MN 3042 Business Economics & Financial Accounting

Economic interpretations for

production, costing, revenue and profits
maximization
Group Assignment

DEPARTMENT- Electrical Engineering

GROUP MEMBERS
M.A.K.S Boralessa 120058D
R.D.T.M Hemarathne 120205D
G.G.K.C Rathnasiri 120531X
T.S.S Senarathna 120601M
S.P.K.D Somathilaka 120635U
INTRODUCTION

This report covers the core definitions of economics theory by providing economic interpretations
for production, costing, revenue and profit maximisation. Each area is explained including a
practical example related to the theory.

PRODUCTION

Definition:-

According to the Oxford advanced learners dictionary, the definition of production is the action
of making or manufacturing from components or raw materials, or the process of being so
manufactured.

Here, the raw materials are the basic materials we use to manufacture. We can make something
from those basics or we can assemble the already created small parts which are called the
components. The process of giving something to the market needs production. The efficiency,
quality, quantity of the production involves in deciding the cost and the revenues too. Production
is mainly based on the human needs and demands. The firm has to produce what the customer asks
for. Production is not just the transformation of physical resources. It includes all the activities
such as the labor, personal training and organizational structures.

There are three types of productions. They are:

market production
public production
household production
The industrial productions are done by the marketing production. To optimize the production to
give the maximum output using the limited resources we use the production function.

Production function:-

Inputs Outputs

Firm

The production function is a function which links the outputs to the inputs. It is the process in
between the input resources and the output product. It can be a one to one, one to many, many to
one or many to many function. For example, a production of bottled water is a one to one function.
Input is the unpurified water and the output is the purified water. If it is the production of gee and
butter, it is a one to many function. The input is milk and the outputs are gee and butter. In car
assembling different spare parts are brought together as input and joined together by to form one
output that is a car. In pharmaceutical industries making one tablet will involves a mixture of
different ingredients as the inputs. Those are examples to many to one functions. That is the most
used function in production.

The final type is many to many functions. This kind of functions are rare. Sugar production can be
taken as an example for this. The inputs are Sugar beet, water, electricity and heat. The outputs are
Sugar, molasses, feed pills and Grass. It has many inputs as well as many outputs.

Factors of production:-

The inputs are the factors of production. They are labor, land, materials, capital, knowledge, etc.

Labor: - Labor is the human input of the production system. This is essential unless the system is
fully automated.

Land: - Land is the natural resources available for production. Some nations are endowed with
natural resources and exploit this by specializing in the extraction and production of these
resources - for example - the development of the North Sea Oil and Gas.
only one major resource is for the most part free - the air we breathe. The rest are scarce,
because there are not enough natural resources in the world to satisfy the demands of
consumers and producers. Air is classified as a free good since consumption by one
person does not reduce the air available for others - a free good does not have an
opportunity cost.
Capital:- Capital refers to the machines, roads, factories, schools and office blocks which human
beings have produced in order to produce other goods and services. A modern
industrialized economy possesses a large amount of capital, and it is continually
increasing. Increases to the capital stock of a nation are called investment. Investment is
important if the economy is to achieve economic growth in the long run.

Knowledge:-
Entrepreneurs are people who organize other productive resources to make goods and
services. Some economists regard entrepreneurs as a specialist form of labor input.
Others believe that they deserve recognition as a separate factor of production in their
own right. The success and/or failure of a business often depends critically on the quality
of entrepreneurship.

Total, average and marginal product:-

Total product : - The total output is called the total product. It will rise when the units of
labor, resources increases. First it increases at an increasing rate, then at a
decreasing rate and finally it will decline. The explanation for this behavior
can be explained through the concept of marginal product.

Marginal Product : - Marginal product is the change in output associated with a unit change in
one input factor, holding other inputs constant.

Average Product : - Average product is the total product divided by the units of inputs
employed.
ECONOMIC INTERPRETATION FOR COSTING

It is essential for a managerial economist to have a proper understanding about the concepts
regarding costs because without a clear idea about costing it is very difficult to have clear business
thinking. In economics decision making play a very important role. This knowledge is important
in taking the right economic decisions. There are several number of cost concepts. They are
described in this assignment.

Definition of economic cost

The total cost of choosing one action over another. The economic cost includes the
accounting cost, or actual funds spent carrying out the action, and the opportunity cost, or the
amount of money that could have been made by using funds and other resources dedicated to the
action on some other objective.

Total, Average and Marginal costs

Total cost

Total Cost (TC) is made up of the summation of Total Fixed Cost (TFC) and the Total
Variable Cost (TVC).

= +

TFC always remains constant at all the levels of the output. These are said to be fixes since
they do not change in short-run. In the following figure TFC is shown by the horizontal line.

TVC is the cost which varies directly with the output. In this case the TVC per unit cost
always remain constant. In the shown curve TVC starts from the origin as there is no variable cost
when the output is zero.
Average cost

This is the cost per unit output and we can get this by dividing Total cost by the total
number of quantities demanded.

Marginal cost

This is the change in the total cost which is affected by the change in one unit of the product.

Lets try to understand these concepts by using a practical example. Lets assume that a
company produces 5000 pens per year. If the total fixed cost for the year is Rs.100 000. Direct
material cost per umbrella and direct labor costs respectively are as Rs.20 and Rs.10. Now we will
calculate the total cost, average cost and the marginal cost.
TFC = Rs.100 000.00
Variable cost per pen = Rs. (20 + 10) = Rs.30.00
TVC = Rs.30 5000 = Rs.150 000.00
= TFC + TVC = Rs.250 000.00
250 000
Average cost = = = Rs.50.00
5000

To determine the marginal cost lets assume that the output is increased by 1 unit.
Now TC = 100000 + 5001 30 = Rs.250 030.00
So we can see that the additional cost needed when increasing the number of production from
5000 to 5001 is Rs.30.00. This is the marginal cost

Now we are going to discuss about some cost concepts.

1. Short run and long run costs

The physical capacity of the firm remains constant during short run period. The output
within this period can be increased only by using the existing physical capacity more intensely.
Short run cost is the cost that varies with output when physical capacity is a constant. This concept
is very much helpful for a manager when he wants to take decision whether they should produce
more or less by a given plant.

Long run is the time period which is possible to change the physical capacity. Long run
cost is the cost that varies with the output when all the inputs are a variable. However it is
impossible to change all the variables together. So we can consider this as a series of short run
periods. Long run cost analysis is very much helpful in taking investment decisions.
 2. Opportunity cost
Businessmen have to make choices between different investment opportunities. So when
he takes his decision he has to compare all the opportunities and to select the best out of them. It
is an obvious fact that when he takes his decision he gives up the possibility of earning profits
from the other investment opportunities. The cost of his choice or the opportunity cost is defined
as the return that would have earned from the other investment opportunities he has given up. We
will understand this concept through a simple example.

Lets assume that a businessman has taken decision to use his own money to buy a land for
his company instead of investing that money at a 10% of interest. According to the above definition
the opportunity cost of investing money for the land is the 10% of interest that he missed.

3. Sunk cost
Sunk cost is which does not modify by any of the change. This is a result of the past
decisions and it cannot be changed by any of the future decisions. This concept also can understand
easily through a simple example.

When an investment is made or an asset was bought that cost does not change from the
future decisions. So those are considered as sunk cost.

4. Explicit and Implicit costs

Explicit costs are which involve cash payments. In fact these are the costs that are included
in the books of accounts. If the employer hires factors for the production from outside, they are
considered as explicit cost. Some examples are salaries paid, payments for the raw materials, rent
for the land and taxes paid for the government.

We will understand the implicit cost through an example. An owner has to put time and
effort for the maintenance of a company rather than expanding it. This can be considered as an
implicit cost of running the business. In fact this is an intangible cost which is not included in the
books. Depreciation and the return on capital contributed by shareholders are two normal implicit
costs.
REVENUE

Definition-Income, especially when of a company or organization and of a substantial nature.

Introduction

Revenue is the income that company or organization receives from business activities like sales of
goods & services, tax income, interest, rent, loyalty or other fees. Revenue of a company in
calculated periodically. Profit or net income is equal to revenue minus total expenses in a period.
It is the top line of income statement.

In non-profit organizations the donations from individuals or companies, government support and
income fund raising programs can be considered as income.

There are three types of basic revenues

1. Cash revenue
2. Sales revenue
3. Tax revenue

In two cash basis and accrual basis accounting, calculation process of revenue are different.
Revenue is recorded in general ledger with summarizing of name that describe the type of revenue
in double entry book keeping system.

Why revenue?

Growth

Revenue is often examined more closely than profits when assessing the growth of a
business. Investors want to see that a business is able to perpetually generate more sales
over time as the company is promoted to an expanding audience. Flat or declining sales
growth suggests that the company has stalled and offers limited hope for continued growth.
Stagnant companies may produce near-term profit, but they don't attract the interest of new
investors

Credit
To qualify for loans and favorable interest rates on credit accounts, lenders need to see that
you are able to generate steady revenue from regular business activities. This, along with
assessments of your existing debt structure, help in their analysis. Poor revenue and weak
attractiveness to lenders makes it difficult for a company to fund new projects and business
activities. This makes it especially challenging to dig your way out of a tough spot.
 Confidence
Revenue also has critical psychological implications both internally and externally for your
business. Employees want to feel confident in their employer and have a sense of security
and stability in their jobs. Strong revenue production offers employees this feeling of
comfort. Revenue affords similar comfort to business partners, suppliers, community
members and other stakeholders impacted by your business.

How to calculate revenue

Basic idea of revenue formulae, Quantity*Price = Revenue

Revenue is the top line or the number that indicates how much overall income the business made
in a given time period. This does not include any deductions, expenses, or costs. Calculating
revenue is relatively easy, if you know the price of your goods and how many were sold. Keeping
good records of all transactions is the key to tip-top financial management.

The revenue received by a company is usually listed on the first line of the income statement as
revenue, sales, net sales or net revenue. Regardless of the method used, companies often report net
revenue (which excludes things like discounts and refunds) instead of gross revenue. For example,
If a company buys shoes for $60 and sells two of them for $100, and offers a 2% discount if the
balance is paid in cash, the gross revenue that the company reports will be [2x$100] = $200. The
company's net revenue will be equal to: [$200*0.98] = $196. The $196 is normally the amount
found on the top line of the income statement.
In a financial statement, there might be a line item called "other revenue." This revenue is money
a company receives for activities that are not related to its original business. For example, if a
clothing store sells some of its merchandise, that amount is listed under revenue. However, if the
store rents a building or leases some machinery, the money received is filed under "other revenue."
Companies account for revenue in their financial statements by either the cash or the accrual
method.

Total revenue on a financial statement

Step 1

Gather income statement from the month, quarter or other period for which you want to calculate
total revenue.
Step 2

Find the amount of product revenue generated during the accounting period on the income
statement. Product revenue is the money earned from selling inventory, such as books or hats.
Product revenue typically appears as gross sales or sales in the first section of the income
statement called operating revenues or revenues.

Step 3

Identify the amount of service revenue earned in the same section. Service revenue includes the
money you earned by completing work for customers, such as altering clothing in a tailoring
business. This revenue might appear as fees earned or service revenue.

Step 4

Find the amount of sales returns and allowances and the amount of sales discounts you had during
the period. Returns and allowances represent money you refunded to customers. Sales discounts
represent the amount by which you reduced the invoices of customers who paid early.

Step 5

Add together product revenue and service revenue. Subtract the amount of sales returns and
allowances and the amount of sales discounts from result to calculate total operating revenue. For
example, assume small business generated $10,000 in product revenue, produced $2,000 in service
revenue, had $200 in sales returns and allowances and gave $500 in sales discounts. Add $10,000
to $2,000 to get $12,000. Subtract $200 and $500 from $12,000 to get $11,300 in total operating
revenue. This means you generated $11,300 in total revenue from your primary business activities.

Step 6

Locate the amount of non-operating revenue you earned, listed in a separate section below your
operating expenses. Add the non-operating revenue to your total operating revenue to calculate the
total revenue you earned during the period. Continuing the example, assume your small business
earned $300 in interest revenue from a bond investment. Add $300 to $11,300 to get $11,600 in
total revenue from primary and secondary business.

For example lets take Saman runs a coffee shop and he wants to understand how many
products in the coffee shop sold and what are they. They can be find by looking cash
register transactions.
 Goods and amount Unit cost($) Respective cost
1500 Nescafe 1.25 1875
500 Icing cakes 2 1000
800 pastries 1 800
150 water bottles 1.5 225
Total cost 3900

Now the total revenue is $3900.

Revenue is an important figure to obtain, not so much because its inherently symbolic of
companys profits, but more because its used to calculate so many other more telling figures. For
example, we now know that the coffee shop made $3900 in total revenue for this quarter. But now
we want to know how much money the saman (owner) is going to make in profit, after all expenses
are included. Without using the revenue formula, we would never know what number to begin
deducting expenses from to get the profit total. Some companies choose different methods of
recognizing their revenue. Many will record income in the books as the job is being done or service
being sold regardless of actual payment. Some, will wait until they have money in hand.

If saman spends $800 on supplies, very quarter, to produce his goods. This expense is called cost
of goods and services and include any material purchased to create the product being sold.
Sometimes damaged goods and discounts are deducted from total revenue to equal the net sales.
Samans deduction for damages is $300 in this quarter. The cost of goods is then deducted from
the net sales to figure out the gross profit. Gross profit is the total sales profit without including
overhead costs or, operating expenses, like rent, utilities, payroll and taxes. His operating expenses
are $200 a month. The net income is calculated by deducting the cost of goods and services and
the operational costs from the revenue.

Coffee shop financial report

Revenue: $3900
COGS: $800
Net Sales: $3600 [$3900(revenue) - $1500(damages and discounts)]
Gross Profit: $3100 [$3600(net sales)-$800(COGS)]
Operational expenses: $200
Net income: $2900 [$3900(revenue)-$800(COGS)-$200(operating expenses)]
 PROFIT MAXIMISATION

Profit is the Difference between revenue and the cost. Usually it is a positive value as all firms try
to keep their revenue higher than their cost for the same level of output. Not only the firms keep
their profit values positive, they always seek ways of maximizing it.

Profit = Total Revenue Gained from Selling Total Cost of Producing

These factors have influenced the development of economic section known as profit maximisation.
To identify the profit maximisation opportunities, the firm should have an understanding of their
revenue and cost with respect to each level of outputs.

Economic parameters related to profit maximisation

Demand curve of the firm provides information about sales at each price.

Total Revenue (TR) is total collected from sales which can be calculated by multiplying price (p)
by quantity (q).

Marginal Revenue (MR) is the change in total revenue by increasing sales quantity by one unit.
This value is normally less than the p as the price should be lowered to sell more. Therefore it is
always below the demand curve.

Price elasticity of demand means the responsiveness of price to the demand

Profit maximisation decision

Marginal cost and Marginal Revenue are the main aspects that decides the production limits. As
an example increasing the output by one may bring additional revenue than its cost implies that
MR is greater than MC and is profitable to produce more. In the reverse case the additional unit
may cost more than its revenue and production should be cut back. MR = MC is another important
state in profit maximisation.

Quantity where the MC and MR curves intersect (q*) gives

an idea about the ideal price (p*).

Multiplication of Absolute Total Cost (ATC) and the q*

provides the Total Cost (TC). The multiplication of p* and
q* gives the Total Revenue.

Profit, by the definition is the difference between above

two quantities. This can be represented graphically as
Figure 1: Revenue, Cost and Demand Functions shown below.
 This graphical representation can be used to identify all
possible aspects of profit. If the ATC curve is high the ATC*
also increases and the shaded area reduces with the reduction
of profit and even negative. The q* value also can make the
profit changes. Profit function can directly represent the profit
change with the quantity.

Figure 2: Graphical Profit

The highest point of the profit curve which represents the

maximum profit occurs at the production of q* which the MC and
MR curves intersect.

Figure 3: The profit function

When TC and TR are equaled the profit of the firm is zero which is also referred as normal profit
situation. When TR exceeds TC the firm is said to be earning Super-normal profit or Abnormal
profit.

Profit maximisation has a significant importance in understanding the firms condition and
improving the variables to improve the profit of the firm.

Practical Example

Returning a loss-making firm to profitable

status.

A garment firm which was initially

profitable has now become a loss-making
one with the following cost and revenue
diagram. The firm is considering closing
down. What solutions could we give the
management to help them regain profit and
remain in the industry?

Figure 4: Negative profit curve

 Decreasing variable costs :-

This can be achieved in a variety of

ways

Persuading the workforce to

accept a lower wage rate. The
workers might be willing to
consider lower remuneration if
the alternative is the threat of
the firms closure.
Changing suppliers and
obtaining the cotton material at
Figure 5: Decreasing variable cost in TC
lower cost.
Workers might work harder if the method of payment changed from a flat rate,
independent of an individuals productivity, to a piece rate, so they can earn relative to
their own productivity

Decreasing fixed costs :-

This can be achieved by,

Decrease expenditure on
research and development.
The firm could consider moving
to cheaper premises. But there is
a chance of additional cost due to
disruption to production and the
act of moving.
The firms owner can try to
negotiate a lower interest rate
with his/her bank manager on a Figure 6: Decreasing fixed cost in TC
loan originally taken out to
purchase capital.

Increasing the level demand :-

Increasing the level of demand at each price causes the demand curve to shift outwards and the
TR curve to shift upwards. For example,
 By using its current advertising expenditure more productively.
Redesigning the product, at no additional cost, to appeal to additional consumers.

Figure 7: Increasing the level demand

If we can shift the TR function upwards, we can have profit at the higher output of Q2 and a
higher price of P2.
APPENDIX

Total Cost (TC)

The cost of output which is made up by Total Fixed Cost (TFC) and Total Variable cost (TVC).
TFC is made up by constant and unavoidable costs. Usually capital costs, rental costs and loan
repayment are categorized under TFC.
TVC is the costs that vary with the output. Labor costs, raw material costs and power costs are
variable costs

Average Total Cost (ATC)

ATC is obtained by dividing the Total Cost (TC) by Quantity (Q).
TC
ATC =

TC = TFC + TVC

ATC = AFC (Average Fixed Cost) + TVC (Average Variable Cost)

TFC
AFC =

TVC
AVC =

Marginal Cost (MC)

Change caused in total cost by one unit production. Determined by the gradient of TC curve.
TC
MC =