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Business is conducted by exchanging liquid assets for fixed assets and vice-versa.
A first type of payment occurs when we exchange cash or another liquid asset for
such things as property, machinery and vehicles. These are material assets that enable
us to make things.
A second type of payment occurs when we purchase such things as raw materials, and
employ people to operate the machines, answer telephones and the like.
Rent is an example of this second type of payment. We may decide to hire rather than
buy a photocopier. The rent on the photocopier must be paid for, and we pay rent for
the use of the photocopier.
The first type of payment is called an investment, and the second type of payment is
called a cost.
Investments increase the material, that is, fixed assets, of the person buying them.
The owner has an item that can be used as a means of production. Investment in such
items is called capital expenditure
The most liquid asset is cash. A liquid asset can be used to pay a bill. The
more liquid an asset the more readily it can be exchanged for cash. Fixed
assets are those that take time to be sold. They cannot be exchanged
immediately for goods and services. Factories and vans are examples of fixed
assets.
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3. Explain how you win a game of Monopoly in terms of the exchanges going on
in the game between fixed and liquid assets.
Monopoly introduces children to the basic rules of capitalism. The players all
start with an equal amount of cash. They win by making judicious
investments – that is, buying property and eventually investing further in this
property by developing houses and hotels. A player that does not buy property
cannot win. The winning strategy is to maintain the optimum ratio between
liquid and non-liquid assets, since it is costly to convert fixed assets into liquid
assets to pay rent.
A capital item is used to make things – in the sense of providing the facilities
for production – a factory, a machine – these are examples of capital items.
But the making of goods requires other factor inputs as well – raw materials
and labour. Every time a good is produced these are consumed. These inputs
are called costs in accounting terms.
Classification of Costs
Classification by type
Direct costs are ones that can be specifically related to the production of a
particular good.
For example, suppose a company manufactures chairs. The cost of the labour
and raw materials that goes into the manufacture of the chairs are direct costs.
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The production overheads include the factory rent and heat, light and power,
and depreciation on plant and machinery.
Classification by behaviour
Fixed costs do not change as the quantity of output changes. Increasing output
does not increase these costs.
It is a mistake to confuse indirect costs with fixed costs. Both direct and indirect costs
can and do vary with output, and both can, and do, contain elements of fixed costs.
For example, the amount of energy used by a company (an overhead) does increase
with the number of goods produced.
The usual example of a direct cost that is also fixed is depreciation on machinery.
Depreciation is the loss of value of an asset owing to ageing. Machinery just wears
out, and so loses value. Depreciation on dedicated machinery means depreciation on
machinery that is used for only one purpose in the production cycle, and so can be
regarded as a direct cost.
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In the short run, because the capital (and hence size of production unit) is fixed, the
fixed costs remain constant. That is, fixed costs are those costs that remain constant
regardless of the quantity produced in the short run.
Costs
FC
Fixed costs
Output
An example of a fixed cost would be rent on a building. The rent remains constant
regardless of how much business is done in it.
Costs
VC
Variable costs
Output
Total costs are the sum of fixed costs and variable costs.
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It is usual to show total costs in a graph as follows
Costs TC
Total costs
VC
Variable costs
FC
Fixed costs
Output
The variable costs are added to the fixed costs to show the total costs.
Costs / Revenue
Sales Revenue Profit
making
Total costs
TC = FC + VC
Fixed costs
Loss FC
making
Break-even Output
point
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Example – Fixed and Variable Costs
Paul is a sole trader. His business manufactures ornamental boxes. His costs
are shown below
Paul makes 600 boxes per week which he sells for £2.20 each. Calculate his
break-even point and his weekly profit, showing your working.
Solution
Each week, before Paul can make a profit, he has to cover these fixed costs.
The contribution for each box is the sale price less the variable cost.
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Contribution = Sale Price − Variable Cost
= 2.20 − 1.20
= £1.00 per item
In order to break-even Paul must cover the fixed costs of £313 per week. This
means that he has to sell 313 boxes each week in order to break-even,
thereafter he makes a profit.
A cost centre is a department within a firm where costs arise, and can be calculated.
A revenue centre is a department within a firm where sales are made. A profit centre
is both a revenue centre and a cost centre, hence profits, which are revenue less costs,
can be calculated for a profit centre.