Costs
A firm's costs can be classified in several ways.
- Fixed costs — an unchangeable amount of money that must be paid regardless of output (e.g. rent).
- Variable costs — costs that vary with the level of output (e.g. the cost of materials, which depends on how much is produced).
- Average cost — the average cost per unit of output.
- Total cost — fixed costs plus variable costs.
Average cost = Total cost ÷ Total output
Total cost = Fixed costs + Variable costs
Economies of scale
Economies of scale — when the cost of production per unit of output decreases as product output increases.
- Purchasing — as the firm grows, it buys inputs in bulk and can negotiate discounts to reduce the cost of materials.
- Risk-bearing — as the firm grows, it spreads risk across the market by producing new products, so it does not have to rely on the profit of one product.
- Financial — large firms can borrow large sums of money at lower interest rates as they are deemed "safer" to invest in by banks.
- Managerial — large firms can afford to hire specialists such as business analysts and accountants.
- Technical — large companies have the finance to utilise machinery, making employees redundant to save costs.
Diseconomies of scale
Diseconomies of scale — when the cost of production begins to increase as product output increases (this happens after economies of scale).
- Poor communication — as production increases and the firm grows, the number of employees gets too large, causing problems with relaying messages.
- Lack of employee commitment — due to the addition of automation, employee motivation decreases and labour turnover increases.
- Weak coordination — this is also related to the growth in the number of employees in a firm; too many employees cause delays in communication and conflicts.
Break-even analysis
A break-even graph is used to analyse the amount of output necessary to meet the cost per output. Firms may also use it as a method to help price goods/services.
- Break-even — the point at which profit and costs are equal.
- Margin of safety — the amount of output and sales a business has over its break-even point (the value of output/sales it has before meeting the break-even point).
Limitations of break-even analysis
- It assumes zero inventory.
- It assumes that variable costs can be depicted as a straight line.
- It assumes that all goods are sold.
- It assumes that fixed costs are always fixed.