 The financial costs incurred in making a product or providing a service can be classified in several ways. Cost classification is not always as clear cut as it seems and allocating costs to each product is not usually very straightforward in a business with more than one product.

 Direct costs  Indirect costs  Fixed costs  Variable costsshort run costs*  Semi-variable costs *period on which no changes to capacity can be made

 These costs can be clearly identified with each unit of production and can be allocated to a cost centre  Examples of direct costs of:  A hamburger in a fast food restaurant: the cost of the meat  Servicing a car in a garage: the labour cost of the mechanic  The business studies department: the salary of the business studies teacher

 Costs which cannot be identified with a unit of production or allocated to a cost centre  Also known as overhead costs  Examples of indirect costs to:  A farm: the purchase of a tractor  A supermarket: promotional expenditure  A school: cleaning costs

 These costs remain the same no matter what the level of output  Example:  rent

 These costs vary as the output level changes  Examples:  Cost of materials used in making a washing machine  Electricity used to cook fast food

 These costs include both a fixed and a variable element  Examples:  The electricity base charge plus cost per unit used  Sales person’s fixed basic wage plus a commission for sales

 Revenue: the income received from the sale of a product  Total Revenue: total income from the sale of all units of the product: TR = Quantity x Price Rearranging the equation we get P = TR/Quantity

 Average revenue AR = TR/Q Since P= TR/Q thenAR = P  Marginal Revenue ; the extra revenues earned from selling additional or extra units of output MR = Change in TR/Change in Quantity

 Subventions – subsidies for businesses that help society  Government grants – to public and private firms  Sale of non-current or fixed assets no longer needed  Rent from factory or office space to another business  Dividends on shares owned in other firms  Interest on deposits held in a bank  Sponsorships, fund raising and donations

 The amount of money that remains after all (direct and variable costs) have been taken away from the sales revenues Contribution = P – AVC In another words it Refers to how much a product contributes to the fixed costs and profit of a business once variable costs have been covered

 Can be calculated either per unit of output or in terms of total contribution of all units produced  Per unit: selling price of a product less variable costs per unit  Total contribution: total revenue from sale of a product less total variable costs of producing it

 Do not confuse this with profit!!!  Remember that profit is calculated by subtracting all costs (fixed and variable) from revenue. Contribution only accounts for what is left after variable costs have been accounted for  So…contribution is what a product contributes towards the fixed costs of a business, and once these are paid, the profits of a business

Contribution per unit = P – AVC  P = Price  AVC = average variable costs  Example: firm sells chairs at $100 each whilst the direct and variable costs are $45 per unit. Therefore, the business makes a contribution of $55 per chair.  BUT! This is not profit because we have not yet considered fixed and indirect costs.

 For every chair that the firm sells, it ‘contributes’ $55 towards paying off the firms fixed and indirect costs  Once fixed and indirect costs have been paid off, all further chairs sold will contribute to profit. So, Profit = total contribution – TFC

 For a multi product firm, each product is likely to make some contribution to paying off fixed and indirect costs.  Even if the product runs at a loss but makes a positive contribution, managers probably won’t remove it. This is because the product is still actually contributing something, and overall, the profits would be lower if it were contributing nothing at all.  A multiproduct firm calculates contribution like this: Profit = Total contribution – (TFC + Indirect Costs)

 Cost centers  A section of a business, such as a department, to which costs can be allocated or charged  Example: A hotel – restaurant/reception/bar/room hire  Profit centers  A section of a business to which both costs and revenues can be allocated  Example: Each branch of a chain shop

 Managers/staff have targets to work towards, which if achievable can act as motivators  Targets can be used to compare with actual performance to identify areas performing well/not so well  Individual performances of divisions and their managers can be assessed and compared  Work can be monitored and decisions made about the future

 Managers/staff may consider their department to be more important than the organisation itself. There could be damaging competition to profit centers to gain new orders  Some costs (indirect) can be impossible to allocate to cost and profit centers accurately and this can result in inaccurate overhead cost allocations  Reasons for good or bad performance of one particular profit centre may be due to external factors

 Complete the activity sheet in your workbooks.  Use the notes in this PowerPoint, your textbook and your own knowledge to construct your repsonses