All resources cost money. In order to pay the resources it uses, a business must make and sell enough of its goods, or provide enough of its services. It is important, therefore, that when a business is setting up or planning its future activities, it takes all its likely costs into consideration.
Types of costs
Fixed costs
Fixed costs are those costs a business must pay, regardless of whether it actually produces anything or not. These costs do not change no matter how many of its products the business actually makes or sells. Examples of the typical fixed costs of a business are: premises costs (for example, rent and rates); insurance; interest on loans and overdrafts; salaries and wages of employees involved in running the business.
Fixed costs may change in the long term. For example, the rent of a factory may be increased, or salaries may rise following a pay increase. However, doubling its output will not affect the level of rent or salaries that a business has to pay, unless it also has to increase its capacity and rent larger premises.
Variable costs do change with the amount of its products a business producers. The more goods or services produced, the higher the variable costs that have to be paid. The fewer goods or services produced, the lower the variable costs that have to be paid. Examples of the typical variable costs of a business are: raw materials; parts and components; wages of employees directly involved in making the product.
Is there a relationship between output and costs?
What is output?
The total amount of goods or services produced by a business in a given period is called the output of the business. Similarly, the output of an employee, or group of employees, or a machine is the total amount of goods or services produced by that employee, group of employees, or machine in a period of time.
Calculating costs
Businesses need to be able to calculate how much it costs them to produce their output of goods or services. This is called the cost of production, and as you will see when you are studying the accounting and finance units, it is a very important piece of information. Table 11.1 shows the costs of production of a business at different levels of output. The diagram based on the table shows you the relationship between output and costs.
Output (units) | Fixed costs ($) | Variable costs ($) | Total costs ($) |
0 1,000 2,000 3,000 4,000 5,000 | 10,000 10,000 10,000 10,000 10,000 10,000 | 0 750 1,400 2,150 2,900 3,750 | 10,000 10,750 11,400 12,150 12,900 13,750 |
Average costs and marginal costs
By calculating the average costs, or unit costs, of production, a business can tell how much on average it has cost to produce one unit of its goods or services. The formula for calculating average costs is: average cost per unit = total costs/total output.
Often, when a business produces more, the average cost per unit falls. Sometimes, however, when average costs have reached a certain level, they start to increase again, as you can see from figure 11.2. The lower the average costs of production, the more efficient the business is at producing its product.
It is also often important for a business to know its marginal cost of production. Marginal cost is the amount by which total costs increase with the production of one additional unit. If the marginal cost of an additional unit production is greater than the additional sales revenue generated, then the business should not produce the additional unit.
Direct costs
The direct costs of a business are those costs that are directly incurred in the production process. They include items such as the raw materials and components that are used to produce goods, and the labour (often called direct labour) of the employees who actually make the goods.
Indirect costs
Indirect costs are all the costs of a business that are not directly incurred in the production process. They include items such as the wages and salaries of all other employees (including factory supervisors and themselves), rent and rates, advertising and marketing, telephone, gas and electricity, postage and other general administrative costs. Indirect costs are sometimes called “overheads”.
The break-even point is the volume of goods or service that a business must produce and sell in order to cover its costs. To calculate the break-even point of a product a business must identity the fixed and variable costs incurred and calculate the revenue generated from any given level of sales of the product, by multiplying the price per unit of product by its price.
Calculating the break-even point of a product assumes that its price has two parts. The first part covers the variable costs of producing one unit of the product. The second part contributes to the fixed costs of the business. This is called the contribution. Once enough units of the product have been sold so that contribution from each cover the fixed costs (the break-even point), the contribution from each additional unit sold contributes to the profit of the business.
The break-even point of a product can be calculated mathematically using the break-even calculation formula or by using a break-even chart.
The break-even point of a product is the number of contributions (at one contribution per unit of production) require to cover the fixed costs of the business. To calculate the break-even point mathematically the business must know: the selling price per unit of product; the variable costs per unit; the total fixed costs. The formula for calculating the break-even point is:
Selling price per unit – variable costs per unit = contribution
Total fixed costs
---------------------- = break-even point Contribution
To find out how much profit a given level of sales will generate, a business can use the formula:
(contribution X units produced) – fixed costs = profit
To find out how many units must be sold to generate a target profit, the formula is:
(Target profit + fixed costs)
------------------------------------- Contribution per unit
Any change in the level of fixed costs, variable costs or selling price per unit will result in a new break-even point and levels of profit or loss produced by given levels of production and sales.
Having calculated the break-even point of a product, the business can decided whether it is able to produce and sell this number of unit of product in the time period – for example has it enough facilities, such as machinery and employees. If the business can produce and sell more than the break-even level, then it will make a profit. This information will help the business decide whether or not to produce the product.
Calculating the break-even point of a product using a break-even chart
Once the fixed and variable costs of a product and the selling price per unit are known, the break-even point can be plotted graphically on a break-even chart. It is then an easy task to read off the profit or loss that will be produced by any given level of production and sales.
In figure 11.3, the line DD represents the fixed costs of the business, which remain constant for all volumes of output. Line DC is he total cost line (variable costs plus fixed costs), which rises as output increases. Note that the variable costs line starts at the level of fixed costs, since even when nothing is produced, the business still has to pay its fixed costs. Line AA is the revenue line. This starts at 0, since when nothing is sold there is no revenue. The point at which the total cost line and the revenue line interest (B) is the break-even point.
The difference between the point on AA and the corresponding point on DC for a given level of sales is the profit or loss produces by that level of sales. If the volume of sales is higher than the break-even point, the difference between the actual level of sales and the break-even point is called the margin of safety.
Summary
· All businesses incur costs.
· The costs of a business can be identified as fixed or variable costs, or direct or indirect costs.
· The lower the average cost per unit of output, the more efficient the business.
· Costs are used in forecasting and planning.
· The break-even point of a business or product is the point at which revenue from sales just covers the running costs of the business or product.
Fixed costs: costs that do not vary with the level of output.
Variable costs: costs that vary with the level of output.
Output: the total number produced by a business, employee or machine over a given period of time.
Average costs: the total cost of production divided by total output.
Direct costs: costs that are directly incurred in the production process.
Indirect costs: costs that are not directly incurred in the production process.
Overhead: indirect costs.
Break-even point: the point at which the level of sales of a business exactly equals its costs.
Break-even calculation: a method of calculating the break-even point of a business using the formula.
Break-even chart: a graph showing the break-even point of a business.
Resource: Chris J. Nuttall, IGCSE Business Studies, Cambridge University 2002
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