How do a firm's costs and revenue combine to give its profit?
Define fixed, variable and total costs, average cost, revenue and profit, and calculate them
A clear O-Level answer on costs, revenue and profit. The difference between fixed and variable costs, how to work out total and average cost, total revenue, and profit, with simple worked calculations.
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What this dot point is asking
The syllabus wants you to define and calculate a firm's costs (fixed, variable, total and average), its revenue, and its profit. The big idea is that every firm faces costs to produce and earns revenue from selling, and the gap between the two is profit, the figure that drives most business decisions.
The answer
Fixed and variable costs
A firm's costs are split into two types according to whether they change with output:
Total cost
Total cost (TC) is everything the firm spends to produce its output:
Average cost
Average cost (AC), also called cost per unit, is the total cost spread over the units produced:
Average cost matters because a firm with a lower average cost than its rivals can charge a lower price or earn a larger margin.
Revenue
Total revenue (TR) is the money a firm receives from selling its output:
Profit
If revenue is greater than total cost, the firm makes a profit. If total cost is greater than revenue, it makes a loss. If they are equal, the firm breaks even.
Examples in context
Example 1. A hawker stall's costs. A hawker stall pays fixed costs such as rent for the stall whether or not it sells anything, and variable costs such as ingredients that rise with the number of dishes sold. Its profit at the end of the day is the takings (revenue) minus all these costs. Lowering average cost, for example by buying ingredients in bulk, raises the profit on each dish.
Example 2. A high-revenue, low-profit business. A delivery start-up might earn millions in revenue yet make a loss, because its variable costs (paying riders and fuel) and fixed costs (technology and offices) are even larger. This shows why investors look at profit, not just revenue, when judging a firm.
Try this
Cue. Distinguish between a fixed cost and a variable cost, with an example of each. A fixed cost does not change with output, such as rent; a variable cost changes with output, such as raw materials.
Cue. State the formula for profit. Profit equals total revenue minus total cost.
Cue. A firm has total revenue of \8000\. State whether it makes a profit or a loss, and by how much. It makes a loss of \1000$, because total cost is greater than total revenue.
Exam-style practice questions
Practice questions written in the style of SEAB exam questions on this dot point, with worked answer explainers. The year tag is the paper they imitate, not the source.
Original5 marksA firm has fixed costs of \2000\ per unit, and it produces units. Calculate its total cost and its average cost per unit.Show worked answer →
A 5 mark calculation rewards the correct method for total cost and average cost.
- Total variable cost
- \8 \times 500 = \.
- Total cost
- total fixed cost plus total variable cost = \2000 + \4000 = \6000$.
- Average cost
- total cost divided by quantity = \dfrac{\6000}{500} = \ per unit.
Markers reward the total variable cost calculation, adding fixed cost to get total cost, and dividing by output to get average cost. A common slip is to forget the fixed cost when finding total cost.
Original5 marksA firm sells units at \15\. Calculate its total revenue and its profit, and explain what the profit figure shows.Show worked answer →
A 5 mark calculation rewards total revenue, profit, and a clear interpretation.
- Total revenue
- price times quantity = \15 \times 500 = \.
- Profit
- total revenue minus total cost = \7500 - \6000 = \1500$.
- Interpretation
- The firm makes a profit of \1500$, because its revenue is greater than its total cost. Profit is the reward to the entrepreneur and a sign that the firm is using its resources in a way that customers value enough to pay for.
Markers reward total revenue as price times quantity, profit as revenue minus total cost, and the point that a positive figure means revenue exceeds costs.
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