Calculating Costs, Revenues and Profits
Profit: Profit is the amount of finance which is left over after the costs of the business have been deducted from the revenue. In essence, profit is a surplus. It is the surplus of the value of sales made by a busienss over its total costs of production. It is very important to entrepreneurs and small businesses for a number of reasons. One of these is that the amount of profit created is used as a measure of success by the owners of a business who have invested capital into it (the more profit they make, the more they receive in drawings or dividends). Another is that banks and other lenders will be unlikely or unwilling to lend to a business that does not either forecast a profit and/or make one (due to the fact that if the business does not make profit, the chances of the bank getting a return on the loan is reduced). It is also the return or reward to entrepreneurs or business owners for taking risks with their capital, and if no profit is made, this discourages further investment and may lead to business closure, and as a surplus, profit provies a source of finance for expansion. Profit can also be reinvested in the business as retained profit. The amount of profit a business makes can be found out by this equation:
Profit= Total Revenue - Total Costs
The sales revenue of a business is the amount of finance that a business has which is coming into the business due to sales. The formula for sales revenue is:
Sales Revenue= Selling Price x Quantity Sold
One of the factors which can affect the sales revenue of a business is the demand for the products sold/services offered, which, in succint terms, is the amount of people who are interested in purchasing the product. If the demand for the product increases, this means that more people are interested in purchasing the product. This means that the quantity sold of the business's products will increase. Therefore, as the quantity sold of the business increases, the sales revenue of the product will also increase. The selling price also has a great effect on the demand. If the price decreases, then the demand increases, and the quantity sold will also increase. If the selling price is within the price elasticity of demand, then the demand will either stay constant or slightly increase. If the price becomes too high, though, demand will decrease. This will mean that the sales revenue which a business makes will also decrease, due to the fact that the quantity sold of the business is not very high, and therefore the sales revenue is also not very high.
Business Costs- Fixed, Variable, and Total Costs
The business costs of production are the expenditures made by a business as part of its trading operations. The costs of production consist of fixed costs and variable costs:
Fixed Costs: The fixed costs of a business are costs of the business which do not change, regardless of the level of output. These costs will have to be paid, regardless of whether a business sells a lot of its products or doesn't sell any products at all. Examples of fixed costs include rent, electricity bills, advertising costs, wages, etc.
Variable Costs: The variable costs of a busienss are the costs of the business which change due to the level of output which the business makes. A classic example of variable costs is raw materials. As the business increases its level of output, the amount of raw materials the business purchases will also have to increase. However, if a business decreases its output, the variable costs also decrease
Total Costs: The total costs of a business are the result of adding the fixed costs of a busienss and the variable costs of a business together. The amount of total costs the business has depends on the value of the fixed costs and the value of the variable costs.
Why calculate costs of production?
There are plenty of reasons that a business needs to forecast the costs of production. The predictions will allow a profit or loss forecast to be made, to determine whether or not the business will be a viable one, as well as forecasts of the likely break-even level of output necessary to break even (where the costs of the business equal the revenues of the business). The cash flow forecasts can also be drawn up so that the financial planning of the business can be undertaken, and pricing decision can also be made based on the cost data.
Once the business is up and running, there are several reasons why the owner needs to know what costs are being incurred. This is because they need to keep a check of actual costs against the forecasted costs that were part of the original business plan, and to see if the firm is exceeding them, and why this is so. They also need to use cost information to help in pricing decision, as rises in the fixed costs and variable costs may lead to an increase in the selling price, and therefore may result in a drop in demand, and to calculate whether the costs are greater or less than revenue, and whether the firm is profitable at this level of sales or whether it is not.