CHAPTER 5:

SUPPLY

Lesson 3: Cost, Revenue, and Profit Maximization

FINDING MARGINAL COST

Fixed Costs:

Fixed costs—the costs that an organization incurs even if there is little or no

activity. Total fixed costs, sometimes called overhead, remain the same.

Fixed costs include salaries paid to executives, interest charges on bonds, rent

payments on leased properties, and state and local property taxes. Fixed costs

also include depreciation—the charge for the gradual wear and tear on capital

goods because of their use over time.

FINDING MARGINAL COST

Variable Costs:

Variable cost, the cost that changes when the business’s output changes.

Variable costs are usually associated with labor and raw materials. For example,

wage-earning workers may be laid off or asked to work overtime as output

changes.

For most businesses, the largest variable cost is labor.

Total Cost:

Total cost of production, which is the sum of the fixed and variable costs. Total

cost takes into account all the costs a business faces in the course of its operations.

FINDING MARGINAL COST

Marginal Cost:

Variable, fixed, and total costs are necessary to compute the most useful

measure of cost, marginal cost—the extra cost incurred when producing one

more unit of output.

To find marginal cost, we have to divide the additional cost of adding each

worker by the additional output the worker generates. To find the marginal cost

of the first worker, we divide the additional cost of $90 by the additional output of

7 to get $12.86. To find the marginal cost of the second worker, we divide the

additional cost of $90 by the additional output of 13 to get $6.92, and so on.

FIGURE 5.6

FINDING MARGINAL REVENUE

The second important measure a business needs to find is its marginal revenue.

Average Revenue:

The average revenue is simply the average price that every unit of output sells

for. For example, if the company sells every unit of output for $15, its average

revenue is $15. This would remain unchanged at $15 if it sold 10, 100, or 1,000

units. Of all the revenue measures, average revenue is the least useful, even

though it is perhaps the easiest to understand.

FINDING MARGINAL REVENUE

Total Revenue:

The total revenue is all the revenue that a business receives. Total revenue is

equal to the number of units sold multiplied by the average price of $15 per unit.

So, if one worker is hired and seven units are produced and sold at $15 each, the

total revenue is $105. If 10 workers are hired and their 148 units of total output sell

for $15 each, then total revenue is $2,220.

FINDIING MARGINAL REVENUE

Marginal Revenue:

The most important measure of revenue is marginal revenue, the extra revenue a

business receives from the production and sale of one additional unit of output.

You can find the marginal revenue by dividing the change in total revenue by

the marginal product.

For example, when the business employs five workers, it produces 90 units of output and generates $1,350 of total revenue. If a sixth worker is added, output

increases by 20 units and total revenues increase to $1,650. If we divide the

change in total revenue ($300) by the marginal product (20), we have marginal

revenue of $15.

The marginal revenue appears to be constant at $15 for every level of output.

PROFIT MAXIMAZATION AND BREAK EVEN

Profit Maximization:

Having made a profit with the sixth worker, the business would hire the seventh

and eighth workers for the same reason. While the addition of the ninth worker

neither adds to nor takes away from total profits, the firm would have no

incentive to hire the tenth worker. If it did, it would find that profits would go

down, and it would go back to using nine workers.

Eventually, the profit-maximizing quantity of output—the volume of production

where marginal cost and marginal revenue are equal—is reached.

PROFIT MAXIMIZATION AND BREAK-EVEN

Break-Even Analysis:

Sometimes a firm may not be able to sell enough to maximize its profits right

away, so it may want to know how much it must sell just to cover its costs. This is

when the firm needs to find its break-even point, the level of production that

generates just enough revenue to cover its total operating costs.

If it employed two workers and could sell 20 units, the company would cover all

of its costs. The result is that two workers would have to be hired to break even.

Most businesses want to do more—they want to maximize the amount of profits

they can make, not just cover their costs. To do this, they would have to compute their marginal costs and marginal revenues to find the level of output where they

were equal.

PROFIT MAXIMIZATION AND BREAK-EVEN

Costs and Business Operation:

Many stores are flocking to the Internet, making it one of the fastest-growing

areas of business today. Stores do this because the overhead, or the fixed costs

of operation, on the Internet is so low.

When customers visit the “store” on the Web, they see a range of goods for sale.

In some cases, the owner has the merchandise in stock; in other cases, the

merchant simply forwards the orders to a distribution center that handles the

shipping.