Costs

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Costs Break-Even
GCSE Business Studies
tutor2u
Revision Presentations 2004
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Introduction

• A business has many different costs, from paying
  for raw materials through to paying the rent or
  the heating bill
• By careful classification of these costs a
  business can analyse its performance and make
  better-informed decisions.
• The main ways in which a business needs to manage
  its costs are as follows
• Classification of costs into fixed and variable,
  direct and indirect
• Variance analysis to see if the business is
  keeping control of its costs
• Break even analysis which tells a business what
  it needs to sell to cover its costs

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Variable and Fixed Costs

• Variable costs
• Change in proportion to amount of output
  produced E.g.
• Raw materials
• Workers wages
• Energy/fuel for machines
• Fixed costs
• Remain same, no matter how much business
  produces. E.g.
• Rent
• Salaries of head office workers
• Heating and lighting
• Insurance

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Semi-Fixed Costs

• Costs which are normally fixed, but change (i.e.
  become variable) as the business reaches stages
  of growth
• Costs which only change when there is a large
  change in output
• For example, costs associated with buying a new
  machine to cope with increased production

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Standard Cost

• A way of estimating what the likely cost of
  something is going to be
• Cost per unit of production when product is made
  with
• Correct quantity and quality of materials, and
• In exact time allowed for its production
• Standard costs are often used in the preparation
  of the annual production / cash flow budget
• Estimate what raw material and production labour
  costs will be based on the expected level of
  output
• Can then compare actual costs against standard

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Variances

• When ACTUAL cost is either greater or less than
  standard cost
• Where actual costs are more than standard
  adverse variance
• Where actual costs are less than standard
  positive variance

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Using Standard Costing to Manage a Business

• A variance (difference) from standard may
  indicate what course of action to take to correct
  something which is going wrong
• A greater cost than standard (adverse variance)
  might lead to an investigation into how inputs
  were being used
• E.g. too much waste of raw materials, incorrect
  operation of machinery

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Opportunity Cost

• Financial benefit forgone of next best
  alternative use of money
• A business can measure outcome of a decision by
  comparing it with benefits (profits or revenue)
  it could have had if it had taken next best
  option
• Opportunity cost of buying a new piece of
  machinery might be compared with spending money
  instead on a new advertising campaign

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Direct and Indirect Costs

• Direct costs
• Costs which can be identified directly with
  production of a good or service
• E.g. raw materials
• Indirect costs
• Costs which cannot be matched against each
  product because they need to be paid whether or
  not production of good or services takes place
• E.g. rent on premises

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Break-even Point

• Point at which contribution from number of units
  sold exactly equals all fixed costs of business
• Profit is made above break even point when number
  of units sold exceeds number of units at break
  even point
• Contribution
• Amount of money each unit sold contributes to pay
  for fixed and indirect costs of business.
• Contribution selling price less variable cost
  per unit
• E.g. a product sells for 15 and has variable
  costs per unit of 11. Each unit sale therefore
  makes a contribution of 4 towards fixed costs of
  business. If business had fixed costs of
  20,000, then it would need to sell 5,000 units
  (4 x 5,000 20,000 contribution) in order to
  break even

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Break Even Chart - Example
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Importance of the Break-even Point

• Contribution from every unit sold above breakeven
  point adds to profit
• Breakeven point provides a focus for business
• Also helps it work out whether forecast sales
  will be enough to produce a profit and whether
  further investment in product is worthwhile.
• How calculated
• Number of units needed to break even is
  calculated by
• FIXED COSTS
• SELLING PRICE - VARIABLE COSTS

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Limitations of Break-even Charts

• Do not take into account possible changes in
  costs over time period
• Do not allow for changes in selling price
• Analysis only as good as quality of information
• Do not allow for changes in market conditions in
  time period e.g. entry of new competitor