What Is the Relationship Between a Firm's Total Revenue, Profit and Total Cost?
The goal of most businesses is to maximize profits and reduce costs. A company's proficiencies in these areas depends on the relationship between its total revenue, profits and total costs. Because these factors are interconnected, a change in any one can affect the others.
Each business, regardless of industry or size, operates with respect to the revenue, profit and cost relationship. Whenever a good or service is produced and sold, a company must assess how well it is operating in terms of its revenue, profit and cost. If a furniture company sells a couch for $1,000, and it cost the company $950 to make the couch, the company's total revenue would be $1,000, its total cost $950 and its net profit $50 ($1,000-$950), or 5 percent.
A company's total revenue is equal to the amount of sales and other income it receives over a specified period. As part of the business' total revenue, profits take into account the difference between income and the amount of money spent to generate that income. In a company with a 5 percent net profit, every $20 of revenue earns $1 of profit. This creates a 20 to:1 relationship between revenue and profit.
In accounting terms, a company's total cost is equal to the sum of its fixed and variable costs, which include things like storage, shipping, rent and other similar expenses. The relationship between cost and profit is usually straightforward. Using the previous example, for every $1 of cost that a company can reduce, it can also increase its profits by $1. In this scenario, cost and profits have a 1 to 1 relationship.
Since the relationship between cost and profit is 1 to 1 and the relationship between revenue and profit is 20 to 1, the relationship between revenue and cost must also be 20 to 1. In business terms this means that if you add $1 of cost you lose $1 of profit, and it takes $20 of revenue to generate $1 of revenue. Therefore, a business with a 5 percent net profit needs to make $20 of revenue to make up for each dollar of cost.