Cost Analysis

Cost concepts & classifications

Actual Cost Opportunity Cost Imputed cost:

Imputed costsare the costs whicharenotactually incurredbut would have been incurred in the absence of employment of self-owned factors. For example, in the case of an owner-manager, very often the cost of managerial functions is ignored( eg 1)

Incremental Costs (Differential Costs) and Sunk Costs

Incremental costisthe additional cost due to a

change in the levelornature of business activity.The change may take several forms,e.g.,addition of a new product-line, changing the channel of distribution, adding a new machine, replacing a machine by a better machine, expansion into additional markets, etc. Thus, the question of incremental or differential cost would not arise when a business is to be set up afresh. It arises only when a change is contemplated in the existing business.

Sunk

costisone whichisnot affectedoralteredbya change in the levelornatureof business activity. It will remain the same whatever the level of activity. The most important example of sunk cost is the amortization of past expenses,e.g.,depreciation. Eg 2

This point can be explained by means of an

example. Suppose a decision is to be made between purchasing a machine or acquiring it on hire. The costs associated with the machine may be classified as follows: Acquisition Costs, Service and Maintenance Costs, Operating Costs (Labour, Power, etc.), and Space Occupancy Costs (depreciation, taxes and insurance on that part of the building in which the machine will be housed).

Past Costs and Future Costs

Past costs are actual costs incurred in the past

and are generally contained in the financial accounts. The measurement of past costs is essentially a record-keeping activity and an essentially passive function insofar as the management is concerned. Future costs are costs that are reasonably expected to be incurred in some future period or periods. Their actual incurrence is a forecast and their management is an estimate. Future costs' are the only costs that matter for managerial decisions because they are the only costs subject to management control.

Short-run and Longrun Costs

Short-run costs are costs that vary with output

when fixed plant and capital equipmentremain the same. Long-run costs are those which vary with output when all input factors including plant and equipment vary.

Fixed and Variable Costs Direct and Indirect Costs Common Production Costs

Joint Costs
For

product costing, it is desirable to distinguish between two broad categories of common products:joint products and alternative products.When an increase in the production of one product causes an increase in the output of another product,then the products and their costs are traditionally defined as joint.For example,

when gas is produced from coal, coke and other

products also emerge. The latter will have as joint cost the purchase price of coal. Here, the processing of material automatically results in two or more distinct products being produced. In contrast, when an increase in the output of a product is accompanied by a reduction in other products, the products may be called alternative. Slag and steel are joint products, but steel rails and steel bars are alternative products. When the proportion of the various products is fixed, separate product costs are indeterminate and there is no point in contemplating their separation.

Urgent and Postponable Costs Out-of-Pocket and Book Costs Escapable and Unavoidable Costs Replacement & historical costs Average, Marginal & total cost

Average cost is equal to total cost divided by the

number of units produced. For example. at an output of13units, the total cost is Rs. 624. Here the average cost is Rs. 48. The total cost is equal to the sum of fixed cost and all the marginal costs incurred. For example, at an output of5units. the total cost is176+75+55+45+34+29=414.It may be noted that the fixed cost is the initial cost to which the firm is committed irrespective of the quantity produced. Where marginal cost is falling. total cost will be rising at a declining rate: on the other hand. where marginal cost is rising. total cost will be

When marginal cost is lower than the average

cost, average cost would be falling: for example. up to12units of output as shown in Table 4. This will be so irrespective of the fact whether the marginal cost is rising or falling. For example. for an output of11and12units. the marginal cost is rising. but the average cost is falling. Where the marginal cost is greater than the average cost, the average cost would berising; for example. for outputs at14and15units.

If

the marginal cost first falls and then rises,ie.,the marginal cost curve is U-shaped, the marginal cost will be equal to the average cost at a point where the average cost is the minimum. For example, at an output of 13 units, the average cost is the lowest at Rs. 48 where the marginal cost is also Rs. 48. If the marginal cost is below the average variable cost, the latter must be falling. This is exemplified in the Table up to 11 units of output.

If the marginal cost is higher than the average

variable cost, the latter must be rising. This is exemplified in the Table at output levels of 13, 14 and 15 units. If the marginal cost first falls and then rises, it will be equal to the average variable cost at a point where the average variable cost is the minimum. This is so at an output level of 12 units where the margiP.al cost and the' average variable cost are equal to Rs. 33.