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Chapter 19- Cost, Scale of Production

Chapter 19 discusses cost classification, including fixed and variable costs, and introduces break-even analysis as a method to determine the minimum sales needed to cover total costs. It outlines economies of scale that benefit larger firms, such as purchasing, marketing, financial, managerial, and technical advantages, while also addressing the potential diseconomies of scale that can arise from inefficiencies in large organizations. Key formulas for calculating total cost, average cost, and break-even production levels are provided to aid in business decision-making.

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16 views

Chapter 19- Cost, Scale of Production

Chapter 19 discusses cost classification, including fixed and variable costs, and introduces break-even analysis as a method to determine the minimum sales needed to cover total costs. It outlines economies of scale that benefit larger firms, such as purchasing, marketing, financial, managerial, and technical advantages, while also addressing the potential diseconomies of scale that can arise from inefficiencies in large organizations. Key formulas for calculating total cost, average cost, and break-even production levels are provided to aid in business decision-making.

Uploaded by

sparshnainani
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© © All Rights Reserved
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Chapter 19: Cost, Scale of operations and Break-

Even analysis
Identify and classify costs

Fixed cost: This is 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 = TOTAL FIXED COSTS + TOTAL VARIABLE COSTS

 TOTAL COST = AVERAGE COST * OUTPUT

 AVERAGE COST (unit cost) = TOTAL COST/ TOTAL OUTPUT

 A business can use these cost data to make different decisions. Some examples are: setting prices (if the
average cost of one unit is $3, then the price would be set at $4 to make a profit of $1 on each
unit), deciding whether to stop production (if the total cost exceeds the total revenue, a loss is being
made, and so the production might be stopped), deciding on the best location (locations with the cheaper
costs will be chosen) etc.

 Marginal Cost: This is a cost that arises as a result of an increase in production by one unit. In general
terms, marginal cost at each level of production includes any additional costs required to produce the next
unit. So, the marginal costs involved in making one more wooden table are the additional materials and
labour cost incurred.

BREAK-EVEN ANALYSIS

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

Breakeven: Level of output where total costs equal total revenue

When Total cost = Revenue, the business will break even.


Break-even can also be calculated without drawing a chart. A formula can be used:
Break-even level of production =Total fixed costs/ Contribution per unit

Contribution = Selling price – Variable cost per unit (this is the value added/contributed to the product when
sold)

Economies and Diseconomies of scale

As firms grow in size, they acquire certain advantages that are known as Economies of scale. In other
words, economies of scale are the benefits enjoyed by a firm because of large scale production. These can be
classified into five categories:

Purchasing Economies:
When business buys in large quantities, they are able to get discounts and special prices because of buying in bulk. This
reduces the unit cost of raw materials and a firm gets an advantage over other smaller firms. (e.g. Coca-Cola buying large
bulks of sugar from supplier)

Marketing Economies:
The cost of advertising and distribution rises at a lower rate than rises in output and sales. In proportion to sales,
large firms can advertise more cheaply and more effectively than their smaller rivals.

Financial Economies:
A larger company tends to present a more secure investment; they find it easier to raise finance. Banks and other
lending institutions treat large firms more favourably and these firms are in a position to negotiate loans with
preferential interest rates. Further, large companies can issue shares and raise additional capital. (e.g. lower bank
loans because banks view large businesses as less risky)

Managerial Economies:
A large company benefits from the services of specialist functional managers. These firms can employ a number of
highly specialized members on its management team, such as accountants, marketing managers which results in
better decision being taken and reduction in overall unit costs.

Technical Economies:
In large scale plants there are advantages in terms of the availability and use of specialist, indivisible equipment
which are not available to small firms. Large manufacturing firms often use flow production methods and apply
the principle of the division of labour. This use of flow production and the latest equipment will reduce the average
costs of the large manufacturing businesses.

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.
 Weak coordination- It often takes longer for decisions made by managers to reach all parts of a large
business and different groups of workers. This could make it difficult to coordinate the work and
decisions of all parts of the business and ensure that they are working towards the same objectives.
Employees could also take a long time to react to a managerial decision once it has been taken. The top
managers will be so busy directing the affairs of the business that they may have no contact at all with
the customers of the business. They could become too removed from the products and markets the
business operates in.

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