AP® Business with Personal Finance review sheet from Aim for Five (aimforfive.com/business-finance/units/3/3-4)
Unit 3 · Topic 3.4
3.4 Business Expenses
Before a business can earn anything, it has to spend: on startup costs and then on recurring costs. This topic shows how businesses sort their costs (one-time or recurring, direct or indirect, fixed or variable) and how insurance protects against big losses.
Key terms
- startup costs
- direct costs
- cost of goods sold (COGS)
- operating expenses
- fixed vs. variable costs
- insurance
Startup costs
Startup costs are what it takes to launch a new business or product. They include one-time expenditures, like legal fees, fees to incorporate (legally form the business), licenses and sometimes equipment. They also include initial expenses: the first rent (occupancy), research and development, marketing, insurance and the first batch of inventory. Once the business is running, those initial expenses keep coming back as ongoing costs.
Direct vs. indirect costs
Direct costs are tied to producing or delivering specific goods or services. For a business that makes goods, direct costs are called the cost of goods sold (COGS): raw materials, production supplies, factory workers' wages and benefits, and the cost of running the factory. For a service business, they're called cost of sales: the workers who deliver the service, their travel and any materials used.
Indirect costs, which accountants call operating expenses, keep the whole business running rather than making any one product: rent for offices or stores, salaries and benefits for office and sales staff, marketing and advertising, supplies, utilities, maintenance and insurance.
Fixed vs. variable costs
A second way to sort recurring costs is by how they react to output. Fixed costs stay the same whether you make 10 units or 10,000, like rent. Variable costs rise as you produce more, like raw materials.
The two systems overlap. COGS can include both: factory rent is fixed, and raw materials are variable. Operating expenses are usually fixed. Because fixed costs get spread over more units, the cost per unit usually falls as output rises.
| Example cost (bakery) | Direct or indirect? | Fixed or variable? |
|---|---|---|
| Flour and butter | Direct (COGS) | Variable |
| Rent on the kitchen where bread is baked | Direct (COGS) | Fixed |
| Instagram ads | Indirect (operating expense) | Usually fixed |
| Bookkeeper's salary | Indirect (operating expense) | Fixed |
Insurance and risk
Businesses and individuals buy insurance to protect against big financial losses from accidents, injuries or property damage. Some insurance is required by law; for example, businesses with employees generally must carry workers' compensation insurance, which covers workers hurt on the job. Much insurance is optional. How much to buy depends on risk tolerance: some owners would rather pay for protection, while others accept more risk to save money.
Worked examples
Try each one yourself first, then open the solution.
- Example 1Calculator allowed
Adding up startup costs
Rosa is launching a food truck. One-time costs: used truck $38,000, permits and license $1,500, LLC filing and legal help $900. Initial expenses: first month's parking and kitchen space $1,200, opening marketing $2,000, first quarter's insurance $1,100, first food inventory $3,000. What are her total startup costs, and which items will become ongoing costs?
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- Step 1: One-time expenditures: $38,000 + $1,500 + $900 = $40,400.
- Step 2: Initial expenses: $1,200 + $2,000 + $1,100 + $3,000 = $7,300.
- Step 3: Total startup costs: $40,400 + $7,300 = $47,700.
- Step 4: The initial expenses (space, marketing, insurance, inventory) recur once the truck is running.
Answer: $47,700 in startup costs. Parking and kitchen space, marketing, insurance and inventory become ongoing costs.
- Example 2Calculator allowed
Why cost per unit falls as output rises
Rosa's fixed costs are $6,200 a month and her variable cost is $3.50 per meal. Find her total cost and cost per meal at 2,000 and at 3,000 meals a month.
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- Step 1: Total cost = fixed costs + variable cost per meal × meals.
- Step 2: 2,000 meals: $6,200 + $3.50 × 2,000 = $13,200. Per meal: $13,200 ÷ 2,000 = $6.60.
- Step 3: 3,000 meals: $6,200 + $3.50 × 3,000 = $16,700. Per meal: $16,700 ÷ 3,000 ≈ $5.57.
- Step 4: Fixed costs are spread over more meals, so each meal costs less.
Answer: 2,000 meals: $13,200 total, $6.60 per meal. 3,000 meals: $16,700 total, about $5.57 per meal.
Common mistakes
- Assuming direct means variable and indirect means fixed. Factory rent is direct but fixed.
- Leaving initial expenses like inventory and marketing out of startup costs. Startup costs include them, not just one-time fees.
- Calling cost of sales and COGS different ideas. Both are direct costs; COGS is the term for goods, cost of sales for services.
On the exam
- Expect to classify a list of costs as direct or indirect and fixed or variable, or to total a business's startup costs from a table.
- On Question 1, you may need to name your own project's main startup costs and explain how you'd pay for them.
Connected topics
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Check yourself: 3.4 Business Expenses
4 questions on 3.4 Business Expenses. Pick an answer to see if you got it, and why.
A landscaping company hires its first five employees. Which type of insurance is most likely to be legally required in its state?
| Cost item | Amount |
|---|---|
| Business license and legal fees to form an LLC | $1,200, paid once |
| Espresso machine and grinders | $14,000, paid once |
| Rent | $3,500 per month |
| Manager's salary | $4,000 per month |
| Advertising | $500 per month |
| Insurance | $250 per month |
| Coffee beans, milk and cups | $1.10 per drink sold |
Projected costs for Bean & Bloom, a hypothetical café. Each drink will sell for $4.50.
What are Bean & Bloom's one-time startup expenditures?
Which cost is a variable cost that is also a direct cost of making the café's product?
Bean & Bloom buys liability insurance even though it isn't required. This choice most likely reflects
0 of 4 answered