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Theory of Production and Cost, Break-even Analysis

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Theory of Production and Cost, Break-even Analysis

  1. 1. Sarvajanik College of Engineering and Technology Subject: Management Project By: ● Kumar Pawar - 130420109538 ● Rangat Mehta – 130420109518 ● Jay Kheni - 130420109513
  2. 2. Topics Covered in Presentation Theory of Production Concept of Costs Break Even Analysys - BEP
  3. 3. Theory of Production Topics Covered: 1. Meaning of Production 2. Production Function 3. Factors of Production 4. Law of variable proportions & Law of returns to scale
  4. 4. Meaning of Production Production is a process of combining various material inputs and immaterial inputs (plans, know-how) in order to make something for consumption (the output). It is the act of creating output, a good or service which has value and contributes to the utility of individuals. Economic well-being is created in a production process, meaning all economic activities that aim directly or indirectly to satisfy human needs. The degree to which the needs are satisfied is often accepted as a measure of economic well-being. The satisfaction of needs originates from the use of the commodities which are produced. The need satisfaction increases when the quality-price-ratio of the commodities improves and more satisfaction is achieved at less cost. Improving the quality-price-ratio of commodities is to a producer an essential way to enhance the production performance but this kind of gains distributed to customers cannot be measured with production data
  5. 5. Production Function The production function is the relationship between the maximum amount of output that can be produced and the inputs required to make that output. Put in other way, the function gives for each set of inputs, the maximum amount of output of a product that can be produced. It is defined for a given state of technical knowledge (If technical knowledge changes, the amount of output will change.) A production function is a model (usually mathematical) that relates possible levels of physical outputs to various sets of inputs, eg. Q = f (Labour, Kapital, Land, technology, . . . ). To simplify the world, we will use two inputs Labour (L) and Kapital (K) so, Q = f (L, K, technology, ...)
  6. 6. Factors of Production According to classical economics there are 3 factor of production and they are: ● Land or Natural Resource: Naturally occurring goods like water, air, soil, minerals, flora and fauna that are used in the creation of products. The payment for use and the received income of a land owner is rent. ● Labor: human effort used in production which also includes technical and marketing expertise. The payment for someone else's labor and all income received from ones own labor is wages. Labor can also be classified as the physical and mental contribution of an employee to the production of the good(s). ● The Capital Stock: human-made goods which are used in the production of other goods. These include machinery, tools, and buildings.
  7. 7. Law of variable proportions & Law of returns to scale Under Law of variable proportion: only one variable input varies all other variable kept constant. Under Law of Return to Scale: All the variable inputs varies except the enterprise. Law of variable proportion is for short period; law of return to scale is for long period. Law of variable proportion shows the relationship if one variable input increase (eg: Labour) by keeping all other variable constant; total product and marginal product increase upto a certain point after that it will increase at a diminishing rate. it shows in three stage first increase then constant and then decrease. Law of return to scale shows the relationship between inputs and output at three different stages: 1. output increase more than inputs, 2. output and input are constant, 3. output is less than proportionate input.
  8. 8. Concept of Cost Topics Covered: ● What is Cost? ● Short run & Long run cost ● Fixed & Variable cost ● Total & Average cost ● Marginal & Opportunity cost
  9. 9. What is Cost? An amount that has to be paid or given up in order to get something. In business, cost is usually a monetary valuation of (1) effort, (2) material, (3) resources, (4) time and utilities consumed, (5) risks incurred, and (6) opportunity forgone in production and delivery of a good or service. All expenses are costs, but not all costs (such as those incurred in acquisition of an income-generating asset) are expenses.
  10. 10. Short run & Long run Cost Short run cost: All production in real time occurs in the short run. The short run is the conceptual time period in which at least one factor of production is fixed in amount and others are variable in amount. Costs that are fixed, say from existing plant size, have no impact on a firm's short-run decisions, since only variable costs and revenues affect short-run profits. Such fixed costs raise the associated short-run average cost of an output long-run average cost if the amount of the fixed factor is better suited for a different output level. In the short run, a firm can raise output by increasing the amount of the variable factor(s), say labor through overtime. A generic firm already producing in an industry can make three changes in the short run as response to reach a posited equilibrium: ● increase production ● decrease production ● shut down Long run cost: In the long run, firms change production levels in response to (expected) economic profits or losses, and the land, labor, capital goods and entrepreneurship vary to reach associated long-run average cost. In the simplified case of plant capacity as the only fixed factor, a generic firm can make these changes in the long run: ● enter an industry in response to (expected) profits ● leave an industry in response to losses ● increase its plant in response to profits ● decrease its plant in response to losses.
  11. 11. Fixed & Variable cost Variable Cost: Variable costs are costs that change in proportion to the good or service that a business produces. Variable costs are also the sum of marginal costs over all units produced. They can also be considered normal costs. Fixed costs and variable costs make up the two components of total cost. Direct costs, however, are costs that can easily be associated with a particular cost object. However, not all variable costs are direct costs. For example, variable manufacturing overhead costs are variable costs that are indirect costs, not direct costs. Variable costs are sometimes called unit-level costs as they vary with the number of units produced. Direct labor and overhead are often called conversion cost, while direct material and direct labor are often referred to as prime cost. Fixed Cost: In economics, fixed costs, indirect costs or overheads are business expenses that are not dependent on the level of goods or services produced by the business.[1] They tend to be time-related, such as salaries or rents being paid per month, and are often referred to as overhead costs. This is in contrast to variable costs, which are volume-related (and are paid per quantity produced). In management accounting, fixed costs are defined as expenses that do not change as a function of the activity of a business, within the relevant period. For example, a retailer must pay rent and utility bills irrespective of sales.
  12. 12. Total & Average cost Total cost: In economics, and cost accounting, total cost (TC) describes the total economic cost of production and is made up of variable costs, which vary according to the quantity of a good produced and include inputs such as labor and raw materials, plus fixed costs, which are independent of the quantity of a good produced and include inputs (capital) that cannot be varied in the short term, such as buildings and machinery. Total cost in economics includes the total opportunity cost of each factor of production as part of its fixed or variable costs. The rate at which total cost changes as the amount produced changes is called marginal cost. This is also known as the marginal unit variable cost. Average cost: In economics, average cost or unit cost is equal to total cost divided by the number of goods produced (the output quantity, Q). It is also equal to the sum of average variable costs (total variable costs divided by Q) plus average fixed costs (total fixed costs divided by Q). Average costs may be dependent on the time period considered (increasing production may be expensive or impossible in the short term, for example). Average costs affect the supply curve and are a fundamental component of supply and demand.
  13. 13. Marginal & Opportunity cost Marginal cost: In economics and finance, marginal cost is the change in the total cost that arises when the quantity produced has an increment by unit. That is, it is the cost of producing one more unit of a good. In general terms, marginal cost at each level of production includes any additional costs required to produce the next unit. For example, if producing additional vehicles requires building a new factory, the marginal cost of the extra vehicles includes the cost of the new factory. In practice, this analysis is segregated into short and long-run cases, so that over the longest run, all costs become marginal. At each level of production and time period being considered, marginal costs include all costs that vary with the level of production, whereas other costs that do not vary with production are considered fixed. Opportunity cost: In microeconomic theory, the opportunity cost of a choice is the value of the best alternative forgone, in a situation in which a choice needs to be made between several mutually exclusive alternatives given limited resources. Assuming the best choice is made, it is the "cost" incurred by not enjoying the benefit that would be had by taking the second best choice available. The New Oxford American Dictionary defines it as "the loss of potential gain from other alternatives when one alternative is chosen". Opportunity cost is a key concept in economics, and has been described as expressing "the basic relationship between scarcity and choice". The notion of opportunity cost plays a crucial part in ensuring that scarce resources are used efficiently. Thus, opportunity costs are not restricted to monetary or financial costs: the real cost of output forgone, lost time, pleasure or any other benefit that provides utility should also be considered opportunity costs.
  14. 14. Break Even Analysis Meaning: The break-even level or break-even point (BEP) represents the sales amount—in either unit or revenue terms—that is required to cover total costs (both fixed and variable). Total profit at the break-even point is zero. Break-even is only possible if a firm’s prices are higher than its variable costs per unit. If so, then each unit of the product sold will generate some “contribution” toward covering fixed costs. For example, if a business sells fewer than 200 tables each month, it will make a loss; if it sells more, it will make a profit. With this information, the business managers will then need to see if they expect to be able to make and sell 200 tables per month. If they think they cannot sell that many, to ensure viability they could: ● Try to reduce the fixed costs (by renegotiating rent for example, or keeping better control of telephone bills or other costs) ● Try to reduce variable costs (the price it pays for the tables by finding a new supplier) ● Increase the selling price of their tables. Any of these would reduce the break-even point. In other words, the business would not need to sell so many tables to make sure it could pay its fixed costs.
  15. 15. Objective of BEP The main objective of break-even analysis is to find the cut-off production volume from where a firm will make profit. Let s=selling price per unit v=variable cost per unit FC=fixed cost per period Q=volume of production The total sales revenue (S) of the firm is given by the following formula: S = s ́Q The total cost of the firm for a given production volume is given as TC = Total variable cost + Fixed cost = v ́Q + FC The linear plots of the above two equations are shown in figure. The intersection point of the total sales revenue line and the total cost line is called the break-even point
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