GROUP 3 Production process and cost analysis and estimation

DRAFT

Production Theory Most products we enjoy as consumers underwent some form of processing. The
patty in burger you enjoyed for lunch was processed from meat, the bun came from wheat; the cheese
came from cow's milk, and such. The juice you drank was from fruit extract that was mixed with sugar
and perhaps flavoring and coloring. Can you imagine the process of raw materials undergo to become
finished products we now enjoy as consumers?

Production is the process of converting input into output. It is represented by the figure below:

Just think of things a baker needs to bake a loaf of bread. The baker will need raw materials such as
eggs, milk, flour, eggs, baking powder, sugar, salt, water, among others. He will also need an oven or a
stove, rolling pin, baking trays and the like and he might also need the services of an assistant baker. The
raw materials that the baker needs to produce a loaf of bread could be considered, in the model as
input. Before it became a loaf of bread, it was kneaded and baked hence, with such methods of
preparation are considered as the process in the model we presented. Finally, the loaf of bread that we
are enjoying during breakfast or at snack time considered as output. Therefore, production paves the
way for the creation of utility or usefulness of a product or service.

Production Function
The production function expresses the amount of output that can be produced given certain amounts of
input. Recalling the circular flow diagram, the economic resources of land, labor, capital and
entrepreneurship shall be utilized as input to produce goods and services. In general, the production
function can be expressed as:
Q = f (L,K)
where: Q is the level of output
L is the number of units of labor
K is the number of units of capital

In the production function presented, labor (L) and capital (K) are treated as input. Mathematically, they
are also the arguments of the function or independent variables. On the other hand, Q is the output
level or dependent variable that states the firm's quantity of output depends on the quantity of input.
*Cobb Douglas Production Function
This is a function that defines the maximum amount of output that can be produced with a
given level of inputs. Let us assume that all input factors of production can be grouped into two
categories such as labor and capital (K).The general equilibrium for the production function is Q = f (K, L)

*Short-Run Production Function

Production in the short-run, treats one of the inputs as fixed or meaning the amount or level of
capital tends to be fixed. In the real world, capital tends to be fixed in the short-run. Firms cannot easily
vary the size of their production facilities, such as the plant or purchase a new parcel of land or sell the
same. Hence, the short-fun production function is given by: Q = f(L) where: Q is the level of output L is
the number of units of labor In the short-run, a firm can easily hire people than expand or decrease its
capital requirements. This justifies why only L appears as an argument of the said production function.

*Long-Run Production Function

A firm can vary both its labor and capital requirements hence, both L and K appear as arguments
(independent variables) of the production function. Firms, in the long run, can freely expand its
production facilities, as well as its labor requirements.

*Total, Marginal and Average Product

Total product (Q) is measured in physical units and is also known as total physical product while,
marginal product refers to the extra product or output produced by an extra unit of input, say labor (or
capital) while other input say capital (or labor) is held constant hence, we have marginal product of
labor (MPL) and the marginal product of capital (MPK). Average product is simply the ratio of the total
output to total units of input. If we divide the total product y the number of units of labor, we have the
average product of labor (APL) and if we divide the total product by the number of units of capital, we
have the average product of capital (APK)

The given table shows the summary of the formulas needed when determining the marginal product
and average product:
*The Law of Diminishing Returns
In the combination of input factors when one particular factor is increased continuously without
changing other factors the output will increase in a diminishing manner. Let us assume that a person
preparing for an examination continuously prepares without any break. The output or the
understanding and the coverage of the syllabus will be more in the beginning rather than in the later
stages. There is a limit to the extent to which one factor of production can be substituted for another.
The total production increases up to an extent and it gets saturated or there won’t be any change in the
output due to the addition of the input factor and further it leads to negative impact on the output. That
means the marginal production declines up to an extent and it reaches zero and becomes negative. The
point at which the MP becomes zero is the maximum output of the firm with the given set of input
factors. This law is applicable in all human activities and business activities

*The Law of Returns to Scale

In the long run the fixed inputs like machinery, building and other factors will change along with
the variable factors like labor, raw material etc. With the equal percentage of increase in input factors
various combinations of returns occur in an organization.

-Returns to scale : the change in percentage output resulting from a percentage change in all the factors
of production. They are increasing, constant and diminishing returns to scale.

-Increasing returns to scale may arise if the output of a firm increases more than in proportionate to an
increase in all inputs. For example the input factors are increased by 50% but the output has doubled
(100%).

-Constant returns to scale when all inputs are increased by a certain percentage the output increases by
the same percentage. For example input factors are increased by 50% then the output has also
increased by 50 percentages. Let us assume that a laptop consists of 50 components we call it as a set.
In case the firm purchases 100 sets they can assemble 100 laptops but it is not possible to produce more
than 100 units.

-Diminishing returns to scale when output increases in a smaller proportion than the increase in inputs it
is known as diminishing return to scale. For example 50% increment in input factors lead to only 20%
increment in the output

Stage I: The total production increased at an increasing rate. We refer to this as increasing stage where
the total product, marginal product and average production are increasing.

Stage II: The total production continues to increase but at a diminishing rate until it reaches the next
stage. Marginal product, average product are declining but are positive. The total production is at the
maximum level at the end of the second stage with a zero marginal product.

StageIII: In this third stage total production declines and marginal product becomes negative. And the
average production also started decline. Which implies that the change in input factors there is a decline
in the overall production along with the average and marginal
COST ANALYSIS
Cost analysis and estimation is made difficult by the effects of unforeseen inflation,
unpredictable changes in technology, and the dynamic nature of input and output markets. Wide
divergences between economic cost and accounting valuations are common. This makes it extremely
important to adjusted accounting data to generate an appropriate basis for managerial decisions. Cost in
decision-making analysis could be classified into:

*HISTORICAL VS. CURRENT COST

Historical vs. Current Costs: Cost data are historical if they are stored for a period of
time and then used, while cost data are current when they are paid under prevailing market conditions.
Although it is typical for current costs to exceed historical costs. However, this is not always the case.
Computers cost much less today than they did just a few years age. Therefore, the current cost for such
items is determined by what is referred to as a replacement cost which is defined as the cost of
duplicating these items by using the current technology.

*EXPLICIT VS IMPLICIT COST

Explicit Costs are defined as the out of pocket money, such as paid wages, utility expenses,
payment for raw materials and so on. Implicit costs are more difficult to compute and are likely to be
overlooked in decision analysis. Implicit cost is normally computed based on the opportunity cost
concept so as to reach an accurate estimate of total cost.

*INCREMENTAL VS. SUNK COST

Incremental cost refers to change in cost caused by a given managerial decision while sunk cost
is cost that does not change or vary across decision alternatives.
For example, suppose a firm has spent $ 5,000 on an option to purchase land for a new factory at a price
of $100,000. Also, assume that it is later offered an equally attractive site for $90,000. What should the
firm do? The first thing to recognize is that the $5,000 spent on the purchase option is a sunk cost that
must be ignored. To understand this, consider the firm's current decision alternatives. If the firm
proceeds to purchase the first property, it must pay a price of $100,000. The newly offered property
required an expenditure of $90,000 and results in a $10,000 savings. In retrospect, purchase of the
$5.000 option was a mistake. It would be a compounding of this initial error to follow through with
purchase of the first property and lose an additional $10,000.

*SHORT VS. LONG RUN COST

Short-run cost is the cost of production at various production (output) levels for a specific plant
size and a given operating environment. There for total short-run cost can be classified into fixed cost
(FC) which is known as contractual costs in the long-run (rent, interest payments, and overhead cost)
and variable cost (VC) such as wages, cost of raw material, power bills, and so on
Long-run cost: In the long-run all costs are variable costs. It shows the cost of production at
various plant size or scale and operating conditions. It reflects the economies, diseconomies of scale,
and optimal plant sizes which are a helpful guide for decisions-making process

*ECONOMIES VS. DISECONOMIES OF SCALE

 Economics of scale exists when the long-run average cost (LRAC) declines with enlarging the size of
the as output expands along with the plant size due to labor specialization, applying better
technology, commercial, financial-managerial advantages, and also learning economies.

Diseconomies of scale exist when the long-run average cost (LRAC) increases as output along
with the plant size enlarges. This cost rises due mainly to the administrative disadvantage of large
scale when the firm size expands beyond the optimal size.
Learning curve concept
When knowledge is gained from manufacturing, experience is used to improve production methods.
This accumulated "know-how" results in a decline in the LRAC is said to reflect itself in the firm's
learning curve.

ESTIMATE OF COST AND PROFIT MAXIMIZATION

The shape of LRAC curve is important not only because of its implications for plant scale decision
but also because of its effects on the potential level of competition especially when it declines in
some industries. Normally firms encounter a (U) shaped LRAC while other firms encounter an (L)
shape LRAC. Insight of the competitive implications of cost/output relation can be gained by
estimating the minimum LRAC (Plant optimal size), as shown in Figure 3.3.

*ESTIMATE OF THE MINIMUM EFFICIENT SCALE

MES is determined at the minimum point of U-shaped LRAC curve, (Q1) or the minimum point of
L-shaped LRAC curve (Q2). The following numerical example explains the underlined concept.

Profit Maximization:
The following example shows the procedures of how profit is maximized:
Assume that (X) company has the following:

1) P = 940 - 0.02 Q (estimated demand equation)

MR = 940 - 0.04 Q (estimated Marginal Revenue-derived equation)

2) TC = 250000 + 40 Q + 0.01 Q* (estimated total cost equation)

 Mc = 40 + 0.02 Q (derived marginal cost equation profit identity.
л = TR - TC
= (p) (Q) - TC
= (940 - 0.02 Q) Q - (250000 - 40 Q - 0.01 Q3)
= - 0.03 Q2 + 900 Q – 250000

The profit-maximizing activity level with centralized production is the

output level at which marginal profit (MH) = MR - MC = 0 and,
therefore, MR=MC.

Setting marginal revenue (MR) equal to marginal cost (MC) and solving for the related output
quantity as follows:
MR = MC
$940 - $0.04Q = $40Q + $0.02Q
$0.06Q = $900
Q = 1500
At Q = 15000, Profit will be maximized at the following calculated.
P = $940 - $0.02Q
= $940 - $ 0.02 (15000)
= $640
And maximum profit is calculated as follows:
= -$0.03(15000) + $900(15000) - $250000
= $6500.000

*ECONOMIES OF SCOPE
Economies of scope exist when the cost of joint production is less than the cost producing
multiple outputs separately. In other words, a firm will produce products that are complementary in
the sense that producing them together costs less than producing them individually.
Suppose that a regional airline offers regularly scheduled passenger service between midsize city
pairs and that it expects some excess capacity. Also, assume that there is a modest local demand for
air parcel and small- package delivery service. Given current airplane sizes and configurations, it is
often costly for a signal carrier to provide both passenger and cargo services in small regional
markets than to specialize in one or the other. Thus, regional air carriers often provide both services.
This is an example of economies of scope. Other example of scope economies abound in the
provision of both goods and services. In fact, the economies of cope concept explain why firms
typically produce multiple products. Also, studying economies of scope forces management to
consider both direct and indirect benefits associated with individual lines of business.

*Exploiting Economies of Scope

Economies of scope are important because they permit a firm to translate superior skill in a
given product line into unique advantages in the production of complementary products. Effective
competitive strategy often emphasized the development or extension of product lines related to a
firm's current stars, or areas of recognized strength. For example, PepsiCo, Inc. has long been a
 leader in the soft drink market. Over time, the company has gradually broadened its product line to
include various brands of regular and diet soft drinks. Fritos and Doritos Corn chips, Grandma are
Cookies, and other snack foods. PepsiCo can no longer be considered just a soft drink manufacturer.
It is a widely diversified snack foods company for whom well over one-half of total current profits
come from non-soft drink line. PepsiCo snack foods product line extension strategy was effective
because it capitalized on the distribution network and marketing expertise developed in the firm's
soft drink business. In the case of PepsiCo, snack foods and soft drinks are good example of how a
firm has been able to take the skills gained in developing one star (soft drinks) and use them to
develop a second star (snack foods).

The economies of scope concept offer a useful means for evaluating the potential of current and
prospective lines of business. It naturally leads to definition of those areas in which the firm has a
comparative advantage and its greatest profit potential.

BREAK-EVEN ANALYZING AND OPERATING LEVERAGE

Breakeven analysis called Cost-volume-profit analysis is an important analytical technique used
to study relations among costs, revenues, and profit. Both graphic and algebraic methods are used.
For simple problems, simple graphic methods work best. In more complex situations, analytic methods,
possibly involving spreadsheet software programs, are preferable, as shown in Figure 3.4.
Degree of Operating Leverage

A basic cost-volume-profit chart composed of a firm's total cost and total revenue curves is depicted
in Figure 3.4. Volume of output is measured on the horizontal axis; revenue and cost are shown on
the vertical axis. Fixed costs are constant regardless of the output produced and are indicated by
horizontal line. Variable costs at each output level are measured by the distance between the total
cost curve and the constant fixed cost. The total revenue curve indicates the price/demand relation
for the firm's product; profits or losses at each output are shown by the distance between total
revenue and total cost curves.

In the example depicted in Figure 3.4, fixed costs of $60000 are represented by a horizontal line.
Variable costs for labor and materials are $1.80 per unit, so total costs rise by that amount for each
additional unit of output. Total revenue based on a price of $3 per unit is a straight line through the
origin. The slope of the total revenue line is steeper than that of the total cost line.

Output levels below the breakeven point produce losses. As output grows beyond the breakeven
point; increasingly higher profits results.

DEGREE OF OPERATING LEVERAGE

Cost-volume-profit: analysis also a useful tool for analyzing the financial characteristics of
alternative production systems. This analysis focuses on how total costs and profits vary with
operating leverage or the extent to which fixed production facilities are used.

The relation between operating leverage and profits is shown in Figure 3.5, which contrasts the
experience of three firms, A, B, and C, with differing degrees of leverage. The fixed costs of firm B
are typical.
Firm A uses relative less capital equipment and has lower fixed costs, but it has a steeper rate of
increase in variable costs. Firm A breaks even at a lower activity level than does firm B. For example,
at a production level of 40000 units, B is losing $8000 but breaks even.
Firm C is highly automated and has the highest fixed costs, but it variable costs rise slowly. Firm C
has a higher breakeven point than either A or B, but once C passes the breakeven point, profits rise
faster than those of the other two firms.

The degree of operating leverage is the percentage changes in profit that results from 1% change in
units sold:

The degree of operating leverage is an elasticity concept. Its the elasticity profits with respect to
output. When based on linear cost and revenue curves, this elasticity will vary. The degree of
operating leverage is always greatly close to the breakeven point.

For firm B in Figure 3.5, the degree of operating leverage at 100000 units of output is 2.0, calculated
as follows: