Unit 6

Manufacturing Cost Analysis

Introduction to Cost Concept

Cost
Cost may be defined as the amount of expenditure incurred on a particular thing.

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Nature of Cost
 Fixed cost
 Variable cost
 Mixed cost

Fixed cost

Costs that do not vary with the volume being produced.

Purchase costs of machinery and tools and setup costs are considered fixed costs.
No matter what volume is produced, these costs remain the same.
Typical fixed costs include insurance and taxes on facilities, general management
and administrative salaries, license fees, and interest costs on borrowed capital.

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 Fixed cost -10 million / Plant / truck / 0~ 30,000 trucks
For more than 30,000 truck, need more fixed cost, for another plant

Relevant range

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 Variable Cost

 Costs that vary with the quantity produced.

 For example, the costs of material and labor used in a

product or service are variable costs, because they vary

in total with the number of output units, even though
the costs per unit stay the same.

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Mixed Cost
Mixed cost is partly fixed and partly variable. Because of variable component, it
fluctuates with output and because of the fixed component, they will not change
with the production volume.
Eg. renting a car
If your fixed daily rental charge is $40, your variable cost is $0.20 per mile, and
your activity level is 100 miles, what is the amount of your rental cost?

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 Element of Cost

 Material Cost
Direct Material Cost
Indirect Material Cost

 Labour Cost
Direct Labour Cost
Indirect Labour Cost

 Expenses
Direct Expense
Indirect Expense

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Material Cost
The cost of material, required for manufacturing a product.

Direct Material Cost

 Cost that can be reasonably measured and allocate to a specific output
or work activity.
 The materials costs directly associated with a product and service.

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 Indirect Material Cost

 Cost that are allocated through a selected formula

to the outputs or work activities.
 The cost of common tool, general supplies, and
equipment maintenance in a plant are treated as
indirect cost.

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Labour Cost
The cost of remuneration paid to the employees of the organization.

Direct Labour Cost –

identified with the individual cost centre and is incurred for those employees
who are engaged in the manufacturing process.
Wages paid to machinist, blacksmith , welder, etc.

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Indirect Labour Cost –
cost which cannot be identified with the individual cost centre and is incurred for
those employees who are not engaged in the manufacturing process but only
assist.
wages paid to foreman/storekeeper, salary of works manager, Accountant,
Personnel dept. salaries etc.

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Expense
Apart from material cost and labour cost, there are several other
expenditures such as cost of avdvertisement, cost of transportation etc., are
called expenses.

Direct Expense
It is that cost, which is charged directly to a particular job and are done for a
particular job.
e.g Cost of preparing drawings for manufacturing
Cost of experimental workdone.

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Indirect expenses
They are those expenses, which cannot be charged directly to a
particular product being manufactured.
Factory expenses – cost of fuel and power
Administrative expenses – general administration
Selling expenses – marketing
Distribution expenses – packaging, store officer, storekeeper

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 Component of Cost (Selling Price Determination)

i. Prime Cost
ii. Factory Cost
iii. Office cost or Production Cost
iv. Total Cost
v. Selling Cost

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Prime Cost
It is the direct cost and consists of direct material
cost, direct labour cost and direct expense

Direct Material Cost

+
Direct Labour Cost Prime Cost
+
Direct Expenses Cost

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 Factory Cost
It consist of prime cost and factory expenses

Prime Cost
+ Factory Cost
Factory expenses

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Office Cost or Production Cost
It consists of factory cost and administrative expenses.

Total Cost
It includes production cost, selling expenses and distribution expenses.

Production Cost
+
Selling expense Total Cost
+
Distribution Expenses

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Selling Price
Selling price of a product is obtained by adding the total cost to profits.
Selling price is the cost at which the customer get an item.
Profit
Distribution
expense
Selling
expenses

Determination of selling price Administrati

ve expenses

Selling Price
Total Cost
Production Cost
Factory
expenses

Factory Cost
Direct material
cost
Prime Cost

Direct labour
cost

Direct expenses

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 Example 3.1
A product manufacturing company has an annual production of 5000
units. Various associated costs are as follows:
i. Costs of raw material including transpiration = £ 10,000
ii. Wages of direct labour = £ 15,000
iii. Wages of supervisory staff = £ 5,000
iv. Expenditure on marketing = £ 10,000
v. Expenditure of administrative =£ 5,000
vi. Costs of tools, jib and fixture = £ 5,000
Find (a) prime cost (b) manufacturing cost (c)S.P, if 10% profit rate on
manufacturing cost.

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Example 3.2
A radio manufacturing company has the following expenditures”
Direct material cost = $ 20,000
Direct labour cost = $ 3000
Factory overheads = 10% of prime cost
Other overheads = 10% of work cost
Profit = $ 30% of total cost
Number of units produced per month = 30
Estimate selling price per unit.

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 Breakeven Analysis

Concept of Breakeven
Breakeven analysis implies that at some point in the operations, total revenues
equals to total cost.
Basically, breakeven analysis is concerned with finding the point at which
revenues and costs agree exactly-hence the term breakeven point.

Breakeven Point
A decision-making aid that enables a manager to determine whether a particular
volume of sales will result in losses or profits.

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 Basic Concepts

 Fixed costs remain roughly the same regardless of

sales/output levels.
 Variable costs are costs that change with changes in
production levels or sales.
 Revenue is the total income received.

 Profit is the money you have after subtracting fixed and

variable cost from revenue.

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 Fixed Cost and Variable Cost

Fixed cost is a cost that remains same while variable cost changes with the
regardless of volume of production level of production

Fixed cost is a time related variable cost is a volume related

Fixed cost are required to pay whether Variable costs only occurred when there
there is production or not. is production.

Fixed production is combination of Variable cost is combination of direct

fixed production overhead, fixed material, direct labor, direct expenses,
administration overhead and fixed variable production overhead, variable
selling and distribution overhead. selling and distribution overhead.

Examples of fixed costs are: Examples of variable costs are:

Staff salary, insurance, depreciation, Direct productive labour, Direct
rent, tax etc material, Direct expense

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 Angle of incidence

Margin of Safety

Fig. Break even chart

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 Breakeven Point

F
F F ( BEP) revenue 
( BEP) quantity    V
C S V 1  
 S
C=S-V
Where:
F = fixed costs
C = Contribution
V = Variable cost of each unit
S = Selling price of per unit
Ps = target profit

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Margin of Safety

 It is the distance between break even point and output to produce.

 A large margin of safety indicates that profits can be earned, if there is a reduction
in output.
 A small margin of safety indicated profits will be small when the output is
dropped.

 Sales  Sakes at BEP 

M arg in of safety     100
 Sales 
Pr ofit
M arg in of Safety 
V
1
S
Profit = Sales income – total Cost

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Angle of incidence
The angle between the total cost line and the total revenue line is called angle of
incidence.
A large angle of incidence represents large profit.
A narrow angle of incidence shows profits even though fixed overhead are
recovered.

Contribution
Contribution is defined as the difference between total sales and total variable cost
C = Selling price – Variable cost

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 Profit Volume (P/V) ratio
Profit to volume ratio measures the profitability.
Contribution
P/V ratio =  100
Sales
S V
 100
S

Profit BEP Profit

Loss Quantity

Fig. P/V graph

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 Solved Examples based on Break Even Analysis

Example 3.1
A company is producing glass bottles. The fixed cost assets = $40,000.
Variable cost = $10 per unit. If unit sales = $20,
(i) What is the minimum level of production, to attain profits, if firm produces
8000 units.
(ii) Find break even point.
(iii) Find margin of safety

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 Solution
F = $ 40,000
V= $ 10 per unit
S = $ 20 per unit
Q = 8000
VC = 8000 x 10 = $ 80,000
TC = FC + VC
= 40,000 + 80,000 = $ 120,000

F F 40,000
( BEP) quantity     4000 units
C S  V 20  10

F 40,000
( BEP) revenue    $80,000
 V  1  10
1  
 S 20

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Thus, minimum of 4000 units are to be produced to attain profits

 Sales  Sakes at BEP 

M arg in of safety     100
 Sales 
1,60,000  80,000
M arg in of safety   100  50%
1,60,000

Total Sale = Q x S =8000 x 20 =160,000

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 Example 3.2
The fixed cost for year 2001-2002, for a rubber industry is $ 80,000. Estimated
sales for that period is valued to be $2,00,000. The variable cost per unit is $ 4.
If each unit is sold at $ 20, and number of units involved coincides with expected
volume of output. Construct break even chart and determine
(i) Break even point.
(ii) How many units to be produced to seek profits.
(iii) Determine profits earned for turnover of $ 1,60,000.
(iv) Also find margin of safety.

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Solution
F = $80,000
V=$4
S = $ 20
Total revenue = $ 200,000
Unit produce = $200,000/ $ 20 = 10000 unit
Total V = $ 4 x 10000 =$ 40000
Total cost = F + V = $ 80,000 + 40,000 = $ 120,000
(i) BEP = (5000,10000)
(ii) Min of unit produced to seek profit = 5000 unit
(iii) Profit for turnover 0f $ 160,00
= 160000 – 112000 = $ 48,000
(i) Margin of Safety = 200000- 100000/200000 = 50%

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 Example 3.3, 3.4, 3.5, 3.6
Short Answer Type Questions
Exercise

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 Ref :

Anmol Bhatia, Industrial Engineering and Operations Management,

New Delhi, 2015

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