Let's begin by getting in the mindset of a business.
The point of owning a business, for most business owners, is to make a profit, which is simply revenues minus costs.
Profit = Revenues - Costs
Revenues are all the money taken in, or sales, from selling an item, while costs comprise everything it costs to get that product to market.
If a business has any money left over, then they have made a profit.
For the purposes of this tutorial, we are specifically discussing an accounting profit, which is total revenue minus total cost, where total cost includes only explicit costs.
Now, we know that profit is total revenue minus total cost. Total revenue--abbreviated TR--is the price of the product times the quantity sold.
Total cost is the cost per unit times the quantity.
Let's explore this concept by looking at an example.
Sue opens a diner and wants to know if she has made an accounting profit in her first year.
She sold 15,000 meals at $10 each.
She figures out that her overall cost per meal, after factoring in explicit costs such as food, labor, and overhead costs, etc., was $8 per meal.
In terms of an accounting profit, again, we take total revenue minus total cost:
| Total Revenue | Total Cost |
|---|---|
| P x Q | Cost per Unit x Q |
| $10 x 15,000 | $8 x 15,000 |
| $150,000 | $120,000 |
This leaves Sue with an accounting profit of $30,000.
However, we need to make a couple notes on cost per unit.
First of all, the costs can be impacted by the scale of production.
If Sue expands her business, she may enjoy some cost savings from buying in bulk, for instance.
Secondly, businesses do not necessarily sell everything they produce. In reality, it is actually quite rare for them to sell everything that they produce.
What if Sue had actually produced more than the 15,000 meals but not sold them all? Let's look at the changes, highlighted in green.
| Total Revenue | Total Cost |
|---|---|
| P x Q | Cost per Unit x Q |
| $10 x 15,000 | $8 x 16,000 |
| $150,000 | $128,000 |
Her revenue stayed the same. In fact, She sold 15,000 meals for $10 each, so her total revenue would still be $150,000.
However, let's assume that she produced more than the 15,000 that she sold. She produced 16,000 and had to throw 1,000 away.
She still needs to account for this on the cost side. Her cost was still $8 per unit, but she produced 16,000 of them, which brings her total cost to $128,000.
Notice that this cost eats into her profit. Therefore, her accounting profit is $22,000 instead of $30,000.
Source: Adapted from Sophia instructor Kate Eskra.
