Cost Revenue Analysis

Classification of cost
According to:
1. Nature/ Elements
2. Function
3. Degree of traceability to product
4. Change in volume
5. Controllability
6. Normality
Classification of cost contd….
7. Time
8. Planning & control
9. In relationship with accounting period
10. Association with product
11. Managerial decisions
Cost
 Costs are defined as those expenses faced
by a business when producing a good or
service for a market.
 Firm will have fixed and variable costs of

production. Total cost is made up of fixed

costs and variable costs
Cost measures in decision making
 Actual cost, (or) out lay cost or book cost
 Opportunity cost
 Sunk cost
 Explicit cost and implicit cost
 Accounting cost and economic cost
 Direct cost and indirect cost
 Private cost and social cost
 Shutdown cost and abandonment cost
The production process
Elements of Costs

Materials
Materials Labour
Labour Expense
Expense

The Product
Direct Materials
Those materials that become an integral part of
the product and that can be conveniently traced
directly to it.

Example:
Example: AA radio
radio installed
installed in
in an
an automobile
automobile
 Indirect Material
Those materials that do not become an integral
part of the product but which helps in
production.

Example:
Example: indirect
indirect materials
materials

Materials used to support the

production process.
Examples: lubricants and
cleaning supplies used in the
automobile assembly plant.
Direct Labor
Those labor costs that can be easily traced to
individual units of product.

Example:
Example: Wages
Wages paid
paid to
to automobile
automobile assembly
assembly workers
workers
Indirect Labour

Those labor costs that cannot be easily traced to

individual units of product.

Examples:
Examples: Indirect
Indirect labor
labor

Wages paid to employees who are not

directly involved in production work.
Examples: maintenance
workers, janitors and security
guards.
Expense
 Thecost of services provided to an undertaking
and the notional cost of the use of owned asset.
 Expenses are of two types:

Direct expense
Indirect expense
 Expense
 Direct expense is an expense which is incurred with
manufacture of a product.
Eg: Purchase of raw materials, factory labour, factory wages,
electricity

 Indirect expense also called as overhead are additional

expenses which are incurred on bringing a product to final
customer.
Eg: Sales and Distribution, Office Salary, office electricity,
office water, printing and stationery, outsourcing expenses,
advertising expenses etc.
By Function

Marketing and Selling

Administrative Cost
Cost

Costs necessary to get the order and All executive, organizational, and
deliver the product. clerical costs.
Direct Costs and Indirect Costs

Direct costs Indirect costs

Costs that can be Costs cannot be easily
easily and conveniently and conveniently traced
traced to a unit of to a unit of product or
product or other cost other cost object.
objective. Example:
Examples: direct manufacturing
material and direct labor overhead
Cost Classifications for Predicting
Cost Behavior

How
How aa cost
cost will
will react
react to
to changes
changes in in the
the level
level of
of
business
business activity.
activity.
 Total

Totalvariable
variablecosts
costs change
changewhen
whenactivity
activity changes.
changes.
 Total

Totalfixed
fixedcosts
costs remain
remainunchanged
unchangedwhen
when activity
activity
changes.
changes.
Cost Classifications for
Predicting Cost Behavior

Behavior of Cost (within the relevant range)

Cost In Total Per Unit

Variable Total variable cost changes Variable cost per unit remains
as activity level changes. the same over wide ranges
of activity.
Fixed Total fixed cost remains Fixed cost per unit goes
the same even when the down as activity level goes up.
activity level changes.
 F.C=Rs.1000 TFC=1000
 AFC for 100 units
 1000/100=Rs.10
 AFC for 200 units
 1000/200=Rs.5
 AFC for 1000 units
 1000/1000=Rs.1
Classification of cost contd….

Controllability

Controllable Uncontrollable
cost cost
Classification of cost contd….

Normality

Normal Abnormal
cost cost
Classification of cost contd….

Time

Predetermined
Historical cost
cost
Classification of cost contd….

Planning
& Control

Standard Budgeted
cost Cost
Differential Costs and Revenues

Costs and revenues that differ among

alternatives.

Example: You have a job paying 1,500 per month in your

hometown. You have a job offer in a neighboring city that
pays 2,000 per month. The commuting cost to the city is
300 per month.

Differential revenue is:

2,000 – 1,500 = 500

Differential cost is:

300
Opportunity Costs
The potential benefit that is
given up when one alternative
is selected over another.

Example: If you were

not attending college,
you could be earning
15,000 per year.
Your opportunity cost
of attending college for
one year is 15,000.
Sunk Costs
Sunk costs cannot be changed by any decision.
They are not differential costs and should be
ignored when making decisions.

Example: You bought an automobile that cost

1,00,000 two years ago. The 1,00,000 cost is
sunk because whether you drive it, park it, trade
it, or sell it, you cannot change the 1,00,000 cost.
The Irrelevance of Sunk Costs
 Sunk cost is one that already has been paid,
or must be paid, regardless of any future
action being considered
 Should not be considered when making

decisions
 Even a future payment can be sunk
 If an unavoidable commitment to pay it has
already been made
Theory of the Firm: Production & Cost
 A business firm is an organization, owned and
operated by private individuals, that specializes
in production

 Production is the process of combining inputs to

make outputs

 The firm buys inputs from households or other

firms and sells its output to consumers

 Profit of the firm = sales revenue – input costs

The Meaning of Costs
 Opportunity costs
 meaning of opportunity cost
 examples

 Measuring a firm’s opportunity costs

 factors not owned by the firm: explicit costs
 factors already owned by the firm: implicit costs
 Costs
 Short run – Diminishing marginal returns
results from adding successive quantities of
variable factors to a fixed factor
 Long run – Increases in capacity can lead to

increasing, decreasing or constant returns to

scale
Costs
 In buying factor inputs, the firm will incur costs
 Costs are classified as:
 Fixed costs – costs that are not related directly
to production – rent, rates, insurance costs,
admin costs. They can change but not in relation
to output
 Variable Costs – costs directly related to
variations in output. Raw materials, labour, fuel,
etc
 Costs
 Total Cost - the sum of all costs incurred in
production
 TC = FC + VC For 100 units
1000+2000=3000
 Average Cost – the cost per unit
of output
 AC = TC/Output 3000/100 units=Rs.30
 Marginal Cost – the cost of one more or one
fewer units of production
 MC = TC – TC
n n-1 units
 For 100 units Rs.3000
Additional unit means 101 unit, the cost incurred to
produce the additional unit is M.C 3000+30=3030
Sunk costs cannot be changed by any decision. They
are not differential costs and should be ignored when
making decisions
Opportunity Cost: The potential benefit that is given
up when one alternative is selected over another.
Explicit Cost: Out-of-pocket costs for a firm for
example, payments for wages and salaries, rent, or
materials.
Implicit Cost: The cost of resources already owned by
the firm that could have been put to some other use.
Social Cost: Total cost of production of a product, and
includes direct and indirect cost incurred by society.
River pollution, factory smoke, vehicle exhaust (air
pollution) etc.
Explicit vs. Implicit Costs
 Types of costs
 Explicit (involving actual payments)
 Money actually paid out for the use of inputs.
 Included in both economic and accounting cost.

 Implicit (no money changes hands)

The cost of inputs for which there is no direct money


payment
 Included in economic cost, but excluded in accounting

cost.
So Economic Cost is higher than Accounting Cost.
Average Costs

Average Total cost – firm’s total cost divided by its level of

output (average cost per unit of output)
ATC=AC=TC/Q

Average Fixed cost – fixed cost divided by level of output

(fixed cost per unit of output)
AFC=FC/Q

Average variable cost – variable cost divided by the level of

output.
AVC=VC/Q
Marginal Cost – change (increase) in cost resulting from the
production of one extra unit of output

Denote “∆” - change. For example ∆TC - change in total cost

MC=∆TC/∆Q

Example: when 4 units of output are produced, the cost is 80, when
5 units are produced, the cost is 90. MC=(90-80)/1=10

MC=∆VC/∆Q

since TC=(FC+VC) and FC does not change with Q

MC = TCn – TCn-1 units

Short-run Costs and Marginal Product

 production with one input L – labor; (capital is fixed)

 Assume the wage rate (w) is fixed
 Variable costs is the per unit cost of extra labor times the amount
of extra labor: VC=wL

Denote “∆” - change. For example ∆VC is change in variable cost.

MC=∆VC/∆Q ; MC =w/MPL,
where MPL=∆Q/∆L

With diminishing marginal returns: marginal cost increases as

output increases.
Short-Run Cost Functions

Total Cost = TC = f(Q)

Total Fixed Cost = TFC
Total Variable Cost = TVC
TC = TFC + TVC
Short-Run Cost Functions

Average Total Cost = ATC = TC/Q

Average Fixed Cost = AFC = TFC/Q
Average Variable Cost = AVC = TVC/Q
ATC = AFC + AVC
Marginal Cost = TC/Q = TVC/Q
Outp F.C V.C T.C= M.C AFC= AVC= ATC=
ut F.C+V.C TCn – F.C/Q V.C/Q T.C/Q
TCn-1
0 50 0 50+0=50 - - - -
1 50 50 50+50=100 50 50 50 100/1=100

2 50 78 50+78=128 28 50/2=25 78/2=39 128/2=64

3 50 98 50+98=148 20 50/3=16.6 98/3=32.6 148/3=49.3

4 50 112

5 50 130

6 50 150

7 50 175
8 50 204
9 50 242
10 50 300
11 50 385
A Firm’s Short Run Costs
Short Run Cost Curves for a Firm

TC (TVC + FC)
Cost 400
($ per Total cost
year) TVC
is the vertical
sum of FC
and VC.
300
Variable cost
increases with
production and
the rate varies with
increasing &
200
decreasing returns.

Fixed cost does not

100 vary with output
50 FC

0 1 2 3 4 5 6 7 8 9 10 11 12 13 Output
The Firm’s Total Cost Curves
Rupees

435 TC

375 TFC TVC

315
255
195
135
TFC

0 30 90 130 161 184 196

Units of Output
The Total cost curve will initially increase at a
decreasing rate, then at an increasing rate due to
the law of diminishing returns(caused by the
influence of TVC over TFC). Total cost will change
in the same proportion as total variable cost.
 Average and marginal costs
MC

Diminishing
marginal
Costs (£)

returns set in here

fig
Output (Q)
The Relationship Between MP, AP,
MC, and AVC
AP and AVC are inversely related.
Thus AVC is an inverted U shaped curve

The Marginal cost is the inverse of the MP curve.

 Average and marginal costs
MC
ATC

AVC
Costs

x
AFC

fig
Output (Q)
Average And Marginal Costs
Dollars MC
4

AFC ATC
2 AVC

0 30 90 130 161 196

Units of Output
Relationship Between Marginal and
Average Costs
Marginal and average total cost reflect a general
relationship that also holds for marginal cost and
average variable cost.

To summarize:
If MC < ATC, then ATC is falling.
If MC = ATC, then ATC is at its low point.
If MC > ATC, then ATC is rising.

If MC < AVC, then AVC is falling.

If MC = AVC, then AVC is at its low point.
If MC > AVC, then AVC is rising.
Average And Marginal Costs
 At low levels of output, the MC curve lies below the
AVC and ATC curves
 These curves will slope downward
 At higher levels of output, the MC curve will rise
above the AVC and ATC curves
 These curves will slope upward
 As output increases; the average curves will first
slope downward and then slope upward
 Will have a U-shape
 MC curve will intersect the minimum points of the
AVC and ATC curves
 Average total cost curve (ATC)
The average fixed cost curve is a rectangular hyperbola as
the curve becomes asymptotes to the axes.
The average variable cost is a mirror image of the average
product curve .
The average total cost curve is the sum of AFC and the
AVC.
When both the curves are falling, the ATC which is the
sum of both is also falling.
When AVC starts to rise, the average fixed cost curve falls
faster and hence the sum falls. Beyond a point, the rise in
AVC is more than the fall in AFC and their sum rises.
Hence the ATC is an U shaped curve
Outpu F.C V.C T.C= M.C AFC= AVC= ATC=
t F.C+V. TCn – F.C/Q V.C/Q T.C/Q
C TCn-1

0 60 0
1 60 20

2 60 30

3 60 45

4 60 80

5 60 135
Short-Run Cost Functions

Q TFC TVC TC AFC AVC ATC MC

0 $60 $0 $60 - - - -
1 60 20 80 $60 $20 $80 $20
2 60 30 90 30 15 45 10
3 60 45 105 20 15 35 15
4 60 80 140 15 20 35 35
5 60 135 195 12 27 39 55
Short run Cost Curves
 (a) Total-Cost Curve
Total
Cost
$18.00 TC
16.00
14.00
12.00
10.00
8.00
6.00
4.00
2.00

0 2 4 6 8 10 12 14
Quantity of Output (bagels per hour)

Copyright © 2004 South-Western

 (b) Marginal- and Average-Cost Curves

Costs

$3.00

2.50
MC
2.00

1.50
ATC
AVC
1.00

0.50
AFC
0 2 4 6 8 10 12 14
Quantity of Output (bagels per hour)

Copyright © 2004 South-Western

COSTS IN THE SHORT RUN AND IN
THE LONG RUN
 Formany firms, the division of total costs
between fixed and variable costs depends on
the time horizon being considered.
 In the short run, some costs are fixed, total cost
starts from Fixed cost
 In the long run, fixed costs become variable costs.
 In the Long run total cost starts from the origin
 COSTS IN THE SHORT RUN AND IN
THE LONG RUN
 Because many costs are fixed in the short run
but variable in the long run, a firm’s long-run
cost curves differ from its short-run cost curves.
 (LRAC) Long run Average Cost curve shows the
minimum cost of producing any given output, when all
the inputs are variable.
 The LRAC curve is derived from a series of short-run
average cost (SAC) curves. Tangential points of these
SAC curves are joined to form the LRAC curve.
Long-Run Cost Curves

Long-Run Total Cost = LTC = f(Q)

Long-Run Average Cost = LAC = LTC/Q
Long-Run Marginal Cost = LMC = LTC/Q
Relationship Between Long-Run and
Short-Run Average Cost Curves
 Average Total Cost in the Short and Long Run

Average
Total ATC in short ATC in short ATC in short
Cost run with run with run with
small factory medium factory large factory

12,000

ATC in long run

0 1,200 Quantity of
Cars per Day
 Summary
In the short run, the total cost of any level of output is the sum
of fixed and variable costs: TC=FC+VC

Average fixed (AFC), average variable (AVC), and average total

Costs (ATC) are fixed, variable, and total costs per unit of output;
marginal cost is the extra cost of producing 1 more unit of output.

AFC is decreasing

AVC and ATC are U-shaped, reflecting increasing and then

Diminishing returns.

Marginal cost curve (MC) falls and then rises, intersecting both
AVC and ATC at their minimum points.
Average Cost and Plant Size
 Plant - Collection of fixed inputs at a firm’s disposal
 In the long run, the firm can change the size of its plant
 In the short run, it is stuck with its current plant size
 ATC curve tells us how average cost behaves in the
short run, when the firm uses a plant of a given size

 To produce any level of output, it will always choose that

ATC curve—among all of the ATC curves available—that
enables it to produce at lowest possible average total
cost
Graphing the LRATC Curve
 A firm’s LRATC curve combines portions of each
ATC curve available to firm in the long run

 In the short run, a firm can only move along its

current ATC curve

 In the long run it can move from one ATC curve

to another by varying the size of its plant
Long-Run Average Total Cost
Dollars
ATC1 LRATC
4.00 ATC3
ATC0 ATC2
3.00 C
D
2.00 B
A E
1.00

0 30 90 130 161 184 250 300

175 196
Use 0 Use 1 Use 2 Use 3
automated automated automated automated
lines lines lines lines
Units of Output
The Envelope Relationship
 Inthe long run all inputs are flexible, while in
the short run some inputs are not flexible.
 As a result, long-run cost will always be less

than or equal to short-run cost.

 The Long-Run Cost Function
 LRAC
is made up for
SRACs
 SRAC curves represent
various plant sizes
 Once a plant size is
chosen, per-unit
production costs are
found by moving along
that particular SRAC
curve
The Long-Run Cost Function
 The
LRAC is the lower envelope of all of the
SRAC curves.
 Minimum efficient scale is the lowest output level
for which LRAC is minimized
The Envelope Relationship
 The envelope relationship explains that:
 At the planned output level, short-run average
total cost equals long-run average total cost.
 At all other levels of output, short-run average

total cost is higher than long-run average total

cost.
 Deriving long-run average cost curves:
factories of fixed size
SRAC1 SRAC SRAC5
2
SRAC4
SRAC3

5 factories
Costs

1 factory
2 factories 4 factories

3 factories

O
Output
fig
 Deriving long-run average cost curves:
factories of fixed size
SRAC1 SRAC SRAC5
2
SRAC4
SRAC3

LRAC
Costs

O
Output
fig
Envelope of Short-Run
Average Total Cost Curves

LRATC
SRATC4
Costs per unit

SRATC1
SRMC1
SRMC2 SRMC4
SRATC2 SRATC3
SRMC3

0
Q2 Q3 Quantity
Envelope of Short-Run Average Total
Cost Curves

LRATC
Costs per unit

SRATC4
SRATC1
SRMC1
SRMC2 SRMC4
SRATC2 SRATC3
SRMC3

0
Q2 Q3 Quantity
Long-Run Average Cost as the
Planning Horizon
 The Learning Curve
 As firms gain experience in
the production of a commodity
or service, their Average cost
of production usually declines.

 Measures the percentage

decrease in additional labor
cost each time output
doubles.
The LR Relationship Between
Production and Cost
 In the long run, all inputs are variable.
 What makes up LRAC?
Long run production - returns to scale
In the long run, all factors of production are variable. How
the output of a business responds to a change in factor inputs
is called returns to scale.

Increasing returns to scale occur when the % change in

output > % change in inputs
Decreasing returns to scale occur when the % change in
output < % change in inputs
Constant returns to scale occur when the % change in
output = % change in inputs
Economies and Diseconomies of Scale
 Average Total Cost in the Short and Long Run

Average
Total ATC in short ATC in short ATC in short
Cost run with run with run with
small factory medium factory large factory ATC in long run

$12,000

10,000

Economies Constant
of returns to
scale scale Diseconomies
of
scale

0 1,000 1,200 Quantity of

Cars per Day
Production in the Long run
 Economies of scale
 specialisation & division of labour
 indivisibilities
 container principle
 greater efficiency of large machines
 by-products
 multi-stage production
 organisational & administrative economies
 financial economies
 Production in the Long run
 Diseconomies of scale
 managerial diseconomies
 effects of workers and industrial relations
 risks of interdependencies

 External economies of scale

 Location
 balancing the distance from suppliers and consumers
 importance of transport costs
 Ancillary industries-by products
 Internal economies and diseconomies
affect the shape of the LAC
 External Economies affect the position of the

LAC
 External Diseconomies may cause increase

in prices of the factors of production

Economies of Scope
 There are economies of scope when the
costs of producing goods are interdependent
so that it is less costly for a firm to produce one
good when it is already producing another.
 S = TC(Q )+TC(Q )- TC(Q Q )
A B A B

TC(Q A,QB )
 Economies of Scope
 Firms
look for both economies of scope and
economies of scale.

 Economies of scope play an important role in

firms’ decisions of what combination of goods
to produce.
 Economies of Scope
Firms look for both economies of scope and economies of
scale.
 Exist for a multi-product firm when the joint cost of

producing two or more goods is less than the sum of the

separate costs for specialized, single-product firms to
produce the two goods:
LTC(X, Y) < LTC(X,0) + LTC(0,Y)
 Firms already producing good X can add production of good

Y at a lower cost than a single-product firm can produce Y:

LTC(X, Y) – LTC(X,0) < LTC(0,Y)
 Arise when firms produce joint products or employ common

inputs in production
 Economies of scope play an important role in firms’

decisions of what combination of goods to produce.

Restructuring Short-Run Costs
Summary

 An economically efficient production process

must be technically efficient, but a technically
efficient process may not be economically
efficient.
 The long-run average total cost curve is U-
shaped because economies of scale cause
average total cost to decrease; diseconomies of
scale eventually cause average total cost to
increase.
Summary

 Marginal cost and short-run average cost curves

slope upward because of diminishing marginal
productivity.
 The long-run average cost curve slopes upward
because of diseconomies of scale.
 The envelope relationship between short-run and
long-run average cost curves shows that the
short-run average cost curves are always above
the long-run average cost curve.
Summary

 Marginal cost and short-run average cost curves

slope upward because of diminishing marginal
productivity.
 The long-run average cost curve slopes upward
because of diseconomies of scale.
 The envelope relationship between short-run and
long-run average cost curves shows that the
short-run average cost curves are always above
the long-run average cost curve.
Summary

 Marginal cost and short-run average cost curves

slope upward because of diminishing marginal
productivity.
 The long-run average cost curve slopes upward
because of diseconomies of scale.
 The envelope relationship between short-run and
long-run average cost curves shows that the
short-run average cost curves are always above
the long-run average cost curve.
The Short Run and the Long Run
 Useful to categorize firms’ decisions into
 Long-run decisions

 Short-run decisions

 To guide the firm over the next several years

 Manager must use the long-run lens
 To determine what the firm should do next week
 Short run lens is best
Production in the Short Run
 When firms make short-run decisions, there is
nothing they can do about their fixed inputs
 Fixed inputs
 An input whose quantity must remain constant,
regardless of how much output is produced
 Variable input
 An input whose usage can change as the level of
output changes
 Total product
 Maximum quantity of output that can be produced
from a given combination of inputs
Production in the Short Run
 Marginal product of labor (MPL) is the change in
total product (ΔQ) divided by the change in the
number of workers hired (ΔL)
ΔQ
MPL 
ΔL
– Tells us the rise in output produced when one more
worker is hired, leaving all other inputs unchanged
Total and Marginal Product
Units of Output

196 Total Product

184
161
DQ from hiring fourth worker
130
DQ from hiring third worker
90

DQ from hiring second worker

30
DQ from hiring first worker

1 2 3 4 5 6 Number of Workers
increasing diminishing
marginal marginal returns
returns
Marginal Returns To Labor
 As more and more workers are hired
 MPL first increases
 Then decreases
 Patternis believed to be typical at many
types of firms
Increasing Marginal Returns to Labor
 When the marginal product of labor increases
as employment rises, we say there are
increasing marginal returns to labor
 Each time a worker is hired, total output rises by
more than it did when the previous worker was
hired
Diminishing Returns To Labor
 When the marginal product of labor is
decreasing
 There are diminishing marginal returns to labor
 Output rises when another worker is added so
marginal product is positive
 But the rise in output is smaller and smaller with each
successive worker
 Law of diminishing (marginal) returns states that
as we continue to add more of any one input
(holding the other inputs constant)
 Its marginal product will eventually decline
Costs
A firm’s total cost of producing a given level
of output is the opportunity cost of the owners
 Everything they must give up in order to produce
that amount of output
Costs in the Short Run
 Fixed costs
 Costs of a firm’s fixed inputs
 Variable costs
 Costs of obtaining the firm’s variable inputs
Measuring Short Run Costs: Total Costs

 Types of total costs

 Total fixed costs
 Cost of all inputs that are fixed in the short run
 Total variable costs
 Cost of all variable inputs used in producing a
particular level of output
 Total cost
 Cost of all inputs—fixed and variable
 TC = TFC + TVC
The Firm’s Total Cost Curves
Dollars

$435 TC

375 TFC TVC

315
255
195
135
TFC

0 30 90 130 161 184 196

Units of Output
 Average Costs
 Average fixed cost (AFC)
 Total fixed cost divided by the quantity of output produced
TFC
AFC 
Q
• Average variable cost (TVC)
– Total variable cost divided by the quantity of output produced
TVC
AVC 
Q
• Average total cost (TC)
– Total cost divided by the quantity of output produced
TC
ATC 
Q
Marginal Cost
 Marginal Cost
 Increase in total cost from producing one more unit or
output
 Marginal cost is the change in total cost (ΔTC)
divided by the change in output (ΔQ)
ΔTC
MC 
ΔQ
– Tells us how much cost rises per unit increase in output
– Marginal cost for any change in output is equal to shape
of total cost curve along that interval of output
Average And Marginal Costs
Dollars MC
$4

AFC ATC
2 AVC

0 30 90 130 161 196

Units of Output
Explaining the Shape of the
Marginal Cost Curve
 When the marginal product of labor (MPL)
rises (falls), marginal cost (MC) ___ (___)
 Since MPL ordinarily rises and then falls, MC

will do the _____—it will ____ and then

______

 Thus, the MC curve is U-shaped

Average And Marginal Costs
 At low levels of output, the MC curve lies below
the AVC and ATC curves
 These curves will slope downward
 At higher levels of output, the MC curve will rise
above the AVC and ATC curves
 These curves will slope upward
 As output increases; the average curves will first
slope downward and then slope upward
 Will have a U-shape
 MC curve will intersect the minimum points of
the AVC and ATC curves
Production and Cost in the Long Run
 In the long run, there are no fixed inputs or
fixed costs - All inputs and all costs are
variable

 The firm’s goal is to earn the highest possible

profit
 To do this, it must follow the least cost rule
Production And Cost in the Long Run
 Long-run total cost
 The cost of producing each quantity of output when
the least-cost input mix is chosen in the long run
 Long-run average total cost
 The cost per unit of output in the long run, when all
inputs are variable
 The long-run average total cost (LRATC)
 Cost per unit of output in the long-run
LRTC
LRATC 
Q
The Relationship Between Long-Run
And Short-Run Costs
 For some output levels, LRTC is smaller than
TC

 Long-run total cost can never be ____ than,

short-run total cost (LRTC __ TC)

 Long-run average cost can be never be ____

than the short–run average total cost (LRATC
__ ATC)
Average Cost And Plant Size
 Plant - Collection of fixed inputs at a firm’s disposal
 In the long run, the firm can change the size of its plant
 In the short run, it is stuck with its current plant size
 ATC curve tells us how average cost behaves in the
short run, when the firm uses a plant of a given size

 To produce any level of output, it will always choose that

ATC curve—among all of the ATC curves available—that
enables it to produce at lowest possible average total
cost
Graphing the LRATC Curve
 A firm’s LRATC curve combines portions of each
ATC curve available to firm in the long run

 In the short run, a firm can only move along its

current ATC curve

 In the long run it can move from one ATC curve

to another by varying the size of its plant
Long-Run Average Total Cost
Dollars
ATC1 LRATC
$4.00 ATC3
ATC0 ATC2
3.00 C
D
2.00 B
A E
1.00

0 30 90 130 161 184 250 300

175 196
Use 0 Use 1 Use 2 Use 3
automated automated automated automated
lines lines lines lines
Units of Output
Economies of Scale
 Economics of scale
 Long-run average age total cost _______ as output
increases

 When an increase in output causes LRATC to

______, we say that the firm is enjoying
economies of scale
 When long-run total cost rises proportionately
less than output, production is characterized by
economies of scale
 LRATC curve slopes downward
The Shape Of LRATC
Dollars
$4.00

3.00
LRATC
2.00

1.00

0 130 184

Economies of Scale Constant Diseconomies of Scale

Returns to
Scale Units of Output
Gains From Specialization
 One reason for economies of scale is gains
from specialization

 Opportunitiesfor increased specialization

occur at lower levels of output
 With a relatively small plant and small workforce
More Efficient Use of Lumpy Inputs
 Economies of scale involves the “lumpy” nature
of many types of plant and equipment

 Plant and equipment must be purchased in large

lumps

 Making more efficient use of lumpy inputs will

have more impact on LRATC at low levels of
output
 When these inputs make up a greater proportion of
the firm’s total costs
Diseconomies of Scale
 Long-run average total cost _______ as output
increases
 As output continues to increase, most firms will
reach a point where bigness begins to cause
problems
 When long-run total cost rises more than in
proportion to output, there are diseconomies of
scale
 LRATC curve slopes upward
 Diseconomies of scale are more likely at higher
output levels
Constant Returns To Scale
 Long-run average total cost ___ _________
as output increases

 When both output and long-run total cost rise

by the same proportion, production is
characterized by constant returns to scale
 LRATC curve is flat
In sum…
 The LRATC, often shows the following
pattern
 Economies of scale (decreasing LRATC) at
relatively low levels of output
 Constant returns to scale (constant LRATC) at
some intermediate levels of output
 Diseconomies of scale (increasing LRATC) at
relatively high levels of output
 This
is why LRATC curves are typically U-
shaped
Long Run Costs, Market
Structure and Mergers
 Thenumber of firms in a market determines
the market structure

 What
accounts for these differences in the
number of sellers in the market?
 Shape of the LRATC curve plays an important
role in the answer
LRATC and the Size of Firms
 The output level at which the LRATC first hits bottom is known as
the minimum efficient scale (MES) for the firm
 Lowest level of output at which it can achieve minimum cost per unit
 Can also determine the maximum possible total quantity demanded
by using market demand curve
 Applying these two curves—the LRATC for the typical firm, and the
demand curve for the entire market—to market structure
 When the MES is small relative to the maximum potential market
 Firms that are relatively small will have a cost advantage over relatively large
firms
 Market should be populated by many small firms, each producing for only a
tiny share of the market
LRATC and the Size of Firms
 There are significant economies of scale that continue as
output increases
 Even to the point where a typical firm is supplying the maximum
possible quantity demanded
 This market will gravitate naturally toward monopoly
 In some cases the MES occurs at 25% of the maximum
potential market
 In this type of market, expect to see a few large competitors
 There are significant lumpy inputs that create economies
of scale
 Until each firm has expanded to produce for a large share of the
market
How LRATC Helps Explain
Market Structure

Dollars LRATCTypical Firm

160 F

E
80

DMarket

0 1,000 3,000 100,000

Units per Month
How LRATC Helps Explain
Market Structure
LRATCTypical Firm
Dollars

160

80

DMarket

0 100,000
Units per Month
How LRATC Helps Explain
Market Structure

Dollars
LRATCTypical Firm
200 H F

E
80
DMarket

0 25,000 100,000
Units per Month
How LRATC Helps Explain
Market Structure

Dollars LRATCTypical Firm

160

E F
80

DMarket

0 1,000 10,000 100,000

Units per Month
Purchasing Economies of Scale
 Purchasing economies of scale arise when
large-scale purchasing of raw materials
enables large buyers to obtain lower input
prices through quantity discounts
Purchasing Economies of Scale
Learning or Experience Economies
 “Learning by doing” or “Learning through
experience”
 As total cumulative output increases, learning

or experience economies cause long-run

average cost to fall at every output level
Learning or Experience Economies
Relations Between Short-Run &
Long-Run Costs

 LMC intersects LAC when the latter is at its

minimum point
 At each output where a particular ATC is tangent
to LAC, the relevant SMC = LMC
 For all ATC curves, point of tangency with LAC is
at an output less (greater) than the output of
minimum ATC if the tangency is at an output less
(greater) than that associated with minimum
LAC
Long-Run Average Cost as the
Planning Horizon
Restructuring Short-Run Costs
 Because managers have greatest flexibility to
choose inputs in the long run, costs are lower
in the long run than in the short run for all
output levels except that for which the fixed
input is at its optimal level
 Short-run costs can be reduced by adjusting fixed
inputs to their optimal long-run levels when the
opportunity arises
Restructuring Short-Run Costs
Revenue Theory

 Revenue is the income that a firm receives

from selling its products, goods and
service over a certain period of time.
 Measurement of
Revenue

Total Average Marginal

Revenue(TR) Revenue(AR) Revenue(MR)
Total Revenue(TR)
 TR is the total amount of money that a
firm receives from selling its goods and
services in a given time period.
 P=Rs.10, q= 1000 TR=10,000

TR= p x q
Average Revenue(AR)
 AR is the revenue that a firm receives per
unit of its sale.
 TR=10000 Q=1000 10000/1000=10

TR
AR= ----- = P
q
Marginal Revenue(MR)
 MR is the extra revenue that a firm gains
when it sells one more unit of a product in a
given time period
 1000 units TR=10000 1001 Units

TR=10010
TR
 MR= -----------
 q
Revenue
 Total revenue – the total amount received from
selling a given output
 TR = P x Q
 Average Revenue – the average amount received
from selling each unit
 AR = TR / Q
 Marginal revenue – the amount received from selling
one extra unit of output
 MR = TR – TR
n n-1 units
 1001-1000 units
 Change in TR= 10010-10000=10
Relationship among TR, AR and MR
Perfect Competition (Price=10)

Output TR AR MR
0 0 - -
1 10 10 10
2 20 10 10
3 30 10 10
4 40 10 10
5 50 10 10
6 60 10 10
7 70 10 10
8 80 10 10
9 90 10 10
Total Revenue and Output
 TR when price does not
change.(Horizontal
demand curve)
 The firm does not have to

lower the price to sell more

output.
 P=AR=MR=D (Perfect

Market)
 TR curve is upward sloping.
Relationship among TR, AR and MR
Imperfect Market

Output TR AR MR
0 0 - -
1 10 10 10
2 18 9 8
3 24 8 6
4 28 7 4
5 30 6 2
6 30 5 0
7 28 4 -2
8 24 3 -4
9 18 2 -6
Total Revenue and Output
 TR when price change as output increase.
(downward sloping demand curve)
 Firm has to lower price to sell more.
 PED falls as output increases.

Imperfect Market
Relationship between TR, AR,
MR and PED.
 TR rises at first but will eventually
falls as output increases.
 When PED is elastic, to
increase revenue, lower the
price.
 When PED is inelastic, to
increase revenue, raise the
price.
 When PED is unity, to increase
revenue, leave the price
unchanged.
 Profit Theory
 Generally,
 Profit =TR-TC.
 But for an economist,
 Profit= TR-Economic Cost(Explicit + Implicit

Cost)
Normal Profit and Abnormal Profit
 TR<TC…Loss (Negative economic profit)
TR=1,00,000 TC=1,20,000 Loss= -20,000
 TR=TC…Normal Profit (Zero economic profit)
 TR=1,0,000 TC=1,00,000 Loss/Profit=0
 TR > TC…Abnormal Profit(Economic Profit)
 TR=1,20,000 TC=1,00,000 Profit= 20,000
 TR and TC
Firm A Firm B Firm C
Total 200 000 200 000 200 000
Revenue
TFC 40 000 40 000 40 000
TVC 80 000 100 000 120 000
Implicit Cost 60 000 60 000 60 000
Total Cost 180 000 200 000 220 000

Firm A: TR>TC Abnormal Profit

Firm B: TR=TC Normal Profit
Firm C: TR<TC Loss
Shut down price
 Shut down Price is the level of the price that
enables a firm to cover its variable costs in
the short run (PAVC).
 If price does not cover AVC, then the firm will

shut down in the short run.

 Shut down price
 At price P, firm is
able to cover
variable cost in the
short run.
 Shut down price is P.P1 =ATC
 P=AVC P=AVC

 Below this price, firm

will shut down in the

short-run.
Figure 3 The Competitive Firm’s Short Run Supply
Curve

Costs
Firm’s short-run
If P > ATC, the firm supply curve MC
will continue to
produce at a profit.

ATC

If P > AVC, firm will

continue to produce AVC
in the short run.

Firm
shuts
down if
P< AVC
0 Quantity

Copyright © 2004 South-Western

 Summary of Short-Run Output Decisions

Break-even
point Marginal cost Firm’s short-run S curve
5
p5 d5 p5>ATC, q5, economic profit
Average total cost
4
Dollars per unit

p4 d4 p4=ATC, q4, normal profit

Average variable cost
3
p3 d3 ATC>p3>AVC, q3, loss <FC
2
p2 d2 p2=AVC, q2 or 0, loss=FC
p1 1 d1 p1<AVC, shut down,
Shutdown
q1=0,loss=FC
point
0
q1 q2 q3 q4 q5 Quantity per period
 Whether to produce or not?
Firm A Firm B Firm C

TR 80 000 120 000 150 000

TFC(including opp.cost) 100 000 100 000 100 000

TVC 100 000 120 000 140 000

TC 200 000 220 000 240 000

Loss 120 000 100 000 90 000

 Whether to produce or not?
Firm A Firm B Firm C

TR 80 000 120 000 150 000

TFC(including opp.cost) 100 000 100 000 100 000

TVC 100 000 120 000 140 000

TC 200 000 220 000 240 000

Loss 120 000 100 000 90 000

Firm A: Loss = FC+20,000 VC firm has to stop production

to reduce the loss to TFC
Firm B: Loss = FC Continue or stop no difference
Firm C: Loss = <FC Continue production 10,000 benefit in
the loss
 Break-Even Analysis
Current Price=20, if price increases to 30 and if price decreases to 10
what will happen to the BE Units or BEP

The Break-even
Costs/Revenue TR point occurs where
TC
total revenue
VC
equals total costs –
the firm, in this
example would
have to sell Q1 to
generate sufficient
revenue to cover its
costs.

FC

Q1=1000 Output/Sales
 Break-Even Analysis

Costs/Revenue TR (p = Rs30) TR (p = Rs.20) TC If the firm chose

to set price
VC higher than
Rs.20 (say
Rs.30) the TR
curve would be
steeper – they
would not have
to sell as many
units to break
even

FC

Q2 Q1 Output/Sales
 Break-Even Analysis

TR (p = Rs.10)
Costs/Revenue TR (p = Rs.20) If the firm chose to
TC set prices lower
VC (say Rs.10) it would
need to sell more
units before
covering its costs

FC

Q1 Q3 Output/Sales
 Break-Even Analysis
TR TC
TR (p = Rs.20)
Costs/Revenue
Profit VC

Loss
FC

Q1 Output/Sales
 Break Even Analysis
Contribution
 Contribution is the difference between sales and

marginal or variable costs. It contributes toward fixed

cost and profit. The concept of contribution helps in
deciding breakeven point, profitability of products,
departments etc. to perform the following activities:
 Selecting product mix or sales mix for profit
maximization
 Fixing selling prices under different circumstances such
as trade depression, export sales, price discrimination
etc.
Break Even Analysis
Profit Volume Ratio (P/V Ratio), its Improvement and
Application
 The ratio of contribution to sales is P/V ratio or C/S ratio.

It is the contribution per rupee of sales and since the fixed

cost remains constant in short term period, P/V ratio will
also measure the rate of change of profit due to change in
volume of sales. The P/V ratio may be expressed as
follows:
P/V ratio = Sales – Marginal cost of sales = Contribution
Sales
Sales
 A fundamental property of marginal costing system is that

P/V ratio remains constant at different levels of activity.

 P/V Analysis
 A change in fixed cost does not affect P/V ratio. The concept
of P/V ratio helps in determining the following:
• Breakeven point
• Profit at any volume of sales
• Sales volume required to earn a desired quantum of profit
• Profitability of products
• Processes or departments

 The contribution can be increased by increasing the sales

price or by reduction of variable costs. Thus, P/V ratio can be
improved by the following:
• Increasing selling price
• Reducing marginal costs by effectively utilizing men, machines,
materials and other services
• Selling more profitable products, thereby increasing the overall P/V
ratio
Breakeven Point

 Breakeven point is the volume of sales or

production where there is neither profit nor
loss. Thus, we can say that:
Contribution = Fixed cost
 Now, breakeven point can be easily calculated

with the help of fundamental marginal cost

equation, P/V ratio or contribution per unit.
BEP Equation
 BEP (Units) = FC/ Price p.u.- AVC p.u. or
=Fixed Cost/ Contribution p.u.

 BEP Sales = F.C*Sales / Sales – VC or

 = F.C/ P V ratio
 BEP Sales for Desired Profits =

= F.C + Profit / Contribution p.u.

= F.C.+ Profit / P V ratio.
Margin of Safety
 Margin of safety represents the difference
between the sales at break-even point and the
total actual sales.
 Three measures of the margin of safety are

given below:
 Margin of Safety = Profit * Sales / (PV ratio)
 Margin of Safety = Profit / (PV ratio)
 Margin of Safety = Sa – Sb / Sa * 100
 A higher
price would
Break-Even Analysis lower the
break even
TR (p = Rs.30)
point and the
TR (p = Rs.20) TC
Costs/Revenue margin of
VC safety would
widen
Margin of
safety shows
how far sales
can fall before
losses made.
If Q1 = 1000
Margin of Safety and Q2 =
FC 1800, sales
could fall by
800 units
before a loss
would be
made
Q3 Q1 Q2 Output/Sales
Example
 A firm has purchased a plant to manufacture a
new product. Cost data for the plant is given
below: Estimated Annual Sales 24000 units

Estimated Costs
Material Rs. 4.00 per unit
Direct Labour Rs. 0.60 per unit
Overhead Rs. 24,000 per year
Administrative Expenses Rs. 28,000 per year
Selling costs Rs. 1,590 per year

 Calculate selling price if profit per unit = Rs. 1.02

 Find break even output level
Solution
Sales Qty 24,000 units

Material 4.00 /units

Direct Labour 0.60 /units
Overhead 24,000 / year
Administrative Expenses 28,000 / year
Selling costs 1,590 / year

Fixed Costs = Overhead + Admin + Selling 53,590

Variable Costs per unit 4.60

Variable Costs = VC/unit * units 110,400

Total Costs = FC + VC 163,995

Total Profit = Qty * Profit/unit 24,480

Total Revenues = TC + Profit 188,475

Selling Price per unit 7.85

Brealk Even Sales = FC / Contribution 16,473
Break-Even Analysis
Remember:
A higher price or lower price does not mean that
break even will never be reached!
 The BE point depends on the number of sales
needed to generate revenue to cover costs.
 The BE chart is NOT time related!
Break-Even Analysis

Importance of Price Elasticity of Demand:

 Higher prices might mean fewer sales to
break-even but those sales may take a longer
time to achieve.
 Lower prices might encourage more
customers but higher volume needed before
sufficient revenue generated to break-even
Break-Even Analysis

Links of BE to pricing strategies and elasticity

 Penetration pricing – ‘high’ volume, ‘low’ price –
more sales to break even
 Market Skimming – ‘high’ price ‘low’ volumes –
fewer sales to break even
 Elasticity – what is likely to happen to sales
when prices are increased or decreased?
 TFC=200
 AVC=5
 Price=10

 QB= TFC/P-AVC

 Target

 QB =TFC+╥T/P-AVC
Break Even Analysis
A small firm incurs fixed expenses
amounting to Rs.12,000. Its variable cost
of product X is Rs.5 per unit. Its selling
price is Rs.8. Determine its Break Even
Quantity and Safety Margin for the sales
5000 units.
 TFC = 480
 Price = 50
 AVC = 10 per unit.

 Calculate BEP in units

 Show TR = TC
 An Travel carries 10,000 passengers per
 month at a fare of Rs.850/-, variable cost is

Rs.100/- per passenger and fixed cost is

30,00,000. Find out
 1. Break even volume of output.
 2. Break even Sales and
 3. Break even percentage of capacity.
 How the answer will change, if a target profit of

Rs. 20,00,000 is fixed by the airline.

A Manufacturer buys certain components for
producing X at Rs.20 per unit. If he has to make
these components it would require a fixed cost
of Rs.15,000 and average variable cost Rs.5.
His present requirement is 1000 units of these
components.
Advise him whether he should make or buy
them, if he intends to double the output.
Purchase price to be taken as P.
A firm incurs fixed cost of Rs.4000 and variable
cost of Rs.10,000 and its total sales receipts are
Rs.15,000. Determine the BEP.
A firm starts its business with fixed expenses of
Rs.60,000 to produce commodity X. Its variable
cost is Rs.2 per unit. Prevailing market price of
the product is Rs.6. How much should the firm
produce to earn profit of Rs.20,000 at this price?
Thank You