Understanding Costs, Revenue & Profit

Understanding Costs, Revenue & Profit

In this lesson, you’re expected to:
– learn about the different kinds of costs associated with production and consumption
– understand how revenue and costs are related
– discover the conditions required to maximize profit

Businesses or firms strive to earn the most profit possible. They try to increase profitability by trying to increase revenue and decrease cost.

In a competitive environment, firms can’t do much to increase revenue since they lack pricing power.

Firms do, however, have the ability to control costs, so in order to maximize their profits, they try to produce at the lowest cost possible.

In this lesson, we’ll see how these three concepts (costs, revenue & profit) are related.

Costs of Production

Costs of production relate to the different expenses that a firm faces in producing a good or service.

Economists break down costs into different categories:
– Fixed Costs
– Variable Costs
– Total Cost

1) Fixed Costs

The first category of costs is fixed costs or overhead. A firm’s fixed costs are those costs that don’t change regardless of the level of production.

These are costs that do not vary with output. However many goods are produced, fixed costs will remain constant.

For example, rent, property tax, and management salaries. Whether a factory is running at full capacity or is idle, the overhead remains the same.

Average Fixed Costs: As more goods are produced, the average costs will fall.

[Optional] What are examples of fixed costs?
2) Variable Costs

Firms also face variable costs. Variable costs change with the level of a firm’s output.  As a firm’s production increases, so do its variable costs.

Utilities, hourly wages, and per-unit taxes are representative of variable costs.

For example, as you produce more cars, you will have to pay for more raw materials, such as metal, tires and plastic.

[Optional] What are examples of variable costs?
Accounting Costs vs. Economic Costs

Accounting Cost – this is the monetary outlay for producing a certain good. Accounting costs will include your variable and fixed costs that you have to pay.

Economic Cost – this cost includes both the actual direct costs (accounting costs) plus the opportunity cost. For example, if you take time off work to take part in a training scheme, you may lose a week’s pay $350, plus also have to pay the direct cost of $200. Thus, the total economic cost = $350 + $200 = $550.

Total Costs

Total cost refers to the total expense incurred in reaching a particular level of output.

If the total cost is divided by the quantity produced, average or unit cost is obtained.

Total Fixed Costs
Given that total fixed costs (TFC) are constant as output increases, the curve is a horizontal line on the cost graph.

Total Variable Costs
The total variable cost (TVC) curve slopes up at an accelerating rate, reflecting the law of diminishing marginal returns.

Total Costs
The total cost (TC) curve is found by adding total fixed and total variable costs. Its position reflects the amount of fixed costs, and its gradient reflects variable costs.
=> TC = TFC + TVC

See enlarged version: http://bit.ly/2lSmOSv
Total Fixed Costs
Given that total fixed costs (TFC) are constant as output increases, the curve is a horizontal line on the cost graph.

Total Variable Costs
The total variable cost (TVC) curve slopes up at an accelerating rate, reflecting the law of diminishing marginal returns.

Total Costs
The total cost (TC) curve is found by adding total fixed and total variable costs. Its position reflects the amount of fixed costs, and its gradient reflects variable costs.
=> TC = TFC + TVC

See enlarged version: http://bit.ly/2lSmOSv
Marginal Cost of Production

The marginal cost of production is of special interest to economists. Marginal cost is the change in total cost for each unit produced. Think of marginal cost as the additional cost of producing one more item.

For each additional unit of output a firm produces, it incurs more variable cost and hence more total cost. This means that its marginal cost increases as well.

Average Cost

Average Cost or unit cost is equal to total cost divided by the number of goods produced (the output quantity, Q).

It is also equal to the sum of average variable costs (total variable costs divided by Q) and average fixed costs (total fixed costs divided by Q).

Therefore, ATC (Average Total Cost) = AFC + AVC

Average Cost Curves
ATC (Average Total Cost) = Total Cost / Quantity
AVC (Average Variable Cost) = Variable Cost / Quantity
AFC (Average Fixed Cost) = Fixed Cost / Quantity

The MC curve always passes through the lowest point of the average cost curve.

Enlarged version: http://bit.ly/2kN5cGC

Cost Schedule

Below is an example of the costs associated with producing 4 units of a good.

– Note that FC (fixed costs) remain constant. Therefore the more  you produce, the lower the average fixed costs will be.
– To work out marginal cost, you just see how much TC has increased by.
– For example, the first unit sees TC increase from 1,000 to 1,200 (therefore the increase (MC) is 200)
– For the second unit, TC increases from 1,200 to 1,300 (therefore the MC is 100)

Enlarged version: http://bit.ly/2laTJBV
[Optional] Costs of Production
Revenue & Profit
Many people confuse the concepts of revenue and profit. Revenue is all of the income a business earns.

For a firm selling a single type of product at one price, revenue is equal to the quantity sold multiplied by the price. If you’ve got a hundred apples that you sell for $1 each, then your total revenue, assuming you sell all the apples, is $100.
Revenue = Quantity x Price

Profit, on the other hand, is the income a company has left over after covering all of its costs.
Profit = Revenue – Cost  

Important Formulae

1) Total Revenue (TR): This is the total income a firm receives.
TR = P x Q
2) Average Revenue (AR) = TR / Q
3) Marginal Revenue (MR) = the additional revenue gained from selling an extra unit of a good.

Profit = Total Revenue (TR) – Total Costs (TC) or [(AR – AC) × Q]

Marginal Revenue

Firms maximize their profits when they produce at the point where marginal cost equals marginal revenue.

In other words, if a firm wants to make the largest profits it can, it will produce up to the point where the additional cost of producing one more item is the same as the additional revenue earned by producing one more item.

Profit Maximization

– In classical economics, it is assumed that firms will seek to maximize their profits. This occurs when the difference between TR – TC is the greatest.
– Profit maximization will also occur at an output where MR = MC.
– When MR> MC, the firm is increasing its profits and total profit is increasing.
– When MR< MC, total profit starts to fall.
– Therefore profit is maximized when MR = MC.

Enlarged version: http://bit.ly/2lmJUmm
Profit Maximization
To understand this principle, look at the diagram below. If a firm produces less than Q1 (5 units), MR > MC. Therefore, for this extra output, the firm is gaining more revenue than it is paying in costs. Total revenue will increase. However, after Q1, the marginal cost of the output is greater than the marginal revenue. This means the firm will see a fall in its profit level.

Enlarged version: http://bit.ly/2lmJUmm

Economic profits in an industry are important because they provide firms in other industries with an incentive to employ their land, labor, capital, and entrepreneurial ability in the economically profitable industry.
Jim Rohn