Different Types of Costs (Cambridge International IGCSE Business)

Different Types of Business Costs

Spec point — "• Classifying costs using examples, e.g. fixed, variable, average, total • Use cost data to help make simple cost-based decisions, e.g. to stop production or continue"

Different types of business costs

• Businesses incur a range of costs

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

• These costs can be classified as follows

  • Fixed costs
  • Variable costs
  • Total costs
  • Average costs

1. 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
  • 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

2. Variable costs

• Variable costs (VC) are costs that change directly with the output

  • These increase as output increases and vice versa
  • Examples include raw material costs and wages of workers directly involved in the production

Graphical representation of total variable costs

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

3. Total costs

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

Graphical representation of total costs

• 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

4. Average costs

• 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

Graphical representation of average costs

• As a firm continues increasing its scale of output, it will reach a point where its average total costs (AC) will start to increase
• The reasons for the increase in the average costs are called diseconomies of scale

Cost calculations

• Based on the above definitions, we can calculate several different types of costs

1. Total costs

• Total costs are calculated using the following formula:

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

2. Total variable costs

• Total variable costs are calculated using the following formula:

$\mathrm{Total} \mathrm{variable} \mathrm{cost}(\mathrm{TVC})=\mathrm{Variable} \mathrm{cost}(\mathrm{VC})\times\mathrm{Quantity}(Q)$

Cost Calculations Using the Above Formulas Where FC is $200 and VC is $60 per unit

Worked Example Aromas Cannelles manufactures luxury scented candles. The production of each candle incurs the following costs:

Item	€ per Candle
Wax	0.14
Perfume oil	0.72
Loan repayment	100
Glass jar	1.46
Outer Packaging	0.33

Calculate the variable cost in € for each candle.(2)

Step 1 - Identify the variable costs in the list

Loan repayment is classified as a fixed cost and should not be included in the calculation

Step 2 - Total the variable costs listed

$0.14+0.72+1.46+0.33=2.65$ (1 mark)

Step 3 - Express the answer in € per Candle

equals space € 2.65 (1 mark)

Exam Hint Take care when calculating variable costs per unit, as it is likely that one or more fixed costs will be included in the list as seen above.

If you are asked to calculate the total variable costs, follow the above process and multiply the answer by the number of units produced/sold.

Using cost data to make Decisions

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

Accurate cost data can help a firm to be more precise in its price setting and production decisions

1. To reduce costs

• Accurate cost data can help a business identify if their costs are too high

• An important way to improve profit is to reduce costs

  • Fixed costs may be reduced by relocating to cheaper business premises, reducing salaries for workers, spending less on promotional activities or seeking lower-priced utility providers

  • Variable costs may be reduced by sourcing cheaper materials, buying raw materials in bulk, or outsourcing distribution to a third party business

    • E.g., Many businesses sell their products using Amazon which manages the packaging and shipping of items, usually at a cost much lower than the business itself could achieve

• Businesses must carefully consider the impacts of reducing costs on customer service, quality and speed of delivery

  • Paying lower salaries to staff may mean that employees have fewer customer service skills or experience
  • Cheaper raw materials and components may lead to worsening quality

2. To set prices

• Costs play an important role in the determination of selling prices

  • They are a crucial part of making, or increasing profit
  • E.g., If the average cost of making a cake is $3 and the business wants to make $1 profit on each cake sold, it will need to charge a price of $4

3. To make production decisions

• If the cost of producing a product is higher than the revenue it generates, the business will make a loss

  • It will need to decide whether to continue making the product or stop

• This decision depends on various factors including

  • Whether the product has just been launched on the market, in which case the sales revenue may increase in future
  • Whether the fixed costs will still have to be paid

4. To make location decisions

• Property rental or the purchase of premises can be a substantial monthly cost

• Some locations are cheaper than others

  • A business must weigh up the cost of the location against other important factors such as transport links, proximity to customers and availability of a workforce