4.2 Costs, scale of production and break-even analysis

Cambridge IGCSE Business Studies 4.2 – Costs, scale of production and break-even analysis

4.2.1 – Identify and classify costs

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 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


4.2.3 – 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

Disadvantages 

  • 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.

4.2.2 – Economies and diseconomies of scale

Economies of scale – Factors that lead to a reduction in average cost as a business increase 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 – 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.
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