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We can generally say that there are two kinds of costs that face a business. One of these kinds of costs is called fixed costs and the other is called variable costs. Fixed costs are also called “overhead.”
Fixed costs are costs that do not change with the amount of a good or service that is being produced. For example, if you have a t-shirt factory, the number of sewing machines that you own and the size of the building that you rent are both fixed. They stay the same no matter how many t-shirts you make.
You have already expended a great deal of money on these sewing machines and the rent. This is your overhead. If you only make a few t-shirts, you have very high average costs for each t-shirt because your overhead is not spread out over very many of the t-shirts. Let’s say you pay $100 per day for your rent and the payments on the sewing machine. If you only make 100 shirts, the overhead costs you $1 per shirt (this is called Average Fixed Costs in economic terms). Now, if you start doing more work and you make 200 shirts, your overhead is still $100 per day but now it is spread out over 200 shirts and you are only paying $.50 per shirt in overhead.
Thus, the more units of output you produce, the more your overhead/fixed costs are spread out and you pay lower average fixed costs per unit of output. This makes for lower costs per unit and more profit.
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