Costs and revenues

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Costs and revenues

  1. 1. Unit 7 Costs and RevenuesObjectives:After going through this unit, you will be able to explain:The concept business costsTypes of business costsCost curvesThe concept of revenueTotal, average, and marginal revenueRevenue and demandStructure:1.1 Introduction1.2 The economic concept of costs1.3 Accounting and Opportunity cost1.4 Transaction cost1.5 Explicit and Implicit costs1.6 Total, Fixed and Variable costs1.7 Average and Marginal costs1.8 Sunk costs1.9 Revenue concepts1.10 Total, Average, and Marginal Revenues1.11 Summary1.12 Key words1.13 Self-assessment questions
  2. 2. 1.1 IntroductionCost concepts and decisions are very crucial decision making areas for managers. This isparticularly true in contemporary times of competition when cost advantages becomecritical success factors in determining competitiveness of firms. While profitmaximization is a prime goal of all businesses universally, costs in the short run areimportant ingredients in determining the volume of margins and growth of the business inthe long run. Costs are bad things endured or good things lost. Cost always means cost todo something. The following section provides useful insights on costs and various costconcepts.1.2 The economic concept of costsIn economics, business, and accounting, a cost is a price paid, or otherwise associatedwith, a commercial event or economic transaction. All business activities and decisionsare associated with some or the other costs. They are often described based on theirtiming or their applicability. Consider some of the following types of costs that arerelevant with business decisions.1.3 Accounting and Opportunity CostAccounting Costs represent the total amount of money spent or the money value ofgoods. It is the amount denoted on invoices and recorded in book-keeping records.Opportunity cost, also called as economic cost, is the benefits derived from the bestalternative that was not chosen in order to pursue the current endeavor, i.e., what couldhave been accomplished with the resources expended in the best alternate undertaking. Itrepresents opportunities forgone.For example, if a person has a job offer that pays Rs.100 for an hour’s work, but hedecides, instead, to take a nap. The accounting cost of the nap is zero because the person
  3. 3. did not hand over any money in order to nap. However, the opportunity cost is Rs.100because he could have been earned this amount had he been working instead of napping.So while the accounting cost of a nap is zero, the opportunity cost of the nap is Rs.100.Opportunity cost need not always be assessed in monetary terms, but rather, is assessed interms of anything that is of value to the person or the business firm doing the assessingbetween alternative courses of actions. Sometimes it is evaluated in terms of time orgrowth prospects. To the extent these non-money evaluations of lost benefits can becalculated by business value terms it becomes easier to use the concept of decisionmaking purposes. The consideration of opportunity costs is one of the key differencesbetween the concepts of economic cost and accounting cost.1.4 Transaction costIn business when exchanges or transaction take place they involve a cost. A transactioncost is a cost incurred in making an economic exchange. For example, consider thefollowing costs, (i) Commission paid to the broker when buying or selling shares (ii) Cost of travel and the time and effort spent when one travels to the grocery store to buy groceryIn the first case the commission and in the second case the cost of travel and theopportunity cost can be called transactions cost, the costs above and beyond the actualcost of the goods and services are the transaction costs. When rationally evaluating apotential transaction, it is important not to neglect transaction costs that might provesignificant. A number of kinds of transaction cost have come to be known by particularnames. Consider the following, (i) Cost of exploration and investigation are costs such as those incurred in determining the availability of particular goods and services in the market,
  4. 4. alternative brands in the same product category, brand which has the lowest price, etc. (ii) Cost of negotiation are the costs required to come to a mutual agreement with the other party for the transaction to happen, drawing up an appropriate contract, etc. (iii) Cost of conditional transaction. Some contracts can be conditional, for instance job contracts which involve training for the fresh recruit. The cost of training would be over and above the salary to be paid to the recruit and is a transaction cost to the employer. (iv) Policing and enforcement costs are the costs of making sure the other party sticks to the terms of the contract, and taking appropriate action if this turns out not to be the case. For example, bonds signed in employment contracts.1.5 Explicit and Implicit costsIn business not all costs are visible. This leads us to an important cost distinction, that of,explicit an implicit costs. a) Explicit costs are out-of-pocket expenses such as payments for resource utilization – wages, rent, interest etc. b) Implicit costs are the opportunity costs of using resources already owned by the firm.Implicit costs can be related to forgone benefits of any single transaction and can be theopportunity costs, or can occur when a business firm incurs costs in terms of time valueetc. When a firm uses fixed capital investments done in the past for current decisions oruses the time of existing human resources for future projects are all examples of implicitcosts.
  5. 5. 1.6 Total, Fixed and Variable costsTotal cost (TC) is the sum of all costs. It describes the total economic cost of production.For accounting purposes it is calculated as a sum total of fixed and variable costs asshown in the following equation, TC = VC + FCFixed costs (FC) are those that remain the same irrespective of the level of output. Inother words, they simply they do not respond to production levels. Consider thefollowing diagram, Costs FC OutputFor instance, the cost of building an office, acquisition of resources, purchases oftechnology etc. are fixed costs.Variable costs (VC) are those that vary with the level of output. If the output is zero thevariable cost is also zero. In this sense, the variable costs grow with higher levels ofproduction, proportionally or otherwise. Consider the following diagram,
  6. 6. Costs VC OutputAdding the fixed and variable costs diagrammatically we get the following figure, Costs TC VC FC Output1.7 Average and Marginal CostsThe Average Cost (AC) can be defined as per unit cost of production or cost accruedbecause of manufacturing one unit of output. It can be calculated as the Total Costdivided by the total number of units of output, expressed in the following equation,
  7. 7. AC = TC QWhere Q is the quantity of output manufactured.Average costs affect the supply curve and are a fundamental component of supplydecisions. Average cost can also be calculated as, AC = AFC + AVCWhere AFC is Average Fixed Cost and AVC is Average Variable Cost.Marginal cost (MC) is defined as the change in total costs resulting from a oneadditional unit of output. It indicates by how much the total costs changes when one moreunit of output is manufactured. Marginal costs can be calculated using the followingequation, MC = ΔTC ΔQThe cost curves are U-shaped. This follows form the principle of economies anddiseconomies of scale. When initially more and more units of output are manufactured byexpanding the scale of production, the cost conditions are favorable. This is because ofeconomies of scale and shown by the downward slope of the cost curves. After a certainpoint when production goes beyond the optimum level and diseconomies appear, costsconditions become unfavorable. When this happens the cost curves start sloping upwards.Consider the following figure which shows average and marginal cost curves:
  8. 8. Costs MC AC Quantity of outputAt this point we can identify a relationship between average and marginal cost. It can besummed up in following points: (i) When average cost is declining as output increases, marginal cost is less than average cost. (ii) When average cost is rising, marginal cost is greater than average cost. (iii) When average cost is minimum, marginal cost equals average cost.1.8 Sunk costsGrowing business firms constantly face decision situations which involve incurringvarious costs. These decisions may involve new product development or entry into newmarkets etc. It may so happen that when such a new decision situation is faced not allcosts may freshly incur; some may already have been incurred in the past. This leads usto the concept of Sunk costs.Sunk costs are costs incurred before a certain activity takes place. Such costs cannot berecovered by the possible sale of the asset they produced as a consequence of currentbusiness decisions. Sunk costs are important decision making criteria hen firms enter newmarkets or exit current markets. If firms want to exit an industry sunk costs acts as
  9. 9. barriers to exit. A firm which has incurred in high sunk costs will have difficulties indeciding to exit the market even if it sees good opportunities outside. On the other hand,firms that decide to enter into a new industry as a part of horizontal or vertical integrationstrategy or into totally new business arena, it will have to consider with a particularattention the sunk costs and the risk that during the operations period that might incur.This is because such costs might not be recovered if the business risk becomes fatal. Sunkcosts, in this perspective, pose barriers to entry.1.9 Revenue conceptsRevenue is the income generated from the sale of goods and services by firms. It is alsoknown as sales turnover. The revenue the firm generates depends on the strength ofdemand for the products they are supplying. There are three revenue concepts associatedwith business decisions, viz., (i) Total Revenue (ii) Average Revenue (iii) Marginal Revenue1.10 Total, Average, and Marginal RevenueTotal Revenue (TR) is defined as the total earnings generated out of total sales of output.It can be calculated as expressed in the following equation, TR = P x Qwhere P is the price per unit of output and Q is the total number of units of output soldAverage Revenue (AR) is defined as the revenue generated by one more unit of outputsold. It can be calculated by dividing total revenue generated by the number of units ofoutput. In other average revenue is nothing but the unit price (P) of the output, expressedas follows, AR = P
  10. 10. The average revenue curve for a firm is the same as the demand curve that the firm facesin the market.Marginal Revenue (MR) is the addition to the total revenue when every next unit of theoutput is sold. It is calculated as the change in total revenue as a result of selling oneextra unit of output as shown in the following equation, MR = ΔTR ΔQConsider the following figures which express total, average, and marginal revenuediagrammatically. Price AR=MR Quantity Price TR Quantity
  11. 11. The above figure shows when the demand curve (AR) is perfectly elastic, AR = MR andtotal revenue will rise at a constant rate as price per unit increases. However, most firmsface a downward sloping demand curve for their products. For such a situation considerthe following diagrams: Price AR Quantity MR Price TR QuantityIn above figure, as AR falls, MR will fall as well. Total revenue will rise at a decreasingrate until marginal revenue is zero. At this point (MR=0) and total revenue is maximized.1.12 Summary
  12. 12. In this we discovered that cost decisions are very crucial decision making areas formanagers, particularly in contemporary times of competition when cost advantagesbecome critical success factors in determining competitiveness of firms. All businessactivities and decisions are associated with some or the other costs. Based on their timingor their applicability costs can be viewed as accounting or opportunity costs, explicit orimplicit, total, average or marginal, variable or fixed, sunk or incremental. Whenproducts are sold in the market business earns revenues. Revenues can be viewed as total,average or marginal.1.13 Key words a) Accounting Costs: The total amount of money or the money value of goods denoted on invoices and recorded in book-keeping records. b) Opportunity cost: Also called as economic cost, this is the benefits derived from the best alternative that was not chosen in order to pursue the current endeavor. c) Transaction cost : Cost incurred in making an economic exchange. d) Explicit costs: Out-of-pocket expenses such as payments for resource utilization – wages, rent, interest etc. e) Implicit costs: Opportunity cost of using resources already owned by the firm. f) Total cost: The sum of all costs. g) Fixed costs: Costs that remain the same irrespective of the level of output. h) Variable costs: Costs that vary with the level of output. i) Average Cost: Cost per unit of output. j) Marginal cost: Change in total costs resulting from a one additional unit of output. k) Sunk costs: Costs incurred before a certain activity takes place which cannot be recovered by the possible sale of the asset they produced as a consequence of current business decisions. l) Total Revenue: Total earnings generated out of total sales of output. m) Average Revenue: earnings per unit of output.
  13. 13. n) Marginal Revenue: Addition to the total revenue when every next unit of the output is sold.1.14 Self-assessment questions1) Explain the concept of cost in business. Discuss the significance of cost control and cost minimization.2) What are the various types of costs?3) Distinguish between: a) Explicit and implicit cost b) Fixed and variable cost c) Accounting and opportunity cost4) Write a short note on Transaction and sunk cost.5) Explain total, average, and marginal revenue.6) In contemporary times of competition when cost advantages become critical success factors in determining competitiveness of firms. a) True b) False c) Neither true nor false d) None of the above7) Opportunity cost is also called, a) Economic cost b) Explicit cost c) Accounting cost d) Total cost8) Costs that remain the same irrespective of the level of output are called, a) Fixed cost b) Variable cost c) Opportunity cost d) Marginal cost9) Costs that vary with the level of output are called,
  14. 14. a) Fixed cost b) Variable cost c) Opportunity cost d) Marginal cost10) Earnings per unit of output are called, a) Total Revenue b) Average Revenue c) Marginal Revenue d) None of the above11) Fill in the blanks: a) ___________________ is the total amount of money or the money value of goods denoted on invoices and recorded in book-keeping records. b) ___________________ is the benefits derived from the best alternative that was not chosen in order to pursue the current endeavor. c) ___________________ is the cost incurred in making an economic exchange. d) ___________________ is the out-of-pocket expense such as payment for resource utilization – wages, rent, interest etc. e) ___________________ is the opportunity cost of using resources already owned by the firm. f) ___________________ is the sum of all costs. g) ___________________ is the cost per unit of output. h) ___________________ is the change in total costs resulting from a one additional unit of output. i) ___________________ is the cost incurred before a certain activity takes place j) ___________________ is the total earnings generated out of total sales of output. k) ___________________ is the addition to the total revenue when every next unit of the output is sold.

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