Chapter Summary
- Fixed Costs don't change with output (rent, salaries). Variable Costs change with output (materials, labour). Together they make Total Costs.
- Economies of Scale reduce average costs as a business grows (bulk discounts, specialist managers, better tech).
- Diseconomies of Scale increase costs when firms grow too large (poor communication, weak coordination, low morale).
- Break-Even Point is where Total Revenue = Total Costs. A business makes a loss below this point, profit above it.
- Margin of Safety shows how far sales can drop before the business breaks even.
- Break-Even Analysis helps with pricing, production planning, and financial decisions — but relies on accurate data.
1. Different Types of Costs
Every business has to pay for things: raw materials, staff, rent, electricity. Understanding what these costs are and how they change is the foundation of good business planning.
Fixed Costs (FC)
Fixed costs are expenses that stay the same no matter how much you produce.
Whether your factory makes 0 units or 10,000 units, you still have to pay the rent, insurance, and your managers' salaries. These don't budge.
Real-world examples:
- Rent or mortgage on premises
- Salaries of managers and office staff
- Insurance premiums
- Bank loan repayments
- Depreciation of machinery
On a graph, fixed costs show up as a horizontal line. It's flat because the cost never changes with output.
Variable Costs (VC)
Variable costs change directly with output. The more you make, the more they cost.
If you're a candle maker and each candle needs £2 of wax, then:
- 0 candles = £0 wax
- 100 candles = £200 wax
- 1000 candles = £2000 wax
Real-world examples:
- Raw materials (wood, plastic, fabric)
- Direct labour (wages of factory workers who make the product)
- Packaging
- Shipping and delivery costs
On a graph, variable costs show up as an upward sloping line, starting at 0 and climbing as output increases.
Total Costs (TC)
Total Costs = Fixed Costs + Variable Costs
It's simple: add them together. At zero output, your total costs equal your fixed costs (because you have no variable costs yet). As you produce more, the total climbs because variable costs climb.
Example: A bakery has £500/month rent (fixed). Each loaf needs £1.50 in flour and labour (variable).
At 200 loaves: TC = £500 + (£1.50 × 200) = £500 + £300 = £800
Average Costs (AC)
Average Cost = Total Cost ÷ Quantity produced
This tells you how much it costs, on average, to make one unit. It's useful for pricing decisions.
Average costs are interesting because as a firm produces more, the average cost usually falls. Why? Because fixed costs get spread across more units.
Example:
COST ($) |
| ← As output increases,
80 | / average cost falls
| /
40 | /
|___________ OUTPUT LEVEL
0 |
0 500
Worked Example: Aroma Cannelles
What to Memorise