Unit 3:- Cost and Revenue Profit Functions

Sl No Contents Page
3.1 Cost Concepts, Fixed and variable costs
3.2 Total Cost, Average Cost, Marginal Cost, Opportunity Cost
3.3 Short-run and Long-run Cost Curves
3.4 Determinants of Short term profits
3.5 Determinants Long Term Profits, Measurement of Profit.
3.6 Break Even Analysis- Meaning, Assumptions, Determination of
BEA, Limitations and Uses of BEA in Managerial Economics
(Problems on BEP only)
 Unit 3: Cost and Revenue Profit Functions
Prepared By: - Dr Virupaksha Goud

Understand the meaning , importance and the determinants of various cost concepts

Meaning of cost of production.

Cost of production refers to the total money expenses (Both explicit and implicit) incurred
by the producer in the process of transforming inputs into outputs. In short, it refers total
money expenses incurred to produce a particular quantity of output by the producer. The
knowledge of various concepts of costs, cost-output relationship etc. occupies a prominent place
in cost analysis.

Managerial Uses of Cost Analysis

A detailed study of cost analysis is very useful for managerial decisions. It helps the management
–
1. To find the most profitable rate of operation of the firm.
2. To determine the optimum quantity of output to be produced and supplied.
3. To determine in advance the cost of business operations.
4. To locate weak points in production management to minimize costs.
5. To fix the price of the product.
6. To decide what sales channel to use.
7. To have a clear understanding of alternative plans and the right costs involved in them.
8. To have clarity about the various cost concepts.
9. To decide and determine the very existence of a firm in the production field.
10. To regulate the number of firms engaged in production.
11. To decide about the method of cost estimation or calculations.
12. To find out decision making costs by re-classifications of elements, reprising of input factors
etc, so as to fit the relevant costs into management planning, choice etc.

Different Kinds of Cost Concepts.

1. Money Cost and Real Cost

When cost is expressed in terms of money, it is called as money cost It relates to money outlays
by a firm on various factor inputs to produce a commodity. When cost is expressed in terms of
physical or mental efforts put in by a person in the making of a product, it is called as real cost.

2. Implicit or Imputed Costs and Explicit Costs

Explicit costs are those costs which are in the nature of contractual payments and are paid by an
entrepreneur to the factors of production [excluding himself] in the form of rent, wages, interest
and profits, utility expenses, and payments for raw materials etc.
3. Actual costs and Opportunity Costs

They are the actual expenses incurred for producing or acquiring a commodity or service by a
firm. Opportunity cost of a good or service is measured in terms of revenue which could have
been earned by employing that good or service in some other alternative uses.

4. Direct costs and indirect costs

Direct costs are those costs which can be specifically attributed to a particular product, a
department, or a process of production.

5. Past and future costs.

Past costs are those costs which are spent in the previous periods. On the other hand, future costs
are those which are to be spent. in the future. Past helps in taking decisions for future.

6. Marginal and Incremental costs

Marginal cost refers to the cost incurred on the production of another or one more unit .It
implies additional cost incurred to produce an additional unit of output It has nothing to do
with fixed cost and is always associated with variable cost.

7. Fixed costs and variable costs.

Fixed costs are those costs which do not vary with either expansion or contraction in
output. They remain constant irrespective of the level of output. They are positive even if
there is no production. They are also called as supplementary or overhead costs.

On the other hand, variable costs are those costs which directly and proportionately increase
or decrease with the level of output produced. They are also called as prime costs or direct
costs.

8. Accounting costs and economic costs.

Accounting costs are those costs which are already incurred on the production of a
particular commodity. It includes only the acquisition costs. They are the actual costs involved
in the making of a commodity. On the other hand, economic costs are those costs that are to be
incurred by an entrepreneur on various alternative programs. It involves the application of
opportunity costs in decision making.
Determinants Of Costs

1. Technology

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. On the other hand, primitive
technology would lead to higher production costs.

2. Rate of output: (the degree of utilization of the plant and machinery)

Complete and effective utilization of all kinds of plants and equipment’s would reduce
production costs and underutilization of existing plants and equipment’s would lead to higher
production costs.

3. Size of Plant and scale of production

Generally speaking big companies with huge plants and machineries organize production on
large scale basis and enjoy the economies of scale which reduce the cost per unit.

4. Prices of input factors

Higher market prices of various factor inputs result in higher cost of production and vice-versa.

5. 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.

6. Stability of output

Stability in production would lead to optimum utilization of the existing capacity of plants and
equipment’s. It also brings savings of various kinds of hidden costs of interruption and learning
leading to higher output and reduction in production costs.

7. Law of returns

Increasing returns would reduce cost of production and diminishing returns increase cost.

8. 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.

Thus, many factors influence cost of production of a firm.

Learn short – run and long – run cost functions

Cost and output are correlated. Cost output relations play an important role in almost all business
decisions. It throws light on cost minimization or profit maximization and optimization of
output. The relation between the cost and output is technically described as the “COST
FUNCTION”. The significance of cost-output relationship is so great that in economic analysis
the cost function usually refers to the relationship between cost and rate of output alone and we
assume that all other independent variables are kept constant. Mathematically speaking TC = f
(Q) where TC = Total cost and Q stands for output produced.

Types of cost function.

Generally speaking there are two types of cost functions.

1. Short run cost function.

2. Long run cost function.

MEANING OF SHORT RUN

Short-run is a period of time in which only the variable factors can be varied while fixed factors
like plant, machinery etc remains constant.

1. Fixed costs

These costs are incurred on fixed factors like land, buildings, equipment’s, plants, superior type
of labor, top management etc.
Fixed costs in the short run remain constant because the firm does not change the size of plant
and the amount of fixed factors employed. Fixed costs do not vary with either expansion or
contraction in output.

2. Variable costs

The cost corresponding to variable factors are discussed as variable costs. These costs are
incurred on raw materials, ordinary labor, transport, power, fuel, water etc, which directly vary in
the short run.

Cost-output relationship and nature and behavior of cost curves in the short run

In order to study the relationship between the level of output and corresponding cost of
production, we have to prepare the cost schedule of the firm. A cost-schedule is a statement of
a variation in costs resulting from variations in the levels of output. It shows the response
of cost to changes in output. A hypothetical cost schedule of a firm has been represented in the
following table.
Output in Units TFC TVC TC AFC AVC AC MC
0 360 – 360 – – – –
1 360 180 540 360 180 540 180
2 360 240 600 180 120 300 60
3 360 270 630 120 90 210 30
4 360 315 675 90 78.75 168.75 45
5 360 420 780 72 84 156 105
6 360 630 990 60 105 165 210

On the basis of the above cost schedule, we can analyses the relationship between changes in the
level of output and cost of production. If we represent the relationship between the two in a
geometrical manner, we get different types of cost curves in the short run. In the short run,
generally we study the following kinds of cost concepts and cost curves.

1. Total fixed cost (TFC)

TFC refers to total money expenses incurred on fixed inputs like plant, machinery, tools &
equipments in the short run.

2. Total variable cost (TVC)

TVC refers to total money expenses incurred on the variable factors inputs like raw
materials, power, fuel, water, transport and communication etc, in the short run.

TVC curve slope upwards from left to right. TVC curve rises as output is expanded. When
output is Zero, TVC also will be zero. Hence, the TVC curve starts from the origin.
3. Total cost (TC)

The total cost refers to the aggregate money expenditure incurred by a firm to produce a
given quantity of output. TC = TFC +TVC.

TC varies in the same proportion as TVC. In other words, a variation in TC is the result of
variation in TVC since TFC is always constant in the short run.

The total cost curve is rising upwards from left to right. In our example the TC curve starts form
Rs. 300-00 because even if there is no output, TFC is a positive amount. TC and TVC have same
shape because an increase in output increases them both by the same amount since TFC is
constant. TC curve is derived by adding up vertically the TVC and TFC curves. The vertical
distance between TVC curve and TC curve is equal to TFC and is constant throughout because
TFC is constant.

4. Average fixed cost (AFC)

Average fixed cost is the fixed cost per unit of output. When TFC is divided by total units of
output AFC is obtained, Thus, AFC = TFC/Q
AFC and output have inverse relationship. It is higher at smaller level and lower at the higher
levels of output in a given plant. The reason is simple to understand. Since AFC = TFC/Q, it is a
pure mathematical result that the numerator remaining unchanged, the increasing denominator
causes diminishing product. Hence, TFC spreads over each unit of output with the increase in
output. Consequently, AFC diminishes continuously. This relationship between output and fixed
cost is universal for all types of business concerns.

5. Average variable cost: (AVC)

The average variable cost is variable cost per unit of output. AVC can be computed by
dividing the TVC by total units of output. Thus AVC = TVC/Q. The AVC will come down in
the beginning and then rise as more units of output are produced with a given plant. This is
because as we add more units of variable factors in a fixed plant, the efficiency of the inputs first
increases and then it decreases.

The AVC curve is a U-shaped cost curve.

6. Average total cost (ATC) or Average cost (AC)

Ac refers to cost per unit of output. AC is also known as the unit cost since it is the cost per
unit of output produced. AC is the sum of AFC and AVC. Average total cost or average cost is
obtained by dividing the total cost by total output produced. AC = TC/Q Also AC is the sum of
AFC and AVC.

In the short run AC curve also tends to be U-shaped. The combined influence of AFC and AVC
curves will shape the nature of AC curve.

As we observe, average fixed cost begin to fall with an increase in output while average variable
costs come down and rise. As long as the falling effect of AFC is much more than the rising
effect of AVC, the AC tends to fall. At this stage, increasing returns and economies of scale
operate and complete utilization of resources force the AC to fall.

When the firm produces the optimum output, AC becomes minimum. This is called as least –
cost output level. Again, at the point where the rise in AVC exactly counter balances the fall in
AFC, the balancing effect causes AC to remain constant.

In the third stage when the rise in average variable cost is more than drop in AFC, then the AC
shows a rise, When output is expanded beyond the optimum level of output, diminishing returns
set in and diseconomies of scale starts operating. At this stage, the indivisible factors are used in
wrong proportions. Thus, AC starts rising in the third stage.

The short run AC curve is also called as “Plant curve”. It indicates the optimum utilization of a
given plant or optimum plant capacity.

7. Marginal Cost (MC)

Marginal cost may be defined as the net addition to the total cost as one more unit of
output is produced. In other words, it implies additional cost incurred to produce an
additional unit. For example, if it costs Rs. 100 to produce 50 units of a commodity and Rs. 105
to produce 51 units, then MC would be Rs. 5. It is obtained by calculating the change in total
costs as a result of a change in the total output. Also MC is the rate at which total cost changes

with output. Hence,

It is necessary to note that MC is independent of TFC and it is directly related to TVC as we

calculate the cost of producing only one unit. In the short run, the MC curve also tends to be U-
shaped.

The shape of the MC curve is determined by the laws of returns. If MC is falling, production will
be under the conditions of increasing returns and if MC is rising, production will be subject of
diminishing returns.

The table indicates the relationship between AC & MC

Difference in Rs.
Output in Units TC in Rs. AC in Rs.
MC
1 150 150 –
2 190 95 40
3 220 73.3 30
4 236 59 16
5 270 54 34
6 324 54 54
7 415 59.3 91
8 580 72.2 165
Relation between AC and MC

From the diagram it is clear that:

Both MC and AC fall at a certain range of output and rise afterwards.

1. When AC falls, MC also falls but at certain range of output MC tends to rise even though
AC continues to fall. However, MC would be less than AC. This is because MC is
attributed to a single unit where as in case of AC, the decreasing AC is distributed over
all the units of output produced.
2. So long as AC is falling, MC is less than AC. Hence, MC curve lies below AC curve. It
indicates that fall in MC is more than the fall in AC. MC reaches its minimum point
before AC reaches its minimum.
3. When AC is rising, after the point of intersection, MC will be greater than AC. This is
because in case of MC, the increasing MC is attributed to a single unit, where as in case
of AC, the increasing AC is distributed over all the output produced.
4. So long as the AC is rising, MC is greater and AC. Hence, AC curve lies to the left side
of the MC curve. It indicates that rise in MC is more than the rise in AC.
5. MC curve cuts the AC curve at the minimum point of the AC curve. This is because,
when MC decreases, it pulls AC down and when MC increases, it pushes AC up. When
AC is at its minimum, it is neither being pulled down nor being pushed up by the MC.
Thus, When AC is minimum, MC = AC. The point of intersection indicates the least cost
combination point or the optimum position of the firm. At output Q the firm is working at
its “Optimum Capacity” with lowest AC. beyond Q, there is scope for “Maximum
Capacity” with rising cost.
Cost Output Relationship In The Long Run

Long run is defined as a period of time where adjustments to changed conditions are
complete. It is actually a period during which the quantities of all factors, variable as well as
fixed factors can be adjusted. Hence, there are no fixed costs in the long run. In the short run, a
firm has to carry on its production within the existing plant capacity, but in the long run it is not
tied up to a particular plant capacity. As all costs are variable in the long run, the total of these
costs is total cost of production. Hence, the distinction between fixed and variables costs in
the total cost of production will disappear in the long run. In the long run only the average
total cost is important and considered in taking long term output decisions.

Long run average cost is the long run total cost divided by the level of output. In brief, it is the
per unit cost of production of different levels of output by changing the size of the plant or scale
of production.

The long run cost – output relationship is explained by drawing a long run cost curve through
short – run curves as the long period is made up of many short – periods as the day is made up of
24 hours and a week is made out of 7 days. This curve explains how costs will change when the
scale of production is varied.

Production cost difference in the short run and long run

Important features of long run AC curves

1. Tangent curve

Different SAC curves represent different operational capacities of different plants in the short
run. LAC curve is locus of all these points of tangency. The SAC curve can never cut a LAC
curve though they are tangential to each other. This implies that for any given level of output, no
SAC curve can ever be below the LAC curve. Hence, SAC cannot be lower than the LAC in the
long run. Thus, LAC curve is tangential to various SAC curves.

2. Envelope curve

It is known as Envelope curve because it envelopes a group of SAC curves appropriate to

different levels of output.

3. Flatter U-shaped or dish-shaped curve.

The LAC curve is also U shaped or dish shaped cost curve. But It is less pronounced and much
flatter in nature. LAC gradually falls and rises due to economies and diseconomies of scale.

4. Planning curve.

The LAC cure is described as the Planning Curve of the firm because it represents the least cost
of producing each possible level of output. This helps in producing optimum level of output at
the minimum LAC. This is possible when the entrepreneur is selecting the optimum scale plant.
Optimum scale plant is that size where the minimum point of SAC is tangent to the minimum
point of LAC.

5. Minimum point of LAC curve should be always lower than the minimum point of SAC
curve.

This is because LAC can never be higher than SAC or SAC can never be lower than LAC. The
LAC curve will touch the optimum plant SAC curve at its minimum point.

A rational entrepreneur would select the optimum scale plant. Optimum scale plant is that size at
which SAC is tangent to LAC, such that both the curves have the minimum point of tangency. In
the diagram, OM2 is regarded as the optimum scale of output, as it has the least per unit cost. At
OM2 output LAC = SAC.

LAC curve will be tangent to SAC curves lying to the left of the optimum scale or right side of
the optimum scale. But at these points of tangency, neither LAC is minimum nor is SAC
minimum. SAC curves are either rising or falling indicating a higher cost
Summary

In this unit-5 we have discussed about the meaning of production, production function and its
managerial uses. Production in economics implies transformation of inputs into outputs for our
final consumption. Production function explains the quantitative relationship between the
amounts of inputs used to.. get a particular physical quantity of outputs. The ratios between the
two quantities are of great importance to a producer to take his decisions in the production
process. There are two kinds of production functions – short run and long run. In case of short
run production function we come across a change in either one or two variable factor inputs
while all other inputs are kept constant. The law of variable proportion explain how there will be
variations in the quantity of output when there is change in only one variable factor inputs while
all other inputs are kept constant. On the other hand Iso-Quants and Iso-cost curves explain how
there will be changes in output when only two variable inputs are changed while all other inputs
are kept constant. Under long run production function, the laws of returns to scale explain
changes in output when all inputs, both variable as well as fixed changes in the same proportion.
Economies of scale give information about the various benefits that a firm will get when it goes
for large scale production. Economies of scope on the other hand tells us how there will be
certain specific advantages when one firm produces more than two products jointly than two or
three firms produce them separately. Diseconomies of scale and diseconomies of scope tells us
that there are certain limitations to expansion in output Cost analysis on the other hand, indicates
the various amounts of costs incurred to produce a particular quantity of output in monetary
terms. The various kinds of cost concepts help a manager to take right decisions. Cost function
explains the relationship between the amounts of costs to be incurred to produce a particular
quantity of output. Short run cost function gives information about the nature and behavior of
various cost curves. Long run cost function tells us how it is possible to obtain more output at
lower costs in the long run. Thus, the knowledge of both production function and cost functions
help a business executive to work out the best possible factor combinations to maximize output
with minimum costs.
DETERMINANTS OF SHORT-TERM & LONG TERM PROFITS
SIGNIFICANCE
Profits are the difference between revenues and costs. In a trade transaction, profit is the difference between the
price at which you sell a good and the price at which you bought it. Running a business, net profit is what is left out
of turn-over after paying suppliers, workers, financing institution, and the state. In insurance companies, it's the
difference between the sums of the premiums collected and the total claims resulting from insured negative shocks.
Distributed profits are the income source of the owners of business. As a social group, they are called "owners" or
"capitalists". The part of the value added not distributed as wages, interests, and taxes, remain within the firm to
finance investments.

DETERMINANTS
Maximizing profits is said to be the objective of all firms. Indeed, it's not always easy for the management to find
out which are the right decisions that would maximize them. For instance, short-run profits can be easily pumped
up by avoiding maintenance, discretionary costs, investments, that however are necessary of on-going
competitiveness, as you can experiment with this free business game.

Proceeding with other determinants of profits, rising prices of competitors, better sales conditions and skills,
rate of growth of the economy, market structures, demand situation, expenditure on promotional efforts,
process innovation, product innovation and a higher overall price level allow for higher prices of the
considered firm's products, thus increase nominal profits to the extent that costs are inelastic, i.e. they rise
less than proportionally to revenues.

Cost structure and its general elasticity to production level is thus relevant to profits. Economies of scale increase
profits more than proportionally when sales grow. Conversely, a recession with falling sales levels will hit
profits particularly hard in industries where there are economies of scales and high fixed costs.

High trade profits can prompt other people to entry the market and begin to compete with current traders. In
manufacture, this effect, although still present, crucially depends on the easy of imitation of product features and
production processes. It's often difficult to enter into highly profitable markets.

PROFITS FROM PROCESS INNOVATION

Consider the case of a competitive market where many firms sell basically the same product at the same price. If
they had the same technology and faced the same input prices (e.g. wages), they would enjoy similar profit levels.
Let's assume that one specialized supplier introduce a new machine that is better than the state-of-art, say a faster
machine. The suppler sells it to one of the firms on the market. This will result in lower costs per unit of output,
thus higher profits. These profits are used, retrospectively, to pay for the investment in the new machine but after
the pay-back period they can be distributed to firm's owners.

In a certain point on time, firms that did not adopt the new machine will see their profits seriously hit by
competition and will have to choose whether to exit the market, to adopt, or to find other competitive advantages.
Pressure to reduce wages in failing firms can be an example of this short-term defensive strategy.
PROFITS FROM PRODUCT INNOVATION

Consider a market with product differentiation, as this. An R&D investment over the years leads to an
improvement of one product features and the management decides to substitute this new model to the existing one.
Let's imagine for simplicity's sake that costs of product are the same as the previous version.

Three main effects will increase sales:

1. consumers who did not buy the good because it did not satisfied their minimum requirements on this feature can
now buy, to the extend the improvement is sufficient at their eyes;

2. Consumers who decides by a "top-quality" rule and positively value the feature could switch from their current
provider, to the extend the overall quality of the new good becomes superior;

3. Consumers who decides by a "value-for-money" rule could switch from their current provider, to the extend the
price / quality relationships of the new good becomes more convenient.

At the same time, the price of this new version could be set higher than before, so that sales would be broken, unit
profits boosted. Overall profits would soar.

Impact on other variables

Taxation from profits and capital gains soars to give more funds to the State for spending and balancing the budget.
However, the rich and the very rich employ a vast array of sophisticated techniques to exploit any loophole in the
tax code to minimize their burden. In certain countries, their interests are so protected by lobbies and political
parties that the same tax code is written to open such loopholes.

Taxes on capital gains and profits can be lower than on labor; since the rich have a disproportionally high share of
income coming from the former; the effect is a violation of "vertical equity" which requires that taxation be related
to contribution capability.

LONG-TERM TRENDS

There is no long-term trend in profitability. Absolute profits rise with GDP. The share of profits on value added
depends on social group’s compromises and conflicts. A certain tendency to a rise of this share can be noticed in
Western countries, without being an automatically consequence of development or technology.

BEHAVIOUR DURING THE BUSINESS CYCLE

Profits are extremely pro-cyclical. At the early stages of recovery, inventories go down, with sales surpassing
production and injecting new liquidity to the business. The following increase in production is obtained by a higher
production utilization of plants and employment. Productivity steeply rises and profits as well.

During recovery and boom, employment and capital accumulation (investments) can go hand in hand, increasing
absolute profits if not profitability.
At the end of the boom phase, high interest rates on loans (taken for funding investment and discretionary costs)
hurt profits, as well as higher wages can do.

Often unexpected, the demand downturn make inventories piling up, freezing resources and forcing a fall in
production. Before this adjustment takes place, profits plunge even into negative values.

The Measurement of Profit

Accounting standards are set out to ease the measurement and reporting of profit. When
measuring profit, income and expenses arising from the business’ activities are directly
connected. Profit is calculated by subtracting total costs from total revenue.

Total Profit = Total Revenue – Total Costs

When the value of profit is 0, the business is said to be at a break-even point; which corresponds
to the situation where total costs – variable and fixed – perfectly match total revenue. The break-
even point is often used by business owners to analyses at which point the business could
become profitable considering the differences between fixed and variable costs.

1. Economic Profit vs. Accounting Profit

There are two ways to calculate the performance of a company’s financial assets: the accounting
profit measurement or the economic one.

Accounting profit: It must include the monetary excess of a business by subtracting total
expenses from total income; considering realized or actual financial gains and losses.

Accounting expenses include the assets spent by the business and any provision for losses or
depreciation over a particular period of time.

Accounting profit = Total income – Total expenses

The accounting profit takes into consideration:

– Leased assets – generally an equipment, vehicle or software. The lessee will be able to use that
asset for a specified period of time and will have to pay a rent to the lessor;

– Allowances – often separated into a distinct account, it takes into account the amount of losses
due to price reduction. In fact, when there is a problem of quality, delay or interruption, the seller
lowers its price. The amount lost for the seller is computed in this section;

– Non-cash adjustments – A cost which does not necessitate cash but which will lower earnings.
For instance, if a company realizes after acquiring it, that the true value of another company’s
goodwill is lower, it will take a non–cash charge amounting the value of the difference between
the evaluated and actual goodwill value of the company acquired. This in turn will negatively
affect the company’s earnings.

– Provisions – legal clause that could be included in a contract protecting one or several parties
in the event of a particular situation. It could also prevent a party –or several – from performing a
specified thing in a specified time.

– Transaction for depreciation – related to the lost in value of plant and equipment. –

And development costs – total expenses related to the developing of the business’ operations;
they include categories such as research & development, plant and equipment, wages and many
others, depending on the project’s size and complexity.

Economic profit: Unlike accounting profit, economic profit takes into consideration implicit
costs including potential value of goods and/or services. Also called opportunity costs and
explicit costs, they are monetary amounts directly paid, easily identified and quantified.

Implicit costs include:

– Use of the firm’ own building: Being the owner of the business’ building properties is an
implicit cost because rent is a tax deductible expense.

– Use of its own capital: Spending its own capital instead of borrowing from financial
institutions may be viewed as a loss accounted as an opportunity cost.

– Use of the business owner’s time for the production of goods and services: Investing time and
money into the company’s maintenance rather than working on the production processes and
expansions can be considered as an implicit cost.

Explicit costs include:

– Wages: fixed and consistent payment for work or services;

– Materials: input necessary to create economic value;

– Rent: payment for the use of another entity’s property;

– Other expenses such as energy costs.

Economic Profit = Total Revenue – Total Costs both Explicit and Implicit
 BREAK-EVEN ANALYSIS & PROFIT PLANNING

A fundamental of accounting is that all revenues and costs must be accounted for and the
difference between the revenues and costs is the profit, or loss, of the business. Costs can be
classified as either a fixed cost or a variable cost. A fixed cost is one that is independent of the
level of sales; rather, it is related to the passage of time. Examples of fixed costs include rent,
salaries and insurance. A variable cost is one that is directly related to the level of sales, such as
cost of goods sold and commissions. The revenue curve related to unit sales, as well as the fixed
costs and variable costs of production are generally depicted graphically in the following
manner:

Total
R Costs
s
Revenues

Variable
Costs

Fixed Costs

Q* Units

The revenues increase at a decreasing rate since, as you observe in market economics, the
only way to gain more sales from competitors is to lower your price. The variable cost curve
reflects both increasing and decreasing returns to scale. The objective of production efforts is to
operate at that level that maximizes the profits, indicated on the graph as Q* units.

For our purposes, we will assume that the revenues and costs are linear, at least within the
relevant range. The relevant range is that range of output where we can reasonably anticipate
operating, at least in the short-run. For instance, the lower end of the relevant range may be
certain contracts that the company has, while the upper end may be defined by plant capacity.
These relationships can be expressed as

Revenues = Fixed Costs + Variable Costs + Profit

or

P*Q = FC + V*Q + 

#: The number of participants needed to break-even

F: Fixed costs

V: Variable costs per person

R: Per-person revenue (price)

In general, when a person pays for something, the price they pay (R) covers certain variable costs
(V) associated directly with their participation and the remainder (R-V) contributes to the fixed
costs (F) of the event. Therefore, the number of people needed to break-even financially is
determined by dividing the fixed costs (F) by the contribution (R-V) made by each person
towards those fixed costs.

BEP = F__
(R – V)

An example to illustrate common errors

If we are pricing an event with fixed costs of Rs1,000 and variable costs associated with each
person of Rs 15, we can determine the number of participants needed to break-even when the
ticket price is Rs 40 as follows:

BEP = F/(R-V) = 1000/(40-15) = 1000/25 = 40 participants

Starting a Business

Suppose you intend to open a franchise business to supply a nationally-known line of women’s
shoes, Al Bundy’s Bunion-Frees for Women. You’ve found a good location in a strip mall to
open your shop, and have determined that the average prices and costs of operating the store are

Price = Rs 50 per pair

Cost = Rs 30 per pair
Rent = Rs 2,500 per month
Insurance = Rs 500 per month
Utilities & Telephone = Rs 300 per month
 In addition, you plan to hire two salespersons on a commission basis of 10% in order to
provide them with incentive to sell shoes. The fixed costs are Rs 3,300 per month while the
variable costs are Rs 35 per pair (Rs 30 cost plus Rs 5 commission). To determine the breakeven
point, we simply set the profit to zero and solve for Q:

P * Q = FC + V * Q + 

Rs 50Q = Rs 3,300 + Rs 35Q + 0

Rs 15Q = Rs 3,300

Q = 220

Two hundred pairs of shoes must be sold each month in order to yield total revenues of Rs
11,000 to cover the fixed costs of Rs 3,300 and the variable costs of Rs 7,700 (Rs 6,600 for the
shoes and Rs 1,100 in commissions). The breakeven point can be written as

FC
Breakeven Point  Q 
P-V

The denominator, P-V, is referred to as the contribution margin; i.e., the amount per sale that is
contributed towards covering the fixed costs (or towards profits after fixed costs is covered).
The breakeven point can be written in dollar terms as well:

FC
Breakeven in Sales  P * Q 
V
1-
P

The denominator of this equation is the same as the gross profit margin.

But we don’t go into business to just break even. Suppose we want to show a before-tax
profit of Rs 6,000 per month on our investment in the firm. What do monthly sales have to be in
order to accomplish this?

P * Q = FC + V * Q + 

Rs 50Q = Rs 3,300 + Rs 35Q + Rs 6,000

Rs 15Q = Rs 9,300

Q = 620
The number of pairs of shoes that must be sold to generate a fair profit on the investment has
increased substantially. Total Revenues will now be Rs 31,000 while fixed costs remain Rs
3,300 and variable costs amount to Rs 21,700 (consisting of Rs 18,600 for purchasing the shoes
and Rs 3,100 in commissions). The commission of Rs 3,100 amounts to Rs 1,550 per
salesperson. Suppose we pay a fixed wage rate of Rs 1,200 per month to the two employees
rather than a commission. What happens to the breakeven point now?

FC
BEP 
P-V

5,700

50 - 30

 285 pairs of shoes

The breakeven point has gone up from 220 pairs of shoes to 285 pairs per month that must be
sold. Why? The reason is because we now have higher fixed costs due to the fact that we have
guaranteed a fixed income to our salespeople. How many shoes do we need to sell in order to
make a profit of Rs 6,000 per month if we pay each of our two salespersons Rs 1,200 per month?

Revenue
s
TC-Comm.

TC-Salary

FC-Salary

FC-Comm.
BEP-Comm. BEP-Salary
P * Q = FC + V * Q + 

Rs 50Q = Rs 5,700 + Rs 30Q + Rs 6,000

Rs 10Q = 11,700

Q = 585

The number of pairs of shoes that we need to sell to earn our required profit has now fallen from
620 to only 585 pairs. This effect is referred to as Operating Leverage and has the same effect as
we saw with financial leverage inasmuch as it magnifies profits and losses. Operating leverage
is the substitution of a fixed cost in place of a variable cost. Losses can be bigger at low sales
levels (compare breaking even at 220 shoes when we pay commissions versus being below
breakeven for a salary basis of compensation) because we must make the fixed payments of a
salary no matter what sales we experience. What is the fixed cost that must be paid in the case of
financial leverage? (Interest expense.)

Larger profits can also be realized since, once the fixed costs are covered, more money
per unit of sales is contributed toward profit since our variable costs are lower. Thus, with a
fixed salary compensation scheme, Rs 20 per pair of shoes is going towards higher profit after
we reach Rs 6,000 in profits at a sales level of 585 pairs, whereas the commission basis has not
even reached the level of the minimum Rs 6,000 profit until sales reach 620 pairs. Graphically,

The increase in the variability of the profits (the difference between the revenue line and the total
cost line of each alternative) translates into higher risk for the salaried alternative. This greater
variability can be seen in the following graph:

What are the advantages of Breakeven Analysis?

1) It’s easy
2) Can project profits, materials required, and to some extent the prices that need to be
charges

What are the disadvantages of Breakeven Analysis?

1) Only one product is considered here
2) Allocating overhead costs by product line can be difficult
3) It’s only useful in the short-term. In the long-term, cost/revenue relationships change.

Longer term considerations will be considered when we look at capital budgeting.

Questions for Previous Question Papers

1. List out the three uses of Break-even Analysis? (3 M) (June 2015)

2. What is Opportunity Cost? Explain with one example. ?(3 M) (Dec. 2014)

3. What is meant by Break even analysis? What are its limitations? (5 M) (Dec. 2014)

4. Define Total , Average and marginal Cost?(3 M) (Dec. 2014)

5. Explain Total, Average and marginal Cost in short run with an example. (7M) (Dec.2014)