Cost, Revenue & Profit
Why Do Costs and Revenue Matter to a Business?
Every business needs to understand where its money comes from and where it goes. Revenue is the money flowing in; costs are the money flowing out. The difference between the two is what makes a business viable — or not. A smartphone manufacturer selling millions of handsets still goes bust if its costs are higher than its revenue. Getting this balance right is the fundamental challenge every producer faces.
Types of Cost
Costs are split into two categories based on how they behave as output changes. Fixed costs stay the same regardless of how much a firm produces. A coffee shop pays the same rent whether it serves 50 customers or 500 in a day. Fixed costs must be paid even when output is zero — which is why they are sometimes called “overhead costs.”
Variable costs, by contrast, rise and fall with output. The more coffee the shop makes, the more coffee beans, milk and cups it needs. If output doubles, variable costs roughly double too. Adding fixed and variable costs together gives total cost.
Total Cost = Fixed Costs + Variable Costs. Fixed costs do not change with output (e.g. rent). Variable costs rise and fall with output (e.g. raw materials).
Average cost (also called unit cost) is total cost divided by the number of units produced. If a trainers brand spends £600,000 making 20,000 pairs of shoes, the average cost is £30 per pair. Average cost matters because it determines the minimum price the firm must charge to avoid a loss. As output rises and fixed costs are spread across more units, average cost typically falls — this is the foundation of economies of scale, covered in the next lesson.
Revenue: Total and Average
Revenue is calculated by multiplying the price charged by the quantity sold. If a streaming service charges £10 per month and has 2 million subscribers, total revenue is £20 million. This is total revenue. Dividing total revenue by the number of units sold gives average revenue, which equals the price per unit in a straightforward market. Firms track total revenue closely because it determines how much money is available to cover costs.
Profit: the Central Goal
When total revenue exceeds total cost, a firm makes a profit. The formula is straightforward: Profit = Total Revenue − Total Cost. If a firm’s revenue is £500,000 and its total costs are £380,000, profit is £120,000. When total cost exceeds total revenue, the firm makes a loss.
Most private-sector businesses list profit maximisation as a primary objective. A higher profit rewards the entrepreneur for the risk they have taken and provides funds for reinvestment — new machinery, more staff, entering new markets. Without profit, a firm cannot grow or even survive in the long run.
Profit = Total Revenue − Total Cost. A firm increases profit by raising revenue, cutting costs, or both. Total Revenue = Price × Quantity Sold.
Profit as an Incentive and a Signal
Profit plays two roles in a market economy. First, it is an incentive: the prospect of profit motivates entrepreneurs to set up businesses, take risks and innovate. Without the reward of profit, fewer people would be willing to invest their savings or time into a new venture.
Second, profit acts as a signal. When profits are high in an industry — say, electric vehicle charging networks — this signals to other firms that there is money to be made there. New producers enter the market, increasing supply. This process steers resources to where they are most valued by consumers. Conversely, persistent losses signal that resources should move out of an industry and into more productive uses.
Profit maximisation is the dominant objective for most private firms, but it is not the only one. Some businesses prioritise sales growth — they accept lower margins to win a bigger share of the market, betting that volume will eventually deliver higher total profits. Others focus on increasing market share, which gives them greater pricing power over rivals. A new firm entering a competitive market may set prices deliberately low to attract customers and build market share — a strategy called penetration pricing. By contrast, predatory pricing is a strategy used by an existing dominant firm, which sets prices below cost specifically to drive rivals or new entrants out of the market; it is illegal under UK competition law.
There are also ethical and moral conflicts. A firm might earn higher profits by paying suppliers in lower-income countries as little as possible, or by polluting a river to avoid the cost of treating its waste water. These choices boost profit in the short run but impose costs on others — the suppliers, local communities, or the environment. This tension between private profit and wider social costs is a key theme in economics and underpins much of the debate around market failure and government intervention.
How Firms Aim to Increase Profit
There are two routes to higher profit. A firm can raise revenue — by selling more units, raising prices (if demand will bear it), or launching new products. Alternatively, it can reduce costs — by switching to cheaper suppliers, automating tasks to cut labour costs, or producing on a larger scale so that fixed costs are spread more thinly. In practice, successful firms pursue both strategies at once. A supermarket running a promotional price cut may accept lower revenue per item, gambling that the extra volume sold will lift total revenue high enough to more than compensate.
The relationship between price and revenue is not always simple. If a firm raises its price, each unit sold earns more — but if demand falls sharply as a result, total revenue may actually drop. This is why understanding price elasticity of demand (covered in the earlier unit on prices) matters so much when firms set their pricing strategy.
Students often confuse these two. The test is simple: ask “does this cost change if the firm produces one more unit?” If the answer is yes, it is a variable cost. If the answer is no, it is a fixed cost. Wages can fall into either category: a worker paid a monthly salary is a fixed cost (the bill is the same whether output is high or low), while a worker paid by the piece is a variable cost (more output means higher wages). Similarly, electricity has a standing charge (fixed) and a usage charge (variable).