Identify and classify costs
Fixed cost: This is a cost that does not change as the amount of products produced or sold changes.
- Examples of fixed cost – rents such as office space or land, insurance and employee salaries
- Fixed cost per product can be lowered by making more products.
Variable cost: A cost which changes as the amount of goods produced or sold changes.
- Examples of variable cost – Materials used to produce product, wages of production workers
Total cost – Fixed cost and variable costs are combined
Average cost per product = Total cost / Number of products produced
Marginal Cost:This is a cost that arises as a result of an increase in production by one unit. In general terms, marginal cost at each level of production includes any additional costs required to produce the next unit. So, the marginal costs involved in making one more wooden table are the additional materials and labour cost incurred.
Explain, interpret and use a simple break-even chart
Break Even – method for finding out the minimum level of sales needed for a firm to pay for its total cost.
Break even: Level of output where total costs equal total revenue
When Total cost = Revenue, the business will break even.
Advantages of break even charts
- Enables managers to see the level of production/sales needed to break even
- Allows managers to read off expected profit/loss for different levels of sales
- Impacts of business decisions can be seen (e.g. See effects of lowering variable costs)
- Break even chart shows safety margin
- The chart is merely a forecast for the future. There is no guarantee that the figures will prove to be correct.
- Assumes all goods manufactured will be sold. This may not always happen!
- Assumes costs and revenue are always drawn as straight lines. This is unlikely to be the case.
Economies and Diseconomies of scale
As firms grow in size, they acquire certain advantages that are known as Economies of scale. In other words economies of scale are the benefits enjoyed by a firm because of large scale production. These can be classified into five categories:
When business buys in large quantities, they are able to get discounts and special prices because of buying in bulk. This reduces the unit cost of raw materials and a firm gets an advantage over other smaller firms.
The cost of advertising and distribution rises at a lower rate than rises in output and sales. In proportion to sales, large firms can advertise more cheaply and more effectively than their smaller rivals.
A larger company tends to present a more secure investment; they find it easier to raise finance. Banks and other lending institutions treat large firms more favorably and these firms are in a position to negotiate loans with preferential interest rates. Further, large companies can issue shares and raise additional capital.
A large company benefits from the services of specialist functional managers. These firms can employ a number of highly specialized members on its management team, such as accountants, marketing managers which results in better decision being taken and reduction in overall unit costs.
In large scale plants there are advantages in terms of the availability and use of specialist, indivisible equipment which are not available to small firms. Large manufacturing firms often use flow production methods and apply the principle of the division of labour. This use of flow production and the latest equipment will reduce the average costs of the large manufacturing businesses.
Diseconomies of scale: As a business becomes too large, it becomes less efficient leading to higher cost of production.
- Poor communication:
1. Difficult to send and receive accurate messages in large organisations.
2. Takes longer for decisions to be made
3. Top managers lose contact with customers.
- Low motivation: Workers begin to feel unimportant and not valued by management. This leads to lower efficiency.