UNIT-II

PRODUCTIONFUNCTION AND COST ANALYSIS

Introduction: The production function expresses a functional relationship between physical inputs
and physical outputs of a firm at any particular time period. The output is thus a function of inputs.
Mathematically production function can be written as

Q=f(A,B,C,D)

Where “Q” stands for the quantity of output and A, B, C, D are various input factors such as land,
labour, capital and organization. Here output is the function of inputs. Hence output becomes the
dependent variable and inputs are the independent variables.

The above function does not state by how much the output of “Q” changes as a consequence
ofchange of variable [Link] order to expressthequantitativerelationship between inputs and
output, Production function has been expressed in a precise mathematical equation i.e.

Y=a+b(x)

Whichshowsthatthereisaconstantrelationshipbetweenapplicationsofinput (theonly factor input „X‟ in

this case) and the amount of output (y) produced.

Importance:

1. When inputs are specified in physical units, production function helps to estimatethe level of
production.
2. It becomes is equates when different combinations of inputs yield the same level of output.
 3. It indicates the manner in which the firm can substitute on input for anotherwithout altering
the total output.
4. When price is taken into consideration, the production function helps to select the least
combination of inputs for the desired output.
5. It considers two types‟ input-output relationships namely „law of variable proportions‟ and
„law of returns to scale‟. Law of variable propositions explains the pattern of output in the
short-run as the units of variable inputs are increased to increase the output. On the other
hand law of returns to scale explains the pattern of output in the long run as all the units of
inputs are increased.
6. The production function explains the maximum quantity of output, which can be produced,
from any chosen quantities of various inputs or the minimum quantities of various inputs
that are required to produce a given quantity of output.

Productionfunctioncanbefittedtheparticularfirmorindustryorfortheeconomyas whole. Production function

will change with an improvement in technology.
Assumptions:

Productionfunctionhasthefollowingassumptions.

1. Theproductionfunctionisrelatedtoaparticularperiodoftime.
2. Thereisnochangeintechnology.
3. Theproducerisusingthebesttechniquesavailable.
4. Thefactorsofproductionaredivisible.
5. Productionfunctioncanbefittedtoashortrunortolongrun.

Cobb-Douglasproductionfunction:

Production function of the linear homogenous type is invested by Junt wicksell and first tested by C. W.
Cobb and P. H. Dougles in 1928. This famous statistical production function is known as Cobb-
Douglas production function. Originally the function is applied on the empirical study of the
American manufacturing industry. Cabb – Douglasproduction function takes the following
mathematical form.

Y=(AKXL1-x)
WhereY=output
K=Capital
L=Labour
A,∞=positiveconstant

Assumptions:
Ithasthefollowingassumptions
 1. [Link] labour.
2. Itisalinearhomogenousproductionfunctionofthefirstdegree
3. Thefunctionassumesthatthelogarithmofthetotaloutputoftheeconomyisa linear function of
the logarithms of the labour force and capital stock.
4. Thereareconstantreturnstoscale
5. Allinputsarehomogenous
6. Thereisperfectcompetition
7. Thereisnochangeintechnology

ISOQUANTS:

ThetermIsoquantsisderivedfromthewords„iso‟and„quant‟–„Iso‟meansequaland
„quent‟[Link],[Link]-product curves or
isoquants or production difference curves can represent a production function with two variable
inputs, which are substitutable for one another within limits.

Iqoquants are the curves, which represent the different combinations of inputs
[Link] of
output.

Foragivenoutputlevelfirm‟sproductionbecome,

Q=f(L,K)

Where„Q‟,theunitsofoutputisafunctionofthequantityoftwoinputs„L‟and„K‟.

Thus an isoquant shows all possible combinations of two inputs, which are capable of producing
equal or a given level of output. Since each combination yields same output,the producer becomes
indifferent towards these combinations.

Assumptions:

1. Thereareonlytwofactorsofproduction,[Link].
2. Thetwofactorscansubstituteeachotheruptocertainlimit
3. Theshapeoftheisoquantdependsupontheextentofsubstitutabilityofthetwo inputs.
4. Thetechnologyisgivenoveraperiod.
Anisoquantmaybeexplainedwiththehelpofanarithmeticalexample.

Combinations Labour(units) Capital(Units) Output(quintals)

A 1 10 50
B 2 7 50
C 3 4 50
D 4 4 50
E 5 1 50

Combination „A‟ represent 1 unit of labour and 10 units of capital and produces „50‟ quintals of a
product all other combinations in the table are assumed to yield the same given output of a product
say „50‟ quintals by employing any one of the alternative combinations of the two factors labour
and capital. If we plot all these combinations on a paper and join them, we will get continues and
smooth curve called Iso-product curve as shown below.

Labour is on the X-axis and capital is on the Y-axis. IQ is the ISO-Product curve which shows all the
alternative combinations A, B, C, D, E which can produce 50 quintals of a product.

Producer’sEquilibrium:

The tem producer‟s equilibrium is the counter part of consumer‟s equilibrium. Just as the consumer is
in equilibrium when be secures maximum satisfaction, in the same manner, the producer is in
equilibrium when he secures maximum output, with the least cost combination of factors of
production.
Theoptimum positionoftheproducercanbefoundwiththehelpofiso-product [Link] Iso-product
curve or equal product curve or production indifference curve shows different combinations of two
factors of production, which yield the same output. This is illustrated as follows.

Let us suppose. The producer can produces the given output of paddy say 100 quintals by
employing any one of the following alternative combinations of the two factors labour and capital
computation of least cost combination of two inputs.

L K Q L&LP(3Rs.) KXKP(4Rs.) Totalcost

Units Units Output Costof labour costof capital

10 45 100 30 180 210

20 28 100 60 112 172
30 16 100 90 64 154
40 12 100 120 48 168
50 8 100 150 32 182

It isclear from the abovethat10unitsof „L‟combined with45units of„K‟ wouldcost the producer Rs.
20/-. But if 17 units reduce „K‟ and 10 units increase „L‟, the resulting cost would be Rs. 172/-.
Substituting 10 more units of „L‟ for 12 units of „K‟ further reduces cost pf Rs. 154/-/ However, it
will not be profitable to continue this substitution process further at the existing prices since the rate
of substitution is diminishing rapidly. In the
abovetabletheleastcostcombinationis30unitsof„L‟usedwith16unitsof„K‟whenthe
costwouldbeminimumat Rs.154/-.Sothisistheystage“theproducer isinequilibrium”.

LAWOFPRODUCTION:

Productionanalysisineconomicstheoryconsiderstwotypesofinput-outputrelationships.

1. Whenquantitiesofcertaininputs,arefixedandothersarevariableand
2. Whenallinputsarevariable.

Thesetwotypesofrelationshipshavebeenexplainedintheformoflaws.

i) Lawofvariableproportions
ii) Lawofreturnstoscale
 I. Lawofvariableproportions:

The law of variable proportions which is a new name given to old classical concept of “Law of
diminishing returns has played a vital role in the modern economics theory. Assume that a firms
production function consists of fixed quantities of all inputs (land, equipment, etc.) except labour
which is a variable input when the firm expands output by employing more and more labour it alters
the proportion between fixed and the variable inputs. The law can be stated as follows:

“Whentotaloutput orproductionofacommodityisincreasedbyaddingunits ofavariable input while the

quantities of other inputs are held constant, the increase in totalproduction becomes after some
point, smaller and smaller”.

“If equal increments of one input are added, the inputs of other production services being held
constant,beyond a certain point theresulting increments of product willdecrease i.e. the marginal
product will diminish”. (G. Stigler)

“As theproportion of onefactor in a combination of factors is increased, aftera point, first the marginal
and then the average product of that factor will diminish”. (F. Benham)

The law of variable proportions refers to the behaviour of output as the quantity of one Factor is
increased Keeping the quantity of other factors fixed and further it states thatthe marginal product
and average product will eventually do cline. This law states three types of productivity an input
factor – Total, average and marginal physical productivity.

AssumptionsoftheLaw:Thelawisbaseduponthefollowingassumptions:

i) The state of technology remains constant. If there is any improvement in technology, the
average and marginal out put will not decrease but increase.
ii) Only one factor of input is made variable and other factors are kept constant. This law
does not apply tothose cases wherethe factorsmust be used in rigidly fixed proportions.
iii) Allunitsofthevariablefactorsarehomogenous.

Threestagesoflaw:

The behaviors of the Output when the varying quantity of one factor is combines with a fixed quantity
of the other can be divided in to three district stages. The three stages can be better understood by
following the table.

Fixedfactor Variablefactor Totalproduct Average Marginal

 (Labour) Product Product
1 1 100 100 - Stage
1 2 220 120 120 I
1 3 270 90 50
1 4 300 75 30 Stage
1 5 320 64 20 II
1 6 330 55 10
1 7 330 47 0 Stage
1 8 320 40 -10 III

Above table reveals that both average product and marginal product increase in the beginning and
then decline of the two marginal products drops of faster than average product. Total product is
maximum when the farmer employs 6th worker, nothing is produced by the 7th worker and its
marginal productivity is zero, whereas marginalproduct of 8 th worker is „-10‟, by just creating
credits 8th worker not only fails to make a positive contribution but leads to a fall in the total output.

Production function with one variable input and the remaining fixed inputs is illustrated as below

From the abovegraph the law of variableproportions operates in three stages. In the first stage, total
product increases at an increasing rate. The marginal product in this stage increases at an increasing
rate resulting in a greater increase in total product. Theaverage product also increases. This stage
continues up to the point where average product is equal to marginal product. The law of increasing
returns is in operation at this stage. The law of diminishing returns starts operating from the second
stage awards. At the second stage total product increases only at a diminishing rate. The average
product also declines
II. LawofReturnsofScale:

The law of returns to scale explains the behavior of the total output in response to change in the
scale of the firm, i.e., in response to a simultaneous to changes in the scale of the firm, i.e., in
response to a simultaneous and proportional increase in all the inputs. More precisely, the Law of
returns to scale explains how a simultaneous and proportionate increase in all the inputs affects the
total output at its various levels.

The concept of variable proportions is a short-run phenomenon as in these period fixed factors can
not be changed and all factors cannot be changed. On the other hand in the long-term all factors can
be changed as made variable. When we study the changes in output when all factors or inputs are
changed, we study returns to scale. An increase in the scalemeansthat all inputs or factors
areincreased inthe sameproportion. In variable proportions, the cooperating factors may be
increased or decreased and one faster (Ex. Land in agriculture (or) machinery in industry) remains
constant so that the changes in proportionamongthefactorsresultincertainchangesin
[Link] necessary factors or production are increased or decreased to the same
extent so that whatever the scale of production, the proportion among the factors remains the same.

When a firm expands, its scale increases all its inputs proportionally, then technicallythere
arethreepossibilities.(i) Thetotal outputmayincreaseproportionately (ii) Thetotal output may increase
more than proportionately and (iii) The total output may increaseless than proportionately. If
increase in the total output is proportional to the increase in input, it means constant returns to
[Link] increase in the output is greater than the proportional increase in the inputs, it means
increasing return to scale. If increase in the output is less than proportionalincrease in the inputs, it
means diminishing returns to scale.

Let us now explain the laws of returns to scale with the help of isoquants for a two-input and single
output production system.
 ECONOMIESOFSCALE

Production may be carried on a small scale or o a large scale by a firm. When a firm expands its
size of production by increasing all the factors, it secures certain advantages known as economies of
production. Marshall has classified these economies of large-scale production into internal
economies and external economies.

Internal economies are those, which are opened to a single factory or a single firm independently of
the action of other firms. They result from an increase in the scale of output of a firm and cannot be
achieved unless output increases. Hence internaleconomies depend solely upon the size of the firm
and are different for different firms.

External economies are those benefits, which are shared in by a number of firms or industries when
the scale of production in an industry or groups of industries increases. Hence external economies
benefit all firms within the industry as the size of the industry expands.

Causesofinternaleconomies:
Internaleconomiesaregenerallycausedbytwofactors
1. Indivisibilities [Link].

1. Indivisibilities
Many fixed factors of production are indivisible in the sense that they must be used in a fixed
minimum size. For instance, if a worker works half the time,he may be paid half the salary. But he
cannot be chopped into half and asked to produce half the current output. Thus as output increases
the indivisible factors which were being used below capacity can be utilized to their full capacity
thereby reducing costs. Such indivisibilities arise in the case of labour, machines, marketing,
finance and research.

2. Specialization.

Division of labour, which leads to specialization, is another cause of internal economies.

Specialization refers to the limitation of activities within a particular field of production.
Specializationmaybeinlabour,capital,[Link] example,theproduction
processmaybesplit intofourdepartmentsrelationtomanufacturing, assembling,packing and marketing
under the charge of separate managers who may work under the overall charge of the general
manger and coordinate the activities of the for departments. Thus specialization will lead to greater
productive efficiency and to reduction in costs.

InternalEconomies:
Internaleconomiesmaybeofthefollowingtypes.

A). TechnicalEconomies.

Technical economies arise to a firm from the use of better machines and superior techniques of
production. As a result, production increases and per unit cost of production falls. A large firm,
which employs costly and superior plant and equipment, enjoys a technical superiority over a small
firm. Another technical economy lies in the mechanical advantage of using large machines. The
cost of operating large machines is less than that of operating mall machine. More over a larger firm
is able to reduce it‟s per unit cost of production by linking the various processes of production.
Technical economies may also be associated when the large firm is able to utilize all its waste
materials for the development of by-products industry. Scope for specialization is also available in a
large firm. This increases the productive capacity of the firm and reduces the unit cost of
production.

B). ManagerialEconomies:

These economies arise due to better and more elaborate management, which only the large size
firms can afford. There may be a separate head for manufacturing, assembling, packing, marketing,
general administration etc. Each department is under the charge ofan expert. Hence the appointment
of experts, division of administration into several departments, functional specialization and
scientific co-ordination of various works make the management of the firm most efficient.

C). MarketingEconomies:

Thelargefirmreapsmarketingor commercialeconomiesinbuyingitsrequirementsandin selling its final

products. The large firm generally has a separatemarketingdepartment. It can buy and sell on behalf
of the firm, when the market trends are more favorable. In the matter of buying they could enjoy
advantages like preferential treatment, transport concessions, cheap credit, prompt delivery and fine
relation with dealers. Similarly it sells its products more effectively for a higher margin of profit.

D). FinancialEconomies:

The large firm is able to secure the necessary finances either for block capital purposes or for
working capital needs more easily and cheaply. It can barrow from the public, banks
[Link] reaps financial
economies.

E). Riskbearing Economies:

The large firm produces many commodities and serves wider areas. It is, therefore, ableto absorb any
shock for its existence. For example, during business depression, the prices fall for every firm.
There is also a possibility for market fluctuations in a particular product of the firm. Under such
circumstances the risk-bearing economies or survival economies help the bigger firm to survive
business crisis.

F). EconomiesofResearch:

Alargefirm possesseslarger resources andcan establish it‟s ownresearch laboratory and

[Link] increasing its
output and reducing cost.

G). Economiesofwelfare:

A large firm can provide better working conditions in-and out-side the factory. Facilities like
subsidized canteens, crèches for the infants, recreation room, cheap houses, educationalandmedical
facilitiestendto increase the productive efficiency of the workers, which helps in raising production
and reducing costs.

ExternalEconomies.

Businessfirmenjoysanumberofexternaleconomies,whicharediscussedbelow:

A). EconomiesofConcentration:

When an industry is concentrated in a particular area, all the member firms reap some common
economies like skilled labour, improved means of transport and communications, banking and
financial services, supply of power and benefits from subsidiaries. All these facilities tend to lower
the unit cost of production of all the firms in the industry.

B). EconomiesofInformation

The industry can set up an information centre which may publish a journal and pass on information
regarding the availability of raw materials, modern machines, export potentialities and provide other
information needed by the firms. It will benefit all firms and reduction in their costs.

C). EconomiesofWelfare:

An industry is in a better position to provide welfare facilities to the workers. It may get land at
concessional rates and procurespecial facilities from thelocal bodies for setting up,
 educational institutions both general and technical so that a continuous supply of skilled labour is
available to the industry. This will help the efficiency of the workers.

D). EconomiesofDisintegration:

The firms in an industry may also reap the economies of specialization. When an industry expands,
it becomes possible to spilt up some of the processes which are taken over by specialist firms. For
example, in the cotton textile industry, some firms may specialize in
manufacturingthread,othersinprinting,stillothersindyeing,someinlongcloth,somein dhotis, some in
shirting etc. As a result the efficiency of the firms specializing in different fields increases and the
unit cost of production falls.

Thusinternaleconomiesdependuponthesizeofthefirmandexternaleconomiesdepend upon the size of

the industry.

DISECONOMIESOFLARGESCALEPRODUCTION

Internal and external diseconomies are the limits to large-scale production. It is possible that
expansion of a firm‟s output may lead to rise in costs and thus result diseconomies
[Link] expandsbeyondproper limits,it isbeyondthecapacity of the manager
to manage it efficiently. This is an example of an internal diseconomy. In
thesamemanner,theexpansion ofan industrymayresult in diseconomies, whichmaybe
[Link] efficient and
they are obtained at a higher cost. It is in this way that externaldiseconomies result as an industry
expands.

Themajordiseconomiesoflarge-scaleproductionarediscussedbelow:

InternalDiseconomies:

A). FinancialDiseconomies:
For expanding business, the entrepreneur needs finance. But finance may not be easily available in
the required amount at the appropriate time. Lack of finance retards the production plans thereby
increasing costs of the firm.

B). Managerialdiseconomies:
There are difficulties of large-scale management. Supervision becomes a difficult job. Workers do
not work efficiently, wastages arise, decision-making becomes difficult,
coordinationbetweenworkersandmanagementdisappearsand production costsincrease.
C). MarketingDiseconomies:

As business is expanded, prices of the factors of production will rise. The cost willtherefore rise.
Raw materials may not be available in sufficient quantities due to their scarcities. Additional output
may depress the price in the market. The demand for the products may fall as a result of changes in
tastes and preferences of the people. Hence cost will exceed the revenue.

D). TechnicalDiseconomies:

There is a limit to the division of labour and splitting down of production p0rocesses. The firm may
fail to operate its plant to its maximum capacity. As a result cost per unit increases. Internal
diseconomies follow.

E). DiseconomiesofRisk-taking:

As the scale of production of a firm expands risks also increase with it. Wrong decision by the
management may adversely affect production. In large firms are affected by any disaster, natural or
human, the economy will be put to strains.

ExternalDiseconomies:

When many firm get located at a particular place, the costs of transportation
increasesduetocongestion. Thefirmshavetoface considerabledelays in getting rawmaterials and
sendingfinished productsto the marketing centers. The localization of industriesmay lead to scarcity
of raw material, shortage of various factors of production like labour and capital, shortage of power,
finance and equipments. All such external diseconomies tendto raise cost per unit.
 COSTANALYSIS

Profit is the ultimate aim of any business and the long-run prosperity of a firm depends upon its
ability to earn sustained profits. Profits are the difference between selling price and cost of
production. In general the selling price is not within the control of a firm but many costs are under
its control. The firm should therefore aim at controlling and minimizing cost. Since every business
decision involves cost consideration, it is necessary to understand the meaning of various concepts
for clear business thinking and application of right kind of costs.

COSTCONCEPTS:

A managerial economist must have a clear understanding of the different cost concepts for clear
business thinking and proper application. The several alternative bases of
classifyingcostandtherelevanceofeachfordifferent kinds ofproblemsaretobestudied. The various
relevant concepts of cost are:

1. Opportunitycostsandoutlaycosts:

Out lay 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 byassessing 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. This concept is very important in capital expenditure budgeting. The
concept is also useful for taking short-run decisions opportunity cost isthecost concept touse when
the supply of inputs is strictly limitedand 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.

2. Explicitandimplicitcosts:

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, renton 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.

3. HistoricalandReplacementcosts:

Historical cost is the original cost of an asset. Historical cost valuation shows the cost ofan asset as
the original price paid for the asset acquired in the past. Historical valuation is the basis for financial
accounts.

A replacement cost is the price that would have to be paid currently to replace the same asset.
During periods of substantial change in the price level, historical valuation gives a poor projection
of the future cost intended for managerial decision. A replacement cost isa relevant cost concept
when financial statements have to be adjusted for inflation.

4. Short–runandlong–runcosts:

Short-run is a period during which the physical capacity of the firm remains fixed. Any increase in
output during this period is possible only by using the existing physicalcapacity more extensively.
So short run cost is that which varies with output when the plant and capital equipment in constant.

Long run costs are those, which vary with output when all inputs are variable including plant and
capital equipment. Long-run cost analysis helps to take investment decisions.

5. Out-ofpocketandbookscosts:

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.

Butthebook costs aretakenintoaccount indeterminingtheleveldividendpayable 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.

6. Fixedandvariablecosts:

Fixed cost is that cost which remains constant for a certain level to output. It is not affected by the
changes in the volume of production. But fixed cost per unit decrease, when the production is
increased. Fixed cost includes salaries, Rent, Administrative expenses depreciations etc.
Variable is that which varies directly with the variation is output. An increase in total output results
in an increase in total variable costs and decrease in total output results ina proportionate decline in
the total variables costs. The variable cost per unit will be constant. Ex: Raw materials, labour,
direct expenses, etc.

7. PostandFuturecosts:

Post costs also calledhistorical costs are the actual cost incurred and recorded in the book of account
these costs are useful only for valuation and not for decision making.

Future costs are costs that are expected to be incurred in the futures. They are not actual costs. They
are the costs forecasted or estimated with rational methods. Future cost estimate is useful for
decision making because decision are meant for future.

8. Traceableandcommoncosts:

Traceablecostsotherwisecalleddirectcost,isone,whichcanbeidentifiedwithaproducts process or
product. Raw material, labour involved in production is examples of traceable cost.

Common costs are the ones that common are attributed to a particular process orproduct. They are
incurred collectively for different processes or different types of products. It cannot be directly
identified with any particular process or type of product.

9. Avoidableandunavoidablecosts:

Avoidable costs are the costs, which can be reduced if the business activities of a concern are
curtailed. For example, if some workers can be retrenched with a drop in a product – line, or
volume or production the wages of the retrenched workers are escapable costs.

The unavoidable costs are otherwise called sunk costs. There will not be any reduction in this cost
even if reduction in business activity is made. For example cost of the ideal machine capacity is
unavoidable cost.

10. Controllableanduncontrollablecosts:

Controllable costs are ones, which can be regulated by the executive who is in change of it. The
concept of controllability of cost varies with levels of management. Direct expenses like material,
labour etc. are controllable costs.
basis of allocation and is independent of the actions of the executive of that department. These
apportioned costs are called uncontrollable costs.

11. Incrementalandsunkcosts:

Incremental cost also known as different cost is the additional cost due to a change in the level or
nature of business activity. The change may be caused by adding a new product, adding new
machinery, replacing a machine by a better one etc.

Sunk costs arethosewhich arenot altered by any change – They arethecosts incurred in the past. This
cost is the result of past decision, and cannot be changed by future decisions. Investments in fixed
assets are examples of sunk costs.

12. Total,averageandmarginalcosts:

Total cost is the total cash payment made for the input needed for production. It may be explicit or
implicit. It is the sum total of the fixed and variable costs. Average cost is the cost per unit of
output. If is obtained by dividing the total cost (TC) by the total quantity produced (Q)
TC
Averagecost=------
Q
Marginal cost is the additional cost incurred to produce and additional unit of output or itis the cost
of the marginal unit produced.

13. AccountingandEconomicscosts:

Accounting costs are the costs recorded for the purpose of preparing the balance sheetand profit and
ton statements to meet the legal, financial and tax purpose of thecompany. The accounting concept
is a historical concept and records what has happenedin the post.

Economics concept considers future costs and future revenues, which help futureplanning, and
choice, while the accountant describes what has happened, the economics aims at projecting what
will happen.

COST-OUTPUTRELATIONSHIP

A proper understanding of the nature and behavior of costs is a must for regulation and control of
cost of production. The cost of production depends on money forces and an understanding of the
functional relationship of cost to various forces will help us to take various decisions. Output is an
important factor, which influences the cost.
The cost-output relationship plays an important role in determining the optimum level of
production. Knowledgeof thecost-output relationhelps themanager incost control,profit prediction,
pricing, promotion etc. The relation between cost and its determinants is technically described as
the cost function.

C=f(S,O,P,T….)

Where;
C=Cost(Unitortotalcost)
S=Sizeofplant/scaleofproduction O=
Output level
P=Pricesofinputs T=
Technology

Considering the period the cost function can be classified as (a) short-run cost function and (b)
long-run cost function. In economics theory, the short-run is defined as thatperiod during which the
physical capacity of the firm is fixed and the output can be increased only by using the existing
capacityallows to bring changes in output by physical capacity of the firm.

(a) Cost-OutputRelationintheshort-run:

The cost concepts made use of in the cost behavior are total cost, Average cost, and marginal cost.

Total cost is the actual money spent to produce a particular quantity of output. Total cost is the
summation of fixed and variable costs.

TC=TFC+TVC

Up to a certain level of production total fixed cost i.e., the cost of plant, building, equipment etc,
remains fixed. But the total variable cost i.e., the cost of labour, raw materials etc., Vary with the
variation in output. Average cost is the total cost per unit. It can be found out as follows.

TC
AC=
QQ
The total of average fixed cost (TFC/Q) keep coming down as the production is increased and
average variable cost (TVC/Q) will remain constant at any level of output.

Marginal cost is the addition to the total cost due to the production of an additional unit of product.
It can be arrived at by dividing the change in total cost by the change in total output.
Intheshort-runtherewillnot [Link] implies change in
total variable cost only.

Cost–outputrelations

Unitsof Total Total Total Average Average Average Marginal

Output fixed variable cost variable fixed cost cost
Q costTFC cost (TFC + cost cost (TC/Q) MC
TVC TVC)TC (TVC / (TFC / AC
Q)AVC Q)AFC
0 - - 60 - - - -
1 60 20 80 20 60 80 20
2 60 36 96 18 30 48 16
3 60 48 108 16 20 36 12
4 60 64 124 16 15 31 16
5 60 90 150 18 12 30 26
6 60 132 192 22 10 32 42

The above table represents the cost-output relation. The table is prepared on the basis of the law of
diminishing marginal returns. The fixed cost Rs. 60 May include rent of factory building, interest on
capital, salaries of permanently employed staff, insurance etc. The table shows that fixed cost is
same at all levels of output but the average fixed cost, i.e., the fixed cost per unit, falls continuously
as the output increases. The expenditure on the variable factors (TVC) is at different rate. If more
and more units are produced with a given physical capacity the AVC will fall initially, as per the
table declining up to 3rd unit, and being constant up to 4 th unit and then rising. It implies that
variable factors produce more efficiently near a firm‟s optimum capacity than at any other levels of
output.

[Link]„AVC‟starts rising from the 5 th

unit onwards whereas the „AC‟ starts rising from the 6 th unit only so long as „AVC‟ declines „AC‟
also will decline. „AFC‟ continues to fall with an increase in
[Link]„AVC‟ismorethanthedeclinein„AFC‟,thetotalcostagainbegin to rise. Thus
there will be a stage where the „AVC‟, the total cost again begin to rise thus
therewillbeastagewherethe„AVC‟mayhavestartedrising,yetthe„AC‟isstilldeclining
becausetherisein„AVC‟ islessthanthedroopin„AFC‟.

Thus the table shows an increasing returns or diminishing cost in the first stage and diminishing
returns or diminishing cost in the second stage and followed by diminishing returns or increasing
cost in the third stage.
In the above graph the “AFC‟ curve continues to fall as output rises an account of its spread over
more and more units Output. But AVC curve (i.e. variable cost per unit) first
[Link]
“ATC‟curvedependsuponthebehaviorof„AVC‟curveand„AFC‟[Link]
ofproductionboth„AVC‟and„AFC‟declineandhence„ATC‟[Link] point
„AVC‟ starts rising. If the rise in variable cost is less than the decline in fixed cost, ATC will still
continue to decline otherwise AC begins to rise. Thus the lower end of „ATC‟ curve thus turns up
and gives it a U-shape. That is why „ATC‟ curve are U-shaped. The lowest point in „ATC‟ curve
indicates the least-cost combination of inputs. Where the total average cost is the minimum and
where the “MC‟ curve intersects „AC‟ curve, It is not be themaximum output levelrather
itisthepoint whereper unitcost ofproductionwillbeat its lowest.
Therelationshipbetween„AVC‟,„AFC‟and„ATC‟canbesummarizedupasfollows:

1. IfbothAFCand„AVC‟fall,„ATC‟willalsofall.
2. When„AFC‟fallsand„AVC‟rises
a. „ATC‟willfallwherethedropin„AFC‟ismorethantheraisein„AVC‟.
b. „ATC‟remainsconstantisthedropin„AFC‟=risein„AVC‟
c. „ATC‟willrisewherethedropin„AFC‟islessthantherisein„AVC‟

[Link]-outputRelationshipinthelong-run:

Longrun isaperiod, duringwhich allinputsare variableincludingthe 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
[Link]
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
[Link]-runaveragecost(SAC)curveappliestoonlyoneplant whereasthe long-run average cost
(LAC) curve takes in to consideration many plants.

Thelong-runcost-outputrelationshipisshowngraphicallywiththehelpof“LCA‟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, mediumandlarge,
„SAC‟,forthesmallsize,„SAC2‟forthemediumsizeplantand„SAC3‟ forthelargesizeplant.
Ifthefirmwants toproduce„OP‟units of output,itwillchoosethe
[Link]„OQ‟[Link] 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 „LCA‟ curve drawn will be
tangential to the entire family of „SAC‟ curves i.e. the „LAC‟ curve touches each „SAC‟ curveat
onepoint, and thus it is known as envelopecurve. It is alsoknown as planning curve as it serves as
guide to the 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.
 BREAKEVENANALYSIS

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. Allcostsareclassifiedintotwo–fixedandvariable.
2. Fixedcostsremainconstantatalllevelsofoutput.
3. Variablecostsvaryproportionallywiththevolumeofoutput.
4. Sellingpriceperunitremainsconstantinspiteofcompetitionorchangeinthe volume of
production.
5. Therewillbenochangeinoperating efficiency.
6. Therewillbenochangeinthegeneralpricelevel.
7. Volumeofproductionistheonlyfactoraffectingthecost.
8. [Link] stock.
9. [Link] constant.

Merits:

1. InformationprovidedbytheBreakEvenChartcanbeunderstoodmoreeasilythen those
contained in the profit and Loss Account and the cost statement.
2. BreakEvenChartdisclosestherelationshipbetweencost,[Link] reveals how
changes in profit. So, it helps management in decision-making.
3. Itisveryusefulforforecastingcostsandprofitslongtermplanningandgrowth
4. Thechartdisclosesprofitsatvariouslevelsofproduction.
5. Itservesasausefultoolforcostcontrol.
6. Itcanalsobeusedtostudythecomparativeplantefficienciesoftheindustry.
7. AnalyticalBreak-evenchartpresentthedifferentelements,inthecosts –direct material,
direct labour, fixed and variable overheads.

Demerits:

1. [Link] such as capital

amount, marketing aspects and effect of government policy etc., which are necessary in
decision making.
2. Itisassumedthatsales,totalcostandfixedcostcanberepresentedasstraight lines. In actual
practice, this may not be so.
 3. [Link] increase the profit
without increasing its output.
4. AmajordrawbackofBECisitsinabilitytohandleproductionandsaleofmultiple products.
5. Itisdifficulttohandlesellingcostssuchasadvertisementandsalepromotionin BEC.
6. Itignoreseconomicsofscaleinproduction.
7. Fixedcostsdonotremainconstantinthelongrun.
8. Semi-variablecostsarecompletelyignored.
9. [Link] 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 natureof business and economic activities is a well-known defect of
BEC.

1. Fixedcost
2. Variablecost
3. Contribution
4. Marginofsafety
5. Angleof incidence
6. Profitvolumeratio
7. Break-Even-Point

1. Fixed cost:Expenses that do not vary with the volume of production are known as
[Link]‟ssalary,rentandtaxes,[Link] 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. Contribution is a sure test to decide whether a product is
worthwhile to be continued among different products.

Contribution=Sales–Variablecost Contribution
= Fixed Cost + Profit.

4. Margin of safety: Margin of safety is the excess of sales over thebreak even sales. It can be
expressed in absolute sales amount or in percentage. It indicates the extent to
[Link] indicates the soundness of the
business. The formula for the margin of safety is:

Presentsales–Breakeven sales or Profit

[Link]
Marginofsafetycanbeimprovedbytakingthefollowingsteps.
1. Increasingproduction
2. Increasingsellingprice
3. Reducingthefixedorthevariablecostsorboth
4. Substitutingunprofitableproductwithprofitableone.

5. Angle of incidence:This is the angle between sales line and total cost line at the Break-
[Link] [Link] 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 Ratiois usually called P. V. ratio. It is one of themost 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 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.

Theformulais, Contribution
X100
Sales

7. Break–Even-Point:Ifwedividetheterm intothreewords,thenit doesnotrequire further

explanation.
Break-divide
Even-equal
Point-placeorposition
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 [Link] 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. BreakEvenpoint(Units)=
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