A business must determine the ideal amount of expenditures to receive the maximum amount of benefits from business investments, a state known as equilibrium. Since a business cannot easily visualize equilibrium, it can use the total-revenue-total-cost approach to provide a graphical representation of how much loss it takes or profit it gains when producing or selling products and services.
Total revenue equals the sale price of products multiplied by the total amount of units sold. Total cost equals the sum of fixed costs to purchase or produce products and services, such as wholesale prices and machinery, and variable costs to sell the product, such as business taxes, payroll, utility bills and rent. Profit equals total revenue minus total cost.
A business will design graphs to compare revenues and costs. It will mark the y-axis as costs and the x-axis as output or revenue. On a regular basis, the business will draw one set of points on the graph to represent total cumulative costs over a time frame and another set of points on the graph to represent total revenue. It will calculate the best fit for these points to form two lines, one for total cost and another for total revenue. Businesses usually draw a third line to represent profit based upon the gap between the two lines.
On a graph, total-revenue takes the form of a straight line, while a total-cost line has a wavy or curved form. The difference between these two lines determines whether business operations run at a loss or profit. If the total-cost line moves above the total-revenue line, the difference between the two lines signifies a loss. If below the line, the difference represents profit. The profit line fluctuates based upon the difference between the two lines. Business owners can compare the ups and downs of the profit line to help them understand how business profits change over time.
Most businesses that provide products and services use a total-revenue-total-cost approach. A business can apply total-revenue-total-cost modeling to a specific area of operations or the entire business. For example, a business owner who retails a new toy may use this approach to determine how many units of the toy he should purchase (cost) to obtain the most profit. He may find he profits more by purchasing a large volume of the toy and selling to a large customer base or buying a small volume and selling at higher prices.
Businesses can update their total-revenue-total cost model to modify their costs and outputs. If a manufacturing business finds that costs exceed revenues, it can lower output, lay off workers and upgrade or improve machinery. If revenues are lower than anticipated, the business may need to increase output due to a high volume of sales or lower the price on products. A business can determine equilibrium by adjusting costs and revenues and observing how its profit curve changes in response.