Costs, Profit, Contribution & Break-even Analysis

Capital Expenditure and Costs

Business is conducted by exchanging liquid assets for fixed assets and vice-versa.

A first type of payment occurs when we exchange cash or another liquid asset for
such things as property, machinery and vehicles. These are material assets that enable
us to make things.

A second type of payment occurs when we purchase such things as raw materials, and
employ people to operate the machines, answer telephones and the like.

Rent is an example of this second type of payment. We may decide to hire rather than
buy a photocopier. The rent on the photocopier must be paid for, and we pay rent for
the use of the photocopier.

The first type of payment is called an investment, and the second type of payment is
called a cost.

Investments increase the material, that is, fixed assets, of the person buying them.
The owner has an item that can be used as a means of production. Investment in such
items is called capital expenditure

1. What is the distinction between fixed and liquid assets?

The most liquid asset is cash. A liquid asset can be used to pay a bill. The
more liquid an asset the more readily it can be exchanged for cash. Fixed
assets are those that take time to be sold. They cannot be exchanged
immediately for goods and services. Factories and vans are examples of fixed
assets.

2. Why is business conducted by exchanging fixed assets for liquid assets?

Money is in itself unproductive. It does not make anything. So cash (the

ultimately liquid asset) must be used to by other assets that can be productive,
such as machinery. These fixed assets are used in conjunction with other
inputs – labour and raw materials – so make goods and services that can be
sold for cash. Hence liquid assets are exchanged for fixed assets, which
produce goods and/or services that result in sales, bringing in further liquid
assets.

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3. Explain how you win a game of Monopoly in terms of the exchanges going on
in the game between fixed and liquid assets.

Monopoly introduces children to the basic rules of capitalism. The players all
start with an equal amount of cash. They win by making judicious
investments – that is, buying property and eventually investing further in this
property by developing houses and hotels. A player that does not buy property
cannot win. The winning strategy is to maintain the optimum ratio between
liquid and non-liquid assets, since it is costly to convert fixed assets into liquid
assets to pay rent.

4. What is the distinction between costs and capital expenditure?

A capital item is used to make things – in the sense of providing the facilities
for production – a factory, a machine – these are examples of capital items.
But the making of goods requires other factor inputs as well – raw materials
and labour. Every time a good is produced these are consumed. These inputs
are called costs in accounting terms.

5. Does property always appreciate in value?

The value of a property is determined by a market in accordance with supply

and demand. If demand increases ahead of supply, then property prices will
increase. The price of a property is not determined by any intrinsic (inner)
value, such as the cost of the building materials and labour to make it. So, of
course, property can go down in value – that is, price. If, for any reason,
supply grows more than demand, prices of properties will fall.

Classification of Costs

Costs are payments incurred in day-to-day production. It is possible to analyse costs

in two separate ways.

Classification by type

Costs are classified as either arising directly or indirectly.

Direct costs are ones that can be specifically related to the production of a
particular good.

Indirect costs are those that are not so specifically related.

For example, suppose a company manufactures chairs. The cost of the labour
and raw materials that goes into the manufacture of the chairs are direct costs.

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 The production overheads include the factory rent and heat, light and power,
and depreciation on plant and machinery.

Indirect costs are also frequently called overheads.

Classification by behaviour

This is concerned with the way an impact of a change in output causes a

change in costs.

Costs are classified in this way as either fixed or variable.

Fixed costs do not change as the quantity of output changes. Increasing output
does not increase these costs.

Variable costs do change. Variable costs increase as output increases.

It is a mistake to confuse indirect costs with fixed costs. Both direct and indirect costs
can and do vary with output, and both can, and do, contain elements of fixed costs.
For example, the amount of energy used by a company (an overhead) does increase
with the number of goods produced.

The usual example of a direct cost that is also fixed is depreciation on machinery.
Depreciation is the loss of value of an asset owing to ageing. Machinery just wears
out, and so loses value. Depreciation on dedicated machinery means depreciation on
machinery that is used for only one purpose in the production cycle, and so can be
regarded as a direct cost.

Direct costs Indirect costs

Fixed Depreciation on Rent
dedicated
machinery
Variable Raw materials Energy

Fixed and variable costs – Break-even analysis

Economists classify costs as either fixed or variable. At present we are concerned

with how costs vary with output in the short run. The short run is defined as a period
of time in which at least one factor of production is fixed – usually capital. That is, a
firm as a fixed size of plant. In the long run the firm can move to larger or smaller
premises.

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In the short run, because the capital (and hence size of production unit) is fixed, the
fixed costs remain constant. That is, fixed costs are those costs that remain constant
regardless of the quantity produced in the short run.

Costs

FC
Fixed costs

Output

An example of a fixed cost would be rent on a building. The rent remains constant
regardless of how much business is done in it.

Variable costs are those cost that change as output increases.

Costs
VC

Variable costs

Output

Total costs are the sum of fixed costs and variable costs.

Total costs = Fixed costs + Variable costs

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It is usual to show total costs in a graph as follows

Costs TC
Total costs

VC
Variable costs

FC
Fixed costs

Output

The variable costs are added to the fixed costs to show the total costs.

From this point it is possible to calculate the breakeven point.

Costs / Revenue
Sales Revenue Profit
making
Total costs
TC = FC + VC

Fixed costs
Loss FC
making

Break-even Output
point

The break-even point is where revenue is equal to total costs.

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Example – Fixed and Variable Costs

Paul is a sole trader. His business manufactures ornamental boxes. His costs
are shown below

Fixed Costs £ per week

Rent 60.00
Rates 25.00
Depreciation 18.00
Interest on Loan 30.00
Drawings 180.00
Variable Costs £ per item
Materials 0.80
Power 0.40

Paul makes 600 boxes per week which he sells for £2.20 each. Calculate his
break-even point and his weekly profit, showing your working.

Solution

First we total the fixed costs

Fixed Costs £ per week

Rent 60.00
Rates 25.00
Depreciation 18.00
Interest on Loan 30.00
Drawings 180.00
Total Fixed Costs 313.00

Each week, before Paul can make a profit, he has to cover these fixed costs.

The contribution for each box is the sale price less the variable cost.

The variable cost for each box is

Variable Costs £ per item

Materials 0.80
Power 0.40
Total per item 1.20

Thus the contribution per item is

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 Contribution = Sale Price − Variable Cost
= 2.20 − 1.20
= £1.00 per item

In order to break-even Paul must cover the fixed costs of £313 per week. This
means that he has to sell 313 boxes each week in order to break-even,
thereafter he makes a profit.

His total contribution is

Total Contribution = Number of items sold × Contribution per item

= 600 ×1
= £600

So his profit per week is

Profit = Total Contribution − Fixed Costs

= 600 − 313
= £287 per week

Cost centres, revenue centres, profit centres

A cost centre is a department within a firm where costs arise, and can be calculated.
A revenue centre is a department within a firm where sales are made. A profit centre
is both a revenue centre and a cost centre, hence profits, which are revenue less costs,
can be calculated for a profit centre.

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