Costs and revenues

A fixed cost is a cost that does not change with the level of output in the short run — its total stays the same whether the business produces a lot or nothing at all. An example is factory rent, which remains the same each month regardless of how many units are made.

A direct cost can be clearly traced to the production of a specific product, such as the raw materials used in one item. An indirect cost, or overhead, cannot be traced to a single product and is shared across the whole business, such as the managing director's salary. The key distinction is traceability: direct costs attach to one product, overheads are shared.

Total revenue = price × quantity sold = 15 × 2,000 = $30,000.

Total variable cost = 1.50 × 6,000 = $9,000. Total cost = fixed + variable = 12,000 + 9,000 =$21,000. Average cost = total cost ÷ output = 21,000 ÷ 6,000 = $3.50 per loaf. The average cost tells the owner that each loaf costs$3.50 to produce once both fixed and variable costs are taken into account. This is the benchmark for pricing: to make a profit on every loaf the selling price must be set above $3.50, and the gap between price and this$3.50 unit cost is the profit margin per loaf. It also shows that if the bakery raised output, the $12,000 fixed cost would spread over more loaves, lowering average cost and allowing either a lower price or a wider margin.

Contribution per unit = selling price − variable cost per unit = 4 − 1.50 = $2.50. This means every cup the juice bar sells contributes$2.50 toward covering its $7,000 monthly fixed costs. Until total contribution reaches$7,000 (which requires 7,000 ÷ 2.50 = 2,800 cups) the business is making a loss; each cup sold beyond 2,800 then adds $2.50 straight to profit. Contribution therefore shows the owner how much each sale helps pay off fixed costs and how sensitive profit is to sales volume — a low-price, low-contribution product must sell in high volume to be viable.

Fixed costs are those unchanged by output: rent $10,000 + manager's salary$5,000 + machine insurance $2,000 =$17,000. Variable costs change with output: fabric $4 + thread/buttons$1 = $5 per garment, so at 3,000 garments total variable cost = 5 × 3,000 =$15,000. Total cost = 17,000 + 15,000 = $32,000. The split matters because it lets the manufacturer see how costs behave as output changes: the$17,000 fixed cost is incurred regardless of production, so producing more spreads it over more garments and cuts unit cost, whereas the $5 variable cost is added for every extra garment. Knowing this split is essential for calculating contribution and break-even, for deciding a price that covers unit cost, and for judging the profit impact of raising or cutting output.

Additional revenue streams would reduce the restaurant's heavy dependence on evening dining. At present, with 60% of revenue from one source, a fall in evening trade — from a recession, a new competitor or seasonal quiet spells — hits total revenue hard. Adding a lunch menu, delivery and event hire spreads this risk: if evenings weaken, daytime and event income cushion the total, making revenue more stable and improving cash-flow predictability. Each new stream also raises total revenue (total revenue = the sum of price × quantity across all streams) and makes fuller use of assets the restaurant already pays for — the kitchen, premises and staff are fixed costs, so using them at lunchtime or for events spreads those fixed costs over more sales and lowers average cost.

However, new streams are not costless. Delivery requires drivers, packaging and possibly commission to a delivery platform, all of which add variable costs and may deliver thin contribution per order; a lunch service adds staffing and food-prep costs and may not attract enough customers to cover them; event hire can disrupt normal service. There is also a risk of overstretching management and diluting the quality and brand that made the evening offering successful — spreading the kitchen too thin could harm the core business that still provides most revenue.

On balance, developing additional revenue streams is likely to be worthwhile for this restaurant PROVIDED each new stream is tested for its own contribution and does not damage the core evening service. The strongest case is for streams that use existing spare capacity cheaply — a lunch menu and event hire use assets already paid for — while delivery should be adopted more cautiously because its extra variable costs and platform commissions can erode contribution. The judgement is therefore conditional: diversify, but selectively, prioritising streams with healthy contribution and low risk to the core brand, rather than adding every option at once.

Cutting the variable cost per unit by $3 directly raises the contribution per unit by$3 (contribution = selling price − variable cost per unit), so at any given sales volume the firm covers its fixed costs faster and earns more profit per unit. If the firm sells, say, 20,000 units, an unchanged volume would add $60,000 to total contribution and profit, and it could even lower price while keeping the same margin, potentially winning price-sensitive customers. On a pure cost basis the switch looks attractive because it improves the profitability of every unit sold.

The danger lies on the revenue side. Revenue = price × quantity, and if the cheaper material lowers perceived quality, quantity sold may fall — and possibly the price the market will bear too. The extra contribution per unit is worthless if far fewer units are sold: a $3 gain per unit is wiped out if volume drops enough that total contribution falls. There is also a longer-term risk to brand reputation and customer loyalty, which could damage revenue well beyond the first period, and a risk of higher returns or complaints adding hidden costs.

The decision therefore hinges on how price-sensitive versus quality-sensitive the firm's customers are, and on the size of the likely volume fall relative to the $3 saving. For a budget, price-led product where customers care most about price, the switch is likely justified because the cost saving can be defended or passed on with little volume loss. For a premium or reputation-dependent product, the switch is dangerous: the revenue lost from lower volume and weaker brand image would probably outweigh the per-unit saving. On balance I would recommend the switch only if the firm competes mainly on price and the research suggests the volume fall is small; otherwise the risk to revenue and brand makes protecting quality the better choice. The firm should ideally quantify the break-even volume fall — the drop in sales at which the extra contribution is exactly cancelled — before deciding.

Contribution per unit shows what each sale adds toward fixed costs and profit. For Product X, contribution = 20 − 8 = $12 per unit; for Product Y, contribution = 20 − 14 =$6 per unit. On a per-unit basis X is twice as profitable, which would suggest promoting X. However, the decision depends on TOTAL contribution, not contribution per unit alone, because Y is expected to sell twice the volume. If X sells, say, 10,000 units, its total contribution is 12 × 10,000 = $120,000; if Y then sells 20,000 units, its total contribution is 6 × 20,000 =$120,000 — identical. So at this volume ratio the two products contribute the same in total, and the higher per-unit figure of X is exactly offset by the higher volume of Y.

This means the firm must look beyond the numbers to make the call. Factors in X's favour: it earns more from each sale, so it is less exposed if total demand disappoints, and it may need less production capacity and lower variable-cost financing to generate a given contribution. Factors in Y's favour: high volume builds market presence, can create economies of scale that later cut its variable cost, and may attract customers to other products. There is also uncertainty in the 'twice the volume' assumption — if Y's higher volume fails to materialise, its low $6 contribution makes it far riskier, whereas X delivers strong contribution even at modest volumes.

On balance, if the volume forecasts are reliable the two are financially equivalent, so the firm should prioritise X for its lower risk — its higher contribution per unit means it does not depend on selling large quantities to be worthwhile, and it is more resilient if demand is weaker than expected. Y would only be the better choice if the firm is confident of the high volume and values the strategic benefits of market share and future scale economies. The judgement is therefore conditional on the reliability of the volume forecast and the firm's appetite for risk, but the safer, recommended priority is Product X.