COST ANALYSISMARKET AND COMPETITIVE ANALYSIS

PGMAX (2014-2015)

Deepak Gupta (Roll no. 8)

Anupam Ghosh (Roll no. 6)

Contents

Deepak

Theory of Costs

Cost Functions

Short Run Cost

Long Run Cost

Economics Of Scale

Internal Economics

External Economics

Anupam

Cost Volume Profit Analysis

Break-even Analysis

Break-even Point

Market Analysis

Competitor Analysis

Porters’s Five Forces Model

Theory Of Costs

Accounting Cost concepts

• Opportunity cost and Actual cost

• Explicit and Implicit costs

Analytical Cost concepts

• Fixed and Variable cost

• Total, Average and Marginal costs

• Short Run and Long Term Costs

• Historical and Replacement costs

Accounting Costs

• Opportunity Cost: It is defined as expected returns from the next best use of

resources which are foregone due to scarcity of resources.

• Actual Cost: These are actually incurred by firm in payment of labour, material, plant,

building, equipment, travelling , transport, advt etc.

• Explicit Costs: Actual costs entered in books of accounts. Like wages, insurance

premium, depreciation charges etc.

• Implicit Costs: These do not take the form of cash outlays, nor do they appear in

accounting system.

Cost functions

• Cost functions are derived functions. They are derived from production function ,which

describes the efficient method of production at any one time.

Both in Short run and Long run, total cost is a multivariable function.That is, total cost is determined by many factors.SymbolicallyC(L)=f(X,T,P)C(S)=f(X,T,P,K)WhereC=Total cost X=Output T=Technology K=Fixed FactorsP=Price of FactorsCost curves imply cost is a function of output C=f(X)

Short term costs

Short run costs are accumulated in real time throughout the production process. Fixed costs have no impact of short run costs, only variable costs and revenues affect the short run production. Variable costs change with the output. Examples of variable costs include employee wages and costs of raw materials. The short run costs increase or decrease based on variable cost as well as the rate of production.

In the long run there are no fixed factors of production. The land, labor, capital goods, and entrepreneurship all vary to reach the long run cost of producing a good or service. Examples of long run decisions that impact a firm's costs include changing the quantity of production, decreasing or expanding a company, and entering or leaving a market.

Long Term costs

Short Run Costs

• In traditional theory of firm, total costs are split into two groups:

Total fixed costs and Total variable costs.

• TC=TFC+TVC

• Fixed costs includes Salaries, Depreciation of machinery, expenses for land

maintenance etc.

• Variable costs includes raw material, costs of direct labor, running expenses of fixed

capital fixed capital like fuel, ordinary repairs and routine maintenance.

Total Cost Curve

• By adding TFC and TVC we obtain the TC of the firm

Average total cost / Marginal cost

• Average fixed cost=Total fixed cost/Output(X)

• Average Variable cost=Total variable cost/Output(X)

• Average Total cost=Total cost/Output(X)=(TFC+TVC)/X

• Marginal Cost=It is defined as the change in TC which results from unit

change in output.

Summary

• In Summary: The traditional theory of costs postulates that in short run the cost curves (AVC,ATC,MC) are V Shaped reflecting the law of variable proportions. In the short run with a fixed plant there is a phase of increasing productivity(falling unit costs) and a phase of decreasing productivity (increasing unit costs ) of variable factors.

• Between these two phases of plant operation there is a single point at which unit costs are minimum. When this point is reached the plant is utilized optimally. That is with the optimal proportions of fixed and variable factors.

Long Run Total Cost Curve

Long Run Costs

• In long run all factors are assumed to become variable. The long run average cost curve is derived from short run cost curves. Reach point on LRTC corresponds to a point on a short run cost curve which is tangent to the LRAC at that point.

U Shape of LRATC

• A serious assumption of traditional U shaped cost curves is that each plant size is designed to produce optimally a single level of output. Any departure from that no matter how small leads to increased costs. The plant is completely inflexible. There is no reserve capacity ,not even to meet seasonal variations in demand. As a consequence of this assumption the Long Run Average curve envelops the short run Average cost curve.

Economics Of Scale

• When more units of a good or a service can be produced on a larger scale, yet with (on average) less input costs, economies of scale (ES) are said to be achieved. Alternatively, this means that as a company grows and production units increase, a company will have a better chance to decrease its costs. According to theory, economic growth may be achieved when economies of scale are realized.

Internal Economies

• Alfred Marshall made a distinction between internal and external economies of scale. When a company reduces costs and increases production, internal economies of scale have been achieved.

External Economies

• External economies of scale occur outside of a firm, within an industry. Thus, when an industry's scope of operations expands due to, for example, the creation of a better transportation network, resulting in a subsequent decrease in cost for a company working within that industry, external economies of scale are said to have been achieved. With external ES, all firms within the industry will benefit.

Cost Volume Profit Analysis

Cost Volume Profit analysis

• CVP analysis studies the relationship between expenses, revenues and net income.

• The aim is to establish what will happen to financial results if a specified level of

activity or volume fluctuates.

• Breakeven analysis can be used to determine a company’s breakeven point (BEP)

• Breakeven point is a level of activity at which the total revenue is equal to the total

costs.

• At this level, the company makes no profit.

Assumption of BEP analysis

• Relevant range

– The relevant range is the range of an activity over which the fixed cost will remain fixed

in total and the variable cost per unit will remain constant

• Fixed cost

– Total fixed cost are assumed to be constant in total

• Variable cost

– Total variable cost will increase with increasing number of units produced

• Sales revenue

– The total revenue will increase with the increasing number of units produced

Key Terminology: Breakeven Analysis

• Break even point - the point at which a company makes neither a profit

or a loss.

• Contribution per unit - the sales price minus the variable cost per unit. It

measures the contribution made by each item of output to the fixed costs

and profit of the organisation.

• Margin of safety - a measure in which the budgeted volume of sales is

compared with the volume of sales required to break even

Breakeven Points

• Break-even Quantity:

QB = TFC

P – AVC

• Break-even Sales:

QS = TFC

1 – (AVC / P)

• Break-even Percentage:

QP = TFC x 100

(P – AVC) Qmax

• TFC = Total Fixed Cost

• P = Selling Price per unit

• AVC = Avg. variable Cost per Unit

• Qmax = Maximum Quantity

Breakeven Chart

Problem

Calculate the followings based upon following data:

1. Break-even Quantity

2. Break-even Sales

3. Break-even Percentage

4. Margin of safety Sales

5. Margin of safety Quantity

6. Targeted Profit

Data•Max. units can produced = 1,00,000•Selling Price / Unit = Rs.850•Variable Cost / unit = Rs.100•Fixed Cost / month= Rs.75,00,000•Profit Target = Rs.75,00,000

Solution1. Break-even Quantity:

QB = TFC = Rs.75,00,000 = 10,000 Units P – AVC Rs.850 – Rs.100

2. Break-even Sales:

QS = TFC = Rs.75,00,000 = Rs.85,00,000 1 – (AVC / P) 1 – (Rs.100 / Rs.850)

3. Break-even Percentage:

QP = TFC x 100 = Rs.75,00,000 = 10% of 1,00,000 = 10,000 Units (P – AVC) Qmax (Rs.850 – Rs.100) (1,00,000)

4. Margin of Safety:

In Units = Total Unit Capacity – Break-even unit point = 1,00,000 – 10,000 = 90,000 Units

In Sales = Total Sales Capacity – Break-even sales point = (1,00,000 x 850) – (10,000 x 850) = Rs.76,50,00,000

5. Targeted Profit:

Unit = Rs.75,00,000 + Rs.75,00,000 = 20,000 Units Rs.850 – Rs.100

Sales = Rs.75,00,000 + Rs.75,00,000 = Rs.1,70,00,000 1 – (Rs.100 / Rs.850)

Percentage = Rs.75,00,000 + Rs.75,00,000 = 20% (Rs.850 – Rs.100) (1,00,000)

Limitations of B/E analysis

• Breakeven analysis assumes that fixed cost, variable costs and sales revenue behave

in linear manner. However, some overhead costs may be stepped in nature. The

straight sales revenue line and total cost line tent to curve beyond certain level of

production

• It is assumed that all production is sold. The breakeven chart does not take the

changes in stock level into account

• Breakeven analysis can provide information for small and relatively simple

companies that produce same product. It is not useful for the companies producing

multiple products

CVP Analysis

• It is attempt to apply BE analysis for multi-product firms.

• It enables the prediction of costs and profits for different volumes of activity.

• It is useful in setting up flexible budgets.

• It helps in performance evaluation for the purpose of control.

• It helps in formulating price policies by projecting the effect on costs and

profits.

• The study of CVP analysis is necessary to know the amount of overhead costs,

which could be charged to products costs at various levels of operation.

Profit Volume (P/V) Ratio

• This ratio indicates the contribution earned with respect to one rupee of sales.

• It is also known as Contribution Volume or Contribution sales ratio.

• Fixed costs remain unchanged in the short run, so if there is any change in

profits, that is only due to change in contribution.

ContributionsP/V Ratio = Sales

Market Analysis

• Market = A Collection

of Businesses and

Customers

• Features to Understand:

– Market Size

– Market Share

– Market Trends

– Market Growth Rate

Market Segment

• The part of the market you will operate in• SWOT focuses on what impacts the segment

Segment Analysis

• What is important to customers?

• Customer view of your vs. competitor

• Trends impacting segment

Competitor Analysis

• Always competitors!

• Purpose:

– Identify top competition

– Determine strengths/weaknesses of competition

– Develop strategies based on analysis to increase success

• Analyze successful and unsuccessful competitors

Who is a Competitor?

• Companies with a product/service addressing similar needs

• Products/services considered to be close substitutes

• Don’t define too narrowly

• Analyzing broader competitors allows for innovation maximization

• With which businesses you should actually compete

• What new things competitors will try to do

• How competitors react to other businesses’ actions

• How to use the competitor’s behavior to your advantage

Analyzing Competitor Information

PORTERS’S FIVE FORCES

Rivalry among existing

competitors

Threat of new entrants

Bargaining power of

buyers

Threat of substitutes

Bargaining power of suppliers

Threat of New Entrant

Production costs •Are there any economies of scale? •What are the capital requirements? •What is the absolute cost advantage?

Brand •How different is the product? •How strong is the brand identity? •How high are the switching costs?

Distribution •Is it easy to access distribution channels? •What are the government policies?

Power of suppliers

Substitution •What are the switching costs of suppliers and firms in the industry? •Is there any presence of substitute inputs? Players •What is the suppliers’ concentration? •How high is the concentration of suppliers?

Integration •What is the suppliers’ threat of forward integration? •What is the buyers’ threat of backward integration?

Power of BuyersBuyer‘s type •How strong is the difference between buyer concentration vs. firm concentration? •What is the buyer volume? •What are the buyer switching costs relative to the firm’s switching costs? •Is the buyer capable of backward integration?

Information •How much information does the buyer have? •Are they attracted by substitutes? •How much does product differences effect the buyer?

Brand awareness •How does the buyer judge the brand identity? •How high is the impact of quality/performance?

Threat of Substitutes

What is the relative price performance of substitutes? •What are the prices of my products comparatively? •Are the substitute prices stable? (increase or decrease)

How high are the switching costs? •What are the differences relative to my products? •What would the costs incurred be to change my products?

What is the buyer propensity to substitute? •What are the buyers preferences on the product category? •What are the differences regarding my products? (quality, prices)

Rivalries among existing competition

Competitors •How many direct or indirect competitors are there? •What are the size of my competitors? •How diverse are my competitors?

Industry •What is the industry growth rate? •What are the strategic stakes?

Products •How different is my product? •What are the buyers’ switching costs?

Thank You…!