COST INDEX

Cost index
A cost index is merely an index value for a given point in
time showing the cost at that time relative to a certain base
time. If the cost at some time in the past is known, the
equivalent cost at the present time can be determined by
multiplying the original cost by the ratio of the present index
value to the index value applicable when the original cost
was obtained.
Index number
• What is index number?
• Price indices - P
1. Price of the item in the period of interest – pn
2. Price of the item in the base period – p0
• Quantity indices - Q
1. Quantity of the item in the period of interest – qn
2. Quantity of the item in the base period – q0
 Index number
construction

Aggregative
method Relative
method

Simple Weight
aggregativ aggregative Simple Weight
e formula formula average average of
of relative relative

Edgewoth- Fisher’s
Laspeyre‘s Paasche’s
marshall’s ‘’ideal’’
formula formula
formula formula
Simple Aggregative Method
• What is simple index number?
We use this method of construction for computation of
index price. As a result, the total cost of any commodity in
any given year to the total cost of any commodity in the
base year is in percentage form.

Simple Aggregative Price Index =(∑ Pn/ ∑ P0) * 100%

∑Pn = Sum of the price of all the respective commodity in
the current time period.
∑Po = Sum of the price of all the respective commodity in
the base period.
Example 1
• The following table indicates the prices, in dollars, and
quantities (in Kg) sold at a small company for three years

Acids
carbonates

Nitrides
Solution
• Simple price index for sugar
carbonate in 2008 with 2007 as base

year

Acids
carbonat
es
Nitrides

5.29
= ∗ 100% = 106%
4.99
Example 2
• Example: For the given data find-
a) Simple Aggregative Index for the year 1999 over the year 1998.
b) Simple Aggregative Index for the year 2000 over the year 1998.

Commodity 1998 1999 2000

Cheese (100
12 15 15.60
gm)

Egg (per
3 3.60 3.30
piece)

Potato (per kg) 5 6 5.70

Aggregate 20 24.60 24.60

Index 100 123 123

Solutions
Simple Aggregative Index for the year 1999 over the year
1998

• (∑ Pn/ ∑ P0) = ( 24.60/20.00 ) * 100 = 123

Simple Aggregative Index for the year 2000 over the year
1998

• (∑ Pn/ ∑ P0) = ( 24.60/20.00 ) * 100 = 123

Disadvantages of simple method
there is a serious defect in this method. The first
commodity, here, has more influence than the rest two.
This is so because the first commodity has a high price
than the rest.

In order to remove the errors and flaws coming from a

simple aggregative index, a replacement would be a better
choice. Hence, we can use a simple average of relatives
method for construction of Index.
Example 3
Solution
Types of cost index
• Many different types of cost indexes are published
regularly. Some of these can be used for estimating
equipment costs; others apply specifically to labor,
construction, materials, or other specialized fields. The
most common of these indexes are the
1. Marshall and Swift all-industry and process-industry
equipment indexes.
2. the Engineering News-Record construction index.
3. the Nelson-Farrar refinery construction index.
4. the Chemical Engineering plant cost index.
Limitation of cost index
• Cost indexes can be used to give a general estimate, but
no index can take into account all factors, such as special
technological advancements or local conditions. The
common indexes permit fairly accurate estimates if the
time period involved is less than 10 years.
Marshall & Swift Equipment Cost Indexes

• all-industry equipment index - arithmetic average of indexes for 47

different types of industrial, commercial, and housing equipment
• based on an index value of 100 for the year 1926
• account for cost of machinery and major equipment plus costs for
installation, fixtures, tools, office, and minor equipment
Break even analysis
• Break-even point analysis is a measurement system that
calculates the margin of safety by comparing the amount
of revenues or units that must be sold to cover fixed and
variable costs associated with making the sales. In other
words, it’s a way to calculate when a project will be
profitable by equating its total revenues with its total
expenses. There are several different uses for the
equation, but all of them deal with managerial accounting
and cost management.
• The margin of safety is a financial ratio that measures the
amount of sales that exceed the break-even point. This is
the amount of sales that the company or department can
lose before it starts losing money
Break even analysis
Formula of break even points
• The break-even point formula is calculated by dividing the total fixed
costs of production by the price per unit less the variable costs to
produce the product.

• This computes the total number of units that must be sold in order for
the company to generate enough revenues to cover all of its
expenses.
•
Break even points in money
• The break-even formula in sales dollars is calculated by
multiplying the price of each unit by the answer from our
first equation.

• This will give us the total dollar amount in sales that will
we need to achieve in order to have zero loss and zero
profit
Level of profitability
• First we take the desired dollar amount of profit and divide
it by the contribution margin per unit. The computes the
number of units we need to sell in order to produce the
profit without taking in consideration the fixed costs. Now
we must add back in the break-even point number of
units. Here’s what it looks like.
Example
• In a furniture factory it is required to produce and sell a
new model couch. According to the production state
provided below, determine the number of units and sell
that reqiured in order to cover the expenses and to make
200,000$ in profit.

• Total fixed costs: $500,000

• Variable costs per unit: $300
• Sale price per unit: $500
• Desired profits: $200,000
Solution

• The amount of sell in dollars

Solution
• Number of units that must be produced in order to meet
the required profitability.
Margin of safety
• The margin of safety formula is calculated by subtracting
the break-even sales from the budgeted or projected
sales.
Example
• Bob produces boat propellers and is currently debating
whether or not he should invest in new equipment to
make more boat parts. Bob’s current sales are $100,000
and his breakeven point is $75,000. Thus, Bob would
compute his margin of safety like this.
Break even between two alternatives

Two types of cost are considered

Fixed cost: related to the cost of equipment and tools and it is

constant and does not depend on the quantity of the products

Variable cost: takes into account the cost changes with the number
of objects ex. Energy consumption, material cost and labor cost.
Breakeven analysis

y
Break even analysis

𝐹𝐶1 + 𝑦 ∗ 𝑉𝐶1 = 𝐹𝐶2 + 𝑦 ∗ 𝑉𝐶2

y
Example
Solution
• Fixed cost
• Permanent molding 112 500 (tooling)+ 202 (set
up)=112 702
• Die casting 210 000( tooling)+ 540 (set up)=210 540
• Variable cost
• Permanent molding 14 (labor)+14 (material)=28
• Die casting 10 (labor)+ 7( material)=17
𝐹𝐶2−𝐹𝐶1
• y=
𝑉𝐶1−𝑉𝐶2
• y= (210 540 − 112 702)/(28-17)= 8894
• This means that the permanent method will be more
economic for number of products below 8894
otherwise die casting will be the choice.
Example
• A construction company has two alternatives to purchase an excavator
which is to be employed at a construction site for excavation of earth. The
cash flow details of the two alternatives are presented as follows;
• Alternative-1: Initial purchase cost = Rs.4865000
• Salvage value = Rs.1250000
• Useful life = 12 years
• Operating cost:
• The operating cost for excavating 1m3 of earth is Rs.11.0. The excavator
(Alternative-1) can excavate 52 m3 of earth in one hour.
• Alternative-2: Initial purchase cost = Rs.5350000
• Salvage value = Rs.1410000
• Useful life = 12 years
• Operating cost:
• The operating cost for excavating 1m3 of earth is Rs.8.0. The excavator
(Alternative-2) can excavate 60 m3 of earth in one hour.
• The company's minimum attractive rate of return (MARR) is 10.5% per
year. How many hours the excavators have to operate per year, for the
equivalent uniform annual worth of cash flows of both the alternatives to be
equal?
Solution
• In case of presence of salvage value, years (n), we need
to transform to either present or annual cost
• Let ‘y' is the number of operating hours per year.
• The annual operating cost (Rs.) for Alternative-1 is given
by;

• Now the equivalent uniform annual worth (Rs.) of

Alternative-1 is given by;
Solution
• The annual operating cost (Rs.) for Alternative-2 is given
by;
• The equivalent uniform annual worth (Rs.) of Alternative-2
is given by;

• Now equating equivalent uniform annual worth

Alternative-1 to that of Alternative-2;
Solution
• Now equating equivalent uniform annual worth
Alternative-1 to that of Alternative-2;
Break even point for more than two points
• Exam materials
How to find break even point of more than two
alternatives???
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