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Types of costs
Types of costs, using examples (AO2)
Costs are the charges that an organization incurs from its operations. Examples of business costs include:
The purchase of raw materials and components for production
The purchase of stocks (inventory) of components or finished goods from suppliers
Rent for hiring the commercial premises or mortgage payments for financing land, premises and buildings
Insurance payments for public liability, buildings insurance and vehicle insurance
Salaries and wages paid to employees
Payment for utility bills for gas, electricity and telephone charges.
Costs are the charges that an organization incurs from its business operations
This section of the IB Business Management syllabus is common to SL and HL students, covering an understanding of the following types of cost, using examples (AO2):
fixed
variable
direct
indirect (overhead)
Teacher only boxNote to teachers:
The new guide has removed semi-variable costs from this section of the syllabus. Do watch out for this if/when using past examination questions with students.
Fixed costs of production do not change with the level of output. These costs that have to be paid irrespective of how much is produced or sold. Examples include: rent payments, insurance premiums on buildings, leasing costs of (hiring) machinery and equipment, and salaries to management.
Note that these costs can (and do) change over time, but the meaning of "fixed" cost is that they do not change with the level of production or output.
The fixed cost (FC) or sometimes referred to as the total fixed costs (TFC) line is shown diagrammatically as a horizontal line along the x-axis starting at the value of fixed costs on the y-axis.
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Total fixed costs (TFC) of $100,000 for a business, as shown by the y-axis intercept
Common error!
Too often, students write that “fixed costs are those that do not change” (or something similar). It is important to be aware that fixed costs can and do change, but the definition means these costs are not directly related to the level of production or the output of a business.
For example, rents can and do change over time, often due to rising demand or higher inflation (an increase in the economy's general price level). However, the change in fixed costs in not because of the firm’s output level. The same applies to salaries paid to managers, or insurance premiums paid to insurance companies.
Variable costs of production are items of a firm's expenditure that change with the level of output. These costs rise when the firm's output or sales volume increases. Examples of variable costs include: the cost of purchasing raw materials and components for production, commission paid to sales staff, and the wages paid to employees.
Diagrammatically, the total variable costs (TVC) line is shown using an upwards sloping linear line, which starts at the origin. This is because there are no variable costs that need to be paid if there is no output or production.
The total variable cost (TVC) curve for a business, which always starts at the original
When a firm's fixed costs are combined with its variable costs, the total cost of production can be determined. The average cost of production (used to determine the extent to which a firm experiences economies of scale) is calculated as the total cost divided by the units of output. Read more about total costs and average costs by clicking on the icon below.
Note that the following is useful for understanding break-even analysis (see Unit 5.5).
Total costs (TC)
The total cost of production (TC) is the aggregate amount of money spent on the output of a business.
Total costs are made up of total fixed costs (TFC) and total variable costs (TVC).
Hence, TC = TFC + TVC.
Diagrammatically, the total cost (TC) line is shown as an upwards sloping line which starts at the intercept of the total fixed cost (TFC) line. This shows that even if there is zero output, the firm still has to pay its fixed costs.
The total costs of a business are the sum of its variable costs and fixed costs
Average costs (AC)
Average cost (AC) refers to the cost per unit, i.e. AC = TC ÷ Q, where Q = quantity of output.
Average cost can also be calculated by adding the average fixed cost (AFC) to average variable cost (AVC), i.e. AC = AFC + AVC.
A decline in average cost as output rises shows the organization experiences economies of scale (see Unit 1.6).
A rise in average cost as output rises shows the organization experiences diseconomies of scale (see Unit 1.6).
Average fixed cost (AFC) will always fall when the level of output increases because total fixed cost (TFC) is spread over an increasingly larger level of output, so the AFC must fall.
Insurance payments are a direct cost for taxi drivers
Direct costs are the items of expenditure that can be evidently and explicitly associated with the output or sale of a certain good, service, or business operation. Direct costs (sometimes referred to as the cost of goods sold) may comprise of:
Variable costs, such as direct raw materials and direct labour costs, or
Fixed costs, such as third party motor insurance and depreciation costs for taxi drivers. Rent is another example of a direct cost if this fixed cost is for a production facility.
Common error!
Students often use direct costs and variable costs interchangeably. Although direct costs are typically variable costs, they can also include fixed costs. The examples above should show you why direct and variable costs are not necessarily the same.
Can you think of at least five direct costs associated with running the IB DP Business Management course?
Direct costs are items of expenditure attributed to the production or output of a good or service. To run a Business Management course, the following direct costs might be incurred:
Salaries paid to the BM teacher
Payment made to a teaching assistant
Lighting and power
Furniture and classroom facilities
Costs of textbooks and other learning resources
Stationery costs
Heating or air conditioning
Photocopying (worksheets, for example)
Note: Higher Level students need to be understand the role of cost centres and profit centres (see Unit 3.9 - Budgeting) in allocating direct costs of production.
Lighting is an indirect cost for many firms
Indirect costs (or overhead costs) are costs that are not easily identifiable with the sale or output of a specific good, service, department, or business operation. Examples of indirect costs for most businesses include:
Rent on premises
Salaries for administrative staff
Fees paid for legal and accounting services, as well as utility bills (gas, electricity, and water)
General insurance for third parties, fire, and theft
Costs involved with maintaining and running the organization.
Higher Level students need to be aware that indirect costs (overheads) are difficult or somewhat subjective to allocate to cost and profit centres (see Unit 3.9) and BMT 14 - Contribution (HL only).
ATL Activity - Classifying costs
Reflect on your understanding of different types of costs by identifying each of the following items as a:
fixed cost or
variable cost
Apply this to the context of a fast food business such as McDonald's or Subway.
Item of business expenditure (cost) | Type of cost |
Advertising costs | Fixed |
Capital equipment | Fixed |
Furniture, e.g. office tables and chairs | Fixed |
Ingredients | Variable |
Office supplies | Fixed |
Packaging (food wrapping) | Variable |
Rent (of commercial premises) | Fixed |
Salaries for managers | Fixed |
Utility bills (gas, water and electricity) | Variable (as these are direct) |
Wages for employees | Variable |
Exam Practice Question 1 - Snippets Hair Salon Co.
Snippets Hair Salon Co. has annual fixed costs of $1.2 million. The company has an annual output of 150,000 customers, with a variable cost per customer of $15. Calculate the total annual costs for Snippets Hair Salon Co. [2 marks]
Teacher only boxAnswer
Total costs (TC) is the sum of total fixed costs (TFC) and total variable costs (TVC)
TVC = Average variable cost (AVC) multiplied by the output level, i.e. $15 × 150,000 = $2,250,000.
Therefore, TC = $1,200,000 + $2,250,000 = $3,450,000
Award [1 mark] for the correct answer, and [1 mark] for showing appropriate working out.
Exam Practice Question 2 - Thompsons Farms
Thompsons Farms has annual fixed costs of $2 million. It has an annual output of 1,250,000 units, with variable cost per unit of $2. Calculate the total annual costs for Thompsons Farms. [2 marks]
Teacher only boxAnswer
Total costs (TC) is the sum of total fixed costs (TFC) and total variable costs (TVC)
TVC = Average variable cost (AVC) multiplied by the output level, i.e. $2 × 1.25m = $2.5m
Therefore, TC = $2m + $2.5m = $4.5 million
Award [1 mark] for the correct answer, and [1 mark] for showing appropriate working out.
Exam Practice Question 3 - MisTech Limited
MisTech Limited is a large manufacturer with monthly fixed costs of $1 million. It has an annual output of 150,000 units. The variable cost per unit is $150. Calculate the total annual cost for MisTech Limited. [2 marks]
Teacher only boxAnswer
• Total costs = Total fixed costs + Total variable costs
• TC = TFC + TVC = ($1m × 12) + ($150 × 150,000)
• TC = $12m + $22.5m = $34.5 million
Award [1 mark] for the correct answer, and [1 mark] for showing appropriate working out.
Exam Practice Question 4 - Gardeners’ Pots
Gardeners’ Pots has total costs of $2,000 and fixed costs of $1,100 for an output level of 600 units. Calculate the variable cost per unit for the firm. [2 marks]
Teacher only boxAnswer
• Variable cost per unit = Average variable cost (AVC)
• AVC = TVC / Q (where Q = Quantity of output)
• TVC = TC – TFC = $2,000 – $1,100 = $900
• AVC = $900 / 600 = $1.50
Award [1 mark] for the correct answer, and [1 mark] for showing appropriate working out.
Return to the Unit 3.3 - Costs and revenues homepage
Return to the Unit 3 - Finance & accounts homepage
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