Business Economics
1.2.3 Business costs, revenues and profit
Business economics
Business costs
Costs can be grouped by how they behave when a firm changes the amount it produces.
Fixed costs
Fixed costs: costs that do not vary with the level of output.
Fixed costs are also called overheads. Rent, business rates, insurance, advertising, loan interest, and research and development are all examples. They stay the same however much the firm produces, and they still have to be paid even if it produces nothing.
Total fixed costs are all of a firm’s fixed costs added together.
Formula:
Total fixed costs = Total costs – Total variable costs
Variable costs
Variable costs: costs that change when output levels change.
Raw materials, packaging, fuel and the wages of workers paid for each item they make are all examples. If a firm produces more, its variable costs rise, and if it produces nothing, its variable costs are zero.
Formula:
Total variable costs = Variable cost per unit × Quantity produced
Total costs
Total costs: fixed costs and variable costs added together.
Formula:
Total costs = Total fixed costs + Total variable costs
Average (total) costs
Average cost: the cost of producing a single unit of output.
Formula:
Average cost = Total costs ÷ Quantity produced
Revenue and profit
Total revenue
Total revenue: The amount of money gained from the sale of all products.
Formula:
Total revenue = Price × Quantity sold
Profit
Profit: the difference between total revenue and total costs.
Formula:
Profit = Total revenue – Total costs
If total costs are greater than total revenue, the answer is negative and the firm has made a loss.
Calculating costs, revenue and profit
Show the currency in every answer, and round to two decimal places where needed.
Example: a phone case maker
A firm makes phone cases. Each month it pays $2 000 rent, $300 insurance and $200 interest on a loan. Each case uses $1.50 of materials, $0.30 of packaging and $1.20 of labour. It sells each case for $5.
- Total fixed costs: $2 000 + $300 + $200 = $2 500 a month.
- Variable cost per unit: $1.50 + $0.30 + $1.20 = $3.00 per case.
- Total variable costs (4 500 cases): $3.00 × 4 500 = $13 500.
- Total costs: $2 500 + $13 500 = $16 000.
- Average cost: $16 000 ÷ 4 500 = $3.56 per case (to two decimal places).
- Total revenue: $5 × 4 500 = $22 500.
- Profit: $22 500 – $16 000 = $6 500.
In a quiet month, the firm makes and sells only 1 000 cases. Its total costs are $2 500 + ($3.00 × 1 000) = $5 500, and its total revenue is $5 × 1 000 = $5 000. Profit = $5 000 – $5 500 = –$500, so the firm makes a loss. Its average cost rises to $5 500 ÷ 1 000 = $5.50 per case, because the same fixed costs are shared between fewer cases.
