Unit – II

THEORY OF PRODUCTION AND COST ANALYSIS

Introduction to Production Cost:-

Production cost refers to the expenses incurred in creating goods or services. It includes costs
related to raw materials, labor, equipment, utilities, and overhead. Understanding production costs
is essential for businesses to determine pricing, manage profitability, and make informed decisions
about their operations. Different industries and businesses have varying production cost structures
based on factors like economies of scale, technology, and market conditions.

Nature of production cost:-

The nature of production costs can be classified into several categories:

Interdisciplinary Nature:
This analysis draws from various fields such as economics, accounting, finance, and
operations management. It combines economic theories, financial principles, and operational
concepts to provide a comprehensive understanding of production and cost dynamics.

Short-term and Long-term Perspectives:

Production and cost analysis takes into account both short-term and long-term perspectives.
Short-term analysis focuses on immediate decisions like pricing and output adjustments, while
long-term analysis considers factors like capital investments, technology upgrades, and economies
of scale.

Cost Classification:
One of the foundational aspects of this analysis is the classification of costs. Costs are
categorized into fixed costs (remain constant regardless of production levels), variable costs
(change with production quantities), and semi-variable costs (partly fixed and partly variable).

Comparative Analysis:
Businesses often compare different production methods, technologies, or input
combinations to identify the most cost-efficient approach. Comparative analysis helps in making
choices that optimize resources.

Decision Support:
Production and cost analysis provides crucial information for managerial decision-making. It
aids in choosing production levels, pricing strategies, cost reduction measures, and investment
decisions.

Cost-Volume-Profit Relationship:
The interaction between production volume, costs, and profit is at the heart of this analysis.
Understanding how changes in these variables impact each other helps businesses determine their
break-even points and profit potential.
Profit Maximization:
Ultimately, the goal of production and cost analysis is to help businesses maximize profits.
By finding the optimal production levels that balance revenue and costs, organizations can work
toward achieving their financial objectives.

Significance of production cost:-

The significance of production costs is paramount for businesses and decision-makers due to
several reasons:

Pricing Strategy: Production costs are a fundamental factor in setting prices for goods and
services. Businesses need to ensure that the prices they charge cover their production expenses
while remaining competitive in the market.

Profitability Analysis: By accurately calculating production costs, businesses can determine their
profit margins on products or services. This information is crucial for evaluating the financial
health of the company and making informed decisions.

Cost Control and Efficiency: Understanding production costs helps identify areas where cost-
saving measures can be implemented. This might involve optimizing processes, reducing waste, or
negotiating better deals with suppliers.

Budgeting and Financial Planning: Accurate knowledge of production costs enables effective
budgeting and financial forecasting. Businesses can allocate resources more effectively and plan
for future growth and investment.

Resource Allocation: With insights into production costs, businesses can allocate resources, such
as labor and materials, more efficiently to maximize productivity and minimize waste.

Investment Decisions: When considering new equipment, technology, or expansion,

understanding production costs helps assess the potential return on investment and the impact on
overall operations.

Competitive Strategy: Businesses can gain a competitive advantage by strategically analyzing

production costs. This might involve differentiating based on cost leadership or focusing on value-
added services.

Negotiation Power: Knowledge of production costs empowers businesses when negotiating with
suppliers, vendors, and contractors, leading to more favorable terms and agreements.

Risk Management: Accurate cost analysis allows businesses to assess the impact of external
factors like fluctuations in raw material prices or changes in market demand, helping to mitigate
risks.

In essence, production costs provide the foundation for effective decision-making across various
aspects of a business, contributing to its long-term success and sustainability.
Advantages of production cost:-

Production costs offer several advantages to businesses and decision-makers:

Pricing Accuracy: Production costs provide a solid foundation for setting accurate and
competitive prices for products or services, ensuring that they cover expenses and contribute to
profitability.

Profitability Assessment: By comparing production costs with revenues, businesses can gauge
the profitability of individual products, services, or projects, aiding in effective resource allocation.

Cost Control: Understanding production costs helps identify areas where costs can be reduced or
eliminated, leading to increased efficiency, lower expenses, and improved margins.

Budgeting and Planning: Accurate production cost data allows for better budgeting and financial
planning, helping businesses allocate resources effectively and make informed investment
decisions.

Resource Allocation: Knowledge of production costs assists in allocating labor, materials, and
other resources more efficiently, leading to improved productivity and reduced waste.

Performance Evaluation: Monitoring actual production costs against projected costs enables
businesses to evaluate the effectiveness of management decisions and operational strategies.

Risk Management: Understanding production costs helps assess the impact of external factors on
operations, enabling better risk mitigation and contingency planning.

Strategic Decision-Making: Production cost data informs strategic choices such as expansion,
market entry, and technology adoption, contributing to better-informed decisions.

Negotiation Power: Armed with accurate production cost information, businesses can negotiate
better terms with suppliers, contractors, and vendors, leading to cost savings.

Competitive Advantage: Effective cost management based on production cost analysis can lead
to a cost leadership advantage in the market, making a business more competitive.

Innovation and Efficiency: Knowledge of production costs can inspire innovation by encouraging
the development of new products, processes, or technologies that reduce costs or improve quality.

Investment Evaluation: When considering investments, production costs provide insights into
potential returns and risks, aiding in decision-making.

In summary, production costs play a pivotal role in helping businesses make informed decisions,
control expenses, optimize resource allocation, and maintain profitability. They are essential for
effective management and sustainable growth.
FACTORS OF PRODUCTION:-
Land
Land has a broad definition as a factor of production and can take on various forms, from
agricultural land to commercial real estate to the resources available from a particular piece of land.
Natural resources, such as oil and gold, can be extracted and refined for human consumption from
the land.

Cultivation of crops on land by farmers increases its value and utility. While land is an essential
component of most ventures, its importance can diminish or increase based on industry. For
example, a technology company can easily begin operations with zero investment in land. On the
other hand, land is the most significant investment for a real estate venture.

Labor
Labor refers to the effort expended by an individual to bring a product or service to the market.
Again, it can take on various forms. For example, the construction worker at a hotel site is part of
labor, as is the waiter who serves guests or the receptionist who enrolls them into the hotel.Skilled
and trained workers are called “human capital” and are paid higher wages because they bring more
than their physical capacity to the task.

For example, an accountant’s job requires the analysis of financial data for a company. Countries
that are rich in human capital experience increased productivity and efficiency. The difference in
skill levels and terminology also helps companies and entrepreneurs create corresponding disparities
in pay scales. This can result in a transformation of factors of production for entire industries. An
example of this is the change in production processes in the information technology (IT) industry
after jobs were outsourced to countries with lower salaries.

Capital
In economics, capital typically refers to money. However, money is not a factor of production
because it is not directly involved in producing a good or service. Instead, it facilitates the processes
used in production by enabling entrepreneurs and company owners to purchase capital goods or land
or to pay wages. For modern mainstream (neoclassical) economists, capital is the primary driver of
value.

It is important to distinguish personal and private capital in factors of production. A personal vehicle
used to transport family is not considered a capital good, but a commercial vehicle used expressly
for official purposes is. During an economic contraction or when they suffer losses, companies cut
back on capital expenditure to ensure profits. However, during periods of economic expansion, they
invest in new machinery and equipment to bring new products to market.

As a factor of production, capital refers to the purchase of goods made with money in production.
For example, a tractor purchased for farming is capital. Along the same lines, desks and chairs used
in an office are also capital.

Entrepreneurship
Entrepreneurship is the secret sauce that combines all the other factors of production into a product
or service for the consumer market. An example of entrepreneurship is the evolution of the social
media behemoth Meta (META), formerly Facebook.

Mark Zuckerberg assumed the risk for the success or failure of his social media network when he
began allocating time from his daily schedule toward that activity. When he coded the minimum
viable product himself, Zuckerberg’s labor was the only factor of production. After Facebook, the
social media site, became popular and spread across campuses, it realized it needed to recruit
additional employees. He hired two people, an engineer (Dustin Moskovitz) and a spokesperson
(Chris Hughes), who both allocated hours to the project, meaning that their invested time became a
factor of production.

Technology

Though technology isn’t the fifth factor officially, many consider it to be one. In the current world,
technology plays a very important role in coming up with a product or service.

Technology is a very broad term. It could include software, hardware, or a combination of two to
make the production process more efficient. So, it won’t be wrong to say that technology helps in the
efficient utilization of all four factors of production. For instance, the use of robots in production can
help a company to raise productivity, as well as reduce costs. Technology also helps an entrepreneur
to make better decisions.

PRODUCTION FUNCTION:-

Samuelson define the production function as “the technical relationship which reveals the
maximum amount of output capable of being produced by each and every set of inputs”

Michael define production function as “that function which defines the maximum amount of output
that can be produced with a given set of inputs”.

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

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

Where Q is the quantity of production, F explains the functions, that is, the type of
relation between inputs and outputs , L1,L2,C,.O,T refer to land, labout, capital, organization
and technology respectively. These inputs have been taken in conventional terms. In reality,
material also can be included in a set of inputs.

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

technical knowledge, the process of various factors of production and his efficiency level to
manage. He should not only select the factors of production but also should work out the different
permutations and combinations which will mean lower cost of inputs for a given level of
production.

In case of an agricultural product, increasing the other factors of production can increase
the production, but beyond a point, increase output can be had only with increased use of
agricultural land, investment in land forms a significant portion of the total cost of production for
output, whereas, in the case of the software industry, other factor such as technology ,
capital management and others become significant. With change in industry and the requirements
the production function also needs to be modified to suit to the situation.
 Production Function with One Variable Input :-
The laws of returns states that when at least one factor of production is fixed or factor input is
fixed and when all other factors are varied, the total output in the initial stages will increase at an
increasing rate, and after reaching certain level or output the total output will increase at declining
rate. If variable factor inputs are added further to the fixed factor input, the total output may decline.
This law is of universal nature and it proved to be true in agriculture and industry also. The law of
returns is also called the law of variable proportions or the law of diminishing returns.

Definition According to G. Stigler

“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”.

According to F. Benham

“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”.

Marginal
Units of
product Average product
labour Total production(tp) Stages
(mp) (ap)

0 0 0 0
1 10 10 10
Stages 1
2 22 12 11
3 33 11 11
4 40 7 10
Stages 2
5 45 5 9
6 48 3 8
7 48 0 6.85
Stages 3
8 45 -3 5.62
 From the above graph the law of variable proportions operates in three stages. In the first
stage, total product increases at an increasing rate. The marginal product in this stage increases at
an increasing rate resulting in a greater increase in total product. 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 zero. The marginal product
becomes negative in the third stage. So the total product also declines. The average product
continues to decline.

Production Function With Two Variable Inputs And Laws Returns:-

Production process that requires two inputs, capital and labour (L) to produce a given
output (Q). There could be more than two inputs in a real life situation, but for a simple
analysis, we restrict the number of inputs to two only. In other words, the production function
based on two inputs can be expressed as

Q = f( C,L)

Where C= capital , L = labour,

Normally, both capital and labour are required to produce a product. To some extent, these
two inputs can be substituted for each other. Hence the producer may choose any combination of
labour and capital that gives him the required number of units of output, for any one combination
of labour and capital out of several such combinations. The alternative combinations of labour and
capital yielding a given level of output are such that if the use of one factor input is increased , that
of another will decrease and vice versa. However, the units of an input foregone to get one unit of
the other input changes, depends upon the degree of substitutability between the two input factors,
based on the techniques or technology used, the degree of substitutability may vary.
ISO - QUANTS

The term Isoquants is derived from the words „iso‟ and „quant‟ – „Iso‟ means equal
and „quent‟ implies quantity. Isoquant therefore, means equal quantity. Isoquant are also called
iso-product curves, an isoquant curve show various combinations of two input factors such as capital
and labour, which yield the same level of output.

As an isoquant curve represents all such combinations which yield equal quantity of output, any or
every combination is a good combination for the manufacturer. Since he prefers all these
combinations equally , an isoquant curve is also called product indifferent curve.

An isoquant may be explained with the help of an arithmetical example

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

A 1 10 50

B 2 7 50

C 3 4 50

D 4 2 50

E 5 1 50

Combination „A represent 1 unit of labour and 10 units of capital and produces „50
quintals of a product all other combinations in the table are assumed to yield the same given output
of a product say „50 quintals by employing any one of the alternative combinations of the two
factors labour and capital. If we plot all these combinations on a paper and join them, we will
get continues and smooth curve called Iso-product curve as shown below.
 Labour is on the X-axis and capital is on the Y-axis. IQ is the ISO-Product curve,
which shows all the alternative combinations A, B, C, D, E which can produce 50 quintals of a
product.

Features of isoquant:-
1. Downward sloping: isoquant are downward sloping curves because , if one input increase,
the other one reduces. There is no question of increase in both the inputs to yield a given output. A
degree of substitution is assumed between the factors of production. In other words, an isoquant
cannot be increasing, as increase in both the inputs does not yield same level of output. If it is
constant, it means that the output remains constant through the use of one of the factor is
increasing, which is not true, isoquant slope from left to right.

2. Convex to origin: isoquant are convex to the origin. It is because the input factors are not
perfect substitutes. One input factor can be substituted by other input factor in a diminishing
marginal rate. If the input factors were perfect substitutes, the isoquant would be a falling straight
line. When the inputs are used in fixed proportion, and substitution of one input for the other
cannot take place, the isoquant will be L shaped

3. Do not intersect: two isoquant do not intersect with each other. It is because, each of these
denote a particular level of output. If the manufacturer wants to operate at a higher level of output,
he has to switch over to another isoquant with a higher level of output and vice versa.

4. Do not axes: the isoquant touches neither X-axis nor Y- axis, as both inputs are required to
produce a given product.

ISO COST:-

Iso cost refers to that cost curve that represents the combination of inputs that will cost the
producer the same amount of money. In other words, each isocost denotes a particular level of total
cost for a given level of production. If the level of production changes, the total cost changes and
thus the isocost curve moves upwards, and vice verse.

Isocost curve is the locus traced out by various combinations of L and K, each of which
costs the producer the same amount of money (C ) Differentiating equation with respect to L,
we have dK/dL = -w/r This gives the slope of the producer‟s budget line (isocost curve). Iso
cost line shows various combinations of labour and capital that the firm can buy for a given factor
prices. The slope of iso cost line = PL/Pk. In this equation , PL is the price of labour and Pk is the
price of capital. The slope of iso cost line indicates the ratio of the factor prices. A set of isocost
lines can be drawn for different levels of factor prices, or different sums of money. The iso cost
line will shift to the right when money spent on factors increases or firm could buy more as the
factor prices are given.

With the change in the factor prices the slope of iso cost lien will change. If the price of
labour falls the firm could buy more of labour and the line will shift away from the origin. The
slope depends on the prices of factors of production and the amount of money which the firm
spends on the factors. When the amount of money spent by the firm changes, the isocost line may
shift but its slope remains the same. A change in factor price makes changes in the slope of isocost
lines as shown in the figure.

Least Cost Combination Of Inputs

The manufacturer has to produce at lower costs to attain higher profits. The isocost and
isoquants can be used to determine the input usage that minimizes the cost of production. Where
the slope of isoquant is equal to that of isocost, there lies the lowest point of cost of production.
This can be observed by superimposing the isocosts on iso-product curves. It is evident that the
producer can, with a total outlay.

The firm can achieve maximum profits by choosing that combination of factors which
will cost it the least. The choice is based on the prices of factors of production at a particular
time. The firm can maximize its profits either by maximizing the level of output for a given cost or
by minimizing the cost of producing a given output. In both cases the factors will have to be
employed in optimal combination at which the cost of production will be minimum. The least
cost factor combination can be determined by imposing the isoquant map on isocost line. The
point of tangency between the isocost and an isoquant is an important but not a necessary
condition for producers equilibrium. The essential condition is that the slope of the isocost line
must equal the slope of the isoquant. Thus at a point of equilibrium marginal physical
productivities of the two factors must be equal the ratio of their prices. The marginal physical
product per rupee of one factor must be equal to that of the other factor. And isoquant must be
convex to the origin. The marginal rate of technical substitution of labour for capital must be
diminishing at the point of equilibrium.
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.

The Cobb-Douglas production function is expressed as:

Q = A.LαKβ

where Q is output and L and K are inputs of labour and capital respectively. A, α and β are positive
parameters where = α> 0, β > 0.

The conclusion drawn from this famous statistical study is that labour contributed about 3/4 th and
capital about 1/4th of the increase in the manufacturing production.

α + β = 1 (Constant Returns to scale)

α + β > 1 (Increasing Returns to scale)

α + β < 1 (Decreasing Returns to scale)

Assumptions:

It has the following assumptions

1. The function assumes that output is the function of two factors viz. capital and labour.
2. It is a linear homogenous production function
3. There are constant returns to scale
4. All inputs are homogenous
5. There is perfect competition
6. There is no change in technology
Marginal Rate of Technical Substitution
The marginal rate of technical substitution (MRTS) refers to the rate at which one input
factor is substituted with the other to attain a given level of output. In other words, the lesser units
of one input must be compensated by increasing amounts of another input to produce the same
level of output.

Isoquants are typically convex to the origin reflecting the fact that the two factors are
substitutable for each other at varying rates. This rate of substitutability is called the “marginal rate
of technical substitution” (MRTS) or occasionally the “marginal rate of substitution in production”.
It measures the reduction in one input per unit increase in the other input that is just sufficient
to maintain a constant level of production. For example, the marginal rate of substitution of labour
for capital gives the amount of capital that can be replaced by one unit of labour while keeping
output unchanged.

To move from point A to point B in the diagram, the amount of capital is reduced from Ka
to Kb while the amount of labour is increased only from La to Lb. To move from point C to point
D, the amount of capital is reduced from Kc to Kd while the amount of labour is increased from Lc
to Ld. The marginal rate of technical substitution of labour for capital is equivalent to the absolute
slope of the isoquant at that point (change in capital divided by change in labour). It is equal to 0
where the isoquant becomes horizontal, and equal to infinity where it becomes vertical.

The opposite is true when going in the other direction (from D to C to B to A). In this case
we are looking at the marginal rate of technical substitution capital for labour (which is the
reciprocal of the marginal rate of technical substitution labour for capital).

It can also be shown that the marginal rate of substitution labour for capital, is equal to the
marginal physical product of labour divided by the marginal physical product of capital.
LAW OF RETURNS TO SCALE

There are three laws of returns governing production function. They are

1. Law of increasing returns to scale

This law states that the volume of output keeps on increasing with every increase in the
inputs,. Where a given increase in inputs leads to a more than proportionate increase in the
output, the law of increasing returns to scale is said to operate. We can introduce division of
labour and other technological means to increase production. Hence, the total product
increases at an increasing rate.
2. Law of constant returns to scale
When the scope for division of labour gets restricted, the rate of increase in the total output
remains constant, the law of constant returns to scale is said to operate, this law states
that the rate of increase/decrease in volume of output is same to that of rate of
increase/decrease in inputs.
3. Law of decreasing returns to scale
Where the proportionate increase in the inputs does not lead to equivalent increase in
output, the output increases at a decreasing rate, the law of decreasing returns to scale is
said to operate. This results in higher average cost per unit.

INPUTS TOTAL PRODUCT MARGINAL PRODUCT

1 4 4
2 10 6
3 18 8
4 28 10
5 38 10
6 48 10
7 56 8
8 62 6
9 66 4

These laws can be illustrated with an example of agricultural land. Take one acre of land. If you
till the land well with adequate bags of fertilizers and sow good quality seeds, the volume
of output increases the following table illustrates further
ECONOMIES OF SCALE:
Advantages or benefits that acquire to a firm as a result of increasing in the scale of production or
maximization of profits.
Economies of Scale is of two types
1. Internal Economies of Scale
2. External Economies of Scale

INTERNAL ECONOMIES OF SCALE

INTERNAL ECONOMIES refer to the economies all the development which you do inside
your company. The internal economies occur as a result of increase in the scale of production.
Enjoy the benefits by the large firms.

1. Managerial Economies: as the firm expands, the firm needs qualified managerial
personnel to handle each of its functions marketing, finance, production, human resources
and others in a professional way. Functional specialization ensure minimum wastage and
lowers the cost of production in the long –run.

2. Commercial Economies: the transaction of buying and selling raw material and other
operating supplies such as spares and so on will be rapid and the volume of each
transaction also grows as the firm grows, there could be cheaper savings in the procurement,
transportation and storage cost, this will lead to lower costs and increased profits.

3. 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.

4. 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.
5. Marketing Economies: The 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.
6. 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.
7. Economics of Research And Development: large organizations such as Dr.Reddys labs,
Hindustan Lever spend heavily on research and development and bring out several innovative
products. Only such firms with a strong research and development base can cope with
competition globally.

EXTERNAL ECONOMIES OF SCALE:

External economics refer to all the firms in the industry, because of growth of the industry as a
whole or because of growth of ancillary industries, advantages or benefits obtained by our firm
because of other firms of similar products. External economies benefit all the firms in the
industry as the industry expands. This will lead to lowering the cost of production and thereby
increasing the profitability.

1. Locational Economies: Firms often locate in areas where they can easily access the inputs they
need for production. As mentioned earlier, external economies of scale can result from businesses
clustering together in a certain location. This can lead to cost savings and increased efficiency for
individual firms due to shared infrastructure, skilled labor.

2. 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.

3. Economies of Research And Development: all the firms can pool resources to finance
research and development activities and thus share the benefits of research. There could be a
common facility to shares journals, newspapers and other valuable reference material of common
interest.

4. Economies of Welfare: there could be common facilities such as canteen, industrial housing,
community halls, schools and colleges, employment burearu, hospitals and so on, which can be
used in common by the employees in the whole industry.

5. Economies of Information: When several firms are located close to each other, they can
access perfect information on the prices of inputs. Since all firms purchase inputs from the same
suppliers, the latter cannot charge different prices from different firms. The elimination of
discriminatory pricing ensures that no firm pays a higher amount for inputs, and it reduces the
overall average cost.
6. Economies of Innovation: Many firms prefer to set up their premises close to centers engaged in
research and development of efficient production methods. Firms can then quickly adapt to all
innovations developed by these centers in order to achieve greater efficiency in production and,
therefore, lower their costs.

COST:
The institute of cost and management accountants (ICMA) has define cost as “the amount
expenditure, actual or notional, incurred on or attributable to a specified thing or activity”.
It is the amount of resources sacrificed to achieve a specific objective. A cost must be with
reference to the purpose for which it is used and the conditions under which it is computed. To
take decision, managers wish to know the cost of something.

Cost refers to the expenditure incurred to produce a particular product or services. All cost
involves a sacrifice of some kind or other to acquire some benefit. For example , if I want to eat
food, I should be prepared to sacrifice money.

Cost refers to the amount of expenditure incurred in acquiring something. In business firm, it
refers to the expenditure incurred to produce an output or provide service. Thus the cost
incurred in connection with raw material , labour, other heads constitute the overall cost
of production.

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:

OPPORTUNITY COST AND OUTLAY COST:

In simple terms, it is the earning from the second is alternative. It represents the maximum possible
alternative income that was have been earned if the resources were put to alternative use.

Opportunity cost can be distinguished from outlay costs based on the nature of sacrifice. Outlay
costs are those costs that involve cash outflow at sometime and hence they are recorded in the
book of account. Opportunity cost refers to earnings/profits that are foregone form alternative
ventures by using gives limited facilities for a particular purpose.

FIXED COST AND VARIABLE COST

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.
 DIFFERENCE BETWEEN FIXED COST AND VARIABLE COST:

Fixed Cost Variable Cost

Fixed costs are costs that do not change with the Variable costs change with the change in the
changing volume of production of a firm. The volume of production. There is a change in
volume, when increases, show better productivity productivity with changing volume in the case
though. of variable costs.

Fixed cost is based on time. It is time-dependent and Variable costs are dependent on the volumes
change after a certain period of time. These costs are manufactured. The costs change depending on
therefore made daily, weekly, monthly, or on a the production volume and there is nothing
yearly basis depending on the nature of the cost. related to time in the case of variable costs.

Fixed costs are costs of total production. They don’t

Variable costs are costs per unit of production.
have anything to do with the number of units
It is the cost of each unit that is produced. That
produced. This means that the cost of production
is why, when production goes up, the costs
stays the same even when the number of units
also go up.
produced is increased.

Fixed costs usually go down with an increase in the

Variable costs do not change with an increase
number of production. As the production goes up,
in volume. It will remain the same per unit
the per unit cost comes down which decreases the
even when the production goes up.
total cost of the process.

The profitability does not change in the case of

In the case of fixed costs, higher production leads to variable costs even when production goes up.
more profitability as the cost per unit comes down. This happens because the per unit cost remains
the same.

Examples of variable costs include the cost of

Some examples of fixed costs are salaries, rent, and
raw materials, labor costs, and sales
property taxes.
commissions.

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.

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.

INCREMENTAL COST AND SUNK COST:

Incremental costs are the changes in future costs and that will occur as a result after a decision is
made. Ultimately if a future cost or revenue is not going to change as a result of a decision, then it is irrelevant
to the decision and should be ignored in the decision-making process.

A sunk cost refers to money that has already been spent and cannot be recovered. A manufacturing
firm, for example, may have a number of sunk costs, such as the cost of machinery, equipment, and
the lease expense on the factory.

BREAKEVEN ANALYSIS

A business is said to break even when its total sales are equal to its total costs. It is a point of no
profits no loss. Break even analysis 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.

Determination of Break Even Point

1. Fixed cost
2. Variable cost
3. Contribution
4. Margin of safety
5. Angle of incidence
6. Profit volume ratio

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
Variable Cost: Expenses that vary almost in direct proportion to the volume of production of sales
are called variable expenses. Eg. Electric power and fuel, packing materials consumable stores. It
should be noted that variable cost per unit is fixed.
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.

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

Profit

Present sales – Break even sales or PV ratio

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

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

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.
10. All the goods produced are sold. There is no closing stock.
Limitations of BEA

 Break – even - point is based on fixed cost, variable cost and total revenue. A
change in one variable is going to affect the BEP
 All cost cannot be classified into fixed and variable costs. We have semi-variable costs
 also.
 In case of multi-product firm, a single chart cannot be of any use. Series of charts have to be
made use of.
 It is based on fixed cost concept and hence holds good only in the short – run.
 Total cost and total revenue lines are not always straight as shown in the figure. The
quantity and price discounts are the usual phenomena affecting the total revenue line.
 Where the business conditions are volatile, BEP cannot give stable results

Significance of BEA
 To ascertain the profit on a particular level of sales volume or a given capacity of
production
 To calculate sales required to earn a particular desired level of profit.
 To compare the product lines, sales area, methods of sales for individual company
 To compare the efficiency of the different firms
 To decide whether to add a particular product to the existing product line or drop one from
it
 To decide to “make or buy” a given component or spare part
 To decide what promotion mix will yield optimum sales
 To assess the impact of changes in fixed cost, variable cost or selling price on BEP and
profits during a given period.

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
The chart discloses profits at various levels of production.
4. It serves as a useful tool for cost control.
5. It can also be used to study the comparative plant efficiencies of the industry.
6. Analytical Break-even chart present the different elements, in the costs – direct
material, direct labour, fixed and variable overheads.

Demerits:
1. Break-even chart presents only cost volume profits. It ignores other considerations such as
capital amount, marketing aspects and effect of government policy etc., which are
necessary in decision making.
2. It is assumed that sales, total cost and fixed cost can be represented as straight lines. In
actual practice, this may not be so.
3. It assumes that profit is a function of output. This is not always true. The firm may
increase the profit without increasing its output.
4. A major drawback of BEC is its inability to handle production and sale of
multiple products.
5. It is difficult to handle selling costs such as advertisement and sale promotion in BEC.
6. It ignores economics of scale in production.
7. Fixed costs do not remain constant in the long run.
8. Semi-variable costs are completely ignored.
9. It assumes production is equal to sale. It is not always true because generally there may
be opening stock.
10. When production increases variable cost per unit may not remain constant but may
reduce on account of bulk buying etc.

Marginal Costing Formulae:-

1. Contribution = Sales-Variable cost

= Fixed Cost + Profit
= P/V Ratio × Sales
100
2. BEP (in units) = Total fixed cost
Contribution

3. BEP (in sales)= BEP(in units) ×Selling price per unit

= Total fixed cost × 100
P/V Ratio
= Sales – Margin of safety

4. Margin of Safety = Sales – BEP Sales

= Profit × 100
P/V Ratio
= Sales × Margin of safety ratio

5. Sales when desired profit given = Fixed cost + Desired Profit

P/V Ratio

6. Units when desired profit given = Fixed cost + Desired Profit

Contribution

7. Profit = (Contribution × Number of units sold) – Total Fixed Cost

8. P/V Ratio = Contribution × 100
Sales
= Fixed cost × 100
BEP Sales
= Profit × 100
Margin of Safety
= Changes in Profit × 100
Changes in Sales

PROBLEMS

1. From the following information find out a)BEP in Units b)P/V Ratio c) BEP in value
d)Number of units to be sold to achieve a target profit of Rs.1,20,000 e)Profit at sale of 8000
units.
Selling Price/Unit- Rs.50,
Variable Cost/ Unit-Rs.30
TFC- Rs.1, 00,000.

Given the information:

Selling Price/Unit: Rs. 50
Variable Cost/Unit: Rs. 30
Total Fixed Costs (TFC): Rs. 1,00,000
a) BEP in Units:
BEP (in units) = Total fixed cost
Contribution
Contribution = Selling Price per Unit - Variable Cost per Unit
Contribution = Rs. 50 - Rs. 30 = Rs. 20
BEP (in units) = Rs. 1,00,000 / Rs. 20 = 5000 units
b) P/V Ratio:
P/V Ratio = Contribution × 100
Sales
Contribution = Selling Price per Unit - Variable Cost per Unit = Rs. 20
Sales = Selling Price per Unit = Rs. 50
P/V Ratio = (20 / 50) × 100 = 40%

c) BEP in Value:
BEP (in value) = BEP (in units) × Selling Price per Unit
BEP (in value) = 5000 units × Rs. 50 = Rs. 2,50,000

d) Number of Units to Achieve Target Profit of Rs. 1,20,000:

Units when desired profit given = Fixed cost + Desired Profit
Contribution
= 1,00,000 + 1,20,000
20
= 2,20,000
20
= 11,000 units
e) Profit at Sale of 8000 Units:
Profit = (Contribution Margin per Unit × Number of Units Sold) - Total Fixed Costs
Profit = (Rs. 20 × 8000) - Rs. 1,00,000
Profit = Rs. 1,60,000 - Rs. 1,00,000 = Rs. 60,000

2. The information about Raj & Co. is given below.

P/V Ratio is 20%
TFC is Rs.36,000
Selling Price/ Unit is Rs.150
Compute a) Contribution/Unit b) Variable Cost/Unit c) BEP in Units & Rupees.

Given the information:

P/V Ratio: 20%
Total Fixed Costs (TFC): Rs. 36,000
Selling Price/Unit: Rs. 150

a) Contribution per Unit:

Contribution = P/V Ratio × Sales
100
= 20 % × 150
100
= 20 × 150
100
= Rs. 30
b) Variable Cost per Unit:
Contribution per Unit = Selling Price per Unit - Variable Cost per Unit
Rs. 30 = Rs. 150 - Variable Cost per Unit
Solving for Variable Cost per Unit:
Variable Cost per Unit = Rs. 150 - Rs. 30 = Rs. 120

c) BEP in Units:
BEP (in units) = Total Fixed Costs / Contribution per Unit
BEP (in units) = Rs. 36,000 / Rs. 30 = 1200 units
BEP in Rupees:
BEP (in rupees) = BEP (in units) × Selling Price per Unit
BEP (in rupees) = 1200 units ×Rs. 150 = Rs. 1,80,000
3. If actual sales are 10,000 units, Selling price is Rs. 20/Unit, Variable Cost is Rs. 10/Unit and
Fixed Cost is Rs.80, 000, Find out a) BEP in units and value b) What should be the sales
required for earning a profit of RS.60,000.

Selling Price/Unit: Rs. 20

Variable Cost/Unit: Rs. 10
Fixed Costs (TFC): Rs. 80,000
Actual Sales: 10,000 units

a) BEP (Break-Even Point) in Units:

BEP (in units) = Total Fixed Costs / Contribution per Unit
Contribution per Unit = Selling Price per Unit - Variable Cost per Unit
Contribution per Unit = Rs. 20 - Rs. 10 = Rs. 10
BEP (in units) = Rs. 80,000 / Rs. 10 = 8000 units
BEP in Value:
BEP (in value) = BEP (in units) × Selling Price per Unit
BEP (in value) = 8000 units × Rs. 20 = Rs. 1,60,000

b) Sales Required for Earning a Profit of Rs. 60,000:

Sales when desired profit given = Fixed cost + Desired Profit
P/V Ratio

P/V Ratio = Contribution × 100

Sales
= 10 × 100
20
= 50 %
 Sales when desired profit given = 80,000 + 60,000
50 %
= 1,40,000
0.5
= Rs. 2,80,000

4. a) Break-even point in terms of sales value and in units.

b) Number of units that must be sold to earn a profit of Rs. 80,000.

Fixed Factory Overheads cost – 70,000

Fixed Selling Overheads cost – 15,000

Variable Manufacturing Cost per unit – 15

Variable Selling Cost per unit – 5

Selling Price per unit – 30

a) Breakeven point = Fixed cost/Selling price per unit-Variable cost per unit

Variable cost per unit = 15+5 = 20

Total Fixed Cost = 70,000+15000 = 85,000

= 85,000/30-20

Breakeven point(in units) = 8,500

Breakeven point(in sales value) = 8,500 ×30 = 2,55,000

b) Number of units that must be sold to earn a profit of Rs. 80,000.

Units when desired profit given = Fixed cost + Desired Profit

Contribution
= 85,000 + 80,000
20
= 1,65,000
10
= 16,500 units
5. You are the given the information about 2 companies in 2000
Particulars Company A Company- B
Sales 50 00 000 50 00 000
F.E 12 00 000 17 00 000
V.E 35 00 000 30 00 000
You are required to calculate, p/v ratio, BEP, margin of safety.

Sol:-
Company-A
Sales = 50, 00, 000
F.E = 12, 00, 000
V.E = 35, 00, 000

a) P/V Ratio = Contribution × 100

Sales
P/V Ratio = 50,00,000 – 35,00,000 × 100
50,00,000
= 15,00,000 × 100
50,00,000
= 30%
b) BEP( in units)= Total fixed cost
Contribution
= 12,00,000
15,00,000
= 0.8 units

BEP( in sales)= BEP(in units) × Sales

= 0.8 × 50,00,000
= Rs. 40,00,000

c) Margin of sales = Sales - BEP sales

= 50,00,000 - 40,00,000
= Rs. 10,00,000/-

Company-B
Sales = 50,00,000
F.E = 17,00,000
V.E = 30,00,000
a) P/V Ratio = Contribution × 100
Sales
P/V Ratio = 50,00,000 – 30,00,000 × 100
5000000
= 20,00,000 × 100
50,00,000
= 40%
b) BEP( in units)= Total fixed cost
Contribution
= 17,00,000
20,00,000
= 0.85 units

BEP( in sales)= BEP(in units) × Sales

= 0.85 × 50,00,000
= Rs. 42,50,000

c) Margin of sales = Sales - BEP sales

= 50,00,000 - 42,50,000
= Rs.7,50,000/-

6. A company prepares a budget to produce 3 lakh units, with fixed cost as Rs. 15 lakhs and
average variable cost of Rs. 10 each. The selling price is to yield 20% profit on cost. You are
required to calculate (a) p/v ratio (b) BEP.

Sol:- Given information:

Sales = 3, 00,000 units
Variable cost per units = 10/-
Fixed cost = 1500,000
Profit = 20% of cost

Total variable cost = Sales × Variable cost per unit

=3,00,000 × 10/-
= Rs. 30,00,000/-
Total cost = fixed cost + variable cost
= 30,00,000 + 15,00,000
= Rs. 45,00,000
But profit = 20% on cost
Profit = 45,00,000 × 20/100
= Rs. 9,00,000
Sales = F.E + V.E+P
= 15,00,000 + 30,00,000 +9,00,000
= Rs. 54,00,000
Contribution = S - V
= 54,00,000 – 30,00,000
= Rs. 24,00,000
P/V ratio = Contribution × 100
Sales
= 24,00,000 × 100
54,00,000
= 44.44%
BEP sales = Fixed cost = 1500000 × 100
P/V ratio = Total fixed cost × 100
P/V Ratio
= 15,00,000 × 100
44.44%
= 15,00,000 × 100
44.44
= Rs.33,75,338

7. The P/V ratio of a company is 40% and the margin of safety is 30%. You are required to
work out the BEP Sales and net profit if the sales value Rs. 14000.

Sol:- Given information,

P/V ratio=40%
Margin of safety = 30%
Sales= 1400/-

Margin of safety = sales × margin of safety ratio

= 14000 × 30%
= 4200/-
Margin of safety = Profit × 100
P/V Ratio
Net Profit= Margin of safety × P/V Ratio
= 4200 x 40%
= 1680/-

BEP sales = Sales - Margin of safety

= 14000 - 4200
= 9800/-

8. Sales are Rs. 110000/- producing a profit of Rs. 4000/- in period 1. Sales are Rs.150000/-
producing a Rs. 12000/- in period2. Determine BEP and fixed expenses and margin of safety for
two periods.
Sol:- Given Period 1 Period2
Sales 110000/- 150000/-
Profit 4000/- 12000/-

P/V ratio = Changes in Profit × 100

Changes in Sales
= 12000 - 4000 × 100
110000 - 150000
= 8000 × 100
40,000
= 20%

Contribution for Period(1) = Sales x P/V ratio

100
= 110000 × 20
100
= 22,000/
But Contribution= fixed cost+ Profit

Fixed cost for Period (1) = Contribution - Profit

= 22000 – 4000
= 18,000

Contribution for Period (2)= sales × P/V ratio

100
= 150000 x 20
100
= 30,000/-
But Contribution= fixed cost+ Profit

Fixed cost for Period (2) = Contribution - Profit

= 30000 - 12000
= 18,000/-

BEP Sales for Period (1) = Fixed cost

P/V Ratio
=18000
20%
= 90,000/-

BEP Sales for Period (2) = Fixed cost

P/V Ratio
=18000
20%
= 90,000/-

Margin of Safety for Period (1) = Sales - BEP sales

= 1,10,000 – 90,000
= 20,000/-

Margin of Safety for Period (2) = Sales - BEP sales

= 150000 - 90000
= 60,000/-