Costs, Scale of Production and Break-Even Analysis

Business costs

• The costs of operating the factory can be compared with the revenue from the sale of the sports shoes to calculate whether or not the business will make a profit or loss.
• The costs of two different locations for the new factory can be compared, helping the owner make the best decision.
• Costs help the manager decide what price should be charged for a specific product/service.

Fixed costs and variable costs

• Fixed costs are costs which do not vary in the short run with the number of items sold or produced. They have to be paid whether the business is making sales or not.
  • They are also known as overhead costs.
• Variable costs are costs which vary directly with the number of items sold or produced.

Total cost and average costs

• Total costs are fixed and variable costs combined.
• Average cost per unit is the total cost of production divided by total output.

Economies of scale

• Economies of scale are the factors that lead to a reduction in average costs as a business increases in size.
• There are five economies of scale:
  • purchasing economies
  • marketing economies
  • financial economies
  • managerial economies
  • technical economies

Purchasing economies

• Buying in bulk leads to discounts and lower costs per unit.
  • This gives the firm an advantage over businesses which buy in small quantities.

Marketing economies

• Spreading marketing costs over a larger output reduces the cost per unit.

Financial economies

• Larger businesses frequently get better interest rates and easier access to capital.

Managerial economies

• Larger firms can afford to hire specialized managers, which can improve efficiency.

Technical economies

• Investing in more advanced machinery and technology reduces production cost.

Diseconomies of scale

• Diseconomies of scale are the factors that lead to an increase in average costs as a business grows beyond a certain size.
• There are three main diseconomies of scale:
  • poor communication
  • lack of commitment from employees
  • weak coordination

Poor communication

• As a company grows, communication between departments becomes more complex and less efficient.

Lack of commitment

• Employees in large businesses may feel less connected to the company, reducing their motivation and productivity.

Weak coordination

• Managing and coordinating multiple divisions and departments starts to become increasingly difficult, leading to inefficiencies.

Break-even charts: comparing costs with revenue

• Break-even level of output is the quantity that must be produced/sold for total revenue to equal total costs.
  • This is also known as the break-even point.

Concept

• The break-even level of output indicates to the owner or manager of a business the minimum level of output that must be sold in order to cover total costs.
• At this break-even level of output, it is crucial to note that a profit is not being made but neither is a loss.
  • The quicker a newly established business can reach break-even point, the more likely it is to survive.
• You are able to identify the break-even level of output either by drawing a graph or performing calculations.

Break-even charts

• ** are graphs which show how costs and revenues of a business change with sales. They show the level of sales the business must make in order to break even.
• The revenue of a business is the income during a period of time from the sale of goods and services.
  • $\text{Total revenue}=\text{Quantity sold}\times \text{price}$
• The graph shows that the break-even point of production is where total costs and total revenue cross. This indicates to the business that they must sell $x$ products in order to avoid making a loss.
  • At production below the break-even point, the business is making a loss.
  • At production above the break-even point, it makes a profit.
    • Maximum profit is made when maximum output is reached.

Advantages

• able to read the expected profit or loss to be made at any level of output
• impact on profit or loss of certain business decisions can also be shown by redrawing the graph
• margin of safety is shown
  • Margin of safety is the amount by which sales exceed the break-even point.

Disadvantages

• it assumes that all goods produced by the firm are actually sold, and doesn’t show the possibility that inventories may build up if not all goods are sold
• fixed costs only remain constant if the scale of production remains unchanged
• there are many other aspects of the operations of a business which need to be analyzed, break-even charts only concentrate on the break-even point of production
• simple charts used only assume that costs and revenues can be drawn with straight lines.