Application of Cost Analysis Concept


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Application of Cost Analysis Concept

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Application of Cost Analysis Concept

  1. 1. December 8, 2012
  2. 2. Prepared by  Ali Abbas  Aneel Usmani  Arif Deen  M. Atiq  Naveed Ali Presented to  Mr. Shujaat Mubarik
  3. 3.  It is an economic evaluation technique  It involves the systematic collection, categorization, and analysis of costs  It can also be used within the frameworks of  Cost-effectiveness analysis  Cost-benefit analysis  Cost-utility analysis
  4. 4.  Costs are the values of all the resources used to produce a good or a service  Economists think of costs as consequences of choices  i.e., the value of benefits that would have been derived if the resources had been allocated to their next best use
  5. 5. Explicit Costs:  The costs that involve an actual payment to other parties  The monetary payment made by a firm for use of an input owned or controlled by others Implicit Costs:  Represent the value of foregone opportunities but do not involve an actual cash payment  Implicit costs are just as important as explicit costs but are sometimes neglected because they are not as obvious  Implicit cost is the opportunity cost of using resources that are owned or controlled by the owners of the firm
  6. 6.  Accountants have always been concerned with firms’ financial statements  Accountants tend to evaluate past performances  The accounting costs are useful for managing taxation needs as well as to calculate profit or loss of the firm
  7. 7.  Economists take forward-looking view of the firm  They are concerned with what cost is expected to be in the future and how the firm might be able to rearrange its resources to lower its costs and improve its profitability  They are concerned with opportunity cost
  8. 8.  To produce more, a firm must employ more labour which means it must increase its costs  The following concepts are important in the short run  Total Cost (TC): The cost of all the factors of production it uses.  Marginal Cost: The increase in the total cost that results from a one unit increase in output.  Average Cost: The average cost includes three factors of production i.e., average fixed cost, average variable cost, average total cost
  9. 9. It includes:  Total Fixed Cost (TFC): The cost of the firm’s fixed factors  Total Variable Cost (TVC): The cost of the firm’s variable factors  Equation: TC = TFC + TVC
  10. 10.  It includes  Average Fixed Cost: The total fixed cost per unit  Average Variable Cost: The total variable cost per unit  Average Total Cost: The total cost per unit of output  Equation: ATC= AFC + AVC
  11. 11.  A firm can vary both the quantity of labour and the quantity of capital  The firm’s costs are variable  The behavior of the long run cost depends on the firm’s production function
  12. 12.  Production Function: The relationship of between the maximum output attainable and the quantities of both labour and capital  Economies of Scale They are the features of a firm’s technology that make average total cost fall as output increases.  Diseconomies of Scale They are features of a firm’s technology that make the average total cost rise as output increases.  Constant returns to Scale They are features of a firm’s technology that keep average total cost constant as output increases.  Minimum efficient scale It is a firm’s smallest output at which long run average cost reaches its lowest level.
  13. 13.  Explicit Cost A firm pays Rs. 100 per day to a worker and engages 15 workers for 10 days, the explicit cost will be Rs. 15,000 incurred by the firm. Other types of explicit costs include raw material purchase, renting a building, amount spent on advertising, utility bills etc.
  14. 14.  Implicit Cost A manager who runs his own business foregoes the salary that could have been earned working for someone else. This implicit cost is generally not reflected in accounting statements, but ideally it should be considered. Therefore, an implicit cost is the opportunity cost of using resources that are owned or controlled by the owners of the firm. The implicit cost is the foregone return, the owner of the firm could have received had they used their own resources in their best alternative use rather than using the resources for their own firm’s production.
  15. 15.  Economic Profit and Accounting Profit Mr. Ali is a small storeowner. He has invested Rs. 200,000 as equity in the store and inventory. His annual turnover is Rs. 800,000, from which he must deduct the cost of goods sold, salaries of hired staff, and depreciation of equipment and building to arrive at annual profit of the store. He asked help of a friend who is an accountant by profession to prepare annual income statement. The accountant reported the profit to be Rs. 150,000. Mr. Ali could not believe this and asked the help of another friend who is an economist by profession. The economist told him that the actual profit was only Rs. 75,000 and not Rs. 150,000. The economist found that the accountant had underestimated the costs by not including the implicit costs of time spent as Manager by Mr. Ali in the business and interest on owner’s equity.