ANALYSIS OF COST, PROFIT

AND TOTAL REVENUE

Presented by:
Roy B. Gacus
 Accounting versus Economic Costs
• Economic cost are forward looking cost, meaning,
economists are in tune with future cost because
these costs have major representation on the
potential profitability of the firm. Economists are
also giving emphasis on the so-called opportunity
cost, or cost that are incurred by not putting the
resources to optimum use.
• If opportunity cost are measurable, it should be
included in the decision making process, even
though it is expensive to do so.
 Accounting versus Economic Costs
• But there are some costs that should not be used in
decision making such as sunk costs, because these are
costs that are irretrievable due to the fact that these
are already incurred and do not affect a firm’s decision.
• Accounting costs tend to be reflective; they recognized
costs only when these are made and properly
recorded. They do not adjust these costs even if
opportunity costs change. Therefore, the difference
between economic costs and accounting costs is the
opportunity cost.
 Implicit versus Explicit Costs
• Explicit costs refer to the actual expenses of the firm in
purchasing or hiring the inputs it needs.

• Implicit costs refer to the value of inputs being owned by

the firm and used in its own production process
 Short-run Cost Analysis
• Short-run for a firm is a time horizon when one input is
held constant.
• To analyze the short-run costs, it is essential to fix the
level of capital and study the changes in the quantity of
labor hired.
• The following are the types of short-run costs:
1. Total fixed cost (TFC). These are the costs that do not
vary with output. Examples of these costs are
depreciation of buildings and machineries, salaries of
top management, rent expenses on leased plant, and
interest payments on borrowing capital.
 Short-run Cost Analysis
•2.   Total variable costs (TVC). These are costs that vary
with output. Examples of these costs are payment for
raw materials, wages, tax payments, and operating
expenses (electricity, fuel, and water).
3. Total cost (TC). It is the sum of total fixed costs and
total variable costs.

4. Average fixed cost (AFC). This refers to the total fixed

costs divided by the number of output produced (Q).
 Short-run Cost Analysis
•5.  Average variable cost (AVC). This refers to the total variable
cost divided by the number of output produced (Q).

6. Average total cost (ATC). This refers to the total cost divided
by the number of output produced (Q). It is also defined as
the cost per unit of output.

7. Marginal cost (MC). It refers to changes in total cost divided

by the change in output produced (Q). It is also the
additional cost incurred from producing additional unit of
output.
 Short-run Cost Analysis
• Example: Complete the table using the data below. Then, plot TFC, TVC,
TC in the same axes, and AFC, AVC, ATC, and MC in the same axes.

Q TFC TVC TC AFC AVC AC MC

0 30 0 30 - - -
1 30 15 45 30 15 45 15
2 30 20 50 15 10 25 5
3 30 22.5 52.5 10 7.5 17.5 2.5
4 30 27.5 57.5 7.5 6.875 14.375 5
5 30 37.5 67.5 6 7.5 13.5 10
6 30 60 90 5 10 15 22.5
 Long-run Cost Analysis
• Long-run is a time period wherein all fixed factors
can be varied.
• The long-run average total cost (LAC) of producing
a given level of output is always the lowest point of
the short-run average total cost of producing that
output.
• The LAC is the curve tangent to each short-run
average cost (SAC) representing different plant sizes
that the firm can build in the long-run.
 Long-run Cost Analysis
Suppose that four of the option scales of plants
that the firm could construct in the long-run are
Cost given by SAC1 , SAC2 , SAC3 and SAC4 in figure.

A SAC4
19 SAC1
LAC
15 B SAC3 D
SAC2
14 C
11

Quantity
0 4 9 15 20
 Long-run Marginal Cost
• The long-run marginal cost (LMC) measures
the change in long-run total cost from a given
change in output.
• The LMC IS U-shaped and reaches its
minimum point before the LAC curve reaches
its minimum just like in the short-run analysis.
 Long-run Marginal Cost
In figure, LMC is over
Costs LAC at the increasing
LMC portion of the LAC

LAC

0 Quantity
 Profit Analysis
• Business Profit refers to the difference between
total revenue and explicit cost.

• Economic profit is the difference between total

revenue and both explicit and implicit costs.
 Point of Maximum Profit
• Profit(π)
  equals total revenue (TR) less total cost (TC).
Whereas, total revenue is equal to price (P) multiplied by
quantity (Q). In symbols:
= TR – TC
TR = P x Q
• To maximize profits, the firm must find the equilibrium
price and quantity that give the largest profit on the largest
difference between TR and TC. The rule is simple:
TR > TC = profit
TR < TC = loss
TR = TC = break even
 Point of Maximum Profit
• To illustrate the concept, let us assume that the price of a
good is P16.00. Solve TR and profit given the quantity (Q)
each point. Then, graph the TC and TR.
Points Quantity (Q) Total Cost (TC) Total Revenue (TR) Profit (π)
A 0 1,600 0 -1,600
B 100 4,000 1,600 -2,400
C 200 4,600 3,200 -1,400
D 300 4,800 4,800 0
E 400 5,048 6,400 1,352
F 500 5,550 8,000 2,450
G 600 6,400 9,600 3,200
H 700 8,000 11,200 3,200
I 800 12,800 12,800 0
 The Profit of the Firm in the Short-run
• A competitive firm takes the market price as
constant. If it wants to maximize profits, the
optimum level of production in the short-run is
when its marginal cost is equal to its price (since in a
competitive market, price is also equal to marginal
revenue).
 Price is greater than average total
cost (P > ATC)
In figure, the optimum of
MC the firm in the short-run is
Price
given by Q0, where P= MC.
Profit We use ATC to find the total
cost in order to compute for
the profit. In this case the
P = MR
firm is earning profits
ATC
because price is greater
AVC than the cost (ATC) given by
the shaded region.
Quantity
Q0
Optimum Output in the Short-run
 Price is equal to average total cost
(P = ATC)

MC The figure shows the

Price case where a firm is
either experiencing
profits or losses. As
ATC shown in the graph,
P = MR price is equal to
AVC marginal cost denoting
the best level of output.
But since price equals
ATC, the firm is at a
Quantity breakeven (TR = TC).
Profit is zero at price
Q0
equal to ATC.
Firm is neither experiencing Profit nor Loss
 Price is less than average total cost
(P < ATC)
Even if the price is below ATC, the
MC firm may continue operating in
Price the short-run as long as price is
greater than AVC (P > AVC). In
figure, price intersects marginal
cost indicating the best level of
ATC
output, but is above the AVC
P = MR curve which means that the firm
should not shutdown even though
AVC
profits are negative. Why?
Because TR > TVC, and shutdown
the business will eliminate this
extra revenue. The firm can still
Quantity pay the wages, its operating
expenses, and can still purchase
Q0 some raw materials, but not
Profits are negative but P > AVC (No shutdown) enough to cover the fixed cost.
 The Shutdown Point

MC MC
Price Price

ATC ATC
AVC AVC
P P

Qty Qty
Q0 Q0
P = AVC (Shutdown Point) Profits are negative and P < AVC (shutdown point)
 The Shutdown Point
• The firm should shutdown if any of the following
occurs, P = AVC or P < AVC. The left figure shows
that price is equal to its marginal cost and average
variable cost. It is no longer practical to continue to
do business because revenue is just enough to
cover the variable cost of the firm, and there is no
excess revenue to cover fixed cost.
• In the right figure, if P < AVC, the decision is to
shutdown also, because total revenue is insufficient
to pay variable costs.