Calculating Costs

Costs Aim: Understand what a business costs are. HW: Ch 16 Q. 1 & 2 pg 65 & 67

L/O State and explain the cost structure of a business Demonstrate understanding as to why the process of production generates costs Classify costs into fixed and variable/ direct/ indirect Identify examples of different types of costs using the fixed and variable classification

Hungry Horace’s Pizza factory What are the costs involved in starting a pizza factory?

Objectives of a firm What is the main aim of a business? Does Horace have a desire to provide the world with pizza? Does he have a love for the pizza business? More likely to make money! Most business goals are to maximise profit. What is a business’ Profit?

Profit The amount that a business receives from the sale of its output (pizza) is called total revenue. The amount that the firm pays to buy the inputs (flour cheese, workers, ovens, etc) is called total costs. Profit is a firm’s total revenue minus total costs. That is: PROFIT = Total revenue – Total costs. Horace objective is to make his firm's Profit as large as possible.

Firstly we must understand costs.. Costs are the expenses incurred by a business in producing and selling its products (recap) START UP COSTS

Activity Brainstorm all the costs a business would need to incur before starting a business:  In Pairs

Start up costs Market research Premises (purchase price or rent deposit) Any building alternations Fixture and fittings Legal/ professional fees Equipment Furniture Communication equipment Advertising/ promotional materials Insurance Utilities Transport Business stationary Licences and permits.

Start Up costs Start up costs are costs which need to be met before a business can start selling the new product

Running Costs Otherwise known as Operating costs. Running costs need to be met so that a business can go through the day-to-day process of producing and selling their products.

Activity Brainstorm running costs for a business:  In Pairs

Running Costs Salaries Insurance premiums Rent/lease payments utility payments Business rates Accountancy fees Raw materials or stock Loan repayments Packaging materials Tax Postal and distribution charges

Fixed and variable Running Costs can be split into fixed and variable costs

Costs Fixed costs (also called INDIRECT or OVERHEADS) have to be paid even if no products are sold DO NOT VARY with OUTPUT No matter how many items are produced or sold these costs remain the same. They are therefore include all the general business overheads Brainstorm three examples:

There are two types of costs: Variable costs (or DIRECT) increase by a step every time an extra product is sold (eg cost of pizza topping etc.) DO VARY with OUTPUT The more goods are produced or sold the higher the variable costs. They include raw material, packaging, sales, commission payments, piece rate pay.

Split into fixed and variable costs for Hungry Horace’s Pizza factory FIXED COSTS VARIABLE COSTS

Semi-Variable Costs Fixed and variable costs are convenient. However, not all costs are easily classified. Take a delivery vehicle operated by a local bakery. Many operating costs of this vehicle are fixed – Insurance, road licence. However, if demand raises sharply, transport costs will rise as the business increases it’s delivery. More fuel will be needed, more services, more mileage, wear and tear. In these circumstances we should say that this vehicle costs is semi-variable, i.e. part fixed part variable.

Total Costs When added together, fixed costs and variable costs (plus any semi-variable costs) give the total costs for a business. TVC + TFC = TC Easy to calculate but what does it mean?

Total Costs If a business has high fixed costs, then they would want to maximise sales to ensure they the fixed costs are spread across many units of output as possible.

Total cost: TVC + TFC = TC Managers need to know this to make decisions on how many to produce and the resources to do so. They can also use the total cost figure to calculate how much each individual product cost to make. Total cost per unit = Total cost Number of units produced

Why calculate costs of production? When starting a new business A forecast of profit or loss to be made Forecast breakeven Cash flow forecast to be drawn up so that financial planning is undertaken Pricing decisions to be made based on cost data

Why calculate costs of production? When business is up and running: Keeping a check of actual costs against the forecasted costs that were part of the original business plan (is the business exceeding these costs and why) Using cost information to help on pricing decisions Calculate whether costs are greater or less than revenue (is the business profitable)

Why do managers need to be aware of the costs of all aspects of their business? They need to know the costs of production to assess whether it is profitable to supply the market at the current price. They need to know actual costs to allow comparisons with their forecasted (or budgeted) costs of production. This will allow them to make judgements concerning the cost efficiency of various parts of their enterprise. They also need to know if they have sufficient finance to afford the expected costs.

Activity In pairs consider starting a takeaway sandwich shop. You have one full time employee (40 hours a week) Two part time employees (15 hours each) Make a list of all your start up costs (assume you rent) Make a list of all the running costs Assume your shop will take four months to get popular. Estimate the minimum amount of money you think you will need to raise to start the business.  In groups of four

Activity: Compare answers How easy do you think it is to plan the finance for this business? Why do you think planning is important to the success of a business?