1. Unit 7
Costs and Revenues
Objectives:
After going through this unit, you will be able to explain:
The concept business costs
Types of business costs
Cost curves
The concept of revenue
Total, average, and marginal revenue
Revenue and demand
Structure:
1.1 Introduction
1.2 The economic concept of costs
1.3 Accounting and Opportunity cost
1.4 Transaction cost
1.5 Explicit and Implicit costs
1.6 Total, Fixed and Variable costs
1.7 Average and Marginal costs
1.8 Sunk costs
1.9 Revenue concepts
1.10 Total, Average, and Marginal Revenues
1.11 Summary
1.12 Key words
1.13 Self-assessment questions

2. 1.1 Introduction
Cost concepts and decisions are very crucial decision making areas for managers. This is
particularly true in contemporary times of competition when cost advantages become
critical success factors in determining competitiveness of firms. While profit
maximization is a prime goal of all businesses universally, costs in the short run are
important ingredients in determining the volume of margins and growth of the business in
the long run. Costs are bad things endured or good things lost. Cost always means cost to
do something. The following section provides useful insights on costs and various cost
concepts.
1.2 The economic concept of costs
In economics, business, and accounting, a cost is a price paid, or otherwise associated
with, a commercial event or economic transaction. All business activities and decisions
are associated with some or the other costs. They are often described based on their
timing or their applicability. Consider some of the following types of costs that are
relevant with business decisions.
1.3 Accounting and Opportunity Cost
Accounting Costs represent the total amount of money spent or the money value of
goods. It is the amount denoted on invoices and recorded in book-keeping records.
Opportunity cost, also called as economic cost, is the benefits derived from the best
alternative that was not chosen in order to pursue the current endeavor, i.e., what could
have been accomplished with the resources expended in the best alternate undertaking. It
represents opportunities forgone.
For example, if a person has a job offer that pays Rs.100 for an hour’s work, but he
decides, instead, to take a nap. The accounting cost of the nap is zero because the person

3. did not hand over any money in order to nap. However, the opportunity cost is Rs.100
because he could have been earned this amount had he been working instead of napping.
So while the accounting cost of a nap is zero, the opportunity cost of the nap is Rs.100.
Opportunity cost need not always be assessed in monetary terms, but rather, is assessed in
terms of anything that is of value to the person or the business firm doing the assessing
between alternative courses of actions. Sometimes it is evaluated in terms of time or
growth prospects. To the extent these non-money evaluations of lost benefits can be
calculated by business value terms it becomes easier to use the concept of decision
making purposes. The consideration of opportunity costs is one of the key differences
between the concepts of economic cost and accounting cost.
1.4 Transaction cost
In business when exchanges or transaction take place they involve a cost. A transaction
cost is a cost incurred in making an economic exchange. For example, consider the
following costs,
(i) Commission paid to the broker when buying or selling shares
(ii) Cost of travel and the time and effort spent when one travels to the grocery
store to buy grocery
In the first case the commission and in the second case the cost of travel and the
opportunity cost can be called transactions cost, the costs above and beyond the actual
cost of the goods and services are the transaction costs. When rationally evaluating a
potential transaction, it is important not to neglect transaction costs that might prove
significant. A number of kinds of transaction cost have come to be known by particular
names. Consider the following,
(i) Cost of exploration and investigation are costs such as those incurred in
determining the availability of particular goods and services in the market,

4. alternative brands in the same product category, brand which has the lowest
price, etc.
(ii) Cost of negotiation are the costs required to come to a mutual agreement
with the other party for the transaction to happen, drawing up an appropriate
contract, etc.
(iii) Cost of conditional transaction. Some contracts can be conditional, for
instance job contracts which involve training for the fresh recruit. The cost
of training would be over and above the salary to be paid to the recruit and
is a transaction cost to the employer.
(iv) Policing and enforcement costs are the costs of making sure the other party
sticks to the terms of the contract, and taking appropriate action if this turns
out not to be the case. For example, bonds signed in employment contracts.
1.5 Explicit and Implicit costs
In business not all costs are visible. This leads us to an important cost distinction, that of,
explicit an implicit costs.
a) Explicit costs are out-of-pocket expenses such as payments for resource
utilization – wages, rent, interest etc.
b) Implicit costs are the opportunity costs of using resources already owned by the
firm.
Implicit costs can be related to forgone benefits of any single transaction and can be the
opportunity costs, or can occur when a business firm incurs costs in terms of time value
etc. When a firm uses fixed capital investments done in the past for current decisions or
uses the time of existing human resources for future projects are all examples of implicit
costs.

5. 1.6 Total, Fixed and Variable costs
Total cost (TC) is the sum of all costs. It describes the total economic cost of production.
For accounting purposes it is calculated as a sum total of fixed and variable costs as
shown in the following equation,
TC = VC + FC
Fixed costs (FC) are those that remain the same irrespective of the level of output. In
other words, they simply they do not respond to production levels. Consider the
following diagram,
Costs
FC
Output
For instance, the cost of building an office, acquisition of resources, purchases of
technology etc. are fixed costs.
Variable costs (VC) are those that vary with the level of output. If the output is zero the
variable cost is also zero. In this sense, the variable costs grow with higher levels of
production, proportionally or otherwise. Consider the following diagram,

6. Costs
VC
Output
Adding the fixed and variable costs diagrammatically we get the following figure,
Costs
TC
VC
FC
Output
1.7 Average and Marginal Costs
The Average Cost (AC) can be defined as per unit cost of production or cost accrued
because of manufacturing one unit of output. It can be calculated as the Total Cost
divided by the total number of units of output, expressed in the following equation,

7. AC = TC
Q
Where Q is the quantity of output manufactured.
Average costs affect the supply curve and are a fundamental component of supply
decisions. Average cost can also be calculated as,
AC = AFC + AVC
Where AFC is Average Fixed Cost and AVC is Average Variable Cost.
Marginal cost (MC) is defined as the change in total costs resulting from a one
additional unit of output. It indicates by how much the total costs changes when one more
unit of output is manufactured. Marginal costs can be calculated using the following
equation,
MC = ΔTC
ΔQ
The cost curves are U-shaped. This follows form the principle of economies and
diseconomies of scale. When initially more and more units of output are manufactured by
expanding the scale of production, the cost conditions are favorable. This is because of
economies of scale and shown by the downward slope of the cost curves. After a certain
point when production goes beyond the optimum level and diseconomies appear, costs
conditions become unfavorable. When this happens the cost curves start sloping upwards.
Consider the following figure which shows average and marginal cost curves:

8. Costs
MC
AC
Quantity of output
At this point we can identify a relationship between average and marginal cost. It can be
summed up in following points:
(i) When average cost is declining as output increases, marginal cost is less
than average cost.
(ii) When average cost is rising, marginal cost is greater than average cost.
(iii) When average cost is minimum, marginal cost equals average cost.
1.8 Sunk costs
Growing business firms constantly face decision situations which involve incurring
various costs. These decisions may involve new product development or entry into new
markets etc. It may so happen that when such a new decision situation is faced not all
costs may freshly incur; some may already have been incurred in the past. This leads us
to the concept of Sunk costs.
Sunk costs are costs incurred before a certain activity takes place. Such costs cannot be
recovered by the possible sale of the asset they produced as a consequence of current
business decisions. Sunk costs are important decision making criteria hen firms enter new
markets or exit current markets. If firms want to exit an industry sunk costs acts as

9. barriers to exit. A firm which has incurred in high sunk costs will have difficulties in
deciding to exit the market even if it sees good opportunities outside. On the other hand,
firms that decide to enter into a new industry as a part of horizontal or vertical integration
strategy or into totally new business arena, it will have to consider with a particular
attention the sunk costs and the risk that during the operations period that might incur.
This is because such costs might not be recovered if the business risk becomes fatal. Sunk
costs, in this perspective, pose barriers to entry.
1.9 Revenue concepts
Revenue is the income generated from the sale of goods and services by firms. It is also
known as sales turnover. The revenue the firm generates depends on the strength of
demand for the products they are supplying. There are three revenue concepts associated
with business decisions, viz.,
(i) Total Revenue
(ii) Average Revenue
(iii) Marginal Revenue
1.10 Total, Average, and Marginal Revenue
Total Revenue (TR) is defined as the total earnings generated out of total sales of output.
It can be calculated as expressed in the following equation,
TR = P x Q
where P is the price per unit of output and Q is the total number of units of output sold
Average Revenue (AR) is defined as the revenue generated by one more unit of output
sold. It can be calculated by dividing total revenue generated by the number of units of
output. In other average revenue is nothing but the unit price (P) of the output, expressed
as follows,
AR = P

10. The average revenue curve for a firm is the same as the demand curve that the firm faces
in the market.
Marginal Revenue (MR) is the addition to the total revenue when every next unit of the
output is sold. It is calculated as the change in total revenue as a result of selling one
extra unit of output as shown in the following equation,
MR = ΔTR
ΔQ
Consider the following figures which express total, average, and marginal revenue
diagrammatically.
Price
AR=MR
Quantity
Price
TR
Quantity

11. The above figure shows when the demand curve (AR) is perfectly elastic, AR = MR and
total revenue will rise at a constant rate as price per unit increases. However, most firms
face a downward sloping demand curve for their products. For such a situation consider
the following diagrams:
Price
AR
Quantity
MR
Price
TR
Quantity
In above figure, as AR falls, MR will fall as well. Total revenue will rise at a decreasing
rate until marginal revenue is zero. At this point (MR=0) and total revenue is maximized.
1.12 Summary

12. In this we discovered that cost decisions are very crucial decision making areas for
managers, particularly in contemporary times of competition when cost advantages
become critical success factors in determining competitiveness of firms. All business
activities and decisions are associated with some or the other costs. Based on their timing
or their applicability costs can be viewed as accounting or opportunity costs, explicit or
implicit, total, average or marginal, variable or fixed, sunk or incremental. When
products are sold in the market business earns revenues. Revenues can be viewed as total,
average or marginal.
1.13 Key words
a) Accounting Costs: The total amount of money or the money value of goods
denoted on invoices and recorded in book-keeping records.
b) Opportunity cost: Also called as economic cost, this is the benefits derived from
the best alternative that was not chosen in order to pursue the current endeavor.
c) Transaction cost : Cost incurred in making an economic exchange.
d) Explicit costs: Out-of-pocket expenses such as payments for resource utilization
– wages, rent, interest etc.
e) Implicit costs: Opportunity cost of using resources already owned by the firm.
f) Total cost: The sum of all costs.
g) Fixed costs: Costs that remain the same irrespective of the level of output.
h) Variable costs: Costs that vary with the level of output.
i) Average Cost: Cost per unit of output.
j) Marginal cost: Change in total costs resulting from a one additional unit of
output.
k) Sunk costs: Costs incurred before a certain activity takes place which cannot be
recovered by the possible sale of the asset they produced as a consequence of
current business decisions.
l) Total Revenue: Total earnings generated out of total sales of output.
m) Average Revenue: earnings per unit of output.

13. n) Marginal Revenue: Addition to the total revenue when every next unit of the
output is sold.
1.14 Self-assessment questions
1) Explain the concept of cost in business. Discuss the significance of cost
control and cost minimization.
2) What are the various types of costs?
3) Distinguish between:
a) Explicit and implicit cost
b) Fixed and variable cost
c) Accounting and opportunity cost
4) Write a short note on Transaction and sunk cost.
5) Explain total, average, and marginal revenue.
6) In contemporary times of competition when cost advantages become
critical success factors in determining competitiveness of firms.
a) True
b) False
c) Neither true nor false
d) None of the above
7) Opportunity cost is also called,
a) Economic cost
b) Explicit cost
c) Accounting cost
d) Total cost
8) Costs that remain the same irrespective of the level of output are called,
a) Fixed cost
b) Variable cost
c) Opportunity cost
d) Marginal cost
9) Costs that vary with the level of output are called,

14. a) Fixed cost
b) Variable cost
c) Opportunity cost
d) Marginal cost
10) Earnings per unit of output are called,
a) Total Revenue
b) Average Revenue
c) Marginal Revenue
d) None of the above
11) Fill in the blanks:
a) ___________________ is the total amount of money or the money value of
goods denoted on invoices and recorded in book-keeping records.
b) ___________________ is the benefits derived from the best alternative that
was not chosen in order to pursue the current endeavor.
c) ___________________ is the cost incurred in making an economic
exchange.
d) ___________________ is the out-of-pocket expense such as payment for
resource utilization – wages, rent, interest etc.
e) ___________________ is the opportunity cost of using resources already
owned by the firm.
f) ___________________ is the sum of all costs.
g) ___________________ is the cost per unit of output.
h) ___________________ is the change in total costs resulting from a one
additional unit of output.
i) ___________________ is the cost incurred before a certain activity takes
place
j) ___________________ is the total earnings generated out of total sales of
output.
k) ___________________ is the addition to the total revenue when every next
unit of the output is sold.