unit iii cost & productions analysis

7/30/2019 Unit III Cost & Productions Analysis

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25 April 2013 1PROF. SEEMA LADDHA


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Cost Definition: The total money, time and resources associated

with a purchase or activity.

Economic cost Definition The sacrifice involved in performing an activity,

or following a decision or course of action. Itmay be expressed as the total of opportunity

cost (cost of employing resources in one activitythan the other) and accounting costs (the cashoutlays).



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Cost means sacrifice

Cost may be defined as a sacrifice or foregoing which

has already occurred or potential to occur in future

with an objective to achieve a specific purpose

measured in monetary terms

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1. Rate of output i.e. utilization of fixed plant

2. Size of plant

3. Prices of input factor (material and labour)4. Technology

5. Size of lot

6. Stability of output

7. Efficiency of management as well as labour



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The concepts of cost, which are relevant to

business operations and decisions, can be

grouped, on the basis of their purpose, undertwo overlapping categories such as concepts used

for accounting purposes and concepts used in

economic analysis of business activities.



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Opportunity Cost and Actual Cost

Business Costs and Full Costs

Explicit and Implicit or Imputed Costs

Out-of-Pocket and Book Costs Fixed and Variable Costs

Total, Average and Marginal Costs

Short-run and Long-run Costs

Incremental Costs and Sunk Costs

Historical and Replacement Costs

Private and Social Costs



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Production is the process of transformation of inputs

into goods and services of utility to consumers and or

producers.

It is the process of creation of value or wealth through

the production of goods and services that have

economic value to either consumers or other producers.

Such process of adding value may occur by change in

form ( say steel into car ) or by change in place (from

retailer to consumer )

Production of goods include all tangible items &

services include all intangible items.



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Short Run : Short run refer to the period of time when firm cannot varysome of its input i.e. for short run some of its output is fixed .

Variable cost is one that can be mad to vary in short run

Ex. Raw material , semi-skilled or unskilled labour

Fixed cost can not be vary in short run

Running cost and depreciation on capital assets areincluded in short run cost

Long Run:

All inputs are variable in the long run.

All costs are variable in the long run.

In long run fixed cost become variable as the size of thefirm or scale of production increases



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1.Land: is gift of nature and not the result of human effort. It includes allnatural resources.

Ex. Forest , river , sunlight,seas, minerals .

All these are fixed supply& therefore return from land is called rent.

2. Labour The physical & mental efforts of human being that undertake aproduction process is labour

The return from labour is termed as wages & salary.3. Capital is that wealth which is used for further production,is not nature

of gift , but produce by human capital

Return for capital is interest

4.Enterprise: The ability and action to collect , and utilise all the factors of

production for the pupose of economic gain is k/as enterprise .&entrepreneur define as the ability to take risk. Hence entrepreneurremuneration is profit.



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McGraw-Hill/Irwin 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

The Production Process

The production process can be divided intothe long run and the short run.


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The Long Run and the Short

RunA long-run decision is a decision in which

the firm can choose among all possible

production techniques. A short-run decision is one in which the

firm is constrained in regard to what

production decision it can make.


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Production Tables and Production Functions

A production tableshows the output resulting from variouscombinations of factors of production or inputs.

Marginal product is the additional output that will be

forthcoming from an additional worker, other inputs remainingconstant

Average product is calculated by dividing total output by thequantity of the output.

Production functiona curve that describes the relationshipbetween the inputs (factors of production) and outputs.

The production function tells the maximum amount of output

that can be derived from a given number of inputs.


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Cost output Relationship Cost output relationship is very important for various kind of

managerial problems Ex. Expence control, profit prediction,

pricing and promotion

It is relationship between cost and rate of output & assume that

all other variables are constant

The cost out put relation is important to study because it is

subject to faster and more frequent changes

Once the cost output function is determined, estimates future

costs of production at various levels can usually be obtainedby adjusting the cost function to reflect the effect of other

forces , such as wage rates , material prices and lot size

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It is tool of analysis used to explain inputoutput releationship

Emperical production function is very complex because it

includes wide range of input

Q = f ( Ld, L, K , M , T, Te )

Production functions are normally divided into two broad

categories

1. One variable input/ Variable proportion production function.2. Two variable input/ Constant proportion production function

Production Function


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The short run production function shows the maximum output

a firm can produce when only one input can varied & other

input remain fixed

Q = f ( L, K )

Q is output, L is labour, and K denotes the fixed amount of capital

One variable input/ Variable proportion production function.


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A Production Table

Number ofworkers Total output

Marginalproduct

Averageproduct

467653

1025

12345

6789

10

0 455.75.85.65.24.64.03.32.5

4101723283132323025

0


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Output

3230282624

222018161412108

6420

1 2 3 4 5 6 7 8 9 10Number of workers

TP

Outputperworker


7

6

5

4

3

2

1

0

MP

(a) Total product (b) Marginal and average product

AP

A Production Function


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The Law of Diminishing Marginal Productivity

Both marginal and average productivities initially increase, but

eventually they both decrease.

This means that initially the production function exhibits

increasing marginal productivity.

Then it exhibits diminishing marginal productivity.

Finally, it exhibits negative marginal productivity.

The most relevant part of the production function is that

part exhibiting diminishing marginal productivity.


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The Law of Diminishing

Marginal Productivity Law of diminishing marginal

productivity as more and more of a

variable input is added to an existing fixedinput, after some point the additional outputone gets from the additional input will fall.


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Marginal ProductivityNumber of

workersTotal

outputMarginalproduct

Averageproduct

Increasingmarginal returns

Diminishingmarginal returns

Diminishingabsolute returns

4676531025

12345

6789

10

0455.75.85.6

5.24.64.03.32.5

4

10172328

3132323025

0


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Output

Diminishingmarginal

returns

Diminishingabsolute

returns3230282624

222018161412108

6420

1 2 3 4 5 6 7 8 9 10

Increasingmarginal

returns

Number of workers

TP

Outputperworker


7

6

5

4

3

2

1

0

MP

Diminishingmarginal

returns

Diminishingabsolute

returns

(a) Total product (b) Marginal and average product

AP


Marginal Productivity


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Marginal Productivity This law is also called the flower pot law.

If it did not hold true, the worlds entire food

supply could be grown in a single flowerpot.


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The Costs of Production

There are many different types of costs.

Invariably, firms believe costs are too high

and try to lower them.


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Fixed Costs, Variable Costs, and Total Costs

Fixed costs are those that are spent and cannot bechanged in the period of time under consideration.

In the long run there are no fixed costs since all costsare variable.

In the short run, a number of costs will be fixed.

Workers represent variable costs those that changeas output changes.

The sum of the variable and fixed costs are total costs.

TC = FC + VC


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Average Costs Much of the firms discussion is of average cost.

Average total cost (often called average cost) equals total costdivided by the quantity produced.

ATC = TC/Q Average fixed costequals fixed cost divided by quantity

produced.

AFC = FC/Q

Average variable cost equals variable cost divided byquantity produced.

AVC = VC/Q


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Average Costs

Average total cost can also be thought ofas the sum of average fixed cost and

average variable cost.

ATC = AFC + AVC


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Marginal Cost

Marginal cost is the increase (decrease)in total cost of increasing (or decreasing)

the level of output by one unit. In deciding how many units to produce, the

most important variable is marginal cost.


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The Cost of Producing Earrings

Output FC VC TC MC AFC AVC ATC

3 50 38 88

16.67 12.66 29.33

4 50 50 100 12 12.50 12.50 25.00

9 50 100 150 5.56 11.11 16.67

10 50 108 158 8 5.00 10.80 15.8016 50 150 200 3.13 9.38 12.50

17 50 157 207 7 2.94 9.24 12.18

22 50 200 250 2.27 9.09 11.36

23 50 210 260 10 2.17 9.13 11.3027 50 255 305 1.85 9.44 11.30

28 50 270 320 15 1.79 9.64 11.42


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Graphing Cost Curves

To gain a greater understanding of theseconcepts, it is a good idea to draw a graph.

Quantity is put on the horizontal axis and adollar measure of various costs on thevertical axis.


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Total Cost Curves

The total variable cost curve has the sameshape as the total cost curveincreasing

output increases variable cost.


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Totalcos

t

$400

350

300

250

200

150

10050

0

FC

2 4

M

6 8 10 20 30Quantity of earrings

VCTC

L

Total Cost Curves

O

TC = (VC + FC)


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Average and Marginal Cost

Curves The marginal cost curve goes through the

minimum point of the average total cost

curve and average variable cost curve. Each of these curves is U-shaped.


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Average and Marginal Cost

Curves The average fixed cost curve slopes down

continuously.


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Downward-Sloping Shape of

the Average Fixed Cost Curve The average fixed cost curve looks like a

childs slide it starts out with a steep

decline, then it becomes flatter and flatter. It tells us that as output increases, the

same fixed cost can be spread out over a

wider range of output.


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The U Shape of the Average

and Marginal Cost Curves When output is increased in the short-run,

it can only be done by increasing the

variable input.


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and Marginal Cost Curves The law of diminishing marginal

productivity sets in as more and more of a

variable input is added to a fixed input. Marginal and average productivities fall

and marginal costs rise.


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and Marginal Cost CurvesAnd when average productivity of the

variable input falls, average variable cost

rise.


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and Marginal Cost Curves The average total cost curve is the vertical

summation of the average fixed cost curve

and the average variable cost curve.


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and Marginal Cost Curves If the firm increased output enormously,

the average variable cost curve and the

average total cost curve would almostmeet.

The firms eye is focused on average total

costit wants to keep it low.


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Cost

$3028262422201816141210

8

642

0Quantity of earrings

2 4 6 8 10 12 14 16 18 20 22 24 26 28 30 32

Per Unit Output Cost Curves

AFC

AVCATCMC


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The Relationship Between

Productivity and Costs The shapes of the cost curves are mirror-

image reflections of the shapes of the

corresponding productivity curves.


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Productivity and Costs When one is increasing, the other is

decreasing.

When one is at a maximum, the other is ata minimum.


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Costsperunit

Productiv

ityofworkersatt

hisoutput

$1816

141210

86

42

0 4 8 12 16 20 24

98

76543

21

0 4 8 12 16 20 24

AVC

MC

Output Output

A

APofworkers

MPof workers


Productivity and Costs


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Relationship Between

Marginal and Average Costs The marginal cost and average cost curves

are related.

When marginal cost exceeds average cost,average cost must be rising.

When marginal cost is less than average cost,average cost must be falling.


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Marginal and Average Costs Marginal cost curves always intersect

average cost curves at the minimum of the

average cost curve.


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Marginal and Average Costs The position of the marginal cost relative to

average total cost tells us whether average

total cost is rising or falling.


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Marginal and Average Costs To summarize:

If MC > ATC, then ATC is rising.

If MC = ATC, then ATC is at its low point.

If MC < ATC, then ATC is falling.


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Marginal and Average Costs Marginal and average total cost reflect a

general relationship that also holds for

marginal cost and average variable cost.

If MC > AVC, then AVC is rising.

If MC = AVC, then AVC is at its low point.

If MC < AVC, then AVC is falling.


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Marginal and Average CostsAs long as average variable cost does not

rise by more than average fixed cost falls,

average total cost will fall when marginalcost is above average variable cost,


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Marginal and Average Costs$90

80

70

6050

4030

2010

0Quantity

Area B

Area A Area CMC

ATC

AVC

1 2 3 4 5 6 7 8 9

Q1

B

AVC

ATC

MCQ0A


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To make their long-run decisions:

Firms look at costs of various inputs and thetechnologies available for combining theseinputs.

Then decide which combination offers the lowestcost.

The firm makes long-run decisions on thebasis of the expected costs and expected

usefulness of inputs.


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In the long run, a firm has many sizes to choosefrom.

The short run requires that scale be fixed only

one or a few resources can be changed.


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The law of diminishing marginal productivity does not

hold in the long run.


The shape of the long-run cost curve is due to the

existence of economies and diseconomies of scale.


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Scale means size.

Economies of scale: the decrease in per unitcosts as the quantity of production increasesand all resources are variable

Diseconomies of scale: the increase in per unitcosts as the quantity of production increasesand all resources are variable

Constant returns to scale: unit costs remain

constant as the quantity of production isincreased and all resources are variable


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QuantityTotal Costsof Labor

Total Costof Machines

Total Costs =TC

L+ TC

MAverage TotalCosts = TC/Q

11

1213141516

17181920

$381

390402420450480

510549600666

$254

260268280300320

340366400444

$635

650670700750800

850915

1,0001,110

$58

5452505050

50515356



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Averagetotal cost

Costs

perun

it

$64626058565452

5048

11 12 13 14 15 16 17 18 19 20 Quantity

Minimum efficientlevel of production



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To make their long-run decisions:

Firms look at costs of various inputs and the technologies

available for combining these inputs.

Then decide which combination offers the lowest cost.

The firm makes long-run decisions on the basis of the

expected costs and expected usefulness of inputs.



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The law of diminishing marginal productivity does not

hold in the long run.


The shape of the long-run cost curve is due to the

existence of economies and diseconomies of scale.



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Scale means size.

Economies of scale: the decrease in perunit costs as the quantity of production

increases and all resources are variableDiseconomies of scale: the increase in per

unit costs as the quantity of productionincreases and all resources are variable

Constant returns to scale: unit costsremain constant as the quantity ofproduction is increased and all resources

are variable 25 April 2013 60PROF. SEEMA LADDHA


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QuantityTotal Costsof Labor

Total Costof Machines

Total Costs =TC

L+ TC

MAverage TotalCosts = TC/Q

11

1213141516

17181920

381

390402420450480

510549600666

254

260268280300320

340366400444

635

650670700750800

850915

1,0001,110

58

5452505050

50515356

McGraw-Hill/Irwin 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.25 April 2013 61PROF. SEEMA LADDHA

(Amt.in Rs. lakh )


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Averagetotal cost

Costs

perun

it

$64626058565452

5048

11 12 13 14 15 16 17 18 19 20 Quantity

Minimum efficientlevel of production



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Averagetotal cost

C

osts

perun

it

$6462

6058565452

5048

11 12 13 14 15 16 17 18 19 20 Quantity

Economiesof Scale

Diseconomiesof Scale

Constantreturnsto Scale



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Q

Costs perunit

11

$50

$55

17

$60

14 20

Long-runaverage totalcost (LRATC)

ATC falls becauseof economies

of scale

ATC is constantbecause of constant

returns to scale

ATC rises becauseof diseconomies of

scale

Minimumefficient

level ofproduction

13-6525 April 2013 65PROF. SEEMA LADDHA


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Economies and diseconomies of scale playimportant roles in real-world long-runproduction decisions.

The long-run and the short-run average costcurves have the same U-shape, but theunderlying causes of these shapes differ.

Economies and diseconomies of scaleaccount for the shape of the long-run totalcost curve.



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In the short run all expansion must proceed byincreasing only the variable input

This constraint increases cost

There is an envelope relationshipbetween long-runand short-run average total costs. Each short-runcost curve touches the long-run cost curve at onlyone point.

Long-run costs are always less than or equal to short-

run costs because: In the long run, all inputs are flexible

In the short run, some inputs are fixed



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SRMC3SRATC3

SRMC4

SRATC4

SRMC1

SRATC1

SRMC2SRATC2

LRATC

Q

Costs perunit

The long-runaverage total

cost curve

(LRATC) is anenvelope of

the short-runaverage totalcost curves

(SRATC1-4)



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Long-run average total cost (LRATC): thelowest-cost combination of resources withwhich each level of output is produced when allresources are variable.

The long-run average total cost curve gets itsshape from economies and diseconomies ofscale.



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If producing each unit of output becomes less costly

there are economies of scale.

If producing each unit of output becomes more costlythere are diseconomies of scale.

If unit costs remain constant as output rises there areconstant returns to scale.



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Cost elasticity is C = C/C Q/Q.

C < 1 means falling AC,

increasing returns.C = 1 means constant ACconstant returns.

C > 1 means rising AC,decreasing returns.



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Economies of Scope Concept Scope economies are cost advantages that stem

from producing multiple outputs.

Big scope economies explain the popularity of

multi-product firms. Without scope economies, firms specialize.

Exploiting Scope Economies

Scope economics often shape competitive

strategy for new products.



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Cost-volume-profit Charts

Cost-volume-profit analysis shows effects ofvarying scale.

Breakeven analysis shows zero profit points ofcost coverage.



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Economies of scale long run average totalcosts decrease as output increases.

In real-world production processes,economies of scale are extremely importantat low levels of production.

An indivisible setup costis the cost of anindivisible input for which a certain minimumamount of production must be undertakenbefore the input becomes economicallyfeasible to use.


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Indivisible setup costs create many real-world economies of scale.

The cost of a blast furnace or an oilrefinery is an example of an indivisiblesetup cost.


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In the longer run all inputs are variable, soonly economies of scale can influence theshape of the long-run cost curve.


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Because of the importance of economies ofscale, business people often talk of aminimum efficient level of production.


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The minimum efficient level of productionis the amount of production that spreadssetup costs out sufficiently for firms toundertake production profitably.


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The minimum efficient level of production isreached once the size of the market expandsto a size large enough so that firms can takeadvantage of all economies of scale.


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Most industries experience both economies and

diseconomies of scale.

The minimum efficient scale (MES)is theminimum point of the long-run average-costcurve; the output level at which the cost perunit of output is the lowest.

The MES varies considerably across industries.


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Diminishing marginal productivityrefers tothe decline in productivity caused byincreasing units of a variable input beingadded to a fixed input.


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Diseconomies of scale refer to decreases inproductivity which occur when there areequal increases of all inputs (no input isfixed).

Diseconomies of scale occur on the rightside of the long-run average cost curvewhere it is upward sloping, meaning thataverage cost is increasing.


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As the size of the firm increases, monitoringcosts generally increase.

Monitoring costs are those incurred bythe organizer of production in seeing to itthat the employees do what they are

supposed to do.


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Team spirit is the feelings of friendshipand being part of a team that brings outpeoples best effort

As the size of the firm increases, team spiritor morale generally decreases.


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Constant returns to scale is where long-runaverage total costs do not change as outputincreases.

It is shown by the flat portion of the LRATCcurve.


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Averagetotal cost

Costs

perun

it

$64626058565452

5048

11 12 13 14 15 16 17 18 19 20 Quantity

Economiesof Scale

Diseconomiesof Scale

Constantreturnsto Scale


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Q

Costs perunit

11

$50

$55

17

$60

14 20

Long-runaverage totalcost (LRATC)

ATC falls becauseof economies

of scale

ATC is constantbecause of constant

returns to scale

ATC rises becauseof diseconomies of

scale

Minimumefficient

level ofproduction

13-95


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Economies and diseconomies of scale playimportant roles in real-world long-runproduction decisions.


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The long-run and the short-run average costcurves have the same U-shape, but theunderlying causes of these shapes differ.


99/110

Economies and diseconomies of scaleaccount for the shape of the long-run totalcost curve.


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In the short run all expansion must proceed byincreasing only the variable input

This constraint increases cost

There is an envelope relationshipbetween long-runand short-run average total costs. Each short-run costcurve touches the long-run cost curve at only one point.

Long-run costs are always less than or equal to short-

run costs because: In the long run, all inputs are flexible

In the short run, some inputs are fixed

13-100


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SRMC3SRATC3

SRMC4

SRATC4

SRMC1

SRATC1

SRMC2SRATC2

LRATC

Q

Costs perunit

The long-run averagetotal cost curve (LRATC)is an envelope of the

short-run average totalcost curves (SRATC1-4)

13-101


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Long-run average total cost (LRATC): the lowest-

cost combination of resources with which each levelof output is produced when all resources arevariable.

The long-run average total cost curve gets its shapefrom economies and diseconomies of scale.


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If producing each unit of output becomes less costly

there are economies of scale.

If producing each unit of output becomes more costlythere are diseconomies of scale.

If unit costs remain constant as output rises there areconstant returns to scale.


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Economies of Scale

Long-run cost curves showminimum cost in an idealenvironment.



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unit iii cost & productions analysis

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