- Opportunity cost puts a value on a business decision, based on what the business has to give up as a result.
- Businesses must choose where to spend their limited finance. Managers compare opportunity costs when they're making their decisions. For example, the opportunity cost of an advert halfway through a prime time TV show might be five screenings of the same advert in the middle of another programme.
- Each department is given its own expenditure budget and has to decide what to spend its allocated money on, and what to do without. E.g. if the production department spends its expenditure budget on a new piece of machinery, it might not be able to afford to employ a new member of staff, so the opportunity cost to the production department of the piece of machinery is a new member of staff.
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- Social costs are the internal and external costs of business decisions.
- Most of the costs involved in business transactions are paid by the business itself (e.g. rent, the cost of raw materials etc.). These are known as internal costs. E.g. if a business decides to open a new out-of-town shopping centre, the internal costs are the cost of buying the land, building the shopping centre, paying staff, etc.
- There can also be an external cost to some business decisions. External costs aren't just financial costs - they include all the negative effects of business decisions on people outside the business. E.g. the new out-of-town shopping centre might lead to increased traffic and pollution in the area, and a longer journey time for shoppers and employees. It could also mean that shops in the town centre might get less business and have to close, which would mean that staff would lose their jobs.
- Social costs are the total internal and external costs of a decision. Social costs take into account all the financial and other costs of a business decision, whoever they affect.
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Businesses try to minimise their costs
- A business' profit margin is the proportion of revenue from each sale that is profit. E.g. if a bottle of shampoo costs £1.20 to produce and sells for £3.50, the business makes a profit of £2.30 (66%) on each bottle sold.
- Businesses can increase their profit margins by either increasing their prices or reducing their costs. Most businesses try to keep their costs as low as possible in order to benefit from large profit margins without putting their prices up (since this is likely to reduce demand for their products).
- Minimising costs is particularly important for businesses operating in very competitive markets. They're forced to keep their prices low in order to compete, so the only way for them to increase their profits is by cutting costs.
- Businesses can cut the average cost of making a product by producing in large quantities so that they can benefit from economies of scale. Other ways of cutting costs include switching to cheaper suppliers (or negotiating cheaper deals with existing suppliers), increasing capacity utilisation, cutting staffing levels or taking on less experienced staff who don't need to be paid as much.
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Costs influence business decisions
- Before they make a decision, businesses usually consider the costs involved. Businesses tend to focus on the internal costs (the costs the business has to pay) because they have a direct impact on the business' profits.
- Cutting costs doesn't always mean that a business' profits will increase. If cutting costs reduces the quality of the company's products or services, it could end up causing a fall in profits. E.g. a food company might change to a cheaper type of packaging to cut costs, but if the new packaging is prone to leaking, the company's reputation could suffer and sales will probably fall.
- When making decisions about which raw materials to use, which supplier to use, which staff to employ, etc, businesses don't just look at the cost. They also consider other issues depending on the company's aims, culture, etc. E.g. a health food company that prides itself on having knowledgeable staff to advise customers won't want to reduce costs by cutting back on staff training, because this would go against its basic aims and principles.
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- Fixed costs are costs that don't change with output - they stay the same regardless of how much the business produces. Even if the business doesn't produce anything at all, it still has to pay its fixed costs.
- Fixed costs are things like rent on business premises, senior managers' salaries and the cost of new machinery.
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- Variable costs change depending on output. If output increases, variable costs increase. If output falls, variable costs fall. E.g. if you need 10,000 beads to make 100 necklaces, you'll need 20,000 beads to make 200 necklaces, so the cost of the beads will double if output doubles.
- Hourly wages of staff, the cost of raw materials and the cost of packaging are all variable costs.
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- Direct costs are costs that are directly linked to producing products or providing services.
- The cost of raw materials and the hourly wages of the staff who make the products / provide the service are direct costs.
- Direct costs are almost always variable.
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- Indirect costs (also called overheads) are costs that are not directly related to the production of goods or provision of services.
- Business rates and rent, and the wages and salaries of staff who work for the company but aren't directly involved in making the product are all indirect costs.
- Indirect costs are almost always fixed.
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