Meaning of Cost Analysis
Basic Cost Concept
Basic concept of financial Accounting/ Accounting Rules-Problems
Depreciation
Methods of Depreciation -Problems
Break Even Analysis
Marginal Uses of BEA
Introduction to Entrepreneurship and Characteristics of an Entrepreneur
Cost analysis & Break even analysis
1. Cost Analysis &
Break Even
Analysis
Dr. R.SAROJA DEVI
Assistant Professor
Department of Commerce
Karpagam Academy of Higher Education
(Deemed to be University)
Coimbatore-21.
2. OUTLINE:
Meaning of Cost Analysis
Basic Cost Concept
Basic concept of financial Accounting/
Accounting Rules-Problems
Depreciation
Methods of Depreciation -Problems
Break Even Analysis
Marginal Uses of BEA
3. Cost Analysis
Definition: In economics, the Cost
Analysis refers to the measure of the cost –
output relationship, i.e. the economists are
concerned with determining the cost incurred
in hiring the inputs and how well these can be
re-arranged to increase the productivity
(output) of the firm.
4. Cost Concept
There are two types of cost concept. The given below;
1.Cost Concepts Used for Accounting Purposes
2.Analytical Cost Concepts Used for Economic Analysis of
Business Activities
1. Cost Concepts Used for Accounting Purposes
Generally, the accountants used the financial position of
the firm.
They are concerned with arranging the finances of the
firm and therefore keep a track of the assets and
liabilities of the firm.
This costs are used for taxation purposes and calculating
the profit and loss of the firm. These are seven types of
accounting Purposes.
5. Cont…
Opportunity Cost: : It is refers to the expected returns from the
second best alternative use of resources that are foregone due to
the scarcity of resources such as land, labor, capital, etc.
Business Cost : It is includes all the costs (fixed, variable, direct,
indirect) incurred in carrying out the operations of the business.
It is similar to the real or actual costs that include all the
payments and contractual obligations along with the book cost of
depreciation on both the plant and equipment.
Full Cost: It is the total cost incurred in production and is
comprised of business cost, opportunity cost, and normal profit.
Explicit Cost: The Explicit cost, also called as Actual Cost is the
cost actually incurred by the firm for making all the physical
payments and the contractual obligations. The physical payments
include the cost of material, labor, plant, equipment, building,
technology, advertisement, etc.
6. Cont..
Implicit Cost : The Implicit Cost, also called as Imputed
Cost is the implied cost that does not take a form of cash
outlay, and neither is recorded in the books of accounts.
Out-of-Pocket Cost: It is involves the potential future cash
payments or cash transfers both recurring and non-
recurring, paid during the current accounting period or
during the project. It is the direct monetary payment for the
work done during the project.
Book Cost: It is refers to those expenses which do not
involve actual cash payments, but rather the provisions are
made in the books of accounts to include them in the profit
and loss accounts and avail the tax advantages.
7. Cont..
2. Analytical Cost Concepts Used for Economic Analysis of Business
Activities:
This cost concepts are used by the economists to analyze the likely cost of
production in the future.
They are concerned with how the cost of production can be managed or
how the input and output can be re-arranged such that the overall
profitability of the firm gets improved. These costs are:
Fixed Cost: It is the cost that remains fixed for a certain volume of output.
In other words, the cost that does not change with the change in the output
or sales revenue, i.e. it remains fixed irrespective of the volume of output is
called the fixed cost.
Variable Cost: The Variable cost is the cost proportionally related to the
level of output, i.e. it increases with the increase in the production and
contracts with the decrease in the total output. Simply, the cost which varies
with the change in the total output is called the variable cost.
8. Cont,..
Total Cost: It is the actual cost incurred in the production of a given level
of output. In other words, the total expenses (cost) incurred, both explicit
and implicit, on the resources to obtain a certain level of output is called the
total cost.
Average Cost: It is the per unit cost of production obtained by dividing the
total cost (TC) by the total output (Q). By per unit cost of production, we
mean that all the fixed and variable cost is taken into the consideration for
calculating the average cost.
Marginal Cost: It is refers to the change in the total cost as a result of the
production of one more unit of the product. In other words, the marginal
cost is the increase or decrease in the total cost due to the production of one
additional unit of the product.
Short-run Cost: The Short-run Cost is the cost which has short-term
implications in the production process, i.e. these are used over a short range
of output. These are the cost incurred once and cannot be used again and
again, such as payment of wages, cost of raw materials, etc.
9. Cont..
Long-Run Cost: It is the cost having the long-term implications in the
production process, i.e. these are spread over the long range of output.
These costs are incurred on the fixed factors, Viz. Plant, building,
machinery etc. but however, the running cost and the depreciation on plant
and machinery is a variable cost and hence is included in the short-run
costs.
Incremental Cost: It is refers to the additional cost that a company incurs
in undertaking certain actions such as expanding the level of production or
adding a new variety of product to the product line, etc.
Sunk Cost: It is the cost already incurred by the firm and cannot be
recovered or refunded. The cost which was incurred in the past and is now
permanently lost is called as a Sunk Cost.
Historical Cost: The assets and liabilities recorded in the balance sheet
with its original acquisition cost, the i.e. amount spent at the time of its
acquisition are called as the Historical Cost. It is an accounting method in
which the assets of the firm are recorded in the books of accounts at the
same value at which it was first purchased.
10. Cont..
Replacement Cost: It is the cash outlay that firm has to pay in order to
replace an old asset at the current market price. Simply, the amount paid
to replace the existing property with the new one having the similar
utility, without considering the depreciation constitutes the replacement
costs.
Private Cost: It is the cost related to the working of the firm and is used
in the cost-benefit analysis of the business decisions. These costs are
borne by the firm itself.
Social Cost: The Social Cost is the cost related to the working of the
firm but is not explicitly borne by the firm instead it is the cost to the
society due to the production of a commodity.
It is used in the social cost-benefit analysis of the overall impact of the
operations of the business on the society as a whole and do not normally
figure in the business decisions.
11. Cost- Output Relationship
There are Two aspects of output Relationship.
1. Cost-output Relationship in short run
2. Cost- output Relationship in Long run
The short run is a period which does not permit
alterations in the fixed Equipment and in the size of
Organization.
The Long run is a period which there is sufficient time
to alter the equipment and the size of organization.
Output is increased without any limits being placed by
fixed factors of production.
12. Short-run Relationship
It is studied by
1. Average Fixed Cost
2. Average Variable Cost
3. Average Total Cost
Average fixed cost.
The greater the output, the lower the fixed cost per unit i.e., total fixed cost remain
the same do not change with a change in output.
Average Variable Cost
The Average Variable cost will first fall and then rise as more and more units are
produced in a given place.
E.g: Electricity charge, Labour Cost etc..
Average Total Cost
1. It is known as average cost, would decline first and then rise upwards.
2. Average cost consists of average fixed cost plus average Variable cost.
3. Average fixed cost continues to fall with an increase in output while average cost
first declines and them rises.
4. When the rise in AVC is more than the drop in average fixed cost that the ATC
will show rise.
14. Long run Relationship
Long run period enables the producers to change all the factor and will be able
to meet the demand by adjusting supply, change in fixed factors like building,
machinery, managerial staff etc..
All factors became variable in the long run
It is three cost i.e.,
Total cost
Average cost
Marginal cost
Following formula,
Total cost = TFC+ TVC
Average Cost = TC/Output
Marginal cost= change in TC as a Result of change in output by one unit.
15. Cont..
When all the short run situations are combined, it forms the long run industry.
During short-run, demand is less and the plant’s capacity is limited. When
demand rise, the capacity of the plant is expanded.
When short-run AC Curves of all such situations depicted, we can drive a long
run cost curve out of that.
We can a make long run cost curve joining the tangency points of all short-run
curves.
Long run cost to decide scale issues for example merger.
In the long-run, we can build any size of factory we wish based on anticipated
demand, profit and other considerations.
Conversely too large a factory results in large fixed cost and low profitability.
17. Meaning of Financial Accounting
Financial accounting is a specific branch of accounting
involving a process of recording, summarizing, and
reporting the myriad of transactions resulting from
business operations over a period of time.
These transactions are summarized in the preparation of
financial statements, including the balance
sheet, income statement and cash flow statement, that
record the company's operating performance over a
specified period.
18. Definition
According to the American Institute of Certified
Public Accountants (AICPA) “Accounting is the
art of recording, classifying and summarizing in a
significant manner and in terms of money
transactions and events which are of a financial
character and interpreting the results thereof”.
19. Objectives of Accounting
Maintenance of Accounting Records: its records are
basis for accounting work, the records have to be
systematically. While maintaining the accounting
records. It is generally accounting conventions and
concepts.
Ascertainment of P&L: It is expected to ascertain and
reveal the net results of the operations of business.
Various interested parties like owners, management,
investor and creditor should be supplied with the
results of operations as per their specific requirements.
20. CONT..
Depiction of financial position: A true and fair value of the
financial position should be presented. The properties and
assets presented by the business should be shown at
appropriate values as per the prevailing practices. The stake of
creditors and owners in the business should be clearly.
Providing Information: It is most important objectives, the
American Accounting Association has list out the following
purpose,
1. Making decisions concerning the use of limited resources
including identification of crucial decision areas and
determination of objectives and goals.
2. Effectively directing and controlling of an organization
human and material resources.
3. Maintaining the report on the custodianship of resources.
4. Facilitating social functions and control.
21. ADVANTAGES OF ACCOUNTING
Systematic Records: All business transactions are
recorded in the books of account.
Preparation of financial Statements: Result of
business operation and the financial position of the
concern are provided by accounting periodically.
This essential for distribution of profits to the owners
and for planning for future.
Assessment of progress: Its analyses and interprets
financial statements to reveal the progress and
identify the area of weakness and stagnation.
Management provided for liquidity, profitability and
stability aspects of the business.
22. cont..
Aid to decision making: Management of a firm has
to make innumerable routine and policy decisions
while discharging its functions. Accounting
provides the relevant data to make the decisions
appropriate and effective.
Statutory requirements: various legal requirements
maintenance of provident fund for employees,
employees state insurance contributions,
deduction of tax. Filling of tax returns.
Information to interested groups: Accounting
supplies appropriate information to different
interest group as owners, creditors, employees,
financiers, tax authorities and government
23. CONT..
Evidence in Courts: Accounting records are
usually accepted as authentic evidence in court
of law in the settlement of disputes.
Taxation problems: Accounting records are the
basic source for computation and settlement of
sales tax, income tax and other local taxes.
Merger of firms: when two or more existing
business decide to merge, accounting records
are the basis for deciding the terms of merger
and any compensation payable as a consequence
of merger.
24. Types of Accounts
Type of
Accounts
Personal
A/C
Proprietor Creditors Debtors
Impersonal
A/C
Real A/C
Assets
Meant for
Use
Goods
Meant for
resale
Nominal
A/C
Expenses
& Losses
Incomes &
Gains
25. Accounting Rules /Golden Rules
The double entry system of book-keeping is a scientific and
complete system . Hence, the transaction should be recorded to
accounting rules. A transaction should be divided into two aspects
Debit aspect
Credit aspect
Personal
A/C
• Debit the Receiver
• Credit the Receiver
Real A/C
• Debit what comes in
• Credit what goes out
Nominal
A/C
• Debit all expenses and losses
• Credit all incomes and Gains
26. Trading Account- P&L A/c
From the following balances extracted at the close of the year ended 31st
Dec.1996. prepare Profit and Loss A/c of Mr.Maha as at that date;
Rs Rs
Gross Profit 55,000 Repairs 500
Carriage on sales 500 Telephone charges 520
Office rent 500 Interest (Dr) 480
General Expenses 900 Fire insurance premium 900
Discount to customers 360 Bad debts 2100
Interest from Bank 200 Apprentice Premium
(Cr.)
1500
Travelling Expenses 700 Printing & Stationery 2500
Salaries 900 Trade expenses 300
Commission 300
27. Solution:
Profit And Loss A/C Of Mr. Maha For The Year Ending 31-12-
1996
Rs. Rs.
To carriage on sales
To office Rent
To General Expenses
To Discount to customers
To travelling Expenses
To salaries
To commission
To Repairs
To telephone Exp
To Interest paid
To Fire Insurance Premium
To Bad debts
To printing & Stationery
To trade Exp
To Net Profit
500
500
900
360
700
900
300
500
520
480
900
2100
2500
300
45,240
By Gross profit
By bank Interest
By Apprentice Premium
55,000
200
1,500
56,700 56,700
28. Trading A/c – Balance sheet Preparation
From the following adjusted Trial Balance, Prepare Balance sheet of Rama
as at 31st December 1996. Net Profit 42,000
Dr.
Rs.
Cr.
Rs.
Capital
Closing stock
Fixed Assets less Depreciation Rs.16,000
Sundry Debtors
Provision for Bad Debts
P &L A/c
Sundry Creditors
Liabilities for Expenses
Drawings
Cash & Bank
-
40,000
72,000
1,00,000
-
-
-
-
6,000
20,000
1,00,000
-
-
-
5,000
42,000
80,000
11,000
-
-
2,38,000 2,38,000
29. Balance sheet of Rama as on 31-12-96
Liabilities Rs. Assets Rs.
Capital
Add: Net Profit
Less: Drawings
1,00,000
42,000
1,36,000
Fixed Assets
Less:
Depreciation
Debtors
Less: Provision
for Bad Debts
88,000
16,000 72,000
95,000
1,42,000
6,000 1,00,000
5,000
Sundry Creditors
Liabilities for Exp
80,000
11, 000
Debtors
Cash & Bank
40,000
20,000
2,27,000 2,27,000
30. Depreciation
Depreciation is a permanent decline in the value of an
assets. The gradual decrease, both in the value and
usefulness, of an asset due to its nature and usage is
termed as depreciation .
For example: All fixed assets include the Machinery,
Furniture, Buildings. Land is Fixed asset but not subject to
depreciation because it has infinite lifetime.
Definition
According to the Institute of Chartered Accountants of
India, “ Depreciation is a measure of the wearing out,
consumption or other loss of value of a depreciable asset
arising from use, effluxion of time or obsolescence
through technology and market changes.
31. Causes of Depreciation
Causes of
Depreciation
Usage of
Product
Wear & Tear Obsolescnce
Technology
Changes/
Market Changes
32. Methods of
Depreciation
Straight-line method
(or) Fixed Installment
method (or) Original
Cost method
Written down method
(or) Diminishing
balance Method (or)
Reducing installment
method
The same amount of
depreciation is charged
every year throughout the
life of the asset .
Depreciation is
calculated at fixed rate
on the book value of an
asset every year. But
amount of depreciation
goes on decreasing every
year.
33. Straight line methods –Problems
A machine purchased on 1st July 1983 at a cost
Rs.14,000 and Rs. 1,000 was spent on its
installation. The depreciation is written off at
10% on the original cost every year. The books
are closed on 31st December each year. The
machine was sold for Rs. 9,500 on 31st March
1986. show the machinery account for all the
years.
35. Diminishing Balance Method/ Written
Down Value Method- Problems
A Company acquired a machine on
1.1.88 at a cost of Rs.40,000 and spent
Rs. 1,000 on its installation. The firm
writes off depreciation at 10% on the
diminishing balance. The books are
closed on 31st December of each year.
Show the Machinery A/c for 3 years.
37. Break Even Analysis
It is a financial tool which helps you to determine at what
stage your company, or a new service or a product, will be
profitable.
It is Calculation of Margin of Safety
In other words, it’s a financial calculation for determining
the number of products or services a company should sell
to cover its costs (particularly fixed costs).
It is useful in studying the relation between the variable
cost, fixed cost and revenue. Generally, a company with
low fixed costs will have a low break-even point of sale.
For an example, A company has a fixed cost of Rs.0
(zero) will automatically have broken even upon the first
sale of its products
38. Components of Break Even
Analysis
Fixed costs
It is called as the overhead cost. These overhead costs occur
after the decision to start an economic activity is taken and
these costs are directly related to the level of production, but
not the quantity of production. It is include (but are not
limited to) interest, taxes, salaries, rent, depreciation costs,
labour costs, energy costs etc.
Variable costs
Variable costs are costs that will increase or decrease in direct
relation to the production volume. This cost include cost of
raw material, packaging cost, fuel and other costs that are
directly related to the production.
40. Break even point –problems
(i) Break-even point in terms of sales value and in units.
(ii) Number of units that must be sold to earn a profit of Rs.
90,000.
Rs.
Fixed factory overhead costs 60,000
Fixed Selling overhead costs 12000
Variable Manufacturing cost per Unit 12
Variable selling cost per Unit 3
Selling price per unit 24
42. Managerial Uses of Break-Even Analysis
The following points highlight the top ten managerial uses
of break-even analysis. the managerial uses are:
1. Safety Margin
2. Target Profit
3. Change in Price
4. Change in Costs
5. Decision on Choice of Technique of Production
6. Make or Buy Decision
7. Plant Expansion Decisions
8. Plant Shut Down Decisions
9. Advertising and Promotion Mix Decisions
10. Decision Regarding Addition or Deletion of Product
Line.
43. Cont..
1. Safety Margin:
The break-even chart helps
the management to know at a
glance the profits generated at
the various levels of sales.
The safety margin refers to
the extent to which the firm can
afford a decline before it starts
incurring losses.
Formula;
Safety Margin = (Sales -
BEP)/Sales x 100
2. Target Profit
The break-even analysis can be
utilized for the purpose of
calculating the volume of sales
necessary to achieve a target
profit.
Formula,
Target Sales Volume = Fixed
Cost + Target Profit/Contribution
Margin Per Unit.
44. Target profit
The break-even analysis
can be utilized for the
purpose of calculating
the volume of sales
necessary to achieve a
target profit.
Formula,
Target Sales Volume = Fixed
Cost + Target
Profit/Contribution Margin
Per Unit.
45. Cont..3. Change in Price
The management is often faced with a
problem of whether to reduce prices or
not. Before taking a decision on this
question, the management will have to
consider a profit. A reduction in price
leads to a reduction in the contribution
margin.
This means that the volume of sales will
have to be increased even to maintain
the previous level of profit. The higher
the reduction in the contribution
margin, the higher is the increase in
sales needed to ensure the previous
profit.
Formula
New Sales Volume = Total Fixed
Cost + Total Profit/New Selling Price
– Average Variable Cost
4. Change in Costs
There are two types of cost.
1.Change in variable cost, and
2. Change in fixed cost
Variable cost
An increase in variable costs
leads to a reduction in the
contribution margin. This
reduction in the contribution
margin will shift the break-even
point downward. Conversely,
with the fall in the proportion of
variable costs, contribution
margins increase and break-even
point moves upwards.
46. Cont..
2.Fixed Cost Change:
An increase in fixed cost of a
firm may be caused either due
to a tax on assets or due to an
increase in remuneration of
management, etc.
It will increase the contribution
margin and thus push the
break-even point upwards.
Again to maintain the earlier
level of profits, a new level of
sales volume or new price has
to be found out.
5. Decision on Choice of Technique of
Production:
A firm has to decide about the most
economical production process both at
the planning and expansion stages.
There are many techniques available to
produce a product. These techniques
will differ in terms of capacity and
costs.
The breakeven analysis is the most
simple and helpful in the case of
decision on a choice of technique of
production.
For example, for low levels of output,
some conventional methods may be
most probable as they require
minimum fixed cost.
47. Cont..
6. Make or Buy Decision:
Firms often have the option of making
certain components or for purchasing
them from outside the concern. Break-
even analysis can enable the firm to
decide whether to make or buy.
For Example:
A manufacturer of car buys a certain
components at Rs. 20 each. In case he
makes it himself, his fixed and variable
cost would be Rs. 24,000 and Rs.8 per
component respectively.
BEP = Fixed Cost/Purchase Price – Variable
Cost
=24,000/20-8 = 24,000/12 = 2,000
units
From this, we can infer that the
manufacturer can produce the parts
himself if he needs more than 2,000 units
per year.
7. Plant Expansion Decisions:
The break-even analysis may
be adopted to reveal the effect
of an actual or proposed
change in operation condition.
This may be illustrated by
showing the impact of a
proposed plant on expansion
on costs, volume and profits.
Through the break-even
analysis, it would be possible
to examine the various
implications of this proposal.
48. Cont..8. Plant Shut Down Decisions:
In the shut-down decisions, a distinction
should be made between out of pocket and
sunk costs. Out of pocket costs include all
the variable costs plus the fixed cost which
do not vary with output. Sunk fixed costs
are the expenditures previously made but
from which benefits still remain to be
obtained e.g., depreciation.
Advertising and Promotion Mix Decisions:
The main objective of advertisement is to
stimulate or increase sales to all
customers—former, present and future.
It is keen competition, the firm has to
undertake vigorous campaign of
advertisement.
The management has to examine those
marketing activities that stimulate
consumer purchasing and dealer
effectiveness.
The break-even point concept helps
the management to know about the
circumstances. It enables him not
only to take appropriate decision but
by showing how these additional
fixed cost would influence BEPs. The
advertisement cost pushes up the total
cost curve by the amount of
advertisement expenditure.
10. Decision Regarding Addition or
Deletion of Product Line:
If a product has outlived its utility in
the market immediately, the
production must be abandoned by the
management and examined what
would be its consequent effect on
revenue and cost.
Alternatively, the management may
like to add a product to its existing
product line because it expects the
product as a potential profit spinner.
The break-even analysis helps in such
a decision.