Business Studies

Chapter 18 – Costs, Scale of Production and Break-Even analysis

Business Costs
Reasons why manager needs to think about costs:
help
needed to managers to
 The costs of operating the factory can be compared with revenue to calculate make
conclude whether or not profit or loss is made profit and loss decisions
 The costs of two different locations for the new factory can be
compared. This would help owner to make the best decision BUSINESS
 To help manager decide what price should be charged for product
COSTS
Therefore, accurate cost information is important for managers
TOTAL COST can be
Fixed and Variable Costs = fixed + either fixed
variable or variable
The main types of costs are fixed costs and variable costs: costs with output

Fixed OR overhead Costs: These are costs which do not vary with the
number of items sold or produced in the short run. They have to be paid whether business is making any sales or not
(e.g. management salaries, rent for property).

Variable Costs: These are costs which vary directly with the number of items sold or produced. Variable costs increase as
production increases. (e.g. material cost, piece-rate labour costs)

Total Cost and Average Cost

Total Costs: These are fixed and variable costs combined.

𝑇𝑜𝑡𝑎𝑙 𝐶𝑜𝑠𝑡𝑠 𝑜𝑓 𝑃𝑟𝑜𝑑𝑢𝑐𝑡𝑖𝑜𝑛 (𝑇𝐶) = 𝐹𝑖𝑥𝑒𝑑 𝐶𝑜𝑠𝑡𝑠 (𝐹𝐶) + 𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝐶𝑜𝑠𝑡𝑠 (𝑉𝐶)
OR

𝑇𝑜𝑡𝑎𝑙 𝐶𝑜𝑠𝑡 = 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑐𝑜𝑠𝑡 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡 × 𝑜𝑢𝑡𝑝𝑢𝑡

Average cost per unit OR unit cost: It is the total cost of production divided by total output

𝑇𝑜𝑡𝑎𝑙 𝑐𝑜𝑠𝑡𝑠 𝑜𝑓 𝑝𝑟𝑜𝑑𝑢𝑐𝑡𝑖𝑜𝑛 (𝑖𝑛 𝑎 𝑡𝑖𝑚𝑒 𝑝𝑒𝑟𝑖𝑜𝑑)

𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑝𝑟𝑜𝑑𝑢𝑐𝑡𝑖𝑜𝑛 =
𝑇𝑜𝑡𝑎𝑙 𝑜𝑢𝑡𝑝𝑢𝑡 (𝑖𝑛 𝑎 𝑡𝑖𝑚𝑒 𝑝𝑒𝑟𝑖𝑜𝑑)

Using cost data

Once a business had classified all costs into either fixed or variable, this information can be used to help make business decisions

Use of cost data Example Explanation

Setting prices Average cost of making pizza = $3
If the business wants $1 profit/pizza
It will be sold for $4 each
Deciding whether If the total annual cost of producing a product is $25000
to stop production but the total revenue is only $23000, then the business is
making a loss and could decide to stop making the
product
Deciding on the Location A for a new shop has total annual costs of $34k
best location Location B for a new shop has total annual costs of $50k
On this data alone, Location A should be chosen
If the average cost per unit wasn’t known,
the business could charge a price that leads
to a loss being made on each item sold
No business will willingly continue to make a
loss but the decision to stop making a
product will also depend on whether:
 The product has just been launched on
the market – sales revenue might
increase in future
 The fixed costs will have to be paid e.g.
if the factory being used for the product
is not sold
Costs are not the only factor to consider –
there might not be any point in choosing a
low-cost location for a new shop if it is in the
worst part of town!
Economies and Diseconomies of Scale
Economies of Scale
Economies of Scale are the factors

that lead to a reduction in average costs as a business increases in size

5 Economies of Scale
Purchasing economies
Marketing economies
Financial economies
Managerial economies
Technical economies

Diseconomies of Scale
Diseconomies of Scale are the factors that lead to an increase in average costs as a business grows beyond a certain size

Some Diseconomies of Scale:

Poor communication
Low Morale
Slow decision-making

Transport
advertising
Marketing

Bulk buying Purchasing

discounts
Causes of ECONOMIES
Lower Average
Lower interest
Costs
OF SCALE
rates Financial

Specialisation and
latest equipment Technical

Specialist in all
departments Managerial
 poorer
communication

slower decision Causes of DISECONOMIES

making Higher OF SCALE
Average Costs

low morale

Break-even charts: comparing costs with revenue

The concept of break-even
The break-even level of output/break-even output is the quantity that must be produced/sold for total revenue to equal total costs.
At this point neither is profit nor loss is made. The sales or point below break-even point will always indicate loss for business

Break-even level can be worked out in two ways:

1. Drawing a break-even chart

2. The Calculation point

Drawing a break-even chart

Break-even charts are graphs which show how costs and revenues of a business change with sales. They show the level of sales the
business must make in order to break even.

In order to draw a break-even chart, we need information about the fixed costs, variable costs and revenue of a business.

help in decision BREAK-EVEN GRAPH INFORMATIONS

show safety show area of
margin making profit or loss
 The ‘y’ axis measures money amounts – costs and
revenue
 The ‘x’ axis shows the number of units produced
and sold
show break-  The fixed costs do not change at any level of
even output USES / BREAK- output
Advantages  The total cost line is the addition of variable costs
EVEN and fixed costs
CHARTS
LIMITATIONS/ Break-even point: the calculation method
Disadvantages 𝑇𝑜𝑡𝑎𝑙 𝐹𝑖𝑥𝑒𝑑 𝐶𝑜𝑠𝑡𝑠
Breakeven level of production =
𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑝𝑒𝑟 𝑈𝑛𝑖𝑡
concentrate on
break-even

assume no
inventories
fixed costs not 'straight line'
always constant assumptions