Well, now let's see a few words about cost behavior, keeping in mind this fixed or variable nature of costs. So, let's put it here. Well, we said that variable costs, they depend upon the number of units while fixed costs they don't. A very simple idea. Now, what is less trivial is that any cost or in major cases, any cost can be treated as either fixed or variable. Let me give you an example. You talk about labor costs for the factory that makes shorts. And if for example, you pay these people by the number of shorts they produce, that's a classic variable cost. Because if someone makes two shorts, that means that he or she receives twice as much compared to a person who made one short. However, if you took a bigger picture, and let's say that these people who work in this enterprise, it's somewhere in a country where there's specific trade and labor laws. So these people have let's say lifetime employment, they are controlled and covered by trade unions. So in this case, maybe the amount that you pay them does not depend on how much they produce. If for example they make no shorts this month but still that they must be paid. And in this case, this pay becomes fixed costs. Well, strictly speaking, in comparing fixed and variable costs, we have to make some assumptions. And, so, I put like any cost, Or almost any cost. [INAUDIBLE] May be, Either. One. But now, the assumptions that we have to make here in studying the difference is that, first of all, we have to specify, Cost object. We have to specify time period And strictly speaking, we have to have just one cost driver that makes the graph that will show up on the next page of flip chart more realistic, one cost driver. Again, this is just an observation to to be sort of consistent. And now, in what follows in this episode, I will provide some graphs that are oftentimes used by the people and they are quite well known. And they are instrumental in making some important managerial decisions. Well first of all, this is a graph, Of total cost with respect to the number of units. And we talk about a factor that makes a widgets. Well first of all, this is fixed cost, because as you can see, it's horizontal line, because it does not depend on the number of units. Well, there is also variable costs that is outputted with a dotted line. So this is the variable cost, that clearly is a linear function of that because remember, there is one cost variable. And basically, if we make two pieces that the variable component is twice as large as the one that is cost for one piece. And if we add them up, we have in red output, the graph, this is the total cost. Now this is the overall cost. So the more we produce, the higher these costs are. Well, with the exception of fixed cost so the total cost is going to be higher. Now on the next graph, I will show what happens with a per unit cost. So here still is the number of units. But here I will put total cost per unit. Well, here the situation changes. First of all, there is the floor and this is the variable cost of 1 unit. But if you produce a few of these pieces then clearly the effect of fixed cost is high so the total cost will go like this. So this total cost per unit. So the more you produce, the closer it is to the variable cost because now this fixed cost is being charged against many units. And therefore, the contribution to each unit is progressively smaller. So these are graphs that are widely used in managerial decisions because you can see for example, unless you introduce new technology you cannot bring this down. If you can, then the situation changes. The next chart that is maybe the most famous here, this is the chart on which, again here this is the number of units, But we combine the costs and revenue. So we know that the total cost goes like this. Total cost is, This, that's taken from the previous chart. With respect to revenues, revenues are just proportional to the number of units, because unless you sold anything, it's zero. So revenues, they go like this. This is total, Revenue. Now see what happens. First of all, this is a famous point that's called break-even point, so this is the point. So how many units you have to produce to stop losing money? Because you see what happens, if you produce less than that, then this is the area of losses. And this is the area of profit. So basically, your idea is to produce more to be able to cover all fixed costs and then all variable costs. Well, first of all, you can see on this graph that if this line does not go steeper than that one, if it goes like this, then there is no intersection. And that means that if for example, you have a variable cost of $5 per a piece but you sell that at 4, then you will never ever make a penny of profit. But if you produce that at a cost of 5, but sell at a cost of 6, you start selling them, but that does not mean that you will immediately start making profit. And that is, we will discuss that on the next page of flip chart. But for now, we can see that basically this graph that gives you an idea of CVP analysis. And CVP means cost volume profits. Looking at that graph, we can see that we deal with pricing, because like I said, if this is like this, then no profit ever. So in raising price, we turn this blue line this way. So for example, if we doubled the price, then the revenue would go steeper, and the break-even point would be lower. And then clearly that deals with ideas of costs and output. Because for example, you can say, well if you produce that much then clearly you run a loss. Then in order to remove this loss, you have to do one of the two things. Either to raise the price, but then you lose any competitive battle. Or you should have to squeeze more of these outputs. So you can see that these graphs, the previous and this one, they are instrumental in making some actual managerial decisions. And now, I would like to wrap up this episode with funny diagram that is oftentimes used to show the idea of fixed cost. And that will be a diagram that deals with a very special term that's called contribution margin. Well, I'll draw a picture. So let's say that this is the pipe, and from this pipe, we have revenues that are in droplets. And these revenues, they fall in the pool. And then from this pool, there's another pipe. And from here come smaller, hopefully smaller, droplets that are variable costs. So if this droplet is smaller than this one, we can see that everything that comes here, it just gets down here in the area of variable cost. And there is nothing that can go from here. But in case that revenues are greater than variable costs, then this pool, there is something that goes out of that. And this something goes to another pool. And this pool is the pool that's called fixed costs. Now, this something, this, this is called contribution margin. Now see what happens. So contribution margin is the difference between the revenues and variable costs. And there is a small droplet here, but unless this pool of fixed costs is filled up, there is not profit. So your profit comes from here, Only when, This whole pool is filled up. So again, well that might be a funny thing. And you can say well, this is sort of a kindergarten story. But that really helps you to keep in mind that first of all, if your contribution margin is not positive then you can forget about this altogether, and forget about profit altogether. But even if you did, if your contribution margin is small, then it takes a lot of droplets. So you have to produce a lot of these units to be able to squeeze even a penny of the profit. So this is the idea of the overall cost behavior with respect to fixed and variable. But that clearly is not the only and not the primary distinction. And in what follows, we'll continue to study other important ideas about costs.
