4.2.

Costs, Scale of Production, and Break-Even Analysis

4.2.1 IDENTIFY AND CLASSIFY COSTS
Learning Outcomes:
• Classifying costs using examples, e.g. fixed, variable, average, total.
• Use cost data to help make simple cost-based decisions, e.g. to stop production or continue.

CLASSIFYING COSTS
Costs are money spent by a business to purchase factors of production for producing goods and
services and to run its daily operations.
Type of Cost Definition Example/Formula
Fixed Cost (FC) Costs that remain the same regardless • Rent • Advertising
of the level of output. • Salary • Machinery
Variable Cost (VC) Costs that increases with direct Cost of buying cotton increases as more t-
proportion to output. shirts are produced.
Total Cost (TC) Sum of fixed and variable costs of 𝑇𝐶 = 𝐹𝐶 + 𝑉𝐶
producing a certain level of output.
Average Total Cost The cost of producing one unit of 𝑇𝐶
𝐴𝐶 =
(ATC) output. 𝑇𝑜𝑡𝑎𝑙 𝑂𝑢𝑡𝑝𝑢𝑡

Example 4.2.1: The Casual Shoe Company (TCSC)

TCSC has monthly fixed costs of $2,000. The variable cost per pair of shoes is $3. In January, TCSC makes
1,000 pairs of shoes.
The total variable cost of producing 1,000 pairs of shoes in January will be:
1,000 × $3 = $𝟑, 𝟎𝟎𝟎
The total cost for January will be:
$3,000 + $2,000 = $𝟓, 𝟎𝟎𝟎
The average cost for making one pair of shoes in January is:
$5,000
= $𝟓
1,000

Exercise 4.2.1: Classifying Costs

Khaliq, the owner of TCSC knows that it is important to classify costs properly when making business decisions. He has
asked you to help him classify the following costs. The first cost has been completed as an example.

Fixed Variable
Factory rent
Leather used in making some shoes
Electricity used to power machinery
Machinery maintenance
Advertising
Production workers’ wages
Operation Manager’s salary
Delivery of finished goods to customers
Safety equipment for production workers

1
Exercise 4.2.2: Output vs Costs
The following are the costs of TCSC at different levels of output.

Output (pairs of Fixed Costs Variable Costs ($3 Total Costs Average Costs
shoes) per pair of shoes)
$ $ $ $
0 2,000 -
1,000 2,000 3,000
2,000 2,000
3,000 11,000
4,000

1. Complete the table above.

2. Draw a graph showing the relationship between TCSC’s output and costs (Hint: Put output on x-axis).

Output vs. Fixed Costs Output vs. Variable Costs

Output vs. Total Costs Output vs. Average Costs

2
USING COST DATA TO MAKE SIMPLE COST-BASED DECISIONS
Businesses can use cost data to make a variety of decisions.
For example, recalling cost-plus pricing from Marketing, by knowing how much it costs to produce a
unit of output, the business can set the selling price higher than that in order to ensure that they make
a profit for each unit sold.
Cost data can also be used in deciding whether a business should continue or stop producing a
product.
Consider the example below:

Example 4.2.1: The Casual Shoe Company (TCSC)

A business manufactures two products. The revenue, cost, and profit data for each product is shown below.

Product A Product B Total

$000 $000 $000

Revenue 20 50 70

Fixed Costs 10 15 25

Total Variable Costs 12 18 30

Total Costs 22 33 55

Profit (2) 17 15

We can see that Product A made a loss of $2,000. The Marketing Manager wants to stop the production of
Product A, but the company’s accountant disagrees. Who is right?

If the business stops producing A, then they also miss out on the revenue they could have potentially gained.
On top of that, they still have to pay for the fixed costs. So therefore, if they stop producing A, they will
actually be incurring a loss of $10,000.

Product A Product B Total

$000 $000 $000

Revenue - 50 50

Fixed Costs 10 15 25

Total Variable Costs - 18 18

Total Costs 10 33 43

Profit (10) 17 7

Therefore, the accountant is right. It is better to lose $2,000 than to lose $10,000. The business should keep
producing product A until they no longer have to pay for the fixed costs.

3
4.2.2 ECONOMIES AND DISECONOMIES OF SCALE

Learning Outcomes:
• The concept of economies of scale with examples, e.g. purchasing, marketing, financial, managerial, technical.
• The concept of diseconomies of scale with examples, e.g. poor communication, lack of commitment from
employees, weak coordination.

ECONOMIES OF SCALE
As a business increases its scale of production, they may benefit from reduced average costs due to
economies of scale. This occurs because the output increases by a greater proportion than the costs
of production.
Economies of Scale Definition
Purchasing Larger businesses can purchase greater quantities of raw materials than
smaller businesses. In return for their bulk purchase, suppliers offer them
discounts.
Marketing As output increases, the average marketing costs decreases as the total
marketing costs gets spread out to a larger amount of output.
Financial Larger businesses are more likely able to secure a bank loan and at lower
interest rates because banks perceive them as less risky compared to
smaller businesses.
Managerial Larger businesses attract and retain specialist employees whose skills can
help ensure that work on the production line is done more efficiently.
Technical Larger businesses can afford to purchase new capital and technology,
leading to more efficient production and lower average costs in the long
run.

Exercise 4.2.1: Case Study

Ronaldo owns a business that manufactures cardboard boxes used by other companies when packaging their
goods. The capacity of Ronaldo’s current factory is too small for him to take on all the orders he receives. He
has decided to relocate to a larger factory.
Identify and explain three economies of scale that Ronaldo might benefit from as a result of expanding his
business.
Economies of scale # 1 _____________________________________
Explanation:
_________________________________________________________________________________________
_________________________________________________________________________________________
Economies of scale # 2 _____________________________________
Explanation:
_________________________________________________________________________________________
_________________________________________________________________________________________
Economies of scale # 3 _____________________________________
Explanation:
_________________________________________________________________________________________
_________________________________________________________________________________________

4
DISECONOMIES OF SCALE
A business may experience an increase in its average costs as it increases its scale of production due
to diseconomies of scale. This occurs because management face difficulties trying to monitor and
control a business that has become too large. As a consequence, the total costs of production
increases by a greater proportion than the output does.

Diseconomies of Scale Definition

Poor communication It becomes more difficult for managers to communicate with workers
if the business gets too large, leading to slow and poor decision-
making and more mistakes which causes costs to increase.
Lack of employee If a business becomes too large, workers may feel isolated as they
motivation may no longer have direct contact with their managers, leading to
demotivation, reduced productivity, and therefore rising average
costs.
Poor coordination Larger businesses tend to have more departments and production
between departments lines. The average cost may go up as the different departments and
production lines may be working towards different objectives,
leading to waste of resources and unnecessary costs.

Exercise 4.2.2: Economies or Diseconomies of Scale?

The table shows the unit of factors of production that a firm needs to employ for two different levels of output.

Land Labor Capital Output

5 2 4 100
10 4 8 150
What is the firm experiencing?

A. Economies of scale
B. Diseconomies of scale

5
4.2.3 BREAK-EVEN ANALYSIS

Learning Outcomes:
• The concept of break-even.
• Construct, complete or amend a simple break-even chart.
• Interpret a given chart and use it to analyze a situation.
• Calculate break-even output from given data.
• Define, calculate, and interpret the margin of safety.
• Use break-even analysis to help make simple decisions, e.g. impact of higher price.
• Understand the limitations of break-even analysis.

THE CONCEPT OF BREAK-EVEN

Break-even is the level of output where the revenue of a business equals its total cost. At this level,
the business is neither making a loss or a profit (profit equals zero).
Break-even analysis is a technique that graphically illustrates the relationship between revenue, costs,
and output/sales.
A business may use this technique to:

• calculate how many units of output it needs to sell before it makes a profit.
• calculate the effect of changes in price on profit.
• calculate the effect of changes in costs on profit.

CALCULATING BREAK-EVEN OUTPUT

𝑓𝑖𝑥𝑒𝑑 𝑐𝑜𝑠𝑡𝑠
𝑩𝒓𝒆𝒂𝒌 𝒆𝒗𝒆𝒏 𝒐𝒖𝒕𝒑𝒖𝒕 =
𝑝𝑟𝑖𝑐𝑒 − 𝑣𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝑐𝑜𝑠𝑡 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡

Example 4.2.2: Calculating break-even output.

JJ’s School Supplies incurs a total fixed cost of $6,000 this month. The variable cost per notebook sold is $15
and the selling price per notebook is $50. Calculate the break-even output of JJ’s School Supplies for this
month.
$6,000
𝐵𝑟𝑒𝑎𝑘𝑒𝑣𝑒𝑛 𝑜𝑢𝑡𝑝𝑢𝑡 =
$50 − $15
= 171.43 ==> 𝟏𝟕𝟐 (𝑎𝑙𝑤𝑎𝑦𝑠 𝑟𝑜𝑢𝑛𝑑 𝑢𝑝)

BREAK-EVEN CHART
The break-even chart is a graphical model that measures a business’s costs & revenue (y-axis) against
the level of output or sales (x-axis). The break-even point can be identified by where the total revenue
(TR) intersects the total costs (TC). The fixed cost (FC) will always be a horizontal line as the amount
will never change regardless of how many products are made or sold.

6
Example 4.2.3: Constructing a break-even chart.

JJ’s School Supplies manufactures notebooks for $15 each and sells them at $50. The total fixed incurred this
month is $6,000. Construct a fully-labeled break-even chart and interpret the break-even point.

Step 1: Construct the x and y axes. Label ‘Cost and Revenue’ on the y-axis and ‘Quantity/Output’ on the x-
axis.
Step 2: Give the y-axis a scale. Go by intervals of the fixed cost.
Step 3: Calculate the break-even quantity. Give the x-axis a scale so that the break-even quantity is relatively
in the middle of the graph.
Step 4: Draw the ‘Fixed Cost’ line. This is simply a horizontal line drawn at where y equals the fixed cost.
Label this line ‘Fixed Cost’

Step 5: Calculate the break-even quantity by applying the formula from the previous page. Calculate the
break-even revenue by multiplying the break-even quantity by price. Plot a point on the graph to indicate
this point. Label this point the ‘break-even point’.
Step 6: Draw the ‘Total Revenue’ line so that it runs through the origin (0,0) and the point plotted in step 5.
Label this line ‘Total Revenue’.
Step 7: Draw the ‘Total Cost’ line so that it runs through (0, fixed cost) and the point plotted in step 5. Label
this line ‘Total Cost’.
Step 8: Draw a vertical dotted line from the point plotted in step 5 down to the x-axis. Label this point the
‘break-even quantity or BEQ’.
Step 9: Draw a horizontal dotted line from the point plotted in step 5 across to the left to the y-axis. Label
this point the ‘break-even revenue’.

16000
Total Revenue
14000
Break-
12000
Cost and Revenue ($)

even point
10000 Total Cost
Break-even
8000 Revenue
6000 Fixed Cost
4000
2000
0
0 100 BEQ = 172 200 300
Quantity/Output

Based on the analysis of the break-even chart above, JJ’s School Supplies will need to produce and sell 172
notebooks in order to completely cover its total costs.

Notice that the break-even quantity of 172 notebooks determined by the break-even chart is the same
answer we obtained by using the calculation formula on the previous page.
The break-even revenue will be $50 × 172 = $𝟖𝟔𝟎𝟎

7
MARGIN OF SAFETY
The margin of safety measures the difference between the break-even quantity of output or sales and
the current level. The greater the difference, the safer the business profits will be. A negative margin
of safety indicates that the business is producing less than the break-even quantity.

𝑴𝒂𝒓𝒈𝒊𝒏 𝒐𝒇 𝒔𝒂𝒇𝒆𝒕𝒚 = 𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑜𝑢𝑡𝑝𝑢𝑡 − 𝑏𝑟𝑒𝑎𝑘𝑒𝑣𝑒𝑛 𝑜𝑢𝑡𝑝𝑢𝑡

Example 4.2.4: Calculating margin of safety

JJ’s School Supplies manufactures notebooks for $15 each and sells them at $50. The total fixed incurred
this month is $6,000. Assuming that JJ sells 250 notebooks this month, calculate the margin of safety.
Step 1: Calculate the break-even quantity.
6,000
𝐵𝑟𝑒𝑎𝑘 𝑒𝑣𝑒𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 =
50 − 15
Step 2: Calculate the margin of safety by applying the formula above:
𝑀𝑎𝑟𝑔𝑖𝑛 𝑜𝑓 𝑆𝑎𝑓𝑒𝑡𝑦 = 250 − 172 = 78

Step 3: On a break-even graph, draw a dotted vertical line at the break-even output. Draw a vertical dotted
line at the current level of output.
Step 4: Draw a horizontal arrow between the two vertical dotted lines to indicate that the distance between
them is the margin of safety. Label this distance the ‘margin of safety’.

16000
TR
14000
12000
Cost and Revenue ($)

$12,500 Profit
10000 TC
$9,750
8000
6000 Margin FC
of
4000
Safety
2000
0
172 250
0 100 200 300
Output

Hence, JJ’s School Supplies produces 78 notebooks above the break-even quantity and is therefore making
a profit.
At the current level of output, 250, JJ’s School Supplies will earn a profit of
$12,500 − $9,750 = $𝟐, 𝟕𝟓𝟎

8
Exercise 4.2.3: Break-even Practice

Pairs of Price per Revenue from Fixed Costs Variable Total Costs Profit/(Loss)
Jeans sold pair Jeans sold Costs

0 $150 0 $1,200 0 $1,200 ($1,200)

10 $150 $1,500 $1,200 $700 $1,900

20 $150 $3,000 $1,200 $1,400 $2,600

30 $150 $4,500 $1,200 $2,100 $3,300 $1,200

40 $150 $6,000 $1,200 $2,800 $4,000

50 $150 $7,500 $1,200 $3,500 $4,700

Referring to the table above, answer the following questions:

1. Complete the profit/(loss) column.
2. Calculate the variable cost per jeans and the break-even output. Show all work.

3. Construct a break-even chart using the information in the table and show the break-even quantity
on your graph.

4. Calculate and show on the graph the margin of safety at 45 pairs of jeans sold. Show all work.

9
Benefits Limitations
• Provide an easy and visual means of • Assumes that all output is sold, which
analyzing a firm’s financial position at ignores storage costs.
various levels of outputs and sales. • It assumes that revenue and cost lines are
• Can be used as decision-making tool such as linear, which is often not the case in reality.
deciding on whether a business should • Fixed costs can change at different levels of
relocate or merge with another firm. output (e.g. rent for property is a fixed cost
• Managers can compare different prices and that can increase after a few years).
costs and how they affect break-even • The break-even charts may not be able to
quantity, profit, and margin of safety. cope with constant fluctuations in prices or
costs due to external environment influences
(e.g. inflation causes prices and costs to rise).

Master Your Definitions

Costs: money spent by a business to purchase factors of production for producing goods and services and to
run its daily operations.
Fixed Cost: costs that remain the same regardless of the level of output.

Variable Cost: costs that increase in direct proportion with the level of output.
Total Cost: the sum of fixed costs and variable costs of producing a certain level of output.
Average Cost: the cost of producing one unit of output.
Economies of Scale: as a business increases its scale of production (output), the average costs of production
decreases.
Diseconomies of Scale: as a business increases its scale of production (output), the average costs of production
increases.
Break-even Output: the level of output where the revenue of a business equals its total cost. At this level, the
business is neither making a loss or a profit (profit equals zero).
Break-even Chart: a technique that graphically illustrates the relationship between revenue, costs, and
output/sales.
Margin of Safety: the difference between the break-even quantity of output or sales and the current level.

10