The nature of business

What a business is

A business is an organisation that tries to earn a profit by providing goods or services that customers want. Goods are tangible: a laptop, a loaf of bread, a bicycle. Services are intangible: they cannot be held, touched or stored, such as a haircut, a flight, legal advice or a streaming subscription. Many businesses sell to households; others sell to organisations, such as a firm that supplies hospitals with scanners. Together they produce most of what people use every day.

Standard of living and quality of life

A country's standard of living is the quantity of goods and services its people's incomes can purchase. It depends on prices as well as incomes: a high wage buys little if everything is expensive. Quality of life is broader: general wellbeing, shaped by life expectancy, health, education, sanitation, safety and leisure time. Businesses raise the standard of living by producing and paying wages; governments and not-for-profits add to quality of life through schools, hospitals, parks and clean water.

Worked example: wages and what they buy

Two invented countries each price the same weekly basket of food. In Country A the average hourly wage is 25 dollars and the basket costs 50 dollars. In Country B the wage is 30 dollars and the basket costs 75 dollars. 1. Baskets per hour of work in A: \(25 \div 50 = 0.5\). 2. Baskets per hour in B: \(30 \div 75 = 0.4\). 3. Compare: a worker in B earns more dollars but buys 20% fewer baskets per hour, since \(0.4 \div 0.5 = 0.8\). 4. Conclusion: by this measure the standard of living is higher in A. Higher wages alone do not prove people are better off; prices matter too.

Revenue, costs and profit

Revenue is the money a company receives from selling goods or providing services. Costs are the expenses it incurs to make and sell them: rent, salaries, materials, energy, transport, advertising and many more. What is left after all costs are paid is profit:

When costs are greater than revenue, the result is negative and the firm makes a loss. A business improves profit by raising revenue, for example by selling more or charging more, or by holding costs down. The accounting topics later in the course measure these items precisely; here the simple subtraction is enough.

Worked example: a thin margin

A small bakery, call it Crumb and Co., has yearly revenue of 240,000 dollars and total costs of 210,000 dollars. 1. Profit: \(240000 - 210000 = 30000\) dollars. 2. Profit as a share of revenue: \(30000 \div 240000 = 12.5\%\). 3. Now flour, energy and wages push costs up by 8% while prices stay the same: new costs are \(210000 \times 1.08 = 226800\) dollars. 4. New profit: \(240000 - 226800 = 13200\) dollars. 5. Interpret: an 8% rise in costs cut profit by 56%, because the margin was thin. Small firms watch costs closely for exactly this reason.

Risk and the reward of profit

Risk is the chance of losing time or money, or of failing to reach an organisation's goals. Nobody guarantees a business a profit. Owners invest savings and effort first and find out later whether customers will pay enough. Profit is the reward for taking that chance, and in general the greater the risk, the greater the possible profit or loss. US Bureau of Labor Statistics data show the scale of the risk: across the yearly groups of new private-sector establishments it has tracked since the 1990s, roughly four in five survive their first year and only about half survive five years. Firms that play too safe also face risk, because nimbler rivals may overtake them.

Not-for-profit organisations

A not-for-profit organisation exists to achieve a goal other than profit: feeding families, running a museum, protecting wildlife, treating patients. Charities, most hospitals, many universities, arts groups, civic groups and religious organisations are examples, and government is the largest not-for-profit of all. They still need revenue, from donations, grants, fees and ticket sales, and they still have costs. If revenue exceeds costs, the difference is a surplus, which is reinvested in the mission rather than paid to owners. Not-for-profits do not compete for customers the way rival shops do, but they do compete for donations, volunteers' time and skilled staff.

Blurring the boundary

The line between the two sectors is less sharp than it once was. Well-run not-for-profits use business methods: strategic plans, careful budgets and performance measures. A museum director must balance artistic goals against the fact that ticket sales cover only part of the costs, so much of the job is fundraising. Meanwhile many companies now take on social goals, a theme of the topic "Managing a socially responsible business".

The factors of production

Every organisation needs inputs called factors of production. Natural resources, often simply called land, are inputs useful in their natural state: farmland, forests, water, minerals and oil. Labour is the work of people, using their minds and muscles. Capital is the physical means of production: machines, tools, vehicles and premises. Money is not capital in this sense, because money produces nothing; it only buys inputs. Entrepreneurship is the initiative of people who combine the other factors and take the risk of a venture. Many analysts add a fifth factor, knowledge: the combined skills and know-how of the workforce.

Worked example: sorting a vineyard's inputs

Classify the inputs of a family vineyard. 1. The hillside soil, the sunshine on it and the water from its well: natural resources. 2. The pickers who harvest the grapes and the staff who run the tasting room: labour. 3. The grape press, steel tanks, tractors and the cellar building: capital. 4. A 100,000-dollar bank loan: not a factor itself, but money used to buy capital such as a new press. 5. The owner who decided to plant, borrowed the money and carries the risk: entrepreneurship. 6. The winemaker's expertise in blending: knowledge. Check: every input has exactly one home, and the loan is the trap.

Common mistakes to avoid

First, confusing revenue with profit: a firm can have high revenue and still make a loss if its costs are higher. Second, counting money as capital; in economics, capital means productive tools and buildings, and money only buys them. Third, assuming not-for-profits cannot earn more than they spend; they can have a surplus, but they reinvest it rather than distribute it to owners. Fourth, treating a higher wage as proof of a higher standard of living without checking prices. Fifth, thinking risk guarantees reward: higher risk raises the possible profit and the possible loss together.

Key takeaways

A business seeks profit by providing goods, which are tangible, and services, which are intangible. Businesses help create a nation's standard of living, what people can buy with their income, while quality of life also covers health, education and leisure. Profit equals revenue minus costs; a negative result is a loss. Profit rewards risk, and about half of new US establishments close within five years. Not-for-profits pursue other goals and reinvest any surplus. The factors of production are natural resources, labour, capital (not money) and entrepreneurship, with knowledge increasingly treated as a fifth.

Question 1 of 5

A gift shop takes in 150,000 dollars from sales in a year, and its costs total 162,000 dollars. What is the result?

Question 2 of 5

Which of these is capital, as a factor of production, for a bakery?

Question 3 of 5

Workers in Country X earn higher average wages than workers in Country Y. Why might Country X still have a lower standard of living?

Question 4 of 5

A wildlife charity ends the year with revenue 40,000 dollars above its costs. What normally happens to that money?

Question 5 of 5

Which statement about risk and profit in business is most accurate?