Costs, revenue and objectives
Firms make decisions by comparing their costs with their revenue. Costs show how much it costs to produce goods and services. Revenue shows the income earned from selling them. A firm then uses this information to decide prices, output, profit and future plans.
1. Cost of production
Cost of production means the total amount of money a firm spends to produce goods or services. These costs include payments for resources such as land, labour, capital and enterprise.
Factory example
A factory pays for raw materials, machinery, electricity, workers and rent.
Coffee shop example
A coffee shop pays for coffee beans, milk, cups, staff wages and shop rent.
Delivery firm example
A delivery firm pays for drivers, fuel, vehicles, repairs and insurance.
2. Types of costs
Fixed costs
Fixed costs are costs that do not change when output changes in the short run. The firm has to pay them even if it produces nothing.
- Examples: rent, insurance, loan interest, security costs and salaries of permanent managers.
- Key idea: fixed costs stay the same whether the firm produces 10 units or 1,000 units.
How to read the graph: the fixed cost line is horizontal at $4,000. This means fixed costs remain the same at every output level. Even if output rises, fixed costs do not rise.
Variable costs
Variable costs are costs that change directly with output. When the firm produces more, variable costs rise. When the firm produces less, variable costs fall.
- Examples: raw materials, packaging, fuel, hourly wages and electricity used in production.
- Key idea: variable costs start at zero when output is zero and increase as output increases.
How to read the graph: the variable cost line slopes upward from the origin. This shows that as output increases, total variable costs also increase.
Total cost
Total cost is the full cost of producing a given level of output. It includes both fixed costs and variable costs.
Total cost (TC) = Fixed cost (FC) + Variable cost (VC)
How to read the graph: the total cost curve starts at the fixed cost level of $4,000, not at zero. This is because the firm must pay fixed costs even before producing any output. As output rises, variable costs are added, so total cost rises.
3. Average costs
Average costs show the cost per unit of output. They help a firm understand whether producing each unit is becoming cheaper or more expensive.
| Cost | Meaning | Formula |
|---|---|---|
| Total cost (TC) | Total cost of producing all output. | TC = FC + VC |
| Average fixed cost (AFC) | Fixed cost per unit of output. | AFC = FC ÷ Q |
| Average variable cost (AVC) | Variable cost per unit of output. | AVC = VC ÷ Q |
| Average total cost (ATC) | Total cost per unit of output. | ATC = TC ÷ Q or AFC + AVC |
Average fixed cost
Average fixed cost falls as output rises because the same fixed cost is spread over more units.
How to read the graph: average fixed cost falls as output increases. For example, if rent is $4,000, producing more units spreads that rent over more products, so the fixed cost per unit becomes lower.
Average total cost
Average total cost often falls at first and then rises later. It may fall because the firm uses resources more efficiently as output increases. It may rise later if the firm becomes too large or difficult to manage.
How to read the graph: average total cost falls from point a towards point b, meaning each unit is becoming cheaper to produce. After point b, average total cost rises, meaning each unit becomes more expensive to produce.
4. How changes in output affect costs
- When output rises, fixed costs stay the same in the short run.
- When output rises, variable costs rise because more materials and labour may be needed.
- Total cost rises as output rises because variable costs are added to fixed costs.
- Average fixed cost falls as output rises because fixed costs are spread over more units.
- Average total cost may fall first and rise later because efficiency improves at first but problems may occur if the firm grows too large.
Simple example
If a bakery pays $1,000 rent each month, this rent is fixed. If it makes 100 cakes, rent per cake is $10. If it makes 500 cakes, rent per cake is $2. This is why average fixed cost falls when output increases.
5. Revenue
Revenue is the income a firm receives from selling goods or services. It is not the same as profit because profit is found after costs are deducted.
| Revenue | Meaning | Formula |
|---|---|---|
| Total revenue (TR) | Total income from selling output. | TR = Price × Quantity sold |
| Average revenue (AR) | Revenue per unit sold. | AR = TR ÷ Quantity sold |
| Marginal revenue (MR) | Extra revenue from selling one more unit. | MR = Change in TR ÷ Change in Q |
Example: if a firm sells 200 units at $5 each, total revenue is:
TR = $5 × 200 = $1,000
If total revenue is $1,000 from 200 units, average revenue is:
AR = $1,000 ÷ 200 = $5
6. Profit
Profit is the money left after total costs are subtracted from total revenue.
Profit = Total revenue − Total cost
If total revenue is greater than total cost, the firm makes a profit. If total cost is greater than total revenue, the firm makes a loss.
7. Objectives of firms
Not all firms have exactly the same aim. Some focus mainly on profit, while others may focus on survival, growth or social welfare.
Survival
A new or struggling firm may simply aim to stay open, pay its bills and keep customers.
Social welfare
Some firms aim to help society, such as reducing pollution, supporting workers or helping the local community.
Growth
A firm may aim to become larger by increasing sales, opening more branches or entering new markets.
Profit
Many firms aim to make profit so owners can earn returns and the business can reinvest.
Profit maximisation
This means choosing the output level where profit is as high as possible.
Profit maximisation
Profit maximisation means producing the level of output where the difference between total revenue and total cost is greatest. In more advanced analysis, profit is maximised where marginal revenue equals marginal cost.
Profit maximisation condition: MR = MC
Quick exam check
- Fixed costs do not change with output in the short run.
- Variable costs rise when output rises.
- Total cost equals fixed cost plus variable cost.
- Average revenue is revenue per unit sold.
- Profit equals total revenue minus total cost.