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Unit-II
Theories of Production and Cost analysis

Production Function:

Michael R Baye defines production function as “that function which

defines the maximum amount of output that can be produced with a given set

of input”.

Production function is more concerned with physical aspects of

production. It is the concern of the engineer rather than that of the manager to

know how much can be the production with a given set of input.

Input-Output Relationship or Production function

The inputs for any product or services are land, labor, capital,

organization, and technology. In other words, the production here is the

function of these five variable inputs. Mathematically, this is expressed as!

Q = f (L1, L2, C, O, T)

Where!

Q = Quantity or product, F = Explains the function, L1 = Land, L2 = Labor,

C = Capital, O = Organization. T = Technology. These inputs have been

conventional terms. In reality, materials also can be included in a set of inputs.

A manufacturer has to make a choice of the production function by

considering his technical knowledge, the process of various factors of

production and his efficiency level to manage. He should not only select the

factors of production but also should work out the different permutations and

combinations which will mean lower cost of inputs for a given level of

production.
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Production functions with One Variable Input and Laws of Returns:

The Law of return states that when at least one factor of

production is fixed or factor input is fixed and when all other factors are varied,

the total output in the initial stages will increase at an increasing rate, and after

reaching certain level of output the total output will increase at declining rate. If

variable factor inputs are added further to the fixed factor input, the total input

may decline. The law is of universal nature and it proved to be true in

agriculture and industry also. The Law of Returns is also called the Law of

Variable Proportions or Law of diminishing returns.

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Output with Fixed Capital and Variable Labor Input

Units of Total Marginal Average Stages

Labour Product Product Product
(TP) (MP) (AP)
0 0 0 0 Stage I
1 10 10 10
2 22 12 11
3 33 11 11 Stage II
4 40 7 10
5 45 5 9
6 48 3 8
7 48 0 6.85 Stage III
8 45 -3 5.62

In the short run, it is assumed the capital is a fixed factor input and labout is

variable input. It is also assumed that technology is given and is not change.

Under such circumstances , the firm starts production with a fixed amount of

capital and uses more and units of labour.

In the initial stage, output increases at an increasing rate because

capital is grossly underutilized. Productivity will increase up to point A when

more units of labour are increased. After point A, output increases at a

declining rate till the it reaches maximum at point C. After point C, the total

output declines and the marginal product of labout is negative. This indicates

that the additional units of labour are not contributing anything positively to the

total output. Even if labour is available free of cost, it is not worth using it.
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Production Function with Two Variable Inputs and Law of

Returns

Let us consider a production process that required two inputs, capital (C)

and labour (L) to produce a output (Q). These could be more than two inputs

in a real life situation, but a simple analysis, we restrict the number of inputs to

two only. In other words, the production function based on two inputs can be

expressed as:

EQ = f(C, L)

Where C refers to Capital, L is Labour.

Normally, both capital and labour are required to produce. To some

extent, these two inputs can be substituted for each other. Hence the producer

may choose any combination of labour and capital that gives him the required

number of units of output.

For any given level of output , a producer may hire both capital and labour,

but he is free to choose any one combination of labour and capital out of

several such combinations. The alternative combinations of labour and capital

yielding a given level of output are such that if the use of one factor input is

increased, that of another will decrease and vice versa.

However, the units of an input foregone to get one unit of the other input

changes, depends upon the degree of substitutability between the two input

factors. Based on the techniques or technology used, the degree of

substitutability may vary.

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Isoquants
‘Iso’ means equal; ‘Quant’ means quantity. Isoquant means that the

quantities throughout a given Isoquant are equal. Isoquants are also called

isoproduct curves. An isoquant curve shows various combinations of two input

factors such as capital and labour, which yield the same level of output.

As an isoquant curve represents all such combinations which yield

equal quantity of output, any or every combination is a good combination for

the manufacturer. Since he prefers all these combinations equally, an isoquant

curve is also called ‘product indifference curve’.

The concept of Isoquant is explained in through Table:

Combinations Capital ([Link] Lakh) [Link] Labourers

A 1 20
B 2 15
C 3 11
D 4 8
E 5 6
F 6 5

According above table shows the different combination of input factors to

yield an output of 20,000 units of output. As the investment goes up, the

number of labourers can be reduced. The combination of A shows I unit of

capital and 20 units of labour to produce say, 20,000 units of output. All the

above combinations of inputs can be plotted on a graph, the locus of all the

possible combinations of input shows up an Isoquant as shown in fig.

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Features of an Isoquant
Downward sloping: Isoquants are downward sloping curve because, if one

input increases, the other one reduces. There is no question of increase in

both the inputs to yield a given output.

Convex to origin: Isoquants are convex to origin. It is because the input

factors are not perfect substitutes. One input factor can be substituted by other

input factor in a diminishing marginal rate. Isoquant shape L.

Do not intersect: Two do not intersect with each other. It is because, each of

these denote a particular level of output. If the manufacture wants to operate

at a higher level of output, he has to switch over to another isoquant with a

higher level of output and vice versa.

Do not touch axes: The is quant touches neither X- axis nor Y-axis, as both

inputs are required to produce a given product.

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Marginal Rate of Technical Substitution

The marginal rate of technical substitution (MRTS) refers to the rate

at which one input factor is substituted with the other to attain a given level of

output. In other words, the lesser units of one input must be compensated by

increasing amounts of another input to produce the same level of output.

Presents the ratio of MRTS between the two input factors, say capital and

about. 5 units of decrease in labour are compensated by an increase in 1 unit

of capital, resulting in a MRTS.

Ratio of MRTS between Capital and Labour

Combinations Capital([Link]) Labour MRTS

A 1 20 _
B 2 15 5:1
C 3 11 4:1
D 4 8 3:1
E 5 6 2:1
F 6 5 1:1
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Change in one input ∆K

MRTS = –––––––––––––––––– Or ––––

Change in another input ∆L

∆K = Changing in Capital, ∆L = Changing in Labour.

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IsoCosts

Isocosts refers to that cost curve that represents the combination of

inputs that will cost the producer the same amount of money. In other words,

each isocost denotes a particular level of total cost for a given level of

production. .

If the level of production changes, the total cost changes and thus the

isocost curve moves upwards, and vice versa.

Present three downward sloping straight line cost curves (Assuming

that the input price fixed, no quantity discount are available) each costing

Rs.1.0Lakh, Rs.1.5Lakh and Rs. 2.0Lakh for the output levels of 20,000,

30,000 and 40,000 units. (The total cost, as represented by each cost curve, is

calculated by multiplying the quantity of each input factor with its respective

price.)

Isocosts farther from the origin, for given input costs, are associated with

higher costs. Any change in input price changes the slope if isocost lines.
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Least cost Combination of Inputs

The manufacture has to produce at lower costs to attain higher profits.

The isocosts and isoquants can be used to determine the usage that

minimizes the cost of production.

Where slope of isoquant is equal to that of isocost, there lays the lowest

point of cost of production. This can be observed by superimposing isocost on

isoproduct curves. It is evident that the producer can, with a total outlay of Rs.

1.5lakh, reach the highest isoquant curve which is IQ2.

If he wants to reach IQ3. He has to bring additional resources, which is,

let us assume, not possible. He cannot compromise with IQ1. As it means

lower output. There is no other input combination on IQ2 other than point Q,

which is cheaper than Rs.1.5lakh. So the obvious choice for the producer is Q

combination of inputs only on IQ2.

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The points of tangency P, Q and R on each of the isoquant curves

represent the least cost combination of inputs, yielding maximum level of

output. Any output lower or higher than this will result in higher cost of

production.

Cobb – Douglas Production Function

Cobb and Douglas put forth a production relating output in American

manufacturing industries from 1899 to 1922 to labout and capital inputs. They

used the following formula:

Where P is Total Output,

L = the index of employment of Labour in manufacturing

C = index of fixed capital in manufacturing

The exponents ‘a’ and ‘1-a’ are the elasticity of production.

The measure the percentage response of output to percentage change in

labour and capital respectively.

The function estimated for the USA by Cobb and Douglas is

The production function shown that one percentage change in labour input,

capital remaining the same, is associated with a 0.75 percentage in output.

Similarly, one percentage change in capital labour remaining the same is

associated with a 0.25 percentage change in output change in output.

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The coefficient of determination means that 94% of the variations on

the dependent variable (P) where account for by the variations in the

independent variables (L and C). it is indicates constant returns to scale which

means that there are no economics or diseconomies of large scale of

production.

On an average, large or small scale plants are considered equally

profitable in the US manufacturing industry, on the assumption that the

average and marginal production costs were constant.

Though Cobb-Douglas production function was based on macro-level study,

it has been very useful for interpreting economic results. Later investigations

revealed that the sum of the exponents might be very slight large than unity,

which implies decreasing costs. But the difference was so marginal that

constant costs would seem to be a safe assumption for all practical purposes.
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Leontief production function

In economics, the Leontief production function or fixed proportions

production function is a production function that implies the factors of

production will be used in fixed (technologically pre-determined) proportions,

as there is no substitutability between factors. It was named after Wassily

Leontief and represents a limiting case of the constant elasticity of

substitution production function.

For the simple case of a good that is produced with two inputs, the function is

of the form:

Q=Min (Z1/a, Z2/b).

where q is the quantity of output produced, z1 and z2 are the utilized quantities

of input 1 and input 2 respectively, and a and b are technologically determined

constants.

Example

Suppose that the intermediate goods "tires" and "steering wheels" are used in

the production of automobiles (for simplicity of the example, to the exclusion of

anything else). Then in the above formula q refers to the number of

automobiles produced, z1 refers to the number of tires used, and z2 refers to

the number of steering wheels used. Assuming each car is produced with 4

tires and 1 steering wheel, the Leontief production function is Number of cars

= Min{¼ times the number of tires, 1 times the number of steering wheels}.
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Returns to Scale and Returns to Factors

Returns to scale refers to the returns enjoyed by the firm as a result of

change in all the inputs. Its explains the behavior of the returns when the

inputs are changed simultaneously. The returns to scales are governed by law

of returns to scale.

Law of Returns to Scale: There are 3 of returns governing production. They

are

1. Law of Increasing Returns to Scale: This Law states that the volume of

output keeps on increasing with every increase in the inputs. Where a given

increase in inputs leads to a more than proportionate increase in the output,

the law of increasing returns to scale is said to operate. We can introduce

division of labour and other technological means to increase production. Here,

the total product increases at an increasing rate.

2. Law of Constant Returns to Scale: When the scope for division of labour

gets restricted, the rate of increase in the total output remains constant, the

law of constant returns to scale is said to operate. This law states that the rate

of increase/decrease in volume of output is same to that of rate of

increase/decrease in inputs.

3. Law of Decreasing Returns to Scale: Where the proportionate increase in

the inputs does not lead to equivalent increase in output, the output increases

at decreasing rate, the law of decreasing return to scale is said to operate.

This results in higher average cost per unit.

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The Laws of Returns to Scale

Capital Labour % of Output % of Laws

(in (In Increase (In Increase Applicable
Units) Units) in both Units) in Output
inputs
1 3 –– 50 ––

Law of
2 6 100 120 140 Increasing
returns to
scale
Law of
4 12 100 240 100 constant
returns to
scale
Law of
8 24 100 360 50 decreasing
returns to
scale

From the above table, it is clear that with 1 unit of capital

and 3 units of labour, the firm produces 50 units of output. When the inputs

are doubled 2 units of capital and 6 units of labour, the output has gone up to

120 units. (From 50 unit’s to120 units). Thus, when inputs are increased by

100%, the output has increased by 140%. That is, output has increased by

more than double. This is governed by Law of Increasing Returns to Scale.

When the inputs are further doubled that is to 4 units and

12 units of labour, the output has gone up to 240 units. (From 120 units to 240

units). Thus, when inputs are increased by 100%, the output has increased by

100%. That is, output also has doubled. This is governed by Law of Constant

returns to Scale.
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When the inputs are further doubled, that is, to 8 units of

capital and 24 units labour, the output has gone up to 360 units. (From 240

units to 360 units). Thus, when input are increased by 100%, the has

increased only by 50%. This is governed by Law of Decreasing Returns to

Scale.

Returns to Factors

Returns to factors are also called factor productivities.

Productivity is the ratio of output to the input. Factor productivity refers to the

short-run relationship of input and output.

The productivity of one unit of a factor of production will

be equal to the output it can generate. The productivity of particular factor is

measured with the assumption that the other factors are not changed or

remain unchanged. Only that particular factor under study is changed.

The change in productivity can be measured in terms of!

1. Total productivity: The total output generated at varied levels of input of a

particular factor (While other factors remain constant), is called total physical

product.

2. Average Productivity: The total physical product divided by the number units

of that particular factor used yields average productivity.

3. Marginal productivity: The marginal physical product is the additional output

generated by adding an additional unit of the factor under study, keeping the

other factors constant.

The total physical product increases along with an

increase in the input. However, the rate of increase is varied, not constant.
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The total physical product at first increases at an increasing rate because of

the law of increasing return to scale, and later its rate of increase declines

because of the law of decreasing returns to scale.

Economics and Diseconomies of Scale

The Economies of scale result because of increase in the scale of production.

Alfred Marshal divided the economies of scale into two groups.

1. Internal Economies 2. External Economies

1. Internal Economies: internal economies of refers to the economies in

production costs which accrue to the firm alone when it expands its output.

The internal economies occur as a result of increase in the scale of

production.

A. Managerial Economics: As the firm expands, the firm needs qualified

managerial personal to handle each of its functions: marketing, finance,

production, human resource and other in a professional way.

B. Commercial Economies: The transactions of buying and selling raw

materials and other operating supplies such as spares and so on will be rapid

and the volume of each transaction also grow as the firm grows.

C. Financial Economies: There could be cheaper credit facilities from the

financial institutions to meet the capital expenditure or working capital

requirements.

D. Technical Economies: Increasing in the scale of production follows when

there is sophisticated technology available and the firm is in a position to hire

qualified technical manpower to make use of it.

E. Marketing Economies: As the firm grows larger and larger, it can afford to

maintain a full-fledged marketing department independently to handle the

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issues related to design of customer surveys, advertising material, promotion

campaign, handling of sales and marketing staff, renting of hoardings

launching a new product and so on.

F. Risk-bearing Economies: As there is growth in the size of the firm, there is

increase in the risk also. Sharing the risk with the insurance companies is the

first priority for the any firm. The firm can insure its machinery and other

assets against the hazards of fire, theft and other risks.

G. Indivisibilities and automated Machinery: To manufacture goods, a plant of

certain minimum capacity is required whether the firm would like to produce

and sell at the full capacity or not.

For Ex: To be in business a firm requires a telephone, a manager, an

accountant. Just because the production is lesser, the firm cannot hire half

the manager or half the telephone. Likewise, with a given plant certain

minimum quantity can be produced. A firm producing below such minimum

quality will have to bear higher costs.

H. Economies of Research and Development: Large organizations such

as [Link]’s Labs, Hindustan Lever spend heavily on research and

development and bring out several innovative products. Only such firms

with a strong R&D base can cope with competition globally.

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2. External Economies: External economies benefit all the firms in the industry

as the industry expands. This will leads to lowering the cost of production and

thereby increasing the profitability.

A. Economies of Concentration: Because all the firms are located at one place,

it is likely that there is better infrastructure in terms of approach road,

transportation facilities such as railway lines and so on, banking and

communication facilities, availability of skilled labour and such factors.

B. Economies of R&D: All the firms can pool resources together to finance

research and development activities and thus share the benefits of research.

There could be a common facility to share journals, newspapers and other

valuable reference material of common interest.

C. Economies of Welfare: There could be common facilities such as canteen,

industrial housing, community halls, schools and colleges, employment

‘bureau’ hospitals and so on, which can be used in common by the employees

in the whole industry.

Diseconomies of Scale

Diseconomies of scale are mostly managerial in nature. Problems of

planning, coordination, communication and control may become increasingly

complex as the firm grows in size resulting in increasing average cost per unit.

Sometimes, the firm may also collapse.

Diseconomies of scale are said to result when an increase in the scale of

production leads to a higher cost per unit. All inputs increasing by 10% but the

production increasing by only 5%. Expansion of firm beyond a particular limit

may lead to diseconomies of scale.

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Cost Concept or Cost Analysis

The managerial economics is concerned with making managerial

decisions. Different business proposals are evaluated in terms of their costs

and revenues. To know what cost are to be examined, it is necessary to

understand what ‘cost’ is and how to analyze the same.

The cost concept also deals with the possible variations in the concept of

cost and its relationship with both in the short-run and long-run. The concept

of optimum size of firm is explained here.

“Cost refers to the expenditure incurred to produce a particular

product or service. All costs involve a sacrifice of something or other to

acquire some benefit.”

For Ex: If I want to eat food, I should be prepared to sacrifice money.

The cost of production normally, includes the cost of raw materials,

labour, and other expenses; this cost is known as total cost (TC). This is

compared with the total revenue (TR). This is compared with the total revenue

(TR) realized on the sale of the products manufactured. The different between

total revenue and total cost is terms as profit (TR-TC = Profit).

The following are the possible variations in the concept of cost.

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1. Long-Run Vs Short-Run Costs: Difference between Long & Short

Run.

Long run is defined as a period of adequate length during which a

company may alter all factors of production with high degree of

flexibility.

The short run is defined as the period relatively shorter when at

Least some of the factors of production are fixed.

Long run cost covers the cost of changes in the size and kind of plant.

Short run costs cover the costs associated with the variation in the

utilization of fixed plant or other facilities. In long run, there is perfect

flexibility in the size of plant, labour force, and executive talent and so

on. Such a degree of flexibility is lacking in short run.

2. Fixed Vs Variable cost:

Fixed cost is those costs that are fixed in the short run. Whether the

production is taken up or not, we have to incur certain expenses such

as rent for factory and office buildings, insurance, telephone, electricity

and so on. Even the production stopped temporarily for a short period,

we continue to spend on these fixed costs.

Variable costs are those costs that vary with the volume of

production. Variable costs comprise the cost of raw materials, wages

paid to the labour and so on. These costs incurred only when there is

production.
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3. Semi-Fixed or Semi-Variable Costs:

Semi-fixed or semi-variable costs refer to such costs are fixed to some

extent beyond which they are variable. Telephone charges or electrical

charges from good example for this. If we have connection, we have to

pay the minimum charges. This is fixed charges. The more you use the

facility, the more you have to pay.

4. Opportunity Vs Outlay Costs:

Outlay cost also known as actual costs obsolete costs

are those expends which are actually incurred by the firm these are the
payments made for labour, material, plant, building, machinery traveling,
transporting etc., These are all those expense item appearing in the
books of account, hence based on accounting cost concept.

On the other hand opportunity cost implies the earnings

foregone on the next best alternative, has the present option is
undertaken. This cost is often measured by assessing the alternative,
which has to be scarified if the particular line is followed.

The opportunity cost concept is made use for long-run

decisions. This concept is very important in capital expenditure
budgeting. The concept is also useful for taking short-run decisions.
Opportunity cost is the cost concept to use when the supply of inputs is
strictly limited and when there is an alternative. If there is no alternative,
Opportunity cost is zero. The opportunity cost of any action is therefore
measured by the value of the most favorable alternative course, which
had to be foregoing if that action is taken.
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5. Explicit and implicit costs:

Explicit costs are those expenses that involve cash

payments. These are the actual or business costs that appear in the
books of accounts. These costs include payment of wages and salaries,
payment for raw-materials, interest on borrowed capital funds, rent on
hired land, Taxes paid etc.

Implicit costs are the costs of the factor units that are
owned by the employer himself. These costs are not actually incurred
but would have been incurred in the absence of employment of self –
owned factors. The two normal implicit costs are depreciation, interest
on capital etc. A decision maker must consider implicit costs too to find
out appropriate profitability of alternatives.

6. Out-of pocket and books costs:

Out-of pocket costs also known as explicit costs are those costs that
involve current cash payment. Book costs also called implicit costs
do not require current cash payments. Depreciation, unpaid interest,
salary of the owner is examples of back costs.

But the book costs are taken into account in determining the level
dividend payable during a period. Both book costs and out-of-pocket
costs are considered for all decisions. Book cost is the cost of self-
owned factors of production.
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Cost-Output Relationship

The costs and output are related. The cost of production depending

upon several factors such as volume of production: relational ship

between the costs and output: prices and productivity of the inputs such

as land, labour, capital and the time scale.

The cost-output relationship facilities many managerial

decisions such as

• Formulating a relational policy on plant size and the standards

of operation.

• Expense control

• Profit prediction

• Pricing

• Promotion

Cost in the Short-Run

Cost in the short – run is classified into fixed costs and

variable costs. The fixed costs may be ascertained in terms of total

fixed cost and variable fixed cost per unit. The variable cost can be

determined in terms of average variable cost. The following table

explains the behavior of cost in the short-run.

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Monthl Total Total Total [Link] [Link] [Link] Margin

y Fixe variabl Cost d Cost. e Cost. al Cost al Cost
Output d e cost Rs. E=(b/a) Rs.F=(c/a) Rs. Rs.(H)
( units) cost. Rs. D=(b+c G=(d/a)
(A) (B) (C) )

0 100 0 100 ----- ------- 100 -----

1 100 30 130 100 30 130 30

2 100 54 154 50 27 77 24

3 100 72 172 33.3 24 57.3 18

4 100 96 196 25 24 49 24

5 100 150 250 20 30 50 54

6 100 216 316 16.6 36 52.6 66

7 100 320 420 14.2 45.7 69.9 104

Note: Marginal Cost = In Total cost column, Lower value mines upper

value.
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It can be noticed that as the output goes on increasing, average fixed

cost curve (AFC) will continue to decrease. Hence, AFC curve will

slope downwards and it appears to meet the X axis but it will never

meet the axis for obvious reasons.

The variable cost (AVC) is a U-shape curve denoting that

the AVC curve tends to fall in the beginning when the output in

increasing but after a particular level of output, it rises because of the

application of Law of Return or Law of Variable Proportions or Law of

Diminishing Returns.

Average Total Cost (ATC) is the sum of AVC and AFC. It

is to be noted that it will be nearer the AFC curve in the initial stages

because the higher AFC decreases, the influence of AFC on ATC also
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will decline. Hence, with increasing output, the ATC curve will be

distancing itself from the AFC curve.

In the final stage, the ATC curve will be nearer the AVC

curve because the influence of AVC on ATC is greater at higher level of

output. It is to be noted that the ATC curve will never touch the AVC

curve or the AFC curve for obvious reasons.

The marginal cost curve is also a U-shaped curve. It falls

in the beginning and rises sharply. The rising marginal cost curve will

pass through the minimum point of the AVC and the minimum point of

ATC at R and S respectively.

Cost in the Long-Run

Cost-output Relationship in the long-run:

Long run is a period, during which all inputs are variable including the one,
which are fixes in the short-run. In the long run a firm can change its output
according to its demand. Over a long period, the size of the plant can be
changed, unwanted buildings can be sold staff can be increased or reduced.
The long run enables the firms to expand and scale of their operation by bringing
or purchasing larger quantities of all the inputs. Thus in the long run all factors
become variable.

The long-run cost-output relations therefore imply the relationship between

the total cost and the total output. In the long-run cost-output relationship is
influenced by the law of returns to scale.

In the long run a firm has a number of alternatives in regards to the scale of
operations. For each scale of production or plant size, the firm has an
appropriate short-run average cost curves. The short-run average cost (SAC)
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curve applies to only one plant whereas the long-run average cost (LAC) curve
takes in to consideration many plants.

The long-run cost-output relationship is shown graphically with the help of

“LAC’ curve.

To draw on ‘LAC’ curve we have to start with a number of

‘SAC’ curves. In the above figure it is assumed that technologically there are
only three sizes of plants – small, medium and large, ‘SAC’, for the small size,
‘SAC2’ for the medium size plant and ‘SAC3’ for the large size plant. If the firm
wants to produce ‘OP’ units of output, it will choose the smallest plant. For an
output beyond ‘OQ’ the firm wills optimum for medium size plant. It does not
mean that the OQ production is not possible with small plant. Rather it implies
that cost of production will be more with small plant compared to the medium
plant.

For an output ‘OR’ the firm will choose the largest plant as the cost of production
will be more with medium plant. Thus the firm has a series of ‘SAC’ curves. The
‘LAC’ curve drawn will be tangential to the entire family of ‘SAC’ curves i.e. the
‘LAC’ curve touches each ‘SAC’ curve at one point, and thus it is known as
envelope curve. It is also known as planning curve as it serves as guide to the
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entrepreneur in his planning to expand the production in future. With the help of
‘LAC’ the firm determines the size of plant which yields the lowest average cost
of producing a given volume of output it anticipates.

Optimum Size of the Firm

The term ‘Optimum’ literally means the conditions that produce the best result
wherein the firm maximizes the profit per unit at minimum average cost.
Optimum size is defined by several experts.

According, [Link], Principles of Economics, P.99. An optimum firm is “that

organization of business enterprise which, in given circumstances of
technology and the market for its products can produce is goods at the lowest
average unit costs in the long-run.

From the above definition, it is clear that the firm is said to be optimum size
when it is in a position to utilize its resources, including technology, most
efficiently. As a result of this, the cost of production is the minimal and the
productivity is very high. Many a time, we find a business unit of a particular
size operating efficiently than a unit of slightly bigger or smaller size. This size
is called the optimum size. The size of the firms depends on the nature of
industry.
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A firm can achieve optimum size in the long run only when its Long-Run
Average Cost (LAC) is the lowest. In the short-run, it can only ensure optimum
utilization of given plant.

The optimum quantity of production is OQ at OC cost. The lowest point

of LAC indicates the lowest cost of production. A firm must expand till it
reaches optimum size as it goes on reducing the average cost per unit. If the
firm diseconomies of scale and average cost will go on increasing.

The output does not always increase commensurate with increase in

inputs. The production is governed by certain law of returns to scale, which
are popularly known as scale economies. These are certain economies the
firm enjoys because of the scale of its operations. Growth beyond the
manageable size may lead to diseconomies also, unless it is strategically
managed.

BREAKEVEN ANALYSIS/ Cost – Volume – Profit Analysis

The study of cost-volume-profit relationship is often referred as BEA. The

term BEA is interpreted in two senses. In its narrow sense, it is concerned with
finding out BEP; BEP is the point at which total revenue is equal to total cost. It
is the point of no profit, no loss. In its broad determine the probable profit at any
level of production.

Assumptions:

1. All costs are classified into two – fixed and variable.

2. Fixed costs remain constant at all levels of output.
3. Variable costs vary proportionally with the volume of output.
4. Selling price per unit remains constant in spite of competition or change
in the volume of production.
5. There will be no change in operating efficiency.
6. There will be no change in the general price level.
7. Volume of production is the only factor affecting the cost.
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8. Volume of sales and volume of production are equal. Hence there is no

unsold stock.
9. There is only one product or in the case of multiple products. Sales mix
remains constant.

Merits:

1. Information provided by the Break Even Chart can be understood more

easily than those contained in the profit and Loss Account and the cost
statement.
2. Break Even Chart discloses the relationship between cost, volume and
profit. It reveals how changes in profit. So, it helps management in
decision-making.
3. It is very useful for forecasting costs and profits long term planning and
growth
4. The chart discloses profits at various levels of production.
5. It serves as a useful tool for cost control.
6. It can also be used to study the comparative plant efficiencies of the
industry.
7. Analytical Break-even chart present the different elements, in the costs
– direct material, direct labour, fixed and variable overheads.

Demerits:

1. Break-even chart presents only cost volume profits. It ignores other

considerations such as capital amount, marketing aspects and effect of
government policy etc., which are necessary in decision making.
2. It is assumed that sales, total cost and fixed cost can be represented as
straight lines. In actual practice, this may not be so.
3. It assumes that profit is a function of output. This is not always true.
The firm may increase the profit without increasing its output.
4. A major drawback of BEC is its inability to handle production and sale
of multiple products.
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5. It is difficult to handle selling costs such as advertisement and sale

promotion in BEC.
6. It ignores economics of scale in production.
7. Fixed costs do not remain constant in the long run.
8. Semi-variable costs are completely ignored.
9. It assumes production is equal to sale. It is not always true because
generally there may be opening stock.
10. When production increases variable cost per unit may not remain
constant but may reduce on account of bulk buying etc.
11. The assumption of static nature of business and economic activities is a
well-known defect of BEC.

1. Fixed cost
2. Variable cost
3. Contribution
4. Margin of safety
5. Angle of incidence
6. Profit volume ratio
7. Break-Even-Point

1. Fixed cost: Expenses that do not vary with the volume of production are
known as fixed expenses. Eg. Manager’s salary, rent and taxes, insurance
etc. It should be noted that fixed changes are fixed only within a certain
range of plant capacity. The concept of fixed overhead is most useful in
formulating a price fixing policy. Fixed cost per unit is not fixed.
2. Variable Cost: Expenses that vary almost in direct proportion to the volume
of production of sales are called variable expenses. Eg. Electric power and
fuel, packing materials consumable stores. It should be noted that variable
cost per unit is fixed.
3. Contribution: Contribution is the difference between sales and variable
costs and it contributed towards fixed costs and profit. It helps in sales and
pricing policies and measuring the profitability of different proposals.
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Contribution is a sure test to decide whether a product is worthwhile to be

continued among different products.

Contribution = Sales – Variable cost

Contribution = Fixed Cost + Profit.

4. Margin of safety: Margin of safety is the excess of sales over the break
even sales. It can be expressed in absolute sales amount or in percentage.
It indicates the extent to which the sales can be reduced without resulting in
loss. A large margin of safety indicates the soundness of the business. The
formula for the margin of safety is:
Profit
Present sales – Break even sales or
P. V. ratio

Margin of safety can be improved by taking the following steps.

1. Increasing production
2. Increasing selling price
3. Reducing the fixed or the variable costs or both
4. Substituting unprofitable product with profitable one.

5. Angle of incidence: This is the angle between sales line and total cost line
at the Break-even point. It indicates the profit earning capacity of the
concern. Large angle of incidence indicates a high rate of profit; a small
angle indicates a low rate of earnings. To improve this angle, contribution
should be increased either by raising the selling price and/or by reducing
variable cost. It also indicates as to what extent the output and sales price
can be changed to attain a desired amount of profit.

6. Profit Volume Ratio is usually called P. V. ratio. It is one of the most useful
ratios for studying the profitability of business. The ratio of contribution to
sales is the P/V ratio. It may be expressed in percentage. Therefore, every
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organization tries to improve the P. V. ratio of each product by reducing the

variable cost per unit or by increasing the selling price per unit. The concept
of P. V. ratio helps in determining break even-point, a desired amount of
profit etc.

Contributi on
The formula is, (Expression in %) P/V = X 100
Sales

P/V Ration in units is!

Fixed cost X Sales

Sales − Variable cos t

Or

Fixed cost
PV / raio

7. Break – Even- Point: If we divide the term into three words, then it does
not require further explanation.
Break-divide

Even-equal

Point-place or position

Break Even Point refers to the point where total cost is equal to total
revenue. It is a point of no profit, no loss. This is also a minimum point of
no profit, no loss. This is also a minimum point of production where total
costs are recovered. If sales go up beyond the Break Even Point,
organization makes a profit. If they come down, a loss is incurred.

Fixed Expenses
1. Break Even point (Units) =
Contributi on per unit

Fixed expenses
2. Break Even point (In Rupees) = X sales
Contributi on
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3. To ascertain the volume of sales required to achieve a targeted

amount of profit:

Fixed costs + Targeted profit

Volume of sales to attain a targeted profit = -----------------------
Contribution margin

Graphical representation of Break-Even Point (BEP).

1. TC = Total Variable Cost + Total Fixed Cost (TEC)

2. The variable cost line is drawn first. It varies proportionately with
volume of production and sales.
3. The total cost line is derived by adding total fixed costs line to the total
variable cost line. The total cost line is parallel to variable cost line.
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4. The total revenue line start from ‘0’ point and increases along with
volume of sales intersecting total cost line at point BEP.
5. The zone below BEP is loss zone and the zone above BEP is profit
zone.
6. OP is the quantity produced / sold at OC the cost/price at BEP.
7. The angle formed at BEP, that is, the point of intersection of Revenue
and total cost is called angle of incidence.
8. The large the angle of incidence, the higher is the quantum of profit
once the fixed costs are absorbed.
9. Margin of safety refers to the excess of production or sales over the
BEP of production/sales. The margin of safety is OQ minus OP. The
sales value at OQ is OD. It can be observed that the firm reaches
breakeven point at point BEP. At BEP, the total cost is equal to total
revenue. Op is the volume of production/sales at the cost/revenue of
OC. The zone below BEP is called loss zone and zone above BEP is
called profit zone. Total cost curve is based on the total of fixed cost
and variable cost.

Problems of BEP

BEP Equation: Sales xxxxx

Less: Variable Cost xxxxx

––––––––––––
Contribution xxxxx
Less: Fixed Cost xxxxx
–––––––––––
Profit: xxxxx

–––––––––––––
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Determination of Break-Even Point

The following the key terms used in determinations of Break-Even Point:

Selling Price = Fixed cost + Variable Cost + profit

Selling price – Variable Cost = Contribution
Contribution per unit = Selling Price per Unit – Variable cost per Unit.
1. Problem: A firm has a fixed cost of Rs.10,000;
Selling price per unit is Rs.5
Variable cost per unit is Rs.3.

a. Determine Break-Even point in terms of volume and also sales

value.
b. Calculate the marginal safety considering that the actual production
is 8000 units.
Solution:

a. Determination of BEP;

Fixed Cost
Break-Even point (Units) =
Contributi on Margin per unit
Where contribution margin per unit = Selling per unit – Variable cost per unit.
=5–3=2
10,000
Break-even point (Units) =
2
= 5000 Units.

BEP can also be determined in term of value (in rupees)

Fixed Costs
Break Even point (In Rupees) =
Contributi on margin ratio
Selling price - Variable Cost
Where contribution marginal ratio =
Selling price
In the above example, the contribution margin ratio is (5 – 3)/5 = (2/5)
BEP in terms of sales value is calculated as below:

10,000 10,000
= Rs .25,000 = Rs .25,000
= 2/5 or 4.5
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b. Determination of Margin of safety:

Margin of safety (Units) = Number of units sold – Break – Even point in
units.

Margin of safety = 8000 – 5000 = 3000 Units.

2. Problem:

A high-Tech rail can carry a maximum of 36,000 passengers per

annum at a fare of Rs.400. the variable cost per passengers is Rs.150
while the fixed cost are Rs.25, 00,000 per year. Find the Break-even
point in term of number of passengers and also in terms of fare
collections.

Solution:

A. Determination of BEP:

Fixed Costs
Break Even point (In Units) =
Contributi on margin per unit

Contribution margin per passenger = Fare per Passenger – Variable

cost per passenger

= 400 – 150
Contribution per unit= 250

25, 00,000
BEP in units of passengers ---------------- = 10,000 passengers
250

BEP in sales Rupees:

Fixed Costs
BEP in sales value =- -------------------------
Contribution margin ratio

Selling price – Variable cost

Contribution Margin Ratio = --------------------------------------
Selling price
40

Contribution = (400 – 150)/400 = (250/400)

25, 00,000
= ------------------- = Rs. 40, 00,000.
(250/400)

Problem: 3

Srikanth Enterprises deals in the supply of hardware parts of

computer. The following cost data is available for two
successive periods.

Year – I (Rs) Year – II (Rs)

Sales 50,000 1,20,000
Fixed costs 10,000 20,000
Variable costs 30,000 60,000
Determine (A) BEP (B) Margi of Safety.

Solution: Here the unit per data is not available. Hence use the
formula of P/V ratio to find out BEP.
Contributi on
The formula is, (Expression in %) P/V = X 100
Sales

Contribution and profit during the year II and I are calculated as below:

Year – I (Rs) Year – II (Rs)

Sales 50,000 1,20,000
Less: Variable Cost 30,000 60,000
Contribution 20,000 60,000
Less: Fixed Cost 10,000 20,000
Net profit 10,000 40,000
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P/V Ratio Year – I (Rs) Year – II (Rs)

Contributi on 20,000 60,000
= X 100 X 100 = 40% X 100 =
Sales 50,000 1,20,000
50%

BEP 10,000 20,000

Fixed Cost 40% 50%
=
P/V ratio
= Rs. 25,000 = Rs. 40,000
Margin of safety 10,000 40,000
Net profit 40% 50%
=
P/V ratio = 25,000 = 80,000
The answered can be verified by using the following formula:

Sales = BEP sales + Margin of safety

Problem: 4
Determining BEP when there is an increase in fixed cost

A firm has a fixed cost of Rs. 50,000, selling price per unit is Rs.50
and variable cost per unit is Rs.25. present level of production is
3500 units.

Find out:

1. Determine Break-Even-point in terms of volume and also sale

value.
2. Calculate the margin of safety.
3. What is the change the BEP and margin of safety if fixed costs
increase from Rs. 50,000 to Rs 60,000/-
Solution:
1. Determination of BEP:

Fixed Costs
BEP in sales Units =- -------------------------
Contribution margin per unit

Where contribution margin per unit = Selling price per unit – variable
cost per unit.
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= 50 – 25 = Rs.25

50,000
BEP in Units =
25 = 2000 Units.

BEP in terms of value (in rupees):

Fixed Costs
BEP in sales Value =- -------------------------
Contribution margin ratio

Selling price – Variable cost

Contribution Margin Ratio = --------------------------------------
Selling price

In the above example, the contribution margin ratio is(50-25)/50

= (25/50).

BEP in term’s sales value is calculated as below:

50,000
=
(25/50)

Rs.1,00,000

2. Determining of margin of safety:

Margin of safety = Number of units sold – BEP in units

= 3500 – 2000 = 1500 Units

3. Determination of BEP with fixed costs of Rs.60,000/-

Where contribution margin per unit = Selling price per unit – variable cost per
unit.
= 50 – 25 = 25.

Fixed Costs
BEP in sales Units =- -------------------------
Contribution margin per unit
43

60,000
25

= 2400 Units

BEP in terms of value (in rupees)

Fixed Costs
BEP in sales Value =- -------------------------
Contribution margin ratio

Selling price – Variable cost

Contribution Margin Ratio = --------------------------------------
Selling price

Contribution margin ratio = (50 -25)/50 = (25/50)

60,000
BEP Value =------------------- = Rs. 1, 20,000/-
(25/50)

Margin of safety = Number of units sold – BEP in units

= 3500 – 2400 = 1100 units.

The above calculations show that firm has to produce 400 more units (2400 –
2000) in the event of increase in fixed costs by Rs.10, 000. This reduces
margin of safety also by 400 units (1500 – 1100).

Important Question Unit- 2

1. What do you know about Production Function? Explain Production
Function with One Variable Input and Two Variable /and Law of
Return.( With diagram)
2. Define Isoquant and Features of Isoquant. Explain through different
diagrams.
3. Define Isocost and explain through diagram.
4. What is mean by Marginal Rate of Technical Substitution (MRTS)?
Explain Least Cost Combination of Inputs.
5. What do you know about Economies and Diseconomies of Scale? Explain
6. What is Cost concept? Explain different Cost Concepts.
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7. What do you know about Cost – Output relationship? Explain Short &
Long costs through diagram.
8. What do you know about Break- Even – analysis or Cost – Volume – Profit
analysis? Explain through diagram.