Costs & Break-Even GCSE Business Studies tutor2u™ Revision Presentations 2004

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

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

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

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

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”

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

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

Direct and Indirect 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

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

Break Even Chart - Example

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

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