Total, Average, and Marginal Cost

Total Cost (TC)

• Total Cost (TC) is the sum of all costs incurred in producing goods or services within a specific period.
• It includes direct costs (directly attributed to production) and indirect costs (not directly traceable to a specific product or service).
• To calculate TC for a month, add up the direct materials, direct labor, and factory overhead costs.
• Example: If direct materials are $10,000, direct labor is $5,000 and factory overhead is $3,000, then TC = $18,000.

Average Cost (AC)

• The Average Cost (AC) determines the average cost per unit of production or service.
• It provides insights into cost efficiency and profitability for pricing decisions, financial analysis, and budgeting.
• To calculate AC, divide the Total Costs by the Number of Units Produced.
• Example: A software company has total costs of $100,000 in a month to develop 500 software applications, so AC = $200 per application.

Marginal Cost (MC)

• The Marginal Cost (MC) formula helps in understanding the additional cost incurred by producing one more unit of output.
• It is essential for decision-making processes like determining the optimal level of production and pricing strategies.
• To calculate MC, divide the Change in Total Cost by the Change in Quantity.
• Example: If a company produces 100 widgets for a total cost of $10,000, and they then produce an additional unit and the total cost increases to $10,100, then MC = $100.

Contribution Margin (CM)

• The Contribution Margin (CM) formula determines the portion of revenue that contributes to covering fixed costs and generating profit after accounting for variable costs.
• It is a key metric for assessing the profitability of individual products or services and conducting break-even analysis.
• To calculate CM, subtract Variable Costs from Total Revenue.
• Example: If a company generates $10,000 in revenue and has $6,000 in variable costs, then CM = $4,000.

Gross Profit (GP)

• The Gross Profit (GP) formula determines the profitability of a business's core operations before other expenses.
• It shows the revenue remaining after deducting the direct costs associated with producing goods or services.
• To calculate GP, subtract the Cost of Goods Sold (COGS) from Total Revenue.
• Example: A retail store has clothing sales generating $50,000 and the cost of goods sold (COGS) amounts to $30,000, GP = $20,000.

Break-Even Point (BEP)

• The Break-Even Point (BEP) formula determines the sales or production volume at which a business neither makes a profit nor incurs a loss.
• It represents the point where total revenue equals total costs (fixed and variable).
• To calculate BEP in units, divide Fixed Costs by the Contribution Margin per Unit.
• Example: A company has fixed costs of $50,000, and a contribution margin per unit is $10, Break-Even Point = 5,000 units.

Return on Investment (ROI)

• Return on Investment (ROI) is a financial metric used to evaluate the profitability and efficiency of an investment.
• It measures the return or gain generated from an investment relative to its cost.
• To calculate the Return on Investment (ROI), first determine the net profit or gain by subtracting the cost of investment from the total proceeds: Net Profit = Total Proceeds – Cost of Investment. The divide the Net Profit by the Cost of Investment and multiply by 100.
• Example: ($12,000 + $500) – $10,000 = $2,500, then ROI = ($2,500 / $10,000) x 100 = 25%

Cost of Goods Sold (COGS)

• Cost of Goods Sold (COGS) refers to the direct costs incurred in producing or acquiring goods sold by a business during a specific period.
• These include expenses directly associated with the production or procurement of the goods (raw materials, direct labor, and direct overhead costs).
• To calculate COGS, add Beginning Inventory to Total Purchases on the Specified Period and subtract Ending Inventory.
• Example: Beginning inventory is $3,000. Additional inventory purchased during amounts to $2,000 and $1500 ending inventory recorded at the fiscal year ended 2024, COG = $3,000 + $2,000 – $1,500 = $3,500

Overhead Allocation

• Overhead Allocation fairly and accurately allocates indirect costs to relevant cost objects using a predetermined allocation method or cost driver.
• This helps businesses determine the true cost of products.
• Overhead Allocation = (Total Indirect Cost / Total Direct Labor Hours) x Direct Labor Hours for Specific Product.
• Example: A Company has $10,000 a month in overhead costs, Product A requires 100 direct labor hours and Product B requires 200 direct labor hours. Overhead Allocation for Product A = ($10,000 / (100 + 200)) x 100 = $2,000 and Overhead Allocation for Product B = ($10,000 / (100 + 200)) x 200 = $4,000

Cost Variance

• Cost Variance assesses the cost performance and control of a project or activity.
• It helps businesses evaluate deviations from the budgeted or standard costs to identify areas where costs are over or under budget.
• Cost variances can expose inefficiencies, cost overruns, or cost savings.
• The formula is: Cost Variance = Actual Cost - Budgeted Cost.
• Example: the budgeted cost for completing a building is $500,000, actual cost incurred is $550,000. Cost Variance = $550,000 – $500,000 = $50,000

Price Variance

• Price Variance assesses the impact of changes in prices on the overall cost of production.
• It aids businesses in evaluating the efficiency of cost management and control, and Price variances can highlight opportunities for cost savings.
• The formula is: Price Variance = (Actual Price – Standard Price) x Actual Quantity
• Example: Standard cost of producing one widget is $10, due to changes in the market and the actual cost is $12 per widget. The company produced 1,000 widgets. Price Variance = ($12 – $10) × 1,000 = $2,000

Labor Efficiency Variance

• Labor Efficiency Variance: the difference between the actual hours of labor used and the standard hours that should have been used, multiplied by the standard hourly labor rate.
• Standard labor cost per unit is 3 hours/unit * $20/hour = $60/unit.
• For example, a manufacturer estimates 3 hours to produce one unit, with a standard labor cost of $20 per hour. In a month, they produce 1000 units (3,000 hours of labor). However, the company actually used 3,200 hours of labor to produce these 1000 units. The labor efficiency variance = (3,000 hours – 3,200 hours) * $20/hour = -200 hours * $20/hour = -$4,000 Unfavorable Variance

Predetermined Overhead Rate (POR)

• The Predetermined Overhead Rate allocates indirect manufacturing costs to the products or services being produced.
• Indirect costs include expenses such as factory rent, utilities, maintenance, and supervision.
• In order to calculate: divide the estimated total overhead costs by the estimated activity base. POR = Estimated Total Overhead Costs/ Estimated Activity Base
• Example: If annual manufacturing overhead costs are $500,000 and estimates that it will produce 10,000 units, then POR = $500,000 / 10,000 units = $50 per unit

Economic Order Quantity (EOQ)

• EOQ optimizes inventory management by identifying the ideal quantity to order at each reorder point by minimizing holding costs.
• The formula is: EOQ = √[(2 * Annual Demand * Ordering Cost) / Holding Cost per Unit per Year]
• Example: retailer with an annual demand of 10,000 units, an ordering cost of $100 per order, and a holding cost of $5 per unit per year. EOQ = √[(2 * 10,000 * $100) / $5] = √[200,000 / $5] = √40,000 ≈ 200 units

Cost of Quality (COQ)

• Cost of Quality (COQ) measures the overall expense a business incurs to prevent, identify, and correct flaws or quality issues in its goods or services.
• Formula: COQ = Prevention Costs + Appraisal Costs + Internal Failure Costs + External Failure Costs.
• Example if Prevention Costs, Appraisal Costs, Internal Failure Costs, and External Failure Costs are $50,000, $20,000, $30,000 and $10,000. Then COQ = $50,000 + $20,000 + $30,000 + $10,000 = $110,000

Production Volume Variance

• Production Volume Variance evaluates the efficiency and effectiveness of production activities to understand the relationship between production volume and costs.
• To calculate: multiply the difference between the standard and actual production volume by the standard cost per unit. Production Volume Variance = (Standard Production Volume – Actual Production Volume) * Standard Cost per Unit
• Example: The standard cost per unit is $10. An entity budgets a standard production volume = 1,000 unit while actually producing a volume of 900 units. Production Volume Variance = (1,000 – 900) * $10 = 100 * $10 = $1,000

Margin of Safety

• The margin of safety is the difference between the actual sales volume and the break-even sales volume.
• It highlights the proportion of current sales that determine the firm's profit.
• First calcuate the Break-even sales = Fixed costs / Contribution margin per unit, then find the Margin of safety = Actual sales volume - Break-even sales volume to get the Margin of safety Ratio = Margin of safety / 100,000
• Example: Actual sales (4,000 units @ $25/unit) = $100,000. Contribution margin per unit = $15 and Total fixed costs = $25,000, Break-even sales = 25,000 / 15 = 1,667 units, then Margin of safety = = 100,000 - 41,675 = $58,325 andMargin of safety

Availability

• Availability measures the fraction of time that a piece of equipment is expected to be operational, ranging from 0 (never available) to 1.00 (always), depends on equipment with a high availability factor.
• The formula to calculate is Availability = MTBF / MTBF + MTR, where MTBF = Mean time between failures and MTR = Mean time to repair, including waiting time
• Example: If MTBF = 200 hours and MTR = 2 hours, then Availability = 200 / 200 + 2 = 0.99

Reorder Point

• The reorder point is the quantity on hand to a predetermined amount, which includes expected demand during lead time and stock.
• The formula is: Reorder point (ROP) = d x LT, where d = Demand rate (units per day or week) and LT = Lead time in days
• For example if usage is at 2 vitamins a day, and it takes 7 days for the vitamins to be delivered. The ROP = Usage x Lead time which will equal 2 vitamins per day x 7 days = 14 vitamins.

Takt Time

• Takt time is the cycle time needed in a production system to match the pace of production to the demand rate.
• It can calculated by Net time available per day / Daily demand
• Suppose in a production facility, Total time per shift is 480 minutes per day, and there are two shifts per day. There are two 20-minute rest breaks and a 30-minute lunch break per shift. Daily demand is 80 units. Net time available per shift = 480 - 40 - 30 = 410 minutes per shift Net time available per day = 410 x 2 shifts/day = 820 minutes per day Takt Time = 820 minutes per day / 80 units per day = 10.25 minutes per cycle