IB Business Management Unit 3/Section 3.2 Costs and Revenues

3.2 COSTS AND REVENUES On completing this chapter you should be able to Explain the different types of costs, using examples. Comment on the meaning of the term revenue and, using examples, suggest various revenue streams available to organizations.

Cost, revenue, profit Cost refers to the total expenditure incurred by a business in order to run its operations. Revenue is a measure of the money generated from the sale of goods and services. Profit is calculated by finding our the difference between revenues and costs.

TYPES OF COSTS Related to time Fixed costs do not change with the amount of goods or services produced. Related to time Examples: Monthly rent, insurance and salaries Variable costs change with the amount of goods or services produced. Related to activity Examples: Raw materials, sales commissions, packaging and wages TC ( Total Costs) = TFC ( Total Fixed Costs) + TVC ( Total Variable Costs)

TYPES OF COSTS Direct costs can be identified with the production of specific goods or services. Examples: Cost of raw materials, labor, packaging, electricity to run machines Indirect costs are shared and cannot be easily identified with the production of specific goods or services. Examples: Rent, office worker salaries, legal expenses, advertising, insurance Notes: Fixed cost category is similar to Indirect, and variable cost is similar to Direct. Semi-variable costs remain fixed for a given level of production, after which they become variable. Example: Overtime made for working extra hours

Which would you choose? Fixed/Variable Costs Rent Cost of materials used in making a washing machine Electricity used to cook fast food Fixed Variable

Direct/Indirect Costs Which would you choose? Direct/Indirect Costs A hamburger in a fast food restaurant: the cost of the meat A farm: the purchase of a tractor Servicing a car in a garage: the labor cost of the mechanic A supermarket: promotional expenditure The business studies department: the salary of the business studies teacher Direct Indirect

Total Revenue = price per unit x quantity sold Total Revenue is the total amount of money a firm receives from its sales. Total Revenue = price per unit x quantity sold TR = P x Q Example: If a toy-producing firm charges $8 per toy and sells 200.000 toys a month, then its total revenue for the month will be ($8 x 200.000) $1.600.000.

Revenue “Streams” A firm’s revenue is obtained not only from its trading activities. Examples of other revenue streams: Rental income - renting part of a factory to another firm Sale of fixed assets - selling old buildings or machinery Dividends - firms have investments in other companies Interest on deposits Donations Grants and subsidies from government

IB Business Management Unit 3/Section 3.3 Break-even analysis

3.3 BREAK-EVEN ANALYSIS On completing this chapter you should be able to Distinguish between contribution per unit and total contribution. Draw a break-even chart and calculate the break-even quantity profit and margin of safety. Calculate target profit output, target profit and target price. Analyse the effects of changes in price or cost on break-even quantity profit and margin of safety, using graphical and quantitative methods. Examine the benefits and limitations of break-even analysis.

CONTRIBUTION Can be used in calculating how many products need to be sold in order to cover a firm’s costs. Contribution per unit = price per unit – variable cost per unit Total contribution = total revenue – total variable cost Total contribution = contribution per unit x number of units sold Profit = total contribution – total fixed costs

IN CLASS – EXERCISE OXFORD PG 180

BREAK-EVEN POINT BREAK-EVEN CHART Where the total costs equal the total revenue. At this point a business will neither make a profit nor a loss. Graphical method that measures the value of a firm’s costs and revenues against a given level of output sales or units of production. BREAK-EVEN CHART

Break even analysis made easy Follow my simple instructions, and you’ll be alright Break even analysis made easy

Label the x axis output i. e Label the x axis output i.e. sales/units, and the y axis cost or revenue, i.e. $ money

Fixed cost (FC) is always a horizontal line because it doesn’t change as output increases

OUTPUT Money Fixed cost s Variable costs With no units of output there will be no variable costs (VC). The higher the units produced the higher the variable costs 1000

OUTPUT Money Fixed cost s Variable Total costs Draw a line parallel to the variable cost line, that starts where the FC line does

With no output sold there will not be revenue With no output sold there will not be revenue. Therefore the Total Revenue line begins from the origin (zero) OUTPUT Money Fixed costs Variable Total Total Revenue 1000

Where the revenue and total cost lines cross is the break even point OUTPUT Money Fixed costs Variable Total Total Revenue Break even point Break even quantity 1000

PROFIT The positive difference between total revenue and total costs.

The left of the break-even point shows the loss, whereas the right of this point shows the profit OUTPUT Money Fixed costs Variable Total Total Revenue Break even point Profit Loss Break even quantity 1000

Margin of safety = current output – break-even output A measure of the difference between the break-even level of output and the actual (current) level of output. The greater the difference between the break-even quantity and the sales levels, the greater the safety net or the safer a firm will be in its profit earnings. Margin of safety = current output – break-even output

OUTPUT Money Fixed costs Variable Total Total Revenue Margin of safety is the difference between current output, and the break- even point Margin of safety Break-even point Current output

IN CLASS – EXERCISE OXFORD PG 182

CALCULATING BREAK-EVEN QUANTITY 1. Using contribution per unit Break-even quantity = fixed costs/ contribution per unit 2. Using total costs= total revenue method Total Revenue ( TR) = Total Costs (TC) P x Q = TFC + TVC

Profit or loss Profit = Total Revenue (TR) – Total Costs (TC) Profit = (P x Q) - (TFC + TVC)

TARGET PROFIT OUTPUT The level of output that is needed to earn a specified amount of profit. Target profit output = fixed costs + target profit contribution per unit (target price per unit – variable cost per unit)

Break-even Revenue = fixed costs x price per unit It is the revenue required to cover both the fixed and variable costs in order for a firm to break even. At this point the break-even revenue is equal to the break-even costs. Break-even Revenue = fixed costs x price per unit contribution per unit

IN CLASS – EXERCISE OXFORD PG 186

EFFECTS OF CHANGES IN PRICE OR COSTS

IN CLASS – EXERCISE OXFORD PG 188

IN CLASS – EXERCISE OXFORD PG 188

BENEFITS AND LIMITATIONS OF THE BREAK-EVEN ANALYSIS Easy visual analysis At a glance Formulae friendly Easy to compare changes Strategic decision-making tool Limitations: Assumes all output produced is sold, with no stock Assumes all revenue and cost lines are linear no discounts No semi-variable costs Relies on accuracy and quality of data