Business Studies
Production costs
This Revision Bite will help you understand the different types of production costs and how to calculate them.
Types of production costs
A manufacturing company's production department will need to consider the quality and quantity of a product in relation to cost. If a firm wants to make a profit, it has to know what it is spending as well as what it is earning. Here are some of the costs it needs to know to do this:
- Fixed
- Variable
- Total
- Marginal
- Average
Now look at each of these costs in more detail:
Fixed costs
These costs do not change however many units of a product are made. Factory rent, insurance premiums and administration salaries stay the same, whether the factory is working at full capacity or producing nothing. The owner of the business may have taken out a loan to buy equipment or refurbish a building. The loan will have to be repaid whether or not the business has customers.
Variable costs
Variable costs change as outputoutput: the term denoting either an exit or changes which exit a system and which activate/modify a process changes. For example, the amount of raw materials needed varies as the levels of output go up or down. Piece-work [Piece-work: The employee is paid according to the number of units produced. ] wages also fluctuate, depending on the employees' efficiency and the demand for the company's products.
Total costs
The fixed costs and the variable costs are added together to establish the total costs. The fixed costs remain constant, but the variable costs increase in direct proportion with output.
Marginal costs
Compact Discs
Using marginal cost [Marginal cost: The amount spent on producing one extra unit. It is the increase in total cost when one more unit is produced. ] is a way of measuring how much more it will cost a company to make one more individual item. Here is an example:
A company produces compact discs. It has produced 99 CDs and the total costs have amounted to £999. If the total costs increase to £1,000 when the hundredth CD is made the marginal cost of the last CD is £1.00.
The firm knows that now each CD should cost only £1.00 or less to produce. As the cost per unit usually decreases with a rise in output, it should become cheaper to produce each one. The firm may be able to offer a more competitive price to customers.
Average costs
The example of the CD shows the benefits of economies of scale, where mass production results in a lower unit cost. The reason is that the fixed costs do not change and are spread across a greater level of output.
Finding out the average cost of production [Average cost of production: The amount spent on producing each unit of output. It is calculated by dividing the total level of cost by the level of output. ] helps a firm to monitor its progress, and makes it easier to set prices. It is calculated by dividing total cost by total output.
Using the example of the compact disc firm above:
Total costs/Total output = Average cost of production
£1,000/100 CDs = £10 per CD
This might seem expensive, but if the firm produces another hundred units at a marginal cost of £1.00 per CD, its average cost will fall radically:
Total costs/Total output = Average cost of production
£1,100/200 CDs = £5.50 per CD
The firm can use this information to decide whether it is worth accepting a new order for goods.
Remember
The examiner will want to see that you understand what the different costs are, how they are calculated, and why it is important for a firm to work them out. You will be expected to apply your understanding to a real life situation.
A company will always incur costs, no matter how efficient it is. Wages, raw materialsraw materials: Raw materials are anything naturally occurring in or on the earth/in the sea before being processed. These are obtained through primary activities such as mining, fishing, forestry and farming., transport and power all have to be paid for. The company needs to establish all its costs to ensure it doesn't lose money.
Sample question
Read the case study and answer the question below
- Question
Martin and Ashley started their window cleaning business with £1,500 they borrowed from Ashley's dad, and a £550 bank loan. They used the money to buy a second hand van and cleaning equipment. Ashley's dad doesn't charge any interest. They pay him back £50 a month. They also have to pay the bank £50 a month over two years. They don't get many bookings in winter when the weather is bad. Martin and Ashley aim to pay themselves £50 a month each.
What costs do Martin and Ashley have to meet even when they have no customers? (10 marks)
When you have finished take a look at the sample answers on the next page.
Sample answer
- Answer 1
Jamie wrote: They have got to pay back the money they borrowed.
Examiner's note
Jamie needs to give far more explanation. He should use business terms and show he understands what fixed costs are.
- Answer 2
Morag wrote: They have to pay Ashley's father each month, as well as the loan from the bank. They may have other costs, like the cleaning materials they buy to run their business.
Examiner's note
Morag started her answer quite well, mentioning both loans which, as fixed costs, have to be repaid. The cleaning materials, however, form part of the variable, rather than the fixed costs.
- Answer 3
Rani wrote: Costs which have to be paid, regardless of the level of output, are called fixed costs. Martin and Ashley have the fixed costs of repaying Ashley's dad £50 a month, and they probably pay bank interest on the loan. Their pay is a fixed cost. They might want to consider paying themselves piece rate, to help their business survive. The road tax and insurance on the van are fixed costs they have to pay. They have already bought the van, so this is a sunk cost, and no longer a fixed cost they have to pay.
Examiner's note
Rani's answer would probably get a A grade. She has answered the question well, and has shown she can use business terms like fixed costs. She has thought about the pay they only receive when they have the business, and correctly counted it as a fixed cost.
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