Cost Indifference Point

DR. AVIJIT ROYCHOUDHURY

INSPECTOR OF COLLEGES,
VIDYASAGAR UNIVERSITY
 Sometimes there are two alternatives—one having low
variable cost and high fixed cost and the other having high
variable cost and low fixed cost. The cost indifferent point has
to be determined by linking the incremental fixed overhead by
the savings in variable costs.
This is another important tool that managers use to help
them choose between alternative cost structures is the
indifference point. The indifference point is the level of volume
at which total costs, and hence profits, are the same under both
cost structures. If the company operated at that level of
volume, the alternative used would not matter because income
would be the same either way. At the cost indifference point,
total costs (fixed cost and variable cost) associated with the two
alternatives are equal.
 In case of selection of machine, this point will be helpful
in calculating the levels of sales at which both machines earn
equal profits and the range of sales at which one is more
profitable than the other.

Definition:
The cost indifference point analysis tool determines
the point at which there is no difference in total cost between two
alternative methods. This tool is used to compare two strategies
and this analysis can be used to decide between
different cost structures or selling prices.
Distinction between Cost Indifference Point and Break Even
Point:
(i) The cost indifference point is the activity level at which
total cost under two alternatives are equal.
Whereas break-even point is the activity level at which the
total revenue form a product mix is equal to its cost.
(ii) Cost indifference point is used to choose between two
alternative processes for achieving the same objective. The choice
depends on the estimated activity level.
Break even point is used for profit planning.
Cost indifference point can be calculated as follows:
Cost Indifference Point = Differential fixed
cost/Differential variable cost per unit
Alternatively, we may calculate the indifference point by
setting up an equation where each side represents total cost
under one of the alternatives. (Because selling price is the same
under both of these alternatives, profits will be the same when
total costs are the same.) At unit volumes below the indifference
point, the alternative with the lower fixed cost gives higher
profits; at volumes above the indifference point, the alternative
with the higher fixed cost is more profitable.
Illustration: (Selection of Machine)
X Limited has been offered a choice to buy a machine between ‘A’
and ‘B’. You are required to compute:
a) Break-even point for each of the machines.
b) The level of Sales at which both machines earn equal
profits.
c) The range of Sales at which one is more profitable than the
other.
The relevant data is as given below: Machines
A B
Annual Output (in units) 10,000 10,000
Fixed Cost (₹) 30,000 16,000
Profit at above level of production (₹) 30,000 30,000

The market price of the product is expected to be ₹ 10 per unit

Solution (a):
Machines
A B
₹ ₹
Sales (10,000 x ₹ 10) 1,00,000 1,00,000
Less : Variable Cost (Bal. fig.) 40,000 60,000

Contribution (Fixed Cost plus 60,000 40,000

Profit)
P Contribution 60% 40%
Ratio = × 100
V Sales

Break Even Point (S)

Fixed Cost ₹ 30,000 ₹ 16,000
= = ₹ 50,000 = ₹ 40,000
60% 40%
P
V 𝑅𝑎𝑡𝑖𝑜
Break Even Point (in units) 5,000 4,000

Contribution per unit ₹6 ₹4

Variable Cost per unit ₹4 ₹6
(b) As the selling price of the products produced by A and B are
same, the machines will earn equal profit when total cost of
operation of both machines are the same.
If x be the output when total cost of the machines are the same,
we have total cost of machine A = 4x + ₹ 30,000
and machine ‘B’ = 6x + ₹ 16,000
Therefore,
4x + ₹30,000 = 6x + ₹16,000
2x = 14,000
x = 7,000
At a production level of 7,000 units the profits made by the
machines ‘A’ and ‘B’ are equal.
(c) The breakeven point of ‘A’ is at 5,000 units compared to that of
4,000 units in case of B and at a production level of 7,000 units
they earn equal profit.
It is quite clear that the profit earning capacity for machine ‘B’ is
more in the range of 4,000 to 6,999 units, as it starts earning profit
at lower point. But ‘A’ will earn more beyond 7,000 units, as it has
a higher P/V ratio, which will enable it to earn more contribution
on the increasing sales.
Illustration:
S manufactures a component that it sells for ₹8 per unit. The
company is contemplating an increase in selling price to ₹9 per
unit. If selling price is increased, the volume of sales is expected
to decline. Company is willing to increase the price if resulting
net income is greater than ₹30,000. The present position of the
company is as follows:
₹ ₹

Sales (25,000 units @ ₹ 8) 2,00,000

Less: Variable Costs (25,000 @ ₹ 5) 1,25,000
Fixed Costs 45,000
1,70,000
Profit 30,000

How far can the volume of sales decline before the price
indifference point is reached?
Solution:
Determination of sales levels at which profit of ₹30,000 is earned
with revised selling price:
We know that
(Selling Price per unit x Units sold = (Variable Cost x Units sold +
Fixed Costs + Target Profit) Suppose, x represents number of units
sold, then
9x = 5x + ₹45,000 + ₹30,000
or 4x = ₹75,000 or x = ₹18,750 units
This means that, if new price is to be accepted, sales must be more
than 18,750 units, which represents price indifference point.