1.1 Concepts and Types of Cost Economic Cost and Accounting Cost Private Cost and Social Cost Actual Cost and Opportunity Cost Explicit Cost and Implicit Cost Incremental Cost and Sunk Cost Fixed Cost and Variable Cost.

BECO II

UNIT 1

Cost and Revenue

1.1 Concepts and Types of Cost- Economic Cost and Accounting Cost, Private Cost and Social Cost, Actual Cost and Opportunity Cost, Explicit Cost and Implicit Cost, Incremental Cost and Sunk Cost, Fixed Cost and Variable Cost.

Cost analysis is concerned with determining the money value of input used for production which is called as overall cost of production.

Definition:

In economics, the Cost Analysis refers to the measure of the cost – output relationship, i.e. the economists are concerned with determining the cost incurred in hiring the inputs and how well these can be re-arranged to increase the productivity (output) of the firm.

Concepts of cost:

Types of cost are as follows-

Nominal and real cost –

Nominal cost is the money value of cost of production. It is also called expenses of production. The expenses paid to the factors he employs in the process of production.
The real cost are the pain and sacrifices of labour involved in the process of production.

2. Explicit and implicit cost –

Explicit cost is the cost made to other owner for the purchase or hiring of various other factors in the course of running a business. It is also called as accounting cost. Examples of explicit costs include wages, lease payments, utilities, raw materials, and other direct costs.

An implicit cost has already occurred but not necessarily shown as separate expense. It is also called as opportunity cost. Implicit costs are a part of opportunity cost. They are the theoretical costs ie., they are not recognised by the accounting system and are not recorded in the books of accounts but are very important in certain decisions. They are also called as the earnings of those employed resources which belong to the owner himself. Implicit costs are also called as "Imputed costs".

Examples: Rent on idle land, depreciation on dully depreciated property still in use, interest on equity capital etc.

3. Accounting cost and Economic cost –

Accounting costs are the actual or outlay costs that point out the amount of expenditure that has already been incurred on a particular process or on production as such accounting costs facilitate for managing the taxation need and profitability of the firm.

Examples: All Sunk costs are accounting costs

Economic costs are related to future. They play a vital role in business decisions as the costs considered in decision - making are usually future costs. They have the nature similar to that of incremental, imputed explicit and opportunity costs.

4. Private cost and social cost –

Private costs for a producer of a good, service, or activity include the costs the firm pays to purchase capital equipment, hire labor, and buy materials or other inputs. Private costs are paid by the firm or consumer and must be included in production and consumption decisions. In a competitive market, considering only the private costs will lead to a socially efficient rate of output only if there are no external costs.

Social costs include both the private costs and any other external costs to society arising from the production or consumption of a good or service. External costs are directly associated with producing or delivering a good or service, but they are costs that are not paid directly by the producer.

5. Opportunity cost and actual cost –

Opportunity costs are incomes from the next best alternative that is foregone when the entrepreneur makes certain choices.

Ex – a manufacturing company has a factory. He uses the factory for his business purpose instead of giving it for rent. These costs calculate the missed opportunity and calculate income that we can earn.

Actual cost is defined as the cost or expenditure which a firm incurs for producing or acquiring a good or service. The actual costs or expenditures are recorded in the books of accounts of a business unit. Actual costs are also called as "Outlay Costs" or "Absolute Costs" or "Acquisition Costs".

Examples: Cost of raw materials, Wage Bill etc.

6. Business cost and full cost –

Business costs include all the expenses which are incurred in carrying out a business. The concept of business cost is similar to the accounting or actual cost.

Full cost includes the opportunity cost and normal profit. Normal profit is minimum earning which a firm earns to remain in its present occupation.

7. Total, Average and Marginal cost –

Total cost refers to the total expenditure, both explicit and implicit on the resources used to produce a given output.

Average cost is the cost per unit of output which is obtained by dividing the total cost (TC) by the total output (Q), i.e., Average cost = TC/Q

Marginal cost is the addition made to the total cost as a result of producing one additional unit of the product.

8. Fixed cost and variable cost –

Fixed costs are the expenditure incurred on the factors such as capital, equipment, plant, factory building which remain fixed in the short run and cannot be changed. Fixed costs are independent of output ie. these costs will have to be incurred, if no output is produced in the short run.

Variable costs are costs incurred by the firms on the employment of variable factors such as labour, raw materials, etc., whose amount can be easily increased or decreased in the short run. Variable costs will not be incurred, if the firm decided not to produce any output,

9. Direct and indirect cost –

Direct costs are those cost which id directly used in a particular product and process. Ex – manufacturing cost relating to production.

Indirect cost – indirect cost are not directly related to production. Eg – office expense, salary

10. Incremental and sunk cost-

These costs are incurred when the business makes a policy decision. As the costs can be avoided by not bringing any variation in the activity in the activity, they are also called as "Avoidable Costs" or "Escapable Costs". More ever incremental costs resulting from a contemplated change is the Future, they are also called as "Differential Costs". For example, change of product line, acquisition of new customers, upgrade of machinery to increase output are incremental costs.

Suck costs are costs which the entrepreneur has already incurred and he cannot recover them again now. These include money spent on advertising, conducting research, and acquiring machinery. Sunk costs are those do not alter by varying the nature or level of business activity. Sunk costs are generally not taken into consideration in decision - making as they do not vary with the changes in the future. Sunk costs are a part of the outlay/actual costs. Sunk costs are also called as "Non-Avoidable costs" or "Inescapable costs".

Key takeaways –

Nominal cost is the money value of cost of production

Suck costs are costs which the entrepreneur has already incurred and he cannot recover them again now

Full cost includes the opportunity cost and normal profit

Actual cost is defined as the cost or expenditure which a firm incurs for producing or acquiring a good or service.

1.2 Relation between Total Cost, Average Cost and Marginal Cost

The relationship between output and cost is expressed in terms of cost function. The companies use cost function to minimize cost and maximize production efficiently.

The following functions are applied to take decision-

Total cost.

Average cost.

Marginal cost.

Total cost:

It is the full cost of producing any given level of output. The cost is divided into 2 parts-
1. Total fixed cost does not vary with the level of output. For eg – land.
2. Total variable cost changes directly with the output. For eg – labour.

Average cost:

Average total cost is the total cost per unit of output.
Average fixed cost is the fixed cost per unit of output.
Average variable cost is the variable cost per unit of output.

3. Marginal cost:

Marginal cost is the proportionate change in total cost from the proportionate change in output

MC = Change in TC

Change in output

Relation between average cost and marginal cost:

Average cost can be worked out by dividing the total cost by total output.

Likewise, marginal cost can also be calculated from total cost. The addition made to the total cost by producing one more unit of the commodity is called marginal cost. MC = TCn – TCn-1

When average cost falls, marginal cost also falls. In this case, marginal cost falls more rapidly than the average cost. That is why when marginal cost curve is falling; it is below the average cost curve.

When average cost rises, marginal cost also rises but marginal cost rises more rapidly than the average cost.

MC cuts AC at its lowest point : When average cost is minimum then marginal cost will be equal to it.

For a brief stretch, AC may continue to decline even when MC is rising : Shows that between points F and E, marginal cost is rising while AC continues to fall.

Mutual Interaction between MC and AC : When marginal cost is more than average cost, average cost has a tendency to rise. It seems as if marginal cost curve is pulling the AC curve upward. On the other hand, when MC is less than AC, it pulls the AC curve downward. When MC is equal to AC then the latter is constant.

Key takeaways –

Average cost (AC) – total costs divided by output (AC = TFC/q + TVC/q). Marginal cost (MC) – the change in the total cost when the quantity produced changes by one unit.

1.3 Cost Curves in Short run and Long run

Short run cost:

Short run cost is the cost where the quantity of one input is fixed and the quantity of other input varies. In this case, the land and machinery is fixed whereas the other factors such as labour and capital vary with time. Thus expansion is done in hiring more labour and increasing capital.

Total fixed cost (TFC)-

Total fixed cost remains fixed in short run period. The cost does not change with the change in the level of output.

These costs are also called indirect costs, overhead costs, historical costs, and unavoidable costs.

Definition:

In the words of Ferguson, “Total fixed cost is the sum of the ‘short run explicit fixed costs and implicit costs incurred by the entrepreneur.”

From the above figure , we can see TFC curve is horizontal to X axis.TFC remains constant with proportionate change in the output.

2. Total variable cost-

Refers to the cost changes with the change in the level of output.

Ex – cost incurred in purchase of raw material, hiring labour, etc

Definition:

According to Ferguson, “total variable cost is the sum of amounts spent for each of the variable inputs used”

If the output is zero, total variable cost is zero.

These costs are also called prime costs, direct costs, and avoidable costs.

In the above figure, TVC changes with the change in the level of production

3. Total cost-

TC = TFC+TVC

Total cost is the sum of fixed and variable cost. It changes with the change in the level of production

In the above fig, initially total cost increases at diminishing rate, means the rate of cost increases with respect to less output. Later total cost increases at increasing rate, as cost increases with respect to output is more.

4. Average fixed cost (AFC)–

Refers to fixed cost of production divided by the quantity of output produced.

AFC= TFC/Output

AFC curve is declining in the above figure. The TFC remains constant as production increases, thus AFC falls

5. Average variable cost (AVC)-

It refers to total variable cost divided by total production

AFC = TVC/Output

AVC decreases as the output increases. But after a point, AVC increases as the output increases. Thus, it is U shaped curve

6. Average cost of production (AC)-

Refer to the total costs of production per unit of output.

AC= TC/Output

AC is also equal to the sum total of AFC and AVC. AC curve is also U-shaped curve as average cost initially decreases when output increases and then increases when output increases.

7. Marginal cost (MC)-

Refers to change in total cost of production on addition unit of the product.

MC = proportionate change in TC

Proportionate change in output

In the above figure, we can see marginal cost initially decreases as output increases and later, rises as output increases. Thus, MC curve is also a U-shaped curve.

Long run cost:

In long run, all the factors of production vary. Long run is period in which all cost change as all the factors of production are variable. To produce at a lower cost in long run, the organization should have the ability to change the factors of production. There is no difference between TC and TVC as there is no fixed cost.

Long run total cost (LTC)–

It refers to the minimum cost at which a given level of output can be produced.
Definition:

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 is always less than or equal to short run total cost (STC), but it is never more than short run cost.

In the above figure, STC 1,2,3 is the cost at different plant size. The LTC curve is made by joining the minimum points of STC curves.

2. Long run average cost (LAC)-

It refers to long run total cost divided by the output.

The long run average costs curve is also called planning curve or envelope curve as it helps in making plans for expanding production and achieving minimum cost.

In the above figure, LAC is derived from the short run average cost(SAC) curve. The organization will operate on the SAC2 plant as it entails lower cost than SAC1. If organization wants to produce more output, then it will be beneficial to produce at SAC3 than SAC2.

LAC curve first falls then rises, so it is U shaped curve.

3. Long run marginal cost (LMC)-

Long run Marginal Cost (LMC) is defined as added cost of producing an additional unit of a commodity when all inputs are variable.

LMC is derived from SMC

On the graph, Output A,B,C intersects SMC at P,Q,R. LMC is drawn by joining P,Q and R respectively which is the tangency between LAC and SAC.

Key takeaways-

In the short run, there are both fixed and variable costs.

In the long run, there are no fixed costs.

Efficient long run costs are sustained when the combination of outputs that a firm produces results in the desired quantity of the goods at the lowest possible cost.

Variable costs change with the output. Examples of variable costs include employee wages and costs of raw materials.

1.4 Concept of Total Revenue, Average Revenue and Marginal Revenue

The term revenue refers to income obtained by the firm through sale of goods and services at different prices.

Definition:

In the words of Dooley, ‘the revenue of a firm is its sales, receipts or income’.

Revenue are of 3 types as given below-

Concepts of Revenue

Total Revenue:

Income received by the seller after selling the output is called total revenue.
“Total revenue is the sum of all sales, receipts or income of a firm.” Dooley.
TR = Q x P

Where,

TR – Total Revenue

Q – Quantity of sale (units sold)

P – Price per unit of output

2. Average Revenue:

Refers to revenue earned by the seller be selling the per unit of commodity

“The average revenue curve shows that the price of the firm’s product is the same at each level of output.” Stonier and Hague.

AR=TR/Q.=

Where, AR – Average Revenue, TR – Total Revenue – Total units sold

3. Marginal revenue:

Marginal revenue is the net revenue the firm receives by selling an additional unit of the commodity.

“Marginal revenue is the change in total revenue which results from the sale of one more or one less unit of output.” Ferguson.

MR=Change in TR/ change in unit sold.

Key takeaways-

Income received by the seller after selling the output is called total revenue.

Marginal revenue is the net revenue the firm receives by selling an additional unit of the commodity.

Average revenue earned by the seller selling the per unit commodity.

References

Business economics by H.L Ahuja.

Business economics application and analysis by Dr. Raj kumar.

Business economics by T Aryamala.

Business economics by SK Agarwal.

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