Cost Analysis : Definition of Cost, Types of Cost and Cost-output Relationship

Cost Analysis

Contents :

Cost Analysis:

1. Cost Concept:i. Definition of Costii. Different types of Costsiii. Cost Control and Cost Efficiency• Cost-Output Relationship

2. Break Even Analysis:i. Meaning of BEAii. Determinants of BEPiii. Simple Problems on BEP

Introduction to Cost Analysis₹Cost is a major source for ‘Profit Maximization’

₹Cost is a main consideration for ‘Every Business Decision’

₹Cost is the matter for ‘Every Activity of Business’

₹Cost is a issue for acquisition of ‘Factors of Production’

₹Cost is subject for expansion of ‘Business Operations’

₹Cost is a weapon to fight with ‘Market Competition’

₹Cost is a question for ‘Success of a Technology’

₹Cost is significant to attain ‘Customer Satisfaction’

₹Cost is a foremost challenge to ‘Entrepreneurial Success’

₹Cost is an important aspect to ‘Managerial Economist’

Definition of Cost• Cost refers to the money incurred to produce a

particular product or service.

• All costs involve a sacrifice of some kind or other to acquire some benefit

• Cost incurred to perform all the activities of a business process where starting from purchase factors of production to selling of product in market.

• Cost is called as ‘Cost of Production’

• Cost of Production - ‘Total Cost of Business Activities’

Types of CostS.NO. COST CONCEPTS BASIS

1 Short Run Cost vs. Long Run Costs Time Factor

2 Variable Cost vs. Fixed Costs Degree of Variability

3 Opportunity Cost vs. Outlay Cost Nature of Sacrifice

4 Past Cost vs. Future Cost Degree of Anticipation

5 Separate Cost vs. Joint Cost Unit of Operation

6 Out of Pocket Cost vs. Book Cost Involvement of Cash flow

7 Incremental Cost vs. Sunk Cost Increasing level of Activity

8 Escapable Cost vs. Unavoidable Cost Degree of Compulsion

9 Controllable vs. Non-controllable Cost Degree of Controllability

10 Replacement Cost vs. Historical Cost Timing of Valuation

11 Urgent Cost vs. Postponable Cost Degree of Urgency

Cost-Output Relationship• Understanding the nature and behavior of costs is

must for regulation and control of cost of production.

• The cost of production depends on many forces and an understanding of the functional relationship of cost to various forces like Output is an important factor.

• It is to determine the optimum level of production.

• Cost-Output relation helps the manager in cost control, profit prediction, pricing, promotion etc.

• Cost function is C = f (S,O,P,T….n)

• Cost function is Cost – Output Relation

Cost-Output Relation• Total costs is the actual money spent to produce a

particular quantity of output. Total cost is the summation of Total Fixed and Variable cost

• Formula to calculate : TC = TFC + TVC

• Average Cost : AC = TC/Q

• Average Fixed Cost : AFC = TFC/Q

• Average Variable Cost : AVC = TVC/Q

• Marginal Cost (MC) is the addition to the total cost due to the production of an additional unit of product

• MC = Change in Total Cost / Change in Total Output

Cost-Output Relationship Units

of Output (Q)

Total Fixed Cost (TFC)

Total Variable

Cost (TVC)

Total Cost

(TC=TFC+TVC)

Average Fixed

Cost (AFC=TFC/Q)

Average Variable

Cost (AVC = TVC/Q)

Average Cost

(AC=TC/Q)

Marginal Cost (MC)

1 60 20

2 60 36

3 60 42

4 60 64

5 60 95

6 60 132

Graph: Cost-Output Relationship

MC

ATC

AVC

AFC

Graph: Cost-Output Relationship

MC

ATC

AVC

AFC

Average Fixed Cost (AFC) curve continues to fall as output rises an account of its spread over more and more units Output

Graph: Cost-Output Relationship

MC

ATC

AVC

AFC

Average Variable Cost (AVC) curve first falls and than rises due to the operation of the law of variable proportions

Graph: Cost-Output Relationship

MC

ATC

AVC

AFC

The behavior of ATC curve depends upon the behavior of AVC and AFC curve. Initial stage of production both AVC and AFC decline and hence ATC also decline still AFC =AVC. But after a certain point AVC starts rising so ATC also rise

Graph: Cost-Output Relationship

MC

ATC

AVC

AFC

ATC curve is U shaped because AVC starts increasing and AVC >AFC. The lowest point in ATC curve indicates the least-cost combination of inputs

Graph: Cost-Output Relationship

MC

ATC

AVC

AFC

Where ATC is minimum and the MC curve intersects AC curve. It is the point where per unit cost of production will be lowest.

Why Cost-Output Relationship

1. To determine Least Cost Combination of inputs

2. To understand the behavior of ATC curve, Why It is

U-Shaped

3. To know the affect of AVC curve on behavior of

ATC

4. To know where the total ATC is the minimum and

where the MC curve intersects ATC curve

THANK YOU