What Is the Connection Between Marginal Revenue and Total Revenue?

Revenue is the amount of money earned by a company by selling its goods or services at a set price. It is the starting point of an income statement that determines how much net income a company makes after expenses, taxes, and interest are deducted. As such, it is one of the most important business lines.

Although it may be one number, there are many different ways to look at it. These varying degrees of insight are helpful to businesses, analysts, and investors Two of the most common forms of revenue are total revenue and marginal revenue. While total revenue represents the total amount of money earned by a business (sales multiplied by the prices of products and services), marginal revenue refers to the increase in revenue achieved by selling one additional unit of a product or service.

KEY TAKEAWAYS

• Revenue is the total amount of money a company earns by selling products and services at a certain price.

• The starting point for any income statement is revenue that will eventually lead to net income after expenses are deducted.

• Total revenue, which is the full amount of total sales, is calculated by multiplying the total amount of goods and services sold by their prices.

• Marginal revenue is the increase in revenue from selling one additional unit of a good or service.

• Companies continue producing and selling more goods and services until marginal revenue equals marginal cost.

Total Revenue vs. Marginal Revenue

As noted above, total revenue is the total amount of sales of goods and services. It is calculated by multiplying the total amount of goods and services sold by the price of the goods and services. Marginal revenue is directly related to total revenue because it measures the increase in total revenue from selling one additional unit of a good or service.

Total revenue is important because businesses strive to maximize the difference between their total revenues and total costs as they try to grow profits. Understanding the subtleties of the relationship between revenues and costs distinguishes the best business managers from the lesser ones. That's because increasing production leads to an increase in sales and total revenue and there are also costs involved with increasing production.

Marginal revenue is important because it measures increases in revenue from selling more products and services. Marginal revenue follows the law of diminishing returns, which states that any increases in production will result in smaller increases in output. This means the optimal level has passed. As long as marginal revenue is above marginal cost, a company is making profits because it costs money to make and sell an additional unit. Once the marginal revenue equals marginal cost, it makes no sense for a company to produce or sell more units of its products or services.

There is a direct relationship between marginal demand and the price elasticity of demand. This is the change in consumption of goods and services based on their prices. Positive marginal revenue means demand is elastic. It is negative when marginal revenue is negative.

Law of Diminishing Marginal Returns

As noted above, marginal revenue adheres to the economic theory known as the law of diminishing returns.

According to the rule, any additional factors of production may actually lead to a drop in output. That's because workers and the manufacturing process end up reaching their peak or optimal level. Put simply, factoring in one additional unit of production will have a negative impact on the returns related to per-unit increases—even if they're incremental ones.

This can be visualized in a concave chart. The total revenue earned from aggregate unit production rises only to plateau once the optimal level of production is achieved. At some point, it may even start to fall, too. Since there is a positive correlation between these two types of revenue, total revenue drops when marginal revenue does.

Based on the law of diminishing marginal returns, companies need to find the right balance when it comes to the right production levels. Doing so can help them maintain both total and marginal revenue.

How Businesses Can Use Total Revenue and Marginal Revenue

Businesses, analysts, and investors can use total and marginal revenue to determine the competitiveness and success of companies. Both of these types of revenues have a direct relationship to corporate income. Companies that are successful often have consistent total and marginal revenue.

In order to remain competitive, companies must be able and willing to increase production—but only to a certain extent. Since we already know that reaching optimal levels can lead to a drop in returns, companies must regularly monitor production levels. A cost-benefit analysis is usually required once their marginal production costs begin to exceed their marginal revenue.

Example of Total Revenue and Marginal Revenue

The calculation of total revenue frequently takes timetables into account. For instance, a restaurateur may tabulate the number of hamburgers sold in an hour or the number of orders of medium-sized french fries sold throughout the business day. In the latter case, the total daily revenue would be the number of fries sold—say 300, multiplied by the price per unit—at a price of $2 per day.

But consider what happens if the restaurateur drops the price of a unit of french fries to $1, and he heavily advertises the new discounted price. This could result in a bump in sales—let’s say to 500 units per day. Consequently, the total revenue bumps up to $500 in sales.

Total revenue changes with respect to price, and quantity can be visually demonstrated on a graph, in which a demand curve is drawn, that signals the price and quantity that would maximize total revenue.

Calculating Marginal Revenue

To calculate marginal revenue, divide the change in total revenue by the change in the quantity sold. Therefore, the marginal revenue is the slope of the total revenue curve. Use the total revenue to calculate marginal revenue:

Marginal Revenue = Change in Total Revenue/Change in Quantity Sold

Let's go back to the example from above. Suppose the company sells one unit of fries for a price of $2 for each of its first 100 units. If it sells 100 toys, its total revenue would be $200 (100 x 2). The company sells the next 100 units of fries for $1.50 a unit. Its total revenue would be $350 ($200 + 100 x 1.50).

Suppose the company wanted to find its marginal revenue gained from selling its 101st unit. The total revenue is directly related to this calculation. First, the company must find the change in total revenue. The change in total revenue is $1.50 ($151.50 - $150). Next, it must find the change in the fries sold, which is 1 (101 - 100). Thus, the marginal revenue gained by producing the 101st toy is $1.50.

Is Marginal Revenue a Derivative of Total Revenue?

Marginal revenue is a derivative of total revenue—at least when it comes to demand. That's because marginal revenue reflects the change in total revenue when one additional good or service is produced. You can calculate marginal revenue by dividing total revenue by the change in the number of goods and services sold.

Does Marginal Revenue Increase If Total Revenue Increases?

There is a positive correlation between marginal and total revenue. This means that when total revenue increases, marginal revenue is positive. When it falls, you end up with a negative marginal revenue.

What Is the Difference Between Marginal Cost and Marginal Revenue?

Marginal cost is the extra expense a business incurs when producing one additional product or service. Marginal revenue, on the other hand, is the incremental increase in revenue that a business experiences after producing one more product or service. Adjustments to a company's marginal revenue may mark a change in its marginal cost. A company's production reaches its optimal point when marginal cost and revenue are equal.

The Bottom Line

Total revenue is the total amount of money a company brings in from selling its goods and services. It determines how well a company is bringing in money from its core operations based on demand and price.

Marginal revenue measures the increase in revenues from selling an additional unit of a good or service, which helps management determine if it is in the best interest to produce and sell more. Once the marginal cost of producing an extra unit is greater the marginal revenue, a company will halt production as it is not making profits on the additional units sold.

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