Direct costs
Direct costs are costs which can be identified directly with the production of a good or service; e.g. raw materials.
Indirect costs
Indirect costs are costs which cannot be matched against each product because they need to be paid whether or not the production of good or services takes place; e.g. rent on the premises.
Classification of costs help allocate costs to right parts of the profit and loss account and also helps analysis of the break even point of the business.
Average costs
The example of the CD shows the benefits of economies of scale, where mass production results in a lower unit cost. The reason is that the fixed costs do not change and are spread across a greater level of output.
Finding out the helps a firm to monitor its progress, and makes it easier to set prices. It is calculated by dividing total cost by total output.
Using the example of the compact disc firm above:
Total costs / Total output = Average cost of production
£1,000 / 100 CDs = £10 per CD
This might seem expensive, but if the firm produces another hundred units at a marginal cost of £1.00 per CD, its average cost will fall radically:
Total costs / Total output = Average cost of production
£1,100 / 200 CDs = £5.50 per CD
The firm can use this information to decide whether it is worth accepting a new order for goods.
Operating costs
Variables costs and fixed costs added together are known as operating or running costs since they are both incurred when a business is running.
Revenue
In business, revenue or revenues is income that a company receives from its normal business activities, usually from the sale of goods and services to customers.
Sales these are the main source of revenue for most organisations because customers pay for the goods or services they buy.
Leasing a part of a building to another business can also provide a source of income. Some businesses specialise in leasing cars or equipment to other organisations.
Interest this earned when a business has no money in an interest bearing accounts at the bank.
Calculating total revenue
To do this we need two items of information:
- The selling price
- The number sold
We then need use the following formula:
Profit
Profit generally is the making of gain in business activity for the benefit of the owners of the business. Profit is the difference between the income of the business and all its costs/expenses. It is normally measured over a period of time.
Profit is important in three ways:
- It rewards the business people who have taken risks to run it
- It provides the funds to develop the business further
- It is a source of cash, which allows the business to meet its debts
Gross profit
This is the difference between sales income and the direct costs of making those products. Gross profit is used as a performance indicator to help the business make decisions over its pricing policies and use of materials.
In the example, the business had sales of £18,000 over the year. Its cost of sales was £4,850 and its gross profit, therefore, was £13,150.
Net profit
Net profit represents gross profit less all expenses associated with the normal running of the business. Net profit shows how well the business performs under its normal trading circumstances. It is used to calculate the “primary efficiency” ratio.
Net profit is the final profit of the business. It is the amount of profit made by the owners of the business at the end of the period.
In this Example when we take expenses into account, we can see that what was a gross profit of £13,150 is now a net loss of £1,650.
Retained profit
Retained profit is the profit left over after the shareholders have been paid their dividends. Retained profit is normally reinvested in the business.
Profit is important to a business because it is a reward to the owners of the business. They have taken risks with their money and time. If there was no profit, then there would be little point in starting up or putting more money into the business, they might as well put the money into a bank or building society
Profit maximization
Profit maximization is the process by which a firm determines the price and output level that returns the greatest profit. There are several approaches to this problem. The total revenue -- total cost method relies on the fact that profit equals revenue minus cost.
There are two basic ways of improving profits:
- Increasing sales income
- Reducing running costs
Increasing sales income
There are different way’s of trying to achieve this. They all have risks as shown in the charts.
Reducing operating costs
We already know that cost fall in to two variables and fixed. Many business have operating cost like bills, labours, raw materials etc. An example of reducing operating profit is given below, a valeting business have a list which begins:
Staff wages £200,000
Property rental £50,000
And end with
Ball pens £20.00
Paper clips £4.50
Method of reducing costs falls into main categories:
- Minimising usage
- Finding the best purchase deal
The importance of profit
After tax is paid the business can spend the remaining money in several ways. If the business is a limited company with shareholders, some of the profits will be paid as dividends. These are the rewards paid to shareholders for investing their money- similar to the interest you if you save money in the bank.
- For small business, most of the profit is used to pay the owner a wage.
- Equipment could be upgrade or update to improve efficiency.
- If the business has taken out then loan, some or all it could be rapid
- Profit can be kept in the back as reserves to be used in future for any emergency.