Theory of Cost & Break Even Analysis

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THEORY OF COST & BREAK EVEN

ANALYSIS


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INTRODUCTION

The cost of production is an important factor in almost allbusiness analysis & decisions:-

Locating the weak points in production management

Minimizing the cost

Finding the optimum level of output

Determination of price & dealers margin

Estimating or projecting the cost of business operation.

COST CONCEPT:- Cost can be grouped on the basis of

their nature & purpose under 2 overlapping categories:- Concepts used for accounting purposes

Analytical concepts used in economic analysis of business activities.


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ACCOUNTING CONCEPTS

A). OPPORTUNITY COST & ACTUAL COST:-

Opportunity cost:- Opportunity cost is the cost related to the next-best

choice available to someone who has picked among several mutually

exclusive choices.

May be defined as the expected returns from the second best use of the

resources which are forgone due to scarcity of resources.

Also known as Alternative cost. It has been described as expressing "the

basic relationship between scarcity and choice.

A person who has $15 can either buy a CD or a shirt. If he buys the shirt

the opportunity cost is the CD and if he buys the CD the opportunity cost is

the shirt. If there are more choices than two, the opportunity cost is stillonly one item, never all of them.

Actual Cost:- Cost which are actually incurred by the firm in payment of

labor, material, plant, building, machinery, equipment, travelling &

transportation, advertisement, etc.


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B). BUSINESS COSTS & FULL COSTS:-

Business Cost:- Include all the expenses which are incurred to carry out a

business.

Include all the payments & contractual obligations made by the firmtogether with the book cost of depreciation on plant & equipment.

Used for calculating business profits & losses & for filing returns for income

tax & other legal purposes.

Full Cost:- Includes business cost, opportunity cost & normal profit.

C). EXPLICIT & IMPLICIT OR IMPUTED COST:-

An Explicit cost is a business expense accounted cost that can be easily

identified such as wage, rent and materials.

This cost directly effect the revenue.

Intangible expenses such as goodwill and amortization are not

explicit expense because these expenses don't show clear effects on abusiness's revenue and expenses.

An Implicit cost, cost which do not take the form of cash outlays, nor they

appear in accounting system. Eg. Opportunity cost.

Implicit cost + Explicit Cost = Economic cost


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D). OUT OF POCKET COST & BOOK COST:-

Out Of Pocket cost:- Items of expenditure which involve cash transfers,

both recurring & non-recurring.

All explicit cost falls under this category.

Book Cost, business cost which do not involve cash payments but a

provision is therefore made in the books of account & they are taken into

account while finalising the profits & loss accounts.

Eg. Depreciation allowances & unpaid interest on the owners own fun.


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ANALYTICAL COST CONCEPTS

A). FIXED & VARIABLE COST:-

Fixed costs costs that are not related directly to production rent,

rates, insurance costs, depreciation cost, maintenance of land, admincosts. They can change but not in relation to output.

Variable Costs costs directly related to variations in output. Rawmaterials primarily, running cost of fixed capital as fuels, repair,routine maintenance expenditure & cost of all other inputs that varywith ouput.


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B). TOTAL, AVERAGE & MARGINAL COST:-

Total Cost - the sum of all costs incurred in production

TC = FC + VCAverage Cost the cost per unit of output

AC = TC/Output

Marginal Cost the cost of one more or one fewer units of production

MC= TCn TCn-1 units

Or MC =H TC / H Q

C). SHORT-RUN & LONG-RUN:-

Short-run, cost which vary with the variation in output, size of the firm

remaining same.

Long-run, costs which are incurred on the fixed assets like plant,building, machinery, etc.

Become variable as the size or scale of production increases.


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D). INCREMENTAL COSTS & SUNK COSTS:-

Incremental cost, refers to the total additional cost associated with thedecision to expand output or to add a new variety of product. Etc.

In long run firms expand their production, they hire more men, materials,machinery & equipments.

Sunk costs, cost which cannot be altered, increased or decreased, by varyingthe rate of output.

Sunk Costs, Is an expenditure that cannot be recovered . In essence, it becomespart of fixed costs. E.g., abandon building.

E). HISTORICAL & REPLACEMENT COST:-

Historical cost, cost of an asset acquired in the past where as replacement costrefers to the outlay which has to be made for replacing the old assets.

F). PRIVATE & SOCIAL COSTS:-

Private costs, which are actually incurred or provided for by an individual or a

firm on the purchase of goods & goods from the market. All actual cost, bothimplicit & explicit are private costs.

Social cost, cost borne by the society due to production of commodity. Itincludes cost of resources for which company is not compelled to pay a price &cost of the disutility created by the company.


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SHORT-TERM COST-OUPUTRELATIONSHIP

Period over which the firm is unable to vary all its inputs.

Short Run TC = TFC + TVC TFC= Total fixed cost

FVC= Total variable cost

a). Total Cost:-

Actual cost incurred to produce a given quantity of output in the short run,include both fixed & variable inputs.

In the short run TC will only increase as TVC increases.

b). Total Fixed cost:-

Total obligations incurred by the firm per unit of time for all fixed inputs. These costs do not vary with the changes in output.

Have to bear irrespective to the size of output.

Eg. salaries of admt. staff., depreciation, property taxes, insurance, rent,etc


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CONT Also called as Overhead cost, all common to all units produced.

Other name for it are, supplementary cost & unavoidable cost.

c). Total Variable cost:-

Can be increased or decreased by the manager in short run

Variable costs will increase as production increases.

Total Variable cost (TVC) is the summation of the individual variable costs.

VC = (the quantity of the input) X (the inputs price).

eg. Cost of raw materials, cost of labor, cost of fuel, electricity,

Cost of transportation.

Cost(Rs.)

Output (Units)

Total fixed cost


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Shows variable cost directly proportional to output.

TVS

is 0 when output is 0 and rise when output rises. Its total productivity increases at an increasing rate, TVC

increases at a increasing rate.

Diminishing returns, more of variable factor combined with the

fixed factor, total productivity increases at decreasing.

Cost (Rs.)

Output (Units)

Total variable cost

Cost (Rs.)

Output (Units)

Total variable cost


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TOTAL COST

The sum of total fixed costs and total variable

costs:TC = TFC + TVC

In the short run TC will only increase as TVCincreases.


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Typical Total Cost

Curves


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Typical Total Cost Curves(selected attributes)

TFC is constant and unaffected by output level.

TVC is always increasing: First at a decreasing rate.

Then at an increasing rate.

TC is parallel to TVC:

TC is higher than TVC by a distance equal to TFC.


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Average Total Cost Average total cost per unit of output:

AFC + AVC

ATC = TC

Output


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Marginal Cost The additional cost incurred from producing an additional unit of output:

MC = ( TC

( Output

MC = ( TVC

( Output


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Typical Average &

Marginal Cost Curves


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Typical Average &

Marginal Cost Curves(selected attributes) AFC is always declining at

a decreasing rate.

ATC and AVC decline at

first, reach a minimum,

then increase at higher

levels of output.

The difference betweenATC and AVC is equal to

AFC.

MC is generally increasing.

MC crosses ATC and AVC at

their minimum point. If MC is below the average value:

Average value will be

decreasing.

If MC is above the average value:

Average value will be

increasing.


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Farm Size in the Long-

Run Nothing is fixed everything is variable.

Manager has time to adjust all inputs to the level that results in thedesired farm size.


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The Long-Run Cost Function

LRAC is made up for SRACs

SRAC curvesrepresent variousplant sizes

Once a plant size ischosen, per-unitproduction costs arefound by moving

along that particularSRAC curve


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Relation Between Output and Costs

as Farm Size IncreasesPercent change in total costs

Percent change in total output value

Three possible results:Ratio value Type of Costs Returns to Size

< 1 Decreasing Increasing

=

1 Constant Constant> 1 Increasing Decreasing


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Possible Size-Cost

Relations


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Economies of Size Increasing returns to size.

LRAC curve is decreasing.

Economies of size result from:

Full utilization of labor, machinery, buildings.

Ability to afford specialized labor and machineryand new technology.

Price discounts for volume purchasing of inputs.

Price advantages when selling large amounts of

output.


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Long-Run Average Cost Curve(Economies of Size)


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Diseconomies of Size

Decreasing returns to size.

LRAC curve begins to increase.

Diseconomies of size result from:

Lack of sufficient managerial skill.

Need to hire, train, supervise, and coordinate larger labor force.

Dispersion over a larger geographical area.

Disease control, waste disposal.


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Long-Run Average Cost Curve(Diseconomies of size)

Theory of Cost & Break Even Analysis

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