Theory of Cost & Break Analysis

8/3/2019 Theory of Cost & Break Analysis

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The cost of production is an important factor in almost allbusiness analysis & decisions:-

Locating the weak points in production management

Minimizing the cost

Finding the optimum level of output

Determination of price & dealers margin

Estimating or projecting the cost of business operation.

COST CONCEPT:- Cost can be grouped on the basis oftheir nature & purpose under 2 overlapping categories:-

Concepts used for accounting purposes

Analytical concepts used in economic analysis of business

activities.


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A). OPPORTUNITY COST & ACTUAL COST:- Opportunity cost:- Opportunity cost is the cost related to the

next-best choice available to someone who has picked amongseveral mutually exclusive choices.

May be defined as the expected returns from the second best use

of the resources which are forgone due to scarcity of resources. Also known as Alternative cost. It has been described as

expressing "the basic relationshipbetween scarcity and choice.

A person who has $15 can either buy a CD or a shirt. If he buys the

shirt the opportunity cost is the CD and if he buys the CD theopportunity cost is the shirt. If there are more choices than two,the opportunity cost is still only one item, never all of them.

Actual Cost:- Cost which are actually incurred by the firm inpayment of labor, material, plant, building, machinery,equipment, travelling & transportation, advertisement, etc.


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B). BUSINESS COSTS & FULL COSTS:- Business Cost:- Include all the expenses which are incurred

to carry out a business. Include all the payments & contractual obligations made by

the firm together with the book cost of depreciation on plant &equipment. Used for calculating business profits & losses & for filing returns

for income tax & other legal purposes. Full Cost:- Includes business cost, opportunity cost &

normal profit.

C). EXPLICIT & IMPLICIT OR IMPUTED COST:- An Explicit cost is a business expense accounted cost that can be

easily identified such as wage, rent and materials. This cost directly effect the revenue. Intangible expenses such as goodwill and amortization are not

explicit expense because these expenses don't show clear effectson a business's revenue and expenses. An Implicit cost, cost which do not take the form of cash

outlays, nor they appear in accounting system. Eg. Opportunitycost.

Implicit cost + Explicit Cost = Economic cost


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D). OUT OF POCKET COST & BOOK COST:- Out Of Pocket cost:- Items of expenditure which involve

cash transfers, both recurring & non-recurring.

All explicit cost falls under this category.

Book Cost, business cost which do not involve cashpayments but a provision is therefore made in the books ofaccount & they are taken into account while finalising the

profits & loss accounts. Eg. Depreciation allowances & unpaid interest on the

owners own fun.


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A). FIXED & VARIABLE COST:-

Fixed costs

costs that are not related directly toproduction rent, rates, insurance costs, depreciationcost, maintenance of land, admin costs. They canchange but not in relation to output.

Variable Costs costs directly related to variations inoutput. Raw materials primarily, running cost of fixedcapital as fuels, repair, routine maintenance expenditure& cost of all other inputs that vary with ouput.


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B). TOTAL, AVERAGE & MARGINAL COST:-

Total Cost -the sum of all costs incurred in production

TC = FC + VCAverage Cost the cost per unit of output

AC = TC/Output

Marginal Cost the cost of one more or one fewer units of

production MC= TCn TCn-1 units

Or MC = TC / Q

C). SHORT-RUN & LONG-RUN:- Short-run, cost which vary with the variation in output, size of

the firm remaining same.

Long-run, costs which are incurred on the fixed assets likeplant, building, machinery, etc.

Become variable as the size or scale of production increases.


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D). INCREMENTAL COSTS & SUNK COSTS:- Incremental cost, refers to the total additional cost associated with

the decision to expand output or to add a new variety of product. Etc. In long run firms expand their production, they hire more men,

materials, machinery & equipments. Sunk costs, cost which cannot be altered, increased or decreased, by

varying the rate of output. Sunk Costs, Is an expenditure that cannot be recovered . In essence, it

becomes part of fixed costs. E.g., abandon building.

E). HISTORICAL & REPLACEMENT COST:- Historical cost, cost of an asset acquired in the past where as

replacement cost refers to the outlay which has to be made forreplacing the old assets.

F). PRIVATE & SOCIAL COSTS:-

Private costs, which are actually incurred or provided for by anindividual or a firm on the purchase of goods & goods from themarket. All actual cost, both implicit & explicit are private costs.

Social cost, cost borne by the society due to production ofcommodity. It includes cost of resources for which company is notcompelled to pay a price & cost of the disutility created by the

company.


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Period over which the firm is unable to vary all its inputs.

Short Run TC = TFC + TVC TFC= Total fixed cost FVC= Total variable cost

a). Total Cost:- Actual cost incurred to produce a given quantity of output

in the short run, include both fixed & variable inputs. In the short run TC will only increase as TVC increases.

b). Total Fixed cost:- Total obligations incurred by the firm per unit of time for all

fixed inputs. These costs do not vary with the changes in output.

Have to bear irrespective to the size of output. Eg. salaries of admt. staff., depreciation, property taxes,


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Also called as Overhead cost, all common to all units

produced. Other name for it are, supplementary cost &

unavoidable cost.

c). Total Variable cost:- Can be increased or decreased by the manager in short run Variable costs will increase as production increases.

Cost(Rs.)

Output (Units)

Total fixed cost


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Shows variable cost directly proportional to output.

TVC is 0 when output is 0 and rise when output rises.

Its total productivity increases at an increasing rate, TVCincreases at a increasing rate.

Diminishing returns, more of variable factor combined withthe fixed factor, total productivity increases at decreasing.

Cost (Rs.)

Output (Units)

Total variable cost

Cost (Rs.)

Output (Units)

Total variable cost


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The sum of total fixed costs and total

variable costs:TC = TFC + TVC

In the short run TC will only increase asTVC increases.

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TFC is constant and unaffected by output level.

TVC is always increasing: First at a decreasing rate. Then at an increasing rate.

TC is parallel to TVC:

TC is higher than TVC by a distance equal to TFC.

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Average total cost per unit of output:

AFC + AVC

ATC = TC

Output

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The additional cost incurred from producing anadditional unit of output:

MC = TC Output

MC = TVC Output

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AFC is always decliningat a decreasing rate.

ATC and AVC decline atfirst, reach aminimum, thenincrease at higher

levels of output. The difference between

ATC and AVC is equalto AFC.

MC is generallyincreasing.

MC crosses ATC and AVCat their minimum point.

If MC is below the averagevalue:

Average value will be

decreasing.

If MC is above the averagevalue:

Average value will beincreasing.


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Nothing is fixed everything is variable.

Manager has time to adjust all inputs to thelevel that results in the desired farm size.

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LRAC is made up forSRACs SRAC curves

represent various

plant sizes Once a plant size is

chosen, per-unitproduction costs are

found by movingalong that particularSRAC curve


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Percent change in total costs

Percent change in total output value

Three possible results:Ratio value Type of Costs Returns toSize

< 1 Decreasing Increasing

= 1 Constant Constant

> 1 Increasing Decreasing

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The LAC curve is an envelop curve of all possible plantsizes. Also known as planningcurve

It traces the lowest average cost of producing each level ofoutput.

It is U-shaped because of Economies of Scale

Diseconomies of Scale


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LAC

SAC1

Q0

COST

SAC2

LONG-RUN AVERAGE COST CURVE


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LAC

Q0

COST

SAC1

q0


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LAC

Q0

COST

SAC1

q0

SAC2

Building a larger sized plant (size 2) will

result in a lower average cost of producing q0


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LAC

Q0

COST

SAC1

q0

SAC2

Likewise, a larger sized plant (size 3) will result to

a lower average cost of producing q1

q1

SAC3


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Increasing returns to size. LRAC curve is decreasing.

Economies of size result from: Full utilization of labor, machinery, buildings.

Ability to afford specialized labor and machineryand new technology.

Price discounts for volume purchasing of inputs. Price advantages when selling large amounts of

output.


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LAC

SAC1

Q0

COST

SAC2

LONG-RUN AVERAGE COST CURVE

Q1

Economies of Scale Diseconomies of Scale


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Decreasing returns to size. LRAC curve begins to increase.

Diseconomies of size result from: Lack of sufficient managerial skill.

Need to hire, train, supervise, and coordinate largerlabor force.

Dispersion over a larger geographical area. Disease control, waste disposal.


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LAC

SAC1

Q0

COST

LONG-RUN AVERAGE and MARGINAL COST CURVES

Q1

LMC

SMC1

SMC2

SAC2


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Long-run Average Cost (LAC) curve is U-shaped.

the envelope of all the short-run average costcurves;

driven by economies and diseconomies of size.

Long-run Marginal Cost (LMC) curve Also U-shaped;

intersects LAC at LACs minimum point.


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TYPES OFCOST

FUCNTION

Engineeringapproach

Accountingapproach

Statisticalapproach


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Cost relationship based directly on the physical relationship of

inputs to output. Uses price of inputs as the determinants of costs.

Rest clearly on the knowledge that shape of cost functiondependent on:-

The production function The price of inputs

Cost curve can be formulated by multiplying each input in thecost combination by its price, to develop the cost function.

This method of cost estimation is called as engineering approachas its mainly provided by the engineers.

Assumptions:-

Technology & factor prices are constant.

More relevant in short-run as in long run the prices use tochange.


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Cost-output relationship estimated by dividing total costinto fixed, variable & semi-variable cost.

Avg. variable cost, semi-variable cost & fixed cost aredetermined on the basis of inspection & experience.

Appears to be quite simple but is cumbersome as detailedbreakdown of cost have to be maintained as per the outputduring different period of time.


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Most widely adopted method for determining cost &output relationship.

Takes the help of the historical data on cost & outputto determine the cost-output relationship.

This method involves 3 basic steps:-Determinants ofcosts are identified

Functional form ofcost function isspecified

Least squaremethod is appliedto estimate thechosen form.


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Linear Equation C= a0 + bQ + CiXi

Quadratic

C= a0

+b1

Q+b2

Q +Ci

Xi

Cubic

C= a0+b1Q+b2Q +b3Q +CiXi

Double Log C= Log a0+a1LogQ+CiLogXi

2

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Theory of Cost & Break Analysis

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