3.3 Costs and revenues

Full video class on YouTube, summary and notes on Instagram, class extracts on TikTok, text below. Have fun!

The main point of this class is to categorise all costs into two groups and understand where income comes from, in addition to product sales.

Costs refer to the amount that has to be spent on purchasing the resources that are necessary to produce or sell a product. There are two categories of costs:

1. Variable and fixed costs
2. Direct and indirect costs (overheads)

Fixed costs are costs that a business has to pay regardless of how much it produces or sells (rent, interest, advertising, salaries, security, etc). For example, regardless of how many haircuts the barbershop provides each moth, the internet fee remains the same. Very often students think that fixed costs can’t change. It is not true! They can change, but the main point is that the change is not caused by increased/decreased output/production. For example, if the internet provider decides to raise the internet fee, then this fixed cost will change, but it has nothing to do with how many haircuts the barbershop gives.

Variable costs are costs that change in proportion to the level of output (raw materials, piece-rate wages, etc). For example, the more haircuts the barbershop gives, the more shampoo it’ll spend on washing customers’ hair. Thus, shampoo would be a variable cost. If you say “the difference between fixed and variable costs is that fixed costs don’t change, but variable costs change” then you’re wrong. Again, it’s not about “change or don’t change”, it about “change or don’t change relative to output”.

So, to cut long story short, fixed costs do not relate to the output, while variable costs relate to output. Both fixed and variable costs can change. The difference is in what causes the change in costs.

Direct costs relate specifically to a particular project or product (consultancy costs, mortgage fees, etc). If we continue the barbershop example, then shampoo would be a direct cost, because you can directly connect the cost of shampoo to the number of customers and haircuts. Internet fee, however, would be an indirect cost, because it’s impossible to say how much internet is spent per haircut, because these two variables are completely unrelated.

Indirect costs (overheads) are costs that cannot be traced to any particular product (rent, advertising). In addition to internet fee for a barbershop, rent could be another example of an indirect cost. Rent is paid monthly, regardless of how many haircuts barbershop gives and regardless of the type of haircut (hair, beard, hair plus beard). Since it’s impossible to connect rent and internet fee with any type of haircut offered by the barbershop, they are overheads.

Very often indirect costs (overheads) are fixed and direct costs are variable (for instance, in the barbershop example above), but it is not always like this. Keep in mind that fixed & variable and direct & indirect costs are two different categories that do not have to overlap.

Revenue is money/income that comes from product sales. Product sales refer to sales of goods and/or services that an organisation provides. Revenue is synonymous to turnover but not synonymous to profit. Profit = Revenue – Costs, while (Total) Revenue (TR) = Price (P) x Quantity (Q). Average revenue (AR) is the same as price, mathematically. Having said that, equations below should make sense to you now:

TR = P x Q

AR = TR ÷ Q

P = TR ÷ Q, thus P = AR

There are other means to get income, in addition to the main trading activity of selling goods and/or services. These means are called revenue streams. Some examples of revenue streams are explained below.

Dividends: organisations, just like individuals, can have shares of different companies and get interest payments. For example, Microsoft owns some Apple shares, and Porsche is the majority shareholder of Volkswagen.

Interest on deposits: another thing that organisations can do in the same way as individuals is depositing money in a bank account and getting interest earnings.

Merchandise: in addition to the main trading activity, some organisations sell their souvenirs or clothes to get extra revenues. For example, Disney, in addition to making movies, sells its merchandise (toys and clothes) to fans.

Donations: this is usually one of the main revenue streams for popular streamers on Steam and YouTube. In addition, it is one of the main revenue streams for charities.

Sponsorship deals: the way it usually works is sponsor gives you financial support in exchange for an extra advertising space and publicity. For example, Emirates airlines sponsor FC Arsenal and Arsenal players have Emirates logo on their uniforms.

Advertising revenue: this is when an organisation is offering advertising space and charges other organisations for posting ads in this space. For example, Telegram and YouTube show ads to users who have free subscription.

Subscription: there are many kinds of subscriptions nowadays and it becomes a really popular revenue stream for more and more companies. For example, Apple offer iCloud storage space in exchange for a monthly fee.

Royalties: royalty payments are made to artists for the use of their artworks (for example, if you want to use someone’s song in your film) or to franchisors for the use of franchise. Either way, royalties are payments for the use of intellectual property.

Rental income: some organisations own property that they rent out. You might be surprised but one of the main revenue streams for McDonalds is renting out its property to franchisees.

Make sure you can define all of these:

1. Costs
2. Fixed costs
3. Variable costs
4. Direct costs
5. Indirect costs (overheads)
6. Revenue
7. Revenue streams
8. Dividends (revenue stream)
9. Interest on deposits (revenue stream)
10. Merchandise (revenue stream)
11. Donations (revenue stream)
12. Sponsorship deals (revenue stream)
13. Advertising commission (revenue stream)
14. Subscription (revenue stream)
15. Royalties (revenue stream)
16. Rental income (revenue stream)