UNIT-II

PRODUCTION AND COST ANALYSIS

Production Function

Samuelson defines the production function as the technical relationship which reveals the maximum
amount of output capable of being produced by each and every set of inputs. It is defined for a given state
of technical knowledge

Meaning: production is an activity that transforms inputs into outputs.

Definition: According to Michael R Baye defines production function as “that function which defines the
maximum amount of output that can be produced with a given set of inputs

Production is the result of the combinations of factors for the creation of values and utility to the
corresponding commodities. The factors of production are namely Land, Labour, Capital, Organization
and Technology.

Inputs Outputs

1. Men Money 1. Tangible goods

Processing 2. Intangible goods
2. Machinary
3. Material
4. Technology

.In other words it may be defined as it is a process of converting input into output is called as production

Production Function: The function for the production is stated as:

Q = f{L1, L2, C, O, T}

Where Q = Quantity of Production, F = Relation between Inputs and Outputs, L1 = land, L2= Labour,
C = Capital, O = Organization, T = Technology.

The level of output of a firm can be increases in to two ways:

1. By increasing only one factor and keeping the other factors constant.

2. By increasing all factors of Production.

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 PRODUCTION FUNCTIONS: It is broadly categorized in to three types. Those are

1. COBB-DOUGLAS PRODUCTION FUNCTION

Cobb and Douglas put forth a production function relating output in American Manufacturing industries
from 1899 – 1922 to labour and capital inputs. They used the following formula:

P = b La C1-a

Where P is total output

L = the index of employment of labour in manufacturing

C = Index of fixed capital in manufacturing.

The exponents “a and1-a” are the elasticity of production these measures the percentage
response of output to percentage changes in labour and capital respectively.
P = 1.01 L0.75 C0.25

R2 = 0.9409.

The production functions shows that one percentage change in labour inputs, capital remaining the
same is associated with a 0.75 percentage change in output, similarly one percentage change in capital,
labour remaining the same is associated with a 0.25 percentage change in output . The coefficient of
determinations (R2) means that 94 % of the variations on the dependent variables (P) were accounted for
by the variations in the independent variable (L and C)

Thus Cobb Douglas production function was based on macro level study, it has been very useful
for interpreting economic results

It assumes constant returns of scale

.
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LEONTIEF PRODUCTION FUNCTION (OR) FIXED PROPORTIONS PRODUCTION
FUNCTION:

It is a production function that implies the factors of production will be used in fixed (technologically pre-
determined) proportions, as there is no substitutability between factors.

For the simple case of a good that is produced with two inputs, the function is of the form
Q= Min (Z1 /a, Z2 /b)
where q is the quantity of output produced, z1 and z2 are the utilized quantities of input 1 and input 2
respectively, and a and b are technologically determined constants.

Example: Suppose that the intermediate goods "tires" and "steering wheels" are used in the production of
automobiles (for simplicity of the example, to the exclusion of anything else). Then in the above
formula q refers to the number of automobiles produced, z1 refers to the number of tires used, and z2 refers
to the number of steering wheels used. Assuming each car is produced with 4 tires and 1 steering wheel,
the Leontief production function is
Number of cars = Min{¼ times the number of tires, 1 times the number of steering wheels}.

PRODUCTION FUNCTION WITH ONE VARIABLE INPUT AND LAWS OF

RETURNS:

The laws of returns states that when at least on factor of production is fixed or factor inputs is fixed and
when all other factors are varied, the total output in the initial stages will increase at an increasing
rate ,and after reaching certain level of output will increase at declining rate. It variable factor input are
added further to the fixed factor input, the total output may decline. This law is of universal nature and it
proved to be true in a agriculture and industry also. The law of returns is also called the Law of
Variable Proportions or the Law of Diminishing returns.

In the short run, it is assumed that capital is a fixed factor input and labour is variable input. It is
assumed that technology is given and is not going to change. Under such circumstances, the firm starts
production with a fixed amount of capital and uses more and more units of labour. In the initial stages,
output increases at an increasing rate because capital is grossly underutilized. Productivity will increase
up to point A when more and more units of labour are increased. After point A, output increases at a
declining rate till the it reaches maximum at point C. after point, C, the total output declines and the
marginal product of labour is negative. This indicates that the additional units of labour are not
contributing any thing positively to the total output. Even if labour is available free of cost, it is not worth
using it.

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Diagrammatic representation of the Law: The law of Diminishing returns was explained with the help
of following diagram given below:

Units of labour Total Product Marginal Average Products Stages

(TP) Product (MP) (AP)
0 0 0 0 Stage I
1 10 10 10
2 22 12 11
3 33 11 11 Stage 2
4 40 7 10
5 45 5 9
6 48 3 8
7 48 0 6.85 Stage 3
8 45 -3 5.62

PRODUCTION FUNCTION WITH TWO VARIABLES INPUTS AND LAW OF

RETURNS:

Let us consider a production that requires two inputs, capital © and Labour (L) to produce given output
( Q). there could be more than two inputs in a real life situation but for a simple analysis restrict the
number of inputs to two only. In other words, the production function based on two inputs can be
expressed as

Q = f (C, L)

Where C refers to capital, L refers to Labour.

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ISOQUANTS

“Iso” means Equal “Quant” means Quantity. Isoquant means that the quantities throughout a given
isoquant are equal. Isoquants are also called isoproduct curves. An isoquant curve shows various
combinations of two input factors such as capital and labour, which yields the same level of output.

As an Isoquant curve represents all such combinations which yield equal quantity of output, any or every
combination is a good combination for manufacture, an isoquant curve is also called Product indifference
curve. It shows different combination of input factors to yield an output of 20,000 units of output. As the
investment goes up, the number of laborers can be reduced. The combination of A shows 1 unit of capital
and 20 units of labour to produce say 20,000 units of output. The above combinations of inputs can be
plotted on agraph, the locus of all the possible combinations of inputs up an Isoquants are show in figure.

Labour (units) Capital (units) Output (units)

5 3 10

10 4 10

15 6 10

20 9 10

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 Feature of an isoquant:

 Down ward sloping: isoquant are down ward sloping curve, because if one input increases the
other one reduces. There is no question of increase in both the inputs to yield a given output. A
degree of substitution is assumed between the factors of production.
 Convex to Origin: Isoquant are convex to the origin. It is because the input factors are not perfect
substitutes. One put factors can be substituted but other input factor in a “diminishing marginal
rate”.
 Do not intersect: Two iso products do not intersect with each other, because each of these
denotes a particular level of output. If the manufacturer wants to operate at a higher level of
output, he has to switch over to another isoquant with a higher level of output and vice-versa.
 Do not touch axes: The isoquant touches neither X-axis, nor Y-axis as both inputs are required to
produce a given product.
Types of isoquants:
Isoqunat assume different shapes depending up on the degree of substitutability of inputs under
consideration
 Linear Isoquant
 Right angle Isoquant
 Convex isoquant
 Smooth convex isoquant

 Linear Isoquant: here there is a perfect substitutability of combined inputs to have a same desired level
of output.

Eg: a power plant equipped to burn either oil or gas, various amounts
of electric power can be produced by burning gas only, oil only or
various amounts of each. Gas and oil are perfect substitute here.
Hence the isoquants are straight lines.

 Non linear isoquant: here there is not having perfect substitution

between the inputs to have a same desired output.

E.g.: Exactly two wheels and one frame are required to produce a
bicycle (scooter) and in no way can wheels be substituted for frame or
vice versa. Likewise, two wheels and one chassis are required for a
scooter. This is also known as “Leontief isoquant” or “Input-output isoquant”.

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ISOCOSTS (BUDGETING)
“Isocost” cost refers to the cost curve that represents the
combinations of inputs that will cost the producer
the same amount of money. In other words, each
isocost denotes a particular level of total cost for a
given level of production. If the level of production
changes, the total cost changes and thus the isocost
curve moves upwards and vice versa.
Meaning: “The different possible combinations of inputs
which the firm can buy with the help of its possible resources (given input prices) are represented as
Isocost line.
Eg: Figure shows three downward slopping straight line cost curves (assuming that the input prices are
fixed, no quantity discounts are available) each costing Rs.1.0 lakh, Rs 1.5lakh and Rs2.0 Lakh for
output levels of 20,000, 30,000, 40,000 units.

LEAST COST COMBINATION OF INPUTS

The manufacturing has to produce at lower costs to attain higher profits. The isocost and
isoquants can be used to determine the inputs usage that minimizes the cost of Production.

When a firm’s expenditure increase on inputs it would lead to a parallel shift isocost lines each isocost
line gives a new tangency point and therefore a new equilibrium point. If we join these equilibrium points
we get a curve known as a “Expansion Path”.

The points of tangency P,Q, and R on each of the isoquant curves represents the least cost combinations
of inputs yielding maximum level of outputs. Any output lower or higher than this will result in higher
cost of production.

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MARGINAL RATE OF TECHNICAL SUBSTITUTIONS (MRTS)

The Marginal Rate of Technical Substitution refers to the rate at which one input factor is substituted with
the other to attain a given level of output. In other words the lesser units of one input must be
compensated by increasing amounts of another input to produce the same level of output.

MRTS = Change in one input

Change in another input

= ∆K/∆L

∆K = Change in Capital

∆L = Change in Labour
Combinations Capital (Rs. In Lakh) Labour MRTS

A 1 20 ___

B 2 15 5:1

C 3 11 4;1

D 4 8 3;1

E 5 6 2:1

F 6 5 1:1

RETURNS TO SCALE:

Returns to scale refer to the returns enjoyed by the firm as a result of change in all the inputs. It
explains the behavior of the returns when the inputs are changed simultaneously. the returns to scale are
governed by laws of returns to scale.

1. Law of Increasing Returns to Scale

2. Law of constant Constant Return to Scale
3. Law of Diminishing Returns to Scale

1. Increasing Return to Scale: When an increase in the factors of production causes a more than
proportionate increases in the output. It is called increasing return to scale. In other words increasing
returns to scale refers to that “the rate of change in the output is greater than the rate of change in
input”.
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2. Constant Return to Scale: Increasing returns to scale will not be continuing in definitely. After a
certain stage the advantages and disadvantages of a large scale production are equal and we get the
constant returns to scale.

The numerically value of constant returns to scale is always equal to one. If the inputs are
doubled, the output will also be doubled.
3. Diminishing Return to Scale: In the stage the “rate of change in the output is less than the rate of
change in input”.
The numerical value of diminishing returns is less than one. When inputs are doubled, the output
cannot be doubled. In this stage the advantages of large scale of Production are dominated by the
disadvantages of production.

There are some other reasons for diminishing returns:

 Lack of proper control

 Inefficiency of Management
 Storage of raw materials
 Lack of Proper division of labour

ECONOMIES OF SCALE:

The economies of scale result because of increase in the scale of production. “Alfred Marshall” divides
the economies of scale into two groups:

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 I. Internal Economies of Scale: It refers to the economies in production costs which accrue to the
firm alone, when it expands its output. The internal economies occur as a result of increase in the
scale of production.
1) Managerial Economies: As the firm expands the firm needs qualified managerial personnel to handle
each of its function marketing, finance, production, human resource and others in a professional way.
Specialization ensures minimum wastage and lowers the cost of production in the long run.
2) Commercial Economies: The transactions of buying and selling raw materials and other operating
supplies such as spares and soon will be rapid and the volume of each transaction also grows as the
firm grows. There could be cheaper savings in the procurement, transportation and storage costs will
leads to lower costs and increased profits.
3) Financial Economies: There could be cheaper facilities from the financial institutions to meet the
capital expenditure or working capital requirements. A larger firm has larger assets to give security to
the financial institutions which can consider reducing the rate of interest on loans.
4) Technical Economies: Increase in the scale of production follows when there is sophisticated
technology available and the firm is in a position to hire qualified technical manpower to make use of
it.
5) Marketing Economies: As the firm grows larger and larger it can afford to maintain a full fledged
marketing department independently, to handle the issue related to design of customer survey’s,
advertising, Materials, promotion campaign, handling of scales and marketing staff, launching a new
product and soon.
6) Risk Bearing Economies: As there is growth in the size of the firm, there is increase in the risk also.
Sharing the risk with the insurance companies is the first priority for any firm. The firm can insure its
machinery and other assets against the hazards of fire, thefts and other risks. The larger firms can
spread their risk so that they do not keep all their eggs in one basket; they purchase raw materials
from different sources. They more often deal in more than one product to offset the losses by the
profit from the sale of others.
7) Economies of research and Development: Large organizations such as Dr. Reddy’s Labs, Hindustan
lever spend heavily on research and development and bring out several innovative products only such
firms with a strong R & D base can cope with competition globally.
II) External Economies of Scale: It refers to all firms in the industry of growth of the industry as
a whole or because of growth of ancillary industries. External economies benefits all the firms
in the industry as the industry expands. This will lead to lowering the cost of production and
thereby increasing the profitability. The external economies can be grouped under three types.
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1) Economies of Concentration: Because all the firms are located at one place, it is likely that there is
better infrastructure in terms of approach roads, transportation facilities such as railways lines, banking
and communications facilities and soon.
2) Economies of R&D: All the firms can pool resources together to finance research and development
activities and thus share the benefits of research. There could be a common facility to share journals,
newspapers and other available reference material of common interest.
3) Economies of Welfare: There could be common facilities such as canteen, industrial housing,
community halls, schools and colleges, employment bureau, hospitals and soon, which can be used in
common by the employee in the welfare industry.
DISECONOMIES OF SCALE: Diseconomies are mostly managerial in nature. Problems of planning,
coordination, communication and control may become increasingly complex as the firm grows in size
resulting in increasing average cost per unit. Sometimes the firm may also collapse.
Diseconomies of scale are said to result when an increase in the scale of production leads to a higher
cost per unit. All inputs increase by 10 % but the production increases by only 5%. Expansion of a firm
beyond a particular limit may leads to diseconomies of scale.
Similarly when the industrial estates are booming with activity, industry as a whole expands and
there is keen competition for inputs and other operating supplies. As a result the price on inputs and
other factors of production such as skilled labour rise substantially. This leads to diseconomies as a result
of the expansion of the industry.

COST ANALYSIS:

Introduction:

The Managerial economist is concerned with making Managerial decisions. Different business proposals
are evaluates of their costs and revenues.

Concept and Nature of Cost: Cost refers to the expenditure incurred to produce a particular product or
service. All costs involve a sacrifice of some kind or other or acquire some benefits.

Eg: I want to eat food; I should be prepared to sacrifice Money. Costs may be monetary or non monetary,
tangible or intangible, determined subjectively or objectively. Social costs such as pollution, noise or
traffic congestion to the cost concept.

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 The cost of production normally includes the cost of raw materials, labour and other expenses. These
are called Total cost (TC). This is compared with the total revenues (TR) realized on the sale of the
products manufactured. The difference between total revenues and total cost is known as Profit (P)

Profit (p) = TR-TC

In decision making Cost refers needs to be analyzed and understood in a wider perspective. Though the
data for studying the costs is obtained from the financial records, these need to be supplemented by
specific details. The costs as reported by financial accounts are more suited to the legal and financial
purpose for which they are designs. But financial records cannot provide all the necessary information
about costs.

An understanding of the meaning of various cost concepts is essential for clear business thinking. They
facilitate clear understanding of the management problem and also of the concept of cost that is relevant
to it.

Opportunity Cost: Opportunity cost refers to the earning / profits that are foregone from alternatives
ventures by using given limited facilities for a particular purpose. They represent only the sacrificed
alternatives. So they are never recorded in the books of accounts. These costs must be considered for
decision making. Opportunity cost refers to the “cost for the next best alternatives foregone”. We have
scarce resources and all these have alternative uses. Where there is an alternative, there is an opportunity
to reinvest the resources. In other words if there are no alternatives there are no opportunity costs.

Eg: If the firm owns land there is no cost of using the land (i.e rent) in the firms account. But the firm has
an opportunity cost of using this land, which is equivalent to the rent foregone by not letting the land out
on rent.

Actual cost: Actual cost is defined as the cost or expenditure which a firm incurs for producing or acquiring
a good or service and they are recorded in the books of accounts of a business unit.

Example: cost of raw material, rent, interest, wagebill, etc.

Explicit vs Implicit costs: The costs of using resources in production involve both explicit costs. It is
also called as out-of-Pocket cost and other non cash costs called Implicit costs entered in the books of
accounts. Explicit costs involve payment of cash. The rent for the land lord, wages for the laborer, interest
paid are the explicit cost. Other examples of explicit costs are:

Cost of raw material, Salaries, Power charges, Rent of business, insurance premium
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Implicit Costs: These are also called imputed costs do not involve payment of cash as they are not
actually incurred. They do not take the form of cash outlays, nor outlays, nor they do not appear in the
accounting system. Eg: wages of labour rendered by the entrepreneur himself, Interest on capital supplied
by him.

Out-of-Pocket costs: The costs that involve an immediate outflow of cash. These are spent in the day- to-
day life of the business, such as purchase of raw material, payment of salaries interest on loans and so on.
Out of pocket costs are also called explicit costs because they are incurred in reality.

Fixed cost vs Variable cost: Economists often divide costs into two main groups they are fixed cost and
Variable cost. Fixed costs are that part of the total cost of the firm which does not vary with output. Eg:
Expenditure depreciation rent of land and building, property taxes etc. If the period under consideration is
long enough to allow the necessary adjustments in the capacity of the firm. The fixed costs no longer
remain fixed.

Variable Costs: It directly dependent on the volume of output or service variable costs increase but not
necessarily in the same proportion as the increase in output. The degree of proportionality between the
variable cost and output depends up on the utilization of fixed facilities and resources during the process
of production.

Imputed/ Book Cost : Sometimes book costs is also known as imputed cost. Book costs are those business
costs which don’t involve any cash payment but a provision is made in the books of accounts. Books costs
are imputed costs or the payments made by the firm itself.

Example : Cost of using owners money, depreciation of fully-written-off-property, the firm own capital
equipment etc.

Margin of Safety: It is the excess of sales over the break even sales. It can be expressed in percentage or
in absolute sales amount. A large margin of safety indicates the soundness of the business. The formula
for the margin of safety is:

MOS = Actual sales (present sales – break even sales)

MOS = Net Profit/P/V Ratio.

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BREAK EVEN ANALYSIS (BEP)/ COST VOLUME PROFIT ANALYSIS (CVP)

Introduction: Break even analysis refers to analysis of the breakeven point. The BEP is defined as a no
profit or no loss point. It is necessary to determine the BEP when there is neither profit nor loss. It is
important because it denoted the minimum volume of production to be undertaken to avoid losses.

In other words BEP refers to the point where total cost is equal to total revenues

BEP equal to TC=TR. It is points of no profit no loss. Break even analysis is defined of costs and their
possible impact on revenues and volume of the firm. Hence it is also called the Cost-Volume-Profit
Analysis. A firm is said to attain the BEP when its total revenue is equal to total cost (TR=TC).

Total cost comprises fixed cost and variable cost. The significant variables on which the BEP is based
are fixed cost, variable cost and Total Revenues.

Break Even Chart: The graphical representation of breakeven point in a breakeven chart is Output is
shown on Horizontal axis and Revenues on Vertical axis.

 TC = Total variable cost (TVC) + Total Fixed Cost (TFC).

 The variable cost line is drawn first. It varies proportionately with volume of production and sales.
 The total cost line is derived by adding total fixed cost line to the total variable cost line. The total cost
line is parallel to variable cost line.
 The total revenue line starts from zero point and increase along with the volume of sales intersecting
total cost line at point BEP.
 The zone below BEP is loss zone and above is BEP profit zone.
 OP is the quantity produced/ sold at OC. The cost/price at BEP.
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 The angle formed at BEP that is the point of intersection of total revenues and total cost is called
“Angle of Incidence”.
 The larger the angle of incidence, the higher is the quantum of profit. Once the fixed costs are
absorbed.

Applications of Breakeven Analysis:

 Make or Buy Decision: The manager is confronted with “Make or Buy” decision. The necessary
components or spare parts, where the consumption is larger making may be economical.
 Choosing a product mix when there is a limiting factor: It is very likely that the company may be
dealing in more than one product and company wants to know, in view of the limited plant capacity.
 Drop or Add Decision: It is common that the firm keep on adding new products to their product
range, while dropping the old ones to keep space with the changing demand. In this process we
proposed to be dropped, saves the firm from the losses then |Break even analysis helps in such
decisions.

Assumptions of Break Even Analysis

 Cost perfectly classified fixed and variable

 Selling price does not change with volume of sales simply price discounts are not allowed
 Assume all the produced goods are sold in the market ie No of units produced equals to No of
units sold.
 Only one product is available for sale if multi product firm , the product mix does not change.

Significance of Break Even Analysis:

 To ascertain the profit on a particular level of sales volume or a\ given capacity of production.
 To calculate sales required to earn a particular desired level of profit.
 To compare the product line, sales area, method of sale for individual company.
 To compare the efficiency of the different firms.
 To decide whether to add a particular product to the existing product line or drop one from it.
 To decide to “Make or Buy” a given component or spare part.
 To decide what promotion mix will yield optimum sales.

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Limitations of BEA:
 Breakeven point is based on fixed cost, variable cost and total revenue a change in one variable is
going to affect the BEP.
 All costs cannot be classified into fixed and variable costs.
 It is based on fixed cost concept and hence holds good only in the short run.
 Constant selling price is not true.
 No importance is given to opening and closing stocks.

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