IB Business and Management 5.2 – Costs and Revenues

LEARNING OUTCOMES Define, explain and give examples of each different type of cost: Fixed Variable Semi-variable Direct Indirect Explain the meaning of revenue and comment on possible sources of revenue for different firms Explain and calculate the contribution to fixed costs Explain the nature of cost and profit centres Analyse the value of cost and profit centres Analyse the role of contribution analysis in determining the viability of each product for a multi product firm

RECAP – Cost Classifications

Why are costs important? If businesses do not keep a record of costs then they will be unable to take effective and profitable decisions. Keeping cost records allow comparisons to be made with past periods of time. Past cost data can help to set budgets for the future.

Costs we need to know about… Fixed Variable Semi-variable Direct Indirect In Pairs…… Can you define each of these? (Imagine you are writing a 2 mark definition answer)

Fixed Costs A cost which does not change as the levels of production of output change. Examples of Fixed Costs are: Rent, Rates, insurance, salaries of managers. NOTE: Fixed costs per unit of output will decrease as production increases (vice versa) Costs Output Costs are constant (the same) at all levels of production

Variable Costs A Variable Cost is a cost which tends to change as the level of production changes. It’s the cost of production which increases directly as output increases. Example: materials used in production; wages of production staff Note: Variable costs per unit of production does not change $1000 Output Costs Variable Costs 400 $1500 600

Semi-variable Costs Costs with both a fixed and a variable element. Often the cost is fixed up to a certain level of output and then becomes variable after that level is exceeded Examples: -Telephone Bill -Electricity Bills -Some Labour costs Can you explain why these costs are semi-variable?

Direct Costs These are costs which are clearly defined with each unit of production. They are costs directly incurred in producing a product. Examples are: Cost of meat in a hamburger restaurant Labour cost of a mechanic in garage Note: The two most common direct costs are labour and materials.

Indirect Costs These costs cannot be identified with a unit of production because they are usually associated with performing a range of tasks or producing a range of products. Indirect costs are usually referred to as overheads Examples of these are: Promotion expenditure Rent

Administrative Overheads Selling and Distribution Overheads Finance Overheads Production Overheads Factory rent, rates, power, depreciation of equipment. Office rent and rates, clerical and executive salaries Warehouse, salaries of sales staff Interest on bank loans and debentures

Identify the costs….. Fixed Costs Variable Costs Semi Variable Costs Direct Costs Indirect Costs

What is meant by revenue?

Revenue Revenue or turnover is income that a company receives from its normal business activities, usually from the sale of goods and services to customers. So what types of income does revenue NOT include?

Revenue = Selling Price X Quantity Calculating Revenue Revenue = Selling Price X Quantity

What are the revenue streams?

Contribution

Contribution: Contribution is the amount that each product sold makes towards paying off fixed costs. Once fixed costs have been covered all contribution will be profit What is the formula for contribution? Contribution Per Unit = Selling Price – Variable Cost per unit* *or average variable cost

Contribution - Example A carpenter makes tables that he sells for $500. He pays himself $50 an hour. The cost of the wood is $150 per table and takes him 4 hours to make. What is the contribution per unit? = $500 – [$150 + (4 x $50)] = $150

Total Contribution Total contribution is the overall amount of contribution that the business makes at a particular level of output: Total Contribution = Contribution per unit x Quantity Sold

Question If the carpenter sells 9 tables per week what is the total contribution? = 9 x $150 = $1,350 Does this mean that the carpenter is making $1,350 profit? How would we work out the profit?

Contribution and Profit We need to subtract fixed costs from total contribution in order to calculate profit. Profit = Total Contribution – Fixed Costs If the carpenter’s fixed costs are rent $150, rates $50, utilities $50 and advertising $50 what will his profit be? $1,350 – ($150 + $50 + $50 + $50) = $1,050

Contribution and the Margin of Safety A business breaks even once they have sold enough units to cover their fixed costs: Hence BEP = Fixed Costs Contribution per unit Any units sold above the break even output all of the contribution will be profit. The number of units a business sells above the breakeven point is called the margin of safety Therefore Profit = Margin of Safety x Contribution per Unit

Uses of Contribution Analysis Special Order Decisions Contribution Cost Pricing Product Portfolio Management Make or Buy Decisions

Scenario- Special order decision Simpson Ltd produces cartons of freshly squeezed fruit juice. The average cost of producing one carton is £1.15. It usually sells them for £1.50 to supermarkets and independent retailers. A company have approached Simpson’s with a one-off order for 10,000 units but are only prepared to pay £1.10 per unit. Should the company accept the order?

Financial Information Variable costs per unit are as follows: Packaging £0.20 Ingredients £0.50 Labour £0.05 Transportation £0.05 How much additional contribution would accepting the order generate? What other information would have to be considered by the firm when making the decision as to whether to accept the order?

Contribution Analysis for Multi-product firms

Contribution Analysis – Burger Van Product Hot Dog Ham Burger Cheese Burger Chicken Burger Veggie Burger Fries Selling Price $3 $4 $4.50 $2 Variable Cost $1.50 $2.20 $2.50 $0.2 Unit Contribution $2.30 $1.80 What is the Unit Contribution for each product? Which product makes the most contribution? How does this information help the business?

Total contribution is also important: Product Hot Dog Ham Burger Cheese Burger Chicken Burger Veggie Burger Fries Selling Price $3 $4 $4.50 $2 Variable Cost $1.50 $2.20 $2.50 $0.2 Unit Contribution $2.30 $1.80 Unit sales per month 400 600 700 100 3,000 Total Contribution $600 $1,200 $1,610 $900 $250 $5,400 What is the total contribution? $9960 Assuming that the burger van has fixed costs of $6,000 per month what will be the profit be? $3,960 How can the burger van use this information to help them make decisions? Contribution Cost Pricing Product Portfolio Management Make or Buy Decisions

Cost and Profit Centres What are they and what is the difference? Cost and Profit Centres

What is the difference between cost and profit centres? What might be some examples of each?

Profit Centres This is a section of the business in which both costs and revenues can be identified. It that part of the business which is accountable for costs and revenues. It may be called a business centre, business unit, or strategic business unit. Examples of Profit Centres Each branch of a chain of shops, restaurant or store A sales person Each department of a store Each product of a multi product firm

Cost Centres These are individual parts of the business that incurs costs but is not directly involved in making any profit. A Cost Centre is part of a business for which costs can be identified and easily recorded. For example: a functional department such as marketing or human resources an employee an item of equipment, e.g. a photocopier, telephone line or vehicle.

Costs and Profit Centres – How they are used As a business grows bigger it becomes more difficult to manage its finances. Often businesses will be divided up into cost/profit centres. Budgets will be drawn up for each cost/profit centre Each Cost/Profit centre has a manager who is responsible for decision making and in making sure that budgets are met Senior managers can monitor the performance of each cost/profit centre over time and also compare with other cost/profit centres

Benefits and drawbacks of Cost/Profit Centres? What do you think are the main benefits of cost/profit centres? Watch the video

In summary…. Advantages of Cost and Profit Centres Disadvantages of Cost and Profit Centres Some control of operations is delegated to the local level, which can be motivating parts of the firm can put themselves before the business as a whole The success and failures of individual departments can be identified clearly The reason for good or bad performance may be external to the cost centre, and not under its control Problems can be traced more easily Not all costs and revenues can be associated directly with a particular part of the firm Decision making is aided They can create extra pressure on more junior managers

Homework Question May 2012 (Paper 2) 5(c) Analyse the implications for the CEO of converting CC into four cost centres. [6 marks] Word limit – 300 words

Product Hot Dog Ham Burger Cheese Burger Chicken Burger Veggie Burger Fries Selling Price $3 $4 $4.50 $2 Variable Cost $1.50 $2.20 $2.50 $0.2 Unit Contribution Unit sales per month Total Contribution Print this slide for students to work o