0264 · 4.4.1Identify and classify costs

Fixed and variable costs

0:00A business can produce more and spend a larger total, while each item becomes cheaper to make. Understanding that relationship helps managers decide what to produce and what price to charge. It also helps them compare suppliers and decide whether production should continue. By the end, you will understand how costs behave and how to use them in simple business decisions. Production is using resources to make goods or provide services, and output is the quantity produced in a given period.

0:26A business incurs costs when it uses resources, such as premises, materials and employees. We will compare costs and output over the same month, because monthly rent cannot be matched with a whole year’s production. Fixed costs are costs that do not change with the level of output in the short run; variable costs change directly with the level of output. Fixed costs must be paid even if nothing is produced.

0:51Interest is the payment made for borrowing money. Examples of fixed costs include rent, salaries, insurance and loan interest. Cedar Works makes wooden trays. Its monthly rent stays unchanged when production increases within the capacity of its existing premises. Each additional tray needs more wood and packaging, so spending on these materials rises with output. The distinction depends on how a payment responds to production during the period being considered.

1:16Raw materials are basic inputs a business turns into products. Packaging and power for machines also rise with each extra item made. Piece-rate wages are payments to employees for each item they produce. These wages therefore increase with output, while an agreed monthly salary remains unchanged within the period. Costs stay fixed only in the short run, while the business keeps the same premises and contracts. A landlord can raise rent when a contract changes, and a growing business may eventually need additional premises.

1:47Within our example, the rent and salaries stay unchanged all month. We also assume that materials cost the same amount for each tray throughout the output range.

Calculating total and average cost

1:56Total cost is the combined amount of all fixed and variable costs. To find it, add the payments that remain unchanged to those that depend on production. Average cost is the cost per unit of output. Dividing the overall amount between the units produced shows how much each item costs on average. Cedar Works has total fixed costs of six thousand dollars per month. The variable cost per unit is four dollars for each tray.

2:20We will compare monthly outputs of one thousand and two thousand trays. Our assumptions are unchanged premises, sufficient production capacity and the same material requirements for every item. Total variable cost equals variable cost per unit times the number of units. Multiplication adds together the materials and other variable spending required for every tray. Four dollars times one thousand gives four thousand dollars. At the higher output, four dollars times two thousand gives eight thousand dollars.

2:48Total cost equals total fixed costs plus total variable costs. For one thousand trays, six thousand dollars plus four thousand dollars gives ten thousand dollars. At two thousand trays, six thousand dollars plus eight thousand dollars gives fourteen thousand dollars. More materials are needed at the higher output, so the overall amount rises. Average cost equals total cost divided by the number of units. Ten thousand dollars divided by one thousand gives ten dollars per tray.

3:16For the higher output, fourteen thousand dollars divided by two thousand gives seven dollars per tray. Division spreads all the production costs across the items made during that month. Return to the table and compare its columns. Total cost rises from ten thousand dollars to fourteen thousand dollars, while average cost falls from ten dollars to seven dollars. The unchanged fixed costs of six thousand dollars are spread over more trays.

3:40Each item therefore carries a smaller share of those payments, although its variable cost remains four dollars. Willow Care produces dressings for hospitals. Its total variable cost is twenty-seven hundred dollars for nine hundred dressings. Variable cost per unit equals total variable cost divided by the number of units. Twenty-seven hundred dollars divided by nine hundred gives three dollars per dressing. This calculation starts with the combined variable spending and shares it across the output.

4:08Average cost includes both fixed and variable costs in its numerator. The variable cost per unit calculation uses only the spending that changes directly with production. Reading the question carefully tells you which amount belongs in the division.

Using costs for production decisions

4:22Cost information becomes useful when managers connect it with expected sales and the circumstances of their business. Revenue is the income a business receives from selling goods or services. Managers then judge each option by its profit, and profit is total revenue minus total costs. Four practical decisions concern product choice, continuing production, selling price and supplier selection. Bramble Fields grows vegetables and can use one available plot for either carrots or spinach.

4:50Expected revenue is equal, while total costs are four hundred and eighty dollars for carrots and six hundred and twenty dollars for spinach. Both estimates cover the same season and include every relevant payment. Customer demand and growing risks are also assumed equal. I recommend carrots because they have the lower total cost for the same expected revenue. Six hundred and twenty dollars minus four hundred and eighty dollars gives one hundred and forty dollars, so carrots earn one hundred and forty dollars more profit.

5:16Spinach offers weaker financial results under these assumptions. If expected sales or growing conditions change, the business should update its comparison before choosing what to produce. Moss Prints makes posters and expects eight hundred and fifty dollars of revenue next month. Continuing production involves seven hundred dollars of fixed costs and four hundred dollars of variable costs. Seven hundred dollars plus four hundred dollars gives a total cost of eleven hundred dollars.

5:42A loss is when total costs are greater than total revenue. Revenue of eight hundred and fifty dollars minus eleven hundred dollars leaves a loss of two hundred and fifty dollars. If production stops for that month, the seven hundred dollars of fixed costs must still be paid. There would be no sales or variable spending, so the loss would be seven hundred dollars. These figures assume that all output sells and temporary closure creates no additional payments.

6:07Stopping therefore makes the loss larger. I recommend continuing for this month because the loss is smaller while production operates. Eight hundred and fifty dollars minus four hundred dollars leaves four hundred and fifty dollars towards the unavoidable fixed costs. For a longer closure, managers must check which payments could end and whether sales could improve. The decision depends on the costs that actually change when production stops.

Pricing and supplier choices

6:30Amber Corner sells takeaway drinks from a small café. Its average cost at expected monthly sales is two dollars and fifty cents per drink. Customers are willing to pay three dollars and fifty cents. The cost estimate includes all fixed and variable payments, and the business expects to sell everything it produces. I recommend a price of three dollars and fifty cents under these conditions. Customers are willing to pay that amount, and it exceeds the average cost at expected sales.

6:55Three dollars and fifty cents minus two dollars and fifty cents leaves one dollar per drink above average cost. Managers should check actual demand because lower sales spread fixed costs across fewer drinks. A workable price needs both cost information and evidence about customers. Larch Medical packages surgical tools and needs one thousand protective boxes every month. Quality is producing a good or service that meets customers' expectations and is free from faults.

7:21Two suppliers offer boxes of the required quality. The first charges one dollar and eighty cents per box but delivered late three times last year. Its rival charges two dollars per box and has always delivered on time. Each late delivery stops packing for a day and costs five hundred dollars of lost output. One dollar and eighty cents times one thousand gives eighteen hundred dollars a month from the first supplier.

7:44For the second, two dollars times one thousand gives two thousand dollars. Two thousand dollars minus eighteen hundred dollars gives an extra cost of two hundred dollars each month. I recommend the second supplier, even though its boxes cost two hundred dollars more each month. A single late delivery from the cheaper option would cost five hundred dollars of lost output. That loss is larger than the monthly saving, and the cheaper firm was late three times last year.

8:10Reliable deliveries keep packing running, so Larch Medical meets its customers' orders on time.

Exam technique and recap

8:15For examination calculations, keep every figure tied to its period and unit. Monthly fixed costs belong with monthly output, and average cost should be expressed in dollars per item. Classify a payment by how it behaves as production changes. Salaries remain fixed within the period, while piece-rate wages increase directly with the quantity produced. Explain means set out purposes or reasons, say why and how, supported with relevant evidence. An exam-style question asks you to explain Cedar Works’ lower average cost at the higher output.

8:47Its total fixed costs remain six thousand dollars at both production levels. These payments are spread across more trays, so average cost falls from ten dollars to seven dollars. To summarise, fixed costs are costs that do not change with the level of output in the short run; variable costs change directly with the level of output. Adding the two categories gives the overall amount spent on production. Total cost is the combined amount of all fixed and variable costs.

9:13Keep both categories in view when assessing the full cost of operating. Finally, average cost is the cost per unit of output. Spreading unchanged fixed payments across more units explains why this measure can fall as production rises. Cost data supports choices about products, production, prices and suppliers. Sound decisions also depend on expected sales, quality, reliability and the payments each option would actually change.