Total Cost & Total Revenue Method
The total cost and revenue method is an accounting practice that uses a perfect competition model to calculate the total costs to the company at every level. The alternative is a margin-based model that focuses on the product-specific costs and revenue. Using the total cost and revenue, a business knows exactly where the profit margin sits with every single expense factored into the equation.
The total costs include everything in the business's overhead model, such as costs for raw materials, production, employees and everything included in the overhead structure. In addition to fixed costs, you must figure variable costs. These are not as stable or predictable as fixed costs unless you have a long-term set of data to measure against. Variable costs are influenced by increases in production that require sourcing more material and labor than your fixed costs calculations. Variable costs correlate directly to production, increasing and decreasing accordingly.
The total revenue calculation is fairly simple. Putting together the total cost portion of the equation is the most intensive aspect of the total cost and total revenue method. Total revenue multiples the price by the quantity. If a single output is priced at $5 and you produce 10,000 units, the total revenue will be $50,000.
Take your total revenue figure and subtract the total costs to calculate you company's profit. Using this method has the advantage of delivering an accurate profit number from that single equation. The margin-based method requires factoring overhead into the equation after the fact. Use the equation to calculate profit at different output levels, as well. Start with the total costs without variable costs to set a baseline profit, and then scale up to show profitability at different levels in the variable cost equation.
The initial benchmark for any company is to build a model with higher total revenue than total costs. This ensures profitability. The next step is to measure market demand while using the total cost and revenue method to determine the maximum profit potential. How much product will the market absorb? This is the big question, and scaling production until a peak is reached will maximize your profit. If variable costs rise enough to outpace total revenue at any point, scaling down production will return you to a more profitable place. Additionally, minimizing total costs while maximizing total revenue will ultimately drive a higher profit margin.