Cost and Revenue Concepts

Meaning and Definition of Cost

The term cost simply means cost of production. It is the expenses incurred in
the production of goods. It is the sum of all money-expenses incurred by a firm in
order to produce a commodity. In short, expenses incurred on the factors of
production are known as the cost.
Types of Cost (or Cost Concepts)
Money cost: Money cost means the total money expenses incurred by a business
firm on the various items entered into the production of a particular product. In
short, cost expressed in monetary terms is known as money cost. Money cost is also
called nominal cost.
Real cost: Real cost is a subjective concept. the ‘efforts’ of workers and sacrifices of
owners undergone in the production of a particular product. It is the amount of pain
or unpleasantness or real human sacrifice incurred for production. It Is implicit cost.
Opportunity Cost: Opportunity cost refers to the cost of foregoing or giving up an
opportunity. It is the cost of the next best alternative. It is useful in determination of
relative prices of different goods. It is also useful in fixing the price of an input factor.
The goods are priced because of their opportunity cost. Above all, it helps in the best
allocation of available resources.
Sunk Cost: Sunk costs are those which have already been incurred and which
cannot be changed by any decision made now or in the future. These are the costs
that cannot be recovered after incurring.
Incremental Cost: These are additional costs incurred due to a change in the level
or nature of activity.
Differential Cost: It refers to the change in cost due to change in the level of activity
or pattern of production or method of production.
Explicit Cost: Explicit costs are those costs, which are actually paid (or paid in
cash). These are the payments made in cash to others (outsiders).
Implicit Cost: Implicit costs are those costs, which are not paid in cash to anyone.
These are the costs, which the entrepreneur pays to himself. For example, rent
charged on owned premises, wages of entrepreneur, interest on owned capital etc.
Accounting Cost: Accounting costs represent all such expenditures, which are
incurred by a firm on factors of production. Thus, accounting costs are explicit costs.
In short, all items of expenses appearing on the debit side of trading and profit and
loss account of a firm represent the accounting cost. Accounting costs are also
known as hard costs.
Economic Cost: Economic cost refers to the total of explicit cost and implicit cost.
Difference between Accounting Cost and Economic Cost
Accounting cost means the expenses incurred by the firm on production and
sale of goods or services. These are paid by the firm to the outsiders. These include
payments and charges made by the enterprise to the suppliers of resources. It is the
explicit cost. But economic cost includes not only explicit cost but also implicit or
imputed cost. Implicit cost is not included in accounting cost. Accounting cost
includes only explicit costs which are recorded in the books of account. Implicit cost
will not be recorded in the books of account.
Accounting costs are generally used for financial reporting and control.
Economic costs are used for decision-making.
In short, accounting costs involve only cash payments made by the
entrepreneur. On the other hand, economic costs include all these accounting costs
plus the implicit cost.
Social Cost of Production (or Social Costs): In the production of goods costs will
be incurred not only by the owners of business but also by the society. Cost incurred
by a society in terms of resources used in the production of a commodity is known
as social cost of production. Social costs include not only the cost borne by the
owners of a business (or producers) but also the cost passed on to the society. Thus,
social cost is the total cost of the society on account of production of a commodity.
Knowledge of social cost and social benefit is extremely important in the efficient
utilisation of limited resources.
Private Costs of Production (Private Costs): Private costs are the costs incurred
by a firm in producing a commodity or service. Private costs are those costs which
are incurred when an individual or a firm produces or consumes something.
Difference between Private Cost and Social Cost
Private costs are the costs incurred by a firm in producing a commodity or
service. But social costs are those costs, which are incurred by the society in
producing commodities or services. Social costs include private costs and external
costs. Private costs include both explicit and implicit costs. Private costs do not
include external costs.
Fixed Cost: Fixed costs are those costs which do not change with the volume of
production. These costs remain fixed or constant upto a certain level of production.
Even if the production is zero, a firm will have to incur fixed costs.
Average fixed cost (fixed cost per unit) changes with a change in the quantity of
production. If the volume of production increases, average fixed cost will decrease.
If the quantity of production decreases, average fixed cost will increase. Thus, there
is an inverse relationship between fixed costs and quantity of production. the total
fixed cost curve is horizontal. On the other hand, the average fixed cost curve slopes
from left to right.
Variable Cost: Variable costs are those costs, which vary or change according to the
quantity of production or output. When the output increases, variable cost also
increases. When the output decreases, the variable cost also decreases.
The average variable cost (variable cost per unit) remains constant when the output
changes.
The total variable cost curve rises from left to right. This implies that when the output
increases total variable cost increases and when the output decreases total variable
cost decreases. AVC curve is horizontal. In the short run, the AVC remains constant
irrespective of the level of production. Hence the AVC curve will be U-shaped. The
AVC decreases as output increases upto the optimum capacity of the firm. This is
because of increasing returns or decreasing total cost. After the optimum point is
reached the AVC will begin to rise due to decreasing returns or increasing cost. Thus,
the AVC curve will be U-shaped (in the long run).
Difference between Fixed Cost and Variable Cost
Fixed Cost Variable Cost
Incurred on the fixed factors of Incurred on the variable factors of
production like machineries, buildings production like labour, raw materials
etc. etc.
Does not change with the change of Changes with change in the level of
Output. output.
Cannot be changed during short run. Can be changed during short run.
Never becomes zero (even when Becomes zero when production stops.
production is stopped).
Total Cost, Average Cost and Marginal Cost
Total Cost: The aggregate money cost of production of a commodity is called total
cost. it is the total of fixed cost and variable cost.
Average Cost (Average Total Cost): Average cost is the cost per unit of output. It is
equal to total cost divided by number of units produced.
Marginal Cost: It is the additional cost of producing an additional unit. It is the cost
of the last unit produced. It is the amount by which total cost changes when there
is a change in output by one unit.
Short run and Long run Costs
Short run cost: Short run is a period of time in which output can be increased or
decreased by changing only the variable factors such as raw material, labour etc.
Short run costs are those costs which vary with output while fixed factors remain
constant. In short, short run costs are the same as variable costs.
Long run cost: Long run is the period of time in which all input factors can be varied.
In other words, in the long run there are no fixed costs but all costs are variable in
the long run. In the long run, output can be increased or decreased by increasing or
decreasing all input factors. Thus, long run costs are those costs which vary with
output when all input factors (fixed and variable) are variable. In short, the cost
relating to long run is called long run cost.
The concept of short run cost helps the management to decide whether to produce
more or less with the existing plant. Long run concept helps management in taking
decisions for the future.
Difference between Short Run Cost and Long Run Cost
Short Run Long Run
These are the costs when at least one These are the costs when all factors of
factor of production is fixed. production are variable.
These are made only once. Such costs These have a long run implication in the
cannot be used again and again. process of production. These are used
over a long range of output.
Running costs and depreciation of the Running costs and depreciation of the
capital assets are included. capital assets are not included.
These are associated with variations in These are associated with the changes in
the utilisation of fixed plant or other the size and kind of plant.
facilities.
These are costs within a given These are costs across all possible
production capacity. production capacities.
These cost concepts are useful for These cost concepts are useful for
determining optimum output within a determining optimum plant size.
given plant size.
Short run Cost Function (Short run Cost-Output Relationship)
During the short run, the fixed factors (land, building, plant, machinery etc.) are
constant. Output can be changed by changing the variable factors only. In the short
period, fixed cost does not change. Therefore, as output increases, the average fixed
cost (AFC) falls. Variable cost (VC) increases but not proportionately. When more and
more output is produced, average variable cost (AVC) will fall in the beginning and
then it gradually increases.
In the short run, total cost is equal to fixed cost plus variable cost. Since fixed cost
does not change, any change in total cost is due to change in variable cost. When
output is zero total variable cost is zero. TVC increases with increase in output. In
the beginning total variable costs (TVC) increases gradually but later more steeply.
Even if the production is zero, the firm will incur fixed cost. Thus at zero output total
cost (TC) curve starts from TFC. Total fixed cost remains fixed for all levels of
production.
Relation Between Average Cost and Marginal Cost
Let us say a cricket player takes 50 runs in the first innings. And in the second
innings he scores 42 runs. Thus his average score per innings comes down (46); but
his marginal score (42) comes less than his average score. In the next innings if he
scores 61 runs, then his average score rises (51) and his marginal score also rises
(61) than his average score. If his average score is 50 runs in all the three innings
and if he scores 50 runs in the next innings, then his average score and the marginal
score become equal (i.e., both remain the same).
Relation among AFC, AVC, AC and MC
1) ATC curve Is U-shaped because of the operation of the Law of variable
proportion.
2) Short run marginal cost curve is also U-shaped because of the operation of law
of variable proportion.
3) AFC falls as output increases.
4) AVC first falls and then rises, so also the ATC.
5) AVC starts rising earlier than ATC curve.
6) MC curve cuts both AVC curve and ATC curve at their lowest points.
Relationship between LAC and LMC
As the firm increases output LAC and LMC both decline in the beginning due to
increasing returns. However, as compared to AC the decline in LMC is at a higher
rate. LAC will still be diminishing but LMC starts rising. LMC becomes equal to LAC
at the minimum point of the LAC. In the last stage of production both LAC and LMC
rise due to diminishing returns to scale. However, as compared to LAC the rise in
LMC is at a higher rate.
Revenue Concepts
Meaning and Definition of Revenue
Revenue simply means 'sales receipts'. It is the amount of income, which a firm
receives by the sale of its output. It is the monetary value of the output sold in the
market.
According to Dooley, "The revenue of a firm is its sales receipts or money receipts
from the sale of a product".
Types of Revenue
Total Revenue: Total revenue refers to the total sale proceeds of a firm by selling its
total output at a given price. It is obtained by multiplying the price per unit of
commodity with the total number of units of the commodity sold.
Average Revenue: It is the revenue earned per unit of output. It is the revenue per
unit of the commodity sold. It is obtained by dividing the total revenue by the number
of units sold.
Marginal Revenue: Marginal revenue is the addition to total revenue by selling one
more unit of the commodity.
Relation among AR, MR, and TR
1) When AR is falling, MR is also falling.
2) MR is falling faster than AR.
3) TR increases but at a diminishing rate. It continues to increase until MR is
positive.
4) TR falls when MR becomes negative.
5) TR will be maximum when MR becomes zero.
6) TR starts to fall when MR becomes negative.
Incremental Revenue: Incremental revenue simply refers to increase in revenue. It
is the difference between the new total revenue and the existing total revenue. It
measures the impact of decision alternatives on the total revenue.
Difference between Marginal Revenue and Incremental Revenue
Marginal revenue is the change in total revenue per unit of change in sales. In other
Words, marginal revenue is the addition made to the total revenue by selling an
additional or extra unit of output. But the incremental revenue is the change in total
revenue irrespective of the change in output. Further, incremental revenue is not
restricted to the effects of price change. It is the consequence of any kind of
managerial decision on total revenue.
Determination of Price Elasticity of Demand on the basis of Total Revenue Test
On the basis of total revenue test, we can determine whether the demand is elastic
or Inelastic.
If an increase in price causes an increase in total revenue, then demand can be said
to be inelastic. This is because the increase in price does not have a large impact on
quantity demanded.
If an increase in price causes a decrease in total revenue, then demand can be said
to be elastic. This is because the increase in price has a large impact on quantity
demanded.
If the change in price results in no change in total revenue, then the elasticity is
unitary (e = 1).
Degree of Elasticity Change in Price Impact on Demand What happens to
TR
A firm rises its price Smaller decrease Increase in TR
PED is inelastic (<1)
A firm lower its price Smaller increase Decrease in TR
A firm rises its price Greater decrease Decrease in TR
PED is elastic (>1)
A firm lower its price Greater increase Increase in TR
%decrease in demand =
A firm rises its price % increase in price
PED is unit elastic Total revenue
(=1) %increase in demand = remains the same
A firm lower its price %decrease in price

Relationship between Price Elasticity, TR and MR

1) When the co-efficient of price elasticity is greater than one (e=>1). The MR will
be Positive and the TR will increase as price falls.
2) When the co-efficient of price elasticity is unity (e=1), the MR will be zero and
the TR will not change with a change in the price.
3) When the co-efficient of price elasticity is less than one (e=c1), the MR will be
negative And the TR will fall as the price falls