cHAPTER 5 Revenue and the Cost of Production The central role of any business is to earn. There is no individual who enters into a business to sustain a loss. No one is excited to lose money. We are driven by the reward of higher income and of cost minimization—the two options in increasing a company’s profit. One can increase a company’s net profit by either increasing revenue or minimizing costs. Whatever amount is left after costs are deducted from the revenue is the yardstick a business uses to measure its profitability. It may speak of one or more issues that should be resolved or improvements that should be made, but one thing is for sure: people are to incentives while businesses are to profit. This means that the very incentive of a businessman to engage in industry is to gain profit. ‘As Adam Smith has said in his published Wealth of Nations: “It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from | their regard of their own interest. We address ourselves not to their humanity but to their self-love, and never talk to them of our necessities, but of their advantage.” Keeping this in mind, we should know that crucial decisions would most likely be made by businessmen in regard to their revenue and profit. Thus, we need to understand the difference between the revenue in the point of view of businessmen and accountants as compared to that of economists. What is income? What is cost? Whatever definitions you have in mind now may not be the same ones that you will have after reading this chapter. 69Learning Objectives At the end of this chapter, the student should be able to: 1. differentiate the different t 'ypes of income and the different types of cost in Production; 2. determine what consider: ations should be made by individuals in making business decisions; and : discuss situations that may affect businesses’ Production and cost, Definitions Before we discuss co: sts and profit in detail, let us first know Revenue is computed by what total revenue is, multiplying price with quantity. Total Revenue = Price x Quantity Revenue is driven by the amount paid by the buyers to sellers (bcice) in purchasing a commodity and the number of commodities being purchased (quantity). Table 5.1 shows how quantity can change the total revenue, whereas Figure 5.1 shows the relationship of the numbers in the said table. Table 5.1. Relationship of Quantity to Total Revenue 2 i100 ‘200 4 100 400 +— 6 100 600 8 100 800 10 100 1,000 1000 ° 2 800 3 600 = 400 2 200 0 2 4 6 8 40 Quantity Figure 5.1. Relationship of Quantity to Total Revenue wos v 70 MANAGERIAL ECONOMICS IN THE 21st CENTURYThis is how we arrive at total revenue. To mathematically compute for net profit, most of Us use the basic and the most common understanding of income: accounting income. This is the income that is reflected in the business records. This is computed as follows: Accounting Income = Total revenue — Total Cost This is the formula that we usually encounter. Meanwhile, we also have the economic profit. This considers other types of cost, “Total Cost” that we have computed above is what we call ey it cost, which is theta being paid by the firm to its suppliers, employees, and expenses. = a TR = : lc % ae oe) Ree a Is Opportunity Cost a Cost? Wai ‘also considers to arrive at his/her profit, called thé économic profit. When dpportunity cost is included in the computation of profit, it will be known asd € opportunity cost pursuing one Option over the other. Thus, having a implicit costs, accounting profit is computed as: distinction between explicit and Accounting Profit = Total Revenue — Explicit Cost Meanwhile, economic profit is computed as: Economic Profit = Total Revenue — [Explicit Cost + Implicit Cost] xplicit ¢ mplicit C To make this more understandable, let us look at the story of Respy and her ar apartment rentals. ao Accounting Profit vs. Economic Profit Respy is a landlady who owns 10 units of house and lot that she rents out for Php per month. As part of her agreement with the tenants, she is the one who 10,000 per unit, incidental costs of the property. This cost is usually at Php 1,500 aes ; pays for repairs and other i Per month. ‘Computing her accounting profit, Respy earns: Ye \ Tétal neon < (Explicit Cos Accounting Profit > 000 x10 (1,501 units) (Total Reverie — Explicit Cost) (10,000 x 10 units) v 100,000 \ 15000 [ 85,000 Vv uy . ey e EE CHAPTERS Revenue and the Cost of Production 7.a Amonth ago, Respy was approached by Velio, a haircutter, who wants to use two units and turn them into salon; Because he will occupy two units at the same time, he asked if he can just pay Php\18,009 for the two units every month in exchange for “friendship.” Respy now has a concrete option not to renew the agreement with the tenants of those two units to accommodate the proposal of the famous haircutter, Velio. Their friendship will give Respy access to numerous parties, social gatherings, and pictorials. Following the proposal, Respy computes her economic profit: Total Revenue Explicit Cost. _Implicit Cost (10,000 x 10 units) (1,500 x 10 units) ¢ Opportunity (Total Revenue — Explicit Cost cost - — Implicit Cost) , 100,000 15,000 18,000 67,000 Economic Profit Whatever the option is, economic income is always lower than accounting income as it considers another factor—its implicit costs. Looking at it closely, we can differentiate accounting and economic profit more through Figure 5.2. How Accountants View Profit Accounting Profit Explicit Cost VERSUS. How Economists View Profit Explicit Cost Implicit Cost Economic Profit Figure 5.2. Differentiation of View on Profit Price and Production SG. Prices are importantiin income management and costing decisions, When considering sy rices, we need to understand the two functions of price: rationing and allocative. & allacatiy ‘ation function of price is the changes in price attributed to the distribution resources to consumers who need them the most (Frank & Bernanke, 2013). This is lt distributing resources (which are scarce) equitably, For example, there are two peopl 5 ” 72 MANAGERIAL ECONOMICS IN THE 21st CENTURYwho need water but you only have 10 liters with you. Normally, we can just say that the 10-liter water be distributed equally between the two, giving each one of them 5 liters. Consider that one only consumes about 3 liters of water because of his/her body built, whereas the other drinks 7 liters, given his/her size and activities. This will make you revisit your qual distribution and will make you distribute the 10 liters equitably instead—according to each one’s need. away from overcrowded markets and to markets that are (undeserved (Frank & Bernanke, 2013). We can relate the aflocative function of price to the concept of utilitarianism. This concept was used by different countries as part of their measures to reduce unemployment rate. For example, in 10 years’ time, we expect an oversupply of nurses in the country. The government shall then prohibit incoming freshmen from taking nursing as ieee but will suggest programs which they can select from. These are __ programs whose future occupations or work prospects will not be oversupplied 10 years from now. > : S, Meanwhile, Qoeative function of price is the change in prices (cin What Are the Concerns in Production? After learning the different types of cost, as well as pricing considerations, we shall now discuss the concerns of production and the cost involved in the production. The first thing that we should know is the ion function itself. The prod on shows the relationship betwee i inputs used to create a good and the quantity - of output produced. If the firm is a clothing Company and it wants to see the production of shorts, then a production function is likely to show the output of shorts in every number of sewers, If it is a bakery, then it is likely to show the output of every number of bread per baker. To have a clearer example of the production function, let us take a look at Table 5.2. The table shows the production output of a bakeshop called Baked by Chris. Table 5.2. Production Output of the Bakers at Baked by Chris : 55 100 0 100 fi 50 50 100 20 120 2 90 40 100 40 140 3 120 30 100 60 160 4 140 20 100 80 180 3 ai 150 eee 100 100 200 The production function in this table will be the first two columns. This can be made into a graph by placing the number of workers on the X axis and the output on the Y axis. This is shown in Figure 5.3. CHAPTERS Revenue and the Cost of Production 3oe ‘As mentioned in the [Link] of this textbook, economists are often concerned with marginal analysis, so if there is a production function, we also need to analyze production at a fmargih. That could be done-by looking’ he marginal product (see the third column of Table 5.2). By definition, marginal product is thé change (increase or decrease) in output from one additional unit-of [Link] could be [Link] subtracting de cirrent value to its preceding value: We con seerthe valued in Table 3:2, the merginst product decreases as the number of input increases. How is this possible? Let us compare the output of a baker running a simple enterprise and the bakers from a bigger bakery. Let us assume that the demand on both communities will be 100. If a bakery has only one baker, the baker of that business does not have any choice but tormeet the demand. 20 .——— 150 100 Output 50 0 01 2 394'8 Bakers Figure 5.3. Production Output of Bakers at Baked by Chris Meanwhile, if the bigger bakery has five employees, each person-may have different types of bread to produce every day. if we will focus on the quantity of output alone (others may argue that more workers May lead to a better qualify of bread),-the simple enterprise’s worker produced more than that from the bigger baker {t we call law of diminishing marginal product. The law of di (ous the scenario where the marginal product of ar(input decreases as the quantity of the input increases, An example would be the scenario mentioned earlier that as they hire more workers, the productivity per worker diminishes. This scenario might exist if the demand is constat quipment are the same; it is also likely to lead to each additional worker contributing lesser to the production. Let us go back to the table of production output of the. bakers at Baked by Chris (Table 5.2). The last three columns of the table are the costs of production. The fourth column is what we call fixed cost, the fifth is what we call variable cost, and the sixth column is the total cost. Let us start by defining each type of cost: + Fixed costs (FC) are costs that shaper the quantity produced. This means that it is the payment that a company pays regardless of whether it is gaining proft or not. Examples of this type of cost are the monthly rent, insurance payments: some government regulatory body payments, and others. . Mariable costs (VC) are costs that vary with the quantity produced. These are vs the input that a firm shoulders for every unit of production that it has. Examples these are raw materials, cost for laborers, and other overhead)costs. 7” MANAGERIAL ECONOMICS IN THE 21st CENTURY« Total Cost (TC) is the combination of fixed costs and variable costs (TC = FC + VC). To have a wider perspective on how cost may affect production, we will introduce four other measures of cost. These are: (1) Average Fixed Cost (AFC), (2) Average Variable Cost (AVC), (3) Average To! TC), and (4) Marginal Cost (MC). The first three types of cost are Average Costs. are also called per-unit cost and can be determined by dividing the firm’s tota-cost by the quantity of output it produces. Therefore, the formulas for these values are: Fixed Cost F( ——— or AFC= fe Quantity" Q aves Variable Cost, VC Quantity 4 arc= Total Cost 5 TC jee MG . Quantity Q Yes or ATC = AFC + AVC {iri do (MC), meanwhile, is the tse acon 1) tom an additional unit-6f production. In our previous example, Baked by CHTIS had an increase in cost from an extra unit of laborer hired. This is a natural thing in production because changes occur due to the use of additional raw materials and labor. Therefore, marginal cost can also be defined as the increase in total variable cost (VC) in every additional unit of production, To explain the other types of cost further, let us consider the urn production of Jotik’s Funeral Parlor. Table 5.3. Cost of Production of Jotik’s Funeral Parlor of ums Fixed | Variable | Total made per | “Ost Cost Cost cost the dS taro). | (ave) | (are) ° 300 : 1 300 300 30 330 30 2 300 150 40 190 50 3 300 150 450 100 50 150 70 4 300 a1. 240 540 7s 60 135 90 5 300 350 650 60 70 130 to 6 300 480 780 50 80 130 130 7 300 630 930 3 90 133 | 150 a 300 ‘300 1,100 38 100 138 170 9 300 990 1,290 2 110 443 190 10 300 | 1,200 1,500 30 120 150 210 Me nee ee CHAPTER'S Revenue and the Cost of Production 75,. ” He ” : = - e - 2 VIN WES err ne xample. Le The first four columns are similar to the values of the Dea vend tie observe the succeeding columns. The fifth column. (ABC) shows Sout he Senora is apparently because the numerator (FC) remains unchanged, * ) tit (quantity of urns made) is increasing, Therefore, AFC decreases ° CaaS increases. This can be seen in Figure 5.4 where cost Is placed on the a on the X axis. 380, ——$—$_$_$_$_$_ 300 250 Fined Cost 200 150 ave 100 50 °° 423456789 10 Quantity of urns produced per day Figure 5.4. Average Fixed Cost of Jotik's Funeral Parlor The sixth column (AVC) shows an increasing trend. This is because the numerator (VC) is increasing and the denominator (quantity of urns made) is also constantly increasing. Therefore, AVC increases as VC increases. This can also be seen in Figure 5.5 where cost is on the Y axis and quantity is on the X axis. The seventh column is the ATC. Because ATC = AFC + AVC, and AVC shows an increasing trend, then we can also expect an increasing trend on the ATC. Figure 5.6 shows where cost is on the Y axis and quantity is on the X axis. 350 __ 1400 8 1200 % 300 @ 1000 2 250 3 3 3 600 B 200 3 600 gic ? 400 8 100 s 200 Hyg OO $ 7 o ar 129456789 10 VIP 906 8) ore Quantity of urns made per day Quantity of urns made per day f Jotik's Figure 5.5. Average Variable Cost o Wares: tess lor -6. Average Total Co: si Funeral Pa Hanlon of Jotik's 76 MANAGERIAL ECONOMICS IN THE 21st CENTURYThe lest point. the ATE curve is called sin Gfctenncole musa in this example, quantities Sand 6 are the efficient scale output/asithese are where the graph is at its lowest point. Remember that these two points only show efficient scale output, but we do not know yet if at this point, cost will also be minimized. It will be discussed in the latter part of this chapter. How can we say that the lowest point is the efficient scale output? Let us look at the formula again: ATC = TC = output. Let us give two overstated scenarios of firms with the same commodity. In the first scenario, firm A incurred Php ,000,000 worth of total cost with an output of 10, Using the formula, ATC = 1,000,000 + = 100,000. In the second scenario, firm B incurred Php 1,000,000. worth of total cost. with an output of 1,000 units. Using the formula, ATC = 1,000,000 4.009 1,000. 250 200 150 100 Marginal Cost 50 oie 123456789 10 uantity of urns made per day a ) tu Figure 5.7. Marginal Cost of Jotik’s Funeral Parlor Intuitively, we can say that firm B is more efficient because given the same budget, it was able to produce more, Firm B also has a lower ATC, which proves that lower ATC means mor ncy. At low levels of output, ATC is high because the fixed cost is spread cover the few units that are produced. One observable thing with ATC is that it is like a U-shaped curve. This is because it is a normal state of the market. It shows that at the beginning, ATC projected an increase in output while total cost declines. This scenario is true on quantities 1, 2, 3, and 4. However, it will also reach a point where ATC is constant, as shown in quantities 5 and 6. After that, cost will increase again, as shown in quantities 7 to 10. Therefore, we normally expect a U-shaped curve in graphin ‘[Link] ATC. The eighth and Jast column would be the marginal cost. Marginal Cost (MC) is the change in total c ) from an additional unit of production. As mentioned earlier, the changes in marginal cost that leads to an extra unit of production is due to additional input, such as raw materials, laborers, and others. In economics, we assume that marginal cost increases with the amount of output produced because of. diminishing ! with the a product. This can be seen in Figure 5.7. CHAPTERS Revenue and the Cost of Production = 7 —————i by one, itis time to combing ; : een pee auld form an image shown ili the ea otAFC, AVC, ATC, and MC wi the four graphs. The com! in Figure 5.8, Point Where MC erosses the 300 250 pt 00 / i are { 150 ave 100 50 ES | J Pyv2 e456 7 og BE ag LS — Quantity of urns made per day Figure 5.8. Cost of Production of Jotik's Funeral Parlor What is the significance of this graph? It could give us an idea on the Condition of the Cost of urns at Jotik’s Funeral Parlor. Let us start with the relationship between MC and ATC. We can observe that there is one point in the graph where MC Crosses the ATC curve, 1 ise when MC ri es the Curve, Jotik’s urns are at the efficient scale. Cece is the quanti at minimis: . How can this statement be correct? First, it is at the lowest point of the ATC This is said to be the efficient scale output, _ Second, if the additional cost (MC) of a certain point in the Production is equal to the overall cost per product of the firm (ATC), it is like spending every additional unit at an equal level where the total Cost is most efficient. If that is the case, we can also conclude the following: (1) whenever MC is below ATC, ATC must be decreasing; and (2) whenever MC is greater than ATC, ATC must be increasing. Are the Costs Likely to Change? As mentioned earlier, we normally expe ve on the ATC. The U-shaped Braph in Figure 5.9 is the ATC Curve of m 78 MANAGERIAL ECONOMICS IN THE 21st CENTURYAverage, Total 0 “Quantity of Mobile Phones. Figure 5.9. Hypothetical Long-Run ATC Curve of Mobile Phones The Long-Run Average Total Cost (LRATC) is derived from different Short-Run Average Total Cost (SRATC), as seen in Figure 5.10. eos Clee peal SRATC LRAT ‘Quantity of Mobile Phones Figure 5.10. Hypothetical Long-Run and Short-Run ATC Curve of Mobile Phones The figure shows three SRATC to arrive at ‘this LRATC. As can be seen, the graph is divided into three parts. Part | shows that cost is going down as input increases. This is what we call as economies of scale. By definition, ecoffomies of scale Tefers to the state where long-run average total cost falls as the quantity of ogtput neaases. This means that at this point, if a’firm wishes to increase its input, it can also pect a higher-level output than the inputs_made. This 1s because it is the point of the production where capital, and others have an increasing impact on the quantity +t having a lower impact on average). This is the ideal sto expand their business or production because [Link] that they are ir production. It is possible that at this point, 239% increase in input ‘ase in output. Part II shows constant returns to scale. -run average total cost stays the requirements for labor, of output as well as cost (with cos! point for firm: CHAPTERS Revenue and the Cost of Production 79eg ae 7). ir is means that increasing quantity will lead to th, juantity of output increases. This me: t : sane aount af cost. If we [Link] this point and we increase our cost, we Can just exp, the same level of increase. A 1% increase in input at this point might also have a 1 impact on the output. However, the least ideal state in the long run is Part Ill, where ATe ish : we increase our production. This is what we call the diseconomies Of scale iseconomies of scale tefers to the state where long-run average total cost risesias the quantity of output increases. This is the least ideal part because we know that higher Ate means less productions, but more input. If we are at this point, the budget for input may be increasing, but it does not translate to a relevant output. *\ low of diminishing marginal product is the scenario where the y » , ; ~ ; ~e H ;~ 1 : 80 SUMMARY Total revenue is driven by quantity and price. Changes on any of the two will influence total revenue of firms. Distinction should be made between accounting and economic profit. countidy profit is the result of subtracting-explicit cost from total revenue, while economic profit not only-subtracts explicit but also implicit a from total revenue. ~~ Prices have different function: g and ive. The first is the distribution of resources equitably, while the latter is the distribution of fesures ay on markets. where they t may no longer be needed. The production function is the relationship between quantity of inputs used to create quantity of output of such. Meanwhile, marginal product is the change (increase or decrease) in output from one additional unit of input. marginal product of an input decreases as the quantity of the input increases. The costs of a production are listed as follows: (1) fixed costs, (2) variable costs, and (3) total cost. Fixed costs (FC) are costs that doffot vary with the quantity produced. Variable costs (VC) are constant the quantity produced. Total cost (TC) is the combination of fixed costs and variable costs (TC = FC + VC). The average costs of these values are also called ger-uni ‘ost, and can be determined by di iding the firm’s total co: luantity of output it produces. The lowest point of thea called the efficient scale it. Meanwhile, when MC crosses the ATC curve, itis at the effici le. In the long run, all of the costs are already arable, LRATC will show us three possible scenarios, namely: economic scale, constant returns to scale, and diseconomies of scl, £Cohomles of eae Ser to the tite here Tones n average total cost falls as the quantity of output increases, pd era refers to the state wh erage total cost staysthe same as the quantity of output increases. scale refers to the state wheretong-run-average total cost, rises as ity of output increases. At MANAGERIAL ECONOMICS IN THE 21st CENTURY BAEnd of Chapter Assessment © CHAPTER 5: Revenue and the Cost of Production Name: ZPUN ¥Pne, A SUVOLD Section: BSA \e Date: St Part |. True or False. write FALSE. Write TRUE beside the number ifthe statement is correct. Otherwise, Lume Total cost is the difference between fixed and variable costs. Average costs are cost per unit, not lump sum. Prices may be allocative and rational, ~ ™*? 9! Accounting profit is generally greater than economic profit. Initially in the short run, all costs are variable. Production function establishes the relationship between inputs and outputs. Diseconomies of scale results from long-run total fixed cost increase as the quantity of goods produced increases. Price and quantity drive total revenue. LRATC means Long-Run Average Total Cost. People are to incentives while businesses are to profit. Part Il. Multiple Choices. Write the letter of the correct answer on the line before the number. 1. _ The quantity that minimizes average total cost A. Marginal utility C. Average variable cost B. Quantity of output D. Efficient scale 2. A situation in which the marginal product of am input decreases as the quantity of input increases Law of scarcity Law of diminishing marginal product Law of diminishing marginal returns ODP > Law of diminishing marginal utility CHAPTERS Revenue andthe Cost of Production gytC. _3. The(change in total cost (TC) from an additional unit of production A. ATC cmc magphal apt B. FC D..2ve We Costs that are considered in computing accounting profit Are TR- ES ¢. Marginal A. Explicit D. Economic B B. Implicit ___.5. The author of Wealth of Nations A. John Maynard Keynes c. John Smith B. Adam Smith D. Smith Allen x Part Ill. Reflection Question In applying the economy at the level of your community, how do you explain the following? “It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard of their own interest. We address ourselves not to their humanity but to their self-love, and never talk to them of our necessities, but of their advantage.” ep