4.2 Costs, scale of production and break-even analysis Flashcards
Define variable costs.
Give an example.
Variable costs are costs that change as production output increases.
So in a cookie factory the more cookies that are produced the higher the costs of ingredients.
Define fixed costs.
Fixed costs are costs that don’t change as output increases.
So in my cookie factory no matter how many cookies I produce I will still have to pay rent, and insurance and salaries to the office or management team.
Define total costs
Total costs are calculated by adding all costs, fixed and variable.
Define average costs
Average costs are calculated for each unit of production.
So we divide total costs by total output. Average costs are often used for figuring out the selling price of a product.
We also can see average cost decrease with economies of scale.
If we use the cost data for two production lines at the cookie factory, it appears that production should continue for chocolate chip cookies but production should stop for wholemeal cookies, as they are making a loss.
However, it’s important to remember that the fixed costs may have to be paid even if no wholemeal cookies are being produced. So the Cookie Monster Co. should wait until fixed costs have been paid before stopping production of wholemeal cookies.
When is cost data most often used?
break even analysis
Define economies of scale.
Give an example
Economies of scale mean that as output rises, average cost of each unit decreases.
e.g. Giancarlo’s shirt production.
So if he can produce 10 shirts for a total of $100 the unit cost of each shirt will be $10.
But if he produces 1000 shirts for a total of $6,000 the unit cost of each shirt will be $6.
What is the impact of economies of scale?
The impact of economies of scale decreasing average costs means businesses can charge lower prices and increase sales, or make large profit margins for every product sold.
Explain purchasing economies of scale.
Give an example.
Purchasing economies of scale or “buying in bulk” is what most people think of with economies of scale.
If Giancarlo buys ten times as much material from his supplier, he won’t pay ten times as much, but will be able to negotiate a much lower price.
If you walk around a supermarket you can see examples of offers of economies of scale all around. Generally, if you buy in a bigger quantity you will get a lower price per unit.
Explain marketing economies of scale.
Give an example.
Marketing economies of scale mean that as a business grows in size it can spend a smaller share of its budget on marketing.
If a small business spends 5% of its $100,000 revenue on marketing it will have a marketing budget of $5,000.
However, if a large business spends 1% of its $1,000,000 revenue on marketing it will still have a larger marketing budget of $10,000.
explain technical economies of scale.
Technical Economies of scale are available to large companies that use flow production and computer aided manufacturing.
Mass produced goods with high levels of automation leads to lower unit production costs.
Small businesses can’t afford the high capital costs to set up these expensive, advanced production methods, and therefore have higher unit costs.
Explain managerial economies of scale.
Managerial economies of scale occur as larger businesses can employ experts in finance, marketing and other areas of the business who specialise in these areas and drive higher efficiency and effectiveness.
In small businesses, for example my business, I have to do everything. I’m not an expert in social media marketing or computer systems, so these parts of my business or not run as well as in a large business, pushing up average costs.
Define diseconomies of scale.
when a business becomes so large it becomes badly run, less efficient and less effective
What causes diseconomies of scale? Explain
As businesses grow it becomes more difficult for all leaders and employees to communicate effectively. This can lead to slow decision making, and more mistakes due to employees receiving the wrong information.
Furthermore, employees can feel demotivated working for a large organisation, with thousands of other employees. Workers may feel that their contribution does not matter and they are “only a number” to management. This leads to lower productivity and less commitment to the organisations goals.
Finally, for large organisations coordination between departments can be a challenge. A large multinational organisation may find it difficult to keep all of the different parts of the businesses working towards the same aims. There is a much greater chance of duplication, two departments carrying out the same work, which will lead to wasted effort.
Explain the role of break-even analysis.
Break-even analysis shows the output required to break even, where sales revenue earned is the same as the total costs, or where the business is not making a profit or a loss.
