COST, REVENUE AND PROFIT FUNCTIONS

This topic is concerned with how to manage costs and maximize output and
revenue in order to optimize profit and business outcomes

Definition of Terms
i. Cost; a set of expenses incurred in production or operations in an
organization
ii. Revenue; this is the amount of money generated by selling the
products (goods and services) of an organization
iii.Profit; this is the amount of money left after all the costs incurred in
production or operation has been recovered. It is the difference
between revenue obtained from sales of a given number of units of an
output and the costs incurred in production of the output
iv.Loss; loss is a negative profit, we end up with a loss when costs
outweigh revenue

Cost functions
Cost functions are mathematical expressions representing costs incurred by
an organization
Types of Costs and their Functions

a) Fixed Costs and their Functions; these are costs that remain
unchanged irrespective of the level of output or operation eg. Rent,
salaries and wages, security etc. in the short run
Since fixed costs do not change, they are always expressed as a
constant in an equation.
Therefore,

FC =c ,
where c is a constant cost
i. Average Fixed Cost; fixed cost assignable to one unit of output
Average fixed cost is obtained by dividing total fixed cost with not of
units of output produced.
TFC
AFC=
Q
ii. Marginal Fixed Cost
 This is the additional fixed cost incurred as a result of production of
one more unit of output.
We know that fixed cost does not change, irrespective of production
level.
Therefore, marginal fixed cost is always zero.
Since marginal cost is a constant;
FC =C
The marginal fixed cost functions is therefore expressed as
Δ TFC
MFC=
ΔQ
dFC
MFC= =0
dQ

When plotted on a graph, total fixed cost and average fixed cost
behave as shown.

Shs

As shown in the graph above, the total fixed cost remains constant even as
production level is increased.
Average fixed cost reduces with increase in production output, but does not
get to zero. This is because, as more units are produced, the fixed costs is
share out, hence the fixed cost assignable to one unit decreases
b) Variable Cost;
These are costs that vary with the level of output. As level of output is
increased, the variable costs also increases. In practical business
environment, the variables are very important in decision making since they
can be managed.
Variable costs include; cost of fuel, cost of materials, cost of consumables
etc.
Variable cost function is a function of the number of units of output
produced.
VC =f (Q)
Where Q is the number of units produced
i. Total Variable Cost; is obtained by multiplying the unit variable
cost by the number of units produced
TVC =VQ
Where; V −¿ unit variable cost
Q−¿ number of units of output produced
ii. Average Variable Cost
This is the variable cost assignable to one unit of output
It is obtained by dividing total variable cost by the number of units produced
Therefore, the average variable function is expressed as;
TVC
AVC=
Q
iii. Marginal Variable Cost
This is the additional variable cost incurred when an extra unit of output is
produced.
Marginal variable cost is obtained by dividing change in total variable cost
by change in the number of outputs.
Given total variable cost equation, then, the marginal variable cost is
obtained by differentiating the total variable cost with respect to the level of
output.
Δ TVC
MVC=
ΔQ
Given total variable cost equation,
dTVC
MVC=
dQ

c) Total Cost and its Function;

This is the sum of all costs/expenses incurred in production of a given level
of output.
It is function of total fixed cost and total variable cost
The total cost function can therefore be expressed as;
TC=TVC +TFC

This expression can be put as;

TC=V .Q+TFC

Where V-variable cost per unit

Q-number of units produced
TVC - Total Variable Cost
TFC - Total Fixed Cost
When TFC, TVC and TC are plotted on a graph, the following graphs are
obtained.

i. Average Total Cost and its Functions

Average cost is the cost assigned to one unit of output. It is obtained by
dividing total cost by the number of units produced.
The average cost function therefore is expressed as;
TC
AC=
Q
Where TC is total cost
 Q is the number of units produced

The expression can be re-written as

TFC +TVC
AC=
Q
ii. Marginal Total Cost and its Functions
This is the extra cost incurred when one more unit of output is produced.
Marginal cost is obtained by dividing change in total cost by change in
quantity of output
Given a total cost function, then we obtain marginal cost function by
differentiating the total cost function
Therefore; marginal cost function is expressed as;
Δ TC
MC=
ΔQ
Given TC equation, then
dTC
MC=
dQ
When plotted on a graph, MC, ATC and AVC give the following curves

Kshs
d) Revenue and their Functions
Revenue is the amount of money received from sales of outputs.
i. Total Revenue and its Function
Total revenue is the amount of money obtained from sales if a given level of
output.
It is obtained as a product of unit price and the number of units sold
Therefore, total revenue function is expressed as;
TR=PQ
Where P- unit price
Q- quantity of output sold
ii. Average Revenue and its Function
This is the revenue assignable to one out of output sold
Average revenue is obtained by dividing total revenue by the number of
units sold.
The average revenue is equal to the unit price where one product is
concerned
The average revenue function is expressed as;
TR
AR=
Q
this is the same as unit price (where there is no quantity discount)
TR
P(unit ) =
Q(sold )

iii. Marginal Revenue and its Function

This is the additional revenue obtained when one extra unit of output is sold.
This is the same as unit price for the concerned product where no trade
discounts are considered.
Marginal revenue function is expressed as;
Δ TR
MR=
Δ Q(sold )
Given the total revenue equation, then
dTR
MR=
dQ
When plotted on a graph, AR, and MR give the following shapes;
e) Profit and its Function
Profit is the amount of money obtained from sales of a given number of
outputs after all costs incurred in production of the same units of output have
been deducted or recovered
It economic analysis, we use ‘π’ to denote profit
i. Total Profit and its Function
Total profit is expressed as the difference between total revenue and total
cost
Tπ=TR−TC
ii. Average Profit
Average profit is the profit assignable to one unit of output sold.
It is obtained by dividing total profit by the number of units sold
Average profit is expressed as;
Tπ
Aπ=
Q(sold )
The above expression can be re-written as;
TR−TC
Aπ=
Q
iii. Marginal Profit
This is the additional profit obtained when one more unit is sold
It is obtained by dividing change in profit by change in output
It can be expressed as;
Δ Tπ
Mπ =
Δ Q sold
If given the total profit function then
dTπ
Mπ =
dQ
Illustrations;
1. Revenue and cost functions for a company are given below;
2
R=−36 x +2000
C=125 x+ 6500
Obtain the following (interpret your answers);
i. Average Revenue function
ii. Marginal Revenue function
iii. Maximum Revenue
iv. Average Cost function
v. Marginal Cost function
vi. The profit function
Soln;
i. Average Revenue Function
TR
AR=
Q(sold)
2
but TR=−36 x + 2000
2
−36 x +2000
AR=
x
2000
AR=−36 x +
x
…….. AR equation
The equation represents the revenue generated from sale of one unit
of the item

ii. Marginal Revenue function

We are given the TR function; therefore, we obtain MR function by
differentiating TR with respect quantity of output sold
dTR
MR=
dx
2
TR=−36 x +2000
dTR
=2 (−36 x )
2−1
dx
Therefore;
MR=−72 x………. MR function
iii. Maximum Revenue
Given TR=−36 x 2+2000
∂ TR
At maximum revenue, ∂x
=0

∂ TR
=−72 x
∂x
Therefore;
At maximum revenue,
−72 x=0
0
x=
−72
x=0 (this
is the maximum point of the TR curve/line)
Therefore, we substitute x in the TR function to obtain Max Revenue
2
MaxR=−36 (0) + 2000
MaxR=2000
iv. Average Cost Function
TC
AC=
x
TC=125 x+ 6500
Therefore,
125 x+ 6500
AC=
x
6500
AC=125+
x
……………. (average cost function)
v. Marginal Cost Function
∂ TC
MC=
∂x
TC=125 x+ 6500
Therefore,
MC=¿ 125
vi. Profit Function
π=TR−TC
2
TR=−36 x +2000 and TC=125 x+ 6500
Therefore,
π=(−36 x2 +2000 ) −(125 x +6500)
2
π=(−36 x −125 x+ 2000−6500)
2
π=−36 x −125 x−4500
π=36 x +125 x+ 4500…….. profit function
2

2. A firm has fixed cost of kshs 150 and variable cost per unit of kshs
175. The firm sells its products at kshs 500 per unit.
Required,
Given that x units of output are produced and sold, obtain
 i. Total cost function
ii. Average revenue function
iii. Profit when 100 units are sold
Soln
i. Total Cost Function
TC=TFC +TVC
TFC =150
TVC =175 x
TC=150+175 x ………..total cost function
ii. Average Revenue
TR
AR=
Qsold
TR=P unit x Q sold
When x units are sold,
TR=500 x
500 x
AR=
x
AR=500 /=

iii. Profit when 100 units are sold

π=TR−TC
π=(500 x)−(150+175 x)
π=500 x−150−175 x
π=500 x−175 x−150
π=325 x−150 …… profit function
Profit when x=100
π=325 ( 100 )−150
π=kshs32350

3. A manufacturing company incurs fixed costs kshs 6,000 and variable

cost of kshs 25 for every unit of its product produced. The firm sells
one unit of the final product at kshs 50.
Required;
i. The profit function, and the profit when 1000 units are sold
ii. The number of units to be produced and sold to yield a profit of
kshs 10,000
Soln
i. Profit function
π=TR−TC
TR=P unit . Qsold
 Total revenue when x units are sold
TR=50 x
When 1000 units are produced
TR=50 (1000 )
TR=50,000/=
TC=TFC +TVC
Total cost when x units are produced
TC=6000+25 x
When 1000 units are produced
TC=6000+25 (1000)
TC=31,000/=
π=TR−TC
When 1000 units are produced,
π=50,000−31,000
π=19000 /=

ii. Number of units to sell to make a profit of kshs 10000

π=25 x−6000
Equate the profit function to 10000 and solve for x
25 x−6,000=10,000
25 x=16000
x=640 units
Practice Questions
1. A firm has determined that price for one of its products can be
summarized as P=100−2 x their total cost function is given by C=300+8 x
where x is the number of units of the product produced and sold
Require;
i. Marginal Revenue function
ii. Total profit when 1000 units are sold
2. The cost function of a company is given as 6 x 2+ 5 x +100
Required;
i. Marginal Cost
ii. Minimum cost the firm can achieve
Profit Maximization(optimization)
We know that profit is given as the difference between revenue and cost.
π=TR−TC
Profit is maximized when revenue is kept at maximum and cost is kept at
minimum (when the gap between total revenue and total cost is maximum).
In economic analysis, maximum profit is achieved at the point where
marginal cost is equal to marginal revenue.
The profit maximization formula therefore is;
MR=MC
Similarly, at maximum profit, average revenue, marginal revenue and unit
price are equal
D= AR=MR
The profit maximization condition is are presented in the graph below
Illustrations;
1. Demand Function of a firm is given D=160−0.0025 x . The Cost function of
the firm isC=15 x+ 0.0025 x2. Find the profit maximizing output level
Soln
To determine profit maximizing quantity, we need to obtain MR and MC
and equate the functions and solve for quantity
TR=P unit . Qsold
Given, D=160−0.0025 x ,
We multiply demand function by x to obtain TR
TR=( 160−0.0025 x ) x
2
TR=160 x −0.0025 x
dTR
MR= =160−0.005 x
dx
MR=160−0.005 x
2
TC=15 x+ 0.0025 x
dTC
MC= =15+0.005 x
dx
MC=15+ 0.005 x
At the level of profit maximizing, MC = MR
Therefore, we equate MR to MC and solve for the quantity
160−0.005 x=15+0.005 x
Solving for x,
160−15=0.005 x +0.005 x
145=0.01 x
x=14,500 units
The firms maximizes profit if 14,500 units of the output are sold

2. Weekly profit function of a company is given by π=1400 q – q 2−240,000

where q is the number of units sold per week. Calculate the number of
units to be sold to maximizing the weekly profit.
Soln
2
π=1400 q – q −240,000
At maximum profit, slope of the profit function is zero
dπ
=0
dq
We therefore obtain the first derivative, and equate to zero to solve for
q
dπ
=1400−2q
dq
Equating the function to zero;
1400−2q=0
1400=2q
q=700units
the firm maximizes profit when 700 units are sold

Break Even Analysis

Break even analysis is a quantitative process used to determine the
production/sales level that a business is able to recover costs incurred in
production of operations with respect to the quantity of output under
consideration.
Components of break-even analysis include; fixed cost, variable cost and
revenue (already discussed)
The point at which an organization is able to recover its costs is called the
break-even point (BEP).
Determination of Break Even Point

a) Graphical Approach
BEP can be obtained graphically by the total revenue and total cost on one
graph.
BEP point in units is obtained by dropping a line perpendicular to quantity’s
axis and reading the value the point where the line touches the quantity’s
output.
BEP in money value is obtained by drawing a horizontal line from the point
of intersection to the revenue/cost axis and reading the value at the point
where the line touches the y axis.
Illustration
Bata Company has established that for one of its leather shoes, the fixed cost
for a production run that produces 100 pairs of shoes is kshs 3900 while
variable cost per pair of shoes is kshs 90. Finished pair of shoes are sold at
kshs 150 per pair. Using the graphical approach, determine the break-even
point in units and in shillings.

Soln
Take any two production units between 0 and 100
Qtty Total Cost (FC+VC) Total Revenue (P.Q)
0 (3900 + (0x90)) = 3900 (150x0) = 0
100 (3900 + (100x90)) = (150x100) = 15000
12900
Coordinates
(0,3900) and (100,12900) for total cost and (0,0) and (100,15,000) for total
revenue

Plot TC and TR on one graph

1600 TR
0

1400 TC
BEP (shs)
0 ≃ kshs 11000

1200
0

1000 BEP

8000

6000

4000

2000
 20 40 60 80 100 120
BEP (qtty) ≃ 72 units

b) Formula Method
BEP in quantity can be obtained by dividing fixed cost by contribution per
unit
FC
BEP qtty =
Contribution per Unit
Contribution per unit is obtained as the difference between unit price and
unit variable cost
Contribution per Unit =Priceunit −Variable Cost unit

Therefore,
FC
BEP qtty =
Punit −VC unit
Break-even point in money value can be obtained by multiplying the break-
even quantity by unit price
Illustrations
A processing organization has established that its unit variable cost is kshs
400. The company sells its final output as unit price of 600. The company
has also established that its fixed cost of production is kshs 10,000,000.
Required
i. What quantity should the company produce in order to break even?
ii. What is the break-even point in shillings?
Soln
FC
BEP qtty =
P−VC unit

10,000,000
BEP qtty =
600−400

BEP qtty =5000 units

The company should produce 5000 units in order to break even
BEP money value =BEP qtty . P
BEP money value =5000.600
BEP money value =kshs3000000
The company will break even at 3000000kshs
Reading assignment
Read on the application of break-even analysis in practical business
environment