UNIT 3

PRODUCTION AND COST ANALYSIS: THEORY OF PRODUCTION- PRODUCTION FUNCTION, LAW OF VARIABLE
PROPORTIONS, LAW OF RETURNS TO SCALE, PRODUCTION OPTIMISATION, LEAST COST COMBINATION OF INPUTS,
ISOQUANTS, COST CONCEPTS- EXPLICIT ANS IMPLICIT COST, FIXED AND VARIABLE COST, OPPORTUNITY COST,
SUNK COSTS, COST FUNCTION, COST CURVES, COST AND OUTPUT DECISIONS, COST ESTIMATION

PRODUCTION AND COST ANALYSIS

Cost Analysis:

• A production function tells us how much output a firm can produce with its existing plant and equipment.
The level of output depends on prices and costs. The most desirable rate of output is the one that maximizes
total profit that is the difference between total revenue and total cost.
• Entrepreneurs pay for the input factors- Wages for labour, price for raw material, rent for building hired,
interest for borrowed money. All these costs are included in the cost of production.
• The economist’s concept of cost of production is different from accounting. This chapter helps us to
understand the basic cost concepts and the cost output relationship in the short and long runs. Having
looked at input factors in the previous chapter it is now possible to see how the law of diminishing returns
affect short run costs.
• Cost Determinants The cost of production of goods and services depends on various input factors used by
the organization and it differs from firm to firm.
• The major cost determinants are:
1. Level of output: The cost of production varies according to the quantum of output. If the size of production
is large then the cost of production will also be more.
2. Price of input factors: A rise in the cost of input factors will increase the total cost of production.
3. Productivities of factors of production: When the productivity of the input factors is high then the cost of
production will fall.
4. Size of plant: The cost of production will be low in large plants due to mass production with
mechanization.
5. Output stability: The overall cost of production is low when the output is stable over a period of time.
6. Lot size: Larger the size of production per batch then the cost of production will come down because the
organizations enjoy economies of scale.
7. Laws of returns: The cost of production will increase if the law of diminishing returns applies in the firm.
8. Levels of capacity utilization: Higher the capacity utilization, lower the cost of production
9. Time period: In the long run cost of production will be stable.
10. Technology: When the organization follows advanced technology in their process then the cost of
production will be low.
11. Experience: over a period of time the experience in production process will help the firm to reduce cost
of production.
12. Process of range of products: Higher the range of products produced, lower the cost of production.
13. Supply chain and logistics: Better the logistics and supply chain, lower the cost of production.
14. Government incentives: If the government provides incentives on input factors, then the cost of
production will be low.

THEORY OF PRODUCTION- PRODUCTION FUNCTION

In economics, production theory explains the principles in which the business has to take decisions on how much of
each commodity it sells and how much it produces and also how much of raw material ie., fixed capital and labor it
employs and how much it will use. It defines the relationships between the prices of the commodities and productive
factors on one hand and the quantities of these commodities and productive factors that are produced on the other
hand.
Concept
Production is a process of combining various inputs to produce an output for consumption. It is the act of creating
output in the form of a commodity or a service which contributes to the utility of individuals.
In other words, it is a process in which the inputs are converted into outputs.
Function
The Production function signifies a technical relationship between the physical inputs and physical outputs of the firm,
for a given state of the technology.
Q = f (a, b, c, . . . . . . z)
Where a,b,c ....z are various inputs such as land, labor ,capital etc. Q is the level of the output for a firm.
If labor (L) and capital (K) are only the input factors, the production function reduces to −
Q = f(L, K)
Production Function describes the technological relationship between inputs and outputs. It is a tool that analysis the
qualitative input – output relationship and also represents the technology of a firm or the economy as a whole.
Production Analysis
Production analysis basically is concerned with the analysis in which the resources such as land, labor, and capital are
employed to produce a firm’s final product. To produce these goods the basic inputs are classified into two divisions
Variable Inputs Inputs those change or are variable in the short run or long run are variable inputs.
Fixed Inputs Inputs that remain constant in the short term are fixed inputs.

Cost Function
Cost function is defined as the relationship between the cost of the product and the output. Following is the formula
for the same −
C = F [Q]
Cost function is divided into namely two types −
Short Run Cost
Short run cost is an analysis in which few factors are constant which won’t change during the period of analysis. The
output can be changed ie., increased or decreased in the short run by changing the variable factors.
Following are the basic three types of short run cost −

Long Run Cost

Long-run cost is variable and a firm adjusts all its inputs to make sure that its cost of production is as low as possible.
Long run cost = Long run variable cost
In the long run, firms don’t have the liberty to reach equilibrium between supply and demand by altering the levels of
production. They can only expand or reduce the production capacity as per the profits. In the long run, a firm can
choose any amount of fixed costs it wants to make short run decisions.

LAW OF VARIABLE PROPORTIONS

 • Law of Variable Proportion is regarded as an important theory in Economics. It is referred to as the law
which states that when the quantity of one factor of production is increased, while keeping all other factors
constant, it will result in the decline of the marginal product of that factor.
• Law of variable proportion is also known as the Law of Proportionality. When the variable factor becomes
more, it can lead to negative value of the marginal product.
• The law of variable proportion can be understood in the following way.
• When variable factor is increased while keeping all other factors constant, the total product will increase
initially at an increasing rate, next it will be increasing at a diminishing rate and eventually there will be
decline in the rate of production.

Assumptions of Law of Variable Proportion

Law of variable proportion holds good under certain circumstances, which will be discussed in the following lines.

1. Constant state of Technology: It is assumed that the state of technology will be constant and with
improvements in the technology, the production will improve.
2. Variable Factor Proportions: This assumes that factors of production are variable. The law is not valid, if
factors of production are fixed.
3. Homogeneous factor units: This assumes that all the units produced are identical in quality, quantity and
price. In other words, the units are homogeneous in nature.
4. Short Run: This assumes that this law is applicable for those systems that are operating for a short term,
where it is not possible to alter all factor inputs.
The law of variable proportions has following three different phases −

• Returns to a Factor
• Returns to a Scale
• Isoquants
Returns to a Factor
Commonly referred to as factor productivity, the returns to a factor can be described as the short-term relationship
between the output and the input. The productivity generated from one production unit will be the same as the
output generated. The factor’s productivity is calculated with an assumption that all other factors remain
unchanged.

Returns to factors are also called factor productivities. Productivity is the ratio of output to the input. Factor
productivity refers to the short-run relationship of input and output. The productivity of one unit of a factor of
production will be equal to the output it can generate. The productivity of a particular factor is measured with the
assumption that the other factors are not changed or remain unchanged. Only that particular factor under study is
changed.

Increasing Returns to a Factor

Increasing returns to a factor refers to the situation in which total output tends to increase at an increasing rate when
more of variable factor is mixed with the fixed factor of production. In such a case, marginal product of the variable
factor must be increasing. Inversely, marginal price of production must be diminishing.
Constant Returns to a Factor
Constant returns to a factor refers to the stage when increasing the application of the variable factor does not result
in increasing the marginal product of the factor – rather, marginal product of the factor tends to stabilize. Accordingly,
total output increases only at a constant rate.
Diminishing Returns to a Factor
Diminishing returns to a factor refers to a situation in which the total output tends to increase at a diminishing rate
when more of the variable factor is combined with the fixed factor of production. In such a situation, marginal product
of the variable must be diminishing. Inversely the marginal cost of production must be increasing.

LAW OF RETURNS TO SCALE

Returns to scale in economics refers to a term that states that the degree of change in input factors changes the
output proportionally and concurrently during the production process. It reflects the quantitative change that applies
in the long-term using similar technology. It forms the basis of measuring a firm’s or industry’s efficiency of
production capacity.

As per the law, a firm has to bear less cost of production when output increases with an increase in output factors
and vice versa. Therefore, it is helpful for firms, businesses, and organizations to know their maximum production
capacity. It is also important for the government to decide whether an industry will be of small or large
manufacturers.

• Returns to scale in economics is the measure of proportional change in output with respect to the input
factors in the long run at constant technology used for the production process.

• It helps measure the efficiency of a firm and policy formation in industry categorization and allows the
maximum capacity of production of a firm.

• Its assumptions include – only two inputs, fixed technology, constant pricing, and labor plus capital used as
inputs.

• There are three types of return to scale – constant returns to scale, increasing returns to scale, and
decreasing returns to scale.
Returns to scale in economics is a term that defines the relationship between the input changes in proportion with
the output during production using the same type of technology. It reflects the change or variation in productivity. A
producer commonly uses inputs such as labor and capital to produce goods and services. Therefore, it is the best
method to measure the efficiency of production. The lesser the amount of input a producer uses to produce more
output, the better its efficiency, and vice versa.

In the manufacturing sector, it is a commonplace to have the highest output level with minimum raw material inputs
like labor and capital. However, all factors of production are variable in the long run. So, by changing the production
factor’s quantity, producers can change the production scale and make it optimal. For example, to increase the
production output, firms must change the input levels proportionally and utilize them to the best capacity. During
such a scenario, it is necessary to find the relationship between changes in input with the changes in output during
production.

While applying the law of returns to any factory, one has to consider these assumptions:

• Producers should consider using only capital and labor as input factors of production.
• Producers should add both labor and capital together in a fixed ratio.
• The prices of these factors remain constant.

Producers use the same technology in the long term.

Returns To Scale Graph

After considering all the above assumptions, the changes in inputs at the same level led to proportional changes in
the production process during the long term at the same level of technology. The input changes can lead to three
types of proportional output: constant, increasing, or decreasing/diminishing returns to scale. Economists or
producers can represent it in a graph.

The X-axis represents the labor and capital, and the Y-axis represents the output.

One can observe from the graph that at the same level of technology and after applying the assumptions, one gets
the following values.
 Nature of law of return applicable Level of input changes (%) level of output changes (%)

Increasing the law of returns 100% 260%

Constant law of returns 20 20

Decreasing the law of returns 60 % 33%

Types

Thus, any proportional change in a firm’s input can lead to variable output proportions depending on production
efficiency. Here are the three types of returns to scale:

#1 – Constant Returns To Scale

It means that increasing the input in proportion to the output gives the same level of increase in the output during
the production. For illustration, let a firm increase the input to three times, then the output level will also be three
times during the process of production (figure 2). So, it happens during the long term of the production process for a
firm.

Here, internal and external equals the internal and external diseconomies. A good example of this homogeneous
production function is the Cobb-Douglas linear homogenous production function.

#2 – Increasing Returns To Scale

One can also refer to it as diminishing cost. It happens when an increase in inputs of production by a small
proportion as compared to output produces an unexpected higher proportion of the output. For example, if the
producers doubled the input concerning the output, the production tripled output (figure 2). Hence, one can say that
the firm has experienced an increasing return to scale. It also happens during the long term of the production
process for a firm, causing increasing RTS. Finally, it occurs due to the increase in efficiency of a firm’s production by
factors like division of labor.

#3 – Decreasing Returns to Scale

One can also refer to diminishing returns to scale as increasing cost. It means that the increase in input
corresponding to the output leads to a decrease in output as expected during the production process. For instance, if
a factory increased the input by 60% concerning the output during the production process, but the output was only
33%, then the firm is said to go through decreasing scale returns (figure 2).

The decreased efficiency or production of a firm causes it.

PRODUCTION OPTIMISATION

Production optimization comprises a range of activities related to measuring, analyzing, modeling, prioritizing, and
implementing actions to enhance productivity. Product optimization addresses these manufacturing problems:

• Slow production lines

• Long pending work in progress
• Separate workstations overwhelmed with work in progress
• Unnecessary space being utilized for storage
• Multiple errors that require reworking
• Bottlenecks at workstations
• Extended times for delivery
• Inconsistency in productivity
• Convoluted production process and management
• With production optimization, a company is in a better position to understand and manage its production
processes and bottlenecks. Manufacturers optimize the system for productivity and delivery times. As a
result, sales increase, and the company can think about expansion plans for the future.
• Production optimization also monitors a range of performance through indicators, while encouraging
employees to be responsible for eliminating wasteful practices. Some other benefits are reduced production
times, improved productive capacity, and better quality--all at lower production costs.

How does Production Optimization Work?

As with any process, production optimization works with the company first, identifying the main issues it has in its
production process. Once done, the organization needs to have proper goals put in place, and a manager must be
able to answer these questions:

1. Has the organization identified specific bottlenecks and ascertained the needed resources to achieve
production targets?
2. Can the organization provide precise, objective, and quantitative data to improve processes and increase
productivity?
3. What is the strategy of the company? How is it defining achievable goals?
4. Can the organization identify measurement, frequency, and calibration methods in its production processes?
5. Can the organization identify and manage all possible hurdles to the optimization process (such as
insufficient staffing information, communication, or software)?
6. Can the organization modularize its activities and optimize every module?

Once all these questions are answered, the company needs to consider the various modeling, simulation,
optimization, and control methods it will use. What is the input to each of them? Is it people or capital, natural
resources, or return of investment issues? Is the organization looking to compete with others in the market, address
a new law that has come in, or simply adapt to market demand? What are the variations the organization faces in
each of these factors and why are there variations? What are the optimal input parameters? How are these optimal
input parameters maintained? Are they always the same?

These considerations will continuously optimize and improve over time. Companies should learn how they can find
and update newer sets of optimal input parameters, especially because products and raw materials change
constantly. The optimal production criteria is determined by:

• Price
• Quality
• Quicker and better deliveries
 • Environment-safe products

Most production optimization methods make use of a major cost function analysis along with numerous input
parameters (factors that can be controlled or not).

Benefits of Production Optimization

Production optimization can change manufacturing operations and make it efficient on multiple levels. There are a
range of benefits that the organization can achieve if optimization is implemented correctly:

• Improve the general efficacy of the equipment

• Reduce production delays
• Ensure a reduction in equipment breakdown
• Improve equipment effectiveness
• Monitor the availability of equipment and its performance regularly
• Boost quality and yield performance
• Predict production performance variations with the help of cloud-based ML (machine learning) to analyze
wastage and spot inefficiencies
• Reduce downtime or overtime and any unscheduled maintenance with AI to increase factory transformation
• Optimize energy usage to save costs and the environment
• Analyze sources of scrap, waste, and any inefficiencies with AI

LEAST COST COMBINATION OF INPUTS

A given level of output can be produced using many different combinations of two variable inputs. In choosing
between the two resources, the saving in the resource replaced must be greater than the cost of resource added.
The principle of least cost combination states that if two input factors are considered for a given output then the
least cost combination will have inverse price ratio which is equal to their marginal rate of substitution.

The objective of factor-factor relationship is two fold:

1) Minimization of cost at a given level of Output.
2) Optimization of output to the fixed factors through alternative resource use combinations.

y =f (x1, x2, x3, x4…………….. xn)

Y is the function of x1 and x2 while other inputs are kept at constant. The relationship can be better explained by the
principle of least cost combination.

Principle of Least Cost combination:

A given level of output can be produced using many different combinations of two variable inputs. In choosing
between the two completing resources, the saving in the resource replaced must be greater than the cost of
resource added.
The principle of least cost combination states that if two factor inputs are considered for a given output the least
cost combination will be such where their inverse price ratio is equal to their marginal rate of substitution.

1. Marginal Rate of substitution: MRS is defined as the units of one input factor that can be substituted for a single
unit of the other input factor. So MRS of x2 for one unit of x1 is
Number of unit of replaced resource (x2)
=——————————————————–
Number of unit of added resource (x1)

2. Price Ratio (PR) =

Cost per unit of added resource
= ————————————————–
Cost per unit of replaced resource
Price of x1
= ———————–
Price of x2

Therefore the least cost combination of two inputs can be obtained by equating MRS with inverse price ratio.

i.e. x2 * Px2 = x1 * Px1

This combination can be obtained by following algebraic method or Graphic method.

A) Isoquant (Iso product) curve: Iso means equal and quant means quantity.
An Isoquant represents the different combinations of two variable inputs used in the production of a given amount
of output.

Properties of Isoquant:

1) They slope down ward to the right: If more of one is used less of another input will be employed at the given
level of output.
2) They are convex to the origin: It is because of diminishing MRS of one input for another. The additional units of
an input will replace less and less units of another input.
3) Isoquant does not intersect: It is not possible to have different outputs from a single combination of inputs.
4) Slope of Isoquant represents the MRS.

B) Iso-Cost line: An Iso-cost line indicates all possible combinations of two inputs which can be purchased with a
given amount of investment fund (outlay)
Each combination of inputs has same total cost which includes the cost of two inputs. (X1 and X2) combined.
Total cost = Px1. x1 + Px2. x2

Properties of Iso-cost line:

1) As total outlay increases, the Iso- cost line moves higher and higher away from the origin and vis- a-visa.
2) The Iso- cost lines are straight
3) Slope of Iso-cost line represents price ratio i.e. Px1/ Px2 when x1 is taken on x axis and x2 on y axis.

Least cost combination point: One Iso-cost and Iso-quant curves are depicted, it is now easy to locate the point of
least cost combination. The slope of Isoquant and Iso-cost line represent the MRS and Price ratio respectively. The
criteria for obtaining least and combination is MRS = PR and hence graphically it can be obtained where slope of
Isoquant = slope of Iso-cost lines. This is found whore Iso-quant and Iso-cost lines tangent to each other. From this
tangency point takes perpendiculars to both axis and obtains units of and x2. That combination is having least cost
combination.
As discussed, Isoquants represent combination of inputs which can be produced the given level of output. Therefore
different Isoquants represent different quantities of output. Isoquants nearer to origin represent less quantity of
output and vis-a-visa. If we have numerous Isoquants then we can depict the isocline, ridge line and expansion path.
These are depicted in the above diagram. The meaning of these concepts is given below.

1) Iso-cline: It is a line passes through the points of equal slope or MRS on an Isoquant surface. With the input price
ratio being constant for each Isoquant the MRS between the inputs is the same for each level of output.

2) Ridge line: These are also called as border line. Ridge lines join the end points of Isoquants. The area within the
ridge lines is rational region of production arid beyond that the two regions are irrational. Therefore these lines
represent the limits of economic relevance.

3) Expansion Path: It is Isoclines for one set of prices for a given period. It connects the points of least cost
combinations of inputs for all output level. As such, the MRS must be equal to the input price ratio.

ISOQUANTS

Isoquants are a geometric representation of the production function. The same level of output can be produced by
various combinations of factor inputs. The locus of all possible combinations is called the ‘Isoquant’.
Characteristics of Isoquant

• An isoquant slopes downward to the right.

• An isoquant is convex to origin.
• An isoquant is smooth and continuous.
• Two isoquants do not intersect.
Types of Isoquants
The production isoquant may assume various shapes depending on the degree of substitutability of factors.
Linear Isoquant
This type assumes perfect substitutability of factors of production. A given commodity may be produced by using only
capital or only labor or by an infinite combination of K and L.
Input-Output Isoquant
This assumes strict complementarily, that is zero substitutability of the factors of production. There is only one method
of production for any one commodity. The isoquant takes the shape of a right angle. This type of isoquant is called
“Leontief Isoquant”.
Kinked Isoquant
This assumes limited substitutability of K and L. Generally, there are few processes for producing any one commodity.
Substitutability of factors is possible only at the kinks. It is also called “activity analysis-isoquant” or “linear-
programming isoquant” because it is basically used in linear programming.

Table 1: An Isoquant Schedule

Units
Combinations Units of
of
of Labor and Capital Output of Cloth (meters)
Labor
Capital (K)
(L)

A 5 9 100

B 10 6 100

C 15 4 100

D 20 3 100

The above table is based on the assumption that only two factors of production, namely, Labor and Capital are used
for producing 100 meters of cloth.

Combination A = 5L + 9K = 100 meters of cloth

Combination B = 10L + 6K = 100 meters of cloth
Combination C = 15L + 4K = 100 meters of cloth
Combination D = 20L + 3K = 100 meters of cloth

The combinations A, B, C and D show the possibility of producing 100 meters of cloth by applying various
combinations of labor and capital. Thus, an isoquant schedule is a schedule of different combinations of factors of
production yielding the same quantity of output.
An iso-product curve is the graphic representation of an iso-product schedule.

Thus, an isoquant is a curve showing all combinations of labor and capital that can be used to produce a given
quantity of output.

Isoquant Map

An isoquant map is a set of isoquants that shows the maximum attainable output from any given combination
inputs.

COST CONCEPTS- EXPLICIT ANS IMPLICIT COST, FIXED AND VARIABLE COST, OPPORTUNITY COST, SUNK COSTS,
COST FUNCTION COST CURVES, COST AND OUTPUT DECISIONS, COST ESTIMATION

EXPLICIT AND IMPLICIT COST

• Fixed cost is referred to as the cost that does not register a change with an increase or decrease in the
quantity of goods produced by a firm. Fixed costs are those costs that a company should bear irrespective of
the levels of production.
• Fixed costs are less controllable in nature than the variable costs as they are not dependent on the
production factors such as volume.
• The different examples of fixed costs can be rent, salaries, and property taxes.

Variable cost: Meaning

Variable cost is referred to as the type of cost that will show variations as per the changes in the levels of production.
Depending on the volume of the production in a company, the variable cost increases or decreases.
The various examples of variable costs are the cost of raw materials that are used for production, sales commissions,
labour cost, and more.
OPPORTUNITY COST

Opportunity cost is a concept in Economics that is defined as those values or benefits that are lost by a business,
business owners or organisations when they choose one option or an alternative option over another option, in the
course of making business decisions.

Importance of opportunity cost

The fundamental problem of economics is the issue of scarcity. Therefore, we are concerned with the optimal use
and distribution of these scarce resources. Wherever there is scarcity we are forced to make choices. If we have £20,
we can spend it on an economic textbook, or we can enjoy a meal in a restaurant. Therefore, many choices involve
an opportunity cost – having to make choices between the two.
SUNK COSTS

A sunk cost is money that has already been spent and cannot be recovered. In business, the axiom that one has to
"spend money to make money" is reflected in the phenomenon of the sunk cost. A sunk cost differs from future
costs that a business may face, such as decisions about inventory purchase costs or product pricing. Sunk costs are
excluded from future business decisions because they will remain the same regardless of the outcome of a decision.

• Sunk costs are those which have already been incurred and which are unrecoverable.
• In business, sunk costs are typically not included in consideration when making future decisions, as they are
seen as irrelevant to current and future budgetary concerns.
• Sunk costs are in contrast to relevant costs, which are future costs that have yet to be incurred.
• The sunk cost fallacy is a psychological barrier that ties people to unsuccessful endeavours simply because
they've committed resources to it.
• Examples of sunk costs include salaries, insurance, rent, nonrefundable deposits, or repairs (as long as each
of those items is not recoverable).

COST FUNCTION COST CURVES

Cost function refers to the functional relationship between cost and output. It studies the behaviour of cost at
different levels of output when technology is assumed to be constant. It can be expressed as below:

C= f(Q)

(Here, C= Cost of production; and Q= Quantum of output).

Short-run costs are important to understanding costs in economics. The distinction between short-run and long-run based
on fixed and variable factors of production makes the concept of understanding short run costs simpler.

The Concept of Short Run

It is key to understand the concept of the short run in order to understand short run costs. In economics, we distinguish
between short run and long run through the application of fixed or variable inputs.

Fixed inputs (plant, machinery, etc.) are those factors of production that cannot be changed or altered in a short span of
time because the time period is ‘too small’. This makes the short run. Here, the inputs are of two types: fixed and
variable.

In the long-run, all the inputs become variable (eg. raw materials). By this, we mean that all inputs can be changed with a
change in the volume of output. Thus, the concept of fixed inputs applies only to the short-run. It is to short-run costs
that we now turn.

Short Run Cost Function

The cost function is a functional relationship between cost and output. It explains that the cost of production varies with
the level of output, given other things remain the same (ceteris paribus). This can be mathematically written as:

C = f(X)

where C is the cost of production and X represents the level of output.

Total Fixed Cost
Fixed cost refers to the cost of fixed inputs. It does not change with the level of output (thus, fixed). Fixed inputs include
building, machinery etc. Hence the cost of such inputs such as rent or cost of machinery constitutes fixed costs. Also
referred to as overhead costs, supplementary costs or indirect costs, these costs remain the same irrespective of the level
of output.

Hence, if we plot the Total Fixed Cost (TFC) curve against the level of output on the horizontal axis, we get a straight
line parallel to the horizontal axis. This indicates that these costs remain the same and that they have to be incurred even
if the level of output is zero.

Total Variable Cost

The cost incurred on variable factors of production is called Total Variable Cost (TVC). These costs vary with the level of
output or production. Thus, when production level is zero, TVC is also zero. Thus, the TVC curve begins from the origin.

The shape of the TVC is peculiar. It is said to have an inverted-S shape. This is because, in the initial stages of production,
there is scope for efficient utilization of fixed factor by using more of the variable factor (eg. Workers employing
machinery).

Hence, as the variable input employed increases, the productive efficiency of variable inputs ensures that the TVC
increases but at a diminishing rate. This makes the first part of the TVC curve that is concave.

As the production continues to increase, more and more variable factor is employed for a given amount of fixed input.
The productive efficiency of each variable factor falls and it adds more to the cost of production. So the TVC increases
but now at an increasing rate. This is where the TVC curve is convex in shape. And so the TVC curve gets an inverted-S
shape.

Total Cost
Total cost (TC) refers to the sum of fixed and variable costs incurred in the short-run. Thus, the short-run cost can be
expressed as

TC = TFC + TVC

Note that in the long run, since TFC = 0, TC =TVC. Thus, we can get the shape of the TC curve by summing over TFC and
TVC curves.
 Fig.1

(Source: economicsdiscussion)

The following can be noted about the TC curve:

• The TC curve is inverted-S shaped. This is because of the TVC curve. Since the TFC curve is horizontal, the
difference between the TC and TVC curve is the same at each level of output and equals TFC. This is
explained as follows: TC – TVC = TFC

• The TFC curve is parallel to the horizontal axis while the TVC curve is inverted-S shaped.

• Thus, the TC curve is the same shape as TVC but begins from the point of TFC rather than the origin.

• The law that explains the shape of TVC and subsequently TC is called the law of variable proportions.
Average cost and marginal cost:

The critical differences between Average Cost vs. Marginal Cost are as follows –

• The average cost is the sum of the total cost of goods divided by the total number of goods, whereas the
Marginal Cost increases in producing one more unit or additional unit of product or service. Marginal cost
changes in the total cost of production upon the change in output that changes the quantity of production.
• The average cost aims to assess the impact on total unit cost with the change in output level. In contrast, the
objective of marginal cost is to find whether it is beneficial to produce an additional unit of goods.
• The formula for Average cost = Total cost / Number of goods, whereas the formula Marginal cost = Change in
total cost / Change in quantity.
• The average cost curve in starting falls due to declining fixed costs but rises due to increasing average
variable costs. Whereas the Marginal cost curve is concave with increasing returns, then moves linearly and
smoothly with a constant return, and finally changes in convex when marginal cost shows an increased
return.
• The best criteria to decide the production level on average cost is when cost minimizes, and the marginal cost
is when profit maximizes.
• The average cost has two components: average fixed cost and average variable cost, and Marginal cost is a
single unit and does not have any component.

Relationship Between Average and Marginal Cost

Average cost and marginal cost impact one another as production fluctuate:

Cost curve: This graph is a cost curve that shows the average total cost, marginal cost, and marginal revenue. The
curves show how each cost changes with an increase in product price and quantity produced.

• When the average cost declines, the marginal cost is less than the average cost.
• When the average cost increases, the marginal cost is greater than the average cost.
 • When the average cost stays the same (is at a minimum or maximum), the marginal cost equals the
average cost.

COST AND OUTPUT DECISIONS

The cost-output relationship plays an important role in determining the optimum level of production. Knowledge of
the cost-output relation helps the manager in cost control, profit prediction, pricing, promotion etc. The relation
between cost and its determinants is technically described as the cost function.

C= f (S, O, P, T ….)

Where;

• C= Cost (Unit or total cost)

• S= Size of plant/scale of production
• O= Output level
• P= Prices of inputs
• T= Technology

Considering the period the cost function can be classified as

(1) short-run cost function and

(2) long-run cost function.

In economics theory, the short-run is defined as that period during which the physical capacity of the firm is fixed and
the output can be increased only by using the existing capacity allows to bring changes in output by physical capacity
of the firm.

1. Cost-Output Relationship in the Short-Run

The cost concepts made use of in the cost behavior are Total cost, Average cost, and Marginal cost.

Total cost is the actual money spent to produce a particular quantity of output. Total Cost is the summation of Fixed
Costs and Variable Costs.

TC=TFC+TVC

Up to a certain level of production Total Fixed Cost i.e., the cost of plant, building, equipment etc, remains fixed. But
the Total Variable Cost i.e., the cost of labor, raw materials etc., vary with the variation in output. Average cost is the
total cost per unit.

Marginal Cost is the addition to the total cost due to the production of an additional unit of product. It can be arrived
at by dividing the change in total cost by the change in total output.In the short-run there will not be any change in
Total Fixed C0st. Hence change in total cost implies change in Total Variable Cost only.
2. Cost-output Relationship in the Long-Run

Long run is a period, during which all inputs are variable including the one, which are fixes in the short-run. In the long
run a firm can change its output according to its demand. Over a long period, the size of the plant can be changed,
unwanted buildings can be sold staff can be increased or reduced. The long run enables the firms to expand and scale
of their operation by bringing or purchasing larger quantities of all the inputs. Thus in the long run all factors become
variable.

The long-run cost-output relations therefore imply the relationship between the total cost and the total output. In the
long-run cost-output relationship is influenced by the law of returns to scale.

In the long run a firm has a number of alternatives in regards to the scale of operations. For each scale of production
or plant size, the firm has an appropriate short-run average cost curves. The short-run average cost (SAC) curve applies
to only one plant whereas the long-run average cost (LAC) curve takes in to consideration many plants.

The long-run cost-output relationship is shown graphically with the help of “LCA’ curve.

To draw on ‘LAC’ curve we have to start with a number of ‘SAC’ curves. In the above figure it is assumed that
technologically there are only three sizes of plants — small, medium and large, ‘SAC’, for the small size, ‘SAC2’ for the
medium size plant and ‘SAC3’ for the large size plant. If the firm wants to produce ‘OP’ units of output, it will choose
the smallest plant. For an output beyond ‘OQ’ the firm wills optimum for medium size plant. It does not mean that the
OQ production is not possible with small plant. Rather it implies that cost of production will be more with small plant
compared to the medium plant.

For an output ‘OR’ the firm will choose the largest plant as the cost of production will be more with medium plant.
Thus, the firm has a series of ‘SAC’ curves. The ‘LCA’ curve drawn will be tangential to the entire family of ‘SAC’ curves
i.e. the ‘LAC’ curve touches each ‘SAC’ curve at one point, and thus it is known as envelope curve. It is also known as
planning curve as it serves as guide to the entrepreneur in his planning to expand the production in future. With the
help of ‘LAC’ the firm determines the size of plant which yields the lowest average cost of producing a given volume
of output it anticipates.

COST ESTIMATION

Cost Estimate is the preliminary stage for any project, operation, or program wherein a reasonable calculation of all
the project costs is done and, therefore, involves precise judgment, experience and accuracy.

• Cost Estimation is often done by separate individuals trained to estimate costs accurately. It is a challenge
considering the ever-changing economic environment. If a project is significant, then companies need to
pass the Tender. Once the Tender is accepted, the particular company gets the project and starts working.
• So to pass the Tender, the company will have to estimate all the costs related to the project. If the project is
going to take a long time, then the company will have to determine the inflation and other changes that may
occur. So the cost estimation for big projects is complicated and needs to be performed accurately.
Characteristics

• There are several ways by which cost estimates can be prepared. The most important characteristic is the
preparation of cost estimates. Companies often use models to precisely estimate the cost.
• Quality is directly proportional to cost, so options for different deliveries involving different costs are set up.
So the project manager has to choose the quality he wants, considering the cost.
• The budget for the overall project or operation is set. Since the scariest thing is the capital, acceptance of a
project depends on the budget set for the project.
• Another essential characteristic is keeping the whole operation within the budget mentioned.

Methods of Cost Estimate

#1 – Least Square Regression

Least Square regression of statistics is used to find the best fit line for variable and fixed costs. So this method helps
to build a model which shows that for a particular production level, this much should be the variable cost, and this
much should be the Fixed Cost. So once a model is set, this method becomes easy as new data can be incorporated
easily.
#2 – High-Low Method

High Low method shows you the highest and lowest level of cost that you may incur. So it doesn’t throw the
possibility of the cost that lies in the middle. This method is generally easy to compute and helps to have a
preliminary idea regarding the cost.
#3 – Statistical Modelling

This method is the most sophisticated. It involves estimating several economic factors that may lead to a change in
cost estimation. Statistical models are extremely accurate as several factors are considered to set up costs. These
models are costly to set up, making it difficult for small businesses to build statistical models.

Importance

Cost Estimation is the most critical step for project management. Without proper estimation, it will be complicated
to make a budget for the project. Incorrect estimation may lead to losses. A project’s IRR and profitability are
decided based on the cost that is estimated. So inaccurate estimation of the cost may lead to acceptance of a wrong
project or rejection of a profitable project.
Conclusion: This step is the most crucial step for any project or operation of a business. Proper estimation helps a
firm to accept positive NPV projects, which adds value to the firm. A trained person must be appointed to carry out
the cost estimation. Several third parties sell data for accurate cost estimation. So different resources must be used
to make projections accurate.