CHAPTER 16: COSTS, SCALE OF PRODUCTION AND BREAK-EVEN ANALYSIS
The classification of costs helps in business decision-making.
How are costs classified?
• Fixed costs
Costs that do not change with output. That is, the fixed cost will be the same amount when
output is zero or when producing maximum output.
• Variable costs
Costs that change with output. If output increases by 50% then the variable costs will also
increase by 50%.
• Total costs
It is all the costs of making a certain level of output.
Total cost = foxed costs + total variable costs
• Average costs
It is the total costs divided by the number of units produced.
Using cost data to make simple cost-based decisions
Cost data can be used for:
• Setting prices
• Break-even analysis
• Decisions about whether to continue or stop producing a product.
• Deciding whether to continue or stop producing a loss-making product.
Economies and Diseconomies of scale
Economies of scale
It refers to the reduction in average costs as a result of increasing the scale of operations.
1. Financial economies
Lenders, such as banks, prefer to lend to large businesses because they consider them less of
risk than smaller businesses.
2. Managerial economies
Specialist managers would be more willing to work for bigger businesses as there are more
career prospects.
They will improve the quality of business decisions and make fewer mistakes than non-
specialist managers.
3. Marketing economies
While total marketing costs rise as a business gets larger, they do not rise at the same rate as
sales output. This means that the average cost of marketing falls as output and sales increase.
4. Purchasing economies
Because large businesses buy greater quantities of raw materials, suppliers often offer
discounts on bulk purchase. They are also called bulk-buying economies.
5. Technical economies
Large businesses usually use flow production to produce their output. This method of
productions often uses the latest technology, such as computer-aided manufacturing (CAM).
such technology may be very expensive and only large business can afford this investment.
The technology enables businesses to produce very high levels of output at lower unit costs
than smaller businesses.
For example, large container ships carry more containers than smaller ships at a lower unit
cost.
Diseconomies of scale
They are factors that cause average costs to rise as the scale of operations increases.
Diseconomies occurs when businesses become too large.
Causes of diseconomies of scale:
1. Poor communication
Managers may no longer be able to communicate directly with workers. This can lead to slow
and poor decision-making and an increase in mistakes.
2. Demotivation of workers
Managers may no longer have regular contact with workers thus this can lead to demotivation
as workers may feel that they are no longer a valued part of the business.
Demotivation can lead to high labour turnover, poor quality and a fall in productivity.
3. Poor control
The number of departments grow as the business grows; therefore, the control and coordination
of managers can present many problems.
There is also the risk of duplication of work as well as wastes of resources.
The importance of economies and diseconomies of scale
Economies of scale reduce average costs
Diseconomies of scale increase average costs.
As output increases, unit costs fall and continue to do so until diseconomies of scale occur
and unit costs begin to rise.
The best scale of operation is where unit costs are at their lowest – the bottom curve at the
point Q.
Simple break-even charts
What is Break-even?
It is the level of output where the revenue equals total costs, that is, the business is making
neither profit nor loss.
If revenue is equal to the total costs of producing it, then the business is making neither profit
nor loss; it is break even.
If revenue is greater than the total costs, then the business earns profit.
If revenue is less than the total costs, then the business will make a 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.
Break-even analysis is used to:
• Calculate how many units a business needs to sell before it starts to make a profit
• Calculate the effects on profit of increasing or decreasing the price of a product
• Calculate the effect on profits of an increase and decrease in business costs.
Simple break-even charts
The Break-even chart can be used to work out the break-even output; that is the level of output
that must be produced and sold to earn revenue which equals the total costs of producing that
level of output.
To produce a break-even chart, a business needs to know its:
• Revenue at zero output and at capacity output
• Total costs at zero output and at capacity output.
• Fixed costs at zero output and at capacity output.
Margin of safety
It is the amount by which actual sales exceed the break-even level of output.
Margin of safety = actual sales – break-even output
It measures the amount by which sales can fall before losses are made.
The higher the margin of safety, the lower the risk of a loss being made.
Benefits of break-even charts
• Easy to construct and interpret
• Provide useful information about the output that must be sold to cover all costs and how
different sales volumes affect the margin of safety and profitability.
• Can help with other important business decisions such as the location and relocation of
a business.
Limitations of break-even charts
• It is not easy to separate costs into fixed and variable.
• Assume that all output is sold – do not allow for inventories and the costs of holding
these.
Break even = Fixed Cost / contribution per unit
contribution per unit = selling price per unit - variable cost per unit
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