Identifying & Classifying Costs

Introduction to costs

Introduction to costs

• Businesses incur a range of costs 

  • Examples include purchasing raw materials, paying staff salaries and wages and paying utility bills such as electricity 

• These costs can be classified as follows:

  • Fixed costs

  • Variable costs

  • Total costs

  • Average costs

Fixed costs

Fixed costs

• Fixed costs (FC) are costs that do not change as the level of output changes

  • These have to be paid whether the output is zero or 5000 units

  • Examples include rent, management salaries, insurance and bank loan repayments

• Fixed costs can be plotted on a graph as a horizontal line

• The fixed costs for this firm are $4,000 at all levels of output

Variable costs

Variable costs

• Variable costs (VC) are costs that are directly linked to output

  • They increase as output increases and vice versa

  • Examples include raw material costs and wages of workers directly involved in production

• Variable costs are plotted on a graph as an upwards sloping line, starting at 0

Total costs

Total costs

• The total cost is the sum of the variable and fixed costs

• Total costs are calculated using the formula

$\mathrm{Total} \mathrm{costs} \left(\mathrm{TC}\right) = \mathrm{Total} \mathrm{fixed} \mathrm{costs} \left(\mathrm{TFC}\right) + \mathrm{Total} \mathrm{variable} \mathrm{costs} \left(\mathrm{TVC}\right)$

• The total costs cannot be 0, as all firms have some level of fixed costs

• Total costs are plotted on a graph as an upwards sloping line, parallel to the variable costs, starting at the level of fixed costs

Average costs

Average costs

• The average cost is the typical cost of producing one unit of output

  • It is sometimes called the unit cost

• As a firm grows, it is able to increase its scale of output generating efficiencies that lower its average total costs (AC) of production

  • These efficiencies are called economies of scale 

• As a firm continues increasing its scale of output, it will reach a point where its average total costs (AC) start to increase

  • These inefficiencies are called diseconomies of scale 

Using cost data to make decisions

Using cost data to make decisions

• Businesses can use cost data to make data-driven business decisions

1. To reduce costs

• Accurate cost data helps a business see if costs are too high

• Reducing costs is a key way to increase profit

  • Fixed costs can be reduced by moving to cheaper premises, lowering staff salaries, cutting promotional spending or using cheaper utility suppliers

  • Variable costs can be lowered by buying cheaper or bulk raw materials, or outsourcing delivery

• Businesses must consider how cost-cutting affects customer service, product quality and delivery speed

  • Paying lower wages may lead to less experienced or skilled staff

  • Cheaper materials might reduce product quality

2. To set prices

• Costs are important when deciding the selling price.

• They directly affect how much profit a business makes.

  • For example, if a cake costs $3 to make and the business wants to make a $1 profit on each cake, it must sell them for $4

3. To make production decisions

• If production costs are higher than revenue, the business will make a loss

  • The business must decide whether to keep or stop making it

• This depends on factors including

  • Whether it’s a new product, with sales likely to rise

  • Whether fixed costs will need to be paid, even if production stops

4. To make location decisions

• Renting or buying premises is a major cost

• Some areas are cheaper than others

• Businesses must compare these savings to other factors like transport, closeness to customers and available workers