Cost analysis and production theory

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Cost analysis and production theory

  1. 1. Chapter 5: COST ANALYSIS AND PRODUCTION THEORY Chapter 5: Contents:  Cost Concept  Types of Cost  BEP – Analysis and its assumptions. 1. COST CONCEPT: Cost denotes the amount of money that a company spents on the creation or production of goods or services. It does not include the mark-up for profit. From a seller’s point of view, cost is the amount of money that is spent to produce a good or a product. If a seller sold his products at the production price, he would break even, meaning that he would not lose money on his sales. However, he would not make a profit either. From a buyer’s point of view the cost of a product can be called the price. This is the amount that the seller charges for a product, and it includes both the production cost and the mark-up cost, which is added by the seller in order for him to make a profit. When a new company’s business plan is developed, organizers will often create cost estimates. These are used to assess whether the benefits and revenues of a proposed business will more than cover the costs. This is called a cost-benefit analysis. Underestimating the costs of a business may result in a cost overrun once operations begin. This means that costs are higher than the income, and consequently the company will lose money. Thus the profit can be analysed by considering two important factors cost and revenue. The revenue depends on the market area which cannot be decided by the firm so the company’s focus on the cost area and tries to reduce the cost of the product which results in abnormal profit area. An economic model that seeks to include the cost of negative externalities into the pricing of goods and services. Supporters of this type of economic system feel products and activities that directly or indirectly cause harmful consequences to living beings and/or the environment should be accordingly taxed to reflect the somewhat hidden costs. 2. TYPES OF COST : 2.1 Actual Cost V/S Opportunity Cost: Actual cost is the total amount of materials, labour costs, and any directly associated overhead costs that can be charged to a specific project. The actual cost is different from the standard cost, although both approaches are often used to evaluate the profitability of a given project. With actual costs, the goal is to break down the specifics of the costs involved with Page 1
  2. 2. Chapter 5: COST ANALYSIS AND PRODUCTION THEORY the project and determine if the production process associated with the project is in fact working at optimum efficiency. Understanding the difference between the standard cost and the actual cost is very important when looking at the expenses associated with a given job or project. The standard cost assumes a standard value and uses that figure to track the usage of resources. This tracking is usually in the form of either hours or the number of units consumed, and can identify variance between the production and consumption. In contrast, the actual cost is concerned only with the costs incurred during the course of the project, and not the units produced. Determining the actual cost is very important when it comes to judging the profitability of any production process. Knowing how much it actually costs to engage in that production for a specific period, such as a month, makes it easier to compare the revenue that is generated for the same period. If the actual cost was exceeded by the amount of revenue received during the same period, then the company is operating at a profit. If not, this calculation of the actual cost can motivate business owners to take a closer look at each expense involved with the manufacturing process and identify ways to cut costs and increase the chance of becoming profitable. Comparing the actual cost of production from a given period to previous periods can also help identify situations where the cost of production is increasing for some reason. If this increase proves to be an on-going trend, looking at each of the factors involved may yield clues as to what is happening. For example, an investigation may uncover the fact that an excessive amount of overtime is the reason for the higher production costs. If this is the case, the business can look closely for the reasons why the overtime took place, and determine if there is any better way to arrange the use of labor to offset this increase. From this perspective, calculating the actual cost is viewed as a valuable tool that helps to keep the production process efficient, thus maximizing the opportunity to generate the highest amount of profits possible from the process. When economists refer to the “opportunity cost” of a resource, they mean the value of the next-highest-valued alternative use of that resource. If, for example, you spend time and money going to a movie, you cannot spend that time at home reading a book, and you cannot spend the money on something else. If your next-best alternative to seeing the movie is reading the book, then the opportunity cost of seeing the movie is the money spent plus the pleasure you forgo by not reading the book. The word “opportunity” in “opportunity cost” is actually redundant. The cost of using something is already the value of the highest-valued alternative use. But as contract lawyers and airplane pilots know, redundancy can be a virtue. In this case, its virtue is to remind us that the cost of using a resource arises from the value of what it could be used for instead. This simple concept has powerful implications. It implies, for example, that even when governments subsidize college EDUCATION, most students still pay more than half of the cost. Take a student who annually pays $4,000 in tuition at a state college. Assume that the government subsidy to the college amounts to $8,000 per student. It looks as if the cost is $12,000 and the student pays less than half. But looks can be deceiving. The true cost is $12,000 plus the income the student forgoes by attending school rather than working. If the student could have earned $20,000 per year, then the true cost of the year’s schooling is Page 2
  3. 3. Chapter 5: COST ANALYSIS AND PRODUCTION THEORY $12,000 plus $20,000, for a total of $32,000. Of this $32,000 total, the student pays $24,000 ($4,000 in tuition plus $20,000 in forgone earnings). In other words, even with a hefty state subsidy, the student pays 75 percent of the whole cost. This explains why college students at state universities, even though they may grouse when the state government raises tuitions by, say, 10 percent, do not desert college in droves. A 10 percent increase in a $4,000 tuition is only $400, which is less than a 2 percent increase in the student’s overall cost (see HUMAN CAPITAL). 2.2 Fixed Cost V/S Variable Cost : In economics, total cost (TC) describes the total economic cost of production and is made up of fixed and variable costs. Variable costs change according to the quantity of a good produced and include inputs (i.e., labour and raw materials); while fixed costs are independent of the quantity of a good produced and include inputs (capital) that cannot be varied in the short term (i.e., buildings and machinery). Total cost in economics includes the total opportunity cost of each factor of production as part of its fixed or variable costs. Fixed costs remain the same as production changes. For example, no matter how many pizzas Pete cooks in his pizza oven, the cost of the pizza oven is the same. Also, it doesn't matter if Pete sells 100 pizzas or 1,000 pizzas; the pizzeria costs the same amount. Variable costs change as production changes. Returning to the example of Pete's Pizza, one cook can only make so many pizzas. If Pete wants to increase the number of pizzas produced to more than one cook can handle, he has to hire another cook. Therefore, labour is an example of a variable cost because it increases as production increases. Note the following relationship between total cost, fixed cost, and variable cost: Total Cost (TC) = Fixed Cost (FC) + Variable Cost (VC) Economists generally assume that in the short term, capital is fixed and labour is variable. In the long term, there are no fixed costs since firms can change the amount of capital they use as well as how much labour they employ. 2.3 Explicit Cost V/S Implicit Cost : Economists distinguish between explicit and implicit costs. Explicit costs, also called accounting costs, are out-of-pocket costs, such as expenses on labor, raw materials, and rent. Implicit costs are costs a business incurs without actually spending money. They are estimates of the value of alternative activities you have sacrificed. A person who invests $100,000 of her/his own money in a business does not have to pay any finance charges to a bank for using this money. Thus, there is no explicit cost for using this money. However, the implicit cost is the earnings the owner sacrifices by not using the $100,000 in an alternate activity, such as investing in stocks or bonds. Implicit and explicit business transactions relate to a company's opportunity costs and cash expenditures. A business incurs explicit costs from a variety of sources, including hiring Page 3
  4. 4. Chapter 5: COST ANALYSIS AND PRODUCTION THEORY workers and purchasing production equipment. Implicit costs are more difficult to quantify because these costs don't represent physical exchanges of cash for goods and services. Explicit costs in business include all the transactions pertaining to factors of production utilized by a given company. Paying explicit costs always requires a business to expend cash. If the company doesn't expend cash on given factors of production, those factors are not explicit costs for business transaction purposes. Explicit costs can also be variable or fixed, depending on how these costs change as the company increases output. Fixed costs don't change as the company increases production, whereas variable costs can fluctuate as company output increases. Explicit Cost Examples A company's explicit costs can include employee wages, payments made to purchase raw materials, business rent/mortgage payments and fees related to purchasing manufacturing equipment. Of these explicit costs, a business considers rent/mortgage payments and the cost of purchasing manufacturing equipment as fixed costs. Variable explicit costs include employee wages because the cost of paying workers increases as the business ramps up production. Equipment maintenance costs and utility payments for retail store locations can also increase as a business raises production levels. Implicit costs represent opportunity costs that use a company's internal resources without any explicit compensation for utilizing those resources. Implicit costs are opportunity costs because the business forgoes any chance of earning money for allowing consumers or other companies the chance to purchase those internal resources. A business doesn't record implicit costs or transactions for accounting purposes because no money is changing hands. Implicit costs or transactions only represent the loss of potential income and not the actual loss of profits. A business can still elect to include implicit costs as costs of doing business, because these costs represent potential sources of income. Implicit Cost Examples A business owner who chooses to work for her company without drawing a salary is forgoing the opportunity to earn a fair wage for her business skills and talents. The business owner's salary is an implicit cost. In the case of a small business, an owner forgoing a salary in the early days of the company is common. This decreases the cost burden on the company and provides a greater chance to maximize revenue during the company's inception when every dollar is crucial to sustaining success. Page 4
  5. 5. Chapter 5: COST ANALYSIS AND PRODUCTION THEORY 2.4 Out of Pocket Cost V/S Book Cost : Out-of-pocket costs are those costs or expenses that require a cash payment in the current period or during a project. For example, the wages of the person setting up a machine for a new production run are an out-of-pocket cost. However, the cost of the lost opportunity to be producing profitable output during the setup time is not an out-of-pocket cost. (The cost of not earning profits during the setup time, known as an opportunity cost, is often far greater than the out-ofpocket costs.) Another example of out-of-pocket costs are the current year’s repairs and maintenance expenses on a church that was constructed 15 years ago. However, the current depreciation expense on the church is not an out-of-pocket cost. The current period’s depreciation is also referred to as a noncash expense. Out-of-pocket expenses and moneys paid directly for necessary items by a contractor, trustee, executor, administrator or any person responsible to cover expenses not detailed by agreement. They may be recoverable from a defendant in a lawsuit for breach of contract, allowable for reimbursement by trustees, executors or administrators, or deductible by a landlord from a tenant's security deposit for damages beyond normal wear and tear. The acquisition cost of property as reflected on accounting statements. Generally includes the purchase price , installation, and indirect costs such as interest during construction. The book cost of Rs. 10,000 is a historical fact; it is not a measure of current value or of replacement cost, either of which may be greater or less than Rs. 10,000. The book valueis that at which an asset is carried on a balance sheet. To calculate, take the cost of an asset minus the accumulated depreciation. 2. The net asset value of a company, calculated by total assets minus intangible assets (patents, goodwill) and liabilities. 3. The initial outlay for an investment. This number may be net or gross of expenses such as trading costs, sales taxes, service charges and so on. Also known as "net book value (NBV)." Book value is the accounting value of a firm. It has two main uses: 1. It is the total value of the company's assets that shareholders would theoretically receive if a company were liquidated. 2. By being compared to the company's market value, the book value can indicate whether a stock is under- or overpriced. Page 5
  6. 6. Chapter 5: COST ANALYSIS AND PRODUCTION THEORY 3. In personal finance, the book value of an investment is the price paid for a security or debt investment. When a stock is sold, the selling price less the book value is the capital gain (or loss) from the investment. 3. BREAK EVEN ANALYSIS: The break-even point (BEP) is the point at which cost or expenses and revenue are equal: there is no net loss or gain, and one has "broken even". A profit or a loss has not been made, although opportunity costs have been paid, and capital has received the risk-adjusted, expected return. Break-even analysis is a technique widely used by production management and management accountants. It is based on categorizing production costs between those which are "variable" (costs that change when the production output changes) and those that are "fixed" (costs not directly related to the volume of production). Total variable and fixed costs are compared with sales revenue in order to determine the level of sales volume, sales value or production at which the business makes neither a profit nor a loss (the "break-even point"). In its simplest form, the break-even chart is a graphical representation of costs at various levels of activity shown on the same chart as the variation of income (or sales, revenue) with the same variation in activity. The point at which neither profit nor loss is made is known as the "break-even point" and is represented on the chart below by the intersection of the two lines. In the diagram above, the line OA represents the variation of income at varying levels of production activity ("output"). OB represents the total fixed costs in the business. As output increases, variable costs are incurred, meaning that total costs (fixed + variable) also increase. At low levels of output, Costs are greater than Income. At the point of intersection, P, costs are exactly equal to income, and hence neither profit nor loss is made. Formulas of Break Even Analysis are as follows: Page 6
  7. 7. Chapter 5: COST ANALYSIS AND PRODUCTION THEORY 1. BEP (in units) = Total Fixed Cost /Contribution per unit 2. BEP (in Rs) = Total Fixed Cost /Contribution per unit* Sales Price per unit. Where, Contribution per unit = Sales price per unit – Variable price per unit. 3.1 ASSUMPTIONS OF BEP: 1. The total cost is been divided into 2 parts : I. II. Fixed Expenses Variable Expenses 2. Fixed cost remains constant i.e. it is independent of the quantity produced eg. Salary of executives, rent of building, etc. 3. The variable cost varies with the proportion of the production units. V.C. = Cost per unit *Quantity 4. The sales price does not change with the change in the sales. 5. The firm deals only with one product or the product mix remains the same. 6. It is assumed that everything which is produced is sold and there is no change in the inventory. 7. Productivity of worker and efficiency of plant remains unchanged. Page 7

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