costs of production revision

Costs of production©

Unit 03

1RASHAIN PERERA CIMA Adv. Dip. MA, UOR (Mgt)

Prepared by; RASHAIN PERERA077 059 37 [email protected]

RASHAIN PERERA CIMA Adv. Dip. MA, UOR (Mgt)

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INTRODUCTION Section 01


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Business objectives Profit maximization is the fundamental

objective of a business Profit is the excess of income over

expenses Income is mainly through selling goods

and services There are various components of costs

such as variable costs, fixed costs and overhead costs.


Other business objectives Maximizing earning per share Satisfying customers Quality products Continuous improvement Satisfactory service Business social responsibility (CSR) Growth and development Research and development AND other financial and non financial

objectives5RASHAIN PERERA CIMA Adv. Dip. MA,

UOR (Mgt)

The production process Conversion of raw materials to finished

goods could be simply known as the production process.

Conversion process, transformation process are some of the similar terms that are used by various parties for production process


Production process involves inputs and its outcome could be termed as output

Therefore it is clear that there’s a direct relationship between inputs and outputs

This relationship could be shown in terms of the production function


Production Function The production function shows the

relationship between the inputs and the outputs of a particular production process.

The production function can be presented as below


Q = f{L/M, K}

In some processes some inputs might be fixed.

For example if capital is fixed the production function could be re stated as


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Q = f { L/M, K }

Short run Vs Long run

Short Run Short run is a time period in which both variable

factors and fixed factors exists. In the short run some factors remain fixed while

some of the factors can be changed in line with the requirement.

For example suppose that you need to park 4 cars in your garden but you don’t have enough space to do so. In the short run you garden space remains fixed while in the long run you can change it either by buying the land next to your house or by building an underground car park


Long Run In the long run all factors are variable

and no fixed factors can be seen


Variable factors Vs Fixed factors

Variable Factors Variable factors are the inputs/ factors

which change if the activity level or output changes

For example if we consider a tuition class, the tutorial cost would be variable


Fixed Factors These are the factors or inputs that stay

the same or constant regardless of the output produced or activity level

Considering the same example mentioned in the previous slide, the fixed factor is the building that is being used to deliver the lecture


SHORT RUNSection 02


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Short run production function


Q = f { L/M, K }


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TP

MP

AP

Law of diminishing marginal returns This says that proportion of one factor

in a combination of factors is increased, after a certain point first the marginal then the average product of that factor will diminish

In other words total output will increase at a decreasing rate when more and more variable factors are assigned to a fixed input

Refer notes for graphical presentation19RASHAIN PERERA CIMA Adv. Dip. MA,

UOR (Mgt)

Short run revenue functions Revenue is the income gained by selling

goods and services Key formulas;


TR = P X Qty

AR= TR/Qty

MR= change in TR/change in Qty

Short run cost functions There are 7 types of short run costs

Fixed costs Variable costs Total costs Average fixed cost Average variable cost Average total cost Marginal cost


Fixed costs This is the cost that stays a same

regardless of the output level


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TFC

Cost

Qty

Variable costs The costs that changes with the activity

level or output level


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Cost

Qty

TVC

Total costs This is the totality of variable and fixed

costs


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TC = VC + FC

Average fixed costs


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AFC = TFC / QtyCost

Qty

TFC

AFC

Average variable costs


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AVC = TVC / QtyCost

Qty

AVC

Average total costs


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ATC = AFC + AVC Cost

Qty

AVC

ATC

AFC

Marginal costs


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MC = Chg TC/Chg QCost

Qty

AVC

ATCMC

Cost functions VS production functions



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Short run profit functions Profit the excess of revenue over

expenditure

Where TR is a function of price and quantity sold

TC is a function of variable, fixed costs and overheads


Profit = TR - TC

Types of profits Accountants profit

Economists profit


= TR – explicit costs

= TR – implicit – explicit costs

Explicit costs Explicit costs are the costs that can be

accountant in monetary terms. For example electricity paid 10 000

Implicit costs These are the opportunity costs or

unseen decision costs.


Types of economic profits Normal profit

The minimum required by a firm to be in operation

Here the economic profit = 0 Abnormal profit/supernormal profit

This is an excess Here economic profit > 0

Subnormal profit Is an actual loss Here economic profit < 0


LONG RUNSection 03


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Long run production function Is a time period where only variable

factors exists Long run production function can be

explained with the help of economies of scale

Economies of scale refers to an advantageous situation derived by a firm with increase in capacity, size and production


Envelop curve It is said that LRAC is made of several

SRAC curves. LRAC is derived by joining the optimums of those SRAC curves as shown below.


LRAC

SRAC 1 SRAC 2

Economies of scale and LRAC curve


Optimum level

EOSDEOS

Returns to scale and LRAC curve


Increasing returns to scale

constant returns to

scale

Decreasing returns to scale

Increasing returns to scale Firms experience this if their average cost

per unit in production falls as the firms expand in size/ activity level

Reasons Bulk buying Spreading overheads Risk bearing economies Financial economies Marketing economies of scale Specialization


Decreasing returns to scale Reasons

Depreciation of resources Stress Lack of control Poor communications in the large firm Weaknesses in the management and

coordination.


MARKET STRUCTURES Section 04


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Characterization of markets Number of firms? Size of firms? Type of product? Barriers to entry and exit? Information availability?


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Perfect competition Characteristics

Large number of small firms Homogenous or identical product No/low barriers to entry and exit Perfect information available for both

consumers and producers No advertising can be seen A price taker Faces a perfectly elastic demand curve No/low competition Ex; paddy farmers, wheat farmers etc


Industry VS firms demand curve (price taker)


Industry Firm

P

S

D

P=D=AR=MR

Price = demand = AR = MR


Price Demand

TR AR MR

10 1 10 10 1010 2 20 10 1010 3 30 10 1010 4 40 10 10

P=D=AR=MR 10


D=AR=MR=P

MC

AC

Short run equilibrium- abnormal profit


D=AR=MR=P

MC

AC

Short run equilibrium-sub normal profit


D=AR=MR=P

MC

AC

Long run equilibrium- normal profit


D=AR=MR=P

MC

AC

Shut down point- case 1since AVC can be covered the firm will continue its operations

AVC


D=AR=MR=P

MC

AC

Shut down point- case 2since AVC can not be covered the firm will shut down or discontinue

AVC


D=AR=MR=P

MC

AC

Supply curve of a perfect competitive firm- case 1

AVC


MC

AC

AVC

Supply curve of a perfect competitive firm- case 2

Monopoly Characteristics

Only one firm Sells a unique product High entry and exit barriers Less or no information available for customers No need to advertise Faces a normal downward sloping demand

curve A price maker No competition Ex; CGR


MR=0.5AR


Short/long run equilibrium-abnormal profit


D=ARMR

MC

AC

Monopolistic competition Characteristics

Large number of small and large firms Homogenous or heterogeneous product Barriers to entry and exit are comparatively high Imperfect information Faces a normal downward sloping demand curve Advertising can be seen Can be a price taker or a maker Brand competition can be seen Ex; soft drinks, soap, tooth paste


Short run equilibrium-abnormal profit


D=ARMR

MC

AC

Long run equilibrium-normal profit


D=ARMR

MC

AC

Oligopoly Characteristics

Few large firms Differentiated inter dependent product High barriers to entry and exit Mutually interdependent Advertising can be seen Faces a kinked demand curve High competition Ex; television broadcasting, newspaper

publishers60RASHAIN PERERA CIMA Adv. Dip. MA,

UOR (Mgt)

Kinked demand curve


Competition methods Price competition

Decreasing the price to increase sales discounts

Non price competition Advertising Internet shopping Extension of opening hours Home delivery Cash on delivery COD


Price leadership When one firm has a dominant position

in the industry, that firm will be able to control the prices of other firms in the industry up to a certain extent. The dominant firm is named as price leader.


The bad of oligopolies Inefficient in allocation of resources In equal distribution of income

The good of oligopolies Widen the product range Benefits the customer with innovative

products Can take advantage of economies of

scales


Types of barriers to entry and exit Barriers to entry

Economies of size Capital intensive Intellectual property High switching cost of barriers Established brand loyalty Legal requirements Government standards

Barriers to exit Investment in specialized equipment Specialized skills High fixed costs


END


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