There are two main measures of revenue that companies use to gauge sales. Total revenue looks at the total sales as an average number per unit and then multiplies it by the number of units sold. By contrast, marginal revenue measures the money that a company will make per additional unit sold. This might seem like a redundant measure, but marginal revenue signals the point at which making additional units will result in less revenue per unit. When a company is profitable and efficient, total revenue should match the marginal revenue. But at a certain point of increased production, sales will have diminishing returns. This means that even if total revenue increases, the marginal revenue, or additional revenue for each sale, can decline.
Finding marginal revenue uses a formula that divides the change in revenue over the change in quantity sold.
Marginal Revenue = Change in Revenue / Change in Quantity
Example
If an auto manufacturer sells cars for $50,000 ("total revenue rate") and sells 1000 cars, the total revenue for the year is $50,000,000. If at the last minute of the year another car is sold, the new total revenue is $50,050,000. The marginal revenue is: ($50,050,000-$50,000,000)/(1,001-1,000) = $50,000, which is the same total revenue rate as before that last car was sold.
However, if the auto manufacturer had two leftover units at the end of the year and sold them at discounted prices of $45,000 and then $35,000, the marginal revenue for the unit that sold for $45,000 would be: ($50,045,000-$50,000,000)/(1,001-1,000) = 45,000/1 = $45,000. Then, the marginal revenue for the other unit would be: ($50,080,000-$50,045,000)/(1,002-1,001) = $35,000/1 = $35,000. In this case, the marginal revenue has decreased with both additional units sold.
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The image below shows a typical, total revenue graph with the sales on the y axis and the units sold on the x-axis. The line will move equally to the right as long as the price of sold goods remains the same.
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The formula for finding total revenue is simple. It uses two data points. The first data point is the quantity of units, services, or subscriptions sold. The second data point is the price per unit. The price per unit is either the price of an item or the average price of units that have different price points. The formula looks like this:
Total Revenue (TR) = Quantity Sold (Q) x Price (P)
The total revenue is found below using the total revenue formula and by plugging in the granite yard data from the example above.
TR = 100,000(units sold) X 30(price per unit)
TR = $3,000,000
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Total revenue calculations are not always so straightforward. The above example assumes that the company sells only one kind of granite and that the price stays constant. The reality might be very different.
- If the price of the unit sold changed, then the average price per sale has to be calculated first. This entails adding the total sales for all of the same good and dividing it by the number of units sold. That will produce the average sale price per unit.
- If the company sells more than one kind of good, then an average sale price per unit must be calculated for each good.
- The TR formula must be used to calculate the revenue for each good. For example, if a company sells shirts and ties, they will calculate the total revenue for the ties and then the total revenue for the shirts.
- Once there is data for the total revenue for each product sold, the revenues can be added together to get the total revenue for all the products. The company would add the total tie revenue to the total shirt revenue to get the company's total revenue.
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If the granite yard from the example above wants to calculate its annual revenue for all their granite products, and it currently sell four different granite types, it would need to calculate the total revenue of each of the granite types and then add those four sums. The following table shows the products and their average prices per square foot.
| Product | Price Per Sq Ft | SqFt Units Sold | Revenue |
|---|---|---|---|
| Slab A | $30 | 100,000 | $3,000,000 |
| SlabB | $12 | 50,000 | $600,000 |
| Slab C | $50 | 5000 | $250,000 |
| Slab D | $20 | 200,000 | $4,000,000 |
| Totals | $28 avg per sqft | 355,000 | $7,850,000 |
The table shows that total revenue for the granite yard was $7,850,000 by breaking down the revenue of each product. This helps the granite yard to understand where pricing changes might be needed. Slab D is very popular and generated more than half of total revenue. The company might therefore consider a price increase. Slab C is not a big seller, so the company might consider lowering the price or even dropping the product from its line and reallocating resources.
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If the granite yard was looking to make changes to pricing based on their revenues, they would also want to consider the elasticity of the demand for the products they sell. Elasticity refers to the extent that the demand will change given a change in price. The more that demand changes as price changes, the more elastic the demand is.
- When demand is inelastic it means that changes in price won't cause a big change in demand. If the demand for Slab D is inelastic, the granite yard can increase its price without hurting demand and therefore increase its revenue for that product.
- When demand is elastic it means that prices will change demand significantly. If demand is quite elastic, the best course of action would be to lower prices. For example, if the granite yard lowered the price of Slab C to $40 a square yard, a 20% reduction in price, and if the demand for Slab C is very elastic, the number of units sold could increase by more than 20%.
- When demand is unitary elastic, it means that demand will change to the exact same degree as the price change. For example, if the price of Slab A is raised by 10%, there would be a 10% decrease in demand.
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The calculation of total revenue helps individual companies make both short and long-term decisions. There are three basic choices in a market segment that a company faces. They can: enter the market and sell their goods; exit the market; or shut down their operations altogether. These decisions are generally based on total revenue.
- Entering a Market - A company might choose to enter a market when the revenues of competitors are high and demand is increasing. The company might determine that they could compete and make a profit based on revenue numbers.
- Exiting a Market - If total revenues in a market segment begin to decline sharply, a company may decide to leave the market altogether. Leaving the market means that the company stops selling in a specific market. For example, if a company whose primary product is soda enters the clothing market. they might exit the clothing market but still sell soda.
- Shuttering Operations - This means that a company exits the only market that it sells in and cannot competitively sell in another market. This effectively means that the company goes out of business.
There are also two terms that are considered when making operational decisions based on total revenue.
- Short Run - This looks at the near future of the marketplace to make decisions. Short term decisions usually involve price changes, production changes, and employment decisions based on projected revenue.
- Long Run - Long term decisions involve looking further down the road. This is where large shifts can take place such as entering or exiting a market.
The automotive industry is a good example to highlight here. Its short term decisions in 2022 will be based on the skyrocketing prices of cars, but the long term will focus on the viability of companies that do not sell electric vehicles because many countries will be banning the sale of combustion engines in the next decade.
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Total revenues are a company's combined total sales before taking expenses into account. Total revenues are slightly different than marginal revenues, which calculate how much each additional unit sale will change the total revenue. Total revenue is calculated by taking the total number of products sold and multiplying it by the price per unit.
In some cases, a company will average the unit cost if the price changes. Sometimes companies have to consider different products with different price points. Elasticity is when demand changes based on the price of a product. Total revenue helps a company make long and short-run operational decisions like price changes, entering the market, exiting the market, or shuttering the company altogether.
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Video Transcript
What Is Total Revenue in Economics?
In business and economics, one of the most important measures for evaluating your success and progress is looking at the trends in your total revenue. You need to know this important measure so that you can eventually calculate your total profit for a business.
Total revenue in economics refers to the total receipts from sales of a given quantity of goods or services. It is the total income of a business and is calculated by multiplying the quantity of goods sold by the price of the goods. For example, if Company A produces 100 widgets and sells them for $50 each, the total revenue would be 100 * $50 = $5,000. In economics, total revenue is often represented in a table or as a curve on a graph.
It is important to note that the concept of revenue in economics usually involves two other key terms. The first term is average revenue (AR), which refers to the revenue per unit of output sold. It is obtained by dividing the total revenue by the number of units sold.
The second term is marginal revenue (MR), which is the additional revenue generated from the sale of an additional unit of output. In other words, it's the change in total revenue from the sale of one more unit of a good. For example, if Company A sold one more widget and their revenue increased from $5,000 to $5,050, the marginal revenue would be equal to $50.
Using Total Revenue in Business
Marginal revenue is important because it helps us understand the relationship between the number of units sold and the total revenue. As you can see on this chart, how much you charge per item can affect how much you sell, which, in turn affects your total revenue. In other words, just charging a lot for each item isn't the best strategy for increasing revenue.
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You will notice that total revenue is maximized when this company prices its product at $60 and sells 9 units. In order to sell the tenth unit, however, the company would have to lower its price per unit to $50, and it would actually generate $40 less in total revenue. If the business sold its product at $65, it could sell 8 units for a total revenue of $520; this is a higher average price but lower overall total revenue than if it sold 9 units.
Total revenue can change based on the price elasticity of a product. Price elasticity is a measure used in economics to show how consumers respond, or demand a product, based on changes in price. Different products or goods have different elasticities. People are more price sensitive (elastic) or less price sensitive (inelastic) toward different products. For example, inelastic goods include items like toilet paper, water, milk or baby formula. This means that if the price goes up, you will probably still pay for these goods because you need them for daily life.
On the other hand, an elastic good might include organic fruit, newspaper subscriptions or furniture. Changes in the prices of these goods are more likely to result in changes in your demand for these products. If the prices go up, you may live without them or more easily find alternatives to meet your needs. For example, maybe you'd decide to no longer buy organic fruits and purchase frozen fruit instead. Or maybe you'd decide to simply read your news online rather than pay a subscription fee for a newspaper. It is important for businesses to understand their product and how responsive people are to changes in price. This will help them maximize their total revenue.
A total revenue test is a way for a company to determine whether demand for its product or good is elastic or inelastic. If an increase in price causes an increase in total revenue, then the demand is inelastic. Just like baby formula or milk, the increase in price does not have a large impact on the quantity demanded. On the contrary, if an increase in price causes a decrease in total revenue, then the demand can be said to be elastic. A business with elastic demand that is selling a name brand soup might be hesitant to raise prices because it knows that increases in price can greatly decrease the quantity demanded.
Why does all this matter? By knowing the elasticity of products, businesses can make more accurate decisions regarding how changes in prices will affect their total revenue and sales. They can figure out the optimum number of units to produce and the selling price that maximizes their total revenue.
Formula for Total Revenue
Total revenue can be calculated as the selling price of the firm's product multiplied by the quantity sold. It looks like this:
Total Revenue (TR) = Price (P) x Quantity (Q)
or
TR = P * Q
Lesson Summary
Let's review. Total revenue in economics refers to the total sales of a firm based on a given quantity of goods. It is the total income of a company and is calculated by multiplying the quantity of goods sold by the price of the goods. Performing total revenue tests to understand the price elasticity of the demand for your products will help your business make good decisions on how to increase total revenue through price changes. Total revenue is calculated with this formula: TR = P * Q, or Total Revenue = Price * Quantity.
Learning Outcomes
This lesson equips students to:
- Define total revenue and explain its relationship to marginal and average revenue
- Discuss how price elasticity can affect total revenue
- Recall the formula used to calculate total revenue
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