Cost and revenue analysis

Concept of Cost
 Expense incurred on the factors of prod-
uction is known as the cost of production.
 Costs are taken as function of output.
 Cost is categorized in two part. As:
 Economic Cost
 Accounting Cost

Economic Costs
Implicit /Opportunity Cost :
 Inputs owned by owner and used them by own
firm in the production process. Such as :
• Implicit cost includes rent which could be earned
by renting out the entrepreneur’s own land which is
used for own Business purpose.
• Implicit cost include the salary that the
entrepreneur could earn from working for someone
else as manager.

Accounting Cost -Accounting Cost -
 Explicit Cost -Explicit Cost -
 Out of pocket expenditures of theOut of pocket expenditures of the
firm to purchase or hire the inputsfirm to purchase or hire the inputs
requires in production. Such as :requires in production. Such as :
 Wages for LabourWages for Labour
 Interest on borrowed capitalInterest on borrowed capital
 Rent on land and buildingsRent on land and buildings

Short Run and Long Run Costs:
 In short Run some factors are fixed and
some are variable therefore cost is divided
into two parts:
 Fixed Costs: (It do not vary between
zero and a certain level of output.)
 Variable Costs: (It do vary with the
variation in output)
 In long run all costs are variable because of
variable factors due to change in output.

Total Cost :
It covers fixed cost and variable cost.
 Total Fixed Cost
 Fixed cost is the cost
of employing fixed factors
( machinery, building).
 Fixed cost is a fixed
amount which must be
incurred by the firm at
large output and arsmall or Zero and as well
TFC
Y
X
OUTPUT
Fixed Cost
0

Total Variable Cost (TVC)
TC,TFC,TVC
Variable cost is incurred
on the employment of variable
factors like raw material, fuel,
Labour, maintenance. It is also
called prime and direct
Cost.
 TVC originates from 0,
Indicating zero cost at nil
output.
 Total Cost (TC)
 TC = TFC+TVC It increases as with an increase in the
level of output, as TC is mainly based on TVC.
TFC
Y
X
Output
TV
C
TC

TC,TVC,TFC
Output
Q
TFC Labour
N0.
TVC
W*N0
TC =
TFC+
TVC
0 140 0 -- 140
10 140 7 70 210
20 140 11 110 250
30 140 18 180 320
40 140 28 280 420
50 140 42 450 590
60 140 72 720 860
70 140 112 1120 1260

Average Cost
Q AFC AVC AC MC
0 - - - -
10 14.
0
7 21.0 7
20 7.0 5.5 12.5 4
30 4.7 6.0 10.7 7
40 3.5 7.0 10.5 10
50 2.8 9.0 11.8 17
60 2.3 12.0 14.3 27
 AFC = TFC
Q
AVC = TVC
Q
ATC = AVC + AFC
 MC = TC
Q

Incremental Cost :
These costs are incurred when the business
activity is changed (change in product line,
addition or replacement of a machine, changes
in distribution channels) which can be avoided
by not bringing changes in production line.
 These incremental costs are avoidable costs or
controllable costs.

Sunk Cost:
It is an expenditure that has been incurred and
can not be recovered.
Expenditure that have been made in the past or
that must be paid in the future as part of
contractual agreement.
Example - The cost of inventory and future
rental payments for warehouse that must be
paid as part of a long-term lease agreement.
Thus sunk costs are uncontrollable and
unavoidable costs.

Concept of Revenue
 The amount of money that the producer
receives in exchange for the sale of
goods is called producer’s revenue or
receipts.

Total Revenue (TR)
TR= Q X P
Total Revenue = Number of unit sold
x Price of commodity

Marginal Revenue
Addition to total revenue by selling ‘n’ units of
product.
MR = TR
Q
MR is change in total revenue associated with
a change in quantity sold.

Average Revenue
Average revenue is the revenue that a firm
gets, per unit of the good sold.
 AR = TR = P X Q = P
Q Q
Q= number of units of good sold.
 In economics, AR and price are used
synonymously.

Profit
 Profit = Total Revenue - Total
Cost
Economic Profit = Total Revenue –
Economic Cost
Economic Cost = Accounting Cost +
Opportunity Cost (Implicit Cost)
Accounting Cost = Explicit Cost
(Explicit Cash outflow)

Profit as motive of Business :
Example :
 Wages of helpers = Rs.50,000/-
 Rent = Rs.12,000/-
 Cost of Cloth = Rs.26,000/-
 Other accessories = Rs.5,000/-
 Accounting Cost = Rs.93,000/-
 Owner’s time = Rs.20,000/-
 Economic Cost = (Rs.93,000/+20,000/)
= (Rs.113,000/-)

Profit Maximizing Level
of Output
Q TR TC TR-TC
10 90 70 20
20 160 120 40
30 210 150 60
40 240 160 80
50 250 225 25
60 240 300 -60

TR, TC, Profit
 The quantity
at which profit is
the highest 40.
 Gap between
TR and TC is 80 at
40 Q.
Quantity
350
300
250
200
150
100
50
0 10 20 30 40 50 60
.
.
.
.
.
.
. . .
.
Break
even
point
.
TC
TR

Economies and Diseconomies
 Economies refers to cost of advantages.
 Cost advantages may result because of
two reasons:
 Extending the scale of production
(Economies of Scale)
 Exploring the scope of production
(Economies of Scope)

Economies and Diseconomies of
Scale
 When a business firm expands its scale of
production to earn profit, it derives many
economies of large scale production, which in
turn help in lowering the cost of production and
increasing its productivity.
When a business firm over utilizes these
economies, it may convert into diseconomies,
cost disadvantage.

Example
 Suppose a trader incurs an expenditure of
Rs.20,000/- on installing a stone cutter
machine.
 If he cuts 10,000 pieces of stone:
 AFC= 20,000/10,000 = Rs. 2/-
 If he cuts 20,000 pieces
AFC = 20,000/20,000 = Rs. 1/-

Sources of Economies
 Specialization and division of Labor
 Technical Economies arises from the greater
efficiency of large size of plants and capital
equipments which large firms can afford not
small ones.
 Production Economies -In the case of large
firm they can obtain backward and forward
linkages on their own.

Managerial Economies (managerial efficiency
increases because of separate departments)
Marketing Economies. (Large firm can obtain
raw material at low cost because it needed in
bulk quantity.)
Financial Economies (Large firm with a large
asset base and good will is able to secure the
necessary funds.
Risk and Survival Economies (at the point of
stagnation in demand of product large firm can
enter into diversified production but small firm
can not)

Source of Diseconomies:
 Inefficiency of Management because the cost of
gathering, organizing and reviewing information on all
aspects of a large firm may increase more rapidly than
output. Managing large number of employee is also costly.
 Transportation Cost also one of the diseconomies as the
Firm consolidates two or more geographically dispersed
plants, production cost may decline but transportation
cost will increase.
 Large firm need more labour resultantly to meet demand it
has to pay higher wages which will offset other sources of
cost reduction.

Economies of Scope
Firms often find that per-unit of costs are lower
than two or more products are produced.
Example-
A firm can produce both stationary and notebook
paper . The cost of Rs.50,000 per 1,000 rims of
paper and Rs.30,000 per 1,000 rims of notebook
paper. If firm produces both type of paper the
cost would be Rs.70,000/-

 A measure of economies of scope-
 S = TC(QA)+TC(QB) - TC(QA,QB)
TC(QA,QB)
S = 50,000 +30,000 – 70,000 = 0.14
70,000
14 percent reduction in total cost if both the
products will be produced.

Cost and revenue analysis

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