UNIT-3 THEORY OF PRODUCTION AND COST ANALYSIS PRODUCTION FUNCTION:

The term production function refers to the relationship between the inputs and outputs produced by them. Thus the relationship is purely physical or technological in character. It ignores the prices of inputs and outputs. The study of production function is directed towards establishing the maximum output which can be achieved with a given set resources or outputs and with given state of technology.

From this figure, steel plate and a host of other inputs are combined with labor in various combinations to produce motor cars, school rooms, books, teachers; students are combined to produce an elastic output called education. Sometimes an output of one production process is an input to another (ex:-tyre) such goods are known as intermediate outputs.

Samuelson defines 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. Michel R Baye defines 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 can be stated in a general form of a equation.

Y=F(X1, X2, etc)

Where Y, the units of a output is a function of the quantity of the two or more inputs with X1 including units of labor, for example andX2 units of machinery. The production function can be estimated by the methods of least squares. In economic theory, we are concerned with 3 types of production functions viz.., 1. Production functions with one variable input. 2. Production functions with two variable input. 3. Production functions with all variable input.

PRODUCTION FUNCTIONS WITH ONE VARIABLE INPUT:In economics, the production function with one variable input is illustrated with the well known law of variable proportions. It is also known as law of diminishing marginal returns (also some times) known as law of diminishing marginal productivity. Law of variable proportion shows the inputs output relationship or production function with one factor variable while other factors are kept constant.

EXAMPLE:-For a farmer capital, land, machinery are fixed assets or fixed

investment, but labor is a variable factor. The change in the number of labor capacity will change the output.

THREE STAGES OF PRODUCTION PROCESS:The total, marginal and average product curve in this figure demonstrate the law of variable proportions. The figure also shows 3 stages of production associated with law of variable proportions.

TOTAL PHYSICAL PRODUCT(TPP) STAGE 1:Increase at increasing rate.

MARGINAL PHYSICAL PRODUCT(MPP) Increases, reaches its maximum and then declines till MR=AP

AVERAGE PHYSICAL PRODUCT(APP) Increases and reaches its maximum.

STAGE 2:Increasing at diminishing Is diminishing and rate till it reaches become equal to zero. maximum. STAGE 3:Starts declining. Becomes negative

Starts diminishing.

Continues to decline.

ASSUMPTIONS:1. CONSTANT TECHNOLOGY: - If technology changes, marginal

and average product may rise instead of diminishing.

2. SHORT RUN: - The law operates in the short run because it is here
that some factors are fixed and others are variable. In long run, all factors are variable.

3. HOMOGENEOUS OUTPUT:-The variable input as applied unit by

unit is homogeneous or identical in amount and quality.

4. It is possible to use variable factor on the fixed factors of production.

PRODUCTION FUNCTION TWO VARIABLE INPUTS:To known the production function with two variables inputs, it is necessary to explain what an isoquant is. An isoquant is also known as iso product curve, equal product curve or a production indifference curve. This curve shows the various combinations of two variable inputs resulting in the same level of output.

LABOR AND CPITAL INPUT IS RELATION TO OUTPUT:LABOR (UNITS) CAPITAL (UNITS) OUTPUT(UNITS) 1 5 10 2 3 10 3 2 10 4 1 10 5 0 10 In this above figure it can be assumed that the different pairs of labor and capital results in the same output. It can be observed that the output will be some either by employing 4L+1C or by 5L+0C, the results in an iosquant.

ISOQUANTS:An isoquant is defined as the curve passing through the plotted points representing all the combinations of the two factors of production which will produce a given output. From this iso means equal, quant means quality. Isoquant means that qualities throughout a given isoquant are equal.

The figure gives a typical isoquant diagram whereas one moves upward to the right, higher level of outputs are observed, using larger qualities of output. Too each level of output there will be a different isoquant when the whole array of isoquants is represented on a graph. It is called isoquant map.

ASSUMPIONS:SUBSTITUTABILITY OF INPUTS: - An important assumption in the

isoquant diagram is that the inputs can be substituted for each other.

MARGINAL RATE OF TECHNICAL SUBSTITUTION (MRTS):The slope of the isoquant has a technical name MRTS or the marginal rate of substitution in production. Thus, in terms of inputs of capital services K and labor L. MRTS=dK/L

RATIO OF MRTS BETWEEN CAPITAL AND LABOR:COMBINATIONS A B C D E F CAPITAL(UNITS) 1 2 3 4 5 6 LABOR 20 15 11 8 6 5 MRTS 5:1 4:1 3:1 2:1 1:1

TYPES OF ISOQUANTS:1. Linear isoquants. 2. Right angle isoquants. 3. Convex isoquants.

1. LINEAR ISOQUANTS:In this perfect suitability of inputs and output is required. The substitution of inputs and outputs should be in same proportion and in a resultant combination.

EXAMPLE: - 100Units can be produced by a combination of 1 unit of labor

and 5 units of capital.

2. RIGHT ANGLE ISOQUANTS:Here is a complete non substitutability between the inputs (or strict complimentary).

EXAMPLE: - Exactly two wheels and one frame are required to produce a
bicycle and in no may can wheels be substituted for frames or vice-versa.

CONVEX ISOQUANTS:This form assumes substitutability at inputs but the substitutability is not perfect.

EXAMPLE:-A shirt can be made with relatively small amount of labor (L1)
and large amount of cloth (C1). The same shirt can be well made with less

cloth (C2), if more labor (L2) is used Because the further will have to cut the cloth more carefully and reduce wastage finally, the shirt can be made with still less cloth (C2) but the further must take pain so that labor inputs requirement measure to L3. So, while a relatively small addition of labor from L1 to L2 allows the input of cloth to be reduced from C1 to C2, a very large increase in labor from L2 to L3 is needed to obtain small reduction in cloth from C2 to C3. Thus substitutability of labor for cloth diminishes from L1 to L2 to L3.

CHERACTERISTICS OF ISOQUANTS:1. An isoquant is elvwnward stop nayto the right. i.e. negatively inclined.
This implies that for the same level of output, the quantity of marble will have to reduced in order to increase the quantity of other variable. 2. A higher isoquant represents larger output. That is with the same quantity of one input and larger quantity of the other input, larger output will be produced. 3. No two isoquants intersect or touch each other. If two isoquants intersect or touch each, this would mean that there will be a common point on the two curves and this would implify that the same amount of two inputs can produce two different levels of output (i.e. 400and 500 units) observed.

4. Isoquants is convex to the origin. This means that its slope declines from
left to right along the curve. In other words, when we go on oncreasing the quantity of one input say labor by reducing the quantity of the other inputs say capital. We see that less units of capital are scarified for the additional units of labor.

ISOCOST CURVES:In this connection, one has to consider yet another but important diagram consisting of isocost curves. Here also the quantity of the inputs X and Y.

Suppose, the quantity of output has to be produce by a given set of inputs which is earlier fixed as L1 and L2. By means while no discount or other reasons for the firm to get larger quantities at lower prices. We now plot the various quantities of X and Y which may be obtained from the given monetary outlays. For the given isoquants curve showing the quantities of X and Y that can be purchased for Rs 1000, another isocost curve showing the quantities of X and Y which can be purchased for an expenditure of Rs 2000 and so on. By intersect the isocost curve into isoquant, one can ascertain the maximum output for a given outlay, say Rs200. This maximum output which is possible with outlay, is represented optimum combination of inputs is represented by the isoquant tangent to isocost curve; the optimum combination of inputs is represented by point E, the point of tangency. At this point marginal rate of substitution (MRTS), between the inputs is equal to the ratio between the prices of the inputs.

LEAT COST COMBINATION OF INPUTS: This method is Useful for the determine the best Combination of Inputs like Capital & labour to produce good out put. One has to know the amount of finance available to producer to spend on inputs

Ex: Producer has spends Rs.10,000 for Two inputs. Prices of two inputs are
Rs.1,000 per unit of capital & Rs.200 per unit of labour respectively. Then the firm will have 3 alternatives I. To spend only on capital to secure 10 units of capital II. To spend the amount only on labour & secure 50units III. To spend amount equally on both capital & labour

From the above figure we can take equal product curves IQ1, IQ2,
IQ3 respectively & it represents out puts 1,000 , 2,000, 3,000 units respectively. Here is AB is the factor price line At point E, factor price line touches to IQ2 isoquant, it represents 2,000 units of out put. IQ3 Isoquant falls out side the factor price line AB. Therefore firm cant choose this combination.

IQ1 is drawn between R&S, so It is not preffered by the firm So at point E , IQ2 is considering as Ideal Combination & so this combination gives maximizing the out puts & Minimising the cost.

MARGINAL RATE OF TECHNICAL SUBSTITUTION

Technical name for Isoquant curve is called as MRTS.

Otherwise it is called as Marginal rate of substitution in Production. MRTS having 2kinds of Inputs, those are Capital (K) & Labour (L). MRTS= change in one outputs Change in another inputs = -K L Where K is change in capital and L is change in labor.

PRODUCTION FUNCTION WITH ALL VARIABLES:Production function with all variables confirmed with all variable such as raw material, labor, capital, building, machinery etc. Therefore in any production may be vary time to time as per the requirements. The producer should be concentrate on Minimization of inputs. Maximization of outputs.

By these two aspects, producer should use some quantitative techniques such as optimization techniques and linear programming to provide better solution. Computers have further simplified the complexity of production function in multiple input factor setting.

COBB-DOUGLAS PRODUCTION FUNCTION:Cobb-Douglas production function has based on macro level study, it has been very useful for interpreting economic results. This production function is always concentrating on constant cost.

Cob Douglas put forth a production function relating output in American manufacturing industries from 1899 to 1922 to labor and capital inputs. P=bL a e1-a Where p is total output, L=labor employed=capital invested, a & (1-a) are elastics of production. The measurement of result is depends on the percentage response of output to percentage change in labor and capital respectively. Estimation by Cobb & Douglas is P=1.01L
0.75

0.25

R2=0.9409 or 94% From this above estimation, it can be concluded that production function shows that one percentage change in labor input, capital remaining the same in associated with 0.75 percentage change in output. Similarly, one percentage change in capital, labor remaining the same, is associated with a 0.25 percentage change in output. The coefficients of determination R2 means that 94% of the variation on the dependent variable (p) were accounted for by the variations in independent variables L and C.

ASSUMPTIONS:1. It indicates constant return to scale which means that there are no economics or dis-economics of large scale of production. 2. On an average, large or small scale plants are considered equally profitable. 3. The average and marginal production costs are constant.

LAW OF RETURNS:-

Law of returns refers to the returns enjoyed by the firm as a result of change in all inputs. It explains the behavior of the returns when the inputs are changed simultaneously. There are various laws of returns governing production function. They are 1. Law of increasing return to scale. 2. Law of constant return to scale. 3. Law of decreasing return to scale.

1.

LAW OF INCREASING RETURN TO SCALE:-

Her, the total production increase at an increasing rate, this law studies 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.

2.

LAW OF CONSTANT RETURN TO SCALE:-

The 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 RETURN TO SCALE:-

Where the proportionate increase in the inputs does not lead to increases in output. The output increases at a decreasing rate, the law of

decreasing return to scale is said to operate. This law results in higher average cost per unit.

ECONOMICS OF SCALE (INTERNAL AND EXTERNAL):Alfred marshal divides the economics of scale into two groups, internal and external.

INTERNAL ECONOMICS: - It refers to the economics in production costs

which occurs to the firm alone when it expands its output. The internal economics occurs as a result of increase in the scale of production. The internal economics may be of following types:-

1.

MARGINAL ECONOMICS:-

When a production unit expands its production, it should ensure minimum wastage and lower coast of production in long run. Therefore it is required to engage the expert personal in marketing, finance, production, human resources and other professional way.

2.

COMMEREIAL ECONOMICS:- The transitions of buying and

selling raw materials and other operating supplies such as spares and so on will be rapid and the volume of each transition also grows s the firm grows. There would be cheaper savings in the procurement, transportation and storage costs. This will lead to lower costs and increased profits.

3.

FINANCIAL ECONOMICS:-

To meet the financial requirement, there could be cheaper credit facilities from financial institutions to reduce the interest rates.

4.

TECHNICAL ECONOMICS:-

Increase in the scale of production follows when there is sophisticated technology available and the firm is in position to hire qualified technical manpower to make use of it. There could be substantial in the hiring of manpower due to larger investment in technology.

5.

MARKETING ECONOMICS:-

For the growth and development of scales in production or output, marketing department independently to handle the issues related to design of customer survey, advertisement, self campaign, rules promotions etc.

6.

RISK BEARING ECONOMICS:-

As there is growth in size of the firm, there is increase in the risk also. Showing the risk with the insurance companies the first priority for any firm. The firm can insure its machinery and other assets against the hazards of fire, and other risks. The large firm can spread their risk so that they do not keep all there eggs in one basket. They purchase raw material from different sources. They more often, deal in more than one product to offset the losses by the profits from the scales of others.

7.

ECONOMICS OF RESEARCH AND DEVELOPMENT:-

Every firm or industry is interested to develop its research and development units for the sake of profit. Large organizations such as Dr.Reddys labs, HUL, Godrej, P&G etc. spend heavily on research and development and bring out several innovative products.

EXTERNAL ECONOMICS:External economics refers to all the firms which surrounded by an industry. Therefore every firm is depends upon every industries growth. This will lead to lowering the cost of production and thereby increasing the profitability. The external economics can be grouped under three types:-

1.

ECONOMICS OF CONCENTRATION:-

Suppose all the firms are in one location and supporting to each other. Then there will be an good infrastructure such as roads, railways and

transportation facilities. The location would be expanded through banking and communication facilities, availability of skilled labor and such factors.

2.

ECONOMICS OF R & D:-

The entire firm can pool resources together to finance research and development activities and thus share the benefits of research. There could be a common facility to phase journals, newspapers and other valuable reference material of common interest.

3.

ECONOMICS TO WELFARE:-

All the welfare facilities like school, colleges, park etc. which can be used in common by the employees in the whole industry.

COST ANAYSIS The managerial economics is concerned to decision making and forward planning through past date and present information and cost and revenue. Therefore al the industries and business concerns are deals with east analysis in every time. These concept is based on the possible output for a given in out relationship in short run and long run. The concept of optimum size of the firm is explained here.

COST CONCEPT:Cost refers to the expenditure incurred to produce a particular product or service. All the costs involves a scarifies of some kind or other to acquire some benefit.

EXAMPLE:-Purchasing of a material is particularly concerned to scarifying

money in terms of benefit. Cost may be classified in terms various aspects: Monetary or non-monetary. Tangible or intangible. Subjectively or objectively.

 Social cost. Above all, the characteristics are different with nature. Social costs such as population congestion, pollution are the dimension to the cost concept.

EXAMPLE:-Smoke generated from functions which destroy the health of

human beings, animals or plants etc. cost of production =cost of materials, labor + other expenses Or TC=cost of material etc + other expenses (total cost) Thus, profit =TR-TC Where TR is total revenue and TC is the total cost.

OBJECTIVES: In decision making cost needs to be analyzed and understand in a perspective. Supplementary date can be analyzed by cost analysis: It can help in financial records for the necessary information about costs. It can utilize in legal and financial purpose.

OPPORTUNITY COST:Actual cost means the actual expenditure incurred for acquiring or producing goods are service.

EXAMPLE:-Actual cost for purchasing a goods.

So these costs are always recorded in book of accounts for estimation. Opportunity cost refers to earning profits that are foregone from alternative ventures by using given limited facilities for particular facilities for a particular purpose. As these are scarified alternative, it must be considered for decision making.

Where there is an alternative, there is an opportunity to reinvest the resources. In other words there are no alternatives, there are no opportunity costs.

EXAMPLE:-Firm to invest Rs250000/- in a residential plot instead of buying

a government bond, the interest that could have been earned on the bond must be added to the explicit cost of Rs25000/- in other words. The cost of the residential plot is not just Rs25000/- but Rs25000/- plus the interest on the bond that could have occurred had the amount been invested in the bonds.

FIXED VS VARIABLE COSTS:Total cost (TC) could be divided into two components, fixed costs and variable costs. Fixed costs are the costs which remain constant in total regardless of changes in volume up to a certain level of output. They are not affected by changes in the volume of production. The fixed cost will have incurred even when output is nil.

EXAMPLE:- Machinery purchase for production construction of building for

production installation of tools in the time of production. Total variable costs are the cost which may be vary per unit of output or production Variable cost is those costs that vary with the volume of the production. Variable cost comprises the cost of raw material, wages paid to the labor etc.

DISTINCTION BETWEEN FIXED VS VARIABLE COST:1) Fixed cost doesnt change with 1)it is vary from time to time with a change in the volume but vary output per unit of volume inversely with volume. 2) Fixed cost are those cost that 2) it is not fixed in short run are fixed in short run Ex:- payment of electricity bills, insurance etc.

SEPARATION OF FIXED AND VARIABLE COSTS:1) Least square method 2) High and low point method.

LEAST SQUARE METHOD:Suppose the fixed element is a variable element b. Ten Y=a+bxFrom this equation the value of a _ _ =Y-Bx b=

PROLEM:Determine the fixed and variable components of the cost of the indirect labor.

MONTH
1 2 3 4 5

DIRECT MAN HOURS(RS)

44 40 45 42 36

INDIRECT LABOR
870 850 870 850 750

6 7 8 9 10 11 12

22 23 15 30 38 41 44

550 500 450 600 700 800 850

MONT H
1 2 3 4 5 6 7 8 9 10 11 12

DIREC T MAN HOUR( X)

44 40 45 42 36 22 23 15 30 38 41 44 X=420 X/n=35

INDIREC T LABOR( RS)Y

870 850 870 850 750 550 500 450 600 700 800 850 Y=8640 Y/n=720

X FROM 35
9 5 10 7 1 13 12 20 5 3 6 9 X=0

X2

Y FROM 72
150 130 150 130 30 170 220 270 120 20 80 130 Y=0

XY

81 75 100 49 1 169 144 400 75 9 36 81 X2=112 0

1350 650 1500 910 30 2212 2640 5400 600 60 480 1170 XY=168 80

Therefore i.e., RS15 per 1000/- direct man hours.

. (1)

=720-15(35) = 720-525

=195. (2)

HIGH AND LOW POINT METHOD:Here two costs are distinguished by one high and other low.

Q calculate the fixed and variable costs the following. Output (units) 3,420 1,368 Total cost (Rs) 13,880 8,750

SOLUTION: - Incremental cost= 13,880 - 8,750 = 5,130

Incremental output= 3,420 - 1,368 = 2,052 Variable cost per unit= Total costs for 3,420 units =13,880 Variable costs for 3,420 units 3,420*2.50 = 8,550 Therefore fixed cost= 13,880 - 8550 = Rs 5330

EXPLICIT COSTS VS IMPLICIT COSTS:Explicit costs are the ready cash cost where as implicit cost noncash are cost. Explicit costs involve payment of cash. These are directly related to the production function.

EXAMPLE:-rent for the land lord

Saving in terms of salary due on own superstation. Both implicit and explicit costs are important for decision making.

OUT OF PACKET COST VS IMPUTED COST: Out of packet costs are the costs for which cash is spent. These are also called explicit costs.

 Imputed costs do not involve cash unit flow. They are also called implicit costs.

COST OUTPUT RELATIONSHIP:The cost and output are related with each other which depends upon several factors such as volume of production, relationship between the cost and output, price and productivity of the inputs such as land, labor, capital etc.., The cost output relationship is different in short run in long run. In short run the cost classified into fixed costs and variable costs, whereas in the long run, the cost-output relationship studies the effect of varying the size of its plants upon its cost. Cost-output relationship facilities much managerial decision such as: Formulating relational policy. Expense control. Profit predication. Privacy. Promotion.

BREAK-BREAK ANALYSIS:Profit maximization is the ultimate goal of every business organization. Therefore the business concerns are always depends on internal and external factors for monitoring and central business, break even point is necessary for minimization of inputs and convex the lasses. Break even analysis refers to analysis of break even point (BEP). This point is refers to no loss and no profit zone. Break even analysis is defined as analysis of casts and their possible impact on revenue and volume of the firm. It is also called as the cost volume profit analysis. A firm can reach at BEP point when TR=TC or total revenue is equal to total coast.

DETERMINATION OF BREAK EVEN POINT:Determining the break even point is important is important to sustain in between no loss and no profit zone. It is depends on various factors such as fixed costs, variable cost, total cost, total revenue, contribution margin profits, etc..,

HOW TO DETERMINE THE BREAK EVEN POINT?

Selling price=fixed cost + variable cost + profit

EXAMPLE:-A firm gas affixed cost of RS 10,000 selling price per unit is RS5
and variable cost per unit is RS 3 (1) Determine break even point in terms of volume and sales value. (2) Calculate the margin of safety considering that the actual production is 8000 units.

SOLUTION: - From this above problem (1)

Break even point (units) =

Or, contribution margin per unit = selling price per unit variable cost per unit =5-3 =2 So, BEP (units)= units.

BEP in terms of value (rupees) BEP in sales value =

Or, contribution = =

Or, BEP =

VARIFICATION:TR=TC IN CASE OF BEP Or, 25,000=500*5=25,000 (2) Margin of safety (units) = number of units sold break even points in units. Marginal of safety = 8000-5000 =3000units Therefore as the margin of safety is 3000 and BEP is 5000. The company should not full below. Once it reaches the BEP, it is advisable for the firm to rech or understanding as it can not afford any more delay. If production fulls below BEP, the firm suffers loss.

EXAMPLE: - SAI enterprises deal in the supply of hardware parts of

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

SALES

YEAR(1) RS 50,000

YEAR(2) RS 1,20,000

FIXED COST 10,000 20,000 VARIABLE COST 30,000 60,000 Determine the margin of safety and break even point.

SOLUTION: - If per unit date is not available then we should find out p/v
ratio So p/v ratio= Contribution and profit during 1 & 2 years as:-

SALES
LESS VARIABLE COST CONTRIBUTION LESS FIXED COST

1 YEAR 50,000
30,000 20,000 10,000

2 YEAR 1,20,000
60,000 60,000 20,000

NET PROFIT P\V RATIO = =

10,000

40,000

= =40% =50% = =40,000 = =RS80,000

BEP=

= =RS25,000

Marginal of safety =

= =RS25,00

APPLICATION OF BEP:(1) MAKE OR BUY DECISION: - The managerial should confirm with
make or buy decision. Where the consumption is large, making may be economical. (2) Choosing a product when there is a limiting factor.

(3)

DROP AND ADD DECISIONS: - Dropping the old product

production and change it into new product can be analyze with the help of break even analysis.

SIGNIFICANCE OF BEP:BEP is an important aspect by which so many can be do. To ascertain the profit on a particular levels 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 levels, sales are method sales for individual company. To compare the efficiency of different company. To decide to make or buy a given component or spare parts.