Costs of Production

Fixed costs (FC) are costs that are fixed in the short-term running of a business and have to be paid even when no production is taking place. Examples: rent, interest on bank loans, telephone bills. These costs do not depend on the amount of output produced.
Average Fixed Cost (AFC) = Total Fixed Cost (TFC) / Total Output
FC and AFC

Variable costs (VC) are costs that are variable in the short-term running of a business and are paid according to the output produced. The more the production, the more the variable costs are. Examples: wages, electricity bill, cost of raw materials.
Average Variable Cost (AVC) = Total Variable Costs (TVC) / Total Output
AVC

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

TC = TVC + TFC
This is a simple graph showing the relation between TC, FC and VC. The gap between the TC and TVC indicates the TFC

Average cost or Average total Cost (ATC) is the cost per unit of output.
Average Total Cost (ATC) = Total Cost (TC) / Total Output or
Average Cost (AC) = Average Variable Cost (AVC) + Average Fixed Cost (AFC)
TC and ATC

(Remember ‘average’ means ‘per unit’ and so will involve dividing the particular cost by the total output produced. In the graphs above you will notice that the average variable costs and average total costs first fall and then start rising. This is because of economies of scale and diseconomies of scale respectively. As the firm increases its output, the average costs decline but as it starts growing beyond a limit, the average costs rise).

Let’s calculate some costs in an example:

Suppose, a TV manufacturer produces 1000 TVs a month. The firm’s fixed costs in rent is $900, and variable cost per unit is $500. What would its TFC, TVC, AVC, AFC, AC and TC be, in a month?

No. of units of TVs produced = 1000

Total Fixed Costs for one month = $900
Average Fixed Cost = $900 / 1000 = $0.9 per unit

Variable Cost of producing one unit of TV = $500
Total Variable Costs for producing 1000 TVs in a month = $500 * 1000 = $500,000
Average Variable Cost = $500,000 / 1000 = $500 (AVC is the same as VC per unit!)

Total Costs = Total Fixed Costs + Total Variable Costs  ==> $900 + $500,000 = $500,900
Average Costs = Total Costs / Total Output  ==> $500,900 / 1000 = $500.9
or Average Costs = AFC + AVC ==> $0.9 + $500  ==>  $500.9

 

Revenue

Revenue is the total income a firm earns from the sale of its goods and services. The more the sales, the more the revenue.

Total Revenue (TR) = No. of units sold (Sales) * Price per unit (P)

Average Revenue = Total Revenue (TR) / No. of units sold (Sales)  (= Price per unit (P)!)

Suppose, from the example above, a TV is sold at $800 and the firm sells all the units it produces, what is the firm’s Total Revenue and Average Revenue, for a month?

No. of units sold (Sales) in a month = No. of units produced in a month = 1000
Total Revenue = Sales * Price  ==>  1000 * $800 = $800,000
Average Revenue = Total Revenue / Sales = $800,000 / 1000 = $800

 

Objectives of Firms

Objectives vary with different businesses due to size, sector and many other factors. However, many business in the private sector aim to achieve the following objectives.

  • Survival: new or small firms usually have survival as a primary objective. Firms in a highly competitive market will also be more concerned with survival rather than any other objective. To achieve this, firms could decide to lower prices, which would mean forsaking other objectives such as profit maximization.
  • Profit: profit is the income of a business from its activities after deducting total costs from total revenue.  Private sector firms usually have profit making as a primary objective. This is because profits are required for further investment into the business as well as for the payment of return to the shareholders/owners of the business.
  • Growth: once a business has passed its survival stage it will aim for growth and expansion. This is usually measured by value of sales or output. Aiming for business growth can be very beneficial. A larger business can ensure greater job security and salaries for employees. The business can also benefit from higher market share and economies of scale.
  • Market share: market share can be defined as the sales in proportion to total market sales achieved by a business. Increased market share can bring about many benefits to the business such as increased customer loyalty, setting up of brand image, etc.
  • Service to the society: Some operations in the private sectors such as social enterprises do not aim for profits and prefer to set more social objectives. They aim to better the society by aiding society financially or otherwise.

A business’ objectives do not remain the same forever. As market situations change and as the business itself develops, its objectives will change to reflect its current market and economic position. For example, a firm facing serious economic recession could change its objective from profit maximization to short term survival.

 

 

 

Notes submitted by Lintha

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2 thoughts on “3.7 – Firms’ Costs, Revenue and Objectives

  1. Hi! I’ve got one question, you said that “Average Fixed Cost = $600 / 1000 = $0.9 per unit”, but shouldn’t the answer be $0.6?

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