chapter Outcomes after completing the chapter, you will be able to: ' Understand the cost concept. Describe the cost categories. ¢ Classify the costs. ‘¢ Analyse the production costs. Define the concept of Breakeven analysis. Define the Concept of BEP. Describe the methods of lowering BEP. fe Carryout CVP analysis. ae ‘31 INTRODUCTION ‘he production manager must maintain a close watch over the costs that are incurred in duction department. The type and nature of the costs incurred must be known before riate measures can be implemented. ee broad heads of costs are associated with production, ie., costs of capital assets “d costs of production. The classification and analysis of costs are important to enable the Man, i wnt, to exercise proper control on costs so as to manufacture the products at the pre- “tablished cost level, "2 costs oF pRopUCTION NE COsts of Production include: 1 Purchase costs of raw materials, bought out components and subassemblies, Procurement and transportation costs. 851 Scanned with CamSeannerTre ee eee a | 852 Industrial Engineering and Production Management 2 Purchase costs of supplies such as oi machinery spares, cotton waste, etc. 3. Wages and salaries paid to direct production workers, stores staff, supervisors and other staff. 4. Costs paid to subcontractors for the orders placed on them, 5, Cost of production line rejections, wastage, spoilage and rework, 6. Expenses towards rent and insurance of factory buildings, machinery, stores, etc. 7. Interest on working capital to the extent it relates to inventory. 8. Cost of procurement of capital assets like buildings, machinery, tooling, inspect equipment, furniture, etc., and the depreciation of these capital assets. ion ,Tubricants, tools of small value, fay fuel oi, maintenance inspectign insurance on plant ang 33.3 CONCEPT OF COST Costis the amount of resources sacrificed or given up to achieve a specific objective which may be the acquisition of goods or services. Costs are always expressed in money ten eg., amanufacturer incurs costs in buying materials and in hiring labour, ete. % 33.4 COST CENTRE Cost centre is defined as “a location or item of equipment, (or group of these) for which costs may be ascertained and used for the purpose of cost control.” Usually a department or responsibility centre or area of responsibility under the control of manager who is responsible for costs incurred is referred to as cost centre. There are some cost centres which do not play a direct role in production. eg, stores, finance. etc, and they are called service cost centres. They provide services to other cost centres, 33.5 COST UNIT Itis the unit of output in relation to which costs are determined. Examples Industry Costy Unit Cement” Tonnes Steel Tonnes Automobile Number Power KW-hr Wood Cubic Feet Transport Tonnes-Km or Seat-Km 33.6 CLASSIFICATION OF COSTS Classification of costs are based on the following: 1. Natural characteristics (material, labour and overhead) 2, Changes in activity or volume (fixed, variable, mixed) 3. Degree of traceability to the product (direct cost, indirect cost) 4 |. Costs for analytical and decision-making (sunk costs, opportunity costs, controllable and non-controllable, differential, imputed costs) 5, Other classifications (product cost, period cost). _— Scanned with CamSeanner| ___ Production Cost Concopts and areakavon nays 5 f nee _ _- _eieation of Costs ton refers tothe basic physical characteristics of the cost. In @ manufac ih jpo total cost ofa proxtuct includes the following four elements Fg act material: Direct material refers to the cost of materials which b inh product. They are the raw materia that become a integ) atta! product and are traceable to specific units of output. of direct materials are: Raw cotton in textiles, crude oil to m: St te parts: The following groups of material come under direct mal aerials purchased for a particular job, process or product. 0 Apter acquit from tres for production. aa Ai ponents or parts purchased or produced. @ nateials passing from one process to another process. e tr labour Direct abou i defined a the labour associated with workers who jn the production process. It is the labour costs for specific work perf 8 that is traceable to end products oF about of machine operators, assembly operators. rect expenses: The expenditure incurred (other than direct material and direct specific job or product are included in direct expenses. ‘These are also called turing: ecome a ral part ake diesel, steel to terial: mH on a se expenses. Eumples: Cost of special layout, design or drawings, hiring special machines for eiicproduct manufacture, etc. * p)Facory overheads: These are also called manufacturing costs. These include the cssofindiect materials, indirect labour and indirect expenses. ig Indirect material refers to materials that are needed for the completion of the proict but it i not possible to trace or identify it with end product ¢$- cutting {il lubricants cannot be charged to specific product. .ded which will not directly affect {@ Indirect labour refers to the labour hours expen the composition or construction of the finished product. framples: Foreman, shop clerks, material handlers, maintenance employees. Their ‘burs considered indirect because it is not economically possible to trace their with ‘pele product. li) Indirect expenses are the expenditure incurred by tl from the beginning (start) of production to its comple! g00ds store. Direct costs and factory overheads together all Distribution and administrative ove cantictng or selling overheads. These costs inclu mmission, packaging, storage, transportation and sales administrative costs. ky renee overhead includes costs of planning and controlling of general business fons. All costs which are not charged to production and sales are included in “ini the manufacturing company tion and transfer to finished are called conversion costs. heads: Distribution overheads are also ile advertising, salesmen salaries, tative overheads, ¢.g., nes salary, fees of board of directors, Costs are represented in the Table 33.1. rent of administrative office. kK Scanned with CamSeannerIndustrial Engineering and Production Management Table 33.1: Costs of Manufacturing Company 7 Direct Material + Direct Labour + Direct Expenses = Prime Cost 2 Indirect Material + Indirect Labour + Indirect Expenses = Factory Overhead 3. Prime Cost + Factory Overhead = Factory Cost 4. Factory Cost + Distribution And Administrative Overhead = Total Cost 2. Classification Based on Activity or Volume i i change for a given period in spite of ' (A) Fixed cost: The costs which do not chang: Period inspite of chan volume of production. This cost is independent of volume of production. eo Examples of fixed costs are rent, taxes, salaries of supervisors, depreciation, Fixed costs are normally expressed in terms of time period. * ie, per day, per annum, etc. Fixed costs are represented as shown in Fig. 33.1. insurance, ete, Fixed cost 1,000 Cost a ae a a) Volume —» Fig, 33.1: Fixed costs * Fixed cost does not mean that they never change. They are constant up to specific volume or range of volume (B) Variable costs: These vary directly and proportionately with output, There is a constant ratio 1500 between the change in the cost and change in the level of output. Direct material cost and direct | labour costs are generally variable costs. Variable costs results from the utilisation of raw materials and direct labour in production |, departments. Variable cost is represented in Fig. 33.2. 00 2000-3000 «40005000 (C) Mixed costs: Mixed costs * — Production units are made up of fixed and variable “<— Variable cost 1000 —+Material cost Fig. 33. Le __ Scanned with CamSeanner fariable costProduction Cost Concepts and Break-even Analysis 855 | -—They are combination | ot atvaiable and semi- 1 costs. Because of variable 4000. | nent, they fluctuate i volume, because of fixed | vi enent, they will not change oe | fect proportion to output. i genifixed costs are those costs $ 2000+ | “\ich remain constant up to i Peertain level of output after | \tich they become variable as 1000 | ted in Fig. 33.3. Semi- | arable cost is the cost which i i ' —Total cost x basically variable but whose 1000 2000 3000 4000 ope may change abruptly when Units produced —> | ascertain output level is reached. Fig. 33.3: Semi-fixed cost. | LOpportunity Costs Opportunity cost is defined as the benefits lost by rejecting the best competing alternative | tothe one chosen. The benefit lost is usually the net earnings or profits that might have teen earned from the rejected alternative. ‘4.Sunk Costs: | tis an expenditure for equipment or productive resources which has no economic | relevance to the present decision-making process. It is a cost that has either already been | incurred or is yet be incurred but will be same no matter which alternative course of action isselected. Generally, it is known as unavoidable cost. 5. Controllable and Non-contrallable Costs A controllable cost is the cost over which a manager has direct and complete decision authority, ie., the manager has complete control over these costs, e.g., indirect labour, cutting tool, lubricants. ‘A cost which cannot be influenced by the action of the specified member of an organisation is referred to as uncontrollable cost. 6 Imputed Costs | Imputed costs are costs not actually incurred in some transaction but which are relevant to the decision as they pertain to a particular situation, These costs do not enter into traditional accounting system® 8+ interest on internally generated funds, rental value of company owned property, etc: 7.0ut of Pocket Costs A e cash cost associ signify the cash cost associated with an activi sre are nat included in oUt of pocket costa, UY: Non-eash costs such as i 33.7 ANALYSIS OF PRODUCTION Costs 1. Diract Matorial CF a ccuy identifi pe directly identified wi The materi il to know what items man Ze mas Production can by ake up theo e classified as direct irect material cost, — - Scanned with CamScannerIndustrial Engineering and Production Management x Direct materials costs are analysed regards to purchase, Pura ae seen ane Aneffective procurement : ieninimsing costs of purchase of direct materials, : en should be standardised and classification and cod; +A sound purchase policies and procedures, # Procurements should be based on authorised material re, + Purchases should be made preferably after floating tend * The company should devsop a een ae rating sytem, ii) Di , and issue: After the material is rece, OO eee carne a all Seti Would be aise oars 12 ng Reeord of these receipts will be made by the storekeeper on the bin ee ss The organisation should follow a procedure for issues and implemery gal issue control. A lot of costs can be saved and unnecessary wastage of Materials aygig,™ proper control over issues is exercised. A 2. Direct Labour Costs In organisations itis normally easy to distinguish between the direct workers ted ing workers. Incase of machine operators and tools setters a particular machine orem machines may be considered as the cost centre and wages of these Machine. Operators tool setters may be allocated to the cost centres. Labour cost control is very much essential. A part from fixing proper time. standanis measuring the actual time spent and comparing actual with standard, = monitoring of attendance time with actual time booked to the various idle time costs and overtime costs will greatly help in control of labo Any idle time involves payment of wages for not working and, hence, idle tine should not be allowed to occur. The idle times which are unavoidable, the costs should te minimised and other idle times are to be avoided. Overtime is going to cost the company double the regular time. Sinceitis costly, ade control over sanction of overtime and production during overtime should be maziuned normal salaries and ‘Wages during overtime are considered as direct labour costs ani additional overtime premium is considered as indirect expense. | 3, Production Overhead The costs which cannot be traced with the Product like indirect material, indirect labo and indirect expenses incurred at the cost centre are called overheads and that portion the overhead relating to the production function is called the production overhead. Allocation and Apportionment of Overhead Costs (i) Primary overheads: The overhead costs can be directly identified witha en department or cost centre as having been incurred for that cost centre. These Procedure wo, bg re, oy ty hy, ificationign ‘Wuisitions, ers, 8 Jobs and isolation Ur costs. iyo of overhead cannot be traced to proclucts ot jobs but ean be allocated specific) departments, os Examples are — repairs and maintenance expenses, overtime, indirect ma! supplies, etc, Expenses such as power, : light, rent, depreciation of factory and buildings °P shared by all departments ca innot be charged directly to the department. Scanned with CamSeannerProduction Cost Concepts and Break-even Analysis. 387 these costs should be the process do ae originate in any department. Therefore, any oral part ie using such items. Cost apportionment ‘xpensesinan equitable proportion to the various cost centres or department iyo ma “ving are the basis of apportionment. ‘he ct IXbOUT hours/or machine hours. of workers employed. occupied. distribution: The reassignment of service department partments or centres is termed as secondary distribution. I Number oor area ane ergucing oe Fhe ot secondary dstibution ae: 1 Benefits obtained. » ability © PAY + etcency or incentives. ‘ods of absorption of factory overheads: The allotment of overhead to cost @™ ® és nits (output) is called overhead absorption. ts overhead to yds Mr Percentage on direct labour. 2 Percentage on direct wages. 3, Prime cost percentage. 1, Unit of production basis. § Machine hour rate. 8 BREAK-EVEN ANALYSIS Keaeren analysis establishes the relationship amos the factors affecting profit. Tadaates at what level cost and revenue are in equilibrium. It is a simple method of senting to management the effect of changes in volume on profit. The detailed analysis Fea aaa edate will help the management to understand the effect of alternative aisions that convert costs from variable to fixed, the costs which increase sales volume alrevenue. Itis a powerful tool in evaluating alternative course of action. MI Assumptions in Break-Even Analysis 1. Selling prices will remain constant at available) 2. There isa linear relationship between sales volume and costs 3. The costs are divided into two categories—Fixed costs, those costs which does not Vary with volume (quantity) and variable costs will be varying in direct proportion all sales levels (Quantity discounts are not 4. Production and sales quantities are equal. (There is no inventory) pt the quantity. * No other factors will influence the cost excel ‘ a Break-Even Point bing *¥ point refers to the level point at which ren re) eval the total costs. Its 3 (Gold) above break-even point result in profi volume) at which the sales income the profit is zero. The quantities ts and quantity below break-even of sales (sales Scanned with CamSeannerIndustrial Engineering and Production Management Fired cost Quantity — Fig. 33.4: Break-even chart. | Let F _represents the fixed cost. Q _ isquantity produced and sold. b _ isthesales price per unit. 4 is variable cost per unit. 5Q total income (revenue). 4Q total variable cost. Total costs = Fixed cost + variable cost = F + aQ. At BEP, Total costs equal total income Therefore, Total income. 4Q Sales - Variable cost = b-a Fixed cost Contribution Break-even Quantity (units) = Margin of Safety Margin of safety is the difference between the existi eee output at BEP. en the existing level of output Sales at BEP een oe I Margin ofsaety = “* ales Angle of Incidence ig ie sims at This is an angle at which the sales line cuts the total cost line. The management ai largest angle of incidence because large angle of incidence indicates a high profi narrow angle will show that even fixed overheads are absorbed and relatively low * return. Scanned with CamSeannerProduction Cost Concepts and Break-even Analysis 859 at ods of Lowering BEP at lower break-even point so that their fixed costs are recovered PP aniston a ‘fit begins after the sales starts exceeding BEP. Lower BEP increases the fg the Pr oe towered by the following methods: ‘ff yee fixed costs Fe re cost 8 reduced from F to F’ Fe eguced BEP (Q") = 0.F'/F is Break-even Quantity at Fixed Cost F. educe te variable cost L variable cost is reduced from a toa’. pede BEP (Q’)= 0. (0-a/0-A) j-s)iscontibation at variable costa {1 scontibution at variable costa! « nsease te slope ofthe income Fine from btob. reduced BEP Q' =Q-b-a/b'~a isthe increased price per unit pis the current price per unit. Applications of BEP safety margin: Break-even. chart helps the management to know at a glance the profits isnt levels of activity and the safety margin refers to the extent to which an ‘enston cn afford to loose its sales before it starts incurring losses. LIthelps to plan the profit: It is useful to calculate the volume needed: to attain tetaget profit. Sometimes the firm aims to generate a particular amount of profit in a ssi period. For this purpose, with the help of contribution margin it is convenient to late volume of sales necessary to achieve targeted profit. 4ithelps to compute up to what level the sales price can be reduced in’ competition or ampute additional sales volume required to ‘maintain a particular level of profit. ‘Ithelps to make the decisions with respect to selection of equipment amongst the ‘natives, selection of a process, etc. Slthelps to take decision regarding make or buy. 6.lthelps to decide the product mix and promotion mix. Es Cost-Volume-Profit (CVP) Analysis | Stvohume-profit analysis is concerned with the effect of change in costs, volume and | agence ‘on profits. It is a useful technique for planning the profits (budgeting) pricing | vag’ Stes mix decisions and production capacity decisions. Based upon the concept determine break-even sales volume to calculate profits and answer many questions that arise and ity oe variable costs, it is possible to |e level necessary to generate desire |. °™@nagement planning. | ,, tm (PA) graph | Seqrethisused along with breakeven chart Profit (or loss) is plotted on a y-axis, and | Stoont ducts (quantity) Sales revenue oF percentage of activity is plotted on x-axis, A | is drawn on the graph to separate profits from losses. kt Scanned with CamSeanner860 Industrial Engineering and Production Management Profits and losses at various sales level are plotted and are connec Break-even point is mensured at the point where the profit line intersect ash ; P/V graph focuses on the relationship between volume and Profit hog n PV graph is shown in Fig. 33.5. Ker ” Profit BaP oe }_..__¥ 7 — Quantity (Sates volume) Loss Total fixed expenses, }. 33.5: Profit volume chart, ‘The important relationships are: | | _ _ Fixed cost BEP (units) = Contribution Contribution = Sales ~ Variable Cost _ _ Contribution PNRatio = Contribution = Sales x P/V Ratio pep = Fixed cost ~ P/V ratio ) _ Fixed Cost + Profit Se cocamien Problem 1: A manufacturing firm incurs a fixed cost of ® 18000. The variable costs aus &8 per unit and selling price is & 13. Find the number of pieces to be produced to break-even. Solution: Fixed Cost (F) = 18000 Variable cost (a) = € 8 /unit Selling price (b) = % 13 /unit Fixed cost 18000 BEP = —————_ = =—— Contribution b-a 13-8 = 3600 pieces Problem 2: ABC company plans to sll an article ata local market. The aricept at 8 5 on the condition that all unsold articles shall be returned. The rent fort? moo ¥ 2000, The articles willbe sold at & 9. Determine the numberof articles wich mist Lael ( break-even, (b) To earn & 400 as profit (c) If the company sells 750 articles. Calculate safety and profit. Solution: (a = Fixedcost_ __F__ 2000 ° BP = Contribution “ba "9-8 Scanned with CamSeannerProduction Cost Concepts and Break-avon Analysis 964 On 500 units tof € 400 « a pot be __ Fixed cost + Profit _F # asa : Contribution 2000+ 400 = 600 ur . ghould sell 600 units to earn the profit of & 400. Sales ~ Sales at BEP if safety = ; Margin of safety Sales x 100 _ 750 — 500 x 100 ~ 750 = 33.3 percent 32 750 units. wt Profit = Total revenue - Total cost = Total contribution ~ Fixed cost = 3000 - 2000 = % 1000 eben 3 Determine the amount of fixed cost from the following information: Sales = 24,000 Direct material = 80,000 Direct labour = 50,000 Variable overheads = 20,000 Profit = 50,000 Variable cost = Direct Material + Direct labour + Variable Overhead = 80,000 + 50,000 + 20,000 = 1,50,000 \iehave the relation, Sales - variable cost = Fixed cost + profit. 2,40,000 - 1,50,000 = F + 50,000 * F= 40,000 rgd 4: PQR Limited company has been 0 8. You are required to compute. © BEP of each machine. © Theleel of sales at which both machines earn equa profits? flowing data is given offered a chance to buy between Machine Aand ‘Machine A ‘ual output (in units) 10,000 ed cots 30,000 at above level 30,000 Te, utkt price ofthe product is expected to be € 10/unit. Scanned with CamSeannerParticulars Machine : A 1 Sales & (10,000 x 10) / 900 Contribution (Fixed cost + Profit) som Variable cost 000 P/V Ratio (Contribution/Sales) 60% BEP (Fixed cost / P/V Ratio) 50,000 Contribution per unit 6 Variable cost/unit 4 (6) Since selling prices of A and B are equal, the machines will total cost of operations on both machines is equal. Let X be the output when the total costs on both are equal. SOP Qual prof Machine A Total cost = 4x + 30,000 Machine B Total cost = 6x + 16,000 4 4x + 30000 = 6x + 16000 Solving the equation for x x = 7000 units. At production level of 7000 units both machine give equal profits, Problem 5: An analysis of the company reveals the following information Cost element Variable cost Fiedoar Direct material 328 5 Direct labour 28.4 - Factory overheads 12.6 1,89,900 Distribution overheads 41 58,400 General administrative overheads 11 66,700 Budgeted sales are 18,50,000 Determine 1, Break-even sales volume. 2. The profit at the budgeted sales volume. i 3. The profit ifthe actual sales (a) drop by 10 per cent, (b) increase by 5 per cent budgeted sales. Solution: Total variable costs as Percentage of sales = 32.8 + 28.4+12.6+41+! = 79 per cent P/V Ratio = Contribution _ 100-79 Sales 100 Total fixed costs = 3,15,000 1, Break-even Sales Volume Bp, = Pixedcost _ 315000 © P/V Ratio 0.21 21 per cent — | Scanned with CamSeannerProduction Cost Concepts and Break-even Analysis 863 500,000 profit at budgeted Sales volume Profit = Sales x P/V Ratio - Fixed cost '8,50,000 x 0.21 - 31,5000 = 3,88,500 - 3,15,000 = 73,500 4 profit when actual sales drop by 10 per cent a ‘Actual sales = 18,50,000 - 1,85,000 = 16,65,000 Profit = Sales x P/V Ratio - Fixed cost 6 65,000 x 0.21 ~ 3,15,000 4,650 «profit when actual sales are increased by 5 per cent ‘Actual sales = 18,50,000 + 92,500 = 19,42,500 19,42,500 x 0.21 - 3,15,000 = 4,07,925 ~ 3,15,000 2,925 Problem 6: ASMIT corporation has given the following information on its capacity, sales and ates follows: 4. Current capacity = 1,00,000 units. : 2. Atcurrent level of operations, its margin of safety is 5 per cent of its break-even point. 3.Contribution Margin P/V Ratio = 2 5 per cent. 4,The unutilised capacity at present is 10,000 units 5. Sales price & 40 per unit. (a) Find (i) Break-even point in sales volume. (ii) Fixed costs. | Gti) Variable costs per unit. (io) Margin of safety in units. (If the fixed costs are decreased by € 1,80,000 fo what extent can the price be reduced to ‘uintain the iotal profit at current level. Solution: (a) (i) Break-even point in sales volume Profit Current capacity 1,00,000 units sss unutlised capacity 10,000 units Utilised capacity 90,000 units Utilised capacity — BEP = Margin of safety Utilised capacity - BEP = 50 per cent of BEP Utilised capacity = BEP + 50 per cent BEP = 11/2 (BEP) BEP = 90,000/1.5 = 60,000 units BEP (Value) = 40 x 60,000 = 2,40,000 Scanned with CamSeanner(ii Fived costs P EP Fixed cost Sontribution per unit cost price » contributi 60,000 = 60,000 = ; Fixed cost = 6,00,000 Gii) Variable cost per unit alae (Based on contribution margin ratio of 25%) Variable cost i fet io) Margin of af0'Y 50% of BEP 50 x 60,000 30,000 units. (ty Currently the contsbation is &9,00,000 (90,000 10). After reducing te fa, 300000. Ifthe fixed costs were to decline by & 1,80,000 to maintain am.” ae see sootlon ‘can come down by the same amount and even the sales ce i. ite T sevettion in sales price would, therefore, to be equal to reduction in sales vy uantil ae 1,80,000 7 = = =2 2 per unit 90,000 Problem 7: Fora particular product, the following information is given: Selling price per unit 10 Variable cost per unit 6 Fixed Costs % 1,00,000 Due to inflation variable costs increase by 10% while fixed costs increase by 3. i's ‘even quantity is to remain constant by what percentage should the sales price to be raised, Solution: Selling price per unit 10 Less: Variable cost per unit 6 Contribution per unit 4 Break-even quantity = see New variable cost = % 6,6/unit New fixed cost = 1,05,000 At, BEP, Sales = Total costs AAs, BEP is to be unchanged at 25,000 units Total costs = 25000 x 6.6 + 1,05,000 = & 2,70,000 Sales = Total cost = 2,70,000 at BEP Revised Sales Price = ae =%10.8 /unit. Scanned with CamSeanner