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Cost, Revenue and Profit Functions

Michael Cooney

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Many business situations allow us to model how cost, revenue and vary
with respect to different parameters, and how they combine to yield a
functional expression for profit.
In most cases, it is then possible to attempt to maximise and minimise
these functions using calculus techniques.

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In any commercial environment, the (gross) profit can be considered as a
simple functions of the difference between the revenue obtainable from
the sale of a number of products and the costs involved in producing those
products, i.e.
Profit(P) = Revenue(R) − Costs(C)

To give a very simple example, if a wholesaler can buy items at e6.50


each and sells them at e7.20, the profit per item is e7.20 - e6.50 =
e0.70. The total profit realised from the handling of x items can be
expressed in a similar form:

Profit from x items = Revenue from x items − Cost of x items


= (7.20)x − (6.50)x
= (0.7)x

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The Profit Function

Normally, both cost and revenue functions of x (the number of items


demanded or supplied) and so an expression for profit, also as a function
of x, can be derived as the difference between the revenue and cost
functions:

Definition: The Profit Function


P(x) = R(x) −C(x)

where x is the quantity of items demanded


(supplied or produced)
P(x) is the profit function in terms of x
R(x) is the revenue function in terms of x
C(x) is the cost function in terms of x

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It is usual to assume that supply and demand of items (or products) is
identical unless specifically stated otherwise.
A maximum profit point for some process can be defined through normal
calculus methods.

Definition: Maximum Profit Point


The Maximum Profit Point for some process can be
solved by solving the equation

P′ (x) = 0

for x, where

x is the quantity of items demanded (supplied or produced)


P is the profit function in terms of x

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Question: A manufacturer knows that if x products are demanded (in
units of 100) in a particular week, then the total cost function is 14 + 3x
and the total revenue function is 19x − 2x2 (in units of e1000).

a) Derive the (total) profit function.


b) Find the profit break-even points.

c) Calculate the level of demand that maximises profit (i.e. the


maximum profit point) and the amount of profit obtained.

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a) Here, the total cost and revenue functions are

C(x) = 14 + 3x
R(x) = 19x − 2x2

Therefore, the total profit function is

P(x) = R(x) −C(x)


= (19x − 2x2 ) − (14 + 3x)
= 19x − 2x2 − 14 − 3x
= −2x2 + 16x − 14

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b) The profit break-even points are the levels of demand which make
P(x) = 0.
Thus, we have

−2x2 + 16x − 14 = 0
=⇒ x2 − 8x + 7 = 0
=⇒ (x − 1)(x − 7) = 0

Thus, x = 1 or x = 7.
Thus, the profit break-even points are when the demand is either 100
or 700 products.

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c) Profit is maximised when P′ (x) = 0.
Now,

P(x) = −2x2 + 16x − 14


=⇒ P′ (x) = 16 − 4x

and so
P′ (x) = 0 =⇒ x = 4
We note that P′′ (x) = −4 < 0 and so we have a maximum at x = 4.
Thus,

P(x = 4) = −2(4)2 + 16(4) − 14


= −32 + 64 − 14
= 18

So the maximum profit is earned when the demand is for 400 units
and the profit is e18,000.

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In general however, the precise form of cost and revenue functions
are not known and it is more likely that it will be necessary to derive
them from supplied information.

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Cost Functions

There are normally a number of components to the cost of produced:


Fixed (or setup) costs This type of cost is normally associated with the
purchase, rent or lease of equipment and fixed overheads. It can
sometimes include the transportation and manpower movement costs
also.
In general, it can be considered as all those costs that need to be
borne before production can physically begin (and thus is
independant of the number of items to be produced).
Variable costs These are costs normally associated with the supply of
the raw materials and overheads necessary to manufacture each
product. Thus, they will depend on the number of items produced.
For example, if x is the number of items produced in a day and each
item costs e2.50, then the daily variable cost is (2.5)x.

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Special costs This option cost factor is sometimes included in a total cost
function and might cover costs relating to storage, maintenance or
deterioration. The total costs involved are normally expressed in the
form cx2 , where c is a relatively small value and x is the number of
items under consideration.
The effects of this type of cost would only be significant for large
production rungs or other large processes. Hence, a total cost
function takes a general form as follows:

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Definition: Form of a Cost Function
C(x) = a + bx + cx2

where x is the quantity of items demanded


(supplied or produced)
a is the fixed cost associated with the product
b is the variable cost per item
c is the (optional) special cost factor

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Question: The variable costs associated with a certain process are e0.65
per item. The fixed costs per day have been calculated as e250 with
special costs estimated as (e0.02)x2 , where x is the size of the production
run.

a) Derive a function to describe cost per item for a day’s production.

b) Calculate the size of the daily run that will minimise cost per item.
c) Find the cost of a day’s production for a run that minimises cost per
item

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a) The total cost function is Ctotal (x) = 250 + (0.65)x + (0.02)x2 for the
production of x items (using the information given in the question).
Thus, the cost per item is
Ctotal
C =
x
= 250 + (0.65)x + (0.02)x2
250
= + 0.65 + (0.02)x
x

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b) The cost per item is minimised when C′ (x) = 0.

C′ (x) = −250x−2 + 0.02


250
= − 2 + 0.02
x
and so C′ (x) = 0 gives us
250
− 2
+ 0.02 = 0
x
250
=⇒ x2 = = 12500
0.02
=⇒ x = 112

That is, the size of the daily run which minimises cost per item is 112.

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c) The cost of a daily run which minimises the cost per item is simply
given by Ctotal (x = 112).

Ctotal (x = 112) = 250 + (0.65)(112) + (0.02)(112)2


= 150 + 72.8 + 250.88
= 573.68

Thus, the cost of a day’s run which minimises cost per item is
e573.68.

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Revenue Functions

We can write the revenue function from the output of some process as
follows:

Definition: Form of a Revenue Function

R(x) = x pr (x)

where x is the quantity of items demanded


pr (x) is the fixed cost associated with the product.

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The Demand Function

It is quite usual in a business environment for item price to depend on the


number of items in demand. That is, the more items that are in demand,
the less the price per unit is. Hence, the reason that price is expressed in
terms of x.
It is usually known as the demand function, where it should be
remembered that (unless otherwise stated) it is assumed that supply and
demand are equal.
The following two sections outline its form and the technique that
sometimes need to be used to identify it.
Demand functions are used to vary the price of an item according to how
many items are being considered. As mentioned in the previous section,
the more the number of items, the less the price per item and vice versa.

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This is simply the standard business principle of ‘economies of scale,’
where it is generally more efficient to operate on as large a scale as can be
coped with.
Demand functions are normally linear.

Definition: The Demand Function


pr (x) = a + bx

where x is the quantity of items demanded


a, b ∈R
pr (x) is the price function

Thus, if we have pr (x) = 25 − 2x then R(x) = x(25 − 2x) = 25x − x2 .

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Constructing the Demand Function

In many cases the demand function will not be stated specifically, but
rather given in terms of the price of the unit at two different demand
levels.
In these cases, we assume that the demand function is linear, and
construct the demand function accordingly.
As an example, suppose the price of a product is e0.85 per item when
100 products are demanded, but is e0.68 when 500 items.
So, we assume the demand function is linear and so has the form

pr (x) = a + bx

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Substituting our two sets of values gives us:

(0.85) = a + b(100)
(0.68) = a + b(500)

Subtracting
=⇒ (0.17) = −400b
and so we have b = −0.000425 and so a = 0.85 + 0.0425 = 0.8925
Thus, our demand function is

pr (x) = 0.8925 − (0.000425)x

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Question: Given that the price of an item is e3.50 when 250 items are
demanded, but e5.50 per item when only 50 are demanded, identify the
linear demand function and calculate the price per item at a demand level
of 115.

So, we have pr (x) = a + bx, and so

3.5 = a + 250b
5.5 = a + 50b

Subtracting we get 200b = −2 and so b = −0.01.


Substituting into the second equation, 5.5 = a − 0.5 =⇒ a = 6.
Thus, we have pr (x) = 6 − (0.01)x.
Now, pr (115) = 6 − (0.01)(115) = 4.85 and so at a demand level of 115,
the price per item is e4.85.

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Question: Given the demand function pr (x) = 10.4 − (1.3)x, where x is
in units of 100, find the level of production which maximises total
revenue.

The revenue function has previous be defined as R(x) = x pr (x), and so


we have

R = x pr (x)
= x(10.4 − 1.3x)
= (10.4)x − (1.3)x2

To maximise revenue, we need to solve the equation R′ (x) = 0.


But R′ (x) = 10.4 − (2.6)x and R′′ (x) = −2.6 so the extrema is a
maximum (as we would expect).

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Thus,

R′ (x) = 0
=⇒ 10.4 − (2.6)x = 0
=⇒ x = 4

So, the level of production necessary to maximise revenue is 400 units.

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Marginal Cost and Revenue Functions
If, for some process, the total cost function, C(x), and the revenue
function, R(x), are identified, where x is the level of activity, then
marginal cost function is defined to be C′ (x) and can be interpreted as
the extra cost incurred of producing another item at activity level x.

marginal revenue function is defined to be R′ (x) and can be interpreted


as the extra revenue obtained from producing another item at activity
level x.

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We can use the marginal cost and revenue functions as an alternative way
to calculate the maximum profit point, since, if x = xmax is the maximum
profit point then

P′ (xmax ) = 0
=⇒ C′ (xmax ) − R′ (xmax ) = 0
=⇒ C′ (xmax ) = R′ (xmax )

Thus, solving R′ (x) = C′ (x) also gives us the maximum profit point.

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Definition: Maximum Profit Point
The maximum profit point for some process can be found
by solving the equation

R′ (x) = C′ (x)

where C(x) = is the total cost function


R(x) = is the total revenue function

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Question: A refrigerator manufacturer can sell all the refrigerators of a
particular type that he can produce. The total cost of producing q
refrigerators per week is given by 300q + 2000. The demand function is
estimated as 500 − 2q

a) Derive the revenue function R.


b) Obtain the total profit function.

c) How many units per week should be produced in order to maximise


profit?
d) Show that the solution of the equation R′ (q) = C′ (q) where C(q) is
the cost function, gives the same value for q as in part c.
e) What is the maximum profit available?

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a) The demand function is pr (q)500 − 2q and so the revenue function is
R(q) = qpr (q) = 500q − 2q2 .

b) The cost function is given as

C(q) = 300q + 2000

Thus, the profit function is

P(q) = R(q) −C(q)


= 500q − 2q2 − (300q + 2000)
= −2q2 + 200q − 3000

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c) P′ (q) = −4q + 200 (with P′′ (q) = −4, a local maximum).
Thus

P′ (q) = 0
=⇒ −4q + 200 = 0
=⇒ q = 50

Thus, 50 units must be produced per week to maximise the profits.


d) R′ (q) = 500 − 4q, C′ (q) = 300 and so

R′ (q) = C′ (q)
=⇒ 500 − 4q = 300
=⇒ 4q = 200
=⇒ q = 50

This agrees with our previous result.

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e) Substituting q = 50 into the profit function gives us

P(q = 50) = 200(50) − 2(50)2 − 2000


= 10000 − 5000 − 2000
= 3000

Thus, the maximum profit available is e3,000.

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