Educerie · IB Diploma · Business Management
Unit 3 Finance and accounts · 3.3 Costs and revenues
What you must be able to do
| You must be able to | Level | What it looks like in the exam |
|---|---|---|
| Define fixed and variable costs, with examples from the case | SL, HL | "Define fixed costs" (2 marks); "Identify two variable costs for [the business]" (2 marks) |
| Define direct and indirect (overhead) costs, with examples | SL, HL | "Distinguish between direct and indirect costs" (4 marks) |
| Classify a cost both ways: fixed or variable, and direct or indirect | SL, HL | A list of costs from the stimulus to classify (1 mark each) |
| Calculate total cost, total revenue and profit from data | SL, HL | Paper 2: "Calculate the total cost of producing 4,000 units" (2 marks), then the profit (2 marks) |
| Explain total revenue and identify a business's revenue streams | SL, HL | "Describe two revenue streams for [the business]" (4 marks) |
| Evaluate a decision about costs or revenue streams | SL, HL | Section B: "Discuss whether [the business] should add a new revenue stream" (10 marks) |
Before you start
You need 3.1: revenue expenditure is what most costs are. You need the idea of output, the number of units a business produces or sells in a period, because fixed and variable costs are defined by how they behave as output changes. The arithmetic is multiplication and adding, and every cost and revenue must be for a stated period: a month, a year.
1The idea in one paragraph
A cost is what a business pays to produce and sell its output. Costs can be sorted in two separate ways. By how they behave: fixed costs stay the same whatever the output, variable costs rise and fall with it. By whose they are: direct costs can be traced to one product, indirect costs or overheads are shared by the whole business. On the other side, total revenue is the money coming in from sales, price times quantity, and most businesses earn it from more than one revenue stream. Profit is total revenue minus total cost, so every decision a business makes about price, output or cost-cutting runs through these few ideas.
2Fixed costs
Fixed costs are costs that do not change with the level of output in the short run. They must be paid even if the business produces nothing.
Follow an invented business. Ondine Bakery bakes sourdough loaves for cafés and shops. Every month, before a single loaf is baked, it owes:
| Fixed cost | € per month |
|---|---|
| Rent of the bakery | 3,900 |
| Lease on the oven | 1,400 |
| Manager's salary | 3,000 |
| Insurance and accounting software | 450 |
| Interest on a bank loan | 250 |
| Total fixed costs | 9,000 |
Whether Ondine bakes 500 loaves or 5,000, the rent is the same. That is what "fixed" means. Figure 1 panel (a) draws it: a horizontal line.
Two warnings about the word.
Fixed does not mean it never changes. The landlord can raise the rent next year, and the manager can get a pay rise. Fixed means it does not change because of output. When it changes for another reason, the whole horizontal line moves up or down.
Fixed only holds in the short run and over a range of output. If Ondine wanted to bake 20,000 loaves it would need a second oven and a bigger building, and its fixed costs would jump. Over the output it can actually produce now, they stay put.
3Variable costs
Variable costs are costs that change directly with the level of output. Produce nothing and they are zero; produce twice as much and they roughly double.
For Ondine, every loaf needs flour, salt, water and starter (€0.75), a paper bag and label (€0.15) and the energy to bake it (€0.30). So the variable cost per unit, also called average variable cost, is €1.20 a loaf.
Figure 1 panel (b) draws it: a straight line from the origin, rising €1.20 for every loaf. Other common variable costs are raw materials and components, packaging, piece-rate wages (paid per item made), sales commission, and delivery charged per parcel.
Some costs are partly both. A phone contract with a fixed monthly charge plus a charge per call, or an electricity bill with a standing charge plus a charge per unit used, is a semi-variable cost. In an exam, split it into its fixed and variable parts if the data let you, and say so.
4Total cost, and why cost per unit falls
Total cost = total fixed costs + total variable costs
Figure 2 builds total cost for Ondine. The line starts at €9,000, not at zero, because fixed costs are paid before the first loaf. Then it rises by €1.20 a loaf.
Now divide total cost by output to get average cost, the cost of each unit.
| Loaves a month | Fixed costs (€) | Variable costs (€) | Total cost (€) | Average cost (€ per loaf) |
|---|---|---|---|---|
| 1,000 | 9,000 | 1,200 | 10,200 | 10.20 |
| 2,000 | 9,000 | 2,400 | 11,400 | 5.70 |
| 3,000 | 9,000 | 3,600 | 12,600 | 4.20 |
| 4,000 | 9,000 | 4,800 | 13,800 | 3.45 |
| 5,000 | 9,000 | 6,000 | 15,000 | 3.00 |
Average cost falls steeply at first and then more slowly. Figure 3 shows why: the variable part of each loaf stays at €1.20, but the €9,000 of fixed costs is shared over more and more loaves.
This is one of the most useful ideas in the course. It is why businesses with high fixed costs chase volume, why a half-empty hotel or aircraft is a problem even if every guest pays full price, and why a new business with few customers struggles to match an established rival on price. It is also the start of break-even analysis in 5.5.
5Direct and indirect costs
The second way to sort costs asks a different question: not how the cost behaves, but whose it is.
A direct cost can be traced to, and charged to, one particular product, service or department. An indirect cost (an overhead) is shared by several products or the whole business and cannot be traced to any one of them.
Ondine has started making pastries as well as loaves. Now look at its costs again.
- The flour in a loaf is a direct cost of loaves. The butter in a croissant is a direct cost of pastries.
- Ondine has hired a part-time pastry chef on a fixed monthly wage, who works only on pastries. Her wage is a direct cost of pastries, even though it is fixed.
- The rent, the manager's salary, the insurance and the oven (which bakes both) are indirect costs. They serve the whole bakery. There is no honest way to say how much of the rent belongs to one croissant.
Here is the point students miss. Fixed and variable is one question; direct and indirect is another. A cost can be fixed and direct (the pastry chef), fixed and indirect (the rent), variable and direct (the flour), or variable and indirect (card-payment fees charged on all sales together). Figure 4 puts the four boxes side by side.
Most direct costs are variable and most overheads are fixed, which is why students assume the two pairs mean the same thing. They do not, and an exam question that asks you to classify a cost as direct or indirect is not asking whether it changes with output.
Why the difference matters: a worked example. In one month Ondine's figures are:
| € per month | Loaves | Pastries | Whole bakery |
|---|---|---|---|
| Revenue | 16,000 | 7,500 | 23,500 |
| Direct costs | 4,800 | 4,700 | 9,500 |
| Revenue minus direct costs | 11,200 | 2,800 | 14,000 |
| Indirect costs (overheads) | 9,000 | ||
| Profit | 5,000 |
The pastry direct costs are ingredients and packaging (€2,100) plus the pastry chef (€2,600). The accountant then shares the €9,000 of overheads equally between the two lines, €4,500 each, because each uses half the bakery.
The owner is tempted to stop making pastries. Work out what would actually happen.
The pastries' direct costs disappear, but the €9,000 of overheads does not: the rent is still due. Pastries were bringing in €2,800 more than their own direct costs, and that €2,800 was helping to pay the rent. The "loss" came from the way the overheads were shared, not from the pastries. Dropping a product only saves its direct costs. Overheads stay behind and fall on whatever is left. (HL students meet this idea again, with its proper name, as contribution in the business management toolkit.)
The lesson for evaluation: any figure for the profit of one product depends on how overheads were shared out, and there is no single correct way to share them. Treat such figures with care.
6Total revenue and revenue streams
Total revenue is the money a business receives from selling its output in a period: price × quantity sold, added up across everything it sells.
For Ondine selling 4,000 loaves at €4.00:
Revenue is not profit. Ondine takes in €16,000 but keeps €2,200. A business can grow its revenue fast and still lose money, if its costs grow faster.
When a business sells several products, total revenue is the sum of each one's price times quantity. Ondine's €23,500 in the table above is €16,000 from loaves plus €7,500 from 3,000 pastries at €2.50.
A revenue stream is a distinct source of revenue: a separate way the business earns money from its customers or others. Many businesses have several. Common types:
- Sales of goods, the obvious one: loaves, cars, phones.
- Fees for services: a haircut, a repair, a consultation.
- Subscriptions: a regular payment for continued access, such as a streaming service, a gym, or Ondine's weekly bread delivery for cafés.
- Advertising: selling the attention of an audience, the main stream for most free apps and websites.
- Commission: a percentage of a sale the business arranges for someone else, as an estate agent or a booking platform earns.
- Licensing and royalties: letting others use a brand, a patent or a copyright for a fee.
- Franchise fees: payments from franchisees for the right to trade under the brand.
- Rental or hire income: renting out space or equipment the business owns.
- Sponsorship: payments from another organisation to be associated with the business or its events.
- Donations and grants, for non-profit organisations and social enterprises.
Worked example. Lantern Hall (invented) is a live music venue. Its revenue for one year was €1.3 million from five streams. Figure 5 shows them.
Presenting revenue streams as a bar or pie chart of shares is the descriptive statistics tool from the toolkit at work, and a Paper 2 question may hand you such a chart and ask what it shows.
Why businesses add revenue streams.
- To spread risk. If ticket sales fall in a bad year, the bar, room hire and sponsorship still bring money in. A business with one stream has one point of failure.
- To use spare capacity. Lantern Hall's building stands empty on weekday daytimes; hiring it out for conferences earns revenue from an asset whose fixed costs are already paid, which also lowers the average cost per event (section 4).
- To earn more from customers already there. A concert-goer who buys a drink and a T-shirt is worth more than the ticket alone.
Why it can go wrong. A new stream needs management time and may have costs of its own; it can distract from the core business; and a badly chosen one can damage the brand (a family venue selling heavy alcohol promotions, a quality newspaper filled with low-quality advertising). A good answer weighs the extra revenue against these, and asks whether the new stream's revenue covers its own extra costs.
7Where marks are lost
Saying fixed costs never change. They do not change with output. A rent rise is still a change in fixed costs; it moves the whole line.
Treating direct and variable as the same thing. A pastry chef on a fixed wage who works only on pastries is a fixed direct cost. Answer the question you are asked: behaviour or traceability.
Starting total cost at zero. On a graph or in a table, total cost at zero output equals fixed costs, not zero.
Confusing revenue with profit. Revenue is what comes in from sales. Profit is what is left after costs. "Revenue rose, so the business is doing well" is not a conclusion.
Dropping a product because its share of overheads makes it look unprofitable. Closing it removes only its direct costs. The overheads remain and fall on the rest, so profit can fall.
Missing the time period. Costs and revenues are per month or per year. A total that mixes a monthly rent with an annual salary is wrong, and a calculation with no period stated is incomplete.
Listing revenue streams without applying them. "Advertising, subscriptions, sponsorship" scores little. Say which the business in the case has, or could have, and why.
8Write it right
- Define with the test: fixed and variable by how the cost behaves as output changes; direct and indirect by whether it can be traced to one product.
- Classify with a reason from the case: "rent is fixed and indirect, because the bakery pays it whatever it bakes and it serves both product lines".
- Write the formula, then substitute, then the answer with units and period: "TC = FC + VC = 9,000 + 4,800 = €13,800 a month".
- Show every step of a calculation. Method marks are awarded even when the final figure slips.
- When a product "makes a loss", ask what happens to the overheads if it is dropped, and show the numbers.
- For revenue streams, name the stream, say how it earns money, and tie it to the business.
- In an extended response, weigh extra revenue against extra costs and risk, then judge.
9Try it
Marks in brackets. Answers and marker's notes are at the end.
Print Pals (an invented business) prints custom T-shirts and caps from a rented unit and sells them online.
Q1. Define indirect costs. 2 marks
Q2. Classify each of Print Pals' costs as fixed or variable, and as direct or indirect: (a) blank T-shirts; (b) rent of the print unit; (c) the monthly lease of an embroidery machine used only for the cap range; (d) card-payment fees charged on all online sales. 4 marks
Q3. Print Pals' fixed costs are €6,400 a month. The variable cost of printing a T-shirt is €5.50 and the selling price is €14. In one month it sells 1,000 T-shirts.
(a) Calculate Print Pals' total cost for the month. 2 marks
(b) Calculate its total revenue and profit for the month. 2 marks
Q4. Print Pals' cap range earns revenue of €3,000 a month, has direct costs of €2,200 a month, and is charged €1,200 a month as its share of overheads. The owner wants to close it because "it loses €400 a month". Explain, with calculations, why closing the cap range would reduce Print Pals' profit. 4 marks
Q5. Lantern Hall (Figure 5) stands empty on weekday daytimes. The manager proposes turning the main hall into a co-working space from 9 a.m. to 5 p.m., Monday to Friday, charging freelancers a monthly membership. She estimates membership revenue of €60,000 a year, against extra costs of €22,000 a year for a daytime supervisor, €8,000 a year for cleaning and energy, and €15,000 once for desks and Wi-Fi. Discuss whether Lantern Hall should add this revenue stream. 10 marks
Plan for Q5 before you write: (1) what a revenue stream is, and that this one uses spare capacity; (2) the numbers: extra revenue against extra yearly costs, and the one-off cost; (3) the case for: risk spread, fixed costs of the building already paid, possible bar sales; (4) the case against: the estimate is uncertain, clashes with evening set-up, brand fit, management time; (5) a judgement with the condition that would change it, and the limits of the data.
10In one breath
A cost is what a business pays to produce and sell. Fixed costs, like rent and salaries, do not change with output in the short run; variable costs, like materials and packaging, rise with every unit, so total variable cost is cost per unit times output. Total cost is fixed plus variable, so it starts at the fixed costs when output is zero, and average cost falls as output rises because the fixed costs are spread over more units. Separately, a direct cost can be traced to one product, while an indirect cost or overhead is shared; the two classifications are independent, so a cost can be fixed and direct or variable and indirect. Dropping a product saves only its direct costs, because overheads stay. Total revenue is price times quantity across everything sold; it is not profit, which is total revenue minus total cost. Most businesses earn from several revenue streams, such as sales, subscriptions, advertising, commission, licensing, hire and sponsorship, which spread risk and use spare capacity but bring costs and distractions of their own.
Answers
Q1. Indirect costs (overheads) are costs that are shared by the whole business or by several products and cannot be traced to any single product or service, such as rent or the salaries of administrative staff. 1 for shared across the business or several products, 1 for cannot be traced to one product. An example alone scores 0.
Q2. (a) Blank T-shirts: variable and direct, because one is used for each T-shirt printed. (b) Rent: fixed and indirect, because it is the same whatever the output and serves the whole business. (c) Embroidery machine lease: fixed and direct, because the payment does not change with output but the machine is used only for caps. (d) Card-payment fees: variable and indirect, because they rise with sales but are charged on all products together. 1 for each item with both classifications correct. One classification right out of two scores 0 for that item.
Q3. (a)
(b)
[(a) 2: 1 for correct working, 1 for €11,900. (b) 2: 1 for total revenue of €14,000, 1 for profit of €2,100. Accept an own-figure profit from an incorrect total cost in (a). Missing € signs or period: 1 mark lost once only.]
Q4. The cap range's revenue minus its direct costs is 3,000 − 2,200 = €800 a month. The €1,200 of overheads is shared, not caused by caps: rent and other overheads would still be paid if caps stopped. So closing the range removes €3,000 of revenue and €2,200 of direct costs, and profit falls by €800 a month. The apparent €400 loss (800 − 1,200) comes only from how the overheads were shared out; the caps were contributing €800 a month towards overheads that the T-shirts would now have to cover alone. 1 for €800, 1 for explaining that overheads remain if the range closes, 1 for concluding profit falls by €800, 1 for explaining where the €400 "loss" comes from. A conclusion without calculations is capped at 2.
Q5. A top-band answer does the following. It identifies the stream as rental income (membership fees) that uses spare capacity: the hall's rent, insurance and building costs are already paid, so the new stream only has to cover its own extra costs. It uses the numbers: extra yearly revenue of €60,000 against extra yearly costs of €22,000 + €8,000 = €30,000 leaves €30,000 a year, which repays the €15,000 set-up cost in about six months, and adds a stream worth roughly 4.6% of current revenue (60,000 ÷ 1,300,000). It argues for: risk spread across a sixth stream that does not depend on the music calendar; possible extra bar and café sales to members; a daytime presence that may win new customers for evening shows. It argues against: €60,000 is an estimate with no evidence of demand, and if membership is half the estimate the stream makes almost nothing (30,000 − 30,000 = 0); desks must be cleared before evening set-up every day, which may raise costs or damage the hall's main business; a co-working space may not fit a music venue's brand; managers' time is limited. It judges, for example: add the stream, but as a low-cost trial with a minimum membership target, because the downside is small once the €15,000 is spent and the building is otherwise idle. It notes limits: no market research on local demand, no figure for the cost of daily set-up and clearing, and no view from the evening staff. markbands. Explaining revenue streams in general stays in 3–4. A one-sided case with some numbers reaches 5–6. Balanced arguments applied to Lantern Hall with a judgement reach 7–8. The 9–10 band needs the numbers used in the argument, both sides weighed, a justified judgement with a condition, and a comment on the limits of the data.
Educerie · written from the published IB Diploma Programme Business Management guide, first assessment 2024, section 3.3 Costs and revenues. Original text, examples and questions. Diagrams drawn by Educerie. Last reviewed 25 September 2026.