BUSI 103 - Introduction to Business (Chapter 3)
July 25, 2026
Two people can run the exact same business and one of them goes broke. How do costs decide which one?
Read time ~25 min - ~3,712 words - problems ~45 min
Why this matters. Costs are central to profitability and decision-making. It’s not just about what you’re spending, but managing it well - understanding the relationship between costs and how profits are made is the first step in how you unlock profitability, make good investments, and manage risk.
What you’ll be able to do.
The big ideas.
Key terms. cost, revenue, profit, direct and indirect cost, explicit and implicit cost, fixed cost, variable cost, mixed cost, cost function, cost structure, economies of scale, crossover volume, cost driver, MECE.
Imagine you and your groupmates get four weeks to run a smoothie stand. The price per smoothie is $8, and you’re trying to figure out two different ways to run the same business - and decide what’s better under different volume assumptions.
Option A keeps fixed costs real low. You’ve got a pop-up permit and cart storage at $120 a week, and you’re renting a blender at $80 a week. The rest rides on each cup: labor at about $2.50 per smoothie, ingredients at $2.25 per smoothie, and card processing at $0.25 per smoothie if customers pay with credit cards.
Option B is you actually get a lease, and it’s expensive - $520 a week. You’re also leasing equipment at $180 a week, and you have labor on scheduled shifts at $260 a week. In exchange, your ingredients are cheaper - $1.85 per smoothie, with card processing still $0.25 - but the cheaper ingredients come in batches of at least 200 units.
So: which option has lower total costs at 60 smoothies a week? What about at 280? You’re going to get different results at different volumes - hold that question, because the rest of this chapter is about what the answer depends on.
Costs are the piece of the business closest to you - and the first place you can get good information.
The basic premise of business is that you get money from customers for providing something that they want - a good or a service. That’s what we call revenue. To provide it, you’re going to have to do something valuable, and that’s going to cost you something. The difference between what you get from customers and what it costs to provide that good or service is profit, and profit is the measure of value creation in a business:
\[ \text{Profit} = \text{Revenue} - \text{Costs} \]
I want to start with the cost piece because that’s the piece we understand the most. It’s what’s close by us. You don’t have to ask questions about what the world could be like - you can look directly in your own shop, identify things, call people up and ask how much this stuff costs. It’s the first place where we can get some really good information.
So costs represent decisions. A cost is the monetary resources a business uses to create and deliver its good or service - and not all costs are the same. Some are more direct: that’s the stuff that’s directly in your product. The most obvious version is being a retailer, where you buy something and sell that exact thing - the cost of what you’re selling is a direct pass-through. Sometimes you’re buying ingredients: a coffee shop buys coffee beans, coffee grounds, milk. All of this is directly in the product.
Then there are indirect things. You incur these costs, and while they’re not in the product, you kind of need them in the action of actually running the business. In a cafe you might have Wi-Fi, electricity, ambient temperature - these all create a setting, and that’s part of what you’re selling. It’s not directly in the product of your coffee, but it’s going on in the background and it’s still an important part of running your business. You might have an accountant helping you keep track of things. That’s not in the coffee, but that cost is definitely helping you run the business.
Explicit costs are the ones we actually pay for - we write a check, we buy something, we have to pay for it. Implicit costs are the hidden ones, and a lot of beginners forget about them. These are the opportunity costs, and just because we don’t write a check doesn’t mean it doesn’t cost something. I’ll say that again: just because we don’t write a check doesn’t mean it doesn’t cost something. What it’s costing is the alternative - what we could have done. Every time in life we’re making a choice, doing something means we’re not doing something else. If we go to a music concert, we could have gone to a really nice restaurant; we cannot do both at the same time. So the implicit cost of doing anything is the foregone opportunity of doing something else. There’s always the opportunity cost of your time - if you’re doing this, you could be enjoying your life or running some other business.
Tracking costs tells us where our money is going, and it helps you figure out:
Bottom line: tackling this side of the equation is a really important part of doing business well.
What’s set in stone, and what changes as your business grows?
If we’re running a cafe, you’ve got to cover your rent, you’ve got to pay your staff, and you buy ingredients. Not all of these costs behave the same way as you run your business.
Something like rent we call fixed: it doesn’t matter if you sell one cup of coffee or a thousand cups, you’re going to be paying rent. Say it’s $3,000 a month - it’s not moving, whatever the scale of your business. Coffee beans, on the other hand, are variable: if you sell more coffee, you’re going to need to buy more beans and more cups. That cost is directly related to the volume of your business activity.
This is where it gets interesting: not all costs are that easy to classify. Think about barista labor - fixed or variable? On one hand, you could hire seasonal workers and pay hourly wages, and that feels like a variable cost. On the other hand, you’re making a commitment to a person. If you’ve committed to keeping people on for this many hours, that starts to feel like a fixed cost.
Wages are where this gets really difficult. At first blush they seem variable: we hire more people if we produce more stuff, and if we didn’t have as much volume, we’d hire fewer people - it seems very related to output. But that’s not how we actually make commitments about wage costs, because people want to know upfront if they’re going to be employed. We tend to write contracts even for hourly workers. People like to have schedules; they don’t like to be told they could just be let go; and it takes time for people to get up to speed. Everything around labor, even if it is per hour, makes us want to make commitments - or at least act as if we were sure. In this case, wages start looking very fixed instead of variable. We need to think about not just how the simple math works, but what we are actually going to do - and how difficult it would be to do or undo the decision.
Some things depend on the form. If your advertising is a billboard, that can just be a fixed cost: you pay for it, and it doesn’t matter if a ton of people look at it or nobody does. If you have ads on Facebook and you’re paying for every single impression delivered, that cost is variable - not necessarily variable with how much your business grows, but certainly variable with respect to how much it’s used. Utilities can be mixed, because there can be a flat fee for having the electricity hookup even if you don’t use any of it, and more cost as you utilize it.
All of this nuance matters because we think about fixed and variable costs differently. Fixed costs are something we have to figure out how to cover - we pay them regardless. For variable costs, we need to understand that as the business grows, there are going to be more of them. It’s good to keep those things straight. And sometimes when you’re growing, you only count the cost you were explicitly looking at. Say the cafe wants to add seating, and the only price you count is the extra rent - what are you missing? You have to think it completely through. More seats means it’s going to be busy. If it’s going to be busy, we need to sell more stuff; we might need more waiters, because now we need to serve more people. It could even be that the more people we put in, the more congested it gets - people can’t move around as much, or the atmosphere isn’t so good. We need to think about the implication of not just the first thing we think of when we add a cost, but everything that could happen by that action.
Bottom line: classify costs by how they behave, because fixed and variable costs behave differently - and that difference is what changes your decisions.
Cost structure shapes scalability, and therefore risk.
So is one cost structure better or worse? It’s really not about better or worse - it’s about what the implications are when we grow. There are trade-offs.
Think about it this way. A business with a lot of high fixed costs, like Netflix, buys a huge amount of computing capability and content up front. It costs a lot, but then as you add more customers, you don’t have to add more costs. Compare that to a catering service, which has a lot of direct costs that are highly variable. Both of these businesses can succeed, but how they become profitable is different.
When you have high fixed costs, you’re spending a ton of money up front, and it comes with a lot of risk: you’re not really sure how many subscribers you’re going to have, and if you don’t have enough, you’re going to be unprofitable, because those costs don’t go away. But if you get a lot of customers - because you’ve built all of this up front - you can really scale. Once those fixed costs are covered, every additional subscriber drops straight to the bottom line. That’s why we say a business like this has economies of scale: the bigger it is, the more profitable it’s going to be. But you have to hit a certain break-even point first.
Now, with a lot of variable costs, like the catering business: the more orders it has, the more staff it has and the more it spends on logistics. The good news is it’s pretty agile. Without a lot of fixed costs, if things go bad it’s not a big deal - you just won’t buy as much food and won’t hire as many people. But as you grow, for every dollar of revenue you earn there’s going to be a good bit of cost riding alongside it. The profit margin is smaller, the cost rises with you, and it takes longer for growth to make you profitable.
The cost structure is going to shape the strategy. If fixed costs are high, you really want to grow as fast as you can, and you become more efficient as you do. If variable costs are really high, the good news is you’re pretty flexible, but maintaining margin is difficult, and as you grow the rewards are less acute.
The smoothie stand is exactly this choice in miniature. It’s good to take the two different cost functions and write them out. A cost function is just fixed cost plus variable cost per unit times the number of units \(Q\):
\[ \text{Total cost} = \text{Fixed cost} + (\text{Variable cost per unit} \times Q) \]
For Option A, the fixed costs are the $120 permit and the $80 blender, so $200 a week, and the variable costs are $2.50 + $2.25 + $0.25 = $5.00 a cup:
\[ C_A(Q) = 200 + 5.00\,Q \]
For Option B, the fixed costs are the $520 lease, the $180 equipment plan, and the $260 of scheduled labor, so $960 a week, with $1.85 + $0.25 = $2.10 a cup as long as you’re buying at least 200 units of ingredients:
\[ C_B(Q) = 960 + 2.10\,Q \quad (\text{for } Q \ge 200) \]
Worked example: which option has lower total costs, and when?
Step 1 - low volume, 60 smoothies a week. What does Option A actually cost at 60? Let’s look through those numbers:
\[ C_A(60) = 200 + 5.00(60) = 200 + 300 = \$500 \]
Now Option B at 60 - and keep in mind, they have to buy those 200-unit batches of ingredients. They’re kind of stuck with that. So what are you paying for, and what’s wasted?
\[ C_B(60) = \underbrace{960}_{\text{fixed}} + \underbrace{200 \times 1.85}_{\text{ingredients (forced bulk)}} + \underbrace{60 \times 0.25}_{\text{card fees}} = 960 + 370 + 15 = \$1{,}345 \]
We basically have to buy the stuff and we’re not producing - at small volumes, that’s pretty bad. Option A wins by a mile, $500 to $1,345.
Step 2 - high volume, 280 smoothies a week. Now look at 280 - what happens?
\[ C_A(280) = 200 + 5.00(280) = \$1{,}600 \]
\[ C_B(280) = 960 + 2.10(280) = \$1{,}548 \]
Now it doesn’t matter that we had to force-buy 200 units, because we’re producing way more than that - there’s no waste. In fact, we get a big bonus for having made that commitment. At high volumes, Option B looks a lot better: $1,548 to $1,600.
Step 3 - find the point of indifference. One thing that’s interesting to do is take the two cost functions and figure out at what point you like one better than the other. It’s kind of like solving two equations. When you set them equal to each other, you’re basically asking: at what point am I indifferent?
\[ 200 + 5.00\,Q = 960 + 2.10\,Q \quad\Rightarrow\quad 2.90\,Q = 760 \quad\Rightarrow\quad Q \approx 262 \]
We might say 262 is the break-even between the two options. Be very clear about what that answers: at this point, we’re indifferent between these two different choices. It’s not a goal - it’s not where we want to be. If we believed volume was going to land right here, it wouldn’t matter which one we picked. If we thought it was going to be higher, we’d rather choose Option B; if lower, we’d rather choose Option A. And notice the crossover volume is 262, not 200, where the pre-order discount kicks in - try 200 cups and figure out what that is. Even at exactly 200, Option A still costs less, $1,200 against $1,380. The discount alone doesn’t make the committed setup worth it.
Tie this example back: Netflix is like an extreme version of Option B. It has enormous fixed costs and very small variable costs, and this makes it risky - if you don’t get the volume, you’re really going to be in a world of hurt, because you have all these fixed costs. If you do, and you grow a lot, every single person you add actually ends up being really good. If your volume is higher than you expect, you can profit quite a bit - and that’s kind of the magic of economies of scale.
Bottom line: if fixed costs are high, grow fast; if variable costs are high, you’re flexible but margin is hard - and the crossover volume tells you exactly which side of the line you’re on.
Getting a nice classification system is how you know you’ve got everything and you’re not double counting.
One of the biggest things when it comes to cost is making sure we’ve classified things right - but also making sure we’ve got everything and we’re not counting anything twice. I like to use a framework called MECE - mutually exclusive, collectively exhaustive - which I picked up in management consulting. Any time you break down a problem, you want to make sure you’re thinking about the whole thing, but also not getting confused by thinking about things redundantly. What’s really nice is if you can break costs into buckets, where the categories you dump costs into have no overlaps and no gaps. That helps you think about costs in a structured way and get organized.
The product costs - the direct material, the labor, the overhead - are all the stuff that goes into the product. For a cafe:
All of that is directly tied to the service. Then there are sustainment costs, like maintaining those machines, renewing licenses, software subscriptions. There’s another set around selling and distribution: we’ve got to get ads out there, we’ve got to tell people we’re here - posters, online ads. Then administrative costs: the people managing the books, HR salaries - people doing work that’s not directly making coffee but is still making the business run. Development costs are what you spend to build what’s next - testing a new menu item, building a mobile-ordering app. Finally, I keep a category for opportunity costs: not costs we write checks for, but things we give up because we’re doing this.
Now run some examples through it. You’re a cafe thinking about adding a food menu. Using the MECE framework: how do the cost buckets change? Would adding sandwiches mean higher product costs? What would happen to sustainment costs? What would happen to administrative costs? Getting a nice classification system is a great way of understanding how costs behave and what could change if the business changes.
Bottom line: buckets with no overlaps and no gaps are how you catch the cost you’d otherwise miss.
Even two cafes right next door can carry very different costs - understanding why is understanding how they compete.
What shapes a cost structure? Even in the same business you could have very different cost structures - one cafe runs leaner than another right next door. How does that work? Understanding the underlying factors - what activities drive costs in the business - helps us understand how these two compete. And it’s not just an industry in general: the same industry can have very different cost structures because of choices made by a very specific business.
Scale is a big one. A larger business can spread those fixed costs over a lot of sales, and if you’re doing it right, the cost per unit is lower. Amazon has huge scale and really big logistics, and because of that they can do amazing things - but they’ve got to have a lot of business to spread that fixed cost over. All of that business makes everything really efficient; without it, the volume doesn’t justify the scale.
Another way businesses compete is on the direct input costs. If coffee prices go up, or a small cafe is paying more for its inputs than the shop next door, it’s going to be at a disadvantage. There’s also technology investment - a related fixed cost. If one cafe spends a lot on really advanced machines, that’s expensive up front, but they might save on direct costs or labor somewhere else.
Other things make real differences too. Geography: things in New York are more expensive than in a rural area. And markets are different - the audience in New York might be different from a rural audience, and that can drive costs as well.
Food service is full of businesses making exactly these kinds of moves:
Real companies, real choices.
- Ghost kitchens (Chili’s). A delivery-only brand run out of kitchen capacity Chili’s was already paying for - its “It’s Just Wings” virtual brand reportedly cleared over $150M in its first year - turning a fixed cost into another revenue stream.
- Pre-cut inputs (Chipotle). Chipotle will buy pre-shredded cheese and pre-cut ingredients. That means they can move faster and not spend so much on labor - of course, the direct cost of the input is going to be more expensive.
- Co-branding (Taco Bell and KFC). Owned by the same company, they can advertise as two brands in one place but share fixed costs - one kitchen, the staff, the checkout person. They’re being thoughtful about how to share fixed costs while running two different places.
- Scheduling technology (Domino’s). Domino’s spent a lot on IT to be more data-driven in scheduling as a way to manage labor costs. Labor is thought of as a variable cost, but they spend money on high-tech forecasting to make sure they can control it.
All of these different configurations represent trade-offs in how a company can make choices to figure out how to compete.
Costs aren’t something you’re stuck with. They’re decisions - you can decide how to do it, and how that will affect this one side of the profit equation, and under what volume scenarios.
Bottom line: costs are driven by scale, inputs, technology, and location - and all of those are choices.
So what’s the real question between A and B? We’re talking about two different ways to run the same business, and they differ by cost structure. Which one we want to do has a lot to do with what we think growth and volume are going to be - and how sure we are of it. Suppose demand is uncertain - say a 25% chance of 50 smoothies, a 50% chance of 140, and a 25% chance of 260. You can do expected values on that, and what the exercise lets you see is that which cost structure wins has a lot to do with our certainty of demand. If we’re not sure, we don’t want to take the risk of putting forth all these upfront costs - if demand disappoints, you’re not stuck paying $960 a week for a stand you can’t fill. If we know it’s going to be big - or even bigger - then we’re more confident that something that scales is the better decision, and every cup past the crossover widens the gap.
3-1 The Crossover. [LO2, LO3] Using the smoothie cost functions \(C_A(Q) = 200 + 5.00Q\) and \(C_B(Q) = 960 + 2.10Q\) (for \(Q \ge 200\)): (a) compute the total cost of each option at 150 smoothies a week; (b) compute each at 300; (c) solve for the crossover volume between the two options and state, in one sentence, the decision rule you’d give the team.
3-2 Reclassify the Stand. [LO1] Take Option B’s $260 of scheduled-shift labor and suppose you switch to paying workers hourly only when the stand is open, which you estimate would run about $1.40 per smoothie at expected volume. Rewrite Option B’s cost function with this change. Does the business become more or less risky if demand is uncertain? Explain in terms of fixed versus variable cost.
3-3 Add the Food Menu. [LO1, LO4] The cafe from the chapter is deciding whether to add sandwiches. Using the MECE cost buckets, list at least one specific new cost in each of three different buckets, then state which single cost you’d want the most certainty about before saying yes, and why.
3-4 Uncertain Demand. [LO2, LO4] Next week’s demand is uncertain: a 25% chance of 50 smoothies, a 50% chance of 140, and a 25% chance of 260. (a) Compute expected demand. (b) Compute the expected total weekly cost under each option, remembering Option B’s 200-unit bulk rule at low volumes. (c) Which option would you choose, and how does your answer change if you care most about the worst-case week?
© 2026 Eric Lin. All rights reserved. This chapter is provided for students in BUSI 103 - please do not repost or redistribute without permission.