Student Handout

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Elements of Cost
In Food and Beverage operations the cost of operations are analyzed by their nature and by their
behavior related to change in sales volume.

The Elements of Cost.

Cost may be analysed under three categories depending upon their nature. It is important to note that
in most catering operations, costs and net profits are expressed as a percentage of sale.
A) Material Cost: Cost of material utilized in the production of saleable food items will be
considered Material cost. Cost of Food and Beverage consumed in the operation along with tobacco is
taken as Material cost. In case material is utilised for staff, the amount of material used should be
deducted from material cost and added to labour cost. The food cost can then be calculated as follows:
Opening inventory/stock + purchases = Total available
Total available – (Closing Stock + cost of staff meals) = Material Cost
OR
Opening inventory/stock + purchases – Closing Stock - cost of staff meals = Material Cost
In the case of beverages, the material is calculated in the similar manner as the food cost.
Beverage cost=Opening stock + purchases - closing stock – complimenteries -transfer to kitchen.
B) Labour Cost: This cost is a sum total of cash and non cash benefits given to the employees.
Salaries, wages paid to the staff and any other contribution in the form of provident fund, Bonus,
Medical insurance, cost of staff accommodation, commissions, Pension and staff meals are
collectively treated as Labour charges.
C) Overhead Cost: Fuel, Repair and Maintenance, Replacement cost, Taxes, License fees, Rent
payable, Depreciation of assets, Insurance premiums, Printing expense, Stationary and capital
investment in equipment are costs other than Material and Labour.
D) Total Cost: Sum total of all the costs is Total Cost.
Costs are also examined on the basis of their behavior with change in volume of sale. On the basis of
this criteria, cost may be classified into following cost groups:
A) Fixed Cost: These costs remain static or unchanged irrespective of change in the volume of sales.
When sales increase or decrease, costs like Rent, Insurance premium, Management fees, Taxes,
salaries of permanent staff etc will generally not change.
B) Semi Fixed Cost: These costs will vary with change in volume of sales but not in direct proportion.
Cost like Gas, Electricity, Replacement, Renewals, Laundry, Cleaning etc will increase with
increase in sales and will decrease with decrease in sales. The increase or decrease has no direct
relation to change in sales volume.
C) Variable Cost: Costs which will change in direct relation to change in volume of sales. Cost of
Food, Cost of Beverages and Tobacco will show same percentage of rise or fall as in sales.

Basic Concept of Profit

Following three concepts of profits are generally used in the catering establishments:
1. Gross Profit – It is the excess of sales over cost of materials. This profit is also called kitchen
profit or bar profits. It will be calculated as:
Sales – Cost of Material = Gross Profit

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 2. Net Margin - It is the excess of sales over cost of materials and the labour cost. Also termed as
after wage profits. It will be calculated as:
Sales – (Material Cost + Labour Cost) = Net Margin
OR
Gross Profit – Labour Cost= Net Margin
3. Net Profit – It is the excess of sales over all cost incurred in the catering operations. It can be
determined by the relation:
Sales – (Material Cost + labour Cost + Overhead Cost) = Net Profit
OR
Net Margin – Overhead Cost = Net Profit

Break even Analysis

Business operations demand that the owner or the manager understand and relate the relationship
between cost, revenues, volume of output and profits. The financial decisions have an impact on the
overall profitability of the business since they are instrumental in achieving various levels of financial
success. This relationship is termed as CVP Analysis. In the F&B operations, management is
concerned about certain questions relating to the business like level of cost that may be affordable, the
price level that needs to be set for food and beverage, the level of profits required at the departmental
level, level of profits required at the unit level and the number of customers to be served so as to cover
cost or make desired profits. Some other issues that requires management attention are level of sales
required to meet fixed costs, level of sales required to increase net profits by ‘X’ amount, Impact of
increase in price by ‘Y’% on sales, effect of higher ASP by Rs ‘Z’on the net profits, effect of discounts
provided on beverages during a promotion activity or the relation between investment in an F&B
outlet and sales. Answers to such questions can be satisfactorily provided by Break even Analysis. It
helps to represent the relationship between different costs at a given volume of sale on a graph. The
analysis helps to identify, graphically or mathematically, that volume of business at which neither loss
nor profits is made by the operation. This stage of the business is called Break Even point. The term
Break even point is defined as that volume of business where all operating cost balance total sales and
a situation of No Loss/ No Profit is reached. Beyond this point, all sales will lead to net profits while
any sale below this point will lead to net losses. The core concept is to predict hoe cost will behave in
response to changes in activity levels. This requires that all cost be classified into Fixed cost and
Variable cost. Fixed costs are constant regardless of variation in activity levels. Variable costs are
uniformly variable so that they are incurred at a constant rate per unit of output. The primary source of
income for a firm is from the sale of units produced. The cost and the revenue is, thus, related to
volume of production. In this analysis, it is assumed that the price per product shall remain static
irrespective of the number of units sold.
The above technique is based upon following assumptions:
1. The sale price of the product will remain constant irrespective of volume of sale.
2. There is consistency in the output given by the equipment or machines in use.
3. Output given by the labour remains constant.
4. Some of the unit costs will remain same for a range of sales during a definite trading period.
Another concept of importance in this Analysis is Contribution margin. It is defines as the excess of
sales over the variable cost. The Contribution margin is used for meeting fixed costs and the excess if
any represents profits.

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Contribution Margin = Total Sales – Total variable cost
Contribution Margin = Profit+ fixed costs. Or Contribution Margin – fixed cost = Profits
When the contribution margin is related to sales, we get Contribution margin ratio or P / V ratio.
The profit volume ratio is an indication of profitability of the product.
P / V Ratio = Contribution margin per unit / Selling price x 100
= S-V / S x 100 or 1- V/ S
(S = selling price, V= variable cost)
Alternatively, P/V Ratio = Contribution Margin / Sales x 100

Mathematically, the break Even formula may be calculated as follows:

B/E = C = Units of output at the break even
S–V
Here C = The total cost of establishing production facility. Will include rent, Taxes payable,
Insurance premium, Salaries, Depreciation of Machine and Building.
S = Sales price per unit of the product.
V= Variable cost per unit of the product.
The break-even point for a product is the point where total revenue received equals the total costs
associated with the sale of the product (TR=TC). A break-even point is typically calculated in order
for businesses to determine if it would be profitable to sell a proposed product, as opposed to
attempting to modify an existing product instead so it can be made lucrative. Break even analysis can
also be used to analyse the potential profitability of expenditure in a sales-based business.

Breakeven point (for output) = fixed cost / contribution per unit

Contribution (p.u) = selling price (p.u) - variable cost (p.u)

Breakeven point (for sales) = fixed cost / contribution (p.u) * sp (p.u)

Margin of safety represents the strength of the business. It enables a business to know what is the
exact amount gained or lost over or below the breakeven point.

Margin of safety = (sales - break-even sales) . If P/V ratio is given then Sales / PV ratio

If the product can be sold in a larger quantity than at the breakeven point, then the firm will make a
profit; below this point, the firm will make a loss. Break-even quantity is calculated by:

Total fixed costs / (selling price - average variable costs).

Explanation - in the denominator, "price minus average variable cost" is the variable profit per unit, or
contribution margin of each unit that is sold.
This relationship is derived from the profit equation: Profit = Revenues - Costs
Where
Revenues = (selling price x quantity of product) and Costs = (average variable costs x quantity) + total
fixed costs.
Therefore, Profit = (selling price x quantity) - (average variable costs x quantity + total fixed costs).
Solving for Quantity of product at the breakeven point when Profit equals zero, the quantity of product
at break even is Total fixed costs / (selling price - average variable costs).Firms may still decide not to
sell low-profit products, for example those not fitting well into their sales mix.
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Firms may also sell products that lose money - as a loss leader, to offer a complete line of products,
etc. But if a product does not break even, or a potential product looks like it clearly will not sell better
than the break even point, then the firm will not sell, or will stop selling, that product.
An example:
Assume we are selling a product for Rs 100.00 each.
Assume that the variable cost associated with producing and selling the product is Rs 29.00
Assume that the fixed cost related to the product (the basic costs that are incurred in operating the
business even if no product is produced) is Rs 48000.00
In this example, the firm would have to sell (48000 / (100 - 29.00) = 1548) 1548 units to break even.
In that case the margin of safety value of NIL and the value of BEP is not profitable or not gaining
loss.

Break Even = FC / (SP − VC)

Where FC is Fixed Cost, SP is Selling Price and VC is Variable Cost

Limitations

x Break-even analysis is only a supply side (i.e. costs only) analysis, as it tells you nothing about
what sales are actually likely to be for the product at these various prices.
x It assumes that fixed costs (FC) are constant
x It assumes average variable costs are constant per unit of output, at least in the range of likely
quantities of sales. (i.e. linearity)
x It assumes that the quantity of goods produced is equal to the quantity of goods sold (i.e., there
is no change in the quantity of goods held in inventory at the beginning of the period and the
quantity of goods held in inventory at the end of the period).
x In multi-product companies, it assumes that the relative proportions of each product sold and
produced are constant (i.e., the sales mix is constant).
Graphic Analysis
For graphic depiction of Breakeven Analysis, level of activity is shown on the X axis, and the Y axis is
used for cost or revenues. The fixed cost is shown by a straight line parallel to the X axis at a height
given by the amount of fixed cost. The variable component is than added to get the total cost line. The
sales revenue is plotted on the graph. The point where the two lines intersect, gives the breakeven
point. The part of the graph below the breakeven point indicates that cost are higher than sales while
the part above the breakeven point indicates that sales are higher than all the costs. This is the profit
zone. The wider the profit zone, better the stability of the business as any change in the sales volume
will not bring losses. The narrower the profit zone, the riskier the operation as a minor change will
immediately cause losses. It becomes easier to predict sales from given number of covers sold in a
trading period or no’s of covers to be sold to earn definite revenue. Thus the analysis helps to take
decisions which influence the level of operations and the profitability.
ABC analysis
It is a business term used to define an inventory categorization technique often used in materials
management. Analysis of a range of items which have different levels of significance and should be
handled or controlled differently. It is a form of Pareto analysis in which the items (such as activities,
customers, documents, inventory items, and sales territories) are grouped into three categories (A, B,
and C) in order of their estimated importance. 'A' items are very important, 'B' items are important, 'C'
items are marginally important. For example, the best customers (typically 20 percent of the total
number of customers) who yield highest revenue (typically 80 percent of the total revenue) are given
the 'A' rating, are usually attended by the sales manager, and receive most attention. 'B' and 'C'
customers warrant progressively less attention. ABC analysis provides a mechanism for identifying
items which will have a significant impact on overall inventory cost whilst also providing a
mechanism for identifying different categories of stock that will require different management and
controls. In this analysis, inventory items are classifies on the basis of their usage in monetory terms.

When carrying out an ABC analysis, inventory items are valued (item cost multiplied by quantity
issued/consumed in period) with the results then ranked. The results are then grouped typically into
three bands. These bands are called ABC codes.

ABC codes
1. "A class" inventory will typically contain items that account for 80% of total value, or 20% of
total items.
2. "B class" inventory will have around 15% of total value, or 30% of total items.
3. "C class" inventory will account for the remaining 5%, or 50% of total items.
ABC Analysis is similar to the Pareto principle in that the "A class" group will typically account for a
large proportion of the overall value but a small percentage of the overall volume of inventory. The
method of this analysis is as follows:
1. Collect the list of items with information of unit cost and periodic consumption.
2. Calculate the usage value of each item. ( Cost price x consumption)
3. Determine the value of item as % of the aggregate usage value.
4. Rank the items as per their decreasing usage value.
The calculation will provide information of most expensive items on the inventory and least expensive
items. Strict controls will be required on the most expensive items (Class A) while least controls are
needed for the cheap (Class C) inventory items. Moderate controls are required on those items which
are midway (Class B Items)
It will be seen that decisions on holding inventory can be taken carefully and expenses monitored to
avoid unnecessary blockage of cash. Administering controls on the inventory is expensive and it may
be easier to identify and control items which account for most investment. Items in category C may be
controlled with a simple control system as these items do not account for very investment.
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The division of the items into three categories (i.e. A, B, C) is made easier by plotting the usage value
of the items to obtain distribution curve, also called Pareto curve.