THEORY OF COST & BREAK EVEN

ANALYSIS
 INTRODUCTION
• The cost of production is an important factor in
almost all business 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

of their nature & purpose under 2 overlapping
categories:-
– Concepts used for accounting purposes
– Analytical concepts used in economic analysis of business
activities.
 ACCOUNTING CONCEPTS
A). OPPORTUNITY COST & ACTUAL COST:-
– Opportunity cost:- Opportunity cost is the cost related to the next-best
choice available to someone who has picked among several 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 relationship between 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 the opportunity 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 in payment of
labor, material, plant, building, machinery, equipment, travelling &
transportation, advertisement, etc.
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 effects on 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. Opportunity cost.
– Implicit cost + Explicit Cost = Economic cost
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 cash payments but a
provision is therefore made in the books of account & they are taken into
account while finalising the profits & loss accounts.
– Eg. Depreciation allowances & unpaid interest on the owner’s own fun.
ANALYTICAL COST CONCEPTS
A). FIXED & VARIABLE COST:-

– Fixed costs – costs that are not related directly to production – rent,
rates, insurance costs, depreciation cost, maintenance of land, admin
costs. They can change but not in relation to output.

– Variable Costs – costs directly related to variations in output. Raw

materials primarily, running cost of fixed capital as fuels, repair,
routine maintenance expenditure & cost of all other inputs that vary
with ouput.
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 for replacing the old assets.
F). PRIVATE & SOCIAL COSTS:-
– Private costs, which are actually incurred or provided for by an individual or a
firm on the purchase of goods & goods from the market. All actual cost, both
implicit & explicit are private costs.
– Social cost, cost borne by the society due to production of commodity. It
includes cost of resources for which company is not compelled to pay a price &
cost of the disutility created by the company.
 SHORT-TERM COST-OUPUT
RELATIONSHIP
• 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, insurance, rent,
etc
 CONT…
– Also called as Overhead cost, all common to all units produced.
– Other name for it are, supplementary cost & unavoidable cost.

Total fixed cost

Cost(Rs.)

Output (Units)

c). Total Variable cost:-

– Can be increased or decreased by the manager in short run
– Variable costs will increase as production increases.
– Total Variable cost (TVC) is the summation of the individual variable costs.
– VC = (the quantity of the input) X (the input’s price).
– eg. Cost of raw materials, cost of labor, cost of fuel, electricity,
Cost of transportation.
 Total variable cost

Cost (Rs.)

Output (Units)
– Shows variable cost directly proportional to output.
– TVS is 0 when output is 0 and rise when output rises.
– Its total productivity increases at an increasing rate, TVC
increases at a increasing rate.
– Diminishing returns, more of variable factor combined with the
fixed factor, total productivity increases at decreasing.

Total variable cost

Cost (Rs.)

Output (Units)
 TOTAL COST
• The sum of total fixed costs and total variable
costs:

TC = TFC + TVC

• In the short run TC will only increase as TVC

increases.

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Typical Total Cost
Curves

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 Typical Total Cost Curves
(selected attributes)

• 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
• Average total cost per unit of output:

AFC + AVC

ATC = TC
Output

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Marginal Cost
• The additional cost incurred from producing an additional unit of
output:

MC =  TC
 Output

MC =  TVC
 Output

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Typical Average &
Marginal Cost Curves

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 Typical Average &
Marginal Cost Curves
(selected attributes)
• AFC is always declining at • MC is generally increasing.
a decreasing rate. • MC crosses ATC and AVC at
• ATC and AVC decline at their minimum point.
first, reach a minimum, • If MC is below the average value:
then increase at higher – Average value will be
levels of output. decreasing.
• If MC is above the average value:
• The difference between
– Average value will be
ATC and AVC is equal to increasing.
AFC.

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 Farm Size in the Long-
Run
• Nothing is fixed – everything is variable.

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

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The Long-Run Cost Function
• LRAC is made up for SRACs
– SRAC curves
represent various
plant sizes
– Once a plant size is
chosen, per-unit
production costs are
found by moving
along that particular
SRAC curve
Relation Between Output and Costs
as Farm Size Increases
Percent change in total costs
Percent change in total output value

• Three possible results:

Ratio value Type of Costs Returns to Size
<1 Decreasing Increasing
=1 Constant Constant
>1 Increasing Decreasing

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Possible Size-Cost
Relations

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 Economies of Size
• 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 machinery
and new technology.
– Price discounts for volume purchasing of inputs.
– Price advantages when selling large amounts of
output.

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Long-Run Average Cost Curve
(Economies of Size)

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 Diseconomies of Size
• 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 larger labor force.
– Dispersion over a larger geographical area.
– Disease control, waste disposal.

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Long-Run Average Cost Curve
(Diseconomies of size)

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