particular point where the company has made no profit or no loss then the point is
breakeven point. At breakeven point fixed expenses are equal to contribution.

Total cost line and total sales line intersect in graphical presentation of cost / volume /
profit relationship. That point of intersection is called breakeven point.

Margin of safety
The margin of safety is the difference between actual out put or sales and output sales at
breakeven point. This is expressed in percentage of sales.

Margin of safety = sales – breakeven point.

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The main tools of CVP analysis are


o Break even analysis.
o Contribution margin analysis.
o Operating leverages

– BE analysis; we have already discussed Break even analysis before.


– Contribution margin analysis: this is a technique used in brand marketing
and product management to help a company to decide what products to add to its products
list. The management is interested to know the reaction on profit if we add a new product or
discontinues the existing product.
Contribution margin is sales revenue less variable cost. This is an amount available to
meet fixed cost and provide for profit.
Contribution = fixed cost + profit.
Contribution margin per unit = selling price per unit– variable cost per unit.
Contribution margin percentage= contribution margin per unit / selling price per unit.

Profit per unit 100units %


Sales = $10 $1000 100%
Variable cost = $ 5 $ 500 50%
Contbn. Margin = $ 5 $ 500 50%

Contribution margin income statement;

Sales in 0 10 20 30 40
Units
Sales
Revenue $0 $100 $200 $300 $400
Variable
Cost 0 $ 50 $100 $150 $200
Fixed
Cost $100 $100 $100 $100
Operating
Income ($50) $0 $50 $100

Operating leverage:

The operating leverage is a measure of how the growth of revenue turns into growth in
operating income. Generally contribution margin is a measure of operating leverage The
higher contribution margin increase with sales. If contribution is a fixed quality, it does
not change with sales.

Another point we have to remember is the operating expenses consists of fixed cost and
variable costs. If the variable cost is equal to operating expense then the operating margin
would be constant as sales grow.

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CVP employs the following assumptions:

• Costs have classified accounting as either fixed or variable. This is very


difficult in practice.
• Ability to predict cost at different levels of activity volumes must be
possible.
• The analysis presumes all units produced are sold.
• Differential price policy makes breakeven analysis a difficult exercise. This
warrants a series of breakeven charts.
• The analysis presumes that efficiency & productivity remains unchanged.
• Production equals sales
• The time value of moneys is ignored
• Selling price is not constant at all levels of sales. High level sales may be
possible by offering substantial discount, depend up on competition
• Prices of input factors will remain constant.
• Volume is the only relevant factors affecting cost, but other factors also
affects cost and sales. In the breakeven analysis, the factor of sales and cost are presented
when other factors are ignored.
• Fixed cost remains constant over a given range of volume. But they vary
indirectly with the volume.
• Technology, marginal policies and production efficiency are constant.

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