Cost structure of the firm

    Cost structure of the firm. A firm’s costs are divided into fixed costs and variable costs. Fixed costs consist of pre-committed outgoings, which are payable regardless of the level of output Variable costs represent outgoings, such as materials, energy and distribution costs, which rise and fall in accordance with the volume of output. Fixed costscan be subdivided into sunk costs and other fixed costs. Sunk costs refer to past expenditure on fixed assets which have no alternative use and the cost of which can be amortised or recouped only by trading. Examples of sunk costs include the costs of a nuclear power station, large steel plants or the Channel Tunnel. By contrast,the cost of the lease of an office building is a fixed cost, but is not a sunk

cost, since the building could be sub-let to another firm. Sunk costs play an

important role in determining the firm’s output and price strategy. Over time, all

costs except sunk costs become variable. In economics jargon, the long run is

defined precisely as that period of time over which fixed costs can be converted

into variable costs.

    The cost structure of a firm is illustrated in Figure 5.3. Costs are measured on

the vertical axis and level of the firm’s output on the horizontal axis. Fixed costs

have to be paid regardless of the level of sales and are depicted by a straight

horizontal line. Total variable costs are shown as an upward-sloping line, reflecting

the fact that variable costs are a positive function of output. Thus, a rise

in output from 500 units to 600 units raises total costs from £10 million to

£12 million. The variable costs incurred in adding 100 units of output amount to

£2 million.

    In calculating the contribution of a new product to profits, variable costs are

sometimes assumed to be linearly related to output.The breakeven chart, for example,includes information on costs and revenues, and depicts a situation where a certain minimum level of sales is required for the firm to break even.

After this point, the firm enters a profit zone, with profits being calculated as a

constant contribution per unit. Breakeven charts are used to estimate the effects

on profits of variations in sales volumes around the breakeven point.

    Studies of cost structures, however, suggest a more complex picture than the

linear relationship suggests. The key point is that variable costs per unit of output

are not constant as output increases. In the short run, they tend to fall. Then,

beyond a certain output level, they begin to rise. A simple starting point is to

depict the relationship between unit costs and sales volumes by a U-shaped curve

,The initial cost decline is attributed to economies of scale: the flattening,

and eventual rise, of the unit cost curve is explained by the growing

weight of diseconomies of scale. These concepts, which occupy a central role in our

understanding of the size and cost structure of firms, now need to be explained.