Lecture Notes: Costs, Scale of Production, and Breakeven Analysis

Key Topics:

• Identifying and Classifying Costs
• Economies and Diseconomies of Scale
• Break-even Analysis

Costs

Fixed Costs

• Costs that do not vary with production or sales volume.
• Incurred regardless of output (e.g., rent, insurance, salaries).
• Also known as overhead costs.

Variable Costs

• Costs that vary directly with production or sales volume.
• Associated with materials needed per product (e.g., dough, toppings for pizza).

Total Costs

• Sum of fixed and variable costs.

Average Cost

• Calculated as total cost divided by total output.

Economies of Scale

• Reduction in average costs as a firm increases in size.

Types of Economies

1. Purchasing Economies: Buying in bulk to reduce unit costs.
2. Marketing Economies: Cost advantages in production and distribution.
3. Financial Economies: Access to cheaper loans due to size and reliability.
4. Managerial Economies: Hiring specialized managers to optimize efficiencies.
5. Technical Economies: Investing in machinery and technology to improve production efficiency.

Diseconomies of Scale

• Increase in average costs as a firm grows beyond an optimal size due to:
  • Poor communication
  • Low employee morale
  • Slow decision-making processes

Break-even Analysis

Concept and Importance

• Determines the minimum output level needed to achieve profitability.
• At break-even, total revenue equals total costs (no profit, no loss).

Break-even Diagram Components

• Fixed Costs: Constant across output levels.
• Variable Costs: Increase with production (starts at zero when output is zero).
• Total Costs: Sum of fixed and variable costs.
• Total Revenue: Income from sales at different output levels.

Analyzing Break-even

• Benefits: Provides insight into required output for profit, helps in planning, and acquiring loans.
• Limitations: Assumes all products are sold, constant selling prices, doesn’t account for inventory costs, and predictions can be inaccurate.

Important Calculations

• Total Revenue: Price x Quantity Sold.
• Total Cost: Fixed Cost + Variable Cost.
• Average Cost: Total Cost / Total Output.
• Contribution: Selling Price - Variable Cost per Unit.
• Break-even Quantity: Total Fixed Cost / Contribution per Unit.
• Margin of Safety: Total Units Sold - Break-even Output.

Examination Questions

• Diseconomies of Scale Examples: Low employee morale and poor communication.
• Economies of Scale for TT:
  • Purchasing: Best due to reduced average costs from bulk buying.
  • Technical: Not ideal as equipment is already in place.
  • Financial: Less impactful as large finances are accessible internally.

Applications of Break-even to SSE

• Shows margin of safety, area of profit/loss, break-even output, and impact of cost changes.

Calculations

• Break-even Level of Output: Break-even = Fixed Cost / Contribution; e.g., $10,000 / $125 = 80 units.
• Margin of Safety: Total Sales - Break-even Output; e.g., 100 units - 80 units = 20 units.

Conclusion: Break-even analysis is a crucial tool for understanding the financial viability of business operations, identifying necessary output levels to avoid losses, and preparing for financial planning.