About Break-Even Analysis and its importance as well as limitations

1. COST CONCEPT
AND BEHAVIOR
Chapter 3

2. Unit Price of an Ice Cream Cone

3. GENERAL COST TERMS
• Manufacturing costs
Direct materials, direct labor and manufacturing
overhead include indirect materials, indirect labor,
maintenance and repairs on production equipment (heat and
light, property taxes, depreciation, insurance, etc.)
• Non-manufacturing costs
• Overhead – heat and light, property taxes,
depreciation.
• Marketing or selling – advertising,
sales travel, sales salaries.
• Administrative – executive compensation,
general accounting, public relations,
and secretarial support.

5. Classifying Cost for Financial
Statements
• In financial accounting, the Matching
Concept states that the costs incurred to
generate particular revenue should be
recognized as expenses in the same period
that the revenue is recognized.
• Period cost: those costs that are charged to
expenses in the time period basis.
(advertising, public executive salaries, sales
commission, public relations, other non-
manufacturing costs)
• Product costs: those costs that are involved
in the purchase or manufacturing of goods.
Since product costs are assigned to
inventories, known as inventory costs. (all
costs related to manufacturing process.)

7. Classifying Cost for Uptown Ice Cream
Shop

8. Solution:

9. COST FLOWS AND CLASSIFICATION IN
MANUFACTURING COMPANY
• Raw materials
• Work-in-process
inventory
• Finished goods
inventory
Cost of revenue=
cost of

10. COST CLASSIFICATION FOR PREDICTING COST BEHAVIOR (DESCRIBES HOW
COST ITEM WILL RESPOND TO CHANGES IN THE LEVEL OF BUSINESS
ACTIVITY)
• Volume index - Operating cost respond in some way to
changes in its operating volume. Need to determine some
measurable volume or activity which has strong influence
on the amount incurred. (volume index may be based on
production inputs/outputs. Energy consumption, labor
hours, kilowatt hours generated or miles per year driven
by a car.
• Cost Behaviors – Fixed cost, Variable cost, Mixed cost.
In the car case,
depreciation, occurs from passage of time (fixed portion)
and more miles driven a year loses its market value
(variable portion)
• Average unit costs - Average cost per unit of production is
equal to total cost of production divided by the number of
units produced. It is also known as the unit cost. Especially
over the long-term, average cost normalizes the cost per
unit of production.

11. COST VOLUME
• It is necessary to distinguish between changes arising
solely from price changes and those arising from other
influences such as quantity and quality, which are
referred to as changes in "volume".
• A volume index is presented as a weighted average of
the proportionate changes in the quantities of a
specified set of goods or services between two periods
of time.
• The quantities compared must be homogeneous, while
the changes for different goods and services must be
weighed up by their economic importance as measured
by their values in one or other, or both, periods.

13. Volume Index (Illustrated Example)
• Consider an industry that produces two different
models of automobile, one selling for twice the price
of the other.
• From an economic point of view these are two quite
different products even though described by the same
generic term "automobile". Suppose that between two
periods of time:
• (a) The price of each model remains constant; (b) the
total number of automobiles produced remains
constant; (c) The proportion of higher priced models
produced increase from 50% to 80%

14. • It follows that:
• The total value of the output produced increased
by 20% because of the increase in the proportion of
higher-priced models. This constitutes a volume
increase of 20%. As each higher-priced automobile
constitutes twice as much output as each lower-priced
automobile, a switch in production from low-to-high
priced models increases the volume of output even
though the total number of automobiles produced
remains unchanged. The fact that the value increase is
entirely attributable to an increase in volume also
follows from the fact that no price change occurs for
either model. The price index must remain constant in
these circumstances.
• Cost cheaper * 50 + cost expansive * 50
• Before 1 * 50 + 2 * 50 =150
• after 1 * 30 + 2 * 80 = 160 + 30 = 80

15. FIXED COSTS OR CAPACITY COST
• Definition: The costs of
providing a company’s basic
operating capacity
• Cost behavior: Remain
constant over the time though
volume may change.
• Some examples: Annual
insurance premium, property
tax, and license fee, building
rents, depreciation of
buildings, salaries of
administrative and production

16. VARIABLE COSTS
• Definition: Costs that vary
depending on the level of
production or sales
• Cost behavior: Increase or
decrease according to the
level of volume change.
• Example: Ice cream cone
company. Wages, payroll
taxes, sales tax, and
supplies. Fuel
consumption is directly
related to miles driven.

17. AVERAGE UNIT COST
• Definition: Activity cost on a per unit basis.
• Cost behaviors:
✓ Fixed cost per unit varies with
changes in volume.
• ✓ Variable cost per unit of volume is
• constant.

18. Cost Classification of Owning and
Operating a Passenger Car

19. Cost Volume Relationship

22. COST CONCEPTS RELEVANT TO THE
DECISION MAKING
• Costs are an important feature of many
businesses’ decisions. In order to male
such decisions following cost needed to be
well understood…
• Differential costs
• Opportunity costs
• Sunk costs

23. Differential (incremental) costs revenues
• Definition: Difference in costs between any two
alternatives known as differentia; cost.
• The difference in revenues between any two
alternatives is known as differential revenue.
• Cost-volume relationship based on differential costs find
many engineering applications such as short-term
decision making.
• Example:
• The base case is the status quo (current operation). We
propose an alternative to the base case. If alternative
has lower cost, we accept that alternative assuming

24. • Differential cost = difference in total cost that results
from selecting one alternative instead of the other.
• Problem of this type are generally called trade off
problems because one type of cost is traded by another
type of cost.
• Key features: new investment in physical asset not
required, planning horizon short, relatively few cost
items are subject to change by the decision.
Examples:
• Method change.
• Operations planning.
• Make or buy decision.

25. Differential cost associated with adopting a
new production method example:

26. Operations planning example:
• Breakeven point: the level of output at which the costs of
production equal revenue.
• Breakeven point refers to the stage or level of activity at
which the sales or revenue precisely matches total
expenses.
• It is the point in a company’s operations where sales are
barely enough to cover all fixed and variable costs.
• Additionally, before a business can profit, it must reach the
breakeven point. There are various methods for calculating
the accounting breakeven point.
• To calculate this method of accounting, the company needs
to know the fixed costs, variable costs, and selling price per
unit.

27. Formula:

28. Example:
Crave Limited has recently entered the business of
making Table fans. The company’s management is
interested in knowing the breakeven point at which there
will be no profit/loss. Below are the details about the
cost incurred:

37. • Thus Crave limited need to sell 1000 units of electric Table
fans to break even at the current cost structure. At this
break-even point of 1000 units, Crave Limited will succeed
in meeting both its Fixed and Variable expenses of the
business. Below the breakeven point of 1000 units, Crave
Limited will make losses on a net basis if the same cost
structure exists.
• Here it is essential to understand that the Fixed Cost (in
this case $60000) is constant and doesn’t vary with the
level of Sales Revenue generated by Crave Limited. Thus,
once Crave Limited succeeds in making Break-Even Point,
all Sales over and above that level will lead to profits as the
excess of sales over Variable Cost will be a positive value
since Fixed Cost has already been fully absorbed by Crave
Limited on attaining the Breakeven Sales Level.

38. Make or buy example:
• Many firms perform certain activities using their own
resources and pay outside firm to perform certain
other activities.
• It is a good policy to constantly seek to improve the
balance between these two types of activities.

40. OPPORTUNITY COST
• Opportunity costs represent the
potential benefits that an
individual, investor, or business
misses out on when choosing
one alternative over another. It
is the potential benefit that is
given up as you seek alternative
course of action.
• The formula for the
calculation of the opportunity
cost is:
• Opportunity Cost=FO−CO
• where:FO=Return on best forgo
ne option
• CO=Return on chosen option​

41. Examples:
1. Assume the expected return on
investment (ROI) in the stock market is 12%
over the next year, and your company expects
the equipment update to generate a 10%
return over the same period. The opportunity
cost of choosing the equipment over the
stock market is 2% (12% - 10%). In other
words, by investing in the business, the
company would forgone the opportunity to
earn a higher return.
2. When you decide to pursue a college degree,
your opportunity cost would include the 4

42. MARGINAL ANALYSIS
• Principle: “Is it worthwhile?”
• Decision rule: To justify any course of
action.
• Definition: Marginal analysis is an
economic and financial decision-making
tool that involves evaluating the
incremental changes in costs and
benefits associated with a specific
action or decision. It aims to determine
whether the additional or marginal
benefit gained from taking that action
exceeds the incremental or marginal
cost incurred. In essence, it helps
individuals, businesses, and
policymakers make informed choices by
comparing the pros and cons of a
particular course of action at the
margin.

43. GROUP 2 REPORTERS:
GADAONI, JUSTINE ANNE A.
ANACLETO, ACE ROI
LAZARO, JONA MAY
REGALA, IVYLYN