Cost and Breakeven Analysis

Cost Concepts
PME0401-DR.G.M.BRAHMANANDHAN
Costing Systems/Methods
Historical
Absorption
Direct
Marginal
Standard
Uniform
COST CLASSIFICATION
Elements
Behaviour
Functions
Normality
Control
Decision Making
Elements
MATERIAL
LABOUR
EXPENSES
MATERIAL
Direct: traceable to one particular process, job or
product identified with each unit of product

Example: manufacturing an apparel
Cloth, collar, buttons, cufflinks, thread
Primary packing material (e.g., carton, wrapping,
cardboard, boxes, etc.)
Fuel, lubricating oil etc for operating &
maintenance of machine
Small tools
Materials used for repairs & maintenance
LABOUR
Inspectors
Supervisors
Internal transport staf
Storekeeper, maintenance staf
EXPENSES
Expenses leading to a job or contract

Traveling expenses for negotiation
Special pattern, design
Special tools for executing the contract
Rent
Insurance
Canteen, hospital, power , lighting,
maintenance
Behaviour
Fixed
in short run & long run
Variable
Varies with volume and constant per unit
Semi-variable
A cost could be variable for one level of activity whereas it could

be fixed for another.
Not inherently fixed or variable
Many costs are semi-variable in nature
Fixed Cost
Committed Fixed Costs consists largely of those fixed costs
that arise from the possession of planti, equipment and a basic

organizational structure. For example, once a building is
constructed and plant is installed, nothing much can be done to
reduce the costs such as depreciation, property taxes,
insurance and salaries of the key personnel, etc., without
impairing the organization's competence to meet the long-term
goals.
Discretionary Fixed Costs : set at fixed amount, for specific
time periods by the management, in the budgeting process.
These costs directly reflect top management policies and have
no particular relationship with volume of output. These costs
can therefore be reduced or eliminated entirely, if the
circumstances so require. Examples of such costs are: research
and development costs, advertising and sales promotion costs,
donations, management consulting fees, etc. these costs are
also termed as managed or programmed costs.
Functions
Production Cost
Administration Cost
Selling Cost
Distribution Cost
10
Planning & Control

Budgeted Cost: estimate of expenditure for
diferent business operations

Standard Cost: for prescribed set of operating
conditions, labour, material and overheads are

predetermined; budget translated into actual
operation through standard costs
11
Decision Making
Marginal vs. Absorption Costing
(with fixed cost and without FC)

Sunk - irrelevant
Committed pre committed
Opportunity
Incremental / Diferential
Avoidable & Unavoidable
controllable / uncontrollable
12
Cont..
Irrelevant cost: not relevant for decision
making
Example: Sunk costs: Sunk cost is the cost of
abandoned plant less salvage value. Not
relevant for decision making.
Imputed (Notional cost): Actually not
incurred (interest on own capital, rent on
owned building, etc.) Taken into account in
capital budgeting decisions.
Replacement cost: Cost of replacing at
current market price.
13
Cont..
Avoidable and unavoidable cost: Cost
that can be avoided by eliminating a

product or department is avoidable and
that which cannot be, is unavoidable.
Ex. Rent of factory is unavoidable if a
product is discontinued.
14
Other costs:
Future costs: cost to be incurred in future

Programmed cost: Cost incurred as per policy of
top management. Ex.- Donation to charity.

Joint cost: cost of joint or by-products incurred
before separation, which cannot be traced to
particular products.
Conversion cost: cost of converting raw material
to finished goods = Production cost- direct material.
Discretionary cost: not essential for decision on
hand. Ex.- Training expenses of workers, R&D cost.
Committed cost: Costs incurred due to past
decisions and are not within control in the short run
at present. Ex.- Depreciation on Plant, Rent, etc.
15
INVENTORIABLE COSTS AND PERIOD

COSTS
Inventoriable cost/ product cost is that cost which
is regarded as asset when incurred, but becomes

a part of cost of goods sold when the product is
sold. For MUL, all manufacturing cost is
inventoriable cost. (Raw material to WIP to
Finished goods) For a service sector unit, absence
of inventory means all are period costs.
Period costs (non-product cost): all costs in P&L
account except cost of goods sold. So, in a mfg.

sector unit, all non-manufacturing costs are period
costs. (Ex. Distribution cost, design cost, R&D
costs, Marketing costs, customer-service costs,
etc.)
16
Costs and
Budgeting
17
Costs and Budgeting
18
Costs
19
Costs
Anything incurred during the production of
the good or service to get the output into

the hands of the customer
The customer could be the public (the final
consumer) or another business
Controlling costs is essential to business
success
Not always easy to pin down
where costs are arising!
20
Cost Centres
21
Cost Centres
Parts of the business to which particular
costs can be attributed

In large businesses this can be
a particular location, section
of the business, capital asset
or human resource/s
Enable a business to identify where costs
are arising and to manage those costs
more efectively
22
Full
Costing
A method of allocating indirect costs to

a range of products produced by the
firm.
e.g. if a firm produces three products - a, b,
and c - and has indirect costs of 1 million,

assume proportion of direct costs of 20% for
a, 55% for b and 25% for c
Indirect costs allocated as 20% of 1 million
to a, 55% of 1 million to b and 25% of 1
million to c
23
Absorption Costing
All costs incurred are allocated
to particular cost centres direct costs,

indirect costs, semi variable costs and selling
costs
Allocates indirect costs more accurately to the
point where
the cost occurred
24
Marginal Costing
The cost of producing one extra unit of
output (the variable costs)

Selling price MC = Contribution
Contribution is the amount which can
contribute to the overheads (fixed costs)
25
Standard Costing
The expected level of costs associated with
the production
of a good/service
Actual costs Standard costs = Variance
Monitoring variances can help
the business to identify

where inefficiencies or efficiencies might lie
26
Total Revenue
27
Total Revenue
Total Revenue = Price x Quantity Sold
Price can be raised or lowered
to change revenue price elasticity

of demand important here
Diferent pricing strategies can be used
penetration, psychological, etc.
Quantity Sold can be influenced
by amending the elements

of the marketing mix 7 Ps
28
Break Even
29
Break Even Analysis

TR
TR
TC
VC
Total
The
Initially
break
revenue
even
a firm
is
The
lower
the
determined
point
occurs
incur
by
where
fixed
Aswill
output
is
price,
the
less
The
total
costs
the
total
costs,
price
revenue
these
generated,
the
steep
thecharged
total
therefore
and
equals
do
the
not
total
quantity
depend
costs
firm willcurve.
incur
revenue
(assuming
sold
the
on
firm,
output
again
incosts
this
this
or
variable
accurate
will
example,
sales.
be vary
would
these
forecasts!)
is the
determined
have
to sell
by
Q1 to
directly
with
sum of FC+VC the
expected
generate
amount sufficient
forecast
revenue
sales
to cover its
produced.
initially.
costs.
FC
Q1
Output/Sales
30
Costs/Revenue
Break Even Analysis

TR (p = 3)
TR (p = 2)
TC
VC
If the firm
chose to set
price higher
than 2 (say
3) the TR
curve would
be steeper
they would not
have to sell as
many units to
break even
FC
Q2
Q1
Output/Sales
31
Break Even Analysis

TR (p = 1)
Costs/Revenue
TR (p = 2)
TC
VC
If the firm
chose to set
prices lower
(say 1) it
would need to
sell more units
before
covering its
costs.
FC
Q1
Q3
Output/Sales
32
Break Even Analysis

TR (p = 2)
Costs/Revenue
Profit
TC
VC
Loss
FC
Q1
Output/Sales
33
Break Even Analysis

Costs/Revenue
TR (p = 3)
TR (p = 2)
TC
VC
Margin of
safety shows
A higher price
how far sales
would
lower the
Assume
can fall before
break
even
current
sales
losses made. If
point
and
at Q2. the
Q1 = 1000 and
margin of safety
Q2 = 1800,
would widen.
sales could fall
by 800 units
before a loss
would be
made.
Margin of Safety
FC
Q3
Q1
Q2
Output/Sales
34
Costs/Revenue
Eurotunnels
problem
High initial FC.
FCon1debt
Interest
rises each year FC
rise therefore.
FC
Losses get bigger!
TR
VC
Output/Sales
35
Break Even Analysis

Remember:
A higher price or lower price does not
mean that break even will never be

reached!
The break even point depends on the
number of sales needed to generate
revenue to cover costs the break even
chart is NOT time related!
36
Break Even Analysis

Importance of Price Elasticity
of Demand:
Higher prices might mean fewer sales
to break even but those sales may take
a longer time to achieve
Lower prices might encourage more
customers but higher volume needed
before sufficient revenue generated
to break even
37
Break Even Analysis

Links of break even to pricing
strategies and elasticity

Penetration pricing high volume, low
price more sales to break even
Market Skimming high price low
volumes fewer sales to break even
Elasticity what is likely to happen
to sales when prices are increased
or decreased?
38
Budgets
39
Budgets
Estimates of the income and

expenditure of a business or a part
of a business over a time period
Used extensively in planning
Helps establish efficient use
of resources
Help monitor cash flow and identify
departures from plans
Maintains a focus and discipline
for those involved
40
Budgets
Flexible Budgets budgets that take
account of changing business conditions

Operating Budgets based on
the daily operations of a business
Objectives Based Budgets - Budgets
driven by objectives set by the firm
Capital Budgets Plans of the
relationship between capital spending and
liquidity (cash) in the business
41
Budgets
Variance the diference between planned
values and actual values

Positive variance actual figures less than
planned
Negative variance actual figures above
planned
42

Cost and Breakeven Analysis

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Cost and Breakeven Analysis

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Cost Concepts

product identified with each unit of product

Expenses leading to a job or contract

in short run & long run

Varies with volume and constant per unit

A cost could be variable for one level of activity whereas it could

that arise from the possession of planti, equipment and a basic

Planning & Control

diferent business operations

conditions, labour, material and overheads are

(with fixed cost and without FC)

that can be avoided by eliminating a

Future costs: cost to be incurred in future

top management. Ex.- Donation to charity.

INVENTORIABLE COSTS AND PERIOD

is regarded as asset when incurred, but becomes

Period costs (non-product cost): all costs in P&L

account except cost of goods sold. So, in a mfg.

Costs and Budgeting

the good or service to get the output into

costs can be attributed

A method of allocating indirect costs to

and c - and has indirect costs of 1 million,

to particular cost centres direct costs,

output (the variable costs)

Actual costs Standard costs = Variance

Monitoring variances can help

the business to identify

Price can be raised or lowered

to change revenue price elasticity

penetration, psychological, etc.

Quantity Sold can be influenced

by amending the elements

Break Even Analysis

Break Even Analysis

Break Even Analysis

Break Even Analysis

Break Even Analysis

Break Even Analysis

mean that break even will never be

Break Even Analysis

Break Even Analysis

strategies and elasticity

Estimates of the income and

account of changing business conditions

values and actual values

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