<4.2 COSTS, SCALE & BREAKEVEN>

TOTAL COST (TC) = TOTAL FIXED COST (TFC) + TOTAL VARIABLE COST (TVC)

-- AVERAGE TOTAL COST (ATC) = TC / Q--

-- AVERAGE FIXED COST (AFC) = TFC / Q --

-- AVERAGE VARIABLE COST (AVC) = TVC / Q --

-- ATC = AFC + AVC --

WHAT PRICE TO SET?

As long as we set a price higher than the average cost we can make a profit, but what is our profit margin? 

ARE WE MAKING A PROFIT/LOSS?

If we are losing money should we shut down? Will sales pick up in the future? Can we  

SHOULD WE 

• ECONOMIES OF SCALE (INTERNAL), refers to how a firm is able to LOWER ITS AVERAGE COSTS* as they expand 'GROW IN SCALE'.

• Assuming prices stay the same these lower average costs will result in a LARGER PROFIT MARGIN per unit.

• *NOTE: As a firm expands its TOTAL COSTS will certainly RISE, but with economies of scale its AVERAGE COSTS will FALL)

• There are numerous costs that a firm incurs which when divided by output give the average cost per unit. Now If we were to breakdown these costs for a typical good or service we would get most (if not more of...) the following categories:

• Raw materials costs.

• Advertising costs.

• Debt repayment costs (if bank loans were taken).

• Management salary costs.

• Capital equipment costs.

• Obviously as the firm grows in 'scale' total costs for each of these categories will likely rise however the average cost per unit can fall thanks to economies of scale like those listed below:

• The cost of placing an advert in the newspaper, on TV, online etc... remains the same regardless of the amount of units sold, hence the AVERAGE MARKETING COST FALLS as scale increases.

• As a firm grows in scale it accumulated MORE ASSETS (property and capital equipment etc...), which can be used as COLLATERAL to secure loans at LOWER INTEREST RATES.

• Therefore the AVERAGE COST OF REPAYING DEBT will FALL as output increases.

• LOW COLLATERAL = HIGH RISK = HIGH INTEREST RATES

• HIGH COLLATERAL = LOW RISK = LOW INTEREST RATES

As a firm grows in scale it CAN HIRE MORE SPECIALISTS who are much more skilled which IMPROVES EFFICIENCY which in turn IMPROVES PRODUCTIVITY which will LOWER AVERAGE MANAGERIAL COSTS. 

Give an example for each of the economies of scale listed above for TES.

"TES recently expanded its operations by building phase 3 at the high school and is currently constructing a brand new middle school. As a result they will be able to lower their average costs in the following way,....."

• As a firm grows its levels of management, its chains of command and spans of control also grow, therefore there is greater potential for MISCOMMUNICATIONS, DISAGREEMENTS, and SLOWER DECISION-MAKING to occur. All of which can result in higher average costs.

• As a firm grows its output level will grow and it will likely become a MASS-PRODUCER, which as discussed above often DEMOTIVATES WORKERS due to the MUNDANE-NATURE of their tasks. This LOSS of passion may REDUCE PRODUCTIVITY and lead to a RISE IN AVERAGE COSTS.

• The verb 'TO BREAK-EVEN' generally means you are 'NO LONGER LOSING', and in business, it refers to THE LEVEL OF OUTPUT at which a firm is 'NO LONGER MAKING LOSSES' in other words when their TOTAL COSTS are COVERED BY THE TOTAL REVENUE they earn. (TC = TR, when PROFIT = $0)

• Understanding Costs and Revenues: A break-even chart clearly shows where a business’s total costs equal its total revenues. This visual representation helps business managers quickly see at what point the business will start making a profit (break-even point) and how changes in production levels or sales can affect profitability.

• Decision Making for Pricing: Break-even charts help businesses determine how pricing changes can impact their profitability. By adjusting the selling price in the chart, a business can see how many units need to be sold to break even or achieve a desired profit level, or margin of safety helping to make strategic pricing decisions.

• Analyzing the Impact of Fixed and Variable Costs: These charts can illustrate how different costs behave. Fixed costs remain constant regardless of sales volume, while variable costs change with production levels. Understanding these relationships can help in planning cost management and predicting how changes in cost will affect the break-even point.

• Planning for Profit Goals: Businesses can use break-even charts to set and achieve profit targets. By seeing how many units need to be sold to reach a certain profit level, managers can set realistic sales targets and adjust business strategies accordingly.

•  1. Assessing Risk Before Expansion

• Break-even charts show how many units need to be sold to cover the new fixed and variable costs that come with scaling.

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• Helps managers understand the level of sales required to justify expansion.

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• 💸 Forecasting Profitability

• Charts help project when the business will start making profit post-expansion.

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• Visualizing total revenue vs. total costs helps estimate profit margins at various output levels.

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• ⚖️ Cost-Benefit Analysis of Scaling Options

• Helps compare current vs. future break-even points if new equipment, larger premises, or additional staff are required.

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• Managers can weigh higher fixed costs (e.g., new factory) against the potential for higher output and sales.

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• 🧩 Evaluating Impact of Economies of Scale

• If scaling up reduces variable costs per unit, the break-even chart will shift favorably.

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• Charts help highlight whether scaling brings cost efficiencies.

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• 🎯 Setting Realistic Sales Targets

• Provides a clear sales goal: the minimum units to sell to avoid loss.

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• Useful for motivating teams and aligning marketing/sales strategies post-scaling.

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• 📉 Scenario Planning

• Managers can use charts to simulate:

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• Increased fixed costs (e.g., new rent)

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• Changes in price per unit

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• Changes in variable costs

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• This allows "what-if" analysis before committing resources.

This chart relies on some rather UNREALISTIC ASSUMPTIONS:

1. Firstly, It assumes the FIRM IS ABLE TO SELL ALL THE GOODS THEY PRODUCE UP TO THEIR CAPACITY, which is very optimistic given the variables that impact demand such as tastes and preferences, the price of substitutes etc...

2. Secondly it assumes that ALL THE PRODUCE WIL BE SOLD BY CHARGING EXACTLY THE SAME PRICE PER UNIT, ignoring the fact that firm's may need to lower prices in order to sell more and remain competitive with rivals.

3. Thirdly, it assumes that the FIXED COSTS REMAIN THE SAME, however often external factors cause them to increase, e.g. growing demand for factory space means the owner of the factory increases the rent.

4. Fourthly, it assumes that VARIABLE COSTS PER UNIT ARE FIXED such as wages, which presupposes workers will simply work more if they are asked, however in reality workers may seek overtime or extra pay, especially if workers are already employed