Lesson 6 Continued… (Production and Cost Concept)

LEARNING OUTCOMES:
At the end of the lesson, the students were able to
 Comprehend the concept of cost in the production, manufacturing, and operation of business
 Analyze the relationship of cost and production and the market structures
 Differentiate the different market structures and able to distinguish which market do the firms and
other companies belong

The Cost of Production

Analysis of Cost, Profit, and Total Revenue

¬ Cost exists because resources are scarce, productive, and have alternative uses.
Economic Cost
¬ A payment that must be made to obtain and retain the services of a resource; an income a firm must provide
to a resource supplier to attract the resource away from an alternative use
Opportunity Cost
¬ The cost that are incurred by not putting the resources to optimum use. These are measurable but expensive
and this cost must be included in decision-making process.
¬ It also the sacrificed value of a resource in order to obtain one resource.
Accounting Cost
¬ It is money paid out at some time in the past that are recorded in a journal entry. They recognize costs only
when these are made and properly recorded. Therefore, the difference between economic cost and
accounting cost is opportunity cost.
Explicit costs
¬ Refer to actual expenses of the firm in purchasing or hiring the inputs it need; they are monetary payments
a firm makes to those who supply labor services, materials, fuel, transportation services and the like.
Implicit Costs
¬ Refer to the value of inputs being owned by the firm and used in its own production process; opportunity
costs of using self-owned, self-employed resources.

Normal Profit
¬ This is a payment made by a firm to obtain or retain entrepreneurial ability; the minimum income
entrepreneurial ability must receive to induce it to perform entrepreneurial functions for a firm.
Economic Profit
¬ It is a profit earned after deducting economic cost from the total revenue

Short –Run Cost Analysis

a. Total Fixed Cost (TFC) = cost that do not vary with output. They are associated with the very existence
of a firm’s plant and therefore must be paid even if output is zero.
b. Total Variable Cost (TVC) = cost that change with the level of output.
c. Total Cost (TC) = the sum of fixed cost and variable cost at each level of output.
𝑇𝑇𝑇𝑇 = 𝑇𝑇𝑇𝑇𝑇𝑇 + 𝑇𝑇𝑇𝑇𝑇𝑇
d. Average Variable cost (AVC) = the cost of one variable input that is used in producing an output.
𝑇𝑇𝑇𝑇𝑇𝑇
𝐴𝐴𝐴𝐴𝐴𝐴 =
𝑄𝑄
e. Average Fixed Cost (AFC) = a cost from the total fixed cost of a firm that is apportioned to an output.
𝑇𝑇𝑇𝑇𝑇𝑇
𝐴𝐴𝐴𝐴𝐴𝐴 =
𝑄𝑄

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f. Average Total Cost (ATC) = the cost per unit of output
𝑇𝑇𝑇𝑇
𝐴𝐴𝐴𝐴𝐴𝐴 =
𝑄𝑄
g. Marginal Cost (MC) = it is the additional cost incurred from producing additional output.
∆𝑇𝑇𝑇𝑇 𝑇𝑇𝑇𝑇2 − 𝑇𝑇𝑇𝑇1
𝑀𝑀𝑀𝑀 = 𝑜𝑜𝑜𝑜 𝑀𝑀𝑀𝑀 =
∆𝑄𝑄 𝑄𝑄2 − 𝑄𝑄1

EXAMPLE
Table 6: A hypothetical Cost Schedules

Q TFC TVC TC AFC AVC ATC MC

0 30 0 30 ∞ ∞ ∞ ∞
1 30 15 45 30 15 45 15
2 30 20 50 15 10 25 5
3 30 22.5 52.5 10 7.5 17.5 2.5
4 30 28 58 7.5 7 14.5 5.5
5 30 38 68 6 7.6 13.6 10
6 30 60 90 5 10 15 22

• The distinction between fixed and variable cost is significant to the business manager. Variable cost
can be altered or changed in the short run by changing production levels thus it can be controlled by
the business manager. On the other hand, fixed cost is not significant for business manager’s decision
because in the short run they are incurred and must be paid regardless of output level.
• Producers are interested in their total costs, but they are much concerned with per unit cost.
Particularly, average – cost data are more meaningful for making comparison with product price.

Figure 11: total cost, fixed cost and variable cost

100
90 T
80
70
60 TVC
costs

50
40
30 TFC
20
10
0
0 2 4 6 8
output/quantity

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 Figure 12: per unit costs

50
45
40
35

per unit costs

30
25
MC
20
15 ATC
10 AVC
5 AFC
0
0 2 4
output/quantity 6 8

AFC: because total fixed cost is the same regardless of output, AFC must decline as output increases because
a fixed amount is distributed to a larger and larger amount, this process is called “spreading the overhead”

AVC: as added variable resources increase output, AVC declines initially, reaches minimum, and then increases
again. Going back to the production phase, at the 1st phase of the production, output increases (marginal returns
increases) thus it takes fewer and fewer additional variable resources needed to produce each output. As a
result, variable cost per unit declines, when a resource produces it highest output then AVC hits its minimum.
When production process reaches its second phase, lesser output is added to total product, thus it takes more
variable needed to produce more output; AVC now increases.

ATC: it is the amount of per unit of good out of the total cost incurred. As added output increases, the cost also
increases but the cost per unit at first stages of production decreases because total cost is spread over a larger
units of output. As output is maximized, ATC is at minimum then if firms continue increases production more
cost will be incurred then eventually, cost per unit increases due to the increase in the variables needed to
produce the total output.
MC: these are cost the firm can control directly, and immediately. MC are used for marginal decision because it
designates all the cost incurred in producing the last unit of output and the cost that can be “saved” by not
producing that last unit. A firms’ decision as to what output level to produce are typically a marginal decision
which is either to produce few more or few less.

M athem atical Application

Total Cost = total variable cost + fixed cost
C(x) = mx + b is as example of a cost function.

Example 1: the variable cost pf processing one kilo of boneless bangus is ₱50.00 and the fixed cost per day
₱500. a) Determine the cost equation and draw its graph. b) Find cost of processing 50 kilos of boneless
bangus per day.

Using the cost function, we C(x) = mx + b where “m” is the variable cost per unit “b” the fixed cost.
a. Given
variable cost/kilo = ₱50.00
fixed cost/day = ₱500.00
solution:
C(x) = mx + b
C = 50x + 500
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Using the intercepts method to graph the function C(x) = 50x + 500
Let x = 0 Let C(x) = 0
C = 50(0) + 500 0 = 50x + 500
50x 500
C = 500 − =
−50 −50
(0, 500) x = - 10

b. Find the cost

Using the cost function C = 50x + 500 and setting x = 50, then solve for cost function
C(50) = 50x + 500
= 50(50) + 500
= 2,500 + 500
C(50) = ₱3,000, the cost of processing 50 kilos of bangus per day

Long – Run Cost Analysis (LAC)

¬ Long – run is a period wherein all fixed factors can be variable. At this period, industry and individual firm
can undertake all desired resource adjustments. That is, they can change the amount of all inputs used.
¬ The firm size and costs; at first, a single – plant manufacturer begins on a small scale and then expands
successively larger plant sizes with larger output capacities. Thus, constructing larger plants will lower the
minimum average total costs through larger capacities but as plants expands further, it will mean a higher
minimum average total cost.

Figure 13: Long Run Average Cost

25

20 SAC1
15
LAC
costs

10

0
0 5 10 15
quantity 20 25 30

Economies and Diseconomies of Scale

Economies of scale
¬ It is also the economies of mass production which explains the downward sloping part of the long run
ATC curve. As plant size increases, a number of factors will for a time lead to lower average cost of
production
a. Labor specialization
b. Managerial specialization
c. Efficient capital

Diseconomies of Scale
¬ A factor/s that increases the average total cost of producing a product as firm expands the size of its
plant capacity in the long run. This explain the upward sloping of the long run average cost
¬ The main factor causing this is the difficulty of efficiently controlling and coordinating a firm’s operations
as it becomes a large-scale producer.
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 Constant Returns to Scale
¬ At this point long run average cost does not change.

Profit Analysis

Business Profit versus Economic Profit

• Business Profit refers to the difference between total revenue and explicit cost
• Economic Profit is the difference between total revenue and both explicit and implicit cost

Point of Maximum Profit

 Profit maximization happens at a point where the difference of total revenue and total cost is at largest.
 There are two ways to determine the level of profit maximization or minimum loss

A. Total – Revenue – Total – Cost Approach

 An approach which can use to determine which output could produce the highest profit or the output that
could not create a loss.

 Simply comparing the TR and TC; if TR and TC intersect, this means that TR covers all cost but there is no
economic profit. For this reason economist call this output a break – even point: an output at which a
firm makes a normal profit but not an economic profit.

 A normal profit is a zero profit. At this point a firm will not shut down production because even if they
are not creating a positive profit at least all the cost involved in the production are paid or covered.

 The firms profit is maximized at that output where total revenue exceeds total cost. At the figure above a
firm can decide to operate between the two break – even points but below and above the break-even
points, a firm will rather shutdown the operation.

Figure 14: total cost & total revenue curves

16000
TC
14000
TR
break-even pt.
12000
10000
COSTS

8000
maximum profit
6000
4000 Break-even pt.

2000
0
0 200 400 600 800 1000
QUANTITY

B. Marginal Revenue – Marginal – Cost Approach

 The second approach, the firm compares the amounts that each additional unit of output could add to the
total revenue and to total cost. Marginal decision is very important to a firm’s decision because these marginal
costs are the costs that a firm can manipulate.
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 At this approach, if producing is preferable than shutting down the business, a firm should produce any unit
of output whose marginal revenue exceeds its marginal cost because a firm would gain more in revenue in
selling the product than it would add to its cost.

• TR > TC = Positive Profit

• TR < TC = Loss or a negative profit
• TR = TC = Normal Profit
• MR > MC = Positive Profit
• MR < MC = Negative Profit
• MR = MC = shutdown or proceed with production depending on the relationship of price and the average
costs (optimum level of production)

REVENUE AND PROFIT CONCEPTS

• Revenues refer to the sales generated by an enterprise, they are necessary for the producers to
determine how much output they sold and how much from the output they produced were able to sell.
• Profits refers to the entrepreneurial ability thus it is computed as the difference between TR and TC
𝑇𝑇𝑇𝑇 = 𝑆𝑆𝑆𝑆 𝑥𝑥 𝑄𝑄
𝑇𝑇𝑇𝑇 = 𝑇𝑇𝑇𝑇𝑇𝑇 + 𝑇𝑇𝑇𝑇𝑇𝑇
𝝅𝝅 /𝑻𝑻𝑻𝑻 = 𝑻𝑻𝑻𝑻 − 𝑻𝑻𝑻𝑻

Kinds of Profits

1. Normal profit = is the minimum profit received by a firm to do it operational function and to retain its
entrepreneurial ability
2. Pure Profit = the income acquired after deducting all the cost including implicit and explicit cost from
the total revenue

Break – even Analysis

 The main importance of the break-even point is for the enterprise to determine what production point
they need to reach and consequently surpass to start making profits or positive returns for the
enterprise.

Example 1:

Suppose that the predetermined fixed cost are Php 150, 000. Let us further suppose that the computed
variable cost per unit is Php 50.00 and the selling price is set at Php 75.00
Mathematically:

TFC = Php 150,000

TVC = (variable cost/unit) x (unknown # of units)
= (Php 50) (Q)
TR = (selling price/unit) x (unknown # of units)
= Php 75 (Q)
TC = TFC + TVC
= Php 150,000 + Php 50Q

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In computing the break – even, we get
TR = TC
75Q = 150,000 + 50Q

Since Q is unknown, Q maybe computed using the later equations

TR = TC
75Q = 150,000 + 50Q
75Q – 50Q= 150,000
25Q = 150, 000
25 25
Q = 6, 000 units, the break – even quantity

Thus break – even amount is

TR = Php 75 (Q)
= 75 (6,000)
= 450,000

TC = 150,000 + 50Q
= 150,000 + 50 (6,000)
= 150,000 + 300,000
= 450, 000
To check:
TP = TR - TC
= 450, 000 - 450, 000
= 0 (break – even)

Example 2: JP Company’s daily TC (in pesos) of producing x items is given by equation 𝑇𝑇𝑇𝑇 = 5𝑥𝑥 + 600
a. If each item sells for ₱10, what is the break-even point?
b. If the selling price increased to ₱20 per item, what is the new break-even point?
c. It is known that 200 items can be sold each day, what price should be charged to guarantee no loss
d. Find the profit at a sale of 250 items

SOLUTION
a. Given:
𝑇𝑇𝑇𝑇 = 5𝑥𝑥 + 600
𝑇𝑇𝑅𝑅 = 10𝑥𝑥
TR = TC
10𝑥𝑥 = 5𝑥𝑥 + 600
10𝑥𝑥 − 5𝑥𝑥 = 600
5𝑥𝑥 600
=
5 5
𝑥𝑥 = 120 𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖, 𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏 𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒 𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞

Solve for the break-even revenue

𝑇𝑇𝑇𝑇 = 10𝑥𝑥
= 10(120)
= 1,200
So BEP (120, 1200)

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 b. The selling price increased to ₱20
𝑇𝑇𝑇𝑇 = 5𝑥𝑥 + 600
TR = 20x

TR = TC
20𝑥𝑥 = 5𝑥𝑥 + 600
20𝑥𝑥 − 5𝑥𝑥 = 600
15𝑥𝑥 600
=
15 15
𝑥𝑥 = 40 𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖, 𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏 𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒 𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞

𝑇𝑇𝑇𝑇 = 20𝑥𝑥
= 20(20)
= 800
The new BEP (40, 800)

c. x = 200

TR = 200p
and the cost of producing x =200 items is
𝑇𝑇𝑇𝑇 = 5𝑥𝑥 + 600
Or 𝑇𝑇𝑇𝑇 (200) = 5(200) + 600
𝑇𝑇𝑇𝑇 (200) = 1, 600
To guarantee a break-even situation, we must have
TR =TC
200p = 1,600
200𝑝𝑝 1,600
=
200 200
𝑝𝑝 = ₱8 𝑝𝑝𝑝𝑝𝑝𝑝 𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖 should be charged to guarantee a break-even 200 items will be sold each day

d. find the profit

𝜋𝜋 = 𝑇𝑇𝑇𝑇 − 𝑇𝑇𝑇𝑇
𝜋𝜋 = 10𝑥𝑥 − (5𝑥𝑥 + 600)
= 10𝑥𝑥 − 5𝑥𝑥 − 600
= 5𝑥𝑥 − 600
𝜋𝜋 = 5(250) − 600
= 650, 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 𝑎𝑎𝑎𝑎 250 𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢 𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠

Take Note:
• Above the break – even quantity would yield a positive returns or a profit because there are more
revenues to cover the cost
• Below the break – even quantity would yield a negative returns or a loss because there is no enough
revenue to cover the cost

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 The Profit of the Firm in the Short – run

¬ A competitive firm takes the market price as constant, therefore a firm can maximize profits at the optimum
level of production which is the point where marginal cost is equal to its price (price is the same with the
MR)

• Price is greater than marginal cost (P >ATC)

In this case, the firm is earning profits because price is greater than the cost of producing the output

• Price is equal to ATC (P = ATC)

In this case, the firm is either experiencing profits or losses. If price is equal to marginal cost, this denotes
the best level of output. But since price is equal to average total cost, the firm is at break – even.

• Price is greater than AVC (P > AVC)

¬ At this case, price is lower than the average total cost but though, the firm may continue operating in the
short – run as long as the price is greater than average variable cost. Even if the firm at this case is
earning negative profits, shutting down the business is not preferable because total revenue is still greater
than total variable costs, and if the firm will shut down the business they will eliminate the revenue earned.

• The Shutdown Point

¬ The firm should shut down if any of the following occurs, P = AVC or P < AVC. If price is equal to marginal
cost and average variable cost, it is no longer practical to continue to do business because revenue is just
enough to cover the variable cost of the firm and there is no excess to cover the fixed cost.
¬ If price is lesser than the cost per variable, the decision is to shut down also, because total revenue is
insufficient to pay the variable costs.
¬ As general rule, a profit maximizing firm will produce at a point where the marginal cost incurred in the
production should equal the marginal revenues earned from the same production process

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