CHAPTER 6

THEORY OF COST AND PROFIT

COSTS ANALYSIS
Cost is the most important consideration in production. A producer will not just jump into a
particular investment by simply looking at the potential revenue of the business. Revenue may be
substantial, but the producer will think twice because of the implication on the pricing of the
commodity. Consumers will not be so enthusiastic in patronizing the offered product if the price is
quite high. Inefficiency in the production process has a direct impact on cost because it takes away the
incentives being rewarded by the market for producers that are not wasteful. The market forces the
producer to manage the cost of production by finding the least cost in expanding output.
 COST - This refers to the total amount of money spent on producing goods or services.

TYPES OF COSTS
1. ACCOUNTING COST - is the total monetary expenses incurred by a firm in producing a
commodity. Form of managerial accounting that aims to capture a company’s total cost of
production by assessing the variable costs of each step of production as well as fixed costs.

2. ECONOMIC COSTS - is the cost of any good or service which pertains to the totality of all
sacrifices made to bring the good or service into existence. This includes accounting costs and
implicit costs, which are hypothetical expenses used when making a business decision to forecast
potential profit. This means that economic costs include both explicit and implicit costs. Accountants
and business leaders use economic costs when creating financial projections or determining the best
strategic outcome, such as reallocating funds or using a more efficient mode of production.
Economic costs allow accountants to take into consideration both the explicit accounting costs and
the hypothetical costs of a potential business decision.
 Explicit Cost - It is the paid-out cost. It means payments made for the production resources.
 Implicit Cost - It is the cost of self-owned resources.

3. OPPORTUNITY COSTS - are the cost of the sacrifice of the best alternative foregone in the
production of a good or service.

4. PRODUCTION COSTS - cost incurred for production of goods.

 Variable Costs – are production cost which change with the change in the firm’s output
 Fixed Costs – are production costs which do not change with the change in output (in the short
run)

5. PRIVATE COSTS - are the costs incurred by a firm in producing a commodity or service.

6. SOCIAL COSTS - are the costs society bears due to industrialization.

7. SUNK COSTS - are the costs that have been incurred and definitely not recoverable or changeable
whether the particular project or business goes on or not.

8. Incremental Cost - the change in cost owing to a new decision.

COST FUNCTION
SHORT-RUN COSTS ANALYSIS
The short-run for a firm is the time horizon when one input is held constant, To analyze the short-
run costs, it is essential to fix the level of capital and study the changes in the quantity of labor hired. The
following are the types of short-run costs:
1. TOTAL FIXED COSTS (TFC)
 Are costs that do not vary with output. Examples of these costs are depreciation of buildings and
machinery, salaries of top management, rent expenses on leased plant, and interest payments on
borrowed capital.

2. TOTAL VARIABLE COSTS (TVC)

 It is the costs that vary with output. Examples of these costs are payment for raw materials,
wages, tax payments, operating expenses (light, fuel, and water).

3. TOTAL COSTS (TC)

 It is the sum of total fixed costs and total variable costs.
 Formula: TC = TFC + TVC

4. AVERAGE FIXED COSTS (AFC)

 Average fixed cost (AFC) is the fixed cost per unit and is calculated by dividing the total fixed
cost by the number of output/quantities produced.
 Formula: AFC = TFC/Q

5. AVERAGE VARIABLE COSTS (AVC)

 Average variable cost (AVC) refers to the per unit variable cost of production. It is calculated
by dividing TVC by total output/quantities produced.
 Formula: AVC = TVC/Q

6. AVERAGE TOTAL COSTS (ATC)

 Average total cost (ATC) refers to the per unit total cost of production. It is calculated by
dividing TC by total quantity produced.
 Formula: ATC = TC/Q

7. MARGINAL COSTS (MC)

 Marginal cost is the change in total production cost that comes from making or producing one
additional unit. Marginal Costs changes in total costs divided by the change in output produced
(Q). It is also the additional cost incurred from producing an additional unit of output.
 Formula: MC = ΔTC/ΔQ
Example of Short Run Analysis

Quantit
TFC TVC TC AFC AVC ATC MC
y
0 100 0 100 0 0 0 0
1 100 50 150 100 50 150 50
2 100 80 180 50 40 90 30
3 100 95 195 33 32 65 15
4 100 125 225 25 31 56 30
5 100 180 280 20 36 56 55
6 100 280 380 17 47 63 100

MC of 1 Unit.
AFC or 1 Unit. Change∈Total Cost
 AFC = TFC/Q = 100/1 = 100 MC=
Change∈Quantity
TC2−TC 1
AVC of 1 Unit. ¿
Q2−Q1
 AVC = TVC/Q = 50/1 = 50
150−100
¿
1−0
ATC of 1 Unit. 50
¿
 ATC = TC/Q = 150/1 = 150 1
MC=50

LONG-RUN COST ANALYSIS (LAC)

Long-run is a time period Cost wherein all fixed factors can be variable. Thus, the long run
consists of variable inputs only, and the concept of fixed inputs does not arise. The firm can increase the
size of the plant in the long run. Thus, you can well imagine no difference between long-run variable cost
and long-run total cost, since fixed costs do not exist in the long run.The long-run average total cost
(LAC) of producing a given level of output is always the lowest point of the short-run average total cost
of producing that output. The LAC is the curve tangent to each short-run average cost representing
different plant sizes that a firm can build in the long-run.
LONG-RUN MARGINAL COST (LMC)
The Long-Run Marginal Cost (LMC) measures the change in long-run total cost from a given
change in output. The LMC is U-shaped and reaches its minimum point before the LAC curve reaches its
minimum just like in the short-run analysis. At the increasing portion of the LAC, LMC is over LAC.

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PROFIT ANALYSIS
TOTAL REVENUE
It is the total amount of money generated from selling goods or services.

PROFIT
It is the financial gain obtained after deducting all expenses (including costs) from. It represents
the amount of money a business earns.

 Formula - Profit = Total Revenue - Total Costs

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1. PROFIT MAXIMIZATION - Profit Maximization is the goal of a company to make as much

profit as possible by finding the right balance between the price it charges for its products or services
and the costs it incurs to produce them. In economics, profit maximization is the process by which
a firm may determine the price, input and output levels that lead to the highest profit.

FORMULA FOR PROFIT

Profit ( P )=Total Revenue ( TR )−Total Costs(TC)

RULES
 MARGINAL REVENUE = MARGINAL COST
 AR > ATC
 To maximize profits, the firm must find the equilibrium price and quantity that gives the largest
profit on the largest difference between TR and TC. The rule is simple: if TR> TC, the firm incurs
profit, if TR<TC, the firm incurs loss and if TR= TC, the firm experiences break-even condition.

TR > TC = profit
TR < TC = loss
TR = TC = break-even

The break-even point is the point at which total cost and total revenue are equal, meaning there
is no loss or gain for your business.

2. LOSS MINIMIZATION - In economics, loss minimization applies to a firm that is incurring a

short-run economic loss that is less than total fixed cost.

 LOSS = TOTAL REVENUE (TR) – TOTAL COSTS (TC)

 (Where TC is greater than TR)

 MARGINAL REVENUE = MARGINAL COST

 ATC>AR>AVC

3. SHUTDOWN POINT - With shutdown, the firm incurs a smaller loss by producing NO output and
incurring a loss equal to its fixed cost.

 LOSS = TOTAL REVENUE (TR) – TOTAL COSTS (TC)

 (Where TC is greater than TR)

 MARGINAL REVENUE = MARGINAL COST

 ATC>AR<AVC

Example:
PRICE OF GOOD = 50.00
Marginal Revenue Average Fixed Cost Average Variable
Fixed Cost Variable Total Cost (TC) Marginal Cost (MC) Total Revenue (TR) Average Cost (AC) Profit
Quantity Price (MR) (AFC) Cost (AVC)
(FC) Cost (VC)
TC = FC + VC MC= ΔTC/ΔQ MR= ΔTR/ΔQ TR = Q x P AC = TC/Q AFC = FC/Q AVC = VC/Q Profit = TR - TC
0 50.00 30.00 - 30.00 - - - - - - (30.00)
1 50.00 30.00 15.00 45.00 15.00 50.00 50.00 45.00 30.00 15.00 5.00
2 50.00 30.00 27.00 57.00 12.00 50.00 100.00 28.50 15.00 13.50 43.00
3 50.00 30.00 37.00 67.00 10.00 50.00 150.00 22.33 10.00 12.33 83.00
4 50.00 30.00 48.00 78.00 11.00 50.00 200.00 19.50 7.50 12.00 122.00
5 50.00 30.00 60.00 90.00 12.00 50.00 250.00 18.00 6.00 12.00 160.00
6 50.00 30.00 74.00 104.00 14.00 50.00 300.00 17.33 5.00 12.33 196.00
7 50.00 30.00 90.00 120.00 16.00 50.00 350.00 17.14 4.29 12.86 230.00
8 50.00 30.00 109.00 139.00 19.00 50.00 400.00 17.38 3.75 13.63 261.00
9 50.00 30.00 134.00 164.00 25.00 50.00 450.00 18.22 3.33 14.89 286.00
10 50.00 30.00 166.00 196.00 32.00 50.00 500.00 19.60 3.00 16.60 304.00