Just as consumers make decisions about what goods and services to buy, entrepreneurs make decisions about what goods and services to produce and how to do this. Whatever method of organizing production an entrepreneur uses, the aim is to reduce costs to their lowest possible level so as to try and make as much profit as possible.
- Types of costs
There are two types of costs. The first one is known as fixed costs. These are the costs that do not vary with the amount of production. These fixed costs usually include weekly or monthly payments to be made by business such as paying fixed taxes, or rent of the building/machinery etc.
The graph of fixed cost would look like this:-
The other type is the variable cost. Variable costs are those costs which change with the level of output produce. Examples would include the cost of raw materials, as well as the wages of workers.
The graph of variable costs is as shown below.
Please note that the graph is passing through origin.
If we combine Fixed costs and variable costs, we get the total cost of production. Therefore TC = FC + VC
The following graph shows the relationship of total cost with both fixed costs and variable costs.
After that we’ve got average costs. The formula of average cost is :-
Average cost (AC) = (Total cost / Number of units produced)
For example if the total cost of producing 20 teddy bears is Rs.4000, then the average cost would be (4000/20) = Rs.200
- Revenue and Profit
The total revenue is the amount of money earned by the business by the sale of their goods. Total sales revenue is also known as turnover. Total revenue can be calculated as:-
Total revenue (TR) = (Price per item) x (Number of items sold)
Just like average cost, we also have average revenue. The formula is also similar:-
Average revenue (AR) = (Total Revenue / (Numbers of items sold)
Then we also have profits. To calculate the profit or loss to the business, total cost of the business needs to be subtracted from total revenue. If the business is successful, its total revenue will exceed its total costs and it will make a profit.
Profit (or loss) = TR – TC
- Break even point
Here’s a graph showing both Total Revenue and Total Costs
Where the curves of total revenue and total cost intersect, no profit or loss is made. This level or output and sales is known as the break-even point of production. This means that if the business manages to sell all the items it produces at this point, it will just cover the costs and be able to prevent bankruptcy. As you can see from the graph above that operating above break even point results in Profit (as total revenue outweighs total cost), while operating below it results in a loss (as total cost outweighs total revenue.)