ENGINEERING ECONOMICS AND MANAGEMENT

COST AND

BREAK EVEN ANALYSIS

PREET|patel (151310109032)2ND YEAR B.E ELCETRICALAIIE

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COST CONCEPT

Cost is the price we are paying for the usage of factors of production – labor, land, and capital. Costs exist because resources are scarce and have alternative uses. Use of resources in producing some goods implies that we are forgoing some alternative uses of resources. Cost in economic terms refers to the best opportunity we are forgoing by not producing alternative goods and services.

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TYPES OF COSTS

• Economic cost• Explicit and Implicit Cost• Historical and Replacement Cost • Incremental and Sunk Cost• Fixed and variable cost• Separate and Common Cost• Separate and Common Cost• Private and Social Cost

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The economic cost that a firm incurs in the production of good refers to the payments it must make to all the resources employed by in the production of that good.

Economic costs are classified into two parts: 1. Explicit costs2. Implicit costs.

ECONOMIC COST:

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• Explicit cost also called the out-of -pocket costs, stands for the payments that must be made to the factors hired from outside the control of the firm.

• In contrast, implicit costs, also known as book cost or non-cash costs, refers to the payments made to the self-owned resources used in the production.

• The only difference between these two cost concepts is in terms of whether the amount spent is on hired factors or no self-owned ones; alternatively, whether it involves cash payment or a book cost.

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EXPLICIT AND IMPLICIT COSTS:

Explicit cost refers to the monetary payment made by the firm to an outsider to obtain a resource. Explicit costs are also known as out-of-pocket costs. E.g. rent, salaries, electricity charges, etc. Implicit cost (also known as opportunity cost) refers to the opportunity or benefit we are forging by not using a resource for the most attractive alternative. For example, the opportunity cost of a student is the income that he would have earned if he had employed his labor resource on a job rather than spending his time on studying economics, accounting, and so on.

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Accounting profits are the firm's total revenue less its explicit costs. The entrepreneur is receiving a return just large enough to retain his or her talents in the present line of production. If a firm's total receipts exceed all its Accounting costs, the residual accruing to the entrepreneur is called an Accounting, or Normal profit.

NORMAL PROFIT:

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• The cost of family labour is referred to as implicit wage, the cost of the use of self-owned premises in the business as implicit rent, the cost of self-owned money in the business as implicit interest, and the cost of owner’s time as implicit cost of entrepreneurship or normal profit.

• Thus, the normal profit is a component of implicit cost.

• In the example of wheat, the cost of family labour is inclusive of normal profit, for family labour in that includes the time spent on entrepreneurial function.

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• If a firm has positive implicit costs, its economic costs would be more than accounting costs and as such, economic profit would be smaller than accounting profit. Hence these costs are important for managers.

• Accounting cost considered only such costs which can be identified, measured and accounted for.

• Opportunity cost is the benefit forgone from the next best alternative that is not selected.

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INCREMENTAL AND SUNK COSTS:

Incremental costs vary with the decision, when sunk costs are invariance with the decision.

FIXED AND VARIABLE COSTS:

Variable costs are those costs that vary with changes in output. E.g. raw materials, machine hours, wages, etc. Fixed cost, on the other hand, does not change with changes in output. E.g. building rent, salaries to employees.

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• Ex: Suppose university starts an evening MBA program.

The evening program is intended to use faculty time, administrator’s time and some time of the clerk-cum-peon.

In addition, some cost on electricity, chalk, etc.

• Here, the cost of the time of faculty, administrator, clerk-cum-peon, and the amount spent on electricity bill, chalk etc. will be the Incremental Costs and the cost of the use of class room and blackboard would be the sunk cost.

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Costs can also be classified on the basis of their traceability. The cost that can be easily attributed to a product, a division, or a process are called separate costs, and the rest are called non-separate or common costs. The distinction between separate and common costs is of particular significance in a multi-product firm for setting up economic prices for different products.

SEPARATE AND COMMON COSTS:

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Private costs are costs that accrue directly to the firms or individuals engaged in a business activity. Putting the same differently, private costs are monetary payments made by the individual/firm for obtaining resources. E.g. salaries, rent, wages, administrative expenses, etc. Social costs, on the other hand, are passed on to individuals who are not involved in the activity in any direct way (i.e. they are passed on to society at large).

PRIVATE AND SOCIAL COSTS:

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These are concerned with long and short-run production functions. The former refers to costs when all factors of production are subject to change, while the latter stands for costs when at least one of the factors of production is fixed.

In the long-run, a firm is concerned with the optimum plant size and in short-run, it is concerned with optimum output within a given plant size.

LONG-RUN AND SHORT-RUN COSTS:

BREAK-EVEN ANALYSIS

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INTRODUCTION

• A breakeven analysis is used to determine how much sales volume your business needs to start making a profit.

• The breakeven analysis is especially useful when you're developing a pricing strategy, either as part of a marketing plan or a business plan.

BREAK EVEN CALCULATERFixed Cost:The sum of all costs required to produce the first unit of a product. This amount does not vary as production increases or decreases, until new capital expenditures are needed.

Variable Unit Cost:Costs that vary directly with the production of one additional unit.

Expected Unit Sales:Number of units of the product projected to be sold over a specific period of time.

Unit Price:The amount of money charged to the customer for each unit of a product or service.

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• Total Variable Cost:The product of expected unit sales and variable unit cost.

(Expected Unit Sales * Variable Unit Cost )

• Total Cost:The sum of the fixed cost and total variable cost for any given level of production.

(Fixed Cost + Total Variable Cost )

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• Total Revenue:The product of expected unit sales and unit price.

(Expected Unit Sales * Unit Price )

• Profit (or Loss):The monetary gain (or loss) resulting from revenues after subtracting all associated costs.

(Total Revenue - Total Costs)

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• BREAK EVEN POINT:Number of units that must be sold in order to produce a profit of zero (but will recover all associated costs).

• Break Even Point (IN UNIT)= Fixed Cost /S. Price- Variable Unit Cost

• Break Even Point (in Rs)=Fixed Cost/ S. Price-Variable unit Cost*Units

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• For example, suppose that your fixed costs for producing 100,000 product were 30,000 Rs a year.

• Your variable costs are 2.20 Rs materials, 4.00 Rs labour, and 0.80 Rs overhead, for a total of 7.00 Rs per unit.

• If you choose a selling price of 12.00 Rs for each product, then:30,000 divided by (12.00 - 7.00) equals 6000 units.

This is the number of products that have to be sold at a selling price of 12.00 Rs before your business will start to make a profit.

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Break-Even AnalysisCosts/Revenue

Output/Sales

Initially a firm will incur fixed costs, these do not depend on output or sales.

FC

As output is generated, the firm will incur variable costs – these vary directly with the amount produced

VCThe total costs therefore (assuming accurate forecasts!) is the sum of FC+VC

TCTotal revenue is determined by the price charged and the quantity sold – again this will be determined by expected forecast sales initially.

TR The lower the price, the less steep the total revenue curve.

TR

Q1

The Break-even point occurs where total revenue equals total costs – the firm, in this example would have to sell Q1 to generate sufficient revenue to cover its costs.

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Break-Even Analysis

Costs/Revenue

Output/Sales

FC

VCTCTR (p = £2)

Q1

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

TR (p = £3)

Q2

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Break-Even AnalysisCosts/Revenue

Output/Sales

FC

VCTCTR (p = £2)

Q1

If the firm chose to set prices lower (say £1) it would need to sell more units before covering its costs

TR (p = £1)

Q3

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Break-Even AnalysisCosts/Revenue

Output/Sales

FC

VCTCTR (p = £2)

Q1

Loss

Profit

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Break-Even Analysis

Costs/Revenue

Output/Sales

FC

VC

TCTR (p = £2)

Q1 Q2

Assume current sales at Q2

Margin of Safety

Margin of safety shows how far sales can fall before losses made. If Q1 = 1000 and Q2 = 1800, sales could fall by 800 units before a loss would be madeTR (p = £3)

Q3

A higher price would lower the break even point and the margin of safety would widen

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USES OF BREAK EVEVN POINT

• Helpful in deciding the minimum quantity of sales.• Helpful in the determination of tender price.• Helpful in examining effects upon organization’s profitability.• Helpful in deciding about the substitution of new plants.• Helpful in sales price and quantity.• Helpful in determining marginal cost.

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LIMITATIONS

• Break-even analysis is only a supply side (costs only) analysis, as it tells you nothing about what sales are actually likely to be for the product at these various prices.

• It assumes that fixed costs (FC) are constant

• It assumes average variable costs are constant per unit of output, at least in the range of likely quantities of sales.

• It assumes that the quantity of goods produced is equal to the quantity of goods sold (i.e., there is no change in the quantity of goods held in inventory at the beginning of the period and the quantity of goods held in inventory at the end of the period.

• In multi-product companies, it assumes that the relative proportions of each product sold and produced are constant.

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CONCLUSION

• Break even analysis should be distinguished from two other managerial tools :-

Flexible budgets and standard cost the variable expense budget is built on the same basic cost – output relationship, but it is confined to costs and is primarily can concerned with the components of combined cost since the purpose is to control cost by developing expenses standards that are flexibly to achieving rate this purpose often leads to measures of achieving that differ among costs and operation so that they cant be readily added or translated in to an index of output for the enterprise as a whole standard costs on the other hand on.

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THANK|you