ODWAR VINCENT-LIRA UNIVERSITY

TOPIC
Concept of Cost of Production:

By "Cost of Production" is meant the total sum of money required for the production of a
specific quantity of output. It relates to the different expenses that a firm faces in producing a
good or service.

"In Economics, cost of production has a special meaning. It is all of the payments or
expenditures necessary to obtain the factors of production of land, labor, capital and
management required to produce a commodity. It represents money costs which we want to
incur in order to acquire the factors of production".

In the words of Campbell: "Production costs are those which must be received by resource
owners in order to assume that they will continue to supply them in a particular time of
production".

Elements of Cost of Production:

The following elements are included in the cost of production:

(a) Purchase of raw machinery, (b) Installation of plant and machinery, (c) Wages of labor, (d)
Rent of Building, (e) Interest on capital, (f) Wear and tear of the machinery and building, (g)
Advertisement expenses, (h) Insurance charges, (i) Payment of taxes, (j) In the cost of
production, the imputed value of the factor of production owned by the firm itself is also
added, (k) The normal profit of the entrepreneur is also included In the cost of production.

Normal Profit:
By normal profit of the entrepreneur is meant in economics the sum of money which is
necessary to keep an entrepreneur employed in a business. This remuneration should be equal
to the amount which he can earn in some other alternative occupation. If this alternative return
is not met, he will leave the enterprise and join alternative line of production.

Classifications of Cost of Production:

Classification of total cost on the basis of the cost fixed and variable inputs is not enough for
taking managerial decisions. A firm has to work out in detail the different expenses that it
incurs on various heads. In order to compute profit and loss a form has to analyze the
‘components’ or ‘elements’ of total cost.

Functionally, the major components of the total cost of a product the comprises the total costs
can be divided as follows;
(i) Prime Cost = Direct Material + Direct Wages + Direct Expenses
(ii) Production Overhead = Indirect Material + Indirect Wages + Indirect Expenses
(iii) Production cost = Prime Cost + Production overhead
(iv) Costs Related to General Administration, Marketing/Sales, Research & Development

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(v) Total = Production Cost + Costs Related to other

functions Illustration

However, Prof, Mead in his book, "Economic Analysis and Policy" has classified these costs into
three main sections:

(1) Production Costs:

It includes material costs, rent cost, wage cost, interest cost and normal profit of the
entrepreneur.

(2) Selling Costs:

It includes transportation, marketing and selling costs.

(3) Sundry Costs:

It includes other costs such as insurance charges, payment of taxes and rate, etc., etc.

Concept of Economic Costs:

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We have discussed the important types of cost which a firm has to face. From economics point
of view, costs are splited up into the following parts.

(1) Explicit Cost:

Explicit cost is also called money cost or accounting cost. Explicit cost represents all such
expenditure which is incurred by an entrepreneur to pay for the hired services of factors of
production and in buying goods and services directly. In other words, they are the expenses
which the business manager must take into account of because they must actually be paid by
the firm.

The explicit cost includes wages and salary payments, expenses on the purchase of raw
material, light, fuel, advertisements, transportation, taxes and depreciation charges.

(2) Implicit Cost:

The implicit costs are the imputed value of the entrepreneur's own resources and services.
Implicit costs can be defined as: "Expenses that an entrepreneur does not have to pay out of his
own pocket but are costs to the firm because they represent an opportunity cost".

For instance, if a person is working as a manager in his own firm or has invested his own capital
or has built the factory at his own land, the reward of all these factors of production at least
equal to their transfer prices is, included in the expenses of a business.

Implicit costs, thus, are the alternative costs of the self-owned and self-employed resources of a
firm. The total costs of a business enterprise is the sum total of explicit and implicit costs. If the
implicit costs are not included in the firm's total cost, the cost of the firm will be understated
and it will result in serious error.

(3) Real Cost:

Real costs are the pains and inconveniences experienced by labor to produce a commodity.
These costs are not taken in the costing of a commodity by the firm. Real cost has been defined
differently by different economists. Classical economists understood by real costs the pains and
sacrifices of labor.

(4) Opportunity Cost:

The concept of opportunity cost has a very important place in economic analysis. It is defined
as: "The value of a resource in its next best use. It is the amount of income or yield that could
have been earned by investing in the next best alternative".
"The opportunity cost of using any factor is what is currently foregone by using it".
The idea of opportunity cost has an important bearing on the decisions involving scarcity of
resources, their alternative uses and the choice.

(5) Sunk Cost: It is the cost that is already been incurred and cannot be recovered.

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Factors affecting costs of production

(i), Wage costs. For labour intensive industry (service sector/manufacturing of clothes) a small
change in wage costs has a big impact on the overall costs of firms.

(ii). Labour productivity. New technology which improves output per worker enables the firm to
cut back on employing workers, leading to lower costs.

(iii). Exchange rate. A rise in the exchange rate makes imports cheaper. If the firm needs to
import raw materials, an appreciation can reduce the cost of production (though exports will be
less competitive)

(iv). Raw materials. A rise in the cost of raw materials, e.g. oil, plastic, and metal – will increase
the cost of firms. Nearly all firms will be affected by higher oil prices – which increase the cost
of transport.

(v). Tax. Higher national insurance (tax on workers) raises costs.

(vi). Bureaucracy and administration. Firms which have to fill in paperwork and complicated tax
returns will have higher costs. This could be significant for firms who export but have to pass
through administrative hurdles (non-tariff barriers)

(vii). Transport costs

(viii). Interest rates. Firms who borrowed to invest will be affected by an increase in interest
rates – which raises the cost of loan repayments.

IMPORTANT METHODS OF COSTING:

(i). Unit costing: It is also called the single output costing. It is used in costing of products that
are expressed in identical units and suitable for products that are manufactured by continuous
activity.

(ii). Job costing: Under this method, costs are ascertained for each work order separately as
each has its own specification and scope. Tailor made products also get covered by this type of
costing.

(iii). Contract costing: In this method costing is done for jobs that involve heavy expenditure
and stretches over long period and across different sites. It is also called as terminal costing.

(iv). Batch costing: Through this method the costing is done for units that are produced in
batches that are uniform in nature and design.

(v). Process costing: It is used for the products which go through different processes. Like in the
process of manufacturing cloth, different processes are involved namely spinning, weaving and

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finished product. Each process gives an output that is a finished product in itself and can be sold.
That is why; process costing is used to ascertain the cost of each stage of production

(vi). Service or operating costing: It is the method used for the costing of operating a service
such as Public Bus, Railways, Nursing home. It is used to ascertain the cost of a particular
service.

(vii). Multiple costing: When the output comprises different assembled parts like in televisions,
cars or electronic gadgets, cost has to be ascertained for the component as well as the finished
product. Such costing may involve different / multiple methods of costing.

(viii). Product Costing: Product costing methods are used to assign cost to a manufactured
product. The main costing methods available are process costing, job costing and direct costing.
Each of these methods applies to different production and decision environments.

(ix). Inventory Costing: Different inventory costing methods are best suited to different
situations and financial goals.

• First In, First Out (FIFO). Under this method, the oldest costs are assigned to inventory
items sold, regardless of whether the sold items were actually purchased at that cost.
When the number of inventory items purchased at the oldest cost is sold, the next
oldest cost is assigned to sales.
• Last In, First Out (LIPO). The last in, first out method (LIFO) is the exact opposite of the
FIFO method, assigning the most recent inventory costs to items sold

Importance of Costing in Managerial Decision Making

(i). Pricing Decisions. Knowing how much your company spends to produce a unit of product is
invaluable important. If you plan on competing on prices, you will want to ensure that your
product is priced lower than that of your competitors, but if you sell your product for less than
its cost, you won't be in business for very long. While costing is useful for setting a normal sales
price, it is also useful for determining whether or not to take special orders at lower prices

(ii). Company Performance. Because costing methods have uniform rules, managers rely on the
consistency of costing techniques to evaluate performance across companies. By examining the
company's filings, you can determine how many units of product the company sold and at what
cost.

(iii). Financial Reporting. Adherence to specific costing techniques are required under generally
accepted accounting principles, called GAAP, for external financial reporting purposes. GAAP
requires that all manufacturing costs are assigned to product, and that no non-manufacturing
costs are assigned to products. Costing systems that treat costs in this manner are known as
absorption, traditional, or full-cost costing systems. Small-business owners should recognize
that not all costing systems treat costs in this manner. For example, variable costing systems
seek to stabilize net income with regard to changes in production levels, so they do not assign

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all manufacturing costs to products. This method of costing may be useful for internal decision
making, but would not be appropriate for external reporting.

(iv). Sell or Process Further. Costing methods are important when companies are deciding
whether to sell an intermediate product or to process the product further. For example, a dairy
farmer has many options to consider when determining what products to bring to market. The
dairy could sell raw milk to a creamery, process the milk into pasteurized dairy products, make
butter or ice cream, or produce cheese. By using a costing technique called relevant cost
analysis, the dairy's owner can determine what amount of processing is the most profitable for
the dairy.

Analysis of cost in the Production period:

(a). Short Run: Short run is a period of time over which at least one factor must remain fixed.
For most of the firms, the fixed resource or factors which cannot be increased to meet the
rising demand of the good is capital i.e., plant and machinery.

Short run, then, is a period of time over which output can be changed by adjusting the
quantities of resources such as labor, raw material, fuel but the size or scale of the firm remains
fixed.
(b). Long Run: In the long run there is no fixed resource. All the factors of production are
variable. The length of the long run differs from industry to industry depending upon the nature
of production. For example, a balloon making firm can change the size of firm more quickly
than a car manufacturing firm.

Categories/Types of Costs in the Short Run:

The total cost of a firm in the short run is divided into two categories (1) Fixed cost and (2)
Variable cost. The two types of economic costs are now discussed in brief.

(1) Total Fixed Cost (TFC):

Total fixed cost occurs only in the short run. Total Fixed cost as the name implies is the cost of
the firm's fixed resources, Fixed cost remains the same in the short run regardless of how many
units of output are produced. We can say that fixed cost of a firm is that part of total cost which
does not vary with changes in output per period of time. Fixed cost is to be incurred even if the
output of the firm is zero.
For example, the firm's resources which remain fixed in the short run are building, machinery
and even staff employed on contract for work over a particular period.

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(2) Total Variable Cost (TVC): Total variable cost as the name signifies is the cost of variable
resources of a firm that are used along with the firm's existing fixed resources. Total variable
cost is linked with the level of output. When output is zero, variable cost is zero. When output
increases, variable cost also increases and it decreases with the decrease in output. So any
resource which can be varied to increase or decrease with the rate of output is variable cost of
the firm.

(3) Total Cost (TC): Total cost is the sum of fixed cost and variable cost incurred at each level of
output. Total cost of production of a firm equals its fixed cost plus its:

Formula: TC = TFC + TVC

Short run costs of a firm is now explained with the help of a schedule and diagrams.

Schedule:

(in Dollars)

Units of Output (in Total Fixed

Total Variable Cost Total Cost
Hundred) Cost
0 1000 0 1000
1 1000 60 1060
2 1000 100 1100
3 1000 150 1150
4 1000 200 1200
5 1000 400 1400
6 1000 700 1700
7 1000 1100 2100

The short run cost data of the firm shows that total fixed cost TFC (column 2) remains constant
at $1000/- regardless of the level of output.

The column 3 indicates variable cost which is associated with the level of output. Total variable
cost is zero when production is zero. Total variable cost increases with the increase in output.
The variable does not increase by the same amount for each increase in output. Initially the
variable cost increases by a smaller amount up to 3rd unit of output and after which it increases
by larger amounts.

Column (4) indicates total cost which is the sum of TFC + TVC. The total cost increases for each
level of output. The rise in total cost is sharper after the 4th level of output. The concepts of

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costs, i.e., (1) total fixed cost (2) total variable cost and (3) total cost can be illustrated
graphically.

(i) Total Fixed Cost Curve/Diagram:

In this diagram (13.1) the total fixed cost of a firm is assumed to be $1000 at various levels of
output. It remains the same even if the firm's output is zero.

(ii) Total Variable Cost Curve/Diagram:

In the figure (13.2), the total variable cost curve (TVC) increases with the higher level of output.
It starts from the origin. Then increases at a diminishing rate up to the 4th units of output. It
then begins to rise at an increasing rate.

Total Cost Curve Curve/Diagram:

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In the figure (13.3), total cost curve which is the sum of the total fixed cost and variable cost at
various levels of output has nearly the same shape. The difference between the two is by only a
fixed amount of $1,000. The total variable cost curve and the total cost curve begin to rise more
rapidly as production is increased. The reason for this is that after a certain
output, the business has passed its most efficient use of its fixed costs machinery, building etc.,
and its diminishing return begins to set in.

Average Cost:
The entrepreneurs are no doubt interested in the total costs but they are equally concerned in
knowing the cost per unit of the product. The unit cost figures can be derived from the total
fixed cost, total variable cost and total cost by dividing each of them with corresponding
output.

Classifications of average cost:

(1) Average Fixed Cost (AFC): Average fixed cost refers to fixed cost per unit of output. Average
fixed Cost is found out by dividing the total fixed cost by the corresponding output.

AFC =TFC
Output (Q)

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Behavior of Average Fixed Cost (AFC):

The average fixed cost begins to fall with the increase in the number of units produced, In our
example stated above, average fixed cost in the beginning was $10. As the output of the firm
increased, it gradually came down to $1. The AFC diminishes with every increase in the quantity
of output produced but it never becomes zero.

Diagram/Curve:

The concept of average fixed cost can be explained with the help of the curve, in the diagram
(13.4) the average fixed cost curve gradually falls from left to right showing the level of output.
The larger the level of output, the lower is the average fixed cost and smaller the level of
output, the greater is the average fixed cost. The AFC never becomes zero.

(2) Average Variable Cost (AVC):

Average variable cost refers to the variable expenses per unit of output Average variable cost is
obtained by dividing the total variable cost by the total output.

For instance, the total variable cost for producing 100 meters of cloth is $800, the average
variable cost will be $8 per meter.

AVC =TVC
(Q)

Behavior of Average Variable Cost:

When a firm increases its output, the average variable cost decreases in the beginning, reaches
a minimum and then increases. Here, a question can be asked as to why AVC decreases in the
beginning reaches a minimum and then increases. The answer to this question is very simple.

When in the beginning, a firm is not producing to its full capacity, then the various factors of
production employed for the manufacture of a particular commodity remain partially absorbed.

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As the output of the firm is increased, they are used to its fullest extent. So the AVC begins to
decrease. When the plant works to its full capacity, the AVC is at its minimum. If the production
is pushed further from the plant capacity, then less efficient machinery and less, efficient labour
may have to be employed. This results in the rise of AVC. It is in this way we say that as the
output of a firm increases, the AVC decreases in the beginning, reaches a minimum and then
increases. The AVC can also be represented in the form of a curve.

Illustartion of the Curve:

The shape of the average variable cost curve (Fig. 13.5) is like a flat U-shaped curve. It shows
that when the output is increased, there is a steady fall in the average variable cost due to
increasing returns to variable factor. It is minimum when 500 meters of doth are produced.
When production is increased to 600 meters, of cloth or more, the average variable cost begins
to increase due to diminishing returns to the variable factor.

(3) Average Total Cost (ATC):

Average total cost refers to cost (both fixed and variable) per unit of output. Average total cost
is obtained by dividing the total cost by the total number of commodities produced by the firm
or when the total sum of average variable cost and average fixed cost is added together, it
becomes equal to average total cost.

ATC = Total Cost (TC)

Output (Q)

Behavior of Average Total Cost:

As the output of a firm increases, average total cost like the average variable cost decreases in
the beginning reaches a minimum and then it increases. The reasons for decline of ATC in the
beginning are that it is the sum of AFC and AVC.

Average fixed cost and average variable costs have both the tendency to fall as output is
increased. Average total cost will continue falling so long average variable cost does not rise.

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Even if average variable cost continues rising, it is not necessary that the average total cost will
rise. It can be due to the fact that the increase in average variable cost is less than the fall in
average fixed cost. The increase in average variable cost is counterbalanced by a rapid fall of
average fixed cost. If the rise in the average variable cost is greater than the fall in average fixed
cost, then the average total cost will rise.

The tendency to rise on the part of average total cost-in the beginning is slow, after a certain
point it begins to increase rapidly.

Diagram/Curve:

The average total cost is represented here by a shaped curve in Fig. (13.6). The average total
cost curve is also like a U-shaped curve. It shows that as production increases from 100 meters
to 200 meters of cloth, the cost falls rapidly, reaches a minimum but then with higher level of
output, the average fixed cost begins to increase.

Summary of the shapes of the various types of cost in the production processes.

Short Run and Long Run Average Cost Curves:

Relationship and Difference between Short Run and long run Average Cost Curve:

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In the short run, the shape of the average total cost curve (ATC) is U-shaped. The, short run
average cost curve falls in the beginning, reaches a minimum and then begins to rise. The
reasons for the average cost to fall in the beginning of production are that the fixed factors of a
firm remain the same. The change only takes place in the variable factors such as raw material,
labor, etc.

As the fixed cost gets distributed over the output as production is expanded, the average cost,
therefore, begins to fall. When a firm fully utilizes its scale of operation (plant size), the average
cost is then at its minimum. The firm is then operating to its optimum capacity. If a firm in the
short-run increases its level of output with the same fixed plant; the economies of that scale of
production change into diseconomies and the average cost then begins to rise sharply.

Long Run Average Cost Curve:

In the long run, all costs of a firm are variable. The factors of production can be used in varying
proportions to deal with an increased output. The firm having time-period long enough can
build larger scale or type of plant to produce the anticipated output. The shape of the long run
average cost curve is also U-shaped but is flatter that the short run curve as is illustrated in the
following diagram:

In the diagram 13.7 given above, there are five alternative scales of plant SAC 1SAC2, SAC3, SAC4
and, SAC5. In the long run, the firm will operate the scale of plant which is most profitable to it.

If the anticipated output rate is 1000 per unit of time the firm would build the scale of plant
given by SAC5 and operate it at point E. If we draw a tangent to each of the short run cost
curves, we get the long average cost (LAC) curve. The LAC is U-shaped but is flatter than tile
short run cost curves. Mathematically expressed, the long-run average cost curve is the
envelope of the SAC curves.

In this figure 13.7, the long-run average cost curve of the firm is lowest at point C. CM is the
minimum cost at which optimum output OM can be, obtained.

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Marginal Cost (MC):

Marginal Cost is an increase in total cost that results from a one unit increase in output. It is
defined as: "The cost that results from a one unit change in the production rate".

The marginal cost of the second unit is the difference between the total cost of the second unit
and total cost of the first unit. The marginal cost of the 5th unit is $5. It is the difference
between the total cost of the 6th unit and the total cost of the, 5th unit and so forth.

Marginal Cost is governed only by variable cost which changes with changes in output. Marginal
cost which is really an incremental cost can be expressed in symbols.

Marginal Cost = Change in Total Cost =ΔTC

Change in Output Δq

The readers can easily understand from the table given below as to how the marginal cost is
computed:

Schedule:

Units of Output Total Cost (Dollars) Marginal Cost (Dollars)

1 5 5
2 9 4
3 12 3
4 16 4
5 21 5
6 29 8

Graph/Diagram:

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MC curve can also be plotted graphically. The marginal cost curve in fig. (13.8) decreases
sharply with smaller Q output and reaches a minimum. As production is expanded to a higher
level, it begins to rise at a rapid rate.

Long Run Marginal Cost Curve:

The long run marginal cost curve like the long run average cost curve is U-shaped. As
production expands, the marginal cost falls sharply in the beginning, reaches a minimum and
then rises sharply.

Relationship Between Log Run Average Cost and Marginal Cost:

The relationship between the long run average total cost and log run marginal cost can be
understood better with the help of following diagram:

It is clear from the diagram (13.9), that the long run marginal cost curve and the long run
average total cost curve show the same behavior as the short run marginal cost curve express
with the short run average total cost curve. So long as the average cost curve is falling with the
increase in output, the marginal cost curve lies below the average cost curve.

When average total cost curve begins to rise, marginal cost curve also rises, passes through the
minimum point of the average cost and then rises. The only difference between the short run
and long run marginal cost and average cost is that in the short run, the fall and rise of curves
LRMC is sharp. Whereas In the long run, the cost curves falls and rises steadily.

Relation of Average Variable Cost and Average Total Cost to Marginal Cost:

Illustration of the various types of costs and their relationship should be shown in the form of a
table. This is illustrated in the table below:

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Units ofTotal FixedTotal VariableAverage TotalAverage Average Marginal Cost

Output Cost Cost (TVC) Cost (ATC) Fixed CostVariable Cost(MC)
(TFC) (AFC) (AVC)

($) ($) ($) ($) ($) ($)

1 30 15 45 30 15 15

2 30 16.9 23.4 15 8.4 1.9

3 30 18.4 16.1 10.1 6.1 1.5

4 30 19.4 12.3 7.5 4.8 1

5 30 20 10 6 4.0 0.6

6 30 22 8.7 5 3.7 2

7 30 25 7.8 4.3 3.6 3

8 30 30 7.5 3.7 3.7 5

9 30 36 7.3 3.3 4 6

10 30 43 7.3 3 4.3 7

11 30 60 8.2 2.7 5.5 17

12 30 90 10 2.5 7.5 30

13 30 125 11.9 2.3 9.6 35

14 30 165 13.9 2.1 11.8 40

15 30 210 16 2 14.8 45

16 30 270 18.7 1.9 16.7 60

From the table, the reader can understand the relation of various types of costs to each other.
We take, first of all, the relation of average total cost to marginal cost. As production increases,
the average total cost and the marginal cost both begin to decrease.

The average total cost goes on decreasing up to the 9th unit and then after 10, it begins to rise.
The marginal cost goes on falling up to 5th unit and then it begins to increase. So long as the

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average total cost does not rise, the marginal cost remains below it. When average total cost
begins to increase, toe marginal cost rises more than the average total cost.

Average Variable Cost and Marginal Cost:

The relation of average variable cost and marginal cost is also very clear from the diagram given
below. The AVC goes on falling up to the 7th unit, and then it steadily moves upwards. On the
other hand the marginal cost falls up to the 5th unit and then rises more rapidly than average
variable cost.

Diagram

In the diagram (13.10) AFC, AVC, ATC and MC curves are shown. Here, units of production are
measured along OX and cost along OY. ATC and AVC both fall in the beginning, reach a
minimum point and then begin to rise. So is the case with the marginal cost curve. It first falls
and then after rising, sharply crosses through the lowest point of average variable cost and
average total cost and rises.

Revenues of a firm

We have discussed earlier the various types of costs of a firm. Now the discussion will centre
round the various types of revenue of a firm.

Definition of Revenue: By 'revenue' of a firm is meant the total sale proceeds or the total
receipts of a firm from the sale of the output.

The various kinds of revenue will be discussed here under three heads:

(i) Total Revenue, (ii) Marginal Revenue, (iii) Average Revenue.

(i) Total Revenue (TR):

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By 'total revenue' of a firm is meant the total amount of sale proceeds or the total receipts of
the firm.

Example: If a firm producing cloth sells one hundred meters of cloth in the market at $4 per meter, the
sale proceeds or the receipts of the firm win be $400. This total sale proceed which a firm has received
by selling 100 meters of cloth is called its total revenue. The total revenue varies with the sales of a firm.

Total Revenue = Price x Quantity Sold

TR = P.q

P means price.

q means quantity.

TR means total revenue.

(ii) Marginal Revenue (MR): Marginal revenue is the addition made to the total revenue by a
one unit increase in the volume of sales by the firm in the market. It can also called as the net
revenue earned by selling on additional unit of output.

MR = ΔTR
Δq

(iii) Average Revenue (AR)

Average revenue is revenue earned per unit of output. Average revenue is obtained by dividing
the total revenue by the number of units sold in the market.

Average Revenue = Total Revenue

Total Output Sold

AR=TR
q

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Revenue Curve of an Individual Firm under Imperfect Competition:

Under imperfect competition, whether it may take the form of monopoly, duopoly or oligopoly,
the demand curve facing the firm is negatively inclined or we can say its slopes downward from
left to right. This means that a firm can affect the market price and can sell more goods at lower
prices and less at a higher price.

Under imperfect competition, the behavior of MR curve is that it lies below the AR curve. As
production expands, the distance between the two curves increases. The AR line and the price
line is the same as is clear from the schedule given below: Schedule:

Units Sold Price ($) Total Revenue ($) Marginal Revenue ($) Average Revenue ($)
1 15 15 15 15
2 14 28 13 14
3 12 36 8 12
4 9 36 0 9
5 7 35 -1 7
6 5 30 -5 5

Diagram/Figure:

lt is clear from the above figure (14.4) that average revenue curve and marginal revenue curve
both have a negative slope. MR curve lies below the AR curve because the output is solid at the
falling prices.

BREAK EVEN ANALYSIS

This is the mathematical technique used to represent the behavior of total costs and revenue
and in turns to be able to obtain information about profit level, break even points and the
implication of various pricing and production decisions.

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Break-even analysis is sometimes called Cost-Volume Profit Analysis. The break-even point is
that point at which the total revenue is equal to the total costs or the point on the graph where
the lines of total revenue and the total cost intersect.

Total costs

Firm’s costs are divided in to 2 general categories, the fixed cost and the variable costs. The
fixed costs remain constant at all levels of output. It is represented by the horizontal line with
the y-intercept equals to the fixed cost.

Fixed cost

O Quantity

The variable costs are those costs that vary with the level of outputs and include such costs as
direct labour cost, direct material costs, variable production overheads, promotion costs etc.

The total cost at any level of output is the sum of fixed cost and variable cost of that level of
output ie. TC= TVC+TFC or TC= FC+VC

Illustration Total cost

Fixed cost

Total Revenue

This is the total receipts of the firm from the sale of its outputs. Total revenue is also
represented by a straight line whose y-intercept at the orgin is equal to the price per unit

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Illustration

Price Total Revenue

O Q’ty

Assumption of the Break-Even Analysis

• It assumes that FC are the same in total and VC are the same per unit at all levels of
outputs
• It assumes that selling prices will be the same at all level of activities
• It assumes that production is the same as sales

P&C TR

TC

TR=TC

FC

Qbe Q’ty

BREAK-EVEN ANALYSIS MODELS

(a) TR=PxQ
(b) TC= FC+VC = FC + CQ
(c) The total contribution formula

Contribution per unit is the difference between selling price per unit and variable cost per
unit.

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Implying that contribution per unit = selling price per unit minus variable price per

unit Contribution per unit = P - V

Implying that total contribution = PQ –VQ

At break-even point therefore;

TR = TC ……………………………….(i)

But TR = PQ ……………………….(ii)

And TC = FC +CQ ……………….(iii)

Therefore,

PQ=FC+VQ………………………..(iv)

PQ-VQ= FC…………………………..(V)

Q (P-V) = FC…………………………………(Vi)

Implying that Q = FC/(P – V)………….(Vii)

(Vii) Is the formula for the break event output.

Q= Fixed cost/contribution per unit

Example:

A firm’s fixed costs are shs 21,000,000 and its expected sales are 10,000 units at shs 8,000 each.
It incurs a variable of shs 5,000 per unit of output produced.

Required;

Compute the break-even output and show it graphically.

Using;

(i) Q= FC/P-V but FC= 21,000,000, P= 8,000, V= 5,000

Q = 21,000,000/8,000-5,000 = 21,000,000/3,000 = 7,000 units

TR = P*Q = 8,000*7,000 = 56,000,000.

(ii) Illustration,

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 LIRA UNIVERSITY COLLEGE- CHARLES OPIO

P,C TR

TC

56,000,000

21,000,000 21,000,000= FC

o 7,000 Q’ty

(ii). A firms FC of production for a commodity is $ 5,000, the variable cost is $ 7.5 per unit and
the commodity sales at 10 per unit .What is the break-even quantity?.

Solution:

Q = FC/P-V = 5,000/10-7.5 = 5,000/2.5 = 50,000/25 = 2,000.

Target Profits

A firm may wish to achieve certain profits during a period. To achieve this profit, sales revenue
must cover all the costs and leave the required profit.

We know that, TR = TC+∏

We can re-write this as PQ=FC+VQ+∏

PQ – VQ = FC+∏

Q (P-C) =FC+∏

Q = FC+∏/P-V

Example.

A firm wants to sell 14,000 units of its product which has a variable cost of shs15,000, FC are
SHS 47,000,000 and the required profit is shs 23,000,000.

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Required; calculate the price per unit of this product

Solution.

We know that Q = FC + ∏ but Q = 14,000, V = 15,000, FC = 47,000,000 and ∏ = 23,000,000

P -V

Therefore 14,000 = 47,000,000 + 23,000,000

1 P – 15,000

Implying that, P = shs 20,000

MARGIN OF Safety

The margin of safety is the difference in units between budgeted sale volume and the break-
even sales volumes and is sometimes expressed as a percentage of the budgeted sales volumes.

TR

TC

FC

Q’ty

Qbe Q budgeted

Example.

The budgeted annual output of a factory is 120, 000 units. The fixed overhead costs amounts to
shs 40, 0000,000 and the variable costs are shs500 a unit. The selling price is shs 1000 a unit.

Required

I. Calculate the budgeted profit II.

Ascertain the break-even out put
III. Determine the margin of safety in units and as a percentage of budgeted sales revenue

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Solution

(i). the budgeted profits

Particular Shs

Sales, 120,000 x 1000 120,000,000

Less Variable cost 60,000,000

Contribution 60,000,000

Less Fixed cost 40,000,000

Targeted profit 20,000,000

(ii) Break-even output

Q=FC/P–V,

Q = 40,000,000/1000 – 500 = 40,000,000/500 = 80,000 units

(iii), Margin of safety in units = Q budgeted minus Q break even = 120,000 – 80,000 = 40,000
units

Margin of safety in percentage = 40,000/120,000 x100 = 33.3%

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