Costs of Production and the Shutdown Decision - The Economic Lowdown Podcast Series
“There’s no such thing as a free lunch.” Maybe you’ve heard that before. Or you’ve even said it. If so, you probably know it means that everything has a cost. Businesses are especially aware of costs because costs affect profits, and without profits a business might not survive. This episode of The Economic Lowdown podcast series describes how businesses consider costs when making decisions – including about whether to shut down.
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Below is a full transcript of this audio presentation. It has not been edited or reviewed for accuracy or readability.
“There’s no such thing as a free lunch.” Maybe you’ve heard that before. Or you’ve even said it. If so, you probably know it means that everything has a cost. Businesses are especially aware of costs because costs affect profits and without profits a business might not survive.
Think about the businesses in your neighborhood. They help meet your needs and the needs of the community. But there’s more to it. They are in business to make a profit. But how do they determine profit?
To calculate profit, a business must know two things: its total revenue and its total cost. Revenue is simply the income the business receives from selling its goods or services. Imagine you’re the owner of Caffeinate, a small coffee shop that sells one good—your famous coffee—for $4 a cup. Each cup sold generates revenue. In other words, each $4 cup sold gives Caffeinate an additional $4 in revenue. If the shop sells 5,000 cups of coffee in a month, its total revenue for that month is $20,000.
Revenue is just part of the story, though. Running the shop has costs. Costs are what you and any business must pay to produce your good or service. For example, for Caffeinate, your costs include things like rent for the building, coffee beans, creamer, wages, and cups. When you add up all the costs of running the shop, you get your total cost.
Total cost can then be split into two categories: fixed costs and variable costs. Fixed costs are costs that stay the same no matter how much you produce. In other words, Caffeinate spends the same amount of money on fixed costs whether you produce zero or 20,000 cups of coffee per month. For example, the rent stays the same from month to month because it’s determined by a lease or a contract. It is truly a fixed cost.
In contrast, coffee beans, creamer, cups and so on are variable costs because they are determined by the number of cups of coffee you produce and sell each month. When you produce more cups of coffee, you need to buy more supplies. So, the costs that can vary based on how much you produce are logically called variable costs. Wages are another variable cost because they can vary depending on how many cups of coffee are produced. When sales are high, just like any other business, you’re likely to ask your employees to work more hours or maybe even hire more employees. Likewise, if sales decrease, you might cut back on your employees’ hours or let some employees go. As such, wages are a variable cost.
When total revenue exceeds total cost, a business earns a profit. So for Caffeinate, when your total revenue—the income you receive from selling coffee—exceeds your total cost, you earn a profit. More precisely, this is called the accounting profit. It includes only the costs classified as out-of-pocket costs. Economists suggest that business owners should also think about other types of cost when making decisions, but we’ll discuss other costs a little later.
What happens, though, when a business’s costs are more than its revenue? If that happened to your shop, how would you decide whether to shut down or stay in business and hope for better times ahead? To make that decision, you’ll need to think about your best interests in the short run and the long run.
To simplify things, let’s assume your fixed costs for the coffee shop are $10,000 per month, including the leases on the building and equipment, and your variable costs are also $10,000 per month, including wages and all supplies. So, with fixed costs of $10,000 and variable costs of $10,000, your shop’s total cost is $20,000 per month. And your revenue for quite some time has been about $20,000 a month. At this point, you are earning zero accounting profit.
But say the economy changes, your coffee sales take a nose dive, and your revenue drops to only $16,000 per month. If your total cost were still $20,000, you’d be losing $4,000 per month. Would that force you to shut down? Well, not necessarily. The $10,000 in fixed costs won’t go away until your leases are up. You’d have to pay those whether you‘re in business or not.
What you need to do is focus on your variable costs. As long as you sell enough coffee to cover your variable costs, you should stay in business in the short run. In this case, the short run lasts until your leases are up. For Caffeinate, $16,000 in revenue will cover the $10,000 in variable costs and $6,000 of the fixed costs.
So, in reality, a business might stay in business even if it’s losing money. The goal in the short run is to maximize profits, or at least to minimize losses. If Caffeinate closes, you’ll lose $10,000 per month. But if it stays open, you’ll lose only $4,000 per month. So, the best choice is to stay in business for the short run and re-evaluate your decision at the end of your leases.
But what about the long run?
Eventually, when the leases are up and it’s time to renew them or walk away, you can consider the bigger picture of your costs. If you’re still losing money every month, you’ll likely “exit” -- close Caffeinate and move on.
Remember, that when calculating an accounting profit, only the businesses’ out-of-pocket costs are included. Another name for these costs is explicit costs. These are the payments businesses make to suppliers for the resources they use. But businesses must also consider implicit costs. Implicit costs are costs that do not require an outlay of money. Implicit costs are also known as opportunity costs. An opportunity cost is the value of the next-best alternative when a decision is made; it's what is given up. Let’s say you own the building that houses Caffeinate. How much could you earn if you rented the building to a different business? That amount of rent is an implicit cost. It is the opportunity cost of using your building for Caffeinate.
There’s also an implicit cost, or opportunity cost, for your talents and skills. For example, before you owned Caffeinate, imagine you were an accountant making $6,000 per month. You gave up $6,000 per month to open and manage the coffee shop. The implicit, or opportunity, cost of owning your business is the income you would have earned as an accountant. Let’s take a look at a few cases to see why opportunity costs are important to consider:
- Case 1: Let’s say the profit from your coffee shop is $8,000 per month. That amount exceeds the $6,000 you would have earned as an accountant. In this case, you would be earning an economic profit of $2,000. In other words, Caffeinate generates enough revenue to pay all of your explicit costs plus the opportunity cost of giving up your career as an accountant, and you have money left over. You would have good economic reasons to keep grinding coffee beans.
- Case 2: If the coffee shop generated only $6,000 per month in profit, you—the owner—would be simply covering your opportunity cost of leaving accounting. This level is called normal profit. This is the level of profit you would need for it to make economic sense for you to keep going back to Caffeinate day after day.
- Case 3: If your shop generated only $4,000 per month, your profit would be below the $6,000 per month you could have earned as an accountant. In this case, you would suffer an economic loss. You’d very likely consider going back to accounting, unless the aroma of coffee had special value in your life.
To open and run a business, many decision need to be made. And many of those decisions will be based on costs. Once a business opens, it takes on a number of fixed costs. These costs stay the same no matter how much is produced. How much is produced, however, will determine the variable costs. In the long-run, however, all costs are variable and will determine whether a business stays in business. Many of the costs will be explicit costs. These are the payments to suppliers for the resources used. But there are other costs to consider as well. At least one is the income the business owner could make from other employment opportunities. This is an implicit, or opportunity, cost and must be considered when deciding to operate a business or move on. All this is to say, there really is no such thing as a free lunch.
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