THEORY OF PRODUCTION & COST ANALYSIS

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Mr. R S Ch Murthy Chodisetty
M.Com., MBA (HR)., MBA (FIN)., (PhD).
Faculty of Management, Sreenidhi Institute of Science and Technology,
Hyderabad, Telangana.
2

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THEORY OF PRODUCTION & COST ANALYSIS
LECTURE-2

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Concept of Production:
It a manufacturing process
It’s a process of different commodities
Its includes Raw material, Work in progress & finished goods.
Product
Productivity
production

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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

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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.”

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TYPES OF PRODUCTION FUNCTIONS:
1.Short run production function
2.Long run production function

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Short run production function:
Q= f (L,C,M)
Q = quantity of output produced
L = Labor units
C = Capital employed
M = Material
F = Function

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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

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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

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Marginal Rate of Technical Substitutions:
he marginal rate of technical substitution (MRTS) is the rate at which one
factor must decrease so that the same level of productivity can be maintained
when another factor is increased. The MRTS reflects the give-and-take
between factors, such as capital and labor, that allow a firm to maintain a
constant output.

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Isoquant curve:
®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.

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Types of iso quants:
Basically 3 types
®Linear iso quant
®L-shape iso quant
®Kinked iso quant

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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.

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Law of Returns to scale:
® 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
® 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

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Law of Returns to scale:

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Law of Returns to scale-Types:
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
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%

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Diagrammatic:

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Economies of scale:
Basically 3 types of Economies
1. Small scale
2. Medium scale
3. Large scale

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Types of Economies:
Basically 3 types of Economies
1. Small scale
2. Medium scale
3. Large scale

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Types of Economies:
Basically 2 types of Economies
1. Economies of scale
2. Diseconomies of scale

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Internal Or Real Economies :
1. Economies in production
2. Economies in Marketing
3. Managerial Economies
4. Economies in Transport & Storage

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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

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Types of Cost analysis:
1. Actual cost
2. Opportunity cost
3. Sunk cost
4. Incremental cost
5. Explicit cost
6. Implicit cost or imputed cost
7. Book cost
8. Out of pocket cost
9. Accounting cost
10. Economic cost

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Types of Cost analysis:
1. Direct cost
2. Controllable cost
3. Non-controllable cost
4. Historical cost or Replacement cost
5. Shut down cost
6. Abandonment cost
7. Urgent cost and postponement cost
8. Business cost and full cost
9. Fixed cost
10. Variable cost

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Types of Cost analysis:
1. Total cost
2. Average cost
3. Marginal cost
4. Short-run cost
5. Long run cost
6. AVC, AFC, ATC

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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)

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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

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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

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INCREMENTAL 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. Change in distribution channel adding or deleting a product in the
product line, replacing a machinery

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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

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IMPLICIT OR IMPUTED 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. Rent on idle time, depreciation on fully depreciated property still in
use, interest on equity capital.

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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

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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

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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.

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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.

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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.

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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

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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

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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.

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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.

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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..

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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

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URGENT COST AND POST PONABLE C:
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 of effect
the operational efficiency of the firm
Eg. Maintenance of costs

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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.

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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.

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VARIABLECOSTS :
Variable costs are 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.

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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

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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.

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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

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SHORT RUN COST AND LONG RUN COST :
 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.

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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 analysis is a technique widely used by production management
and management accountants. ... Total variable and fixed costs are compared
with sales revenue in order to determine the level of sales volume, sales
value or production at which the business makes neither a profit nor a loss
(the "break-even point").

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ADVANTAGES OF BEP:
1. To achieve a given amount of profit the break even analysis can be used to
determine the sales volume.
2. It can be used to forecast the future cost and revenue and it can predict the
profit.
3. To control the cost in business the cost functions used in break even analysis
can be useful.
4. The break even analysis useful for profit planning in business.
5. The break even analysis can be useful in sales projection.

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ADVANTAGES OF BEP:
1. To achieve a given amount of profit the break even analysis can be used
to determine the sales volume.
2. It can be used to forecast the future cost and revenue and it can predict
the profit.
3. To control the cost in business the cost functions used in break even
analysis can be useful.
4. The break even analysis useful for profit planning in business.
5. The break even analysis can be useful in sales projection.

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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
4. P/V Ratio = Contribution/sales
= Sales – VC/Sales
= Fixed cost + profit/Sales
5. Sales = Contributions/ P/V Ratio

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6. BEP (in units) = Fixed cost/Contribution per unit
7. BEP (in rupees) = Fixed cost X Sales / Sales- VC
8. Margin of safety = Total sales – BEP Sales
9. Variable cost = Sales – fixed cost
10. Profit = (Sales x P/V Ratio) – F
= P/V Ratio x M/S Ratio x Sales

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THANK YOU