SYNOPTIC NOTES ON

MANAGERIAL ECONOMICS
FOR MMS

PROF. KAZI
[email protected]
9820490844

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 SUBJECT : MANAGERIAL
ECONOMICS
Chapter CONTENTS
1) INTRODUCTION
2) CONSUMER BEHAVIOUR - I
3) CONSUMER BEHAVIOUR - II
4) SUPPLY/EQUILIBRIUM PRICE
5) PRODUCTION FUNCTION
6) RETURNS TO SCALE
7) REVENUE AND COST
8) TYPES OF MARKET
9) PRICING PRACTICES
10) PROFIT MANAGEMENT
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11) CAPITAL BUDGETING
CHAPTER SEVEN – REVENUE AND
COST ANALYSIS

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REVENUE AND COST ANALYSIS

CONTENTS:
(A) SHORT RUN COST FUNCTION
(B) LONG RUN COST FUNCTION
(C) REVENUE CONCEPT
(D) BREAK EVEN ANALYSIS
(E) QUESTIONS/ASSIGNMENTS

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 (A) SHORT RUN COST FUNCTION

A short run cost function is one in which some cost are fixed and some cost are
variable. Thus there are two types of cost namely
(1) Fixed Cost
(2) Variable Cost
Fixed costs are the cost which are incurred on fixed factors. Example land,
building, machine. Fixed cost remains fixed whatever may be the level of
output.
Thus when output is zero fixed cost is not zero.
Variable cost refers to the cost which are incurred on variable factors.
Example labour and raw material. Variable cost varies directly with output. It
rises with a rise in output and falls with a fall in output. When output is zero,
variable cost is zero. This can be seen from the following figure. 5
(A) SHORT RUN COST FUNCTION

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 (A) SHORT RUN COST FUNCTION

From FC and VC we can derive the following costs:

(3) Total cost: It refers to the cost incurred on fixed factor as well as variable
factor. It includes cost of land, building, machine, labour, raw material.
(TC=FC+VC).Total cost varies directly with output.It rises with a rise in output
and falls with a fall in output.
When output is zero, total cost is not zero because of the fixed cost. At zero
ouput, fixed cost is positive but variable cost is zero and therefore total cost is
positive.

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 (A) SHORT RUN COST FUNCTION

Other Cost Concepts:

(4) Average Fixed Cost (AFC)
(5)Average Variable Cost (AVC)
(6) Average Cost (AC)
(7) Marginal Cost (MC)
(4) Average fixed cost is the fixed cost per unit of output. For example
machine cost per garment. It is calculated by dividing fixed cost by total output.
(AFC= FC/Output) AFC goes on diminishing as output increases. However it
will not become zero as cost is always positive.This can be seen from the
following figure:
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(A) SHORT RUN COST FUNCTION

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 (A) SHORT RUN COST FUNCTION

(5) AVC is the variable cost per unit of output. For example labour cost
per unit or raw material cost per unit. It is calculated by dividing variable cost
by total output.(AVC=VC/output).
AVC in the beginning declines marginally and then it goes on increasing
continuously as output increases. It declines because of the initial economies in
operations and it rises because of the rise in variable cost. The shape of AVC
can be seen from the following figure.(Refer slide number 09)

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 (A) SHORT RUN COST FUNCTION

(6) AC is the total cost per unit of output.It is calculated by dividing total cost
by total output.(AC=TC/Output or AC= AFC+AVC)
AC goes on diminishing up to a point and then it goes on increasing. Thus AC is
U shaped.
(7) MC is the cost of producing one more unit of output or it is the net addition
to the total cost. For example when ten units are produced and TC is Rs 100 and
when eleventh unit is produced the TC becomes 120 then marginal cost is Rs
20.MC goes on diminishing upto a point and then it goes on increasing.Thus MC
is also U shaped.
The relationship between AC and MC can be explained with the following
figure:
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(A) SHORT RUN COST FUNCTION

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 (A) SHORT RUN COST FUNCTION

It can be seen from the above figure that AC and MC both have U shape.( first
decline, reaches minimum and then goes on increasing).
When AC is falling, MC is also falling but MC is less than AC.It means additional
cost goes on diminishing. Thus it is profitable for a firm to produce more and
more.
When AC is rising, MC is also rising but MC is higher than AC. It means
additional cost goes on increasing. Thus it is less profitable for a firm to produce
additional output.
MC cuts AC at the lowest point. A firm will go on producing till its AC becomes
the least. This point is called profit maximisation point for a firm. This firm is
called optimum firm.( A firm which produces maximum output at the minimum
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 EXAMPLE: Complete the following table:
(A) SHORT OUTPUT FC VC TC AFC AVC AC MC

RUN COST 0
1
200 0
200 5
FUNCTION 2 200 10
3 200 18
4 200 28
5 200 45
6 200 70
7 200 100

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 (A) SHORT RUN COST FUNCTION

EXAMPLE: Complete the following table:

OUTPUT FC VC TC AC MC
0 500
1 510
2 525
3 550
4 600
5 675
6 775
7 900
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 (A) SHORT
RUN COST
FUNCTION

The generalised shape of

short run cost curves can be
seen as below:

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 (B) LONG RUN COST FUNCTION

In the long run cost function all costs are variable. There is no difference
between the fixed cost and the variable
cost. In other words in the long period a firm can go on changing its capacity and
adjust supply as per the market conditions.
The long run cost function can be seen from the following figure:
Initially the firm operates on short run average cost curve number one or the first
plant.It produces OB output and its AC is BQ. Now when the firm produces
more output on the same plant, the AC goes on increasing from BQ to CJ.
Therefore to cut the cost the firm operates on another plant SRAC 2.Now the
same output can be produced at a much lower cost ie CK. Thus there is saving in
cost by KJ. This process continues and we can derive the long run average cost
by joining the mid points of all short run cost curves. This can be seen from the
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(B) LONG RUN COST FUNCTION

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(B) LONG RUN COST FUNCTION

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 (B) LONG RUN COST FUNCTION

Thus when we join all the mid points of short run average cost curves we get
long run average cost curve. The long run average cost curve is also U shaped
but it is much flat than short run average cost curve. It means a firm in the long
run can produce higher output at lower cost than in short run.
In other words long run output is higher than short run output and long run cost
is lower than short run cost.
The reasons for the U shaped average cost curve in the long run can be
explained in terms of economies and diseconomies of scale. The long run
average cost is also called planning curve or envelope curve.

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 (C ) REVENUE CONCEPTS

The different concepts of revenue are

(1) Marginal Revenue
(2) Total Revenue
(3) Average Revenue
Marginal revenue in the revenue received from the sale of one more unit. For
example when 10 units are sold and the total revenue is Rs 1000 and when 11th
unit is sold, the total revenue is Rs 1200 then the marginal revenue is Rs 200.It is
the difference in the total revenue from the sale of one more product.
Total revenue is the revenue received from the sale of all the products.It is
calculated by multiplying the quantity sold by the selling price of the product.
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 Average revenue is the revenue received from the sale of
products. It is the selling price of the product. It is
(C) calculated by dividing the total revenue by total units sold.(
AR= TR divided by units sold)
REVENUE Example: Complete the following table

CONCEPTS UNITS
1
TR
100
MR AR

2 125
3 170
4 220
5 300
6 400

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 (D) BREAK EVEN ANALYSIS

Meaning and Chart:

BEP is the point at which TC=TR.It is the
Point at which a firm makes neither profit
nor loss or zero profit. BEP can be seen
from the following figure.
In the figure at point P the firm makes
Break even as TC=TR.At any output less
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 (D) BREAK EVEN POINT

Break even point can be calculated with the following formula:

(1) BEP ( Quantity) = Fixed Cost /Selling price – Variable cost
Selling price per unit and variable cost per unit to be taken
(2) BEP ( Sales) = BEP (units) x Selling price
(3) BEP ( % ) = BEP (units)/total units x 100

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 (D) BREAK EVEN POINT

Example: Calculate break even point in units, sales and percentage from the
following data:
Fixed Cost Rs 30000
Variable Cost Rs 60000
Total Revenue Rs 120000
Total output 10000
First calculate selling price per unit and variable cost per unit. Selling price per
unit is calculated by dividing total revenue by total output ( 120000 divided by
10000 = Rs 12) Similarly variable cost per unit is calculated by dividing variable
cost by total output ( 60000 divided by 10000 = Rs 6)
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 (D) BREAK EVEN POINT

Thus the three values we got are

Fixed cost = Rs 30000
Selling price = Rs 12
Variable cost= Rs 6
Therefore break even point will be 30000 divided 12 – 6 or 30000 divided by
6 = 5000 units.
Break even sales will be 5000 units x Rs 12 = Rs 60000
Break even percentage will be 5000 divided by 10000 and multiplying with 100
= 50%

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 (D) BREAK EVEN POINT

Example : Calculate break even point in units, sales and percentage from the
following data:
Fixed Cost Rs 100000
Variable Cost Rs 200000
Total Revenue Rs 400000
Units 10000

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 (D) BREAK EVEN POINT

Applications of BEP:
The various applications of break even point to business can be seen as below:
(1) Useful in evaluating investment projects:
BEP is useful in evaluating investment projects or capital projects. Those
projects are considered to be good or feasible in which the BEP is low.
Generally lower the BEP, higher will be the profitability of the project or higher
the BEP, lower will be the profitability of the project. This can be seen from the
following figures.

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(N) BREAK EVEN POINT (contd.)

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 (D) BREAK EVEN POINT

(2) Useful in finding out the Safety Margin:

BEP is useful in finding out the safety margin in sales.Safety margin refers to the
difference between break even sales and actual sales.For example actual sales
are 10000 units and break even sales are 5000 units then safety margin is 5000
units or 50 %.
Safety margin refers to the point above which a firm starts making losses.In the
above example the safety margin is 50 % and if sales decline by 55 % then the
firm will make a loss. Till 50 % decline in sales there is no risk of loss.
Thus greater the safety margin better will be the position of marketing manager.

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 (D) BREAK EVEN POINT

(3) Helps in deciding volume needed for desired profit:

BEP is useful in deciding the amount of production needed to make desired
profit. It means at break even point firm wants some profit.This is calculated by
the following formula:
BEP= Fixed cost + Desired profit/Selling price –variable cost
For example the fixed cost is Rs 10000 and desired profit is Rs 10000.The
selling price is Rs 10 per unit and the variable cost is Rs 5 per unit.How many
units the firm should produce to attain break even and desired profit.
Therefore 20000 divided by 5 = 4000 units.

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 (D) BREAK EVEN POINT

(4) Deciding Make or Buy:

Companies sometimes make the product within the company and sometimes
outsource from other companies. This depend on marginal cost of making the
product. when marginal cost is low it is desirable to make the product within the
company and when marginal cost is high it is desirable to outsource the product
from other sources. However much also depend on the selling price of the
product.

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 (D) BREAK EVEN POINT

(5) Determine product mix :

BEP is also useful in determining product mix of the organisation. The firm
calculates for each product the Fixed cost, variable cost, selling price, profit
margin and on the basis of the information take final decision about the product
mix of the company.

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 (D) BREAK EVEN POINT

(6) Useful in cost control measures:

BEP is also useful in taking cost control measures. BEP is affected by fixed
cost, variable cost, selling price and quantity produced. Any change in these
variables affect the BEP.
For example when total cost rises,(given the other factors like selling price,
quantity produced)break even point rises and profitability declines.
On the other hand when selling price rises while other variables remaining the
same, the break even point falls and profitability rises.

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 (N) BREAK EVEN POINT

LIMITATIONS OF BEP:
(1) Not the only method of evaluating capital project.
(2) Cannot be easily calculated when firm produces many products.
(3) Assumes that FC,VC,SP remain constant during the process.
(4) Does not cover quality of the product.
(5) Does not provide data on the timing and magnitude of cash flow.
(6) Some cost are not easily divisible due to interdependency of
production.
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 (E ) QUESTIONS/ASSIGNMENTS

Q1 State whether the following statements are True or False.

(1) In the short run all cost are variable.
(2) Land building is an example of fixed cost.
(3) Labour cost is an example of fixed cost.
(4) There is no difference between AR and MR.
(5) AC is U shaped.
(6) MC is U shaped
(7) At zero level of output ,fixed cost in not zero.
(8) When output is zero, variable cost is zero.
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 (E ) QUESTIONS/ASSIGNMENTS

(9)Long run average cost is also called planning curve.

(10) At break even point a firm makes minimum profit.
Q2 Fill in the blanks:
(1) AC= --------- divided by total output.
(a) FC (b) VC (c ) TC (d) AFC
(2) AC is ---------- shaped.
(b) L (b) T (c ) V (d ) U
(3) AFC goes on -------------
(c) Diminishing (b) increasing ( c) fluctuating (d) rising and then falling
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 (E ) QUESTIONS/ASSIGNMENTS

(4) MC is ---------- shaped

(a) U (b) T (c ) V (d) L
(5) At break even point a firm makes -------- profit
(b) Minimum (b ) Maximum (c ) Zero (d) Highest
(6) A project is highly feasible when the break even point is---------
(c) High (b) Medium (c ) low (d) 100%
(7) --------- is an example of fixed cost.
(a) Machine (b ) Raw material (c ) labour ( d) finished goods
(8) When output is zero, variable cost is -----------
(a) Positive (b) negative (c ) Zero (d) infinite
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 (E) QUESTIONS/ASSIGNMENTS

(9) When FC is Rs 1000 and VC per unit is Rs 5 and selling price per unit is Rs
10 then break even point will be -------------
(a) 100 units (b) 150 units (c ) 200 units (d) 300 units
(10) ---------- refers to the difference between break even sales and actual sales.
(a) Safety margin (b ) Break even point (c ) Selling price (d) ROI

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 (E) QUESTIONS/ASSIGNMENTS

Q1 Describe short run cost function (or behaviour of short run cost curves like
FC,VC,TC,AFC,AVC,AC and MC.
Q2 Describe with suitable diagram long run cost function.
Q3 Describe briefly the different revenue concepts (or AR,MR and TR)
Q4 Define break even point and show with the help of suitable diagram.
Q5 Discuss the managerial uses of break even point.

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 (E ) QUESTIONS/ASSIGNMENTS

1 A buyer from Mexico wants to buy from your company. He wants a discount
of 10 % on the price quoted by you. Your price include profit margin of only
10%.How you will deal with this case.
2 Collect data on the cost break up of any suitable product of your choice.

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