Identifying and Classifying Costs
A cost is an expense incurred by a business when producing goods or services.
Businesses need to understand their costs because costs affect:
→ Selling price
→ Profit
→ Production decisions
→ Choice of suppliers
→ Whether to continue producing a product
Fixed Costs
Fixed costs are costs that do not change when the level of output changes, within a given production capacity.
Examples:
→ Rent
→ Insurance
→ Salaries of some employees
→ Business rates
→ Depreciation of machinery
Example:
A factory pays $10,000 rent each month.
→ 1,000 units produced → $10,000 rent
→ 2,000 units produced → $10,000 rent
→ 3,000 units produced → $10,000 rent
The rent remains the same.
Variable Costs
Variable costs change as the level of output changes.
Examples:
→ Raw materials
→ Packaging
→ Components
→ Energy used directly in production
→ Sales commission
Example:
If raw material costs $5 per unit:
→ 100 units → $500
→ 200 units → $1,000
→ 500 units → $2,500
As output increases, total variable cost increases.
Total Cost
Total cost is the total amount spent by a business on production.
Formula:
Total cost = Fixed costs + Total variable costs
Example
A business has:
→ Fixed costs = $20,000
→ Variable cost = $8 per unit
→ Output = 2,000 units
Total variable cost:
→ $8 × 2,000 = $16,000
Therefore:
→ Total cost = $20,000 + $16,000
→ Total cost = $36,000
Average Cost
Average cost is the cost of producing each unit.
Formula:
Average cost = Total cost ÷ Output
Example
→ Total cost = $36,000
→ Output = 2,000 units
Average cost:
→ $36,000 ÷ 2,000
→ $18 per unit
Comparing the Main Costs
| Cost | Meaning | Example |
|---|---|---|
| Fixed cost | Does not change with output | Rent |
| Variable cost | Changes with output | Raw materials |
| Total cost | Fixed cost + total variable cost | All production costs |
| Average cost | Cost per unit | Total cost ÷ output |
Using Cost Data to Make Decisions
Which Product to Produce
Suppose a business can produce either Product A or Product B.
| Product A | Product B | |
|---|---|---|
| Selling price | $30 | $35 |
| Variable cost | $18 | $20 |
| Contribution per unit | $12 | $15 |
→ Product A contribution = $30 − $18 = $12
→ Product B contribution = $35 − $20 = $15
If production capacity is limited, Product B may be considered because each unit contributes more towards fixed costs and profit.
However, the business should also consider:
→ Demand for each product
→ Production capacity
→ Quality
→ Competition
→ Total profit rather than contribution per unit alone
Whether to Continue or Stop Production
A business may compare the revenue generated by a product with its variable costs and avoidable fixed costs.
If a product is making an overall loss, the business should not automatically stop production.
It should consider:
→ Are variable costs covered?
→ Does the product contribute towards fixed costs?
→ Which fixed costs would disappear if production stopped?
→ Is demand likely to increase?
→ Does the product help sell other products?
Example:
A product sells for $20 and has a variable cost of $12.
→ Contribution = $20 − $12
→ $8 per unit
Although the product may make an overall loss because of fixed costs, each unit contributes $8 towards those fixed costs.
Deciding What Price to Set
Cost information helps businesses avoid setting a price that is too low.
For example:
→ Average cost = $25
→ Selling price = $30
→ Profit per unit = $5
However, price should not be based only on cost.
The business should also consider:
→ Competitors’ prices
→ Customer demand
→ Brand image
→ Product quality
→ Pricing strategy
Choosing Suppliers
Businesses can compare suppliers based on:
→ Price
→ Quality
→ Delivery costs
→ Reliability
→ Payment terms
A supplier with the lowest price is not necessarily the best choice.
Example:
Supplier A:
→ $10 per unit
→ Reliable delivery
Supplier B:
→ $8 per unit
→ Frequent delivery delays
The business may choose Supplier A if delays could stop production and cause lost sales.
Economies and Diseconomies of Scale
Economies of scale occur when the average cost per unit falls as a business increases its scale of production.
As a business grows:
→ Production increases
→ Resources may be used more efficiently
→ Average cost may fall
Purchasing Economies of Scale
Large businesses can buy raw materials in large quantities.
→ Bulk-buying discounts
→ Lower cost per unit
→ Lower average cost
Example:
A large supermarket chain may negotiate lower prices because it purchases thousands of units from suppliers.
Marketing Economies of Scale
Large businesses can spread advertising costs over a larger number of products.
Example:
A $1 million advertising campaign costs:
→ $10 per unit if 100,000 units are sold
→ $1 per unit if 1 million units are sold
Therefore, advertising cost per unit falls as output increases.
Financial Economies of Scale
Large businesses may find it easier to obtain finance and may receive loans at lower interest rates.
→ Large businesses may be considered less risky by lenders
→ Lower interest rates reduce finance costs
→ Average costs can fall
Managerial Economies of Scale
Large businesses can employ specialist managers.
Examples:
→ Finance manager
→ Marketing manager
→ Human resources manager
→ Production manager
Specialisation can:
→ Improve decision-making
→ Increase efficiency
→ Reduce average costs
Technical Economies of Scale
Large businesses can afford expensive machinery and technology.
→ Greater automation
→ Higher productivity
→ Higher output
→ Lower cost per unit
Example:
A large car manufacturer can invest in robots that may be too expensive for a small producer.
Diseconomies of Scale
Diseconomies of scale occur when a business becomes so large that its average cost per unit begins to increase.
This can happen because of:
→ Poor communication
→ Lack of employee commitment or loyalty
→ Weak coordination
→ Lack of control
Poor Communication
As a business becomes larger:
→ More employees and managers
→ More departments
→ Longer communication channels
This can result in:
→ Messages being delayed
→ Misunderstandings
→ Poor decisions
→ Production problems
Lack of Employee Commitment or Loyalty
Employees in a very large organisation may feel less connected to the business.
→ Employees may feel less valued
→ Motivation may fall
→ Labour turnover may increase
→ Productivity may decrease
Weak Coordination
Large businesses have many departments and activities that need to work together.
Poor coordination can cause:
→ Duplication of work
→ Delays
→ Excess inventory
→ Production problems
→ Higher costs
Lack of Control
As a business grows, senior managers may find it harder to monitor all activities.
→ Problems may go unnoticed
→ Quality may fall
→ Waste may increase
→ Costs may rise
Economies of Scale vs Diseconomies of Scale
| Economies of scale | Diseconomies of scale |
|---|---|
| Average cost falls | Average cost rises |
| Occur as the business expands | May occur when the business becomes too large |
| Bulk purchasing | Poor communication |
| Specialist managers | Lack of employee commitment |
| Better technology | Weak coordination |
| Lower finance costs | Lack of control |
Break-even Analysis
Break-even is the level of output at which a business’s total revenue equals total cost.
At the break-even point:
→ Total revenue = Total cost
→ Profit = $0
→ Loss = $0
If output is below break-even:
→ Total cost > Total revenue
→ Business makes a loss
If output is above break-even:
→ Total revenue > Total cost
→ Business makes a profit
Break-even Chart
A break-even chart normally shows:
→ Output on the horizontal axis
→ Costs and revenue on the vertical axis
→ Fixed cost line
→ Total cost line
→ Total revenue line
→ Break-even point
Reading a Break-even Chart
Break-even point
→ Where total revenue intersects total cost
Loss
→ Where total cost is above total revenue
Profit
→ Where total revenue is above total cost
Fixed costs
→ Horizontal line because they remain constant as output changes
Calculating Break-even Output
Formula:
Break-even output = Fixed costs ÷ Contribution per unit
Where:
Contribution per unit = Selling price per unit − Variable cost per unit
Example
A business has:
→ Fixed costs = $40,000
→ Selling price = $50 per unit
→ Variable cost = $30 per unit
First calculate contribution:
→ $50 − $30 = $20
Then:
→ Break-even output = $40,000 ÷ $20
→ 2,000 units
The business must sell 2,000 units to break even.
Margin of Safety
The margin of safety shows how much actual or expected sales can fall before the business reaches its break-even point.
Formula:
Margin of safety = Actual output − Break-even output
Example
→ Actual output = 3,000 units
→ Break-even output = 2,000 units
Therefore:
→ Margin of safety = 3,000 − 2,000
→ 1,000 units
The business could experience a fall in sales of up to 1,000 units before making a loss, assuming other factors remain unchanged.
Interpreting Margin of Safety
Large margin of safety:
→ Business is further above break-even
→ Greater protection against a fall in sales
Small margin of safety:
→ Business is close to break-even
→ A small fall in sales could result in a loss
Using Break-even Analysis for Decisions
Break-even analysis can help a business understand the effect of changes in:
→ Price
→ Fixed costs
→ Variable cost per unit
Effect of Increasing Price
If selling price increases while other factors remain unchanged:
→ Contribution per unit increases
→ Break-even output decreases
→ Profit can be higher at the same output
Example:
Selling price = $50
Variable cost = $30
→ Contribution = $50 − $30
→ $20
If price increases to $60:
→ Contribution = $60 − $30
→ $30
The business now needs to sell fewer units to cover its fixed costs.
However:
→ Higher prices may reduce demand
→ Customers may switch to competitors
Effect of Increasing Fixed Costs
If fixed costs increase:
→ Break-even output increases
→ Business must sell more units to cover its costs
→ Margin of safety may decrease
Example:
If rent increases significantly:
→ Fixed costs rise
→ Break-even point increases
→ Greater sales are required before profit is made
Effect of Increasing Variable Cost per Unit
If variable cost per unit increases:
→ Contribution per unit decreases
→ Break-even output increases
→ Profit at a given output may fall
Example:
Selling price = $50
Variable cost increases from $30 to $35.
Old contribution:
→ $50 − $30 = $20
New contribution:
→ $50 − $35 = $15
The business now needs to sell more units to cover its fixed costs.
Limitations of Break-even Analysis
Break-even analysis is useful, but it has limitations.
Costs May Not Be Constant
Break-even analysis often assumes:
→ Fixed costs remain fixed
→ Variable cost per unit remains constant
In reality, costs can change.
Selling Price May Change
The analysis may assume that selling price remains constant.
In reality:
→ Businesses may offer discounts
→ Competitors may reduce prices
→ Prices may change with demand
Sales May Not Equal Production
Break-even analysis often assumes that all output produced is sold.
In reality:
→ Inventory may remain unsold
→ Demand may be lower than expected
Demand Is Difficult to Predict
The calculation does not tell the business whether customers will actually buy the required number of units.
Multiple Products
Break-even analysis is simpler for a business selling one product.
If a business sells many products:
→ Each product may have a different price
→ Each product may have different variable costs
→ Sales proportions may change
This makes break-even analysis more complicated.
External Factors
Break-even analysis does not automatically account for:
→ Changes in competition
→ Changes in customer tastes
→ Economic conditions
→ Changes in technology
→ Supply problems
Using Break-even Analysis in Business Decisions
Break-even analysis should be used alongside other business information.
A business should consider:
→ Break-even output
→ Margin of safety
→ Expected demand
→ Competitors’ prices
→ Costs
→ Available production capacity
→ Customer preferences
Example:
A business calculates that it needs to sell 10,000 units to break even, but market research suggests that only 7,000 units are likely to be sold.
→ The business is likely to make a loss if demand is as expected.
It may consider:
→ Reducing fixed costs
→ Reducing variable costs
→ Increasing price, if demand allows
→ Improving promotion
→ Changing the product
→ Reconsidering whether to launch the product
Key idea:
Break-even analysis provides useful financial information, but it should be combined with market research and other business information when making decisions.