4.

2 Costs, scale of production and break-even analysis

Learners should be able to identify and classify costs and use cost data to help make simple cost-based
decisions.
Cost
• Amount – paid – to buy
• Compare
• Revenue – Profit / Loss
• Two different location
• Price
Fixed and variable cost
• Fixed
• Not vary in short run
• With number of items produced
• Paid – whether the business making sale or not
• Overhead cost
• Example: Management Salaries and Rent
• Variable
• Vary
• With number of items produced
• Example: material cost, piece rate labour
• Total cost
• Fixed cost added to variable cost
• Compared with sales revenue
• Average cost
• Total cost divided by total output
• Unit cost
Answer
Economies of scale:
• Factors:
• leads to –
• Reduction:
• in average costs –
• as business increase in size
Diseconomies of scale
• Factors:
• leads to –
• Increase:
• in average costs –
• as business grow beyond certain size
 Factors of diseconomies of scale
• Poor communication
• Difficult to send and receive message
• Inaccurate communication
• Mistake
• Lower efficiency
• Lack of communication from employees
• Many worker
• Never see top manager
• Unimportant
• Weak coordination
• Decision by managers – take long time to reach all employees
• Top manager no contact with customers
 Breakeven Level of output
Fixed cost = 10 Out put Total Cost = FC + VC Total revenue = SP * output
Variable cost = 2 per unit 0 10+0 = 10 0
Selling price = 3 per unit 1 10+(1*2)= 12 1*3 = 3
Maximum output = 12 2 10+(2*2)= 14 2*3 = 6
12- 10 = 2 3 10+(3*2) = 16 3*3 = 9
Margin of safety 4 10+(4*2) = 18 4*3= 12
5 20 15
6 22 18
7 24 21
8 26 24
9 28 27

10 30 30
11 32 33

12 34 36
 Breakeven level of output (level of output @ which TC = TR).
Breakeven point Neither Profit nor Loss is made

• Fixed Cost
• Variable Cost per unit(Material and Labour cost)
• Selling price per unit
• Maximum output
• Graphical method
• Different level of output
• Total Cost = Fixed Cost + Variable Cost
• Total Revenue = Selling Price * Output
• Plot graph
• Equation method
• Contribution = Selling Price – Variable cost
• BE level of output = Fixed Cost / Contribution
 Graphical Method
• Step 1 – Calculate Total Cost and Sales Revenue @
different level of output
Output 0 20 30
FC
VC
TC
SR
• Step 2 - Plot graph: X axis – Output; Y Axis – Cost and Revenue
• Total Cost – begins @ Fixed cost
• Sales Revenue – starts @ origin
Output 0 5000 10000 15000 25000 30000
FC 200000 Break-even
200000 200000 charts200000 200000
200000
VC 0 175000 350000 525000 875000 1050000
TC 200000 375000 550000 725000 1075000 1250000
SR 0 225000 450000 675000 1125000 1350000

■ fixed costs $200,000

■ Variable cost $ 35 per unit
■ selling price $45 per unit
■ maximum capacity of the factory is 30,000 units.
1. Draw a break-even chart using these data.
2. Show the break-even point and identify the break-even level of output.
3. Identify from the graph the profit expected at maximum capacity.
4. What is the margin of safety at an output level of 25,000 units?
 Output 0 5000 10000 15000 25000 30000
FC 200000 200000 200000 200000 200000 200000
VC 0 175000 350000 525000 875000 1050000
TC 200000 375000 550000 725000 1075000 1250000
SR 0 225000 450000 675000 1125000 1350000

Breakeven Level of Output

1600000

1400000
1350000

1250000
1200000
1125000
1075000
1000000
Cost and Revenue

900000

800000
725000
675000
600000
550000

450000
400000
375000

225000
200000 200000

0 0
0 5000 10000 15000 20000 25000 30000
DRAW BREAK EVEN CHART
• » fixed costs are $5000 per year
• » the variable costs of each pair of shoes are $3
• » each pair of shoes is sold for a price of $8
• » the factory can produce a maximum output of 2000 pairs of shoes per year.

0 400 800 1200 1600 2000

FIXED COST 5000 5000 5000 5000 5000 5000
VARIABLE COST 0 1200 2400 3600 4800 6000
TOTAL COST 5000 6200 7400 8600 9800 11000
SALES REVENUE 0 3200 6400 9600 12800 16000

• Now we can plot the information on the graph. Note the following points:
• » The y-axis (the vertical axis) measures money amounts – costs and revenue.
• » The x-axis (the horizontal axis) shows the number of units produced and sold.
• » The total cost line is the addition of variable costs and fixed costs.
• Total Cost – begins @ Fixed cost
• Sales Revenue – starts @ origin
a Draw a break-even chart from the information in the table.
b From your break-even chart identify:
• the break-even level of output
• the level of profit at maximum output

Namib Tyres Ltd produces motorcycle tyres. The following information about the business has been obtained:
• Fixed costs are $30 000 per year.
• Variable costs are $5 per unit.
• Each tyre is sold for $10.
• Maximum output is 10 000 tyres per year
USES OF BREAK EVEN CHART
• expected profit or loss to be made at any level of output.
• impact on profit or loss - redrawing the graph - What would happen to the
break-even point and the maximum output level if the manager decided to
increase the selling price
• show the margin of safety
• PRICING DECISION
• MANGEMENT DECISION
LIMITATIONS OF BREAK EVEN CHART
• assuming that all goods produced by the firm are actually sold
• Fixed costs only remain constant if the scale of production does not change
• many other aspects of the operations of a business
• assumed that costs and revenues can be drawn with straight lines.
 Equation Method
• BE level of Output = Fixed Cost / contribution per unit
• Contribution per unit = selling price – Variable Cost
• Calculate Break Even Level of output
• Fixed Cost is $200,000
• Variable Cost is $35
• Selling Price is 45
• 200,000 / 45-35
• 200,000 / 10
• 20,000
A fast-food restaurant sells meals for $6 each. The variable costs of preparing
and serving each meal are $2. The monthly fixed costs of the restaurant
amount to $3600.
a How many meals must be sold each month for the restaurant to break even? Using break even chart and equation
method
b If the restaurant sold 1500 meals in one month, what was the profit made in that month?
c If the cost of the food ingredients rose by $1 per meal, what would be the new breakeven level of production?
Fixed cost / Contribution = 3600 / 4 = 900
Contribution = selling price – variable cost = 6 – 2 = 4

0 500 1000 1500

Fixed cost
Variable cost
Total cost
Revenue
Answer and Discuss