Cost theories mm-aagac

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Basic Cost Theories and Break Even Analysis, BEP

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Cost theories mm-aagac

  1. 1. COST THEORIES AN INTRODUCTION Dr.M.Madhavan Assistant Professor of Economics Arignar Anna Government Arts College Namakkal – 637 002, Tamil Nadu
  2. 2. Cost The term cost of production means “expenses incurred in the production of a commodity. This refers the total amount of money spent on the production of a commodity”
  3. 3. Cost of production Three different senses  Money cost  Real cost and  Opportunity cost
  4. 4. Money Cost of Production  Explicit Cost (Accountant point of view)  Wages, interest, rent depreciation charges on fixed capital, taxes paid and other sundry expenses come under this cost.  Implicit Cost  Wages for the work performed by the entrepreneur.  Interest on the capital supplied by him  Rent of land and buildings belonging to the producer and used in production
  5. 5. Economic Cost & Profit  Economic Costs = Explicit costs + Implicit costs  Economic profit = Total Revenue - Economic costs.
  6. 6. Real Cost of Production This is a subjective concept. It expresses the trouble, turmoil and sacrifices involved in producing a commodity. The efforts and sacrifices of the factors or its owners is the real cost.
  7. 7. Opportunity Cost or Alternative Cost This means that the “cost of using something in a particular venture is the benefit forgone (or opportunity lost) by not using it in its best alternative use’. The opportunity cost of any goods is the next best alternative goods sacrificed.
  8. 8. Commodity – A Cost of Production = Rs. 10 Profit = Rs.5 ; Sales = 100 units Profit = Rs.500 Cost of Production = Rs.10 Profit = Rs.3 ; Sales = 200 units Profit = Rs.600 Opportunity Cost or Alternative Cost Example
  9. 9. Cost – Output Relationship  The cost of production of a commodity depends on three factors, which are variables. They are :  Price paid for procuring the factor or services of factors  The output of the firm  The time element involved, i.e., short period or long period.
  10. 10. Fixed cost Fixed costs : The fixed capital of the firm, e.g., equipment, machinery, land, buildings, insurance premium, certain taxes and salaries of permanent staff come with this class. When once engaged, the factors can be used over a period of time. Some economists include opportunity cost in fixed costs.
  11. 11. Variable cost The other inputs which are exhausted by a single use, e.g., raw materials, fuel, etc. In the long period all costs become variable. Fixed costs of a firm are called supplementary cost of production or overhead costs. Variable costs are called prime cost of production or direct costs. The total cost of a business is the sum of its variable cost and fixed cost of a particular level output.
  12. 12. Total Cost TC = TFC + TVC Where, TC = Total Cost TFC = Total Fixed Cost TVC = Total Variable Cost The Variable cost will increase with the increase in output. So, the total cost will increase with increase in output, as the total variable cost will increase due to increase in output.
  13. 13. Total Cost, Variable and Fixed Costs Curves TC TVC C O S T Output X TFC Y O
  14. 14. Marginal Cost Marginal cost may be defined as the addition made to the total cost by the production of one additional unit of output. This means marginal cost is the addition to the total cost of producing n units instead of n-1 units where n is any given number MCn = TCn – TC n-1
  15. 15. MARGINAL COST OUTPUT TOTAL COST MARGINAL COST 0 200 - 1 260 60 2 310 50 3 350 40 4 380 30 5 422 42 6 472 50 7 532 60 8 602 70
  16. 16. Marginal Cost Curve M A R G I N A L C O S T MC Y 0 OUTPUT X
  17. 17. Assumptions for Marginal Cost  The law of variable proportion determines the shape of the cost curve. If increasing returns is in operation, the marginal cost curve will be declining.  The changes in the marginal cost is due to the changes in the variable cost   The price of the variable factor remains constant as the firm expands its output. Otherwise a change in factor price may disturb our conclusions.
  18. 18. LAC – PLANT CURVES P1 P2 P3 P4 P5SAC1 SAC2 SAC3 M1 M2 M3O Y X OUTPUT AC
  19. 19. LAC – CONSTANT RETURN P1 P2 SAC1 SAC2 SAC3 M1 M2 M3O Y X OUTPUT AC P3 LAC
  20. 20. LAC at Variable Return Y SAC 6 SAC 5 SAC 4 SAC 3 SAC 2 SAC1 LACA V E R A G E C O S T O M1 M2 Output X
  21. 21.  The amount of money that the firm receives by the sale of its output in the market is known as its revenue.  ♦ Total revenue TR = q * p  ♦ Average revenue TR TR AR = P = q q  ♦ Marginal revenue MRn = TRn – TRn-1 Revenue
  22. 22. BREAK – EVEN ANALYSIS  Break-even analysis is a study of costs, revenues and sales of a firm and finding out the volume of sales where the firm’s costs and revenues will be equal. The Break- even point is the zone of no-profit and no-loss as the costs equal revenues.
  23. 23. BEP in terms of Physical Unit Output in Units Total Revenue Price Rs.4/- per unit Total Fixed Cost Total Variable Cost Total Cost 0 0 300 0 300 100 400 300 300 600 200 800 300 300 600 300 1200 300 900 1200 400 1600 300 1200 1500 500 2000 300 1500 1800 600 2400 300 1800 2100
  24. 24. Break – Even Point 0 300 600 900 1200 1500 1800 2100 2400 2700 1 2 3 4 5 6 7 TR TC Loss Zone Profit Zone BEP
  25. 25. ALTERNATIVE METHOD FOR BEP Total Fixed Cost BEP = Contribution Margin per unit Contribution Margin = Selling price – AVC 300 BEP = = 300 4 - 3
  26. 26. BEP (in terms of Sales Value) Total Fixed Cost BEP = Contribution Margin per unit (CM) Total Revenue minus Total Variable Cost CM = Total Revenue Rs.300 BEP = = Rs. 1200/- 0.25
  27. 27. BEP Total Revenue ---- Rs. 1200/- Total Cost ---- Rs.1200/- (TFCRs.300+TVC Rs. 900) Net Profit / Loss ----- NIL
  28. 28. Sl. No. Particulars Amount In Rs. 1. Salary for the Administrative Staffs 455600 2. Wages for the workers 1966000 3. Expenses on raw materials and accessories 3545000 4. Electricity 40000 5. Fuel for the generator 25000 6. Transportation 73000 7. Telephone Bill 12000 8. Security 10000 9. Maintenance 17000 10. Lodging facilities for the buyers & visitors 25000 11. Advertisement 700000 12. Rent for the Land & building 12000 13. Interest for the amount borrowed from ICICI 95500 14. Interest for capital supplied by the entrepreneur 125000 7101100Total Lakshmi Narashima Garments is producing 25,000 Garments during the month of August 2002. This includes 15,000 Mercerized T-Shirt and rests of them are polo T-shirt. The selling price of mercerized T-shirt is Rs.549.95 and the Polo T-shirt is Rs.175.75.Following is the details of expenditure for the month of August 2002 listed in the accountant book. Calculate the Break – Even point of the firm as well as the profit earned during the month of August 2002. Give your suggestion for the improvement and modification to be made in the company. PROBLEM
  29. 29. Sl. No. Particulars TOTAL COST FC VC 1. Salary for the Administrative Staffs 455600 2. Wages for the workers 1966000 3. Expenses on raw materials and accessories 3545000 4. Electricity 40000 5. Fuel for the generator 25000 6. Transportation 73000 7. Telephone Bill 12000 8. Security 10000 9. Maintenance 17000 10. Lodging facilities for the buyers & visitors 25000 11. Advertisement 700000 12. Rent for the Land & building 12000 13. Interest for the amount borrowed from ICICI 95500 14. Interest for capital supplied by the entrepreneur 125000 7101100 715100 6386000Total AMOUNT IN RUPEES FIXED COST AND VARIABLE COST IDENTIFICATION
  30. 30. BEP (in terms of Sales Value) Total Fixed Cost BEP = Contribution Margin per unit (CM)
  31. 31. CALCULATION OF BEP Total Revenue minus Total Variable Cost CM = Total Revenue Mercerized T shirt = 15,000 X 549.95 = 8249250 Polo T shirt = 10,000 X 175.75 = 1757500 Total Revenue = 10006750 Total Variable Cost = 6386000 Total Fixed Cost = 715100
  32. 32. CALCULATION OF BEP Total Revenue minus Total Variable Cost CM = Total Revenue 10006750 –6386000 3620750 CM = = = 0.362 10006750 10006750 TOTAL FIXED COST 715100 BEP = = = Rs. 1975414.364 CM 0.362

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