Engineering Economics| ME 2001 | 3 Credits | 3 0 0 3

Lecture 5

Cost Analysis

Course Instructor
Dr. Ashish Malik
Associate Professor, Department of Mechanical Engineering
School of Automobile, Mechanical and Mechatronics Engineering (SAMME)
Manipal University Jaipur

1
Types of COSTS Lecture 5

• Actual cost - actual expenditure incurred for acquiring or producing a Good or Service. These are recorded in the books of
accounts which are also known as Absolute Costs or Outlay Costs. Eg. Actual wages paid, Cost of Materials purchased,
interest paid etc.
• Opportunity Cost is the Cost of opportunity lost. It is also defined as the revenue earned on the best alternative investment.
Eg.: Machine A earning Rs.1,00,000 per year and Machine B earning Rs.2,00,000 per year. In the event of selecting
Machine B, the revenue from machine A of Rs.1,00,000 becomes the Opportunity Cost
• Incremental cost - the additional cost due to the change in level of business activity. It is also known as the differential cost.
Eg. Adding a new product line, changing distribution channel, adding a new M/c etc.
• Sunk Cost - past cost resulting from a decision that cannot be revised. It is not affected by the change in level of business
activity. It is also known as unavoidable cost. Eg. Book value of an asset if it is less than the market value, inventories.
• Short run costs - those, which vary with the output when at least one input factor such as Plant and equipments remain the
same.
• Long run costs - those, which vary with output when all the input factors including plant and equipment vary.
• Fixed cost - are those, which remain fixed irrespective of the quantity of output. Ex. Land, building, equipments etc.
• Variable costs - are those, which vary with the variation in output. Ex.: Cost of raw materials, wages, power, fuel etc.

Total Cost = Fixed Cost + Variable Cost.

2
ELEMENTS OF COSTS Lecture 5
• Cost can be broadly classified into variable cost and overhead cost. Variable cost varies with the
volume of production while overhead cost is fixed, irrespective of the production volume.
• Variable cost can be further classified into direct material cost, direct labour cost, and direct
expenses.
• The overhead cost can be classified into factory overhead, administration overhead, selling
overhead, and distribution overhead.

• The selling price of a product is derived as shown below:

(a) Direct material costs + Direct labour costs + Direct expenses = Prime cost
(b) Prime cost + Factory overhead = Factory cost
(c) Factory cost + Office and administrative overhead = Costs of production
(d) Cost of production + Opening finished stock – Closing finished stock = Cost of goods sold
(e) Cost of goods sold + Selling and distribution overhead = Cost of sales
(f) Cost of sales + Profit = Sales
(g) Sales/Quantity sold = Selling price per unit

3
Marginal COSTS Lecture 5
Marginal Cost
represents additional cost of producing one extra unit of output. Ex. A company producing 100 units of an item for a total cost
of Rs.10,000 and if the total cost of producing 101 units is Rs.10,050, then, the Marginal cost of production is Rs. 50/- for the
101st unit.
Quantity Fixed Cost Variable Cost Total Cost (Rs) Marginal Cost (MC in Rs.)
Q in Units FC (Rs) VC (Rs) TC =FC+VC (TCn - TCn-1) / (Qn – Qn-1)
Total Cost (TC)
0 55 0 55 -- Average or Unit cost (AC) = --------------------- Rs. /Unit
Quantity (Q)
1 55 30 85 30
2 55 55 110 25 Total Fixed Cost (TFC)
3 55 75 130 20 Average Fixed Cost (AFC) = ------------------------ Rs. /Unit
4 55 105 160 30 Quantity (Q)
5 55 155 210 50
Total Variable Cost (TVC)
6 55 225 280 70
Average Variable Cost (AVC) = ------------------------ Rs. /Unit
Quantity (Q)

4
Marginal COSTS Lecture 5
Illustration # 1: You are given the following data. Calculate, TC, MC, AC, AFC and AVC at all levels output

Solution:
Q FC VC TC MC AC AFC AVC
0 55 0 55 --
1 55 30 85 30 85 55 30
2 55 55 110 25 55 27.5 27.5
3 55 75 130 20 43.33 18.33 25
4 55 105 160 30 40 13.75 26.25
5 55 155 210 50 42 11 31
6 55 225 280 70 46.67 9.17 37.5
7 55 315 370 90 52.86 7.86 45
8 55 425 480 110 60 6.88 53.13
9 55 555 610 130 67.78 6.11 61.67
10 55 705 760 150 76 5.5 70.5

5
Marginal COSTS Lecture 5
Illustration # 2: From following data, prepare a cost schedule showing, TFC, TVC, TC, AC, AVC & MC. Fixed investment =
Rs. 1000/- and Labour Costs Rs.5/- per unit.
Labour Input 0 1 2 3 4 5 6 7 8
Quantity of Output (Tonnes) 0 4 12 17 20 21 22 23 24

Solution: TVC = Labour Input x Labour Cost

Q TFC TVC TC ATC AVC MC

0 1000 0 1000 --
4 1000 5 1005 250 1.25 1.25
12 1000 10 1010 83 0.83 0.625
17 1000 15 1015 58 0.88 1
20 1000 20 1020 50 1 1.67
21 1000 25 1025 47 1.11 5
22 1000 30 1030 45 1.36 5
23 1000 35 1035 43 1.52 5
24 1000 40 1040 41 1.67 5

6
BREAK-EVEN ANALYSIS Lecture 5

This point is also called the no-loss or no-gain

situation. For any production quantity which
is less than the break-even quantity, the total
cost is more than the total revenue. Hence, the
firm will be making loss.

For any production quantity which is more than

the break-even quantity, the total revenue will
be more than the total cost. Hence, the firm will
be making profit.

7
BREAK-EVEN ANALYSIS Lecture 5
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 the following formula:
S=s Q
The total cost of the firm for a given production volume is given as
TC = Total variable cost + Fixed cost = v Q + FC

Profit = Sales – (Fixed cost + Variable costs)

= s Q – (FC + v Q)
Break-even quantity = Fixed cost/Selling price/unit - Variable cost/unit
=FC/s-v (in units)
Break-even sales
= {Fixed cost/Selling price/unit - Variable cost/unit }* Selling price/unit
= {FC/s-v }*s (Rs)
Contribution = Sales – Variable costs
Contribution/unit = Selling price/unit – Variable cost/unit
M.S. = Actual sales – Break-even sales
= {Profit/Contribution}*sales
M.S. as a per cent of sales = (M.S./Sales)*100
8
Problem No: 1 Lecture 5

Alpha Associates has the following details:

i. Fixed cost = Rs. 20,00,000
ii. Variable cost per unit = Rs. 100
iii. Selling price per unit = Rs. 200
Find
(a) The break-even sales quantity,
(b) The break-even sales
(c) If the actual production quantity is 60,000, find (i) contribution; and
(ii) margin of safety by all methods.

9
 Problem No: 1
Solution
Fixed cost (FC) = Rs. 20,00,000
Variable cost per unit (v) = Rs. 100
Selling price per unit (s) = Rs. 200
(a) Break-even quantity = FC/s-v
= 20,00,000/100 = 20,000 units
(b) Break-even sales = [FC/s-v] *s (Rs.)
= 20 00 000/100 * 200
= Rs. 40,00,000
(c) (i) Contribution = Sales – Variable cost
= s *Q – v *Q
= 200 *60,000 – 100 *60,000
= 1,20,00,000 – 60,00,000
= Rs. 60,00,000
Lecture 5
(ii) Margin of safety
METHOD I
M.S. = Sales – Break-even sales
= 60,000 *200 – 40,00,000
= 1,20,00,000 – 40,00,000 = Rs. 80,00,000
METHOD II
M.S. = Profit/Contribution * Sales
Profit = Sales – (FC + v Q)
• = 60,000 *200 – (20,00,000 + 100 * 60,000)
= 1,20,00,000 – 80,00,000 = Rs. 40,00,000
M.S. =40,00,000/60,00,000 *1,20,00,000
= Rs. 80,00,000
M.S. as a per cent of sales = (M.S./Sales)*100
= 80,00,000/ 1,20,00,000 *100
= 67%
10
PROFIT/VOLUME RATIO (P/V RATIO) Lecture 5

P/V ratio is a valid ratio which is useful for further analysis.

P/V ratio = Contribution/Sales
= Sales - Variable costs/ Sales
The relationship between BEP and P/V ratio is as follows:
BEP = Fixed cost/(P/V ratio)
The following formula helps us find the M.S. using the P/V
ratio:
M.S. = Profit / (P/V ratio)

11
Problem No: 2 Lecture 5

Consider the following data of a company for the year 1997:

(i) Sales = Rs. 1,20,000
(ii) Fixed cost = Rs. 25,000
(iii) Variable cost = Rs. 45,000
Find the following:
(a) Contribution
(b) Profit
(c) BEP
(d) M.S.
12
Problem No: 2 Lecture 5
Solution
Given: BEP = Fixed cost/ (P/V ratio)
(i) Sales = Rs. 1,20,000 = 25000/62.50* 100
(ii) Fixed cost = Rs. 25,000 = Rs. 40,000
(iii) Variable cost = Rs. 45,000
(a) Contribution = Sales – Variable costs M.S. = Profit/P/V ratio
= Rs. 1,20,000 – Rs. 45,000 = 50 000/62 50 * 100
= Rs. 75,000 = Rs. 80,000
(b) Profit = Contribution – Fixed cost
= Rs. 75,000 – Rs. 25,000
= Rs. 50,000
(c) BEP
P/V ratio = Contribution / Sales
= 75,000/1,20,000 = 62.50%

13
Problem No: 3 Lecture 5

Consider the following data of a company for the year 1998:

(i) Sales = Rs. 80,000
(ii) Fixed cost = Rs. 15,000
(iii) Variable cost = 35,000
Find the following:
(a) Contribution
(b) Profit
(c) BEP
(d) M.S.
14
Problem No: 3 Lecture 5
Solution
Given: BEP = Fixed cost/ (P/V ratio)
(i) Sales = Rs. 80,000 = 15000/56.25* 100
(ii) Fixed cost = Rs. 15,000 = Rs. 26,667
(iii) Variable cost = Rs. 35,000
(a) Contribution = Sales – Variable costs M.S. = Profit/(P/V ratio)
= Rs. 80,000 – Rs. 35,000 = 30 000/56.25 * 100
= Rs. 45,000 = Rs. 53,333.33
(b) Profit = Contribution – Fixed cost
= Rs. 45,000 – Rs. 15,000
= Rs. 30,000
(c) BEP
P/V ratio = Contribution / Sales
= 45,000/80,000
= 56.25%

15
Thank you