Fixed costs: Costs that do not change as output changes. E.g: rent, salaries, insurance.
Variable costs: Costs that change as output changes. E.g. raw materials, wages.
Direct costs: Costs that can be directly linked to particular product lines. E.g. costs of running the machinery used to manufacture individual products, cost of raw materials used in the product.
Indirect costs/Overheads: Costs that are shared between the different product lines and do not relate to one particular product line. E.g. cost of stationery used for all the company’s products, salaries of office staff who are involved with all the products.
A break-even chart shows how much you need to sell. The break-even point is the level of output where the firm will just cover its costs. Sell more and it will make a profit, sell less and it will make a loss. To calculate the break-even point, you have to do this calculations:
selling price - variable cost = contribution
total fixed costs ÷ unit contribution = break-even point
Break-even analysis has its limitations:
- It assumes that the firm can sell any quantity of the product at the current price.
- It assumes fixed costs never change - but as output increases the firm may need more machines, bigger offices and so.
- Finally it assumes that all the products will be sold. This doesn’t always happen.
