This is “Revenue, Cost, and Profit”, section 2.1 from the book Managerial Economics Principles (v. 1.0).
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Most businesses sell something—either a physical commodity like an ice cream bar or a service like a car repair. In a modern economy, that sale is made in return for money or at least is evaluated in monetary terms. The total monetary value of the goods or services sold is called revenueThe total monetary value of the goods or services that a business sells..
Few businesses are able to sell something without incurring expenses to make the sale possible. The collective expenses incurred to generate revenue over a period of time, expressed in terms of monetary value, are the costThe collective expenses incurred to generate revenue over a period of time, expressed in terms of monetary value.. Some cost elements are related to the volume of sales; that is, as sales go up, the expenses go up. These costs are called variable costsExpenses that change as the the volume of sales changes.. The cost of raw materials used to make an item of clothing would be an example of a variable cost. Other costs are largely invariant to the volume of sales, at least within a certain range of sales volumes. These costs are called fixed costsExpenses that remain the same regardless of the volume of sales or that remain the same within a certain range of sales volumes.. The cost of a machine for cutting cloth to make an item of clothing would be a fixed cost.
Businesses are viable on a sustained basis only when the revenue generated by the business generally exceeds the cost incurred in operating the business. The difference between the revenue and cost (found by subtracting the cost from the revenue) is called the profitThe difference between revenue and cost when revenue exceeds the cost incurred in operating the business.. When costs exceed revenue, there is a negative profit, or lossThe difference between revenue and cost when the cost incurred in operating the business exceeds revenue..
The students in our simple venture realize they need to determine whether they can make a profit from a summer ice cream bar business. They met the person who operated an ice cream bar business in this building the previous summer. He told them last summer he charged $1.50 per ice cream bar and sold 36,000 ice cream bars. He said the cost of the ice cream bars—wholesale purchase, delivery, storage, and so on—comes to about $0.30 per bar. He indicated his other main costs—leasing the building, license, local business association fee, and insurance—came to about $16,000.
Based on this limited information, the students could determine a rough estimate of the revenue, costs, and profit they would have if they were to repeat the outcomes for the prior operator. The revenue would be $1.50 per ice cream bar times 36,000 ice cream bars, or $54,000. The variable cost would be $0.30 per ice cream bar times 36,000 ice cream bars, or $10,800. The fixed cost would be $16,000, making the total cost $26,800. The profit would be $54,000 minus $26,800, or $27,200.
Based on this analysis, the students are confident the summer business venture can make money. They approach the owner of the building and learn that if they want to reserve the right of first option to lease the building over the summer, they will need to make a nonrefundable $6000 deposit that will be applied to the lease. They proceeded to make that deposit.
A few weeks later, all three students were unexpectedly offered summer business internships at a large corporation. Each student would earn $10,000. However, the work site for the internships is far from the beach and they would be in an office all day. They now must decide whether to accept the internships and terminate their plan to run a business at the beach or turn down the internships.