Costs, Revenue and Profit: Marginal Cost, Economic Profit and Break-even

Every business decision comes down to a comparison of what it costs with what it brings in. Costs, revenue and profit are the language of that comparison.

Economists and accountants use the words slightly differently, and the Institute of Chartered Accountants of Nigeria (ICAN) Business Environment paper expects you to know both uses, to calculate them from data, and to explain how a firm finds the output that earns it the most profit.

This topic covers the types of cost, explicit and implicit costs, the three meanings of profit, revenue, profit maximisation, economies and diseconomies of scale, and break-even analysis. Most of it is arithmetic, so work through the numbers as you read.

Types of cost

• Fixed costs do not change when output changes, in the short run. Examples: rent, insurance, salaries of permanent staff.
• Variable costs change with output. Examples: raw materials, packaging, piece-rate wages.
• Total cost (TC) is fixed cost plus variable cost.
• Average cost (AC) is total cost divided by the number of units: AC = TC ÷ Q.
• Marginal cost (MC) is the extra cost of producing one more unit: MC = change in TC ÷ change in Q.

The short run is a period in which at least one input, such as factory size, cannot be changed. In the long run all inputs can be changed, so all costs are variable.

A cost schedule

Bako Bakery has fixed costs of ₦100,000 a day. The table shows how its costs change as it bakes more batches.

Read the pattern. Average cost falls at first, because the fixed cost is spread over more units. Marginal cost falls and then rises, because extra output eventually needs more labour and effort per unit. Average cost starts to rise once marginal cost climbs above it, which here happens between 5 and 6 batches. Marginal cost always cuts the average cost curve at its lowest point.

Explicit and implicit costs

• Explicit costs are payments the firm makes to outsiders: wages, rent, materials, interest. They appear in the accounts.
• Implicit costs are the opportunity cost of resources the owner already owns or supplies, such as the salary the owner gave up or the rent the owner could have earned by letting out the premises. They are not paid to anyone, so they do not appear in the accounts.

Opportunity cost is the value of the best alternative given up when a choice is made.

Three meanings of profit

When economic profit is zero, the firm earns normal profit. It covers all its costs, including the owner’s best alternative, and there is no reason to leave or enter. When economic profit is positive, the firm earns abnormal profit and other firms are attracted. When it is negative, the owner would do better elsewhere.

Economic loss, and when a firm stays in business

When economic profit is positive it is also called supernormal or pure profit. If entry is free, it attracts new firms. When total revenue equals total cost including implicit costs, the firm earns normal profit and has no reason to enter or leave. When total cost exceeds total revenue the firm makes an economic loss.

In the short run, a firm that can still cover its variable costs stays in business, because it is losing less than it would by closing. A firm that cannot cover its variable costs leaves.

Worked example: accounting profit and economic profit

Ngozi’s normal profit is ₦1,800,000, the sum of her implicit costs. She earns ₦400,000 of abnormal profit above it, so staying in the shop is worth more to her than her best alternative.

Revenue

• Total revenue (TR) = price × quantity sold.
• Average revenue (AR) = TR ÷ Q, which equals the price.
• Marginal revenue (MR) = the extra revenue from selling one more unit.

A firm that must lower its price to sell more sees marginal revenue fall faster than price. A firm that takes the market price, as in perfect competition, has a constant marginal revenue equal to that price.

Price-taking and price-making firms

A price-taking firm has little influence over the price of its goods. The market sets the price and the firm can sell any quantity at it. This is typical of perfect competition. Its price, average revenue and marginal revenue are all equal. At a market price of ₦500, every extra unit adds ₦500 to total revenue, so total revenue rises in a straight line through the origin.

A price-making firm has substantial control over the price of its product, as under monopoly and monopolistic competition. To sell more it must lower the price, so marginal revenue falls below price and average revenue, as in the schedule shown earlier.

Profit maximisation

A firm gains by producing an extra unit whenever the revenue it adds (marginal revenue) is greater than the cost it adds (marginal cost). It stops when the next unit would add more to cost than to revenue. Profit is therefore greatest at the output where marginal revenue equals marginal cost, or where the last unit that adds more revenue than cost is made.

A firm is in equilibrium when it maximises profit or minimises loss. Two conditions must hold. The necessary condition is that marginal revenue equals marginal cost. The sufficient condition is that marginal cost is rising at that output.

Worked example: finding the profit-maximising output

Combine Bako Bakery’s marginal cost with the marginal revenue above.

The fourth batch is the last one where MR (₦70,000) exceeds MC (₦50,000). The fifth costs ₦70,000 and brings in only ₦60,000, so it lowers profit. Profit is highest at 4 batches, at ₦40,000. The profit column confirms it: ₦20,000 at 3, ₦40,000 at 4 and ₦30,000 at 5.

Production and productivity

Production is the process of turning inputs, land, labour, capital and enterprise, into outputs of goods and services. It is not complete until the product reaches the final customer. In the short run at least one input, such as plant size, is fixed, so output depends on how much of the variable factor, usually labour, is added.

A production schedule

Bako Bakery has one oven (fixed) and adds bakers (variable). The table shows output in batches a day.

Read the relationships. Marginal product rises to a maximum of 15 at the third baker, then falls. It crosses average product at the maximum of average product, where both equal 13. Total product reaches its maximum of 63 when marginal product is zero. After that, marginal product is negative and total product falls.

The three stages of production

Production is therefore carried out in Stage 2. Where in Stage 2 depends on prices. The point of maximum profit and economic efficiency is where the marginal product of the variable input matches its price relative to the output price. Technical efficiency is at the end of Stage 2, where MP is zero.

Returns to the variable factor

• Increasing returns. At first there is too little variable input, so the fixed input is not used well. Each extra worker makes better use of it, and MP rises.
• Diminishing returns. Past the maximum MP, each extra unit of variable input adds less to output than the one before.
• Negative returns. When too much variable input crowds the fixed input, each extra unit gets in the way and total output falls.

Economies and diseconomies of scale

Economies of scale occur when average cost falls as the scale of production rises. Diseconomies of scale occur when average cost rises as the firm grows too large.

Internal economies of scale

External economies arise from the growth of the whole industry in an area, such as a skilled labour pool, specialist suppliers and good transport links near a cluster of firms.

Diseconomies of scale

• Control and coordination. A very large firm is hard to manage.
• Communication. Messages slow down or are distorted through many levels.
• Motivation. Staff feel remote and less committed.
• Duplication and bureaucracy add cost.

Long-run costs and external effects

In the long run all inputs can be changed, so all costs are variable. The long-run average cost (LAC) curve is a planning curve for an entrepreneur deciding how far to expand. It is derived from the short-run average cost curves of plants of different sizes, because the firm picks the plant size with the lowest cost for each level of output.

This produces the usual U shape: average cost falls while economies of scale operate and rises when diseconomies set in.

The syllabus adds research and development to the list of internal economies: larger firms can set aside part of their income for research and product development. It also describes internal diseconomies: as a firm grows, indivisible factors may be duplicated, coordination and management become harder, bureaucratic red tape slows decisions, and staff become disenchanted, which lowers morale and raises average cost.

External effects arise from the growth of the whole industry, not of one firm. Internal effects arise from the growth of the firm itself.

Break-even analysis

The break-even point is the output at which total revenue equals total cost, so profit is zero. It uses the contribution, the amount each unit adds towards fixed costs.

Contribution per unit = selling price − variable cost per unit
Break-even units = fixed costs ÷ contribution per unit

Example. A firm sells a product at ₦500. Variable cost is ₦300 a unit and fixed costs are ₦400,000.

• Contribution = 500 − 300 = ₦200 a unit.
• Break-even = 400,000 ÷ 200 = 2,000 units.
• If it sells 3,000 units, profit = (3,000 × 200) − 400,000 = ₦200,000.
• The margin of safety is the amount by which sales exceed break-even: (3,000 − 2,000) ÷ 3,000 = 33.3% of sales.

Costs, revenue and profit in more detail

A full worked schedule

Bako Bakery has fixed costs of ₦100,000 a day. Total costs for 1 to 6 batches are ₦160,000, ₦210,000, ₦250,000, ₦300,000, ₦370,000 and ₦460,000. Each batch sells for ₦80,000.

Marginal cost is the change in total cost for one more batch. The first batch adds 160,000 − 100,000 = ₦60,000 because the fixed cost is paid even at zero output. Average cost is total cost divided by batches. Because price is constant at ₦80,000, marginal revenue is also ₦80,000. The fifth batch adds ₦80,000 of revenue for ₦70,000 of cost, so it adds profit. The sixth adds ₦80,000 for ₦90,000, so it reduces profit.

Profit is greatest at five batches, at ₦30,000, where marginal cost has risen to just below marginal revenue. The break-even output, where revenue first covers cost, lies between three and four batches.

The shape of the cost curves, explained

Average fixed cost falls as output rises because the fixed cost is spread over more units. Average variable cost and marginal cost first fall, because specialisation and fuller use of equipment make each extra unit cheaper, and then rise as diminishing returns set in: each extra worker in a fixed kitchen adds less.

Marginal cost cuts average cost at the lowest point of average cost, because when the cost of one more unit is below the average it pulls the average down, and when above it pushes it up.

Accounting and economic profit with figures

A trader earns revenue of ₦5,000,000 and pays explicit costs of ₦3,000,000, so accounting profit is ₦2,000,000. But the owner could have earned a salary of ₦1,200,000 elsewhere, and the ₦3,000,000 of his own capital could have earned ₦300,000 of interest. These implicit costs total ₦1,500,000. Economic profit is 2,000,000 − 1,500,000 = ₦500,000. It is positive, so the business is worth running.

If the owner could have earned more than ₦2,000,000 elsewhere, economic profit would be negative even though accounting profit is positive.

Diminishing returns in a schedule

With one oven, a first baker adds 10 batches, a second 14, a third 15, a fourth 13, a fifth 8. Up to the third baker marginal product rises, because the oven was underused. After that it falls: there is too little oven for each extra baker. This is the law of diminishing returns, and it is why marginal cost rises.

Exam focus: the production function and marginal product

A production function shows the relationship between the inputs a firm uses and the output it can produce. In the short run at least one input, usually capital, is fixed, so output is raised by adding a variable input such as labour.

• Total product is the total output at each level of the variable input.
• Marginal product is the extra output from one more unit of the variable input. It measures how total product changes in response to variations in a variable factor, and it was a November 2025 Section A question.
• Average product is total product divided by the number of units of the variable input.

At first, marginal product usually rises as workers specialise. After a point it falls, which is the law of diminishing marginal returns. A production schedule question gives you labour and output columns, and you fill in the marginal and average columns by subtraction and division.

External economies of scale are advantages a firm gains from being in an area with a high concentration of similar businesses, such as skilled labour and suppliers nearby. They are different from internal economies, which come from the firm’s own size.

Exam focus: internal and external economies and diseconomies of scale

Economies of scale are falling long-run average costs as output grows. They are a long-term effect. The new text splits them into internal (specific to the firm) and external (benefits of the industry growing).

Internal economies

• Technical. Large machines that need a minimum size to be worthwhile, specialised machines for different tasks, a spare machine against breakdown, and a deeper division of labour.
• Marketing. Bulk buying of inputs at discounts, and advertising and selling costs per unit that fall as sales rise.
• Financial. Cheaper loans because large firms can offer collateral and are seen as creditworthy; easy access to the stock market; and credit from suppliers.
• Managerial. Specialist managers for each department, mechanised management tasks with computers and e-mail, and training for future managers.
• Research and development. Large firms can set aside funds for product research.

External economies

• Economies of skilled labour. Specialist bodies train labour for the whole industry.
• Economies of research and development. Industry research is shared by all firms.
• Economies of common services. Shared water, power, roads, transport, telecoms and bank support.

Diseconomies of scale

• Internal. Duplication of indivisible factors, harder coordination and control, bureaucratic red tape that delays decisions, and falling staff morale. Average total cost rises as a result.
• External. When an industry grows beyond its ideal size, outside forces raise costs: increasing raw material cost, increasing cost of skilled labour, and excess marketing cost.

Common mistakes in the exam

• Leaving out implicit costs when asked for economic profit.
• Treating normal profit as zero profit. It is the return needed to keep the owner in business and is counted as a cost.
• Confusing marginal cost with average cost. Marginal is the extra unit. Average is total divided by output.
• Choosing the output with the highest revenue or the lowest average cost as the profit-maximising output. Compare MR and MC.
• Calling a fixed cost variable because it changes between years. Fixed and variable describe the response to output in the short run.
• Mixing economies of scale with a short-run fall in average cost from spreading fixed cost.

Quick revision

• Fixed costs do not move with output in the short run. Variable costs do. TC = FC + VC.
• AC = TC ÷ Q. MC = change in TC ÷ change in Q. MC cuts AC at its minimum.
• Explicit costs are paid. Implicit costs are opportunity costs of owner resources.
• Accounting profit = revenue − explicit costs. Economic profit = accounting profit − implicit costs. Normal profit equals implicit costs.
• Profit is greatest where MR = MC.
• Production: TP, AP = TP ÷ L, MP = change in TP ÷ change in L. MP crosses AP at AP’s maximum. Rational production is in Stage 2.
• Returns: increasing, then diminishing, then negative. Long-run costs are all variable, and external economies come from the industry’s growth.
• Economies of scale: technical, purchasing, financial, managerial, marketing and risk-bearing. Diseconomies come from size and weak control.
• Break-even units = fixed costs ÷ (price − variable cost per unit).

Practice questions

These are original questions written in the style of the ICAN exam. Try each one before you open the answer.

Section A style: multiple choice

Section B style: written questions

A further written question

Model answers

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