Business Costs and Break-Even Analysis Chapter 16 Notes

COSTS, SCALE OF PRODUCTION AND BREAK-EVEN
Business costs
-business costs are classified as;
i. fixed costs/overhead costs- costs that do not change with output
-they will be the same amount when output is zero or when the firm is producing its
maximum output/capacity. for example, factory rent,salary of managers
ii. variable costs/direct costs- costs that change in direct proportion to output
-changes with output. If output increases by 50%, the the variable costs will also
increase by 50%. For example raw materials
iii. total costs- all the variable and fixed costs of producing the total output. A the cost
of making a certain level of output.
Total costs=fixed costs + variable costs OR average cost per unit × output
iv. Average costs- the cost of producing a single unit of output.
Average costs = fixed costs + variable costs ÷ number of output
Complete the table with a tick

Fixed costs Variable costs
Factory rent
Leather used in making some shoes
Electricity used to power machinery
Machinery maintenance
Advertising
Production worker’s wages
Operations manager’s salary
Delivery of finished goods to customers
Safety equipment for production workers
Government taxes
Complete the table
Output Fixed costs Variable costs Total costs
[pairs of shoes $3 per pair of shoes
$ $ $
0 2 000
1 000 2 000 3 000
2 000 2 000
3 000 11 000
4 000
The marketing department thinks they should stop selling product A but the
accountant say no. What do you think?
Product A Product B Total
$000 $000 $000
Revenue 20 50 70
Fixed costs 10 15 25
Total variable costs 12 18 30
Total costs 22 33 55
Profit [2] 17 15
Economies and diseconomies of scale

Economies of scale- the reduction in average costs as a result of increasing the
scale/size of operations
- as output grows, the business often benefits from reduced average costs due to
economies of scale
- there are different types of economies of scale;
i. Purchasing economies/Bulk-buying economies
- large businesses usually buy large quantities of raw materials and goods than smaller
businesses.
- Suppliers often offer discounts on large or bulk purchases and small businesses do
not benefit from discounts
ii. Financial economies
- lenders such as banks often prefer to lend money to large businesses because they
consider them less of a risk than smaller businesses
- large businesses find it easier to borrow money and often do so at a lower rate of
interest than smaller businesses
iii. Managerial economies

- as a business grows, it employs specialist managers for the different functional areas
of the business such as marketing, finance, operations and human resources
- specialist managers improve the quality of business decisions and make fewer
mistakes than non- specialist managers
iv. Marketing economies
- While total marketing costs rise as a business gets larger, they do not rise at the same
rate with sales output. So if business doubles its output and sales, it will not double its
marketing costs, meaning average cost of marketing falls as output ans sales increase
v. Technical economies
- large businesses usually use flow production to produce their output. This method
often uses the latest technology such as computer-aided manufacturing [CAM].
- such technology may be very expensive and only very large businesses can afford
the level of investment required.
- the technology allows the business to produce very high levels of output at lower
prices, which are also of high quality.
Diseconomies of scale - are those factors that cause average costs to rise as the scale
of operations increases
- diseconomies of scale 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;
i. Poor communication
- if a business becomes to hard managers may find it difficult to communicate directly
with employees, this can lead to slow and poor decision - making and an increase in
mistakes
ii. Lack of commitment from employees
- in large organisation managers may not have a day-to-day contact with employees.
This can lead to a lack of commitment from the employees who feel that they are no
longer a valued part of the business . employees may become demotivated and this
can lead to high labour turnover, poor quality and fall in production
iii. Weak coordination

- as a business grow, so too will the number of departments, products and production
units. The control and coordination of these can present managers with problems,
especially where production units are located in other countries.
- Average cost may increase as a result of different departments or different
production units of the same business working towards different objectives
Break-even analysis- the level output where revenue equals total costs, the business
is making neither profit nor loss from the sale of its products
- it shows the relationship between revenue, costs and volume of output/ sales.
- a business might use break-even analysis to;
i. calculate how many units it needs to sell before it starts to make a profit
ii. calculate the effect on profit of increasing or decreasing the price of a product
iii. calculate the effect on profits of an increase or decrease in business costs
- the break even level of output can be worked out in two ways by;
 drawing a break-even chart
 calculation
Break-even point: Using break-even charts

- the purpose of a break-even chart is to show the relationship between a business’s
revenue and costs at different levels of output
-the chart can also be used to work out the level of output that must be produced and
sold to earn revenue which is equal to the costs of producing that level of output
known as break-even output
break even level of output/sales- indicates to the owner or manager of a business the
minimum level of output that must be sold so that total costs are covered but without
making a profit or loss.
-To produce a break-even chart a business needs to have information about;
 fixed costs
 Variable costs
 total costs
 revenue of a business
 maximum output/capacity
Break-even point- is the level at which total costs=total revenue

Margin of safety- is the difference between the current level of output and break-
even output
Margin of safety = actual sales-break-even output
- this is a measure of the amount by which sales can fall before loses are made. The
higher the margin of safety, the lower the risk of a loss being made.
Advantages of break-even point

i. show area of profit or loss- managers are able to read off from the graph the
expected profit or loss to be made at any level of output
ii. show safety margin- which is the amount by which sales exceed the break-even
point
iii. helps decision making process
iv. show break-even output- shows output which needs to produced in-order to
break-even with production costs
Disadvantages of break-even
i. assumes no inventory- it assumes that all goods are actually sold and the graph
does not show possibilities that inventories can build up if all goods are not sold
ii. fixed costs remain constant- it assumes that fixed costs are fixed but they only
remain constant if the scale of production does not change. for example, a decision to
double up output will increase fixed costs through more space to rent and machinery
iii. straight line assumption- fixed costs are the same, that the lines are straight
iv. Concentrate on break-even- disregards aspects of the operations of a business
such as reducing wastage
Break-even point:Using the calculation method

Contribution of a product is its selling price less its variable costs
Classification of costs
Economies of scale
Diseconomies of scale

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COSTS, SCALE OF PRODUCTION AND BREAK-EVEN

Complete the table with a tick

Economies and diseconomies of scale

iii. Managerial economies

iii. Weak coordination

Break-even point: Using break-even charts

Break-even point- is the level at which total costs=total revenue

Advantages of break-even point

Break-even point:Using the calculation method

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