Calculating Costs, Revenues and Profit

Today’s session  Identification of fundamental business cost elements  Distinguishing between revenue and profit  Calculating costs and revenue at different levels of output  Calculating profit or loss

Calculating costs Why businesses need accurate and reliable cost information

Defining Costs  QUESTION – WHY do businesses need to define potential COSTS?  ANSWER – to enable them to make informed business decisions in order to remain profitable  Identifies likely BUSINESS VIABILITY e.g enables the business to forecast actual profit or loss that will be made  Allows the business to make PRICING DECISIONS  A PROFIT SURPLUS can provide a source of finance for further expansion ACTIVITY – using the whiteboard, list as many costs as you can think of for a new business – we will come back to these costs later...

Opportunity Cost What is the definition of OPPORTUNITY COST – write the answer on your whiteboard Opportunity Cost = the cost of the next best alternative forgone. The value that could have been earned if a resource was employed in its next best use. e.g. if spend £40k on advertising campaign it could have been earning interest in a bank account.

Accounting Costs  Accounting costs are recorded in the business accounts as an ASSET or as an EXPENSE Accounting Cost = the value of an economic resource used up in production Jot down an example of an ASSET and an EXPENSE in your notes

Changing costs – Short and Long Run  Costs can change over a period of time as a business grows and develops  SHORT RUN  At least one factor of production is fixed e.g. Amount of space, available machinery  LONG RUN  All factors may vary. Capacity may be increased but when saturation is reached another SHORT RUN period will begin.

Types of Cost  Costs can be  FIXED  The same at all levels of output in the short run  VARIABLE  Costs of production that increase directly as output rises  SEMI-VARIABLE  Costs that consist of a fixed value + a variant value which can increase dependent on usage  TOTAL COSTS are all the fixed and variable costs added together – TC = FC + VC Jot down an example of a FIXED COST, a VARIABLE COSTS and a SEMI-VARIABLE COST in your notes. Compare your list.

Fixed Costs  Diagram shows that even as output increases fixed costs stay the same. It’s a short run scenario usually.

Stepped Fixed Costs  This can occur over a longer period of time following for example an investment in new machinery.

Variable Costs  Diagram shows that as output increases the variable costs increase.

Total Costs  As output increases fixed costs become smaller part of total costs

ACTIVITY – 3 minutes Fixed costs £000Variable costs £000TOTAL COSTS £ Calculate the fixed, variable and total costs for trading at Sycks Buckets

How did you do... Fixed costs £000Variable costs £000TOTAL COSTS £ Calculate the fixed, variable and total costs for trading at Sycks Buckets

Activity  Using the list on the board and working in pairs, identify which costs are FIXED, VARIABLE and SEMI-VARIABLE  Compare your answers to the next pair – do they match?

More on costs...  Costs can be  DIRECT  identified to a specific product  Usually VARIABLE  INDIRECT  accrued across the business  Usually FIXED  Also known as OVERHEADS

Identify which are DIRECT and which are INDIRECT costs at Sycks Buckets RentBucket moulds CateringTelephon e Factory heating Business loan PackagingBucket handles Bucket rivets Productio n labour Accounts staff Bucket sales team

How did you do? RentBucket moulds CateringTelephon e Factory heating Business loan PackagingBucket handles Bucket rivets Productio n labour Accounts staff Bucket sales team KEY:- DIRECT INDIRECT

Activity  Using the list on the board and working in pairs, identify which costs are DIRECT and INDIRECT  Compare your answers to the next pair – do they match?

Yet more on costs..  AVERAGE COST (UNIT COST)  Cost per unit of production  Calculation:- Average cost = Total cost Output QUESTION – What does the TOTAL COST figure consist of? ANSWER – FIXED COSTS + VARIABLE COSTS AC= FC + VC Output

You can also calculate average costs for...  AVERAGE FIXED COST  Calculation:- Average fixed cost = Total fixed cost Output AFC= FC Output £ AVERAGE VARIABLE COST € Calculation:- Average variable cost = Total variable cost Output AVC= VC Output

Calculate the average costs OutputFixed Cost Average fixed cost Variable Cost Average variable cost Total Cost Average cost

Average cost calculations OutputFixed Cost Average fixed cost Variable Cost Average variable cost Total Cost Average cost

Marginal cost  Marginal cost is the cost of increasing total output by one more unit Marginal cost = Change in Total Cost Change in Output MC= CITC CIO OutputFixed Cost Variable Cost Total Cost Change in output Change in total cost Marginal cost

COSTS Checkpoint – what you can remember??  Working in your teams, match the COSTS to the DEFINITIONS  First group to complete the puzzle wins the prize and gets the points  In the event of a draw, there will be a finance tie-breaker...

Cost classification – the theory...  By TYPE, i.e. Analysing business costs to identify if they are  Direct or indirect  By BEHAVIOUR i.e. the effect a change in output levels has on costs  Fixed, variable, semi-variable, average, marginal  By FUNCTION i.e. The business function they are associated with  Production, selling, administration, HR  By the NATURE of the resource i.e. Classifying according to resource acquired  Materials, labour, expenses  By PRODUCT, CUSTOMER or CONTRACT

Cost classification – the reality...  Cost classification not always straightforward  Difficulties in options for cost classification dependent on nature of cost e.g.  Piece rate – direct or variable  Administrator salary – fixed or indirect  Challenges of allocating indirect costs to each product Classification often depends on classification purpose as well as management viewpoint

Total Revenue  Total revenue is the amount of money received from selling a product Total Revenue= Quantity Sold x Price TR=QS x P Output (000) Total Revenue £000 Q- What is the total revenue for 500 products sold at £5 each? A- 500 x £5 = £2500

Profit and Loss  PROFIT is the difference between REVENUE and COSTS  Revenue EXCEEDS Costs = PROFIT  Costs EXCEED Revenue = LOSS Q - If Sycks Buckets have a monthly revenue of £30,000 for and costs of £26,400 how much profit have they made? A - £30,000 - £26,400 = £3,600 Q - If costs increase by 15% and revenue remains static, how much profit have they made now? A - £30,000 - £30,360 = (£360) LOSS

Profit  Profit is a surplus. It is important for 4 reasons: 1. Used as a measure of success by the owners of a business who have invested capital into it. 2. Banks/other lenders may be unwilling to lend to businesses making a loss or not forecasting a profit. 3. It is the return/reward for the entrepreneurs risk taking 4. Can provide a source of finance for the business.

Why calculate costs?  To help forecast profit/loss  To forecast breakeven point  For financial planning  For pricing decisions  To keep check of actual costs against projected ones

Today’s session  Identification of fundamental business cost elements  Distinguishing between revenue and profit  Calculating costs and revenue at different levels of output  Calculating profit or loss Any Questions?? Next session - contribution