COST ANALYSIS AND

PRODCUTION ANALYSIS
BREAK EVEN ANALYSIS
MODULE 3
INTRODUCTION OR PRODUCTION
CONCEPTS:
• Production can be defined as an organized activity of transforming
physical inputs into output which will satisfy the products needs of the
society.
• Production is an act of creating value that satisfies the wants of the
individuals.
• Production refers to the transformation of inputs or resources into
outputs or goods and services.
• Production is a process in which economic resources or inputs
(composed of natural resources like labour, land and capital equipment)
are combined by entrepreneurs to create economic goods and services
(outputs or products).
• Firms are required to take different but interrelated production decisions like:
• 1. Whether or not to actually produce or shut down?
• 2. How much to produce?
• 3. What input combination to use?
• 4. What type of technology to use?
• Factors of Production:
• Factors of production include resource inputs used to produce goods and services.
• Economist categorizes input factors into four major categories such as land, labor, capital and
organization.
• Land: Land is heterogeneous in nature. The supply of land is fixed and it is a permanent
factor of production but it is productive only with the application of capital and labour.
• Labour: The supply of labour is inelastic in nature but it differs in productivity and
efficiency and it can be improved.
• Capital: is a man made factor and is mobile but the supply is elastic. Capital used in
production is of two types namely, physical capital and human capital.
• Entrepreneurship: the organization plans, supervises, organizes and controls the
business activity and also takes risks.
 PRODUCTION ANALYSIS:
• Production Analysis refers to analyzing the inputs or resources that are used
to produce a firm’s final product.
• It defines the relationships between the prices of the commodities and
productive factors on one hand and the quantities of these commodities and
productive factors that are produced on the other hand.
• Production analysis basically is concerned with the analysis in which the
resources such as land, labor, and capital are employed to produce a firm’s
final product.
• To produce these goods the basic inputs are classified into two divisions:
• Variable Inputs: Inputs those change or are variable in the short run or long run are
variable inputs.
• Fixed Inputs: Inputs that remain constant in the short term are fixed inputs.
• Production Function signifies the technical relationship between the
physical inputs and physical outputs of the firm for given production
technology.
Q = f (a, b, c,............z)
• Where a,b,c.... z are various inputs such as land, labor ,capital etc. Q is
the level of the output for a firm.
• If labor (L) and capital (K) are only the input factors, the production
function reduces to---
Q = f(L, K)
Production Function describes the technological relationship between
inputs and outputs. It is a tool that analysis the qualitative input – output
relationship and also represents the technology of a firm or the economy as
a whole.
• Short Run & Long Run of A Firm:
• The distinction between the short run and the long run is based on the difference
between fixed and variable factors.
• A factor of production is treated as a fixed factor if it cannot easily be varied over the
time period under consideration.
• On the other hand, a variable factor is one which can be varied over the time period
under consideration.
• The short run is defined to be that period of time when some of the firm’s inputs are
fixed.
• Since it is most difficult to change plant and equipment among all inputs, the short
run is generally accepted as the time interval over which the firm’s plant and
equipment remain fixed.
• The long run is that period over which all the firms’ inputs are variable. In other
words, the firm has the flexibility to adjust or change its environment.
• Production processes of firms generally permit a variation in the proportion in which
inputs are used. In the long run, input proportions can be varied considerably.
• MEASURE OF PRODUCTIVITY OR PRODUCTION SCHEDULE:
• Production schedule refers to table showing the fixed inputs and variable
inputs and the total production, marginal and average production accordingly.
• Total Product is the total output resulting from the efforts of all the factors of
production combined together at any time.
• Average Product is the total product per unit of the variable input.
• Marginal Product is the change in the total product per unit change in the
quantity of variable factor.
• PRODUCTIONS FUNCTION WITH ONE VARIABLE INPUT:
• The production function shows the maximum output or total product
(TP) that can be produced by employing a combination of factors of
production at a given time period.
• The average product (AP) depicts the TP per unit of input used. The
marginal product (MP) is the change in the total product resulting from
a unit change in a variable input.
• If we assume labour (L) as a variable input, then
• TPL=f(L)
• APL=TP/L
• MPL=ΔTP/ΔL
LAW OF VARIABLE PROPORTION OR
LAW OF RETURNS TO FACTOR:
• States that “As the proportion of one factor in a combination of factors is
increased, after certain point first the marginal product and then the
average product of that factor will diminish.”
• Assumptions of Law of variable proportion:
• 1. Only one factor in combination of factors is variable and rest are
constant
• 2. All units of variable factor are homogenous
• 3. Technology pf production remains constant
• 4. Firm considers to be in short run
• 5. Output products are measured in physical units.
• Three Stages of the Law:
• 1. First Stage: Increasing Returns
• First stage starts from point ‘O’ and ends up to point F. At point F average product is maximum and
is equal to marginal product. In this stage, total product increases initially at increasing rate up to
point E. between ‘E’ and ‘F’ it increases at diminishing rate. Similarly marginal product also
increases initially and reaches its maximum at point ‘H’. Later on, it begins to diminish and
becomes equal to average product at point T. In this stage, marginal product exceeds average
product (MP > AP).
• 2. Second Stage: Constant returns
• It begins from the point F. In this stage, total product increases at diminishing rate and is at its
maximum at point ‘G’ correspondingly marginal product diminishes rapidly and becomes ‘zero’ at
point ‘C’. Average product is maximum at point ‘I’ and thereafter it begins to decrease. In this
stage, marginal product is less than average product (MP < AP).
• 3. Third Stage: Diminishing Returns
• This stage begins beyond point ‘G’. Here total product starts diminishing. Average product also
declines. Marginal product turns negative. Law of diminishing returns firmly manifests itself. In this
stage, no firm will produce anything. This happens because marginal product of the labour
becomes negative. The employer will suffer losses by employing more units of labourers. However,
of the three stages, a firm will like to produce up to any given point in the second stage only.
PRODUCTION FUNCTION WITH TWO
VARIABLE INPUTS:
• Refers to the relationship between the output resulting in production
by varying the two or more inputs. There may be various technical
possibilities of producing a given output by using different factor
combinations. Which particular factor combination will be actually
selected by the firm depends both on the technical possibilities of
factor substitution as well as on the prices of the factors of
production. Production Function with two Variable Inputs explains the
production behavior of the firm with all variable factors. We are
restricting our analysis to two variable inputs because it simply allows
us the scope for graphical analysis
LAW OF RETURNS TO SCALE:
• Stated as “The relationship between changes in the output and
proportionate change in all factors of production”
• Assumptions of Law of returns to scale:
• 1. All inputs or factors of production are variable
• 2. Production technology remains constant
• 3. Product produce is measure in physical units
• Stage 1: Increasing Returns to Scale
• In figure, stage I represents increasing returns to scale. During this stage, the
firm enjoys various internal and external economies such as technical
economies, managerial economies and marketing economies.
• Economies simply mean advantages for the firm. Due to these economies, the
firm realizes increasing returns to scale.
• This stage is also explained saying increasing returns in terms of “increased
efficiency” of labor and capital in the improved organization with the expanding
scale of output and employment factor unit.
• It is referred to as the economy of organization in the earlier stages of
production.
• Stage 2: Constant Returns to Scale
• In figure, the stage II represents constant returns to scale. During this
stage, the economies accrued during the first stage start vanishing and
diseconomies arise.
• Diseconomies refers to the limiting factors for the firm’s expansion.
Emergence of diseconomies is a natural process when a firm expands
beyond certain stage.
• In the stage II, the economies and diseconomies of scale are exactly in
balance over a particular range of output.
• When a firm is at constant returns to scale, an increase in all inputs leads
to a proportionate increase in output but to an extent.
• Stage 3: Diminishing Returns to Scale
• In figure, the stage III represents diminishing returns or decreasing
returns. This situation arises when a firm expands its operation even
after the point of constant returns.
• Decreasing returns mean that increase in the total output is not
proportionate according to the increase in the input.
• Because of this, the marginal output starts decreasing. Important factors
that determine diminishing returns are managerial inefficiency and
technical constraints.
 INDIFFERENCE CURVES
ISO-QUANTS & ISO-COST LINE
• An isoquant is a firm’s counterpart of the consumer’s indifference curve. An
isoquant is a curve that shows all the combinations of inputs that yield the
same level of output.
• ‘Iso’ means equal and ‘quant’ means quantity. Therefore, an isoquant
represents a constant quantity of output. The isoquant curve is also known
as an “Equal Product Curve” or “Production Indifference Curve” or Iso-
Product Curve.”
• Iso-Quant is a curve showing all possible combinations of inputs or factors of
production physically capable of producing a given level of output.
• Iso-quants are also called as Iso-Products or Equal-product curves. Isoquants
are a geometric representation of the production function.
• The same level of output can be produced by various combinations of factor
inputs. The locus of all possible combinations is called the ‘Isoquant’.
• The above table is based on the assumption that only two factors of
production, namely, Labor and Capital are used for producing 100 meters
of cloth.
• Combination A = 5L + 9K = 100 meters of cloth
• Combination B = 10L + 6K = 100 meters of cloth
• Combination C = 15L + 4K = 100 meters of cloth
• Combination D = 20L + 3K = 100 meters of cloth.
• The combinations A, B, C and D show the possibility of producing 100
meters of cloth by applying various combinations of labor and capital.
Thus, an isoquant schedule is a schedule of different combinations of
factors of production yielding the same quantity of output.
• ISOQUANT MAP
• An isoquant map is a set of isoquants that shows the maximum attainable
output from any given combination inputs.
• ISOQUANTS VS INDIFFERENCE CURVES
• An isoquant is ‘analogous’ to an indifference curve in more than one way.
• The properties of isoquants are similar to the properties of indifference
curves.
• However, some of the differences may also be noted.
• Firstly, in the indifference curve technique, utility cannot be measured. In the case
of an isoquant, the product can be precisely measured in physical units.
• Secondly, in the case of indifference curves, we can talk only about higher or
lower levels of utility. In the case of isoquants, we can say by how much IQ2
actually exceeds IQ1 (figure 2).
 PROPERTIES OF ISOQUANTS
• 1. An isoquant lying above and to the right of another
isoquant represents a higher level of output:
• This is because of the fact that on the higher isoquant,
we have either more units of one factor of production
or more units of both the factors. This has been
illustrated in figure 3. In figure 3, points A and B lie on
the isoquant IQ1 and IQ2 respectively.
• At point A we have = OX1 units of Labor and OY1 units
of capital.
• At point B we have = OX2 units of Labor and OY1 units
of capital.
• Though the amount of capital (OY1) is the same at both
the points, point B is having X1X2 units of labor more.
Therefore, it will yield a higher output. Hence, it is
proved that a higher isoquant shows a higher level of
output.
• 2. Two isoquants cannot cut each other:
• Just as two indifference curves cannot cut each
other, two isoquants also cannot cur each other. If
they intersect each other, there would be a
contradiction and we will get inconsistent results.
This can be illustrated with the help of a diagram as
in figure 4.
• In figure 4, the isoquant IQ1 shows 100 units of
output produced by various combinations of labor
and capital and the curve IQ2 shows 200 units of
output,
• On IQ1, we have A = C, because they are on the
same isoquant.
• On IQ2, we have A = B, Therefore B = C This is
however inconsistent since C = 100 and B = 200.
Therefore, isoquants cannot intersect.
• 3. Isoquants are convex to the origin
• An isoquant must always be convex to the origin. This
is because of the operation of the principle of
diminishing marginal rate of technical substitution.
MRTS is the rate at which marginal unit of an input
can be substituted for another input making the level
of output remain the same.
• In figure 5, as the producer moves from point A to B,
from B to C and C to D along an isoquant, the
marginal rate of technical substitution (MRTS) of
labor for capital diminishes.
• The MRTS diminishes because the two factors are not
perfect substitutes. In figure 5, for every increase in
labor units by (ΔL) there is a corresponding decrease
in the units of capital (ΔK).
• It cannot be concave as shown in figure 6. If they are
concave, MRTS of labor for capital increases. But this
is not true of isoquants.
• Since MRTS must diminish, the isoquants must be convex to the origin.
• 4. No isoquant can touch either axis
• If an isoquant touches the X-axis it would mean that the commodity can be
produced with OL units of labor and without any unit of capital.
• Point K on the Y-axis implies that the commodity can be produced with OK
units of capital and without any unit of labor.
• However, this is wrong because the firm cannot produce a commodity with
one factor alone.
• 5. Isoquants are negatively sloped
• An isoquant slopes downwards from left to
right. The logic behind this is the principle of
diminishing marginal rate of technical
substitution. In order to maintain a given
output, a reduction in the use of one input
must be offset by an increase in the use of
another input.
• Figure 8 shows that when the producer moves
from point A to B, the amount of labor
increases from OL to OL1, but the units of
capital decreases from OK to OK1, to maintain
the same level of output.
• The impossibility of horizontal, vertical or
upward sloping isoquants can be shown with
the help of the following diagrams.
• Consider figure 9(A) At point A, we have OL units of labor and OK units of capital and at B, we have OL1
units of labor and OK units of capital.
• OL1 + OK > OL + OK, and so combination B will yield a higher output than A. Therefore, points A and B
on the IQ curve cannot represent an equal level of the product. Hence, the isoquant cannot be a
horizontal straight line like AB.
• Consider figure 9(B) At point A, we have OL units of labor and OK units of capital. At point B, we have OL
units of labor and OK1 units of capital.
• Since B is having KK1 more units of capital it is wrong to assume that both A and B will yield the same
level of output. The conclusion is that the isoquant cannot be a vertical straight line.
• Similarly at point B in figure 9(C), we have LL1 units of more labor and KK1 units of more capital.
• As compared to point A, both the inputs are higher at point B. Therefore, it is absurd to assume that
both the combinations A and B will give the same level of output.
• 6. Isoquants need not be parallel
• The shape of an isoquant depends upon the marginal rate of technical
substitution. Since the rate of substitution between two factors need not
necessarily be the same in all the isoquant schedules, they need not be
parallel.
• 7. Each isoquant is oval-shaped
• An important feature of an isoquant is that it enables
the firm to identify the efficient range of production
consider figure 11.
• Both the combinations Q and P produce the same
level of total output. But the combination Q
represents more of capital and labor than P.
combinations Q must therefore be expensive and
would not be chosen. The same argument can be
made to rule out combination T or any other
combination lying on a portion of the isoquant where
the slope is positive. Positively sloped isoquants
imply that an increase in the use of labor would
require an increase in the use of capital to keep
production constant.
• In general, for any input combination on the positively
sloped portion of an isoquant, it is possible to find
another input combination with less of both the inputs
on the negatively convex portion that will produce the
same level of output. Therefore, only the negatively
sloped segment of isoquant is economically feasible.
• In figure 12, the segment P1S1 is the economically
feasible portion of the isoquant for IQ. If we consider
such feasible portions for all the isoquants, then the
region comprising of these portions is called the
economic region of production. A producer will
operate in this region. It is shown in figure 12. The
lines OP1P2 and OS1S2 are called ridge lines. Ridge
lines may be defined as lines separating the downward
sloping portions of a series of isoquants from the
upward sloping portions. They give the boundary of
the economic region of production.
Properties of Iso-Quants:
Property 1: An isoquant curve slopes downward, or is negatively sloped.
• This means that the same level of production only occurs when increasing
units of input are offset with lesser units of another input factor. This property
falls in line with the principle of the Marginal Rate of Technical Substitution
(MRTS). As an example, the same level of output could be achieved by a
company when capital inputs increase, but labor inputs decrease.
Property 2: An isoquant curve, because of the MRTS effect, is convex to its
origin.
• This indicates that factors of production may be substituted with one another.
The increase in one factor, however, must still be used in conjunction with the
decrease of another input factor.
Property 3: Isoquant curves cannot be tangent or intersect one another.
• Curves that intersect are incorrect and produce results that are invalid, as a common
factor combination on each of the curves will reveal the same level of output, which is
not possible.
Property 4: Isoquant curves in the upper portions of the chart yield higher outputs.
• This is because, at a higher curve, factors of production are more heavily employed.
Either more capital or more labor input factors result in a greater level of production.
Property 5: An isoquant curve should not touch the X or Y axis on the graph.
• If it does, the rate of technical substitution is void, as it will indicate that one factor is
responsible for producing the given level of output without the involvement of any other
input factors.
Property 6: Isoquant curves do not have to be parallel to one another; the rate of
technical substitution between factors may have variations.
Property 7: Isoquant curves are oval-shaped, allowing firms to determine the most
efficient factors of production.
**Graphs for the properties are given above**
TYPES OF ISOQUANT:
• Isoquants are differentiated on the basis of substitutability of the
factors of production and they are as below
1. Linear Isoquant: This type of isoquant are depicted by a straight
line sloping downward from left to right, as shown in Figure-(a).
It indicated a perfect and unlimited substitutability between two
factors implying that the product may be produced even by using
only capital or labour or by infinite combinations of the two factors.
2. Right angled Isoquant: are L-shaped curve Figure-(b) and also
known as Leontief isoquants. They assume a perfect
complementary nature between factors implying zero
substitutability. Factors are jointly used in a fixed proportion. It
means that there is only one method of production to produce a
commodity. Hence, to increase output, both factors are to be
increased holding the proportion constant.
3. Convex Isoquant: In this the inputs can be substituted but not
perfectly. The curve of this type is convex to origin as we always
consider for the isoquant curve.
ISO-COST CURVE:
• Isocost line shows all combinations of inputs which cost the same total
amount. The use of the Iso-cost line pertains to cost-minimization in
production, as opposed to utility-maximization. An Isocost line shows
the maximum amount which a firm is willing to expend on production.
• For the two production inputs labor and capital, with fixed unit costs of
the inputs, the equation of the is cost line is
• rK + wL=C
• Where w represents the wage rate of labor, r represents the rental rate
of capital, K is the amount of capital used, L is the amount of labor used,
and C is the total cost of acquiring those quantities of the two inputs.
• The cost-minimization problem of the firm is to choose an input bundle
(K,L) feasible for the output level that costs as little as possible. A cost-
minimizing input bundle is a point on the isoquant for the lowest possible
iso-cost line.
INDIFFERENCE CURVE:
• An indifference curve connects points on a graph
representing different quantities of two goods, points
between which a consumer is indifferent. An indifference
curve is a graph showing combination of two goods that give
the consumer equal satisfaction and utility. Each point on an
indifference curve indicates that a consumer is indifferent
between the two and all points give him the same utility.
• Graphically, the indifference curve is drawn as a downward
sloping convex to the origin. The graph shows a combination
of two goods that the consumer consumes. The above
diagram shows the U indifference curve showing bundles of
goods A and B. To the consumer, bundle A and B are the
same as both of them give him the equal satisfaction. In
other words, point A gives as much utility as point B to the
individual. The consumer will be satisfied at any point along
the curve assuming that other things are constant.
• LEAST COST COMBINATION FACTOR:
• Producer’s equilibrium or optimization occurs when he earns maximum profit with optimal combination of
factors.
• A profit maximization firm faces two choices of optimal combination of factors
• 1. To Maximize its output for a given cost
• 2. To minimize its cost for given output
• Thus the least cost combination of factors refers to a firm producing the largest volume of output from a
given cost and producing a given level of output with the minimum cost when the factors are combined in
an optimum manner.
• Assumptions made for to understand this concept are:
• 1. There are two factors, labour and capital.
• 2. All units of labour and capital are homogeneous.
• 3. The prices of units of labour (w) and that of capital (r) are given and constant.
• 4. The cost outlay is given.
• 5. The firm produces a single product.
• 6. The price of the product is given and constant.
• 7. The firm aims at profit maximisation.
• 8. There is perfect competition in the factor market.
• 1. To maximize output for given cost:
• The firm maximizes its profits by maximizing its output, given
its cost outlays, and the prices of the two factors. This analysis
is based on the same assumptions, as given above.
• From the fig, the firm can reach the optimal factor
combination level of maximum output by moving along the
iso-cost line CL from either point E or F to point P.
• This movement involves no extra cost because the firm
remains on the same iso-cost line the firm is maximising its
output level of 200 units by employing the optimal
combination of OM of capital and ON of labour, given its cost
outlay CL.
• But it cannot be at points E or F on the iso-cost line CL, since
both points give a smaller quantity of output, being on the
isoquant 100, than on the isoquant 200. The firm cannot
attain a higher level of output such as isoquant 300 because
of the cost constraint.
• The firm is in equilibrium at point P where the isoquant curve
200 is tangent to the iso-cost line CL Thus the equilibrium
point has to be P with optimal factor combination OM + ON.
• 2. To minimize cost for given output:
• Given these assumptions, the point of least-cost combination of
factors for a given level of output is where the isoquant curve is
tangent to an iso-cost line.
• The iso-cost line GH is tangent to the isoquant 200 at point M. The
firm employs the combination of ОС of capital and OL of labour to
produce 200 units of output at point M with the given cost-outlay
GH.
• At this point, the firm is minimising its cost for producing 200 units.
Any other combination on the isoquant 200, such as R or T, is on
the higher iso-cost line KP which shows higher cost of production.
• The iso-cost line EF shows lower cost but output 200 cannot be
attained with it.
• Therefore, the firm will choose the minimum cost point M which is
the least-cost factor combination for producing 200 units of output.
• M is thus the optimal combination for the firm.
• The point of tangency between the iso-cost line and the isoquant is
an important first order condition but not a necessary condition for
the producer’s equilibrium.
 ECONOMIES & DISECONOMIES OF SCALE:
• ECONOMIES OF SCALE are defined as the cost advantages that an
organization can achieve by expanding its production in the long run.
• In other words, these are the advantages of large scale production of the
organization.
• The cost advantages are achieved in the form of lower average costs per unit.
It is a long term concept.
• Economies of scale are achieved when there is an increase in the sales of an
organization.
• Economies of scale are the cost advantages that enterprises obtain due to
their scale of operation, with cost per unit of output decreasing which causes
scale increasing.
• Figure illustrates that average cost falls
as output increases, with the result that
large firms may enjoy lower costs that
smaller competitors.
• This competitive cost advantage allows
large firms to have larger profit margins
and have more options in pricing policy.
Reason for Economies of Scale:
1. Managerial - managers are on a fixed salary
2. Marketing - advertising, endorsements promotional events do not
directly depend on quantity produced
3. Technical - machinery, buildings etc. are paid for as a fixed amount
4. Bulk buying - remember it is the cost per unit of buying in bulk not the
total cost (Great example is supermarkets and local shop)
5. Financial - similar in principle to buying in bulk but this time interest
rates a more favorable
 INTERNAL ECONOMIES:
• As a firm increases its scale of production, the firm enjoys several economies
named as internal economies.
• Basically, internal economies are those which are special to each firm.
• For example, one firm will enjoy the advantage of good management; the
other may have the advantage of specialization in the techniques of
production and so on.
• “Internal economies are those which are open to a single factory, or a single
firm independently of the action of other firms. These result from an increase
in the scale of output of a firm and cannot be achieved unless output
increases.” Cairncross
• Refer to real economies which arise from the expansion of the plant size of
the organization. These economies arise from the growth of the organization
itself.
A. Technical Economies of Scale:
• Technical economies have their influence on the size of the firm. Generally, these economies accrue
to large firms which enjoy higher efficiency from capital goods or machinery.
• Bigger firms having more resources at their disposal are able to install the most suitable machinery.
Therefore, a firm producing on large scale can enjoy economies by the use of superior techniques.
• Technical economies are of three kinds:
(i) Economies of Dimension: A firm by increasing the scale of production can enjoy the technical economies. When
a firm increases its scale of production, average cost of production falls but its average return will be more.

(ii) Economies of Linked Process: A big firm can also enjoy the economies of linked process. A big firm carries all
productive activities. These activities get economies. These linked activities save time and transport costs to the
firm.

(iii) Economies of the Use of By-Products: All the large sized firms are in a position to use its by-products and waste-
material to produce another material and thus, supplement to their income. For instance, sugar industries make
power, alcohol out of the molasses.
B. Marketing Economies of Scale:
• When the scale of production of a firm is increased, it enjoys numerous selling or marketing
economies.
• In the marketing economies, we include advertisement economies, opening up of show
rooms, appointment of sole distributors etc.
• Moreover, a large firm can conduct its own research to effect improvement in the quality of
the product and to reduce the cost of production.
• The other economies of scale are advertising economies, economies from special
arrangements with exclusive dealers. In this way, all these acts lead to economies of large
scale production.
C. Labor Economies of Scale:
• As the scale of production is expanded their accrue many labour economies, like new
inventions, specialization, time saving production etc.
• A large firm employs large number of workers.
• Each worker is given the kind of job he is fit for. The personnel .officer evaluates the working
efficiency of the labour if possible.
• Workers are skilled in their operations which save production, time and simultaneously
encourage new ideas.
D. Managerial Economies of Scale:
• Managerial economies refer to production in managerial costs and proper
management of large scale firm.
• Under this, work is divided and subdivided into different departments. Each
department is headed by an expert who keeps a vigil on the minute details of his
department. A small firm cannot afford this specialisation.
• Experts are able to reduce the costs of production under their supervision. These
also arise due to specialization of management and mechanisation of managerial
functions.
E. Economies of Transport and Storage:
• A firm producing on large scale enjoys the economies of transport and storage. A big
firm can have its own means of transportation to carry finished as well as raw
material from one place to another.
• Moreover, big firms also enjoy the economies of storage facilities. The big firm also
has its own storage and go down facilities.
• Therefore, these firms can store their products when prices are unfavorable in the
market.
• EXTERNAL ECONOMIES:
• External economies refer to all those benefits which accrue to all the firms
operating in a given industry.
• Generally, these economies accrue due to the expansion of industry and other
facilities expanded by the Government.
• According to Cairncross, “External economies are those benefits which are
shared in by a number of firms or industries when the scale of production in
any industry increases.”
• Moreover, the simplest case of an external economy arises when the scale of
production function of a firm contains as an implicit variable the output of the
industry. A good example is that of coal mines in a locality.
• Occur outside the organization. These economies occur within the industries
which benefit organizations. When an industry expands, organizations may
benefit from better transportation network, infrastructure, and other facilities.
This helps in decreasing the cost of an organization.
A. Economies of Concentration:
• As the number of firms in an area increases each firm enjoys some benefits
like, transport and communication, availability of raw materials, research and
invention etc.
• Further, financial assistance from banks and non-bank institutions easily accrue
to firm. We can, therefore, conclude that concentration of industries lead to
economies of concentration.
B. Economies of Information:
• When the number of firms in an industry expands they become mutually
dependent on each other.
• In other words, they do not feel the need of independent research on
individual basis. Many scientific and trade journals are published.
• These journals provide information to all the firms which relates to new
markets, sources of raw materials, latest techniques of production etc.
C. Economies of Disintegration
• As an industry develops, all the firms engaged in it decide to divide and sub-divide
the process of production among themselves.
• Each firm specializes in its own process. For instance, in case of moped industry,
some firms specialize in rims, hubs and still others in chains, pedals, tires etc.
• It is of two types-
• horizontal disintegration.
• vertical disintegration.
• In case of horizontal disintegration each firm in the industry tries to specialize in one
particular item whereas, under vertical disintegration every firm endeavors to
specialize in different types of items.
• Material of one firm may be available and useable as raw materials in the other
firms. Thus, wastes are converted into by-products. The selling firms reduce their
costs of production by realizing something for their wastes.
• The buying firms gain by getting other firms’ wastes as raw materials at cheaper
rates. As a result of this, the average cost of production declines.
SIGNIFICANCE OF ECONOMIES OF SCALE:
• The significance of economies of scale is discussed as under:
(a). Nature of the Industry: The foremost significance of economies of scale is
that it plays an important role in determining the nature of the industry i.e.
increasing cost industry, constant cost industry or decreasing cost industry.
(b). Analysis of Cost of Production: When an industry expands in response to an
increase in demand for its products, it experiences some external economies as
well as some external diseconomies. The external economies tend to reduce the
costs of production and thereby causing an upward shift in the long period
average cost curve, whereas the external diseconomies tend to raise the costs
and thereby causing an upward shift in the long period average cost curve. If
external diseconomies outweigh the external economies, that is, when there
are net external diseconomies, the industry would be an Increasing cost
industry.
• DISECONOMIES OF SCALE are when the cost per unit of production
(Average cost) increases because the output (sales) increases.
• Reasons for diseconomies of scale
1. Communication - becomes more complex
2. Coordination - between departments
3. X- Inefficiency - management costs increase (non-productive costs)
4. Principle agent problem - delegating to employees who are not as committed as the
owner.
 COST ANALYSIS
• Cost Analysis refers to the measure of the cost – output relationship, i.e. the
economists are concerned with determining the cost incurred in hiring the
inputs and how well these can be rearranged to increase the productivity
(output) of the firm.
• In other words, the cost analysis is concerned with determining money value
of inputs (labor, raw material), called as the overall cost of production which
helps in deciding the optimum level of production.
• Cost refers to the money value that is incurred in acquiring the resources and
producing the product.
 Determinants of Cost

• Level of output: The cost of production varies according to the quantum of

output. If the size of production is large then the cost of production will also
be more.
• Price of input factors: A rise in the cost of input factors will increase the total
cost of production.
• Productivities of factors of production: When the productivity of the input
factors is high then the cost of production will fall.
• Size of plant: The cost of production will be low in large plants due to mass
production with mechanization.
• Output stability: The overall cost of production is low when the output is
stable over a period of time.
• Lot size: Larger the size of production per batch then the cost of production
will come down because the organizations enjoy economies of scale.
• Laws of returns: The cost of production will increase if the law of diminishing
returns applies in the firm.
• Levels of capacity utilization: Higher the capacity utilization, lower the cost of
production.
• Time period: In the long run cost of production will be stable.
• Technology: When the organization follows advanced technology in their
process then the cost of production will be low.
• Experience: over a period of time the experience in production process will
help the firm to reduce cost of production.
• Supply chain and logistics: Better the logistics and supply chain, lower the cost
of production.
 TYPES OF COST
• Fixed Costs (FC):
• The costs which don’t vary with changing output. Fixed costs might include the cost of
building a factory, insurance and legal bills. Even if your output changes or you don’t
produce anything, your fixed costs stay the same.
• Variable Costs (VC):
• Costs which depend on the output produced. For example, if you produce more cars,
you have to use more raw materials such as metal. This is a variable cost.
• Marginal Costs (MC):
• It is the cost that incurred due to the production of an extra or additional unit.
• Opportunity Cost:
• Opportunity cost is the next best alternative foregone. “It is cost incurred due to one’s
own choice”, i.e the opportunity an individual loose by choosing other.
• Incremental cost:
• Incremental cost is the total cost incurred due to an additional unit of product being produced.
• Explicit costs:
• These are costs that a firm directly pays for and can be seen on the accounting sheet. Explicit costs can be
variable or fixed and it is a clear amount.
• Implicit costs:
• These are opportunity costs, which do not necessarily appear on its balance sheet but affect the firm.
• For example the assets of the owner used for the purpose of business.
• Sunk Cost:
• These are costs that have been incurred and cannot be recouped. Depreciation is considered as one of
the best example for sunk cost.
• Example if you spend money on advertising to enter an industry, you can never claim these costs back.
• Future Cost:
• It is a type of cost, where the cost incurred to estimate the future data or forecasting of the organization.
It is a type of cost which cannot be exceptional in nature.
• Social Cost:
• This is the total cost to society. It will include the private costs plus also the external cost (cost incurred by
a third party). May also be referred to as ‘True costs’ where the company spends on betterment of the
society.
 COST CURVES:
• Total fixed costs: Given that total fixed
costs (TFC) are constant as output
increases, the curve is a horizontal line
on the cost graph.
• Total variable costs: The total variable
cost (TVC) curve slopes up at an
accelerating rate, reflecting the law of
diminishing marginal returns.
• Total costs: The total cost (TC) curve is
found by adding total fixed and total
variable costs. Its position reflects the
amount of fixed costs, and its gradient
reflects variable costs.
Cost – Output Relationship in
the Short Run and in the Long
Run.
• Cost – Output Relationship in Short Run:
• The diagram shows Average Cost (AC),
Average Fixed Cost (AFC), Average
Variable Cost (AVC) and Marginal Cost
(MC) on OY-axis and units of output on
OX-axis.
• AC, MC and AVC are U-shaped curves. The
U-shaped curves are on account of the
operation of the laws of return during
short period.
• AFC curve shows a decreasing trend.
• MC curve passes through the minimum
points of AC and AVC curves
• From the graph;
• 1. Average Fixed Cost in Short Run:
• The average fixed cost is the total fixed cost divided by the volume of output.
• There is an inverse relation between output and average fixed cost.
• With the increase in output average fixed cost decreases and with the decrease in output the average
fixed cost will increase.
• It is calculated from the following formula:
AFC = TFC/Q
• Q is volume of output
• AFC and TFC are average fixed cost and total fixed cost.
• 2. Average Variable Cost (AVC):
• The average variable cost is total variable cost divided by the volume of output.
• Average variable cost falls with the increase in output, reaches at its minimum and then starts rising.
• By the operation of law of increasing returns the AVC decreases, and by the operation of constant returns
leads to constancy in AVC and the law of diminishing returns leads to increase in AVC.
• The shape of AVC is U-shaped because of the operation of the laws of returns during short period.
• The AVC is calculated by the formula given below:
AVC = TVC/Q
• AVC and TVC are average variable cost and total variable cost while Q is the volume of output.
• 3. Average Total Cost (ATC):
• Average Total Cost (ATC) is the aggregate of AFC and AVC.
• ATC can be calculated from total cost (TC) divided by the volume of output or by
aggregating AVC and AFC.
• The ATC curve decreases with the increase in output and remains constant up to a
point and thereafter it increases with the increase in output.
• Its shape is U-shaped because of the operation of the laws of return during short
period.
• The following is the formula of calculating AC:
ATC = TC/Q or
ATC = AFC + AVC
• ATC and TC are average total cost and total cost while Q is the volume of output.
• 4. Marginal Cost (MC):
• It is an addition to total cost by producing an additional unit of output.
• It can be calculated as the change in total cost divided by an additional unit change in
the output.
• Marginal Cost changes with the change in average variable cost (AVC) and it is
independent of average fixed cost (AFC).
• Initially, MC Falls, reaches the minimum and thereafter continuously increases.
• MC is also U-shaped curve.
• MC curve cuts the ATC and AVC curves at their minimum points.
• MC = Change in ATC/ Change in Q
Note: to understand the above concept
(1) AFC declines continuously, approaching both axes asymptomatically (as
shown by the decreasing distance between ATC and AVC) and is a
rectangular hyperbola.
(2) AVC first declines, reaches a minimum at Q2and rises thereafter. When
AVC is at its minimum, MC equals AVC.
(3) ATC first declines, reaches a minimum at Q3, and rises thereafter. When
ATC is at its minimum, MC equals ATC.
(4) MC first declines, reaches a minimum at Q1, and rises thereafter. MC
equals both AVC and ATC when these curves are at their minimum
value
• Cost – Output Relationship in Long Run:
• Long period gives sufficient time to business managers to change even the scale
of production.
• All the factors of production are variable.
• All the costs are variable costs and there is no fixed cost.
• The supply of goods can be adjusted to their demands because scale of
production and factors of production can be changed.
 Long Run Average Cost (LAC)
Curve:
• In the long run, all the factors of production are variable and the firm has a
variety of choices to select the size of the plants and the factors of
production to be employed.
• Various short run average cost curves represent the various sizes of the
plants available to a firm.
• We can get the long run average cost curve with the help of all the short run
average cost curves.
• The long run average cost curve envelopes all the short run average cost
curves in it.
• It is also called an ‘Envelope Curve’ or ‘Planning Curve’.
• From the figure long run cost represented
on OY-axis and output on OX-axis.
• SAC, SAC1, SAC2, SAC3 and SAC4 are short
run average cost curves which represent
the different size of plants.
• LAC has been drawn by combining all
those points of least cost of producing the
corresponding output.
• The least per unit cost of production is
OQ, OQ1, OQ2, OQ3, OQ4, and OQ5
respectively.
 BREAK-EVEN ANALYSIS:
MEANING
• Break-even analysis seeks to investigate the interrelationships among a
firm’s sales revenue or total turnover, cost, and profits as they relate to
alternate levels of output.
• A profit-maximizing firm’s initial objective is to cover all costs, and thus to
reach the break-even point, and make net profit thereafter.
• This is explained with the example of an Break Even Chart .
• The basic formula for break-even analysis is derived by DIVIDING THE
TOTAL FIXED COSTS OF PRODUCTION BY THE CONTRIBUTION PER UNIT
 BREAK EVEN CHART:
• Break-Even charts, the concepts like total fixed cost, total variable cost,
and the total cost and total revenue are shown separately. The break
even chart shows the extent of profit or loss to the firm at different levels
of activity.
• In this diagram output is shown on the horizontal axis and costs and revenue
on vertical axis. Total revenue (TR) curve is shown as linear, as it is assumed
that the price is constant, irrespective of the output.
• This assumption is appropriate only if the firm is operating under perfectly
competitive conditions. Linearity of the total cost (TC) curve results from the
assumption of constant variable cost.
• It should also be noted that the TR curve is drawn as a straight line through
the origin (i.e., every unit of the output contributes a constant amount to total
revenue), while the TC curve is a straight line originating from the vertical axis
because total cost comprises constant / fixed cost plus variable cost which rise
linearly.
• In the figure, В is the break-even point at OQ level of output
ASSUMPTIONS OF BREAK EVEN
ANALYSIS:
• (i) The total costs may be classified into fixed and variable costs. It ignores
semi-variable cost.
• (ii) The fixed costs remain constant over the volume under consideration.
• (iii) It assumes constant rate of increase in variable cost.
• (iv) The cost and revenue functions remain linear.
• (v) The price of the product is assumed to be constant.
• (vi) The volume of sales and volume of production are equal.
• (vii) It assumes constant technology and no improvement in labour
efficiency.
• (viii) The price of the product is assumed to be constant.
What is the determination of the break-even
point?

• The breakeven point is calculated by dividing the fixed costs of

production by the price per unit minus the variable costs of
production.
• The breakeven point is the level of production at which the costs of
production equal the revenues for a product.
MANAGERIAL USE OF BREAK EVEN ANALYSIS:

(i) Safety Margin: The break-even chart helps the management to know at a glance the profits
generated at the various levels of sales. The safety margin refers to the extent to which the
firm can afford a decline before it starts incurring losses.
The formula to determine the sales safety margin is:
Safety Margin= (Sales – BEP)/ Sales x 100
(ii) Target Profit: The break-even analysis can be utilized for the purpose of calculating the
volume of sales necessary to achieve a target profit.
(iii) Change in Price: The management is often faced with a problem of whether to reduce
prices or not. Before taking a decision on this question, the management will have to consider
a profit. A reduction in price leads to a reduction in the contribution margin.
This means that the volume of sales will have to be increased even to maintain the previous
level of profit. The higher the reduction in the contribution margin, the higher is the increase
in sales needed to ensure the previous profit.
(iv) Change in Costs: When costs undergo change, the selling price and the
quantity produced and sold also undergo changes.
Changes in cost can be in two ways:
• Change in variable cost
• Change in fixed cost.
Variable Cost Change: An increase in variable costs leads to a reduction in
the contribution margin. This reduction in the contribution margin will
shift the break-even point downward. Conversely, with the fall in the
proportion of variable costs, contribution margins increase and break-even point
moves upwards.
Fixed Cost Change: An increase in fixed cost of a firm may be caused either
due to a tax on assets or due to an increase in remuneration of
management, etc. It will increase the contribution margin and thus push the
break-even point upwards. Again to maintain the earlier level of profits, a
new level of sales volume or new price has to be found out.
• (v) Decision on Choice of Technique of Production: The breakeven analysis is
the most simple and helpful in the case of decision on a choice of technique of
production. For low levels of output, some conventional methods may be
most probable as they require minimum fixed cost. For high levels of output,
only automatic machines may be most profitable. By showing the cost of
different alternative techniques at different levels of output, the break-even
analysis helps the decision of the choice among these techniques.
• (vi) Make or Buy Decision: Firms often have the option of making certain
components or for purchasing them from outside the concern. Break-even
analysis can enable the firm to decide whether to make or buy.
• (vii) Plant Expansion Decisions: The break-even analysis may be adopted to
reveal the effect of an actual or proposed change in operation condition. This
may be illustrated by showing the impact of a proposed plant on expansion on
costs, volume and profits. Through the break-even analysis, it would be
possible to examine the various implications of this proposal.
(viii) Plant Shut Down Decisions: In the shut down decisions, a distinction
should be made between out of pocket and sunk costs. Out of pocket costs
include all the variable costs plus the fixe cost which do not vary with output.
Sunk fixed costs are the expenditures previously made but from which benefits
still remain to be obtained e.g. depreciation.
• (ix) Advertising and Promotion Mix Decisions: The break-even point concept
helps the management to know about the circumstances. It enables him not
only to take appropriate decision but by showing how these additional fixed
cost would influence BEPs. The advertisement pushes up the total cost curve
by the amount of advertisement expenditure.
• (x) Decision Regarding Addition or Deletion of Product Line: If a product has
outlive utility in the market immediately, the production must be abandoned
by the management and examined what would be its consequent effect on
revenue and cost. Alternatively, the management may like to add a product to
its existing product line because it expects the product as a potential profit
spinner. The break-even analysis helps in such a decision
 LIMITATIONS OF BREAK EVEN
ANALYSIS:
1. Break-even analysis is based on the assumption that all costs and expenses can be
clearly separated into fixed and variable components. In practice, however, it may
not be possible to achieve a clear-cut division of costs into fixed and variable types.
2. It assumes that fixed costs remain constant at all levels of activity. It should be
noted that fixed costs tend to vary beyond a certain level of activity.
3. It assumes that variable costs vary proportionately with the volume of output. In
practice, they move, no doubt, in sympathy with volume of output, but not
necessarily in direct proportions.
4. The assumption that selling price remains unchanged gives a straight revenue line
which may not be true. Selling price of a product depends upon certain factors like
market demand and supply, competition etc., so it, too, hardly remains constant.
5. The assumption that only one product is produced or that product mix will remain
unchanged is difficult to find in practice
MARGIN OF SAFETY
• The margin of safety (MOS) is the difference between
your gross revenue and your break-even point.
• Your break-even point is where your revenue covers
your costs but nothing more.
• In other words, your business does not make a loss but
it doesn't make a profit either.
 Margin of safety has multiple definitions,
including in accounting, investing, and health:
• Accounting and sales:
• The difference between a business's sales and its break-even point (BEP). It's a measure of
how much revenue a company generates above its costs. The margin of safety is
calculated by subtracting the break-even sales from the actual sales. It's often expressed
as a percentage, but can also be expressed in dollars or standardized units.
• Investing
• The difference between the intrinsic value of a security or investment and its market
price. It's a cushion to protect investors from the uncertainties of financial markets. The
margin of safety is calculated by subtracting the market price from the intrinsic value, and
then dividing that number by the intrinsic value and multiplying by 100%.
• Health
• The difference between the usual effective dose of a drug and the dose that causes severe
or life-threatening side effects. A wide margin of safety is desirable, but a narrow margin
of safety may be necessary in some cases.
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