Indifference point

Indifference point
See also
Break even pricing Operational gearing Growth shares Free cash flow yield Equity Risk Premium Contribution to sales ratio Full Ratchet ABC method IFE matrix

Cost indifference point is the point where the total cost of the two alternatives is equal. 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. 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.

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.

Calculation 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:

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:

${\frac {E(1-t)}{N1}}={\frac {(E-I)(1-t)}{N2}}$

Where:

• 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.

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