Basic Cost Theories and Break Even Analysis, BEP

1. COST THEORIES
AN INTRODUCTION
Dr.M.Madhavan
Assistant Professor of Economics
Arignar Anna Government Arts College
Namakkal – 637 002, Tamil Nadu

2. Cost
The term cost of production means
“expenses incurred in the production
of a commodity. This refers the total
amount of money spent on the
production of a commodity”

3. Cost of production
Three different senses
 Money cost
 Real cost and
 Opportunity cost

4. Money Cost of Production
 Explicit Cost (Accountant point of view)
 Wages, interest, rent depreciation charges on
fixed capital, taxes paid and other sundry
expenses come under this cost.
 Implicit Cost
 Wages for the work performed by the entrepreneur.
 Interest on the capital supplied by him
 Rent of land and buildings belonging to the producer
and used in production

5. Economic Cost & Profit
 Economic Costs = Explicit costs +
Implicit costs
 Economic profit = Total Revenue -
Economic costs.

6. Real Cost of Production
This is a subjective
concept. It expresses the
trouble, turmoil and sacrifices
involved in producing a
commodity. The efforts and
sacrifices of the factors or its
owners is the real cost.

7. Opportunity Cost or Alternative Cost
This means that the “cost of
using something in a particular
venture is the benefit forgone (or
opportunity lost) by not using it in
its best alternative use’. The
opportunity cost of any goods is the
next best alternative goods
sacrificed.

8. Commodity – A
Cost of Production = Rs. 10
Profit = Rs.5 ; Sales = 100 units
Profit = Rs.500
Cost of Production = Rs.10
Profit = Rs.3 ; Sales = 200 units
Profit = Rs.600
Opportunity Cost or Alternative Cost
Example

9. Cost – Output Relationship
 The cost of production of a
commodity depends on three factors,
which are variables. They are :
 Price paid for procuring the factor or
services of factors
 The output of the firm
 The time element involved, i.e., short
period or long period.

10. Fixed cost
Fixed costs : The fixed capital of
the firm, e.g., equipment, machinery,
land, buildings, insurance premium,
certain taxes and salaries of permanent
staff come with this class. When once
engaged, the factors can be used over a
period of time. Some economists include
opportunity cost in fixed costs.

11. Variable cost
The other inputs which are exhausted by a
single use, e.g., raw materials, fuel, etc.
In the long period all costs become variable.
Fixed costs of a firm are called supplementary
cost of production or overhead costs.
Variable costs are called prime cost of
production or direct costs. The total cost of a
business is the sum of its variable cost and
fixed cost of a particular level output.

12. Total Cost
TC = TFC + TVC
Where,
TC = Total Cost
TFC = Total Fixed Cost
TVC = Total Variable Cost
The Variable cost will increase with the
increase in output. So, the total cost will
increase with increase in output, as the
total variable cost will increase due to
increase in output.

13. Total Cost, Variable and
Fixed Costs Curves
TC
TVC
C
O
S
T
Output X
TFC
Y
O

14. Marginal Cost
Marginal cost may be defined as the addition made
to the total cost by the production of one additional
unit of output. This means marginal cost is the
addition to the total cost of producing n units
instead of n-1 units where n is any given number
MCn = TCn – TC n-1

15. MARGINAL COST
OUTPUT TOTAL COST MARGINAL COST
0 200 -
1 260 60
2 310 50
3 350 40
4 380 30
5 422 42
6 472 50
7 532 60
8 602 70

16. Marginal Cost Curve
M
A
R
G
I
N
A
L
C
O
S
T
MC
Y
0 OUTPUT X

17. Assumptions for Marginal Cost
 The law of variable proportion determines
the shape of the cost curve. If increasing
returns is in operation, the marginal cost
curve will be declining.
 The changes in the marginal cost is due to
the changes in the variable cost
 The price of the variable factor remains
constant as the firm expands its output.
Otherwise a change in factor price may
disturb our conclusions.

18. LAC – PLANT CURVES
P1
P2
P3
P4
P5SAC1
SAC2 SAC3
M1 M2 M3O
Y
X
OUTPUT
AC

19. LAC – CONSTANT RETURN
P1
P2
SAC1 SAC2 SAC3
M1 M2 M3O
Y
X
OUTPUT
AC
P3 LAC

20. LAC at Variable Return
Y
SAC 6
SAC 5
SAC 4
SAC 3
SAC 2
SAC1
LACA
V
E
R
A
G
E
C
O
S
T
O M1 M2 Output X

21.  The amount of money that the firm receives by the
sale of its output in the market is known as its
revenue.
 ♦ Total revenue TR = q * p
 ♦ Average revenue
TR TR
AR = P =
q q
 ♦ Marginal revenue
MRn = TRn – TRn-1
Revenue

22. BREAK – EVEN ANALYSIS
 Break-even analysis is a study of
costs, revenues and sales of a firm
and finding out the volume of
sales where the firm’s costs and
revenues will be equal. The Break-
even point is the zone of no-profit
and no-loss as the costs equal
revenues.

23. BEP in terms of Physical Unit
Output in
Units
Total Revenue
Price Rs.4/- per
unit
Total Fixed
Cost
Total
Variable Cost
Total Cost
0 0 300 0 300
100 400 300 300 600
200 800 300 300 600
300 1200 300 900 1200
400 1600 300 1200 1500
500 2000 300 1500 1800
600 2400 300 1800 2100

24. Break – Even Point
0
300
600
900
1200
1500
1800
2100
2400
2700
1 2 3 4 5 6 7
TR
TC
Loss
Zone
Profit
Zone
BEP

25. ALTERNATIVE METHOD FOR BEP
Total Fixed Cost
BEP =
Contribution Margin per unit
Contribution Margin = Selling price – AVC
300
BEP = = 300
4 - 3

26. BEP (in terms of Sales Value)
Total Fixed Cost
BEP =
Contribution Margin per unit (CM)
Total Revenue minus Total Variable Cost
CM =
Total Revenue
Rs.300
BEP = = Rs. 1200/-
0.25

27. BEP
Total Revenue ---- Rs. 1200/-
Total Cost ---- Rs.1200/-
(TFCRs.300+TVC Rs. 900)
Net Profit / Loss ----- NIL

28. Sl. No. Particulars Amount In Rs.
1. Salary for the Administrative Staffs 455600
2. Wages for the workers 1966000
3. Expenses on raw materials and accessories 3545000
4. Electricity 40000
5. Fuel for the generator 25000
6. Transportation 73000
7. Telephone Bill 12000
8. Security 10000
9. Maintenance 17000
10. Lodging facilities for the buyers & visitors 25000
11. Advertisement 700000
12. Rent for the Land & building 12000
13. Interest for the amount borrowed from ICICI 95500
14. Interest for capital supplied by the entrepreneur 125000
7101100Total
Lakshmi Narashima Garments is producing 25,000 Garments during the month of
August 2002. This includes 15,000 Mercerized T-Shirt and rests of them are polo
T-shirt. The selling price of mercerized T-shirt is Rs.549.95 and the Polo T-shirt is
Rs.175.75.Following is the details of expenditure for the month of August 2002
listed in the accountant book.
Calculate the Break – Even point of the firm as well as the profit earned during the
month of August 2002. Give your suggestion for the improvement and
modification to be made in the company.
PROBLEM

29. Sl. No. Particulars TOTAL COST FC VC
1. Salary for the Administrative Staffs 455600
2. Wages for the workers 1966000
3. Expenses on raw materials and accessories 3545000
4. Electricity 40000
5. Fuel for the generator 25000
6. Transportation 73000
7. Telephone Bill 12000
8. Security 10000
9. Maintenance 17000
10. Lodging facilities for the buyers & visitors 25000
11. Advertisement 700000
12. Rent for the Land & building 12000
13. Interest for the amount borrowed from ICICI 95500
14. Interest for capital supplied by the entrepreneur 125000
7101100 715100 6386000Total
AMOUNT IN RUPEES
FIXED COST AND VARIABLE COST IDENTIFICATION

30. BEP (in terms of Sales Value)
Total Fixed Cost
BEP =
Contribution Margin per unit (CM)

31. CALCULATION OF BEP
Total Revenue minus Total Variable Cost
CM =
Total Revenue
Mercerized T shirt = 15,000 X 549.95 = 8249250
Polo T shirt = 10,000 X 175.75 = 1757500
Total Revenue = 10006750
Total Variable Cost = 6386000
Total Fixed Cost = 715100

32. CALCULATION OF BEP
Total Revenue minus Total Variable Cost
CM =
Total Revenue
10006750 –6386000 3620750
CM = = = 0.362
10006750 10006750
TOTAL FIXED COST 715100
BEP = = = Rs. 1975414.364
CM 0.362