Chapter 16:

Costs, Scale of Production, and

Break-even Analysis
 ▪ In this chapter, you will learn about:
• The different classifications of business costs
• The usefulness of cost data in business decision-making
Objectives • Economies and diseconomies of scale
• Break-even analysis
 ▪
Businesses have to make many decisions. Most business
decisions require managers to have accurate data about
the costs involved. In this chapter, you will learn about
the different ways of classifying costs.

▪ The classification of costs helps in business

decision-making. You will learn how the classification of
costs is important when using the techniques of
Introduction break-even analysis. This is a technique that is used by
many businesses when analyzing the relationship
between their revenue, costs, and volume of output.

▪ You will also study the effect of the scale of production

on business costs and how these might change as a
business grows.
 ▪ The main classifications of costs are:
• Fixed costs
• Variable costs
• Total costs
How are costs • Average costs
classified? ▪ Fixed costs, variable costs, and total costs are usually
explained by linking them to the level of a business’s
output.
 • Fixed costs do not change with output. In other words, a
fixed cost will be the same amount when output is zero or
when the firm is producing its maximum output—this is
known as capacity. Good examples of a fixed cost are factory
rent or the salary of managers.

• Variable costs change with output. If output increases by

Fixed and 50%, then the variable costs will also increase by 50%. A
good example of a variable cost is raw materials.
Variable Costs • Total cost is all the costs of making a certain level of output.
If the fixed costs of producing 2000 units of output is $3000
and the total variable costs of producing 2000 units is $5000,
then the total cost of producing 2000 units is $8000 ($3000 +
$5000).

▪ Total Cost Formula:

total cost=fixed costs+total variable costs
 ▪ Khaliq, the owner of The Casual Shoe Company (TCSC),
knows that it is important to classify costs properly
when making business decisions. He has asked you to
help him classify the following costs. Copy and
complete the table below. The first cost has been
completed as an example.

Activity 16.1

Page.216
 Key Answers

Cost Item Fixed Variable

Factory rent √
Leather used in making some √
shoes
Electricity used to power √
machinery
Machinery maintenance √

Advertising √
Production workers' wages √

Operations manager's salary √

Delivery of finished goods to √

customers
Safety equipment for √
production workers
Activity 16.2
 Key Answers
Activity 16.2 Solution
The table provides information about output, fixed costs, and variable costs, with variable costs calculated at $3 per pair of shoes.
1. Calculate Variable Costs for each level of output.
o 0 pairs: $0

o 1000 pairs: $3 × 1000 = $3000

o 2000 pairs: $3 × 2000 = $6000

o 3000 pairs: $3 × 3000 = $9000

o 4000 pairs: $3 × 4000 = $12000

2. Calculate Total Costs by adding Fixed Costs and Variable Costs.

o 0 pairs: $2000 + $0 = $2000

o 1000 pairs: $2000 + $3000 = $5000

o 2000 pairs: $2000 + $6000 = $8000

o 3000 pairs: $2000 + $9000 = $11000

o 4000 pairs: $2000 + $12000 = $14000

Output (pairs of Fixed Costs ($) Variable Costs ($3 Total Costs ($)
shoes) per pair)
0 2000 0 2000
1000 2000 3000 5000
2000 2000 6000 8000
3000 2000 9000 11000
4000 2000 12000 14000
Activity 16.3
 Key Answers
Activity 16.3 Solution
Calculate Average Costs by dividing Total Costs by Output for each level of output.
o For 1000 pairs: Average Cost=5000/1000=5

o For 2000 pairs: Average Cost=8000000=4

o For 3000 pairs: Average Cost=11000/3000≈3.67

o For 4000 pairs: Average Cost=14000/4000=3.5

o For 5000 pairs: Average Cost=17000/5000=3.4

o For 6000 pairs: Average Cost=20000/6000≈3.33

Output (pairs of shoes) Total Costs ($) Average Costs ($)

1000 5000 5
2000 8000 4
3000 11000 3.67
4000 14000 3.5
5000 17000 3.4
6000 20000 3.33
 ▪ Using cost data to make simple cost-based decisions
A business can use cost data for a variety of different
uses, for example, setting prices, break-even analysis,
and decisions about whether to continue or stop
Using cost data producing a product. The use of cost data to set prices
to make simple was covered in Chapter 12, and you will learn about
break-even analysis later in this chapter.
cost-based
▪ Cost data can be used in making decisions about
decisions whether a business should continue or stop producing a
loss-making product.

Top Tip
Note that fixed costs do not start from zero, whereas variable costs do. This means that total costs will
not start from zero either.
We can see from the data in Table
16.1 that Product A has made a loss The amended data for each product and the
of $2000. The marketing manager company in total is shown below:
thinks that the company should stop
selling Product A, but the
Product A ($000) Product B ($000) Total ($000)
company’s accountant disagrees. Revenue – 50 50
Fixed costs 10 15 25
Total variable – 18 18
Who is right? costs
Total costs 10 33 43
Profit (10) 17 7
You have already learnt that fixed Table 16.2 Revenue, cost, and profit data for the production of Product B only.
costs do not change with output.
Even when output is zero, fixed We can see that if the company decides to stop
costs still have to be paid. So, if the producing Product A, profit will fall from $15000 to
company stops producing Product $7000. Therefore, the accountant is right to continue the
A, it will still have to pay the fixed production of Product A. However, a business will not
costs of $10000. It will not have any want to continue producing a loss-making product
variable costs but will lose the forever. When a business no longer has the fixed costs of
revenue from the sales of Product A. the product then it will stop its production.
Page 219
 Key Answers
1.Define 'fixed costs'.
•Fixed costs are expenses that do not change with the level of production or the number of
passengers. For EasyAir, the fixed cost per journey is $14,000, regardless of the number of
passengers on the flight.
2.Calculate the average number of passengers per flight for the first quarter of 2013.

3.The average number of passengers carried on a flight in the second quarter was 116.
 Key Answers

4.The average cost per passenger per flight in the first quarter was $191.82. Why
does EasyAir continue flights when the average cost per passenger is less than the
revenue per passenger?

EasyAir continues flights even though the average cost per passenger is less than the
revenue per passenger because each additional passenger generates revenue that
contributes to covering both variable and fixed costs. Over time, as the number of
passengers per flight increases, the average cost per passenger decreases, making the
flights more profitable. Even if the average cost per passenger exceeds revenue initially,
higher load factors (more passengers) can reduce the per-passenger cost and help
achieve profitability.
Key Term
Economies of scale: the reduction in average costs as a result of increasing the scale of operations.
▪ Economies of scale
The term 'scale' simply means the size of business operations –
it is a measure of a business’s output. As output grows, a
business often benefits from reduced average costs due to
economies of scale. Businesses may benefit from different
Economies and types of economies of scale, as shown below.

diseconomies
of scale
 ▪ Financial economies
Lenders, such as banks, often prefer to lend to large businesses because they consider
them less of a risk than smaller businesses. As a result, large businesses find it easier to
borrow money and often do so at a lower rate of interest than smaller businesses.

▪ Managerial economies
As a business grows, it often employs specialist managers for the different functional
areas of the business such as marketing, finance, operations, and human resources.
Specialist managers improve the quality of business decisions and make fewer mistakes
than non-specialist managers.

▪ Marketing economies
While total marketing costs rise as a business gets larger, they do not rise at the same rate
as sales output. So, if a business doubles its output and sales, it will not need to double its

Types of marketing costs. This means that the average cost of marketing falls as output and sales
increase.

economies ▪ Purchasing economies

Large businesses usually buy greater quantities of raw materials and goods than smaller
businesses. Suppliers often offer discounts on large, or bulk, purchases. Small businesses
do not benefit from discounts. Purchasing economies are sometimes called 'bulk-buying
economies'.

▪ Technical economies
Large businesses usually save by producing due to production output at a lower unit cost.
This method of production often uses the latest technology, such as computer-aided
manufacturing (CAM). Such technology may be expensive, and only large businesses can
afford the level of investment required. These technologies enable large businesses to
produce very high levels of output at lower unit costs than smaller businesses.
Activity 16.5

Page 220
 Key Answers
Activity 16.5 Solution
Ronaldo, who owns a business manufacturing cardboard boxes, is expanding to a larger factory. Here
are three economies of scale he might benefit from as a result of this expansion:
1.Purchasing Economies:
By increasing production, Ronaldo will likely need to purchase larger quantities of raw materials, such as
cardboard and packaging materials. Suppliers may offer him bulk discounts for these large orders,
reducing the cost per unit of raw materials. This is also known as 'bulk-buying economies,' which allows
him to lower the average cost of production.
2.Technical Economies:
With a larger factory, Ronaldo can invest in more advanced machinery or automated production lines
(such as computer-aided manufacturing, or CAM) that can produce cardboard boxes more efficiently
and at a lower unit cost. The improved technology and equipment enable higher output with lower
per-unit production costs, making his operations more efficient.
3.Managerial Economies:
As his business grows, Ronaldo can afford to hire specialized managers for different functional areas,
such as production, marketing, and finance. These specialists bring expertise that can improve
decision-making, enhance productivity, and reduce costly errors, further lowering the average cost per
unit.
These economies of scale will help Ronaldo reduce his overall costs, improve efficiency, and potentially
increase profit margins as he expands his business.
 ▪ Diseconomies of scale
Sometimes, a business grows so large that it loses the
benefits of economies of scale. Instead, it experiences
the opposite – diseconomies of scale.

▪ Diseconomies of scale are all due to the problems faced

by management in trying to control a business that has
Diseconomies become too large. The main causes of these problems

of scale are:

• Poor communication
• Lack of commitment from employees
• Weak coordination
 ▪ Poor communication
If a business becomes too large, managers may no longer be able
to communicate directly with employees. This can lead to slow
and poor decision-making and an increase in mistakes.
▪ Lack of commitment from employees
In very large businesses, managers may no longer have
day-to-day contact with employees. This can lead to lack of
commitment from employees who feel that they are no longer a
valued part of the business. Employees become demotivated, and
this can lead to high labour turnover, poor quality, and a fall in
productivity.

Main Causes ▪ Weak coordination

As a business grows, so too will the number of departments,
products, and production units. The control and coordination of
these can present managers with many problems, especially
where production units are located in other countries. The
business's average costs may rise as a result of managers in
different departments or different production units working
towards different objectives. Also, there is a greater risk that work
will be duplicated, and this, of course, is a waste of resources and
increases costs unnecessarily.
 ▪ Explore!
Choose two businesses close to your school which are
in the same industry. One business should be small and
the other much larger, for example a local shop and a
supermarket.

1. Compare the two businesses and identify how the

Homework larger one might benefit from economies of scale.

2. How does the size of each business affect the range of

goods or services offered and the prices it charges?

3. Why do you think the smaller business is able to

compete in the same market as the larger business?
 ▪ The importance of economies and diseconomies of
scale
Economies of scale reduce average costs, and
diseconomies of scale increase average costs. The
relationship between average costs and scale of
The importance operation is shown in Figure 16.4, page 222.

of economies
and
diseconomies
of scale
You can see that as output increases, unit costs fall and continue to do so until
diseconomies of scale occur and the unit costs begin to rise. The 'best' scale of
operation is where unit costs are at their lowest – the bottom of the curve at the point
Q.
The fact that most businesses will eventually experience diseconomies of scale, as
the scale of operation grows, explains why most industries are not dominated by just
one or a few firms.
Page 222
 a. Explain three economies of scale Nakumatt Holdings Limited may have achieved as a result of its expansion since 1987.
1.Purchasing Economies:
As a large supermarket chain with over 40 stores, Nakumatt can buy products in bulk from suppliers. Bulk purchasing often leads to
significant discounts and lower costs per unit, reducing overall expenses and allowing Nakumatt to pass on some savings to customers.
2.Managerial Economies:
With expansion, Nakumatt can employ specialized managers for different areas like logistics, finance, marketing, and operations. These
experts bring efficiency and improved decision-making, reducing errors and waste, which contributes to lower average costs.
3.Marketing Economies:
Nakumatt’s large scale allows it to spread its marketing and advertising costs over multiple stores across different countries. This means that
the cost of an advertising campaign is distributed over a larger sales volume, reducing the average cost of marketing per unit sold.
b. Explain how the expansion of Nakumatt Holdings might benefit consumers.
The expansion of Nakumatt Holdings benefits consumers by providing them with a wider variety of products at potentially lower prices due
to bulk purchasing. With more stores in various locations, Nakumatt offers convenience and accessibility, making it easier for consumers to
access high-quality products. Furthermore, the increased scale may allow Nakumatt to introduce more competitive pricing, better service,
and additional amenities in stores.

c.If Nakumatt continues to expand, why might it experience diseconomies of scale?

If Nakumatt continues to expand, it may face diseconomies of scale, such as:
1.Poor Communication:
As Nakumatt grows, effective communication between management and employees across different countries and numerous stores could
become challenging, leading to misunderstandings, slower decision-making, and increased errors.
2.Lack of Commitment from Employees:
In a large organization, employees may feel disconnected or undervalued, especially if they don’t have regular interaction with management.
This can lead to reduced motivation, higher turnover, and a drop in productivity and service quality.
3.Weak Coordination:
Managing and coordinating a large number of stores across multiple regions with diverse needs can be complex. If not properly managed, it
can lead to inefficiencies, duplication of tasks, and inconsistent operations, increasing the average costs and reducing overall efficiency.
These diseconomies of scale could lead to higher costs and potentially impact Nakumatt’s profitability and service quality.

Key Answers
Key Term
Break-even: the level of output where revenue equals total costs; the business is making neither
profit nor loss.

▪ Break-even analysis
Break-even describes a situation where a business is
not making a profit or a loss from the production and
sale of its products. In other words, the revenue a
business earns from selling its output exactly equals the
Break-even total costs of producing the output. If the revenue a

analysis business earns from selling its output is greater than the
total costs of producing it, then the business earns
profit. However, if the revenue earned is less than the
total costs then the business will make a loss. These
three situations are shown in Figure 16.5.
 ▪ The concept of break-even
Break-even analysis is a business technique that shows
the relationship between revenue, costs and volume of
output/sales. A business might use break-even analysis
to:

• Calculate how many units it needs to sell before it starts

The concept to make a profit.
of break-even • Calculate the effect on profit of increasing or
decreasing the price of a product.

• Calculate the effect on profits of an increase or

decrease in business costs.
 ▪
The purpose of a break-even chart is to show the
relationship between a business’s revenue and costs at
different levels of output. The chart can be used to work out
the level of output that must be produced and sold to earn
revenue which exactly equals the total costs of producing
that level of output. This is known as the break-even output.

Simple ▪ To produce a break-even chart, a business needs to know its:

• Revenue at zero output and at its maximum output
break-even (capacity).

charts • Total costs at zero output and at capacity output.

• Fixed costs at zero output and at capacity output.
▪ The revenue and cost information at these two output levels
is then used to produce a break-even chart similar to that
shown in Figure 16.6.
Key Term
Margin of safety: the difference between the current level of output and break-even output.

Margin of safety
The margin of safety is the amount by which actual sales exceed the break-even level of output.
margin of safety=actual sales−break-even output
This is a measure of the amount by which sales can fall before losses are made. The higher the margin of safety, the lower the risk
of a loss being made.
 Here is the break-even chart for pizza sales:
•x-axis represents the "Output and sales of pizzas," scaled from 0 to 800.
•y-axis represents "Cost and revenue" in dollars, ranging from $0 to $2000.
•The Revenue line (blue) and Total Costs line (red) intersect at the break-even point, where Molly needs to sell 400 pizzas per week to cover all costs.
•The Fixed Costs line (green dashed line) shows constant costs across different output levels.
At the break-even point (400 pizzas), both revenue and total costs are $1000, indicating neither profit nor loss at this level.
At 600 pizzas, the revenue is $1,500.

Calculate the profit at 600 pizzas:

• Profit = Revenue - Total Costs Profit = $1,500 - $1,400 = $100

Therefore, if Molly sells 600 pizzas per week, her forecasted profit is $100.

Calculate the profit at 500 pizzas:

• From the chart, at 500 pizzas: Revenue is $1,250

Total costs are $1,200 Profit = Revenue - Total Costs Profit = $1,250 - $1,200 = $50

So, if Molly only sells 500 pizzas per week, her forecasted profit is $50.
 ▪ Once a break-even chart has been produced, it can be
used to show the effect of changes in the business’s
revenue or costs. This could be useful if a business is

Important considering changing its price, or if it knows that it is

likely to have a change in costs. For example, a supplier
may increase the price of raw materials it supplies to
the business.
 ▪ Molly’s first three months of trading have been
disappointing. She realizes that her price of $2.50 per
pizza is more than competitors in the town. She has
decided to reduce the price of her pizzas to $2 each.

1. Use this new price to draw a new revenue line on the

Activity 16.8 graph you prepared earlier. (Remember to recalculate
the revenue at zero and the capacity using the new
selling price.)

2. How many pizzas must Molly now sell to break even?

3. What is Molly’s profit at the new price of $2 per pizza?
Updated break-even chart with the new price of $2 per pizza:
•New Revenue Line - The purple line represents the revenue at the reduced price of $2 per pizza.
•New Break-even Point - At this new price, the break-even point is now 500 pizzas, with both revenue and total costs equal to $1000.
•Profit at 600 Pizzas - If Molly sells 600 pizzas, her revenue is $1200, and her total costs are $1150, resulting in a profit of $50.
This chart shows how the new price impacts the break-even point and profit at different sales levels. Molly now needs to sell more pizzas to cover her costs, but
with a competitive price, she may achieve higher sales volume. Let me know if you need more assistance!
Table 16.4 Benefits and limitations of break-even charts