20A52301 Managerial Economics & Financial Analysis

UNIT – II
THEORY OF PRODUCTION & COST ANALYSIS

Production
Production refers to the transformation of inputs into outputs. It involves transformation of
inputs such as capital, equipment, labour and land into output- goods and service.
Definition: Production is the method of turning raw materials or inputs into finished goods or
products in a manufacturing process. In other words, it means the creation of something from
basic input.

Factors of Production
The factors of production are resources that are the building blocks of the economy;
they are what people use to produce goods and services. Economists divide the factors of
production into four categories: land, labor, capital, and Organization / Enterprise.

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20A52301 Managerial Economics & Financial Analysis

Land is a broad term that includes all the natural resources that can be found on land, such as
oil, gold, wood, water, and vegetation. All resources, whether it is renewable or non-renewable,
can be used as inputs in production in order to produce a good or service. The income that
comes from using land and its natural resources is referred to as rent.
Labour as a factor of production refers to the effort that individuals exert when they produce
a good or service. Productivity is measured by the amount of output someone can produce in
each hour of work. The income that comes from labor is referred to as wages.
Capital, or capital goods, as a factor of production, refers to the money that is used to purchase
items that are used to produce goods and services. For example, a company that purchases a
factory to produce goods or a truck that is purchased to do construction are considered to be
capital goods.
Enterprise as a factor of production is a combination of the other three factors. Entrepreneurs
use land, labor, and capital in order to produce a good or service for consumers.

Production Function
“A Production Function relates physical output of a production process to physical
inputs or factors of production”. It is a mathematical function that relates the maximum amount
of output that can be obtained from a given number of inputs – generally capital and labour.
The production function, therefore, describes a boundary or frontier representing the limit of
output obtainable from each feasible combination of inputs.
Production Function is “The technical relationship which reveals the maximum amount
of output capable of being produced by each & every set of inputs”,
Production function is the mathematical representation of relationship between physical
inputs & physical outputs over a period of time. It can be expressed as:

Q = f (L1, L2, C, O, T, M)
Where,
Q = Total output
L1 = Land
L2 = Labour
C = Capital
O = Organization
T = Technology
M = Machinery (or) materials.
Assumptions
 Production function is related to a specific time period.
 The state of technology is fixed during this period of time.
 The factors of production are divisible into the most viable units.
 There are only two factors of production, labour and capital.
Types of Production Function
Based on the time period the production function is classified into two broad
categories:

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20A52301 Managerial Economics & Financial Analysis

Short Run Production Function: In short run production function one factor of production
remains constant and one factor of production changes. As in short run we can make changes
in labour only the other factor that is capital remains constant as in short period we cannot
immediately make changes in the capital only labour can be changed.
Long Run Production Function: In long run production function all factors of production
changes. As in long run we can make changes in labour as well as the other factor that is
capital also. So in long run all factor of production are variable. Output can be increased by
increasing all the factors of production.

Difference between Short run & Long run Production Function

Importance of Production Function

These are important of production functions which are given below:
1. When inputs are specified in physical units, production function helps to estimate
the 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 another
without 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.

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20A52301 Managerial Economics & Financial Analysis

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.

Features of Production Function

The production function is the input-output relationship with a given state of technology and
it is concerned with the short run as well as the long run. It has the following salient features:
1. Production function studies the physical quantities of inputs and physical
quantities of output. It is not concerned with the monetary calculations.
2. Production function is totally independent of the prices of inputs and output. In
actual practice the production decisions of an individual firm are based on the
prices of inputs and output.
3. The study of production function is based on the assumption that the technical
know-how is given. If the technology goes under change the production function
will also change.
4. The production function is concerned with a given period of time. Different periods
of time have different types of production function.
5. Under production function one input can be substituted by another input and the
more or less units of these inputs can be employed.
6. When an Individual firm employs one factor of production as fixed (land) and other
inputs are kept variable during short period the production function is called short
run production function.
7. During long run all the factors of production are variable. When an individual
operates its production in such a situation it is called long run production function.
8. Production function studies the given techniques of production during short run as
well as long run.

Isoquant
Isoquant is the combination of two different Greek words
‘iso’ means ‘equal’ or ‘same’ and ‘quant’ is the short form of quantity. Thus, an isoquant is a
curve along which output is the same. For the sake of analysis, we are assuming that a
producer employs two inputs—labour (L) and capital (K).
“Isoquant is a graphical representation of all the various combinations of inputs which are
equal in the eyes of the producer as they produce the same level of output.” Isoquants are called
equal-product or iso-product curves. Again, as all the combinations yield the same level of output
the producer tends to be indifferent among them. Hence, isoquants are also known as
producer indifference curves. Further, isoquants share resemblances with the indifference
curves.

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20A52301 Managerial Economics & Financial Analysis

A firm can produce a certain amount of a commodity by employing different combi-

nations of labour and capital. When this information is plotted on a graph paper, we obtain
an isoquant.
Assumptions
 There are only two factor inputs, labour and capital, to produce a particular
product.
 Capital, labour and goods are divisible in nature.
 Capital and labour are able to substitute each other up to a certain limit.
 Technology of production is given over a period of time.
 Factors of production are used with full efficiency.

Isoquant Schedule

The combinations A, B, C and D show the Combination A = 12L + 1K = 1000 meters of

possibility of producing 1000 meters of cloth.
cloth by applying various combinations of Combination B = 8L + 2K = 1000 meters of
labor and capital. Thus, an isoquant cloth.
schedule is a schedule of different Combination C = 5L + 3K = 1000 meters of
combinations of factors of production
cloth.
yielding the same quantity of output
Combination D = 3L + 4K = 1000 meters of
cloth

An iso-product curve is the graphic representation of an iso-product schedule. Thus,

an isoquant is a curve showing all combinations of labor and capital that can be used to
produce a given quantity of output.

Properties / Features
Some of the Properties / Features of isoquant curve are as follows:
1. Isoquant curves slope downwards
2. Isoquant curves are convex to origin
3. Isoquant curves cannot intersect each other

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4. Higher the isoquant the higher the output

Isoquant curves slope downwards
It implies that the slope of the isoquant curve is negative. This is because when capital (K) is
increased, the quantity of labour (L) is reduced or vice versa, to keep the same level of
output.
Isoquant curves are convex to origin
It implies that factor inputs are not perfect substitutes. This property shows the substitution
of inputs and diminishing marginal rate of technical substitution of isoquant. The marginal
significance of one input (capital) in terms of another input (labour) diminishes along with
the isoquant curve.
Isoquant curves cannot intersect each other
An isoquant implies the different levels of combination producing different levels of inputs. If
the isoquants intersect each other, it would imply that a single input combination can produce
two levels of output, which is not possible. The law of production would fail to be applicable.
Higher the isoquant the higher the output
It implies that the higher isoquant represents higher output. The upper curve of the isoquant
produces more output than the curve beneath. This is because the larger combination of
input results in a larger output as compared to the curve that is beneath it.
Do not Touches the axes
The isoquant touches neither X-axis nor Y-axis, as both inputs are required to producw a given
product.
IsoCost
Iso-cost curve is the locus of points of all different combinations of labour and capital
that an organisation can employ, given the price of these inputs. Iso-cost line represents the
price of factors along with the amount of money an organisation is willing to spend on factors.
In other words, it shows different combinations of factors that can be purchased at a
certain amount of money. The slope of the iso-cost line depends upon the ratio of price of
labour to the price of capital.
For example, a producer has a total budget of ₹120, which he wants to spend on the factors
of production, namely, X and Y. The price of X in the market is ₹15 per unit and the price of Y
is ₹10 per unit. Following table depicts the combinations:

COMBINATION UNIT UNIT TOTAL

S S OF S OF EXPENDITUR
X Y E

A 8 0 120

B 6 3 120

C 4 6 120

D 2 9 120

E 0 12 120

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20A52301 Managerial Economics & Financial Analysis

As shown in Figure 6, if the producer spends the whole amount of money to purchase X, then
he/she can purchase 8 units of X. On the other hand, if the producer purchases Y with the
whole amount, then he/she would be able to get 12 units.
If points H and L are joined on X and Y axes, respectively, then a straight line is obtained, which
is called iso-cost line. All the combinations of X and Y that lie on this line, would have the same
amount of cost that is ₹120.

Least Cost Combination

The manufacturer has to produce at lower cost to attain higher profits. The isocost &
isoquants can be used to determine the input usage that minimises the cost of production.
In the theory of production, a producer will be in equilibrium when, given the cost-
price function, he maximizes his profits on the basis of the least-cost combination of factor.
For this he will choose that combination of factors which maximizes his cost of production.
This will be the optimum combination for him.

Assumptions
The assumptions on which this analysis is based are:
1. There are two factors. Capital and labour.
2. All units of capital and labour are homogeneous.
3. The prices of factors of production are given and constant.
4. Money outlay at any time is also given.
5. Perfect competition is prevailing in the factor market.
Where the slope of isoquant curve is equal to that of isocost curve, their lies the lowest
point of cost of production. This is observed by superimposing the isocosts on
isoproduct curves.
The points of tangency P, Q, and R on each of the isoquant curves represent the least
cost combination of inputs, yielding maximum level of output. Any output lower than
or higher than this will result in higher cost of production

Expansion path refers to the line representing the least cost combination of inputs P, Q, R for
different levels of output. Expansion path indicates how the production can be expanded along

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this path, if the factor prices are given. The expansion path is also called as ‘scale line’ as it
indicates how to adjust the scale of operations as the firm changes its output.

Marginal Rate of Technical Substitution – MRTS

The marginal rate of technical substitution (MRTS) is an economic theory that
illustrates the rate at which one factor must decrease so that the same level of productivity
can be maintained when another factor is increased.
It refers to the rate at which one input factor is substituted with the other to attain a
given level of output. The substitution of one input for the another continues until the
producer reaches the pot of least cost combination where MRTS between the inputs is equal
to the ratio between the prices of inputs.

COMBINATIONS CAPITAL (LAKHS) LABOUR MRTS

A 1 20 -

B 2 15 5:1

C 3 11 4:1

D 4 8 3:1

E 5 6 2:1

F 6 5 1:1

Where:
 MP is the Margin Product of each input
 Δ K/Δ L is the Capital that can be reduced
 K is the Capital
 L is the Labor
Uses and Application of MRTS
The isoquants in an MRTS graph display the rate at which the other can be substituted
for a given input, either labour or capital, thus retaining the same output level.
A decrease in MRTS along an isoquant is called the declining marginal rate of
substitution for generating the same level of output.
Producer equilibrium is a term in which all producers aim for the least amount of cost
to achieve the maximum amount of profit. By bringing output factors together in a
combination that needs the least amount of money, the producer gets equilibrium.

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20A52301 Managerial Economics & Financial Analysis

Therefore, the manufacturer is responsible for determining the combination of the

factors of production, which best achieve this result. The decision made by the producer
relates to the MRTS and the substitution principle.
It must be noted that only two factors of production are present in a plant, i.e. factor A
and factor B. The factor A can produce a higher quantity of output than factor B. It can be
done with an equal amount of capital being spent on both. It would result in the producer
choosing factor A for factor B instead.

Cobb-Douglas Production Function

The Cobb-Douglas production function is based on the empirical study of the American
manufacturing industry made by Paul H. Douglas and C.W. Cobb. It is a linear homogeneous
production function of degree one which takes into account two inputs, labour and capital, for
the entire output of the .manufacturing industry.This analysis produced a calculation that is still
in use today, largely because of its accuracy.
The Cobb-Douglas production function reflects the relationships between its inputs -
namely physical capital and labor - and the amount of output produced. It's a means for
calculating the impact of changes in the inputs, the relevant efficiencies, and the yields of a
production activity. Here's the basic form of the Cobb-Douglas production function:

Where,
Q = Output
K = Capital
L = Labour
A, β,α = Positive Constants

The equation tells that output depends directly on L and C, and that part of output which
cannot be explained by L and С is explained by A which is the ‘residual’, often called technical
change.
Criticisms of Cobb-Douglas Production Function
1. The C-D production function considers only two inputs, labour and capital, and neglects
some important inputs, like raw materials, which are used in production.
2. In the C-D production function, the problem of measurement of capital arises because
it takes only the quantity of capital available for production.
3. The C-D production function is criticised because it shows constant returns to scale.
4. The C-D production function is based on the assumption of substitutability of factors
and neglects the complementarity of factors.
5. This function is based on the assumption of perfect competition in the factor market
which is unrealistic.
Conclusion:
Thus the practicability of the C-D production function in the manufacturing industry is a
doubtful proposition. This is not applicable to agriculture where for intensive cultivation,
increasing the quantities of inputs will not raise output proportionately. Even then, it cannot be
denied that constant returns to scale are a stage in the life of a firm, industry or economy. It is
another thing that this stage may come after some time and for a short while.

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20A52301 Managerial Economics & Financial Analysis

Laws of Returns
In the long run all factors of production are variable. No factor is fixed. Accordingly,
the scale of production can be changed by changing the quantity of all factors of production.
Definition:
“The term returns to scale refers to the changes in output as all factors change by the
same proportion.”
“Returns to scale relates to the behaviour of total output as all inputs are varied and is
a long run concept”.

LAW OF PRODUCTION
Production analysis in economics theory considers two types of input-output
relationships.
1. When quantities of certain inputs, are fixed and others are variable and
2. When all inputs are variable.
These two types of relationships have been explained in the form of laws.
i) Law of variable proportions
ii) Law of returns to scale

I. Law of variable proportions

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:
“When total output or production of a commodity is increased by adding units of a variable
input while the quantities of other inputs are held constant, the increase in total production
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 the resulting increments of product will decrease i.e.
the marginal product will diminish”.
“As the proportion of one factor in a combination of factors is increased, after a point, first
the marginal and then the average product of that factor will diminish”.
Assumptions of the Law:
The law is based upon the following assumptions:
i) The state of technology remains constant. If there is any improvement in
technology, the average and marginal output 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 to those cases where the factors must be used in rigidly
fixed proportions.
iii) All units of the variable factors are homogenous.
Three stages of law:
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.
Fixed Factor Variable Factor Total Average Marginal
(Labour) Product Product Product

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20A52301 Managerial Economics & Financial Analysis

1 1 100 100 -
1 2 220 120 120
Stage -I
1 3 270 90 50
1 4 300 75 30
1 5 320 64 20
Stage -II
1 6 330 55 10
1 7 330 47 0
1 8 320 40 -10 Stage -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 marginal product of 8th 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:
this stage increases at an increasing rate
resulting in a greater increase in total
product. The average 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. The second stage comes to
an end where total product becomes
maximum and marginal product becomes
From the above graph the law of variable zero. The marginal product becomes
proportions operates in three stages. In negative in the third stage. So the total
the first stage, total product increases at product also declines. The average product
an increasing rate. The marginal product in continues to decline.

II. Law of Returns to Scale

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., inresponse 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

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20A52301 Managerial Economics & Financial Analysis

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 scale
means that all inputs or factors are increased in the same proportion.
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 proportion among the factors result in certain changes in output. In returns to
scale all the 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 technically there
are three possibilities.
(i) The total output may increase proportionately
(ii) The total output may increase more than proportionately and
(iii) The total output may increase less than proportionately.
If increase in the total output is proportional to the increase in input, it means constant
returns to scale. If 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 proportional
increase 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.

ECONOMIES OF SCALE
The economies of scale results because of increase in the scale of production.
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 internal economies 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.
Causes of internal economies: Internal economies are generally caused by two factors
1. Indivisibilities
2. Specialization.
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. Specialization may be in labour, capital, machinery and place. For example, the

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20A52301 Managerial Economics & Financial Analysis

production process may be split into four departments relation to manufacturing, 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.
INTERNAL ECONOMIES:
Internal economies may be of the following types.
A). Technical Economies. 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). Managerial Economies: 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 of an 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). Marketing Economies: 30 The large firmThe large firm reaps marketing or commercial
economies in buying its requirements and in selling its final products. The large firm generally
has a separate marketing department. 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). Financial Economies: 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 and other financial institutions at relatively cheaper rates. It is in this
way that a large firm reaps financial economies.
E). Risk bearing Economies: The large firm produces many commodities and serves wider
areas. It is, therefore, able to 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). Economies of Research: A large firm possesses larger resources and can establish it‟s own
research laboratory and employ trained research workers. The firm may even invent new
production techniques for increasing its output and reducing cost.
G). Economies of welfare: 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, educational and medical facilities tend to increase the productive efficiency of the
workers, which helps in raising production and reducing costs.
EXTERNAL ECONOMIES:
Business firm enjoys a number of external economies, which are discussed below:

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20A52301 Managerial Economics & Financial Analysis

A). Economies of Concentration: 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). Economies of Information 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). Economies of Welfare: An industry is in a better position to provide welfare facilities to
the workers. It may get land at concessional rates and procure special facilities from the local
bodies for setting up housing colonies for the workers. It may also establish public health care
units, 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). Economies of Disintegration: 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 manufacturing thread, others in printing, still others in dyeing,
some in long cloth, some in 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. Thus internal
economies depend upon the size of the firm and external economies depend upon the size of
the industry.

COST ANALYSIS
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.

COST CONCEPTS
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
classifying cost and the relevance of each for different kinds of problems are to be studied.
The various relevant concepts of cost are:
1.Opportunity costs and outlay costs:
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 by assessing
the alternative, which has to be scarified if the particular line is followed. The opportunity
cost concept is made use for long-run decisions. This concept is very important in capital

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20A52301 Managerial Economics & Financial Analysis

expenditure budgeting. This concept is very important in capital expenditure budgeting. The
concept is also useful for taking short-run decisions opportunity cost is the cost concept to
use when the supply of inputs is strictly limited and when there is an alternative.
2.Explicit and implicit costs:
Explicit costs are those expenses that involve cash payments. These are the actual or
business costs that appear in the books of accounts. These costs include payment of wages
and salaries, payment for raw-materials, interest on borrowed capital funds, rent on hired
land, Taxes paid etc.
Implicit costs are the costs of the factor units that are owned by the employer himself. These
costs are not actually incurred but would have been incurred in the absence of employment
of self – owned factors. The two normal implicit costs are depreciation, interest on capital etc.
A decision maker must consider implicit costs too to find out appropriate profitability of
alternatives.

3.Historical and Replacement costs:

Historical cost is the original cost of an asset. Historical cost valuation shows the cost of an
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
poorprojection of the future cost intended for managerial decision. A replacement cost is a
relevant cost concept when financial statements have to be adjusted for inflation.
4.Short – run and long – run costs:
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 physical capacity
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-of pocket and books costs:
Out-of pocket costs also known as explicit costs are those costs that involve current cash
payment. Book costs also called implicit costs do not require current cash payments.
Depreciation, unpaid interest, salary of the owner is examples of back costs. But the book
costs are taken into account in determining the level dividend payable during a period. Both
book costs and out-of-pocket costs are considered for all decisions. Book cost is the cost of
self-owned factors of production.
6.Fixed and variable costs:
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 in a
proportionate decline in the total variables costs. The variable cost per unit will be constant.
Ex: Raw materials, labour, direct expenses, etc.

E Naveen Kumar Reddy Assistant Professor Department of MBA

20A52301 Managerial Economics & Financial Analysis

7.Post and Future costs:

Post costs also called historical 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.Traceable and common costs:
Traceable costs otherwise called direct cost, is one, which can be identified with a products
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 or product.
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.Avoidable and unavoidable costs:
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.Controllable and uncontrollable costs:
Controllable costs are ones, which can be regulated by the executive who is in charge of it.
The concept of controllability of cost varies with levels of management. Direct expenses like
material, labour etc. are controllable costs. Some costs are not directly identifiable with a
process of product. They are appointed to various processes or products in some proportion.
This cost varies with the variation in the basis of allocation and is independent of the actions
of the executive of that department. These apportioned costs are called uncontrollable costs.
11. Incremental and sunk costs:
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 are those which
are not altered by any change – They are the costs 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, average and marginal costs: 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 Average cost = ------ Q Marginal cost is the additional
cost incurred to produce and additional unit of output or it is the cost of the marginal unit
produced.
13. Accounting and Economics costs: Accounting costs are the costs recorded for the purpose
of preparing the balance sheet and profit and ton statements to meet the legal, financial and
tax purpose of the company. The accounting concept is a historical concept and records what
has happened in the post. Economics concept considers future costs and future revenues,
which help future planning, and choice, while the accountant describes what has happened,
the economics aims at projecting what will happen.

E Naveen Kumar Reddy Assistant Professor Department of MBA

20A52301 Managerial Economics & Financial Analysis

BREAKEVEN ANALYSIS
The study of cost-volume-profit relationship is often referred as BEA. The term BEA is
interpreted in two senses. In its narrow sense, it is concerned with finding out BEP; BEP is the
point at which total revenue is equal to total cost. It is the point of no profit, no loss. In its
broad determine the probable profit at any level of production.
BEA is defined as analysis of costs and their possible impact on revenues and volume
of the firm. Hence it is also called the cost-volume-profit analysis. A firm is said to attain the
BEP when its total revenue is equal to total cost (TR=TC).
Assumptions:
1. All costs are classified into two – fixed and variable.
2. Fixed costs remain constant at all levels of output.
3. Variable costs vary proportionally with the volume of output.
4. Selling price per unit remains constant in spite of competition or change in the volume of
production.
5. There will be no change in operating efficiency.
6. There will be no change in the general price level.
7. Volume of production is the only factor affecting the cost.
8. Volume of sales and volume of production are equal. Hence there is no unsold stock.
9. There is only one product or in the case of multiple products. Sales mix remains constant.
Merits:
1. Information provided by the Break-Even Chart can be understood more easily then those
contained in the profit and Loss Account and the cost statement.
2. Break Even Chart discloses the relationship between cost, volume and profit. It reveals how
changes in profit. So, it helps management in decision-making.
3. It is very useful for forecasting costs and profits long term planning and growth
4. The chart discloses profits at various levels of production.
5. It serves as a useful tool for cost control.
6. It can also be used to study the comparative plant efficiencies of the industry.
7. Analytical Break-even chart present the different elements, in the costs – direct material,
direct labour, fixed and variable overheads.

Graphical Representation of Break – Even Analysis

In this approach, costs and Revenue are plotted on a graph; each of them is shown through
lines; wherever the total costs line intersects the line of sales revenue, that point is treated
as a break-even point. Keeping in mind that the total costs line includes both variable and
fixed costs; while variable costs and fixed costs lines are separately drawn on the graph paper
as well.

E Naveen Kumar Reddy Assistant Professor Department of MBA

20A52301 Managerial Economics & Financial Analysis

In the above graph, the horizontal axis represents the total units of products produced and
sold by a business while the vertical axis represents the amount of revenue earned and the
total costs incurred by a business. In addition, it can be shown that the break-even point will
occur when total costs and Sales revenue lines intersect with each other. In addition, it can
be seen that the total costs line will not be drawn from zero rather it will start from the fixed
costs line, because it includes fixed costs as well. On the other hand, variable costs are the
difference between total costs and fixed costs.
Advantages of using Graphs:
 Graphs represent CPV analysis in such a way that it can even be understood by a
person without financial knowledge; Although accurate analysis is only possible
through numbers.
 They show clearly the break-even point
 The margin of safety can be easily found with the help of graphs
 Graphs represent the impact of changing sales volume on profit visually
Limitations Of Break-Even Charts:
Break-even charts are prepared based on certain assumptions; those assumptions are their
limitations as well.
 It is assumed that the selling price will remain constant throughout the period, which
doesn’t happen practically.
 Variable costs per unit are also assumed to be not changing throughout the period.
 Fixed costs are also assumed to remain constant irrespective of circumstances since
as the scale of operations is increased, a new site; new office or new production area
will be required thus increasing the fixed costs.
 In addition, it is assumed that costs and sales revenue are only affected by sales
volume. But practically increase in output; change in technology can also affect them.
 Moreover, it is assumed that whatever goods are produced by a business are sold;
which rarely happens as the majority of the businesses are left with closing inventory
to deal with.

E Naveen Kumar Reddy Assistant Professor Department of MBA

20A52301 Managerial Economics & Financial Analysis

Some important terms used in Break-Even-Analysis:

1. Fixed cost
2. Variable cost
3. Contribution
4. Margin of safety
5. Angle of incidence
6. Profit volume ratio
7. Break-Even-Point
1. Fixed cost: Expenses that do not vary with the volume of production are known as fixed
expenses. Eg. Manager‟s salary, rent and taxes, insurance etc. It should be noted that fixed
changes are fixed only within a certain range of plant capacity. The concept of fixed overhead
is most useful in formulating a price fixing policy. Fixed cost per unit is not fixed.
2. Variable Cost: Expenses that vary almost in direct proportion to the volume of production
of sales are called variable expenses. E.g. 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 – Variable cost
Contribution = Fixed Cost + Profit.
4. Margin of safety: Margin of safety is the excess of sales over the break even sales. It can
be expressed in absolute sales amount or in percentage. It indicates the extent to which the
sales can be reduced without resulting in loss. A large margin of safety indicates the
soundness of the business. The formula for the margin of safety is: Present sales – Break even
sales or P.V. ratio Profit Margin of safety can be improved by taking the following steps. 1.
Increasing production 2. Increasing selling price 3. Reducing the fixed or the variable costs or
both 4. Substituting unprofitable product with profitable one.
5. Angle of incidence: This is the angle between sales line and total cost line at the Break-
even point. It indicates the profit earning capacity of the concern. Large angle of incidence
indicates a high rate of profit; a small angle indicates a low rate of earnings. To improve this
angle, contribution should be increased either by raising the selling price and/or by reducing
variable cost. It also indicates as to what extent the output and sales price can be changed to
attain a desired amount of profit.
6. Profit Volume Ratio is usually called P. V. ratio. It is one of the most useful ratios for
studying the profitability of business. The ratio of contribution to sales is the P/V ratio. It may
be expressed in percentage. Therefore, every 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. The formula is, Sales Contribution X 100
7. Break – Even- Point: If we divide the term into three words, then it does not require further
explanation. Break-divide Even-equal Point-place or position Break Even Point refers to the
point where total cost is equal to total revenue. It is a point of no profit, no loss. This is also a
minimum point of no profit, no loss. This is also a minimum point of production where total
costs are recovered. If sales go up beyond the Break Even Point, organization makes a profit.
If they come down, a loss is incurred.

E Naveen Kumar Reddy Assistant Professor Department of MBA

20A52301 Managerial Economics & Financial Analysis

MANAGERIAL SIGNIFICANCE OF BREAK EVEN ANALYSIS:

The significance of break-even point and Break-even analysis can be understood from the
following points –
(i) By finding out the break-even point, the Break-even analysis helps in establishing
the point where from the firm can start payment of dividend to its share-holders.
(ii) It evaluates the percentage financial yield from a project, and thereby helps in
choice between various alternative projects.
(iii) To compare the efficiency of the different firms.
(iv) It helps in determining the optimum level of output, below which it would not be
profitable for a firm to produce.
(v) To decide ‘Make’ or ‘Buy’ Decision.
(vi) By using break-even analysis, the firm can determine minimum cost for a given-
level of output.
(vii) The break-even analysis can be. used in finding the selling price which would
prove most profitable for the Finn.
(viii) It helps in determining the target capacity for a firm to get the advantage of
minimum unit cost of production.
(ix) Impact of changes in prices and costs on profits of the firm can also be analysed
with the help of break-even techniques.
LIMITATIONS OF BEA
1. BEA is based on fixed cost, variable cost and total revenue. A change in one variable is
going to affect the BEP.
2. All costs cannot be classified into fixed and variable costs. We have semi-variable costs
also.
3. In case of multi product firm, a single chart cannot be of any use. Series of charts have
to be made use of.
4. It is based on fixed cost concept and hence hold good only in the short -run.
5. Total cost and total revenue lines are not always straight lines.
6. Where the business conditions are volatile, BEP cannot give stable results.

E Naveen Kumar Reddy Assistant Professor Department of MBA