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Unit 2 Learning Aim A

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Understand the costs involved in business and how businesses make a profit

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Types of Costs

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Start-up Costs:

#Examples include purchasing machinery, paying for licenses, or decorating a shop. For instance, opening a bakery might involve buying ovens, mixers, and ingredients.

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Fixed Costs:

Rent, insurance, and salaries. These remain constant regardless of how many products you sell. E.g., a restaurant will pay the same rent whether it serves 50 or 200 customers a night.

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Operating Costs:

These are the day-to-day costs, such as wages, utilities, and rent. For example, a café needs to pay for staff, electricity for coffee machines, and rent for the premises.

Variable Costs:

Ingredients, packaging, and electricity used for production. These increase with higher sales volumes. E.g., a bakery will buy more flour if it plans to bake more cakes.

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Activity

What costs are involved setting up and running a sandwich shop. List these.

Divide your list of running costs for the sandwich shop into fixed and variable costs
Use the formula to calculate total costs of the business for a year if the fixed costs are £1000 and the total variable cost per month is £200
If food prices suddenly increase sugguest two possible actions the owners could take

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Total Cost

Total Cost (TC) refers to the complete sum of all costs a business incurs to produce and sell goods or services. It is essential for businesses to understand total costs as it helps determine profitability, pricing strategy, and the financial health of the business.

The total cost is composed of two primary elements:

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Fixed Costs (FC):

These are costs that remain constant regardless of the level of production or sales. Examples include rent, salaries, and insurance. These costs do not change with the number of goods or services produced.

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Variable Costs (VC):

These are costs that fluctuate depending on the production level. Examples include raw materials, utilities used in production, and packaging. The more products a business produces, the higher the variable costs.

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Formula for Total Cost:

Total Cost (TC) = Fixed Costs (FC) + Variable Costs (VC)

Example:

If a small café has fixed costs of £1,000 per month (rent, insurance) and variable costs of £2 per coffee sold (ingredients, utilities), and it sells 500 coffees in a month, the total cost will be:

TC = £1,000 (FC) + £2 (VC per coffee) × 500 (coffees)

TC = £1,000 + £1,000 = £2,000

So, the total cost for the month would be £2,000.

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How Businesses Make a Profit

The total income a business earns from selling its goods or services over a certain period. It is one of the most important financial metrics for any business, as it represents the inflow of funds into the company from its primary operations.

In simple terms, revenue is the money a business makes from its normal business activities, typically from the sale of goods or services to customers.

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Revenue

Formula for Revenue:

Revenue=Selling Price per Unit×Number of Units Sold

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Types of Revenue:

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Sales Revenue:

This is the income earned from the sale of goods or services. For example, if a bakery sells 200 cakes at £5 each, the sales revenue is:

Revenue = 200 × 5 = £1,000

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Service Revenue:

For businesses that offer services instead of physical products, revenue comes from the services provided. For example, a consulting firm that charges £100 per hour and works 20 hours in a week would have service revenue of:

Revenue = 100 × 20 = £2,000

Recurring Revenue:

Some businesses, particularly subscription-based models, earn recurring revenue. For example, if a gym charges £30 per month and has 50 members, the monthly revenue would be:

Revenue = 50 × 30 = £1,500

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Importance of Revenue

Revenue is critical for businesses as it determines how much money is coming into the business from normal operations. A higher revenue figure generally indicates that the business is selling more products or services, which could lead to profitability. Without sufficient revenue, a business may struggle to cover its costs and make a profit.

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Factors Affecting Revenue

Several factors can influence a business’s revenue, such as:

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Price of the Product or Service:

Increasing or decreasing the price can directly affect revenue. If the price is too high, it may reduce the number of customers, while too low a price may increase sales but lower overall profitability.

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Market Demand:

A higher demand for the product or service generally leads to higher revenue. Seasonal products or services, such as winter clothing, may see fluctuations in revenue depending on the time of year.

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Sales Volume:

The number of units sold directly affects revenue. Businesses that can sell more products or services will typically see higher revenue.

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Example of Revenue Calculation

Let’s say a clothing store sells 100 jackets at £50 each during a sale. The total revenue from Market Demand: A higher demand for the product or service generally leads to higher revenue. Seasonal products or services, such as winter clothing, may see fluctuations in revenue depending on the time of year.the sale of the jackets would be calculated as:

Revenue = 100 × 50 = £5,000

Now, if the same store also sells 200 t-shirts at £20 each in the same period, the total revenue from t-shirts would be:

Revenue = 200 × 20 = £4,000

Thus, the total revenue for the store from both jackets and t-shirts would be:

Total Revenue = 5,000 + 4,000 = £9,000

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Profit

Profit is the financial gain a business makes after subtracting all costs from its total revenue. It is a key measure of a company’s success and a critical indicator of its financial health. A business’s primary goal is to generate profit, which allows for expansion, investment, and sustainability in the long term.

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Profit

Formula for Profit:

Profit = Total Revenue – Total Costs

In this formula:
• Total Revenue is the total income a business earns from sales or services.
• Total Costs include all fixed and variable costs incurred by the business.

The total cost is composed of two primary elements:

Types of Profit

Gross Profit:

Gross profit is the profit a business makes after deducting the cost of goods sold (COGS), which includes the direct costs of producing the goods or services. It shows how efficiently a company uses its resources to produce and sell goods.

Formula: Gross Profit = Revenue – Cost of Goods Sold (COGS)

Example:

If a bakery earns £5,000 from selling cakes and the cost of ingredients and labour (COGS) is £2,000, the gross profit is:
Gross Profit = 5,000 – 2,000 = £3,000

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Operating Profit:

Also known as operating income, this is the profit a business makes from its core operations, after subtracting both the cost of goods sold and operating expenses such as rent, wages, and utilities.

Formula: Operating Profit = Gross Profit – Operating Expenses

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Example:

If a clothing store has a gross profit of £10,000 and operating expenses (rent, utilities, salaries) of £4,000, the operating profit would be:

Operating Profit = 10,000 – 4,000 = £6,000

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Net Profit:

Net profit is the final profit after all expenses are deducted, including taxes, interest, and one-time expenses. It is often referred to as the ‘bottom line.’

Formula: Net Profit = Operating Profit – Interest and Taxes

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Example:

If a tech company has an operating profit of £8,000 and pays £1,500 in taxes and interest, the net profit would be:

Net Profit = 8,000 – 1,500 = £6,500

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Importance of Profit

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Price of the Product or Service:

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Growth and Expansion:

Profits allow a business to invest in growth, whether by expanding into new markets, developing new products, or increasing production capacity.

Attracting Investors:

Profitable businesses are more likely to attract investors or secure loans, as they are seen as lower-risk ventures.

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