UNIT-III

Elements of Managerial
Economics

Prepared by
Prof. Y. G. Jadhav
Cost Analysis for Engineering Projects
Types of costs: 1.fixed costs,
2. variable costs,
3.direct costs,
4. indirect costs,
Cost estimation methods and technique,
Break-even analysis and cost-volume-profit analysis. (6 Hrs)
Cost & cost control
 INTRODUCTION
Most of the enterprises want to maximize the profit, which is
possible by decreasing the production cost.
For this purpose, management uses two efficient tools,
1.cost control and 2. cost reduction.
Cost Control is a technique which makes available the necessary
information to the management that actual costs are aligned with the
budgeted costs or not.
COST Control
Cost Control is a process in which we focus on controlling the total cost
through competitive analysis.
It ensures that the cost incurred on production should not go beyond the
pre-determined cost.
Cost Control involves a chain of various activities, which starts with the
preparation of the budget in relation to production.
Thereafter we evaluate the actual performance.
After that we compute the variances between the actual cost and the
budgeted cost and further, we find out the reasons for the same.
Finally, we implement the necessary actions for correcting discrepancies
Features of Cost Control
It is an attempt to keep the expenses within the control
It is a continuous process which includes formulating standards and
preparing budgets to set a target and then continuously comparing the
actual with these standards.
It requires a continuous cost control report to identify the variances to be
resolved.
It works as motivational and encouragement to the employees to achieve
the budgetary goals and keep the cost, controlled.
It is not only focused on reducing the cost, it also focusses on the effective
utilization of the resources to get better results with the same available
resources.
For example
If current cost of producing a unit is Rs. 100 per unit, then under cost
control attempt will be made to reduce the cost in such a manner
that it does not go beyond Rs. 100.
Organization will attempt to achieve this target. If it is found that
actual cost comes at Rs. 120, it will find the deviation which is Rs. 20.
Then attempt will be made to find the method to reduce the cost to
Rs. 100 This is known as cost control.
Advantages of Cost Control
Cost control helps to achieve expected return on the capital invested
in a company
Cost control reduces the prices or tries to maintain it by reducing the
cost.
Cost control leads to economic use of resources.
It increases profitability and competitive position of a company.
It prospers and increases economic stability of the industry
It increases the sales of the company and maintains the level of
employment.
Techniques of Cost Control
Budgetary control: The budgetary control is process of continuous
comparison. It works with creating budgets and continuous
comparison of these budgets with the actual. It is finding the reasons
for deviations and revising the budgets with needs. It helps in
planning coordination and controlling.
Standard costing: Standard costing is setting a standard cost and
using this standard cost with actual and analyze the variances. It helps
in identifying the causes of variances and cost estimation.
Inventory control: Inventory control is regulating purchase, and usage
of material to maintain the production without blocking the extra
funds into it. It tries to reduce the wastage of the material and leads
to effective utilization of it.
Ratio analysis: Ratio analysis identifies the relationship among
different variables. It helps to identify the trends in an organization.
Ratio analysis is also used for comparison of different organizations
on different aspects. It is mainly used for comparing the performance
with other organizations and external standards.
Variance analysis: Variance analysis is a method of cost control. It
involves the identification of the amount of variance and to analyze
the reasons of these variances. A variance is which varies from the
standards set. It can be favorable or unfavorable.
TYPES OF COSTS
Cost can be broadly classified into variable cost and overhead cost.
Variable cost varies with the volume of production
overhead cost is fixed, irrespective of the production volume.

Variable cost can be further classified into

1.direct material cost,
2.direct labor cost
3.direct expenses.
The overhead cost can be classified into
1.factory overhead
2.administration overhead
3.selling overhead
4.distribution overhead.
 Fixed Costs: These are costs that do not change with the level of production or
sales volume. Examples include rent, salaries of permanent staff, and
insurance premiums.
 Variable Costs: These costs vary directly with the level of production or sales.
Examples include raw materials, direct labor, and commissions on sales.
 Direct Costs: These are costs that can be directly traced to a specific product,
department, or project. For example, the cost of raw materials used in
manufacturing a product.
 Indirect Costs: These costs are not directly traceable to a specific product or
department. Instead, they are shared across multiple products or departments.
Examples include administrative expenses and utilities.
 Marginal Cost: The cost of producing one additional unit of a product. This is
important for decision-making regarding scaling production.
 Opportunity Cost: The value of the next best alternative that is forgone when
making a decision. For example, the profit you could have earned if you had
invested your resources elsewhere.
 Sunk Cost: Costs that have already been incurred and cannot be recovered.
Sunk costs should not influence future decisions but often do in practice.
Lifecycle cost
Lifecycle cost refers to the total cost of owning, operating, and maintaining an asset over
its entire lifespan. It provides a comprehensive view of all costs associated with an asset
from acquisition to disposal.
Acquisition Cost
Operation Costs
Maintenance Costs
Depreciation
Training Costs
budget
A budget is a financial plan that outlines expected revenues and expenditures over a
specific period.
It serves as a tool for managing finances, setting goals, and ensuring that resources are
allocated efficiently.
Budgets are used by individuals, businesses, governments, and organizations to guide
financial decision-making and track performance.
Break-even analysis
Break-even analysis is a financial tool used to determine the point at which total
revenues equal total costs, meaning there is no profit or loss. This point is known as the
break-even point.
Understanding this helps businesses and individuals evaluate the minimum sales needed
to cover all fixed and variable costs and to make informed decisions about pricing,
budgeting, and financial planning.
• Break-Even Point:
• The level of sales at which total revenues equal total costs. It can be calculated in units or
in sales dollars.
Break-Even Point Formulas
Fixed Cost
• Break-Even Point (Units)= Selling price per unit−Variable cost per unit
Example Calculation
Let’s say a company manufactures a product with the following details:
Fixed Costs: $50,000
Selling Price per Unit: $100
Variable Cost per Unit: $60
Calculate the Break-Even Point in Units= 1,250 units
Linear programming
Linear programming (LP) is a mathematical optimization technique used to determine the best
possible outcome or solution from a set of constraints and objective functions.
It is widely applied across various fields to solve problems involving resource allocation,
scheduling, and optimization.
Here are some key applications of linear programming
1. Manufacturing and Production
2. Transportation and Logistics
3. Finance and Investment
4. Agriculture
5. Telecommunications
6. Energy Management
7. Healthcare
8. Supply Chain Management
9. Project Management
10. Education and Training
 Net Present Value (NPV)
• Net Present Value (NPV) is a fundamental financial metric used in investment analysis to evaluate
the profitability of an investment or project. It measures the difference between the present
value of cash inflows and the present value of cash outflows over the life of the investment. NPV
helps investors and managers determine whether an investment is worthwhile and whether it will
generate more value than its cost.
• Key Concepts in NPV
1.Cash Inflows:
1. Expected revenues or savings from the investment over time.
2.Cash Outflows:
1. Initial investment costs and any additional costs associated with the investment.
3.Discount Rate:
1. The rate used to discount future cash flows to their present value. It often reflects the cost of
capital or the required rate of return.
4.Present Value:
1. The value of future cash flows discounted back to the present time using the discount rate.
payback period
• The payback period is a financial metric that measures the time it
takes for an investment to generate enough cash flows to recover its
initial cost. It’s a simple way to assess the risk of an investment: the
shorter the payback period, the less risk involved.
• How to Calculate the Payback Period:
1.Initial Investment: Determine the total cost of the investment.
2.Annual Cash Flows: Estimate the annual cash inflows the investment
will generate.
3.Calculation: Divide the initial investment by the annual cash inflow to
find the payback period in years.
• Example:

• Initial Investment: $10,000

• Annual Cash Inflow: $2,500

• Payback Period = Initial Investment / Annual Cash Inflow

Payback Period = $10,000 / $2,500 = 4 years

Depreciation
• Depreciation is the accounting method used to allocate the cost of a
tangible asset over its useful life.
• It reflects how the value of an asset decreases over time due to wear
and tear, age, or obsolescence.
• Key Concepts:
1.Purpose: Depreciation allows businesses to match the cost of an
asset with the revenue it generates, providing a more accurate
picture of profitability.
2.Types of Assets: Common depreciable assets include buildings,
machinery, vehicles, and equipment.
Salvage value
• Salvage value is the estimated residual value of an asset at the end of
its useful life.
• It represents the amount a company expects to recover when it
disposes of the asset, whether through sale, scrap, or other means.
• This value is important for calculating depreciation and helps
businesses assess the total cost of ownership for an asset.
• Straight-Line Depreciation:
• Most straightforward method.
Cost−Salvage Value
• Annual Depreciation Expense =
Useful life

Example: If an asset costs $10,000,

has a salvage value of $1,000, and
a useful life of 5 years,
the annual depreciation expense would be $1,800.
Time value of money
• The time value of money (TVM) is a financial concept that suggests
money available today is worth more than the same amount in the
future due to its potential earning capacity. This principle is based on the
idea that money can earn interest, so any amount of money is worth
more the sooner it is received.
 Present Value (PV): The current worth of a future sum of money or stream of cash flows,

discounted at a specific interest rate.

 Future Value (FV): The amount of money that an investment will grow to over a period of time at a

given interest rate.

 Interest Rate (r): The percentage at which money will grow over time. This can be a simple interest

rate or a compound interest rate.

 Time (t): The duration for which the money is invested or borrowed.

 Cash Flows: The money that moves in and out of an investment.

Applications of TVM
Investment Decisions: Evaluating whether to invest now or later.
Loan Calculations: Understanding how much a loan will cost over
time.
Retirement Planning: Estimating how much to save for the future.
Valuation of Annuities: Calculating the present value of a series of
future cash flows.
• Understanding TVM helps in making informed financial decisions,
whether in personal finance, investing, or corporate finance. If you
have specific questions or scenarios in mind, feel free to ask!
Business forecasting
• Business forecasting is the process of estimating future trends, sales,
or financial outcomes based on historical data, market analysis, and
various economic indicators.
• It helps organizations make informed decisions about inventory
management, budgeting, staffing, and strategic planning.