COST OF PRODUCTION

The cost of production is an important factor in almost all business analysis and decision, etc..cost

reffers to the expenses incurred in production

Cost analysis refers to the study of behavior of cost in relation to one or more production criteria like size of output, scale of operation, price of factors of production

Cost analysis

There are two basic types of costs a company incurs.

• Variable Costs• Fixed Costs

Variable costs are costs that change with changes in production levels or sales. Examples include: Costs of materials used in the production of the goods.

Fixed costs remain roughly the same regardless of sales/output levels. Examples include: Rent, Insurance and Wages

In order to calculate how profitable a product will be, we must firstly look at the Costs involved -

Break-Even Analysis

TOTAL COSTS◦ Total Costs is simply Fixed Costs and Variable Costs

added together.

TC = FC + VC◦ As Total Costs include some of the Variable Costs then

Total Costs will also change with any changes in output/sales.

Break-Even AnAlysis

Unit TFC TVC TC

0 60 60-60=0 60

1 60 100-60=40 100

2 60 120-60=60 120

3 60 130-60=70 130

4 60 160-60=110 160

5 60 220-60=160 220

6 60 360-60=300 360

TOTAL COST=TFC+TVC

Y

COST

C 0 QUALITY OF OUTPUT

TVC

TC

TFC

X

The Break-even point occurs when Total Costs equals Revenue (Sales Income)

Revenues (Sales Income) = Total Costs

Break-Even Analysis

At this point the business is not making a Profit nor incurring a Loss – it is merely covering its Total Costs

Let us have a look at a simple example.

Bannerman Trading Company opens a flower shop.

Fixed Costs:

• Rent: £400• Helper (Wages): £200

Variable Costs:

• Flowers: £0.50 per bunch

Selling Price:• Flowers: £2 per bunch

So we know that: Total Fixed Costs = £600Variable Cost per Unit = £0.50Selling Price per Unit = £2.00

Break-Even Analysis

We must firstly calculate how much income from each bunch of flowers can go towards covering the Fixed Costs.

This is called the Unit Contribution.Selling Price – Variable Costs = Unit Contribution

£2.00 - £0.50 = £1.50 For every bunch of flowers sold £1.50 can go towards

covering Fixed Costs

Break-Even Analysis

SP = £2.00

VC = £0.50

FC = £600

Now to calculate how many units must be sold to cover Total Costs (FC + VC)

This is called the Break Even PointBreak Even Point =

Fixed Costs Unit Contribution£600 £1.50 = 400 Units

Therefore 400 bunches of flowers must be sold to Break Even – at this the point the business is not making a Profit nor incurring a Loss – it is merely covering its Total Costs

Break-Even Analysis

SP = £2.00

VC = £0.50

Unit cont = £1.50

FC = £600

BREAK EVEN ANALYSIS

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