Theory of Cost and Break Even Analysis

Introduction
• We have discussed the input-output relations in terms of physical quantities of input and output. However, business decisions are generally taken on the basis of money values of the inputs and outputs. Inputs multiplied by their respective prices and added together give the money value of the inputs, i.e., the cost of production. • The cost of production is an important in almost all business analysis and business decisionmaking, pertaining to a) locating the weak point in production management b) minimizing the cost c) finding the optimum level of output d) determining price and dealers, margin; and e) estimating or projecting the cost of business operation.

Cost Concepts
• The cost concepts that are relevant to business operations and decisions can be grouped on the basis of their nature and purpose under two overlapping categories (i) cost concepts used for accounting purposes and (ii) analytical cost concepts used in economic analysis of business activities.

It is also called alternative cost. The concept of full cost.Accounting Costs • Opportunity Cost : The opportunity cost is the opportunity lost. opportunity cost may be defined as the expected returns from the second best use of the resources that are foregone due to the scarcity of resources. Thus. includes business costs. Business costs “include all the payments and contractual obligations made by the firm together with the book cost of depreciation on plant and equipment”. Income maximizing resource owners put their scarce resources to their most productive use and thus they forego the income expected from the second best use of the resources. opportunity costs and normal profit. An opportunity to make income is lost because of scarcity of resources. They are used for calculating business profits and losses and for filing returns for income-tax and also for legal purpose. Business Cost and Full costs: Business costs include all the expenses that are incurred to carry out a business. The concept of business costs is similar to the actual or real costs. Normal profit is a necessary • • .

• Implicit cost are not taken into account while calculating the loss or gains of the business. e. equipment. opportunity cost. machinery. for all practical purpose.Accounting Costs • Actual or Explicit Costs : The actual or Explicit costs are those which are actually incurred by the firm in payment for labour. the actual costs. etc. Such costs are known as implicit or imputed costs. • Implicit Costs: In contrast to explicit costs. plant and building. but they form an important consideration in deciding whether or not to . travelling and transport. The total money expenses.g. material. advertisement. there are certain other costs that do not take the form of cash outlays. recorded in the books of accounts are. nor do they appear in the accounting system.

electricity and telephone expenses.Accounting Costs • Out-of-pocket and Book Costs:  The items of expenditure that involve cash payments or cash transfers.g. wages. are known as out-of-pocket costs. both recurring and non-recurring. All the explicit costs (e. transport expenditure. rent. but a provision is therefore made in the books of account and they are taken into account while finalizing the profit and loss account. Such expenses .. interest.) fall in this category. cost of materials and maintenance. • On the contrary there are certain actual business costs that do not involve cash payments. etc.

Analytical Cost • Fixed and Variable Costs: Fixed costs are those that are fixed in volume for a certain quantity of output. In other words. costs that do not vary or are fixed for a certain level of output are known as fixed costs. such as fuel. routine maintenance expenditure. • The fixed costs include (i) costs of managerial and administrative staff (ii) depreciation of machinery. It includes cost of raw material. • Variable costs are those which vary with the variation in the total output. direct labour wages associated with the level of output and the costs of all other inputs that vary with output. repairs. running cost of fixed capital. . building and other fixed assets (iii) maintenance of land etc.

It refers to the total outlays of money expenditure both explicit and implicit. MC = TCn – TCn-1  . Average and Marginal Costs: Total cost is the total actual cost incurred on the production of goods and services. • Average Cost is of statistical nature. on the resources used to produce a given level of output. It includes both fixed and variable costs. TC/Q • Marginal Cost is defined as the addition to the total cost on account of producing one additional unit of the product.it is not actual cost. It is obtained by dividing the total cost by the total output.Analytical Cost • Total.

short run costs are those that vary with the variation in output. respectively. payment of wages..Analytical Cost • Short-run and Long-run Costs: Short-run and long-run cost concepts are related to variable and fixed costs.e. building. Therefore short run costs are treated as variable costs. machinery are known as long-run costs.g.. Such costs are made once e. cost of raw materials etc. • Long run costs are those that have long-run implications in the process of production. From analytical point of view. • Short run costs are those that have a short-run implication in the process of production. ‘the short run costs are those associated with variables in the utilization of fixed plant or other facilities whereas long-run costs are associated with the changes in the size and kind of . • Broadly speaking. they are used over a long range of output. The costs that are incurred on the fixed factors like plant. i. the size of the firm remaining the same.

increased or . When firm expands its operations it has to incurred additional costs which is incremental cost. • Sunk Costs : The sunk costs are those which are made once and for all and cannot be altered.Analytical Cost • Incremental Costs : Incremental costs are closely related to the concept of marginal cost but with a relatively wider connotation. Incremental cost refers to the total additional cost associated with the decisions to expand the output or to add a new variety of product.

• Historical cost of asset is used for accounting purpose. in the assessment of the net worth of the firm.g. land.Analytical Cost • Historical Cost & Replacement Cost: Refers to the cost incurred in past on the acquisition of productive assets. building. e. whereas replacement cost refers to the outlay that has to be made for replacing an old asset.. The replacement cost figures in business decisions regarding renovation of the . • The concepts are of significance for the unstable nature of price behavior. machinery etc.

rivers.Analytical Cost • Private and Social Costs : The cost concepts that are related to the working of the firm and that are used in the cost-benefit analysis of business decisions. . drainage system etc. Such costs fall in the category of private costs. public utility services like roadways. E. • There are other costs that arise due to the functioning of the firm but do not normally figure in the business decisions and not borne by the firms.g water / air pollution. Such costs are known as Social Costs. lakes.

machinery. Hence these are also referred to as subsidiary costs. Before a firm actually starts producing.COSTS IN THE SHOR RUN • Fixed Costs : These are costs that do not vary with output. These represent fixed costs. it needs to spend on plant. indicating that output may increase to any level without causing any change in the fixed cost. in fact the firm has to bear these costs even if there is no output. . etc. Since such costs do not vary with the level of output. The shape of the Total Fixed Cost (TFC) is a straight line from the origin. equipments. fittings. parallel to the quantity axis.. any decision regarding volume of output does not depend upon fixed cost.

Cost Curves for a Firm (Rs per year) Cost 400 TC Total cost is the vertical sum of FC and VC. VC 300 200 Variable cost increases with production and the rate varies with increasing & decreasing returns. 100 50 0 1 2 3 4 5 6 7 8 9 Fixed cost does not vary with output FC 10 11 12 13 Output .

as we increase the variable input. productivity of the variable input fall because of diminishing rate of technical marginal . • Slope of the TVC curve is less steep in the beginning.COSTS IN THE SHOR RUN • Variable Costs: These are the costs that vary with output and are incurred in getting more and more inputs. starting from origin. if the variable input is increased beyond a certain level. Hence. variable costs are equal to zero if there is no output. with the other input fixed. TVC increases at an increasing rate. • This leads to fall in per unit cost in the beginning. • TVC curve should be a straight line. but TVS is an inverse S shaped upward sloping curve. This shape is determined by the law of variable proportions. its marginal productivity starts diminishing.

total variable and total costs respectively. • Marginal Cost is the change in total cost due to a unit change in output. AC is total cost per unit of output and is thus equal to the ratio of TC and units of output. Since the fixed component of cost cannot be altered. Therefore it is also known as rate of change in total cost. AFC is fixed cost per unit of output and is thus equal to the ratio of TFC and units of output. One can derive Average Fixed Cost AFC. . Average Variable Cost AVC and Average Cost AC from total fixed.COSTS IN THE SHOR RUN • Average and Marginal Cost Functions: Average Cost is cost per unit of output. AC is total cost per unit of output and is thus equal to the ratio of TVC and units of output. MC is virtually the change in variables cost per unit change in output.

reaches a minimum. • AVC curve and the AC curve are both U shaped. stabilise with constant returns and increase with diminishing returns. • When both AFC and AVC fall. AC also falls. and then increases. . This can be explained with the law of variable proportions. As the number of units of output is increased. initially AC falls with increase in output.COSTS IN THE SHOR RUN • Average and Marginal Cost Curves: AFC can be plotted as a rectangular hyperbola. asymptotic to the axes. Fixed Cost remaining the same. Costs decline when there are increasing returns. • AC being the sum of AFC and AVC at each level of output lies above both AFC and AVC curves in. AVC soon reaches a minimum and starts rising. AFC falls steeply at first and then gently. The AC curve is U shaped.

A Firm’s Short Run Costs .

Cost Curves MC ATC AVC AFC .

machinery and technology are all variable.g. This in turn implies radical changes in the cost structure of the firm. • The long run cost function is often referred to as the ‘planning cost function’ and the long run average cost LAC curve is known as ‘planning curve’. Therefore the long run cost curve is the composite of many short run cost curves. e. only the average cost curve is relevant to the firm’s decision making process in the long run.COSTS IN LONG RUN • All costs are variable in the long run since factors of production. As all costs are variable. . size of plant.. a week consists of seven days and a month consists of four weeks and so on. • The long run consists of many short runs.

when plant size increases to II. the short run cost curves shift to the right. the corresponding SAC curve is SAC2 and so on. it would be cost effective for the firm to shift to a higher plant size. at an output level of a. say II. This shift would lower the average cost of the firm. • • • . say I. depending on cost considerations. utilising its installed capacity of I. the firm operates with different plant sizes and can switch over to a different plant size. Hence.COSTS IN LONG RUN • • Long Run Average Cost: When the plant size and other fixed inputs of the firm increase in the long run. this capacity is overworked. As output increases from a to b in the short run. In the long run. Further ahead. Thus SAC1 relates to average cost of the firm when its plant size is. the firm can continue to produce along SAC1. thus switching over from SAC1 to SAC2.

COSTS IN LONG RUN .

. • . So it may have multiple SACs corresponding to different plant sizes. • LAC function is an envelope of the short run cost function and the LAC curve envelopes the SAC curves.COSTS IN LONG RUN • A firm may have multiple alternate plant sizes. hence the LAC curve is also known as “envelop curve”.

P • Average Revenue : AR is the revenue earned per unit of output sold.  TR = Q . It is calculated by determining the difference between the total revenues earned before and after a unit increase in production.  MR = TRq – TRq-1 • MR is the slope of TR. That means AR is nothing but price. When TR is maximum when MR is zero and beyond which MR becomes negative.CONCEPTS OF REVENUE • Total Revenue : TR is the total amount of money received by a firm from goods sold ( or services provided ) during a certain time period. It is equal to the ratio of TR and output. .  AR = TR/Q = Q.P / Q = P • Marginal Revenue : MR is the revenue a firm gains in producing one additional unit of a commodity.

Anything over and above this is supernormal profit. normal profit is a part of total cost and supernormal profit is the accounting profit that occurs when TR>TC. • Under the assumption of rationality a firm will continue to produce till MR is greater than MC and will stop production only when MR is just equal to MC.Rules of Profit Maximization • The profit function shows a range of outputs at which the firm makes positive or supernormal profits. Economists differentiate between normal profit and supernormal profit. • A firm maximizes profit at the point where MR equals MC. • Normal profit is that amount of return to the entrepreneur which must be earned to keep him/her in that business activity. . • In other words.

it is the no profit no loss point. . identifying the break even point and making a managerial decision regarding the relationship between likely sales. • Break Even point is the point where total cost just equals the total revenue.Break Even Analysis • Break Even Analysis examines the relation between total revenue. • BE Analysis is about determining profit at various projected levels of sales. and the breakeven point. total costs and total profits of a firm at different levels of output.

• The chart would be helpful to find out Breakeven point. • It would also throw light on the profit or loss resulting from each level of sales by the firm. Hence. . It can provide valuable information on projected effect of output on costs and profits and firm can ascertain the volume of sales it would need to breakeven. a firm’s total cost function is given as a straight line.Break Even Analysis : Graphical Method • Under graphical method the breakeven chart is constructed by plotting firm’s total revenue and total cost on the vertical axes and output on the horizontal axis. • Break even chart assumes constant AVC for a given range of output.

• Draw a horizontal line for total fixed costs starting at the point on the vertical axis at the level of fixed costs • At the same point on the horizontal axes draw the total costs line. • Assuming constant price. • The gap between the total costs line and revenue line beyond the breakeven point represents the level of profit or loss. plot at least two points from the revenue data and draw the upward moving TR line starting from the origin.Break Even Analysis : Graphical Method • To draw a break even chart following steps need to be followed: • Label the vertical axis ‘revenue and costs in rupees’ and the horizontal axes ‘output/production units’. . • The point where the revenue line crosses the total costs line is the break even point.

Break Even Analysis : Graphical Method • chart .

Crores) was obtained from the chief Accountant of Super at the end of March 2006. Sells personal computers. It was also assumed that wages are fixed cost. The following information (in Rs.300.000 100.000 300.500.000 600.000 Overheads 50. Consider yourself to be a managerial economist and analyse the information.000 Wages 55.000 60. laptops and peripherals. 000 120.000   .000 Materials 2.000 Profit/Loss95.• Super Computers Ltd.000 300. since the company did not lay off any worker and also that 20% of the overheads are variable.000 60.000 20.000 50.      PCs Laptops Peripherals Sales 2.000 50. especially the BEP.

000 310.000 Profit/Loss 95.000 290.483 0.000 704.250.000 Variable cost2.076 0.000 76.000 Contribution = Sales – Variable Cost PV ratio = Contribution / Sales   BEP = FC / PV Ratio .133 BEP 1.000 PV Ratio 0.000 -50.000 16.310.000 -60.000 340.000 600. the modified information is presented in below table:          PCs Laptops Peripherals Sales 2.• From the assumptions.500.000 104. 000 120.000 Fixed Cost 95.000 570.90.000 Contribution 1.

It is also defined as the ratio of marginal change in profit and marginal change in sales. • PV Ratio = Contribution / Sales • Using PV Ratio also.Break Even Analysis : PV Ratio • Profit volume ratio is the ratio of contribution margin and sales. we can calculate BEP as:  BEP = FC / PV Ratio .

hence economies of scale would mean lowering of costs of production by way of producing in bulk. which is nothing but the amount of production that spreads setup costs sufficiently for firms . it is a situation in which the long run average costs of producing a good or service decrease with increase in the level of output. • Economies of scale refers to the efficiencies associated with large scale operations.Economies of Scale • “Economies” refer to lower costs. • Firms are often concerned about a minimum efficient level of production.

Economies of Scale • There are two types of economies of scale: Internal economies (in which cost per unit depends upon the size of firm)  External economies (in which cost per unit depends upon the size of industry) • Internal Economies: • Specialization • Greater efficiency of machines • Managerial Economies • Financial Economies • Production in stages .

Economies of Scale • External Economies: As an industry grows in size. assuming that no input is fixed. • If some cost of a business rises with an increase in size by a greater proportion than the increase in size of operations. • Technological advancement • Easier access to cheaper raw materials • Financial institutions in proximity • Pool of skilled workers • Diseconomies of Scale : Refers to decrease in productivity when there are equal increases of all inputs. it is known as a diseconomy of scale. it would create various economies for the firms in the industry. .

too much specialization may lead to boredom and monotony among workers. than when they are produced separately. management may become less effective and thus indirectly impose costs. • It is applicable to firms that produce more . coordination among different work groups and units may become complex.Economies of Scale • Diseconomies may arise if the size of operations becomes unwieldy by size. • Economies of scope refer to a situation in which average costs of manufacturing a product are lowered when two complementary products are produced by a single firm.

. • Along with that factors like technological know-how. They learn by performing the same activity repeatedly. organizational behaviour help firms in getting work done at least cost. LAC begins to rise. Economies of scale provide the reasoning why LAC decreases with increasing scale of production and diseconomies of scale provide reason for increase in LAC beyond minimum point. The factor is called learning by doing or learning by experience. • Firms engaged in the production of a commodity or service over a long period of time gain experience. mgnt style. • Economists and business analysts have discovered another factor that causes a continuous decrease in average cost of production over a large scale of production.Learning Curves • LAC declines as the scale of production increases to a certain level and beyond this level of production.

firm’s average cost of production continues to fall with increase in production. though the rate of fall in average cost goes on declining. The curve that represents the declining trend in long-run average cost of production is called the .Learning Curves • Thus.

• Learning curve is different from the conventional LAC curve.Learning Curves • The learning curve is widely used by business managers.e.. i. the total output right from the beginning of production of a . economists and engineers to foresee the possible trend in long run average cost of production and plan production accordingly. learning curve gives the average cost of cumulative output. While LAC give the average cost of plant-wise production.

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