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Variable costs

An increase in output will tend to lead to an increase in the amount of raw materials being used, an increase in the power consumed and an increase in certain types of labour. These costs are known as variable costs because they vary with output.

The simplest example of variable costs assumes that the cost of raw materials, labour and power will be the same for each unit produced regardless of the level of output. This simplifying assumption is made to illustrate the concept of variable costs. A business might find that raw material costs decline as output increases because suppliers are willing to reduce the price of orders above a certain size (a bulk discount).

Variable costs of £2 per unit produced (the average variable cost) would result in total variable costs of £20 000 at an output of 10 000 units, £40 000 at an output of 20 000 units and so on until the maximum capacity of the plant was reached. This would give a straight line graph as illustrated in Figure 3.

Figure 3 Variable costs

Costs (£ 000)

200

180

160

140

120

100

80

60

40

20 Total variable costs

10

0 10 20 30 40 50 60 70 80 90 100

Output

Semi-variable costs

The rent of a hired car is a fixed cost, the petrol to keep it running is a variable cost. This marriage of fixed and variable costs is common in business.

Direct cost

Direct cost is a cost that can be clearly allocated to a particular product. The labour and materials will be referred to as direct labour and direct materials.

Indirect costs

Indirect materials will cover stores that are used for all departments, for example lubricants for machines. Indirect labour will include the cost of supervision and maintenance.

Overheads

A business performs a number of other functions in addition to production, for example marketing, personnel, research and development and finance. Costs which are clearly attributable to one of these functions are termed overheads. They include labour, materials and expenses.

Marginal costs

In economic theory marginal cost is defined as the cost of producing one extra unit of output. It is calculated by subtracting the total cost (total fixed costs + total variable costs) of the first level of output from the total costs of the second level of output. Accountants use the same basic definition of marginal cost but use only direct costs in its calculation.

Imputed costs

His is the cost of using something the business already owns. It can be seen as a method of giving a monetary value to the opportunity cost of using a resource.

Classification of costs

The classification of a cost varies according to the use of resource and the purposes of the classification. Labour, for example, can be classified in a variety of ways.

  • Labour employed in the production of a good or service is a direct cost.

  • Labour employed in selling a product is an overhead, unless of course that labour is employed in retailing, when it may be classified as a direct cost.

  • Labour which can be laid off when output falls can be classified as a variable cost. A production line worker might be classified as both direct labour and as part of variable costs.

  • When agreements between management and unions make it impossible to lay off labour then labour costs must be regarded as fixed for the period of time covered by the agreement. This situation might also arise if management has a policy of continuous employment.

  1. Comprehension check.

Working in pairs, answer the questions:

  1. Distinguish between fixed costs and variable costs.

    1. Can you give your own example of semi – variable costs?

    2. What is the difference between direct cost and indirect costs?

    3. What costs belong to overheads?

    4. How are marginal costs calculated?

    5. What is the definition of imputed costs?

  1. Solve the problem.

Given that a business can produce 150000 items in a month; its fixed costs per month are £ 10000; the average variable cost is £ 5 per unit and it is operating at full capacity. What is the cost per unit? Calculate the total production costs.

*4. The owner of a business described in task 3 wishes to make a profit equivalent to 25 per cent of production costs. At what price should the output be sold?

5. Sketch a variable cost curve to show what happens when unit variable costs decline as output increases.

*6. State one problem a business might experience in deciding on imputed cost.

7. Read the definitions below, then complete the phrases that follow by combining an appropriate word from the box with cost (s).

price manufacturing fixed operating

variable labour selling analysis sales

1 Usual expenses such as rent, heating, lighting, which are not changed by the volume of production. ………….. costs

2. Expenses which increase with increased production, e.g. labour, raw materials. ………….. costs

3 All costs directly related to production. ……………… costs

4 All costs directly related to getting someone to buy a product. ………. costs

5 The cost of employing workers and staff. ………………. costs

6 The costs for the day-to-day running of a company or business. ……. costs

7 Selling at a price which is exactly what the product has cost to make.

cost ……………..

8 The study of all likely costs associated with a product. cost……

9 The total costs for all products sold. cost of…………

Pre-reading task

The words and word combinations in the box make a key vocabulary of the text you are going to read. Use your dictionary if necessary.

What is this text about?

break – even point selling price

the lowest possible output intersect

revenue total profit

irrespective of similar

curve calculation

origin total losses

equation margin of error

vertical axes

Reading

  1. Read text 13 and think of the suitable title

Text 13

What is the lowest possible output at which a business can operate without losing money? The answer is called the break-even point. At this level the costs of production are exactly the same as the revenue received from sales, assuming the whole output is sold. The break-even point is illustrated graphically in Figure 4.

Figure 4 Break – even chart

Costs/ revenue (£ 000)

550

500

450

400 3 Revenue

350 5

300

250 4 Break – even point 2 Total costs

200

150 1 Fixed costs

100

50 6 7

0 10 20 30 40 50 60 70 80 90 100

Output (000s)

1. Fixed costs stay the same irrespective of output.

2. Total costs = total fixed costs + total variable costs. As we saw in Figure 3 the total variable cost curve passes through the origin. By introducing fixed costs we have added a constant to the equation which defines the curve. The total cost curve always cuts the vertical axis at the level of fixed costs.

3 The revenue line is found by multiplying the selling price of each unit by the level of output. In this instance the selling price is £4.

4 The point at which the revenue curve and the cost curve intersect is the break-even point.

5 To the right of the break-even point revenue is greater than total cost. The vertical difference between the two curves at any given point will give the total profit.

6 To the left of the break-even point a similar calculation to that described in 5 will give the total losses of the business at any given level of output.

7 If the business is operating at 70 per cent capacity it will still make a profit. The difference between the output at which a business is operating and the break-even output is known as the margin of error.

  1. Comprehension check.

  1. Reading from the information given in Figure 4, state whether or not the business will be making a profit or loss at each of the following levels of capacity: 20000, 35000, 55000, 70000, 90000.

  2. What is the margin of error when output is 80000 units?

Writing

Look at the diagram below showing the break-even point for a business. Then complete the description below using words from the box.

break - even point loss sales revenue variable costs

fixed costs profit total costs

£

Sales revenue

profit

Total costs

X

Variable costs

loss

Fixed costs

A

0 break – even point Amount of sales

The horizontal line shows (1)........................ The dotted line which starts at point 0 shows the (2).......................... for different levels of sales. The (3)....................... are fixed costs and variable costs combined. The solid line starting at point 0 shows the (4).............................................. at different levels of units sold. Point X is the (5)........................ To the left of point X, the business is making a (6)................... To the right, the business is in (7).......................