Costs and profitability
Clear definitions and practical examples to help you understand the numbers and decisions.
Fixed costs
Fixed costs do not change in total with output within a stated activity range and period, though fixed cost per unit falls as volume rises. Rent and a salaried site manager may be fixed for the month, but can change when a lease or capacity decision changes.
Read the explanationVariable costs
Variable costs change in total as output, sales, or another activity driver changes. Materials, sales commission, or delivery charges may vary with units, but the unit rate is stable only within stated purchasing and operating conditions.
Read the explanationMixed costs
Mixed costs contain a fixed component and a component that varies with activity. A utility bill may include a standing charge plus usage; treating the entire bill as fixed or variable distorts forecasts and decisions.
Read the explanationStep costs
Step costs stay constant across a limited activity band, then rise when an additional resource or capacity block is needed. They are neither smoothly fixed nor smoothly variable across all volumes.
Read the explanationDirect costs
Direct costs can be traced to a particular product, job, customer, or other cost object in an economically practical way. The classification depends on the chosen object, not on when cash was paid.
Read the explanationIndirect costs
Indirect costs support more than one product, job, or customer and cannot be traced to one of them economically. They may be allocated for analysis, but allocation is an estimate rather than direct observation.
Read the explanationOverheads
Overheads are indirect costs of running a function, site, or business, such as shared supervision, rent, systems, and support staff. Whether a cost is overhead depends on the cost object and reporting purpose.
Read the explanationCost allocation
Cost allocation assigns a shared indirect cost to products, jobs, customers, or other cost objects using a selected basis such as labour hours, machine hours, or deliveries. It improves visibility but does not turn a shared cost into a directly observed cost.
Read the explanationCost driver
A cost driver is an activity or factor that causes, or usefully explains, a cost to change. It may be units, orders, deliveries, setup hours, support tickets, or another operational measure.
Read the explanationCost centre
A cost centre is a department, function, location, or activity for which costs are collected and monitored. It need not earn revenue and is not automatically responsible for company-wide profit.
Read the explanationProfit centre
A profit centre is an area whose manager is assessed on both revenue and costs and therefore a defined profit measure. The measure must state transfer pricing and shared-cost rules.
Read the explanationContribution margin
Contribution margin is sales revenue less variable costs. It is the amount available to cover fixed costs and then profit; it is not gross profit unless the cost classification and basis happen to match.
Read the explanationContribution margin ratio
Contribution margin ratio equals contribution margin ÷ sales revenue, usually expressed as a percentage. It shows how much of each sales currency unit contributes to fixed costs and profit on the stated cost basis.
Read the explanationGross profit
Gross profit is revenue less cost of sales under the company’s accounting policies. It differs from contribution because cost of sales can include costs that do not vary with a specific sales decision.
Read the explanationGross profit margin
Gross profit margin equals gross profit ÷ revenue, expressed as a percentage. It measures the portion of revenue remaining after cost of sales under the stated accounting basis; it is distinct from markup and contribution margin.
Read the explanationOperating profit
Operating profit is profit from operating activities before financing costs and income tax, as defined by the company’s presentation. It commonly follows gross profit after operating expenses, but classification can vary.
Read the explanationOperating profit margin
Operating profit margin equals operating profit ÷ revenue. It shows the proportion of revenue remaining as operating profit under the company’s presentation, so comparisons require consistent classification and period.
Read the explanationNet profit
Net profit is the profit remaining after all recognised income and expenses for the period, including financing and tax according to the reporting framework. It is an accounting measure and does not equal cash generated.
Read the explanationNet profit margin
Net profit margin equals net profit ÷ revenue. It shows the proportion of revenue remaining as net profit after all recognised income and expenses, and can be affected by financing, tax, and one-off items.
Read the explanationEBIT
EBIT means earnings before interest and tax. It is often used as a profitability measure, but it is not always identical to “operating profit” because presentation and included non-operating items can differ.
Read the explanationEBITDA
EBITDA means earnings before interest, tax, depreciation, and amortisation. It is a performance measure that excludes specified expenses; it is not cash flow because working capital, capital expenditure, taxes, interest, and other cash movements remain.
Read the explanationEBITDA margin
EBITDA margin equals EBITDA ÷ revenue. It expresses the selected earnings measure as a proportion of revenue, but it inherits EBITDA’s exclusions and is not a cash margin.
Read the explanationOperating leverage
Operating leverage describes how a percentage change in sales can produce a larger percentage change in operating profit when a business has fixed operating costs. Contribution means revenue less variable costs. Once it covers fixed costs, additional contribution can flow strongly into operating profit. The same mechanism works in reverse when sales fall.
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