theory of production and cost

1. Unit 2
Theory of Production and
Cost

2. Production
 Production means transforming inputs (labor,
machines, raw materials etc.) into an output.
 The production process does not necessarily
involve physical conversion of raw materials
in to tangible goods, it also includes
conversion of intangible inputs to intangibles
outputs. E.g., layer, doctor, social workers
etc.
 An input is good or service that goes into the
process of production and output is any good
or service that comes out of production

3. Fixed and Variable Inputs
 A fixed input is one whose supply is
inelastic in the short run.
 A variable input is defined as one
whose supply in the short run is
elastic, e.g. labor, raw materials etc.
 A fixed input remains fixed up to a
certain level of output whereas a
variable input changes with change in
output.

4. Production Function
 A firm has two types of production
function:
1. Short run production function
2. Long run production function

5. 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.

6. Long Run Production
 It refers to a period of time I which
supply of all the input is elastic, but not
enough to permit a change in
technology.
 In the long run, the availability of even
fixed factor increases.
 Thus in the long run, production of
coomodity can be increased by
employing more of both, variable and

7. Production Function
 Production function is defined as the
transformation of physical input in to physical
output 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 a
particular period
 K, L etc. are the factors of production
 f = function of pr depends on.

8. 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

9. Factors of Production
 The classic economic resources include
land, labor and capital.
 Entrepreneurship is also considered an
economic resource because individuals
are responsible for creating businesses
and moving economic resources in the
business environment.
 These economic resources are also
called the factors of production.

10. Land
 Land is the economic resource
encompassing natural resources found
within a nation.
 Nations must carefully use their land
resource by creating a mix of natural and
industrial uses.
 Using land for industrial purposes allows
nations to improve the production
processes for turning natural resources
into consumer goods.

11. Labor
 Labor represents the human capital
available to transform raw or national
resources into consumer goods.
 It is a flexible resource as workers can
be allocated to different areas of the
economy for producing consumer goods
or services.
 It can also be improved through training
or educating workers.

12. Capital
 Capital can represent the monetary
resources companies use to purchase
natural resources, land and other
capital goods.
 Capital also represents the major
physical assets (e.g., buildings,
production facilities, equipment,
vehicles and other similar items)
individuals and companies use when
producing goods or services.

13. 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.

14. The Law of Production
 In the short run, input-output relations
are studied with one variable input, while
other inputs are held constant. The law
of production under these assumptions
are called “The Laws of Variable
Production”.
 In the long run input output relations are
studied assuming all the input to be
variable. The long-run input output
relations are studied under Laws of
Returns to Scale.

15. Law of Diminishing Returns (Law
of Variable Proportions)…
 The law which brings out the relationship
between varying factor properties and
output are known as the law of variable
proportion.
 The variation in inputs lead to a
disproportionate increase in output more
and more units of variable factor when
applied cause an increase in output but
after a point the extra output will grow
less and less. The law which brings out
this tendency in production is known as
Law of Diminishing Returns.

16. Continue…
 The law of diminishing returns levels that any
attempt to increase output by increasing only
one factor finally faces diminishing returns.
 The law states that when some factors
remain constant, more and more units of a
variable factors are introduced the production
may increase initially at an increasing rate;
but after a point it increases only at
diminishing rate.
 Land and capital remain fixed in the short-
term whereas labor shows a variable nature.

17. 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)

18. Continue…
 Average product is the product for one unit of
labor, arrived by dividing the total product by
number of workers.
 Marginal product is the additional product
resulting term additional labor, calculated by
dividing the change in total product by the
change in the number of workers.
 From table we can see that the total output
increases at the increasing rate till the
employment of the 4th worker. Any additional
labor employed beyond the 4th labor clearly
faces the operation of the Law of Diminishing
returns.

19. Continue…
 The graphical representation of the table is as below:

20. Continue…
 The law of diminishing returns operation
at three stages.
 At the first stage, total product, marginal
product, average product increases at an
increasing rate. this stage continues up
to the point where AP is equal to MP.
 At the second stage, the TP continues to
increase but at a diminishing rate. As the
MP at this stage starts falling, the AP
also declines. This stage ends where TP
become maximum and MP becomes
zero.

21. Continue…
 The marginal product becomes
negative in the third stage. Total
product also declines. The average
product continues to decline in the
third stage.

22. 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.

23. 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.

24. Increasing Returns to Scale
 Proportionate increase in all factor of production
results in a more than proportionate increase in
output.
 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)

25. Constant Returns to scale
 When all inputs are increased by a certain
percentage, the output increases by the same
percentage, the production function is said to
exhibit 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)

26. Diminishing Returns to Scale
 The term ‘diminishing’(Decreasing) returns to
scale where output increases in a smaller
proportion 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)

27. 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.

28. 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

29. Internal Economies of Scale
 Internal economies are those which arise
from the explanation of the plant-size of
the firm.
 Internal economies of scale may be
classified as:
1. Economies in production
2. Economies in marketing
3. Economies in management
4. Economies in transport and storage

30. Economies in Production
 It arises from
1. Technological advantages
2. Advantages of division of labor and
specialization

31. 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

32. Managerial Economies
 It achieves through:
1. Specialization in management
2. Mechanization of managerial
fucntion

33. Economies in Transport and
Storage
 Economies in transportation and
storage costs arise from fuller
utilization of transport and storage
facilities.

34. External Economies of Scale
 External economies to large size firms arise
from the discounts available to it due to
1. Large scale purchase of raw materials
2. Large scale acquisition of external finance
at low interest
3. Lower advertising rate from advertising
media
4. Concessional transport charge on bulk
transport
5. Lower wage rates if large scale firm is
monopolistic employer of certain kind of
specialized labor.

35. Continue…
 External economies of scale are strictly
based on experience of large-scale firms
or well managed small scale firms.
 Economies of scale will not continue for
ever.
 Expansion in the size of the firms beyond
a particular limit, too much specialization,
inefficient supervision, improper labor
relations etc will lead to diseconomies of
scale.

36. 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.

37. 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

38. 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

39. Fixed Cost
 Fixed cost are those costs which do not
vary with the volume of production.
 Even if the production is zero, a firm will
have to incur fixed costs.
 Examples are rent, interest, depreciation,
insurance, salaries etc.
 It is also called supplementary costs,
capacity costs or period costs or
overhead costs.

40. Variable Cost
 Variable costs are those costs which change
with the quantity of production.
 When the output increases, variable cost also
increases and when the output decreases,
the variable cost also decreases.
 Examples are materials, wages, power,
stores etc.
 Variable costs are also known as prime costs
or direct costs.

41. 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.

42. Full Cost
 The concept of full costs, includes
business costs, opportunity costs and
normal profits.

43. 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.

44. 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

45. Marginal Cost
 Marginal cost is the additional cost to
total cost when an additional unit is
produced.

46. Breakeven Analysis
 BEA is a technique that helps decision
makers understand the relationships
among sales volume, costs and
revenues in any organization.
 It is graphical method of analyzing and
also known as Cost Volume Profit (CVP)
analysis.
 In this method, Break-even Point (BEP)
i.e. the level of sales volume to which
total revenues equal total costs is
determined.

47. Assumptions under BEA
1. It assumes that the total cost is divided into two categories
i.e. i) fixed cost and ii) variable cost. It totally ignores the
semi-variable costs.
2. Fixed cost remains constant throughout the volume of
production.
3. The selling price if the product is constant throughout the
sale.
4. The variable cost changes proportionally (at constant rate)
with volume of production.
5. All the goods produced are sold, i.e. volume of production
and sales are equal or there is no closing stock.
6. The firm is producing only one type of product. In case of
multi-product firm, the product mix is stable.

48. Applications of BEA. . .
1. Break-even analysis is useful in determining
optimum level of output, below which it is not
profitable for the firm to produce its products.
2. To determine minimum cost for a given level
of output.
3. To determine impact of changes in cost or
selling price on break-even analysis.
4. Managerial decision on adding or dropping
product is done by break-even analysis.

49. . . .Applications of BEA
5. It also helps in choosing a product mix when
there ia a limiting factor.
6. Break-even analysis shoes likely profits and
losses 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 of
management.

50. Limitations of Break-Even
Analysis. . .
1. The analysis is based on fixed costs,
variable costs and total revenue. Any
change in one variable affects break-
even point.
2. Semi-variable costs and depreciation
are not accounted which is significant in
any manufacturing firm.
3. Multiple charts are to be produced in
case of multi-product firm.

51. . . .Limitations of Break-Even
Analysis
4. The effect of technological
development, managerial effectiveness
also determines profitability. These
factors are not considered in break-
even chart.
5. The break-even chart is based on fixed
cost concept and hence holds good for
a short period.
6. Break-even analysis is not suitable
under fluctuating business environment.

52. 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

53. Terminologies used in BEA. . .
 Fixed Costs (FC): Costs that remain the
same regardless of volume of output.
 Cost of land/building/machinery, top
management salary, taxes on property,
depreciation, insurance etc. are FC.
 Variable Costs (VC): Costs which are
dependent on volume of production.
 Cost of materials, wages, packaging costs,
transportation of finished products etc. are
VC.

54. . . .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

55. . . .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)]

56. . . .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 in
production capacity may decrease the profits
considerably.
 There should be reasonable margin of safety
otherwise it may be disastrous for the
organization.
 Low margin of safety is the indication of high
fixed costs.

57. . . .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 are
being made at less favorable conditions.
 Contribution: It is the difference between the
selling 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]

58. . . .Terminologies used in BEA
 Profit Volume Ratio (P/V Ratio): It is
the measure of profitability. It is also
known 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

59. Thank You