Analysis of cost

Analysis of Cost
Presented by:
Arshad A Javed
FCA, CISA , CIA, CFE, CFAP, CICA,
CAME, DISA, DipPM, B.Com (Hons)
Finance for Non Finance 1

Revenue and costs
What is a costs and what
are classification of costs

Revenue and costs
Cost is a sacrifice of resources to obtain a benefit
or any other resource. For example in production
of a car, we sacrifice material, electricity, the value
of machine's life (depreciation), and labor wages
etc.
Thus these are our costs
Cost- Definition

Revenue and costs
Direct and Indirect Costs
1. Direct Costs: The product costs that can be specifically
identified with each unit of a product are called direct product
costs. Direct costs can be accurately traced to a cost object
with little effort. Cost object may be a product, a department, a
project, etc.
2. Indirect Costs: Costs which cannot be accurately attributed
to specific cost objects are called indirect costs. These typically
benefit multiple cost objects and it is impracticable to
accurately trace them to individual products, activities or
departments etc. Examples: Cost of depreciation, insurance,
power, salaries of supervisors incurred in a concrete plant.

Revenue and costs
Exercise
Following costs are incurred by a factory on the production of identical
cupboards:
1. Laborers' wages 2. Synthetic wood
3. Power consumption 4. Glass
5. Nails and screws 6. Factory insurance
7. Handles, locks and hinges 8.Wood
9. Supervisors' salaries 10. Factory depreciation
11.Varnish, glue, paints 12. Factory manager's salary
Classify the above costs as direct or indirect.
Solution
1. Direct 2. Direct 3. Indirect 4. Direct
5. Indirect 6. Indirect 7. Direct 8. Direct
9. Indirect 10. Indirect 11. Indirect 12. Indirect

Revenue and costs
Cost- Classification
Product CostsVs. Period Costs
Product costs are costs assigned to the manufacture of
products and recognized for financial reporting when sold.
They include direct materials, direct labor, factory wages,
factory depreciation, etc.
Period costs are on the other hand are all costs other
than product costs. They include marketing costs and
administrative costs, etc.

Revenue and costs
Breakup of Product Costs
Product CostsVs. Period Costs
Product costs are costs assigned to the manufacture of
products and recognized for financial reporting when sold.
They include direct materials, direct labor, factory wages,
factory depreciation, etc.
Period costs are on the other hand are all costs other
than product costs. They include marketing costs and
administrative costs, etc.

Revenue and costs
Breakup of Product Costs
The product costs are further classified into:
1. Direct materials: Represents the cost of the materials that can be
identified directly with the product at reasonable cost. For example,
cost of paper in newspaper printing, Cost of gravel, sand, cement and
wages incurred on production of concrete.
2. Direct labor: Represents the cost of the labor time spent on that
product, for example cost of the time spent by a petroleum engineer
on an oil rig, etc.
3. Manufacturing overhead: Represents all production costs except
those for direct labor and direct materials, for example the cost of an
accountant's time in an organization, depreciation on equipment,
electricity, fuel, etc.
Thus direct material cost and direct labor cost are direct product costs
whereas manufacturing overhead cost is indirect product cost.

Revenue and costs
Prime CostsVs. Conversion Costs
Prime costs are the sum of all direct costs such as
direct materials, direct labor and any other direct
costs.
Conversion costs are all costs incurred to convert
the raw materials to finished products and they equal
the sum of direct labor, other direct costs (other than
materials) and manufacturing overheads.

Revenue and costs
Costs Diagram

Revenue and costs
Fixed CostsVs.Variable Costs
Fixed CostsVs.Variable Costs
Fixed costs are costs which remain constant within a certain
level of output or sales.This certain limit where fixed costs
remain constant regardless of the level of activity is called
relevant range. For example, depreciation on fixed assets, etc.
Variable costs are costs which change with a change in the
level of activity. For example direct materials, direct labor, etc.

Revenue and costs
Opportunity Costs
Opportunity costs are costs of a potential benefit foregone, i.e., the
cost of an alternative that must be forgone in order to pursue a certain
action. Put another way, the benefits you could have received by taking
an alternative action.
For example:
• The opportunity cost of going on a picnic is the money that you
would have earned in that time. Or
• The opportunity cost of going to college is the money you would
have earned if you worked instead
In both cases, a choice between two options must be made. It would be
an easy decision if we knew the end outcome; however, the risk that you
could achieve greater "benefits" (be they monetary or otherwise) with
another option is the opportunity cost.

Revenue and costs
Types of Costs by Behavior
Cost behavior refers to the way different types of production
costs change when there is a change in level of production.
There are three main types of costs according to their behavior:
1. Fixed Costs
2. Variable Costs
3. Mixed Costs

Revenue and costs
Fixed Costs
Fixed costs are those which do not change with the level of activity
within the relevant range.These costs will incur even if no units are
produced. For example rent expense, insurance of plant & assets, etc.
Fixed cost per unit decreases with increase in production. Following
example explains this fact:
Total Fixed Cost $30,000 $30,000 $30,000
÷ Units Produced 5,000 10,000 15,000
Fixed Cost per Unit $6.00 $3.00 $2.00

Revenue and Costs
Fixed Costs

Revenue and Costs
Variable Costs
Variable costs change in direct proportion to the level of
production.This means that total variable cost increase when
more units are produced and decreases when less units are
produced.Although variable in total, these costs are constant
per unit.
For example:
Total Variable
Cost
$10,000 $20,000 $30,000
÷ Units
Produced
5,000 10,000 15,000
Variable Cost
per Unit
$2.00 $2.00 $2.00

Revenue and Costs
Variable Costs

Revenue and Costs
Mixed Costs
Mixed costs or semi-variable costs have properties of both fixed
and variable costs due to presence of both variable and fixed
components in them. An example of mixed cost is telephone
expense because it usually consists of a fixed component such
as line rent and fixed subscription charges as well as variable
cost charged per minute cost. Another example of mixed cost is
delivery cost which has a fixed component of depreciation cost
of trucks and a variable component of fuel expense.
Since mixed cost figures are not useful in their raw form,
therefore they are split into their fixed and variable components
by using cost behavior analysis techniques such as High-Low
Method, Scatter Diagram Method and Regression Analysis

Revenue and Costs
Break-Even Point (BEP)

Revenue and Costs
Contribution Margin (CM)
Contribution Margin (CM) is equal to the difference between total
sales (S) and total variable cost or, in other words, it is the amount by
which sales exceed total variable costs (VC). In order to make profit
the contribution margin of a business must exceed its total fixed costs.
In short:
CM = S −VC
Unit Contribution Margin (Unit CM)
Contribution Margin can also be calculated per unit which is called
Unit Contribution Margin. It is the excess of sales price per unit (p)
over variable cost per unit (v).Thus:
Unit CM = p − v

Revenue and Costs
Contribution Margin Ratio (CM Ratio)
Contribution Margin Ratio is calculated by dividing contribution
margin by total sales or unit CM by price per unit.
CM Ratio =
Unit Contribution Margin
Total Contribution
Margin
Unit Price Total Sales
Contribution margin and contribution margin ratio are used in
the breakeven analysis.

Revenue and Costs
Contribution Margin
Example:
Use the following information to calculate unit contribution margin,
total contribution margin and contribution margin ratio:
Price Per Unit $22
Units Sold 802
TotalVariable Cost $9,624
Solution:
Total Sales = 802 × $22 = $17,644
Total Contribution Margin = $17,644 − $9,624 = $8,020
Contribution Margin Per Unit = $8,020 ÷ 802 = $10
CM Ratio = $8,020 ÷ $17,644 = $10 ÷ $22 ≈ 45%

Revenue and Costs
What is Breakeven Point?
A company's breakeven point is the point at which its sales exactly
cover its expenses. The company sells enough units of its product to
cover its expenses without making a profit or taking a loss. If it sells
more, then it makes a profit. On the other hand, if it sells less, it takes a
loss.
In other words Break-even is the point of zero loss or profit.

Revenue and Costs
Breakeven Point- Calculation
Break-even point can be calculated by
1. CVP Equation method
2. Contribution method or
3. Graphical method

Revenue and Costs
Breakeven Point- Equation method
The equation method is based on the cost-volume-profit (CVP)
formula:
px = vx + FC + Profit
Where,
p is the price per unit,
x is the number of units,
v is variable cost per unit and
FC is total fixed cost.

Revenue and Costs
CostVolume Profit Analysis
Cost-Volume-Profit (CVP) analysis is a managerial accounting
technique that is concerned with the effect of sales volume and
product costs on operating profit of a business. It deals with how
operating profit is affected by changes in variable costs, fixed costs,
selling price per unit and the sales mix of two or more different
products.
CVP analysis has following assumptions:
1. All cost can be categorized as variable or fixed.
2. Sales price per unit, variable cost per unit and total fixed cost
are constant.
3. All units produced are sold.

Revenue and Costs
Breakeven Point- Equation method
BEP in Sales Units
At break-even point the profit is zero therefore the CVP formula is
simplified to:
px = vx + FC
Solving the above equation for x which equals break-even point in sales
units, we get:
BEP in Sales Dollars
Break-even point in number of sales dollars is calculated using the following
formula:
Break-even Sales Dollars = Price per Unit × Break-even Sales Units
Break-even Sales Units = x =
FC
p − v

Revenue and Costs
Breakeven Point- Equation Method- Example
Calculate break-even point in sales units and sales dollars from following
information:
Price per Unit $15
Variable Cost per Unit $7
Total Fixed Cost $9,000
We have,
p = $15
v = $7, and
FC = $9,000
Breakeven Point in Sales Units (x)
FC÷ (p − v)
= 9,000 ÷ (15 − 7)
= 9,000 ÷ 8
= 1,125 units
Break-even Point in Sales Dollars
Price per Unit × Break-even Sales Units
$15 × 1,125 = $16,875

Revenue and Costs
Breakeven Point- Contribution Margin Approach
We learned that, at break-even point, the CVP analysis equation is reduced to:
px = vx + FC
Where p is the price per unit, x is the number of units, v is variable cost per
unit and FC is total fixed cost.
Solving the above equation for x (i.e. Break-even sales units ):
Break-even Sales Units = x = FC ÷ ( p − v )
Since unit contribution margin (Unit CM) is equal to unit sale price (p) less
unit variable cost (v), So,
Unit CM = p − v
Therefore,
Break-even Sales Units = x = FC ÷ Unit CM

Revenue and Costs
BEP in Sales Dollars
Break-even point in dollars can be calculated via:
or
Break-even Sales Dollars = FC ÷ CM Ratio

Revenue and Costs
Calculate the break-even point in units and in sales dollars when sales
price per unit is $35, variable cost per unit is $28 and total fixed cost
is $7,000.
Solution:
Contribution Margin per Unit
( $35 − $28 ) = $7
Break-even Point in Units
FC ÷ Unit CM
$7,000 ÷ $7 = 1,000
Break-even Point in Sales Dollars
Break-even Sales Dollars = FC ÷ CM Ratio
1,000 × $35 or $7,000 ÷ 20% = $35,000

Revenue and Costs
Breakeven Point- Graphical representation
CVP analysis can also be presented graphically.
Graphical representation of a break-even point and break-even analysis

Revenue and Costs
In the graph of the break-even point representation, sales and costs are shown on the vertical axis (Y) and units sold are
shown on the horizontal axis (X).The fixed costs line starts at $10,000 for zero units sold and remains unchanged regardless
of increases in units sold.This happens because fixed costs don't change with the production level.The sales line starts at zero
dollars when zero units are sold and increases as more and more units are sold.The exact increase is $5 per each additional
unit because the selling price for one unit is $5.The total costs line starts at $10,000 for zero units sold because at that level,
only fixed costs of $10,000 are incurred.As the company starts selling units, the total costs increase by $3 for each additional
unit because the variable costs per unit are $3 per unit.
The break-even point is where total costs equal sales. Recall a break-even point is a no-profit situation, which occurs when
sales equal costs.You can see that the break-even point for The Company is 5,000 units or $25,000 in sales
At any point below the break-even mark, the company will have a loss because total costs exceed sales.Vice versa, at points
above the break-even mark, the company will have a profit because total costs are lower than sales.The loss and profit areas
are shown on the graph in red and green colors, respectively.

Analysis of Costs
Advantages of Break Even Point
• It can be interpolated to find the changes in profit levels and break
even points upon changes in fixed costs, variable costs and
commodity prices.
• It is useful in capital budgeting techniques.
• It represents the minimum amount of sales necessary to prevent
losses.
• In order to know how to price your product, you first have to
know how to calculate breakeven point.
Limitations of Break Even Analysis
• The classification of costs into fixed and variable is not very clear.
• It is suited only to the analysis of one product at a time.
• The applicability of break-even analysis is affected by numerous
assumptions.A violation of these assumptions might result in
erroneous conclusions.

Analysis of Costs
Marginal Cost
Marginal cost is the increase or decrease in the
total cost of a production run for making one
additional unit of an item. In other words it is the
change in total cost that comes from making or
producing one additional item.

Analysis of Costs
Marginal Cost
The marginal cost is the added expense of producing one more
unit. Should you expand your business? If so, what is the additional
cost you entail to do so? Frequently, the marginal cost can be
computed.The added cost per square foot of expansion and the
added cost of more workers can be quantified. For a firm operating
a call center, the cost of an additional station and telephone line is
the marginal cost. Marginal costs tend to rise the more a firm
produces. Resources may become more expensive, space gets
tighter and good workers become more difficult (and costly) to
locate.

Analysis of Costs
Marginal Cost- why it is important?
The purpose of analyzing marginal cost is to determine at what
point an organization can achieve economies of scale.The
calculation is most often used among manufacturers as a means
of isolating an optimum production level.
This is because at some point, the benefit of producing one
additional unit and generating revenue from that item will bring
the overall cost of producing the product line down.The key to
optimizing manufacturing costs is to find that point or level as
quickly as possible
Note: Marginal costs are variable costs consisting of labor and material costs,
plus an estimated portion of fixed costs (such as administration overheads
and selling expenses).

Analysis of Costs
Marginal Cost- calculations
Marginal Cost=Change inTotal Cost/Change inTotal Quantity

Analysis of Costs
Marginal Revenue
The increase in revenue that results from the sale of one
additional unit of output. Marginal revenue is calculated
by dividing the change in total revenue by the change in
output quantity.
marginal revenue =
change in total revenue
change quantity
While marginal revenue can remain constant over a certain
level of output, it follows the law of diminishing returns and
will eventually slow down, as the output level increases.

Analysis of Costs
Marginal Revenue
Marginal revenue is the additional revenue that will be
realized by selling one more unit. For a pizza store, the
marginal revenue is the price of one more pizza sold. In
some cases, marginal revenue may be more difficult to
pin down. In the call center example, the marginal
revenue of an additional station will be the projected
revenue that the new employee will generate. In the
absence of past experience, projected revenue may entail
an uncertain forecast.

Analysis of Costs
Marginal Revenue

Analysis of Costs
Maximizing Profits
A business can maximize its profit by producing at the level
where marginal revenue equals marginal cost.As long as
marginal revenue is greater than marginal cost, it pays to
produce more. Each added unit sold will add more to
revenue than to costs. But marginal costs rise and at high
levels of production will exceed marginal revenue. In this
instance, it will pay for the firm to reduce production back
to the level where marginal revenue and marginal cost are
equal. In every decision, the business owner must weigh the
profitability of the decision and consider the opportunity
costs involved.

Analysis of Costs
Maximizing Profits
Perfectly competitive firms continue producing
output until marginal revenue equals marginal
cost.This is the point of Profit Maximization.

Analysis of Costs
Maximizing Profits

Analysis of Costs
Law of Diminishing Return
Economic law stating that if one input used in the manufacture of
a product is increased while all other inputs remain fixed, a point
will eventually be reached at which the input yields progressively
smaller increases in output.
The law of diminishing returns is a classic economic concept that
states that as more investment in an area is made, overall return
on that investment increases at a declining rate, assuming that all
variables remain fixed.To continue to make an investment after a
certain point (which varies from context to context) is to receive
a decreasing return on that input.
It is also known as law of Diminishing Marginal Utility (DMU)

Analysis of Costs
Law of Diminishing Return- Examples
There is a land, and if a farmer,(which is labor) plants a crop, the
result would be the number of crop planted and the profit you get
from the crop if he sells it. If he invest and bought a tractor and
the land remains constant, meaning its still the same size,
productivity and profit will increase. If he buys another tractor, the
profit will not increase the same as before when he first bought
the first tractor, In fact his profit will decrease.
Let's assume you are very hungry.You get a loaf of bread with
some good gravy.You eat it fast and relish it.You are given one
more loaf, you eat that too.When a third loaf is given your hunger
is almost satiated and you eat it slowly.When a fourth loaf is given,
you are too full and don’t feel like eating it. Here you got the
maximum returns in your first loaf and thereafter the returns
started coming down and finally if you are given a fifth loaf - you
don't even want to see it. No returns.

Analysis of Costs
At the crux of LDR is the idea that given a series of
inputs and variables there is a point where the "ideal"
cost-output ratio is met. Changing any of these
variables increases costs or decreases output, both of
which lower your overall efficiency.

Analysis of Costs
• Diminishing Returns occurs in the short run when one factor is fixed
(e.g. Capital)
• If the variable factor of production is increased, there comes a point
where it will become less productive and therefore there will
eventually be a decreasing marginal and then average product
• This is because if capital is fixed extra workers will eventually get in
each other’s way as they attempt to increase production. E.g. think
about the effectiveness of extra workers in a small café. If more
workers are employed production could increase but more and more
slowly.
• This law only applies in the short run because in the long run all
factors are variable

Revenue and costs
50
Contact:
arshadjavedali@gmail.com
arshad235@yahoo.com
Arshad Ali Javed
“There is no elevator to
success.
You have to take the stairs”
Thank You

Analysis of cost

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