Cost Analysis Part 1:Cost Concepts

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Total Cost, Total Revenue and Profits

• Total Revenue
• The amount a firm receives for the sale of its output.
• Total Cost
• The market value of the inputs a firm uses in production.
• Profit is the firm’s total revenue minus its total cost.

Profit = Total revenue - Total cost

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Classification of Costs

1. Opportunity cost: Cost of next best alternative foregone.

• When one course of action is chosen over other, the possible benefit lost from
the rejected alternative is the opportunity cost.
• A theoretical concept. Not incurred cost. Not entered in the book of accounts.
Business Application of Opportunity Cost
• A particular course of action would be beneficial to the firms. But the firm could
possibly derive more or less benefit by devoting resources to an alternative course
of action.
• The management must evaluate all possible opportunities and then commit its
resources to the best, most profitable, available opportunity.

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Cost Concepts

2. Real Cost &Money Cost:

• Real cost refers to the exertion of labour,sacrifice involved in the abstinence from
present consumption by savers to supply capital and social effects of production
like pollution,congestion,environmental degradation etc.Measurement is difficult.
• Money Cost is the monetary expenditure on inputs of various kinds like raw
material,labour etc.It can be measured easily.

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Classification of Costs
3. Explicit &Implicit Cost:
• Explicit Cost: Actual money expenditure of a firm on factors of production which do
not belong to it.
E.g:Expenditure on raw materials,labour etc.
• Implicit Cost: Opportunity cost of the use of factors which a firm does not buy or
hire, but already owns.
E.g - Interest on capital supplied by entrepreneur, value of the services offered by
the entrepreneur

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Relevance of Explicit &Implicit Costs – Calculation of profits
Accounting Vs Economic Profits
• Accounting profit is the total amount of money taken in from sales (total revenue, or
price times quantity sold) minus the cost of producing goods or services(explicit
cost).
• Economic profits are the difference between the total revenue and the sum of
explicit and implicit cost of producing the firm's goods or services.

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Accounting Vs Economic Profits

Accounting profit = Total Revenue – Explicit cost

Economic profit = Total Revenue – (Explicit cost + Implicit Cost)

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Numerical Example :Explicit & Implicit Costs

• A woman managing a photocopying establishment for $25,000 per year decides to

open her own photocopying shop. Her revenue during the first year of operations is
$120,000,and her expenses are as follows:

Calculate
a) Explicit costs
b) Implicit costs
c) Business/Accounting profit
d) Economic profit

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Numerical Example : Solution

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Classification of Costs
4. Marginal Costs
Marginal Costs :Addition to total cost due to the production of an additional unit of
output.
For example, if a firm can produce 150 units of a product at a total cost of $5,000
and 151 units for $5,100, the marginal cost of the 151st unit is $100.

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Classification of Costs

5.Fixed & Variable Costs

• Fixed Cost :Costs incurred on fixed factor inputs. It remains constant irrespective of
the level of output.
• Variable Costs: Costs incurred on variable factors. It depends on the level of output

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Classification of Costs
6. Sunk Cost
• In economics, a sunk cost is any past cost that has already been paid and cannot
be recovered.
Examples
• Marketing study. A company spends $50,000 on a marketing study to see if its
new product will succeed in the marketplace. The study concludes that the product
will not be profitable. At this point, the $50,000 is a sunk cost. The company should
not continue with further investments in the project, despite the size of the earlier
investment.
• Research and development. A company invests $2,000,000 over several years to
develop a particular product. Once created, the market is indifferent, and buys no
units. The $2,000,000 development cost is a sunk cost, and so should not be
considered in any decision to continue or terminate the product.

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Sunk Cost Fallacy/Trap

• Sunk cost trap refers to a tendency for people to irrationally follow through on an
activity that is not meeting their expectations. This is because of the time
and/or money they have already invested.
• The sunk cost trap explains why people finish movies they are not enjoying, finish
meals that taste bad, keep clothes in their closet that they’ve never worn and hold
on to investments that are underperforming.
• The sunk cost trap is also called the Concorde fallacy after the failed supersonic
Concorde jet program that funding governments insisted on completing despite the
jet’s poor outlook.

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 Cost Analysis Part 2:Cost –Output
Relationships in the Short Run

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Cost – Output Relations
1. Short Run (a period during which some factors are fixed and some are variable)
2. Long Run (All factors are variable)

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 Short Run Cost Curves

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Short Run Cost Concepts

Total Fixed
Cost(TFC)
Total Cost(TC)
Total Variable
Costs(TVC)

Short Run Average Fixed

Costs Cost(AFC)
Average
Cost(AC) Average
Variable
Marginal Cost(AVC)
Costs(MC)

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Short Run Cost Concepts
• Total Cost: Total expenditure incurred on fixed and variable factors.
• Total Fixed Cost: Expenditure incurred on fixed factors. Remains constant
irrespective of the level of output.
• Total Variable Cost: Expenditure incurred on variable factors. Changes with level of
output.

TC = TFC + TVC
TVC = TC – TFC
TFC = TC-TVC

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Total Cost Curves
Q TFC TVC TC AFC AVC ATC MC
0 $60 $0 $60 - - - -
1 60 20 80 $60 $20 $80 $20
2 60 30 90 30 15 45 10
3 60 45 105 20 15 35 15
4 60 80 140 15 20 35 35
5 60 135 195 12 27 39 55

• For 0 unit TC and TFC are the same

• Change in TC happens due to change in TVC

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Total Cost Curves

• For Zero unit,TC and TFC are the same.

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Average Costs
• Average Cost: Per unit cost obtained by dividing TC by the number of units of
output(Q).
AC = TC
Q
• Average Variable Cost: AVC is total variable cost divided by the number of units of
output(Q).
AVC = TVC
Q

Average Fixed Cost :AFC is total fixed cost divided by the number of units of
output(Q).
AFC = TFC
Q
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Marginal Cost

• Addition to Total Cost due to the production of an additional unit of output.

MC = ∆TC
∆Q

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Average & Marginal Cost Curves

Q TFC TVC TC AFC AVC ATC MC

0 $60 $0 $60 - - - -
1 60 20 80 $60 $20 $80 $20
2 60 30 90 30 15 45 10
3 60 45 105 20 15 35 15
4 60 80 140 15 20 35 35
5 60 135 195 12 27 39 55

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Average & Marginal Cost Curves

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AFC Curve
• AFC goes on declining continuously.
• Reason: As the output increases,TFC gets spread over a larger and larger level of
output and therefore AFC declines.
• AFC multiplied by the corresponding level of output gives a constant number i.e
TFC.

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AVC Curve
• Declines in the initial stages as output expands, reaches the minimum when
optimum factor combination is reached and increases when the output exceeds the
optimum combination.
• Represents different stages in the law of variable proportion.

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AC/ATC Curve
• ‘U’ Shaped curve
• AC = AFC + AVC
• Behaviour of AC is determined by the behaviour of AFC &AVC.
• Initially both AFC &AVC decline and as result AC also declines.
• After the minimum point AC starts rising, as the rise in AVC is greater than the fall in
AFC.

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MC Curve
• ‘U’ Shaped curve.
• As fixed cost remains the same in short run,MC can be calculated using TC or TVC.
• According to the LVP,the MP of an input rises at low levels of output and then falls
with expansion of output. The opposite happens in the case of MC.
• Declines with increase in output, reaches the minimum and then starts increasing.

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MC & AC Relationship

• When MC < AC, AC falls

• When MC > AC, AC rises
• If MC = AC, AC at minimum.

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MC & AC Relationship Simplified

• Sachin Tendulkar has scored 250 runs in 5 one day matches. So his average works
out to be 250/5 = 50.
• In the sixth match he scores 40 and his marginal score is 40 and total score is
290.After 6 matches his average is 290/6 =48.33
• When marginal score is less than average score, average falls.
• If his marginal score(6th match) was 60,total score would be 310 and average would
be 51.66.
• When marginal is more than average, average increases.

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 Cost Analysis Part 3:Cost-Output
Relationship in the Long Run

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Two Types of Long Run Cost Curves

1. LAC
2. LMC

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Two Types of Long Run Cost Curves

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Derivation of LAC
• LAC derived from Short Run Average Cost Curves(SACs).Each SAC shows
different plant capacity.

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Features of LAC

Envelope Curve

Planning Curve

Tangent

Flatter ‘U’ Shaped

curve

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Relationship Between LAC &LMC
• Initially both LAC &LMC decline.
• After a certain level of output LMC starts increasing while LAC still declines.
• LMC cuts LAC at its minimum point.
• Before the point of intersection LAC is above LMC.
• After the point of intersection LMC is above LAC

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Empirical Studies and shape of LAC

• Theoretically LAC is a ‘U’ shaped curve.

• But based on empirical studies economists have observed three other types of
LAC.
1. Saucer shaped LAC
2. L shaped LAC
3. Downward Sloping LAC

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Saucer shaped LAC Curve

• Flat stretch in the middle of LAC happens when there are more than one output
level at which economies = diseconomies (constant returns to scale).

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L Shaped LAC curves
• Minimum Efficient Scale (MES), which represents the smallest quantity a firm
has to produce to maintain the lowest average cost.

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Downward Sloping LAC

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Why LAC remain constant or falling?

• Improvement in technology helps in reducing average cost.

• Learning curve effect: The more experience a person attains, he/she learns to do
things in a better way than before.
• Development of Appropriate management techniques will reduce the managerial
diseconomies of scale associated with an expansion of the firm.
• If at all there are managerial diseconomies,it will be more than offsetted by the
technical and production economies

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 Break-Even or Cost Volume Profit(CVP)
Analysis

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Importance of BEA
• Objective of the firm – maximization of profit(traditional theory)
• Difficult to predict the output level at which profit is maximum.
• In real life firms begin their activity even at a loss ,in anticipation of profit in future.
• Firms can plan their production better if they know the level of production where
cost and revenue break even.
• BEA is a technique of having a preview of profit prospects and a tool for profit
planning.

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Meaning

BEA is a technique to trace the relationship between costs, revenue and profits at
varying levels of output or sales.

It gives flexible projections of the impact of the volume of output on costs, revenue
and profits.

BEP is the point located at that level of output or sales where TC = TR.

BEP is the NO PROFIT NO LOSS zone.

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Significance /Uses
• Planning & forecasting profit at various levels of activity.
• Identification of minimum volume of activity an enterprise must achieve to avoid
incurring losses.
• Identification of minimum volume of activity an enterprise must achieve to achieve
profit objective.
• Estimate of probable profit or loss expected at different levels of output.
• Guide in fixation of selling price.
• Evaluates the impact of cost factors on profit.

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Approaches to BEA

Graphical
Approach

Algebraic Approach

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 Graphical Approach

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Numerical Example

Revenue Function (TR) = 15Q

Cost Function (TC) = 100 + 10Q

Break Even Point TC = TR

15Q = 100 + 10Q

15Q - 10Q =100
5Q = 100
Q = 100/5 = 20

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Break Even Chart

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 Algebraic Approach

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BEP in Units

• This method is used to calculate BEP of a single product firm.

• BEP in terms of units will be reached when units sold create sufficient revenue to
cover the Total Cost-both fixed and variable costs.
• Each unit of product sold will cover its own variable cost and leave a balance
,called contribution to cover fixed costs and then to create profit.
• Contribution per unit = Price – Average Variable cost(AVC)
• Total contribution = Contribution per unit x Units sold
• BEP will occur when enough units are sold so that total contribution is equal to
TFC.

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Formula for BEP in units

• From the previous example it is obvious that BEP in terms of units can be
computed by dividing fixed costs by contribution per unit.

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Numerical Example
• A manufacturing firm produces a single product whose price is Rs.20 per unit and
the variable cost per unit is Rs.12.The annual fixed cost of the firm is estimated as
Rs.16000.To break even firms contribution from the sale of units of the product
should be equal to the fixed cost of Rs.16000.How many units of the product should
be sold to reach the BEP?

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Numerical Example
• A small firm incurs fixed expenses amounting to Rs.12000.Its variable cost of
product X is Rs.5 per unit and price is Rs.8.Find out the break even quantity.

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Margin of Safety as % of Sales

• Margin of safety represents the difference between the sales at the BEP and the total
actual sales.

• E.G . A firm’s break even sales is Rs.1000,000 and actual sales is Rs.2000000.Find out the
margin of safety.
2000000 – 1000000 x 100 = 50%
2000000
• Margin of safety indicates the extent to which sales may fall before the firm suffers a loss.
• In the numerical example only if the sales fall by 50% firm will reach the BEP.
• Larger the margin of safety, safer is the firm.

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Using BEA to find out Target Profit Sales Volume

TFC = Rs.200, P=Rs.10,AVC = Rs.5,Target profit = Rs.100

200 + 100 = 300 = 60

10- 5 5

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 Break Even Point for Multi Product Firms
Or
Sales Mix Break-even Point Calculation

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Sales Mix and Break Even Point
• Sales mix is the proportion in which two or more products are sold.
• For the calculation of break-even point for sales mix, following assumptions are
made in addition to those already made for CVP analysis:
1. The proportion of sales mix must be pre determined.
2. The sales mix must not change within the relevant time period.
• The calculation method for the break-even point of sales mix is based on the
contribution approach method. Since we have multiple products in sales mix
therefore it is most likely that we will be dealing with products with different
contribution margin per unit .
• This problem is overcome by calculating weighted average contribution margin per
unit .These are then used to calculate the break-even point for sales mix.

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Steps in Sales Mix Break-even Point Calculation
• Step 1: Calculate the contribution margin per unit for each product
Contribution Margin = Price per Unit - Variable Cost per Unit
• Step 2: Calculate the weighted-average contribution margin per unit for the sales
mix
Weighted Average Unit Contribution Margin Product = Product’s CM per Unit ×
Product’s Sales Mix Percentage
• Step 3: Calculate total units of sales mix required to break-even using the formula

• Step 4: Calculate number units of various products in the sales mix products at
break-even point:

• Step 5: Calculate Break-even Point in dollars

✓ Prove that TR=TC at break even
✓61 Prove that TFC= Total contribution at Break even
Numerical Example

1. How many units in total must be sold to break even?

2. How many units of each product must be sold to break even?

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Numerical Example

• Step 1: Calculate the contribution margin per unit for each product:

Contribution Margin = Price per Unit - Variable Cost per Unit

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Numerical Example
• Step 2: Calculate the weighted-average contribution margin per unit for the sales
mix using the following formula
• =Weighted Average Unit Contribution Margin Product =
• Product A CM per Unit × Product A Sales Mix Percentage
+ Product B CM per Unit × Product B Sales Mix Percentage
+ Product C CM per Unit × Product C Sales Mix Percentage

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Numerical Example
• Step 3: Calculate total units of sales mix required to break-even using
the formula:

• $50,000/$40 = 1250

1. How many units in total must be sold to break even? 1250

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Numerical Example
• Step 4: Calculate number units of product Inkjet,Laser and Colour
Laser printers at break-even point:
• Formula

Product Product Product Total

A B C
Sales Mix 20% 30% 50% 100%
1250 1250 1250

Product 250 375 625 1250

Units at
Break-even
Point

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Numerical Example
• Step 5: Calculate Break-even Point in dollars as follows
Product A Product B Product C Total
Sales Mix 20% 30% 50% 100%
Total Units 1250
Product Units at Break- 250 375 625 1250
even Point
Selling Price per Unit $200 $100 $50
Total Revenue 50,000 37,500 31,250 118750

Per Unit Contribution 100 25 25

Total Contribution 25,000 9375 15,625 50,000
Variable Cost Per Unit $100 $75 $25
Total Variable Cost per 25,000 28,125 15625 68750
Product
TFC $50,000 $50,000
Total Cost 118750
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Limitations of BEA

1. Not all costs can be easily and accurately classified into fixed and variable
elements.
2. TFC does not remain constant throughout. It increases in a step like fashion.
3. It assumes that when a firm sells more than one product the sales mix is
constant. But sales mix will be changing continuously due to changes in demand.
4. Assumption of constant selling price and AVC are not valid
5. Short run concept and has limited use in long run planning.

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Practice Problem

The Following information is related to sales mix of product A, B and C.

• Calculate the total units of sales mix required to break-even
• Calculate number units of product A, B and C at break-even point
• Calculate Break-even Point in dollars

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Practice Problem: Solution

• Step 1: Calculate the contribution margin per unit for each product:

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Practice Problem: Solution
• Step 2: Calculate the weighted-average contribution margin per unit for the sales
mix using the following formula:
• Product A CM per Unit × Product A Sales Mix Percentage
+ Product B CM per Unit × Product B Sales Mix Percentage
+ Product C CM per Unit × Product C Sales Mix Percentage
= Weighted Average Unit Contribution Margin

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Practice Problem: Solution
• Step 3: Calculate total units of sales mix required to break-even using the
formula:
• Break-even Point in Units of Sales Mix = Total Fixed Cost ÷ Weighted Average
CM per Unit

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Practice Problem: Solution
• Step 4: Calculate number units of product A, B and C at break-even point:

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Practice Problem: Solution
• Step 5: Calculate Break-even Point in dollars as follows:

• Total contribution and TFC are the same ($40000) at the break even quantity

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