BMT1009

BMT1009
Production
Production and
and Operations
Operations
Management
Management
Unit-II
Unit-II
 Cost Concept
 Cost refers to the expenditure incurred to produce a
particular product or service.

 Costs may be monetary or non-monetary; tangible or

intangible; or/and determined subjectively or
objectively.

 Social costs such as pollution, noise or traffic

congestion add another dimension to the concept of
cost.
 Element of Costs
Costs of Production can be broadly classified into following
elements:
 Material Cost
 Labour Cost
 Expenses
The cost of production normally includes the cost of
raw materials, labour and other expenses. This cost is known
as the total cost (TC). This is compared with the total
revenue (TR) realized on the sale of the products
manufactured. The difference between the TR and TC is
termed as Profit (TR-TC=Profit).
 Element of Costs (Contd.)

Cost

Material Labour Expenses

Direct Direct Direct

Indirect Indirect Indirect

 Direct Material
Direct material cost are those cost of materials that
are used to produce the product. All material which
becomes an integral part of the finished product and
which can be conveniently assigned to specific physical
units is termed as Direct Material. For example, All
materials/ components specifically purchased, produced
or requisitioned from stores; primary packing
materials (boxes, wrapping..etc), and partly produced
or purchased components.
 Indirect Material
All material which is used for purposes ancillary
to the business and which cannot conveniently be
assigned to specific physical units, is termed as
Indirect material.

For example: Consumable stores, Cooling Oil and

Waste cloths, Printing and Stationery materials,
etc.
 Direct Labour
Direct labour cost is the amount of wages paid to
the direct labour involved in the production
activities. Labour which takes an active and direct
part in the production of the particular commodity is
called Direct Labour.
Direct labour costs are, therefore, specifically and
conveniently traceable to specific products.
 Indirect Labour
Labour employed for the purpose of carrying
out tasks incidental to goods produced or
services provided is Indirect labour.

Labour does not alter the construction,

composition or condition of the product.

Ex: Wages of store-keepers, foremen, time

keepers, directors fees, salaries of salesmen.
 Direct Expenses
Direct expenses are those expense that vary in
relation to the production volume, other than the
direct material cost and labour cost. These are
expenses which can be directly, conveniently and
wholly allocated to specific cost centers or cost units.

For example, Hire of some special machinery required

for a particular contract, cost of defective work
incurred in connection with a particular job or
contract, etc.
 Indirect Expenses
These are expenses which cannot be directly,
conveniently and wholly allocated to cost
centers or cost units.

For example such as expenses are Rent,

Lighting, Insurance charges, etc.
 Overheads
A manufacturing organization can be broadly be
divided into three division:
 Factory or Works, where production is done

 Office and administration, where routine as well

as policy matters are decided
 Selling and distribution, where products are sold
and finally despatched to the customers.
 Factory Overheads
 Indirect material used in the factory such as
lubricants, oil, consumable stores etc.
 Indirect labour such as gate – keeper’s salary,
time – keeper’s salary, works manager’s etc.
 Indirect expenses such as factory rent, factory
insurance, factory lighting, etc.
 Components of Total Cost
Prime Cost: It consists of costs of direct material, direct labour, and
direct expenses. It is also known as basic, first or flat cost.
Factory Cost : It comprises prime cost and in addition, works or
factory overheads which include costs of indirect material, indirect
labour and indirect factory expenses. This cost is also known as works
cost, production or manufacturing cost.
Office Cost: It comprises of factory cost and office and administration
overheads. This is also termed as total cost of production.
Total Cost : It comprises of cost of production and selling and
distribution overheads. It is also termed as Cost of Sales.
 Classification of Costs
Costs can be classified into different categories
depending upon the purpose of which information is
required. The costs can broadly be classified into

 Fixed Cost
 Variable Cost,
 Semi – variable Cost, and
 Step Costs.
 Fixed Cost (FC)
These are the costs which remain constants
irrespective of the quantum of output within and up to
the capacity that has been built up. This costs will
exist even if no output is produced.

Examples of such costs are: Rent, Insurance charges,

Management salary, etc.

Fixed costs remain constant for unit of time. Fixed

costs sometimes are also referred to as Period costs.
 Variable Costs (v)
These are the costs which vary in direct proportion to
output. They increase or decrease in the same
proportion in which the output increases or decreases.
The examples of such costs are: Raw material, Wages,
Power, etc.

Variable cost can be further classified into direct

material cost, direct labour cost, and direct expenses.
 Semi – Variable Costs
These are the costs which do vary but not in direct
proportion to output. They are made up of both fixed
and variable cost elements such as depreciation,
repair, lighting, telephones, etc.

Identification of fixed and variable elements of semi-

variable costs is important for the management for
planning their business activities.
 Step Costs
Fixed costs in general remain fixed over a range of
activity and then jump to a new level as activity
changes. For example, a foreman can supervise a
given number of workers. Beyond this number, it is
necessary to hire a second foreman, then a third and
so on. Similarly, the rental cost of delivery vehicles
also follows the same pattern.
 Process choice affects numerous
activities/ functions

Activity/ Function Job Shop Batch Repetitive/ Assembly Continuous

Cost estimation Difficult Somewhat routine Routine Routine

Cost per unit High Moderate Low Low
Equipment used General purpose General purpose Special purpose Special purpose
Fixed costs Low Moderate High Very high
Variable costs High Moderate Low Very low
Labour skills High Moderate Low Low to high
Scheduling Complex Moderately complex Routine Routine
Work in process High High Low Low
inventory
 Break - Even Analysis
 The term “Break – Even Analysis” refers to a
system of determination of that level of
activity where total cost equals total selling
price.
 However, in the broader sense, it refers to
that system of analysis which determines the
Probable profit at any level of activity.
 The relationship between cost of production,
volume of production, profit and sales value is
established by break – even analysis.
Break-Even Analysis: Contd. 1.
The main objectives of break even analysis is to find the cut off production
volume from where a firm will make profit, Let
s = selling price per unit
v = variable cost per unit
FC = fixed cost per period
Q = volume of production
The total sales revenue (S) of the firm is given by following formula:

The total cost of the firm for a given production volume is given as:
TC = Total variable cost + Fixed cost
Break-Even Analysis: Contd. 2.
Profit = Sales - (Fixed cost + Variable costs)

The formulae to find the break even quantity (BEQ) and break even sales (BES):

Fixed cost
Break Even Quantity =
Selling price /unit – Variable cost /unit
FC
= ( in units)
s-v
 Break-Even Analysis: Contd. 3.

BEP
(Sales)

The contribution is the difference between the sales and the variable costs. The margin of
safety (M.S) is the sales over and above the break - even sales (BES). The formulae to
compute these values are:
 Break – Even Chart
Sales

Profit
Total Cost (TC)

Break – even
Variable Cost (VC)
Sales

Fixed Cost (FC)

Loss

BEP (Q*))
Production quantity
 Break – Even Point
It refers to that level of activity where the income of the
business exactly equals its expenditure. In other words, it
is a “no profit, no loss” point. If production is increased
beyond this level, profit shall accrue to the business and if
it is decreased below this level, loss shall be suffered.
 Illustration-1
A factory manufacturing fans has the capacity to
produce 250 fans per annum. The variable cost of a
fan is Rs.400 which is sold for Rs. 500. Fixed
overheads, are Rs 12,000 per annum. Let us calculate
the break – even points for output and sales. Also
show what profit will result if output is 90 % of
capacity?

Solution:
Contribution per fan is Rs 500 – Rs 400 = Rs 100
Contd.1.
Break-even Point for Output

We know, Fixed costs = Rs.12,000 and Contribution per unit = Rs.100

Break-Even Point for Sales

BEP (for sales) = Output x Selling price per unit

= 120 x Rs. 500 = Rs. 60,000

 Contd.1
Profit at 90% of the capacity has been calculated as follows:
Factory Capacity = 250 fans
Output at 90% capacity = 225 fans
Break-even point = 120 fans

Profit on 225 fans = Rs.100 x (225-120) = Rs.10,500/-

Since fixed over heads will be recovered in full at the break-even

point; the entire contribution beyond the break even point will be
profit.
 Criteria for Make
1. The finished product can be made cheaper by
the firm than by outside suppliers
2. The finished product is being manufactured only
by a limited number of outside firms which are
unable to meet the demand.
3. The part has an importance for the firm and
requires extremely close quality control
4. The part can be manufactured with the firm’s
existing facilities and similar to other items in
which the company has manufacturing
experience.
 Criteria for Buy
1. Requires high investments on facilities which are
already available at suppliers place
2. The company does not have facilities to make it and
there are more profitable opportunities for investing
company’s capital.
3. Existing facilities of the company can be used more
economically to make other parts.
4. The skill of personnel employed by the company is not
readily adaptable to make the part.
5. Patent or other legal barriers prevent the company
for making the part
6. Demand for the part is either temporary or seasonal.
 Illustration 2
An automobile company has extra capacity that can be used to
produce gears that the company has been buying for Rs.300
each. If the company makes the gears, it will incur materials
cost of Rs.90 per unit, labour costs of Rs.120 per unit, and
variable overhead costs of Rs.30 per unit. The annual fixed
cost associated with the unused capacity is Rs.2,40,000.
Demand over the next year is estimated at 4,000 units.
Would it be profitable for the company to make gears?
 Illustration 3

Break-Even Analysis:

A manufacturer of motor cycles buys side box at Rs.240

each. In case the company makes it within the factory, the
fixed and variable costs would be Rs.3,00,000 and Rs.90 per
side box respectively. Should the manufacturer make or buy
the side box if there is demand for 2,500 side boxes?
 Illustration 4

Break-Even Analysis:

A manufacturer of TV buys TV cabinet at Rs.500 each. In

case the company makes it within the factory, the fixed and
variable costs would be Rs.4,00,000 and Rs.300 per cabinet
respectively. Should the manufacturer make or buy the
cabinet if the demand is 1,500 TV cabinets?
 Illustration 5
There are three alternatives available to meet the demand of
a particular product. They are as follows:
i.Making the product using process A
ii.Making the product using process B
iii.Buying the product
The details are as follows:
Cost Elements Making using Making using Buy
Process A Process B
Fixed cost/ year 100,000 300,000 ---
Variable cost/ unit 75 70 ---
Purchase price/unit --- --- 80

The annual demand make for the product is 10,000 units

 Illustration 5 (Contd.)

Questions:

a)Should the company make the product using process A or

process B or buy it?

b)At what annual volume should the company switch from

buying to making using process A?

c)At what annual volume should the company switch from

process A to B?
 Illustration 6

A company has extra capacity that can be used to produce a

sophisticated fixture which it has been buying for Rs.900
each. If the company makes the fixtures, it will incur
materials cost of Rs.300 per unit, labour costs of Rs.250 per
unit, and variable overhead costs of Rs.100 per unit. The
annual fixed cost associated with the unused capacity is
Rs.10,00,000. Demand over the next year is estimated at
5,000 units. Would it be profitable for the company to make
fixture?
Thank You and All the
Very Best!