Cost Information (Cambridge (CIE) A Level Business): Revision Note

The need for accurate cost information

• Cost information refers to data about all the costs involved in producing and selling a product

Why is accurate cost information needed?

• To set prices correctly

  • If a business underestimates its costs, it may set prices too low and make a loss

  • Overestimating costs may lead to prices that are too high, reducing demand

• To calculate profit

  • Accurate costs help calculate gross profit and net profit, important for judging performance

• For decision-making

  • Managers use cost data to decide whether to

    • Launch a new product

    • Continue or stop production

    • Change suppliers or production methods

• To carry out break-even analysis

  • This helps decide how many units need to be sold to cover all costs.

  • Accurate costs make break-even analysis more reliable

• To control spending

  • Comparing actual costs with budgets helps identify areas of overspending and take action

Types of costs

• In preparing goods and services for sale, businesses incur a range of costs

• These costs can be broken into different categories

Fixed costs

• Fixed costs do not change according to output

• These have to be paid whether the output is zero or 5,000 

  • Examples include rent, management salaries, insurance and bank loan repayments

• Fixed costs in this instance are $4,000

Variable costs

• Variable costs rise proportionally with output

• These increase as output rises and decrease as output falls

  • Examples include raw material costs and wages of workers directly involved in production and packaging

• At some point, a business may benefit from a purchasing economies, so the rise will no longer be proportional

Total costs

• Total costs is the combination of all fixed and variable costs involved in producing a certain level of output

• Total costs cannot be zero, as all organisations have some level of fixed costs

An alternative way to classify costs

Direct costs

• These are costs that can be directly traced to a specific product, service, or department

• They relate specifically and exclusively to the production of a particular item

• Direct costs can be fixed or variable

  • For example, a one-off licence fee for a software product is a direct fixed cost if it applies only to that product

• Examples of direct costs include:

  • The cost of raw materials used to make a table

  • Wages paid to factory workers assembling a specific product

  • Packaging for a single product line

Indirect costs

• Indirect costs are costs that cannot be traced directly to a specific product, job, or service

  • They support overall operations and are shared across departments or products

  • These costs are necessary for production or business operations, but they are not directly linked to any one unit of output

• Indirect costs can also be fixed or variable

  • For example, the monthly rent paid for a shared office space is an indirect fixed cost, as it supports multiple departments but does not vary with output

• Examples of indirect costs include:

  • Rent and utility bills for a factory or office

  • Salaries of supervisors or administrative staff

  • Office supplies and insurance

  • Depreciation of machinery used across several product lines

Comparison: direct vs indirect costs

Using cost information to make decisions

• Cost data helps businesses make key decisions

Total costs (TC)

• Total costs information can be used to assess how much money is needed to produce at a certain level and is vital for budgeting and cash flow forecasting

Average costs (AC)

• Average cost is the cost of producing one unit of output, calcualted using the formula

• The average cost helps a businesses set prices that cover costs and leave room for profit

• It is also used to compare efficiency over time or between different products

Marginal cost (MC)

• Marginal cost is the cost of producing one extra unit of output, calculated using the formula

• The marginal cost helps a business decide whether producing extra units is profitable

• It is a key consideration for decisions about increasing production, pricing, and entering new markets

• It can also be used for special order pricing and decisions about increasing output

Using cost information to make pricing decisions

• Cost information can help shape a business’s entire pricing strategy, including how to respond to competition, customer demand and market conditions

Cost information and pricing decisions

Setting a minimum price point

• Accurate cost data ensures prices are set above total or marginal cost

• This prevents selling at a loss and is especially important for new products where cost estimates may change as production increases

  • E.g. A small electronics company launching a smart speaker knows its unit cost is $40 and avoids pricing below that, even during a promotion

Choosing between pricing strategies

• Businesses choose strategies like penetration pricing, skimming, or competitive pricing

• Cost information helps assess whether these options are financially sustainable

Adjusting prices when costs change

• When input costs, such as raw materials or wages, rise, cost data helps decide whether to increase prices or reduce other costs while keeping prices stable

Responding to competitors' prices

• Cost information helps businesses know how low they can reduce prices in response to rivals without making a loss

• This is essential in price wars or competitive markets

Planning discounts and promotions

• Even during sales or promotions, businesses must at least cover variable costs

• Accurate cost information prevents making a loss as a result of short-term discounts

Using cost information to monitor and improve business performance

• Cost information is a vital tool for monitoring business performance

• It helps businesses

  • Track profitability

  • Set and measure performance targets

  • Identify problems early

  • Make better decisions for the future

  • Become more efficient and competitive

Uses of cost information in relation to business performance