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cost estimation and break even analysis

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The presentation describes Elements of cost and classification, cost estimation approaches and method, break even analysis, steps and limitation with examples

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cost estimation and break even analysis

  1. 1. Cost Estimation Unit III Characteristics of Forecasts, Forecasting Horizons, Steps to Forecasting, Forecasting Methods, Seasonal Adjustments, Forecasting Performance Measures, Cost Estimation, Elements of cost, Computation of Material Variances Break‐Even Analysis 11/10/2016 1NHU 501 Dr N R Kidwai, JIT Barabanki
  2. 2. Classification of Cost 11/10/2016 2NHU 501 Dr N R Kidwai, JIT Barabanki Cost According to Elements Expenses/ OverheadsMaterial Cost Labour Cost Material cost : Cost of material traceable to one unit of product Labor cost : Cost of human resource involvement Expenses/ overheads : Cost associated with direct /indirect overheads; design, administrative, production, sales/service, distribution
  3. 3. Classification of Cost 11/10/2016 3NHU 501 Dr N R Kidwai, JIT Barabanki Cost According to Behaviour Variable CostFixed Cost Semi Variable Cost Fixed Cost: Fixed in short run and long run Variable Cost: Varies with volume and constant per unit Semi variable Cost: fixed for one level of activity and variable for another
  4. 4. Classification of Cost 11/10/2016 4NHU 501 Dr N R Kidwai, JIT Barabanki Cost According to Functions Administration Cost Production Cost Selling/ promotion/ Distribution Cost R & D Cost
  5. 5. Classification of Cost 11/10/2016 5NHU 501 Dr N R Kidwai, JIT Barabanki Cost According to Management Decisions Differential Cost Marginal Cost Opportunity Cost Replacement Cost Imputed Cost Sunk Cost Marginal Cost is the cost added by producing one extra unit of a product. Differential cost is the difference between the cost of two alternative decisions opportunity cost refers to a benefit that could have been, but not received due to choosing other alternative. Sunk cost: is the cost of abandoned plant less salvage value. Not relevant for decision making Imputed Cost or Notional Cost :Actually not incurred (interest on own capital, rent on owned building, etc.) but taken into account in capital budgeting decisions. Replacement Cost : Cost of replacing equipment at current market price.
  6. 6. Classification of Cost 11/10/2016 6NHU 501 Dr N R Kidwai, JIT Barabanki Cost According to Expenses Direct Cost Indirect Cost • Physical assets • Maintenance and operating costs • Materials • Direct labor • Scrapped and reworked product • Direct supervision of personnel • Utilities • IT systems and networks • Purchasing • Management • Taxes • Legal functions • Warranty and guarantees • Quality assurance • Marketing and publicity
  7. 7. Cost Estimation 11/10/2016 7NHU 501 Dr N R Kidwai, JIT Barabanki Cost Estimation : is finding relationship between activities and cost Cost estimation is done to • Manage cost • Making cost decisions • Plan and set standards Cost estimation results in reduced costs
  8. 8. Cost Estimation: simple model 11/10/2016 8NHU 501 Dr N R Kidwai, JIT Barabanki • This model ignores other cost behaviours and other cost drivers • This model only takes into account the fixed and variable cost TC=F+ Q.V Where TC= Total cost F =Fixed cost Q =Quantity produced V = Variable cost per unit Total Cost TC Fixed Cost F Variable Cost V Quantity Q Cost
  9. 9. Cost Estimation: Unit Method NHU 501 Dr N R Kidwai, JIT Barabanki15-7 • Unit method is Commonly used for preliminary stage estimates • Total cost estimate TC is per unit cost (CU) times number of units (N) TC=Cu × N Example • Cost to operate a car at Rs 5/Km for 500 km: TC = 5 × 500 = Rs 2500/- • Cost to build a 100 m2 house at Rs 3000/m2: TC=3000× 100 = Rs 3 lac Cost factors must be updated time to time In case of several cost components, cost estimate components are added to determine total cost estimate 11/10/2016
  10. 10. Cost Estimation: Cost Indexes NHU 501 Dr N R Kidwai, JIT Barabanki15-8 Cost Index is ratio of cost today to cost in the past • It Indicates cost changes over time & account for inflation • Index is dimensionless • WPI (Wholesale Price Index) is a good example Cost estimate using index can be made as        0 0 I I CC t t ,at timeateindex valu,at timecost t,mepresent tiateindex valut,mepresent tiatcostestimated where 0000 tItC IC tt   11/10/2016
  11. 11. Cost Estimation: Cost-Capacity Equation NHU 501 Dr N R Kidwai, JIT Barabanki15-12 Cost Capacity equation is also called power law and sizing model Where C1= Cost at capacity Q1 C2= Cost at capacity Q2 Exponent x defines relation between capacities If x = 1, relationship is linear x < 1, economies of scale (larger capacity is less costly than linear) x > 1, diseconomies of scale x Q Q CC        1 2 12 11/10/2016
  12. 12. Cost Estimation: Cost-Capacity Combined with Cost Index NHU 501 Dr N R Kidwai, JIT Barabanki15-13 Example: A 1 hp water pump cost was Rs 3000 five years ago when the cost index was 120. Estimate the cost of a 2 hp water pump today when the cost index is 250. The exponent for a 1 hp motor pump is 0.9. Solution: Let C2 represent the cost estimate today C2 = 3000(2/1)0.9(250/120) = Rs 11,663/- Cost-capacity equation can be combined cost index (It/I0) to adjust for effect of time (inflation)              00 0 I I Q Q CC t x t t 11/10/2016
  13. 13. Cost Estimation: Factor Method NHU 501 Dr N R Kidwai, JIT Barabanki15-14 • Factor method is especially useful in estimating total plant cost • Both direct and indirect costs can be included Total plant cost estimate TC is overall cost factor (h) times total cost of major equipment items (CE) TC = h × CE The cost factor is commonly the sum of a direct cost component and an indirect cost component, i.e h = 1 + Σfi , for i components, Example: A packaging machine is expected to cost 2 crore with installation. The cost factor for direct costs of machine in ready to operate condition is 0.45. A cost factor of 0.15 is used to cover indirect cost. What will the cost of the packaging machine ? Solution: h = 1 + 0.45 + 0.15 = 1.6 TC = 1.6*2 crore= 3.2 crore 11/10/2016
  14. 14. Cost Estimation: Indirect Costs NHU 501 Dr N R Kidwai, JIT Barabanki15-17 Indirect costs (IDC) are incurred in production, processes and service delivery that are not easily tracked and assignable to a specific function. Indirect costs (IDC) are shared by many functions because they are necessary to perform the overall objective of the company Indirect costs make up a significant percentage of the overall costs in many organizations – 25 to 50%. Few indirect cost examples • IT services • Quality assurance • Human resources • Management • Safety and security • Purchasing; contracting • Accounting; finance; legal 11/10/2016
  15. 15. Cost Estimation Approach 11/10/2016 15NHU 501 Dr N R Kidwai, JIT Barabanki Equipment and capital Recovery Direct material Direct labour Maintenance and operation Indirect Cost Direct Cost + + + + + Total Cost +Desired Profit Price Bottom Up Approach After Design stage
  16. 16. Cost Estimation Approach 11/10/2016 16NHU 501 Dr N R Kidwai, JIT Barabanki Equipment and capital Recovery Direct material Direct labour Maintenance and operation Indirect Cost Direct Cost + + + + + Total Cost +Desired Profit Price Bottom Up Approach After Design stage Equipment and capital Recovery Direct material Direct labour Maintenance and operation Indirect Cost Direct Cost + + + + + Target Cost +Allowed Profit Market Price Top down Approach: Design to cost Before design stage
  17. 17. Computation of Material Variances 11/10/2016 17NHU 501 Dr N R Kidwai, JIT Barabanki • Material Cost Variance(MCV) : Material cost variance is the difference between actual cost and standard cost. favourable material variance  actual cost < standard cost Unfavourable material variance  actual cost > standard cost direct material cost variance: MCV = (RSQ x SP) - (AQ x AP) where, revised standard quantity (RSQ) = (SQ/SO x AO) SQ = Standard Quantity, SO = Standard Output , AO = Actual Output SP = Standard Price, AQ = Actual Quantity, AP = Actual Price
  18. 18. Computation of Material Variances 11/10/2016 18NHU 501 Dr N R Kidwai, JIT Barabanki Example - Standard quantity of material Q for 400 units of output is fixed as 700 kg. - Standard price per kg. of material Q is estimated to be Rs 350/- - Actual quantity of material Q was 700 kg. - Actual price of material was Rs 315/kg. - Actual output was 300 units. Solution, Revised standard quantity (RSQ) = (SQ/SO) x AO =700/400 x 300 = 550 units. Material Cost Variance(MCV) =(SQxSP)-(AQxAP) =(550x350)-(700x315)= - 28000/- Since, the resulting figure is negative the variance is denoted as unfavourable
  19. 19. Break Even Analysis 11/10/2016 19NHU 501 Dr N R Kidwai, JIT Barabanki A decision maker needs to know which quantity should be sold before entity starts making the profit. Break even analysis determines whether a particular quantity of sales will result in profit or losses Total Cost TC Fixed Cost F Variable Cost V Quantity Cost Revenue Break even Quantity Q Steps of break even chart •Draw fixed cost line •Draw variable cost line •Draw Total cost line by adding the two •Draw Revenue line •The point of intersection of revenue line and total cost line is break even point
  20. 20. Break Even Analysis 11/10/2016 20NHU 501 Dr N R Kidwai, JIT Barabanki Example: Manufacturing of a engineering product requires fixed cost of Rs 42 lac for 1 lac quantity. Variable cost per product unit is Rs 30/- for material, Rs 15/- for labour, and Rs 5/- for other overheads. Selling price of the product is Rs 120/- Determine the quantity beyond which firm starts making profit (break even quantity) Fixed Cost = 50 lac Variable cost / unit = 30+15+5= Rs 50/- Total Cost = 4200000 + 50 x Q Revenue = 120 x Q Break even quantity B: 120 x B = 4200000 + 50 x B B = 60000
  21. 21. Break Even Analysis: Limitations 11/10/2016 21NHU 501 Dr N R Kidwai, JIT Barabanki Break even analysis make some assumptions •Selling price remains constant •Variable cost is proportional to quantity produced •Fixed cost remains constant •All quantity produced is sold These assumptions are not realistic mostly, and are limitations of breakeven analysis

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