Costs, scale of production and break-even analysis

Operations Management
GCSE/IGCSE BUSINESS STUDIES
L1 (4:2) Costs, scale of production & Break-even analysis

1. To be able to identify the different

classifications of business costs.
Learning 2. To be able to understand the importance &
usefulness of cost data in business decision-
Objectives making.
3. To be able to differentiate between economies
and diseconomies of scale.
4. To be able to analyse break-even in a business.
 Business costs
All business activities involve costs of some sort.
These cannot be ignored.

Example: the manager of a business is planning to open a new factory making sports shoes.
Why does the manager need to think about costs?

Some of the reasons are:

 The costs of operating the factory can be compared with the revenue from the sale of the sports
shoes to calculate whether the business will make a profit or a loss. This calculation is one of the
most important made in any business.
 The costs of two different locations for the new factory can be compared. This would help the
owner make the best decision.
 To help the manager decide what price should be charged for a pair of sports shoes.

Accurate cost information is therefore very important for managers.

Cost definitions

Fixed cost – 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 that 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

 Total costs and average cost

The total costs of a business, during a period, are all fixed costs added to all variable costs of production.
This total figure can then be compared with the sales revenue for the period to calculate the profit or loss made.
An average cost per unit can be calculated from the total cost figure. Average cost is the total cost of production
divided by total output.
EXAMPLE
For a sport shoe manufacturer, producing 30 000 pairs of shoes each year, this could be calculated as follows:

Stage 1
Total costs of production (€150 000) = fixed costs (€50 000) + total variable costs (€100 000)
Stage 2

Average cost of production = total costs of production (in a time period) = €150 000 = €5 per pair of shoes
total output (in a time period) 30 000
 Total costs and average cost

If both the average cost of production and the level of output is known, then total cost can be
calculated by multiplying average cost per unit by output.

Total cost = average cost per unit * output

 Do now

 What is meant by Fixed costs?

 What is meant by Variable costs?

 What is the formula for calculating a business's total costs?

 What is the formula for calculating the average cost per
product?
 Do now
 What is meant by Fixed costs?
 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

 What is meant by Variable costs?

 A cost that changes as the amount of goods produced or sold changes.

 Examples of variable cost – Materials used to produce product, wages of production workers

 What is the formula for calculating a business's total costs?

 Fixed costs + variable costs = total costs.

 What is the formula for calculating the average cost per product?
 Average cost per product = Total cost / Number of products produced
Average Costs

 Ifwe add workers and they keep

bringing more and more output,
then our average costs fall, but
our average product/output rises.
Results

Average cost per

Output Total Fixed Costs Total Variable Costs Total Costs
unit

0 €3000 €0 €3000 €0
1000 €3000 €2000 €5000 €5.00
2000 €3000 €4000 €7000 €3.50
3000 €3000 €6000 €9000 €3.00
4000 €3000 €8000 €11000 €2.75
5000 €3000 €10000 €13000 €2.60
6000 €3000 €12000 €15000 €2.50
 Using cost data

Use of cost data Example Explanation

Setting prices Average cost of making a pizza = If the average cost per unit was not
€3. If the business wants to make known, the business could charge
€1 profit on each pizza sold, it will a price that leads to a loss being
charge a price of €4 made on each item sold.
 Using cost data

Use of cost data Example Explanation

Deciding If the total annual cost of No business will willingly continue to

whether to stop producing a product is €25 000
production but the total revenue is only €23
000, then the business is making a
loss and could decide to stop
making the product.
make a loss but the decision to
stop making a product will also
depend on whether:
• The product has just been
launched on the market – sales
revenue might increase in future.

• The fixed costs will still have to be

paid e.g., if the factory being used
for the product is not sold.
 Using cost data
Use of cost data Example
Deciding on the Location A for a new shop has
best location total annual costs of €34 000.
Location B for a new shop has
total annual costs of €50 000.
On this data alone, Location A
should be chosen.
Explanation
Costs are not the only factor to
consider – there might not be any
point in choosing a low-cost
location for a new shop if it is in the
worst part of town!
Economies of scale

Economies of scale – are the factors that lead to a reduction in average

costs as a business increases in size .
• Purchasing economies – Large firms able to negotiate cheaper prices for raw materials
(e.g., Coca-Cola buying large bulks of sugar from supplier)
• Financial economies – Large firms able to negotiate cheaper finance deals (e.g., lower
bank loans because banks view large businesses as less risky)
• Managerial economies – Large businesses can afford to hire specialists to work for them.
This increases efficiency.
• Technical economies – Use of specialist machinery to produce large quantities of
products. (Small businesses cannot afford this)
• Marketing economies – 1. Buying own vehicle to distribute product 2. Advertising costs
can be spread over a large number of products.
 Diseconomies of scale

Poor communication
1. Difficult to send and receive
Diseconomies of scale
accurate messages in large
arises when a business organisations.
becomes too large, it
2. Takes longer for decisions to
becomes less efficient leading
be made
to higher cost of production.
3. Top managers lose contact
with customers.
 Diseconomies of scale

Slow decision making - decisions

take longer to reach all groups
of workers, and this could mean
that it will take a long time for
Low motivation - Workers begin
workers to respond and act
to feel unimportant and not
upon managers’ decisions.
valued by management. This
Managers might spend too
leads to lower efficiency.
much time directing the affairs
of the business hence not being
in contact at all with the
customers of the firm.
Video
Presentation
Do now

 What are Diseconomies of Scale?

 What do they result in?
 Do now

 What are Diseconomies of Scale?

 arises when a business becomes too large, it becomes less efficient leading to higher cost of production.

 What do they result in?

 Poor communication
 Difficult to send and receive accurate messages in large organisations.
 Takes longer for decisions to be made
 Top managers lose contact with customers.

 Slow decision making

decisions take longer to reach all groups of workers, and this could mean that it will take a long time for workers
to respond and act upon managers’ decisions. Managers might spend too much time directing the affairs of
the business hence not being in contact at all with the customers of the firm.
 Low motivation - Workers begin to feel unimportant and not valued by management. This leads to lower
efficiency.
Pair Activity – Business costs
 Pair Activity – Answers - Business costs

 Activity 18.1
 Staffing and employment
 Equipment and supplies
 Stock
 advertising and marketing
 Technology costs (Telephony, Internet connection, Data storage and back-up,
Computers/laptops, Table for meetings/conferences, Comfortable computer chairs, Stationery,
Signage, First aid supplies, Power cables/extension cords)
 Accounting system
 Activity 18.2
 Fixed: rent; insurance; bank fees; management salaries, equipment and supplies, stock,
some technology.
 Variable: raw materials, advertising and marketing
Pair Activity – Calculating total cost and average cost
Pair Activity – Answers - Calculating total cost
and average cost
a)
total variable cost of manufacturing vehicle models Y and Z (all variable costs added together)
Y = $24 million;
Z = $14 million
b)
total cost of manufacturing models Y and Z (total costs = fixed costs + variable costs)
Y = $36 million (24 000 000 + 12 000 000);
Z = £20 million (14 000 000 + 6 000 000)
c)
Y = $3000 (36 000 000/12 000);
Z = $4000 (20 000 000/5 000)
d) The managers can compare these unit costs and use them to set different prices for these two models. If they think that Z
is too expensive to produce compared with Y then they might try to cut these production costs.
Individual activity – complete this activity in your book.
 Activity 18.4 Answer

1. Able to bulk buy raw materials, for example, clay used to make bricks
more cheaply.
2. Able to obtain lower interest rate loans from banks as they believe the
business is now safer and less risky.
3. Able to recruit specialist managers to operate each department and
division, for example, production and marketing.
Pair activity – Analyse this table together, decide on the
answers and record these in your book.
 Activity 18.5 answer

a) Company A = $200 000

Calculation needed – $4 * 20 000 = $80 000 + $120 000
(variable cost per shoe * amount of shoes per year + annual fixed costs)
Company B = $3 850 000
Calculation needed - $2.5 * 700 000 = $1 750 000 + $2 100 000
(variable cost per shoe * amount of shoes per year + annual fixed costs)

b) A = $10 - Calculation needed - $200 000/20 000 units

B = $5.5 – Calculation needed - $3 850 000/700 000 units

c) The average total costs are lower for Company B because it is an economy of scale, possibly a purchasing economy where it is
possible to negotiate cheaper prices for raw materials. It might use special machinery to produce large quantities of products whereas a
smaller company like Company A might not afford to do this. Company B might be able to negotiate cheaper finance deals (e.g., lower
bank loans because banks usually view large businesses as less risky). Company B might also be able to afford to hire specialist to work for
them, increasing efficiency.
d) Lower average costs will allow Company B to charge lower prices and gain a competitive advantage; if Company B keeps its prices
quite high it will make higher profits per product than Company A.
 Break-even analysis

Break-even – method for

finding out the minimum
level of sales needed for
a firm to pay for its total
cost.

When a business breaks

even this means that it is
not making a profit nor a
loss.

When Total costs =

Revenue, the business
will break even.
 Break-even analysis

 In this case to calculate the break-even, i.e., the

amount of chocolate bars (units) needed to break-
even, you need to:
 Subtract the selling price ($3) by the variable cost per
unit ($1) which will equal $2
 Divide the total fixed cost ($8 000) by the result above
i.e., $2 which will equal 4000 chocolate bars/units
 To convert this into revenue i.e., sales of the chocolate
bars, you need to multiply the 4000 bars by $3 which is
the selling price which means the revenue must be
$12 000
Notice that the total cost and fixed cost do NOT start at zero! Reason?
The fixed costs need to be paid whether you are selling or not. In this case it starts at $8000
 The concept of break-even

 Break-even analysis is a business technique that shows the relationship

between revenue, costs and volume of sales/output.

 A business might use break-even analysis to:

 Calculate how many units it needs to sell before it start to make a profit

 Calculate the effect on profit of increasing or decreasing the price of a product

 Calculate the effect on profits of an increase or decrease in business costs.

 The concept of break-even

 To produce a break-even chart a business needs to know its:

 fixed costs
 variable costs
 revenue of a business.

 Margin of safety
 is the amount by which sales exceed the break-even level of output meaning:

 margin of safety = current sales – break-even output

 This is a measure of the amount by which sales can fall before losses are made.

 The higher the margin of safety, the lower the risk of a loss being made.
 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

Advantages and Impacts of business decisions can be seen (e.g., See effects
of lowering variable costs)
disadvantages of Break even chart shows margin of safety.
using Break-Even Disadvantages of break-even charts

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.
Video
Presentation
Pair activity – analyse this
case study and complete
this in your book and
using the graph paper
provided.

You will notice that to break-

even, Namib tyres need to
make 6000 units.

How do we know this?

Break-even = fixed
cost/contribution per unit
 Activity 18.6 answer

a) x = $30 000 – in case study

y = $30 000 ($30 000 + $0)
Z = $0
a = $50 000 (10 000 * $5)
b = $80 000 (30 000 + 50 000)

b) Your Fixed costs should be a straight line starting at $30 000 – Your Variable costs line starts at 0 and should be parallel to your
Total costs line. Your revenue line should also start at 0 and take into account the units produced multiplied by the selling price.

c) If you hav e drawn the chart correctly then you will see that the:
Break-even lev el of output is 6000 units (30 000/5)
Lev el of profit at maximum output:
Maximum output is 10 000 units which in revenue totals $50 000 (10 000 * $5 contribution per unit) meaning that the level of profit is $50 000 – $30
000 (fixed costs) = $20 000
Click to add text
Pair activity –
Complete this
in your book
 Break-even point: the
calculation method.

It is not always necessary to

draw a break-even chart in
order to show the break-even
point of production. All you
need is to carry out a simple
calculation as seen in the
example.

Pair activity – Analyse and

complete in your book