Cost concepts

Fixed Costs (FC).The costs which dont vary with changing output. Fixed costs might include the cost of building a factory, insurance and legal bills. Even if your output changes or you dont produce anything, your fixed costs stay the same. In the above example, fixed costs are always 1,000.

Variable Costs (VC). Costs which depend on the output produced. For example, if you produce more cars, you have to use more raw materials such as metal. This is a variable cost.

Semi-Variable Cost.Labour might be a semi-variable cost. If you produce more cars, you need to employ more workers; this is a variable cost. However, even if you didnt produce any cars, you may still need some workers to look after empty factory.

Total Costs (TC) Fixed + Variable CostsMarginal Costs Marginal cost is the cost of producing an extra unit. If the total cost of 3 units is 1550, and the total cost of 4 units is 1900. The marginal cost of the 4th unit is 350.

Opportunity cost Opportunity cost is the next best alternative foregone. If you invest 1million in developing a cure for pancreatic cancer, the opportunity cost is that you cant use that money to invest in developing a cure for skin cancer.

Economic Cost. Economic cost includes both the actual direct costs (accounting costs) plus the opportunity cost. For example, if you take time off work to a training scheme. You may lose a weeks pay 350, plus also have to pay the direct cost of 200. Thus the total economic cost = 550.

Accounting Costs this is the monetary outlay for producing a certain good. Accounting costs will include your variable and fixed costs you have to pay.

Sunk Costs. These are costs that have been incurred and cannot be recouped. If you left the industry you cannot reclaim sunk costs. For example, if you spend money on advertising to enter an industry, you can never claim these costs back. If you buy a machine, you might be able to sell if you leave the industry.

Avoidable Costs.Costs that can be avoided. If you stop producing cars, you dont have to pay for extra raw materials and electricity. Sometimes known as an escapable cost.

ELEMENTS OF COST

There are broadly three elements of cost - (1) material, (2) labour and (3) expenses.:

The substance from which the product is made is known as material. It may be in a raw state-raw material, e.g., timber for furniture and leather for shoe, etc. It may j also be in manufactured state-components, e.g., battery for car, speaker for radio, etc, Materials can be direct and indirect.

Direct Material: All materials which become an integral part of the finished j product, the cost of which are directly and completely assigned to the specific physical units and charged to the prime cost, are known as direct material. The following are some of the materials that fall under this category:

(a) Materials which are specifically purchased; acquired or produced for a particular job, order or process.

(b) Primary packing material (e.g. carton, wrapping, cardboard, etc.)

(c) Materials passing from one process to another as inputs.

In order to calculate the cost of material, expenses such as import duties, dock charges, transport cost of materials are added to the invoice price.

Material considered direct at one time may be indirect on other occasion. Nail used in manufacturing wooden box is treated as direct material, but treated as indirect material when used to repair the factory building.

Indirect Material: All materials, which cannot be conveniently assigned to specific physical units, are termed as 'indirect material'. Such commodities do not form part of the finished products. Consumable stores, lubrication oil, stationery and spare parts for the machinery are termed as indirect materials.LabourHuman efforts used for conversion of materials into finished products or doing various jobs in the business are known as labour. Payment made towards the labour is called labour cost. It can also be direct and indirect.

Direct Labour: Direct labour is all labour expended and directly involved in altering the condition, composition or construction of the product. The wages paid to skilled and unskilled workers for manual work or mechanical work for operating machinery, which can be specifically allocated to a particular unit of production, is known as direct wages or direct labour cost. Hence, 'direct wage' may be defined as the measure of direct labour in terms of money. It is specifically and conveniently traceable to the specific products Wages paid to the goldsmith for making gold ornament is an example of direct labour.

Indirect Labour: Labour employed to perform work incidental to production of goods or those engaged for office work, selling and distribution activities are known as 'indirect labour'. The wages paid to such workers are known as 'indirect wages' or indirect labour cost.

Example: Salary paid to the driver of the delivery van used for distribution of the product.

ExpensesAll expenditures other than material and labour incurred for manufacturing a product or rendering service are termed as 'expenses'. Expenses may be direct or indirect.

Direct Expenses: Expenses which are specifically incurred and can be directly and wholly allocated to a particular product, job or service are termed as 'direct expenses'. Examples of such expense are: hire charges of special machinery hired for the fob, carriage inward, royalty, cost of special and specific drawings, etc. These are also known as 'chargeable expenses'.

Indirect Expenses: All expenses excluding indirect material and indirect labour, which cannot be directly and wholly attributed to a particular product, job or service, are termed as 'indirect expenses'. Some examples of such expenses are: repairs to machinery, insurance, lighting and rent of the buildings.

Job costingIt involves the detailed accumulation of production costs attributable to specific units or groups of units. For example, the construction of a custom-designed piece of furniture would be accounted for with ajob costingsystem. The costs of all labour worked on that specific item of furniture would be recorded on a time sheet and then compiled on acost sheetfor that job. Similarly, any wood or other parts used in the construction of the furniture would be charged to the production job linked to that piece of furniture. This information may then be used to bill the customer for work performed and materials used, or to track the extent of the company's profits on the production job associated with that specific item of furniture.Process costingIt is used when there ismass production of similar products, where the costs associated with individual units of output cannot be differentiated from each other. In other words, the cost of each product produced is assumed to be the same as the cost of every other product. Under this concept, costs are accumulated over a fixed period of time, summarized, and then allocated to all of the units produced during that period of time on a consistent basis. When products are instead being manufactured on an individual basis,job costingis used to accumulate costs and assign the costs to products. When a production process contains some mass manufacturing and some customized elements, then ahybrid costingsystem is used.Unit - III

Break-Even Analysis

The study of cost-volume-profit relationship is often referred as BEA. The term BEA is interpreted in two senses. In its narrow sense, it is concerned with finding out BEP; BEP is the point at which total revenue is equal to total cost. It is the point of no profit, no loss. In its broad determine the probable profit at any level of production.

Assumptions:1. All costs are classified into two fixed and variable.

2. Fixed costs remain constant at all levels of output.

3. Variable costs vary proportionally with the volume of output.

4. Selling price per unit remains constant in spite of competition or change in the volume of production.

5. There will be no change in operating efficiency.

6. There will be no change in the general price level.

7. Volume of production is the only factor affecting the cost.

8. Volume of sales and volume of production are equal. Hence there is no unsold stock.

9. There is only one product or in the case of multiple products. Sales mix remains constant.Merits:

1. Information provided by the Break Even Chart can be understood more easily then those contained in the profit and Loss Account and the cost statement.

2. Break Even Chart discloses the relationship between cost, volume and profit. It reveals how changes in profit. So, it helps management in decision-making.

3. It is very useful for forecasting costs and profits long term planning and growth

4. The chart discloses profits at various levels of production.

5. It serves as a useful tool for cost control.

6. It can also be used to study the comparative plant efficiencies of the industry.

7. Analytical Break-even chart present the different elements, in the costs direct material, direct labour, fixed and variable overheads.Demerits:

1. Break-even chart presents only cost volume profits. It ignores other considerations such as capital amount, marketing aspects and effect of government policy etc., which are necessary in decision making.

2. It is assumed that sales, total cost and fixed cost can be represented as straight lines. In actual practice, this may not be so.

3. It assumes that profit is a function of output. This is not always true. The firm may increase the profit without increasing its output.

4. A major draw back of BEC is its inability to handle production and sale of multiple products.

5. It is difficult to handle selling costs such as advertisement and sale promotion in BEC.

6. It ignores economics of scale in production.

7. Fixed costs do not remain constant in the long run.

8. Semi-variable costs are completely ignored.

9. It assumes production is equal to sale. It is not always true because generally there may be opening stock.

10. When production increases variable cost per unit may not remain constant but may reduce on account of bulk buying etc.

11. The assumption of static nature of business and economic activities is a well-known defect of BEC.

1. Margin of safety: Margin of safety is the excess of sales over the break even sales. It can be expressed in absolute sales amount or in percentage. It indicates the extent to which the sales can be reduced without resulting in loss. A large margin of safety indicates the soundness of the business. The formula for the margin of safety is:

Present sales Break even sales or

Margin of safety can be improved by taking the following steps.

1. Increasing production

2. Increasing selling price

3. Reducing the fixed or the variable costs or both

4. Substituting unprofitable product with profitable one.

2. Angle of incidence: This is the angle between sales line and total cost line at the Break-even point. It indicates the profit earning capacity of the concern. Large angle of incidence indicates a high rate of profit; a small angle indicates a low rate of earnings. To improve this angle, contribution should be increased either by raising the selling price and/or by reducing variable cost. It also indicates as to what extent the output and sales price can be changed to attain a desired amount of profit.

3. Profit Volume Ratio is usually called P. V. ratio. It is one of the most useful ratios for studying the profitability of business. The ratio of contribution to sales is the P/V ratio. It may be expressed in percentage. Therefore, every organization tries to improve the P. V. ratio of each product by reducing the variable cost per unit or by increasing the selling price per unit. The concept of P. V. ratio helps in determining break even-point, a desired amount of profit etc.

The formula is,

X 100

4. Break Even- Point: If we divide the term into three words, then it does not require further explanation.

Break-divide

Even-equal

Point-place or position

Break Even Point refers to the point where total cost is equal to total revenue. It is a point of no profit, no loss. This is also a minimum point of no profit, no loss. This is also a minimum point of production where total costs are recovered. If sales go up beyond the Break Even Point, organization makes a profit. If they come down, a loss is incurred.

1. Break Even point (Units) =

2. Break Even point (In Rupees) = X sales

DepreciationIt is the process of allocating the cost of an asset over its life rather than all at once with regard to tax deductions and is used by both large and small businesses. The Internal Revenue Code describes the depreciation deduction as a reasonable allowance for the exhaustion, wear, tear and obsolescence of business assets. There are several methods of depreciation but only two that are widely recognized by the IRS.

Straight-Line

The straight-line method is most commonly used method for calculating depreciation because it is the simplest. It can be used for any depreciable property except for those that are required to use accelerated depreciation methods by the IRS. Under the straight-line depreciation method, the basis of the asset deducted evenly over the assets useful life. Each year, the same amount of depreciation is claimed on a businesss tax return. Under Generally Accepted Accounting Principles (GAAP), the straight-line method is used for internal books. In general, the formula for straight-line depreciation equals the asset's depreciable basis--the original costs to purchase it--divided by its estimated longevity.

Accelerated

The Accelerated Cost Recovery System (ACRS) is a method for recovering the cost of personal and real property that has a shorter useful life such, as a computer or automobile. The Internal Revenue Service developed it under the Economic Recovery Tax Act of 1981, and modified it in 1986 (MACRS). The ACRS and MACRS rules were developed to encourage businesses to engage in capital investment more frequently. Different types of property accelerate at different rates according to IRS rules.

Declining Balance

As less common form of deprecation is declining-balance depreciation. This method offers a higher rate of depreciation during the earlier years of an assets life and is only useful for assets with a useful life longer than three years. Using the declining balance does not completely depreciate the asset; however, so the IRS lets you switch to the straight-line depreciation method once during the assets life.

Considerations

Except for the declining-balance method, the IRS requires that you use the same depreciation method as that used in the first year for the same item until its depreciation period has ended. In addition, all items of the same class depreciated in the same tax year must use the same method. Whatever rules or tables were in effect in the first year of depreciation must be used throughout the depreciation period. It is important, therefore, to keep accurate records regarding all asset depreciation items used as tax deductions.

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