Costs : Cost is the price paid to acquire, produce, accomplish, or maintain anything .

An
amount that has to be paid or given up in order to get something.

Types of costs

 Opportunity cost
 Accounting costs
 Economic costs
 Sunk costs
 Short run costs
 Long run costs
 Fixed costs
 Variable costs
 Total costs
 Average costs
 Marginal costs

Opportunity cost:

The value of next best alternative product that is forgone so as to release resources for the greater
production of the former.

Example: If 15 bicycles could be produced with the materials used to produce an automobile,
the opportunity cost of the automobile is 15 bicycles.

Explicit Cost: A direct payment made to others in the course of running a business, such as
wages, rent, and materials, as opposed to implicit costs, which are those where no actual
payment is made.

Implicit Cost: The opportunity cost equal to what a firm must give up in order to use factors
which it neither purchases nor hires.

Economic Costs = Explicit + Implicit Costs

Accounting Costs= Explicit Costs

Sunk cost

A sunk cost is a retrospective (past) cost that has already been incurred and cannot be recovered
changed or altered by any decision made now or in future. Once it is decided to make
incremental investment expenditure and funds are allocated and spent, all preceding cost are
considered as sunk cost. Such cost are based on prior commitment and cannot be revised or
recovered when there is a change in market condition or in business decision makings. The sunk
cost are ignored in managerial decision making as they are irrelevant costs which will not affect
the decision. Suppose a company paid Rs.50000 to purchase machinery five years back. The
machine was used to produce for last few years and now it is obsolete and no longer can be sold.
The amount paid is already incurred and cannot be recovered. So the cost of the obsolete
machine will not be considered in making managerial decisions.

Marginal Cost:

The additional cost of producing one more unit of output is marginal cost.

Incremental Cost: The Incremental Cost are the additions to costs resulting from a change in
the nature and level of business activity. The additional cost of an additional quantity. It is
similar to marginal cost, except that marginal cost refers to the cost of the next unit. Incremental
cost might be the additional cost from the next 200 units.

Costs Example

Last year, Amar decided to open a box factory. Amar built the factory for $200,000. Materials
and wages required to make a box amount to 5 cents per box. Before starting production, Amar
was offered a job at ABC Co. that paid Rs.4,000 a month. Classify Amar’s costs (explicit,
implicit, economic, accounting, and sunk)
• Explicit Costs: Factory (Rs200, 000),Production (5 Rs./box)
• Implicit Costs: Forgone Wage (Rs.4,000/month)
• Sunk Costs= Factory (Rs.200,000)
• Accounting Costs=Explicit Costs(Rs.200, 000)
• Economic Costs = Explicit + Implicit Costs

(Rs.200, 000+ 5 Rs./box +Rs.4,000/month)

Average cost
Average cost is total cost divided by output; a common measure of cost per unit.
• Average cost = AC = TC/q

The short run is the period of time in which a firm must consider some inputs to be absolutely
fixed in making its decisions. The long run is the period of time in which a firm may consider
all of its inputs to be variable in making its decisions.

Social costs :

Those costs that the society in general has to bear because of firm’s activities.

Examples: Pollution, health or environmental degradation

Out of Pocket cost: Out-of-pocket costs are those costs or expenses that require a cash payment
in the current period or during a project.

Common examples of out-of-pocket expenses include gasoline for a car, taking a business client
to lunch and certain medical payments such as prescription costs.
Other Type of cost

1) Direct Cost
2) Indirect Cost
3) Material Cost
4) Labour Cost
5) Overhead Cost (Indirect cost)
6) Administration Cost
7) Selling & Distribution Cost
8) Fixed Cost
9) Variable cost

What are sunk costs?

Sunk costs cannot be recovered if a business decides to leave an industry

Whilst textbooks tend to concentrate on the costs of entering a market, often it is the financial
implications of leaving an industry that act as one of the most important barriers – hence we need
to consider exit costs. A good example of these is the presence of sunk costs.

Sunk costs cannot be recovered if a business decides to leave an industry. Examples include:

Capital inputs that are specific to an industry and which have little or no resale value.

Money spent on advertising, marketing and research and development projects that cannot
be carried forward into another market or industry.

Money spent in building expensive and complex IT systems that are subsequently ditched
because they are unworkable

When sunk costs are high, a market becomes less contestable. High sunk costs act as a barrier
to entry of new firms because they risk making huge losses if they decide to leave a market.

In contrast, markets such as fast-food restaurants, sandwich bars, hairdressing salons and local
antiques markets have low sunk costs so the barriers to exit are low.

1. Asset-write-offs – e.g. the expense associated with writing-off items of plant and
machinery, stocks and the goodwill of a brand
2. Closure or project cancellation costs including redundancy costs, contract
contingencies with suppliers and the penalty costs from ending leasing arrangements for
property
3. The loss of business reputation and goodwill - a decision to leave a market can
seriously affect goodwill among previous customers, not least those who have bought a
product which is then withdrawn and for which replacement parts become difficult or
impossible to obtain.
 4. A market downturn may be perceived as temporary and could be overcome when the
economic or business cycle turns and conditions become more favourable

Definition of 'Sunk Cost Dilemma'

Definition: Sunk costs are irrecoverable costs that have already been incurred and are
independent of any happenings in the future. Dilemma of whether to continue a project with
obscure prospects, which has already absorbed a considerable amount of sunk cost, is known as
sunk cost dilemma.

Description: In a sunk cost dilemma, one can neither walk away from the project as a
considerable amount has already been spent on it and nor can s/he continue with the project and
risk spending more money that might never be recovered. Investors usually face such a
predicament when market conditions change dramatically in the middle of a project.
Money already spent and permanently lost. Sunk costs are past opportunity costs that are
partially (as salvage, if any) or totally irretrievable and, therefore, should be considered irrelevant
to future decision making. This term is from the oil industry where the decision to abandon or
operate an oil well is made on the basis of its expected cash flows and not on how much money
was spent in drilling it. Also called embedded cost, prior year cost, stranded cost, or sunk capital

Marginal cost

Marginal cost is the additional cost incurred in the production of one more unit of a good or
service. It is derived from the variable cost of production, given that fixed costs do not change as
output changes, hence no additional fixed cost is incurred in producing another unit of a good or
service once production has already started.

Marginal cost is significant in economic theory because a profit maximising firm will produce up
to the point where marginal cost (MC) equals marginal revenue (MR).
In economics, marginal cost is the change in the opportunity cost that arises when the quantity
produced is incremented by one unit, that is, it is the cost of producing one more unit of a good.
[1]
Intuitively, marginal cost at each level of production includes the cost of any additional inputs
required to produce the next unit. At each level of production and time period being considered,
marginal costs include all costs that vary with the level of production, whereas other costs that do
not vary with production are considered fixed. For example, the marginal cost of producing an
automobile will generally include the costs of labor and parts needed for the additional
automobile and not the fixed costs of the factory that have already been incurred. In practice,
marginal analysis is segregated into short and long-run cases, so that, over the long run, all costs
(including fixed costs) become marginal.

If the cost function is differentiable, the marginal cost is the first derivative of the cost function
with respect to the quantity.

What is 'Incremental Cost'

Incremental cost, also referred to as marginal cost, is the encompassing change a company
experiences within its balance sheet or income statement due to the production and sale of one
additional unit of production. It is calculated by analyzing the additional charges incurred based
on the change in a certain activity.

BREAKING DOWN 'Incremental Cost'

This activity, for example, may be production levels, sales, machine hours or area dimension. As
the activity increases or decreases, the resulting change in the related expense is the incremental
cost. For example, if production increased from 9,000 units to 10,000 units and the associated
costs increased from Rs.45,000 to Rs.50,000, the incremental cost for the additional 1,000 units
is Rs.5,000.

Usefulness of Incremental Costs

Incremental costs are relevant in making short-term decisions or choosing between two
alternatives. This includes whether to accept a special order. If a special price is established for a
special contract, it is critical the revenue received from the special order at least covers the
incremental costs or the special order results in a net loss. Incremental costs are also useful for
decisions on whether to manufacture or purchase a good. Only the additional costs associated
with the manufacturing of the good should be considered and compared to the retail price.

Unprofitable Business Segment

Incremental cost analysis is utilized to analyze business segments. Certain costs, such as the rent
on an office building, are fixed and not attributable to any specific segment. Therefore, only the
relevant incremental costs such as variable wages, utilities and materials must be considered in
evaluating the profitability of a business segment.

Relevant Costs

Incremental costs are also called relevant costs because they encompass only the items necessary
for analysis. All fixed costs are omitted from incremental cost analysis because they do not
change. Therefore, fixed costs are sunk costs that should not be considered. Only variable costs
such as materials or labor are considered in incremental costs.

Marginal Cost Equaling Marginal Revenue

Incremental costs help determine the profit maximization point for an organization. This point
occurs when marginal costs equal marginal revenues. If a business is earning more marginal
revenue per product than the incremental cost of manufacturing or buying that product, the
business earns profit. Alternatively, once incremental costs exceed marginal revenue for a unit,
the company takes a loss for each item produced. Therefore, knowing the incremental cost of
additional units of production and comparing it to the selling price of these goods assists in
maximizing profit.

Incremental Cost

Definition: The Incremental Cost refers to the additional cost that a company incurs in
undertaking certain actions such as expanding the level of production or adding a new variety of
product to the product line, etc.

The concept of incremental cost is quite similar to the concept of marginal cost, but with a
relatively wider connotation. The marginal cost refers to the addition in the total cost due to the
production of one more unit of a product, generally the next unit. But the incremental costs refers
to the total additional cost incurred in taking a certain action, for example, changing the
production level, not necessarily producing the next unit of a product but instead any ‘nth’ unit
of a product.

The incremental cost is more realistic as it is based on the fact that due to the lack of divisibility
of the inputs it is not possible to use separate factors for each unit of output. Besides, in the long
where firm expands its production hires more manpower, material, machine and equipment, the
expenditure incurred on these factors are the incremental cost and not the marginal cost.

The firm incurs the incremental cost when it undertakes any of the activities: changing the
product line, introducing a new product, replacing obsolete machinery or equipment, replacing
the old methods of production with the new one, etc.

An incremental cost is the increase in total costs resulting from an increase in production or other
activity.

For instance, if a company's total costs increase from Rs.320,000 to Rs.360,000 as the result of
increasing its machine hours from 8,000 to 10,000, the incremental cost of the 2,000 machine
hours is Rs.40,000.

The incremental cost is also referred to as the differential cost. The incremental cost is the
relevant cost for making a short run decision between two alternatives.

COST CONCEPT

When commodities and services are produced, various expenses have to be incurred, e.g.,
purchase of raw materials, payment to labour, landlord, capitalist, etc. The sum total of the
expenses incurred plus the normal profit expected by the producer is called the cost of
production. The various concepts of cost are discussed below:

Nominal Cost and Real Cost: Nominal cost is the money cost of production. The real costs
of production are the pain and sacrifices of labour involved in the process of production.

Explicit and Implicit costs: Explicit costs are the accounting costs or contractual cash
payments which the firm makes to other factor owners for purchasing or hiring the various
factors. Implicit costs are the costs of self-owned factors which are employed by the entrepreneur
in his own business. These implicit costs are the opportunity costs of the self-owned and self-
employed factors of the entrepreneur, that is, the money incomes which these self-owned factors
would have earned in their next best alternative uses.

Accounting Costs and Economic Cost: Accounting costs are the actual or explicit costs
which are paid by the entrepreneurs to the owners of hired factors and services. On the other
hand, economic costs not only include the explicit costs but also the implicit costs of the self-
owned factors or resources which are used by the entrepreneur in his own business.

Opportunity Cost: The opportunity cost (or transfer earnings) of any good is the expected
return from the next best alternative good that is forgone or sacrificed. For example, if a farmer
who is producing wheat can also produce potatoes with the same factors. Then, the opportunity
cost of a quintal of wheat is the amount of output of potatoes given up.

Business Cost and Full Cost: Business costs include all the expenses which are incurred in
carrying out a business. The concept of business cost is similar to the accounting or actual cost.
The concept of Full cost includes two other costs: the opportunity cost and normal profit. Normal
profit is a necessary minimum earning which a firm must get to remain in its present occupation.

Private costs and Social Costs: Private costs are the economic costs which are actually
incurred or provided for by an individual or a firm. It includes both explicit and implicit costs.
Social cost, on the other hand, implies the cost which a society bears as a result of production of
a commodity. Social cost includes both private cost and the external cost. External cost includes
(a) the cost of free goods or resources for which the firm is not required to pay for its used, e.g.,
atmosphere, rivers, lakes etc. (b) the cost in the form of ‘disutility’ caused by air, water, and
noise pollution, etc.

Total, Average and Marginal Costs: Total cost refers to the total outlays of money
expenditure, both explicit and implicit on the resources used to produced a given output. Average
cost is the cost per unit of output which is obtained by dividing the total cost (TC) by the total
output (Q), i.e., TC/Q = average cost. Marginal cost is the addition made to the total cost as a
result of producing one additional unit of the product. Marginal cost is defined as ?TC/?Q.

Fixed Costs and Variable Costs: Fixed costs are the expenditure incurred on the factors such
as capital, equipment, plant, factory building which remain fixed in the short run and cannot be
changed. Therefore, fixed costs are independent of output in the short run i.e., they do not vary
with output in the short run. Even if no output is produced in the short run, these costs will have
to be incurred. Variable costs are costs incurred by the firms on the employment of variable
factors such as labour, raw materials, etc., whose amount can be easily increased or decreased in
the short run. Variable costs vary with the level of output in the short run. If the firm decided not
to produce any output, variable costs will not be incurred.

Short-run and Long-run Cost: Short-run costs are the costs which vary with the change in
output, the size of the firm remaining the same. Short-run costs are the same as variable costs.
On the other hand, long-run costs are incurred on the fixed assets, like plant, building,
machinery, land etc. Long-run cost are the same as fixed-costs. However, in the long-run even
the fixed costs become variable costs as the size of the firm or scale or production is increased.

Relation Between Marginal Cost(MC) and Average Cost(AC)

The relationship between MC and AC may be explained as follows:

 When MC falls, AC also falls but at lower rate than that of MC. So long as MC curve lies
below the AC curve, the AC curve is falling.
 When MC rises, AC also rises but at lower rate than that of MC. That is, when MC curve
lies above AC curve, the AC curve is rising.
 MC intersects AC at its minimum. That is, MC = AC at its minimum.

OPPORTUNITY COST

The resources of any firm operating in the market are limited and investment options are many.
The firm therefore has to decide or select only those investment opportunities/options which
provide the firm with the best return or best income on investment. This means that if a firm can
invest money/ resources only in one investment option then the firm will select that investment
option which promises best return on investment to the firm. In other words while doing so the
firm gives up/rejects the next best option for investing the funds. The opportunity cost of a
company is thus this income/ return which the firm could have earned on the next best
investment alternative.

This can also be understood by a simple example - Let us assume that an individual has two job
offers in hand. One job offer is promising him a salary of Rs. 30, 000 per month while the other
job offer will ensure salary of Rs. 25, 000 per month. If the job profile and other factors related
to the job offers are more or less same then it can be easily expected that the individual will
select the job offer which will provide him with higher salary that is salary of Rs. 30, 000 per
month. Thus, in this case, the opportunity cost is the return involved in the next best alternative
i.e; Salary of Rs. 25, 000 in the next best job offer.

Concept of opportunity cost is closely related to the concept of Economic profit or Economic
Rent. A firm earns or makes Economic profit only when besides covering various costs of
operation, a firm is also able to earn more than its opportunity cost (or its possible earnings under
the next best investment alternative). Opportunity Cost is also termed as Implicit Cost.

Economic Profit is thus earned only when following is true for the Firm:

Income of a Firm > Various Costs of Operations + Opportunity Cost

OR Economic Profit = Earnings or Revenue of Firm - Ecomomic Costs. Here Economic Cost
is various expenses of the business plus the opportunity cost

MARGINAL COST

Marginal costs are defined as the change in total costs resulting from a one unit change in output.
They are the variable costs associated with increasing output in the short run. A change in
marginal costs might come about for example because of a change in the prices of essential raw
materials or an increase in the wage rate paid to part-time employees.

The initial marginal cost curve is assumed to be MC1. If there is a fall in the prices of raw
materials (for example resulting from an increase in the exchange rate or a fall in the market
price of international commodities) then we would see an outward shift in the marginal cost
curve from MC1 to MC2. A business would now be able to produce more output at any given
price. An outward shift in MC is equivalent to an outward shift in the firm's supply curve

If variable costs increase, then we see an inward shift in MC from MC1 to MC3. Firms can now
supply less output at each price level.

The marginal cost of producing an extra unit is linked with the marginal productivity of labour.
If marginal product is falling, assuming the cost of employing extra units of labour is constant,
then the extra costs of the additional units of output will rise.

INCREMENTAL COST

Incremental cost is the cost associated with increasing production by one unit. Because some
costs are fixed and other variable, the incremental cost will not be the same as the overall
average cost per unit. The cost figure can be used for a variety of economic calculations, most
notably the point at which increasing production ceases to be efficient.

A very simple example would be a factory making widgets where it takes one employee an hour
to make a widget. As a simple figure, the incremental cost of a widget would be the wages for
the employee for an hour plus the cost of the materials needed to produce a widget. A more
accurate figure could include added costs, such as shipping the additional widget to a customer,
or the electricity used if the factory has to stay open longer.

The incremental cost total is always made up of purely variable costs. It represents the added
costs that would not exist if the extra unit was not made. That means that many fixed costs such
as rent on a factory or buying a machine are not usually represented. However, if an economist
wanted to be extremely precise, they might include some element of these fixed costs where they
could specifically link them to the production of the extra unit. For example, producing even one
extra widget would cause a tiny bit extra wear and tear on the machine.

SUNK COST

Sunk costs are retrospective (past) costs that have already been incurred and cannot be
recovered. Sunk costs are sometimes contrasted with prospective costs, which are future costs
that may be incurred or changed if an action is taken. Both retrospective and prospective costs
may be either fixed (that is, they are not dependent on the volume of economic activity, however
measured) or variable (dependent on volume).

In traditional microeconomic theory, only prospective (future) costs are relevant to an investment
decision. Traditional economics proposes that an economic actor not let sunk costs influence
one's decisions, because doing so would not be rationally assessing a decision exclusively on its
own merits. The decision-maker may make rational decisions according to their own incentives;
these incentives may dictate different decisions than would be dictated by efficiency or
profitability, and this is considered an incentive problem and distinct from a sunk cost problem.

Evidence from behavioral economics suggests this theory fails to predict real-world behavior.
Sunk costs greatly affect actors' decisions, because many humans are loss-averse and thus
normally act irrationally when making economic decisions.

Sunk costs should not affect the rational decision-maker's best choice. However, until a decision-
maker irreversibly commits resources, the prospective cost is an avoidable future cost and is
properly included in any decision-making processes. For example, if one is considering
preordering movie tickets, but has not actually purchased them yet, the cost remains avoidable. If
the price of the tickets rises to an amount that requires him to pay more than the value he places
on them, he should figure the change in prospective cost into the decision-making and re-
evaluate his decision.

Cost-Volume-Profit (CVP) analysis

Cost-Volume-Profit (CVP) analysis is a managerial accounting technique that is concerned with

the effect of sales volume and product costs on operating profit of a business. It deals with how
operating profit is affected by changes in variable costs, fixed costs, selling price per unit and the
sales mix of two or more different products.

CVP analysis has following assumptions:

All cost can be categorized as variable or fixed.

Sales price per unit, variable cost per unit and total fixed cost are constant.

All units produced are sold.

Where the problem involves mixed costs, they must be split into their fixed and variable
component by High-Low Method, Scatter Plot Method or Regression Method.

CVP Analysis Formula

The basic formula used in CVP Analysis is derived from profit equation:

px = vx + FC + Profit

In the above formula,

p is price per unit;

 v is variable cost per unit;

x are total number of units produced and sold; and

FC is total fixed cost

Besides the above formula, CVP analysis also makes use of following concepts:

Contribution Margin (CM)

Contribution Margin (CM) is equal to the difference between total sales (S) and total variable
cost or, in other words, it is the amount by which sales exceed total variable costs (VC). In order
to make profit the contribution margin of a business must exceed its total fixed costs. In short:

CM = S − VC

Unit Contribution Margin (Unit CM)

Contribution Margin can also be calculated per unit which is called Unit Contribution Margin. It
is the excess of sales price per unit (p) over variable cost per unit (v). Thus:

Unit CM = p − v

Contribution Margin Ratio (CM Ratio)

Contribution Margin Ratio is calculated by dividing contribution margin by total sales or unit
CM by price per unit.

Cost-volume-profit analysis looks primarily at the effects of differing levels of activity on the
financial results of a business

In any business, or, indeed, in life in general, hindsight is a beautiful thing. If only we could look
into a crystal ball and find out exactly how many customers were going to buy our product, we
would be able to make perfect business decisions and maximise profits.

Take a restaurant, for example. If the owners knew exactly how many customers would come in
each evening and the number and type of meals that they would order, they could ensure that
staffing levels were exactly accurate and no waste occurred in the kitchen. The reality is, of
course, that decisions such as staffing and food purchases have to be made on the basis of
estimates, with these estimates being based on past experience.

While management accounting information can’t really help much with the crystal ball, it can be
of use in providing the answers to questions about the consequences of different courses of
action. One of the most important decisions that needs to be made before any business even
starts is ‘how much do we need to sell in order to break-even?’ By ‘break-even’ we mean simply
covering all our costs without making a profit.
This type of analysis is known as ‘cost-volume-profit analysis’ (CVP analysis) and the purpose
of this article is to cover some of the straight forward calculations and graphs required for this
part of the Paper F5 syllabus, while also considering the assumptions which underlie any such
analysis.

THE OBJECTIVE OF CVP ANALYSIS

CVP analysis looks primarily at the effects of differing levels of activity on the financial results
of a business. The reason for the particular focus on sales volume is because, in the short-run,
sales price, and the cost of materials and labour, are usually known with a degree of accuracy.
Sales volume, however, is not usually so predictable and therefore, in the short-run, profitability
often hinges upon it. For example, Company A may know that the sales price for product x in a
particular year is going to be in the region of Rs.50 and its variable costs are approximately
Rs.30.

It can, therefore, say with some degree of certainty that the contribution per unit (sales price less
variable costs) is Rs.20. Company A may also have fixed costs of Rs.200,000 per annum, which
again, are fairly easy to predict. However, when we ask the question: ‘Will the company make a
profit in that year?’, the answer is ‘We don’t know’. We don’t know because we don’t know the
sales volume for the year. However, we can work out how many sales the business needs to
make in order to make a profit and this is where CVP analysis begins.

Methods for calculating the break-even point

The break-even point is when total revenues and total costs are equal, that is, there is no profit
but also no loss made. There are three methods for ascertaining this break-even point:

1 The equation method

A little bit of simple maths can help us answer numerous different cost-volume-profit questions.

We know that total revenues are found by multiplying unit selling price (USP) by quantity sold
(Q). Also, total costs are made up firstly of total fixed costs (FC) and secondly by variable costs
(VC). Total variable costs are found by multiplying unit variable cost (UVC) by total quantity
(Q). Any excess of total revenue over total costs will give rise to profit (P). By putting this
information into a simple equation, we come up with a method of answering CVP type
questions. This is done below continuing with the example of Company A above.

Total revenue – total variable costs – total fixed costs = Profit

(USP x Q) – (UVC x Q) – FC = P (50Q) – (30Q) – 200,000 = P

Note: total fixed costs are used rather than unit fixed costs since unit fixed costs will vary
depending on the level of output.
It would, therefore, be inappropriate to use a unit fixed cost since this would vary depending on
output. Sales price and variable costs, on the other hand, are assumed to remain constant for all
levels of output in the short-run, and, therefore, unit costs are appropriate.

Continuing with our equation, we now set P to zero in order to find out how many items we need
to sell in order to make no profit, ie to break even:

(50Q) – (30Q) – 200,000 = 0

20Q – 200,000 = 0

20Q = 200,000

Q = 10,000 units.

The equation has given us our answer. If Company A sells less than 10,000 units, it will make a
loss; if it sells exactly 10,000 units, it will break-even, and if it sells more than 10,000 units, it
will make a profit.

2 The contribution margin method

This second approach uses a little bit of algebra to rewrite our equation above, concentrating on
the use of the ‘contribution margin’. The contribution margin is equal to total revenue less total
variable costs. Alternatively, the unit contribution margin (UCM) is the unit selling price (USP)
less the unit variable cost (UVC). Hence, the formula from our mathematical method above is
manipulated in the following way:

(USP x Q) – (UVC x Q) – FC = P

(USP – UVC) x Q = FC + P

UCM x Q = FC + P

Q = FC + P

UCM

So, if P=0 (because we want to find the break-even point), then we would simply take our fixed
costs and divide them by our unit contribution margin. We often see the unit contribution margin
referred to as the ‘contribution per unit’.

Applying this approach to Company A again:

UCM = 20, FC = 200,000 and P = 0.

Q = FC

UCM

Q = 200,000

20

Therefore Q = 10,000 units

The contribution margin method uses a little bit of algebra to rewrite our equation above,
concentrating on the use of the ‘contribution margin’.

3 The graphical method

With the graphical method, the total costs and total revenue lines are plotted on a graph; Rs. is
shown on the y axis and units are shown on the x axis. The point where the total cost and
revenue lines intersect is the break-even point. The amount of profit or loss at different output
levels is represented by the distance between the total cost and total revenue lines. Figure 1
shows a typical break-even chart for Company A. The gap between the fixed costs and the total
costs line represents variable costs.

Alternatively, a contribution graph could be drawn. While this is not specifically covered by the
Paper F5 syllabus, it is still useful to see it. This is very similar to a break-even chart, the only
difference being that instead of showing a fixed cost line, a variable cost line is shown instead.

Hence, it is the difference between the variable cost line and the total cost line that represents
fixed costs.The advantage of this is that it emphasises contribution as it is represented by the gap
between the total revenue and the variable cost lines. This is shown for Company A in Figure 2.

Finally, a profit–volume graph could be drawn, which emphasises the impact of volume changes
on profit (Figure 3). This is key to the Paper F5 syllabus and is discussed in more detail later in
this article.

Ascertaining the sales volume required to achieve a target profit

As well as ascertaining the break-even point, there are other routine calculations that it is just as
important to understand. For example, a business may want to know how many items it must sell
in order to attain a target profit.

Example 1
Company A wants to achieve a target profit of Rs.300,000. The sales volume necessary in order
to achieve this profit can be ascertained using any of the three methods outlined above. If the
equation method is used, the profit of Rs.300,000 is put into the equation rather than the profit of
Rs.0:

(50Q) – (30Q) – 200,000 = 300,000

20Q – 200,000 = 300,000

20Q = 500,000

Q = 25,000 units.

Alternatively, the contribution method can be used:

UCM = 20, FC = 200,000 and P = 300,000.

Q = FC + P

UCM

Q = 200,000 + 300,000

20

Therefore Q = 25,000 units.

Finally, the answer can be read from the graph, although this method becomes clumsier than the
previous two. The profit will be Rs.300,000 where the gap between the total revenue and total
cost line is Rs.300,000, since the gap represents profit (after the break-even point) or loss (before
the break-even point.)

A contribution graph shows the difference between the variable cost line and the total cost line
that represents fixed costs. An advantage of this is that it emphasises contribution as it is
represented by the gap between the total revenue and variable cost lines.

This is not a quick enough method to use in an exam so it is not recommended.

Margin of safety

The margin of safety indicates by how much sales can decrease before a loss occurs, ie it is the
excess of budgeted revenues over break-even revenues. Using Company A as an example, let’s
assume that budgeted sales are 20,000 units. The margin of safety can be found, in units, as
follows:

Budgeted sales – break-even sales = 20,000 – 10,000 = 10,000 units.

Alternatively, as is often the case, it may be calculated as a percentage:

Budgeted sales – break-even sales/budgeted sales.

In Company A’s case, it will be 10,000/20,000 x 100 = 50%.

Finally, it could be calculated in terms of Rs. sales revenue as follows:

Budgeted sales – break-even sales x selling price = 10,000 x Rs.50 = Rs.500,000.

Contribution to sales ratio

It is often useful in single product situations, and essential in multi-product situations, to

ascertain how much each Rs. sold actually contributes towards the fixed costs. This calculation is
known as the contribution to sales or C/S ratio. It is found in single product situations by either
simply dividing the total contribution by the total sales revenue, or by dividing the unit
contribution margin (otherwise known as contribution per unit) by the selling price:

For Company A: Rs.20/Rs.50 = 0.4

In multi-product situations, a weighted average C/S ratio is calculated by using the formula:

Total contribution/total sales revenue

This weighted average C/S ratio can then be used to find CVP information such as break-even
point, margin of safety etc

BREAKEVEN POINT

In simple words, the break-even point can be defined as a point where total costs (expenses) and
total sales (revenue) are equal. Break-even point can be described as a point where there is no net
profit or loss. The firm just “breaks even.” Any company which wants to make abnormal profit,
desires to have a break-even point. Graphically, it is the point where the total cost and the total
revenue curves meet.

Calculation (formula)

Break-even point is the number of units (N) produced which make zero profit.

Revenue – Total costs = 0

Total costs = Variable costs * N + Fixed costs

Revenue = Price per unit * N

Price per unit * N – (Variable costs * N + Fixed costs) = 0

So, break-even point (N) is equal

N = Fixed costs / (Price per unit - Variable costs)

About Break-even point

The origins of break-even point can be found in the economic concepts of “the point of
indifference.” Calculating the break-even point of a company has proved to be a simple but
quantitative tool for the managers. The break-even analysis, in its simplest form, facilitates an
insight into the fact about revenue from a product or service incorporates the ability to cover the
relevant production cost of that particular product or service or not. Moreover, the break-even
point is also helpful to managers as the provided info can be used in making important decisions
in business, for example preparing competitive bids, setting prices, and applying for loans.

Adding more to the point, break-even analysis is a simple tool defining the lowest quantity of
sales which will include both variable and fixed costs. Moreover, such analysis facilitates the
managers with a quantity which can be used to evaluate the future demand. If, in case, the break-
even point lies above the estimated demand, reflecting a loss on the product, the manager can use
this info for taking various decisions. He might choose to discontinue the product, or improve the
advertising strategies, or even re-price the product to increase demand.
Another important usage of the break-even point is that it is helpful in recognizing the relevance
of fixed and variable cost. The fixed cost is less with a more flexible personnel and equipment
thereby resulting in a lower break-even point. The importance of break-even point, therefore,
cannot be overstated for a sound business and decision making.

However, the applicability of break-even analysis is affected by numerous assumptions. A

violation of these assumptions might result in erroneous conclusions.

Risk Analysis and Decision Making

CONCEPT OF RISK

Generally everyone has some understanding of the meaning of the word 'risk'. As children we are
taught that something is risky, or we are told not to take risks. But what exatly is 'a risk'?

In fact we all take risks everyday quite happily. We do things knowingly that there is a risk
involved. For example, we know that there is a risk involved in driving a car, or riding a bike, or
going on a skiing holiday. We accept the level of risk because in our minds, although the
potential consequences can be death or serious injury, we think that if we are careful, the chances
of something dreadful happening is very low.

When we evaluate a risk, therefore, we take into account two factors - the probability of
something happening that we don't want, and the consequences if it does.

An airplane flight is a very good example. The consequence of a airplane crash is usually the loss
of most, if not all life on board - dreadful. Fortunately, when we fly, the probability of being in
an airplane crash is very small (1 in 52.6 million according to the National transportation Safety
Board). This very low probability makes the risk very acceptable.

At the other end of the spectrum, there are risks where the probability is very high but the
consequences are relatively low. For example, when we go to work there is a very good chance
that we will catch influenza from a work colleague at some time in the year. The probability of
this happening might be 1 in 4, but if it does happen we will be just laid up in bed for a week and
no serious or long-term damage occurs. This make the risk of getting influenza by going to work
quite acceptable.

So whether we choose to accept or decline a risk depends on the mix of two factors:

 probability; and
 consequence

Identifying, evaluating and understanding risks is a very important aspect of business

management. Businesses can also suffer dreadful consequences if risks are not appropriately
managed. The most widely understood risks are occupational health and safety risks. Most
people generally associate the word 'risk' with injury, health risks and death, but there are many
other types of risk faced by any business.

It is useful to think or risks as falling into two categories:

Risk of harm

Risk of detriment

The risk of "harm" is the type of risk that we mostly think about. The word 'harm' is employed in
relation to something living, usually a person or the natural environment. In a sport and
recreation business, the risk of harm would include injury to a player, sport official, or spectator
as a result of:

 Collisions between players or collisions of a player with a solid structures in the sports
arena
 Being struck by a projectile such as a javelin, cricket ball, or hockey puck that emanates
from the sporting arena
 Being crushed by a riotous crowd at a soccer match
 Lightning strike at golf,

Extreme environmental conditions in a yacht race, or balloon race.

The risk of "detriment" does not involve injury to something living. It generally means some
form of economic loss, which might indeed include a valuation of harm to living things but
which also includes damage of a much wider kind. In a sport and recreation organisation, a
'detriment' could involve:

 Losing a sponsor as a result of a poorly organised tournament

 Repeated cases of athletes testing positive in doping controls and result bad publicity
 A split of the organisation into two political factions that are unable to work together
 Theft of important assets owned by the organisation
 Team members arriving too late at the venue and being unable to compete

Managers of sport and recreation organisations are expected to be conversant in risk

management theory, and to be able to identify and manage risks so that the probability of harm
or detriment occuring is less and/or the consequences of risk are reduced. Pressure is brought to
bear on sporting organisations to engage in and take seriously risk management. The pressure
comes in the form of:

 Legislation in workplace health and safety, and other legal principles such as the 'duty of
care'
 An exclusion from government funding for organisations that are unable to demonstrate
that they have a risk management plan.
Sport and recreation is a risky business, and it is therefore mandatory for sport managers to have
a good understanding of the concept of risk and to engage in risk management.

EXPECTED VALUE COMPUTATION

Expected value is a measurement of the center of a probability distribution. The formula is

derived from that of the mean. Over the long run of several repetitions of the same probability
experiment, if we averaged out all of our values of the random variable we would obtain the
expected value.

The Formula

Given a random variable X with values x1, x2, x3, . . . xn, and respective probabilities of p1, p2,
p3, . . . pn, the expected value of X is given by the formula:

E(X) = x1p1 + x2p2 + x3p3 + . . . + xnpn.

An Example

Flip a coin three times and let X be the random variable of the number of heads. This has
probability distribution of 1/8 for X = 0, 3/8 for X = 1, 3/8 for X = 2, 1/8 for X = 3. Use the
expected value formula to obtain:

(1/8)0 + (3/8)1 + (3/8)2 + (1/8)3 = 12/8 = 1.5

There are many applications for the expected value of a random variable. In this example we see
that in the long run we will average a total of 1.5 heads from this experiment.

HEGDE

A risk management strategy used in limiting or offsetting probability of loss from fluctuations in
the prices of commodities, currencies, or securities. In effect, hedging is a transfer of risk without
buying insurance policies.

Hedging employs various techniques but, basically, involves taking equal and opposite positions
in two different markets (such as cash and futures markets). Hedging is used also in protecting
one's capital against effects of inflation through investing in high-yield financial instruments
(bonds, notes, shares), real estate, or precious metals.

Why it Matters:

Hedging is like buying insurance. It is protection against unforeseen events, but investors usually
hope they never have to use it. Consider why almost everyone buys homeowner's insurance.
Because the odds of having one’s house destroyed are relatively small, this may seem like a
foolish investment. But our homes are very valuable to us and we would be devastated by their
loss. Using options to hedge your portfolio essentially does the same thing. Should a stock or
portfolio take an unforeseen turn, holding an option opposite of your position will help to limit
your losses.

Portfolio hedging is an important technique to learn. Although the calculations can be complex,
most investors find that even a reasonable approximation will deliver a satisfactory hedge.
Hedging is especially helpful when an investor has experienced an extended period of gains and
feels this increase might not be sustainable in the future. Like all investment strategies, hedging
requires a little planning before executing a trade. However, the security that this strategy
provides could make it well worth the time and effort.

Decision Trees

Decision Trees are excellent tools for helping you to choose between several courses of action.
They provide a highly effective structure within which you can lay out options and investigate
the possible outcomes of choosing those options. They also help you to form a balanced picture
of the risks and rewards associated with each possible course of action.

Drawing a Decision Tree

You start a Decision Tree with a decision that you need to make. Draw a small square to
represent this towards the left of a large piece of paper.

From this box draw out lines towards the right for each possible solution, and write that solution
along the line. Keep the lines apart as far as possible so that you can expand your thoughts.

At the end of each line, consider the results. If the result of taking that decision is uncertain, draw
a small circle. If the result is another decision that you need to make, draw another square.
Squares represent decisions, and circles represent uncertain outcomes. Write the decision or
factor above the square or circle. If you have completed the solution at the end of the line, just
leave it blank.

Starting from the new decision squares on your diagram, draw out lines representing the options
that you could select. From the circles draw lines representing possible outcomes. Again make a
brief note on the line saying what it means. Keep on doing this until you have drawn out as many
of the possible outcomes and decisions as you can see leading on from the original decisions.

Once you have done this, review your tree diagram. Challenge each square and circle to see if
there are any solutions or outcomes you have not considered. If there are, draw them in. If
necessary, redraft your tree if parts of it are too congested or untidy. You should now have a
good understanding of the range of possible outcomes of your decisions.

Evaluating Your Decision Tree

Now you are ready to evaluate the decision tree. This is where you can work out which option
has the greatest worth to you. Start by assigning a cash value or score to each possible outcome.
Estimate how much you think it would be worth to you if that outcome came about.

Next look at each circle (representing an uncertainty point) and estimate the probability of each
outcome. If you use percentages, the total must come to 100% at each circle. If you use fractions,
these must add up to 1. If you have data on past events you may be able to make rigorous
estimates of the probabilities. Otherwise write down your best guess.

Calculating Tree Values

Once you have worked out the value of the outcomes, and have assessed the probability of the
outcomes of uncertainty, it is time to start calculating the values that will help you make your
decision.

Start on the right hand side of the decision tree, and work back towards the left. As you complete
a set of calculations on a node (decision square or uncertainty circle), all you need to do is to
record the result. You can ignore all the calculations that lead to that result from then on.

Calculating The Value of Uncertain Outcome Nodes

Where you are calculating the value of uncertain outcomes (circles on the diagram), do this by
multiplying the value of the outcomes by their probability. The total for that node of the tree is
the total of these values.

In the example in Figure 2, the value for "new product, thorough development" is:

0.4 (probability good outcome) x Rs.1,000,000 (value) =

Rs.400,000

0.4 (probability moderate outcome) x Rs.50,000 (value) = Rs.20,000

0.2 (probability poor outcome) x Rs.2,000 (value) = Rs.400

TOTAL Rs.420,400

In this example, the benefit we previously calculated for 'new product, thorough development'
was Rs.420,400. We estimate the future cost of this approach as Rs.150,000. This gives a net
benefit of Rs.270,400.

The net benefit of 'new product, rapid development' was Rs.31,400. On this branch we therefore
choose the most valuable option, 'new product, thorough development', and allocate this value to
the decision node.

Result
By applying this technique we can see that the best option is to develop a new product. It is
worth much more to us to take our time and get the product right, than to rush the product to
market. It is better just to improve our existing products than to botch a new product, even
though it costs us less.