Cost, Revenue, and Contribution Notes

Costs, Revenue, and Contribution

Specific Learning Outcomes

• Define and provide examples of fixed, variable, semi-variable, direct, and indirect costs.

• Calculate total and average costs.

• Explain why businesses need accurate and reliable cost information.

• Define revenue and calculate total and average revenue.

• Explain the concept of contribution and calculate the contribution per unit.

• Explain why profit is important to business and its stakeholders.

• Define and calculate gross profit and operating profit.

Costs of Production

• Costs of production are the amounts a business incurs to make goods and/or provide services.

• Managers need to be aware of costs to make effective and profitable decisions.

• Accurate cost data is key in the 'profit equation,' as profits or losses cannot be calculated without it.

• Businesses need to know actual costs to make judgments concerning the cost efficiency of various parts of the business.

The Need for Accurate Cost Information

• To know profits or losses for new & existing products.

• Cost allows comparisons to be made with past performance.

• If a business doesn't have accurate cost information, they will not know what to produce or how to allocate resources.

What Businesses Need to Know About Costs

• What are the costs to produce the product or service? (Direct costs)

• What are the costs of marketing the product?

• How high are the overheads of the business? (Indirect costs)

• What are the potential costs of a business decision? (Opportunity cost)

  • Opportunity cost: The cost incurred by not enjoying the benefit associated with the alternative choice.

Cost Classifications

• Direct costs

• Indirect costs

• Fixed costs

• Variable costs

Direct Costs

• Costs that can be clearly identified with each unit of production and can be allocated to a cost center.

• Most common direct costs in manufacturing: labor and materials.

• Most important direct cost in a service business (e.g., retailing): the cost of the goods being sold.

  • Example: The cost of meat is a direct cost of a hamburger.

  • Example: The labor cost of a mechanic is a direct cost for a garage servicing a car.

Indirect Costs

• Costs that cannot be identified with a unit of production or allocated accurately to a cost center; often referred to as overheads.

  • Example: The purchase of a tractor is an indirect cost to a farm.

  • Example: Promotional expenditure is an indirect cost to a supermarket.

  • Example: Rent is an indirect cost to a garage.

Fixed Costs

• Costs that do not vary with output in the short run. They remain fixed regardless of the level of output.

• Increase the risk for start-ups because new businesses have to pay these costs even before they make any sales.

Examples of Fixed Costs

• Rent & rates

• Wages and salaries (non-production)

• Marketing (unless specifically allocated to a product campaign)

• Insurance, banking & legal fees

• Software

• Consultant and advisor costs

• Design and development

Variable Costs

• Costs that vary with output. They change as output changes (e.g., direct cost of materials).

• Semi-variable costs include both fixed and variable elements (e.g., a wage plus a bonus).

• Lower risk for a start-up: low levels of production result in low variable costs.

Examples of Variable Costs

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• Raw materials (eggs)

• Bought-in stocks (jellybeans)

• Wages (production wages only) based on hours worked or amount produced

• Marketing costs based on sales (e.g., % commission)

Fixed Costs vs. Variable Costs

• A graph illustrates fixed costs as a horizontal line (constant) and variable costs increasing with the number of units.

Problems in Classifying Costs

• Labor costs are often variable and direct costs. However, when labor is unoccupied (lack of orders), wages can become a fixed cost.

• Salaries of administration, selling, and non-production employees are indirect costs.

• Electricity costs can sometimes be directly allocated but are often classified as an indirect overhead expense.

• Not all direct costs are variable costs.

  • Example: A juicing machine for a hotel bar is a direct cost to the department, but its cost doesn't vary with output.

Firm's Costs of Production

• Fixed Costs + Variable Costs = Total Costs

Average Costs

• Average Variable Cost (AVC): AVC = {VC}{Q}

• Average Fixed Cost (AFC): AFC = {FC}{Q}

• Average Total Cost (ATC): ATC = {TC}{Q} (Also known as AC)

Total and Average Costs

• Total cost: The total cost of producing a product. As output rises, the total cost rises.

• Average cost (unit cost): The average cost of producing each unit. Total {costs}{output}

• Understanding average costs helps organizations determine the selling price of their product.

Total Costs - Example Calculation (Graham's Van Repairs)

• Variable costs: £75 per job

• Fixed costs: Garage rent & rates £500, Wages £1,500, Advertising £100, Other fixed costs £400

• Expected jobs: 100 per month

• Stage 1 - calculate variable costs:
  75 * 100 = £7,500

• Stage 2 - add together the fixed costs
  500 + 1,500 + 100 + 400 = £2,500

• Stage 3 - add variable to fixed costs:
  7,500 + 2,500 = £10,000

Revenue

• Various terms used: Sales, Income, Turnover, Takings

• Sales arise through the trading activities of a business.

• Revenue is the quantity of a product sold multiplied by the price that customers pay.

• Formula: Total revenue = volume sold x average selling price.

Calculating Revenue - Example

Total and Average Revenue

• Total revenue: The total income received when selling a product. As sales increase, revenue increases.

• Average revenue: The average level of income received when selling a product. Total {revenue}{output}

Increasing Revenue

• Increasing quantity sold:

  • Perhaps by cutting the price or offering volume-related incentives.

  • Is demand sensitive to price?

• Achieving a higher selling price:

  • Look to add value rather than simply increase price.

  • Does market research suggest that prices are high enough or too low?

• Or both!

Revenue - Examples

• Footie & Co sells footballs priced at £7.45 each. In a month they sell 234 footballs. Calculate their sales revenue for the month.

• Charlotte’s sells soft toys priced at £4.25 each. Their average sales per month in 2012 were 220 soft toys. Calculate their revenue for 2012.

Activity - Revenue

1. A hotel in Cumbria has 20 rooms. Each room costs £125 per night for Bed & Breakfast. What is the maximum sales revenue the hotel can make from room bookings in one night?

2. The hotel’s annual revenue this year was £675 000. What is the average revenue per month?

3. Variable costs are £18 per person per night. This year they accommodated a total of 10 800 overnight stays. Fixed costs were £300 000. What was the total cost?

Activity - Revenue Answers

1. Sales Revenue = Selling Price x Quantity Sold = £125 x 20 = £2500

2. Average Revenue per month = £675 000/12 = £56 250

Cost Calculation Practice

Given:

• A product sells for £6.75

• Direct material cost per unit £2.50

• Direct labor cost per unit £0.40

• Output is 12000 units per week

• Fixed cost is £5000 per week

Calculate:
a) The total weekly wage cost
b) The total variable cost per week
c) The total cost per week
d) Total revenue per week
e) Weekly Profit

Cost Calculation Practice Answers:

a) The total weekly wage cost
0.4 x 12000 = 4800
b) The total variable cost per week
(2.5 x 12000) + 4800 = 30000 + 4800 = 34800
c) The total cost per week
34800+5000 = 39800
d) Total revenue per week
6.75 x 12000 = 81000
e) Weekly profit
81000 –39800 = 41200

Profit

• Profit is the Difference Between Revenue and Costs
  1) When you deduct a business's total costs from its total revenue, you're left with the profit.
  Profit = total revenue - total costs
  2) If a business's total revenue is greater than its total costs, then it will make a profit.
  If the total costs are greater than the total revenue, then the business will make a loss.

Profit Types

• Gross profit: the amount a business has earned minus the direct costs of manufacturing or the cost of goods sold.

• Operating profit: the amount of the gross profit minus operational costs.

• Profit for the year: the total amount left over after the business has accounted for all deductions, including interest and taxes.

Gross Profit

• Gross profit represents a business' earnings after deducting manufacturing costs.

• Retail companies calculate gross profits by subtracting the cost of goods sold (COGS) from total sales.

• Calculating gross profit tells a company whether its production and pricing are efficient enough to meet revenue goals.

• Gross profit formula
  Gross profit = total sales - COGS

• Assume, for example, that you have $10,000 in sales and $750 in COGS. This would equal a gross profit of $9,250.

Operating Profit

• Operating profit comes from the total income left after a company subtracts its operating costs from its gross profits.

• Operating costs can include direct expenses like sales, administrative expenses and overhead expenses.

• Understanding the operational profit gives businesses deeper insight into productivity and operational efficiency.

• Operating profit formula
  Operating profit = gross profit - indirect or operational expenses

• For example, if you retain $25,000 in gross profits and have $8,000 in operating expenses — like overhead, administrative costs and sales costs — the operating profit is $17,000.

Overheads

They are usually classified into four main groups:

1. Production overheads

2. Selling and distribution overheads

3. Administration overheads

4. Finance overheads

Profit for the Year

• Profit for the year represents all of the income that a business has left over after deducting its remaining expenses, including interest and taxes.

• A business's profit for the year is usually the last item on the income statement, showing the total income the business' executives and shareholders earn.

• Profit for the year formula
  Profit for the year = operating profit - (taxes + interest)

• For instance, if a business has $15,000 in operating profit, $2,500 in taxes and $1,000 in interest, this results in a profit for the year of $11,500.

Profit - Worked Example

Gwen and John's pasta restaurant charges £10 for
three courses and has an average of 800 customers
per week. The variable costs are £4 per customer and
the restaurant has fixed costs of £3,400 per week. To
calculate profit:

1. Calculate revenue: Price x no. of customers
   £10 x 800 = £8,000

2. Calculate total costs: Fixed costs + total variable costs
   (No. of customers x variable costs per meal)
   £3,400+ (800× £4 = £3,200)

3. Calculate profit: Total revenue - Total costs
   £8,000 (£3,400 + £3,200) = £1,400 per week

Profit - Examples

• The revenue of Coffee to Go in 2012 was £545M. Their total costs were £28.5M. Calculate their profit (loss) for 2012.

• Plumpton Ltd made a profit of £25M in 2012. Their revenue was £132M. Calculate their total costs.

• In 2012 Ahmed’s Toys had a revenue of £3.2M, fixed costs of £2.75M and variable costs of £530 000. Calculate their profit (loss) for 2012.

Contribution

• Contribution helps to identify whether an individual product (or activity) is helping the business to make a profit.

• All firms need to pay fixed costs, and these costs must be covered before a profit can be made.

• Contribution ignores the fixed costs and looks at the direct costs of making a product.

• If sales revenue is greater than the direct costs, the product is contributing towards paying off the fixed costs or making a profit.

• Contribution per unit is the returns made on individual products once the direct/variable costs are deducted from the selling price.

• Formula:
  Contribution per unit = selling price per unit – Variable cost per unit

• E.g. if the direct costs of making a pen are 7p and the pen sells for 18p, the contribution per unit is 11p (18p-7p).

Types of Contribution

• Total Contribution is the total returns made from products once the direct/variable costs are deducted from the total revenue. It is not profit.

• The total contribution margin generated by a product represents the total earnings available to pay for fixed expenses and to generate a profit.

• This can be calculated in two ways:

  • Contribution per unit x no. of units sold

  • Sales revenue – direct costs.

Contribution - Missing Words

• Contribution is the surplus generated over variable costs when selling one or more products.

• It can be measured per unit, using the formula: Selling price - variable cost per unit = contribution per unit.

• This shows how much each sale contributes to covering the fixed overheads of the business.

• It can also be looked at in total, i.e. total contribution (contribution per unit x quantity sold). This can be a useful short-cut to calculating profit, as total contribution - fixed overheads = profit.

Contribution - Example

• Let's look at a simple worked example of contribution. Here is some information about a business that just sells one product: Selling price per unit £30. Variable cost per unit £18 Contribution per unit= ? £12 If Units sold= 15,000

• Now use formula to CALCULATE Total contribution
  Total Contribution= £12 x 15,000 units = £180,000

Contribution - Example (Continued)

• Looking at the contribution per unit above (£12), you can see that it can be increased by:

  • Increasing the selling price per unit - i.e. more than £30

  • Lowering the variable cost per unit - i.e. less than £18

• Note that the total contribution of £180,000 is not the total profit made by the business. Why? This is because we have not yet taken account of the fixed costs of the business. Let's do that now…

Contribution - Example (Fixed Costs)

• Imagine that, in the example above, the business has the following fixed costs:

  • Admin: £18,000

  • Marketing: £25,000

  • Payroll: £50,000

  • Other overheads: £23,000
    Total Fixed costs = £116,000

• The total fixed costs of the business are £116,000. If we take these away from the contribution (£180,000), then we can calculate the overall profit or loss of the business:

Contribution - Example (Profit Calculation)

• Calculate the overall profit or loss of the business:
  Total Profit = contribution - fixed costs = £180,000 - £116,000 = £64,000

• Contribution per unit is a really useful number to have when answering questions on break-even.

Practice Question

• The monthly accounts for a business show revenues of £115,000, fixed costs of 42,000 and contribution of 76000. What was the net profit or loss? Answer: PROFIT of £34000

True or False Questions

• Direct product costs such as raw materials are variable costs. (True)

• Fixed costs do not change directly with the level of output in the short term. (True)

• Indirect costs are the overheads for running a business and are not directly related to production. (True)

• An organization starts incurring cost before it sells anything. (True)

• Semi variable costs combine elements of fixed and variable costs. (True)

• A bonus is an example of fixed costs. (False)

• Wages based on hours worked is an example of variable costs. (True)

• Variable costs changes directly with level of output. (True)

• Contribution helps to identify whether an individual product (or activity) is helping the business to make a profit. (True)

• Contribution looks at the fixed costs and direct costs. (False)

• Contribution is the same as profit. (False)

Activities (Multiple Choice)

• Which of the following statements is correct?
  *Fixed costs do not change. (False)
  *Fixed costs do not vary with output in the short-term. (True)
  *Fixed costs change only if output falls. (False)
  *Fixed costs are always higher than variable costs. (False)

• Workers paid using "piece-rates" for each item they complete is an example of a
  *Selling cost (False)
  *Marketing cost (False)
  *Fixed cost (False)
  *Variable cost (True)

• Annual fixed costs are £1.2 million; annual output is 150,000 units and variable cost per unit = £15. What are the total annual costs?
  *£2,400,000 (False)
  *£2,250,000 (False)
  *£1,350,000 (False)
  *£3,450,000 (True). 1.2 + (150,000 *15) = 3450000 (True)

• Which of these would NOT be classified as a variable cost?
  *Raw materials (False)
  *Insurance premiums for a factory (True)
  *Output-related payments to workers (False)
  *Bought-in components (False)

• An indirect cost is one that:
  *A. can be clearly identified as arising from the production of a particular product. (False)
  *B. does not change with the level of output. (False)
  *C. is variable. (False)
  *D. cannot be identified with a unit of production. (True)

• The term ‘contribution’ refers to:
  *a) the difference between revenue and fixed costs. (False)
  *b) the difference between revenue and total costs. (False)
  *c) the difference between revenue and variable costs. (True)
  *d) the difference between revenue and cost of sales. (False)

• A firm produces 25,000 sweatshirts. Fixed costs are £250,000 and variable costs are £5 per sweatshirt. What is the unit cost?
  *a) £5 (False)
  *b) £10 (False)
  *c) £15(False)
  *d) £15 (True)

• The selling price of Product X is £12.50. The total average cost of producing product X is £8 of which £5.50 are fixed costs. The contribution per unit of product X is?
  *a) £12.50 (False)
  *b) £4.50 (True)
  *c) £7 (False)
  *d) £10 (False)

• The main distinction between profit and contribution is that:
  *a) profit is for all products but contribution is for just one product. (False)
  *b) profit is the extra cash that the business earns but contribution is never in a cash form. (False)
  *c) profit is calculated after deducting direct costs from revenue but contribution is calculated before deducting direct costs. (False)
  *d) profit is calculated by deducting total costs from revenue but contribution is calculated by deducting direct costs from revenue. (True)

• If a business sells 10,000 roses at £1.50 each and the direct costs are 40p and fixed costs are £11,500 discuss whether the business should stop selling roses. (12 Marks)