IB Business Management SLTopic 3 — Costs and RevenuesPaper 1 & 2Core skill~11 min read
Fixed, Variable, Direct and Indirect Costs
Two ways of cutting up the same pile of costs. Fixed and variable ask “does this change when we make more?” Direct and indirect ask “can we trace this to one product?” Different questions, different answers — and students who mix them up lose marks all through Topic 3.
📚 What you need to know
Fixed costs (FC) do not change with output. They are paid whether output is zero or 5,000.
Variable costs (VC) change directly with output: make more, pay more.
Total costs (TC) = fixed costs + variable costs.
Total variable cost = variable cost per unit × quantity.
Direct costs can be traced to one product — materials, components, packaging.
Indirect costs (overheads) belong to the whole business — admin, rent, marketing.
Total cost can never be zero, because fixed costs are paid even at zero output.
Fixed, variable, total
The distinction is about behaviour. Ask yourself: if the factory made one more unit tomorrow, would this bill change?
Fixed: rent, insurance, business rates, salaried managers, loan repayments. The rent on the unit is the same whether you produce nothing or run flat out.
Variable: raw materials, packaging, piece-rate wages, power used by machines. Every extra unit adds another lot.
The three you must be able to use
TC = FC + VC • total VC = VC per unit × quantity • average cost = TC ÷ quantity
Total cost and variable cost are parallel lines, always $4,000 apart. If your sketch shows them meeting, something is wrong.
Careful with the word “fixed”: fixed costs are fixed per period, not per unit. Spread over more units, the fixed cost per unit falls — which is exactly why bigger firms can charge less.
Direct and indirect
This second split asks a different question: can you point at a product and say “this cost belongs to that”?
Direct costs attach to one product: the cocoa, sugar, milk and wrapper in one chocolate bar; the wages of the person who makes it.
Indirect costs (also called overheads) belong to the whole business: the head office, the finance team, the advertising, the rent on the building. You cannot say which bar of chocolate the accountant’s salary belongs to.
The overlap is why students confuse the two splits. Direct materials are both direct and variable; factory rent is both indirect and fixed. But a salaried supervisor on the line can be direct and fixed at once.
Cost
Fixed or variable?
Direct or indirect?
Why
Flour in a bakery
Variable
Direct
More loaves, more flour, traceable to the loaf
Shop rent
Fixed
Indirect
Same every month, covers all products
Piece-rate wages
Variable
Direct
Paid per unit made
Manager’s salary
Fixed
Indirect
Same each month, runs the whole business
Packaging
Variable
Direct
One box per product sold
Business insurance
Fixed
Indirect
An annual premium for the whole firm
Watch the electricity bill. The standing charge is fixed; the power drawn by machines while producing is variable. Costs like this are called semi-variable, and spotting one in a case study is an easy way to show you are thinking.
Worked examples
WORKED EXAMPLE 1
Total cost and average cost [4 marks]
A workshop has fixed costs of $4,000 a month. Variable costs are $6 per unit. Last month it made 1,200 units. Calculate the total cost and the average cost per unit.
Step 1: total variable cost$6 × 1,200 = $7,200Step 2: total cost$4,000 + $7,200 = $11,200Step 3: average cost per unit$11,200 ÷ 1,200 = $9.33TC $11,200; average cost $9.33 a unitthe selling price has to beat $9.33 at this output level, not $6 — a very common slip
WORKED EXAMPLE 2
Why bigger firms can charge less [6 marks]
Using the same figures ($4,000 fixed, $6 variable per unit), compare the average cost at 500 units and at 2,000 units, and explain what this means for pricing.
Step 1: at 500 unitsTC = 4,000 + (6 × 500) = $7,000Average cost = 7,000 ÷ 500 = $14.00Step 2: at 2,000 unitsTC = 4,000 + (6 × 2,000) = $16,000Average cost = 16,000 ÷ 2,000 = $8.00$14.00 falls to $8.00 a unitStep 3: explain why
The $4,000 has not changed. It is just being shared over four times as many units, so the fixed cost per unit drops from $8 to $2.
this is the whole idea behind economies of scale, and it is why a small rival cannot match a large firm’s prices
WORKED EXAMPLE 3
Cutting costs in a downturn [6 marks]
Sales at a furniture maker have fallen 30%. The owner wants to cut costs quickly. Explain which costs can be reduced and which cannot.
Step 1: what falls on its own
Variable costs. Making 30% fewer items means roughly 30% less spent on timber, fabric and packaging.Step 2: what does not move
Fixed costs. Rent, insurance and loan repayments are unchanged, so fixed cost per unit rises sharply.
Step 3: what the owner can actually do
Renegotiate rent, sublet unused space, review insurance, delay non-urgent overheads like advertising.
Variable costs fall by themselves; fixed costs need decisionsand warn about the risk: cutting advertising lowers costs today and lowers sales tomorrow, which makes the problem worse
💡 Exam tip
Read the question wording. “Fixed or variable” and “direct or indirect” are different questions with different answers.
Always show VC per unit × quantity as a separate line. Method marks live there.
Label your answers with units and currency.
Sketch cost lines correctly: FC flat, VC from the origin, TC parallel to VC and starting at the FC.
If a question asks about profitability at different outputs, work out average cost and compare it with price.
Use the phrase fixed cost per unit falls as output rises. It shows real understanding in one line.
⚠ Common mix-up
“Fixed costs never change.” They do not change with output. Rent can still go up next year.
Direct always equals variable. Usually, but not always — check each cost separately.
Total cost drawn from the origin. It must start at the level of fixed costs.
Confusing total variable cost with variable cost per unit. One is $6, the other is $7,200.
Calling overheads useless. Indirect costs pay for the things that let the product be made and sold.
Forgetting fixed costs at zero output. If a factory shuts for a month, the rent still arrives.
Up next: Revenue and Revenue Streams — the other half of the picture, and the side you can grow instead of squeeze.
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