Cost, Revenue, and Profit Maximization Chapter 5, Lesson Five
The Purpose of a Business • What is the purpose of a business? • If you are a business owner, what do want? • Hopefully you said to make the most money possible. • How do we make money? • We earn more than we spend. There are a few terms that economists use to explain this very simple idea.
Costs • A business must analyze costs before making decisions. • To simplify decision making, cost is divided into several different categories. • Fixed cost—cost of business incurs even if the plant is idle and output is zero • -In other words, how much it costs you to have the company even if you aren’t producing anything • Examples: salaries (not hourly pay), rent, property taxes, car notes • Usually associated with machines, equipment, buildings, etc.
Costs • Variable costs—costs that change when the business rate of operation or output changes • Costs that change according to how much you produce • Examples: wages (per hour), electricity bill, freight/shipping charges • Usually associated with labor and raw materials
Costs • Total cost (or overhead)—the sum of the variable and fixed costs • Marginal Costs—extra cost incurred when a business produces one additional unit of product. • MC = difference in total costs / marg. Prod. • Fixed costs do not change—marginal cost is the per unit increase in variable costs that stems from using additional factors of production.
Revenue (Makin’ Money) • We want to make more than we spend. We’ve already looked at what we spend (costs), now we need to look at the amount of money we pull in (revenues). • Total Revenue—total amount of money that comes into the business # of units sold multiplied by average price per unit Or quantity sold multiplied by price per unit
Revenue • Marginal revenue—extra revenue associated with the production and sale of one additional unit of output MR = difference in total revenue / marg. Prod.
Marginal Analysis • Economists use marginal analysis, a type of cost-benefit decision making that compares the extra benefits to the extra costs of an action. • This analysis will show us when we are losing money, when we are making money, and when we are breaking even. • Break-even point—total output or total product the business needs to sell in order to cover its total costs.
Marginal Analysis • A business wants to do more than just cover its costs and break even. • It wants to make money! That’s the goal of a business. • We want to minimize our costs and maximize our revenues to find the point that will make use the most amount of money
Profits • Profit—your revenue minus your costs (how much is left over after you pay your bills) • Total profit—Total revenue minus total costs • The total profit is maximized where marginal costs equal marginal revenue. This is were business should operate to make the most possible money. • This is where they are not missing any would be profits and they are not losing any money.