Business cost and revenue

Business cost and revenueCHAPTER 6

Business cost and revenue

This unit will explain: Why businesses need to know the costs of

running their activities and revenue gained by selling their products

The different types of cost involved in running a business

How break-even analysis helps managers make decisions

The purpose of budgets and financial forecasts


Business costs All business activity involves some kind of cost.

Managers need to think about the because:Whether costs are lower than revenues or not. Whether a business will make a profit or not.

To compare costs at different locations. To help set prices.


There are two main types of costs, fixed and variable costs.

Fixed costs = stay the same regardless of the amount of output. They are there regardless of whether a business has made a profit or not.

Common examples of fixed costs include rents, salaries of permanent employees and buildings.


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Fixed Cost

Fixed Cost

Quantity (Q)

Cost

($)


Variable costs = varies with the amount of goods produced. They can be classified as direct costs (directly related to a product).

Variable costs may include wages, utilities, materials used in production, etc.


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Variable Cost

Variable Cost

Quantity (Q)

Cost

($)


The total cost is the amount of money spent by a firm on producing a given level of output. Total costs are made up of fixed costs (FC) and variable costs (VC).

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$100.00$200.00$300.00$400.00$500.00$600.00$700.00$800.00$900.00

$1,000.00

Fixed CostVariable Cost

Total cost


Total costs = fixed + variable costs The variable costs cause the total costs curve to

be upward sloping. The greater the output the higher he costs.

If there was an increase in a fixed cost, would the total cost line

(a) Shift upwards in a parallel direction(b) Shift downwards in a parallel direction(c) Pivot upwards(d) Pivot downwards


IGCSE Business Studies p89 Activity 6.1


Break-even charts, comparing costs with revenue

Break-even charts are graphs which show how costs and revenues of a business change with sales


Break-even charts, comparing costs with revenue Uses of break-even charts There are other benefits from the break-even

chart other than identifying the breakeven point and the maximum profit. However, they are not all reliable so there are some disadvantages as well:


Pros:The expected profit or loss can be calculated at any level of output.

The impacts of business decisions can be seen by redrawing the graph.

The breakeven chart show the safety margin which is the amount by which sales exceed the breakeven point.


Cons:The graph assumes that all goods produced are sold.

Fixed costs will change if the scale of production is changed.

Only focuses on the breakeven point. Completely ignores other aspects of production.

Does not take into account discounts or increased wages, etc. and other things that vary with time.


IGCSE Business Studies p89 Activity 6.2, 6.3


Break-even point: the calculation method.It is possible to calculate the breakeven point without having to draw the graph. We need two formulas to achieve this:

Selling Price - Variable Costs = Contribution Break-even point =


Business costs: other definitionsThere are other types of costs to be analyzed that is split from fixed and variable costs:

Direct costs: costs that are directly related to the production of a particular product.

Marginal costs: how much costs will increase when a business decides to produce one more unit.


Indirect costs: costs not directly related to the product. They are often termed overheads.

Average cost per unit: If the cost of producing computer A was $350,000

and 700 units were made. Avg cost/unit =


Economies scale:Economies of scale are factors that lead to a reduction in average costs that are obtained by growth of a business. There are five economies of scale:


Economies scale Purchasing economies: Larger capital means

you get discounts when buying bulk.

Marketing: More money for advertising and own transportation, cutting costs.


Economies scale Financial: Easier to borrow money from banks

with lower interest rates. Managerial: Larger businesses can now afford

specialized managers in all departments increasing efficiency.

Technical: They can now buy specialized and buy the latest equipment to cut overall production costs.


Diseconomies of scale However, there are diseconomies of

scale which increases average costs when a business grows:

Poor communication: It is more difficult to communicate in larger firms since there are so many people a message has to pass through. The managers might lose contact with customers and make wrong decisions.


Diseconomies of scale Low morale: People work in large businesses

with thousands of workers do not get much attention. They feel they are not needed this decreases morale and in turn efficiency.

Slower decision making: More people have to agree with a decision and communication difficulties also make decision making slower as well.


P95 activity 6.4 P96 activity 6.5

Budget and forecasts: looking ahead

All business should plan for the future.

failure to plan for future could result in a miss opportunity or threat.

Managers may attempt to predict: Sales or consumer demand Exchange rates of the currency Wage increases.


These predictions are called FORECASTS. Forecasts try to reduce uncertainty of future

events.


Forecasting methods: Past sales could be used to calculate the trend,

which could then be extended into the future. Create a line of best fit for past sales and

extend it for the future.

Definitions:A TREND is an underlying movement or direction of data over time.Definition: LINE OF BEST FIT

A line drawn through a series of points, for example, sales data, which best shows the trend of that data. It can be used to forecast results in the future


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1

1.5

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2.5

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3.5

Sales Forecast

Time (years)

Sale

s $


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1.5

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Sales Forecast

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Line of best fit

Forecast


Panel consensus: asking a panel of experts for their opinion on what is going to happen in the future.

Market research.


Costs and Benefits of Forecasting:Benefits:

Aids decision making Informs planning and resource allocation

decisions If data is of high quality,

can be accurate


Costs: Data not always reliable or accurate Data may be out of date The past is not always a guide to the future Qualitative data may be influenced by peer

pressure Difficulty of coping with changes to external

factors out of the business’s control – e.g. economic policy, political developments (9/11?), natural disasters – hurricanes, earthquakes, etc.


Budgets: Budgets are plans for the future containing

numerical of financial targets

Well managed businesses will set budgets for revenue, costs, production levels, raw materials required, labor, and cash flow.

Master budget shows the planned revenue, costs and profit or loss for the business over a given period of time.


The advantages of budgets:

They set objectives for managers and workers to work towards, increasing their motivation.

They can be used to see how well a business is doing by comparing the budget with the actual results. This process is called variance analysis. The variance is the difference between the budget and the result.


The advantages of budgets:

The setting of the budgets can involve all workers and supervisors as well as managers. Participation can lead to greater motivation and more accurate budget.

Helps control the business and its allocation of resources/money

Case study task

Cost Area Budget ($) Actual ($) Variance ($)

Staffing 14,000 17,000 (3,000)Paper 5,200 4,800 400Equipment 6,500 7,500 (1,000)Electricity and telephone

4,000 5,000 X

Rent 3,000 3,000 0Total 32,700 37,300 Y

a) Calculate the x and y variances

Case study task

Budget – actual = varianceVariance X = 4,000 – 5,000 Variance X = (1,000)

Variance Y = 32,700 – 37,300 Variance Y = (4,600)

Case study task

Cost Area Budget ($) Actual ($) Variance ($)

Staffing 14,000 17,000 (3,000)Paper 5,200 4,800 400Equipment 6,500 7,500 (1,000)Electricity and telephone

4,000 5,000 (1,000)

Rent 3,000 3,000 0Total 32,700 37,300 (4,600)

Case study task

b) Should the manager be satisfied with the cost levels of this firm?

No, the manager shouldn’t be satisfied. The firm is over budget, shown by the negative variance. Greater cost control is neededPossible reasons – unrealistic budget.- Unexpected cost or events

Case study task

c) If the manager wanted to reduce cost to the budgeted levels, which costs do you think he should focus on?

Those with negative variance. Start with the greatest negative variance and move your way down.

You should be able to:

Distinguish between fixed costs and variable costs

Understand what the break-even level of output means

Use break-even charts to find the break-even level of output and draw simple break-even charts

Understand the main causes of economies and diseconomies of scale

Explain the purposes of budgets and analyse simple examples

Explain the purposes of forecasts i.e sales forecasts

Business cost and revenue

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