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4.2 – Costs, Scale of

Production and Break-
even Analysis

Home Notes Business Studies – 0450 4.2 – Costs, Scale of Production

and Break-even Analysis

Costs

Fixed Costs are costs that do not vary with output produced or sold in the
short run. They are incurred even when the output is 0 and will remain the same
in the short run. In the long-run they may change. Also known as overhead
costs.
E.g.: rent, even if production has not started, the firm still has to pay the rent.

Variable Costs are costs that directly vary with the output produced or sold.
E.g.: material costs and wage rates that are only paid according to the output
produced.

TOTAL COST = TOTAL FIXED COSTS + TOTAL VARIABLE COSTS

TOTAL COST =   AVERAGE COST * OUTPUT

AVERAGE COST (unit cost) = TOTAL COST/ TOTAL OUTPUT

A business can use these cost data to make different decisions. Some examples
are: setting prices (if the average cost of one unit is $3, then the price would be
set at $4 to make a profit of $1 on each unit), deciding whether to stop
production (if the total cost exceeds the total revenue, a loss is being made, and
so the production might be stopped), deciding on the best location (locations
with the cheaper costs will be chosen) etc.

Scale of production

As output increases, a firm’s average cost decreases.

Economies of scale are the factors that lead to a reduction in average costs as a
business increases in size. The five economies of scale are:

Purchasing economies: For large output, a large amount of components have

to be bought. This will give them some bulk-buying discounts that reduce costs
Marketing economies: Larger businesses will be able to afford its own vehicles
to distribute goods and advertise on paper and TV. They can cut down on
marketing labour costs. The advertising rates costs also do not rise as much as
the size of the advertisement ordered by the business. Average costs will thus
reduce.
Financial economies: Bank managers will be more willing to lend money to
large businesses as they are more likely to be able to pay off the loan than small
businesses. Thus they will be charged a low rate of interest on their borrowings,
reducing average costs.
Managerial economies: Large businesses may be able to afford to hire
specialist managers who are very efficient and can reduce the business’ costs.
Technical economies: Large businesses can afford to buy large machinery
such as a flow production line that can produce a large output and reduce
average costs.

Diseconomies of scale are the factors that lead to an increase the average costs
of a business as it grows beyond a certain size. They are:

Poor communication: as a business grows large, more departments and

managers and employees will be added and communication can get difficult.
Messages may be inaccurate and slow to receive, leading to lower efficiency and
higher average costs in the business.
Low morale: when there are lots of workers in the business and they have non-
contact with their senior managers, the workers may feel unimportant and not
valued by management. This would lead to inefficiency and higher average
costs.
Slow decision-making: As a business grows larger, its chain of command will
get longer. Communication will get very slow and so any decision-making will
also take time, since all employees and departments may need to be consulted
with.

Businesses are now dividing themselves into small units that can control
themselves and communicate more effectively, to avoid any diseconomies from
arising.

Break-even

Break-even level of output is the output that needs to be produced and sold in
order to start making a profit. So, the break-even output is the output at which
total revenue equals total costs (neither a profit nor loss is made, all costs are
covered).

A break-even chart can be drawn, that shows the costs and revenues of a
business across different levels of output and the output needed to break even.

Example:
In the chart below, costs and revenues are being calculated over the output of
2000 units.
The fixed costs is 5000 across all output (since it is fixed!).
The variable cost is $3 per unit so will be $0 at output is 0 and $6000 at output
2000- so you just draw a straight line from $0 to $6000.
The total costs will then start from the point where fixed cost starts and be
parallel to the variable costs (since T.C.= F.C.+V.C. You can manually calculate the
total cost at output 2000: ($6000+$5000=$11000).
The price per unit is $8 so the total revenue is $16000 at output 2000.

Now the break-even point can be calculated at the point where total revenue
and total cost equals– at an output of 1000. (In order to find the sales revenue at
output 1000, just do $8*1000= $8000. The business needs to make $8000 in sales
revenue to start making a profit).

Advantages of break-even charts:

Managers can look at the graph to find out the profit or loss at each level of
output
Managers can change the costs and revenues and redraw the graph to see
how that would affect profit and loss, for example, if the selling price is increased
or variable cost is reduced.
The break-even chart can also help calculate the safety margin- the amount by
which sales exceed break-even point. In the above graph, if the business decided
to sell 2000 units, their margin of safety would be 1000 units. In sales terms, the
margin of safety would be 1000*8 = $8000. They are $8000 safe from making a
loss.
Margin of Safety (units) = Units being produced and sold – Break-even output

Limitations of break-even charts:

They are constructed assuming that all units being produced are sold. In
practice, there are always inventory of finished goods. Not everything produced
is sold off.
Fixed costs may not always be fixed if the scale of production changes. If
more output is to be produced, an additional factory or machinery may be
needed that increases fixed costs.
Break-even charts assume that costs can always be drawn using straight
lines. Costs may increase or decrease due to various reasons. If more output is
produced, workers may be given an overtime wage that increases the variable
cost per unit and cause the variable cost line to steep upwards.

Break-even can also be calculated without drawing a chart. A formula can be

used:

Break-even level of production =Total fixed costs/ Contribution per unit

Contribution = Selling price – Variable cost per unit  (this is the value
added/contributed to the product when sold)

In the above example, the contribution is $8 -$3  =$5, so the break-even level is:
$5000/$5 = 1000 units!

Notes submitted by Lintha

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7 thoughts on “4.2 – Costs, Scale of

Production and Break-
even Analysis”
z2 says:
May 18, 2022 at 3:25 pm

These notes are helpful. I appreciate you making this website and understanding
the concepts!

! Liked by 1 person
REPLY

Lintha says:
May 20, 2022 at 4:32 pm

You’re welcome!

! Like
REPLY

sufyan faisal says:

March 7, 2021 at 2:39 pm

Typo at third bullet point of (Advantages of break-even charts), its Te instead of

“The”

! Like
REPLY

Lintha says:
March 9, 2021 at 2:19 pm

Corrected! Thank you!

! Like
REPLY

Nguyen Khai Minh says:

September 9, 2020 at 1:38 pm

Thankkkkk you so much this note are really helpful

! Liked by 1 person
REPLY

astrix hennry says:

January 9, 2021 at 11:30 am

thank you very much i was simply able to understand every thing clearly an
ddo a presentation for my class and now i have an A* thank you once again

! Liked by 1 person
REPLY

Lintha says:
January 26, 2021 at 7:28 am

Congrats!! So happy that we could help!

! Like
REPLY

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