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 costsWhy 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 £000 Variable costs £000

TOTAL COSTS £000

100 140

750 1000

364 640

Calculate the fixed, variable and total costs for trading at Sycks Buckets

How did you do...

Fixed costs £000 Variable costs £000

TOTAL COSTS £000

100 40 140

250 750 1000

364 640 1004

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

Rent Bucket moulds

Catering Telephone

Factory heating

Business loan

Packaging

Bucket handles

Bucket rivets

Production

labour

Accounts staff

Bucket sales team

How did you do?

Rent Bucket moulds

Catering Telephone

Factory heating

Business loan

Packaging

Bucket handles

Bucket rivets

Production

labour

Accounts staff

Bucket sales team

KEY:-DIRECTINDIRECT

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 costOutput

QUESTION – What does the TOTAL COST figure consist of?

ANSWER – FIXED COSTS + VARIABLE COSTS

AC= FC + VCOutput

You can also calculate average costs for...

AVERAGE FIXED COST

Calculation:-

Average fixed cost = Total fixed costOutput

AFC= FCOutput

£ AVERAGE VARIABLE COST€ Calculation:-

Average variable cost = Total variable costOutput

AVC= VCOutput

Calculate the average costs

Output Fixed Cost

Average fixed cost

Variable Cost

Average

variable cost

Total Cost

Average cost

100 100 150

200 100 300

300 100 450

400 100 600

Average cost calculations

Output Fixed Cost

Average fixed cost

Variable Cost

Average

variable cost

Total Cost

Average cost

100 100 1.00 150 1.50 250 2.50

200 100 .50 300 1.50 400 2.00

300 100 .33 450 1.50 550 1.83

400 100 .25 600 1.50 700 1.75

Marginal cost

Marginal cost is the cost of increasing total output by one more unit

Marginal cost = Change in Total CostChange in Output

MC= CITCCIO

Output Fixed Cost

Variable Cost

Total Cost

Change in

output

Change in total cost

Marginal cost

100 100 150 250 101 252.50 2.50

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