Costs, scale of production and break-even analysis
💰 4.2.1 Identify and Classify Costs
📦 What are Costs?
Costs are the money a business spends to produce goods or services.
🧾 Types of Costs
| Type of Cost | Description | Example |
|---|---|---|
| Fixed Costs | Stay the same no matter how much is produced. | Rent, salaries, insurance |
| Variable Costs | Change depending on how much is produced. | Raw materials, packaging, wages |
| Total Cost | All costs added together. | Fixed costs + Variable costs |
| Average Cost | Cost per unit produced. | Total cost ÷ Number of units |
Example:
If a factory pays $1,000 rent (fixed) and $2 per unit (variable), making 500 units:
- Variable Cost = 500 × $2 = $1,000
- Total Cost = $1,000 (fixed) + $1,000 (variable) = $2,000
- Average Cost = $2,000 ÷ 500 = $4 per unit
📊 Using Cost Data for Decisions
Businesses use cost data to make decisions like:
- Should we continue or stop production?
- Can we reduce costs to increase profit?
- Is the price we charge enough to cover our costs?
Example: If costs are higher than sales revenue, the business may decide to stop production.
🏢 4.2.2 Economies and Diseconomies of Scale
📉 Economies of Scale
When a business grows, its average cost per unit falls because it can operate more efficiently.
💡 Types of Economies of Scale:
| Type | How it Saves Money | Example |
|---|---|---|
| Purchasing | Bulk buying reduces cost per unit | Discounts for large orders |
| Marketing | Spreading marketing costs over more units | One advert = more sales |
| Financial | Easier to get cheaper loans | Banks trust bigger firms |
| Managerial | Hiring specialised managers improves efficiency | HR, finance experts |
| Technical | Using advanced machines to produce faster and cheaper | Automated production lines |
📈 Diseconomies of Scale
When a business becomes too large, its average cost per unit may increase due to problems with management and communication.
⚠️ Causes of Diseconomies:
| Problem | Why it Increases Cost |
|---|---|
| Poor Communication | Too many departments = confusion and delays |
| Lack of Commitment | Workers feel unimportant in a big company |
| Weak Coordination | Difficult to organise and control all parts of the business |
Conclusion: Bigger is not always better! Businesses must grow carefully.
📈 4.2.3 Break-even Analysis
🔍 What is Break-even?
Break-even is the point where total revenue = total costs.
At this point, the business makes no profit and no loss.
🧮 Break-even Formula:
Break-even output = Fixed Costs ÷ Contribution per unit
Contribution per unit = Selling Price – Variable Cost per unit
Example:
Selling price = $10, Variable cost = $6, Fixed cost = $2,000
Contribution per unit = $10 - $6 = $4
Break-even = $2,000 ÷ $4 = 500 units
📊 Break-even Chart
A break-even chart shows:
- Total revenue line
- Total cost line
- Break-even point (where they meet)
- Output on the x-axis
- Costs/revenue on the y-axis
You should be able to:
- Draw, complete, or amend a break-even chart
- Identify the break-even point on the chart
- Interpret what the chart tells you about profit or loss
📏 Margin of Safety
Definition:
The amount by which actual sales exceed break-even sales.
Margin of Safety = Actual Output – Break-even Output
Example:
If a business produces 800 units and break-even is 500 units:
Margin of Safety = 800 - 500 = 300 units
📌 Using Break-even Analysis
Break-even helps with decisions like:
- Should we raise prices?
- Is it worth launching a new product?
- How much do we need to sell to avoid losses?
Example: If price increases, break-even point may be reached sooner.
⚠️ Limitations of Break-even Analysis
- Assumes all units are sold (no waste or unsold stock)
- Assumes fixed and variable costs stay the same
- Doesn’t consider unexpected changes (e.g. inflation, strikes)
- Only useful for short-term planning