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THEORY OF PRODUCTION AND COST
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theory of production and cost

  1. 1. Unit 2 Theory of Production and Cost
  2. 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. 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. 4. Production Function  A firm has two types of production function: 1. Short run production function 2. Long run production function
  5. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 19. Continue…  The graphical representation of the table is as below:
  20. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 30. Economies in Production  It arises from 1. Technological advantages 2. Advantages of division of labor and specialization
  31. 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. 32. Managerial Economies  It achieves through: 1. Specialization in management 2. Mechanization of managerial fucntion
  33. 33. Economies in Transport and Storage  Economies in transportation and storage costs arise from fuller utilization of transport and storage facilities.
  34. 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. 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. 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. 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. 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. 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. 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. 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. 42. Full Cost  The concept of full costs, includes business costs, opportunity costs and normal profits.
  43. 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. 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. 45. Marginal Cost  Marginal cost is the additional cost to total cost when an additional unit is produced.
  46. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 59. Thank You
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