Costs, break-even and production scale

• Businesses incur a range of costs
• Examples of business costs

  • Purchasing raw materials
  • Paying staff salaries/wages
  • Paying utility bills such as electricity
• Types of business costs

  • Fixed costs
  • Variable costs
  • Total costs
  • Average costs
• Fixed costs (FC)


  Costs that do not change as the level of output changes. Have to be paid whether the output is zero or 5000. E.g. Building rent, management salaries, insurance, bank loan repayments etc.
• Variable costs (VC)


  Costs that change directly with the output. Increase as output increases and vice versa. E.g. Raw material costs, wages of workers directly involved in the production
• Total cost (TC)


  The sum of the variable & fixed costs. Cannot be 0 as all firms have some level of fixed costs
• Average Total Cost (AC)

  As a firm grows, it is able to increases its scale of output generating efficiencies that lower its average total costs (AC) of production. Efficiencies are called economies of scale. As a firm continues increasing its scale of output, it will reach a point where its average total costs (AC) will start to increase due to diseconomies of scale
• Cost Calculations


  1. Total costs (TC) = total fixed costs (TFC) + total variable costs (TVC)

  2. Total variable cost (TVC) = variable cost (VC) x quantity (Q)
• Calculating Variable Cost per Candle

  1. Step 1: Identify the variable costs

  2. Step 2: Total the variable costs

  3. Step 3: Express the answer in € per Candle
• Uses of Cost Data

  • Analyse & reduce costs
  • Analyse location decisions
  • Set prices
  • Used to make production decisions
• Reducing costs


  Accurate cost data can help a business identify if their costs are too high. Fixed costs may be reduced by relocating, reducing salaries, spending less on promotion, seeking lower-priced utilities. Variable costs may be reduced by sourcing cheaper materials, buying in bulk, or outsourcing distribution
• Setting prices


  Costs play an important role in the determination of selling prices. They are a crucial part of making, or increasing profit
• Production decisions


  If the cost of producing a product is higher than the revenue it generates the business will make a loss. It will need to decide whether to continue making the product or stop
• Location decisions


  Property rental or the purchase of premises can be a substantial monthly cost. Some locations are cheaper than others. A business must weigh up the cost of the location against other important factors
• Economies of Scale


  As a business grows, it is able to increases its scale of output which generates efficiencies that lower its average costs (AC) of production. These efficiencies are called economies of scale
• Economies of scale help large firms lower their costs of production beyond what small firms are able to achieve
• Economies of scale

  Economies of scale can result in lower average (or unit) costs not lower total costs. The total costs will increase, but at a decreasing rate per unit
• Types of Economies of Scale

  • Purchasing Economy
  • Managerial Economy
  • Marketing Economy
  • Financial Economy
  • Technical Economy
• Diseconomies of Scale


  As a firm continues increasing its scale of output, it will reach a point where its average costs (AC) will start to increase. The reasons for the increase in the average costs are called diseconomies of scale
• Types of Diseconomies of Scale

  • Poor communication
  • Poor coordination
  • Lack of commitment from employees
• Break-even analysis


  A financial tool used to determine the number of units a business must sell to reach the point where the business revenue equals its expenses (no profit nor loss)
• Break-even point


  The number of units that need to be sold for total costs to equal the sales revenue
• Elements of a Break-even Analysis

  • Variable costs
  • Fixed costs
  • Revenue
• Constructing a Break-even Chart

  Requires knowing the estimated fixed costs, variable costs and sales revenue
• Sales revenue


  Number of items sold x selling price
• Break-even charts are graphs which show how costs and revenues of a business change with sales
• Break-even charts identify the number of units a business must sell in order to break-even
• Fixed costs


  Costs that do not change with sales
• Variable costs


  Costs that change with sales
• Tee Crazy Ltd has the following estimates: Fixed costs are $8,800 per year, the variable cost of each t-shirt is $4, each t-shirt is sold for a price of $10, the factory can produce a maximum output of 3000 t-shirts per year
• Production output below the break-even point results in the business making a loss
• Production output above the break-even point results in a profit
• Fixed costs do not change as output increases
• Total costs are made up of fixed and variable costs
• The revenue line slopes upwards as output increases
• The break-even point is the point at which the total costs and revenue lines cross
• Margin of safety


  The amount by which the number of units sold is greater than the break-even point
• Businesses want their margin of safety to be as large as possible
• Examples of Using Break-even in Decision-making

  • Assessing profit or loss
  • Managing costs
  • Pricing decisions
  • Financial planning
• Break-even analysis


  Provides a basis for informed decision making by helping the business assess the costs and expected returns of new projects and expansion plans