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Unit 2
Theory of Production and
Cost
Production
Production means transforming inputs (labor,machines, raw materials etc.) into an output.
The production process does not necessarilyinvolve physical conversion of raw materialsin to tangible goods, it also includesconversion of intangible inputs to intangiblesoutputs. E.g., layer, doctor, social workersetc.
An input is good or service that goes into theprocess of production and output is any goodor service that comes out of productionprocess.
Fixed and Variable Inputs
A fixed input is one whose supply isinelastic in the short run.
A variable input is defined as onewhose supply in the short run iselastic, e.g. labor, raw materials etc.
A fixed input remains fixed up to acertain level of output whereas avariable input changes with change inoutput.
Production Function
A firm has two types of production
function:
1. Short run production function
2. Long run production function
Short Run Production
It refers to a period of time in which
the supply of certain inputs (e.g.,
plant, building, machines, etc) are
fixed or inelastic.
Thus an increase in production during
this period is possible only by
increasing the variable input.
Long Run Production
It refers to a period of time I whichsupply of all the input is elastic, but notenough to permit a change intechnology.
In the long run, the availability of evenfixed factor increases.
Thus in the long run, production ofcoomodity can be increased byemploying more of both, variable andfixed inputs.
Production Function
Production function is defined as thetransformation of physical input in to physicaloutput where output is a function of input.
It can be expressed algebraically as;
Q = f (K, L etc.)
Where,
Q = the quantity of output produced during aparticular period
K, L etc. are the factors of production
f = function of pr depends on.
Production Function
Assumptions The production functions are based on
certain assumptions:
1. Perfect divisibility of both inputs and
output
2. Limited substitution of one factor for
the others
3. Constant technology
4. Inelastic supply of fixed factors in the
short run
Factors of Production
The classic economic resources includeland, labor and capital.
Entrepreneurship is also considered aneconomic resource because individualsare responsible for creating businessesand moving economic resources in thebusiness environment.
These economic resources are alsocalled the factors of production.
Land
Land is the economic resourceencompassing natural resources foundwithin a nation.
Nations must carefully use their landresource by creating a mix of natural andindustrial uses.
Using land for industrial purposes allowsnations to improve the productionprocesses for turning natural resourcesinto consumer goods.
Labor
Labor represents the human capitalavailable to transform raw or nationalresources into consumer goods.
It is a flexible resource as workers canbe allocated to different areas of theeconomy for producing consumer goodsor services.
It can also be improved through trainingor educating workers.
Capital
Capital can represent the monetaryresources companies use to purchasenatural resources, land and othercapital goods.
Capital also represents the majorphysical assets (e.g., buildings,production facilities, equipment,vehicles and other similar items)individuals and companies use whenproducing goods or services.
Entrepreneurship
It is also considered a factor of
production since someone must
complete the managerial functions of
gathering, allocating and distributing
economic resources or consumer
products to individuals and other
businesses in the economy.
The Law of Production
In the short run, input-output relationsare studied with one variable input, whileother inputs are held constant. The lawof production under these assumptionsare called “The Laws of VariableProduction”.
In the long run input output relations arestudied assuming all the input to bevariable. The long-run input outputrelations are studied under Laws ofReturns to Scale.
Law of Diminishing Returns (Law
of Variable Proportions)… The law which brings out the relationship
between varying factor properties andoutput are known as the law of variableproportion.
The variation in inputs lead to adisproportionate increase in output moreand more units of variable factor whenapplied cause an increase in output butafter a point the extra output will growless and less. The law which brings outthis tendency in production is known asLaw of Diminishing Returns.
Continue…
The law of diminishing returns levels that anyattempt to increase output by increasing onlyone factor finally faces diminishing returns.
The law states that when some factorsremain constant, more and more units of avariable factors are introduced the productionmay increase initially at an increasing rate;but after a point it increases only atdiminishing rate.
Land and capital remain fixed in the short-term whereas labor shows a variable nature.
Continue…
The following table explains the
operation of the Law of Diminishing
Returns:No. of
Workers
Total Product
(TP)
Average
Product (AP)
Marginal
Product (MP)
1 10 10 10
2 22 11 12
3 36 12 14
4 52 13 16
5 66 13.2 14
6 76 12.7 10
7 82 11.7 6
8 85 10.5 3
9 85 9.05 0
10 83 8.3 (-2)
Continue…
Average product is the product for one unit oflabor, arrived by dividing the total product bynumber of workers.
Marginal product is the additional productresulting term additional labor, calculated bydividing the change in total product by thechange in the number of workers.
From table we can see that the total outputincreases at the increasing rate till theemployment of the 4th worker. Any additionallabor employed beyond the 4th labor clearlyfaces the operation of the Law of Diminishingreturns.
Continue… The graphical representation of the table is as below:
Continue…
The law of diminishing returns operationat three stages.
At the first stage, total product, marginalproduct, average product increases at anincreasing rate. this stage continues upto the point where AP is equal to MP.
At the second stage, the TP continues toincrease but at a diminishing rate. As theMP at this stage starts falling, the APalso declines. This stage ends where TPbecome maximum and MP becomeszero.
Continue…
The marginal product becomes
negative in the third stage. Total
product also declines. The average
product continues to decline in the
third stage.
Assumptions of Law of
Diminishing Returns The Law of Diminishing Returns is
based on the following assumptions:
1. The production technology remains
unchanged.
2. The variable factor is homogeneous.
3. Any one factor is constant.
4. The fixed factor remains constant.
Law of Returns to Scale
Returns to scale is the rate at which
output increases in response to
proportional increases in all inputs.
The increase in output may be
proportionate, more than proportionate
or less than proportionate.
Increasing Returns to Scale Proportionate increase in all factor of production
results in a more than proportionate increase inoutput.
Increasing Returns => Output > Input
Example :
Output Input
100 Unit = 3L + 3K
200 Unit = 5L + 5K
300 Unit = 6L + 6K
Where L = labor and K=capital (in unit)
Constant Returns to scale When all inputs are increased by a certain
percentage, the output increases by the samepercentage, the production function is said toexhibit constant returns to scale.
Constant Returns => Output = Input
Example :
Output Input
100 Unit = 3L + 3K
200 Unit = 6L + 6K
300 Unit = 9L + 9K
where L = labor and K=capital(in unit)
Diminishing Returns to Scale
The term ‘diminishing’(Decreasing) returns toscale where output increases in a smallerproportion than the increase in all inputs.
Diminishing Returns => Output < Input
Example :
Output Input
100 Unit = 3L + 3K
200 Unit = 7L + 7K
300 Unit = 12L + 12K
Where L = labor and K=capital(in unit)
Economies of Scale
The factors which cause the operation of
the laws of returns to scale are grouped
under economies and diseconomies of
scale.
Increasing returns to scale operates
because of economies of scale and
decreasing returns to scale operates
because of diseconomies of scale where
economies and diseconomies arise
simultaneously.
Continue…
When a firm increases all the factor of
production it enjoys the same
advantages of economies of
production.
The economies of scale are classified
as:
1. Internal economies
2. External economies
Internal Economies of Scale
Internal economies are those which arisefrom the explanation of the plant-size ofthe firm.
Internal economies of scale may beclassified as:
1. Economies in production
2. Economies in marketing
3. Economies in management
4. Economies in transport and storage
Economies in Production
It arises from
1. Technological advantages
2. Advantages of division of labor and
specialization
Economies in Marketing
It facilitates through:
1. Large scale purchase of inputs
2. Advertisement economies
3. Economies in large scale distribution
4. Other large-scale economies
Managerial Economies
It achieves through:
1. Specialization in management
2. Mechanization of managerial
fucntion
Economies in Transport and
Storage Economies in transportation and
storage costs arise from fuller
utilization of transport and storage
facilities.
External Economies of Scale
External economies to large size firms arisefrom the discounts available to it due to
1. Large scale purchase of raw materials
2. Large scale acquisition of external financeat low interest
3. Lower advertising rate from advertisingmedia
4. Concessional transport charge on bulktransport
5. Lower wage rates if large scale firm ismonopolistic employer of certain kind ofspecialized labor.
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External economies of scale are strictlybased on experience of large-scale firmsor well managed small scale firms.
Economies of scale will not continue forever.
Expansion in the size of the firms beyonda particular limit, too much specialization,inefficient supervision, improper laborrelations etc will lead to diseconomies ofscale.
Concepts of Cost
Cost simply means cost of production.
It is the expenses incurred in the
production of goods.
Thus it includes all expenses from the
time the raw material are brought till
the finished products reach the
wholesaler.
Continue …
The cost concept which are relevant to
business operation and decision can
be grouped on the basis of their
purpose under two overlapping
categories:
1. Concept used for accounting
purpose
2. Concept used in economies analysis
of the business
Types of Cost
There are several types of costs.
1. Money cost
2. Real cost
3. Opportunity cost
4. Sunk cost
5. Incremental cost
6. Differential cost
7. Explicit cost
8. Implicit cost
9. Accounting cost
10. Economic cost
11. Social cost
12. Private cost
Fixed Cost
Fixed cost are those costs which do notvary with the volume of production.
Even if the production is zero, a firm willhave to incur fixed costs.
Examples are rent, interest, depreciation,insurance, salaries etc.
It is also called supplementary costs,capacity costs or period costs oroverhead costs.
Variable Cost
Variable costs are those costs which changewith the quantity of production.
When the output increases, variable cost alsoincreases and when the output decreases,the variable cost also decreases.
Examples are materials, wages, power,stores etc.
Variable costs are also known as prime costsor direct costs.
Business Cost
Business cost include all the expenses
which are incurred to carry out a
business.
These cost concepts are used for
calculating business profits and losses
and for filling returns fro income-tax
and also for other legal purposes.
Full Cost
The concept of full costs, includes
business costs, opportunity costs and
normal profits.
Total Cost
Total cost is the sum of total fixed cost
and total variable cost.
In other words it is the aggregate
money cost of production of a
commodity.
Average Cost
Average cost is the cost per unit of
output.
That is the total cost divided by
number of units produced.
Average cost = total average fixed
cost + total average variable cost
Marginal Cost
Marginal cost is the additional cost to
total cost when an additional unit is
produced.
Breakeven Analysis
BEA is a technique that helps decisionmakers understand the relationshipsamong sales volume, costs andrevenues in any organization.
It is graphical method of analyzing andalso known as Cost Volume Profit (CVP)analysis.
In this method, Break-even Point (BEP)i.e. the level of sales volume to whichtotal revenues equal total costs isdetermined.
Assumptions under BEA1. It assumes that the total cost is divided into two categories
i.e. i) fixed cost and ii) variable cost. It totally ignores thesemi-variable costs.
2. Fixed cost remains constant throughout the volume ofproduction.
3. The selling price if the product is constant throughout thesale.
4. The variable cost changes proportionally (at constant rate)with volume of production.
5. All the goods produced are sold, i.e. volume of productionand sales are equal or there is no closing stock.
6. The firm is producing only one type of product. In case ofmulti-product firm, the product mix is stable.
Applications of BEA. . .
1. Break-even analysis is useful in determiningoptimum level of output, below which it is notprofitable for the firm to produce its products.
2. To determine minimum cost for a given levelof output.
3. To determine impact of changes in cost orselling price on break-even analysis.
4. Managerial decision on adding or droppingproduct is done by break-even analysis.
. . .Applications of BEA
5. It also helps in choosing a product mix whenthere ia a limiting factor.
6. Break-even analysis shoes likely profits andlosses at various levels of production.
7. It is useful in budgeting and profit planning.
8. Break-even chart portrays margin of safety.
9. It is a decision making tool in the hands ofmanagement.
Limitations of Break-Even
Analysis. . .1. The analysis is based on fixed costs,
variable costs and total revenue. Anychange in one variable affects break-even point.
2. Semi-variable costs and depreciationare not accounted which is significant inany manufacturing firm.
3. Multiple charts are to be produced incase of multi-product firm.
. . .Limitations of Break-Even
Analysis4. The effect of technological
development, managerial effectivenessalso determines profitability. Thesefactors are not considered in break-even chart.
5. The break-even chart is based on fixedcost concept and hence holds good fora short period.
6. Break-even analysis is not suitableunder fluctuating business environment.
Break-Even Chart
Total Cost
Sales volume
Loss region
Fixed cost line
Fixed cost
Variable cost
Profit
Total revenue line
Total cost line
Profit region
Break-even point
Terminologies used in BEA. . .
Fixed Costs (FC): Costs that remain thesame regardless of volume of output.
Cost of land/building/machinery, topmanagement salary, taxes on property,depreciation, insurance etc. are FC.
Variable Costs (VC): Costs which aredependent on volume of production.
Cost of materials, wages, packaging costs,transportation of finished products etc. areVC.
. . .Terminologies used in
BEA. . . Total Costs:
Total costs = Fixed costs + Variable costs
Total Revenue (TR):
Total revenue = Selling price per unit ×Number of units sold
Profit:
Profit = Total revenue – Total cost
. . .Terminologies used in
BEA. . . The point at which total cost line and total
revenue line intersect is known as break-even point.
Break-even Point in terms of sales value(Rs.):
BEP(Rs.) = [Total fixed cost / (Total revenue –Total variable cost)] × Selling price
Break-even Point in terms of quantity(units):
BEP(units) = [Total fixed cost / (Selling price per unit - Variable cost per unit)]
. . .Terminologies used in
BEA. . . Margin of Safety:
Margin of safety = Actual (Budgeted) sales –Sales at B.E.P.
If the margin of safety is small, drop inproduction capacity may decrease the profitsconsiderably.
There should be reasonable margin of safetyotherwise it may be disastrous for theorganization.
Low margin of safety is the indication of highfixed costs.
. . .Terminologies used in
BEA. . . Angle of incidence (ϴ): It is the angle at which
total revenue line intersects the total cost line.
Large angle of incidence means higher profits.
Small angle of incidence means less profits arebeing made at less favorable conditions.
Contribution: It is the difference between theselling price per unit and variable cost per unit.
Contribution = [Selling price per unit – Variable cost per unit]
OR
Contribution = [Fixed cost per unit + Profit per unit]
. . .Terminologies used in BEA
Profit Volume Ratio (P/V Ratio): It isthe measure of profitability. It is alsoknown as contribution margin ratio.
P/V ratio = (Contribution / Total sales revenue) × 100
P/V Ratio = Change in profit / Change in sales
P/V Ratio = Change in contribution / Change in sales
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