Cost and Break Even Analysis

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CE2451 Engineering Economics

& Cost Analysis
Dr. M. Selvakumar
Associate Professor
Department of Civil Engineering
Sri Venkateswara College of Engineering
Objectives of this course
The main objective of this course is to make the Civil Engineering

student know about the basic law of economics, how to organize a
business, the financial aspects related to business, different
methods of appraisal of projects and pricing techniques. At the end
of this course the student shall have the knowledge of how to start a
construction business, how to get finances, how to account, how to
price and bid and how to assess the health of a project.
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Unit 2: Cost and Break Even Analysis

Types of costing traditional costing approach - activity base costing Fixed Cost variable cost marginal cost cost output relationship in
the short run and in long run pricing practice full cost pricing
marginal cost pricing going rate pricing bid pricing pricing for a rate
of return appraising project profitability internal rate of return pay
back period net present value cost benefit analysis feasibility
reports appraisal process technical feasibility economic feasibility
financial feasibility. Break even analysis - basic assumptions break
even chart managerial uses of break even analysis.
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Cost and Break Even Analysis

Unit 5
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Types of Costing
Costing - Definition
System of computing cost of production or of
running a business, by allocating expenditure
to various stages of production or to different
operations of a firm.
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Types of Costing
There are different types are used in cost
accounting.
Different types is used in different industries to
analyse and presenting for the purpose of
managerial decisions.
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Types of Costing
Marginal costing
Absorption costing
Standard costing
Historical costing
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MARGINAL COSTING
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Marginal Costing
In economics and finance, marginal cost is the
change in the total cost that arises when the
quantity produced has an increment by unit.
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Marginal Costing [MC] Curve
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Marginal Costing
That is, it is the cost of producing one more unit
of a good or commodity.
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Marginal Costing
For example, suppose it costs Rs.1000 to
produce 100 units and Rs.1020 to produce 101
units. The MC of the 101st unit is Rs.20.
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Uses of MC
To determine the optimum selling price where
company can achieve expected profit.
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Uses of MC cont
To check the effect of reducing of current price
on profit.
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Uses of MC cont
Choose of good product mix, for company
producing more than one product.
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ABSORPTION COSTING
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Absorption Costing
Absorption
costing
means
that
all
of
the manufacturing costs are absorbed by the

units produced.
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Absorption Costing
In other words, the cost of a finished unit
in
inventory
materials,
variable
will
direct
and
include
labor,
fixed
direct
and
both
manufacturing
overhead.
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Absorption Costing
As a result, absorption costing is also referred to
as full costing or the full absorption method.
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Absorption Costing
Absorption costing is often contrasted with
variable costing or direct costing.
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Absorption Costing
Under variable or direct costing, the fixed
manufacturing overhead costs are not allocated
or assigned to (not absorbed by) the products
manufactured.
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Absorption Costing
Variable
costing
management's
absorption
is
often
useful
decision-making.
costing
is
for
However,
required
for
external financial reporting and for income tax

reporting.
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STANDARD COSTING
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Standard Costing
Standard costs are usually associated with a
manufacturing
material,
direct
company's
labour,
costs
and
of
direct
manufacturing
overhead.
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Standard Costing
Rather than assigning the actual costs of direct
material,
direct
labour,
and
manufacturing
overhead to a product, many manufacturers

assign the expected or standard cost.
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Standard Costing
This means that a manufacturer's inventories
and cost of goods sold will begin with amounts
reflecting the standard costs, not the actual
costs, of a product.
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Standard Costing
As a result there are almost always differences
between the actual costs and the standard
costs,
and
those
differences
are
known
as variances.
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Standard Costing
If actual costs are greater than standard costs
the variance is unfavorable. An unfavorable
variance tells management that if everything
else stays constant the company's actual profit
will be less than planned.
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Standard Costing
If actual costs are less than standard costs the
variance is favorable. A favorable variance tells
management that if everything else stays
constant the actual profit will likely exceed the
planned profit.
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HISTORICAL COSTING
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Historical Costing
A measure of value used in accounting in
which the price of an asset on the balance sheet
is based on its nominal or original cost when
acquired by the company.
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Historical Costing
Based on the historical-cost principle most
assets held on the balance sheet are to be
recorded at the historical cost even if they have
significantly changed in value over time.
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Historical Costing
For example, say the main headquarters of a
company, which includes the land and building,
was bought for Rs.100,000 in 1925, and its
expected market value today is Rs. 20 million.
The asset is still recorded on the balance sheet
at Rs.100,000.
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How to arrive final cost of a

product/ service/ asset?
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TRADITIONAL COSTING APPROACH/

CONVENTIONAL APPROACH
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Traditional Costing Approach

The traditional method of cost accounting refers
to the allocation of manufacturing overhead
costs to the products manufactured.
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The traditional method assigns or allocates the
factory's
indirect
costs
to
the
items
manufactured on the basis of volume such as

the number of units produced, the direct labor
hours, or the production machine hours.
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By using only machine hours to allocate the
manufacturing overhead to products, it is
implying that the machine hours are the
underlying cause of the factory overhead.
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Traditionally, that may have been reasonable or
at least sufficient for the company's external
financial statements.
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ACTIVITY BASE COSTING (A.B.C)
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Activity Base Costing

Activity based costing (ABC) was developed to
overcome the shortcomings of the traditional
method.
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Instead of just one cost driver such as machine
hours, ABC will use many cost drivers to allocate
a manufacturer's indirect costs.
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A few of the cost drivers that would be used
under ABC include the number of machine
setups, the tones of material purchased or used,
the number of engineering change orders, the
number of machine hours, and so on.
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FIXED COST & VARIABLE COST

APPROACH
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Cost of Production
Short-run Total Cost
In the short run, one or more (but not all) factors of
production (land, labour, machinery and materials)
are fixed in quantity.
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Cost of Production
Total Fixed Cost (TFC) refers to total obligation
incurred by the firm per unit of time for all fixed
inputs. Total Variable Cost (TVC) are the total
obligations incurred by the firm per unit of time for
all variable inputs it uses.
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Cost of Production
i.e. Total Cost equal to TFC + TVC
Consider a hypothetical case for different quantities
(Q) of production as shown below:
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Cost of Production
Q
0
1
2
3
4
5
6
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TFC
60
60
60
60
60
60
60
TVC
0
30
40
45
55
75
120
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TC
60
90
100
105
115
135
180
50
25
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Cost of Production
200
150
Cost
TFC
100
TVC
TC
50
0
0
Quantity Produced
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Cost of Production
INFERENCE:
TFC are constant regardless of the level of output
TVC are zero, when the output is zero and rises
as output rises
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Cost of Production
INFERENCE:
At every output level, TC equals TFC+TVC. Thus,
the TC curve has the same shape as the TVC
curve but everywhere above by an amount equal to
TFC
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Cost of Production
Short-run Average Cost
Average Fixed Costs (AFC) equals to total fixed
cost divided by output. Average Variable Cost
(AVC) equals total variable costs divided by output.
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Cost of Production
Short-run Average Cost
Average Cost (AC) equals total cost divided by
output. AC also equals AFC+AVC. Marginal Cost
(MC) equals the change in TC or change in TVC
per unit change in output.
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Cost of Production
Q
TFC
TVC
TC
AFC
AVC
AC
60
30
90
60
30
90
60
40
100
30
20
50
10
60
45
105
20
15
35
60
55
115
15
13.75
28.75
10
60
75
135
12
15
27
20
60
120
180
10
20
30
45
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MC
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Cost of Production
Typical Cost Curve for Production
100
80
Cost
AFC
60
AVC
40
AC
MC
20
0
0
Quantity Produced
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Cost of Production
Marginal Cost (MC)
50
Cost
40
30
20
10
0
0
Quantity Produced
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Cost of Production
Note
MC schedules are plotted halfway between
successive levels of output
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Cost of Production
While AFC curve falls continuously as output is
expanded, the AVC, the AC and MC curves are Ushaped. The MC curve reaches the lowest point at
a lower level of output than either the AVC or AC
curve
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Cost of Production
The portion of MC intersects the AVC and AC at
their lowest points. This is so because whenever
extra or marginal amount added to total cost (or
variable cost) is less than the average of that cost,
the curve necessarily falls.
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Cost of Production
Conversely, whenever the marginal amount added
to TC (or TVC) is greater than the average of TC,
the average cost rises.
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Cost of Production
AVC = AC AFC
When
MC < AC
AC curve fall continuously
MC = AC Minimum AC
MC > AC AC starts rising
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Long Run Cost

Long-run is the time period long enough for a firm
to be able to vary the quantity used of all inputs.
Thus, in the long-run, there are no fixed factor and
hence no fixed cost and the firm can build any size
or scale of plant.
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Long Run Cost

The Long-run Average Cost (LAC) curve shows the
minimum per unit of cost of producing each level of
output when any defined scale of plant can be built.
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Long Run Cost

LAC is given by a curve tangential to all the shortrun average cost (SAC) curves representing all the
alternative plant sizes that the firm could built in the
long-run.
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25.0
Average Cost
20.0
SAC-1
15.0
SAC-2
SAC-3
10.0
SAC-4
5.0
0.0
0
10
12
14
Quantity
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Long Run Cost

If the firm expected to produce 2 units of output per
unit of time it would built the scale of plant given by
SAC-1 and operate it at point A where AC is 17.
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Long Run Cost

we could have drawn many more SAC curves in
the figure one for each alternative scales of plant
that the firm could built in the long run. By then
drawing a tangent to all these SAC curves, we
could get the LAC curve.
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Shape of Curve
While the SAC curve and the LAC curve have been
drawn as U-shaped, the reason for their shapes is
quite different.
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Shape of Curve
The SAC curves decline at first, but eventually rise
because of the LAW of Diminishing Marginal
Returns (resulting from the existence of fixed inputs
in the short-run)
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FULL COST PRICING
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Full Cost Pricing

It is a price-setting method in which you add:
direct material cost + direct labor cost + selling cost
+
administrative
costs
overhead
costs
+ markup percentage (profit) in order to derive the

price of the product.
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Full Cost Pricing

This method is most commonly used in situations
where products and services are provided based
on the specific requirements of the customer.
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Advantages Full Cost Pricing

It is simple
Likely to get profit
Justifiable
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MARGINAL COST PRICING
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Marginal Cost Pricing

Marginal cost pricing is the practice of setting the
price of a product at or slightly above the variable
cost to produce it.
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This situation usually arises in one of two
circumstances:
A company has a small amount of remaining
unused production capacity available that it
wishes to use; or
A company is unable to sell at a higher price
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The first scenario is one in which a company is
more likely to be financially healthy - it simply
wishes to maximize its profitability with a few more
unit sales.
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The second scenario is one of desperation, where
a company can achieve sales by no other means.
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GOING RATE PRICING
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Going Rate Pricing

Setting a price for a product or service using the
prevailing market price as a basis.
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Going Rate Pricing

Going
rate
pricing
is
with
homogeneous
common
products
with
practice
very
little variation from one producer to another, such

as aluminum or steel.
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BID PRICING
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Bid Pricing
Price offered by bidder (contractor, supplier,
vendor) for a specific good, job, or service,
and valid only for the specified period.
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PRICING FOR A RATE OF RETURN
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Pricing for a Rate of Return

Rate of return pricing is practiced by businesses
that set specific goals for the capital that they
spend and the revenue they wish to generate.
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A business can set prices to ensure that these
goals will be achieved.
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This method of pricing is most effectively achieved
when a company has little or no competition in the
market, since the actions of competitors will likely
affect the rate of return (monopolistic).
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APPRAISING PROJECT
PROFITABILITY
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Appraising Project
Profitability
Project appraisal is the process of assessing and
questioning
proposals
before
resources
are
committed.
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Appraising Project
Profitability
Project appraisal is the process of assessing and
questioning
proposals
before
resources
are
committed.
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Appraising Project
Profitability
Project appraisal helps project initiators and
designers to;
Be
consistent
and
objective
in choosing
projects
Make sure their program benefits all sections of

the community, including those from ethnic
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groups who have been
left out in the past
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Appraising Project
Profitability
Project appraisal helps project initiators and
designers to;
Provide documentation to meet financial and
audit requirements and to explain decisions to
local people.
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INTERNAL RATE OF RETURN
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Internal Rate of Return

IRR calculations are commonly used to evaluate the
desirability of investments or projects.
The higher a project's IRR, the more desirable it is to

undertake the project.
Assuming all projects require the same amount of up-front

investment, the project with the highest IRR would be
considered
the best and undertaken
first.
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Given a collection of pairs (time, cash flow) involved in a
project, the internal rate of return follows from the net
present value as a function of the rate of return. A rate of
return for which this function is zero is an internal rate of
return.
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where,
NPV - Net Present Value
Cn - Cash flow at time n
r - rate of return
n - time period, years
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Year (n)
0
1
2
3
NPV 123400
Cash Flow, Cn
-123400
36200
54800
48100
36200 54800 48100
0
(1 r )1 (1 r ) 2 (1 r )3
r 5.96%
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PAY BACK PERIOD
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Pay Pack Period

Payback period in capital budgeting refers to
the period of time required to recoup the funds
expended in an investment, or to reach the breakeven point.
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Pay Pack Period

For example, a Rs.1000 investment which returned
Rs. 500 per year would have a two-year payback
period. The time value of money is not taken into
account.
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COST-BENEFIT ANALYSIS
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Cost-Benefit Analysis
Broadly, CBA has two purposes:
1. To
determine
if
it
is
sound
investment/decision (justification/feasibility)
2. To provide a basis for comparing projects. It
involves comparing the total expected cost of
each option against the total expected
benefits,
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to
see
whether
the
benefits
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outweigh the costs,
and by how much.
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Cost-Benefit Analysis
The CBA is also defined as a systematic process
for calculating and comparing benefits and costs of
a project, decision or government policy / project.
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FEASIBILITY REPORT
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Feasibility Report
The feasibility study is an evaluation and analysis
of the potential of a proposed project which is
based on extensive investigation and research to
support the process of decision making.
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Feasibility Report
A well-designed feasibility study should provide a
historical background of the business or project, a
description of the product or service, accounting
statements,
the
operations
research
and
details
and
management,
policies,
financial
of
marketing
data,
legal
requirements and tax obligations.

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Feasibility Report
Generally, feasibility studies precede technical
development and project implementation.
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BREAK EVEN ANALYSIS
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Break Even Analysis

Number of units that must be sold in order to
produce a profit of zero (but will recover all
associated costs). In other words, the break-even
point is the point at which your product stops
costing you money to produce and sell, and starts
to generate a profit for your company.
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Break Even Analysis
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Break Even Analysis

TR TC
P X TFC V X
P X V X TFC
X ( P V ) TFC
TFC
X
(P V )
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TR-Total Revenue;
TC-Total Cost;
P-Price per unit;
X-No. of units;
V-Variable Cost;
TFC-Total Fixed Cost
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Break Even Analysis

The quantity, , is of interest in its own right, and is
called the Unit Contribution Margin (C): it is the
marginal profit per unit, or alternatively the portion
of each sale that contributes to Fixed Costs. Thus
the break-even point can be more simply computed
as the point where Total Contribution = Total Fixed
Cost.
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THE END
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Cost and Break Even Analysis

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3/17/2015

CE2451 Engineering Economics

Objectives of this course

The main objective of this course is to make the Civil Engineering

Unit 2: Cost and Break Even Analysis

Cost and Break Even Analysis

Marginal Costing [MC] Curve

the manufacturing costs are absorbed by the

external financial reporting and for income tax

overhead to a product, many manufacturers

How to arrive final cost of a

TRADITIONAL COSTING APPROACH/

Traditional Costing Approach

Traditional Costing Approach

manufactured on the basis of volume such as

Traditional Costing Approach

Traditional Costing Approach

ACTIVITY BASE COSTING (A.B.C)

Activity Base Costing

Activity Base Costing

Activity Base Costing

FIXED COST & VARIABLE COST

AC curve fall continuously

Long Run Cost

Long Run Cost

Long Run Cost

Long Run Cost

Long Run Cost

FULL COST PRICING

Full Cost Pricing

+ markup percentage (profit) in order to derive the

Full Cost Pricing

Advantages Full Cost Pricing

MARGINAL COST PRICING

Marginal Cost Pricing

Marginal Cost Pricing

Marginal Cost Pricing

Marginal Cost Pricing

GOING RATE PRICING

Going Rate Pricing

Going Rate Pricing

little variation from one producer to another, such

PRICING FOR A RATE OF RETURN

Pricing for a Rate of Return

Pricing for a Rate of Return

Pricing for a Rate of Return

Make sure their program benefits all sections of

INTERNAL RATE OF RETURN

Internal Rate of Return

The higher a project's IRR, the more desirable it is to

Assuming all projects require the same amount of up-front

Internal Rate of Return

Internal Rate of Return

Internal Rate of Return

36200 54800 48100

PAY BACK PERIOD

Pay Pack Period

Pay Pack Period

requirements and tax obligations.

BREAK EVEN ANALYSIS

Break Even Analysis

Break Even Analysis

Break Even Analysis

Break Even Analysis