Cost concepts and estimation Techniques

Break-even Point: The break-even point in economics, business—and specifically cost

accounting—is the point at which total cost and total revenue are equal, i.e. "even". There
is no net loss or gain, and one has "broken even", though opportunity costs have been paid
and capital has received the risk-adjusted, expected return.

Figure: Break even point

It is used for analyzing the cost of a project in short and long run. Cost refers the
amount of expenses spent to generate product or services. Cost refers expenditure that may
be actual or nominal expenses incurred to generate output. Cost is the value of economic
resources used as result of producing or doing the things. Cost has many meaning but in
management cost refers the expenditure not the price. As a manager we use cost
information for taking decisions and making plans, programs and policies and strategies.
Type of cost: The following are different types of cost that are involved in various kinds
of engineering and managerial problems:
Investment cost: The investment cost, or first cost, refers to the capital required to start a
project. It may be either a single lump sum, or a series of cash inputs that must be made at
the beginning of the project. For example, if we want to purchase a new car, then the
investment cost for acquiring it is the sum of the down payment, taxes and other charges
involved in obtaining the ownership of the car. For a capital intensive project such as a
construction project which takes several years to complete, the investment cost is usually
spread over time in the form of progressive payments.
Fixed costs: Fixed costs associated with a new or existing project are those costs that do
not change over a wide range of activities of the project. Fixed costs are, at any time, the
inevitable costs that must be paid regardless of the level of output and of the resources
used. For example, interest on borrowed capital, rental cost of a warehouse, administrative
salaries, license fees, property insurance and taxes are fixed costs.
Variable costs: The costs that vary proportionately to changes in the activity level of a
new or existing project are referred to as variable costs. Examples of variable costs include
raw material cost, direct labor cost, power cost, shipping charges, etc.
Variable costs are those associated with an operation that varies in total with the quantity
of output or other measures of activity level. For example, the costs of material and labor
used in a product or service are variable costs, because they vary in total with the number
of output units, even though the costs per unit stay the same. Variable costs are also known
as avoidable costs.
Incremental costs: The additional cost that will result from increasing the output of a
system by one or more unit (s) is called incremental cost. For example, if the cost of
manufacturing 10 pieces is $2,000 and that of 11 pieces is $2,200, then the incremental
cost is $200.
Sunk cost: Sunk cost refers to the cost that has occurred in the past and does not have any
impact on the future course of action. For example, suppose you wanted to buy a second-
hand car. You went to the showroom of a second-hand car dealer. You liked a car that costs
$ 80,000. You made a down payment of $ 5,000 to the dealer, with a condition that, if in
future, you change your decision and do not buy the car you liked, then $ 5,000 will not be
given back to you. Next day your friend told you that he wants to sell his car. Your friend’s
car is almost of a similar condition as that of the car you saw in the dealer’s showroom.
Your friend offered you the car for a price of $70,000. Your friend’s car is definitely
cheaper than that of the dealer. In this situation you will not even think of $5,000 that you
paid to the dealer. You will buy your friend’s car. Thus, $5,000 in this case is a sunk cost,
as it occurred in the past and it does not have any impact on your decision to buy car from
your friend.
Opportunity cost: Opportunity cost or implicit cost refers to the value of the
resources owned and used by a firm in its own production activity. The firm, instead of
using the resources for its own purpose, could sell or rent them out and in turn can get
monetary benefits. The amount that the firm is not getting by renting or selling the owned
resources as it is using them for its own purpose represents the opportunity cost of the
resources.
An opportunity cost is incurred because of the use of limited resources, such that the
opportunity to use those resources to monetary advantage in an alternative use is foregone.
Thus, it is the cost of the best rejected (i.e., foregone) opportunity and is often hidden or
implied.
Consider a student who could earn $20,000 for working during a year, but chooses instead
to go to school for a year and spend $5,000 to do so. The opportunity cost of going to
school for that year is $25,000: $5,000 cash outlay and $20,000 for income foregone. (This
figure neglects the influence of income taxes and assumes that the student has no earning
capability while in school.)
Direct costs: Direct costs are costs that can be reasonably measured and allocated to a
specific output or work activity. The labor and material costs directly associated with a
product, service, or construction activity are direct costs. For example, the materials needed
to make a pair of scissors would be a direct cost.
Indirect cost: Indirect costs are costs that are difficult to allocate to a specific output or
work activity. Normally, they are costs allocated through a selected formula (such as
proportional to direct labor hours, direct labor dollars, or direct material dollars) to the
outputs or work activities. For example, the costs of common tools, general supplies, and
equipment maintenance in a plant are treated as indirect costs.
Standard costs: Standard costs are planned costs per unit of output that are established in
advance of actual production or service delivery. They are developed from anticipated
direct labor hours, materials, and overhead categories (with their established costs per unit).
Because total overhead costs are associated with a certain level of production, this is an
important condition that should be remembered when dealing with standard cost data.
Life-Cycle Cost: In engineering practice, the term life-cycle cost is often encountered.
This term refers to a summation of all the costs related to a product, structure, system, or
service during its life span.