One important way to classify production costs is to divide them into fixed and variable. Fixed costs do not change as output changes: examples include factory rent and office workers’ salaries. Variable costs do change as output changes: examples include the cost of raw materials to make the product, and “piecework” wages. In practice, many costs are semi-variable, having both a fixed and a variable element. An example is the cost of power such as electricity: this often has a standing charge payable whether any power is used or not, and on top of this users pay per unit of electricity used.
This distinction is important to business people because it helps them make decisions. One common application is break-even analysis. A product’s unit contribution − the difference between its selling price and its variable cost − can be calculated. Each unit contribution goes towards the firm’s fixed costs, which must be paid whether or not anything is made. It is now possible to calculate the product’s break-even point: the number of units that must be made and sold to cover total fixed costs.
Break-even point = Total fixed costs / Unit contribution
Another way to explain the break-even point is as the point at which the firm makes neither a profit nor a loss. This gives owners information about the sales they must make to cover their costs, and the product’s margin of safety: the difference between the number the owners expect to sell and the number they need to sell to break even.
The way that firms are organized to make their products varies. There are three main manufacturing (or production) methods:
– job production: making ‘one-off’ items (a single, unique product) such as building an individually designed office block, or a “made-to-measure” item of clothing;
– batch production: a set number of the same product is made, before production switches to a batch of a different product − examples include books and certain items of furniture;
– mass (also known as process or flow) production: large numbers of an identical product are made, and so this form of production is associated with mass market items such as cars, televisions and other consumer durables.
The way production is organized influences the factory layout, the skills needed by employees and how capital-intensive or labour-intensive production will be. Job production typically requires skilled labour, whereas mass production often involves a more capital-intensive approach to manufacture.
Mass production is the form most closely associated with economies of scale. One effect of a firm growing in size and using modern production techniques is that its increased output is spread over the same total fixed costs. Greater production means greater total costs; but economies of scale result in the firm having lower unit costs as output levels rise. The main economies of scale include:
– Financial: increased size makes borrowing easier and less costly.
– Managerial: efficient specialists can be employed who bring greater expertise into the firm.
– Marketing: specialist marketing agencies can be employed, and marketing costs can be spread over a large output, reducing their unit costs.
– Purchasing: bulk buying discounts become possible.
– Technological: larger firms are better able to support research and development, and will benefit from any technological developments that result.
– Increased dimensions: doubling the size of something does not usually double its cost – for example, large firms can buy large-scale transport which is less expensive per item transported.