Chapter 16 –Costs, Scale of Production & Break-Even Analysis

What are the main types of costs?

1. Fixed Cost: “Costs that do not change with output” Cost

2. Variable Cost: “Costs that change in direct proportion to

output”

3. Total Cost: “All the variable and fixed costs of producing

the total output)
Quantity

Fixed Cost

Cost
Cost

Quantity Quantity
Variable Cost
Total Cost

What is average cost?

“The cost of producing a single unit of output”

What is meant by the economies of scale?

“The reduction in average costs as a result on increasing the scale of operation”

What are the types of economies of scale?

 Financial economies- Large businesses are easier to borrow from banks than small businesses.
 Managerial economies: Large business has the ability to employ specialist functional managers
like Human Resources, Finance, and Marketing thus improving the quality of decision making.
 Marketing economies: Average cost of marketing falls as output and sales increase.
 Purchasing economies: Large businesses buy in bulk reducing the cost of raw material.
 Technical economies: Large businesses can afford to acquire latest technologies which in return
increase production, lower production cost and improve profits.

Developed By: Dr. Sherif Mahgoub Mob#01222718705 Mail:[email protected]

What is meant by diseconomies of scale?

“Factors that cause average costs to rise as the scale of operations increases”

What causes diseconomies of scale?

1. Poor communication: Too large business might affect the quality of communication which lead to
slow and poor decision making and in return increase mistakes.
2. Lack of commitment from employees: In very large businesses, managers may no longer have
day to day contact with their employees; this leads to employees feeling devalued, de-motivated,
poor quality and fall in production.
3. Weak coordination: In very large businesses; coordination between different departments
scattered over many countries might be a problem which increase waste and cost of production.

Average Cost

Q Quantity

Average cost curve showing economies and diseconomies of scale

Point Q is the best scale of production where costs are at the bottom right before
diseconomies of scale start to occur

What is meant by break even?

“The level of output where revenue equal total costs; the business is making neither profit nor loss”

How business use break even?

 Calculate how many units needed to sell before it starts to make profit;
 Calculate the effect on profit of increasing or decreasing the price;
 Calculate the effect on profit of increasing or decreasing the cost.

Important definition:

Margin of safety: “The difference between the current level of output and break even output”

Developed By: Dr. Sherif Mahgoub Mob # 01222718705 Mail:[email protected]

What is the information needed to produce break even chart?

1. Revenue at zero output and its maximum output (capacity);

2. Total costs at zero output and at capacity output;
3. Fixed cost at zero output and at capacity output.

Cost/Revenue

Revenue
Area of profit

Total Cost
Break Even Point

Fixed Cost
Area of Loss

Quantity

Simple Break Even Chart

What are the advantages and disadvantages of break even charts?

Advantage Disadvantage
 Easy to construct and implement;  Assume that all costs and revenues can be
 Provide business with useful presented by straight line;
information about sales volume  It is not easy to separate cost into fixed and
needed to achieve break even; variable;
 Can show the effect of a decision to  Assume that all output is sold; do not count
change costs or revenue; inventories and inventory cost.
 Can help with decisions like location
and relocation of business.

Revision Checklist:

 The costs of business can be classified into fixed costs, variable costs, total costs and average costs
and these classifications are useful when making cost based decisions.
 The average costs of business will usually change as the business grows because of economies or
diseconomies of scale.
 Businesses can use break even analysis to show the relationship between costs, revenue, output
and profit and how changes in costs or revenues might affect profits.

Developed By: Dr. Sherif Mahgoub Mob # 01222718705 Mail:[email protected]

Mr. Mahgoub’s extensive
exposure As Group
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reputed companies gives
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Business O level Cambridge IGCSE

Mob # 01222718705
Mail: [email protected]

Developed By: Dr. Sherif Mahgoub Mob # 01222718705 Mail:[email protected]