4.2.1 Identify and Classify Costs
Classifying costs using examples
Costs may not seem as exciting as earning revenue, but costs have a huge impact on profit. It’s essential for business people to understand where their costs come from, how costs change with production and how to control costs.
Identifying and classifying costs is much more likely as a short answer question, but it forms the building blocks of break-even analysis, and can be an key part of paper 2 questions where you are asked to make a choice between two product options.
| ⭐⭐⭐Top Tip ⭐⭐⭐ It’s really important to learn the definitions and examples for each type of cost, so you can easily classify costs between fixed and variable, when calculating break-even point or calculating profits . |
Variable costs are costs that change as production output increases. So in a cookie factory the more cookies that are produced the higher the costs of ingredients.
Fixed costs are costs that don’t change as output increases. So in my cookie factory no matter how many cookies I produce I will still have to pay rent, and insurance and salaries to the office or management team.
Total costs are calculated by adding all costs, fixed and variable.
Average costs are calculated for each unit of production. So we divide total costs by total output. Average costs are often used for figuring out the selling price of a product. We also can see average cost decrease with economies of scale.
Use cost data to help make simple cost-based decisions
| Two Production Lines for Cookie Monster Co. Which one should be closed? |
| Choc Chip Cookies ($) | Wholemeal Cookies $() | |
| Revenue | 50,000 | 20,000 |
| Fixed Costs | 10,000 | 15,000 |
| Variable Costs | 15,000 | 7,000 |
| Total Costs | 25,000 | 22,000 |
| Profit | 25,000 | (2000) |
If we use the cost data for two production lines at the cookie factory, it appears that production should continue for chocolate chip cookies but production should stop for wholemeal cookies, as they are making a loss.
However, it’s important to remember that the fixed costs may have to be paid even if no wholemeal cookies are being produced. So the Cookie Monster Co. should wait until fixed costs have been paid before stopping production of wholemeal cookies.
Cost data is most often used in break even analysis which we will look at after economies of scale.
4.2.2 Economies of Scale
Economies of scale don’t appear that often as a stand alone question, however, economies of scale are crucial in analysing the benefits of business growth and can be an important analysis point in a huge range of different questions from methods of production, costs, profitability, and business objectives to name but a few.
We need to know the concept of economies AND diseconomies of scale, with examples of each.
Concept of Economies of Scale
Economies of scale mean that as output rises, average cost of each unit decreases. Let’s use the example of Giancarlo’s shirt production.
So if he can produce 10 shirts for a total of $100 the unit cost of each shirt will be $10.
But if he produces 1000 shirts for a total of $6,000 the unit cost of each shirt will be $6.
The impact of economies of scale decreasing average costs means Giancarlo can charge lower prices and increase sales, or make large profit margins for every shirt sold.
So how can we explain this reduction in average cost as output increases? So economies of scale are quite straightforward, whereas others are less obvious. But all of them contribute to the decrease in the cost as output rises.
Purchasing economies of scale or “buying in bulk” is what most people think of with economies of scale. If Giancarlo buys ten times as much material from his supplier, he won’t pay ten times as much, but will be able to negotiate a much lower price. If you walk around a supermarket you can see examples of offers of economies of scale all around. Generally, if you buy in a bigger quantity you will get a lower price per unit.
Marketing economies of scale mean that as a business grows in size it can spend a smaller share of its budget on marketing. If a small business spends 5% of its $100,000 revenue on marketing it will have a marketing budget of $5,000. However, if a large business spends 1% of its $1,000,000 revenue on marketing it will still have a larger marketing budget of $10,000.
Technical Economies of scale are available to large companies that use flow production and computer aided manufacturing. Mass produced goods with high levels of automation leads to lower unit production costs. Small businesses can’t afford the high capital costs to set up these expensive, advanced production methods, and therefore have higher unit costs.
Managerial economies of scale occur as larger businesses can employ experts in finance, marketing and other areas of the business who specialise in these areas and drive higher efficiency and effectiveness. In small businesses, for example my business, I have to do everything. I’m not an expert in social media marketing or computer systems, so these parts of my business or not run as well as in a large business, pushing up average costs.
So how can small businesses ever hope to compete against large businesses benefiting from all these economies of scale?
The Concept of Diseconomies of Scale
Well, it’s not all good news for big companies, large businesses can suffer from diseconomies of scale, when a business becomes so large it becomes badly run, less efficient and less effective. There are strong links between diseconomies of scale and unit 2 communication, motivation, leadership and organisation.
As businesses grow it becomes more difficult for all leaders and employees to communicate effectively. This can lead to slow decision making, and more mistakes due to employees receiving the wrong information.
Furthermore, employees can feel demotivated working for a large organisation, with thousands of other employees. Workers may feel that their contribution does not matter and they are “only a number” to management. This leads to lower productivity and less commitment to the organisations goals.
Finally, for large organisations coordination between departments can be a challenge. A large multinational organisation may find it difficult to keep all of the different parts of the businesses working towards the same aims. There is a much greater chance of duplication, two departments carrying out the same work, which will lead to wasted effort.
As we saw in Unit 2, overcoming communication barriers, ensuring workers are motivated and choosing a suitable or organisational structure or leadership style, can reduce or solve diseconomies of scale. The impact of economies of scale can bring huge benefits for a business, but some of the cost savings must be re-invested in the business to lessen or remove diseconomies of scale.
4.2.2 Break-even Analysis
The concept of break-even
So what does it mean to break-even and why is it so important? Break-even analysis shows the output required to break even, where sales revenue earned is the same as the total costs, or where the business is not making a profit or a loss.
Calculate Break-Even Level of Output from Given Data
Lets say Anika wants to set up a new business producing and selling saris (Indian traditional dress) . She wants to figure out how many sari’s she will have to sell so she can cover all her costs.
Her fixed costs are $20,000 per year on her sewing machines and $40,000 per year on rent of her factory. Her variable costs are $20 for the material for every sari.
| Anika’s Saris Cost Data | |
| Rent | $40000 |
| Sewing Machines | $20000 |
| Variable Cost | $20 per sari |
| Selling Price | $50 |
The breakeven point is where total costs are equal to total revenue, or where all costs, (fixed costs and variable costs) have been covered by the sales of saris.
How many saris will she have to produce before she breaks even?
If we know the selling price, we can figure out how much contribution each Sari makes to paying back the fixed costs.
If Anika sets the price at $50 that will cover the $20 cost of materials and leave $30. However, this is not profit. She has to cover her fixed costs first.
| Selling Price – Variable Cost per unit = Contribution $50 – $20 = $30 |
So every sari Anika sells will make a $30 contribution to the fixed costs.
So we divide fixed costs by this contribution to see how many Saris she will have to sell to cover all of her costs and break even.
| Break-Even Point = Fixed Costs ÷ Contribution Break-Even Point = ( $40000 + $20000 )÷$30 = $60000 ÷ $30 = 2000 saris |
So 60000 fixed cost divided by the contribution per Sari of $30 is 2000 Saris break even point.
However, Anika would like to make some profit. So if she wants to make $12000 profit she will have to sell more than the 2000 Saris she needed to get to the break-even point, but how many?
| How many saris will Anika have to sell to make $12000 profit? Target Profit = $12000 ÷ $30 (Contribution) = 400 saris Remember this target profit is achieved after reaching the break-even point of 2000 saris 2000 + 400 = 2400 saris |
We can use the contribution calculation again. After the break-even point, when fixed costs have been covered, each contribution will go straight to profit. So if she divides her target profit by contribution, she will have to sell 400 saris in addition to the 2000 saris it takes her to break even, so 2400 saris.
The 400 additional saris over the break-even point is called the margin of safety.
| Margin of Safety = Output – Break-Even Point |
Construct, complete or amend a simple break-even chart
The second method of calculating break-even is to use a break-even chart.
The syllabus states you need to be able to construct, complete or amend a simple break-even chart. In reality it’s very rare that you will have to draw a break-even chart, the mark scheme is not set up to award marks for drawing charts. You may have to change the chart slightly, then use the data in an answer.
However, we will go through each of the steps in making a break-even chart, as it’s important for understanding how the charts work and the limitations of break-even analysis. We will use the same data from Anika’s Saris.
Firstly, we put in our sales revenue line. It starts at 0 and rises $50 for each unit of output.
Fixed Costs (TFC) stay the same no matter what the output is, so it’s a straight horizontal line at $60,000 for every level of output.
Finally, we put in variable costs (TFC) and total costs (TC). Variable costs start at 0 and rise $30 for each unit of production. If we add variable costs to fixed costs, we get total costs at each level of production.
Where the total cost line crosses the revenue line shows where revenue and total costs are the same. This is the magical break-even point.
So for Anika the breakeven point is 2000 units or saris. After the break even point Anika is making a profit as revenue is greater than total costs, before the breakeven point Anika is making a loss as revenue is less than total costs.
With the break even chart Anika can quickly see at each point of output what her revenue, costs and profit (or margin of safety) or loss will be.
At 40,000 saris produced her margin on safety will be 20,000 units and $60000 profit.
Anika can also see the changes on break even if costs or revenue changes.
So break-even is useful as it can show the output required to break even, how different sales levels will affect profit and loss. It can also be used to assess how changes in costs and selling price will affect break even, profit and loss.
It is easy to calculate and draw the chart, and straightforward to interpret.
Understand the limitations of break-even analysis
However, there are key limitations with break even.
- it assumes all costs and revenues are constant regardless of the production level. As we will see with economies of scale, variable costs may decrease as output increases.
- Output may not always be sold for the same price. Businesses may change the price depending on the stage in the product life cycle or in response to other changes in the market.
- Furthermore, it assumes all output will be sold. Businesses will often hold inventories rather than immediately selling all output.
- Finally, it can be difficult to separate variable and fixed costs. For example, electricity or water bills don’t vary directly with each unit of production, but do rise as production increases.
Despite its limitations, break-even analysis is very useful as a production planning tool. Businesses may need more advanced planning tools to further analyse costs and profits, before starting production.
