Costs, Revenue and Profit Calculations

Costs are the amounts a business spends to produce goods, provide services and operate. A bakery needs ingredients and packaging, but it also needs premises and staff. These costs do not all respond to changes in production in the same way.

Output means the quantity of goods or services produced. Costs are classified as fixed or variable according to whether they change when output changes.

A fixed cost stays the same as output changes over the period being considered. Examples include rent, insurance and a manager’s fixed salary. A bakery must pay its agreed weekly rent even if it produces no cakes that week. Producing more cakes does not itself increase that rent.

Fixed does not mean that a cost can never change. Rent might rise when a lease is renewed; it is fixed because it does not vary directly with output during the period considered.

A variable cost changes with output. Producing more cakes requires more flour, eggs and packaging, so their total cost rises. Producing fewer cakes reduces these costs. Pay based on the number of items produced can also be variable, whereas a fixed salary is a fixed cost.

From cost per unit to total costs

A variable cost per unit is the cost associated with producing one item. It is different from the total variable cost of all the items produced.

If the variable cost per unit stays constant:

$$\text{Total variable costs} = \text{Variable cost per unit} \times \text{Output}$$

Total costs include both types of cost:

$$\text{Total costs} = \text{Fixed costs} + \text{Total variable costs}$$

Consider a bakery with weekly fixed costs of £120 and ingredients and packaging costing £1 per cupcake. Producing 200 cupcakes gives total variable costs of £200. Adding the £120 fixed costs gives total costs of £320 for the week. At zero output, the bakery would still have its £120 fixed costs to pay.

Profit and loss: comparing revenue with total costs

A business makes a profit when revenue exceeds total costs. The profit is the surplus left after those costs have been deducted:

$$\text{Profit} = \text{Revenue} - \text{Total costs}$$

If total costs exceed revenue, the business makes a loss. A negative result from the profit calculation shows the size of that loss. If revenue exactly equals total costs, the business makes neither a profit nor a loss.

Suppose the bakery sells every cupcake it produces for £3 each. The table compares two possible weeks, keeping the weekly fixed costs at £120 and variable costs at £1 per cupcake.

The second week makes a loss even though each cupcake sells for more than its variable cost. The income from those sales is not enough to cover all the fixed costs as well.

Using the figures in business planning

Forecast revenue and costs help an entrepreneur judge whether a planned business is likely to be profitable. Profit can reward the owner for taking risks and provide funds for future growth.

Increasing revenue or reducing costs can improve profit, but the effects need to be considered together. For example, advertising might increase sales while also adding to costs. Higher revenue therefore does not automatically mean higher profit. Forecasts also depend on assumptions about sales and costs, so the eventual result may differ from the plan.

• Fixed costs: unchanged as output changes, for example rent or insurance; still payable at zero output.
• Variable costs: change with output, for example ingredients or packaging.
• A variable cost per unit is not the same as total variable costs.

Interpret the result

• Revenue > total costs → profit.
• Revenue < total costs → loss.
• Revenue = total costs → neither profit nor loss.

Revenue is income from sales, not the amount left after costs. Forecast revenue and costs help assess whether a business plan is financially viable.