UNIT 5

COST AND REVENUE ANALYSIS

INTRODUCTION
Costs play a very prominent role in decision- making as it helps in specifying various
alternatives in terms of their quantitative values. These quantitative values provide indication to
the management about the economically most desirable choice. Hence information on quantified
costs is necessary for taking a decision.
The money expenses incurred in the process of production i.e., transforming resources into
finished product constitute the cost of production. Firms which are unable to produce at the least
cost or the firms which are incapable of covering the cost of production will have to abandon the
production. The cost of production thus determines the very existence of the firms. Moreover, the
supply of product will depend to a great extent upon the cost of production. The cost of
production together with demand determines the price of the product.

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.
Therefore, a clear understanding of these must proceed any discussion of cost output relations.
Classification of Costs:
1. Opportunity costs and outlay/actual 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. Historical and Replacement costs:
Historical cost is the original cost of an asset. Historical cost valuation shows the cost of an asset
as the original price paid for the asset acquired in the past. Historical valuation is the basis for
financial accounts.
A replacement cost is the price that would have to be paid currently to replace the same asset.
During periods of substantial change in the price level, historical valuation gives a poor
projection of the future cost intended for managerial decision. A replacement cost is a relevant
cost concept when financial statements have to be adjusted for inflation.
4. 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.
5. 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.
6. 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.
7. Past and Future costs:
Past 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.
8. Traceable and common costs:
Traceable costs otherwise called direct cost, is one, which can be identified with a products
process or product. Raw material, labour involved in production is examples of traceable cost.
Common costs are the ones that common are attributed to a particular process or product. They
are incurred collectively for different processes or different types of products. It cannot be
directly identified with any particular process or type of product.
9. Avoidable and unavoidable costs:
Avoidable costs are the costs, which can be reduced if the business activities of a concern are
curtailed. For example, if some workers can be retrenched with a drop in a product – line, or
volume or production the wages of the retrenched workers are escapable costs.
The unavoidable costs are otherwise called sunk costs. There will not be any reduction in this
cost even if reduction in business activity is made. For example cost of the ideal machine
capacity is unavoidable cost.
10. Controllable and uncontrollable costs:
Controllable costs are ones, which can be regulated by the executive who is in charge of it. The
concept of controllability of cost varies with levels of management. Direct expenses like
material, labour etc. are controllable costs.
Some costs are not directly identifiable with a process of product. They are appointed to various
processes or products in some proportion. This cost varies with the variation in the basis of
allocation and is independent of the actions of the executive of that department. These
apportioned costs are called uncontrollable costs.
11. Incremental and sunk costs:
Incremental cost also known as different cost is the additional cost due to a change in the level or
nature of business activity. The change may be caused by adding a new product, adding new
machinery, replacing a machine by a better one etc.
Sunk costs are those which are not altered by any change – They are the costs incurred in the
past. This cost is the result of past decision, and cannot be changed by future decisions.
Investments in fixed assets are examples of sunk costs.
12. 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 = ------
Q
Marginal cost is the additional cost incurred to produce and additional unit of output or it is the
cost of the marginal unit produced.
13. 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.
14. Normal Profit and Costs
Normal profit is an economic jargon. It is not a profit but an item of economic and It represents
the opportunity cost of managerial and entrepreneur's skills supplied by owners/entrepreneurs.
Normal profit is the normal return to the entrepreneur's manager and entrepreneurial skills -
management functions of entrepreneur.
A firm earning zero economic profits means that a firm is just covering its costs, meant that all
explicit and implicit costs including normal profits are covered and that entrepreneur is
receiving. Unless other wise indicated, the term economic cost refers to all explicit and implicit
costs. Implicit cost includes normal profit. The term economic profit refers revenues after all
economic costs including normal profits.
COST FUNCTION
There are a number of determinants of costs. Some of them are identifiable in cost behaviour of a
firm. Some are not.
Cost function spells out the determinants of costs. Usually, factors like the prices of inputs, the
rate of output, the size of plant, and the state of technology are the major determinants of the cost
of production. Hence, we may say that cost is a function of prices of inputs, the rate of output,
the size of the plant and the state of technology.
In symbolic terms, the cost function may be stated thus:
C=f(F, O, P. T)
Where,
C stands for the costs,
ƒ denotes functional relationship,
F refers to the factor-input prices,
O stands for the rate of output,
Prefers to the size of plant, and
T stands for the state of technology.
In economic theory, thus, a simplified cost function expresses mathematically the relationship
between cost and output.
In the cost analysis, economists apply costs to the inputs in relation to the output over a period of
time. Functionally, the cost behaviour, ie, cost-output relationship, is observed in the short run as
well as in the long run. We have, thus, short-run cost function which states cost-output
relationship or the behaviour of costs under a given scale of output in the short run. Similarly,
there is the long run cost function which states cost-output relationship or the behaviour of costs
with the changing scale of output in the long run. The short run and long-run cost functions are
important for a firm to consider the price or equilibrium level of output determination.
Cost function of a firm can be expressed statistically as cost schedule or graphically in the form
of a cost curve

SHORT RUN AND LONG RUN COST CURVES: TRADITIONAL APPROACH

SHORT RUN COST FUNCTION:
In the short-run the firm cannot change or modify overhead factors such as plant, equipment and
scale of its organisation. In the short-run output can be increased or decreased by changing the
variable inputs like labour, raw material, etc. Thus, the short-run costs of production are
segmented into fixed and variable costs.
In economic analysis, the following types of costs are considered in studying behavioural cost
data of firm: (1) Total Cost (TC), (2) Total Fixed Cost (TFC), (3) Total Variable Cost (TVC), (4)
Average Fixed Cost (AFC), (5) Average Variable Cost (AVC), (6) Average Total Cost (ATC), and
(7) Marginal Cost (MC).
Behaviour of Total costs in short run:
Total Cost (TC)
Total cost is the aggregate of expenditure incurred by the firm in producing a given level of
output. Total cost is measured in relationship to the production function by multiplying the factor
prices with their quantities.
If the production function is: Q=f(a,b,c,...n), then total cost is; TC=f(Q) which means total cost
varies with output.
Conceptually, total cost includes all kinds of money costs, explicit as well as implicit. Thus,
normal profit is also included in total cost. Normal profit is an implicit cost. If this normal return
is not realised by the entrepreneur in the long run, he will stop his present business and will shift
his resources to some industry.
In short run, total cost may be bifurcated into total fixed cost and total variable cost. Thus, total
cost may be viewed as the sum of total fixed cost and total variable cost at each level of output.
Symbolically: TC = TFC + TVC.
It is the cost pertaining to the entire factor inputs at any given level of output. It is the total cost
of production derived by aggregating total fixed and variable costs together.
Total Fixed Cost (TFC)
Total fixed cost corresponds to fixed inputs in the short-run production function. It is obtained by
summing up the product of quantities of the fixed facors multiplied by their respective unit
prices. TFC remains the same at all Is of output in the short run.
It is the cost pertaining to all fixed inputs like machinery, etc., at any given level of output.
Total Variable Cost (TVC)
Corresponding to variable inputs, in the short-run production, is the total variable cost. It is
obtained by summing up the product of quantities of input multiplied by their prices.
Again TVC=f(Q) which means total variable cost is an increasing function of output.
It is the cost pertaining to all variable inputs like raw materials, etc., at any given level of output.
The relation between total variable cost and output may not be linear, that is, variable cost may
not increase by the same amount for every unit increase in output. This is shown in the table
mentioned below:
Output Total Fixed Cost Total Variable Total Cost
(q) (1) (TFC) (2) Cost (TC) (4)
(TVC) (3)
0 100 0 100
1 100 25 125
2 100 40 140
3 100 50 150
4 100 70 170
5 100 ,100 200
6 100 145 245
7 100 205 305
8 100 285 385
9 100 385 485
10 100 515 615
Above table shows a simplified cost schedule showing the relation between costs for each
different levels output. We can observe the following relations:
• The column (2) shows that TFC remains fixed at all levels output.
• The column (3) shows that TVC varies with the output and it is zero when the output is nil. It
can also be observed from the column (3) that TVC does not change in the same proportion. In
the beginning, , as the output increases, TVC increases at a decreasing rate but after a point it
increases at an increasing rate. This is due to the operation of the law of variable proportions.
• The column (4) shows that total costs are equal to fixed plus variable costs. TC varies with the
change in output in the same proportion.
The above costs and output relations are also shown graphically and joining the plotted points by
smooth curves, we can obtain total fixed, total variable and total cost curves.

It can be seen from the above graph that

  Total fixed cost curve remains constant, TFC curve is parallel to the X-axis.
 The TVC curve begins at zero and then rises gradually in the beginning and eventually, becomes
steeper as the output rises.
 TC curve is obtained by adding up vertically TFC and TVC curves.
 The shape of the TC curve is exactly the same as that of TVC curve because the same vertical
distance separates TC and TVC curves.

Behaviour of Average/ Unit costs in short run:

Average Fixed Cost (AFC)
Average fixed cost is total fixed cost divided by total units of output.
Thus: AFC = TFC / Q where Q stands for the number of units of the product.
Average Variable Cost (AVC)
Average variable cost is total variable cost divided by total units of output.
Thus: AVC = TVC / Q where AVC means average variable cost. Thus, average variable cost is
variable cost per unit of output.
Average Total Cost (ATC) / Average Cost:
Average total cost or average cost is total cost divided by total units of output. Thus:
ATC or AC = TC / Q
In the short run, since: TC=TFC+ TVC
ATC = TC / Q =(TFC +TVC) / Q = (TFC) / Q + (TVC) / Q
Hence, average total cost can be computed simply by adding average fixed cost and average
variable cost at each level of output.
Marginal Cost (MC)
The marginal cost is also a per unit cost of production. It is the addition made to the total cost by
producing one more unit of output. Symbolically, MCn = TC-TCn-1.
Definition: Marginal cost is the cost of producing an extra unit of output.
In other words, marginal cost may be defined as the change in total cost associated with one unit
change in output. It is also called "extra unit cost" or incremental cost, as it measures the amount
by which total cost increases when output is expanded by one unit. It can also be calculated by
dividing the change in total cost by one unit change in output.
Symbolically, thus MC = Δ TC / Δ Q where Δ denotes change in output assumed to change by 1
unit only.
 Quantit Total Total Total Marginal Average Average Average
y Fixed Variable Cost Cost Fixed Variable Total
Cost Cost cost cost cost
Q TFC TVC TC= MC = AFC= AVC= ATC=
TFC+TVC TCn – TCn-1 TFC/Q TVC/Q TC/Q
(1) (2) (3) (4) (5) (6) (7) (8)
0 100 0 100 - - - -
1 100 25 125 25 100 25 125
2 100 40 140 15 50 20 70
3 100 50 150 10 33.33 16.67 50
4 100 70 170 20 25 17.5 42.5
5 100 ,100 200 30 20 20 40
6 100 145 245 45 16.67 24.17 41
7 100 205 305 60 14.3 29.28 43.58
8 100 285 385 80 12.5 35.63 48.13
9 100 385 485 100 11.11 42.99 54
10 100 515 615 130 10 51.5 61.5

From Above table, Column (6) shows that AFC declines continuously as output increases.
We can observe from column (7) that AVC falls initially, reaches a minimum and eventually rises
with the increase in output.
From column (8) we can see that ATC too falls initially, reaches the minimum and then rises as
output increases. It can also be seen that ATC is the sum of AFC and AVC.
Column (5) shows that MC too behaves in the same way as AVC and ATC.
The relationship between AC, AFC, AVC and MC is explained graphically by drawing respective
cost curves
AFC is falling steadily as output increases, the AFC curve is also falling steadily from left to
right. AFC curve approaches both axes, but never touches either axis. Since we are dividing the
constant fixed cost by different levels of output, AFC curve is a rectangular hyperbola. This
implies that if we multiply AFC at any point on the AFC curve with the corresponding quantity
of output, we will always get the same total fixed cost. This property of the AFC curve shows
that TFC is constant throughout.
The AVC curve falls initially, reaches a minimum and then rises as output increases. It falls
slowly as the firm’s output rises from zero to the normal capacity level. Once normal capacity
output is reached AVC curve rises sharply with the increase in output. This is owing to the fact
that the use of more and more of the variable factors, say labour, will lead to overcrowding and
also to problems of organisation. Further, as the existing fixed factors are used more intensively
machines will breakdown more frequently. All these lead to sharp increase in AVC.
In the beginning as output rises ATC curve falls because of the predominance of falling AFC
curve. At higher levels of output AVC curve rises quite sharply and therefore, ATC curve rises
after a point. The continuous fall in average fixed costs will be too small to offset it. Thus AC
curve is ‘U’ shaped.
MC curve is also ‘U’ shaped as Marginal cost curve falls initially, then reaches a minimum point
and finally rises. The shape of the MC curve is determined by the law of variable proportions.
MC curve intersects AC and AVC curves at their minimum. This is due to the important
relationship between marginal and average costs.
The relationship between AVC, ATC and MC can be summarised as follows:
• AVC, ATC and MC fall first, then reach a minimum and finally rise as output increases.
• The rate of change in MC is greater than that in AVC and therefore the MC is lowest at an
output lower than the output at which AVC is lowest.
• The ATC falls for a longer range of output than the AVC and therefore the minimum ATC is at a
larger output than the minimum AVC.
• MC = AVC, when AVC is lowest.
• MC = ATC, when ATC is minimum.
The relationship between AC and MC are the following:
• If MC is below AC, then AC must be falling. This is because, if MC is below AC, then the last
unit produced costs less than the AC of all the earlier units produced.
• If MC is above AC, then the cost of the last unit produced will be higher than the AC of the
earlier units. Hence, the new AC must be higher than old AC. Therefore, when MC is above AC,
AC must be rising.
• If MC is equal to AC, the last unit costs exactly the same as the AC of all earlier units. Hence
the new AC is equal to old AC. Thus, the AC curve is flat when AC equals MC.
LONG RUN COST FUNCTION:
In the long run all factors are assumed to become variable. It is a Planning curve , in the sense
that it is a guide to the entrepreneur in his decision to plan the future expansion of his output.
 The long run average cost is derived from short run cost curves. Each point on the LAC
corresponds to a point on a short- run cost curve, which is tangent to the LAC at that
point.
 Long run average cost curve depicts the least possible average cost for producing all
possible levels of output.
 Short run average cost curves are also called Plant curves, since in the short -run plant is
fixed and each of the short-run average cost curve corresponds to a particular plants. In
the short-run, the firm can be operating on any short-run average cost curve, given the
size of plant.
Derivation of Long Run Curves
Suppose that only these three are technically possible sizes of plants and that no other size of the
plant can be built. Given the size of the plant or short run average cost curve of the firm will
increase or decrease its output by varying the amount of the variable inputs. But in the long run ,
the firm can choose among the possible sizes of plants as depicted by short run average cost
curves SAC1, SAC2 , SAC3.
In the long the firm will examine that with which size of plant or on which short run
average cost curve it should operate to produce a given levels of output at the minimum
possible cost.
It will be seen from figure; that up to OB amount of output, the firm will operate on the shortrun
average cost curve SAC1, though it could also produce with short-run average cost curve SAC2,
because upto OB amount of output, production on SAC1 curve entails lower cost than on SAC2.
If the firm plans to produce an output which is larger than OB(but less than OD), then it will not
be economical to produce on SAC1.
It will be seen from figure that the outputs larger than OB(but Lower than OD), can be produced
at a lower cost per unit on SAC2 than on SAC1. Thus, the output OC is produced on SAC1.
Therefore, if the firm plans to produce between OB and OD, it will employ the plants
corresponding to short-run average cost curve SAC2 .
If the firm has to produce an output which exceeds OD , then the cost per unit will be Lower on
SAC3 than on SAC2. Therefore, for outputs larger than OD, the firm will employ plant
corresponding to the SAC3.
In the above given figure, Output is taken on the OX- axis and AC is taken on the OY-axis. Here,
the long run average curve LAC is not tangent to the minimum point of the SAC curves. When
the LAC curve is declining , i.e; for output less than OQ , it is tangent to the falling portions of
the SAC curves. On the other hand, when the long run average cost curve is rising it will be
tangent to the rising portions of the short run average cost curve. In the traditional theory of the
firm the LAC - curve is U-shaped and it often called the "envelope curve" , because it envelopes
the SAC curve.

ECONOMIES AND DISECONOMIES OF SCALE

ECONOMIES OF SCALE

Economies of scale are a key advantage for a business that is able to grow. 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.

Most firms find that, as their production output increases, they can achieve lower costs per unit.

Economies of scale are the cost advantages that a business can exploit by expanding their scale
of production. The effect of economies of scale is to reduce the average (unit) costs of
production.
These economics of scale have been classified into internal economies and external economies.
Internal Economies:
Internal economies are those economies which are open to an individual firm when its size of
output expands. They emerge within the firm itself as its scale of output increases and thus
cannot be achieved unless output increases. Hence, internal economies depend solely upon the
size of the firm and are different for different firms.
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 cost
of operating large machines is less than that of operating small machine. Eg: Double-Decker
buses.
More over a larger firm is able to reduce it’s per unit cost of production by linking the various
processes of production. Technical economies may also be associated when the large firm is able
to utilize all its waste materials for the development of by-products industry. Scope for
specialization is also available in a large firm. This increases the productive capacity of the firm
and reduces the unit cost of production.
B) Labour Economies:
When the scale of operations is increased and number of labour becomes larger, introduction of a
greater degree of division of labour or specialization becomes possible. If the production is large
enough, then each worker will concentrate on a single job like spinning, weaving, dyeing etc., (or
even a m ore accurate operation). As a result, the worker saves time and with continuous work on
a single operation, he will acquire special skills in that job. This helps to enhance efficiency and
productivity of labour and as a result cost per unit declines.
C). 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.

D). 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.

E). 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.

F). 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.
G). 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.
External Economies
When the firm increase size, the industry also grow in size. When the industry grows it leads to
several advantages. These are referred to as 'external economies". The external economies are
those benefits which are shared by all the firms in an industry or group of entrate an industries.
They are the results of the growth and expansion in of production in an industry.
Economies of Concentration: When an industry is concentrated in a particular area, all the firms
reap some common economies such as availability of raw materials and capital equipment at
lower prices, skilled labour, and communications, banking and financial services, supply of
power and benefits from subsidiaries. All these factors tend to lower the unit cost of production
of all the firms.
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, modem machines,
export potentiality and provide other information needed by the firms. This availability of
information helps in raising the productive efficiency of information helps in raising the
productive efficiency of firms and reduction in their costs.
Economies of Specialisation: The firms in the industry can specialize in one variety of the
product or in one stage of production. 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. Such vertical and lateral specialization reduces the
cost of production.
Economies of Welfare: Housing, colonies, educational institutions, hospitals, recreation facilities
etc., can be provided at lower cost by the industry. This helps to improve the efficiency of
workers

Diseconomies of Scale
Beyond a particular limit, however, certain disadvantages of large-scale production emerge.
When there is an expansion of the firm beyond an optimum size, the external and internal
economies turn out to be diseconomies. These diseconomies raises the average cost of
production.
Internal Diseconomies:
Managerial Diseconomies: When there is an expansion of firm beyond optimum limit, business
may become unmanageable and uneconomical. Large scale management creates difficulties of
supervision, coordination, control and rigidities. With too large scale of operations, it becomes
difficult for the top management to exercise control and to bring about proper coordination.
Thus, increase in the firm's plant beyond certain size involves more bureaucracy, more red-tape,
and lengthens the chain of communication and command and consequently average cost rises.
Labour Diseconomies: With large number of employees firm becomes more impersonal and
contact between management and workers becomes less. As such there are more chances of
occurrence of grievances and industrial disputes lead to strikes, lockouts etc., which prove to be
costly to the large firm.
Increased Risks/Risk bearing diseconomies : As the scale of production increases, investment
also increases, so too the risks of business. The larger the output, obviously greater will be the
loss even for a small error of management.
Marketing Diseconomies: When the industry expands and the firm grows, competition in the
market tends to become stiff. Firms particularly under monopolistic competition will have to
undertake extensive advertising and sales promotion efforts and expenditure which ultimately
lead to higher costs.
External Diseconomies:
External diseconomies will also emerge beyond a certain size of firm.
The external diseconomies mainly arises from higher factor prices. As the industry continues to
expand, the demand for various factors such as raw material, skilled labour, power, finance, land,
capital equipment etc., rises. This leads to increase in their prices.
Moreover, when member firms 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.
All these external diseconomies tend rise average cost of production.
ECONOMIES OF SCOPE

Economies of scope is an economic concept that refers to the decrease in the total cost of
production when a range of products are produced together rather than separately.

Example : A single train can carry both passengers and freight more cheaply than having two
separate trains, one only for passengers and another for freight. In this case, a single train that
has cars dedicated to both categories is far more cost effective

Formula for Economies of Scope

Where:

 C(qa) is the cost of producing quantity qa of good a separately

 C(qb) is the cost of producing quantity qb of good b separately
 C(qa+qb) is the cost of producing quantities qa and qb together

Economies of Scope (S) is the percentage cost saving when the goods are produced together.
Therefore, S would be greater than 0 when economies of scope exist.

For example, a restaurant produces both hamburgers and sandwiches. The cost of separately
producing 1,00,000 hamburgers is Rs. 0.50 each. Likewise, if 4,00,000 sandwiches are produced
separately, the cost is Rs. 0.30 each. If 1,00,000 hamburgers and 4,00,000 sandwiches are
produced together (by using the same preparation and storage facility), the total cost is Rs.
1,50,000.

To determine the economies of scope:

 Determine C(qa) = 1,000,000 * 0.50 = Rs. 50,000

 Determine C(qb) = 4,00,000 * 0.30 = Rs. 1,20,000
 Determine C(qa+qb) = Rs. 1,50,000
  Substitute the numbers into the Economies of Scope formula
 (50,000 + 1,20,000 – 1,50,000) / 1,50,000 = 13.33%. Therefore, the cost of producing
hamburgers and sandwiches together is 13.33% less than the cost of producing them
separately.

Economies of scope differ from economies of scale, in that the former means producing
a variety of different products together to reduce costs while the latter means producing
more of the same good in order to reduce costs by increasing efficiency.

Economies of scope can result from goods that are co-products or complements in
production, goods that have complementary production processes, or goods that share
inputs to production.

Co-Products

Economies of scope can arise from co-production relationships between final products. In
economic terms these goods are called complements in production. This occurs when the
production of one good automatically produces another good as a byproduct in production
process. Sometimes one product might be a byproduct of another, but have value for use by the
producer or for sale. Finding a productive use or market for the co-products can reduce both
waste and costs and increase revenues.

For example, dairy farmers separate raw milk from cows into whey and curds, with the curds
going on to become cheese. In the process they also end up with a lot of whey, which they can
then use as a high-protein feed for livestock or sell as a nutritional product to fitness enthusiasts
for additional revenue. Another example of this is the black liquor produced when processing
wood into paper pulp. Instead of being merely a waste product, black liquor can be burned as an
energy source to fuel and heat the plant, saving money on other fuels. Producing and using the
black liquor thus saves costs on producing the paper.1

Complementary Production Processes

Economies of scope can also result from the direct interaction of two or more production
processes. Companion planting in agriculture is a classic example here, such as the "Three
Sisters" crops historically cultivated by Native Americans. By planting corn, pole beans, and
ground trailing squash together, the Three Sisters method actually increases the yield of each
crop, while also improving the soil. The tall corn stalks provide a structure for the bean vines to
climb up; the beans fertilize the corn and the squash by fixing nitrogen in the soil; and the squash
shades out weeds among the crops with its broad leaves. All three plants benefit from being
produced together, so the farmer can grow more crops at lower cost.

Shared Inputs

Because productive inputs (i.e. land, labor, and capital) usually have more than one use,
economies of scope can often come from common inputs to the production of two or more
different goods.
For Example, assume that company ABC is the leading desktop computer producer in the
industry. Company ABC wants to increase its product line and remodels its manufacturing
building to produce a variety of electronic devices, such as laptops, tablets, and phones. Since the
cost of operating the manufacturing building is spread out across a variety of products, the
average total cost of production decreases. The costs of producing each electronic device in
another building would be greater than just using a single manufacturing building to produce
multiple products.

Proctor & Gamble is an excellent example of a company that efficiently realizes economies of
scope from common inputs since it produces hundreds of hygiene-related products from razors to
toothpaste. The company can afford to hire expensive graphic designers and marketing experts
who can use their skills across all of the company's product lines, adding value to each one. If
these team members are salaried, each additional product they work on increases the company's
economies of scope, because of the average cost per unit decreases.

Different Ways to Achieve Economies of Scope

1. Flexible Manufacturing

Flexible manufacturing exists if multiple products can be produced using the

same manufacturing systems and inputs – for example, using the same preparation and storage
facilities when making hamburgers and fries, as opposed to using two separate facilities.

2. Related Diversification

If a company is able to use its operational expertise, resources, and capabilities across its
organization, then it can take advantage of related diversification. For example, hiring designers
and marketers who can use their skills across different product lines allows for the production of
a wide range of products.

3. Mergers

Mergers often enable a company to share research and development expenses to reduce costs and
diversify its product portfolio or knowledge. For example, two pharmaceutical companies might
merge to combine their research and development expenses to create new products.

EXPERIENCE CURVE

This concept was developed by the Boston Consulting Group In the 1960's. It is representative of
a consistent relationship between the cost of production and the cumulative production quantity
(total quantity produced from the first unit to the last).
Experience curve is the systematic reductions in the production costs that occur over life of a
product.

The experience curve implies that the more experience a firm has in producing a particular
product, the lower are its costs.
Graphical representation of experience effect (created on the basis of cumulative production and
average cost) is called experience curve.

The graph shows the experience curve that normally allows costs to be reduced with additional
output. This is due to two reasons: learning effects and economies of scale.

1. Learning effects: refers to the cost savings that come from learning by doing. Labor
productivity increases as individuals learn the most efficient ways to perform particular
tasks. Management also typically learns how to mange the new operation costs efficiently
over time. But it has been suggested that learning effects are important only during the
start up period of a new process and that they cease after two or three years. After that,
any decline in the experience curve is due to economies of scale.
2. Economies of scale: refers to the reduction in unit cost achieved by producing a large
volume of a product. This is mainly due to the ability to spreads fixed costs over large
volume. By building sales volume more rapidly, international expansion can assist a firm
in the process of moving down the experience curve. By lowering the costs of value
creation, experience economies can help a firm to build barriers to new competition.

A number of studies show that a product’s production costs decline by some characteristics about
each time accumulated output doubles. E.g. in aircraft industry, where each time accumulated
output f airframes was doubled, unit costs typically declined to 80 percent of their previous level.

There is a difference between experience curve and the learning curve. The learning curve
describes the observed reduction in the number of required direct labor hours as workers learn
their jobs whereas the experience curve not only is applicable to labor intensive situations but
also process oriented ones. Also unlike the learning curve, an experience curve takes into
account both fixed and variable costs.

The experience curve can be explained by a combination of

 Learning curve
 Specialization
  Scale
 Investment

CVP 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
sense, it determines the probable profit at any level of production.
REQUIRED TERMS TO DETERMINE THE BREAK EVEN POINT
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.

Contribution
The formula is, Sales X 100
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
Break Even point (Units) = Contribution per unit
 Fixed expenses
1. Break Even point (In Rupees) = Contribution X sales

8. Break – Even- Chart

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/Limitations:
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 BEA.

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