Business economics cost analysis
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Transcript of Business economics cost analysis
04/11/23Sameer Gunjal – Business
Economics (MGBEN 10101)
Business Economics – Cost Analysis
Sameer Gunjal
04/11/23Sameer Gunjal – Business
Economics (MGBEN 10101)
Cost Function
•Cost function is defined using the budget constraint by the following equation:▫C = wL + rK
Where, C = Cost involved w = wage rate L = labor input r = Rate of capital K = Capital
04/11/23Sameer Gunjal – Business
Economics (MGBEN 10101)
Opportunity Cost?
•Opportunity cost is the value of the next best alternative forgone as the result of making a decision.
• Implies the choice between desirable, yet mutually exclusive results.
04/11/23Sameer Gunjal – Business
Economics (MGBEN 10101)
Types of Costs
• Implicit and Explicit costs▫Implicit costs – Opportunity cost▫Explicit costs – Out of pocket expenses
•Direct and Indirect Costs▫Direct Costs – Raw Materials, etc.▫Indirect Costs – Admin expenses
04/11/23Sameer Gunjal – Business
Economics (MGBEN 10101)
Types of costs
•Fixed Cost: These are costs that the firm has to pay independently of whether it is operating or not, e.g. rent on a building.
•Variable Cost: These costs come from the inputs the firm uses in its production process, e.g. the wages paid to laborers.
•Total Cost: These are the sum of fixed and variable costs.▫TC = TFC + TVC
04/11/23Sameer Gunjal – Business
Economics (MGBEN 10101)
Fixed and Variable Costs
•Fixed Costs:
•Variable Costs:
04/11/23Sameer Gunjal – Business
Economics (MGBEN 10101)
Total Costs
04/11/23Sameer Gunjal – Business
Economics (MGBEN 10101)
Isocost Lines
• Isocost is derived from the greek word iso meaning equal.
• Isocost lines represent a combination of inputs which all cost the same amount. The typical isocost line represents the ratio of costs of labour and capital.
•The cost function for the same is given by :▫C = (w*L) + (r*K)
04/11/23Sameer Gunjal – Business
Economics (MGBEN 10101)
Application of Isocost Lines
• Isoquants are used in combination with isocost lines to arrive at the solution to the cost minimization – optimization solution.
04/11/23Sameer Gunjal – Business
Economics (MGBEN 10101)
Changes in cost - Isocost Lines
04/11/23Sameer Gunjal – Business
Economics (MGBEN 10101)
Expansion Path
•The points of tangency between isoquants and isocost lines each show the least expensive way of producing a particular level of output. Connecting these tangency points gives the firm’s expansion path.
04/11/23Sameer Gunjal – Business
Economics (MGBEN 10101)
Optimization ProblemThe level of output varies with the change in the input combinations.Q = 100KL2,w =Rs.25r = Rs.50
• Find the quantity of labour the firm should use to produce 1600 units of output▫ L=1▫ L=2▫ L=3▫ L=4
• Find the quantity of labour the firm should use to produce 1600 units of output▫ K=1▫ K=2▫ K=3▫ K=4
• Find the minimum cost for the same level of output▫ 100▫ 125▫ 150▫ 175
04/11/23Sameer Gunjal – Business
Economics (MGBEN 10101)
Total, Average and Marginal Costs•TC = TFC + TVC•Average Cost = AFC + AVC
▫Ratio of the cost component and the average productivity of the input factor
▫AFC = TFC / Q and AVC = TVC / Q•Marginal Cost is the cost incurred for every one
additional input t production.▫MC = d(TVC)/dQ
04/11/23Sameer Gunjal – Business
Economics (MGBEN 10101)
Illustration to compute, total, average and marginal costs
•Plot the chart of the different costs.
04/11/23Sameer Gunjal – Business
Economics (MGBEN 10101)
Variable and Marginal Cost charts
04/11/23Sameer Gunjal – Business
Economics (MGBEN 10101)
Example
•Suppose a cost function is given as ▫TC = 100 + 5Q + Q2
•Find:▫Equation for AC and MC▫AC and MC for 5 units of output▫The value of Q at which AC = MC
Solution
Sol - 1• TC = 100 + 5Q + Q2
• AC = TC / Q▫AC = 100 / Q + 5 + Q
• MC = d(TC)/dQ▫MC = 5 + 2Q
Sol - 2• AC Q=5 = 100 / 5 + 5 + 5
= 30• MC Q=5 = 5 + 2*5 = 15
Sol - 3• The value of Q for AC =
MC▫100 / Q + 5 + Q = 5
+ 2Q▫100 / Q = Q▫Q2 = 100▫Q = 10
04/11/23Sameer Gunjal – Business
Economics (MGBEN 10101)
Short Run Average Cost Curve
SRAC
04/11/23Sameer Gunjal – Business
Economics (MGBEN 10101)
Long Run Average Cost
Break-Even Analysis
Costs/Revenue
Output/Sales
FC
VCTC
TR
Q1
The Break-even point occurs where total revenue equals total costs – the firm, in this example would have to sell Q1 to generate sufficient revenue to cover its costs.
Break-Even Analysis
Costs/Revenue
Output/Sales
FC
VCTCTR (p = Rs.20)
Q1
If the firm chose to set price higher than Rs.20 (say Rs.30) the TR curve would be steeper – they would not have to sell as many units to break even
TR (p = Rs30)
Q2
Break-Even Analysis
Costs/Revenue
Output/Sales
FC
VCTC
TR (p = Rs.20)
Q1
If the firm chose to set prices lower (say Rs.10) it would need to sell more units before covering its costs
TR (p = Rs.10)
Q3
Break-Even Analysis
Costs/Revenue
Output/Sales
FC
VC
TCTR (p = Rs.20)
Q1
Loss
Profit
04/11/23Sameer Gunjal – Business
Economics (MGBEN 10101)
Break Even Analysis
Contribution • Contribution is the difference between sales and
marginal or variable costs. It contributes toward fixed cost and profit. The concept of contribution helps in deciding breakeven point, profitability of products, departments etc. to perform the following activities: ▫Selecting product mix or sales mix for profit
maximization ▫Fixing selling prices under different circumstances such
as trade depression, export sales, price discrimination etc.
04/11/23Sameer Gunjal – Business
Economics (MGBEN 10101)
Break Even Analysis
Profit Volume Ratio (P/V Ratio), its Improvement and Application
• The ratio of contribution to sales is P/V ratio or C/S ratio. It is the contribution per rupee of sales and since the fixed cost remains constant in short term period, P/V ratio will also measure the rate of change of profit due to change in volume of sales. The P/V ratio may be expressed as follows: P/V ratio = Sales – Marginal cost of sales = Contribution
Sales Sales • A fundamental property of marginal costing system is
that P/V ratio remains constant at different levels of activity.
04/11/23Sameer Gunjal – Business
Economics (MGBEN 10101)
P/V Analysis• A change in fixed cost does not affect P/V ratio. The concept of P/V ratio
helps in determining the following: • Breakeven point • Profit at any volume of sales • Sales volume required to earn a desired quantum of profit • Profitability of products • Processes or departments
• The contribution can be increased by increasing the sales price or by reduction of variable costs. Thus, P/V ratio can be improved by the following: • Increasing selling price • Reducing marginal costs by effectively utilizing men, machines, materials and
other services • Selling more profitable products, thereby increasing the overall P/V ratio
04/11/23Sameer Gunjal – Business
Economics (MGBEN 10101)
Breakeven Point
•Breakeven point is the volume of sales or production where there is neither profit nor loss. Thus, we can say that:
Contribution = Fixed cost •Now, breakeven point can be easily calculated with
the help of fundamental marginal cost equation, P/V ratio or contribution per unit.
04/11/23Sameer Gunjal – Business
Economics (MGBEN 10101)
Margin of Safety
•Margin of safety represents the difference between the sales at break-even point and the total actual sales.
•Three measures of the margin of safety are given below:▫Margin of Safety = Profit * Sales / (PV ratio)▫Margin of Safety = Profit / (PV ratio)▫Margin of Safety = Sa – Sb / Sa * 100
Break-Even Analysis
Costs/Revenue
Output/Sales
FC
VC
TCTR (p = Rs.20)
Q1 Q2
Margin of Safety
Margin of safety shows how far sales can fall before losses made. If Q1 = 1000 and Q2 = 1800, sales could fall by 800 units before a loss would be made
TR (p = Rs.30)
Q3
A higher price would lower the break even point and the margin of safety would widen
04/11/23Sameer Gunjal – Business
Economics (MGBEN 10101)
Example
•A firm has purchased a plant to manufacture a new product. Cost data for the plant is given below:
•Calculate selling price if profit per unit = Rs. 1.02•Find break even output level
Estimated Annual Sales 24000 units
Estimated CostsMaterial Rs. 4.00 per unitDirect Labour Rs. 0.60 per unitOverhead Rs. 24,000 per yearAdministrative Expenses Rs. 28,000 per yearSelling costs Rs. 1,590 per year
04/11/23Sameer Gunjal – Business
Economics (MGBEN 10101)
SolutionSales Qty 24,000 units
Material 4.00 /unitsDirect Labour 0.60 /unitsOverhead 24,000 / yearAdministrative Expenses 28,000 / yearSelling costs 1,590 / year
Fixed Costs = Overhead + Admin + Selling 53,590
Variable Costs per unit 4.60 Variable Costs = VC/unit * units 110,400
Total Costs = FC + VC 163,995
Total Profit = Qty * Profit/unit 24,480 Total Revenues = TC + Profit 188,475
Selling Price per unit 7.85 Brealk Even Sales = FC / Contribution 16,473
04/11/23Sameer Gunjal – Business
Economics (MGBEN 10101)
Break-Even Analysis
Remember:
•A higher price or lower price does not mean that
break even will never be reached!
•The BE point depends on the number of sales
needed to generate revenue to cover costs – the BE
chart is NOT time related!
04/11/23Sameer Gunjal – Business
Economics (MGBEN 10101)
Break-Even Analysis
Importance of Price Elasticity of Demand:
•Higher prices might mean fewer sales to break-even
but those sales may take a longer time to achieve.
• Lower prices might encourage more customers but
higher volume needed before sufficient revenue
generated to break-even
04/11/23Sameer Gunjal – Business
Economics (MGBEN 10101)
Break-Even Analysis
Links of BE to pricing strategies and elasticity
•Penetration pricing – ‘high’ volume, ‘low’ price – more
sales to break even
•Market Skimming – ‘high’ price ‘low’ volumes – fewer
sales to break even
•Elasticity – what is likely to happen to sales when
prices are increased or decreased?
04/11/23Sameer Gunjal – Business
Economics (MGBEN 10101)
Thank You