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2: Key Measures and Relationships
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- 2.1: Revenue, Cost, and Profit
- 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.
- 2.2: Economic Versus Accounting Measures of Cost and Profit
- The discipline of accounting provides guidelines for the measurement of revenue, cost, and profit. Having analyses based on generally accepted principles is important for making exchanges in our economy. For example, corporations must produce financial statements to help investors and creditors assess the health of the corporation. Individuals and businesses must produce tax returns to determine a fair measurement of income for taxation purposes.
- 2.3: Revenue, Cost, and Profit Functions
- There is a relationship between the volume or quantity created and sold and the resulting impact on revenue, cost, and profit. These relationships are called the revenue function, cost function, and profit function. These relationships can be expressed in terms of tables, graphs, or algebraic equations.
- 2.4: Breakeven Analysis
- The volume level that separates the range with economic loss from the range with economic profit is called the breakeven point. From the graph we can see the breakeven point is slightly less than 35,000 units. If the students can sell above that level, which the prior operator did, it will be worthwhile to proceed with the venture. If they are doubtful of reaching that level, they should abandon the venture now, even if that means losing their nonrefundable deposit.
- 2.5: The Impact of Price Changes
- In the preceding analyses of the ice cream venture, we assumed ice cream bars would be priced at $1.50 per unit based on the price that was charged in the previous summer. The students can change the price and should evaluate whether there is a better price for them to charge. However, if the price is lowered, the breakeven level will increase and if the price is raised, the breakeven level will drop, but then so may the customer demand.
- 2.6: Marginal Analysis
- Economists analyze relationships like revenue functions from the perspective of how the function changes in response to a small change in the quantity.
- 2.7: The Conclusion for Our Students
- At first glance, a $5000 profit does not seem like much. However, bear in mind that we already assigned an opportunity cost to the students’ time based on the income foregone by not accepting the corporate internships. So the students can expect to complete the summer with $10,000 each to compensate for the lost internship income and still have an additional $5000 to split between them.
- 2.8: The Shutdown Rule
- Previously, we cited one condition for reaching a breakeven production level where revenue would equal or exceed costs as the point where average cost per unit is equal to the price. However, if some of the costs are already sunk, these should be disregarded in determining the relevant average cost. In a circumstance where a business regards all fixed costs as effectively sunk for the next production period, this condition becomes a statement of a principle known as the shutdown rule.
- 2.9: A Final Word on Business Objectives
- In the example used in this chapter, we assumed the students’ goal in how to operate the ice cream business was to maximize their profit—more specifically, to maximize their economic profit. Is this an appropriate overall objective for most businesses? Generally speaking, the answer is yes. If a business is not able to generate enough revenue to at least cover their economic costs, the business is losing in the net.