Costs are described as fixed or variable.
- Fixed costs are incurred and have to be paid regardless of the volume produced and sold. They are the costs of running a business such as heating, lighting, rent, insurance, marketing and so on.
- In contrast, variable costs are directly related to the job and so change with the level of output. The best example of a direct cost is the raw materials that go into making a product.
Fixed costs plus variable costs are known as total costs:
Figure 1: Illustration of Fixed and Variable Costs.
This is the total amount of money coming in to a business from sales of goods or services. It is a ‘top-line’ figure that excludes deductions of tax, interest and dividend payments. It also usually excludes discounts for early payments and customer returns.
This is often referred to as the ‘bottom-line’ and is the result of subtracting costs from total revenue. It can be expressed as gross profit which is revenue minus the variable cost of goods. It can also be expressed as net profit which also takes off the relevant amount for fixed costs, tax and so on. Profit is perhaps the most important indicator of how well a business doing.
Various calculations, or ratios, can be used to analyse the relationship between costs, revenue and profit. One would be the profit margin. This is found by dividing the profit figure into the revenue figure and allows you to see how well the company controls its costs to turn revenue into profit.
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