What this lesson teaches
I can define total, average, fixed and variable costs.
Syllabus K343, 3.6.1. Definitions of costs of production: total cost (TC), average total cost (ATC), fixed cost (FC), average fixed cost (AFC), variable cost (VC), average variable cost (AVC)
I can calculate costs of production and draw how they change with output.
Syllabus K343, 3.6.2. Calculation of costs of production: calculation of TC, ATC, FC, AFC, VC and AVC; drawing and interpretation of diagrams that show how changes in output affect costs of production
Make a guess
A bakery closes for a week of renovation and bakes nothing. Which costs does it still pay?
- Fixed costs, such as rent and insurance.
- Flour and electricity for the ovens.
- No costs, because it makes nothing that week.
Show the answer
Fixed costs, such as rent and insurance.
Fixed costs do not depend on output, so they are paid even at zero output. Variable costs such as flour fall to zero.
Fixed costs do not change with output, variable costs do, and total cost is the two added together.
Costs of production are what a firm pays to make its output. Fixed costs (FC) do not change when output changes, at least in the short run. Rent, insurance and loan repayments are examples. A firm pays them even if it produces nothing.
Variable costs (VC) change directly with output. Raw materials, packaging and electricity for machines are examples. If output is zero, variable cost is zero.
Total cost (TC) is fixed cost plus variable cost: TC = FC + VC.
Sort these
Sort each cost of a bubble tea shop into fixed or variable.
Groups: Fixed cost, Variable cost.
- Monthly rent for the shop unit
- Yearly insurance on the shop
- Repayments on the loan for the sealing machine
- Plastic cups and straws
- Tapioca pearls
- Tea leaves and milk
Show the answer
Fixed cost
- Monthly rent for the shop unit Rent is the same whether the shop sells 10 cups or 1,000.
- Yearly insurance on the shop Insurance is paid in full however many drinks are sold.
- Repayments on the loan for the sealing machine The loan must be repaid even if sales fall to zero.
Variable cost
- Plastic cups and straws One cup and straw are used per drink, so the cost rises with every sale.
- Tapioca pearls More drinks need more pearls, so this cost changes directly with output.
- Tea leaves and milk Each extra cup uses more of them, so the cost rises with output.
On a diagram, FC is a flat line. VC starts at zero and rises with output. TC starts at the level of FC and rises alongside VC.
- Fixed cost (FC)
- Does not change with output; e.g. rent.
- Variable cost (VC)
- Changes with output; e.g. raw materials.
- Total cost (TC)
- TC = FC + VC.
Worked example: Classifying a bakery's costs
A bakery pays $3,000 a month in rent and $0.40 in ingredients for each loaf.
- Fixed cost: rent of $3,000, paid whatever the output.
- Variable cost: if it bakes 5,000 loaves, ingredients cost 5,000 x $0.40 = $2,000.
- Total cost: $3,000 + $2,000 = $5,000.
- If output doubles to 10,000 loaves, VC rises to $4,000 and TC to $7,000, but FC stays $3,000.
Watch out for this
Fixed costs never change.
Fixed costs do not change with output. They can still change for other reasons: a landlord can raise the rent.
Check your understanding
Which is a variable cost for a car factory?
- Steel used to build each car
- Insurance on the building
- Rent on the factory building
Show the answer
Steel used to build each car
Right. More cars need more steel.
Check your understanding
Which of these is a fixed cost for a cafe?
- The milk used in its drinks
- The monthly rent for the shop
- The paper cups for takeaway drinks
- The coffee beans it uses
Show the answer
The monthly rent for the shop
Right. Rent stays the same whether the cafe sells ten cups or a thousand.
Check your understanding
A firm has fixed costs of $3,000 a month and variable costs of $4 per unit. What is its total cost when it makes 500 units?
- $2,000
- $5,000
- $1,500,000
- $3,004
Show the answer
$5,000
Right. Total cost = fixed cost + variable cost = $3,000 + (500 x $4) = $5,000.