IGCSE Economics 4.2 Costs of Production

Learning Outcomes Define total and average cost, fixed and variable cost and perform simple calculations And some which are not on the syllabus but we’re covering anyway!! To understand the concept of breakeven To be able to identify the breakeven output and revenue on a chart To explain what impact changes in costs and selling price will have on the breakeven output

Some Key Terms Total Costs Fixed Costs Average Costs Variable Costs What do each of these terms mean? Can you explain any differences between them or links between them?

Match the key term with the graph Fixed Costs Variable Costs Total Costs Average Costs

Match the key term with the graph Fixed Costs Variable Costs Total Costs Average Costs

Match the key term with the graph Fixed Costs Variable Costs Total Costs Average Costs

Fixed Costs What might some examples of fixed costs be? A cost which does not change as the level of output changes IN THE SHORT RUN NOTE: Fixed costs per unit of output (Average Fixed Costs) will decrease as production increases (vice versa) What might some examples of fixed costs be?

Variable Costs A Variable Cost is a cost which varies directly with output We normally consider variable costs in two ways: Variable cost per unit Total Variable costs (at a given level of output) What might some examples of variable costs be?

Total Costs At any level of output: Total Costs = Fixed Costs + Total Variable Costs Why does the Total Costs curve look like this?

Average Costs The Average Cost is the cost per unit of production. It is also known as the unit cost. Average Cost = Total Cost Output Also note…… Average Fixed Cost = Fixed Cost Average Cost = VC + AFC

Average Cost Curve – for many firms The average cost of each unit of a good or service will tend to fall as output rises because total fixed costs are spread over a much larger output But, after a point, average costs may start to rise again if it becomes more difficult and expensive to increase output

Reminder - Revenue Revenue is the amount of money a firm has coming in from sales of goods and services. For a particular product it can be calculated by the formula: Revenue = Selling Price x Quantity Sold (Output)

Calculation time

Task – New Magazine Launch A publisher wants to launch a new magazine. They plan to sell the magazine for $5. The costs of producing the magazine each magazine will be $2 for materials and $1 for labour. In addition to this the publisher will have to hire a new printing machine for $2,600 and an office space for $1,400 You have to calculate their costs at different levels of output to help them to decide whether they should launch it or not.

Fill in this table…. Work column by column from left to right Number of magazines per month Fixed Costs Total Variable Costs Total Costs Average Cost Total Revenue Profit/Loss $1,000.00 $2,000.00 $3,000.00 $4,000.00 $5,000.00 $6,000.00 $7,000.00 $8,000.00 Work column by column from left to right

Fixed Costs stay the same at ALL levels of output (in the SHORTRUN) Number of magazines per month Fixed Costs Total Variable Costs Total Costs Average Cost Total Revenue Profit/Loss $1,000.00 $4,000 $2,000.00 $3,000.00 $4,000.00 $5,000.00 $6,000.00 $7,000.00 $8,000.00

TVC = VC per unit x Output Number of magazines per month Fixed Costs Total Variable Costs Total Costs Average Cost Total Revenue Profit/Loss $1,000.00 $4,000 $3,000 $2,000.00 $6,000 $3,000.00 $9,000 $4,000.00 $12,000 $5,000.00 $15,000 $6,000.00 $18,000 $7,000.00 $21,000 $8,000.00 $24,000

TC = FC + TVC Number of magazines per month Fixed Costs Total Variable Costs Total Costs Average Cost Total Revenue Profit/Loss $1,000.00 $4,000 $3,000 $7,000 $2,000.00 $6,000 $10,000 $3,000.00 $9,000 $13,000 $4,000.00 $12,000 $16,000 $5,000.00 $15,000 $19,000 $6,000.00 $18,000 $22,000 $7,000.00 $21,000 $25,000 $8,000.00 $24,000 $28,000

AC = TC Output Number of magazines per month Fixed Costs Total Variable Costs Total Costs Average Cost Total Revenue Profit/Loss $1,000.00 $4,000 $3,000 $7,000 $7.00 $2,000.00 $6,000 $10,000 $5.00 $3,000.00 $9,000 $13,000 $4.33 $4,000.00 $12,000 $16,000 $4.00 $5,000.00 $15,000 $19,000 $3.80 $6,000.00 $18,000 $22,000 $3.67 $7,000.00 $21,000 $25,000 $3.57 $8,000.00 $24,000 $28,000 $3.50

Revenue = Selling Price x Output Number of magazines per month Fixed Costs Total Variable Costs Total Costs Average Cost Total Revenue Profit/Loss $1,000.00 $4,000 $3,000 $7,000 $7.00 $5,000 $2,000.00 $6,000 $10,000 $5.00 $3,000.00 $9,000 $13,000 $4.33 $15,000 $4,000.00 $12,000 $16,000 $4.00 $20,000 $5,000.00 $19,000 $3.80 $25,000 $6,000.00 $18,000 $22,000 $3.67 $30,000 $7,000.00 $21,000 $3.57 $35,000 $8,000.00 $24,000 $28,000 $3.50 $40,000

Profit/Loss = Revenue - TC Number of magazines per month Fixed Costs Total Variable Costs Total Costs Average Cost Total Revenue Profit/Loss $1,000.00 $4,000 $3,000 $7,000 $7.00 $5,000 -$2,000 $2,000.00 $6,000 $10,000 $5.00 $0 $3,000.00 $9,000 $13,000 $4.33 $15,000 $2,000 $4,000.00 $12,000 $16,000 $4.00 $20,000 $5,000.00 $19,000 $3.80 $25,000 $6,000.00 $18,000 $22,000 $3.67 $30,000 $8,000 $7,000.00 $21,000 $3.57 $35,000 $8,000.00 $24,000 $28,000 $3.50 $40,000 Should the publishing company launch the magazine?

Questions…… At what level of output does the business start to make a profit? Why does the Average Cost keep falling? Will the Average Cost continue to fall as output increases? What is the minimum value for the Average Cost? Should the company launch the magaxine?

Clue to the next topic….

Breakeven Analysis

Quick test: Give 2 examples of fixed costs (2) Draw a Fixed Costs, Variable Costs and Total Costs line on a fully labeled axis (5) Give 2 examples of variable costs (2) What is the formula for Revenue? (1) A firm has fixed costs of £2,000 per month. Variable costs of £3 per unit and selling price of £5. In July they sell 1,200 units How much revenue does the firm make? (1) What are the firms Total Costs? (1) What are the firms Total Variable Costs? (1) What are the average costs? (1) How much profit does the firm make in July? (1) Total marks = 15

Profit = Total Revenue – Total Costs What Is Breakeven? If a firm is breaking even it means that the business is neither making a profit or a loss. Breakeven is the output at which a firm’s total revenue is equal to its total costs. Profit = Total Revenue – Total Costs Questions Do you understand what Revenue and Costs are? What is Revenue? How is is calculated? What are costs? When a business is breaking even the profit figure will be 0, can anyone tell me what Total Revenue and Total Costs need to be to get a profit figure of ?

Break Even Charts Costs/Revenue TR TC VC FC Output/Sales The break even point occurs where total revenue equals total costs. The firm will have to produce and sell this number of units to breakeven Total revenue is determined by the price charged and the quantity sold – again this will be determined by expected forecast sales initially. Initially a firm will incur fixed costs, these do not depend on output or sales. The lower the price, the less steep the total revenue curve. As output is generated, the firm will incur variable costs – these vary directly with the amount produced. VC The total costs therefore (assuming accurate forecasts!) is the sum of FC+VC Breakeven Revenue FC Breakeven Output Output/Sales

Break Even Charts – What they show Costs/Revenue TR TC Profit Loss Margin of safety Breakeven Output D2 D1 Output/Sales

Changes in Variable Costs Costs/Revenue TC1 TR TC TC2 If Variable Costs go up the line will become steeper. What will happen to the Break Even Point? If Variable Costs go down the line will become less steep. What will happen to the Break Even Point? The level of variable costs affects the gradient of the Total Costs line. BEP2 BEP BEP1 Output/Sales

Changes in Fixed Costs Costs/Revenue TC1 TR TC TC2 If fixed costs go up, the Total Costs line will shift upwards If fixed costs go down, the Total Costs line will shift downwards The fixed cost line affects where the Total Cost line starts BEP2 BEP BEP1 Output/Sales

Changes in Selling Price TR1 Costs/Revenue TR TR2 TC A decrease in the selling price will make the TR line less steep A change in Selling price will affect the gradient of the Total Revenue line An increase in the selling price will make the TR line steeper BEP1 BEP BEP2 Output/Sales

Questions Explain what will happen to the Breakeven output in the following situations. Illustrate with a diagram. The cost of raw materials increases The company moves to premises with cheaper rent The company decreases the selling price to compete with a new competitor The electricity supplier increases their prices

Using Contribution to calculate the Breakeven Point To calculate the breakeven point in terms of output the following formula can be used Breakeven Output = 𝐹𝑖𝑥𝑒𝑑 𝐶𝑜𝑠𝑡𝑠 𝑆𝑒𝑙𝑙𝑖𝑛𝑔 𝑃𝑟𝑖𝑐𝑒 −𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝐶𝑜𝑠𝑡 (𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛) How can we work out the Breakeven Revenue? Multiply the Breakeven output by the Selling Price

Questions Work out the Breakeven Output and Breakeven Revenue for the following situations (Remember to show working out) Fixed Cost £3,000; Variable Cost £4.25 Selling Price £8 Fixed Cost £89,000; Selling Price £99.99 Variable cost £67.31 Fixed Costs £1,000; Selling Price £1.75 Variable cost 93p

Answers £3,000/£3.75 = 800 units £6,400 £89,000/£32.68 = 2724 units £272,372.76 £1000/£0.93 = 1220 £2,135