Different Types of Costs (CIE IGCSE Business)

• 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
      

An Explanation of the Different Costs of a Business

Type of Cost	Diagram	Explanation
Fixed Cost (FC)		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  E.g. Building rent, management salaries, insurance, bank loan repayments etc. The fixed costs for this firm are $4,000
Variable Cost (VC)		Variable costs (VC) are costs that change directly with the output These increase as output increases and vice versa E.g. Raw material costs, wages of workers directly involved in the production
Total Cost (TC)		The total cost is the sum of the variable & fixed costs The total costs cannot be 0 as all firms have some level of fixed costs
Average Total Cost (AC)		As a firm grows, it is able to increases 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) 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. 
   
2. 
         

Cost Calculations Using the Above Formulas Where VC is £60

Output (Q)	FC	TVC =	TC =
0	200	-	200
1	200	60	260
2	200	120	320
3	200	180	380

 

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

Diagram of what Decisions cost data Influences

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

Explaining the Diagram

Reducing costs

• Accurate cost data can help a business identify of 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

Setting 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 = $3 and the business wants to make $1 profit on each cake sold, it will need to charge a price of $4
    

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

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