Fixed Costs and Variable Costs, and how they affect Price
To help understand basic economics we need to begin with an understanding of how prices are determined. Let’s start with a lemonade stand. Little Sue decides to go into business and sell lemonade in her neighborhood. She starts out with buying materials for the stand for $10 (or what is also called making capital expenditures). Also, lemonade ingredients for ten dollars $10 (these items are also called cost of goods sold) making her total initial investment of $20. Now, let’s assume that Sue has to pay rent for her space of $1 a day. The rent paid here is known as fixed costs, or items whose cost does not increase as volume increases (some other examples would be salaries, leases, or insurance). The lemonade ingredients are known as variable costs, or items whose cost increases as volume increases (other examples would be labor or utilities). Understanding these elements will be important later in the blog. With every $10 of ingredients she can make 10 cups of lemonade so her per unit cost is $1. Sue then decides to sell her lemonade for $2 making a profit of $1 per cup, or if she sells out a total profit of $10, which would be 10 cups x $1 (revenue – cost of goods sold or $20 – $10= $10 and her marginal profit which is profit/units sold is $10/10=$1. (It is important to note here that in some instances the capital expenditure would need to be factored in when determining at what price to sell at. For simplicity we will only go on fixed and variable costs). She opens up shop and sells out of lemonade in the first hour of business. After subtracting her fixed costs of $1 for rent, Sue makes a decent profit of $9. In this case she knows she could have sold a lot more lemonade and made a lot more money, so Sue goes to the store and buys $20 worth of ingredients. However, she can’t make all the ingredients by herself and needs help. So she hires a friend for $1 a day to help make lemonade. Again she sells out of lemonade. So, with $20 worth of ingredients she made 20 cups of lemonade which sold at $2 each cup making her $40 in total sales. Her variable costs were the ingredients that cost her $20 and the $1 in labor. So $40-$20 gave her a profit of $20. After fixed expenses (sometimes called overhead) is subtracted out, $20 profit – $1 labor -$1 rent = $18 net, or a marginal profit of $0.90 per cup sold ($18/20 cups = $0.90). Even though Sue made more in total profit by adding labor, she decreased how much she made on each cup of lemonade. You can see here as demand (or sales) increase so does variable costs. Companies generally will keep growing their sales and variable costs until they reach a breakeven point in which they are making no profit. At each increased level of sales Sue’s per unit profit margin falls like when it went from $1 a cup to $0.90 a cup. Eventually demand for Sue’s lemonade will cause her to not make any money on each cup sold while she is trying to supply everyone with lemonade that she could possibly sell to. In order to stay profitable and not go bankrupt Sue has to eventually raise her price.