Point of Indifference
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.
There may be two methods or two alternatives of doing a thing, say two methods of production. It is also possible at a particular level of activity; one production method is superior to another, and vice versa. There is a need to know at which level of production, it will be desirable to shift from one production method to another production method. This level or point is known as cost indifference point and at this point total cost of two production methods is same.
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.
For example, assume indifference point for a company’s new product is 18,333 units, calculated as follows, with Q equal to unit volume.
Assume the following details about two methods of production, A and B for the new product-
Production Method A = Fixed Rs 40,000; Variable cost per unit Rs 7
Production Method B = Fixed cost Rs 95,000; Variable cost per unit Rs 4
Selling price for both production methods Rs 10 per unit
The indifference point will be 18,333 units, calculated as follows, Q indicates unit Volume.
Total Cost for Production A = Total Cost for Production B
Fixed cost + variable cost = Fixed cost + variable cost
Rs 40,000 + Rs 7 Q = Rs 95,000 + Rs 4Q
Rs 3Q = Rs 55,000
Q = 18,333 units (rounded)
At volumes below 18,333 units, production A gives lower total costs (and higher profits); above 18,333 units, production B gives higher profits.
The line Rs 3Q = Rs 55,000 gives a clue to the trade-off between the alternatives. The company gains Rs 3 per unit in reduced variable costs by increasing fixed costs Rs 55,000. The indifference point shows that the company needs 18,333 units to make the trade-off desirable.
It may be noticed that break-even point for the two methods are:
Production method A= Rs 40,000/Rs 3 = 13,333 units
Production method B= Rs 95,000/Rs 6 = 15,833 units
Managers may have no correct answer in their choice of cost structure. Analytical tools such as the indifference point, margin of safety, and CVP graph help them evaluate alternatives, but the decision depends on their attitudes about risk and return. If they want to avoid risk, they will choose production A, forgoing the potential for higher profits from production B. If they are venturesome, they probably will be willing to take some risk for the potentially higher returns and choose production B.
Cost indifference point is useful in many decision situations, such as quality improvement programmes, different marketing plans, production plans or methods etc.
Cost indifference point should be distinguished from break-even point. Break-even point compares total sales and total cost of a product. Also, at break-even point total cost line intersects total sales line. As stated above, cost indifference signifies equality of total costs of two alternatives. At cost indifference point, total cost lines of two alternatives intersect each other.