Week 8

Group 5
Kyra Iannesa Yanos
Christine Ericka Cristobal
Jessan Leigh Nicole Pimentel
Vida Camacho
Justine John Alvarez
Week 8 Topics
 COST & BREAKEVEN ANALYSIS
 Cost Concepts
 Future & Past Costs
 Incremental & Sunk Costs
 Types of Costs
 Determinants of Costs
 Economies & Diseconomies of Scale
 Contribution and Breakeven Analysis
 Breakeven Chart

Cost and Breakeven Analysis

Break-even analysis is a method of studying the relationship among sales

revenue, variable cost and fixed cost to determine the level of operation at
which all the costs are equal to its sales revenue and it is the no profit no loss
situation.
Cost Concept is all about the study of the behavior of cost with respect to
various production criteria like the scale of operations, prices of the factors of
production, size of output, etc. It is all about the financial aspects of
production.
Types of Cost Concept
Private cost refers to the cost of Production to an individual producer.
Social Cost refers to the cost of producing commodity to society in the form of
resources that are used to produce it.
From the social point of view, the economy has a certain volume of resources in
the form of capital, land etc., which it would be like to put to the best uses.
This depends upon the efficient and full utilization of resources and also the
specific list of commodities to be produced. It would be ideal if the social cost
coincided with the private costs of producing commodity.
Actual Cost and Opportunity Cost: Actual Costs or Outlay Costs or Absolute
Costs mean the actual amount of expenses incurred for producing or acquiring
a good or service. These are the costs which are generally recorded in the books
of accounts for cost or financial purposes such as payment for wages, raw-
materials purchased, other expenses paid etc.
Opportunity Cost or Alternative Costs: The Cost of production of any unit of
a commodity A’ is the value of the factors of production used in producing the
unit. The value of these factors of production is measured by the best
alternative use to which they might have been put had a unit of ‘A’ not been
produced.
Past Costs: Actual costs or historical costs are records of past costs.
Future costs are based on forecasts. The costs relevant for most managerial
decisions are forecasts of future costs or comparative conjunctions concerning
future situations.
Forecasting of future costs is required for expense control, projection of future
income statements; appraisal of capital expenditures, decision on new projects
and on an expansion programmed and pricing.
For Policy Decisions on Price:
The business enterprise depends upon future cost and not on Past Cost. Past
cost or historical cost is relevant only under the assumption that, the cost
conditions of the previous period would be duplicated in the future too.
Explicit Cost and Implicit Cost:
“The total cost of production of any particular goods can be said to include
expenditure or explicit costs and non-expenditure or implicit costs.”
Expenditure or Outlay or Explicit Costs are those costs which are paid by the
employer to the owners of the factor units which do not belong to the employer
itself.
These costs are in the nature of contractual payments and they consist of
wages and salaries paid; payments for raw materials, interest on borrowed
capital funds, rent on hired land and the taxes paid to the Government.
Non-expenditure or Implicit Costs arise when factor units are owned by the
employer himself. The employer is not obligated to anyone in order to obtain
these factors. Expenditure costs are explicit; since they are paid to factors
outside the firm while non-expenditure or implicit costs are imputed costs.
But the latter are costs in the real sense of the term, since the factor units
owned by the organizer himself can be supplied to other producers for a
contractual sum if they are not used in the business of the organizer.
Incremental Cost: Is the additional cost due to change in the level or nature of
business activity.
The change may take several forms e.g.:
(i) Addition of new product line,
(ii) Changing the channel of distribution,
(iii) Adding a new machine,
(iv) Replacing a machine by a better one, and
(v) The expansion into additional markets etc.
The question of this type of cost, would not arise when a business has to be set
up a fresh. It arises only when a change is contemplated in the existing
business.
Sunk Cost: Is one which is not affected or altered by a change in the level or
nature of business activity. It will remain the same whatever the level of activity
may be.
For Example:
The amortization of past expenses e.g., depreciation.
Distinction between the Sunk Cost and Incremental Cost:
It assumes importance in evaluating alternatives. Incremental costs will be
different in the case of different alternatives. The incremental costs are relevant
to the management in the analysis for decision--making. Sunk costs on the
other-hand will remain the same irrespective of the alternatives selected. Thus,
it need not be considered by the management in costs evaluating the
alternatives as they are common to all of them.
Short-Run and Long-Run Costs:
Short-run Costs are costs that vary with output or sales when fixed plant and
capital equipment remain the same.
Long-run Costs are those which vary with output when all output factors
including plant and equipment vary.
Short-run costs become relevant when a firm has to decide whether to produce
more or not in the immediate future and when setting up of a new plant in
ruled out and the firm has to manage with the existing plant.
Long-run costs become relevant when the firm has to decide whether to set up
a new plant or not. Long-run cost can help the businessman in planning the
best scale of plant or the best size of the firm for his purposes.
Thus, long-run costs can be helpful both in the initiation of new enterprises as
well as the expansion of existing ones.
Fixed and Variable Costs: Fixed Costs remain constant in total regardless of
changes in volume of production and sales, up to certain level of output. There
is an inverse relationship between volume and fixed costs per unit. If volume of
production increases, the fixed costs per unit decreases. Thus, total fixed costs
do not change with a change in volume but vary per unit of volume inversely.
Variable Costs vary in total in direct proportion to changes in volume. An
increase in the volume means a proportionate increase in the total variable
costs and a decrease in volume results in a proportionate decline in the total
variable costs.
There is a linear relationship between volume and variable costs. They are
constant per unit. Many costs fall between these two extremes. They are called
as semi-variable costs. They are neither perfectly variable nor absolutely fixed
in relation to changes in volume.
They change in the same direction as volume but not in direct proportion there
to. For Example— Electricity bills often include both fixed charge and a charge
based on consumption.
This is known as two-part Tariff:
Distinction:
The distinction between fixed and variable cost is very important in forecasting
the effect of short-run changes in the volume upon costs and profits. This
distinction has given rise to the concepts of Break-Even chart; Direct costing
and Flexible Budgets.
Direct and Indirect Costs or Traceable and Common Costs:
A Direct or Traceable Cost is one which can be identified easily and
indisputably with a unit of operation, i.e., costing unit/cost center. Indirect or
Common Costs are not traceable to any plant, department or operation as well
as those that are not traceable to indirect final products.
For example:
The salary of a Divisional Manager, when a Division is a costing unit, will be a
direct cost. The monthly salary of the General Manger when one of the
divisions is a costing unit would be an indirect cost.
Cost of Multiple Products:
In some manufacturing enterprises two or more different products emerge from
a single raw material.
For example:
A variety of petroleum products are derived from the refining of crude oil. In a
cigarette factory different parts of the tobacco leaves are used for different
qualities and products. They are identifiable as separate products only at the
conclusion of common processing generally known as the SPLIT OFF POINT.
Common Costs:
The costs incurred up to the Split off Point are common costs. Costs which
cannot be traced to separate products in any direct or logical manner. These
costs should not be identified with individual products if it is not meaningful
and useful to identify them.
In this existing product line some common costs are unaffected by the change
that how to be decided upon i.e., cost of factory building. Fixed common costs
need not be allocated since they are irrelevant for any decision and will remain
constant. Common costs that vary with the decision must be allocated to
individual products.
i) Sunk Cost:
A Past Cost resulting from a decision which can no more be revised is called a
Sank Cost. It is usually associated with the commitment of funds to specialized
equipment or other facilities not readily adaptable to present or future e.g.,
brewing plant in times of prohibition.
(ii) Shut-down Costs:
Are these costs which would be incurred in the event of suspension of the plant
operation and which would have been saved if the operations had continued,
e.g., for storing exposed property. Further additional expenses may have to be
incurred when operations are re-started.
(iii) Abandonment Costs:
Are the costs of retiring altogether a plant from service. Abandonment arises
when there is complete cessation of activities. These costs become important
when management is faced with the alternatives of either continuing the
existing plant or suspending its operation or abandoning it altogether.
Out of Pocket Costs:
Refer to costs that involve current cash payments to outsiders. On the other
hand book costs such as depreciation, do not require current cash payments.
Book costs can be converted into out of pocket costs by selling the assets and
having them on hire. Rent would then replace depreciation and interest, while
understanding expansion; book costs do not come into the picture until the
assets are purchased.
Historical Costs and Replacement Costs:
Historical Costs:
Mean the cost of an asset or the price originally paid for it. Replacement cost
means the price that would have to be paid currently for acquiring the same
plant. The assets are usually shown in the conventional financial accounts at
their historical costs.
But during the period of changing price levels historical costs may not be
correct basis for projecting future costs. Historical costs must be adjusted to
reflect current or future price levels.
Controllable and Non-Controllable Costs:
A Controllable Cost is one which is reasonably subject to regulation by the
executive with whose responsibility that cost is being identified.
Un-controllable Cost:
Un-controllable cost is that cost which is uncontrollable at one level of
responsibility may be regarded as controllable at some other higher level. The
controllability of certain costs may be shared by two or more executives. The
distinction is important for controlling the expenses and efficiency.
Average Cost, Marginal Cost and Total Cost:
(i) Average Cost is the total cost divided by the total quantity produced.
(ii) Marginal Cost is the extra cost of producing one additional unit. It may at
times be impossible to measure marginal cost. For example, if a firm produces
10,000 meters of cloth, it can become impossible to determine the change in
cost involved in producing 10,001 meters of cloth. The difficulty can be solved
by taking units of significant size. In general, economist’s marginal cost is cost
account cost.
The Determinants of Cost:
The cost of producing any given amount of output by a firm depends on
two main factors:
(a) The Quantities of Resources and Their Combinations:
The cost to the firm of producing any output evidently depends upon the
physical quantities of actual resources or services—labour, material, machine
hours, and so forth—used in production. Thus, the cost of producing a tons of
steel depends upon the quantities of iron ore, limestone, coal, blast-furnace,
etc. used in the production.
As the larger output requires the greater amount of resources, the total cost for
larger output becomes large. And the smaller output requires the smaller
resources; the total cost for smaller output becomes small. Besides, the total
cost for producing a given amount of output becomes small when these
resources are combined in optimum proportions.
(b) Techniques of Productions:
A firm can produce at low cost when it produces with the new and improved
techniques of production. Production with the old and outdated technique
involves higher cost. The profit maximization requires the use of the particular
technique of production which would allow the optimum combination of
factors.
In the short period the optimum combination for any given level of output is
the least-cost combination possible with the fixed factor units. But this may
not be the absolute optimum combination if all the factors could be adjusted.
Over the longer period, all factors can be varied, and so the firm is free to select
the production technique of factors.
Economies of scale are when the cost per unit of production (Average cost)
decreases because the output (sales) increases.
Diseconomies of scale are when the cost per unit of production (Average cost)
increases because the output (sales) increases.
Economies and Diseconomies of Scale
Growth brings both advantages and disadvantages to a business. These interact,
and depending on the nature of the business and the way it is managed, decide
the optimum or most efficient size for the business.
This is the area of economies and diseconomies of scale.
Figure 1 illustrates that average cost falls as output increases, with the result
that large firms may enjoy lower costs that smaller competitors. This
competitive cost advantage allows large firms to have larger profit margins and
have more options in pricing policy.

Figure 1: The effect of economies of scale on average cost

Reasons for economies of scale
The most common reason for Economies of scale is that some production costs
are fixed (as production increases these costs stay constant). Therefore, since
costs per unit (Average Costs) are calculated by dividing the cost by the
number of units of output
AC=Costs/quantity
Then any average involving Fixed Costs (Numerator) must decrease as quantity
produced (Denominator) increases (make sure you follow this ok)
AFC=FC/Quantity
Fixed Cost economies of scale:
1. Managerial - managers are on a fixed salary
2. Marketing - advertising, endorsements promotional events do not directly
depend on quantity produced
3. Technical - machinery, buildings etc. are paid for as a fixed amount
Purchasing economies of scale:
Large firms are able to negotiate more favorable terms when buying raw
materials etc.

1. Bulk buying - remember it is the cost per unit of buying in bulk not the total
cost (Great example is supermarkets and local shop)
2. Financial - similar in principle to buying in bulk but this time interest rates
a more favorable.
Reasons for the diseconomies of scale
1. Communication - becomes more complex
2. Coordination - between departments
3. X- Inefficiency - management costs increase (non-productive costs)
4. Principle agent problem - delegating to employees who are not as committed
as the owner
Breakeven Analysis
Break-even analysis entails the calculation and examination of the margin of
safety for an entity based on the revenues collected and associated costs.
Analyzing different price levels relating to various levels of demand a business
uses break-even analysis to determine what level of sales are necessary to
cover the company's total fixed costs. A demand-side analysis would give a
seller significant insight regarding selling capabilities. The concept of break-
even analysis deals with the contribution margin of a product. The contribution
margin is the excess between the selling price of the product and total variable
costs. For example, if an item sells for $100, the total fixed costs are $25 per
unit, and the total variable costs are $60 per unit, the contribution margin of
the product is $40 ($100 - $60). This $40 reflects the amount of revenue
collected to cover the remaining fixed costs, excluded when figuring the
contribution margin.

A break-even chart shows the sale volume level where the total costs are equal
to the total revenue of the company. The point where total costs are equal to
total revenues is known as the break-even point. The company would be in
profit above the breakeven point and would incur losses below this point.
On the vertical axis, the breakeven chart plots the revenue, variable cost and
the fixed costs of the company and on the horizontal axis, the volume is being
plotted. The chart helps in portraying the company’s ability to earn a profit
with the present cost structure.