That is, if it closes its operations, the revenue will be zero but it will still incur a $4,000 fixed cost. The company is obliged to pay it up regardless of whether it operates or not. In economics, we assume that the FC cannot be avoided. Evidently, this manufacturing company is operating at a loss of -$2000 (economic loss). The Average Total Cost (AVC) is $7,000 with a fixed cost (FC) of $4000 and a variable cost (VC) of $3,000 for all units. Example of Shut-Down Point of ProductionĪssume that a manufacturing company produces 1000 units and sells them at $5 each. At this point, the company had better stop operations than keep on running at a loss. The shut-down point of production, on the other hand, is the price at which the marginal cost does not even cover the average variable cost (ATC). Consequently, a U-shaped curve is realized when quantity is plotted on the x-axis against the average variable cost on the y-axis.Īs seen previously, the break-even point is the point at which the marginal cost (MC) equals the average total cost (ATC). After this point, the variable cost rises. The variable cost per unit (written as marginal cost, MC, on the following graph) falls with an increase in the number of units produced up to a certain point. In other words, it is the minimum price and quantity for keeping operations open. The shut-down point refers to the minimum price at companies prefer shutting down their operation instead of continuing to operate. This is the number of units that must be produced and sold to break-even. If we want to determine the number of units that can be produced and sold to break even, we can use the following formula:īreak-even point of production=\(\frac=2,000\) and Therefore, companies will report losses below this point and profits above this point.Īfter identifying the types of production costs, it is now possible to calculate the break-even point of production because this is where you will either make a profit or a loss. At the break-even point of sales, the contribution is strictly equal to the fixed cost. The difference between the selling price and the variable costs is referred to as the contribution to fixed costs and profits.Īn increase in sales causes a direct increase in contribution. Variable costs are directly proportional to the volume produced, and examples include raw materials, wages paid, and other incurred expenses.Ī company must fix its selling price above the variable costs incurred per unit of production. A good example is the cost incurred in setting up production facilities, e.g., rent, fixed interest charges, and depreciation. The production cost of every product is divided into two components: the fixed cost components and the variable cost components.įixed costs are those costs that remain the same regardless of the level of production of any company. At this point, the company does not make any profit or loss it breaks even. The break-even point can be defined as the production and sales levels of a given product at which the revenue generated from the sales is perfectly equal to the production cost.
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