Indifference point
Cost indifference point is the point where the total cost of the two alternatives is equal[1]. It can also be defined as the EBIT level above which the benefits of leverage operate in relation to earnings per share. The debt should be included into capital structure[2]. The cost indifference point is most commonly used in important decision-making situations, such as the preparation of new marketing or production plans or quality improvement programmes[3].
At this point, EPS ( earnings per share) would be the same as the level of EBIT ( earnings before interest and taxes). In other words, the point of intersection can be compared to the most likely level of intersection and can determine the financing combination. If the probability of EBIT falling below the indifference point is high, an equity alternative has to be prepared[4].
Example of cost indifference point
An example of cost indifference point is a company that is deciding whether to purchase a new piece of equipment or to lease it. The company has calculated that the total cost of purchasing the equipment would be $100,000, while the total cost of leasing the equipment over a three-year period would be $90,000. The cost indifference point for this decision would be $90,000, as this is the point at which the costs of the two alternatives are equal. The company would then weigh the additional benefits and drawbacks of each option, such as the flexibility to sell or upgrade the equipment if they purchase it or the lack of ownership if they lease it, to determine the best option for their business.
Formula of cost indifference point
In order to make this calculation, it is necessary to know at what level of production it is desirable to switch from one production method to another. At the point of cost indifference, the total cost of the two production methods is the same. Cost indifference point can be calculated as follow[5]:
Cost indifference point = differential fixed costs ÷ differential veriable costs per unit
Alternatively, the cost indifference point can be calculated by setting up an equation where each side represents total costs under one of the alternatives. Taking into assumption two alternatives, the indifference point can be also calculated using the following equation formula[6]:
Where[7]:
- E = EBIT
- I = Interest on debt capital
- t = corporate tax rate
- N1= Number of own shares outstanding under the first alternative financing plan
- N2= Number of own shares outstanding under the second alternative financing plan
With volume units below an inert point, an alternative with a lower fixed cost yields higher profits and with sizes above an inert point, an alternative with higher fixed costs is more cost-effective[8].
Applications of cost indifference point
The cost indifference point is typically used in situations where a company is comparing two or more alternatives and trying to determine the most cost-effective option. Some examples include:
- Capital Budgeting: When a company is deciding whether to invest in a new project or expand an existing one, the cost indifference point can be used to compare the costs and benefits of different options.
- Production Planning: A company may use the cost indifference point to compare the costs of different production methods or suppliers.
- Marketing: Companies may use the cost indifference point to compare the costs of different marketing strategies or to determine the most cost-effective pricing strategy.
- Quality Improvement: Companies may use the cost indifference point to compare the costs of different quality improvement programs and determine the most cost-effective option.
- Capital Structure: Companies may use the cost indifference point to determine the optimal level of debt in their capital structure.
In general, the cost indifference point can be used in any decision-making situation where a company is comparing the costs of different alternatives and trying to determine the most cost-effective option.
Decision problems related to the cost indifference point can arise in a variety of situations. Some examples include:
- Capital Budgeting: A company may be deciding whether to invest in a new project or to expand an existing one. The cost indifference point can be used to compare the costs and benefits of different options.
- Production Planning: A company may be trying to determine the most cost-effective production method or supplier. The cost indifference point can be used to compare the costs of different options.
- Marketing: Companies may be trying to determine the most cost-effective pricing strategy or marketing campaign. The cost indifference point can be used to compare the costs of different options.
- Quality Improvement: Companies may be trying to determine the most cost-effective quality improvement program. The cost indifference point can be used to compare the costs of different options.
- Capital Structure: Companies may be trying to determine the optimal level of debt in their capital structure. The cost indifference point can be used to determine the optimal debt level that maximizes earnings per share.
- Lease or Buy decision: Companies may be trying to decide whether to lease or buy an equipment, real estate, or other assets. The cost indifference point can be used to compare the costs of different options.
- Outsourcing: Companies may be trying to decide whether to outsource a particular function or to keep it in-house. The cost indifference point can be used to compare the costs of different options.
These are just a few examples of decision problems related to the cost indifference point. The cost indifference point can be used in any situation where a company is trying to determine the most cost-effective option among two or more alternatives.
Limitations of cost indifference point
The cost indifference point has some limitations that should be considered when using it to make decisions. Some of these limitations include:
- Limited information: The cost indifference point only takes into account the costs of the alternatives being compared. It does not consider other factors such as revenue, market demand, or long-term growth potential.
- Assumptions: The cost indifference point is based on certain assumptions such as constant costs, revenues, and interest rates over the entire period of analysis which may not hold true in reality.
- Time horizon: The cost indifference point is only valid for a specific time period. Any changes in costs or revenues beyond that period will not be taken into account.
- Limited to two alternatives: The cost indifference point can only be used to compare two alternatives. When there are more than two alternatives, it can be difficult to determine the optimal choice.
- Uncertainty: The cost indifference point assumes that future costs and revenues are known with certainty which is not the case in reality.
- Lack of consideration of qualitative factors: The cost indifference point is a quantitative analysis, which may not consider the qualitative factors that may affect the decision, such as brand image or customer loyalty.
These limitations should be taken into account when using the cost indifference point to make decisions. It is important to consider other factors and use a holistic approach when making decisions.
Footnotes
| Indifference point — recommended articles |
| Differential cost — Expected utility — Contribution margin ratio — Cost oriented pricing — Competition-based pricing — Competitive parity — Fixed cost — Valuation of companies — Cost per unit |
References
- Barnerjee B (2015) ‚Fundamentals od financial management , PHI Learning Pvt. Ltd. , New Delhi
- Khan Y. M (2004) ‚ Financial Management: Text, Problems And Cases , Tata McGraw-Hill Education, New Delhi
- Lal J (2017) Advanced Management Accouting (Text, Problems & Cases) , S. Chand Publishing, New Delhi
- Lal J (2009) ‚ Cost Accounting 4E , Tata McGraw-Hill Education, New Delhi
- Periasamy P (2009) ‚Financial Management, 2E , Tata McGraw-Hill Education, New Delhi
Author: Veniamin Terokhin
