Theory of Cost and Break

Even Analysis
 Introduction
• We have discussed the input-output relations in
terms of physical quantities of input and
output. However, business decisions are
generally taken on the basis of money values
of the inputs and outputs. Inputs multiplied
by their respective prices and added together
give the money value of the inputs, i.e., the
cost of production.
• The cost of production is an important in almost
all business analysis and business decision-
making, pertaining to a) locating the weak
point in production management b)
minimizing the cost c) finding the optimum
level of output d) determining price and
dealers, margin; and e) estimating or
projecting the cost of business operation.
 Cost Concepts
• The cost concepts that are relevant
to business operations and
decisions can be grouped on the
basis of their nature and purpose
under two overlapping categories
(i) cost concepts used for
accounting purposes and (ii)
analytical cost concepts used in
economic analysis of business
activities.

 Accounting Costs
• Opportunity Cost : The opportunity cost is the opportunity lost.
An opportunity to make income is lost because of scarcity of
resources. Income maximizing resource owners put their
scarce resources to their most productive use and thus they
forego the income expected from the second best use of the
resources. Thus, opportunity cost may be defined as the
expected returns from the second best use of the resources
that are foregone due to the scarcity of resources. It is also
called alternative cost.
• Business Cost and Full costs: Business costs include all the
expenses that are incurred to carry out a business. The
concept of business costs is similar to the actual or real
costs. Business costs “include all the payments and
contractual obligations made by the firm together with the
book cost of depreciation on plant and equipment”. They are
used for calculating business profits and losses and for filing
returns for income-tax and also for legal purpose.
• The concept of full cost, includes business costs, opportunity
costs and normal profit. Normal profit is a necessary
 Accounting Costs
• Actual or Explicit Costs : The actual or Explicit costs are
those which are actually incurred by the firm in
payment for labour, material, plant and building,
machinery, equipment, travelling and transport,
advertisement, etc. The total money expenses,
recorded in the books of accounts are, for all practical
purpose, the actual costs.
• Implicit Costs: In contrast to explicit costs, there are
certain other costs that do not take the form of cash
outlays, nor do they appear in the accounting system.
Such costs are known as implicit or imputed costs. e.g.
opportunity cost.
• Implicit cost are not taken into account while calculating
the loss or gains of the business, but they form an
important consideration in deciding whether or not to
 Accounting Costs
• Out-of-pocket and Book Costs:
 The items of expenditure that involve
cash payments or cash transfers, both
recurring and non-recurring, are known as
out-of-pocket costs. All the explicit costs
(e.g., wages, rent, interest, cost of materials
and maintenance, transport expenditure,
electricity and telephone expenses, etc.) fall
in this category.
• On the contrary there are certain actual
business costs that do not involve cash
payments, but a provision is therefore
made in the books of account and they
are taken into account while finalizing the
profit and loss account. Such expenses
 Analytical Cost
• Fixed and Variable Costs: Fixed costs are those
that are fixed in volume for a certain quantity
of output. In other words, costs that do not
vary or are fixed for a certain level of output
are known as fixed costs.
• The fixed costs include (i) costs of managerial
and administrative staff (ii) depreciation of
machinery, building and other fixed assets
(iii) maintenance of land etc.
• Variable costs are those which vary with the
variation in the total output. It includes cost
of raw material, running cost of fixed capital,
such as fuel, repairs, routine maintenance
expenditure, direct labour wages associated
with the level of output and the costs of all
other inputs that vary with output.
 Analytical Cost
• Total, Average and Marginal Costs: Total cost
is the total actual cost incurred on the
production of goods and services. It refers
to the total outlays of money expenditure
both explicit and implicit, on the resources
used to produce a given level of output. It
includes both fixed and variable costs.
• Average Cost is of statistical nature- it is not
actual cost. It is obtained by dividing the
total cost by the total output. TC/Q
• Marginal Cost is defined as the addition to
the total cost on account of producing one
additional unit of the product. MC = TCn –
TCn-1

 Analytical Cost
• Short-run and Long-run Costs: Short-run and long-run
cost concepts are related to variable and fixed costs,
respectively.
• Short run costs are those that have a short-run
implication in the process of production. Such costs
are made once e.g., payment of wages, cost of raw
materials etc. From analytical point of view, short run
costs are those that vary with the variation in output,
the size of the firm remaining the same. Therefore
short run costs are treated as variable costs.
• Long run costs are those that have long-run implications
in the process of production, i.e., they are used over a
long range of output. The costs that are incurred on
the fixed factors like plant, building, machinery are
known as long-run costs.
• Broadly speaking, ‘the short run costs are those
associated with variables in the utilization of fixed
plant or other facilities whereas long-run costs are
associated with the changes in the size and kind of
 Analytical Cost
• Incremental Costs : Incremental costs are
closely related to the concept of
marginal cost but with a relatively
wider connotation. Incremental cost
refers to the total additional cost
associated with the decisions to
expand the output or to add a new
variety of product. When firm expands
its operations it has to incurred
additional costs which is incremental
cost.
• Sunk Costs : The sunk costs are those
which are made once and for all and
cannot be altered, increased or
 Analytical Cost
• Historical Cost & Replacement Cost:
Refers to the cost incurred in past on
the acquisition of productive assets,
e.g. land, building, machinery etc.,
whereas replacement cost refers to the
outlay that has to be made for
replacing an old asset.
• The concepts are of significance for the
unstable nature of price behavior.
• Historical cost of asset is used for
accounting purpose, in the assessment
of the net worth of the firm. The
replacement cost figures in business
decisions regarding renovation of the
 Analytical Cost
• Private and Social Costs : The cost
concepts that are related to the
working of the firm and that are used in
the cost-benefit analysis of business
decisions. Such costs fall in the
category of private costs.
• There are other costs that arise due to
the functioning of the firm but do not
normally figure in the business
decisions and not borne by the firms.
Such costs are known as Social Costs.
E.g water / air pollution, rivers, lakes,
public utility services like roadways,
drainage system etc.
 COSTS IN THE SHOR RUN
• Fixed Costs : These are costs that do not
vary with output. Before a firm actually
starts producing, it needs to spend on
plant, machinery, fittings, equipments,
etc., in fact the firm has to bear these
costs even if there is no output. These
represent fixed costs. Since such costs do
not vary with the level of output, any
decision regarding volume of output does
not depend upon fixed cost. Hence these
are also referred to as subsidiary costs.
The shape of the Total Fixed Cost (TFC) is
a straight line from the origin, parallel to
the quantity axis, indicating that output
may increase to any level without causing
any change in the fixed cost.
 Cost Curves for a Firm
TC
Cost 400
(Rs per
Total cost
year)
is the vertical
VC
sum of FC
and VC.
300
Variable cost
increases with
production and
the rate varies with
increasing &
200 decreasing returns.

Fixed cost does not

100 vary with output
50 FC

0 1 2 3 4 5 6 7 8 9 10 11 12 13 Output
 COSTS IN THE SHOR RUN
• Variable Costs: These are the costs that vary with
output and are incurred in getting more and more
inputs; variable costs are equal to zero if there is no
output.
• TVC curve should be a straight line, but TVS is an
inverse S shaped upward sloping curve, starting
from origin. This shape is determined by the law of
variable proportions.
• This leads to fall in per unit cost in the beginning; if
the variable input is increased beyond a certain
level, its marginal productivity starts diminishing.
Hence, TVC increases at an increasing rate.
• Slope of the TVC curve is less steep in the beginning;
as we increase the variable input, with the other
input fixed, productivity of the variable input fall
because of diminishing rate of technical marginal
 COSTS IN THE SHOR RUN
• Average and Marginal Cost Functions: Average
Cost is cost per unit of output; One can derive
Average Fixed Cost AFC, Average Variable Cost
AVC and Average Cost AC from total fixed, total
variable and total costs respectively. AFC is
fixed cost per unit of output and is thus equal
to the ratio of TFC and units of output; AC is
total cost per unit of output and is thus equal to
the ratio of TVC and units of output; AC is total
cost per unit of output and is thus equal to the
ratio of TC and units of output.
• Marginal Cost is the change in total cost due to a
unit change in output. Since the fixed
component of cost cannot be altered, MC is
virtually the change in variables cost per unit
change in output. Therefore it is also known as
rate of change in total cost.
 COSTS IN THE SHOR RUN
• Average and Marginal Cost Curves: AFC can be
plotted as a rectangular hyperbola, asymptotic
to the axes. As the number of units of output is
increased, Fixed Cost remaining the same, AFC
falls steeply at first and then gently.
• AVC curve and the AC curve are both U shaped.
This can be explained with the law of variable
proportions. Costs decline when there are
increasing returns, stabilise with constant
returns and increase with diminishing returns.
• AC being the sum of AFC and AVC at each level of
output lies above both AFC and AVC curves in.
The AC curve is U shaped; initially AC falls with
increase in output, reaches a minimum, and
then increases.
• When both AFC and AVC fall, AC also falls. AVC
soon reaches a minimum and starts rising,
A Firm’s Short Run Costs
Cost Curves

MC

ATC

AVC

AFC
 COSTS IN LONG RUN
• All costs are variable in the long run since factors
of production, size of plant, machinery and
technology are all variable. This in turn implies
radical changes in the cost structure of the
firm.
• The long run cost function is often referred to as
the ‘planning cost function’ and the long run
average cost LAC curve is known as ‘planning
curve’. As all costs are variable, only the
average cost curve is relevant to the firm’s
decision making process in the long run.
• The long run consists of many short runs, e.g., a
week consists of seven days and a month
consists of four weeks and so on. Therefore the
long run cost curve is the composite of many
short run cost curves.
 COSTS IN LONG RUN
• Long Run Average Cost: When the plant size and other fixed
inputs of the firm increase in the long run, the short run cost
curves shift to the right.
• In the long run, the firm operates with different plant sizes and
can switch over to a different plant size, depending on cost
considerations.
• Thus SAC1 relates to average cost of the firm when its plant
size is, say I; when plant size increases to II, the
corresponding SAC curve is SAC2 and so on.
• As output increases from a to b in the short run, the firm can
continue to produce along SAC1, utilising its installed
capacity of I. Further ahead, at an output level of a, this
capacity is overworked.
• Hence, it would be cost effective for the firm to shift to a higher
plant size, say II, thus switching over from SAC1 to SAC2.
This shift would lower the average cost of the firm.
COSTS IN LONG RUN
 COSTS IN LONG RUN
• A firm may have multiple alternate plant sizes. So it may
have multiple SACs corresponding to different plant
sizes..
• LAC function is an envelope of the short run cost function
and the LAC curve envelopes the SAC curves; hence the
LAC curve is also known as “envelop curve”.
•
 CONCEPTS OF REVENUE
• Total Revenue : TR is the total amount of money received
by a firm from goods sold ( or services provided ) during
a certain time period.
 TR = Q . P
• Average Revenue : AR is the revenue earned per unit of
output sold. It is equal to the ratio of TR and output. That
means AR is nothing but price.
 AR = TR/Q = Q.P / Q = P
• Marginal Revenue : MR is the revenue a firm gains in
producing one additional unit of a commodity. It is
calculated by determining the difference between the
total revenues earned before and after a unit increase in
production.
 MR = TRq – TRq-1
• MR is the slope of TR. When TR is maximum when MR is
zero and beyond which MR becomes negative.
 Rules of Profit Maximization
• The profit function shows a range of outputs at which
the firm makes positive or supernormal profits.
Economists differentiate between normal profit and
supernormal profit.
• Normal profit is that amount of return to the
entrepreneur which must be earned to keep him/her
in that business activity. Anything over and above
this is supernormal profit.
• In other words, normal profit is a part of total cost and
supernormal profit is the accounting profit that
occurs when TR>TC.
• A firm maximizes profit at the point where MR equals
MC.
• Under the assumption of rationality a firm will
continue to produce till MR is greater than MC and
will stop production only when MR is just equal to
MC.
 Break Even Analysis
• Break Even Analysis examines the
relation between total revenue, total
costs and total profits of a firm at
different levels of output.
• Break Even point is the point where
total cost just equals the total
revenue; it is the no profit no loss
point.
• BE Analysis is about determining profit
at various projected levels of sales,
identifying the break even point and
making a managerial decision
regarding the relationship between
likely sales, and the breakeven point.
 Break Even Analysis :
Graphical Method
• Under graphical method the breakeven chart is
constructed by plotting firm’s total revenue
and total cost on the vertical axes and output
on the horizontal axis.
• Break even chart assumes constant AVC for a
given range of output. Hence, a firm’s total
cost function is given as a straight line.
• The chart would be helpful to find out
Breakeven point.
• It would also throw light on the profit or loss
resulting from each level of sales by the firm.
It can provide valuable information on
projected effect of output on costs and profits
and firm can ascertain the volume of sales it
would need to breakeven.
 Break Even Analysis :
Graphical Method
• To draw a break even chart following steps need to be
followed:
• Label the vertical axis ‘revenue and costs in rupees’
and the horizontal axes ‘output/production units’.
• Assuming constant price, plot at least two points from
the revenue data and draw the upward moving TR
line starting from the origin.
• Draw a horizontal line for total fixed costs starting at
the point on the vertical axis at the level of fixed
costs
• At the same point on the horizontal axes draw the
total costs line.
• The point where the revenue line crosses the total
costs line is the break even point.
• The gap between the total costs line and revenue line
beyond the breakeven point represents the level of
profit or loss.
 Break Even Analysis :
Graphical Method
• chart
• Super Computers Ltd. Sells personal
computers, laptops and peripherals. The
following information (in Rs. Crores) was
obtained from the chief Accountant of
Super at the end of March 2006. It was
also assumed that wages are fixed cost,
since the company did not lay off any
worker and also that 20% of the
overheads are variable. Consider yourself
to be a managerial economist and analyse
the information, especially the BEP.
 PCs Laptops Peripherals
 Sales 2,500,000 600, 000 120,000
 Materials 2,300,000 300,000 100,000
 Wages 55,000 300,000 60,000
 Overheads 50,000 50,000 20,000
 Profit/Loss95,000 50,000 60,000

• From the assumptions, the modified
information is presented in below
table:
 PCs Laptops Peripherals
 Sales 2,500,000 600, 000 120,000
 Variable cost2,310,000 310,000 104,000
 Contribution 1,90,000 290,000 16,000
 Fixed Cost 95,000 340,000 76,000
 Profit/Loss 95,000 -50,000 -60,000
 PV Ratio 0.076 0.483 0.133
 BEP 1,250,000 704,000 570,000
 Contribution = Sales – Variable Cost
 PV ratio = Contribution / Sales
 BEP = FC / PV Ratio
 Break Even Analysis : PV
Ratio
• Profit volume ratio is the ratio of
contribution margin and sales. It is
also defined as the ratio of
marginal change in profit and
marginal change in sales.
• PV Ratio = Contribution / Sales
• Using PV Ratio also, we can calculate
BEP as:
 BEP = FC / PV Ratio
 Economies of Scale
• “Economies” refer to lower costs; hence
economies of scale would mean lowering
of costs of production by way of producing
in bulk.
• Economies of scale refers to the efficiencies
associated with large scale operations; it
is a situation in which the long run
average costs of producing a good or
service decrease with increase in the level
of output.
• Firms are often concerned about a minimum
efficient level of production, which is
nothing but the amount of production that
spreads setup costs sufficiently for firms
 Economies of Scale
• There are two types of economies of scale:
Internal economies (in which cost per unit
depends upon the size of firm)
 External economies (in which cost per
unit depends upon the size of industry)
• Internal Economies:
• Specialization
• Greater efficiency of machines
• Managerial Economies
• Financial Economies
• Production in stages
 Economies of Scale
• External Economies: As an industry grows in
size, it would create various economies for
the firms in the industry.
• Technological advancement
• Easier access to cheaper raw materials
• Financial institutions in proximity
• Pool of skilled workers
• Diseconomies of Scale : Refers to decrease in
productivity when there are equal increases
of all inputs, assuming that no input is fixed.
• If some cost of a business rises with an increase
in size by a greater proportion than the
increase in size of operations, it is known as a
diseconomy of scale.
 Economies of Scale
• Diseconomies may arise if the size of
operations becomes unwieldy by size;
coordination among different work groups
and units may become complex; too much
specialization may lead to boredom and
monotony among workers; management
may become less effective and thus
indirectly impose costs.
• Economies of scope refer to a situation in
which average costs of manufacturing a
product are lowered when two
complementary products are produced by
a single firm, than when they are
produced separately.
• It is applicable to firms that produce more
 Learning Curves
• LAC declines as the scale of production increases to a
certain level and beyond this level of production,
LAC begins to rise. Economies of scale provide the
reasoning why LAC decreases with increasing scale
of production and diseconomies of scale provide
reason for increase in LAC beyond minimum point.
• Economists and business analysts have discovered
another factor that causes a continuous decrease in
average cost of production over a large scale of
production. The factor is called learning by doing or
learning by experience.
• Firms engaged in the production of a commodity or
service over a long period of time gain experience.
They learn by performing the same activity
repeatedly.
• Along with that factors like technological know-how,
mgnt style, organizational behaviour help firms in
getting work done at least cost.
 Learning Curves
• Thus, firm’s average
cost of production
continues to fall
with increase in
production, though
the rate of fall in
average cost goes
on declining. The
curve that
represents the
declining trend in
long-run average
cost of production
is called the
 Learning Curves
• The learning curve is widely used by
business managers, economists and
engineers to foresee the possible
trend in long run average cost of
production and plan production
accordingly.
• Learning curve is different from the
conventional LAC curve. While LAC
give the average cost of plant-wise
production, learning curve gives the
average cost of cumulative output,
i.e., the total output right from the
beginning of production of a