Engineering Economics (ME 703)

Chapter 2 : (2080/02/12) 2nd Class

COST CONCEPTS AND BEHAVIOR

 2.1 Direct material costs

 2.2 Direct Labor costs
 2.3 Manufacturing overheads
 2.4 Non-manufacturing overheads
 2.5 Cost-volume analysis
Cost
concepts

Figure: Various types of manufacturing costs incurred by a

manufacturer
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 Costing
systems
Costing systems aim to report cost of products,
services in using the resources of the firms.
In engineering economics, the term cost is used in
many different ways.
 There are many types of costs, each is classified
differently according to the immediate needs of
management.
 E.g. engineers may want cost data to prepare external
reports, to prepare planning budgets, or to make
decisions.
 Also, each different use of cost data demands a different
classification and definition of cost.
 E.g. the preparation of external financial reports requires
the use of historical cost data, whereas decision
making may require current cost data or estimated
future cost data.

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 Manufacturing
costs
• In converting raw materials into finished
goods, a manufacturer incurs various costs
associated with operating a factory.
 Most manufacturing companies
manufacturing cost divided into three
categories:
– Direct raw material costs,
– Direct labour costs,
– And manufacturing overhead

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• Direct raw materials are any materials
that are used in the final product and that
can be easily traced into it.
• E.g. wood in furniture, steel in bridge
construction, paper in printing firms, and
fabric for clothing manufacturers.
• Finished product of one company can
become the raw materials of another
company. For example, the computers chips
produced by Intel are a raw materials used
by Dell Computer in its personal computers
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 2. Direct labor
costs
• Direct labor incurs costs that go into the
production of a product.
• E.g. labor costs of assembly-line workers,
labor costs of welders in metal-fabricating
industries, carpenters or bricklayers in
home building, and machine operators in
various manufacturing operations.

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 3. Manufacturing
overheads
• The third element of manufacturing cost,
include all costs of manufacturing except the costs
of direct materials and direct labor.
• Not easily traceable to specific units of output.
• E.g. costs of indirect materials; indirect labor;
maintenance and repairs on production equipment;
heat and light; property taxes, depreciation, and
insurance on manufacturing facilities; and overtime
premiums.
• Sometimes it may not be worth the effort to trace
the costs of materials that are relatively
insignificant in the finished products. Materials
such as solder and glue(indirect materials).

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 4. Non-manufacturing
overheads
2.4 Non Manufacturing Costs
• Two additional costs incurred in supporting any
manufacturing operation are
1. Marketing or selling costs and
2. Administrative costs
• Overhead: heat and light, property taxes and
depreciation or similar items associated with the
company’s selling and administrative functions.
• Marketing: advertising, shipping, sales travel, sales
commissions, and sales salaries. Marketing cost
include all executive, organizational and clerical costs
associated with sales activities.
• Administrative functions: executive compensation,
general accounting, public relations, and secretarial
support, associated with the general management of
an organization.
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 Classifying costs for financial
statements
Types of Cost for Financial Statements
• For purpose of preparing financial statements, we often
classify costs as either period costs or product costs
• Period costs: cost charged to expense in the period in
which they are incurred.
– Assumption is that associated benefits are received in the
same period the cost is incurred.
– E.g. all general and administrative expenses, selling
expenses and insurance and income tax expenses.
Therefore, advertising costs, executive’s salaries, sales
commissions, public-relations costs and other non-
manufacturing costs discussed earlier would all be period
costs.
– Not related to the production and flow of manufactured
goods, but are deducted from revenue in the income
statement. In other words, period costs will appear on the
income statement as expenses during the time in which
they occur.
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 Classifying costs for financial
statements
• Product costs: Some costs are better matched
against products than they are against periods.
– Consist of the costs involved in the purchase or
manufacture of goods.
– In the case of manufactured goods, product costs
are the costs of direct materials, direct labor costs,
and manufacturing overhead. Product costs are not
viewed as expenses; rather they are the cost of
creating inventory. Thus, product costs are considered
an asset until the associated goods are sold. At the
time they are sold, the costs are released from
inventory as expenses (typically called cost of goods
sold) and matched against sales revenue.
– Since product costs are assigned to inventories, they
are also known as inventory costs.

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 Classifying costs for financial
statements
How the period costs and product costs flow
through financial statements from manufacturing
floor to sales.

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 Classifying costs for financial
statements
Cost flows and classifications in a manufacturing
company.

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Classifying costs for financial
statements

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 Classifying costs for financial
statements
Solution:
Product costs: cost incurred in preparing 185,000 ice
cream cones per year.

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 Classifying costs for financial
statements
Period costs: cost incurred in running the shop
regardless of sales volume.

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 Costing
system
• Job costing system
In this system, the cost of a product of service is
obtained by assigning costs to a distinct,
identifiable product or service.
• Process costing system
In this system, the cost of a product or service is
obtained by assigning costs to a masses of
similar units and then calculating unit costs on
an average basis.

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 Dev. Of Selling Price of Product
Profit Selling Price
Selling & Total Cost
Distribution
Cost

Administrative Production/
& Manufacturing
Profit Selling Price
Miscellaneous Cost

Factory Factory Cost

Overhead
or factory
oncost
Direct Prime Cost
Material Cost
Direct Labor
Direct
expenses
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1) Prime Cost=DM+DL+DE
2) Factory Cost=Prime Cost + Factory OH
3) Mfg. Cost= Factory Cost +Administrative
Expenses
4) Total Cost = Mfg. Cost+ Selling
Expenses + Distribution Cost
5) Selling Price= Total Cost +Profit Added

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Q1. The catalogue price of drilling machine
is Rs.6000 and the discount allowed to the
distributor is 20%. The administrative and
selling expenses are 50% of the factory cost
and the material cost , labor cost and factory
overhead are in the ratio of 1:3:2.If the cost
of labour on the manufacture of the machine
is Rs . 1200 determine the profit on each
machine.

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Solution:
Catalogue price on each drilling machine = Rs. 6000
The SP of each drilling m/c on distributers
= 6000*(100-20)/100= Rs. 4,800
Direct Labor cost =1,200
DM:DL:Factory Overhead=1:3:2
DM cost= 1,200/3=400
Factory Overhead=1,200x2/3=800
Factory Cost=Prime Cost +Factory OH
=400+1,200+800=2,400
Total Cost of each m/c=Factory cost+ Adm. &
Selling Expenses=2,400+(2,400x50/100)=Rs.3,600
Therefor Profit on each drilling machine
= Rs. 4,800-Rs. 3,600=Rs. 1,200
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Q2. A certain piece of work is produced by a
firm in batches of 100. The direct material
cost for that 100 pieces work is Rs 16000
&the direct labor Cost is Rs 20000. Factory
on cost is 35% of total material and labor
cost. Overhead charges are 20% of the
factory cost. Calculate prime cost and
factory cost. If the management wants to
make a profit of 10% on the gross cost,
determine the selling price of each article.
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Solution: No. of products to be manufactured =100
DM cost =16000
DL cost =20000
Hence Prime Cost=DM+DL=36000
Factory On Cost =36000x35/100=12,600
Factory Cost = Prime Cost + Factory On Cost
=36000+12600=48600
As overhead charges are 20% of the factory cost
Overhead Cost =48,600x20/100=9720
Total Cost=Prime Cost+Factory On Cost + Overheads
=36000+12600+9720=Rs. 58,320
Now Management want profit of 10% on the gross i.e. total Cost
Hence Selling Price of 100 Pieces =110x58320/100=Rs. 64,152
Hence S.P. of each article =64,152/100= Rs. 641.52

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 5. Cost volume
• analysis
In engineering economic analysis, we need to
predict how a certain cost will behave in response to a
change in activity.
– For example, a manager will want to estimate the impact of
5% increase in production will have on the company’s total
wastages, before a decision to alter production is made.
• Cost behavior describes how a cost item will react or
respond to changes in the level of business activity.
The unit of measure used to define “volume” is called
a volume index.
– A volume index may be based on production inputs, such
as tons of coal processed, direct labor hours used, or
machine- hours worked; or it may be based on production
outputs, such as number of kilowatts-hours generated. For
a vehicle, the number of KM/Miles driven per year may be
used as a volume index.

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 5. Cost volume
analysis
• Cost driver
– Any factor that affects costs is called cost driver.
• Variable cost
– It is a cost that changes in total in proportion to changes in a cost
driver.
• Fixed cost
– It is a cost that does not change in total despite changes of a cost
driver.
• Capitalized cost
– A cost that is first recorded as an asset and then becomes an
expense
such as depreciation of machines, computer, equipment etc.
• Inventoriable cost
– Cost associated with purchase of materials and other
manufacturing inputs.
• Period cost
– A cost that is reported as an expense in a particular period.
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• Fixed costs: constant over a
wide range of activity Fixed costs
• Fixed Cost donot change within
a given time period although
volume may change. eg annual
insurance premium, tax etc.
• For example, say that the rent
was $10,000 and 1,000 units
were made. Then you could
argue that it takes
$10 rent to make a unit
($10,000/1,000).
• If, however, 10,000 units were
made, the rental cost per unit
would be only $1
($10,000/10,000). Higher
production volumes are making
better use of the fixed resource.
Source: http://opentuition.com/fia/ma1/cost-
classification/

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• Variable cost: these are
directly proportional
to the level Variable cost
of activity.
• If the number of units
produced doubles, then
variable production
costs will double also.
An example would be
the cost of material
used to produce units.
• If the number of units
sold increases by
20% then variable
selling and
distribution costs
would increase by
Source:
20% also. http://opentuition.com/fia/ma1/cost-
classification/

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 5. Cost volume
analysis
• Fixed cost: A cost that remains constant,
regardless of any change in a company’s activity.
– E.g. the annual insurance premium, property tax,
license fee, rent, wages are fixed costs, since they are
independent of the number of kilometers driven per
year, building rents; depreciation of buildings,
machinery and equipment; and salaries of
administrative and production personnel.
• Variable cost: A cost that changes in proportion to
a change in a company’s activity or business.
– E.g. Petrol is a good example of variable automobile
cost, because fuel consumption is directly related to
miles driven. Similarly, the cost of replacing tires will
increase as a vehicle is driven more.
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 5. Cost volume
analysis
• Mixed cost: Costs are fixed for a set level of
production or consumption, becoming variable after
the level is exceeded.
– E.g. In automobile example, depreciation (loss of value)
is a mixed cost. On the one hand, some depreciation
occurs simply from the passage of time, regardless of how
many miles a car is driven, and this represents the fixed
portion of depreciation. On the other hand, the more miles
an automobile is driven a year, the faster it loses its market
value, and this represents the variable portion of
depreciation.
– A typical example of a mixed cost in manufacturing is the
cost of electric power. Some components of power
consumption, such as lighting, are independent of the
operating volume, while other components (e.g. the
number of machine-hours equipment is operated) may vary
directly with volume.

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 5. Cost volume
analysis
• Average unit cost: We often use the term
average cost to express activity cost on a per
unit basis. In terms of units costs, the
depreciation of cost is quite different.
– Variable cost per unit of volume is a constant.
– Fixed cost per unit varies with changes in
volume. As the volume increases, the fixed cost
per unit decreases.
– Mixed cost per unit also changes as volume
changes, but the amount of change is smaller
than that for fixed costs.

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Average Total cost ATC=TC/Q
TC=ATC*Q
TC=FC+VC

• Average cost is total cost divided by

output; a common measure of cost per
unit.
• If the total cost of producing 25 units is
$100, the average cost would be
$100
AC   $4
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Average Fixed Cost =AFC=FC/Q
Or, FC= AFC*Q
Average Variable Cost =AVC=VC/Q
Or, VC= AVC*Q 29
• Marginal cost is the cost involved in producing
one more unit of product.
Marginal revenue is the revenue that can be
obtained from selling one more unit of product.
Cost
Change in TC
Marginal cost  MC 
Change in q
• The additional cost of producing one more
unit of output is marginal cost.
• If the cost of producing 24 units is $98 and
the cost of producing 25 units is $100, the
marginal cost of the 25th unit is $2.

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Relation Between AFC, AVC,ATC & MC

. MC

Quantity
5. Cost volume
analysis

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5. Cost volume
analysis

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5. Cost volume
analysis

42
 5. Cost volume
analysis(incremental) costs
Differential
Costs that represent differences in total costs, which
results from selecting one alternative instead of
another.

Opportunity costs
These costs are the benefits obtained by following
other courses of action.
– For example, suppose you have a part-time job that
pays you $200 per week while attending college. You
would like to spend a week at the beach during spring
break, and your employer has agreed to give you the
week off. What would be the opportunity cost of taking
the time off to be at the beach? The $200 is lost
wages would be an opportunity cost.

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 5. Cost volume
• Sunk costs are past costs not relevant to decisions
analysis
because they cannot be changed no matter what actions
are taken.
• Suppose that you have a very old car that requires frequent repairs. You
want to sell the car, and figure that the current market value would be
about $1,200 at best. While you are in the process of advertising the
car, you find that the car’s water-pump is leaking. You decided to have
the water-pump repaired, which cost you $200. A friend of yours is
interested in buying your car, and has offered $1,300. Would you take
the offer? Or, decline the offer simply because you cannot recoup the
repair cost with that offer. In this example, the $200 repair cost is a sunk
cost. You cannot change this repair cost whether or not you keep the
car. Since your friend’s offer is $100 more than the best market value, it
would be better to accept the offer.

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32
33
Break Even Analysis
Sales Total Revenue

Angle of Incidence Total Cost

Margin of Safety

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 BE Analysis with Example

Product X Sales Table: SP=Rs.4, VC = Rs. 1.5 & FC=6,000

Items (Units) 0 1000 2000 3000 4000
Output
TR= (SP*Q) 0 4000 8000 12000 16000
TVC= (VC*Q) 0 1500 3000 4500 6000
TFC 6000 6000 6000 6000 6000
TC=TVC+TFC 6000 7500 9000 10500 12000
Profit/Loss (6000) (3500) (1000) 1500 4000

BEP=F.C./(S-V)=6000/(4-1.5)=2400 Units
BEP at Sales= 2400x4=9,600

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The break-even analysis is based on the following set of
assumptions:
i. The total costs may be classified into fixed and variable
costs.
ii. The cost and revenue functions remain linear.
iii. The price of the product is assumed to be constant.
iv. The volume of sales and volume of production are equal.
v. The fixed costs remain constant over the volume under
consideration.
vi. It assumes constant rate of increase in variable cost.
vii. It assumes constant technology i.e. the efficiency of men &
machines remain constant.
viii. In the case of multi-product firm, the product mix is stable

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BEA Formula
Break Even Point Q = F.C./(S-V), No profit/loss
(S-V)= Contribution Per Unit
Total Revenue (TR)= Total Cost (TC)
= TFC + TVC at BEP (No Profit/Loss)
TR-VC= FC+ Profit (Desired Profit by Mgnt.)
QxS-QxV=FC+ Profit
Q(S-V)=FC + Profit
Q=(FC+Profit)/S-V
Profit Volume Ratio = Contribution*100/Sales
P/V= ((S-V)x100%)/Sales
Margin of safety=(Sales-Sales at BEP)*100/Sales
Margin of safety is the distance between the BEP and the
output being produced.
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Nu. Q3)Find BEP both in units and values. What
would be the effect on profit/loss when FC
increases by 20% & selling price decreases by
30%
F.C. = Rs. 30 Million
V.C.=Rs. 25,000 Per unit
S.P.= Rs. 50,000 Per unit

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Solution:
i)BEP=F.C./(S.P.-V.C.)=30000000/(50000-25000)
=1200 Units
Breakeven Cost=1200x50000=60000000
ii) New fixed cost = 20% of 30 Million= 36 Million
Selling price less 30%=50000-50000x30%=35,000
Sales (Total Revenue)-V.C.-F.C.= Profit/Loss
1200x35000-1200x25000-36000000=Profit/Loss
=-24000000
There would be loss when FC increases by 20% &
selling price decrease by 30%

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Home Assignment: Chapter 2
1. What do you understand by BEP? Describe the BEP with
suitable examples. What are the assumption made in Breakeven
analysis?
2. Describe the various elements of cost and explain how selling
price of the product is determined?
3. What do you understand by product cost and period cost in
financial statement? Explain the with proper flow diagram.
4. Explain the following terms with proper diagram: Average
Fixed Unit cost, Average Variable Unit cost, Average Total Unit
Cost and marginal Cost.
5. Write short notes on
a) Opportunity Cost b) Marginal Cost c) Sunk Cost d) Differential
Cost
Nu. Q4. An executive from a large
merchandising firm has called your vice-
president for production to get a price quote for
an additional 100 units of a given product. The
vice-president has asked you to prepare a cost
estimate. The number of hours required to
produce a unit is 5. The average labor rate is
Rs.12 per hour. The materials cost Rs.14 per unit.
Overhead for an additional 100 units is estimated
at 50% of the direct labor cost. If the company
wants to have a 30% profit margin, what should
be the unit price to quote?
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Solution Additional units ordered = 100
Labor cost = ($12)x(5)x(100) = $6,000
Material cost = ($14)x(100) = $1,400
Overhead cost = (50%) x($6,000) = $3,000
Total cost = $6,000 + $1,400 + $3,000 =
$10,400
Profit margin = (30%) ($10,400) = $3,120
∴ Unit price to quote = $10,400 + $3,120 =
$13,520 /100=$13.52
Nu. Q5. A concern is manufacturing a product which is sold for
Rs. 10.50 per unit and the fixed cost of the asset is Rs. 50,000 and
sets a variable cost of Rs. 6.50 per unit. How many units should
be produced to break even? How many units should be produced
to earn a profit of Rs. 10000? What would be the profit for sales
value of 20000 units?
Solution: F.C. =50000, VC=6.5, SP=10.50 Desired profit =10000
i)BEP (Q)=F.C./(S.P-V.C)=50000/(10.50-6.50)=12,500 Units
ii) Q(S-V)= F.C.+ profit
Q(10.50-6.50)=50000+10000
Q=15000 Units
iii) Profit for 20000 Units?
Q(S-V)=FC+Profit
Profit= Q(S-V)-FC
= 20000(10.50-6.50)-50000=Rs. 30,000

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Nu. Q6.Find BEP in units and BEP in sales if
Selling price =90 per unit
Variable Cost(Marketing)=8 per unit
Variable Cost (Mfg.) =50 per unit
Fixed Cost =96,000
Solution: Sales- VC- FC= Profit(=0 at BEP)
90Q-58Q-96000=0
Q= 3000 Unit
BEP in units=3000 Units
BEP in sales = 3000x90=Rs. 270,000
Nu. Q7. The Morton Company produces and sells two products: A and
B. Financial data related to producing these two products are
summarized as follows:
Des. Product A Product B

S.P. Rs. 10 Rs. 12

V.C. Rs. 5 Rs. 10

Fixed Cost Rs. 600 Rs. 2000

(a) If these products are sold in the ratio of 4A for 3B, what is the break-
even point?
(b) If the product mix has changed to 5A for 5B, what would happen to
the breakeven point?
(c) In order to maximize the profit, which product mix should be
pushed?
(d) If both products must go through the same manufacturing machine
and there are only 30,000 machine hours available per period, which
product should be pushed? Assume that product A requires 0.5 hour per
unit and B requires 0.25 hour per unit.
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Solution
a)Product mix that must satisfy: B = 0.75A)
Break-even formula:
Total revenue = Total cost: 10A + 12(0.75)A = 5A + 10(0.75)A + 2,600;
6.5A = 2,600; A = 400 units and B = 300 units
(b) 10A + 12A = 5A + 10A + 2,600; A = B=371.43 units
(c) Compute the marginal contribution rate (MCR) for each
product: Product A = $5, Product B= $2; with the
assumption (A > 0 and B > 0), more preference should be
given to product A
(d) Product A: MCR = $5 per unit; Production time = 0.5
hour per unit; profit per hour = $10
Product B: MCR = $2 per unit; Production time = 0.25 hour
per unit; profit per hour = $8
Conclusion: Product A is more profitable, so it should be
pushed first.
Nu. Q8. Bragg & Stratton Company manufactures a specialized
motor for chain saws. The company expects to manufacture and
sell 30,000 motors in year 2020. It can manufacture an additional
10,000 motors without adding new machinery and equipment.
Bragg & Stratton’s projected total costs for the 30,000 units are as
follows:
Direct Materials NRs. 150,000 Manufacturing overhead:
Direct labor NRs. 300,000 Variable portion NRs. 100,000
Selling and administrative costs: Fixed portion NRs. 80,000
Variable portion NRs. 180,000
Fixed portion NRs. 70,000

The selling price for the motor is NRs. 80. (a) What is the total
manufacturing cost per unit if 30,000 motors are produced? (b)
What is the total manufacturing cost per unit if 40,000 motors
are produced? (c) What is the break-even price on the motors?
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Solution:
(a) Total unit manufacturing costs if 30,000 units are
produced:
Total mfg. costs=$150,000+ $300,000 +$180,000=
$630,000
Unit cost =$630,000 / 30,000= $21
(b) Total unit manufacturing costs if 40,000 units are
produced:
Total mfg. costs =
$200,000+$400,000+$133,333+$80,000=$813,333Unit cost
=$813,333/40,000=$20.33
(c) Break-even price with 30,000 units produced:
Total cost =Mfg. cost + Selling & Admin.
=$630,000+$250,000=$880,000
Unit cost =$880,000/30,000=$29.33
Nu. Q.9 The data of an industrial units is as follow:
Fixed costs of assets=Rs. 24000, Sales price/unit=Rs. 10
Contribution for 8000 units = Rs. 16000
i)What is the sales volume for breakeven?
ii) What should be selling price if the breakeven quantity is to be brought down
to 10000 Units?
Given: FC=24000
Selling prices/Unit=Rs. 10
V= Variable cost perunit
Contribution per piece or unit =16000/8000=Rs. 2 Per unit
Now contribution= S-V=2
Or, 10-V=2
Variable cost per unit = Rs. 8
i)BEP= FC/(S.P-V.C.)=24000/(10-8)=12,000 Units
ii) Also BEP = 10000 Contribution per unit will be
Contribution Per Unit (S-V)= FC/Q=24000/10000=Rs. 2.40
So the sales price perunit = V+ Contribution/Unit
S=V+C=8+2.40= Rs. 10.40
Hence the selling price of BEP of 10000 units should be Rs. 10.40 perunit
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