UNIT IV (COST & REVENUE ANALYSIS)

COST ANALYSIS
 INTRODUCTION
 The word 'cost' has different meanings in different situations. The accounting cost
concept or the historical cost concept is not useful as such for business decision-
making. The accounting records end up with the balance sheet and income
statements which are meant for legal, financial and tax needs of the enterprise. The
financial recordings reveal what has been happening. It is a historical recording
which is not of very much help to the managerial economist in his business
decision-making. The actual cost is not the relevant cost concept for business
decision-making because it only reveals what has been happening. The decision-
making concepts of cost aim at projecting what will happen in the alternative
courses of action. Business decisions involve plans for the future and require
choices among different plans. These decisions necessitate profitability
calculations for which a comparison of future revenues and future expenses of
each alternative plan is needed.
 Economic and Accounting Cost
 Accounting costs are recorded with the intention of preparing the balance sheet
and profit and loss statements which are intended for the legal, financial and tax
purposes of the company. The accounting concept is a historical concept. It
records what has happened. The past cost data revealed by the books of accounts
does not help very much in decision-making. Decision-making needs future costs.
Economic concept considers future costs and future revenues which help future
planning and choice. When the accountant describes what has happened, the
economist aims at projecting what will happen. Accounting data ignores implicit
or imputed cost. The economist considers decision-making costs. For this,
different cost classifications relevant to different kinds of problems are considered.
The cost distinctions such as opportunity and outlay cost, short run and long-run
cost and replacement and historical cost are made from the economic viewpoint.

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 Short-Run and Long-Run Costs

 This cost distinction is based on the time element. Short-Run is a period during
which the physical capacity of the firm remains fixed. Any increase in output
during this period is possible only by using the existing physical capacity more
intensively. Long- Run is a period during which it is possible to change the firm's
physical capacity. All the inputs become variable in the long-term. Short-Run cost
is that which varies with output when the physical I capacity remains constant.
Long-Run costs are those which vary with output when all the inputs are variable.
Short-Run costs are otherwise called variable costs. A firm wishing to change
output quickly can do it only by increasing the variable factors. Short- Run cost
concept helps the manager to take decision when a firm has to decide whether or
not to produce more or less with a given plant. Long-Run cost analysis helps to
take investment decisions. Long-Run increase in output may necessitate
installation of more capital equipment.
 Differences
 The main difference between long run and short run costs is that there are no fixed
factors in the long run; there are both fixed and variable factors in the short run. In
the long run the general price level, contractual wages, and expectations adjust
fully to the state of the economy. In the short run these variables do not always
adjust due to the condensed time period. In order to be successful a firm must set
realistic long run cost expectations. How the short run costs are handled
determines whether the firm will meet its future production and financial goals.

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 Cost curve: This graph shows the relationship between long run and short run
costs.
 Short Run Cost Analysis

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1. Fixed Cost

 Fixed cost itself means cost is fixed whatever the situation of the business or
production or out of the business fixed. The more or less we produce the goods,
fixed cost will not change, it will be constant (not change). Even the the
production or output of the firm is stopped; fixed cost must be faced by the firm.

 eg: (Rent, salaries, Interest on capital) these must be paid by the firm even if there
is production are not.

 Illustration:-

 Fixed Cost schedule table

No. of Units Total fixed

produced cost
0 1000
1000 1000
2000 1000
3000 1000
4000 1000
5000 1000

 If you observe the fixed cost schedule table, one can easily understand concept of
fixed cost and what is fixed cost in the economics. When there are zero units
produced, there is fixed cost as 1000, as fixed cost is constant and fixed cost don't
change according to the output or production.

 Therefore here the fixed cost is 1000 as there is no variable cost which would be
incurred if output is brought out. When the production is started with 1000 units,
fixed cost remains same as 1000/- and thereon fixed will be constant even there is
change in the output

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2. Variable Cost

 The cost which rises with increase in production and decreases with fall in
production is called variable cost. Variable cost incur for total goods produced is
called total variable cost.

 Eg: Raw materials, power, fuel and labour. The more the firm produces the goods
the firm should incur more.

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3. Total Cost

 Total cost includes {Total Cost = total fixed cost + Total Variable cost }

 In economics, total cost means total cost of production that includes total fixed
cost and total variable cost of production.

 Total fixed cost includes salaries of employees, wages, rent of buildings or

equipment, interest on capital, and interest on loan et cetera. Total variable cost are
raw material, electricity, daily labour, and stationary or office expenditure.

 If you observe the below cost schedule table, one can easily understand concept of
total cost and what is total cost in the economics. When there are zero units
produced, there is fixed cost as 1000, as fixed cost is constant and fixed cost don't
change according to the output or production. Therefore here the total cost is 1000
as there is no variable cost which would be incurred if output is brought out. When
the production is started with 1000 units, fixed cost remains same as 1000/- and
variable costs per unit is 1.00/- . Therefore the total fixed cost incurred at this point
is 2000/-.

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 Total Cost Schedule Table

No. of Units Total fixed Total TC = TFC +

produced cost Variable Cost TVC
(A) (B) (C) (B + A*C)
0 1000 0 1000
1000 1000 1.00 2000
2000 1000 0.90 2800
3000 1000 0.87 3610
4000 1000 0.88 4520
5000 1000 1.00 6000

 Total Cost Schedule Graph

4. Marginal Cost (MC)

 Marginal Cost is the additional cost incurred by producing one more unit extra.

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 Relation between Average, Marginal and Total Cost

 Basically, we are focusing on two relationships: 1. Relation between Average Cost

and Marginal Cost, and 2. Relation between Total Cost and Marginal Cost.

 Details are as under:

Y
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 E
P
UNIT IV (COST & REVENUE ANALYSIS)

O Q Q1 Output X

1. When AC Falls, MC is Lower than AC:

 When average cost falls, marginal cost is less than AC. In Table 8, AC is falling
till it becomes Rs.8, and MC remains less than Rs.8. In Fig. 9, AC is falling till
point E, and MC continues to be lower than AC. In this case, marginal cost falls
more rapidly than the average cost. That is why when marginal cost (MC) curve is
falling, it is below the average cost (AC) curve. It is shown in Fig

2. When AC Rises, MC is Greater than AC:

 When average cost starts rising, marginal cost is greater than average cost. In
Table 8, when AC rises from Rs.8 to Rs.9, MC rises from Rs.8 to Rs.16. In Fig. 9,
AC starts rising from point E. And, beyond E, MC is higher than AC.

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3. When AC does not Change, MC is Equal to AC:

 When average cost does not change, then MC = AC. It happens when falling AC
reaches its lowest point. In Table 8, at the 7th unit, average cost does not change.
It sticks to its minimum level of Rs.8. Here, marginal cost is also Rs.8. Thus, Fig.
9 shows that MC curve is intersecting AC curve at its minimum point E.

 Economies and Diseconomies of Scale

 Increasing, constant, and diminishing returns to scale describe how quickly output
rises as inputs increase.
 In economics, returns to scale describes what happens when the scale of
production increases over the long run when all input levels are variable (chosen
by the firm). Returns to scale explains how the rate of increase in production is
related to the increase in inputs in the long run. There are three stages in the
returns to scale: increasing returns to scale (IRS), constant returns to scale (CRS),
and diminishing returns to scale (DRS). Returns to scale vary between industries,
but typically a firm will have increasing returns to scale at low levels of
production, decreasing returns to scale at high levels of production, and constant
returns to scale at some point in the middle.

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 Long Run ATC Curves: This graph shows that as the output (production)
increases, long run average total cost curve decreases in economies of scale,
constant in constant returns to scale, and increases in diseconomies of scale.
 Increasing Returns to Scale
 The first stage, increasing returns to scale (IRS) refers to a production process
where an increase in the number of units produced causes a decrease in the
average cost of each unit. In other words, a firm is experiencing IRS when the cost
of producing an additional unit of output decreases as the volume of its production
increases. IRS may take place, for example, if the cost of production of a
manufactured good would decrease with the increase in quantity produced due to
the production materials being obtained at a cheaper price.
 Constant Return to Scale
 The second stage, constant returns to scale (CRS) refers to a production process
where an increase in the number of units produced causes no change in the
average cost of each unit. If output changes proportionally with all the inputs, then
there are constant returns to scale.

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 Diminishing Return to Scale

 The final stage, diminishing returns to scale (DRS) refers to production for which
the average costs of output increase as the level of production increases. The DRS
is the opposite of the IRS. DRS might occur if, for example, a furniture company
was forced to import wood from further and further away as its operations
increased.

Long Run Total Cost

1. Long Run Total Cost:
 Long run Total Cost (LTC) refers to the minimum cost at which given level of
output can be produced. According to Leibhafasky, “the long run total cost of
production is the least possible cost of producing any given level of output when
all inputs are variable.” LTC represents the least cost of different quantities of
output. LTC is always less than or equal to short run total cost, but it is never more
than short run cost.

 As shown in Figure, short run total costs curves; STC1, STC2, and STC3 are
shown depicting different plant sizes. The LTC curve is made by joining the
minimum points of short run total cost curves. Therefore, LTC envelopes the STC
curves.

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2. Long Run Average Cost Curve

 Long Run is a period of time during which the Firm can vary all of its Inputs .
 The Firm moves from one plant to another in Long Run. To Increase the Output,
Firm acquires Big Plant & vice versa.
 Long Run Cost of Production is the least possible Cost of Producing any given
level of Output when all Individual Factors are Variable.
 The Minimum Point on LRAC Curve is the " Minimum Efficient Scale ".

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 Long Run Cost Curve depicts the Functional relationship between Output & the
Long Run Cost of Production.
 It envelopes the set of U - Shaped Short - Run Average Cost Curves
Corresponding to different Plant Sizes.
 LRAC Curve is " U - Shaped ”, reflecting Economies of Scale ( or Increasing
Returns to Scale ) when Negatively Sloped and Diseconomies of Scale ( or
Decreasing Returns to Scale ) when Positively Sloped .
 Long Run Average Cost Curve Every Point on the Long Run Average Cost Curve
is a Tangency Point with some Short Run AC Curve.
 LAC Curve is not a Tangent to the minimum points of the SAC Curves.
 LAC Curve is called as “ Planning Curve ” as a Firm Plans to Produce any Output
in the Long Run by choosing a Plant on the Long Run Average Cost Curve
corresponding to the given Output.

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3. Long Run Marginal Cost:

 Long run Marginal Cost (LMC) is defined as added cost of producing an
additional unit of a commodity when all inputs are variable. This cost is derived
from short run marginal cost. On the graph, the LMC is derived from the points of
tangency between LAC and SAC.

 The long-run marginal cost curve represents the cost of an additional unit of output
when all the inputs vary. The long-run marginal cost curve (LMC) is derived from
the short-run marginal cost (SMC) curves. LMC curve intersects LAC curve at its
minimum point C. There is only one plant size whose minimum SAC coincides
with the minimum LAC and LMC.
 SAC2 = SMC2 = LAC = LMC
 The point C indicates also the optimum scale of production of the firm in the long-
run or optimum output. Optimum output level is the level of production at which
the cost of production per unit, i.e. AC, is the lowest. The optimum level is not the
maximum profit level. The optimum point is where AC=MC. Here C is the
optimum point.

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CONCEPT OF REVENUE

 Meaning of Revenue:
 The amount of money that a producer receives in exchange for the sale proceeds is
known as revenue. For example, if a firm gets Rs. 16,000 from sale of 100 chairs,
then the amount of Rs. 16,000 is known as revenue.
 Revenue refers to the amount received by a firm from the sale of a given quantity
of a commodity in the market.
 Revenue is a very important concept in economic analysis. It is directly influenced
by sales level, i.e., as sales increases, revenue also increases.
 Concept of Revenue:
 The concept of revenue consists of three important terms; Total Revenue, Average
Revenue and Marginal Revenue.
 Revenue refers to the amount received by a firm from the sale of a given quantity
of a commodity in the market.
 Revenue is a very important concept in economic analysis. It is directly influenced
by sales level, i.e., as sales increases, revenue also increases.

1. Total Revenue (TR):

 Total Revenue refers to total receipts from the sale of a given quantity of a
commodity. It is the total income of a firm. Total revenue is obtained by
multiplying the quantity of the commodity sold with the price of the commodity.

 Total Revenue = Quantity × Price

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 For example, if a firm sells 10 chairs at a price of Rs. 160 per chair, then the total
revenue will be: 10 Chairs × Rs. 160 = Rs 1,600

2. Average Revenue (AR):

 Average revenue refers to revenue per unit of output sold. It is obtained by

dividing the total revenue by the number of units sold.

 Average Revenue = Total Revenue/Quantity

 For example, if total revenue from the sale of 10 chairs @ Rs. 160 per chair is Rs.
1,600, then:

 Average Revenue = Total Revenue/Quantity = 1,600/10 = Rs 160

 AR and Price are the Same:

 We know, AR is equal to per unit sale receipts and price is always per unit. Since
sellers receive revenue according to price, price and AR are one and the same
thing.

 This can be explained as under:

 TR = Quantity × Price … (1)

 AR = TR/Quantity …… (2)

 Putting the value of TR from equation (1) in equation (2), we get

 AR = Quantity × Price / Quantity

 AR = Price

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 AR Curve and Demand Curve are the Same:

 A buyer’s demand curve graphically represents the quantities demanded by a

buyer at various prices. In other words, it shows the various levels of average
revenue at which different quantities of the good are sold by the seller. Therefore,
in economics, it is customary to refer AR curve as the Demand Curve of a firm.

3. Marginal Revenue (MR):

 Marginal revenue is the additional revenue generated from the sale of an

additional unit of output. It is the change in TR from sale of one more unit of a
commodity.

 MRn = TRn-TRn-1

 Where:

 MRn = Marginal revenue of nth unit;

 TRn = Total revenue from n units;

 TR n-1 = Total revenue from (n – 1) units; n = number of units sold For example, if
the total revenue realised from sale of 10 chairs is Rs. 1,600 and that from sale of
11 chairs is Rs. 1,780, then MR of the 11th chair will be:

 MR11 = TR11 – TR10

 MR11 = Rs. 1,780 – Rs. 1,600 = Rs. 180

 TR, AR and MR:

Units Price Total Average Marginal

Sold (Rs.) Revenue Revenue Revenue (Rs.)
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(Rs.) TR = (Rs.) AR =
(Q) (P) MRn=TRn-TRn-1
QxP TR/Q = P
1 10 10=1×10 10 =10 / 1 10 =10-0
2 9 18 =2×9 9 =18 / 2 8 =18-10
3 8 24 =3×8 8 =24 / 3 6 =24-18
4 7 28 = 4×7 7 =28 / 4 4 =28-24
5 6 30 = 5×6 6 =30 / 5 2 =30-28
6 5 30 = 6 x 5 5 =30 / 6 0 =30-30
7 4 28 = 7×4 4 =28 / 7 -2 =28-30

Revenue Curves under Different Markets (With Diagram)

1. Revenue Curve under Perfect competition:

 Perfect competition is the term applied to a situation in which the individual buyer
or seller (firm) represent such a small share of the total business transacted in the
market that he exerts no perceptible influence on the price of the commodity in
which he deals.

 Thus, in perfect competition an individual firm is price taker, because the price is
determined by the collective forces of market demand and supply which are not
influenced by the individual. When price is the same for all units of a commodity,
naturally AR (Price) will be equal to MR i.e., AR = MR. The revenue schedule for
a competitive firm is shown in the table 5.

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 In table 5 we find that as output increases, AR remains the same i.e. Rs. 5. Total
revenue increases but at a constant rate. Marginal revenue is also constant i.e. Rs.
5 and is equal to AR.

 Thus

 TR = AR x Q

 Also TR = MR x Q [Since AR = MR]

 In figure 8, on the X-axis, we take quantity whereas on Y-axis, we take revenue.

At price OP, the seller can sell any amount of the commodity. In this case the
average revenue curve is the horizontal line. The Marginal Revenue curve
coincides with the Average Revenue.

 It is because additional units are sold at the same price as before. In that case AR =
MR. A noteworthy point is that OP price is determined by demand and supply of
industry.

 The firm only follows, (see figure below):

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2. Revenue Curves under Monopoly:

 Monopoly is opposite to perfect competition. Under monopoly both AR and MR

curves slope downward. It indicates that to sell more units of a commodity, the
monopolist will have to lower the price. This can be shown with the help of table
6.

 In case of pure monopoly, AR curve can be rectangular hyperbola as has been

shown in Fig. 9. In this situation, a producer is so powerful that by selling his
output at different prices, he can make the consumer spend his income on the
concerned commodity. In this case AR curve is rectangular hyperbola. It implies
that TR of the monopolist will remain same whatever may be the price. Area
below each point of AR curve will be equal to each other. When TR is constant
MR curve will be represented by OX-axis as has been shown in figure 9.

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3. Revenue Curve under Imperfect Competition:

 When a firm is working under conditions of monopoly or imperfect competition,

its demand curve or AR curve is less than perfectly elastic, the exact degree of
elasticity being different in different market situations depending upon the number
of sellers and the nature of product.

 In other words, the demand/AR curve has a negative slope and the MR curve lies
below it. This is because the monopolist seller ordinarily has to accept a lower
price for his product, as he increases his sales.

 Under imperfect competition conditions, total revenue increases at a diminishing

rate. It becomes maximum and then begins to decline.

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 The position of various revenue curves is shown in Table 7:

 In table 7, 2 units can be sold at a unit price of Rs. 5, bringing in total revenue of
Rs. 10. When 3 units are sold, the price per unit is lowered to Rs. 4 to make it
possible for larger quantity to be sold. The total revenue in this case is Rs. 12.

 The marginal unit is not bringing in Rs. 4 which is its price, but only Rs. 2. This is
because the additional one unit is sold at Re. one less and the first 2 units which
could have been sold for Rs. 5 are also sold at Rs. 4. i.e., Re. one less.

 Fig. 10 A shows that as additional units are sold when price comes down not only
for the marginal units but also for other previous units. As a result, marginal units
do not bring revenue equal to its price. In fig. 10 B. TR increases at a diminishing
rate, becomes maximum at point N and then begins to decline. This has been
represented by the curve TR. AR at any point on the TR curve is given by the
slope of straight line joining the point to the origin. For instance, AR at any point
N on TR curve is given by the slope of line

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4. Revenue Curves under Oligopoly:

 Under oligopoly market situation the number of sellers is small. The price
reduction or extension by one firm affects the other firms. If a seller raises the
price of his product, others will not follow him. They know that by following the
same price, they can earn more profits. That producer, who has raised the price, is
likely to suffer losses because demand of his product will fall.

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 In this case, as shown in Fig. 11, the AR curve becomes highly elastic after K
whereas it was less elastic before K. MR, corresponding to AR curve rises
discontinuously from b. After that it again takes its course at a new higher level.

 If a firm has a kinked demand curve i.e. when it expects that other firms will
follow, then it will cut the price. In that case MR curve will be discontinuous at the
point of the kink. This can be shown with the help of a Fig. 12.

 If under oligopoly, a seller reduces the price of his product; his rivals also follow
him in reducing the price of their product. If it is done so, he may not be in a
position to raise his sales. Thus AR curve becomes less elastic from K onwards
and correspondingly MR curve falls vertically from a to b and then slopes at a
lower level.

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