3.2 - Costs & Revenues
The meaning of costs in business
Costs represent the payments a business must make as part of its operations.
Examples of common business costs:
- Rent for business premises
- Wages paid to employees
- Purchases of raw materials
- Utility bills, such as electricity or water
Fixed, variable, and semi-variable costs
Business costs can be classified based on how they behave in relation to the level of output or production.
Fixed costs
Fixed costs are costs of production that do not change with the level of output, meaning they must be paid even if there is no output.
Examples:
- Lease payments for buildings
- Costs of leasing machinery
- Salaries for senior management
Graphical representation:
- Shown as a horizontal line (total fixed cost or TFC) on a graph of cost against output
- This indicates no change with production levels
Changes over time:
- Fixed costs can alter due to external factors, such as an increase in advertising budgets
- These changes are not linked to output variations
Variable costs
Variable costs are costs of production that do change according to the level of output, meaning they increase when there is a greater level of output or production.
Examples:
- Materials used in manufacturing
- Wages for workers on a production line
Graphical representation:
- Depicted as an upward-sloping line (total variable cost or TVC) starting from the origin on a cost-output graph
- This reflects the rise with increased production
Context dependency:
- What counts as a variable cost varies by business
- For instance, fuel is variable for a transport company but fixed for a shop that does not deliver
Semi-variable costs
Semi-variable costs have characteristics of both fixed and variable costs.
Examples:
- Broadband services with a fixed monthly fee plus extra charges for exceeding data limits
- Gas supply with a standing charge of $50 per month plus $0.10 per unit consumed
Formula for total cost
Where:
- TC = Overall expenses for production (£)
- TFC = Costs unchanged by output (£)
- TVC = Costs that vary with output (£)
Worked example - Calculating total cost
A small bakery has fixed costs of £1,200 per month for rent and equipment leases. Its variable costs are £3 per cake produced. If the bakery makes 450 cakes in a month, calculate the total cost.
Step 1: Identify the values
- Total fixed cost (TFC) = £1,200
- Variable cost per unit = £3
- Output = 450 cakes
Step 2: Calculate total variable cost
Total variable cost (TVC) = £3 × 450 = £1,350
Step 3: Apply the total cost formula
Direct and indirect costs
Costs can also be categorised by how easily they can be linked to a specific product, service, or project. This classification aids in accurate pricing and cost control.
Direct costs
Direct costs are costs that can be clearly and specifically identified with the output of a certain product or project.
Examples:
- Variable direct costs, such as parts for assembling a product
- Fixed direct costs, like insurance for specialised machinery used on a single production line
Indirect costs (overheads)
Indirect costs, also known as overheads, are recurring costs that cannot be clearly identified with the production or sale of a particular good or service.
Examples:
- Rent for shared facilities
- Fees for legal advice
- Salaries for office staff
- General liability insurance
Calculating total revenue and profit
Revenue and profit are key indicators of a business's financial performance, showing income generated and the surplus after covering expenses.
Total revenue
Total revenue refers to the income from the sale of goods and services. Businesses may have multiple revenue streams, which are different sources of this income.
Where:
- TR = Overall income from sales (£)
- P = Selling price of each unit (£)
- Q = Number of units sold
Examples of revenue streams:
- Retail businesses from direct product sales
- Tech firms from ongoing subscription fees
- Franchise owners from fees for licensing their brand
Profit
Profit is the positive difference between total revenue and total costs, representing the financial gain from operations. It can only be recognised once all expenses have been met.
Where:
- Profit = Positive difference after costs (£)
- TR = Income from sales (£)
- TC = All production expenses (£)
Worked example - Calculating total revenue and profit
A coffee shop sells cups of coffee at £2.80 each and sells 650 cups in a week. Its total costs for the week are £1,400. Calculate the total revenue and profit.
Step 1: Identify the values
- Price per unit (P) = £2.80
- Quantity sold (Q) = 650
- Total cost (TC) = £1,400
Step 2: Calculate total revenue
Step 3: Calculate profit
Step 4: Interpretation
The coffee shop makes a profit of £420, meaning it has covered all costs and has surplus funds for reinvestment or owners.