Have you ever heard someone say, "That's a fixed cost.
There's nothing we can do about that."
Well, what is a fixed cost exactly?
It's a cost that's going to remain constant regardless of any changes in the activity
level.
By activity level,we're talking about things like the number units that the firm produces.
So, if the firm produces 50 units instead of 25, that cost is still going to behave
the same.
It's still going to be exactly the same.
Let's just take a really simple example here, like the cost of a business license.
If you want to open a pizzeria and it costs $500 to get a business license, it doesn't
matter how many pizzas you make throughout the year.
Your units produced doesn't have any affect on what this cost is going to be.
That cost is always going to be five hundred dollars.
It doesn't matter whether you make a single pizza or if you make a thousand.
Let's use a more complicated example.
Let's think about a manufacturing plant that manufactures trucks.
This plant costs $50 million.
So, this is a $50 million plant, and let me actually graph this out and take a look at
how the cost behaves.
So let's say that right here is that cost, and it's $50 million and the number of units
produced (or trucks) we'll have down here (that looks like an "a" instead of a "u")
So, that's our number of trucks.
Here's 10,000 and then we've got 20,000 and then we've got 30,000.
Now, how is the cost going to behave as the number love units that we produce changes?
Well look, for our factory we could make 10,000 trucks or we can make 30,000.
It doesn't matter, the factory still costs the same.
It's still $50 million, so the way this is going to look is we're just gonna have a flat
line.
And that line doesn't look exactly flat, that's my fault.
So, basically this cost is not changing.
Irrespective of how many trucks we make, it doesn't change.
But if you think about this intuitively for a moment.
What if this went from 10,000 to a million.
What if we're talking about a million trucks?
Now all of a sudden we start saying, "Maybe we actually need to get another factory."
So in that case, this cost although it is fixed at $50 million.
We say, "well it's fixed within a relevant range."
What we mean by a relevant range is, lets say that we think the max amount trucks we
can make is 50,000 and we know between 0 to 50,000 the cost is gonna be fifty million.
But, if we go beyond 50,000 we can't accommodate that our current plant, so we're actually
going to have to build another plant, and then that's another $50 million.
So the idea being, it's important to remember that not all costs are completely fixed.
Something like a business license, okay you are not going to need another business license
if you make more pizza than you thought you were going to.
However, some costs that we might think, "oh a plant that's fixed" You have to bear in
mind...okay fixed, but in what range?
If the amount of units that we produce actually takes off, beyond what our wildest expectations
are (maybe down the road), it's entirely possible that this cost we thought was fixed might
actually behave a little bit differently when we get outside the relevant range.