### MEFA II UNIT MATAERIAL

• 1. COST ANALYSIS Cost analysis deals with the behaviour of cost. In other words cost analysis is concerned with financial aspect of production relations as against physical considered in production analysis. Therefore cost analysis refers to the study of behaviour of cost in relation size of out-put, scale of operation, price of factors of production and other related economic variables. Cost refers to the amount of expenditure incurred in acquiring something. In business firm it refers to the expenditure incurred to produce an output or provide service. Thus the cost incurred in connection with raw material, labour, other heads constitute the overall cost of production. A managerial economist must have a clear understanding of the different cost concepts for clear business thinking and proper application. Output is an important factor which influences the cost. The cost-output relationship plays an important role in determining the optimum level of production. The knowledge of the cost output relation helps the manager in cost control, profit, production, pricing, promotion etc. the relation between cost and its determinants explained through the following function  ),,,,,( TTLPOSC Where C= Cost S= Size of Plant / Scale of operation O= Output level P= Prices of inputs L= Labour Problems T= Time factor T= Technology As per the formula, as the size of the plant increases, the economies of scale start following and hence the cost per unit will come down. Similarly, an increase in output results in increase in cost and vice versa. Apart from output, prices of inputs represent a positive relationship with cost of production. As we know, a sophisticated technology may reduce cost compared to outdated technology lastly, managerial efficiency also has a bearing on cost of production. Factors which influence the Costs: 1. Size of the plant: Cost is influenced by the size of the plant. If the size of the plant is more, although, the initial fixed costs are high, but the variable costs tend to be low compared with a small sized plant. 2. Price of inputs:
• 2. Cost is also influenced by the prices of production. In modern competitive business environment, technology is generally aims at reducing costs. If the producer uses the well developed technology in production process, then the average cost will be reduced. Technology:  Short Run and Long run Costs: Time is another variable for cost distinction. Short-run is a period during which the physical capacity of the firm remains fixed. Any increase in output during this period is possible only by using the existing physical capacity more intensively. But in the long run it is possible to change the firm’s physical capacity as all the input are variable including plant and capital equipment. Cost Concepts The various relevant concepts of costs used in business decisions are discussed below.  Opportunity Costs and Outlay Cost  Shut down cost and Abandonment Costs  Explicit and Implicit/ Imputed Cost  Historical Cost and Replacement Cost  Short Run and Long run Costs  Fixed Cost and Variable Costs  Past and Future Costs  Traceable Cost and Common Costs  Avoidable Costs and Unavoidable Costs  Controllable Cost and Uncontrollable Cost  Incremental Cost and Suck Costs  Total, Average and Marginal Costs  Accounting and Economic Costs They are Opportunity Costs and Outlay Cost: Out-lay costs are also known as actual costs or absolute costs. These are the payments made for labour, material, plant, transportation etc. All these are appearing in the books of accounts. On the other hand, actual costs are those which are actually incurred by the firm in payment for actual activities in the organisation. Opportunity cost implies the earning foregone on the next best alternative has the present option been undertaken. Opportunity cost also known as alternative costs or sacrificing cost. This cost is often measured by assessing the alternative which has to be sacrificed if the particular line is followed.
• 3. Ex. A business man is able to borrow certain amount at 10% to buy a machine. Instead of buying the machine he can reinvest the borrowed fund at say 12%. In this situation, the opportunity cost is said to be 12% and outlay cost 10%. Shut down cost and Abandonment Costs: Shut down costs may ne those which would be incurred in the event of a temporary end of business activities and which could be saved if operations were allowed to continue. Shut down costs, besides fixed costs, cover the additional expenses in looking after the property not disposed of. Abandonment costs are the cost of retiring a fixed asset from use. For example, a second hand plant installed in war time may not be useful during peace time. Abandonment thus involves permanent end of activity and rises to problem of disposal of assets. Explicit and Implicit/ Imputed Cost Explicit costs are those expenses that involve cash payments. These are the actual or business costs that appear in the books of accounts. Explicit cost is the payment made by the employer for those factors of production hired by him from outside. E.g. Wages, Salaries paid, payments for raw materials, interest on borrowed capital funds Implicit costs are the costs of the factor units that are owned by the employer himself. It does not involve cash payment and hence does not appear in the books of accounts. These costs are not actually incurred but would have been incurred in the absence of employment of self- owned factors. Historical Cost and Replacement Cost: Historical cost is the original cost of an asset. Historical cost valuation shows the cost of an asset paid originally when the asset was acquired in the past. Historical valuation is the basis for financial accounts. Replacement cost is the price that would have to be paid currently to replace the same asset. E.g The price of a machine at the time of purchase was Rs. 17,000 and the present price of the machine is Rs. 20,000 is the replacement cost. Fixed Cost and Variable Costs: Fixed cost is that cost which remains constant for certain level of output. It is not changed by the changes in the volume of production. But fixed cost per unit decrease when the production is increased. E.g. salaries, rent on factory and depreciation on machinery etc. Variable cost is that which varies directly with the variation in output. An increase in total output results in an increase in total variable costs and decrease in total output results in a proportionate decline in the total variable costs. E.g Materials, direct labour expenses, and Routine maintenance expenditure.
• 4. Past and Future Costs: Past Costs also called historical costs, are the actual costs incurred and recorded in the books of accounts. These costs are useful only for evaluation and not for decision making. Future costs are costs that are expected to be incurred in the future. They are not actual costs. They are the costs forecast or estimated with rational methods. Short Run and Long run Costs: Time is another variable for cost distinction. Short-run is a period during which the physical capacity of the firm remains fixed. Any increase in output during this period is possible only by using the existing physical capacity more intensively. But in the long run it is possible to change the firm’s physical capacity as all the input are variable including plant and capital equipment. Traceable and Common Costs: Traceable cost, otherwise called direct cost, is one which can be identified with a production process or a product. Raw material, labour involved in production are examples of traceable cost. Common Costs are the costs are the ones that cannot be attributed to a particular process or product. It cannot be directly identified with any particular process or type of product. Avoidable Costs and Unavoidable Costs: Avoidable costs are the costs which can be reduced if the business activities of a concern are reduced. E.g. if some workers can be retrenched with a drop in a product-line, or volume or production, the wages of the retrenched workers are escapable costs. The unavoidable costs are otherwise called sunk costs. There will not be any reduction in this cost even if reduction in business activity is made. E.g when the volume of production is reduced from 8,000 units to 5,000 units the present machines has some idle capacity. It cannot be unavoidable cost. Controllable Cost and Uncontrollable Cost: Controllable costs are the ones which can be regulated by the executive who is in charge of it. It is based on levels of management.
• 5. Some costs are not directly identifiable with a process of product. They are appointed to various processes or products in some proportions. These costs are called uncontrollable costs. Incremental Cost and Suck Costs: Incremental cost also known as differential cost is the additional cost due to a change in the level or nature of business activity. The change may be caused by adding a new product, adding new machine, replacing a machine by a better one etc. Sunk costs are those which are not altered by any change. They are the costs incurred in the past. This cost is the result of past decision and cannot be changed by future decisions. Once an asset has been bought or an investment made, the funds locked up represent sunk costs. Total, Average and Marginal Costs: Total cost is the cash payment made for the input needed for production. It may be explicit or implicit. It is the sum total of fixed and variable costs. Average cost is the cost per unit of output. It is obtained by dividing the total cost by the total quantity produced. Average Cost = Q TC Marginal cost is the additional cost incurred to produce an additional unit of output. In other words, it is the cost of the marginal unit produced. Accounting and Economic Costs: Accounting costs are the costs recorded for the purpose of preparing the balance sheet and profit and loss statements to meet the legal, financial and tax purpose of the company. Economic concept considers future costs and future revenues which help future planning and choice. These costs are used on the basis of management requirements for decision making.
• 6. BEP ANALYSIS Introduction: Profit maximisation is one of the major goals of any business. The other goals include enlarging the customer base, entering new markets, innovation through major investments in research and development and so on. The volume of profit is determined by a number of internal and external factors. As a part of monitoring the profitability of the operations of the business, it is necessary for the managerial economist to study the impact of changes in the internal factors such as cost, price and volume on profitability, breakeven analysis comes very handy of these purpose. Break-even analysis refers to analysis of the break-even point (BEP). The BEP is defined as a no- profit or no-loss point. Why is it necessary to determine the BEP when there is neither profit nor loss? It is important because it denotes the minimum volume of production to be undertaken to avoid losses. In other words, it denotes the minimum volume of production to be undertaken to avoid losses. In other words, it points out how much minimum is to be produced to see the profits. It is a technique for profit planning and control, and therefore is considered a valuable managerial tool. Break – even analysis is defined as analysis of costs and their possible impact on revenues and volume of the firm. Hence, it is also called the cost-volume –profit analysis. But there is slight difference between the two. CVP analysis is broader and it includes the entire planning for profit, while Break Even Analysis is a technique used in this process. But we used these two terms as interchangeable words. A firm is said to attain the (BEP) when its total revenue is equal to total cost (TR = TC) Total cost comprises fixed cost and variable cost. The significant variables on which the BEP is based fixed cost, variable cost and total revenue. Assumptions Underlying Break-evenAnalysis: The following are the assumptions underlying break-even analysis: a) Costs can be classified into fixed and variable costs. b) Total fixed cost remains constant at all levels of output c) Variable cost is varies on the basis of output
• 7. d) Selling price does not change with volume changes. It remains fixed. It does not consider the price discounts or cash discounts. e) All the goods produced are sold. There is no closing stock. f) There is only one product available for sale. g) In case of multi-product firms, the product mix does not change. Significance ofBEA: Break-even analysis is a valuable tool  To ascertain the profit on a particular level of sales volume or a given capacity of production  To calculate sales required to earn a particular desired level of profit  To compare the product lines, sales area,, methods of sale for individual company  To compare the efficiency of the different firms  To decide whether to add a particular product to the existing product line or drop one from it  To decide to ‘make or buy’ a given component or spare part  To decide what promotion mix will yield optimum sales  To assess the impact of changes in fixed cost, variable cost or selling price on BEP and profits during a given period Limitations of Break-EvenAnalysis: Break-even analysis has certain underlying assumptions which form its limitations  Break-even point is based on fixed cost, variable cost and total revenue. A change in one variable is going to affect the BEP.  All costs cannot be classified into fixed and variable cost. We have semi-variable costs also. Incase of multi-product firm, a single chart cannot be of any use. Series of charts have to be made use of.  In case of multi-product firm, a single chart cannot be of any use. Series of charts have to be made use of.  This analysis is useful in short run not in long run.  Total cost and total revenue lines are not always straight as shown in the figure. The quantity and price discounts are the usual phenomena affecting the total revenue line.  Where the business conditions are volatile. BEP cannot give stable results. -------- S=V+F+P, V=S-F-P, F=S-V-P,P=S-V-F, S-V=C, F+P=C Where  S= Sales  V= Variable Cost  F= Fixed Cost  P= Profit  C= Contribution VS F UnitsBEP  )(
• 8. UnitPericeSellingUnitsBEPSalesBEP Pr*)(  RatioPV F SalesBEP )( Margin of Safety Margin of safety is the excess of sales over the break even sales. It can be expressed in percentage or in absolute sales amount. A large margin of safety indicates the soundness of the business the formulate for the margin of safety is SalesBEPSalesTotalSafetyOfinM arg (or) RatioPV P SalesSafetyofinM )(arg Angle of Incidence: This is the angle between sales line and total cost line at the break even point. It indicates the profit earning capacity of the concern. Large angle of incidence indicate a high rate of profit, a small angle indicates a low rate of earnings. To improve this angle, contribution should be increased either by raising the selling price by reducing variable cost. PV Ratio: Profit Volume ration is usually called PV ratio. It is one of the most useful ratios for studying the profitability of business. The ration of contribution to sales is the P.V ration. It may express in percentage. The organisation increased the P. V ratio by increasing the selling price per unit or buy reducing the variable cost. The formulas are 100* S VS RatioPV   (or) 100* S C RatioPV  (or) 100* S PF RatioPV   100* Pr SalesinChange ofitinChange RatioPV  RatioPV PF SalesDesired   Problem1: Find Break Even Point in Units and BEP sales through the follow Fixed Cost=1,50,000 Variable Cost=Rs. 15 Selling Price per unit =20/- Solution: BEP Units = 𝑭𝒊𝒙𝒆𝒅 𝑪𝒐𝒔𝒕 𝑺𝒆𝒍𝒍𝒊𝒏𝒈 𝑷𝒓𝒊𝒄𝒆 𝑷𝒆𝒓 𝒖𝒏𝒊𝒕−𝑽𝒂𝒓𝒊𝒂𝒃𝒍𝒆 𝑪𝒐𝒔𝒕 𝑷𝒆𝒓 𝒖𝒏𝒊𝒕
• 9. BEP Units = 1,50,000 20−15 BEP Units = 30,000 BEP Sales= BEP units X Selling Price Per Unit BEP Sales= 30,000 X 20 BEP Sales= 6,00,000/- Problem 2: A company prepares a budget to produce 3,00,000 units with fixed cost Rs. 15,00,000/- Variable cost is Rs.10/- per unit Profit is 20% on Total Cost. Calculate BEP Solution: Total Units=3,00,000 Fixed Cost =15,00,000/- Variable Cost= 3,00,000 X 10 =30,00,000 Profit = 20% on Total Cost Total Cost = Fixed Cost + Variable Cost Total Cost = 15,00,000+30,00,000 Total Cost=45,00,000 Profit= 45,00,000 X (20/100) Profit=9,00,000/- Sales= Fixed Cost + Variable Cost + Profit Sales=15,00,000+ 30,00,000 + 9,00,000 Sales=54,00,000/- Selling Price per Unit = Total Sales / Total Produced Units Selling Price per Unit = 54,00,000 / 3,00,000 Selling Price per Unit = 18/- BEP Units = 𝑭𝒊𝒙𝒆𝒅 𝑪𝒐𝒔𝒕 𝑺𝒆𝒍𝒍𝒊𝒏𝒈 𝑷𝒓𝒊𝒄𝒆 𝑷𝒆𝒓 𝒖𝒏𝒊𝒕−𝑽𝒂𝒓𝒊𝒂𝒃𝒍𝒆 𝑪𝒐𝒔𝒕 𝑷𝒆𝒓 𝒖𝒏𝒊𝒕 BEP Units = 15,00,000 18−10 BEP Units = 1,87,500 BEP Sales = BEP Units X Selling Price Per Unit BEP Sales = 1,87,500 X 18 = Rs. 33,75,000/- Problem: 3 From the following information you are required to calculate 1) P.V Ratio 2) BEP Sales 3) Margin of Safety Sales= Rs. 40,000/- Variable Cost = 20,000/- Fixed Cost = 16,000/- 1). P.V Ratio:
• 10. P. V.Ratio = Sales − Variable Cost Sales 𝑋100 P. V.Ratio = 40,000 − 20,000 40,000 𝑋100 P. V. Ratio = 50% 2). BEP Sales: BEP Sales = Fixed Cost P. V. Ratio BEP Sales = 16,000 0.5 BEP Sales = 32,000/− 3) Margin of Safety: BEP Sales = Total Sales − BEP Sales BEP Sales = 40,000 − 32,000 BEP Sales = 8,000/− Problem 4: Determine P.V. Ratio and Fixed Cost and BEP Sales from the following information Particulars I period II Period Sales 1,00,000 1,40,000 Profit 4,000 12,000 1). P.V Ratio: P. V. Ratio = Change in Profit Change in Sales 𝑋100 P. V. Ratio = 8,000 40,000 𝑋100 P. V.Ratio = 20% 𝑜𝑟 0.2 II) Fixed Cost: For finding fixed cost take any period data as base. Desire Sales = F + P P. V. Ratio 1,00,000 = F + 4,000 0.2 1,00,000 X 0.2 = F + 4,000 F = 20,000 − 4,000 F = 16,000/−
• 11. II) BEP Sales: BEP Sales = Fixed Cost P. V. Ratio BEP Sales = 16,000/− 0.2 BEP Sales = Rs. 80,000/- Problem:5 The following figures of Sales and Profit of two periods are available in respect of firm Particulars I period II Period Sales 10,00,000 12,00,000 Profit 1,50,000 2,30,000 You are required to calculate 1. P.V ratio 2. BEP Sales 3.Sales required to earn profit of Rs. 20,000/- 4. Profit of estimated sales of Rs. 1,50,000/- 5. Margin of Safety at a profit of Rs. 50,000 1) P.V ratio: P. V. Ratio = Change in Profit Change in Sales 𝑋100 P. V. Ratio = 80,000 2,00,000 𝑋100 P. V.Ratio = 40% 𝑜𝑟 0.4 2) BEP Sales: Fixed Cost: For finding fixed cost take any period data as base. Desire Sales = F + P P. V. Ratio 10,00,000 = F + 1,50,000 0.4 10,00,000 X 0.4 = F + 1,50,000 F = 4,00,000 − 1,50,000 F = 2,50,000/− BEP Sales = Fixed Cost P. V. Ratio BEP Sales = 2,50,000/− 0.4 BEP Sales = Rs. 6,25,000/- 3. Sales required to earn profit of Rs. 2,00,000/- Desire Sales = F + P P. V. Ratio
• 12. Desire Sales = 6,25,000 + 2,00,000 0.4 Desire Sales = 20,62,500 4. Profit of estimated sales of Rs. 50,00,000/- Desire Sales = F + P P. V. Ratio 50,00,000 = 6,25,000 + P 0.4 50,00,000 X 0.4 = 6,25,000 + P P = 13,75,000/- 5. Margin of Safety at a profit of Rs. 5,00,000/- Margin of Safety = Profit P.V. Ratio Margin of Safety = 5,00,000 0.4 Margin of Safety =12,50,000/- Problem:6 If sales are 10,000 units and selling price is Rs. 20/- per unit, variable coast Rs. 10/- per unit, fixed cost Rs. 80,000/-. Find out BEP and BEP Sales. Calculate profit earned. What should be the sales for earning a profit of Rs. 60,000/- (JNTU Apr./May 2004) Solution: BEP (Units) BEP Units = 𝐹𝑖𝑥𝑒𝑑 𝐶𝑜𝑠𝑡 𝑆𝑒𝑙𝑙𝑖𝑛𝑔 𝑃𝑟𝑖𝑐𝑒 𝑃𝑒𝑟 𝑢𝑛𝑖𝑡−𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝐶𝑜𝑠𝑡 𝑃𝑒𝑟 𝑢𝑛𝑖𝑡 BEP Units = 80,000 20−10 BEP Units = 8,000 units BEP Sales: BEP Sales = BEP Units X Selling Price Per unit BEP Sales= 8,000 X 20 BEP Sales=1,60,000/-
• 13. Profit earned: Profit = Sales – Variable Cost – Fixed Cost Profit= 2,00,000 – 1,00,000 - 80,000 Profit = 20,000/- What should be the sales for earning a profit of Rs 60,000/- Desire Sales = F + P P. V. Ratio Desire sales = 80,000 + 60,000 0.5 Desire Sales = 2,80,000/− P = 13,75,000/- P. V.Ratio = Sales − Variable Cost Sales 𝑋100 P. V.Ratio = 20 − 10 20 𝑋100 P.V. Ratio = 50% 𝑜𝑟 0.5