First things first - what is revenue?
Revenue refers to the money received by a company that is primarily obtained from the sale of goods and services to its customers.
Therefore, total revenue generated refers to the total revenue (income for goods and services) received by a company in a specified period.
You may have heard some other terms like average revenue and marginal revenue. Read on to learn more about all things revenue!
What does the term average revenue mean?
The total revenue is all the money a company earns during a specified period (i.e. on a weekly or monthly basis). Average revenue results from a calculation determining the revenue received per unit of output sold.
By calculating this information with the average revenue formula, a business can more accurately estimate its total revenue (and, by extension, its profits). Not only that, but they can then look into methods of profit maximization for the future.
The market structure determines the relationship between the average revenue of the number of goods produced. If you wish to take market control, you need to understand your position and have a handle on your total revenue.
In the case of a perfectly competitive firm, the average revenue is equivalent to the given price and marginal revenue. In an oligopolistic or monopolistic competition, the average revenue will always exceed the marginal revenue.
How to use the average revenue formula
To calculate the average revenue of a selling unit of output or user, you need to use the average revenue formula.
Using the average revenue formula, begin with the total revenue (all the money earned). Divide it by the total number of units or users within a given period of time. The latter is known as ARPU (average revenue per user).
The number of total units of output sold or users may vary during the timeframe. In order to determine the most accurate results, the number of units and users is estimated. A weighted average may also be used.
In mathematical terms, the average revenue formula is as follows:
AR = TR/Q
AR = Average revenue,
TR = Total revenue earned
Q = Output
How to calculate average revenue
Collect the data
Decide on a period of time, and collect data within that range.
As an example, let’s opt for a week’s worth of data, and during that time, three output units were sold.
Unit 1: $5,000
Unit 2: $7,000
Unit 3: $6,000
Add the data points
To determine the firm’s total revenue amount to base our formula on, we need to add the total revenue from the three units sold together.
$5,000 + $7,000 + $6,000 = $18,000
Divide by the total number of data points
In our example, we’ve used three units. One unit of output = one data point. So now that we have the total revenue amount of $18,000, we can run our formula.
AR = TR/Q
AR = $18,000/3
AR = $6,000
We also have the formula to calculate average revenue per user for SaaS companies, check it out here!
Analyze your results
From the example used above, the company now has valuable data at its disposal. They know the average revenue per unit cost (ARPU) for its nominated time period. They discovered that their average revenue for the week was $6,000.
Armed with these results, they can analyze the revenue further and use it to make forecasting projections.
It would be prudent for businesses to be monitoring their average revenue on a regular basis. Utilize the results to determine the business’ growth and how it is performing against its competitors.
Depending on the nature of your business, this data may be beneficial. For instance, if you sell complex products and can’t readily calculate a standard margin, this can be highly valuable insight. If you compare cable companies with factories that produce one main product, their situations are vastly different.
When undertaking financial analysis on revenue per unit, it is essential to delve deeper into the numbers. Form qualitative findings based on what you know about your business operations and your customer base.
Consider any factors that can skew your numbers. For instance, if you have a subscription-based model, you may know dormant customers who aren’t active users. It is best to remove those figures.
Companies often utilize the average revenue per unit to attribute a monetary value to each service user. This enables them to ascertain how varying levels, add-ons, and features have an impact on each user’s revenue.
For instance, it’s incredibly possible for a lower subscription tier to generate more revenue than a more premium tier. This is because subscribers are regularly being influenced to add-on upgrades or expansions. This is valuable information to have at your disposal as it affects other aspects of the business, such as marketing efforts.
Revenue should theoretically be increasing as the company grows. However, it’s not uncommon for the average revenue to decline. This is due to the company’s capacity to offer lower product prices as the higher sales are coming in. Price changes may be a strategic move to position the company to take market control.
Having said that, it doesn’t ring true for all businesses. Some companies see an average revenue that remains constant and doesn’t move due to additional production and an increase in the number of units sold.
Economic theory would suggest that a business’ average revenue curve and the firm’s demand curve will generally match.
What does the term marginal revenue mean?
Marginal revenue (often abbreviated to MR) refers to the increase in revenue resulting from the sale of additional units of output.
Marginal revenue may remain constant over a certain level of output. However, like many things in life, marginal revenue follows the law of diminishing returns.
Therefore marginal revenue diminishes and eventually slows down as the total output quantity decreases.
Understanding marginal revenue and marginal cost
- Marginal revenue is an incremental change in earnings which is a product of the sale of one additional unit, resulting in additional revenue.
- Performing marginal revenue analysis assists a company in identifying the total revenue generated by the additional unit sold
- If you are looking to maximize your total revenue and profits, you may choose to produce to the point where your marginal revenue equals your marginal costs.
- When your marginal revenue drops below your marginal cost, it’s a good idea to halt normal business activities until you’ve undertaken a cost-benefit analysis.
The relationship between marginal and average revenue
Marginal revenue and average revenue are equal within a competitive firm.
A company’s average revenue is the total revenue generated divided by the total units sold.
In a competitive firm, the marginal revenue is always equal to its average revenue and price. This is because the price remains constant despite varying levels of output.
What is a perfectly competitive firm?
A perfectly competitive firm is a price taker. That means it must accept the equilibrium price at which the firm sells its goods.
If they then try to increase their prices even a little more than the market price, it will fail to make any sales which will have a negative impact on their total revenue.
What is a perfectly competitive market?
According to economic theory, a perfectly competitive market exists when all companies sell identical products.
Market share has no influence over the price, and companies can enter or exit the market without issue.
Buyers can access transparent information, and individual companies cannot set prices.
How to calculate the marginal revenue formula
To calculate MR, you use the marginal revenue formula.
You will need to know your previous total revenue to calculate the change.
The marginal revenue formula is:
Marginal revenue equals the change in its total revenue divided by the change in its total output quantity, or in other words:
The visual representation of this calculation is known as the marginal revenue curve.
Average revenue curve
The average revenue curve is a graphic representation of the relationship between the firm's average revenue for selling units of output and the quantity the company sells.
Average revenue is essentially the price of a unit. The average revenue curve is also the demand curve for a company’s output.
The average revenue curve for a company that currently holds no market control is horizontal. When a company retains market control, its average revenue curve will be negatively sloped.
The demand curve is a graphic that depicts the relationship between the price of a good or service and the quantity demanded for a given period.
In a typical representation of a demand curve, the price will appear on the vertical axis on the left, and the quantity demanded will be shown on the horizontal axis.
When a price rise initiates a sharp decline in the demand for goods, it is known as elastic demand.
When price reduction causes a spike in demand, that market behavior is known as elastic.
Perfectly elastic demand
In the case of perfectly elastic demand, that means there is a certain price where demand is infinite.
For instance, if a company increased the price of an item by 1%, the demand would completely disappear. When demand is perfectly elastic, the demand will be horizontal.
If price changes don’t affect the demand for an item, it’s known as inelastic demand. Prime examples of inelastic demand are for perishable foods and essential medicines.
For example, if the average price of milk increased by 10%, people wouldn’t stop purchasing it. Milk is a commodity sold regardless of price, and the revenue generation capability is essentially limitless.
Understanding average revenue for your business
Calculating average revenue assists stakeholders and executives alike in capturing how the business is evolving and growing over time. It provides a reference point to conduct competitor analysis.
Having the average revenue means you can understand how much your business is earning per unit, subscriber, or user. If your business experiences a surge in revenue or your operations are seasonal, this formula is particularly helpful.
As they say, knowledge is power. It’s incredibly powerful to understand your company’s average revenue per unit. This also provides an indication of its positioning within the marketplace.
One piece of advice is to look beyond the surface calculation of average revenue and consider the complete picture. Any unexpected variance in average revenue points to an incremental change, and a red flag like that requires investigation. Overlooking too many of these anomalies could skew your data in the long term.