Free The 30 Day MBA by Colin Barrow Page B

hypothesized we can arrive at a cost per unit of product of:
    Total costs ÷ Number of units = £/$/€3,500 ÷ 1,000 = £/$/€3.50
    Now, provided we sell out all the above at £/$/€3.50, we shall always be profitable. But will we? Suppose we do not sell all the 1,000 units, what then? With a selling price of £/$/€4.50 we could, in theory, make a profit of £/$/€1,000 if we sell all 1,000 units. That is a total sales revenue of £/$/€4,500, minus total costs of £/$/€3,500. But if we only sell 500 units, our total revenue drops to £/$/€2,250 and we actually lose £/$/€1,250 (total revenue £/$/€2,250– total costs £/$/€3,500). So at one level of sales a selling priceof £/$/€4.50 is satisfactory, and at another it is a disaster. This very simple example shows that all those decisions are intertwined. Costs, sales volume, selling prices and profits are all linked together. A decision taken in any one of these areas has an impact on the other areas. To understand the relationship between these factors, we need a picture or model of how they link up. Before we can build up this model, we need some more information on each of the component parts of cost.
    The components of cost
    Understanding the behaviour of costs as the trading patterns in a business change is an area of vital importance to decision makers. It is this ‘dynamic’ nature in every business that makes good costing decisions the key to survival and provides the MBA with a wealth of opportunities to demonstrate their skills and knowledge.
    The last example showed that if the situation was static and predictable, a profit was certain, but if any one component in the equation was not a certainty (in that example it was volume), then the situation was quite different. To see how costs behave under changing conditions we first have to identify the different types of cost.
    Fixed costs
    Fixed costs are costs that happen, by and large, whatever the level of activity. For example, the cost of buying a car is the same whether it is driven 100 miles a year or 20,000 miles. The same is also true of the road tax, the insurance and any extras, such as a stereo system or navigator.
    In a business, as well as the cost of buying cars, there are other fixed costs such as plant, equipment, computers, desks and answering machines. But certain less tangible items can also be fixed costs, for example, rent, rates, insurance, etc, which are usually set quite independent of how successful – or otherwise – a business is.
    Costs such as most of those mentioned above are fixed irrespective of the timescale under consideration. Other costs, such as those of employing people, while theoretically variable in the short term, in practice are fixed. In other words, if sales demand goes down and a business needs fewer people, the costs cannot be shed for several weeks (notice, holiday pay, redundancy, etc). Also, if the people involved are highly skilled or expensive to recruit and train (or in some other way particularly valuable) and the downturn looks a short one, it may not be cost effective to reduce those short-run costs in line with falling demand. So viewed over a period of weeks and months, labour is a fixed cost. Over a longer period it may not be fixed.
    We could draw a simple chart showing how fixed costs behave as the ‘dynamic’ volume changes. The first phase of our cost model is shown in Figure 1.1 . This shows a static level of fixed costs over a particular range of output. To return to a previous example, this could show the fixed cost, rent and rates for a shop to be constant over a wide range of sales levels. Once the shop owner has reached a satisfactory sales and profit level in one shop, he or she may decide to rent another one, in which case the fixed costs will ‘step’ up. This can be shown in the variation on the fixed cost model in Figure 1.2