Tag: Cost Control and Management Accounting Osmania University b.com Notes

Capital budgeting is a multi-step process businesses use to determine how worthwhile a project or investment will be. A company might use capital budgeting to figure out if it should expand its warehouse facilities, invest in new equipment, or spend money on specialized employee training.

Capital budgeting process consists of five steps:

1. Identify and evaluate potential opportunities

The process begins by exploring available opportunities. For any given initiative, a company will probably have multiple options to consider. For example, if a company is seeking to expand its warehousing facilities, it might choose between adding on to its current building or purchasing a larger space in a new location. As such, each option must be evaluated to see what makes the most financial and logistical sense. Once the most feasible opportunity is identified, a company should determine the right time to pursue it, keeping in mind factors such as business need and upfront costs.

2. Estimate operating and implementation costs

The next step involves estimating how much it will cost to bring the project to fruition. This process may require both internal and external research. If a company is looking to upgrade its computer equipment, for instance, it might ask its IT department how much it would cost to buy new memory for its existing machines while simultaneously pricing out the cost of new computers from an outside source. The company should then attempt to further narrow down the cost of implementing whichever option it chooses.

3. Estimate cash flow or benefit

Now we determine how much cash flow the project in question is expected to generate. One way to arrive at this figure is to review data on similar projects that have proved successful in the past. If the project won’t directly generate cash flow, such as the upgrading of computer equipment for more efficient operations, the company must do its best to assign an estimated cost savings or benefit to see if the initiative makes sense financially.

4. Assess risk

This step involves estimating the risk associated with the project, including the amount of money the company stands to lose if the project fails or can’t produce its previously anticipated results. Once a degree of risk is determined, the company can evaluate it against its estimated cash flow or benefit to see if it makes sense to pursue implementation.

5. Implement

If a company chooses to move forward with a project, it will need an implementation plan. The plan should include a means of paying for the project at hand, a method for tracking costs, and a process for recording cash flows or benefits the project generates. The implementation plan should also include a timeline with key project milestones, including an end date if applicable.

The capital budgeting process consists of three main steps:

(i) Deciding on the amount of capital expenditure needed.

(ii) Ascertaining the availa­bility of capital.

(iii) Deciding on how to allo­cate the available capital among alternative in­vestment proposals.

Search for Investment Opportunities:

As already stated, the first step in the capital budgeting process is a survey of the need for capital in the enterprise. Usually, at the beginning of each period, top management invites proposals for in­vestment projects from the different operating units of the organisation.

This may form a part of the annual budget exercise or of general development plans stretching over a few years. In either case, these numerous suggestions coming from the lower echelons of the decision-making ladder are inte­grated by the management into a comprehensive list of investment opportunities open before the company.

These are the three main points that need to be looked into in any sensible system of capital bud­geting.

The problem of deciding on the required amount of capital is referred to as the problem of demand for capital. Since the capital expenditures are un­dertaken with a view to netting in additional prof­its, this step involves a survey of investment oppor­tunities and a process of screening them from the point of view of prospective profitability.

The second step referred to above is essentially the process of determining the supply of capital. This involves ascertaining how much capital can be raised by the firm internally and from external sources.

The third step is the crucial one of determining which proposed projects among the competing ones are to be undertaken. Our main task will be to elaborate on each of these three steps in the capital budgeting pro­cess.

Investment analysis is a comprehensive term. As a result, it includes a wide variety of calculations and assessments that analyze market trends, investments and financial industries. Meanwhile, analysts may use a variety of metrics including past returns, yield potential, price movement and more to help them make better investment decisions.

Types of Investment Analysis

With all the data and financial information available, there are a variety of methods analysts and investors use. However, investment analysis can be divided into a few different categories.

Bottom-Up

Bottom-up analysis assesses individual stocks by using their merits. For example, these merits include pricing power, management competence and valuation. However, this investment analysis method doesn’t focus on market or economic cycles to determine asset allocations. Instead, this method looks at the best companies and stocks regardless of the state of the economy and market.

In other words, bottom-up analysis has a more microeconomic or small-scale perspective and approach instead of looking at the economy at large.

Top-Down

Top-Down analysis examines the economic, market and industry trends before making a more specific investment decision. For instance, say an analyst evaluates different industries and found that technologies outperformed financials. Consequently, they may decide to allocate their portfolio with greater weight in financials than technologies. They will then seek out the best-performing companies within the financial sector.

In comparison to a bottom-up analysis, an investor may find compelling reasons to purchase a single technology stock and invest a significant amount of capital in the stock. The investor may do this even if the overall outlook on the industry is poor.

Technical Analysis

Technical analysis focuses on finding patterns of stock price movements that’s discovered through analysis of a security’s prices and volume of share trades. While fundamental analysis focuses on the intrinsic value of a stock, the technical analysis evaluates the strength or weakness of a security by reviewing a variety of analytical charting tools, trading signals, and price movements.

Fundamental Analysis

Fundamental analysis focuses around the idea that at any given time a company’s shares have an intrinsic or enterprise value, which the market will acknowledge eventually. To identify this value, the investor must observe the corporation’s financial performance. However, fundamental analysts also assess the state of that firm’s industry and overall economic health.

Fundamental analysts use metrics including earnings-per-share (EPS), dividend yield, price-earnings (P/E) ratio, and return on equity to determine the corporation’s value. This method also focuses on a company’s assets, liabilities, and expenses.

Analysts will closely examine the firm’s reports which are filed with the Securities and Exchange Commission. These reports may include the 10-K and 10-Q, as well as sell-side analysts’ reports on the company.

Fundamental Analysis Details

Now that you understand the big picture of how fundamental analysts determine a company’s value, let’s take a deeper dive into some of the metrics that make up this examination. Keep in mind, some investors may solely rely on each individual metric to make an investment decision.

Price-Earnings Ratio (P/E)

A price-earnings ratio shows the correlation between the price of one share of a stock and the earnings-per-share that the company reports over a period. This period is generally one year. It illustrates the amount of money each investor is putting into the firm for every dollar of earnings the company posts.

You can calculate the P/E ratio by dividing the stock’s market value per share. Often, investors will compare one stock’s P/E to other stock’s P/E in the same industry to determine the value of the stocks. Usually, investors consider lower P/E ratios favorable.

Earnings Per Share

Earnings per share indicates how efficiently revenues filters down to investors. To calculate a company’s earnings-per-share investors should take earnings remaining for shareholders divided by the number of outstanding shares. If a company has high earnings per share, investors may identify them as a profitable firm.

Book Value

Investors may use the price-to-book ratio to identify high-growth companies that are undervalued. While the book value of a company is the total number of assets minus total liabilities, you can calculate the P/B by taking the market price of a company’s stock and dividing by the book value of equity. If a company has a low P/B ratio, it’s viewed as undervalued.

Dividend Yield

The dividend yield is the relationship between a company’s dividend payments and stock price. To calculate the dividend yield you will divide the annual dividend by the current stock price. You can then compare one company’s dividend yield to another. Investors may select companies with higher dividend yields if they are seeking to invest in companies with high dividend payments.

Return on Equity (ROE)

Essentially, the return on equity (ROE) reveals the company’s efficiency at turning shareholder investments into profits. ROE takes the net income from a firms’ income statement and the shareholders’ equity from its balance sheet. Therefore, if a company liquidates its assets to pay off debt, ROE is the amount that’s left over for shareholders.

Risk mitigation refers to the process of planning and developing methods and options to reduce threats or risks to project objectives. A project team might implement risk mitigation strategies to identify, monitor and evaluate risks and consequences inherent to completing a specific project, such as new product creation. Risk mitigation also includes the actions put into place to deal with issues and effects of those issues regarding a project.

Strategies:

1. Risk Acceptance: Risk acceptance comes down to “risking it.” It’s coming to terms that the risk exists and there is nothing you will do to mitigate or change it. Instead, it understands the probability of it happening and accepting the consequences that may occur. This is the best strategy when risk is small or unlikely to happen. It makes sense to adopt risk when the cost of mitigating or avoiding it will be higher than merely accepting it and leaving it to chance.
2. Risk Avoidance: If a risk from starting a project, launching a product, moving your business, etc. is too large to accept, it may be better to avoid it. In this case, risk avoidance means not performing that activity that causes the risk. Managing risk in this way is most like how people address personal risks. While some people are more risk-loving and others are more risk-averse, everyone has a tipping point at which things become just too risky and not worth attempting.
3. Risk Mitigation: When risks are evaluated, some risks are better not to avoid or accept. In this instance, risk mitigation is explored. Risk mitigation refers to the processes and methods of controlling risk. When you identify risk and its probability, you can allocate resources for management.
4. Risk Reduction: Businesses can assign a level at which risk is acceptable, which is called the residual risk level. Risk reduction is the most common strategy because there is usually a way to at least reduce risk. It involves taking countermeasures to decrease the impact of consequences. For example, one form of risk reduction is risk transfer, like that of buying insurance.
5. Risk Transfer: As mentioned, risk transfer involves moving the risk to another third party or entity. Risk transfers can be outsourced, moved to an insurance agency, or given to a new entity as is what happens when leasing property. Risk transfers don’t always result in lower costs. Instead, a risk transfer is the best option when it can be used to reduce future damage. So, insurance can cost money, but it may end up being more cost-effective than having the risk occur and being solely responsible for reparations.

Risk Evaluation

Identification: First and foremost, you must identify and define the types of risks that your business faces. There are both internal and external risks. When identifying risks, consider if they are preventable, such as operational risks, or not avoidable like natural disasters.

Impact assessment: Once you have identified risk, you can estimate their impact. This involves defining the probability that a risk will occur and its respective result or consequence.

Develop strategies: Finally, you can determine the necessary strategy for those risks that are likely to happen with medium or high probability. While you may still want to monitor low risks, they are less of a priority when it comes to taking the next step and making a plan.

The method of calculating break-even point of a single product company has been discussed in the break-even point analysis article. A multi-product company means a company that sells two or more products. The procedure of computing break-even point of a multi-product company is a little more complicated than that of a single product company.

The determination of the break-even point in CVP analysis is easy once the variable and fixed components of costs have been determined.

A problem arises when the company sells more than one type of product. Break-even analysis may be performed for each type of product if fixed costs are determined separately for each product.

However, fixed costs are normally incurred for all the products hence a need to compute for the composite or multi-product break-even point.

In computing for the multi-product break-even point, the weighted average unit contribution margin and weighted average contribution margin ratio are used.

BEP in units  = Total fixed costs / Weighted average CM per unit

BEP in dollars = Total fixed costs / Weighted average CM ratio

The weighted average selling price is worked out as follows:

(Sale price of product A × Sales percentage of product A) + (Sale price of product B × Sale percentage of product B) + (Sale price of product C × Sales percentage of product C) + …….

and the weighted average variable expenses are worked out as follows:

(Variable expenses of product A × Sales percentage of product A) + (Variable expenses of product B × Variable expenses of product B) + (Variable expenses of product C × Sales percentage of product C) + …….

When weighted average variable expenses per unit are subtracted from the weighted average selling price per unit, we get weighted average contribution margin per unit. Therefore, the above formula can also be written as follows:

Breakeven Point = Total fixed expenses / Weighted average contribution margin per Unit

Marginal analysis is also widely used in microeconomics when analyzing how a complex system is affected by marginal manipulation of its comprising variables. In this sense, marginal analysis focuses on examining the results of small changes as the effects cascade across the business as a whole.

Marginal analysis compares the additional benefits derived from an activity and the extra cost incurred by the same activity. It serves as a decision-making tool in projecting the maximum potential profits for the company by comparing the costs and benefits of the activity.

Marginal analysis is an examination of the associated costs and potential benefits of specific business activities or financial decisions. The goal is to determine if the costs associated with the change in activity will result in a benefit that is sufficient enough to offset them. Instead of focusing on business output as a whole, the impact on the cost of producing an individual unit is most often observed as a point of comparison.

Marginal analysis can also help in the decision-making process when two potential investments exist, but there are only enough available funds for one. By analyzing the associated costs and estimated benefits, it can be determined if one option will result in higher profits than another.

Marginal analysis and variables

When you are using marginal analysis for decision-making, you need to take cost and production variables into consideration. The quantity of the products you’re producing is the most common variable companies evaluate. However, there are others, such as the shipping costs, which increase as you produce and distribute a higher number or weight of products. By making incremental changes in production and monitoring the benefits and costs that accompany those changes, you can choose from a range of production levels with varying levels of profitability.

Marginal analysis and opportunity cost

In order to understand the cost and benefit of certain activities, you must also understand opportunity cost. An opportunity cost is a valuable benefit that you miss when you choose one option over another. For example, if a company has room in its budget for another employee and is considering hiring another person to work in a factory, a marginal analysis indicates that hiring that person provides a net marginal benefit. In other words, the ability to produce more products outweighs the increase in labour costs. However, hiring that person still may not be the best decision for the company.

Marginal analysis and observed change

In some cases, it may make sense for a company to make small operational changes and then perform a marginal analysis afterward to observe the changes in costs and benefits that occurred as a result of those changes. For example, a company that manufactures children’s toys may choose to increase production by 1% to see what changes occur in quality and how it impacts resources.

If the managers observe that the benefits of a production increase outweigh any additional costs the company incurs, they may choose to maintain the higher production rate or even raise production by 1% again to observe the changes that occur. Through small modifications and observed change, companies can identify optimal production rates.

Limitations of Marginal Analysis

One of the criticisms against marginal analysis is that marginal data, by its nature, is usually hypothetical and cannot provide the true picture of marginal cost and output when making a decision and substituting goods. It therefore sometimes falls short of making the best decision, given that most decisions are made based on average data.

Another limitation of marginal analysis is that economic actors make decisions based on projected results rather than actual results. If the projected income is not realized as predicted, the marginal analysis will prove to be worthless.

For example, a company may decide to start a new production line based on a marginal analysis projection that the revenue will exceed costs to establish the production line. If the new production line does not meet the expected marginal costs and operates at a loss, it means that the marginal analysis used the wrong assumptions.

Sunk Cost

In economics and business decision-making, a sunk cost (also known as retrospective cost) is a cost that has already been incurred and cannot be recovered. Sunk costs are contrasted with prospective costs, which are future costs that may be avoided if action is taken. In other words, a sunk cost is a sum paid in the past that is no longer relevant to decisions about the future. Even though economists argue that sunk costs are no longer relevant to future rational decision-making, in everyday life, people often take previous expenditures in situations, such as repairing a car or house, into their future decisions regarding those properties.

A sunk cost refers to money that has already been spent and cannot be recovered. In business, the axiom that one has to “spend money to make money” is reflected in the phenomenon of the sunk cost. A sunk cost differs from future costs that a business may face, such as decisions about inventory purchase costs or product pricing. Sunk costs are excluded from future business decisions because the cost will remain the same regardless of the outcome of a decision.

An accounting issue that encourages this adverse behavior is that capitalized costs associated with a project must be written off to expense as soon as the decision is made to cancel the project. When the amount to be written off is quite large, this encourages managers to keep projects running over a longer period of time, so that the expense recognition can be spread out over a longer period of time, in the form of depreciation.

All sunk costs are fixed costs but not all fixed costs are sunk costs. The difference is that sunk costs cannot be recovered. If equipment can be resold or returned at the purchase price, for example, it’s not a sunk cost.

Bygones principle

According to classical economics and standard microeconomic theory, only prospective (future) costs are relevant to a rational decision. At any moment in time, the best thing to do depends only on current alternatives. The only things that matter are the future consequences. Past mistakes are irrelevant. Any costs incurred prior to making the decision have already been incurred no matter what decision is made. They may be described as “water under the bridge”, and making decisions on their basis may be described as “crying over spilt milk”. In other words, people should not let sunk costs influence their decisions; sunk costs are irrelevant to rational decisions. Thus, if a new factory was originally projected to yield Rs 100 crore in value, and after Rs 30 crore is spent on it the value projection falls to Rs 65 crore, the company should abandon the project rather than spending an additional Rs. 70 crore to complete it. This is known as the bygones principle or the marginal principle.

Fallacy effect

The bygones principle does not accord with real-world behavior. Sunk costs do, in fact, influence people’s decisions, with people believing that investments (i.e., sunk costs) justify further expenditures. People demonstrate “a greater tendency to continue an endeavor once an investment in money, effort, or time has been made.” This is the sunk cost fallacy, and such behavior may be described as “throwing good money after bad”, while refusing to succumb to what may be described as “cutting one’s losses”. For example, some people remain in failing relationships because they “have already invested too much to leave.” Others buy expensive gym memberships to commit themselves to exercising. Still others are swayed by arguments that a war must continue because lives will have been sacrificed in vain unless victory is achieved. Likewise, individuals caught up in psychic scams will continue investing time, money and emotional energy into the project, despite doubts or suspicions that something is not right. These types of behaviour do not seem to accord with rational choice theory and are often classified as behavioural errors.

Plan continuation bias

A related phenomenon is plan continuation bias, which is recognised as a subtle cognitive bias that tends to force the continuation of an existing plan or course of action even in the face of changing conditions. In the field of aerospace it has been recognised as a significant causal factor in accidents, with a 2004 NASA study finding that in 9 out of the 19 accidents studied, aircrew exhibited this behavioural bias.

Opportunity costs

In microeconomic theory, the opportunity cost of an activity or option is the loss of value or benefit that would be incurred (the cost) by engaging in that activity or choosing that option, versus/relative to engaging in the alternative activity or choosing the alternative option that would offer the highest return in value or benefit.

Opportunity costs represent the potential benefits an individual, investor, or business misses out on when choosing one alternative over another. Because by definition they are unseen, opportunity costs can be easily overlooked. Understanding the potential missed opportunities foregone by choosing one investment over another allows for better decision-making.

Formula and Calculation of Opportunity Cost

Opportunity Cost = FO−CO

where:

FO = Return on best foregone option

CO = Return on chosen option

Explicit Costs

Explicit costs are the direct costs of an action (business operating costs or expenses), executed either through a cash transaction or a physical transfer of resources. In other words, explicit opportunity costs are the out-of-pocket costs of a firm, that are easily identifiable. This means explicit costs will always have a dollar value and involve a transfer of money, e.g. paying employees. With this said, these particular costs can easily be identified under the expenses of a firm’s income statement and balance sheet to represent all the cash outflows of a firm.

Examples are as follows:

• Land and infrastructure costs
• Operation and maintenance costs; Wages, Rent, Overhead, Materials

Implicit Costs

Implicit costs (also referred to as implied, imputed or notional costs) are the opportunity costs of utilising resources owned by the firm that could be used for other purposes. These costs are often hidden to the naked eye and aren’t made known. Unlike explicit costs, implicit opportunity costs correspond to intangibles. Hence, they cannot be clearly identified, defined or reported. This means that they are costs that have already occurred within a project, without exchanging cash. This could include a small business owner not taking any salary in the beginning of their tenure as a way for the business to be more profitable. As implicit costs are the result of assets, they are also not recorded for the use of accounting purposes because they do not represent any monetary losses or gains. In terms of factors of production, implicit opportunity costs allow for depreciation of goods, materials and equipment that ensure the operations of a company.

Examples of implicit costs regarding production are mainly resources contributed by a business owner which includes:

• Infrastructure
• Human labour
• Time

Non-monetary cost

Seeking a certain profit might have implicit costs such as health, ecological, or other costs. Many of those costs may not be paid directly or immediately after; they may also not be paid by those responsible for the costs. For example, if a company pollutes, the company’s accountants may not be responsible for the costs, but the costs may be externalized onto other people in the case of local pollution, or the entire population, in the case of global warming.

Smoking may personally have higher direct costs, such as health costs; it may also generate direct losses economically or increase the prevalence of health problems which could harm the economy. The tobacco industry generates losses for many sectors, however, for the tobacco industry no cost may be paid. Quitting smoking may reduce hidden costs choosing to take a walk instead of smoking could be beneficial to one’s health, for example. Choosing to work half-time may allow for more rest for a sick person.

Externalities are a kind of cost generated from one economic agent to another. For example, the restaurant sector may be growing but obesity may generate a cost, monetary or otherwise in many domains, such as an increased difficulty in recruiting fit firefighters. Some sectors are growing extensively from such costs, private or not. Dentists are needed partly because both sugary foods and tobacco generate work and demand.

Plane travel may generate externalities by contributing to global warming and air pollution, which harms many sectors such as agriculture and nature tourism. Short-term profit may lead to high costs later. Refusing to invest in infrastructure or maintenance for a company may lead to a loss of customers.

The development of tourism has driven the local consumption industry and a series of related economic growths. At the same time, it can lead to excessive development and utilization of tourism resources, serious environmental damage, and a large number of negative impacts affecting the lives of local people. Overcrowding on holidays may lead to a poor experience and a loss of tourists.

Profit Performance

Financial performance is a subjective measure of how well a firm can use assets from its primary mode of business and generate revenues. The term is also used as a general measure of a firm’s overall financial health over a given period.

Gross margin ratio and contribution margin: What is the business’s gross margin ratio (which equals gross profit divided by sales revenue)? Even a small slip in its gross margin ratio can have disastrous consequences on the company’s bottom line. Stock analysts want to know the business’s contribution margin, which equals sales revenue minus all variable costs of sales (product cost and other variable costs of making sales).

Analysts and investors use financial performance to compare similar firms across the same industry or to compare industries or sectors in aggregate.

Trends: How does sales revenue in the most recent year compare with the previous year? Higher sales should lead to higher profit, unless a company’s expenses increase at a higher rate than its sales revenue. If sales revenue is relatively flat from year to year, the business must focus on expense control to help profit, but a business can cut expenses only so far.

Other ratios: Based on information from a company’s most recent income statement, how do gross margin and the company’s bottom line (net income, or net earnings) compare with its top line (sales revenue)? It’s a good idea to calculate the gross margin ratio and the profit ratio (net income divided by sales revenue) for the most recent period and compare these two ratios with last period’s ratios.

The income statement culminates in net income for the period, but two other specific profit calculations also offer your business leaders and potential creditors critical information about the companies’ income-earning abilities: Gross profit and Operating profit.

Net Profit

Your income statement finally reaches net profit or loss when irregular income and expenses are taken from operating profit. Legal costs such as patent filings or settlements are examples of irregular, one-time expenses. Sales of buildings and equipment are examples of irregular income. While net profits are ideal, one-time expenses do not necessarily affect long-term profitability. Net profits are also used to calculate the net profit margin.

Gross Profit

Gross profit is calculated in the income statement’s first section. It is simply the total amount of money you took in your revenue minus the cost of the goods you sold. The higher your gross profit, the more likely you are to cover your fixed costs and earn income for the period. This initial section also is useful in calculating your gross profit margin ratio.

Operating Profit

In the operating income section of the statement, fixed operating costs are subtracted from gross profit to calculate operating profit for the period. Fixed costs include building and equipment costs, utility expenses and other costs not directly tied to production. A strong operating profit is a good sign of financial health, because it represents your earnings from core business activities. Operating profit also is used to calculate operating profit margin.

Profit Performance Monitor estimates the economic cost of:

• Lack of confidence in the APC performance.
• Clamp MV, CV limits, dropped MVS related to short term operations, equipment, or instrument issues.
• Lack of awareness of the overall performance impact.
• Variance on operator skills.

Alternative Operating levels

The marginal cost of production and marginal revenue are economic measures used to determine the amount of output and the price per unit of a product that will maximize profits.

A rational company always seeks to squeeze out as much profit as it can, and the relationship between marginal revenue and the marginal cost of production helps them to identify the point at which this occurs. The target, in this case, is for marginal revenue to equal marginal cost.

Production costs include every expense associated with making a good or service. They are broken down into two segments: fixed costs and variable costs.

Fixed costs are the relatively stable, ongoing costs of operating a business that are not dependent on production levels. They include general overhead expenses such as salaries and wages, building rental payments or utility costs. Variable costs, meanwhile, are those directly related to, and that vary with, production levels, such as the cost of materials used in production or the cost of operating machinery in the process of production.

Marginal Cost

In economics, the marginal cost is the change in the total cost that arises when the quantity produced is incremented, the cost of producing additional quantity. In some contexts, it refers to an increment of one unit of output, and in others it refers to the rate of change of total cost as output is increased by an infinitesimal amount.

To optimize marginal cost and revenue, it’s essential to understand a few standard production terms. Every business that generates production costs can divide them into two key categories:

• Fixed costs: These are essential expenses that stay relatively flat over time, even if your company increases production. For example, expenses related to equipment and facilities are considered fixed costs.
• Variable costs: These expenses are less consistent from day to day or month to month. Instead, they can rise or fall significantly depending on production levels. For example, raw materials and labour force are considered variable costs.

Short run marginal cost

Short run marginal cost is the change in total cost when an additional output is produced in the short run and some costs are fixed. In the on the right side of the page, the short-run marginal cost forms a U-shape, with quantity on the x-axis and cost per unit on the y-axis.

On the short run, the firm has some costs that are fixed independently of the quantity of output (e.g. buildings, machinery). Other costs such as labour and materials vary with output, and thus show up in marginal cost. The marginal cost may first decline, as in the diagram, if the additional cost per unit is high if the firm operates at too low a level of output, or it may start flat or rise immediately. At some point, the marginal cost rises as increases in the variable inputs such as labor put increasing pressure on the fixed assets such as the size of the building. In the long run, the firm would increase its fixed assets to correspond to the desired output; the short run is defined as the period in which those assets cannot be changed.

Long run marginal cost

The long run is defined as the length of time in which no input is fixed. Everything, including building size and machinery, can be chosen optimally for the quantity of output that is desired. As a result, even if short-run marginal cost rises because of capacity constraints, long-run marginal cost can be constant. Or, there may increasing or decreasing returns to scale if technological or management productivity changes with the quantity. Or, there may be both, as in the diagram at the right, in which the marginal cost first falls (increasing returns to scale) and then rises (decreasing returns to scale).

Marginal Revenue

Essentially the opposite of marginal cost, marginal revenue refers to the extra revenue your business can generate by selling one additional unit. This number is different depending on the market circumstances:

Perfectly competitive market: In this type of idealistic market, marginal revenue tends to remain constant because the market controls the sale price and your business has the power to sell as many units as possible. As a marginal cost and marginal revenue graph would show, the output is proportional to the revenue. Because costs decrease as you increase production, your company’s total profit grows.

Imperfectly competitive market: In this more realistic situation, marginal revenue tends to fluctuate when supply and demand affect the market. In this type of monopoly market, your business can’t continue to make and sell more products at the same sale price. Instead, you have to lower the sale price. Eventually, marginal costs may exceed marginal revenue, which negates any profit. You can use the perfect market as a standard to compare to your real-world market in order to measure its efficiency and effectiveness.

Marginal revenue = Change in total revenue / Change in quantity

Marginal Revenue vs. Marginal Cost

When you adjust for marginal revenue, the cost may also change, which can affect your optimal production levels. To compare marginal cost vs. marginal revenue, it’s helpful to understand how these two numbers behave in relation to one another:

• If marginal revenue is higher than marginal cost, your company should raise production levels to improve efficiency and generate more profit overall.
• If marginal cost and marginal revenue are equal, your business has reached its optimal production level. At this level, efficiency has reached its peak, and you’ve maximized profits.
• If marginal cost is higher than marginal revenue, your business should lower production levels to reduce profit loss.