Published on March 3, 2014
1 COST ANALYSIS Introduction: The managerial economist concerned with making , managerial decisions. Different business proposals are evaluated in terms of their cost and revenues. To know what costs are examined, it is necessary to understand what „cost‟ is and how to analyse the same. COST CONCEPT AND NATURE OF COST: Cost refers to the expenditure incurred to produce a particular product or service. All costs involve a sacrifice of some kind or other to acquire some benefit. Ex: If I want to eat food , I should be prepared to sacrifice money. Costs may be monetary, or non-monetary; tangible, or intangible; determined subjectively or objectively. Social cost such as pollution or noise; psychic costs such as frustration or dissatisfaction resulting from the stress and train of the modern industrial activities add another dimension to the cost concept. The cost of production normally includes the cost of raw materials, labour, and other expenses. This is known as total cost(TC). This is compared with the total revenue (TR) realized on the sale of the products manufactured. The difference between the total revenue and total cost is termed as profit. ( TR-TC = PROFIT) This is the financial accountant‟s interpretation of total cost, total revenue and profit. This may provide base for several legal purpose. In decision making, cost need to be analysed and in a wider perspective. Through this data for studying the costs is obtained from financial records. But some times the financial records may not provide the all the necessary information. But for business decision making we required usually all related information of costs of the business. To get such information we have to understood different or variations of the cost. The following are the possible variations or different types of the cost: Long-run Vs Short-run: Long run is defined as a period of adequate length during which a company may alter all factors of production with higher degree of flexibility. Long-run cost covers the cost of change in the size and kind of plant. Here perfect flexibility in the size of plant, labour force, executive talent and so on., Short-run is defined as the period relatively shorter when at least some of the factors of production are fixed. In the short-run it covers the costs associated with the variation in the utilization of fixed plant or other facilities. Degree of flexibility is lacking in the short-run. Fixed Vs Variable Costs: Variable costs are differentiated from the fixed costs based on the degree of their variability in relation to the rate of output. Fixed costs are those costs that are fixed in the short run. Whether the production is taken up or not, we have to incur certain expenses such as rent for factory and office buildings, insurance, telephone, electricity and so on. Variable costs are those costs that vary with the volume of production. Variable costs comprise the cost of raw materials, wages paid to the labour and soon. Semi-fixed or semi-variable costs: Semi-fixed or semi-variable costs refer to such costs that are fixed to some extent beyond which they are variable. Telephone charges or electricity charges from good example for this. If we have connection, we have to pay minimum charges. This is fixed charge. The more you use the facility, the more you have to pay. This is semi variable cost. Marginal cost: Marginal cost refers to „the additional cost incurred for producing an additional unit‟.it equals the change in the variable cost per unit. This change is due to a change in the level of output. Outlay Cost & Opportunity Cost : Outlay cost are those costs that involve cash outflow at sometime these are generally recorded in the books of account.
2 Ex: Actual wages paid, cost of materials purchases, interest paid etc., Opportunity Costs refer to the „costs of the next best alternative foregone‟ we have scarce resources and all these have alternative uses. It is the minimum possible alternative earning that might have been earned if the productive capacity& service has been put to some alternative use. Ex : - Rs. 10,00,000 can be invested in Bank Deposit : We can get an interest @ 6% per annum only. Multiple Funds : We can get an interest @ 9% per annum only. Any Business : We can get up to 30% interest on investment. Incremental Cost and Sunk Cost : Incremental cost is the Incremental costs are the „added cost due to a change in the level (or)nature of business activity‟. It is also called “differential cost” Ex :- Addition of a new product line, changing the channel of distribution, Adding a new Machine, Replacing a machine by a better machine, expansion into additional markets etc., it arises only when a change in contemplated in the existing business. Sunk costs are those costs that have already been committed in the past. They do not affected the current production. Ex : -Deprciation. A firm may have spent towards Rs 10,000 in connection with aproposal to purchase a new machinery at a price of Rs 1,00,000. Later, suppose, it is offered another machine, of equally good quality, for Rs 70,000 . the amount of Rs 10,000 spent in the connection with the first proposal is a sunk cost. Past and Future Costs : Past costs are those costs that have been spent already in the past.they are also called committed costs or historical costs. Future costs are those costs that will be spent in the future. And these have to be well ascertained now. Urgent and Postponable Costs : This classification based on the cost that have priority. Urgent costs those costs which must be incurred in order to continued operations of the firm are called as urgent costs. Ex:- the cost of materials and labour which must be incurred if production is to take place. Costs, which can be postponed at least for some time are known as postponable costs. Ex:- Maintenance relating to building & machines. Out-of Pocket and Book Costs : This distinction based on the traceability and variability with output. Out of pocket costs refer to costs that involve an immediate outflow of cash. These are spend in the day-to-day life of the business, such as purchase of raw materials, utility expenses, rent of the premesis occupied. It is also called explicit costs. Book cost are those, Such as depreciation do not require current cash expenditure. Book costs can be converted in to out-of-pocket costs by selling the assets and leasing them back from thec buyer. It is also called imputed costs. Ex : the rental payment then replaces the depreciation charge and interest cost of own capital. Escapable & Unavoidable Costs : Escapable costs refers to the costs can be saved by reducing the scale of operations to a lower level. Ex :- Closing Unprofitable Branch House. Reducing Credit Sales. Escapable cost are different from controllable and discretionary costs. Unavoidable costs are those that are essential for the substsance of the business activity and hence they have to be incurred.
3 Replacement and Historical Costs : Historical Costs means the costs that have been originally spent to acquire the assets. The financial statements are generally based on the historical costs. Ex: A plant price originally paid for it to acquire. Replacement cost means the costs that are to be paid currently if the asset were to be replaced. Ex: price that would have to be paid currently for acquiring same plant. In 1974, the cost of a machine Rs.15,000, but now 85,000. 15,000 – Historical Cost, 85,000 – Replacement Cost Controllable and Non-Controllable Costs : These costs can be classified as controllable or non-controllable depends upon the level of management. Some costs are not controlled by the shop level. A controllable cost may be defined as one which is responsible subject to regulation by the executive with whose responsibility that cost is being indentified. Thus a cost which is uncontrollable at one level of responsibility may be regarded as controllable at some other, usually higher level. Direct material, Direct Labour costs are usually controllable and an allocated cost is not controllable. Explicit Vs Implicit costs: Explicit costs involve payment of cash. the rent for the landlord, wages for the labourer, interest paid on the funds borrowed government taxes and so on. are the explicit costs. Implicit costs are also called imputed costs. Implicit costs do not involve payment of cash as they are not actually incurred. Example: Intrest on own character, saving in terms of salary due to own supervision, rent of own premises. Accounting Cost Vs Economic Cost: Accounting Cost refers to what are recorded as expenses in the books of accounting records. The Accountent recognizes the cost only when it is incurred and recorded as this necessarily forms the legal point of view. The economic cost recognized by the economist and managers those are other implicit cost that are never recorded in the books. But we must be considered in managerial decision making. Example: An Economist evaluates the investment proposals based on their returns after converting them to their present value. Separable Cost Vs Joint Cost: These costs are differentiated based on tracebility. The costs which can be traced or identified directly with a particular unit, department, or a process of production are called Separable Cost or Direct cost. Ex. Cost of raw materials used for a particular production process or product. Joint products arise from the production process the costs spent till the common process or split off point, are called common or Joint Cost. Example: Electricity power for running mechines. COST RECORDS AND SELECTION OF DATA: The classifying of costs is a primary exercise in the process of decision-making. Costs are to be viewed from different perspectives such as traceability, controllability, variability and so on,so that these different cost concepts can be made use of in decision-making. It is to be noted that different cost concepts are useful for different purposes. An understanding of the cost concepts will enhance the quality of managerial decisions.
4 Cost records in the standard format cannot provide information as required for each managerial decision. The accounting records, reports to the higher authorities such as Securities Exchange Board Of India(SEBI) and financial institutions, annual reports to shareholders and so forth, form the source of data. COST-OUTPUT RELATIONSHIP: The cost and output are related. The cost of production depends upon several factors such as volume of production; relationship between cost and output; prices and productivity of the inputs such as land, labour, capital and so forth, and the time scale. The cost-output relationship significantly differs in the short-run and in the long-run. It is because, in the short-run, the costs can be classified in to fixed costs and variable costs. The costoutput relationship in the short-run is governed by certain restrictions in terms of fixed costs. Whereas in the long-run , the cost-output relationship studies the effect of varying the size of plants upon its cost. Cost-output relationship facilitates many managerial decisions such as Formulating a rational policy on plant size and the standards of operation, Expense control, Profit prediction, Pricing, Promotion. COSTS IN THE SHORT-RUN Cost in the short-run are classified in to fixed costs and variable costs. The fixed costs may be ascertained in terms of total fixed cost and average fixed cost oer unit. The variable cost can be determined in terms of variable cost, total variable cost. The following table explains the behavior of costs in the short-run. Monthly Output (units) a Total Fixed Cost Rs. Total Variable cost Rs. c b Total cost RS. Average Fixed cost Rs. d=( +(c) b) e= (b)/(a) Average Variable cost Rs. f= (c)/(a) Average Marginal Total cost cost Rs. Rs. h g= (d)/(a) 0 100 0 100 ___ ____ 100 ___ 1 100 30 130 100 30 130 30 2 100 54 154 50 27 77 24 3 100 72 172 33.3 24 57.3 18
5 4 100 96 196 25 24 49 24 5 100 150 250 20 30 50 54 6 100 216 316 16.6 36 52.6 66 7 100 320 420 14.2 45.7 69.9 104 From the table, it is clear that: Total fixed costs remain fixed irrespective of increase or decrease in production activity. Average fixed cost per unit declines as the volume of production increases. The relationship between the fixed cost per unit and volume of production is inverse Fixed cost per unit =1/ Volume of production The total variable cost increases proportionately with production The total cost increases with the volume of production The average total cost decreases upto a certain level of production. After this level, it rises steeply. Marginal cost is the change in total cost resulting from a unit change in output. It also decreases up to a certain level of production but later it rises steeply. Graph: M.C Y Y S ATC AC MC AVC COST R AFC MC X MC < AC Y AC X Y MC AC AC = MC MC AC MC > AC X X From the above diagram it is noticed that as the output goes on increasing, average fixed cost curve(AFC) will continue to decrease. Hence AFC curve will slope downwards but it never touch X axis. The average variable cost (AVC) is U shaped curve denoting that the AVC curve tend to fall in the beginning when the output is increasing but after a particular level of output it rises because of the application of law of variable proportions or law of diminishing returns.
6 Average total cost(ATC) is the sum of AVC and AFC. This ATC curve seems to be closure to the AFC curve in the initial stages, after reaching the certain level of output it indicates the minimum output after that it rises and seems to be closure to AVC curve. Marginal cost curve is a U shaped curve. It falls in the beginning and rises sharply. The rising marginal cost curve will pass through the minimum point of the AVC and the minimum point of ATC at R and S respectively. COST IN THE LONG-RUN Long-run referes to the period of time over which all factors are variable. The firm has more time at it disposal to make any change in the production depending on its requirements. It can expand its production, enter into new markets, make necessary changes in the labour force, import technology. It has no constrains in terms of resources. It has no fixed costs. All costs are variable. A long-run is also expressed as a series of short-runs. It is already discussed that every short-run average cost curve is associated with a short-run. This further explains that the long-run is associated with a series of short-run cost curves. The long-run average cost curve(LAC) is flat U shaped curve enveloping a series of short-run average cost curves(SACs). It is tangential to all the SACs. The points of tangency represent minimum average cost in the long-run, not in the short-run. The U-shape implies that the cost of production continuous to the low till the firm reaches the optimum scale(Marginal Cost = Average Cost) beyond this level the cost of production increases. Graph: Y SA SA SA SA SA LAC Long-run average cost curve is of great utility for the entrepreneur to make decisions relating to expansion of the size of the firm. It helps to minimize the cost to the advantage of the firm. However, it is to be noted that the U-shaped LAC curve assumes away the technological progress. Optimum Size of the Firm: The term Optimum means the conditions that produce the best result where in the firm maximizes the profits per unit at minimum average cost. Optimum size is defined by experts as follows.
7 According to R. T. Bye, an Optimum firm is that organization of business enterprise which, in given circumstances of technology and the market for its products can produces its goods at the lowest average unit costs in the long-run. From the above definition, a firm is said to be an optimum size when it is in a position to utilize its resources, including technology, most efficiently. As a result of this the cost of production is the minimal and the productivity is very high. An understanding of optimum size of the firm will unable the entrepreneur or promoter to choose the right size of the firm in the setting up of project. Generally in every industry, there is an economic size of the firm. A firm can achieve optimum size in the long-run only when its long-run average cost(LAC) is the lowest. In the short-run, it can only ensure optimum utilization of given plant. Graph: Optimum Combination COST OUTPUT The optimum quantity of production is OQ at OC cost. The lowest point of LAC indicates the lowest cost of production. A firm must expand till it reach optimum size as it goes on reducing the average cost per unit. If the firm expands beyond optimum size it suffers from diseconomies of scale and the average cost will go on increasing. Cost – volume profit Analysis (or) B.E.P Analysis: COST or Profit Zone Revenue } Tr TC = TR P(BEP) TFC Loss Zone TVC Volume Production (or) Profit. X
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