Costs, Revenue and Profit Calculations

Numbers that predict behaviour

A business works out its costs and revenue to report what it earned. Economics works out the same numbers to answer a different question: what will this producer do next? A firm that can sell a frame for more than it costs to make has a reason to make more of them. That is why costs and revenue sit in an economics course at all. Learn the arithmetic first, then use it to explain behaviour.

The cost and revenue words

Six terms carry every calculation in this topic.

Formula to meaning

Fixed or variable?

A workshop makes bicycle frames. Which of these is a VARIABLE cost for the workshop?

• The steel tubing used to build each frame
• The monthly rent paid on the workshop unit
• The insurance premium paid once each year
• The salary paid to the workshop manager

Work out the total cost

A workshop makes 300 bicycle frames a month. Its fixed costs are 9000 pounds a month, and each frame costs 40 pounds in materials and labour. Work out its total cost for the month, in pounds, using total cost = fixed costs + total variable costs.

Work out the average cost

The same workshop has a total cost of 21000 pounds and makes 300 frames. Work out its average cost for one frame, in pounds, using average cost = total cost divided by output.

The number that drives the decision

Average cost is what makes this economics rather than bookkeeping. Compare it with the price. If the price is above average cost the producer earns something on every unit sold, so it has a reason to produce more. If the price falls below average cost it loses something on every unit, so it has a reason to produce less. Total profit tells you how last month went; average cost against price tells you what happens next.

Work out the profit

The workshop sells all 300 frames at 110 pounds each, giving total revenue of 33000 pounds. Its total cost is 21000 pounds. Work out its profit for the month, in pounds.

Two routes to more profit

The spec names two ways a producer can raise its profit. Select the TWO changes below that would do so, assuming nothing else changes.

• Reducing the average cost of building each frame
• Selling more frames at the same price as before
• Paying a higher price for exactly the same steel
• Cutting the price without selling any more frames

What is the firm trying to do?

Economics does not assume every producer simply maximises profit. The spec names three objectives, and which one a firm pursues changes the behaviour you should predict.

From revenue to profit

Total cost is fixed costs plus total _____ costs, and dividing that by output gives the _____ cost of one unit. Total revenue is price multiplied by _____. Profit is total revenue minus total _____. When the price rises above average cost, producing each extra unit becomes more _____, which is why a higher price acts as an incentive to supply more.

Why higher prices bring more output

The price of bicycle frames rises while every cost stays exactly the same. Why does economics predict that the quantity produced will rise?

• Each frame now earns more above its average cost, so producing more is more rewarding
• The higher price lowers the average cost of a frame, so more frames can now be built
• The higher price reduces the fixed costs owed, so the workshop has more money to spend
• The higher price cuts the total revenue earned, so more frames are needed to recover it

A full answer, marked

Question: a workshop has an average cost of 70 pounds per frame and the market price falls from 110 pounds to 65 pounds. Analyse the likely effect on its output. Model answer: the price of 65 pounds is now below the average cost of 70 pounds, so the workshop loses 5 pounds on every frame it sells. A producer aiming at profit has an incentive to cut output, because each frame produced adds to the loss. The workshop might instead look for ways to cut its average cost below 65 pounds, since that would make production worthwhile again at the new price. The marks here are not for the subtraction. They are for using the number to predict what the producer does.

Where profit and ethics pull apart

The spec notes that the motivations of producers may conflict with ethical or moral interests. Select the ONE sentence below where that conflict appears.

• The workshop plans to cut the average cost of every frame it builds.
• It finds a cheaper supplier whose workers are paid below the legal minimum.
• The switch would raise the monthly profit of the workshop by 2000 pounds.
• The workshop reports its costs and revenue to its owners every month.

The workshop decides

The workshop has an average cost of 70 pounds per frame and has been selling every frame at 110 pounds. Work through what happens as conditions change.

• Demand falls and the market price drops to 65 pounds a frame. Average cost is still 70 pounds. What does economics predict the workshop will do?
• The workshop then finds a way to build frames for an average cost of 60 pounds, while the price stays at 65 pounds. What changes?
• The owners say their objective is market share rather than profit. How does that change what you would predict?

Explain what the producer will do

A workshop makes 300 bicycle frames a month. Its fixed costs are 9000 pounds and each frame costs 40 pounds to build. It sells every frame at 110 pounds. Using the figures, analyse how this producer would respond if the market price fell.

• State the total cost and the average cost of one frame, showing how you found each
• State the profit, and explain which calculation it comes from
• Explain what the producer has an incentive to do if the price falls below average cost
• Explain how your prediction would differ if the firm aimed at market share rather than profit
• Comment on one way the profit motive can conflict with ethical or moral interests