3.3 - Costs
Resources used in production and how they generate costs
Producing goods and services requires various resources, which create costs for a business.
Key resources in production
- Raw materials - Basic inputs like metals or fabrics needed to create products.
- Machinery - Equipment used in manufacturing or processing.
- Factory space - Buildings or facilities where production takes place.
- Labour - Workers involved in making or delivering goods and services.
- Energy - Power sources such as electricity or fuel to run operations.
These resources lead to costs because businesses must pay for them, and the way costs behave depends on changes in output levels. Costs are broadly classified into fixed and variable types based on this behaviour.
Classifying costs as fixed or variable
Costs in a business can be divided into fixed and variable categories, depending on whether they change with the amount of output produced.
Fixed costs
Fixed costs stay the same no matter how much or how little is produced. They must be covered even if output is zero, and they are often referred to as overheads.
Examples of fixed costs:
- Rent for premises
- Business rates
- Advertising expenses
- Insurance premiums
- Interest payments on loans
- Research and development spending
Variable costs
Variable costs rise or fall directly in line with changes in output. They increase proportionally when more is produced and drop when production slows, reaching zero if nothing is made.
Examples of variable costs:
- Raw materials
- Packaging
- Fuel
- Labour (such as wages for production workers)
Calculating total costs and average costs
Total costs combine fixed and variable costs, providing a full picture of the expenses involved in production. Average costs show the cost per unit, which is useful for pricing decisions.
Formula for total cost
Formula for average cost
Worked example - Calculating total costs and average costs
A gym has fixed costs of £25,000 and variable costs of £300 per member. If they sign up 80 members, calculate the total costs and average cost per member.
Step 1: Identify the values
- Fixed costs (FC) = £25,000
- Variable costs (VC) per member = £300
- Quantity = 80 members
Step 2: Calculate variable costs
Variable costs = £300 × 80 = £24,000
Step 3: Calculate total costs
Step 4: Calculate average cost
Understanding total revenue
Total revenue represents the income a business earns from selling its goods or services. It depends on the price charged and the number of units sold, providing a key measure of sales performance.
Formula for total revenue
Worked example - Calculating total revenue
A coffee shop sells drinks at £4.50 each and serves 200 customers in a day. Calculate the total revenue for that day.
Step 1: Identify the values
- Price (P) = £4.50
- Quantity sold (Q) = 200
Step 2: Apply the total revenue formula
Calculating profit and loss
Profit occurs when a business's income exceeds its expenses, while a loss happens when costs are higher than revenue.
Formula for profit
- A positive result indicates profit.
- A negative result indicates a loss (when TC > TR).
Worked example - Calculating profit
A graphic design firm charges £800 per project and completes 250 projects, generating total revenue of £200,000. Their total costs are £130,000. Calculate the profit.
Step 1: Identify the values
- Total revenue (TR) = £200,000
- Total cost (TC) = £130,000