Cost and Revenue analysis

Cost analysis occupies a very important place both in general economic theory as well as in Business
Economics. Cost is normally considered from the producer’s or firm’s point of view. In producing a
commodity a firm has to engage the services of the various factors of production, say the land, labour,
capital etc. These factors have to be rewarded by the firm for their efforts or contribution made in
producing the commodity. This reward or compensation usually in terms of factors price is generally
known as cost. Thus, the cost of production used of a commodity is the aggregate price paid to the
factors of production that commodity. Cost production, therefore denotes the value of the factors of
production engaged for producing a given article.

Cost analysis is important from another angle also. The financial, human and material resources with
the firm are limited. These resources are obtained at a cost and therefore while utilising these
resources, the firm has to consider the opportunity cost. The firm has to make the most economical
and optimum use of its resources and for this must have before it clear cut picture of the cost analysis.

DETERMEAINTS OF COST:
Factors determining the cost are: manager.
 Size of plant:
There is an inverse relationship between size of plant and cost. As size of plant increases,
cost falls and vice versa.
 Level of Output:
There is a direct relationship between output level and cost. More the level of output,
more is the cost and vice Versa.
 Price of Inputs:
There is a direct relationship between price of inputs and cost. As the price of inputs rises,
cost rises and vice versa.
 State of technology:
More modern and upgraded the technology implies lesser cost and vice versa.
 Management and administrative efficiency:
Efficiency and cost are inversely related. More the efficiency in management and
administration better will be the product and less will be the cost. Cost will of inefficiencies
in management and administration.

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Various Cost concepts
Accounting cost concepts:
Many cost are the total money expenses incurred by a firm in producing a commodity. They include
wages, salary of labour, cost of raw material, expenditure of machines and equipment, depreciation
and obsolescence changes on machines, building and other capital goods etc. and all types of taxes.
There are the accounting cost which an entrepreneur take into consideration in the making payments
to the various factors of production.

Real cost:
Money costs are the expenses of production from the point of view of the production. According to
Marshall the efforts and sacrifices undergone by the various member of the society in producing a
commodity are the real costs of the production.

Production Cost:
Many in the production process, there are many types of factor of production used, in which many
are fixed and variable. They are employed at various prices. The expenditure incurred on them is the
total cost of production of a firm. Production costs reflect all of the expenses associated with a
company conducting its business while manufacturing costs represent only the expenses necessary to
make the product. Various production cost are;

Total Fixed Cost (TFC): Fixed cost

Fixed cost are the amount spent by the firm on fixed inputs in the short run. Fixed cost are thus,
those costs which remain constant, irrespective of the level of output. These costs remain unchanged
even if the output of the firm is nil. Fixed costs therefore, are known as Supplementary costs or
Overhead costs.
Total fixed costs are those costs production that do not change with output. They are independent of
the level of output. They have to be incurred even when the firm stops production temporarily. They
including cost of machineries, rent of land, interest on capital, insurance charges, property tax, salary
and wages of fixed labour.

Total Variable cost (TVC): Variable Cost

Variable costs are those cost that change directly as the volume of output changes. As the production
increases variable cost also increases, and as the product decreases variable costs also decreases, and
when the production stops variable cost is zero.
Total variable costs are those cost of production that change directly with output. They rise when
output increases and fall when output declines. They include expenses on raw material, power, water,
taxes, hiring of labour. , advertisement cost.

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Total cost (TC):
Total cost is total of total fixed cost and total variable cost

TC= TFC +TVC

Short Run Average Cost:

Short run is a period where the time is too short to expand the size of industry and the increased
demand has to be met within the existing size of industry because there are certain factors which
cannot be c hanged in short run. So short run costs are those which vary with output when fixed plant
a capital equipment remain unchanged.
In short run analyses of the firm, average cost are more important than the costs. The units of output
that a produces do not cost the same amount to the firm. They must be sold at the same price.
Therefore, the firm must know per unit cost or average. The short run average costs the average fixed
costs, the average fixed costs and average cost.

Average Fixed cost (AFC):

Equal total fixed cost at each level of output divided by the number of units of produced.
Average fixed cost is obtained by the number of units produced.

AFC = TFC/Q
Where, ‘Q’ refers quantity of production.
Since TFC is constant for any level of activity, fixed cost per unit goes on diminishing as output goes
on increasing. The AFC curve is downward sloping towards the right throughout its length, with a
steep fall at the beginning.

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The average fixed cost diminishes continuously as output increase. This is natural because when a
constant figure, total fixed costs are divided by a continuously increasing unit of output, the result is
continuously diminishing average fixed costs. The AFC curve is downward sloping curve which
approaches the quantity axis without touching it, as shown in the figure which is rectangular
hyperbola.

Average Variable Cost (AVC):

Average Variable Cost is obtained by dividing the TVC by the number of units produced. Therefore:
Due to the operation of the Law of Variable Proportions AVC curve slopes downwards till it reaches
a certain level of output and then begins to rise upwards.

AVC = TVC / Q
Where, ‘Q’ refers quantity of production.
Equal total variable costs at each level of output divided by the number of units produced

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The average variable cost decline with the rise in output as larger quantities of variable factor are
applies to fixed planned equipment. But eventually they begin to rise due to the law of diminishing
returns. The SAVC curve is U-shaped, which is shown by figure.

Average Total Cost (SATC or SAC):

Short run average total cost curve are the costs of producing any given output. They are arrived at by
dividing the total costs at each level of output by the number of units produced. Short run average
cost curve is in U-shaped

ATC = TC / Q

Why Short run average cost curve is in U-shaped?

The ATC curve is very much influenced by the AFC and AVC curves. In the beginning both AFC
curve and AVC curve decline and therefore ATC curve also declines. The AFC curve continues the
trend throughout, though at a diminishing rate. AVC curve continues the trend till it reaches a certain
level and thereafter it starts rising slowly. Since this rise initially is at a rate lower than the rate of
decline in the AFC curve, the ATC curve continues to decline for some more time and reaches the
lowest point, which obviously is further than the lowest point of the AVC curve. Thereafter the ATC
curve starts rising because the rate of rise in the AVC curve is greater than the rate of decline in the
AFC curve.
Average total costs reflect the influences of both the average fixed cost and average variable cost. At
first, average total cost are high at low levels of output because both average fixed cost and average
variable cost curve are large. With increasing in output, the average total cost sharply because of the
steady decline of both average fixed cost and average variable cost till they reach the minimum point.
When production is increased the average total rise quickly because fall in average fixed cost is
negligible in relation to the rising average variable cost.

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Marginal Cost Curve (SMC):
Marginal cost is the additional cost by producing an additional unit of output. Marginal cost is the
additional to total cost of producing n unit instead of n-1 units. Marginal Cost is the increase in TC as
a result of an increase in output by one unit. In other words it is the cost of producing an additional
unit of output. MC is based on the Law of Variable Proportions. A downward trend in MC curve
shows decreasing marginal cost (i.e. increasing marginal productivity) of the variable input. Similarly
an upward trend in MC curve shows increasing marginal cost (i.e. decreasing marginal productivity).
MC curve intersects both AVC and ATC curves at their lowest points.
SMC= TCn –TCn-1

Relationship of Short Run Cost Curves

The relationship between AVC, AFC, ATC and MC can be summed up as follows.
 If both AFC and AVC fall ATC will also fall because ATC = AFC + AVC
 When AFC falls and AVC rises (a) ATC will fall where the drop in AFC is more than the rise in
AVC
 ATC remains constant if the drop in AFC = the rise in AVC, and
 ATC will rise where the drop in AFC is less than the rise in AVC.
 ATC will fall when MC is less than ATC and ATC will rise when MC is more than ATC. The
lowest ATC is equal to MC.

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  The AFC curve decline with increasing in the output and is asymptotic to both axis. The AFC
curve never touches both axis but it approaches both axis.

 The AVC curve first decline, reaches to the minimum point and rise with increasing in the
output.

 The AC curve first decline due to declining of AFC and AVC, reaches at the minimum point
and rise thereafter.

 The MC curve first decline and then rise with increasing in the output of the firm.

Relation between Average cost and Marginal cost

The direct relationship between AC curve and Mc curve as shown by diagram:

1. When Ac falls, MC is less then AC, because the fall in MC is related to one unit of output while in
the case of Ac the same decline is spread over all units of output. That is why the fall in AC is less
and that in MC is more. This also explains the fact that MC reaches its minimum point C before
the minimum point B of AC is reached. When MC starts rising, AC is still declining.
2. When AC is minimum, MC is equal AC. The MC curve cuts the AC curve from below at its
minimum point.
3. When AC rises, MC is greater than AC. MC is above AC when AC rising but the rise in MC is
greater than AC, because rise in MC is the result of the increase in one unit of output while in the
case of AC same increase is spread over all units of output.

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4. When AC is falling, it is not essential that MC must fall, MC can be increasing or fall but it is
definite that MC will be less than AC. When AC increasing, it is not essential that MC must rise,
MC can fall or rise it is definite that MC will be larger than AC. If AC constant, MC must be
constant.

Cost Output Relationship

AFC and Output:

Fixed costs are remaining constant in short run irrespective of the level of output. When firm
increased its output, AFC falls because total fixed cost curve remain same and do not change with
change in output and total cost spread over to more and more unit. That AFC because less. The
relationship between AFC and output is universal one type for all types of business.

AVC and Output:

In beginning the AVC falls and then rise with increasing in production, because of various internal
economies which the firm gets internal stages. If firm add more and more units of variable factor in a
fixed plant, the efficiency first increase and then decline. In beginning output is below normal
capacity, there is full utilization of productive capacity of factors, but as increase, by adding more and

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more units of variable factor, average variable cost falls and firm reaches at normal position. After
optimum position if firm increasing in the output, variable cost increased.

ATC and Output:

Average Total cost is the combination of AFC and AVC, which in beginning ATC falls, then remain
constant and eventually rise with output because of its two components curves. At very low level if
output ATC is very high because fixed costs are spread over a few units. As output increase fixed cost
spread over more units and variable cost can be used more efficiently relatively to the fixed plant.
After reaching at minimum point average total cost rise because of increasing in the variable inputs.

Cost-output relation in short run:

 As output increase AFC falls and its curves is in downward slope.
 Average Variable Cost at first falls and rise after a point.
 Average Total Cost also decline in the beginning, reaches at minimum point and then rise.
 Average Variable cost rises earlier then ATC.
 Marginal cost fall in the beginning and then rising.
 Marginal Cost curves cuts AVC and ATC at lowest points.
 The least cost level of output is at point B of AVC and T of ATC.


Cost output relationship in the long run

As known in the long run the size of an industry can be expanded to meet the increased demand for
products as such in the long run all the factors of production can be varied according to the need.
Long run costs are those which vary with output when all the input factors including plant and
equipment vary. In the long run, there are no fixed factors of production and no fixed cost. The firm

DR. YASHODHARA A BHATT 9

can change its size of scale of plant and employ more inputs. That in long run, all factors are variable
and all costs are variable.
In long run Average Total Cost (LATC) curve of the firm has minimum average cost of producing
various level of output from all possible short-run average cost curves (SAC). The LAC can be
derived from the SAC curves. The Lac curve can be viewed as series of alternative short-run situations
of a particular size for particular range of output. In long run all factors of production can be used in
varying proportions, which change scale of cost curves.
According to the diagram, there are three short run curves which tangent to the long run cost curve.
LAC curve all Sac at P, Q and R point, by which all SAC got output cost level, that SAC1 at A, SAC2
at B and SAC3 at C. Here we can see that SAC2 has lowest minimum level output at B point.

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DR. YASHODHARA A BHATT
The long run average cost curve (LAC) we start with a number of short run average cost(SAC) curves,
each such curve representing a particular size of plant including the optimum plant. One can now
draw a LAC curve which is tangential to all SAC curves. In this connection following features are
highlighted:
 The LAC curve envelopes the SAC curves and is therefore called as envelope curve.
 Each point of the LAC is a point of tangency with the corresponding SAC curve.
 The points of tangency on the falling part of SAC curve for points lying to the left of
minimum point of LAC.
 The points of tangency occur on the rising part of the SAC curves for the points lying to the
right of minimum point of LAC.
 The optimum scale of plant is a term applied to the most efficient of all scales of plants
available. This scale of plant is the one whose SAC curve forms the minimum point of LAC
curve. It is SAC3 in our case which is tangent to LAC curve at its minimum point at R.
 LAC ad SAC curves are U shaped but the difference between the two U shapes is that the U
shape of the LAC curve is flatter or lesser pronounced from bottom. The main reason for this
is that in the long run such economies are possible which cannot be had in the short run,
likewise some of the diseconomies which are faced in short run may not be faced in the long
run.
 The long run cost curve is derived from SAC curves. Each point of LAC curve is tangent of
SAC curves.
 The LAC is also in U-shaped, but difference. The Lac is more flatter than SAC because of in
long run, there are only variable costs and only few cots are remain fixed, so fixed cost can be
reduced to some extent and AFC will rise sharply when output increased compared to short
run. That is why U-shape of the Lac curve is less sharp or more pronounced or dish shaped.
 In long run cost curve is flatter because in the long run such economies, greater divisibility of
the factors of production like machines, management etc.
 The LAC curve shows the cost after including all the plant size.
 The LAC is also known as envelope curve because it envelopes al the short run curves. It is
also referred to as planning curve because it represents the cost data which are relevant to the
firm when it is planning its policy in regard to its scale of operations, output and price over a
long period of time.

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DR. YASHODHARA A BHATT
Revenue curves
The main objective of every firm to produce at the least cost and how much the firm should produces
depends among other things on the market availability for a product and expected sales revenue in
relation to the cost incurred. The equilibrium output will be that output which gives the firm
maximum profit. The earnings which firm gets from the sale of its output are known as revenue.
There are mainly three types of revenue.

Total Revenue (TR):

Total earning of the firm from the sale of its products is known as Total Revenue. It can be obtained
by multiplying the price per unit of the product with the total number of units of the product sold.

Total Revenue= price per unit Χ Total number of units of the product sold.
Average Revenue = Total Revenue/Quantity

Average Revenue (AR):

Average revenue is the revenue per unit of the product sold. It can be that total revenue can be
divided by number of unit sold.

Average Revenue = Total Revenue

Total number of units sold
AR = TR/Q
It should be noted that as the different units of the product are sold at the same price, average revenue
and price are equal. Average is just the same things as the price per unit. The Average Revenue is also
known as the consumer’s demand.

Marginal Revenue (MR):

Marginal Revenue is the additional to the total revenue by selling an additional unit of the firm’s
product. That, marginal revenue is additional to the total revenue earned by selling n+1 units instead
if n units.

Marginal Revenue = TRn – TRn-1

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AR and MR curve in perfect competition:
In perfect competition, the AR curve is a straight line parallel to X-axis because no individual firm of
perfect competition can by its own action for price of commodity. The AR curve of perfect
competition is perfectly elastic and horizontal straight line parallel to X-axis.

AR and MR curve in Monopoly and Monopolistic competition:

The shape of AR and MR is different; both are downwards curve to the right because the firm has to
lower the price in order to sell additional units. The AR curve is downward sloping curve and MR
curve also falls. The falls in MR curve is more rapid than the AR curve. Under both market MR
curve lies below AR curve and normally slopes downward.

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DR. YASHODHARA A BHATT