Module IV

COST AND REVENUE

CONCEPTS
What is cost?
• The expenses incurred in the business activity of supplying goods and
services to consumers are defined as cost.
Cost Analysis?
• The study of the behavior of the cost with respect to several
criteria of production such as size of output, scale of
operations, prices of factors of production and other
relevant economic variables is known as cost analysis.
Kinds/ Types of Cost
• Opportunity cost and Actual cost • Fixed cost and Variable cost
• Direct cost and Indirect cost • Short run cost and Long run cost
• Explicit cost and Implicit costs • Accounting cost and Economic cost
• Out of pocket cost and Book cost • Business cost and full cost
• Real cost and Prime cost • Incremental cost and sunk cost
• Total, Average and Marginal cost • Historical cost and Replacement cost
Opportunity cost and Actual cost
• The loss of earnings due to lost opportunities is known as
opportunity cost/. It is the profit lost when one alternative is selected
over another.
• The expenses incurred actually on labor, material, plant, building,
machinery, equipment's etc. are known as actual cost.
• Actual cost is recorded in the books of accounts.
Business Cost and Full Cost
• The total expenses incurred in carrying out the business are
known as Business cost. The payments and contractual obligations
made by the firm comes under business cost.
• The total of business cost, opportunity cost and normal profit are
included in the concept of full cost.
Direct Cost and Indirect Cost
• Cost associated to a particular product, operation or plant are direct cost.
They are entered directly into cost of production, but are identified separately.
• Example, salary of the employees, payment for raw materials, etc..
• Indirect cost are not directly accountable to a cost object, not directly related
to production.
• Example, cost incurred on electricity, stationary and other office expenses, rent
etc..
Explicit Cost and Implicit cost

• An explicit cost is a direct payment made to

others in course of running a business.
• An explicit cost occurs when the company pays
for the usage of its factors of production.
• Explicit cost is also known as out of pocket
cost.
• Example;- wages, rent, payment for raw
materials, interest etc
• The self owned resource used in the production for which the payment is made is
known as implicit cost.
• Implicit cost occurs when the company uses resources belonging to the owner
such as capital and machinery.
• It is also known as imputed or opportunity cost.
• For eg: when a business man utilizes his services in his own company as a
Manager, thus he foregoes his salary as a manager . This loss of salary becomes an
implicit cost of its own business.
Historical cost and Replacement cost
• Historical cost is the actual cost of an asset incurred at the time when asset was
acquired.
• It is the past cost.
• The price that would have to be paid currently for acquiring the same plant.
• It is the present cost.
• Example ; price of a machine in 2000 was Rs 1,00,000, and its present price is 2,
50,000, then the actual cost of 100000 is the historical cost and 2, 50,000 is the
replacement cost.
Past cost and Future cost
• The cost that is out of the control of the management as being incurred
already is described as Past cost.
• Future cost are those that are expected to be incurred in future.
Shut down cost and Abandonment cost
• The cost which are incurred in the situation of closure of the plant
operations are known as shut down cost.
• Examples ; layoff expenses, all fixed cost etc..
• Cost which are incurred due to the retiring of a plant from use are
known as abandonment
• These cost are associated with the problem of disposal of assets.
Out of pocket cost and Book cost
• All the explicit cost are out of pocket cost.
• It involves cash payments or cash transfers of both recurring and non
recurring nature are known as out of pocket cost.
• Example, wages, rent, interest, transport expenditure etc.
• The payments made by the firm to self is known as book cost.
• Those cost that do not involve cash outlays but are added in the books of
accounts are book cost
• Example , depreciation allowances, interest that is unpaid on friend's deposit etc..
Incremental cost and Sunk cost
• Incremental cost adds up to the existing cost. They are additional cost
incurred for additional level of production.
• Example, changes in distribution line, replacing a machine etc.
• Sunk cost are the cost which are unaltered by change in the level of
output or activity.
• Example, all actual cost and past cost are sunk cost.
Fixed cost and Variable cost
• The cost which remains same regardless of the output or volume is known as
fixed cost.
• Example, Rent, salary, insurance, tax…
• The cost changes with the level of output is known as variable cost.
• Example, material consumed, wages, commission on sales, packing expenses etc..
Total, Average and Marginal cost
• Total cost (TC)is the sum of all cost incurred by a firm in producing a certain
level of output.
• Average cost (AC) is obtained by dividing the total cost (TC) by the total
output(Q).
AC= TC/Q
• Marginal cost (MC) is associated with the production of additional one unit.
It may be expressed as, MC= TC/ Q
Short run and Long run cost
• The cost which has short term implications in the production process.
• These are cost incurred once and cannot be used again and again
• Example, payment of wages, cost of raw materials etc.
• Long run cost are the cost incurred on fixed assets like plant and
machinery, building etc..
Average Fixed Cost and Average Variable
Cost
• AFC is computed by dividing TFC at each level by number of units produced
(Q).
AFC= TFC/Q
• AVC is computed by dividing the TVC by the number of units produced (Q).
AVC= TVC/Q
Determinants of cost
Technology - has a big influence on cost of production. Modern technology leads
to optimum utilization of resources, avoid all kinds of wastages, saving of time,
reduction in production costs and resulting in higher output.
The degree of utilization of the plant and machinery Complete and effective
utilization of all kinds of plants and machinery would reduce production costs and
under utilization of existing plants and machinery would lead to higher production
costs.
Size of Plant and scale of production - Cost is also influenced by the size of the
plant . With a bigger size ,although ,the initial fixed costs are high ,variable costs
tend to be low compared with a small sized plant.
Prices of factor inputs
Higher market prices of various factor inputs result in higher cost of production and
vice-versa but the impact of price of a given factor would depend upon the
contribution which that factor of production makes to the total product.
Efficiency of factors of production and the management - Higher productivity
and efficiency of factors of production would lead to lower production costs and
vice-versa
Stability of output - Stability in production would lead to optimum utilization of
the existing capacity of plants and machinery.
Law of returns -An important determinant of cost is the law of returns
operating .Increasing returns would reduce cost of production and diminishing
returns increase cost.
Time period- In the short run, cost will be relatively high and in the long run, it
will be low as it is possible to make all kinds of adjustments and readjustments in
production process.
COST FUNCTION
Cost functions are derived functions. They are derived from the production function which
describes the available efficient methods of production at any given period of time.
 Cost function expresses a functional relationship between total cost and factors that determine it.
Usually, the factors that determine total cost of production (C) of a firm are:-
C= f(O,S,T,P…)
C= Cost, O= Level of output, S= Size of the plant, T= Time, P= prices of factors of production
Cost- output relationship in the short run
Cost Output Relationship in the short run
• Average fixed cost and output- Greater the output, lesser the fixed
cost( fixed cost remains same and do not change with the output)
• Average variable cost and output- AVC will first fall and then rise as
more and more units are produced in a given plant. If we add more
units of variable factors to fixed plant, the efficiency of the input first
increases and then decreases. Further increase in output will increase
the AVC.
• Total Fixed cost and output – TFC at all levels
remains same and parallel to X axis.
• Total Variable cost and Output-There is a rise in
TVC with rise in the output and falls with decrease
in the output
• Total cost and output- As the variable cost
increases, total cost also increases with the increase
in the output
COST REDUCTION
• A cost reduction program is said to be improve the
profitability of an organization by reducing expenses,
• Profits are increased without making others changes.
Techniques of cost reduction

• Target costing
• Activity based costing
• Just in Time
• Kaizen costing
• Business Process Re engineering
• Total Quality Management
• Value chain
• Bench marking
• Management audit
TARGET COSTING
• This approach is to seek the lower costs by designing a quality product
that reduces costs in the production phase.
• It can be described as a systematic process of cost management and
profit planning.
• Designing of the product and process to produce it
Activity Based Costing
• It is a costing model that identifies the cost pools, or activity centers, in an
organization and assigns costs to products and services (cost drivers) based on the
number of events or transactions involved in the process of providing a product or
service.
• To identify and eliminate the non value added activities and cost
Kaizen costing
• Kaizen refers to continuous and gradual improvement
through small activities.
• It is a process of cost reduction during the manufacturing
phase of an existing product.
Business Process Re- engineering

• It is a complete re design of process on simplification, cost reduction,

improved quality and customer satisfaction
• Updating technology. ...
• Reducing staff. ...
• Improving output. ...
• Cutting costs. ...
• Streamlining processes. ...
• Increasing product quality. ...
• Creating cross-functional teams.
TQM
• All business functions are involved in a process of continuous quality
improvement.
Value Chain
• Value chain analysis is a means of achieving higher customer satisfaction and
managing cost more effectively.
• Set of value creation activities from basic raw material sources, suppliers, to the
ultimate end use product or service delivered to the customer.
Bench marking
• It is a continual search for the most effective method of
accomplishing task by comparing the existing methods and
performance levels with those of other organizations or sub
units within the organization.
Management Audit
• Helps the management to do better job by identifying waste and
inefficiency and recommending a corrective action.
COST CONTROL
• Cost control by management means a search for better and more
economical ways of com­pleting each operation.
• Cost control is simply the prevention of waste within the existing
environment.
• Cost control involves setting standards.
• The firm is expected to adhere to the standards.
• Deviations of actual performance from the standards are analyzed and
reported and corrective actions are taken.
TECHNIQUES OF COST CONTROL
• 1. Planning the budget properly
One method of cost control that most businesses use when starting a
new project is budget management. Setting aside enough time to
develop an accurate budget for new projects is important because
budgeting helps estimate costs.
• 2. Monitoring all expenses using checkpoints
Monitoring all expenses related to a project is a common cost control
method that businesses use to ensure the budget is being followed
correctly.
• 3. Using change control systems
Change control systems are cost control methods that account for any
• 4. Having time management
Time management is a cost control method that can keep the expenses
of a project down by meeting project deadlines.
• 5. Tracking earned value
Using earned value is a cost control method popular among
accountants. It involves multiplying the percentage of work completed
on a project by the budget at the time of the project completion.
Earned value helps professionals predict the financial outcome of a
project depending on the time to complete the project, the total
expense of the project and the overall cost of the project.
REVENUE ANALYSIS
REVENUE
• The revenue of a firm is its sale receipts or money receipts from the sale of a product.
• If a firm sold 100 units for Rs 10 each, then its revenue is Rs 1000/. Therefore total revenue is
Price X Quantity (P x Q).
• If a firm realizes total revenue of Rs 5000 by the sale of 50 units. It implies that Average Revenue
is Rs 100 (5000/50) . The firm has sold the commodity at a price of 100/unit.
• Average revenue is price of one unit of output. Therefore Average revenue can be expressed as :
AR= TR/ Q
AR= P X Q/ Q
AR=P
• If seller collects Rs 2000 by selling 200 units but after selling 201 units, its revenue become Rs
2200, then we can say that its Marginal Revenue is Rs 200.
• MR= Rate of change in total revenue /change in quantity.
Importance of revenue
o It serves as a key performance indicator
o Meeting the expectations of the shareholders
o Building reserves
o Enhances the growth rate
o Build market share
RELATIONSHIP BETWEEN TOTAL,
MARGINAL AND AVERAGE REVENUE
PRICE QUANTITY TR AR MR
20 1 20 20
19 2 38 19 18
18 3 54 18 16
17 4 68 17 14
16 5 80 16 12
15 6 90 15 10
14 7 98 14 8
13 8 104 13 6
12 9 108 12 4
11 10 110 11 2
Significance of revenue curves
• Estimation of profit and losses- Producer aims at maximizing his profit. His
profit will be maximum where he finds AR> AC. Maximum difference between
AR and AC will be the maximum profit.
• Equilibrium- Importance of AR and MR curve is to know how much a producer
should produce. The firm will be in Equilibrium at the point where MR = MC.
• Capacity utilization- through revenue curves, we come to know whether a firm
is producing at its full capacity or not. If AR curve is tangent to AC curve at it’s
minimum point, the firm is said to be functioning at maximum capacity.
• Price changes- The concepts of AR and MR are also useful to the factor services
in determining their price. In factor pricing like rent, wages, interest and profits,
they become inverted U-shaped.
PRODUCER’S EQUILIBRIUM
• A Situation under which a producer gets maximum production from the given
level of factors of production.
• It is that situation in which producer gets maximum profit at minimum cost of
production.
RELATION BETWEEN COST AND
REVNUE CURVES
• Every producer tries to maximize his level of production with a given level of factors of
production
• Every producer has limited resources at a given point of time.
• Producer’s equilibrium is derived at a point where maximum production is achieved at a given
level of money or resources.
Concept of profit has 3 aspects
1. Extra normal profit : TR>TC or AR> AC
2. Normal profit : TR= TC or AR=AC
3. Extra normal losses : TR < TC or AR<AC
Approaches of determining producers
equilibrium
• Total Revenue- Total cost Approach
• Marginal Revenue- Marginal Cost Approach
Total Revenue- Total Cost Approach
Under this approach, a producer’s equilibrium is achieved at that level of output
where
• The difference between TR and TC maximum.
• Profit falls if one or more less unit of output is produced.
Marginal revenue-Marginal cost approach
According to this approach, producer’s equilibrium refers to stage of that output
level at which :-
MC=MR, As long as if MC is less than MR, it is profitable for the producer to go
on producing more, because it adds to its profit.
He stops producing more only, when MC becomes equal to MR.
If MC >MR after MC= MR output level, it means producing more will leads to
decline in profit.