Unit 4.2 - Costs, Scale of Production & Break-Even Analysis

Key Terms + Concepts

Fixed Costs

costs that remain the same even if the level of output increases (ex. rent, salaries)

Variable Costs

costs that increase or decrease with changes in the level of output (ex. raw materials costs, wages)

Total Costs

total cost = total fixed costs + total variable costs

Average Unit Costs

AUC = total cost of production / the number of units produced during that time period

Why should a business use cost data to make decisions?

1. Deciding whether or not to stop production depending on how much its costs to produce the produce

2. Looking at cost data to determine how much the selling price should be to make profit

3. Deciding on the best location for production based on the lowest costs

4. Deciding on the right supplier for raw materials depending on the cost of the suppliers

5. Accurate cost data helps the production department to ensure that the budget for production is affordable for the business

Economies of Scale

the factors that lead to a reduction in average costs as a business increases in size

Purchasing Economies of Scale

• buying in bulk => discounts => reduces average costs of production

• can also get benefits from buying in bulk such as transportation help from the supplier because of how much you pay

Marketing Economies of Scale

• big business can purchase their own vehicles for distributing products rather than relying on other businesses => more cost-effective because the profit goes to them rather than shared with the other business

• advertising products multi-media + can afford more advertisements => create brand image => added value + loyal customers

• big businesses can conduct market research and have a bigger marketing budget

Financial Economies of Scale

• banks willing to lend loans to large business because they are guaranteed that the business will repay the loan

• large businesses can negotiate lower interest rates on their loans (+ get longer repayment period) => reduces average costs of production

Managerial Economies of Scale

• larger businesses can afford to hire specialist managers (headhunting/poaching) => more efficient

Technical Economies of Scale

• flow production methods (continuous production) => more output

• employee productivity is higher because they specialise in a limited number of tasks

• the increase in machinery & automation => more efficient

Diseconomies of Scale

the factors that lead to an increase in average costs as a business increases in size

Diseconomies of Scale: Poor Communication

• many layers of hierarchy => communication processes more complex => misunderstandings => mistakes can occur => increase in the costs of production

Diseconomies of Scale: Low Morale/Motivation

• many layers of hierarchy => greater distance between the top managers and the employees => make employees feel unimportant and undervalued => lowers their motivation and productivity

Diseconomies of Scale: Slow Decision-Making

• coordination between top managers and lower levels in the hierarchy may weaken => distant from each other + unfamiliar with different parts of the business => longer to make decisions

Break-Even Level of Output/Point

the minimum level of output that needs to be sold to allow a business to cover its total costs

Margin of Safety

the difference between the quantity produced and the break-even level of output (actual output - BEP)

Disadvantages of Break-Even Analysis

1. Assumes that all goods produced will be sold

2. Assumes that the fixed costs will remain constant but they can change if the scale of production changes

3. Break-even charts disregard other factors which go into production (ex. the reduction of waste)

4. Costs and revenues may not always increase at a constant rate

Revenue Equation

revenue = price x quantity sold

Profit

when the business earns more revenue than total costs (revenue > total costs)