UNIT II

THEORY OF PRODUCTION
&
COST ANALYSIS
 UNIT 2 - TOPICS
1. Production Function
2. Isoquants
3. Isocosts
4. Internal and External Economies of Scale
5. Law of Returns
6. Cost Analysis
7. Cost concepts
8. Types of costs
9. Break-even Analysis (BEA)- Determination of
Break-Even Point
10. BEP problems
 WHAT IS PRODUCTION???

Production is an activity
that transforms inputs into
output.

It can be defined as the

process of creation of
utility.
 PRODUCTION FUNCTION

Production Function is purely a technological

relationship which expresses the relation
between output of a good and the different
combinations of inputs used in its production.

It shows the maximum production obtained

from a given set of inputs with a given state of
technology.
 MATHEMATICAL EXPRESSION

Production Function can be expresses

mathematically in the form of an equation.
Q = f (L1, L2, C, O, T)

Where, Q= Quantity of production

f = function C = Capital
L1= Land O = Organization
L2= Labour T = Technology
 ISOQUANT

An Isoquant is a curve representing the

various combinations of two inputs that
produce the same amount of output.

An isoquant is also known as iso-product

curve, equal – product curve or production
indifference curve.
 Properties of Isoquants

✔ An Isoquants is downward sloping to the right

✔ Higher Iso-quant represents larger output
✔ No two Isoquants intersect or touch each other
✔ Isoquants are convex to the origin.
 ISOCOSTS

Isocosts refers to that cost curve that represents

the combination of inputs that will cost the
producer the same amount of money.
Capital
IC 3
ISOCOSTS

IC 2

IC 1

Labour
 There are two methods by which output can be raised:

1. Changing some inputs

2. Changing all inputs

Changing some inputs - Law of Variable proportions

(or) Law of Diminishing returns

Changing all inputs - Returns to Scale

LAW OF VARIABLE PROPORTIONS

Law of Variable proportions refers to the short

run.

Law of Variable proportions explains the

changes in output when a factor of production is
varied while keeping other factors constant.

It is also called “ Law of Diminishing returns”

 ASSUMPTIONS OF THE LAW

• The state of technology or the methods of

production remain constant..

• Only one factor of input is made variable and

other factors are kept constant.

• The analysis relates to short period.

• The law assumes labour is homogeneous i.e. no

difference in labour skills.
 EXPLANATION OF LAW

Labour TP AP MP Stages
0 0 0 0
1 5 5 5 STAGE I
2 12 6 7
3 18 6 6
4 20 5 2 STAGE II
5 20 4 0
6 18 3 -2 STAGE III
7 14 2 -4
 RETURNS TO SCALE
Economists use the phrase, “Returns to Scale”
to describe the relationship between output
behavior in the long run in relation to the
variations of factor inputs.

In the long run, adjustments can be made

among the different factors and therefore, all
factors become variable during this period.
Returns to scale are of three types:

Increasing Returns to Scale

Constant Returns to Scale
Decreasing Returns to Scale
 Increasing returns to scale

Increasing returns to scale arise when a

given percentage increase in inputs leads to
a greater percentage increase in the
resultant output.

Hence, the total product increases at an

increasing rate.
 Constant Returns to Scale

Constant returns to scale is a stage where

the given percentage increase in inputs
will be equal to the percentage increase
in the resultant output.
Decreasing Returns To Scale

Decreasing returns to scale will occur

when a firm continues to expand its size
beyond a particular point.

Decreasing returns to scale operate when

the percentage increase in output is less
than the percentage increase in input.
 ECONOMIES OF SCALE

The advantages of large scale production

are called Economies of Scale.

• Internal Economies
• External Economies
 INTERNAL ECONOMIES
Internal Economies are those economies which
are open to an individual firm when its size
expands.

☺ Technical Economies
☺ Marketing Economies
☺ Managerial Economies
☺ Financial Economies
☺ Risk Bearing Economies
 TECHNICAL ECONOMIES

Technical Economies arise when a firm uses

better machines & techniques of production, as
a result of these economies there will be
increase in production and fall in the cost of
production.
 MARKETING ECONOMIES

• A large firm purchases various inputs in bulk

and therefore, it can secure them at cheaper rate
when compared to small firms.

• It can also secure special transport concessions

& better quality inputs etc.

• It can also sell its finished goods without any

difficulty with the help of best marketing
strategies.
 MANAGERIAL ECONOMIES

• A large firm can appoint specially qualified

and highly paid officials to look after the
production, accounts, advertisements etc.

• Managerial Economies arise due to better and

more elaborate management which only large
size firm can afford.
 FINANCIAL ECONOMIES

• A large firm can procure money in time at

cheaper rates of interests because it possesses
large assets and good reputation.

• It can also mobilize fresh capital by issue of

shares and debentures in the capital market
easily.
 RISK BEARING ECONOMIES

A large firm produces a variety of products and

sells them in different areas. Therefore it is in a
better position then a small firm in facing the
risk. It can counter balance the loss in one
product by gain in the other products
 EXTERNAL ECONOMIES
When the number of firms producing the
same commodity increase in a particular area,
all the firms enjoy certain advantages which
are called External Economies.

☺ Economies of Concentration
☺ Economies of Information
☺ Economies of Specialization
☺ Economies of Welfare
 Both internal and external economies
increase the output and reduce the cost of
production.

But, these economies arise only up to a

particular limit beyond which,
diseconomies emerge.
COST ANALYSIS
• Different business proposals are evaluated in
terms of their costs and revenues.

• To know what costs are to be examined, it is

necessary to understand what cost is and how to
analyze the cost.

• Cost refers to expenditure incurred to produce a

product or service.

• Cost of production normally includes cost of

materials, labor, and other overheads this is known
as the total cost.
• Total cost = fixed cost + variable cost + semi
variable cost.

• Total cost is compared with total revenue. The

difference between total cost & total revenue is
termed as profit.

(TR-TC=PROFIT)

• Understanding the meaning of various cost

concepts is essential for clear business
thinking.
• Fixed costs are those costs that are fixed in the
short run.

• Whether the production is taken up or not we have

to incur certain expenses such as rent for factory &
office buildings, insurance, telephone, electricity
and so on.

• In other words total fixed costs remain constant in

the short run.
• Variable cost are those costs that vary with the
volume of production.

• Variable costs comprises cost of raw materials,

wages and so on, these costs are incurred only
when there is production.

• In other words the more the production the more

will be the variable cost and vice versa.
• Marginal cost it refers to additional cost incurred
for manufacturing an additional unit of product.

• Marginal cost in economic theory is useful in

matters relating to allocation of resources, product
pricing decisions, make or buy decisions and so
on.
• Opportunity cost it refers to cost of next best
alternative foregone.

• Opportunity costs refers to earnings/profits that are

foregone from alternative ventures by using given
limited facilities for a particular purpose.

• If there are no alternatives there will be no

opportunity cost.

• They record only the sacrificed alternative so they

are not recorded in the books of accounts.
• Opportunity cost is said to exist when the
resources are scarce and there are alternative uses
for the resources.

• Opportunity cost example:

The cost of getting college education is not merely
you spend on college fee & books. It also includes
the earnings you have foregone throughout the
year by not taking up a full time job.
• Explicit costs are also called as out of pocket costs.

• Explicit costs involves payment of cash.

• Rent for the landlord, wages for the labor, taxes &
duties paid and so on are the explicit costs.

• Explicit costs are also called as out of pocket costs

because they are incurred in reality.
• Implicit costs are also called as imputed costs or
non cash costs or notional cost.

• Implicit costs don't involve payment of cash as

they are not actually incurred.

• They would have been incurred had the owner not

been in the possession of facilities.

• Interest on own capital, rent on own premises,

savings in terms of salary due to own supervision
are examples of implicit cost.
BREAKEVEN ANALYSIS
 INTRODUCTION

• Break even analysis refers to analysis (study) of Break

Even Point (BEP).

• BEP is defined as no profit or no loss point. (BEP is

the point at which total revenue is equal to total cost)

• The term BEA is interpreted in two senses, In its

narrow sense, it is concerned with finding out BEP. In
its broad sense determines the probable profit at any
level of production.
• BEP denotes minimum volume of production to be
undertaken to avoid losses.

• In other words BEP points out, how much minimum

is to be produced to get the profit.

• BEP is a technique for profit planning & control.

• Break Even Analysis is defined as analysis of Costs

& their possible impact on Profits & Volumes of the
firm, hence it is also called as CVP analysis.

• A firm is said to attain the BEP when its Total

Revenue equals to Total Cost (TR =TC).
 Assumptions
underlying Break Even Analysis

• All costs are classified into two – fixed and variable.

• Selling price per unit remains constant in spite of

competition or change in the volume of production.

• There will be no change in operating efficiency.

• Volume of sales and volume of production are equal.

Hence there is no unsold stock (closing stock).
 DETERMINATION OF BREAK
EVEN POINT
Break Even Point can be determined by two methods:

1. Graphical Representation Method &

2. Algebraic Method
Determination of Break even
point with Graphical
representation method
Graphical Representation Method
 Example
No. of Units FC VC TC TR(SP = Rs. Profit / Loss
50)

10 1000 100 1100 10 x 50 = -600

500

20 1000 200 1200 20 x 50 = -200

1000
22 1000 220 1220 22 x 50 = -120
1100
24 1000 240 1240 24 x 50 = -40
1200
25 1000 250 1250 25 x 50 = No Profit,
1250 No loss
30 1000 300 1300 30 x 50 = 200
1500
Break Even Chart explanation:

• The total variable cost (TVC) line is drawn first,

variable cost varies proportionately with the volume
of production.

• Total Fixed cost(TFC) line is horizontal straight line,

it is parallel to X axis since total fixed cost remains
constant in the short run.

• The total cost (TC) line is derived by adding, the

TVC & TFC. The total cost line is parallel to total
variable cost line.
• The total revenue (TR) line starts from origin &
increases along with the volume of sales.

• The total revenue line intersects total cost line at

point BEP. (BEP = TC = TR)

• The zone below BEP point is loss zone & zone

above BEP point is profit zone.

• The point at which total cost line & total revenue

line intersects is called Break – Even Point (BEP),
At this point there exists neither profit nor loss
• The angle formed at BEP, i.e., the point of intersection
of total cost & total revenue is called ANGLE OF
INCIDENCE (AOI).

• The larger the angle of incidence , the higher is the

quantum of profit.

• Sales over & above break even sales are termed as

MARGIN OF SAFETY (MOS).

• In the above graph margin of safety is OQ – OP i.e.,

MOS = total sales – break even sales

 Analysis of Break Even Chart

A break even chart gives us clear picture about the

following:

I. Break Even Point (BEP)

II. Angle Of Incidence (AOI)
III. Margin Of Safety (MOS)
• The lower the BEP the better it is, a firm can survive
even if it is operating at a lower level of activity.

• The larger the AOI the greater is the benefit, angle of

incidence represents the difference between total
revenue & total cost.

• The larger the MOS the better it is for the firm, it has
greater capacity to with stand Recessionary phases.

• Conclusion a high MOS, large AOI & low BEP

denotes the most favorable position to the firm.
 SIGNIFICANCE OF BEA
• BEP denotes minimum volume of production to be
under taken to avoid losses, in other words it points out
how much minimum is to be sold to get the profits.

• It helps in ascertaining the profit on a particular level

of sales volume.

• It also helps in estimating sales required, to earn a

particular desired level of profit.

• It is useful tool in comparing the efficiency of different

firms.
• It helps in “Make or Buy decisions” for a given
component or spare part.

• It helps in assessing the impact of changes in

fixed cost, variable cost & selling price on profits
during a period of time. (CVP analysis)
 LIMITATIONS OF BEA
• BEA is based on Fixed cost concept, & hence holds
good only in the short run.

• If business conditions are Volatile, BEP cannot give

stable results.
• All costs cannot be Classified into Fixed & Variable
costs, some times we may also have Semi variable
costs.

• In case of Multi Product Firm, a single chart cannot

be of any use, series of charts have to be made use
of, which is a complex process.
• The above limitations do not deter the utility of
Break Even Analysis.

• Even today most of the business proposals are

evaluated on the concept of BEP, the given project
is chosen if its break even point is lower.
 APPLICATION OF BEA

The following are some of the areas of

applications of Break Even Analysis

I. Make or Buy decisions

II. Drop or Add decisions
III. Choosing a product mix when there is a limiting
factor
 Determination of BEP - Algebraic
Method
• The following formulae are used to determine Break
Even Point.

SP = FC + VC + profit
SP – VC = FC + Profit
= Contribution

So, Contribution per Unit = SP p.u – VC p.u

BREAK EVEN POINT = FC (in units)

Contribution p.u
 CONTRIBUTION MARGIN

Contribution Margin is the difference between

receipts and variable expenses.

Ex: If a product is sold at Rs.10 per unit and its

variable expenses are Rs.4.

This implies that each unit of the product recovers

Rs.6 over and above its variable expenses of
Rs.4.Thus, Rs.6 is contribution to the recovery of
fixed expenses or profit.
 DETERMINATION OF BREAK EVEN
POINT

BREAK EVEN POINT = FC (in value)

Contribution margin
ratio

Where, CMR = CM p. u
SP p. u
Determination of Break Even Point
when per unit data is not available

BREAK EVEN = FC
POINT (in value) PV Ratio

Where, PV ratio = Profit Volume ratio

= Contribution
Sales
MOS = Net profit
P/V Ratio
 PROBLEMS ON BEP

1. If sales are 10,000 units and selling price is

Rs.20 per unit, variable cost Rs.10 per unit and
fixed cost is Rs.80000, find out BEP in units and
in sales revenue. What is profit earned? What
should be the sales for earning a profit of
Rs.60,000?

2. Determine MOS using above information.

2. The information about Raj & Co., are given below:

i) Profit-Volume Ratio 20%

ii) Fixed Cost Rs.36,000
iii) Selling price per unit Rs.150

Calculate:
a) BEP (in Rs.)
b) BEP (in units)
3. Analyze the following information:

• Sales are Rs. 90,000 producing a profit of Rs.

2900 in period-I

• Sales are Rs. 1, 10,000 producing a profit of Rs.

6000/- in period-II

Determine BEP and Fixed Expenses.

4 .Calculate the following parameters using given
data.

i) p/v ratio
ii) Break even sales volume
iii) Margin of safety
iv) Profit

Given data: Sales Rs 4000, Cost Rs 2000,

Fixed Cost Rs 1600.
5. If Selling Price Per Unit Rs.12,
Variable Cost Per Unit Rs.8,
Fixed Cost Rs.40000

Find out
(a) Break Even sales units and value
(b) profit when sales are Rs.300000
(c) Margin of Safety when sales are Rs.350000.
6. A company prepares a budget to produce 3 lakh
units, with fixed costs 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) Break even point.
END