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Chapter 18 - Costs, scale of production and break-even analysis (Business…
Chapter 18 - Costs, scale of production and break-even analysis
Business Costs
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Total cost (fixed and variable costs combined) can be compared with sales revenue for the period to calculate profit or loss
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Average cost: total cost of production divided by total output (sometimes referred to as ‘unit cost.’)
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Use of Cost Data
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- Deciding whether to stop production
- Deciding on the best location
Economies of Scale: The factors that lead to a reduction in average costs as a business increases in size.
When business buy large number of components, they are able to gain discounts for buying in bulk. Reduces unit cost of each item.
For large businesses, they might be able to afford to purchase its own vehicles to distribute goods rather than depend on firms. Advertising rates in papers and on television do not go up in the same proportion as the size of an advertisement ordered by business. Business won't need twice as many sales staff to sell ten product lines as a smaller firm needs five.
Larger businesses are often able to raise capital more cheaply than smaller ones. Bank managers often consider lending to large firms rather than smaller firms.
Small businesses usually can't afford to pay for specialist managers like marketing managers and qualified accountants. This tends to reduce their efficiency.
Large manufacturing firms often use flow production methods (using specialist machines) however smaller business can't usually afford these equipments.
Diseconomies of Scale: The factors that lead to an increase in average costs as a business grows beyond a certain size.
The larger the organisation the more difficult it becomes to send and receive accurate messages. If there is slow or inaccurate communication then serious mistakes can occur which lead to lower efficiency and higher avg costs.
Large businesses can employ thousands of workers. It is possible that one worker will never see the top managers of the business. Workers may feel that they are unimportant and not valued by the management.
It often takes longer for decisions made by managers to reach all groups of workers and this could mean that it will take a long time for workers to respond and act upon managers' decisions.
Break-even Charts: Graphs which show how costs and revenues of a business change with sales. They show the level of sales the business must make in order to break even.
Advantages
- show break-even output (the quantity that must be produced/sold for total revenue to equal total costs (also known as break-even point)
- show safety margin (the amount by which sales exceed the break-even point)
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- show area of profit or loss
Limitations
- Break-even charts are constructed assuming that all goods are sold- Graph doesn't show the possibility that inventories may build up if not all goods are sold
- Fixed costs are not always constant
- Break-even charts concentrate on the break-even point of production, but there are many other aspects of the operations of a business which need to be analysed by managers.
- The simple charts used in this section have assumed that costs and revenues can be drawn with straight lines. This will not often be the case.
Drawing
In order to draw a break-even chart we need information about the fixed costs, variable costs and revenue (the income during a period of time from the sale of goods or services) of a business.
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