This analysis helped me save INR 1 Lakh (USD 1200)
The analysis discussed here is about the Cost Indifference Point.
What is the Cost Indifference Point?
It is a point at which the total cost under two alternatives is equal.
The concept of “Cost Indifference Point” (hereinafter referred to as CIP), is used in financial decision making and guides a person in making financial decisions that are cost effective.
When it comes to making a decision between choosing one of the two alternatives then the concept of CIP comes to aid. Before we dive deep into it, let me share some background of how I discovered this concept and where this practically helped me make a decision that in turn is indeed a cost effective one.
In the realm of pursuing the course of Chartered Accountancy (CA), the concept of CIP came into light while studying one of the subjects namely SCMPE (layman terms — Costing). CIP is a part or subset of Decision Making. This concept broadly serves as a guide when we have to make a decision of choosing which alternative among the two will help us save costs.
Coming to the practical application, of CIP:
Recently my dad offered our car for sale and wished to get a new car. Yes, there are certain non-financial aspects as well in selecting a car. Similarly, in any case, there are financial as well as non-financial factors to be looked into. However, in this case, we will be focusing on the financial factor itself, which is where we benefit in terms of savings in cost. Moving on to financial aspects in selecting a car; the first point to take note of is the price of the car along with other charges (taxes, insurance, etc.). The second point to note is the cost per kilometre (cost per km).
There could be multiple cases where the price of a car as well as the cost per km of driving will be less than the other one. In such cases, savings in cost are evident, thus making it easy for any person to make a choice. But, for cases where the price of one variant is high and the cost per km is low whereas the price of another variant is low and the cost per km is high. How do we take a decision in such cases?
The answer to this is the concept of Cost Indifference Point. In our case, it is a point where the distance covered by a car would give us the same total cost under both alternatives. This means that the cost for both cars will be equal if driven up to certain kilometres. Any distance covered beyond that or below that would let us know which one to go for as the total cost of one would be less or more depending on the case. Therefore, the Total cost under any alternative will be the fixed cost which is the price of the car along with other charges, and the variable cost which is the cost per km.
To come to a conclusion as to which variant is better we have to find the number of kilometres where cost under both the alternatives would be the same. For the time being, let us assume 25000 kilometres to be our cost indifference point. What does it justify then? It means that if our car drove for a distance of 25000 kilometres then irrespective of which variant we go for, our cost will be the same under both the alternatives.
Further, what we also need to understand is that whenever the car is being driven less than 25000 kilometres then a variant with lower fixed cost and higher variable cost per km would be preferable. Why so? Because the savings which we will be making in cost of purchase (fixed cost) while selecting the petrol variant will get compensated by a higher cost per km to drive (variable cost) till the time it reaches a breakeven point of 25000 km. On the other side, any distance covered beyond 25000 kilometres will help us absorb more of the fixed cost which means that the high cost of purchase which we have incurred will be beneficial if used up to a greater extent. Also, this higher fixed cost will be compensated by a lower variable cost per km as there will be savings in every kilometre of distance that we cover.
We had two variants to choose from, one with a petrol variant and another with a CNG variant. The CNG variant is the one that is costlier in terms of fixed cost which is the cost of purchase as we have to pay an incremental cost for the CNG kit that is provided in the car. Subsequently, taxes and insurance as a percentage of Purchase cost too add up to this incremental cost. While it is now clear that the CNG variant comes with a higher fixed cost, it is also pertinent to note that this variant itself has a lower variable cost that is cost per km as compared to the petrol variant. The reason for this lower variable cost in the case of the CNG variant is due to mileage. Mileage of only petrol variant is low as compared to the CNG variant.
Before we get to numerical values, please note that the price of petrol and CNG have been assumed to be constant for a better analysis. Depending upon the number of years of usage, an average price of petrol or CNG can be considered for calculation or any alternative method as found suitable.
Petrol Variant — Alternative (A)
Fixed cost (Cost of Purchase, Duties and Taxes, Insurance, etc.) = INR 8,57,000 (approx. USD 10,300)
Cost of Petrol — INR 106; Mileage = 14 Kmpl
Therefore, cost per km = Cost of petrol / Mileage = 106 / 14 = INR 7.57
CNG Variant — Alternative (B)
Fixed cost (Cost of Purchase, Duties and Taxes, Insurance, etc.) = INR 9,65,000 (approx. USD 11,600)
Cost of Petrol — INR 76; Mileage = 24 Kmpl
Therefore, cost per km = Cost of petrol / Mileage = 76 / 24 = INR 3.17
Therefore, the formula for CIP would be the Difference in Fixed cost of both the alternatives divided by the difference in variable cost per unit.
This helps us understand that any distance covered beneath 24520 kilometres would make the petrol variant an economic alternative and vice versa.
In our case, it was clear that we do not intend to drive much which helped us realise that the petrol variant can be an economical purchase as compared to the CNG variant. Merely, by comparing the price of petrol and CNG we could never make a choice as such a less distance being covered by a car would give us a cost which would turn out to be on the higher side.
