UNIT - II

PRODUCTION FUNCTION

Introduction: 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 (A, B, C, D)

Where “Q” stands for the quantity of output and A, B, C, D are various input factors such as land, labour,
capital and organization. Here output is the function of inputs. Hence output becomes the dependent variable
and inputs are the independent variables.

The above function does not state by how much the output of “Q” changes as a consequence of
change of variable inputs. In order to express the quantitative relationship between inputs and output,
Production function has been expressed in a precise mathematical equation i.e.

Y= a+b(x)

Which shows that there is a constant relationship between applications of input (the only factor input ‘X’ in
this case) and the amount of output (y) produced.

Importance:

1. When inputs are specified in physical units, production function helps to estimate the level of
production.
2. It becomes is equates when different combinations of inputs yield the same level of output.
3. It indicates the manner in which the firm can substitute on input for another without altering the total
output.
4. When price is taken into consideration, the production function helps to select the least combination of
inputs for the desired output.
5. It considers two types’ input-output relationships namely ‘law of variable proportions’ and ‘law of
returns to scale’. Law of variable propositions explains the pattern of output in the short-run as the
units of variable inputs are increased to increase the output. On the other hand law of returns to scale
explains the pattern of output in the long run as all the units of inputs are increased.
 6. The production function explains the maximum quantity of output, which can be produced, from any
chosen quantities of various inputs or the minimum quantities of various inputs that are required to
produce a given quantity of output.
Production function can be fitted the particular firm or industry or for the economy as whole. Production
function will change with an improvement in technology.

Assumptions:

Production function has the following assumptions.

1. The production function is related to a particular period of time.

2. There is no change in technology.
3. The producer is using the best techniques available.
4. The factors of production are divisible.
5. Production function can be fitted to a short run or to long run.
Cobb-Douglas production function:

Production function of the linear homogenous type is invested by Junt wicksell and first tested by C. W. Cobb
and P. H. Dougles in 1928. This famous statistical production function is known as Cobb-Douglas production
function. Originally the function is applied on the empirical study of the American manufacturing industry.
Cabb – Douglas production function takes the following mathematical form.

Y= (AKX L1-x )

Where Y=output

K=Capital

L=Labour

A, ∞=positive constant

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 of the first degree
3. The function assumes that the logarithm of the total output of the economy is a linear function of the
logarithms of the labour force and capital stock.
4. There are constant returns to scale
5. All inputs are homogenous
6. There is perfect competition
7. There is no change in technology
 ISOQUANTS:

The term Isoquants is derived from the words ‘iso’ and ‘quant’ – ‘Iso’ means equal and ‘quent’
implies quantity. Isoquant therefore, means equal quantity. A family of iso-product curves or isoquants or
production difference curves can represent a production function with two variable inputs, which are
substitutable for one another within limits.

Iqoquants are the curves, which represent the different combinations of inputs producing a particular
quantity of output. Any combination on the isoquant represents the some level of output.

For a given output level firm’s production become,

Q= f (L, K)

Where ‘Q’, the units of output is a function of the quantity of two inputs ‘L’ and ‘K’.

Thus an isoquant shows all possible combinations of two inputs, which are capable of producing equal
or a given level of output. Since each combination yields same output, the producer becomes indifferent
towards these combinations.

Assumptions:

1. There are only two factors of production, viz. labour and capital.
2. The two factors can substitute each other up to certain limit
3. The shape of the isoquant depends upon the extent of substitutability of the two inputs.
4. The technology is given over a period.
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 4 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.

LAW OF PRODUCTION:

Production analysis in economics theory considers two types of input-output relationships.

1. When quantities of certain inputs, are fixed and others are variable and
2. When all inputs are variable.
These two types of relationships have been explained in the form of laws.

i) Law of variable proportions

ii) Law of returns to scale
I. Law of variable proportions:

The law of variable proportions which is a new name given to old classical concept of “Law of
diminishing returns has played a vital role in the modern economics theory. Assume that a firms production
function consists of fixed quantities of all inputs (land, equipment, etc.) except labour which is a variable input
when the firm expands output by employing more and more labour it alters the proportion between fixed and
the variable inputs. The law can be stated as follows:

“When total output or production of a commodity is increased by adding units of a variable input
while the quantities of other inputs are held constant, the increase in total production becomes after some point,
smaller and smaller”.

“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”. (G. Stigler)

“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”. (F. Benham)

Assumptions of the Law: The law is based upon the following assumptions:

i) The state of technology remains constant. If there is any improvement in technology, the average
and marginal out put will not decrease but increase.
ii) Only one factor of input is made variable and other factors are kept constant. This law does not
apply to those cases where the factors must be used in rigidly fixed proportions.
iii) All units of the variable factors are homogenous.

Three stages of law:

The behaviors of the Output when the varying quantity of one factor is combines with a fixed quantity of the
other can be divided in to three district stages. The three stages can be better understood by following the table.
 Fixed factor Variable factor Total product Average Product Marginal Product
(Labour)

1 1 100 100 - Stage I

1 2 220 120 120

1 3 270 90 50

1 4 300 75 30 Stage II

1 5 320 64 20

1 6 330 55 10

1 7 330 47 0 Stage
III
1 8 320 40 -10

Above table reveals that both average product and marginal product increase in the beginning and then decline
of the two marginal products drops of faster than average product. Total product is maximum when the farmer
employs 6th worker, nothing is produced by the 7th worker and its marginal productivity is zero, whereas
marginal product of 8th worker is ‘-10’, by just creating credits 8th worker not only fails to make a positive
contribution but leads to a fall in the total output.

Production function with one variable input and the remaining fixed inputs is illustrated as below
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.

We can sum up the above relationship thus when ‘A.P.’ is rising, “M. P.’ rises more than “ A. P; When ‘A. P.”
is maximum and constant, ‘M. P.’ becomes equal to ‘A. P.’ when ‘A. P.’ starts falling, ‘M. P.’ falls faster than
‘ A. P.’.

Thus, the total product, marginal product and average product pass through three phases, viz., increasing
diminishing and negative returns stage. The law of variable proportion is nothing but the combination of the
law of increasing and demising returns.

II. Law of Returns of Scale:

The law of returns to scale explains the behavior of the total output in response to change in the scale of the
firm, i.e., in response to a simultaneous to changes in the scale of the firm, i.e., in response to a simultaneous
and proportional increase in all the inputs. More precisely, the Law of returns to scale explains how a
simultaneous and proportionate increase in all the inputs affects the total output at its various levels.

The concept of variable proportions is a short-run phenomenon as in these period fixed factors can not be
changed and all factors cannot be changed. On the other hand in the long-term all factors can be changed as
made variable. When we study the changes in output when all factors or inputs are changed, we study returns
to scale. An increase in the scale means that all inputs or factors are increased in the same proportion. In
variable proportions, the cooperating factors may be increased or decreased and one faster (Ex. Land in
agriculture (or) machinery in industry) remains constant so that the changes in proportion among the factors
result in certain changes in output. In returns to scale all the necessary factors or production are increased or
decreased to the same extent so that whatever the scale of production, the proportion among the factors
remains the same.

When a firm expands, its scale increases all its inputs proportionally, then technically there are three
possibilities. (i) The total output may increase proportionately (ii) The total output may increase more than
proportionately and (iii) The total output may increase less than proportionately. If increase in the total output
is proportional to the increase in input, it means constant returns to scale. If increase in the output is greater
than the proportional increase in the inputs, it means increasing return to scale. If increase in the output is less
than proportional increase in the inputs, it means diminishing returns to scale.

Let us now explain the laws of returns to scale with the help of isoquants for a two-input and single output
production system.

ECONOMIES OF SCALE

Production may be carried on a small scale or o a large scale by a firm. When a firm expands its size
of production by increasing all the factors, it secures certain advantages known as economies of production.
Marshall has classified these economies of large-scale production into internal economies and external
economies.

Internal economies are those, which are opened to a single factory or a single firm independently of
the action of other firms. They result from an increase in the scale of output of a firm and cannot be achieved
unless output increases. Hence internal economies depend solely upon the size of the firm and are different for
different firms.

External economies are those benefits, which are shared in by a number of firms or industries when
the scale of production in an industry or groups of industries increases. Hence external economies benefit all
firms within the industry as the size of the industry expands.

Causes of internal economies:

Internal economies are generally caused by two factors

1. Indivisibilities 2. Specialization.
 1. Indivisibilities
Many fixed factors of production are indivisible in the sense that they must be used in a fixed minimum size.
For instance, if a worker works half the time, he may be paid half the salary. But he cannot be chopped into
half and asked to produce half the current output. Thus as output increases the indivisible factors which were
being used below capacity can be utilized to their full capacity thereby reducing costs. Such indivisibilities
arise in the case of labour, machines, marketing, finance and research.

2. Specialization.

Division of labour, which leads to specialization, is another cause of internal economies. Specialization refers
to the limitation of activities within a particular field of production. Specialization may be in labour, capital,
machinery and place. For example, the production process may be split into four departments relation to
manufacturing, assembling, packing and marketing under the charge of separate managers who may work
under the overall charge of the general manger and coordinate the activities of the for departments. Thus
specialization will lead to greater productive efficiency and to reduction in costs.

Internal Economies:

Internal economies may be of the following types.

A). 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 firm and reduces the unit cost of production.

B). Managerial Economies:

These economies arise due to better and more elaborate management, which only the large size firms can
afford. There may be a separate head for manufacturing, assembling, packing, marketing, general
administration etc. Each department is under the charge of an expert. Hence the appointment of experts,
division of administration into several departments, functional specialization and scientific co-ordination of
various works make the management of the firm most efficient.
C). 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.

D). 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.

E). 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.

F). Economies of Research:

A large firm possesses larger resources and can establish it’s own research laboratory and employ trained
research workers. The firm may even invent new production techniques for increasing its output and reducing
cost.

G). Economies of welfare:

A large firm can provide better working conditions in-and out-side the factory. Facilities like subsidized
canteens, crèches for the infants, recreation room, cheap houses, educational and medical facilities tend to
increase the productive efficiency of the workers, which helps in raising production and reducing costs.

External Economies.

Business firm enjoys a number of external economies, which are discussed below:

A). 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.
B). Economies of Information

The industry can set up an information centre which may publish a journal and pass on information regarding
the availability of raw materials, modern machines, export potentialities and provide other information needed
by the firms. It will benefit all firms and reduction in their costs.

C). Economies of Welfare:

An industry is in a better position to provide welfare facilities to the workers. It may get land at concessional
rates and procure special facilities from the local bodies for setting up housing colonies for the workers. It may
also establish public health care units, educational institutions both general and technical so that a continuous
supply of skilled labour is available to the industry. This will help the efficiency of the workers.

D). Economies of Disintegration:

The firms in an industry may also reap the economies of specialization. When an industry expands, it becomes
possible to spilt up some of the processes which are taken over by specialist firms. For example, in the cotton
textile industry, some firms may specialize in manufacturing thread, others in printing, still others in dyeing,
some in long cloth, some in dhotis, some in shirting etc. As a result the efficiency of the firms specializing in
different fields increases and the unit cost of production falls.

Thus internal economies depend upon the size of the firm and external economies depend upon the size of the
industry.

DISECONOMIES OF LARGE SCALE PRODUCTION

Internal and external diseconomies are the limits to large-scale production. It is possible that
expansion of a firm’s output may lead to rise in costs and thus result diseconomies instead of economies.
When a firm expands beyond proper limits, it is beyond the capacity of the manager to manage it efficiently.
This is an example of an internal diseconomy. In the same manner, the expansion of an industry may result in
diseconomies, which may be called external diseconomies. Employment of additional factors of production
becomes less efficient and they are obtained at a higher cost. It is in this way that external diseconomies result
as an industry expands.

The major diseconomies of large-scale production are discussed below:

Internal Diseconomies:

A). Financial Diseconomies:

For expanding business, the entrepreneur needs finance. But finance may not be easily available in the
required amount at the appropriate time. Lack of finance retards the production plans thereby increasing costs
of the firm.
B). Managerial diseconomies:

There are difficulties of large-scale management. Supervision becomes a difficult job. Workers do not work
efficiently, wastages arise, decision-making becomes difficult, coordination between workers and management
disappears and production costs increase.

C). Marketing Diseconomies:

As business is expanded, prices of the factors of production will rise. The cost will therefore rise. Raw
materials may not be available in sufficient quantities due to their scarcities. Additional output may depress the
price in the market. The demand for the products may fall as a result of changes in tastes and preferences of the
people. Hence cost will exceed the revenue.

D). Technical Diseconomies:

There is a limit to the division of labour and splitting down of production p0rocesses. The firm may fail to
operate its plant to its maximum capacity. As a result cost per unit increases. Internal diseconomies follow.

E). Diseconomies of Risk-taking:

As the scale of production of a firm expands risks also increase with it. Wrong decision by the management
may adversely affect production. In large firms are affected by any disaster, natural or human, the economy
will be put to strains.

External Diseconomies:

When many firm get located at a particular place, the costs of transportation increases due to congestion. The
firms have to face considerable delays in getting raw materials and sending finished products to the marketing
centers. The localization of industries may lead to scarcity of raw material, shortage of various factors of
production like labour and capital, shortage of power, finance and equipments. All such external diseconomies
tend to raise cost per unit.
 QUESTIONS

1. Why does the law of diminishing returns operate? Explain with the help of a diagram.
2. Explain the nature and uses of production function.
3. Explain and illustrate lows of returns to scale.
4. a. Explain how production function can be mode use of to reduce cost of
Production.

b. Explain low of constant returns? Illustrate.

5. Explain the following (i) Internal Economics (ii) External Economics (or)
Explain Economics of scale. Explain the factor, which causes increasing returns to scale.

6. Explain the following with reference to production functions

(a) MRTS
(b) Variable proportion of factor
7. Define production function, explain is equate and is cost curves.
8. Explain the importance and uses of production function in break-even analysis.
9. Discuss the equilibrium of a firm with isoquants.
10. (a) What are isocost curves and iso quants? Do they interest each other
(b) Explain Cobb-Douglas Production function.
 COST ANALYSIS

Profit is the ultimate aim of any business and the long-run prosperity of a firm depends upon its ability
to earn sustained profits. Profits are the difference between selling price and cost of production. In general the
selling price is not within the control of a firm but many costs are under its control. The firm should therefore
aim at controlling and minimizing cost. Since every business decision involves cost consideration, it is
necessary to understand the meaning of various concepts for clear business thinking and application of right
kind of costs.

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:

1. Opportunity costs and outlay costs:

Out lay cost also known as actual costs obsolete costs are those expends which are actually incurred
by the firm these are the payments made for labour, material, plant, building, machinery traveling, transporting
etc., These are all those expense item appearing in the books of account, hence based on accounting cost
concept.

On the other hand opportunity cost implies the earnings foregone on the next best alternative, has the present
option is undertaken. This cost is often measured by assessing the alternative, which has to be scarified if the
particular line is followed.

The opportunity cost concept is made use for long-run decisions. This concept is very important in capital
expenditure budgeting. This concept is very important in capital expenditure budgeting. The concept is also
useful for taking short-run decisions opportunity cost is the cost concept to use when the supply of inputs is
strictly limited and when there is an alternative. If there is no alternative, Opportunity cost is zero. The
opportunity cost of any action is therefore measured by the value of the most favorable alternative course,
which had to be foregoing if that action is taken.

2. 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.

3. 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.

4. Out-of pocket and books costs:

Out-of pocket costs also known as explicit costs are those costs that involve current cash payment. Book costs
also called implicit costs do not require current cash payments. Depreciation, unpaid interest, salary of the
owner is examples of back costs.

But the book costs are taken into account in determining the level dividend payable during a period. Both book
costs and out-of-pocket costs are considered for all decisions. Book cost is the cost of self-owned factors of
production.

5. Fixed and variable costs:

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.

6. Post and Future costs:

Post costs also called historical costs are the actual cost incurred and recorded in the book of account these
costs are useful only for valuation and not for decision making.

Future costs are costs that are expected to be incurred in the futures. They are not actual costs. They are the
costs forecasted or estimated with rational methods. Future cost estimate is useful for decision making because
decision are meant for future.

7. Total, average and marginal costs:

Total cost is the total cash payment made for the input needed for production. It may be explicit or implicit. It
is the sum total of the fixed and variable costs. Average cost is the cost per unit of output. If is obtained by
dividing the total cost (TC) by the total quantity produced (Q)

TC

Average cost = ------

Marginal cost is the additional cost incurred to produce and additional unit of output or it is the cost of the
marginal unit produced.

8. Accounting and Economics costs:

Accounting costs are the costs recorded for the purpose of preparing the balance sheet and profit and ton
statements to meet the legal, financial and tax purpose of the company. The accounting concept is a historical
concept and records what has happened in the post.

Economics concept considers future costs and future revenues, which help future planning, and choice, while
the accountant describes what has happened, the economics aims at projecting what will happen.

BREAKEVEN ANALYSIS

The study of cost-volume-profit relationship is often referred as BEA. The term BEA is interpreted in two
senses. In its narrow sense, it is concerned with finding out BEP; BEP is the point at which total revenue is
equal to total cost. It is the point of no profit, no loss. In its broad determine the probable profit at any level of
production.

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.
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
4. The chart discloses profits at various levels of production.
5. It serves as a useful tool for cost control.
6. It can also be used to study the comparative plant efficiencies of the industry.
7. 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 draw back 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.
11. The assumption of static nature of business and economic activities is a well-known defect of BEC.
1. Fixed cost
2. Variable cost
3. Contribution
 4. Margin of safety
5. Angle of incidence
6. Profit volume ratio
7. Break-Even-Point
1. 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.
2. 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.
3. 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.

4. 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
P. V. 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.
5. 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.
6. 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.

Contributi on
The formula is, X 100
Sales

7. Break – Even- Point: If we divide the term into three words, then it does not require further explanation.
Break-divide

Even-equal

Point-place or position

Break Even Point refers to the point where total cost is equal to total revenue. It is a point of no profit,
no loss. This is also a minimum point of no profit, no loss. This is also a minimum point of
production where total costs are recovered. If sales go up beyond the Break Even Point, organization
makes a profit. If they come down, a loss is incurred.

Fixed Expenses
1. Break Even point (Units) =
Contributi on per unit
Fixed expenses
2. Break Even point (In Rupees) = X sales
Contributi on