IB Business Management HLTopic 3 — Costs and RevenuesPaper 1, 2 & 3Core skill~10 min read
Fixed, Variable, Direct and Indirect Costs
Costs are split in two different ways, and students constantly mash the two splits together. Fixed and variable is about whether a cost changes when output changes. Direct and indirect is about whether you can trace the cost to one particular product. Same costs, two different questions.
📚 What you need to know
Fixed costs (FC) do not change as output changes. They are paid whether you make zero units or five thousand.
Variable costs (VC) change directly with output. Make more, pay more.
Total costs (TC) = fixed costs + variable costs.
Direct costs can be traced to one product. Indirect costs (overheads) cannot, because they belong to the whole business.
Total cost can never be zero, because fixed costs still have to be paid at zero output.
Fixed cost per unit falls as output rises, which is why making more usually makes each unit cheaper.
Fixed costs and variable costs
Picture a candle maker. Every month she pays $1,200 rent, $150 insurance and $1,850 in salaries for her two full-time staff. That is $3,200 a month that leaves her account whether she makes 900 candles, 1,800 candles, or none at all. Those are her fixed costs.
Every candle also needs wax ($1.40), a wick ($0.20), a jar ($1.10) and a label ($0.30). That is $3.00 per candle, and it only happens when a candle is actually made. That is her variable cost.
The three cost equations
Total variable cost = variable cost per unit × output
Total cost = fixed costs + total variable cost
Average cost per unit = total cost ÷ output
Three lines worth being able to sketch from memory: flat for fixed, up from the origin for variable, and total running parallel above variable, starting at the fixed cost.
If you are asked to draw this, get two things right and you will pick up the marks: the fixed cost line is horizontal, and the total cost line meets the vertical axis at the level of the fixed costs. Everything else is detail.
WORKED EXAMPLE
Total and average cost at 900 candles
The candle maker has fixed costs of $3,200 a month and variable costs of $3.00 per candle. In March she makes 900 candles. Calculate her total variable cost, total cost, and average cost per candle.
Step 1: Total variable cost$3.00 × 900 = $2,700Step 2: Total cost$3,200 + $2,700 = $5,900Step 3: Average cost per candle$5,900 ÷ 900 = $6.5555…TVC $2,700 · TC $5,900 · AC $6.56round money answers to 2 decimal places unless told otherwise
WORKED EXAMPLE
What happens when output doubles
In April she makes 1,800 candles instead. Calculate the new total cost and average cost, and explain why the average cost has changed.
Step 1: New total variable cost$3.00 × 1,800 = $5,400Step 2: New total cost$3,200 + $5,400 = $8,600Step 3: New average cost$8,600 ÷ 1,800 = $4.7777…TC $8,600 · AC $4.78output doubled but total cost did not, because the $3,200 was shared over twice as many candles
Why making more makes each unit cheaper
This is the idea behind the numbers above, and it is worth a diagram of its own. The fixed costs do not grow when output grows, so each extra unit made carries a smaller slice of them.
This is the idea behind economies of scale, and it is also why a factory running at half capacity is so expensive to operate.
Direct and indirect costs
This is a completely separate split, and it asks a different question: can you trace this cost to one particular product?
Direct costs can be traced. The wax in a lavender candle went into that candle and no other. Raw materials, components, packaging and the wages of workers making that product are all direct.
Indirect costs, also called overheads, cannot be traced to one product because they belong to the whole business. Rent, insurance, the accountant’s salary, marketing, security and the electricity bill for the offices are all indirect.
Cost in a chocolate factory
Fixed or variable?
Direct or indirect?
Cocoa and milk
Variable
Direct
Wrappers and boxes
Variable
Direct
Factory rent
Fixed
Indirect
Marketing manager’s salary
Fixed
Indirect
Wages of workers on the truffle line
Variable
Direct
Building insurance
Fixed
Indirect
The two splits overlap but are not the same. Most direct costs are variable and most indirect costs are fixed, so people assume they are the same thing. They are not. A supervisor paid a fixed salary to run one production line is a fixed cost and a direct cost.
In an exam, read the question wording carefully. “Classify these costs” is not the same instruction as “identify the fixed costs”. If the question uses the words direct and indirect, do not answer with fixed and variable.
🧩 How to classify any cost in seconds
Ask: if output doubled, would this bill get bigger? Yes → variable. No → fixed.
Then ask: can I point at one product and say this cost belongs to it? Yes → direct. No → indirect.
Answer only the question asked. Do not give both splits unless both were requested.
Watch for traps: electricity used by machines is variable; electricity lighting the offices is fixed.
💡 Exam tip
Write out the formula before you calculate. Method marks are given even when the arithmetic slips.
Always show your working line by line. TVC, then TC, then AC.
Include units and a currency symbol. An answer of “8600” is not the same as “$8,600”.
If a question asks you to comment, link the numbers to a decision: can the firm afford this, or should it produce more?
Learn one clear example of a cost that is fixed but direct. It shows the examiner you really understand the two splits.
⚠ Common mix-up
Saying fixed costs never change. They do change over time — rent goes up — they just do not change with output.
Treating direct and variable as the same words. They usually overlap, but they answer different questions.
Forgetting fixed costs when calculating total cost. Total cost is never just the variable costs.
Drawing the total cost line from the origin. It starts at the level of the fixed costs.
Confusing total variable cost with variable cost per unit. One is a monthly figure, one is per item.
Assuming average cost falls forever. Beyond a certain output firms hit diseconomies of scale and it rises again.
Up next: Revenue and Revenue Streams — the other side of the equation, and where the money actually comes in from.
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