THEORY OF COST AND PROFIT

Prepared by:
Asst. Prof. Glenn H. Sadiangcolor
 LEARNING OBJECTIVES:

 What is Cost?
 Economic Cost and Accounting Cost
 The Different Types of Cost
 Graphing the Different Types of Cost
 Total Revenue and Marginal Revenue
 Economic and Accounting Profit
 Profit Maximization and Loss Maximization
 The Decision to Operate or Shut Down
WHAT IS COST?

COST or Economic Cost is

defined as the payment that
must be made to obtain and
retain the services of a resource.
Economic Costs Vs Accounting
Costs
 Economic costs are forward looking costs (i.e.,
economists are in tune with future costs). These
costs have repercussions on the potential
profitability of the firm.
 Accounting costs tend to be retrospective; they
recognize costs only when these are made and
properly recorded. They do not adjust these costs
even if opportunity cost change.
 Therefore, the difference between economic costs
and accounting cost is the opportunity cost.
 TWO TYPES OF ECONOMIC COST

 EXPLICIT COSTS – are the monetary payments it makes

to those from whom it must purchase resources that it
does not own.

 IMPLICIT COSTS – are the opportunity costs of using the

resources that it already owns to make the firm’s own
product rather than selling those resources to outsiders
for cash.

ECONOMIC COST = EXPLICIT COST + IMPLICIT COST

 Explicit Vs Implicit Cost
 Explicit costs refer to the actual expenses of the firm
in purchasing or hiring the inputs it needs, such as,
when the firm purchases a machine worth Php 1 M or
rents a building worth Php 100,000.00 per month.
 Implicit costs refer to the value of inputs being owned
by the firm and used in its own production process.
 Explicit Costs (“accounting costs” or “expenses”)
 Actual payments made to factors of production and
other suppliers
 Implicit Costs (opportunity costs)
 All the opportunity costs of the resources supplied by
the firm’s owners
 Eg: opportunity cost of owner’s time
 Eg: opportunity cost of owner-invested funds
PROFIT ANALYSIS
Business/ Accounting Profit
The difference between the total revenue a firm receives
from the sale of its product minus explicit costs
(“expenses”).

Economic Profit
The difference between the total revenue a firm receives
from the sale of its product minus all costs, explicit and
implicit.
Note: this includes opportunity cost, and is therefore
different than profit in a traditional accounting sense.
 ACCOUNTING AND ECONOMIC
PROFIT
 ACCOUNTING PROFIT (AP) – is what’s
left over from sales after the firm has
paid all its explicit or peso costs.

ECONOMIC PROFIT (EP) – is the result

of subtracting all of your economic
costs – both explicit and implicit costs
– from revenue.
The Difference Between Accounting Profit and
Economic Profit

 Revenue – Acct Costs = Acct Profit

 Revenue – Econ Costs = Econ Profit

 Revenue – Explicit Costs = Acct Profit

 Revenue – (Explicit + Implicit costs) = Econ Profit

 Acct Profit – Implicit Costs = Econ Profit

ACCOUNTING AND ECONOMIC
PROFIT

AP = REVENUE – EXPLICIT
COSTS

EP = REVENUE – EXPLICIT COSTS

– IMPLICIT COSTS
The Difference Between Accounting
Profit and Economic Profit
WHAT ARE THE DIFFERENT TYPES
OF COST?
 Fixed Cost
 Variable Cost
 Total Cost
 Marginal Cost
 Average Fixed Cost
 Average Variable Cost
 Average Total Cost
 Average Marginal Cost
 WHAT ARE THE DIFFERENT TYPES
OF COST?
 FIXED COST

– stays the same no matter how much output

changes; and
– examples are rent, salaries of top management,
interest payments on borrowed capital,
insurance premiums, interest payments and
most of the depreciation allowances of plant
and equipment.
 WHAT ARE THE DIFFERENT TYPES
OF COST?
 VARIABLE COST

– vary with output;

– when output rises, variable cost rises; when
output falls, variable cost falls.
– examples are payment for raw materials,
utilities, fuel, shipping/freight costs, wages, tax
payments and the like.
 WHAT ARE THE DIFFERENT TYPES
OF COST?
 VARIABLE COST

– vary with output;

– when output rises, variable cost rises; when
output falls, variable cost falls.
– examples are payment for raw materials,
utilities, fuel, shipping/freight costs, wages, tax
payments and the like.
 WHAT ARE THE DIFFERENT TYPES
OF COST?
 TOTAL COST

– the sum of variable cost and fixed cost;

– increase in total cost is due to the increase in variable cost.

 MARGINAL COST

– the cost of producing one additional unit of output;

– can be found by calculating the change in total cost when
output is increased by one unit.
 WHAT ARE THE DIFFERENT TYPES
OF COST?
 AVERAGE FIXED COST (AFC)
 WHAT ARE THE DIFFERENT TYPES
OF COST?
 AVERAGE VARIABLE COST (AVC)

AVC = TVC/Q

Where: TVC = Total Variable Cost

Q = Quantity of Output
 WHAT ARE THE DIFFERENT TYPES
OF COST?
 AVERAGE TOTAL COST (ATC)

ATC = TC/Q

Where: TC = Total Cost

Q = Quantity of Output
 Table 6
Hypothetical Costs Schedules
(1) (2) (3) (4) (5) (6) (7) (8)
Q TFC TVC TC AFC AVC ATC 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 6.9 14.8 5

5 30 37.5 67.5 6 7.5 13.5 10

6 30 60 90 5 10 15 22.5
GRAPHING THE DIFFERENT TYPES OF
COST.
Exercise No. 2
WHAT ARE THE DIFFERENT TYPES OF COST?
Compute the following (TC, MC, AFC,AVC and ATC)
below:
TOTAL TOTAL AVERAGE AVERAGE AVERAGE
TOTAL MARGINAL
OUTPUT FIXED VARIABLE FIXED VARIABLE TOTAL
COST COST
COST COST COST COST COST
1 100 50
2 100 80
3 100 100
4 100 110
5 100 150
6 100 220
7 100 350
8 100 640
Exercise No. 2
WHAT ARE THE DIFFERENT TYPES OF COST?
Compute the following (TC, MC, AFC,AVC and ATC)
below:
TOTAL TOTAL AVERAGE AVERAGE AVERAGE
TOTAL MARGINAL
OUTPUT FIXED VARIABLE FIXED VARIABLE TOTAL
COST COST
COST COST COST COST COST
1 100 50 150 - 100 50 150
2 100 80 180 30 50 40 90
3 100 100 200 20 33.33 33.33 66.67
4 100 110 210 10 25 27.50 52.50
5 100 150 250 40 20 30 50
6 100 220 320 70 16.67 36.67 53.33
7 100 350 450 130 14.29 50 64.29
8 100 640 740 290 12.50 80 92.50
GRAPHING THE DIFFERENT TYPES OF
COST.
 GRAPHING THE DIFFERENT
TYPES OF COST.

Question 1: Why does the MC curve

pass through the AVC and ATC curves
at their minimum points?
 Answer # 1

*The MC curve pass through the AVC

and ATC curves at their minimum
points because each marginal value
changes the average value.
 GRAPHING THE DIFFERENT
TYPES OF COST.

Question 2: Why are the AVC and ATC Curves

U-shaped?
 Answer 2

*As output rises, initially both average

variable cost and average total cost
decline, reach minimum points, and
then begin to rise.
 GRAPHING THE DIFFERENT
TYPES OF COST.

Question 3: Why does the AVC curve

begin to rise?
 Answer 3

*The AVC curve begins to rise because

of the concept of Law of Diminishing
Returns, Economies of Scale and
Diseconomies of Scale.
 GRAPHING THE DIFFERENT TYPES OF
COST.
LAW OF DIMINISHING RETURNS
- As successive units of a variable resource
(e.g. labor) are added to a fixed set of
resources (e.g. land), beyond some point
the extra or marginal product attributable
to each additional unit of the variable
resource will decrease.
 GRAPHING THE DIFFERENT TYPES OF
COST.
 ECONOMIES OF SCALE
- Are the economies of mass production, which drive
down average total cost. They are largely responsible
for the declining part of the ATC curve.

 DISECONOMIES OF SCALE
- Are the inefficiencies that become endemic in large
firms. They are evidenced by the rising part of the ATC
curve.
 TOTAL AND MARGINAL REVENUE

TOTAL REVENUE – is price times total

output sold.

MARGINAL REVENUE – is the increase

in total revenue when output sold
goes up by one unit. It is the additional
revenue derived from selling one more
unit of output.
Point of Maximum Profit
By definition 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 = P x Q
π = TR – TC

TR > TC = PROFIT
TR < TC = LOSS
TR = TC = BREAK EVEN
 Hypothetical Data of the Firm’s
Total Cost and Total Revenue (Table 7)
POINTS QUANTITY TOTAL COST TOTAL PROFIT
(Q) (TC) REVENUE (TR) (π)
1 2 3 4 5

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
***Figure 7.4 is a graphical illustration of Table 7.1.
Figure 7.4A of the said figure shows the relationship
between TR and TC while the curve shown in Figure
7.4B represents Profit

 Area I in Figure 7.4A where TR‹TC is equal to

Area III in Figure 7.4B which shows a
negative result. Also. Area II in Figure 7.4 A
where TR› is equal to Area IV in Figure 7.4B
which shows a positive result in Profit. The
firm is in equilibrium if TR=TC.
Figure 7.4 Total Cost and Total
Revenue Curve
 Exercise No. 3
Using the computed table below, compute the Marginal
Revenue, Total Average Cost and the Marginal Cost.
 Exercise No. 3
Using the computed table below, compute the Marginal
Revenue, Total Average Cost and the Marginal Cost.
PROFIT MAXIMIZATION AND LOSS
MINIMIZATION

A firm will maximize its profit

or minimize its loss at the
output where MARGINAL
COST is equal to MARGINAL
REVENUE.
PROFIT MAXIMIZATION AND LOSS
MINIMIZATION
 THE DECISION TO OPERATE OR
SHUT DOWN

Therefore:

A firm will operate in the short run when

prospective sales exceed variable costs.

A firm will shut down in the sort run when

variable costs exceed prospective sales.
THE DECISION TO OPERATE OR
SHUT DOWN

Example 1: If the firm has fixed

costs of 5 million, variable costs of
6 million, and total revenue of 7
million, what must it do in the
short run?

Answer 1: The firm must operate.

 THE DECISION TO OPERATE OR
SHUT DOWN

Example 2: If the firm has fixed costs

of 10 million, variable costs of 9
million, and total revenue of 8 million,
what must it do in the short run?

Answer 2: The firm must shut down.

Price is equal to average total cost (P = ATC)

ATC

P = MC
 The Profit of the Firm in the Short-run
Price is greater than marginal cost (P > ATC)

PRICE

P = MC
 The Shutdown Point
(P = AVC) or (P< AVC)
PRICE
Price is greater than average variable cost
(P > AVC)

PRICE

P = MC
 To Farm or Not To Farm?
 Farmer Dave sells corn
 his revenues are $22,000/yr
 he pays $10,000/yr in explicit costs
 he could earn $11,000 at another job he likes equally
well (implicit costs)
 Dave’s economic profit is
 $22,000 - $10,000 - $11,000 = $1,000
 Dave is earning a positive economic profit
 Dave is earning more than a normal profit
QUESTIONS???
 Thank you!
For your active
participation…