Fixed costs
These do not change simply because output rises or falls within the existing scale of operation. Examples include rent, many management salaries and interest payments.
Exam point: at zero output, a business can still have fixed costs.
Cambridge International AS & A Level Business · 9609 · AS Level
5.4 Costs
Cost information helps managers price products, judge profitability, compare alternatives and decide whether extra orders or new projects are worthwhile. This topic also develops contribution and break-even analysis, two of the most important calculation areas in AS Business.
Exam-focusedComplete Topic 5.4Calculations + diagramsInteractive questions
What you need to know
You should be able to classify costs correctly, calculate and interpret total, average, marginal and contribution figures, compare full costing with contribution costing, use cost information in decisions, and calculate and interpret break-even output and margin of safety.
High-grade habit: show the calculation, interpret what the figure means for the business, and then evaluate whether the figure is reliable enough to support the decision.
Subtopics
These follow the textbook table of contents. Select one to jump directly to it.
5.4.1
Cost information
A cost is an expense a business incurs while operating. Revenue is the income earned from selling goods or services. Managers compare revenue with cost to judge whether the business, product or decision is financially worthwhile.
Total revenueQuantity sold × average selling price
Profit (or loss)Total revenue − total costs
If total revenue is greater than total costs, the business makes a profit. If total revenue is lower than total costs, it makes a loss. If they are equal, the business is at break-even.
Why accurate cost information matters
Start-up decisionsManagers need realistic cost estimates before deciding whether a business idea is viable.
ExpansionExpected extra revenue must be compared with the additional costs of expansion.
PricingCost information helps managers set prices that can cover costs and contribute to profit.
Special ordersManagers need to know the extra cost of an unusual order before accepting it.
Waste controlUnexpected cost increases may reveal inefficiency, waste or weak control.
Profit measurementWithout accurate costs, profit figures and comparisons between products may be misleading.
Fixed and variable costs
Variable costs
These change with the level of output. More production normally requires more raw materials, components, energy and other variable inputs.
Exam point: total variable cost rises with output, although the variable cost per unit may fall if bulk purchasing reduces input prices.
Total costs = total fixed costs + total variable costs
Worked example: a firm has fixed costs of $80,000 and variable costs of $12 per unit. At an output of 5,000 units, variable costs are $60,000 and total costs are $140,000.
Direct and indirect costs
Costs can also be classified according to whether they can be linked directly to a particular product.
Direct costs
Costs that can be identified with the production of a particular product. Examples include direct materials and direct labour used for that product. They are normally variable, although not every direct cost must be variable.
Indirect costs / overheads
Costs that relate to the business as a whole and cannot easily be allocated to one product. Examples include administration, management and some marketing costs. The textbook treats these as fixed overheads.
Common error: fixed/variable and direct/indirect are two different ways of classifying cost. Do not assume the terms are interchangeable.
5.4.2
Approaches to costing
Businesses with several products face a problem: how should overheads that support the whole business be divided between individual products? Two important approaches are full costing and contribution costing.
Full costing
All production costs are allocated to products. Direct costs are traced to the product and a share of indirect costs is then apportioned to it.
Unit full cost = (direct costs + allocated indirect costs) ÷ units produced.
Contribution costing
The product is assessed using its variable costs rather than trying to allocate fixed overheads. The contribution generated is used first to cover fixed costs; any remaining contribution becomes profit.
Full costing and allocating overheads
A business may apportion indirect costs using a basis such as floor space, number of employees, sales revenue or direct costs. The difficulty is that each basis can produce a different apparent profit for a product or division.
Allocation example: total factory overheads are $500,000. Product A uses 60% of the relevant floor space, so allocating overheads by floor space would charge Product A $300,000. A different basis could produce a different figure.
| Full costing: uses | Full costing: limitations |
|---|---|
| Considers all costs before pricing or judging profitability. | Allocating overheads between products can be subjective. |
| Widely used for financial reporting and internal costing. | A product may look unprofitable only because of the allocation method chosen. |
| Encourages managers to think carefully about overhead use. | If actual sales differ from forecasts, overhead cost per unit may differ from the original estimate. |
| Can compare divisions when a consistent allocation method is used. | Stopping an apparently loss-making product may not remove the fixed costs allocated to it. |
Contribution costing
Total contributionSales revenue − total variable costs
Contribution per unitSelling price per unit − variable cost per unit
ProfitTotal contribution − fixed costs
Break-even ideaContribution first pays fixed costs; the remainder is profit
Contribution example: a product sells for $50 and has variable cost of $32. Contribution per unit is $18. If 4,000 units are sold, total contribution is $72,000. With fixed costs of $50,000, profit is $22,000.
Limitations of contribution costing
- Some costs are semi-variable. They contain both fixed and variable elements, making classification difficult.
- Fixed costs may change. A large increase in output can require more premises, supervision, marketing or systems, so fixed costs are not always constant.
- It does not allocate fixed costs to individual products. This can be useful for decisions, but it does not provide a full cost per unit.
- It may not be accepted for all external reporting or tax purposes. Businesses may still need full-cost figures.
Key distinction: contribution is not profit. Contribution is what remains after variable costs; profit remains only after fixed costs have also been covered.
5.4.3
Uses of cost information
Average, marginal and total costs
Average costTotal cost ÷ output
Marginal costExtra cost of producing one additional unit
Total costFixed costs + variable costs
ProfitTotal revenue − total cost
Average cost is also called unit cost. It often falls as output increases because fixed costs are spread over more units. Marginal cost is the extra cost caused by one additional unit and, in many situations, is close to that unit's variable cost because fixed costs are unchanged.
Average-cost example: if total cost is $960,000 at an output of 5,000 units, average cost is $192 per unit. If the next unit adds $75 to total cost, its marginal cost is $75.
Cost-plus pricing
Under cost-plus pricing, a business calculates average cost and adds a mark-up for profit. It is straightforward and ensures the price is above calculated cost if sales occur as expected. However, the method may ignore competitor prices and customers' willingness to pay.
Pricing example: average cost is $125 and the business adds a $25 mark-up. Selling price = $150. This does not guarantee strong sales because customers may consider $150 too expensive.
Contribution pricing
Contribution pricing focuses on whether the selling price exceeds the variable cost. A price below the normal selling price can still be worthwhile if it makes a positive contribution and does not create extra fixed costs. This approach is especially useful when spare capacity exists.
Calculating and comparing profits
Managers combine cost information with expected revenue to estimate profits at different output levels. The highest output does not automatically produce the highest profit: selling more may require lower prices or create higher variable costs.
Forecast output and priceEstimate the revenue achievable at each output.
→Calculate total costsInclude fixed and variable costs for the same output.
→Compare profitRevenue − total cost, then consider uncertainty.
Special-order decisions
A special order is an unusual customer order, often involving a large quantity, a lower-than-normal price, a different specification or a faster delivery requirement. Contribution costing can help decide whether the order is worth accepting.
1Calculate extra revenue
Use the special-order price and quantity.
2Calculate extra variable cost
Include materials, labour, overtime and any special requirements.
3Check capacity and fixed costs
Spare capacity matters. Extra premises or equipment can change the decision.
4Consider qualitative factors
Brand image, future orders, existing customers and strategic objectives may matter.
Special-order example: normal price = $40, variable cost = $30, special-order price = $32 for 5,000 units. If spare capacity exists and no extra fixed costs arise, contribution = $2 per unit = $10,000. The order may therefore raise profit by $10,000. But this conclusion changes if overtime, extra rent or other costs are required.
Why a positive contribution may still not mean “accept”
- The order might require extra fixed costs or expensive overtime.
- Existing customers may discover the lower price and demand similar terms.
- The buyer might resell the product and undercut the normal market.
- A lower selling price could damage a premium brand image.
- The order could use capacity needed for more profitable regular customers.
- On the other hand, a special order may open a new market, build awareness or lead to repeat business.
Evaluation: use the contribution calculation as the starting point, not the final answer. Then judge capacity, extra fixed costs, future business, customer relationships and brand effects.
5.4.4
Break-even analysis
Break-even output is the level of output at which total revenue exactly equals total cost. At this point, the business makes neither profit nor loss.
Why managers use break-even analysis
Test viabilityEstimate whether expected sales are above the break-even output.
Set sales targetsIdentify the minimum output required before profit begins.
Support finance applicationsShow lenders how many sales are needed to cover costs.
Compare scenariosSee how price or cost changes alter the break-even point.
Assess expansionEstimate whether a new product or market can cover its costs.
Measure riskMargin of safety shows how far sales can fall before a loss begins.
Calculating break-even output
Break-even outputFixed costs ÷ contribution per unit
Contribution per unitSelling price − variable cost per unit
Worked example: selling price = $60, variable cost = $35 and fixed costs = $10,000. Contribution per unit = $25. Break-even output = $10,000 ÷ $25 = 400 units.
Understanding a break-even chart
A standard break-even chart plots output on the horizontal axis and costs/revenue on the vertical axis. Fixed costs begin above zero because they exist even when nothing is produced. Total cost begins at the fixed-cost level and rises with output. Revenue begins at the origin because zero sales generate zero revenue. The point where total cost and revenue cross is break-even.
Fixed costsTotal costsRevenue
To the left of the break-even point, total costs exceed revenue, so the business makes a loss. To the right, revenue exceeds total costs, so the business makes a profit. The vertical gap between the revenue and total-cost lines shows the size of the profit or loss at a particular output.
Margin of safety
The margin of safety measures how far current sales are above break-even. A large margin gives more protection against a fall in demand.
Margin of safety (units)Current sales − break-even output
Margin of safety (%)(Current sales − break-even output) ÷ current sales × 100
Example: current sales = 600 units and break-even = 400 units. Margin of safety = 200 units. Percentage margin of safety = 200 ÷ 600 × 100 = 33.3%.
Effects of changes
| Change | Likely effect on break-even output | Reason |
|---|---|---|
| Selling price rises | Falls | Contribution per unit rises, assuming demand remains sufficient. |
| Variable cost per unit rises | Rises | Contribution per unit falls. |
| Fixed costs rise | Rises | More total contribution is needed to cover fixed costs. |
| Fixed costs fall | Falls | Less contribution is needed before profit begins. |
Uses and limitations of break-even analysis
Uses
- Simple and quick to calculate.
- Useful for start-ups and new-product decisions.
- Shows the output needed to cover costs.
- Can compare alternative prices and cost structures.
- Helps forecast profit/loss at different sales levels.
- Can support a loan application.
Limitations
- Assumes all output is sold.
- Assumes a constant selling price.
- Assumes costs behave predictably and can be separated accurately.
- Is harder to use for multi-product businesses.
- Does not itself forecast whether customers will actually buy the required volume.
- Results are only as reliable as the cost, price and sales data used.
Evaluation: break-even is a useful planning guide, but it should be combined with market research and qualitative judgement. A low break-even output is not valuable if the underlying sales forecast is unrealistic.
5.4 revision checklist
Define costs and revenue.
Calculate total revenue and profit/loss.
Explain why accurate cost information matters.
Distinguish fixed and variable costs.
Calculate total costs.
Distinguish direct and indirect costs.
Explain full/absorption costing.
Explain how overheads can be allocated.
Evaluate the limitations of full costing.
Calculate total contribution.
Calculate contribution per unit.
Distinguish contribution from profit.
Evaluate contribution costing.
Calculate average cost.
Explain marginal cost.
Explain cost-plus pricing.
Explain contribution pricing.
Use cost and revenue data to calculate profit.
Apply contribution to special-order decisions.
Evaluate qualitative factors in special orders.
Define break-even output.
Calculate break-even output.
Interpret a break-even chart.
Calculate margin of safety in units and percentage.
Explain how price and cost changes affect break-even.
Evaluate the uses and limitations of break-even analysis.
Questions open in a pop-up. Each answer is marked immediately, with an explanation so you know why it is correct or incorrect.