Cost and profit analysis

Vibha Bhan Rahul Babar

Dhanashree Prasad Bhojane

How it goes……

• Introduction• Classification• Cost function relationship • BEP• Evaluation of cases

COST• Costs of a firm is incurred to

establish the production unit and to purchase different factors of production.i.e. TC = TFC + TVC

• However, nothing is fixed in the long run.

Why…..

• The aim of the business is to maximize profits (Price- Cost).

• For this managers have to increase their revenues and minimize costs.

• The cost of production provides floor to pricing.

Classification of cost

COST RELATIONSHIP

fig

0

20

40

60

80

100

0 1 2 3 4 5 6 7 8

TFC

Output(Q)

01234567

TFC(rs)

1212121212121212

Total costs for firm X

fig

0

20

40

60

80

100

0 1 2 3 4 5 6 7 8

TFC

Output(Q)

01234567

TFC(rs)

1212121212121212

TVC(rs)

010162128406091

Total costs for firm X

fig

0

20

40

60

80

100

0 1 2 3 4 5 6 7 8

TVC

Output(Q)

01234567

TFC(rs)

1212121212121212

TVC(rs)

010162128406091

TFC

Total costs for firm X

fig

0

20

40

60

80

100

0 1 2 3 4 5 6 7 8

TVC

Output(Q)

01234567

TFC(rs)

1212121212121212

TVC(rs)

010162128406091

TFC

Total costs for firm X

fig

0

20

40

60

80

100

0 1 2 3 4 5 6 7 8

TVC

TFC

Output(Q)

01234567

TFC(rs)

1212121212121212

TVC(rs)

010162128406091

TC(rs)

12222833405272

103

Total costs for firm X

fig

0

20

40

60

80

100

0 1 2 3 4 5 6 7 8

TCOutput

(Q)

01234567

TFC(rs)

1212121212121212

TVC(rs)

010162128406091

TC(rs)

12222833405272

103

TVC

TFC

Total costs for firm X

Average fixed cost

Average fixed cost (AFC) = TFC/Q

where TFC = fixed cost, Q = total number of units produced.

Unit fixed costs decline along with volume, following a rectangular hyperbola. As a result, the total unit cost of a product will decline as volume increases.

Average Fixed costs

Q

Costs

AFC

O

Average variable cost

Average variable cost (AVC) is the TVC of a firm divided by the total units of output (Q).

AVC = TVC/Q

Q

costs

Y

AVC

O

Average cost

Average cost (AC) is the TC of a firm divided by the total units of output (Q).

AC = TC/Q = AFC + AVC

Q

costs

Z

AC

O

Marginal Cost

The additional cost incurred to produce one additional unit of output is called the Marginal Cost (MC).

MC = ∆TC/ ∆Q

Output (Q)

Co

sts

(rs)

MC

Marginal costsMarginal costs

Output (Q)

Co

sts

AFC

AVC

MCAC

z

y

Short run average cost curve

Long run cost curves

The Long run average cost (LRAC or LAC) curve illustrates - for a given quantity of production - the average cost per unit which a firm faces in the long run (i.e. when no factors of production is fixed).

figOutputO

Co

sts

LRACEconomiesof scale

Constantcosts

Diseconomiesof scale

A typical long-run average cost curve

fig

Deriving long-run average cost curves: plants of fixed size

SRAC3

Cos

ts

OutputO

SRAC4

SRAC5

5 factories

4 factories3 factories

2 factories

1 factory

SRAC1 SRAC2

fig

LRAC

Cos

ts

OutputO

Deriving a long-run average cost curve: choice of factory size

What is the break-even

point?

What is the break-even

point?

Revenues Costs=

Break-even

Calculating the Break-Even PointCalculating the Break-Even PointCalculating the Break-Even PointCalculating the Break-Even Point

At the break-even point, fixed costs and the contribution

margin are equal.

At the break-even point, fixed costs and the contribution

margin are equal.

Sales (? units) ?Variable costs ?Contribution margin 90,000 Fixed costs 90,000Income from operations 0

25 15

10

Sales (25 x ? units) ?Variable costs (15 x ? units) ?Contribution margin 90,000 Fixed costs 90,000Income from operations 0

25 15

10

Break-even sales (units) =Unit contribution margin

Fixed costs90,000

109,000 units

Sales (25 x 9,000) 225,000Variable costs (15 x 9,000) 135,000Contribution margin 90,000Fixed costs 90,000Income from operations 0

PROOF!PROOF!PROOF!PROOF!

Calculating the Break-Even PointCalculating the Break-Even PointCalculating the Break-Even PointCalculating the Break-Even PointIn UnitsIn Units

Sales (250 x ? units) ?Variable costs (145 x ? units) ?Contribution margin ? Fixed costs 840,000Income from operations 0

250 145

105

Break-even sales (units) =Unit contribution margin

Fixed costs840,000

1058,000 units

Calculating the Break-Even PointCalculating the Break-Even PointCalculating the Break-Even PointCalculating the Break-Even PointIn UnitsIn Units

The unit selling price is 250 and unit variable cost is 145. Fixed costs are 840,000.

Sales (25 x ? units) ?Variable costs (15 x ? units) ?Contribution margin ? Fixed costs 840,000Income from operations 0

250 145

105

Break-even sales (units) =Unit contribution margin

Fixed costs840,000

1008,400 units

250 150

100

Next, assume Next, assume variable costs is variable costs is increased by 5.increased by 5.

Next, assume Next, assume variable costs is variable costs is increased by 5.increased by 5.

Calculating the Break-Even PointCalculating the Break-Even PointCalculating the Break-Even PointCalculating the Break-Even PointIn UnitsIn Units

The unit selling price is 250 and unit variable cost is 145. Fixed costs are 840,000.

Sales ?Variable costs ?Contribution margin ? Fixed costs 600,000Income from operations 0

Break-even sales (units) =Unit contribution margin

Fixed costs600,000

2030,000 units

50 30

20

Calculating the Break-Even PointCalculating the Break-Even PointCalculating the Break-Even PointCalculating the Break-Even PointIn UnitsIn Units

A firm currently sells their product at 50 per unit and it has a related unit variable cost of

30. The fixed costs are 600,000.

Sales ?Variable costs ?Contribution margin ? Fixed costs 600,000Income from operations 0

Break-even sales (units) =Unit contribution margin

Fixed costs600,000

3020,000 units

50 30

20

60 30

30

Calculating the Break-Even PointCalculating the Break-Even PointCalculating the Break-Even PointCalculating the Break-Even PointIn UnitsIn Units

Management increases Management increases the selling price from the selling price from

rs50 to rs60.rs50 to rs60.

Management increases Management increases the selling price from the selling price from

rs50 to rs60.rs50 to rs60.

Summary of Effects of Changes on Summary of Effects of Changes on Break-Even PointBreak-Even Point

Summary of Effects of Changes on Summary of Effects of Changes on Break-Even PointBreak-Even Point

Target ProfitTarget ProfitTarget ProfitTarget Profit

Fixed costs are estimated at 200,000, and the desired profit is 100,000. The unit selling price is 75 and the unit variable cost is45. The firm

wishes to make a100,000 profit.

Sales (? units) ?Variable costs ?Contribution margin ? Fixed costs 200,000Income from operations 0

75 45

30

In Units

In Units

Sales (? units) ?Variable costs ?Contribution margin ? Fixed costs 200,000Income from operations 0

Sales (units) =Unit contribution margin

Fixed costs + target profit200,000 + 100,000

3010,000 units

Target ProfitTarget ProfitTarget ProfitTarget Profit In Units

In Units

75 45

30

Target profit is Target profit is used here to refer used here to refer to “Income from to “Income from

operations.”operations.”

Target profit is Target profit is used here to refer used here to refer to “Income from to “Income from

operations.”operations.”

75 45

30

Sales (10,000 units x 75) 750,000Variable costs (10,000 x 45) 450,000Contribution margin 300,000Fixed costs 200,000Income from operations 100,000

Proof that sales of 10,000 units Proof that sales of 10,000 units will provide a profit of 100,000.will provide a profit of 100,000.Proof that sales of 10,000 units Proof that sales of 10,000 units will provide a profit of 100,000.will provide a profit of 100,000.

Target ProfitTarget ProfitTarget ProfitTarget Profit

Graphic Approach to Cost-Volume-Profit

Analysis

Cost-Volume-Profit ChartCost-Volume-Profit ChartS

ales

an

d C

osts

(rs

000)

Sal

es a

nd

Cos

ts (

rs00

0)

0

Units of Sales (000)

500450400350300250200150100 50

Unit selling price 50Unit variable cost 30Unit contribution margin 20

Total fixed costs 100,000

Unit selling price 50Unit variable cost 30Unit contribution margin 20

Total fixed costs 100,000

60%60%

Total Sales

Variable Costs

1 2 3 4 5 6 7 8 9 10

Cost-Volume-Profit ChartCost-Volume-Profit ChartSa

les

and

Cos

ts (

rs00

0)Sa

les

and

Cos

ts (

rs00

0)

0

Units of Sales (000)

500450400350300250200150100 50

Unit selling price 50Unit variable cost 30Unit contribution margin 20

Total fixed costs 100,000

Unit selling price 50Unit variable cost 30Unit contribution margin 20

Total fixed costs 100,000

60%60%

40%

Contribution Margin

100% 60%40%

1 2 3 4 5 6 7 8 9 10

Cost-Volume-Profit ChartCost-Volume-Profit ChartSa

les

and

Cos

ts (

rs00

0)Sa

les

and

Cos

ts (

rs00

0)

0

Units of Sales (000)

500450400350300250200150100 50

Unit selling price 50Unit variable cost 30Unit contribution margin 20

Total fixed costs 100,000

Unit selling price 50Unit variable cost 30Unit contribution margin 20

Total fixed costs 100,000

Fixed CostsFixed Costs

100% 60%40%

TotalTotalCostsCosts

1 2 3 4 5 6 7 8 9 10

Cost-Volume-Profit ChartCost-Volume-Profit ChartSa

les

and

Cos

ts (

rs00

0)Sa

les

and

Cos

ts (

rs00

0)

0

500450400350300250200150100 50

1 2 3 4 5 6 7 8 9 10

Break-Even Point

Units of Sales (000)

Unit selling price 50Unit variable cost 30Unit contribution margin 20

Total fixed costs 100,000

Unit selling price 50Unit variable cost 30Unit contribution margin 20

Total fixed costs 100,000

100% 60%40%

100,000

20= 5,000 units

Cost-Volume-Profit ChartCost-Volume-Profit ChartSa

les

and

Cos

ts (

rs00

0)Sa

les

and

Cos

ts (

rs00

0)

0

Units of Sales (000)

500450400350300250200150100 50

Unit selling price 50Unit variable cost 30Unit contribution margin 20

Total fixed costs 100,000

Unit selling price 50Unit variable cost 30Unit contribution margin 20

Total fixed costs 100,000

100% 60%40%

Operating Profit Area

Operating Loss Area

Sony Play station ( Case study )

PS3 PS42006 2013

PAST SCENARIO

Earlier Models of PS4 incurred Losses. PS3 was launched in 2 types of models

Manufacturing Cost was $805 and $840Selling Price was $499 and $599

(Per Unit)

Loss of $305 and $245(Per Unit)

REASON FOR LOSSES

Hardware parts Cost: Custom chips and others. Hardware parts weren’t cheap during that period of time.

Sales:

Low Price compare to cost.

PRESENT SCENARIO

Abandoned custom components. Decided to use readily available components.

In turn adequate supply . Hardware prices dropped significantly after 2006.

Manufacturing Cost was $381Selling Price was $399

(Per Unit)

Profit of $18(Per Unit)

High Sales due to low selling price ( just above break even)

Toyota

Three competitorsToyota Honda Nissan

TOYOTA has bigger portion of share than others in Japan

Aim of Toyota:Lower the Break even point by Improving

manufacturing process

ProblemFinancial Crisis i.e. dropping Yen to dollars

(80 yen to $1)&

Low Sales in domestic market

Shifting production overseas or Lower Production Cost

(Nissan) (Toyota)

Possible Solution

Strategy to lower cost of production

They tried to Aim 70% capacity utilization (12000 units daily).

Assumes yen value to dollars of 90 yens to $1

(Preparing for worst case in advance)

Based on this they build production strategy (flexible)

Changed Layout of production ( more compact)

Forecasted fall of sale 17%

( more than predicted overall automobile market in Japan 9.9% )

Plans to produce 3.1 million units

and

sell 58% overseas.

Expected Result

40% less capital spending

Annual expenditure $8.4 billion

( half of previous year)

Lower break even point as a result by

Increasing sales by overseas sale