Cambridge O Level2281

Firms’ costs, revenue and objectives

Economics 2281 Chapter Notes

What this chapter covers

Firms’ costs, revenue and objectives - Definitions of costs of productionFirms’ costs, revenue and objectives - Calculation of costs of productionFirms’ costs, revenue and objectives - Definition of revenueFirms’ costs, revenue and objectives - Calculation of revenueFirms’ costs, revenue and objectives - Objectives of firms
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In this chapter

  1. 1Understanding Costs: Fixed and Variable
  2. 2Calculating and Analysing Average Costs
  3. 3Understanding and Calculating Revenue
  4. 4Profit, Loss, and Break-Even Point
  5. 5Business Objectives: Profit Maximisation

1. Understanding Costs: Fixed and Variable

Every business incurs costs to produce goods or services. These can be split into two main types. Fixed Costs (FC) are expenses that do not change regardless of how much the firm produces. Think of them as the background costs of being in business, such as rent for a factory or office, insurance premiums, and salaries for administrative staff. Variable Costs (VC) are expenses that change directly with the level of output. The more the firm produces, the higher its variable costs will be. Examples include raw materials, components, and wages for production workers paid by the hour. Total Cost (TC) is simply the sum of all fixed and all variable costs for a given level of output. So, even if a firm produces nothing, it still has to pay its fixed costs.

Total Cost (TC) = Total Fixed Cost (TFC) + Total Variable Cost (TVC)

Key term

Fixed Cost: A cost of production that does not change with the level of output in the short run.

Examiner insight

Examiners reward students who can correctly identify and categorise costs from a business scenario as either fixed or variable, providing clear justification.

Common pitfall

Confusing fixed costs with one-time start-up costs. While some start-up costs are fixed, fixed costs are ongoing expenses (like monthly rent) that persist regardless of output, not just initial payments.

Fun fact

For a streaming service like Netflix, the cost of producing a movie is a massive fixed cost. Whether 1 person or 100 million people watch it, the production cost remains the same.

Worked example 14 marks

A bakery has a monthly rent of $1,000. The ingredients (flour, sugar, etc.) for each cake cost $5. The baker is paid $15 per hour and can bake 2 cakes per hour. In one month, the bakery operates for 100 hours and produces 200 cakes. Calculate the Total Fixed Cost (TFC), Total Variable Cost (TVC), and Total Cost (TC) for the month.

  1. 1

    Step 1: Identify and calculate Total Fixed Cost (TFC). The rent is a fixed cost as it does not depend on the number of cakes baked. TFC = $1,000.

  2. 2

    Step 2: Identify and calculate Total Variable Costs (TVC). These are the costs that change with output. This includes ingredients and the baker's wages. Cost of ingredients = 200 cakes * $5/cake = $1,000. Cost of labour = 100 hours * $15/hour = $1,500.

  3. 3

    Step 3: Sum the variable costs to find TVC. TVC = Cost of ingredients + Cost of labour = $1,000 + $1,500 = $2,500.

  4. 4

    Step 4: Calculate Total Cost (TC) by adding TFC and TVC. TC = TFC + TVC = $1,000 + $2,500 = $3,500.

Worked example 24 marks

Explain the difference between a fixed cost and a variable cost, using an example for each for an airline.

  1. 1

    Step 1: Define fixed cost. A fixed cost is a cost that does not vary with the level of output. For an airline, an example is the cost of leasing an aircraft, which must be paid whether the plane flies or not.

  2. 2

    Step 2: Define variable cost. A variable cost is a cost that varies directly with the level of output. For an airline, an example is the cost of aviation fuel. The more flights the airline operates, the more fuel it will consume and the higher this cost will be.

Recap

  • Fixed costs (FC) are constant regardless of the level of output.
  • Variable costs (VC) change in direct proportion to the level of output.
  • Total Cost (TC) is the sum of fixed and variable costs (TC = TFC + TVC).
  • Examples of fixed costs include rent, insurance, and administrative salaries.
  • Examples of variable costs include raw materials, packaging, and production wages.
  • If a firm's output is zero, its total cost is equal to its total fixed cost.

Quick check

  1. Is the electricity bill for running machinery in a factory a fixed or variable cost? Explain your answer.2 marks
  2. If a firm produces zero output, what is its total variable cost?1 mark

2. Calculating and Analysing Average Costs

While total cost is useful, businesses often want to know the cost per unit. This is called the Average Cost (AC), or Average Total Cost (ATC). It's calculated by dividing the Total Cost (TC) by the quantity of output (Q). We can also break this down further. Average Fixed Cost (AFC) is the fixed cost per unit (TFC / Q), and Average Variable Cost (AVC) is the variable cost per unit (TVC / Q). Therefore, AC = AFC + AVC. A key relationship to understand is how average cost changes with output. As a firm produces more, the Average Fixed Cost always falls because the same fixed cost is spread over more units. Initially, this causes the overall Average Cost to fall. However, at higher output levels, factors like overtime pay or machinery strain can cause Average Variable Cost to rise, which eventually pulls the Average Cost up again. This often gives the AC curve a 'U' shape.

Average Cost (AC) = Total Cost (TC) / Quantity (Q)

Average Fixed Cost (AFC) = Total Fixed Cost (TFC) / Quantity (Q)

Average Variable Cost (AVC) = Total Variable Cost (TVC) / Quantity (Q)

AC = AFC + AVC

Key term

Average Cost (AC): The total cost of production divided by the number of units produced, also known as cost per unit.

Examiner insight

Marks are often awarded for showing the calculation steps clearly, not just writing the final answer for average cost. Show the formula and the numbers you are using.

Common pitfall

Forgetting that Average Fixed Cost (AFC) always decreases as output increases. This is a crucial concept for explaining the shape of the average cost curve.

Worked example 14 marks

A firm has total fixed costs of $200. Its total variable cost for producing 10 units is $300. Calculate the Total Cost (TC), Average Fixed Cost (AFC), Average Variable Cost (AVC), and Average Cost (AC) at this output level.

  1. 1

    Step 1: Calculate Total Cost (TC). TC = TFC + TVC = $200 + $300 = $500.

  2. 2

    Step 2: Calculate Average Fixed Cost (AFC). AFC = TFC / Q = $200 / 10 units = $20 per unit.

  3. 3

    Step 3: Calculate Average Variable Cost (AVC). AVC = TVC / Q = $300 / 10 units = $30 per unit.

  4. 4

    Step 4: Calculate Average Cost (AC). AC = TC / Q = $500 / 10 units = $50 per unit. (Alternatively, AC = AFC + AVC = $20 + $30 = $50 per unit).

Worked example 24 marks

Explain why a firm's average cost is likely to decrease as it increases production from a very low level.

  1. 1

    Step 1: State the main reason. The primary reason is the effect of falling average fixed costs.

  2. 2

    Step 2: Explain the concept of 'spreading overheads'. A firm has total fixed costs that are constant regardless of output. When output is very low, this large fixed cost is divided by a small number of units, making the average fixed cost (AFC) per unit very high.

  3. 3

    Step 3: Link increased output to falling AFC. As the firm increases its output, the same total fixed cost is spread over a larger number of units. This causes the AFC to fall significantly.

  4. 4

    Step 4: Conclude the effect on Average Cost. Since Average Cost (AC) is the sum of AFC and Average Variable Cost (AVC), the sharp fall in AFC at low levels of output will pull the overall AC down.

Recap

  • Average Cost (AC) is the cost per unit of output.
  • Calculate average cost by dividing total cost by quantity (AC = TC / Q).
  • Average Fixed Cost (AFC) continuously falls as output increases.
  • Average Variable Cost (AVC) may fall initially but will eventually rise due to diminishing returns.
  • The U-shape of the average cost curve is caused by falling AFC and then rising AVC.
  • Knowing the average cost helps a firm set a price that will cover its costs.

Quick check

  1. If a firm's total cost is $5,000 for producing 100 units, what is its average cost?1 mark
  2. Why can Average Fixed Cost never be zero?1 mark

3. Understanding and Calculating Revenue

Revenue is the income a firm earns from selling its products. It's crucial not to confuse it with profit. Total Revenue (TR) is the total amount of money a firm receives from its sales over a period. It is calculated by multiplying the price of the product by the quantity sold. For example, if a cafe sells 200 sandwiches at $5 each, its total revenue is $1,000. Average Revenue (AR) is the revenue per unit sold. It is calculated by dividing the total revenue by the quantity sold. Using the same example, the average revenue would be $1,000 / 200 = $5. An important rule is that for any firm that sells all its products at the same price, the Average Revenue is always equal to the price of the product.

Total Revenue (TR) = Price (P) × Quantity (Q)

Average Revenue (AR) = Total Revenue (TR) / Quantity (Q)

Key term

Total Revenue (TR): The total income a firm generates from the sale of its goods or services, calculated as price multiplied by quantity sold.

Common pitfall

Confusing revenue with profit. Revenue is the total income from sales, while profit is what's left after subtracting all costs. A firm can have very high revenue but still make a loss if its costs are even higher.

Fun fact

In 2023, Apple's total revenue was over $383 billion. That's more than the entire Gross Domestic Product (GDP) of countries like Finland or New Zealand!

Worked example 13 marks

A smartphone company sells 2 million phones in a quarter at an average price of $450 per phone. Calculate its total revenue and average revenue for the quarter.

  1. 1

    Step 1: Calculate Total Revenue (TR). Use the formula TR = Price × Quantity. TR = $450 × 2,000,000 = $900,000,000.

  2. 2

    Step 2: Calculate Average Revenue (AR). Use the formula AR = TR / Quantity. AR = $900,000,000 / 2,000,000 = $450.

  3. 3

    Step 3: State the final answers clearly. Total Revenue is $900 million. Average Revenue is $450 (which is equal to the price, as expected).

Recap

  • Total Revenue (TR) is the firm's total income from sales (TR = P x Q).
  • Average Revenue (AR) is the revenue per unit sold (AR = TR / Q).
  • For a firm charging a single price, Average Revenue is always equal to the price.
  • Revenue is the income from sales; it is not the same as profit.
  • Firms aim to increase revenue by selling more units or by increasing the price.

Quick check

  1. If a firm's total revenue is $10,000 from selling 500 units, what is the price per unit?1 mark
  2. A band sells 1,000 tickets for a concert at $30 each. What is their total revenue?1 mark

4. Profit, Loss, and Break-Even Point

This is where we bring costs and revenue together. Profit is the ultimate goal for most private businesses. It is the money left over after all costs have been paid. The calculation is simple: Profit = Total Revenue (TR) - Total Cost (TC). If the result is positive, the firm has made a profit. If the result is negative, it has made a loss. A crucial concept for any business is the break-even point. This is the level of output where the firm is making neither a profit nor a loss. It occurs at the exact point where Total Revenue equals Total Cost (TR = TC). At the break-even point, the firm has sold just enough to cover all its costs. Every unit sold after the break-even point contributes to profit. Knowing this point is vital for business planning, as it tells a firm the minimum level of sales it needs to achieve to avoid making a loss.

Profit / Loss = Total Revenue (TR) - Total Cost (TC)

Break-Even Point (in units) = Total Fixed Costs / (Price per unit - Variable Cost per unit)

At Break-Even: Total Revenue = Total Cost

Key term

Break-even Point: The level of output and sales at which total revenue equals total cost, resulting in neither a profit nor a loss.

Examiner insight

Students who can clearly state the break-even condition (TR=TC) or the break-even formula and then use it to solve for quantity often score highly.

Common pitfall

Calculating profit using only variable costs and ignoring fixed costs. Profit is TR minus TOTAL cost (both fixed and variable).

Worked example 14 marks

A firm sells 1,000 units at $10 each. Its total fixed cost is $2,000 and its total variable cost is $5,000. Calculate the firm's profit or loss.

  1. 1

    Step 1: Calculate Total Revenue (TR). TR = Price × Quantity = $10 × 1,000 = $10,000.

  2. 2

    Step 2: Calculate Total Cost (TC). TC = TFC + TVC = $2,000 + $5,000 = $7,000.

  3. 3

    Step 3: Calculate Profit or Loss. Profit/Loss = TR - TC = $10,000 - $7,000 = $3,000.

  4. 4

    Step 4: State the final answer. The firm has made a profit of $3,000.

Worked example 24 marks

A company sells chairs for $50 each. The variable cost per chair is $20, and the firm's total fixed costs are $30,000 per month. How many chairs must it sell to break even?

  1. 1

    Step 1: Identify the formula for the break-even point in units. Break-Even Units = TFC / (Price - VC per unit).

  2. 2

    Step 2: Identify the values from the question. TFC = $30,000. Price = $50. VC per unit = $20.

  3. 3

    Step 3: Calculate the contribution per unit. This is Price - VC per unit = $50 - $20 = $30. This is how much each chair 'contributes' to covering fixed costs.

  4. 4

    Step 4: Calculate the break-even quantity. Break-Even Units = $30,000 / $30 = 1,000 chairs. The company must sell 1,000 chairs to break even.

Recap

  • Profit is made when Total Revenue (TR) is greater than Total Cost (TC).
  • A loss is made when Total Cost (TC) is greater than Total Revenue (TR).
  • The break-even point is the level of output where TR = TC.
  • To calculate profit, use the formula: Profit = TR - TC.
  • The break-even formula is TFC / (Price - Variable Cost per unit).
  • Every unit sold above the break-even point generates profit.

Quick check

  1. If TR = $500 and TC = $650, is the firm making a profit or a loss, and by how much?2 marks
  2. What is the profit level at the break-even point?1 mark

5. Business Objectives: Profit Maximisation

Why do firms exist? In economics, the traditional assumption is that the primary objective of a private sector firm is profit maximisation. This means a firm will manage its costs and revenues in such a way as to make the largest possible profit. It will try to produce at the output level where the difference between total revenue and total cost is greatest. However, in the real world, firms may have other, equally important objectives. For a new start-up, the main goal might simply be survival – just making enough revenue to cover costs and stay in business. Other firms might focus on growth, aiming to increase their size, output, or market share, even if it means lower profits in the short term. Some businesses may prioritise social or ethical goals, such as being environmentally friendly or providing benefits to the local community. Public sector organisations, which are owned by the government, do not aim for profit at all; their objective is to provide a service to the public, such as healthcare or education.

Key term

Profit Maximisation: A business objective where a firm aims to make the largest possible positive difference between its total revenue and its total costs.

Examiner insight

Examiners appreciate answers that recognise that while profit maximisation is a key goal, firms may have other, sometimes conflicting, objectives in the short or long run.

Common pitfall

Assuming all firms only ever want to maximise profit. In reality, a new business might prioritise survival over profit, and a large firm might prioritise growth.

Fun fact

Patagonia, a large outdoor clothing company, has an objective to 'use business to inspire and implement solutions to the environmental crisis.' It gives 1% of its sales to environmental causes, showing that profit isn't its only goal.

Worked example 14 marks

Explain why a new small business might not have profit maximisation as its main objective in its first year of trading.

  1. 1

    Step 1: Identify a more likely objective. For a new business, the primary objective is often survival.

  2. 2

    Step 2: Explain why survival is key. The business needs to establish itself in the market, build a customer base, and cover its initial start-up and running costs. During this period, it may not be possible to make a large profit.

  3. 3

    Step 3: Provide examples of survival strategies. The firm might set low prices to attract customers, which would reduce its profit margin. It might also spend heavily on advertising to build brand awareness. These actions prioritise long-term viability over short-term profit.

  4. 4

    Step 4: Conclude by linking back to the question. Therefore, in the first year, making any profit at all might be considered a success, with the main goal being to survive long enough to become profitable in the future.

Worked example 24 marks

Besides profit maximisation, describe two other possible objectives a large, established company might have.

  1. 1

    Step 1: State the first alternative objective. One objective could be growth or increasing market share. A firm may want to become the dominant player in its industry.

  2. 2

    Step 2: Explain the growth objective. This might involve opening new branches, launching new products, or taking over competitors. This could lead to lower short-term profits due to high investment costs, but could secure higher profits in the long run through economies of scale and greater market power.

  3. 3

    Step 3: State the second alternative objective. Another objective could be satisfying shareholders or 'satisficing'. Instead of maximising profit, managers might aim to achieve a satisfactory level of profit that is just enough to keep shareholders happy, while pursuing other goals like a better work-life balance for staff or personal prestige.

  4. 4

    Step 4: Briefly mention another example. Other objectives could include social responsibility, such as minimising environmental impact, or providing excellent customer service to build long-term brand loyalty.

Recap

  • The main assumed objective for most private firms is profit maximisation.
  • Profit maximisation means achieving the biggest gap between total revenue and total cost.
  • Other business objectives include survival, growth, increasing market share, and social responsibility.
  • A firm's objectives can change over time depending on its circumstances.
  • Public sector firms have non-profit objectives, such as providing essential services to the public.
  • Satisficing is aiming for a satisfactory level of profit rather than the maximum possible.

Quick check

  1. What is likely to be the primary objective of a firm facing a major new competitor and falling sales?1 mark
  2. State the principle of profit maximisation.2 marks

End-of-chapter exercise

Test yourself on the whole chapter. Work through these before moving on.

  1. Define 'variable cost' and give one example of a variable cost for a car manufacturer.2 marks
  2. A firm's total revenue is $50,000 and its total cost is $38,000. Calculate the firm's profit.2 marks
  3. Explain the difference between total revenue and average revenue.4 marks
  4. A firm has total fixed costs of $10,000 per month. Its average variable cost is $5 per unit. If it produces 2,000 units, calculate its total cost and average cost.4 marks
  5. Explain two reasons why a firm might aim for objectives other than profit maximisation.4 marks
  6. A t-shirt printing business sells each shirt for $15. The variable cost per shirt (ink, t-shirt) is $7. The business has fixed costs (rent, machine lease) of $1,600 per month. Calculate the break-even number of t-shirts the business must sell each month.4 marks
  7. A concert promoter is staging a single event. The fixed costs (venue hire, artist fee) are $200,000. The variable costs (security, cleaning) are $5 per ticket sold. The venue has a capacity of 10,000 people. The promoter sells all 10,000 tickets at $45 each. Calculate the total profit from the event.5 marks
  8. Analyse how a sharp increase in the price of electricity would affect a manufacturing firm's fixed costs, variable costs, and total costs.6 marks
  9. 'A firm that is making a loss should always shut down immediately'. Discuss this statement.6 marks
  10. A company's costs and revenues are shown below for a month. It sells its product for $20 per unit. Total Fixed Costs: $60,000; Total Variable Costs: $120,000; Output: 10,000 units. (a) Calculate the company's current profit or loss. [4] (b) The company believes that by reducing the price to $18, it can increase sales to 12,000 units. Its fixed costs will remain the same, but total variable costs will rise to $144,000. Advise the company whether it should make this change. Show your working. [4]8 marks

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