COST AND REVENUE CONCEPTS

TYPES OF COSTS
 TYPES OF COSTS

• Fixed and Variable Costs –

• Average, Marginal and Total Costs –
• Short run and Long run Costs curves–
• Total, Average and Marginal Revenues
functions and curves.
• Break-even point and
• Efficiency of production and optimal
solutions,
• Profit and sales maximization
 FIXED AND VARIABLE COSTS
 Cost is something that can be classified in several
ways, depending on its nature.
 One of the most popular methods is classification
according to fixed costs and variable costs.
 Fixed costs do not change with increases/decreases
in units of production volume, while variable costs
fluctuate with the volume of units of production.
 Fixed and variable costs are key terms in managerial
accounting, used in various forms of
analysis of financial statements.
 FIXED AND VARIABLE COSTS
• The first illustration below shows an
example of variable costs, where costs
increase directly with the number of
units produced.

• In the second illustration, costs are fixed

and do not change with the number of
units produced.
 FIXED AND VARIABLE COSTS
• Graphically, we can see that fixed costs
are not related to the volume of
automobiles produced by the company.
No matter how high or low sales are,
fixed costs remain the same.
• On the other hand, variable costs show
a linear relationship between the
volume produced and total variable
costs.
 Variable Cost Fixed Cost
Definition Costs that vary/change Costs that do not
depending on the change in relation to
company’s production production volume
volume

When Production Total variable costs Total fixed cost stays

Increases increase the same
When Production Total variable costs Total fixed cost stays
Decreases decrease the same
Examples Direct Materials (i.e. Rent
kilograms of wood,
tons of cement)

Direct Labor (i.e. labor Advertising

hours)
Insurance
Depreciation
 Average, Marginal and Total Costs
AVERAGE COST
• The average cost is the sum of the total
cost of goods divided by the total
number of goods.
• The average cost is also known as Unit
cost. The below formula can calculate
the average cost.
Average Cost =
Total Cost / Number of units produced
 Average, Marginal and Total Costs

• It is directly proportional to the total cost

of goods and inversely proportional to the
number of goods, so average cost
decreases when the number of goods
increases.
• It has two components: Variable cost and
Fixed cost.
• The average cost aims to assess the impact
on total unit cost with the change in
 Average, Marginal and Total Costs
MARGINAL COST
• Marginal cost increases the cost of producing one
more unit or additional unit of product or service.
Marginal cost changes in the total cost of
production upon the change in output that changes
the quantity of production. Variable cost is an
important factor in determining the output.
• In short, marginal cost changes the total cost that
arises when the quantity produced changes by one
unit. The marginal cost function is expressed as a
derivative of the total cost concerning quantity.
 Average, Marginal and Total Costs
• It may change with volume, so at each production
level, the marginal cost is the cost of the next unit
produced.
• Marginal cost is equal to the change in total cost
divided by the change in quantity and can be
expressed as below:-
Marginal Cost =
Change in Total Cost / Change in Quantity
 Average, Marginal and Total Costs
• Where,
• Change in Total Cost is the difference in the total
cost of production, including additional units, and
the total cost of production of the normal unit.
• Change in Total Cost = Total Cost of Production
including additional unit – Total Cost of Production
of a normal unit
• Change in quantity is the difference of total
quantity product, including additional units and
total quantity product of normal units.
 Average, Marginal and Total Costs
• Change in quantity = Total quantity product
including additional unit – Total quantity product of
normal unit
• It can be said as the extra expense of producing one
additional unit.
• It helps management to make the best decision for
the company and utilize its resources in a better
and more profitable way, as with quantity, profit
increases if the price is higher than the marginal
cost.
 Average Cost vs. Marginal Cost
Basis – Average
Cost vs. Marginal Average Cost Marginal Cost
Cost

It increases the cost of

producing one more unit or
additional unit of product or
It is the sum of the total
service. Marginal cost changes in
Definition cost of goods divided by the
the total cost of production
total number of goods.
upon a change in output that
changes in the quantity of
production;

The average cost aims to The marginal cost aims to find

Aim assess the impact on total whether it is beneficial to
unit cost with a change in produce an additional unit of
output level. goods.

Average cost = Total cost / Marginal cost = Change in total

Formula
Number of goods cost / Change in quantity.
 Average Cost vs. Marginal Cost

It curves concave when returns

Shape It curves in starting fall due to increase and then move linearly
of declining fixed cost but then and smoothly with the constant
Curve rises due to an increase in return and finally change in
average variable costs. convex when marginal cost
shows increased return.

Best When the objective is to When the objective is profit

Criteria minimize cost; maximization;

Compo It has two components It is a single unit and does not

nent average fixed cost and have any components.
average variable cost.
 Average Cost vs. Marginal Cost
• The average cost vs. marginal cost is used for
better decision-making by efficiently using
resources and identifying and practicing optimum
production levels.
• The average cost is the sum of the total cost of
goods divided by the total number of goods.
• Marginal cost can be said as the extra expense of
producing one additional unit.
• It helps management make the best decision for
the company and utilize its resources better and
more profitable as quantity profit increases if the
 SHORT RUN AND LONG RUN COSTS CURVES
The Shape of Cost Curves
• The shape of cost curves depends on the type of
cost a company might face.
• The labor and capital a company employ determine
how much it costs to produce its product.
• Nevertheless, the shape of the cost curves is
relatively the same.
 SHORT RUN AND LONG RUN COSTS CURVES

• When analyzing the shape of the curve

displaying the entire cost of production.
• It is helpful for a company to begin by
dividing the total costs into two categories:
• fixed costs, which are expenses that
cannot be altered in the short run, and
variable costs, which are costs that may be
controlled.
• The shape of fixed costs is a straight line.
 SHORT RUN AND LONG RUN COSTS CURVES
• In contrast, the shape of the variable costs of a
company is U-shape.
• When the firm faces a U-shape cost curve, the cost
of production initially decreases until it reaches a
point where it begins to increase.

Below we discuss the shape of each cost curve in

great detail.
 TOTAL COST CURVES

Total cost curves represent the

aggregate of all the expenses a company
faces when producing a certain quantity
of product.
The formula for total cost is as follows:
TC=FC+VC
 TOTAL COST CURVES
 Fixed costs include costs such as the costs of a
building lease and machinery used during the
production process. Within reason, fixed costs do
not change as if output increases or decreases.
 In other words, regardless of the company's
production level, the company will still face fixed
costs.
 Variable costs include costs such as the cost of
labor and raw materials. These costs do change
with the level of output.
TOTAL COST CURVES
 TOTAL COST CURVES
• Figure 1 illustrates the total cost curve. Notice that
in the diagram in Figure 1, there are also fixed and
variable costs.
• That's because the total cost curve consists of
these two main curves.
 TOTAL COST CURVES
• Notice also that the fixed cost is a horizontal
line, and that's because fixed costs remain the
same regardless of the amount of output that
is generated.
• Initially, the slope of the total cost is flatter.
That's because a company's total cost
increases at a decreasing rate. As employees
can specialize in their tasks and become more
efficient, producing certain goods is initially
cheaper.
 TOTAL COST CURVES
• After some point, the slope of the
total cost curve becomes steeper, meaning
that a company's production cost increases.
• That's because the company faces
diminishing marginal returns.
• Meaning that additional workers or capital
employed in the production process is
becoming less efficient, leading to an
increase in the total cost that a company
faces.
 SHORT RUN COST CURVES
• Short-run cost curves refer to curves that
represent the amount of cost a firm faces
during the short run.
• Short run is characterized by having the
amount of one of the factors of
production function kept constant.
• In contrast, the number of other factors
may change.
 SHORT RUN COST CURVES
• As a result, a company may raise its overall
productivity by growing its capital or labor.
• This is where the difference between short-run and
long-run cost curves lies.
• There is no such thing as a fixed element in terms of
costs over the long run.
• Over a longer time, factors such as contractual
wages, the overall price level, and other pricing
aspects are adjusted in response to the status of the
economy. In the near term, adjusting some of the
fixed production factors is impossible.
SHORT RUN COST CURVES
 SHORT RUN COST CURVES

• The above figure shows the short-run cost

curves that a company faces.
• In the short run, the costs that are considered
for a company include marginal cost (MC),
average total cost (ATC), average fixed
cost(AFC), and average variable cost (ATC).
• As the AFC of a company decreases with the
increase in production, that is that more output
level covers the fixed cost, yet the ATC curve still
increases. When the AVC begins to increase, it
also causes the ATC curve to increase.
 SHORT RUN COST CURVES

• Point A is the point where marginal cost

and average variable cost intersect.
• Point A is the lowest possible level of the
average variable cost.
• This is the inflection point where output
lower than this experiences decreasing
marginal costs, and output greater will
be subject to increasing marginal costs.
 SHORT RUN COST CURVES
• Point B is the point where marginal cost
intersects the average total cost.
• At this level, the total cost is at its lowest
level.
• At this point, marginal costs are going up at an
increasing rate, while fixed costs are going
down at a decreasing rate.
• This point is the perfect balance of cost
reduction between those two changing costs.
 LONG RUN COST CURVES

 Long-run cost curves show the cost that a company

faces in the long run for producing a certain amount
of output.
 While in the short run, some of the factors of
production are fixed, meaning that the firm isn't
flexible in changing these factors, their cost is also
fixed.
 On the other hand, the cost faced by a company, in
the long run, is entirely variable.
 That's because all factors of production during the
long run are to be variable.
LONG RUN COST CURVES
 LONG RUN COST CURVES
• Figure 3 shows the long-run cost curve. The long-
run cost curve is the long-run average total cost
curve which consists of many short-run average
total costs (ATC).
• The short-run ATC shows a firm's cost when
producing that amount of output in the short run
with a certain combination of variable cost and
fixed cost.
• Over the long run, a firm may produce different
outputs through various combinations of fixed and
variable costs.
 LONG RUN COST CURVES

• This is why the long-run cost curve consists of

many short-run ATC.
• The three different short-run ATC curves
represent the potential large-scale change in
production such as purchasing a larger
factory.
• Notice that the shape LATC curve initially
decreases from point A to point C as the firm's
output increases. On the other hand, the LATC
begins to increase from point C to point B.
 LONG RUN COST CURVES
• That's because of diminishing marginal
returns. As the company adds more inputs to
the production process, these inputs become
less efficient at generating output. At the
same time, the cost that the company faces
increases.
• Point C is the number of output the firm has
to produce to minimize cost over the long
term.
 TOTAL, AVERAGE AND MARGINAL REVENUES
FUNCTIONS AND CURVES
• To understand the meaning of marginal
and average revenue, you have to start
by understanding the meaning of total
revenue.
• The total revenue doesn’t take into
account the cost that the firm incurs
during a production process.
 TOTAL, AVERAGE AND MARGINAL
REVENUES FUNCTIONS AND CURVES
• Instead, it only takes into account the
money coming from selling what the firm
produces.
• As the name suggests, total revenue is
all the money coming into the firm from
selling its products.
• Any additional unit of output sold would
increase the total revenue.
 TOTAL, AVERAGE AND MARGINAL
REVENUES FUNCTIONS AND CURVES
• Average revenue shows how much
revenue there is per unit of output.
• In other words, it calculates how much
revenue a firm receives, on average,
from each unit of product they sell.
• To calculate the average revenue, you
have to take the total revenue and divide
it by the number of output units.
 TOTAL, AVERAGE AND MARGINAL
REVENUES FUNCTIONS AND CURVES
• Marginal revenue refers to the increase in total
revenue from increasing one output unit.
• To calculate the marginal revenue, you have to take
the difference in total revenue and divide it by the
difference in total output.
• Why is the average revenue the firm’s demand
curve?
The average revenue curve is also the firm’s demand
curve. Let's see why.
TOTAL, AVERAGE AND MARGINAL REVENUES
FUNCTIONS AND CURVES
 TOTAL, AVERAGE AND MARGINAL REVENUES FUNCTIONS
AND CURVES
• Total revenue formula
• The total revenue formula helps firms calculate the
amount of the total money that entered the
company during a given sales period. The total
revenue formula equals the amount of output sold
multiplied by the price.
• Total revenue = price *total output sold
 TOTAL, AVERAGE AND MARGINAL
REVENUES FUNCTIONS AND CURVES
Average revenue formula
• We calculate the average revenue, which is the
firm’s revenue per unit of output sold by dividing
the total revenue by the total amount of output.
Average revenue =
Total revenue /total output
 TOTAL, AVERAGE AND MARGINAL
REVENUES FUNCTIONS AND CURVES
Marginal revenue formula
• Marginal revenue, which is the firm’s
additional increase in total revenue from
selling an extra unit of output, is equal to the
difference of total revenues divided by the
difference in total output sold.
Marginal revenue formula=
change in total revenue / change in output
 TOTAL, AVERAGE AND MARGINAL
REVENUES FUNCTIONS AND CURVES
The relationship between marginal and average revenue
• The relationship between marginal revenue and average
revenue can be contrasted between the two opposite
market structures: perfect competition and monopoly.
• In perfect competition, there is a huge number of firms
supplying goods and services that are homogenous.
• As a result, firms can’t influence the market price as even the
slightest increase would lead to no demand for their
product.
• This means that there is perfectly elastic demand for their
product. Due to the perfectly elastic demand, the rate at
which total revenue increases is constant.
 BREAK-EVEN POINT
• The breakeven point (breakeven price) for a trade or
investment is determined by comparing the market price
of an asset to the original cost;
• the breakeven point is reached when the two prices are
equal.
• In corporate accounting, the breakeven point (BEP) formula
is determined by dividing the total fixed costs associated
with production by the revenue per individual unit minus
the variable costs per unit.
• In this case, fixed costs refer to those that do not change
depending upon the number of units sold.
• Put differently, the breakeven point is the production level
at which total revenues for a product equal total expenses.
 BREAK-EVEN POINT
Understanding Breakeven Points (BEPs)
• Breakeven points (BEPs) can be applied to a wide
variety of contexts.
• For instance, the breakeven point in a property
would be how much money the homeowner would
need to generate from a sale to exactly offset the
net purchase price, inclusive of closing costs, taxes,
fees, insurance, and interest paid on the mortgage
—as well as costs related to maintenance and home
improvements.
• At that price, the homeowner would exactly break
even, neither making nor losing any money.
 BREAK-EVEN POINT
• Traders also apply BEPs to trades, figuring
out what price a security must reach to
exactly cover all costs associated with a
trade, including taxes, commissions,
management fees, and so on.
• A company’s breakeven point is likewise
calculated by taking fixed costs and
dividing that figure by the
gross profit margin percentage.
 Benefits of a Breakeven Analysis
• Finding missing expenses. A breakeven analysis
can help uncover expenses that you otherwise
might not have seen coming. Your financial
commitments will be determined at the end of a
breakeven analysis, so there won’t be any
surprises down the line.
• Limiting decisions based on emotions. Making
business decisions based on emotions is rarely a
good idea, but it can be hard to avoid. A
breakeven analysis leaves you with hard facts,
which is a better viewpoint from which to make
 Benefits of a Breakeven Analysis
• Setting goals. You will know exactly what kind of
goals need to be met to make a profit after a
breakeven analysis. This helps you set goals and
work toward them.
• Securing funding. Often, you will need to use a
breakeven analysis to secure funding and show
investors the plan for your business.
• Pricing appropriately. A breakeven analysis will
show you how to properly price your products from
a business standpoint.
 How to Calculate Break Even Point (Step-by-Step)

• For all business owners, particularly

during the earlier stages of a business,
one of the most crucial questions to
answer is: “When will my business break
even?”
• All businesses share the similar goal of
eventually becoming profitable in order
to continue operating.
 How to Calculate Break Even Point (Step-
by-Step)
• An unprofitable business eventually runs out of cash
on hand, and its operations can no longer be
sustained (e.g., compensating employees,
purchasing inventory, paying office rent on time).
• By understanding the required output to break
even, a company can set revenue targets
accordingly, as well as adjust its business strategy
such as the pricing of its products/services and how
it chooses to allocate its capital
 How to Calculate Break Even Point (Step-
by-Step)
• If a company has reached its break-even point, this
means the company is operating at neither a net loss nor
a net gain (i.e. “broken even”).
• All incremental revenue beyond this point contributes
toward the accumulation of more profits for the company.
• Conducting a break-even analysis is a prerequisite to
setting prices appropriately, establishing clear and logical
sales target goals, and identifying weaknesses in the
current state of the business model that could benefit from
improvements (e.g., sales tactics and marketing strategies).
 How to Calculate Break Even Point (Step-
by-Step)
• Furthermore, established companies with a
diverse portfolio of product/service offerings
can estimate the break-even point on an
individualized product-level basis to assess
whether adding a certain product would be
economically viable. In effect, the analysis
enables setting more concrete sales goals as
you have a specific number to target in mind.
 Break Even Point Formula
• The formula for calculating the break-even point
(BEP) involves taking the total fixed costs and
dividing the amount by the contribution margin per
unit.
Break Even Point (BEP)
= Fixed Costs ÷ Contribution Margin ($)
• To take a step back, the contribution margin is the
selling price per unit minus the variable costs per
unit, and this metric represents the amount of
revenue remaining after meeting all the associated
variable costs accumulated to generate that
revenue.
 Break Even Point Formula
• That said, when a company’s
contribution margin (in dollar terms) is
equal to its fixed costs, the company is at
its break-even point.
• If its contribution margin exceeds its
fixed costs, then the company actually
starts profiting from the sale of its
products/services.