CHAPTER 16 – COSTS, SCALE OF PRODUCTION AND BREAK-EVEN ANALYSIS

How are costs classified?

-Fixed costs :costs that do not change with the output.

- A fixed cost will be the same amount when output is 0 or when the business is producing a maximum
output.
- Examples: warehouse rent, house rent, salary of managers

-Variable costs :costs that change in direct proportion to output

- If the output increases the variable costs increases

- Examples: Raw materials

-Total costs: all the variable and fixed costs of producing the total output.

- Total costs = fixed costs + total variable costs

-Average costs:the cost of producing a single unit of output.

- Average cost = total cost / output

Using Cost data to make simple cost-based decisions

Cost data can be used in making decisions about whether a business should continue or stop producing a loss-
marketing product.

Revenue : the amount of money a business gains by selling its products

Profit = difference between revenue and total costs ( Profit = Revenue – total costs )

(2)  any number that is braked is a negative number.

Economies and diseconomies of scale

Economies of scale:

Economies of scale : the reduction in average costs as a result of increasing the scale of operations.

Business may benefit from economies of scale :

1. Financial economies : banks often lend money to larger businesses compared to smaller businesses, because
a larger business will find it easier to repay, it is less risk for the bank, and it will be normally charged with a
smaller interest.
2. Managerial economies: As the business grows it will employ specialists that manage make better decisions
( financial , marketing … ) and less mistakes compared to non-specialist managers
3. Marketing economies: While the total marketing cost rise as a business gets larger, it does not rise at the
same rate as sales output. The cost of marketing does not rise if a business doubles it sales.
4. Purchasing economies: larger businesses usually buy raw materials in bulk because they are buying more of
a product, and so, they usually benefit from a discount. This discount makes the unit price per item cheaper,
this will benefit the business, as it will reduce variable costs. Example: CostCo
5. Technical economies: larger successful businesses can afford expensive and the latest machinery and
software. This means that they can purchase their output at high levels and at a lower unit cost compared to
small businesses.

Diseconomies of scale : factors that cause average costs to rise as the sale of operations increases

Diseconomies of scales are all due to the problems faced by management in trying to control a business that has
become too large.

The main causes of these problems are:

 1. Poor communication  can lead to poor and slow decision making and increase mistakes
2. Lack of communication from employees  this can lead to demotivation, high labour turnover, poor quality
and fall in productivity.
3. Weak coordination between departments  if a business has offices located in different countries, costs
could rise because of employees working towards different objectives, duplication and a waste of resources
and unnecessary increase in costs

The importance of economies and diseconomies of scale:

Economies of scale = reduce average cost

Diseconomies of scale = increase average cost

Break-even analysis

Break even : the levee of output where revenue equals total costs, the business is making neither profit nor loss.

The revenue a business earns from selling its output = the total costs of producing the output

Revenue that a business earns from selling its products > total costs of producing output  Profit

Revenue that a business earns from selling its products < total costs of producing  Loss

The concept of break even

Break even analysis is a business technique that shows the relationship between revenue, costs and volume of
output/sales.

A business may use break even to analyse:

- Calculate how many units it needs to sell before it starts to make a profit
- Calculate the effect on profit of increasing or decreasing the price of products
- Calculate the effect on profits of an increase or decrease in business costs

Simple break-even charts

Purpose : to show the relationship between a businesses revenue and costs at different levels of output.

The chart can be used to work out the level of output that must be produced and sold to earn revenue which exactly
equals the total costs of producing that level of output. = break even output

To produce a break-even chart, a business needs to know its:

- Revenue at zero output and the maximum output capacity

- Total costs at zero output and capacity output
- Fixed costs at zero output and capacity output

See example on Page 224 of the Business Textbook

Benefits and limitations of breakeven charts

Benefits Limitations
Easy to construct and interpret Assume that all the costs and revenues can be
represented by straight lines
Provide businesses with useful information about the It is not easy to separate costs into fixed and variable
output that must be sold to cover all the costs and how
different sales volumes affect the margin of safety and
profitability
Can show the effect of a decision to change costs and Assume that all output is sold – do not allow
revenues inventories and the cost of holding these.
Can help with other important businesses decisions
such as the location and relocation of a business
Exam style question:

a)Fixed costs are costs that do not change with the level of output or sales

b) The break-even point for product B 

45 000 / ( 6-3 ) = 15 000

Profit if the business makes the planned sales of 30000 per month  ( Profit = Revenue – total costs )

Revenue : 30 000 x 6 = 180 000

Total costs : ( 30 000 x 3 + 45 000 ) = 135 000

Profit = 180 000 – 135 000 = 45 000

c) Do you think AFC should stop production of product B ? Justify your answer

I think that AFC should not stop the production of product B because:

Use data

- The fixed costs will be the same , so then the total fixed costs per month are going to be the same. If the
production stopped, then the fixed costs are going to be a loss of money for the business, instead if it is
used, then the business will be able to at least use them and get a less loss than if the product B was not in
use
- It is a positive contribution to pay the fixed costs and at least a small amount of profit is being gained by the
business
- Also, if the demand suddenly increases then it will be a profit for the business.
- The total costs is going to be the same if product A dies not change which also means a loos to the business,
- It is better to get a small amount of profit than having a large amount of loss.
- Also customers can be lost as if a food animal food is stopped being produced then all the farmers and
customers will move to buy to another supplier.

d) Explain two possible economies of scale that AFC could benefit from ?

1. purchasing economies : If AFC buys products in bulk, then they can receive a discount. This will help the business
because the unit price will be bought by AFC ( for example the corn or the ingredients of the animal food ) will be
cheaper meaning that they can have more profit and also, they can be a cheep producer of animal food , which will
attract many customers to buy the food at a cheap, lower price than other producers in the market.

2. Technical economies : AFC can afford to buy expensive specialist materials and equipment, that will help to
produce the animal food. Also, flow production can be used, meaning that more products can be created and mass
production is established, this will help the business a lot, as more cow or horse food can be produced, meaning that
business AFC could sell the food at a lower price. Also, if business AFC can invest money on the development of the
business then this will make the business of food production much better and will increase the profits and revenue
of each product.