Reading Essentials and Study Guide

Transcription

1 Lesson 3 Cost, Revenue, and Profit Maximization ESSENTIAL QUESTION How do companies determine the most profitable way to operate? Reading HELPDESK Academic Vocabulary generates produces or brings into being conducted handled by way of Content Vocabulary fixed costs costs of production that do not change when output changes overhead broad category of fixed costs that includes interest, rent, taxes, and executive salaries variable cost production cost that varies as output changes; labor, energy, raw materials total cost variable plus fixed cost; all costs associated with production marginal cost extra cost of producing one additional unit of production average revenue average price that every unit of output sells for total revenue total amount earned by a firm from the sale of its products; average price of goods sold times quantity sold marginal revenue extra revenue from the sale of one additional unit of output profit-maximizing quantity of output level of production where marginal cost is equal to marginal revenue break-even point production level where total cost equals total revenue; production needed if the firm is to recover its costs e-commerce electronic business or exchange conducted over the Internet TAKING NOTES: Key Ideas and Details Use the graphic organizer below to describe information business people must gather in order to balance costs and revenue. Costs Revenue 1

2 All businesses, including nonprofit organizations, face the challenge of being successful enough to stay in operation. Even better, most hope to operate in a way that maximizes profits. What information does a business need to achieve these goals? 1. What is the cost of the lease, the utility bills, the purchase and repair of equipment, and other daily expenses for doing business? 2. What is the cost of paying employee salaries and benefits? 3. What is the cost of producing each good or providing each service? Finding Marginal Cost Guiding Question: What is the difference between a fixed cost and a variable cost? Businesses need to think about several measures of cost if they want to produce efficiently. But which measure is the most useful if they want to maximize profits? Let s take a look at measures of cost one by one to find out. Fixed Costs The first measure is fixed costs. Fixed costs are the costs that an organization experiences even if there is little or no activity. With fixed costs, it makes no difference whether the business produces nothing, very little, or a large amount. Total fixed costs, sometimes called overhead, stay 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. Depreciation is the charge for the gradual deterioration, or wear and tear, on capital goods because of their use over time. A machine, for example, will not last forever because its parts will wear out slowly and eventually break. Suppose fixed costs are $50 for the firm with the hypothetical production function shown in 5.5 in the previous lesson. To keep all of our numbers together, Figure 5.6 shows the same production function in the first three columns, along with total fixed costs in column four. As you can see, the total fixed cost is $50 for every level of output, even if nothing is produced. Variable Costs The second measure is variable cost. Variable cost is the cost that changes when the business s rate of operation or output changes. While fixed costs are generally related to machines and other capital goods, variable costs are usually related to labor and raw materials. For example, wage-earning workers may be laid off or asked to work overtime as output decreases or increases. Other examples of variable costs include electric power to run machines and shipping charges to deliver the final product. For most businesses, the largest variable cost is labor. Let s say that a business wants to hire one worker to produce seven units of output per day. If the worker costs $90 per day, the total variable cost is $90. If the business wants to hire a second worker to produce additional units of output, then its total variable cost is $180, and so on. These are the numbers shown in column five of the figure. 2

3 Total Cost Figure 5.6 shows the total cost of production. The total cost of production is the sum of the fixed and variable costs. Total cost includes all the costs a business has in its operations. Suppose the business decides to use six workers costing $90 each to produce 110 units of total output. Then its total cost will be $590. This is the sum of $50 in fixed costs plus $540 (or $90 times six) of variable costs. Marginal Cost We need to know variable, fixed, and total costs to figure out the most useful measure of cost, marginal cost. Marginal cost is the extra cost of producing one more unit of output. To find marginal cost, we have to divide the additional cost of each worker by the additional output the worker makes. Let s find the marginal cost of the first worker. To do this, divide the additional cost of $90 by the additional output of 7. The answer is $ To find the marginal cost of the second worker, divide the additional cost of $90 by the additional output of 13 to get $6.92, and so on. You can see all of these values in column seven of Figure 5.6. As we will see next, marginal revenue is the most useful measure of revenue. This is because it helps a firm maximize profit. Reading Progress Check Analyzing If a firm s total output increases, will the fixed costs increase? Explain. Finding Marginal Revenue Guiding Question: What is the difference between average revenue and marginal revenue? The second important measure a business needs to find is its marginal revenue. But before we get to it, we ll look at two other measures of revenue. Average Revenue The average revenue is simply the average price that every unit of output sells for. For example, if the company in Figure 5.6 sells every unit of output for $15, its average revenue is $15. This $15 would stay the same if it sold 10, 100, or 1000 units. Although average revenue is easy to understand, it is the least useful of all the revenue measures. This is why the table in Figure 5.6 does not have a column for average revenue. 3

4 Total Revenue The total revenue is all the revenue that a business receives. For the firm in Figure 5.6, total revenue is shown in column eight. It is equal to the number of units sold multiplied by the average price of $15 per unit. Imagine the firm hires one worker who produces seven units, which are sold at $15 each. The total revenue is $105. Now imagine the firm hires 10 workers who produce 148 units of total output that sell for $15 each. The total revenue would be $2,220. The calculation is the same for any level of output in the table. Column eight in Figure 5.6 shows total revenue. Marginal Revenue The most important measure of revenue is marginal revenue. Marginal revenue is the extra revenue a business receives from the production and sale of one additional unit of output. You can find the marginal revenue in Figure 5.6 by dividing the change in total revenue by the change in total output. Remember, the change in total output is also called the marginal product. For example, imagine the business employs five workers who produce 90 units of output. This generates $1,350 of total revenue at an average price of $15 per unit. If it hires a sixth worker, 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. As long as every unit of output sells for $15, the marginal revenue earned by the sale of one more unit will always be $15. For this reason, the marginal revenue appears to be constant at $15 for every level of output in Figure 5.6. In reality, this may not always be the case. Businesses often find that marginal revenues change, especially if they sell some of their output at different prices. Reading Progress Check Explaining Why is marginal revenue the most important type of revenue? Profit Maximization and Break-Even Guiding Question: What cost advantage does e-commerce offer businesses? Profits are affected by both cost and the revenue from sales. That is why owners have to consider both when they think about profitability. Exploring the Essential Question Imagine you run a company that manufactures widgets. Last week you had $1,000 in total costs and revenue of $1,000. Why do you need to figure out your marginal costs and marginal revenue? 4

5 Profit Maximization Suppose the firm in Figure 5.6 wanted to experiment to try to find the level of output that maximized profits. The business would hire the sixth worker, for example, because the extra output would cost only $4.50 to produce, and it would generate $15 in new revenues. This means that each of the 20 additional units produced would generate $10.50 of profit. This would increase total profits from $850 to $1,060. Based on this, the business would then hire a seventh and eighth worker. But it would find that hiring the ninth worker neither adds to nor takes away from total profits. And the firm would have no reason to hire the tenth worker. If it did, it would find that profits went down, and it would go back to using nine workers. Eventually, the firm would reach the profit-maximizing quantity of output. This is the volume of production where marginal cost and marginal revenue are equal. You can see this in the last column in Figure 5.6. Other levels of output may generate equal profits, but none will be more profitable. The firm in Figure 5.6 found this level of output by using trial and error, or experimenting. But it could have saved some time by looking for the level of output where marginal cost (in column seven) is exactly equal to marginal revenue (in column nine). This is 144 units using nine workers. This is why we computed the marginal cost and revenue measures in the first place. Break-Even Analysis Sometimes a firm may not be able to sell enough to maximize its profits right away. Then 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. This is the level of production that generates just enough revenue to cover total operating costs. For example, the firm in Figure 5.6 could not cover all its costs if it employed one worker and produced 7 units. This is because total costs would be $140, while total revenue is only $105. But if it employed two workers and could sell 20 units, the company would cover all of its costs. This means that the firm has to hire two workers to break even. The break-even point only tells the firm how much it has to produce to cover its costs. 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 figure out their marginal costs and marginal revenues to find the level of output where they are equal. Costs and Business Operation Many stores are opening on the Internet, mostly because overhead costs are so low. This is why the Internet is one of the fastest-growing areas of business today. Remember that overhead is the fixed costs of operation. Another good thing about doing business on the Internet is that a firm does not need as much inventory. And if a business can lower its fixed or variable costs, this also helps its break-even point. It helps by lowering the amount of sales the company needs to cover its total costs. Businesses do not need to spend a large sum of money to rent a building and stock it with inventory if they use e-commerce. E-commerce is electronic business done over the Internet. For just a fraction of the cost of a typical store, the e-commerce business owner can buy Web access along with an e-commerce software package. The package provides everything from Web catalog pages to ordering, billing, and accounting software. Then, the owner of the e-commerce business store puts in pictures and descriptions of the products for sale into the software and loads the program. 5

6 Lesson 3 Cost, Revenue, and Profit Maximization When customers visit the store on the Web, they see a variety 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. Either way, the fixed costs of operation are significantly lower than they would be in a typical retail store. And the break-even point of sales is much lower. Reading Progress Check Contrasting What are the differences between an e-commerce store and a traditional business? 6