CHAPTER – 2

COSTS

ELEMENTS OF COSTS

Cost can be broadly classified into variable cost and overhead cost. Variable
cost varies with the volume of production while overhead cost is fixed,
irrespective of the production volume.
Variable cost can be further classified into direct material cost, direct
labour cost, and direct expenses.
The overhead cost can be classified into factory overhead, administration
overhead, selling overhead, and distribution overhead.
Direct material costs are those costs of materials that are used to produce
the product. Direct labour cost is the amount of wages paid to the direct
labour involved in the production activities. Direct expenses are those
expenses that vary in relation to the production volume, other than the
direct material costs and direct labour costs.
Overhead cost is the aggregate of indirect material costs, indirect labour
costs and indirect expenses.
Administration overhead includes all the costs that are incurred in
administering the business. Selling overhead is the total expense that is

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incurred in the promotional activities and the expenses relating to sales
force. Distribution overhead is the total cost of shipping the items from the
factory site to the customer sites.
The selling price of a product is derived as shown below:
(a) Direct material costs + Direct labour costs + Direct expenses = Prime
cost
(b) Prime cost + Factory overhead = Factory cost
(c) Factory cost + Office and administrative overhead = Costs of production
(d) Cost of production + Opening finished stock – Closing finished stock =
Cost of goods sold
(e) Cost of goods sold + Selling and distribution overhead = Cost of sales
(f) Cost of sales + Profit = Sales
(g) Sales/Quantity sold = Selling price per unit
In the above calculations, if the opening finished stock is equal to the
closing finished stock, then the cost of production is equal to the cost of
good

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 COSTS and REVENUES

Fixed costs
They are constant or unchanged regardless of the level of output or activity.
Fixed costs are costs that are independent of volume. Fixed costs tend to be
costs that are based on time rather than the quantity produced or sold by
your business.
Examples of fixed costs are rent and lease costs, salaries, utility bills,
insurance, and loan repayments. Some kinds of taxes, like business licenses,
are also fixed costs. Since you have to pay fixed costs regardless of how
much you sell. Fixed cost is often called overhead.

Variable cost
Variable costs are costs that change as the volume changes. Examples of
variable costs are raw materials, piece-rate labor, production supplies,
commissions, delivery costs, packaging supplies, and credit card fees. In
some accounting statements, the Variable costs of production are called
the “Cost of Goods Sold.”

Marginal Cost
Marginal cost of a product is the cost of producing an additional unit of
that product. Let the cost of producing 20 units of a product be $10,000,

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and the cost of producing 21 units of the same product be $10,045. Then
the marginal cost of producing the 21st unit is $45.

Marginal Revenue
Marginal revenue of a product is the incremental revenue of selling an
additional unit of that product. Let, the revenue of selling 20 units of a
product be $15,000 and the revenue of selling 21 units of the same product
be $15,085. Then, the marginal revenue of selling the 21st unit is $85.

Average cost
The total cost divide by the number of units used to attain and overall cost
picture of the investment on a per unit basis.

Sunk Cost
This is known as the past cost of an equipment/asset. Let us assume that an
equipment has been purchased for $100,000 about three years back. If it is
considered for replacement, then its present value is not $100,000. Instead,
its present market value should be taken as the present value of the
equipment for further analysis. So, the purchase value of the equipment in
the past is known as its sunk cost. The sunk cost should not be considered
for any analysis done from now onwards.

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Opportunity cost
It is the benefit that is forgone by ongoing a business resources in chosen
activity instead of engaging that same resources in the forgone activity. (a
business resources can be equipment; money; manpower or another
resources).

Example
Friends invited you to Europe. You calculated the cost of a month trip to be
$3000. You have the money and decide to go. By taking the trip; you give
up the opportunity to earn $2000 as a salary
True cost = $3000 + opportunity cost of $2000 = $5000.

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 BREAK-EVEN ANALYSIS

Break Even Analysis is a tool that helps a company to decide at which stage
the products or services provided by the company will start making profits.
To put it in simple language, it is a tool that will help a company decide
how many products or services they should sell to cover the costs.

The main objective of break-even analysis is to find the cut-off production

volume from where a firm will make profit. Let
s = selling price per unit
v = variable cost per unit
FC = fixed cost per period
Q = volume of production
The total sales revenue (S) of the firm is given by the following formula:
𝑆 =𝑠 ×𝑄
The total cost of the firm for a given production volume is given as
TC = Total variable cost + Fixed cost
𝑇𝐶 = 𝑣 × 𝑄 + 𝐹𝐶
The linear plots of the above two equations are shown in Fig. 1.3. The
intersection point of the total sales revenue line and the total cost line is
called the break-even point.
The corresponding volume of production on the X-axis is known as the
break-even sales quantity.

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At the intersection point, the total cost is equal to the total revenue.
This point is also called the no-loss or no-gain situation.
For any production quantity which is less than the break-even
quantity, the total cost is more than the total revenue. Hence, the firm
will be making loss.

For any production quantity which is more than the break-even

quantity, the total revenue will be more than the total cost. Hence, the
firm will be making profit.

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 Revenue = Sales price per unit X quantity

𝑠𝑒𝑙𝑙𝑖𝑛𝑔 𝑝𝑟𝑖𝑐𝑒
𝑆𝑎𝑙𝑒𝑠 = 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 = ×𝑄
𝑢𝑛𝑖𝑡

Profit = Sales – (Fixed cost + Variable costs)

𝑃𝑟𝑜𝑓𝑖𝑡 = 𝑠 × 𝑄 − (𝐹𝐶 + 𝑣 × 𝑄 )

The formulae to find the break-even quantity and break-even sales quantity

𝑓𝑖𝑥𝑒𝑑 𝑐𝑜𝑠𝑡
𝐵𝑟𝑒𝑎𝑘 − 𝑒𝑣𝑒𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 =
𝑠𝑒𝑙𝑙𝑖𝑛𝑔 𝑝𝑟𝑖𝑐𝑒 𝑣𝑎𝑟𝑖𝑏𝑙𝑒 𝑐𝑜𝑠𝑡
−
𝑢𝑛𝑖𝑡 𝑢𝑛𝑖𝑡

𝐹𝐶
𝐵𝑟𝑒𝑎𝑘 − 𝑒𝑣𝑒𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 =
𝑠−𝑣

Contribution per unit = Sales price per unit – Variable cost per unit
Contribution per unit = 𝑠 − 𝑣

𝑓𝑖𝑥𝑒𝑑 𝑐𝑜𝑠𝑡 𝑠𝑒𝑙𝑙𝑖𝑛𝑔 𝑝𝑟𝑖𝑐𝑒

𝐵𝑟𝑒𝑎𝑘 − 𝑒𝑣𝑒𝑛 𝑠𝑎𝑙𝑒𝑠 = ×
𝑠𝑒𝑙𝑙𝑖𝑛𝑔 𝑝𝑟𝑖𝑐𝑒 𝑣𝑎𝑟𝑖𝑏𝑙𝑒 𝑐𝑜𝑠𝑡 𝑢𝑛𝑖𝑡
−
𝑢𝑛𝑖𝑡 𝑢𝑛𝑖𝑡

𝐹𝐶
𝐵𝑟𝑒𝑎𝑘 − 𝑒𝑣𝑒𝑛 𝑠𝑎𝑙𝑒𝑠 = ×𝑠
𝑠−𝑣

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EXAMPLE
Alpha Associates has the following details:
Fixed cost = $2000000
Variable cost per unit = $100
Selling price per unit = $200
Find
(a) The break-even sales quantity,
(b) The break-even sales

Solution
Fixed cost (FC) = $2000000
Variable cost per unit (v) = $100
Selling price per unit (s) = $200

𝐹𝐶
𝐵𝑟𝑒𝑎𝑘 − 𝑒𝑣𝑒𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 =
𝑠−𝑣

2000000
𝐵𝑟𝑒𝑎𝑘 − 𝑒𝑣𝑒𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 = = 20,000 𝑢𝑛𝑖𝑡𝑠
200 − 100

𝐹𝐶
𝐵𝑟𝑒𝑎𝑘 − 𝑒𝑣𝑒𝑛 𝑠𝑎𝑙𝑒𝑠 = ×𝑠
𝑠−𝑣

2000000
𝐵𝑟𝑒𝑎𝑘 − 𝑒𝑣𝑒𝑛 𝑠𝑎𝑙𝑒𝑠 = × 200 = $4000000
200 − 100

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Example

Company Bag Ltd. produces and sells the bags in the market and wants to
conduct the break-even analysis of its business. The accountant in charge
of the company determined that the fixed cost of the company consisting
of salaries of the employees, rent cost, property tax, etc. will remain the
same at $ 1,000,000. The variable cost, which is associated with the
production of one unit of the bag, will come to $ 20. The bag is sold in the
market at a premium price of $ 120. Prepare the break-even chart for
Company Bag Ltd.
Solution:
Given,
 Fixed Cost: $ 1,000,000
 Variable cost: $ 20 per unit
 Sales price: $ 120 per unit
 Contribution per unit = Sales price per unit – Variable cost per unit
 Contribution per unit = $ 120 – $ 20
 Contribution per unit = $ 100
Break-Even Quantity = (Fixed Cost / Contribution per Unit)
Break-Even quantity = ($ 1,000,000 / $ 100)
Break-Even Quantity = 10,000 units
It shows that the company Bag Ltd. would be required to sell the 10,000
units of bags to achieve the break-even at the given fixed cost, selling price,
and the variable cost of the bag.

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Graphical Representation of Break-Even Chart
Below is the Break even chart for the above example of bag ltd:

Total Cost
Total Revenue
No of Fixed Cost Total Variable
Units (Q) (FC) Cost (v x Q) (Total Variable +
(s X Q)
Fixed cost)

0 $1,000,000.00 $0.00 $1,000,000.00 $0.00

2000 $1,000,000.00 $40,000.00 $1,040,000.00 $240,000.00

4000 $1,000,000.00 $80,000.00 $1,080,000.00 $480,000.00

6000 $1,000,000.00 $120,000.00 $1,120,000.00 $720,000.00

8000 $1,000,000.00 $160,000.00 $1,160,000.00 $960,000.00

10000 $1,000,000.00 $200,000.00 $1,200,000.00 $1,200,000.00

12000 $1,000,000.00 $240,000.00 $1,240,000.00 $1,440,000.00

14000 $1,000,000.00 $280,000.00 $1,280,000.00 $1,680,000.00

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Break-Even Chart

Analysis
Now, when the number of units sold exceeds the breakeven point of 10,000
units, then the company Bag Ltd. would be making profits on the goods
sold. As per the chart, when the green line of the revenue is greater than
the total costs red line after the 10,000 units produced and sold, then Bag
Ltd. would be making profits on the goods sold. Likewise, in case the
number of units sold is below 10,000 units, then the company Bag Ltd.
would be in loss.

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 Engineering Economics

Homework - 2

1. Define fixed cost; variable cost; marginal cost; opportunity cost;

sunk cost
2. What is the main objective of break-even analysis?
3. XYZ Company Ltd. has the following details:
Fixed cost = $4000000
Variable cost per unit = $300
Selling price per unit = $500
Find
(a) The break-even quantity
(b) The break-even sales
(c) Prepare the break-even chart
4 - Suppose XYZ Ltd is expecting to sell 10,000 units at a price of $10
each. The variable cost associated with the product is $5 per unit, and
the fixed cost is coming $15,000 per year. Do the break-even analysis
for the given case. Prepare the break-even chart.

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