Calculating Profit, Revenue, and Cost

Figuring Profit from Revenue and Cost

Profit is a good thing. It’s what makes businesses run, become successful, and grow. In order to earn a profit, you have to have fewer expenses than you do income. Your cost of providing merchandise or service has to be less than what you’re paid to provide the goods or service.

Understanding how volume affects profit, revenue, and cost

One of the simpler models or examples of profit, revenue, and the cost is driven completely by the volume — the number of items produced and sold. In this model, the number of items produced and sold is the variable. The price being charged for an item and the cost to produce an item are constant numbers. This simple model doesn’t really apply to big, complicated businesses, but it holds for some of the basic ventures.

Seeing how price is sensitive to demand

Many people are bargain hunters. They shop around until they find the best price for a particular item; some even wait until an item goes on sale before buying it. The merchant, on the other hand, wants to be competitive in pricing, but it also wants to make as much as the market will bear.

A common characteristic of price in relation to the number of items sold is this: the lower the price, the more the items tend to sell. It takes a fine balance, of course, between lowering or raising prices enough but not too much. The following sections show you how to find that balance.

Using an equation for demand

A demand equation is used to represent the effect of a drop in price. Demand equations are projections or predictions of what the sales volume will be based on the price or what the price should be based on estimated sales volume. These equations are produced by marketing analysts who study sales numbers and create models in the form of formulas. A demand function is used instead of a set, unchanging price in the revenue part of a profit function. For example, instead of saying that the revenue is R = 10x, meaning that each item will sell for $10, you use the revenue function R = px, showing that the price, p, changes with the volume, x.

Sorting out variable and fixed costs

You can find two basic types of cost in production or services: fixed cost and variable cost. Fixed cost is the part of the total cost that’s incurred whether you produce anything or not. Fixed costs may be for the use of a building or structure, payments to any salaried employees, insurance, and so on. In simpler models, the fixed cost is the start-up cost. This type of cost is incurred once no matter how many items are produced. For example, when you decide to sell imprinted T-shirts for a sports team, your start-up cost is for the screen-print template, which you pay for only once.

What’s It Gonne Be? Projecting Cost

When determining a company’s profit, you use a formula that subtracts cost from revenue. This formula gives you the net value — which you hope is a positive number. Determining the revenue for this formula is relatively easy; the money comes in or promises are made, and this allows you to record the income for the products or services. Cost, on the other hand, is often a bit more elusive to predict than revenue. After all, you have to juggle many different types of costs, including

Weighing the historical and differential cost

When determining how to price an item, you look at how much that item costs to produce. Well, you at least look at the item’s production cost history — what it has been costing to produce it. Making plans for future production and sales, you look into the future for what it will cost you to continue the same process. Historical cost is what the cost has been in the past. Differential cost is what you predict the cost to be in the future.

Last word

To solve this problem, you need to plot the two costs with their volumes and draw a line through them. On the same graph, plot the two revenues with their volumes and draw a line through them. Estimate where the lines cross, and you’ve found your break-even volume.

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