Costs, Revenue and Profit

Costs

The test for a fixed cost is simple: if the firm produced nothing this month, would it still have to pay? Rent yes, raw materials no.

Average cost falls as output rises, at least at first, because the fixed costs are spread over more units. This is the arithmetic behind economies of scale (2.1).

Revenue

Revenue is the money a firm receives from selling its output. It is not profit, costs have not been taken off yet.

Profit

Profit = total revenue − total cost

If TR is greater than TC the firm makes a profit; if TC is greater than TR it makes a loss.

A worked example. A firm sells 500 units at £12 each. Its fixed costs are £2,000 and its variable costs are £6 per unit.

TR = 500 × £12 = £6,000
VC = 500 × £6 = £3,000; FC = £2,000; so TC = £5,000
Profit = £6,000 − £5,000 = £1,000
AC = £5,000 ÷ 500 = £10, and since AR is £12, the firm makes £2 profit per unit, which checks out: £2 × 500 = £1,000.

Working the answer out two ways like this is a good habit; it catches arithmetic slips.

Break-even is where total revenue exactly equals total cost, so profit is zero. Below that output the firm makes a loss; above it, a profit.

The objectives of firms

Most firms aim to make as much profit as possible, but not all, and Edexcel expects the alternatives:

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Note the trade-off: a firm chasing growth or market share often cuts prices, which reduces profit now in the hope of higher profit later.

Why profit matters: it rewards the owners for the risk they took, it provides retained profit to reinvest in the business, and it attracts new firms into the industry.

Worked example

A coffee shop pays £3,000 a month in rent and staff salaries. Each cup costs £0.80 in ingredients and cups. It sells coffee at £2.80 and sells 2,000 cups in a month.

TR = 2,000 × £2.80 = £5,600
Variable costs = 2,000 × £0.80 = £1,600
TC = £3,000 + £1,600 = £4,600
Profit = £5,600 − £4,600 = £1,000

Now the owner considers cutting the price to £2.40 to attract more customers. Sales rise to 2,600 cups.

TR = 2,600 × £2.40 = £6,240
Variable costs = 2,600 × £0.80 = £2,080; TC = £3,000 + £2,080 = £5,080
Profit = £6,240 − £5,080 = £1,160

The price cut raised profit, because the extra cups sold more than made up for the lower price on each one, demand was elastic (1.3).

Evaluation.

• The result depends entirely on how many extra cups are sold. If sales had risen only to 2,200, revenue would be £5,280 and profit only £520, the price cut would have reduced profit.
• Fixed costs do not change with output, so every extra cup only adds £0.80 of cost. This is why selling more usually helps once fixed costs are covered.
• The shop may not have the capacity to serve 2,600 customers, longer queues could drive customers away.
• A lower price might make customers see the coffee as lower quality, damaging the shop's reputation.
• Rivals may cut their prices too, in which case the extra customers never arrive and everyone earns less.

Judgement: cutting price raises profit only if demand is elastic enough and rivals do not follow. The owner should be confident about both before committing.

Common exam mistakes

• Confusing revenue with profit. Revenue is money coming in; profit is what is left after costs.
• Treating raw materials as a fixed cost, or rent as a variable cost.
• Forgetting that fixed costs must still be paid when output is zero.
• Using the wrong formula: AC = TC ÷ output, not TC × output.
• Forgetting to multiply variable cost per unit by the number of units.
• Saying break-even means the firm is doing badly, it means profit is exactly zero.
• Assuming every firm wants maximum profit.

Exam technique

Set your calculations out line by line, TR, then FC, then VC, then TC, then profit. If you make an arithmetic slip you can still earn method marks, but only if the examiner can see the method.

Always include the units (£) and label each figure.

When asked to comment on a calculation. Do not stop at the number. Say what it means for the firm and what it depends on, usually how many extra units are sold, or whether rivals respond.

Quick revision

• Fixed costs do not change with output; variable costs do.
• TC = FC + VC. AC = TC ÷ output.
• TR = price × quantity. AR = TR ÷ quantity = price.
• Profit = TR − TC. Break-even is where TR = TC.
• Average cost falls as output rises, because fixed costs are spread more thinly.
• Objectives: profit maximisation, survival, growth, market share, sales, social objectives, quality.
• Growth and market share often mean lower profit now for higher profit later.
• Profit rewards risk, funds reinvestment, and attracts new firms in.

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