Transcript Document

UNIT-III
THEORY OF PRODUCTION &
COST ANALYSIS
Concept of Production

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It a manufacturing process
It’s a process of different commodities
Its includes Raw material, Work in progress & finished
goods.
Concept of Production
Basically 3 components in the production process
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

Product
Productivity
production
Concept of Production

Production is an activity of transforming the
inputs in to output

Production involves step-by-step conversion of
one form material in to another form through
mechanical process
Meaning & Definition
According to ES Buffa “Production is a process by which
goods and services are created.”
In economics “the term production means a process in which
the resources are transferred or converted in to a different and
more usually commodities.”
In general production means “Transforming inputs in to an
output. Its however limited to manufacturing organization.”
Process
Inputs
Outputs
Money
Tangible goods
Man
Material
Machinery
Production
In tangible
Goods
Services
Types of production functions
Basically 2 types of functions
1.Short run production function
2.Long run production function
Short run production function
Q= f (L,C,M)
Q = quantity of output produced
L = Labor units
C = Capital employed
M = Material
F = Function
Long run production function
Q= f (Ld L,C,M,T,t)
Q = quantity of output produced
Ld = Land and building
L = Labor units
C = Capital employed
M = Material
T = Technology
t = Time period of production
F = Function
Isoquant curve
It is curve based on production or sales or purchases
It is profit curve also



The term Isoquant has its origin from two words iSo and
qUantus.
iSo is a greek word meaning equal and quantus is Latin
word meaning quantity.
An isoquant curve is therefore called iso-product curve or
production in difference curve.
Meaning & Definition

Iso quants are used to present a production function with
two variable inputs.
Eg. Let us consider a production function with the quantities of out put
produced by using different combinations of two inputs such as labor
and capital
Meaning & Definition

In other words an iso quant is a line joining different
combinations of labor and capital that yield the same level of
production.
Eg. Quantity of out put produced.
Types of iso quants
Basically 3 types
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Linear iso quant
L-shape iso quant
Kinked iso quant
Y
price
P
P1
O
X
M
M1
Demand
Types of iso quants
Linear iso quant
L-shape iso quant
Kinked iso quant
Y
Y
C
a
p
it
a
l
C
a
p
it
a
l
O
C
a
p
it
a
l
C1
C2
O
x
Labor
L1
Labor
x
Labor
L2
Iso cost curve

Iso cost curve refers to that cost curve which will be show
the various commodities of two inputs which can be
purchased with a given amount of total money.
In the Below diagram it can be seen that as the level of production
changes. The total cost will change and automatically the iso cost curve
moves upward.
C
a
p
it
a
l
Labor
Types of Iso cost curves
C
a
p
it
a
l
C
a
p
it
a
l
Labor
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Super imposition of iso cost curve
Iso quant showing line of price level
Labor
Assumptions of Isoquant curves

An isoquant curve has two inputs say labor and capital to produce an
out put.
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The two inputs are perfectly substitutable to each other but at a
diminishing rate.
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The technology applied in the production process in given or
constant.
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The substitution of one input for the other levels the output
unaffected.
MRTS of Isoquant
(Marginal Rate of Technical Substitutions)

If we assumed tow factors of production say labor and
capital. Then the marginal rate of technical substitution of
capital for labor is the number of units of labor which can
be replaced by one unit of capital, which the quantity of
output remaining the same.
Least cost combination of inputs
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When a consumer I faced with the problem of making choice b/w
two or more goods with given resources.
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The producer may be reach an optimum point by choosing the leastcost combination of inputs
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The producer will choose that combination of inputs with produces
maximum out puts at lowest cost.
Formulae
1.
Managerial product of input X
Price of input of X
1.
Managerial product of input Y
Price of input of Y
Expansion path
U
N
I
T
S
O
F
C
A
P
I
T
A
L
K5

K4
K3
K2
K1
L1
L2
L3
L4
UNITS OF LABOR
L5
The expansion path is the curve along with
out expands when factor prices remain
constant. The expansion path shows how
factor proportions change when out put or
expenditure change
Cobb Douglas production functions

It was introduced by Charles W. cobb and Paul H. douglas in
the 1920s. They suggested a production function of the form..
Q = A, Lb K 1-b
Q= quantity of the out put produced
A= constant
L= Labor units
K= Capital units
b = Parameters
Properties
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for output (Q) to exist both labor and capital should be positive and not equal to
zero.
Q = A La K1-b , L>0,K<0
The addition of parameters is equal to one
b+1-b = 1
The later version of production function
Parameters
It helps to find out the short run relationship between Input and Out put
1.Martinal product of labor (MPL)
2.Marginal product of capital (MPC)
Law of Returns to scale
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The behavior of output when the varying quantity of one input is combined with
a fixed quantity of the other can be categorized in to 3 stages
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The law of returns to scale can be designed as the percentage of increase in the
output where all the inputs vary in the same proportion

The law of return to scale refers to the relationship between inputs and outputs in
the long run when all the inputs (both fixed & variable) are varied same
proportion
Law of Returns to scale
A 2 B = INCREASING RETURNS TO SCALE
B
A
B 2 C = CONSTANT G RETURNS TO SCALE
C
C 2 D = DECREASING RETURNS TO SCALE
D
Law of Returns to scale
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Increasing returns to scale occurs when a percentage increase in inputs lead to
a greater percentage increase in the output.
eg. If a 5% increase in inputs results in 10% increase in the output, an
organization is to attain increase returns
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Constant returns to scale if occur an when the percentage in the output is
equal to the percentage of increase in inputs.

eg. If the inputs are increase at 10% and if the result output also increase
at 10%
Decreasing returns to scale If the proportionate increase is less then
proportionate increase in the out put then a situation is called decreasing returns.
eg. If the inputs are increase at 10% and if the result output also increase
at 5%
Law of Returns to scale
Y
o
Y
X o
Y
X
o
X
1.Increase in returns to scale 2.Constant returns to scale 3.Decreasing in returns to scale
Economies of scale
Basically 3 types of Economies
1. Small scale
2. Medium scale
3. Large scale
Law of returns also confined in accordance with the scale of
proportion of the firm.
1.Increasing Returns
2. Constant Returns
3. Decreasing Returns
Types of Economies
Basically 2 types of Economies
1. Economies of scale
2. Diseconomies of scale
Economies of scale
Internal or Real Economies
1. Economies in production
2. Economies in Marketing
3. Managerial Economies
4. Economies in Transport & Storage
Economies of scale (contd..)
External or Pecuniary Economies
1. Large scale of purchase of Raw material
2. Large scale equation of external finance
3. Massive Advt.
4. Establishment of transport & warehouse
Diseconomies of scale
1. Internal Diseconomies
2. External Diseconomies
Introduction to Cost analysis
It means a piece of work
It is process of Raw material and work in progress
It is a unit price of commodity
Types of Cost analysis
Actual cost
Opportunity cost
Sunk cost
Incremental cost
Explicit cost
Implicit cost or imputed cost
Book cost
Out of pocket cost
Accounting cost
Economic cost
Types of Cost analysis (contd..)
Direct cost
Controllable cost
Non-controllable cost
Historical cost or Replacement cost
Shut down cost
Abandonment cost
Urgent cost and postponement cost
Business cost and full cost
Fixed cost
Variable cost
Types of Cost analysis (contd..)
Total cost
Average cost
Marginal cost
Short-run cost
Long run cost
AVC, AFC, ATC
Analysis
Actual cost
Actual cost is defined as the cost or expenditure which a firm
incurs for producing or acquiring a good or service. The actual
costs or expenditures are recorded in the books of accounts of a
business unit. Actual costs are called as “Out lay Costs” or
“Absolute Costs”
Eg. Cost of Raw material, wages, salaries (production)
Analysis (contd..)
Opportunity cost
opportunity cost is concerned with the cost of forgone
opportunities/alternatives. In other words, it is the return from the
second best use of the firms resources which the firm forgoes in
order to avail of the return from the best use of the resources.
Eg. Own land and building of the company or firm
Analysis (contd..)
Sunk cost
Sunk costs are those do not alter by varying the nature or level
of business activity. Sunk costs are generally not taken into
consideration in decision making as they do not vary with the
changes in the future. Sunk costs are a part of the outlay/actual
costs. sunk costs areas “non-avoidable costs”. Or “non-escapable
costs”.
Eg. All the past costs are considered as sunk costs. The best example is
amortization of past expenses, like depreciation
Analysis (contd..)
Incremental cost
Incremental costs are additions to costs resulting from a change
in the nature or level of a business activity. As these costs can be
avoided by not bringing any variation in the activity, they are also
called as “avoidable costs”. Or “Escapable costs”.
Eg. Change in distribution channel adding or deleting a product in the
product line, replacing a machinary.
Analysis (contd..)
Explicit cost
Explicit costs are those expenditures that are actually paid by
the by the firm. Those costs are recorded in the books of accounts.
Explicit costs are important for calculating the profit and loss
accounts and guide in economic decision making. Its are also called
paid up costs.
Eg. Interest payment on borrowed funds, rent payment, wages paid
Analysis (contd..)
Implicit or Imputed cost
These cots are a part of opportunity cost. they are the theoretical
costs. i.e. they are not recognized by accounting system and are not
recorded in the books of accounts. But are very important in certain
decisions. They are also called as imputed costs.
Eg. Rent on idle time, depreciation on fully depreciated property still in
use, interest on equity capital.
Analysis (contd..)
Book costs
Book costs are those costs which don’t involve any cash
payments but a provision is made in the books of accounts in order
to include them in the profit and loss account and take tax
advantages, like provision for depreciation and unpaid amount of
Interest on the owners capital
Analysis (contd..)
Out of pocket cost
Out of pocket costs are those costs or expenses which are current
payments to the outsiders of the firm. All the explicit costs fall into
the category of out of pocket costs.
Eg. Rent paid, wages, Transport charges and salaries
Analysis (contd..)
Accounting costs
Accounting costs are the actual or out lay costs that point out the
amount of expenditure that has already been incurred on a
particular process or on production as such accounting costs
facilitate for managing the taxation needs and profitability of the
firm
Eg. All sunk costs are accounting costs.
Analysis (contd..)
Economic costs
Economic costs are related to future. They play a vital role in
business decisions as the costs considered in decision making are
usually future costs. they have the nature similar to that incremental
imputed, explicit and opportunity costs.
Analysis (contd..)
Direct costs
Direct costs are those which have direct relationship with a unit
of operation like manufacturing a product, organization a process of
an activity et. In other words, direct costs are those which are
directly and definitely identifiable.
Eg. In operating railway services, the costs of wagons, coaches and
engines are direct costs.
Analysis (contd..)
In direct costs
Indirect costs are those which cannot be easily and definitely
identifiable in relation to a plant, a product, a process or a
department. Like the direct costs indirect costs, do not vary means
they may or may not be variable in nature.
Eg. Factory building, The track of railway system
Analysis (contd..)
Controllable costs
Controllable costs are those which can be controlled or
regulated through observation by an executive and therefore they
can be used for assessing the efficiency of the executive. Most of the
costs are controllable.
Eg. Inventory costs can be controlled at the shop level
Analysis (contd..)
Non Controllable costs
Non Controllable costs are those which can not be subjected to
administrative control and supervision are called non controllable
costs.
Eg. Costs due obsolesce and depreciation, capital costs.
Analysis (contd..)
Historical cost & Replacement cost
Historical cost (Original cost) of an asset refers to the original price
paid by the management to purchase it in the past. Whereas the
Replacement cost refers to the cost that a firm incurs to replace or acquire
the same asset now.
The distinction between the historical cost and the replacement cost
result from the changes of prices over time.
Eg. If a firm acquires a machine for rs.20,000 in the year 1990 and the same
machine cost of rs.40,000 now. The amount of rs.20,000 is the historical
cost and the amount of rs.40,000 is the replacement cost.
Analysis (contd..)
Shut down costs
The costs which a firm incurs when it temporarily stops its operations
are called “shutdown costs”. These costs can be saved when the firm again
starts its operations. Shutdown costs include fixed costs, maintenance cost,
lay-off expenses etc..
Analysis (contd..)
Abandonment costs
Abandonment costs are those costs which are incurred for the complete
removal of the fixed assts from use. These may occur due to obsolesce or
due to improvisation of the firm. Abandonment costs thus involve problem
of disposal of the assts
Analysis (contd..)
Urgent cost and Post ponable cost
Urgent costs are those costs which have to be incurred compulsorily by
the management in order to continue its operations.
Eg. Costs of material, labor, fuel
Post ponable costs are those which if not incurred in time do ot effect
the operational efficiency of the firm
Eg. Maintenance of costs
Analysis (contd..)
Business costs & Full costs
Business costs include all the expenses incurred by the firm to carry out
business activities. According to Watson and Donald “Business costs
include all the payments and contractual obligations made by the firm
Eg. Income tax, profit & loss
Full costs include business costs, opportunity costs and normal profit.
Opportunity cost is the expected return /earnings form the next best use of
the firm.
Analysis (contd..)
Fixed costs
Fixed costs are the costs that do not vary with the changes in
output. In other words, fixed costs are those which are fixed in
volume though there are variations in the output level.
Eg. Expenditures on depreciation costs of administrative or
managerial staff, rent on land and building and property tax etc.
Analysis (contd..)
Fixed costs
Y
Fixed cost curve
Total fixed cost
O
X
Output (Q)
Analysis (contd..)
Variable cost
Variable costs ae those that are directly dependent on the output
i.e. they vary with the variation in the volume / level of output.
Variable costs increase with an increase in output level but not
necessarily in the same proportion.
Eg. Cost of raw material, expenditures on labor, running cost or
maintenance costs of fixed assets.
Analysis (contd..)
Variable cost
Y
Variable cost curve
Total variable cost
O
X
Output (Q)
Analysis (contd..)
Total cost
Total cost refers to the money value of the total resources
required for the production of goods and services by the firm. In
other words, it refers to the total outlays of money expenditure, both
explicit and implicit.
TC = VC+FC
TC = Total cost
VC = Variable cost
FC = Fixed cost
Analysis (contd..)
Total cost curve
Y
Total cost
Total cost
O
X
Output (Q)
Analysis (contd..)
Average cost
It refers to the cost per unit of output assuming that production
of each unit of output incurs the same cost. It is statistical in nature
and is not an actual cost. It is obtained by dividing Total cost.
TC
AC =
Q
TC = Total cost incurred in production process.
Q = Output cost
Analysis (contd..)
Marginal cost
MC refers to the incremental or additional costs that are incurred when
there is an addition to the existing output level of goods and services, in
other words it is the addition to the total cost on account of producing
addition units of the output
MC = TC (n+1)
MC = Marginal cost
TCn = Total cost before addition of units
TC(n+1) = Total cost after addition
n = Number of units of output
Analysis (contd..)
Marginal cost curve
Y
Marginal cost
Marginal cost
O
X
Output (Q)
Analysis (contd..)
Short run cost and Long run cost
Both short run and long run costs are related foxed and variable
costs and are often used in economic analysis.
 Short run costs: these costs are which vary with the variations in
the output with size of the firm as same. Short run costs are same as
variable costs.
 Long run costs: these costs are which incurred on the fixed assets
like land and building, plant and machinery etc. long run costs are
same as fixed costs.
Analysis (contd..)
Average fixed cost (AFC)
Average fixed cost is defined as the ratio of total fixed cost and
the total number of units produced/output. Average fixed cost is
given by
TFC
AFC = -------Q
AFC = Average fixed cost
TFC = Total Fixed cost
Q = Output
Analysis (contd..)
Average fixed cost (AFC)
Y
AFC
AFC
O
X
Output (Q)
Analysis (contd..)
Average variable cost (AFC)
Y
AVC
TVC
AVC = --------
AVC
Q
AVC = Average variable cost
TVC = Total Variable cost
Q = Output
O
X
Output (Q)
Analysis (contd..)
Average Total cost (AFC)
Y
ATC
TC
ATC = --------
ATC
Q
ATC = Average total cost
TC = Total cost
Q = Output
O
X
Output (Q)
Analysis (contd..)
Break even analysis
The Break – Even point can be defined as that level of sales at
which total revenue equals total costs and the net income is equal to
zero. This is also known as no-profit and no-loss point.
Break - Even chart
Y
Total Revenue line
Profit zone
TC line
Profit
Fixed cost zone
Cost/Revenue
BEP
VC line
Loss
Variable cost zone
O
X
Sales/production
Advantages of BEP
To achieve a given amount of profit the break even analysis can be
used to determine the sales volume.
It can be used to forecast the future cost and revenue and it can
predict the profit.
To control the cost in business the cost functions used in break
even analysis can be useful.
The break even analysis useful for profit planning in business.
The break even analysis can be useful in sales projection.
Formulas of BEP
1. Marginal cost = Prime cost + Variable cost
2. Contribution = Sales – Marginal cost
Fixed cost + profit/loss
sales x P/V Ratios
3. Sales = Contribution/P/V Ratio
Contribution
4. P/V Ratio =
sales
X 100
Formulas of BEP
Contribution
X 100
4. P/V Ratio =
sales
Sales - VC
X 100
=
Sales
Fixed cost + profit
X 100
=
Sales
Formulas of BEP
Profit
X 100
4. P/V Ratio =
MS Ratio
change in contribution
X 100
=
change in sales
Formulas of BEP
Contribution
5. Sales
X 100
=
P/V Ratio
Fixed cost
6. BEP (in uts)
=
X 100
Contribution per unit
Formulas of BEP
FC X S
6. BEP (in Rs.)
=
S–V
7. Margin of safety = Total sales – BEP Sales
Total sales - BEP Sales
=
Total Sales
Formulas of BEP
8. Variable cost
= Sales – fixed cost
9. Profit
=
(Sales x P/V Ratio) – FC
=
P/V Ratio x M/S Ratio x Sales