COST, REVENUE &

BREAK EVEN ANALYSIS

IB BUSINESS & MANAGEMENT
A COURSE COMPANION
(p232-249)

COSTS & REVENUE

Once a business has worked out how to produce,
it needs to think about how much to produce.
This will depend on a number of factors, but in
most cases production managers will focus on at
least ensuring that they have covered their costs
and not made a loss.
The following simple formula can act as
decision-making framework

PROFIT = TOTAL REVENUE TOTAL COSTS.

Not for Profit

Organizations
Even if a business is a not-for profit
organization it must still abide by the
formula.
Although it may not make profits it
must as least cover it costs and so no
make any losses.

Non-Governmental
Organizations (NGOs)
NGOs need to make enough money
to not only cover their immediate
costs, but also to ensure that they
can reinvest for the future.
Eg: Greenpeace will need enough
money to pay lobbyists or buy boats
for direct action such as monitoring
whaling for scientific purposes by
Japanese vessels.

REVENUE
Revenue is fundamental to all production
decisions.
It is the total money earned from selling the
product.
It also known as sales, sales revenue or
turnover, and it appears in the top line of a
profit and loss account or part of cash in a cash
flow statement.
All these items refer to the operational income
of a business that is money earned from its
business operations.

REVENUE
Non-Operational Activities
Sometimes a business can earn
money from non-operational
activities, such as selling shares in a
subsidiary or company assets
generally.
This form of revenue is classified as
non operational income.

Total Revenue Formula

Total Revenue (TR) = Price (P) x
Quantity (Q)
Example
If a car dealer were to sell 100 BMW
5 Series Cars in 2011 for $200,000
each, there would be $20,000,000 in
revenue. 100 x 200,000.
Remember that revenue is very
different to profit.

Profit Margin
Fast Food Outlet vs Fine Dining Restaurant
With a fast food outlet there is a very low profit
margin as the competition is very fierce and demand
is relatively elastic so the business cannot afford to
put their prices too high.
Prices will not be much more than their costs.
This means a fast food restaurant is dependent on a
high volume of sales (for standardized mass
produced meals) to generate sufficient profit to
operate.
In contrast, the profit margin for a fine dining
restaurant per customer will be significantly higher
than the fast food chains average customer.

Different Types of
Revenue
Cash Sales: Money paid directly as cash.
Credit Sales: Money paid on credit using Visa or
Mastercard, AMEX or Diners Club.
Debit Card: Money transferred electronically from a
bank account.
Cheque: Money transferred from a bank account using
a hand-written note.
Loyalty Cards: Money transferred from a bank
account into a special store account.
Direct Debit: Money transferred from a bank account
for regular payments such as mortgage or cable TV
monthly fee.
Annual Fee: Money paid once a year. Eg:
subscriptions to a tennis club or a car tax.

Which Revenue Source is

Preferred?
Some businesses prefer one form of
payment to another.
Eg: An internet company such as
Amazon finds it much easier to
accept credit card payments, but a
local baker will obviously prefer cash.

COSTS
Five Categories of Cost
There are five categories of costs that can overlap each
other:
Fixed Costs: Costs that do not change as output
does. (eg: cost of buying a factory)
Variable Costs: Costs that do change as output does.
(eg: cost of buying stock)
Semi-variable Costs: Costs that are made up of fixed
and variable components. (eg: basic line cost for
renting phone + call costs)
Direct Costs: Costs that are directly related to output.
Indirect Cost: (Overheads) Costs that are indirectly
related to output.

Fixed Costs - Examples

Example
A car dealer may have to pay for the rent of
the car showroom, even if there are no
customers.
Businesses often refer to these must pay costs
as overheads as they appear as expenses in
the profit & loss account, because they are
indirect costs of production.
Interest payments on loans could be another
example of fixed costs.

Variable Costs
Variable Costs costs which do vary
directly with production.
Eg: If we are selling stock we will
order or make less stock.
Therefore our variable costs can
change.
In the Profit & Loss Account, the
stock we do use appears as the cost
of goods sold.

The Relationship Between

Different Costs

Fixed = Indirect Costs

Variable = Direct Costs
Semi-Variable Partly
Direct
& Partly Indirect

How to we calculate total

costs?

Total Costs (TC) =

Fixed Costs (FC) +
Variable Cost (VC)
TC = FC + VC

Semi-Variable Costs
The semi-variable costs (also known as
quasi-variable costs) are a combination of
fixed and variable costs.
Example Salary of a Car Salesperson
The salary of the car salesperson is
typically made up of two parts a fixed
element (the basic wage) and a variable
element (the commission) which is
dependent on the number of cars sold.

Semi-Variable Costs
Electricity Costs
Electricity bills are usually split into a
fixed element the standing charge
and a variable element which is
taken from the electricity meter and
indicates how much has been used.

Costs Classification
Exercise
TRANSACTION

Rent
Telephone
Electricity
Wages Basic
Wages
Wages
Commission
Costs of Good
Sold (Inventory)

WHAT TYPE OF COST?

Contribution to Fixed
Costs
An important business tool is the contribution a
product makes to the overall profitability of the
business.
When it knows this, a business can decide
which product to focus on, so as to expand
production, increase investment and ultimately
improve sales.
This is particularly useful for a business that
has a range of products as the business will be
able to judge whether one is outperforming
another.

Contribution to Fixed
Costs
In the Boston Consulting Group (BCG)
matrix, this can be a difference
between a star, cash cow and dog
product.

How do we calculate the total

contribution for a company?

We use the following

formula:
Total Contribution =
Total Revenue Total
Variable Costs

The Contribution Per

Unit
We can calculate the contribution per unit for the
business by using the following formula:
Contribution = price variable costs (per unit)
Example
We sell a luxury care for $200,000.
We sell 100 cars.
Our Total Variable Costs are $15,000,000
Insert into formula:
$200,000 - (15,000,000) = $50,000 per car.
100

The Contribution Per

Unit
Further Explanation of Car Example
Each car contributes $50,000 which
can be subtracted from fixed costs to
generate the eventual profit for the
business.

BREAK EVEN ANALYSIS

Another important tool to help production
decisions is break even analysis.
This is especially relevant for a new businesses
or for starting a new venture.
The idea is to calculate the minimum product
that would have to be sold for the business to
break even that is: just to cover the costs and
no more than that.
If a business manages to produce and sell more
than the break even quantity it will make a
profit.

How to calculate the break even

output?

Profit = Total Revenue

Total Costs.

If Profit is O, break even is:

Total Costs = Total Revenue

Three Methods for calculating

the Break Even Level of Output
We can calculate the break even level of output
using the following three methods:

Creating a Table
Drawing a
Chart/Graph
Using a Formula

Semi Variable Costs &

Break Even Analysis

For break even analysis we

do not consider semivariable costs because this
would make things must too
complicated, so we must
always divide costs into fixed
or variable proportions.

Table Method for Break Even

Analysis
Example Question
Business: A vendor selling face Rolex
watches in the Philippines.
A vendor has to pay a sum of $US1000 to
secure the right to sell his watches outside
the tourists hotels on the beach. He paid
this to the local enforcers (mafia)
On average a tourist would pay $US 50 for a
watch and the watches typically cost him
US $25 from his supplier.

Table Method for Break Even

Analysis
Example Question (continued)
Note that fixed costs (the fee for the right to sell watches)
had to be paid up front before he had sold any watches
the sum was a one-off payment, no matter how many
watches were sold.
Variable Costs are 0 if nothing has been sold.
Unsold watches can be returned to the supplier
The price stays the same throughout. Some tourists were
good at haggling and some were not, but the average price
is $50.
If nothing has been bought, the total revenue for 0 is 0.
After this total revenue goes up by multiplying price &
quantity.

BREAK EVEN ANALYSIS VENDOR SELLING

WATCHES EXAMPLE
Quanti COSTS ($ US)
REVENUE ($ US)
ty
Outpu
t
Watche Fixed
s
Cost
Sold

Variabl
e
Cost

Total
Cost

Price

Quantit Total
y
Revenu
Output e

1000

1000

50

10

1000

250

1250

50

10

20

1000

50

20

30

1000

50

30

40

1000

50

40

50

1000

50

50

60

1000

50

60

70

1000

50

70

500

PROFI
T
(Loss)
US

(750)

Watches Example Analysis

After completing the previous table,
it is obvious that the watch seller
breaks even by selling 40 watches.
For every watch sold after this, the
vendor will make a $25 profit.

The Formula Method for

Break Even Analysis
Break Even Quantity = Fixed Costs
Contribution Per Unit.
Contribution = price variable cost per
unit.
Fixed Costs =
$1000
Contribution =
$50 - $25 = $25.
1000/25 = 40 watches.

Graph Method For

Break Even Analysis
It is possible to transfer some of the information
in the table to a graph.
The vertical axis will have costs and revenue on
it and the horizontal axis will have the quantity
of watches sold.
To this we can add fixed costs, which we can
draw as a line parallel to the horizontal axis
starting at $1000.
The line is parallel to the horizontal axis
because these costs do not change as more
watches are sold the costs are fixed.

Tip:
Do not
attempt
to draw a
break
even
graph,
until you
have
calculated
/
determine
d the
break
even
point
using the
formula.
Source: http://fast4cast.com/break-even-calculator.aspx

How is profit & loss represented

in the graph?
The amount of profit or loss is given by the
vertical distance between the total cost and
total revenue lines.
As the vendor sells more watches, his losses get
smaller (the distance between total costs and
total revenue gets less)
After break even, the distance between total
costs and total revenue increases, which means
he makes more profit the more he sells.
However, he must sell a minimum of 40
watches before making a profit at all.

The Margin of Safety

If the watch vendor sells 60 watches,
then he is said to have a margin of
safety of 20 watches.
The margin of safety is just the
difference between actual sales and
break even sales - it like a safety net.
Note: It is the margin of safety output
(quantity) we are interested in, not
revenue, profits etc.

Graphs & Break Even Analysis

Examination Tip
If you need to draw the graph in an
examination, always do the
calculation using the formula first.
It helps centre the two axes so the
scale will work out clearly.
Always aim to try to place the break
even quantity point-mid way on the
horizontal axis.

Break Even Analysis Exercise

A school publishes a magazine.
400 copies are printed.
The costs are as follows:
Fixed Costs:
$600
Variable Costs:
$2 per magazine.
The school will charge $4 for a copy of the
magazine.
Using the three different methods produce a table,
graph and equation to show the break even quantity
of magazines. Note: Do the equation first.