3.3 Costs and revenues | IB DP Business Management

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Profit is revenue minus costs, so every financial decision starts here. This page classifies costs in two ways (fixed or variable, direct or indirect), shows how total cost behaves as output changes, and explains total revenue and the different revenue streams a business can earn. These ideas feed straight into break-even analysis (5.5) and budgeting (3.9).

🎯What you need to be able to do

Explain fixed, variable, direct and indirect (overhead) costs, using examples.
Explain total revenue and revenue streams, using examples.

📚The business management

Fixed and variable costs

Fixed costs (FC)
costs that do not change with the level of output in the short run: rent, salaries, insurance, loan interest, depreciation. Paid even if nothing is produced.

Variable costs (VC)
costs that change directly with output: raw materials, packaging, piece-rate wages, sales commission, energy used in production. Zero when output is zero.

\[ \text{total cost} = \text{fixed cost} + \text{variable cost} = FC + (\text{variable cost per unit} \times Q) \]

A horizontal fixed cost line at 180 thousand dollars, a variable cost line rising from zero at 300 dollars per board, and a total cost line starting at 180 thousand and running parallel to variable cost. At 400 boards, total cost is 300 thousand dollars. — Total cost starts at the fixed cost and rises with each unit produced.

Some costs are semi-variable: a fixed part plus a variable part, such as a phone bill with a monthly fee plus usage, or a salary plus overtime. Fixed costs are fixed only within a range and time period: expanding beyond a factory’s capacity means renting another building, a step up in fixed costs.

Direct and indirect costs

Direct costs
costs that can be clearly identified with a particular product or department: the wood in a table, the wages of the carpenter who made it.

Indirect costs (overheads)
costs that cannot be traced to one product because they are shared: office rent, managers’ salaries, marketing for the whole brand, accounting, security. Must be shared out (allocated) between products, which requires judgment.

The two classifications overlap: direct costs are usually variable (materials), but not always; overheads are usually fixed (rent), but not always (electricity for the whole building rises with overall activity).

Revenue

\[ \text{total revenue} = \text{price} \times \text{quantity sold} \]

A revenue stream is a distinct source of revenue. Businesses increasingly earn from several, which spreads risk:

Sales of goods and services (the main stream for most businesses).
Subscriptions (streaming, software, gym memberships).
Advertising (social media platforms, news sites).
Commission and fees (booking platforms, ride-hailing apps taking a percentage).
Licensing and franchising fees and royalties.
Rental or leasing of assets.
Sponsorship, donations and grants (sports clubs, social enterprises, NGOs).
Interest and dividends from investments.

A surf school, for example, might earn from lessons, board rental, merchandise, café sales and a commission from a nearby hotel for booking guests.

✏️Worked example

A surfboard workshop has fixed costs of $180 000 a year and variable costs of $300 per board. It sells boards at $800. (a) Calculate total cost and total revenue at 400 boards, and the profit. (b) Classify: foam and resin; the workshop rent; the shaper paid per board; the owner’s salary; website hosting.

(a) TC = 180 000 + 300 × 400 = 180 000 + 120 000 = $300 000. TR = 800 × 400 = $320 000. Profit = 320 000 − 300 000 = $20 000.

(b) Foam and resin: variable, direct. Rent: fixed, indirect. Shaper paid per board: variable, direct. Owner’s salary: fixed, indirect. Website hosting: fixed, indirect.

Check it. At zero output, total cost equals fixed cost ($180 000), and the business makes a loss of $180 000. The break-even output is 180 000 ÷ (800 − 300) = 360 boards (5.5).

“Fixed costs never change.” They do not change with output in the short run, but rent can rise and a firm can move to bigger premises.

📝Practise

Work through these on paper, then reveal the answer.

1. [2 marks] Define the term variable cost.

A cost that changes in direct proportion to the level of output, such as raw materials; it is zero when nothing is produced.

2. [2 marks] Distinguish between direct and indirect costs.

Direct costs can be traced to a specific product or department (materials used in it); indirect costs (overheads) are shared across the business and cannot be traced to one product (rent, managers’ salaries).

3. [2 marks] A bakery has fixed costs of $4000 a month and variable costs of $1.20 per loaf. Calculate the total cost of producing 5000 loaves.

TC = 4000 + 1.20 × 5000 = 4000 + 6000 = $10 000.

4. [2 marks] The bakery sells loaves at $2.50. Calculate total revenue and profit at 5000 loaves.

TR = 2.50 × 5000 = $12 500. Profit = 12 500 − 10 000 = $2500.

5. [4 marks] Explain two revenue streams a music streaming app could have.

(1) Subscriptions: monthly fees from premium users for ad-free listening, which give predictable recurring revenue. (2) Advertising: selling ad space to businesses targeting free users, using listener data. (Also: partnerships with phone operators, concert ticket commissions.)

6. [4 marks] Explain why a business might want several revenue streams.

Relying on one stream is risky: a fall in demand, a new competitor or seasonality could cut revenue sharply. Several streams spread risk and can smooth cash flow (a surf school selling merchandise and café food in the rainy season), and can use existing assets and customers to raise total revenue and profit.

🔗Go deeper — other people’s work

These are external resources, not mine. If one stops working, tell me and everything above it on this page still stands.

AccountingCoach — cost behaviour: fixed, variable and mixed costs.
Strategyzer — the Business Model Canvas, including revenue streams.
Tutor2u — revision notes on costs and revenues.