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The relationship between costs, revenue and profit

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The relationship between costs, revenue and profit

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Have you ever wondered why a business that is losing money might still be operating? At what point do they decide to close down? To answer these questions, we need to first understand the relationship between costs, revenue, and profit.

Here are some refreshers:

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Profit is the difference between total revenue (TR) and total costs (TC)

Profit = TR - TC

What are the conditions for profit maximisation?

Profit is maximised when the gap between TR and TC is the largest. This means the firm is earning much more in revenue than it is spending on costs, and therefore, profit is at its highest.
Profit maximisation also occurs where Marginal Cost (MC) equals Marginal Revenue (MR).

Marginal cost is the additional cost of producing one more unit of a good, while marginal revenue is the additional revenue from selling one more unit.
If the marginal revenue of producing an additional unit is greater than the marginal cost (i.e., MR > MC), the firm makes a profit on that unit. Thus, it should continue producing until MR equals MC. Conversely, if the marginal cost exceeds marginal revenue, producing that additional unit would decrease profit, so production should stop.
The point for profit maximisation is where the marginal cost curve is rising (sloping upwards) as it crosses the marginal revenue curve. This indicates that beyond this point, the cost of producing additional units would be higher than the revenue generated, thus reducing profit.

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😊 Click here to see a detailed Explanation of profit maximisation with numbers:

Normal profit, supernormal profit and losses

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Normal profit:

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Normal profit is the minimum amount of profit needed for a business to remain operational. It ensures that the owners and investors have no incentive to leave the business for a different venture.

In economic terms, costs are not just the explicit costs like wages and materials but also the implicit costs, which include the opportunity cost of the resources. Opportunity cost is the benefit that is foregone by not using resources in the next best alternative.
When a business earns enough revenue to cover both its explicit and implicit costs, it is making normal profit. This means it is breaking even and covering all its expenses including opportunity costs.
This is at the point where AC=AR or TC=TR: This means the business is not making any extra profit but is also not incurring losses.

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REMEMBER THIS: Average revenue is equal to the Price, here’s how:

\begin{align*}\text{Total revenue (TR)} &= P \times Q \\\text{Average Revenue (AR)} &= \frac{TR}{Q} = \frac{P \times Q}{Q} = P \times \frac{Q}{Q} = P\end{align*}

Since normal profit is when AC = AR and AR=P we can conclude that normal profit occurs when AC=P

Supernormal profit:

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When a business earns more than what is necessary to cover all its costs, it is making supernormal profit. This type of profit exceeds the normal profit and indicates higher profitability.

This occurs where AR>AC (or P>AC) or TR>TC.
This means the business is generating excess profit above the normal profit level.

Losses:

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A business incurs a loss when it does not generate enough revenue to cover its total costs.

This happens when AR < AC (or P< AC) or when TR < TC, resulting in negative profit.

Short-run and long-run shut-down points

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The shutdown point of a firm is the operating level at which the business does not benefit from continuing its production.

This shutdown point occurs, most commonly when a firm continually incurs higher costs than the revenue generated if it were to continue production, as opposed to the reduced losses from ceasing production entirely.
Simply, it is the point at which the profit from producing an additional unit is negative, hence making them worse off by producing more.

When a business is incurring losses, it isn't always the best decision to shut down immediately.

👉 The decision for a business to shut down depends on the average variable cost (AVC)

Short-run Decision

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If P ≥ AVC then firms should continue production in the short-run:

If a firm's price is greater than or equal to the average variable cost in the short-run, they are likely to continue operating. This is because, in the short-run, fixed costs are considered sunk costs, and the firm only compares revenue to variable costs.
Firms should continue production as each unit generates more revenue than its variable cost, helping cover fixed costs and reducing losses. They should only shut down when fixed costs increase (e.g., machinery replacement, lease renewal).

What are other reasons why a loss-making firm may continue to operate in the short run?

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There are various reasons Why a Loss-Making Firm may continue to operate in the Short Run:

💰 Selling price/average revenue is greater than AVC: The revenue from selling products helps cover variable costs i.e P>AVC

🏠 Contribution towards fixed costs: Revenue minus variable costs helps pay fixed costs.

📉 Temporary downturn: The firm may predict that the downturn is temporary and profitability will recover, hoping that average revenue will equal average costs in the long run.

💼 Fulfilling orders/loyalty: Maintaining existing orders and customer loyalty.

💸 Reserves: The firm may have large reserves to cover losses.

⚙️ High shutdown/restart costs: The cost of shutting down and restarting capital equipment is high.

👷‍♂️ Workforce retention: Keeping the workforce to avoid high costs of replacing experienced or trained staff.

📉 Investor confidence: Avoiding loss of investor confidence by halting production or mothballing factories.

🌍 Strategic market presence: Maintaining a presence in certain markets for strategic purposes.

⏱️ Realisation delay: It may take time for the firm to realise they are making an operating loss.

🦠 Government restrictions (Covid-19): Decision-making may limit customers, but normal operations should resume later.

👩‍🍳 Staffing restrictions: Limitations on how many customers can be served in the hospitality sector due to restrictions.

😷 Consumer confidence: Loss of consumer confidence due to the increased risk of virus exposure.

💸 Anticipating support: Expectation of government financial support to help make normal profit in the future.

When should a business shut down immediently? 👇

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Shutting down: If P< AVC, producing more goods increases losses, so the firm should cease production immediately.

This would mean avoiding variable costs, but the firm would still be liable for its fixed costs, and likely have little to no incoming revenue – which would be considered in the decision.
This would mean avoiding variable costs, but the firm would still be liable for its fixed costs, and likely have little to no incoming revenue – which would be considered in the decision.

Long-run and Short-run Shut-down Points

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Short-run: Firms will produce as long as revenue covers variable costs. The short-run shutdown point is where AVC = AR.

Long-run: Firms need to make at least normal profit to stay in the industry.

Summary of short-down decisions

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Knowledge checkpoint: Describe reasons why a loss-making firm may continue to operate in the short run.

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The relationship between costs, revenue and profit

Block Type

Learn Block

The relationship between costs, revenue and profit

💭

Here are some refreshers:

⚖️

Profit is the difference between total revenue (TR) and total costs (TC)

Profit = TR - TC

What are the conditions for profit maximisation?

Profit is maximised when the gap between TR and TC is the largest. This means the firm is earning much more in revenue than it is spending on costs, and therefore, profit is at its highest.
Profit maximisation also occurs where Marginal Cost (MC) equals Marginal Revenue (MR).

Marginal cost is the additional cost of producing one more unit of a good, while marginal revenue is the additional revenue from selling one more unit.
If the marginal revenue of producing an additional unit is greater than the marginal cost (i.e., MR > MC), the firm makes a profit on that unit. Thus, it should continue producing until MR equals MC. Conversely, if the marginal cost exceeds marginal revenue, producing that additional unit would decrease profit, so production should stop.
The point for profit maximisation is where the marginal cost curve is rising (sloping upwards) as it crosses the marginal revenue curve. This indicates that beyond this point, the cost of producing additional units would be higher than the revenue generated, thus reducing profit.

‣

😊 Click here to see a detailed Explanation of profit maximisation with numbers:

Normal profit, supernormal profit and losses

💭

Normal profit:

🌚

In economic terms, costs are not just the explicit costs like wages and materials but also the implicit costs, which include the opportunity cost of the resources. Opportunity cost is the benefit that is foregone by not using resources in the next best alternative.
When a business earns enough revenue to cover both its explicit and implicit costs, it is making normal profit. This means it is breaking even and covering all its expenses including opportunity costs.
This is at the point where AC=AR or TC=TR: This means the business is not making any extra profit but is also not incurring losses.

⚠️

REMEMBER THIS: Average revenue is equal to the Price, here’s how:

\begin{align*}\text{Total revenue (TR)} &= P \times Q \\\text{Average Revenue (AR)} &= \frac{TR}{Q} = \frac{P \times Q}{Q} = P \times \frac{Q}{Q} = P\end{align*}

Since normal profit is when AC = AR and AR=P we can conclude that normal profit occurs when AC=P

Supernormal profit:

💵

When a business earns more than what is necessary to cover all its costs, it is making supernormal profit. This type of profit exceeds the normal profit and indicates higher profitability.

This occurs where AR>AC (or P>AC) or TR>TC.
This means the business is generating excess profit above the normal profit level.

Losses:

🌚

A business incurs a loss when it does not generate enough revenue to cover its total costs.

This happens when AR < AC (or P< AC) or when TR < TC, resulting in negative profit.

Short-run and long-run shut-down points

⚠️

The shutdown point of a firm is the operating level at which the business does not benefit from continuing its production.

This shutdown point occurs, most commonly when a firm continually incurs higher costs than the revenue generated if it were to continue production, as opposed to the reduced losses from ceasing production entirely.
Simply, it is the point at which the profit from producing an additional unit is negative, hence making them worse off by producing more.

When a business is incurring losses, it isn't always the best decision to shut down immediately.

👉 The decision for a business to shut down depends on the average variable cost (AVC)

Short-run Decision

💡

If P ≥ AVC then firms should continue production in the short-run:

If a firm's price is greater than or equal to the average variable cost in the short-run, they are likely to continue operating. This is because, in the short-run, fixed costs are considered sunk costs, and the firm only compares revenue to variable costs.
Firms should continue production as each unit generates more revenue than its variable cost, helping cover fixed costs and reducing losses. They should only shut down when fixed costs increase (e.g., machinery replacement, lease renewal).