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UNIT-III THEORY OF PRODUCTION & COST ANALYSIS Concept of Production It a manufacturing process It’s a process of different commodities Its includes Raw material, Work in progress & finished goods. Concept of Production Basically 3 components in the production process Product Productivity production 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 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.” Process Inputs Outputs Money Tangible goods Man Material Machinery Production In tangible Goods Services Types of production functions Basically 2 types of functions 1.Short run production function 2.Long run production function Short run production function Q= f (L,C,M) Q = quantity of output produced L = Labor units C = Capital employed M = Material F = Function 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 Isoquant curve It is curve based on production or sales or purchases It is profit curve also 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. Meaning & Definition Iso quants are used to present a production function with two variable inputs. Eg. Let us consider a production function with the quantities of out put produced by using different combinations of two inputs such as labor and capital Meaning & Definition In other words an iso quant is a line joining different combinations of labor and capital that yield the same level of production. Eg. Quantity of out put produced. Types of iso quants Basically 3 types Linear iso quant L-shape iso quant Kinked iso quant Y price P P1 O X M M1 Demand Types of iso quants Linear iso quant L-shape iso quant Kinked iso quant Y Y C a p it a l C a p it a l O C a p it a l C1 C2 O x Labor L1 Labor x Labor L2 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. C a p it a l Labor Types of Iso cost curves C a p it a l C a p it a l Labor Super imposition of iso cost curve Iso quant showing line of price level Labor Assumptions of Isoquant curves An isoquant curve has two inputs say labor and capital to produce an out put. The two inputs are perfectly substitutable to each other but at a diminishing rate. The technology applied in the production process in given or constant. The substitution of one input for the other levels the output unaffected. MRTS of Isoquant (Marginal Rate of Technical Substitutions) If we assumed tow factors of production say labor and capital. Then the marginal rate of technical substitution of capital for labor is the number of units of labor which can be replaced by one unit of capital, which the quantity of output remaining the same. Least cost combination of inputs When a consumer I faced with the problem of making choice b/w two or more goods with given resources. The producer may be reach an optimum point by choosing the leastcost combination of inputs The producer will choose that combination of inputs with produces maximum out puts at lowest cost. Formulae 1. Managerial product of input X Price of input of X 1. Managerial product of input Y Price of input of Y Expansion path U N I T S O F C A P I T A L K5 K4 K3 K2 K1 L1 L2 L3 L4 UNITS OF LABOR L5 The expansion path is the curve along with out expands when factor prices remain constant. The expansion path shows how factor proportions change when out put or expenditure change 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 Properties for output (Q) to exist both labor and capital should be positive and not equal to zero. Q = A La K1-b , L>0,K<0 The addition of parameters is equal to one b+1-b = 1 The later version of production function Parameters It helps to find out the short run relationship between Input and Out put 1.Martinal product of labor (MPL) 2.Marginal product of capital (MPC) 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 Law of Returns to scale A 2 B = INCREASING RETURNS TO SCALE B A B 2 C = CONSTANT G RETURNS TO SCALE C C 2 D = DECREASING RETURNS TO SCALE D Law of Returns to scale 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% Law of Returns to scale Y o Y X o Y X o X 1.Increase in returns to scale 2.Constant returns to scale 3.Decreasing in returns to scale Economies of scale Basically 3 types of Economies 1. Small scale 2. Medium scale 3. Large scale Law of returns also confined in accordance with the scale of proportion of the firm. 1.Increasing Returns 2. Constant Returns 3. Decreasing Returns Types of Economies Basically 2 types of Economies 1. Economies of scale 2. Diseconomies of scale Economies of scale Internal or Real Economies 1. Economies in production 2. Economies in Marketing 3. Managerial Economies 4. Economies in Transport & Storage Economies of scale (contd..) 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 Diseconomies of scale 1. Internal Diseconomies 2. External Diseconomies Introduction to Cost analysis It means a piece of work It is process of Raw material and work in progress It is a unit price of commodity Types of Cost analysis Actual cost Opportunity cost Sunk cost Incremental cost Explicit cost Implicit cost or imputed cost Book cost Out of pocket cost Accounting cost Economic cost Types of Cost analysis (contd..) Direct cost Controllable cost Non-controllable cost Historical cost or Replacement cost Shut down cost Abandonment cost Urgent cost and postponement cost Business cost and full cost Fixed cost Variable cost Types of Cost analysis (contd..) Total cost Average cost Marginal cost Short-run cost Long run cost AVC, AFC, ATC Analysis 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) Analysis (contd..) 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 Analysis (contd..) 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 Analysis (contd..) Incremental cost Incremental costs are additions to costs resulting from a change in the nature or level of a business activity. As these costs can be avoided by not bringing any variation in the activity, they are also called as “avoidable costs”. Or “Escapable costs”. Eg. Change in distribution channel adding or deleting a product in the product line, replacing a machinary. Analysis (contd..) 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 Analysis (contd..) Implicit or Imputed cost These cots are a part of opportunity cost. they are the theoretical costs. i.e. they are not recognized by accounting system and are not recorded in the books of accounts. But are very important in certain decisions. They are also called as imputed costs. Eg. Rent on idle time, depreciation on fully depreciated property still in use, interest on equity capital. Analysis (contd..) 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 Analysis (contd..) 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 Analysis (contd..) 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. Analysis (contd..) 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. Analysis (contd..) 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. Analysis (contd..) 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 Analysis (contd..) 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 Analysis (contd..) 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. Analysis (contd..) 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. Analysis (contd..) 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.. Analysis (contd..) 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 Analysis (contd..) Urgent cost and Post ponable cost 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 ot effect the operational efficiency of the firm Eg. Maintenance of costs Analysis (contd..) 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. Analysis (contd..) 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. Analysis (contd..) Fixed costs Y Fixed cost curve Total fixed cost O X Output (Q) Analysis (contd..) Variable cost Variable costs ae 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. Analysis (contd..) Variable cost Y Variable cost curve Total variable cost O X Output (Q) Analysis (contd..) 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 Analysis (contd..) Total cost curve Y Total cost Total cost O X Output (Q) Analysis (contd..) 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. TC AC = Q TC = Total cost incurred in production process. Q = Output cost Analysis (contd..) 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 Analysis (contd..) Marginal cost curve Y Marginal cost Marginal cost O X Output (Q) Analysis (contd..) Short run cost and Long run cost Both short run and long run costs are related foxed and variable costs and are often used in economic analysis. 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. Analysis (contd..) Average fixed cost (AFC) Average fixed cost is defined as the ratio of total fixed cost and the total number of units produced/output. Average fixed cost is given by TFC AFC = -------Q AFC = Average fixed cost TFC = Total Fixed cost Q = Output Analysis (contd..) Average fixed cost (AFC) Y AFC AFC O X Output (Q) Analysis (contd..) Average variable cost (AFC) Y AVC TVC AVC = -------- AVC Q AVC = Average variable cost TVC = Total Variable cost Q = Output O X Output (Q) Analysis (contd..) Average Total cost (AFC) Y ATC TC ATC = -------- ATC Q ATC = Average total cost TC = Total cost Q = Output O X Output (Q) Analysis (contd..) 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 chart Y Total Revenue line Profit zone TC line Profit Fixed cost zone Cost/Revenue BEP VC line Loss Variable cost zone O X Sales/production Advantages of BEP To achieve a given amount of profit the break even analysis can be used to determine the sales volume. It can be used to forecast the future cost and revenue and it can predict the profit. To control the cost in business the cost functions used in break even analysis can be useful. The break even analysis useful for profit planning in business. The break even analysis can be useful in sales projection. Formulas of BEP 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 Contribution 4. P/V Ratio = sales X 100 Formulas of BEP Contribution X 100 4. P/V Ratio = sales Sales - VC X 100 = Sales Fixed cost + profit X 100 = Sales Formulas of BEP Profit X 100 4. P/V Ratio = MS Ratio change in contribution X 100 = change in sales Formulas of BEP Contribution 5. Sales X 100 = P/V Ratio Fixed cost 6. BEP (in uts) = X 100 Contribution per unit Formulas of BEP FC X S 6. BEP (in Rs.) = S–V 7. Margin of safety = Total sales – BEP Sales Total sales - BEP Sales = Total Sales Formulas of BEP 8. Variable cost = Sales – fixed cost 9. Profit = (Sales x P/V Ratio) – FC = P/V Ratio x M/S Ratio x Sales