CHAPTER 4: COST ANALYSIS

COST ANALYSIS
Profit is the ultimate aim of any business and the long-run prosperity of a firm depends upon its ability
to earn sustained profits. Profits are the difference between selling price and cost of production. In general,
the selling price is not within the control of a firm but many costs are under its control. The firm should therefore
aim at controlling and minimizing cost. Since every business decision involves cost consideration, it is necessary
to understand the meaning of various concepts for clear business thinking and application of right kind of
costs.

COST CONCEPTS:
A managerial economist must have a clear understanding of the different cost concepts for clear
business thinking and proper application. The several alternative bases of classifying cost and the relevance
of each for different kinds of problems are to be studied. The various relevant concepts of cost are:
1. Opportunity costs and outlay costs:
Out lay cost also known as actual costs obsolete costs are those expends which are actually incurred
by the firm these are the payments made for labor, material, plant, building, machinery traveling,
transporting etc., These are all those expense item appearing in the books of account, hence based on
accounting cost concept.
On the other hand, opportunity cost implies the earnings foregone on the next best alternative, has
the present option is undertaken. This cost is often measured by assessing the alternative, which has to
be scarified if the particular line is followed.

The opportunity cost concept is made use for long-run decisions. This concept is very important in
capital expenditure budgeting. This concept is very important in capital expenditure budgeting. The
concept is also useful for taking short-run decisions opportunity cost is the cost concept to use when the
supply of inputs is strictly limited and when there is an alternative. If there is no alternative, Opportunity
cost is zero. The opportunity cost of any action is therefore measured by the value of the most favorable
alternative course, which had to be foregoing if that action is taken.
2. Explicit and implicit costs:
Explicit costs are those expenses that involve cash payments. These are the actual or business costs
that appear in the books of accounts. These costs include payment of wages and salaries, payment for
raw materials, interest on borrowed capital funds, rent on hired land, Taxes paid etc.
Implicit costs are the costs of the factor units that are owned by the employer himself. These costs
are not actually incurred but would have been incurred in the absence of employment of self –
owned factors. The two normal implicit costs are depreciation, interest on capital etc. A decision
maker must consider implicit costs too to find out appropriate profitability of alternatives.
3. Historical and Replacement costs:
Historical cost is the original cost of an asset. Historical cost valuation shows the cost of an asset as
the original price paid for the asset acquired in the past. Historical valuation is the basis for financial
accounts.
A replacement cost is the price that would have to be paid currently to replace the same asset.
During periods of substantial change in the price level, historical valuation gives a poor projection of the
future cost intended for managerial decision. A replacement cost is a relevant cost concept when
financial statements have to be adjusted for inflation.
4. Short – run and long – run costs:
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 extensively. So
short run cost is that which varies with output when the plant and capital equipment in constant.
Long run costs are those, which vary with output when all inputs are variable including plant and
capital equipment. Long-run cost analysis helps to take investment decisions.
5. Out-of pocket and books costs:
Out-of pocket costs also known as explicit costs are those costs that involve current cash payment.
Book costs also called implicit costs do not require current cash payments. Depreciation, unpaid interest,
salary of the owner is examples of back costs.
But the book costs are taken into account in determining the level dividend payable during a period.
Both book costs and out-of-pocket costs are considered for all decisions. Book cost is the cost of self-
owned factors of production.
6. Fixed and variable costs:
Fixed cost is that cost which remains constant for a certain level to output. It is not affected by the
changes in the volume of production. But fixed cost per unit decrease, when the production is
increased. Fixed cost includes salaries, Rent, Administrative expenses depreciations etc.
Variable is that which varies directly with the variation is 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 variables costs. The variable cost per unit will be constant. Ex: Raw materials, labor, direct expenses,
etc.
7. Post and Future costs:
Post costs also called historical costs are the actual cost incurred and recorded in the book of
account these costs are useful only for valuation and not for decision making.
Future costs are costs that are expected to be incurred in the futures. They are not actual costs. They
are the costs forecasted or estimated with rational methods. Future cost estimate is useful for decision
making because decision is meant for future.
8. Traceable and common costs:
Traceable costs otherwise called direct cost, is one, which can be identified with a products process
or product. Raw material, labor involved in production is examples of traceable cost.
Common costs are the ones that common are attributed to a particular process or product. They
are incurred collectively for different processes or different types of products. It cannot be directly
identified with any particular process or type of product.
 9. Avoidable and unavoidable costs:
Avoidable costs are the costs, which can be reduced if the business activities of a concern are
curtailed. For example, 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. For example, cost of the ideal machine capacity is
unavoidable cost.
10. Controllable and uncontrollable costs:
Controllable costs are ones, which can be regulated by the executive who is in charge of it. The
concept of controllability of cost varies with levels of management. Direct expenses like material, labor
etc. are controllable costs.
Some costs are not directly identifiable with a process of product. They are appointed to various
processes or products in some proportion. This cost varies with the variation in the basis of allocation and
is independent of the actions of the executive of that department. These apportioned costs are called
uncontrollable costs.
11. Incremental and sunk costs:
Incremental cost also known as different 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
machinery, 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. Investments in fixed
assets are examples of sunk costs.
12. Total, average and marginal costs:
Total cost is the total cash payment made for the input needed for production. It may be explicit or
implicit. It is the sum total of the fixed and variable costs. Average cost is the cost per unit of output. If is
obtained by dividing the total cost (TC) by the total quantity produced (Q)

Total Cost (TC)

Average cost =
Total Quantity Produced (Q)

Marginal cost is the additional cost incurred to produce and additional unit of output or it is the cost
of the marginal unit produced.
13. Accounting and Economics costs:
Accounting costs are the costs recorded for the purpose of preparing the balance sheet and profit
and ton statements to meet the legal, financial and tax purpose of the company. The accounting
concept is a historical concept and records what has happened in the post.
Economics concept considers future costs and future revenues, which help future planning, and
choice, while the accountant describes what has happened, the economics aims at projecting what
will happen.

COST-OUTPUT RELATIONSHIP
A proper understanding of the nature and behavior of costs is a must for regulation and control of
cost of production. The cost of production depends on money forces and an understanding of the functional
relationship of cost to various forces will help us to take various decisions. Output is an important factor, which
influences the cost.

The cost-output relationship plays an important role in determining the optimum level of production.
Knowledge of the cost-output relation helps the manager in cost control, profit prediction, pricing, promotion
etc. The relation between cost and its determinants is technically described as the cost function.

C= f (S, O, P, T ….)

Where:
C= Cost (Unit or total cost)
S= Size of plant/scale of production
O= Output level
P= Prices of inputs
T= Technology

Considering the period the cost function can be classified as;

(a) short-run cost function and
(b) long-run cost function. In economics theory, the short-run is defined as that period during which
the physical capacity of the firm is fixed and the output can be increased only by using the
existing capacity allows to bring changes in output by physical capacity of the firm.

a) Cost-Output Relation in the short-run:

The cost concepts made use of in the cost behavior are total cost, Average cost, and marginal cost.
Total cost is the actual money spent to produce a particular quantity of output. Total cost is the
summation of fixed and variable costs.

TC = TFC+TVC

Up to a certain level of production total fixed cost i.e., the cost of plant, building, equipment etc.,
remains fixed. But the total variable cost i.e., the cost of labor, raw materials etc., Vary with the variation in
output. Average cost is the total cost per unit.
 The total of average fixed cost (TFC/Q) keep coming down as the production is increased and
average variable cost (TVC/Q) will remain constant at any level of output.

Marginal cost is the addition to the total cost due to the production of an additional unit of product.
It can be arrived at by dividing the change in total cost by the change in total output.
In the short-run there will not be any change in total fixed cost. Hence change in total cost implies change in
total variable cost only.

b) Cost-output Relationship in the long-run:

Long run is a period, during which all inputs are variable including the one, which are fixes in the short
run. In the long run a firm can change its output according to its demand. Over a long period, the size of the
plant can be changed, unwanted buildings can be sold staff can be increased or reduced. The long run
enables the firms to expand and scale of their operation by bringing or purchasing larger quantities of all the
inputs. Thus, in the long run all factors become variable.

The long-run cost-output relations therefore imply the relationship between the total cost and the
total output. In the long-run cost-output relationship is influenced by the law of returns to scale.
In the long run a firm has a number of alternatives in regards to the scale of operations. For each
scale of production or plant size, the firm has an appropriate short-run average cost curve. The short-run
average cost (SAC) curve applies to only one plant whereas the long-run average cost (LAC) curve takes in
to consideration many plants.
The long-run cost-output relationship is shown graphically with the help of “LCA’ curve.

To draw on ‘LAC’ curve we have to start with a number of ‘SAC’ curves. In the above figure it is
assumed that technologically there are only three sizes of plants – small, medium and large, ‘SAC’, for the
small size, ‘SAC2’ for the medium size plant and ‘SAC3’ for the large size plant. If the firm wants to produce
‘OP’ units of output, it will choose the smallest plant. For an output beyond ‘OQ’ the firm wills optimum for
medium size plant. It does not mean that the OQ production is not possible with small plant. Rather it implies
that cost of production will be more with small plant compared to the medium plant.
For an output ‘OR’ the firm will choose the largest plant as the cost of production will be more with
medium plant. Thus, the firm has a series of ‘SAC’ curves. The ‘LCA’ curve drawn will be tangential to the entire
family of ‘SAC’ curves i.e. the ‘LAC’ curve touches each ‘SAC’ curve at one point, and thus it is known as
envelope curve. It is also known as planning curve as it serves as guide to the entrepreneur in his planning to
expand the production in future. With the help of ‘LAC’ the firm determines the size of plant which yields the
lowest average cost of producing a given volume of output it anticipates.

BREAKEVEN ANALYSIS
The study of cost-volume-profit relationship is often referred as BEA. The term BEA is interpreted in two
senses. In its narrow sense, it is concerned with finding out BEP; BEP is the point at which total revenue is equal
to total cost. It is the point of no profit, no loss. In its broad determine the probable profit at any level of
production.

Assumptions:
1. All costs are classified into two – fixed and variable.
2. Fixed costs remain constant at all levels of output.
3. Variable costs vary proportionally with the volume of output.
4. Selling price per unit remains constant in spite of competition or change in the volume of
production.
5. There will be no change in operating efficiency.
6. There will be no change in the general price level.
7. Volume of production is the only factor affecting the cost.
8. Volume of sales and volume of production are equal. Hence there is no unsold stock.
9. There is only one product or in the case of multiple products. Sales mix remains constant.
Merits:
1. Information provided by the Break-Even Chart can be understood more easily than those contained
in the profit and Loss Account and the cost statement.
2. Break Even Chart discloses the relationship between cost, volume and profit. It reveals how changes
in profit. So, it helps management in decision-making.
3. It is very useful for forecasting costs and profits long term planning and growth
4. The chart discloses profits at various levels of production.
5. It serves as a useful tool for cost control.
6. It can also be used to study the comparative plant efficiencies of the industry.
7. Analytical Break-even chart present the different elements, in the costs – direct material, direct labor,
fixed and variable overheads.
 Demerits:
1. Break-even chart presents only cost volume profits. It ignores other considerations such as capital
amount, marketing aspects and effect of government policy etc., which are necessary in decision
making.
2. It is assumed that sales, total cost and fixed cost can be represented as straight lines. In actual
practice, this may not be so.
3. It assumes that profit is a function of output. This is not always true. The firm may increase the profit
without increasing its output.
4. A major drawback of BEC is its inability to handle production and sale of multiple products.
5. It is difficult to handle selling costs such as advertisement and sale promotion in BEC.
6. It ignores economics of scale in production.
7. Fixed costs do not remain constant in the long run.
8. Semi-variable costs are completely ignored.
9. It assumes production is equal to sale. It is not always true because generally there may be opening
stock.
10. When production increases variable cost per unit may not remain constant but may reduce on
account of bulk buying etc.
11. The assumption of static nature of business and economic activities is a well-known defect of BEC.

1. Fixed cost: Expenses that do not vary with the volume of production are known as fixed expenses. E.g.
Manager’s salary, rent and taxes, insurance etc. It should be noted that fixed changes are fixed only within
a certain range of plant capacity. The concept of fixed overhead is most useful in formulating a price fixing
policy. Fixed cost per unit is not fixed.

2. Variable Cost: Expenses that vary almost in direct proportion to the volume of production of sales are called
variable expenses. E.g. Electric power and fuel, packing materials consumable stores. It should be noted that
variable cost per unit is fixed.

3. Contribution: Contribution is the difference between sales and variable costs and it contributed towards fixed
costs and profit. It helps in sales and pricing policies and measuring the profitability of different proposals.
Contribution is a sure test to decide whether a product is worthwhile to be continued among different
products.

Contribution = Sales – Variable cost Contribution = Fixed Cost + Profit.

4. Margin of safety: Margin of safety is the excess of sales over the break-even sales. It can be expressed in
absolute sales amount or in percentage. It indicates the extent to which the sales can be reduced without
resulting in loss. A large margin of safety indicates the soundness of the business.

Margin of safety can be improved by taking the following steps.

i Increasing production
ii Increasing selling price
iii Reducing the fixed or the variable costs or both
iv Substituting unprofitable product with profitable one.

5. 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 indicates 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 and/or by reducing variable cost. It also indicates as to what extent the output and
sales price can be changed to attain a desired amount of profit.

6. Profit Volume Ratio: is usually called P. V. ratio. It is one of the most useful ratios for studying the profitability of
business. The ratio of contribution to sales is the P/V ratio. It may be expressed in percentage. Therefore, every
organization tries to improve the P. V. ratio of each product by reducing the variable cost per unit or by
increasing the selling price per unit. The concept of P. V. ratio helps in determining break-even point, a
desired amount of profit etc.

8. Break–Even Point: Break Even Point refers to the point where total cost is equal to total revenue. It is a point
of no profit, no loss. This is also a minimum point of no profit, no loss. This is also a minimum point of production
where total costs are recovered. If sales go up beyond the Break Even Point, organization makes a profit. If
they come down, a loss is incurred.