Indirect costs

In most business organisations there will be costs which are not directly related to the production of a particular good or service, but which result from the operation of the entire organisation. These are all known as indirect costs or overheads. For example:

• Rent and business rates

• Lighting and heating

• Equipment maintenance

• Insurance

• Cleaning

• Bank charges on loans

• Sales and distribution costs, such as advertising and transport

• The wages and salaries of office staff, managers, accountants, etc.

• Depreciation of equipment used for administrative purposes.

The sum of direct and indirect costs gives the total cost of an organisation’s activities. It is important to know total cost in order to be able to work out total profit.

Variable costs

To expand production a firm is likely to need more materials or components, and more power to drive machinery, or to heat and light premises for longer periods. They may also need to take on more workers or employ existing workers on overtime to produce more.

Costs that vary with the level of output, such as materials, power, and the wages of production workers, are called variable costs. For example, if the variable cost of producing one TV set is 100 pounds, then the cost of producing 1000 TV sets is likely to be 100,000 pounds, unless costs savings can be made from workers and machinery working much harder and improving their productivity. Variable costs are, therefore, just the direct costs of productive activity.

Fixed costs

Costs that do not vary with the level of output but remain fixed independent of many units are produced are known as fixed costs. For example, if it costs 5,000 pounds each month to rent a factory in which to produce television sets, this cost will be unchanged whether 1 or 1000 television sets are produced. Other fixed costs will include rates, lighting and heating, insurance, cleaning and all other overheads – that is, all indirect costs.

Calculating the total cost of production

The total cost of producing a given level of output in an organisation is the sum of its fixed and variable costs. Since the total cost of the same business is also the sum of its direct and indirect costs, it follows that the total cost of producing a given level of output per period in any business is equal to:

Direct costs + Indirect costs = Fixed costs + Variable costs

Calculating unit costs

Once the total cost of each product has been calculated, it is possible to calculate how much, on average, it costs to produce each unit of output (or cost unit). This is particularly useful for a business to know.

A cost unit is simply a unit of product, the cost of which can be calculated and compared to revenues earned from its sale. A cost unit can be any good, for example, a car, a compact disc, a box of washing powder, a lawn mower, a chest of drawers and so on. Or the cost unit can be a service, such as one hour of labour from a car mechanic or hairdresser, one passenger mile on an airplane, train or bus, or one minute of time using a telephone.

Calculating average costs

The average cost per unit of output of a particular good or service produced can be calculated using the following formula:

Total Cost of Output

Average cost per unit = ——————————

Total Output

Consider a manufacturer of toy dinosaurs. If the variable cost of producing each toy dinosaur is 50 pence and fixed costs are £150,000 per year, then the total cost of producing 200,000 toy dinosaurs each year will be £250,000, i.e.

Total variable costs = 200,000 x 50 pence = 100,000

Total fixed costs per year = 150,000

Total costs of 200,000 units per year = 250,000

Thus, the average cost of each toy dinosaur is 1.25p (i.e. 250,000 / 200,000). If the business wanted to sell each toy for £2, it will make a profit of 75 pence per dinosaur, or a total profit of £150,000 if all 200,000 units are sold. That is, the price of £2 absorbs both direct and indirect production costs and leaves a surplus for profit.

In the same way we can calculate the average cost per unit of a service, for example one hour of labour from a car mechanic or one air passenger mile. All we would need to know is the total cost of both direct and indirect costs associated with these activities. So, for example, if a mechanic spends 7 hours working on a car at a total cost of £350 in labour, materials, power, administration and other overheads, then the average cost per labour hour is £50 (i.e. £350 / 7 hours).

Similarly, if it costs a total of £50,000 to fly 100 passengers 2000 miles – a total of 20,000 passenger miles – then the cost per passenger mile is £2.50 (i.e. 50,000 / 20,000 miles).

Calculating marginal cost

Sometimes it is useful for a business not just to know how much it costs on average to produce each unit of output but how much it would cost to produce just one more unit of output. If a firm wants to expand production, it would like to know how much it will cost. It can then decide if this cost is worth paying. That is, will the sale of the extra output generate sufficient revenues to cover the cost of producing it?

Consider the firm producing toy dinosaurs. It wants to expand production by 50,000 units. However, this will mean hiring extra machinery and moving to larger premises. The extra annual cost of machine hire, rent and rates is estimated to be £100,000. If the variable cost of producing each toy dinosaur is 50 pence, then to produce extra 50,000 toys each year will cost:

Additional total variable costs = 50,000 x 50 pence = 25,000

Additional fixed costs = 100,000

Total additional costs = 125,000

This means that it would cost £2.50 to produce each of the additional 50,000 dinosaurs (i.e. £125,000 / 50,000). Because the firm has chosen to price each dinosaur at 2 pounds each, it will not make a profit from the additional output unless it raises their price. However, this may price the toys beyond what consumers are willing to pay for them.

The additional cost of raising output is called the marginal cost of production. The marginal cost per unit of extra output is, therefore, calculated as follows:

Change in Total Cost

Marginal cost of an extra unit of output =

Change in Total Output

Economies of scale

Economies of scale refer to the reductions in average cost per unit of output brought about by an increase in the scale or size of a firm. In general, as output is increased, the average cost per unit will tend to fall, as fixed costs are spread over more and more units of output.

For example, consider a power station generating electricity. Fixed costs of production are £10,000 per week regardless of how much electricity is produced. If 10,000 watts of electricity are produced each week, the average fixed cost per watt will be £1. Doubling output to 20,000 watts per week will reduce average fixed costs per watt to 50 pence. The variable cost per unit of output may also fall as output is increased. For example, the power station may be able to buy more coal and obtain a discount from suppliers.

Falling average costs are an important benefit to firms. If, however, average cost rises as output is increased, then a firm will experience diseconomies of scale, because it will be producing beyond its optimum level of output.

In general, the average cost curve for a given firm is U-shaped. At first, as the scale of production expands, there are cost savings resulting from increases in the scale of output. However, after a certain point, if the firm expands too much, production will become less efficient, and average costs will begin to rise. The firm will then experience diseconomies of scale.

The optimum scale of production, or most efficient size of a firm, is therefore where the average cost of producing each car, toy, pair of shoes, microchip, etc., is at the lowest level possible. At this point, it will be possible to combine and organize resources in the most efficient or cost-effective way. Lowering average production costs will either increase the profit margin on that product, or allow the firm’s owners to lower price to attract more sales.

When a firm expands the scale of production, it has a chance to become more efficient and reduce average costs. This is because expansion can give business managers and owners a chance to reorganize the way in which their firm is run and financed. The advantages which result from this are known collectively as internal economies of scale, and include the following:

Financial economies. A large firm may be able to obtain finance from a greater variety of financial institutions, for example, by selling shares on the Stock Market.

Marketing economies. Large firms, with the necessary finance and storage space, can often take advantage of discounts for bulk purchases offered by suppliers. They may employ specialist sales teams to market their products, and will also have the financial resources to advertise widely through a variety of media to reach and expand their market.

Technical economies. The research and development of new, faster, and more efficient methods and products is often very expensive. A large firm will be able to spread this cost across a large output, and can therefore afford to use a wider range of production methods. It will also be able to benefit from bulk carriers such as juggernauts, or in the case of oil companies, pipelines, and supertankers, to meet its vast distribution requirements.

Risk-bearing economies. A large firm can attempt to minimise or spread risk in a number of ways not open to a smaller enterprise. It can buy materials in bulk from a number of suppliers to minimise the risk of a hold-up in supplies from one outlet. It may also diversify production lines – i.e. produce a range of different products for sale in case the demand for one falls. However, if a firm becomes too large, production may become inefficient. Average costs will rise. This is caused by diseconomies of scale, for example:

Management diseconomies. Large firms can often suffer from too many layers of management, leading to communication problems.

Labour diseconomies. Large firms will use specialised mass-production techniques in an attempt to reduce average production costs. However, as production of the final product id divided up into many specialised tasks, workers may become bored with their repetitive and often monotonous jobs, and productivity and product quality may suffer.