Chapter 19 - Cost, scale of production and
break-even analysis
Costs
- Fixed cost - are costs that do not vary/change 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
Scale of Production - Economies of Scale
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:
Purchasin For large output, a large amount of components have to be bought. This will give
g them some bulk-buying discounts that reduce costs
economies
Marketing Larger businesses will be able to afford its own vehicles to distribute goods and
economies 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 Bank managers will be more willing to lend money to large businesses as they are
economies 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.
Manageria Large businesses may be able to afford to hire specialist managers who are very
l efficient and can reduce the business’ costs.
economies
Technical Large businesses can afford to buy large machinery such as a flow production line
economies that can produce a large output and reduce average costs.
Scale of Production – Diseconomies of Scale
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).
Example
In the chart, 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
Break-even point calculation method
- 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!
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.
Limitations of
- Margin of Safety break-even
(units) = Units being charts:
produced and sold – Break-even output
- 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