In this video, I am going to be guiding you through chapter 4.2, Costs, Scale of Production and Breakeven Analysis. These are the syllabus statements, identifying and classifying costs. Now firstly, we have our first cost, which is a fixed cost. And this is costs that do not vary with the output produced or sold.
These are costs that are incurred regardless, which is the most important word here, of the output of the business. These are costs that are paid even if no products are sold. These are also known as overhead costs. So for instance, if we made zero output, so if we sold zero pizzas, rent will also need to be paid, insurance will need to be paid, and salaries will also need to be paid. These are what we call fixed costs, regardless of output.
Our second cost is variable cost and these are costs that are directly associated with the output produced or sold. So these are costs that are incurred directly to the product sold. Usually, it's in the materials for each product. So, for instance, for a pizza, every pizza requires dough and every pizza requires toppings. So, if we produce one pizza, a small amount will be spent.
And if we produce a million pizzas, a much larger variable cost will appear because we have sold more pizzas. Total costs. These are the total costs of production. So this is the sum of all costs that we have just covered, so which is the total fixed costs plus the total variable costs will equal our total costs.
Our next term is average cost and this is the average cost per unit of output for a business. So this is the average cost to every single item produced for a business and the calculation is the total cost divided by the total output. Economies and diseconomies to scale.
So what is economies of scale? So these are the factors that lead to a reduction of the average cost as a business increases in size. So these are the five economies of scale. Purchasing, marketing, financial, managerial and technological or technical. So our first one is purchasing economies of scale.
This is when a large business can buy their materials in bulk. They generally get very large discounts or cheaper prices. This in turn reduces the unit costs of components, meaning that the costs will be lower.
And if the business purchases more raw materials, the deeper the discount. Next, we have marketing economies of scale. These are the cost advantages with production on their marketing efforts. The business will be able to purchase its own vehicles to distribute products. Transport costs will be decreased, lowering the average cost of production.
And moreover, advertising rates do not rise as much as the size of the advertisement. So what does that mean is that, let's say an advertisement cost a million dollars to make and to put that on television it will cost ten thousand dollars but with marketing economies of scale they can spend twenty million dollars on a more powerful and impactful advertisement but yet the tv broadcaster is only charging them ten thousand dollars for the same slot financial economies of scale is when large firms can get access to much cheaper money, usually in the form of a lower interest rate. Bank managers will be willing to lend very large sums of money to larger businesses, usually because they can trust them. A very low interest rate will be given because they can trust that the large company is able to pay this back. Next.
Managerial economies of scale is when large firms can afford specialist managers to work for them. So what they do is they hire the best specialist managers globally and these specialists are able to optimize and create large efficiencies for the business. This means that they are able to use the least level of inputs whilst maximising their outputs, maximising the productive efficiency of the business. Next, we have technical or technological economies of scale.
This is when larger firms can invest into machinery. Well, what they do is they buy large machinery for their flow production and they use the most up-to-date technology to increase its productive efficiency. Now, one example would be a wheat field owner used to pick their own wheat with their bare hands. Now using technical economies of scale, they can buy a combine harvester to do this for them. Now a combine harvester will be able to do about maybe 100 or 200 people's worth of wheat picking.
Therefore the productive efficiency of this has increased drastically. Now moving on to this economies of scale. This is when the average costs increase for a business. This is due to a few things.
Firstly, it's due to poor communications because there are many departments and lots of employees. So it's difficult to establish an efficient method of communication. Secondly, we have low morale.
This is due to the non-contact with senior managers. This means that the employees might feel unimportant or not valued at all. And lastly, slow decision making. This is because the chain of command of very large businesses is usually very long.
So communication will be very slow to get up to the top. Thus, decision making will take a lot of time. So moving on to the concept of break-even and break-even analysis.
So what is break-even? It indicates to the owner that the minimum level of output required to start making a profit. As no profit is being made until this break-even output has been met.
And at the break-even point, no profit or no losses are being made. So everything equals zero. So this is my example of charting a break-even diagram.
First of all, we have fixed costs, we have variable costs, total costs and total revenue. Now remember, fixed costs are fixed at 0 units and at 2,000 units and that remains constant. I will only be looking at 0 units and 2,000 units for the chart and I'll explain so in a sec.
Firstly, we have our fixed costs and that 0 units is 500 units and 2,000 units They're all the same because costs are fixed regardless of output. So our first line in our break-even diagram is our fixed cost which is a horizontal line and as you can see at zero output we have five thousand dollars and at two thousand outputs we have again five thousand dollars. So moving on to the variable cost, here it's slightly different. You can see that at zero units we have zero variable cost and at 2,000 units we have $6,000.
So at 2,000 units it cost the business $6,000 of raw materials to make said product. So let's chart this. So again at zero output the variable cost line starts at zero. Now the trick here is to find where 6,000 is. On this diagram, It is at this point right here.
So what do we do? We draw a line from 0 all the way to the 6000 and that will be our total variable cost. Next, we have our total cost. Now total cost is the fixed cost plus the variable cost.
So in this example, the total cost will be 5000 at 0 units as 5000 plus 0 is 5000. and at 2,000 units we have $11,000 as $5,000 in fixed costs plus $6,000 in the variable costs will equal $11,000. So let's find that on the chart. So our total cost starts at $5,000 as you can see here and then we need to find $11,000 at the 2,000 units and that is right at this point here.
So we draw a line from 5000 all the way to 11,000, and then we'll label it total costs. And last but not least, we need to find our revenue. Our revenue is $0. As we sell 0 units, we make $0. And at 2,000 units, in this example, it's $16,000.
So on the chart, we need to find $16,000. So $16,000 at 2,000 units. it's up here and as i said before if we sell zero outputs or zero units we make zero dollars so we draw the line this black line here is the total revenue now as you can see this is a finished break-even diagram now i'm going to shade in the area of profit this is the case because our total revenue is greater than our total cost.
And then if we trace down to the dot in the middle, this is when total revenue equals total cost, meaning this is the break-even point. And any value below that would mean that this business is making a loss. And finally, we can identify the margin of safety with this line here, which is the total number of units produced minus the break-even quantity and in this case that's 1000 units.
So let's move on to the analysis of break-even. So the benefits to this is that it allows the managers to know the level of output required to make a profit. It also helps them plan for forecasting for decision making. Furthermore it allows them to apply for finance from banks so banks will know what their break-even output is. and then they will be able to give them a loan based on that. It will help them see what would happen if costs increased diagrammatically, and also it will help identify the margin of safety.
Now moving on to the limitations of breakeven. Firstly, it assumes that all of its products are sold, and we all know that's not the case, as some businesses will have excess inventory left over. It also assumes that the selling price of the units remain unchanged.
It also does not allow for inventory holding costs, as the more inventory you have, the more it costs you. It is also a prediction and a forecast, so it's never truly 100% accurate. And last but not least, fixed costs may change over time, meaning that your rent might increase, for instance.
So moving on to our important calculations. Total revenue, this is price multiplied by quantity sold. Total cost is the total fixed cost plus the total variable cost and we covered this in our break-even section of this video. Average cost, this is the total cost divided by the total output which gives us an average cost of all units sold.
Contribution, the selling price minus The variable cost per unit. This is the money left over from selling a product after paying for the variable cost. Breakeven quantity.
This is the amount required to not make a loss or a profit, which is total fixed cost divided by contributions per unit. And the margin of safety. This is how many sales can the business drop until the business starts to lose money. And this is the units sold or the total units sold minus the breakeven output, which again we have covered in our breakeven section of this video. Moving on to the examination questions.
Please be reminded that I have examination technique playlists in the description below. Explain two diseconomies of scale DBR might experience. Low motivation. Due to low morale, many of its 3000 employees will end up leaving. therefore resulting in a higher turnover.
Bad communication, as there will be repetition of the work and the productive efficiency will decrease selling its diamonds. Consider how TT might benefit from the following three economies of scale as it continues to grow Which is the most likely to have the greatest effect on TT's profit? Justify your answer purchasing, technical and financial. For purchasing They can buy raw materials at cheaper prices in bulk.
This reduces the average cost per item for producing their toys. For technical, they can use specialist machines to make things quicker, so to speed up the production process, and each unit will cost significantly less to produce, increasing their productive efficiency. For financial, they can raise finances very cheaply as they have a lower interest rate, so the cost of borrowing will be reduced. And for the conclusion, technical is not the best as it has already purchased specialist equipment for flow production. Financial is not the best as it is already a large business so it can easily get the 10 million dollars it requires internally instead.
So therefore purchasing is the best as it will allow for TT to maintain a good relationship with its supplier to ensure the supplier will continue supplying the raw materials at even deeper discounts lowering the average cost further. I explained 4 ways that the breakeven chart in Appendix 3 might be helpful to SSE. Way 1 shows margin of safety for its 250 helmets sold above the breakeven output. Shows the area of profit or loss and the expected profit at the maximum output of 1000 helmets per week.
Shows the breakeven output. as it requires 750 helmets in order to break even. And lastly, way four, it shows the impact of change in costs.
So it can show the impact of a change in fixed costs easily from 15,000 and easily show the impact of this on the chart. Using the information in Appendix 2, calculate the break-even level of output per month. So in this case, it's 250 minus 125. equals 125 for its contribution and that's fixed cost which is $10,000 over $125 equals 80 units.
This will be the answer. You get one mark for your calculation and one mark for the correct answer. Calculate the margin of safety per month for tables.
That's 100 units minus 80 units, my calculation, and the answer is 20 units, my answer. Hope that helped. Hope you guys have a good day. Bye-bye.