Sai Vidya Institute of Technology

MODULE-03
COST ANALYSIS & PRODUCTION ANALYSIS
Concepts of Production, production function with one variable input - Law of Variable
Proportion, Laws of returns to scale, Indifference Curves, ISO-Quants & ISO-Cost line,
Economies of scale, Diseconomies of scale. Types of cost, Cost curves, Cost – Output
Relationship in the short run and in the long run, Long- Run Average Cost ( LAC) curve
Break Even Analysis–Meaning, Assumptions, Determination of BEA, Limitations, Margin
of safety, Uses of BEA In Managerial decisions (Theory and simple Problems).

INTRODUCTION OR PRODUCTION CONCEPTS:

Production can be defined as an organized activity of transforming physical inputs into
output which will satisfy the products needs of the society.
or
Production is an act of creating value that satisfies the wants of the individuals.
Production refers to the transformation of inputs or resources into outputs or goods and
services.
Production is a process in which economic resources or inputs (composed of natural
resources like labour, land and capital equipment) are combined by entrepreneurs to create
economic goods and services (outputs or products).

PRODUCTION ANALYSIS:
Production Analysis refers to analyzing the inputs or resources that are used to produce a
firm‟s final product. 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.

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
Inputs : Fixed inputs and Variable inputs
The factors of production that is carry out the production is called inputs.

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Fixed inputs Variable inputs

are varies according to the volume of

remain the same. outputs.

Cost Variable Cost

- Building, Land etc - Raw materials, labour, etc
ixed inputs are become
varies)

What is Production Function?

Production Function signifies the technical relationship between the physical inputs and
physical outputs of the firm for given production technology.
The basic relationship between the factors of production and the output is referred to as a
Production Function.
The firm‟s production function for a particular good (q) shows the maximum amount of the
good that can be produced using alternative combinations of capital (K) and labor (L)
The production function expresses a functional relationship between physical inputs and
physical outputs of a firm at any particular time period. The output is thus a function of
inputs. Mathematically production function can be written as
Q= f (L1, L2, C,O,T)
Importance:
1. When inputs are specified in physical units, production function helps to estimate the level
of production.
2. It becomes is equates when different combinations of inputs yield the same level of output.
3. It indicates the manner in which the firm can substitute on input for another without
altering the total output.
4. When price is taken into consideration, the production function helps to select the least
combination of inputs for the desired output.
5. It considers two types‟ input-output relationships namely „law of variable proportions‟ and
„law of returns to scale‟. Law of variable propositions explains the pattern of output in the
short-run as the units of variable inputs are increased to increase the output. On the other
hand law of returns to scale explains the pattern of output in the long run as all the units of
inputs are increased.
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6. The production function explains the maximum quantity of output, which can be produced,
from any chosen quantities of various inputs or the minimum quantities of various inputs that
are required to produce a given quantity of output.

Assumptions:
Production function has the following assumptions.
1. The production function is related to a particular period of time.
2. There is no change in technology.
3. The producer is using the best techniques available.
4. The factors of production are divisible.
5. Production function can be fitted to a short run or to long run.

Types of production function:-

These two types of relationships have been explained in the form of laws.
i) Law of variable proportions ( short run production function)
ii) Law of returns to scale ( long run production function)

I. Law of variable proportions:

It is also called law of diminishing returns or law of returns to variable factor.
The law of variable proportions which is a new name given to old classical concept of “Law
of diminishing returns has played a vital role in the modern economics theory. Assume that a
firms production function consists of fixed quantities of all inputs (land, equipment, etc.)
except labour which is a variable input when the firm expands output by employing more and
more labour it alters the proportion between fixed and the variable inputs. The law can be
stated as follows:
“When total output or production of a commodity is increased by adding units of a variable
input while the quantities of other inputs are held constant, the increase in total production
becomes after some point, smaller and smaller”
“If equal increments of one input are added, the inputs of other production services being
held constant, beyond a certain point the resulting increments of product will decrease i.e. the
marginal product will diminish”. (G. Stigler)
“As the proportion of one factor in a combination of factors is increased, after a point, first
the marginal and then the average product of that factor will diminish”. (F. Benham)

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The law of variable proportions refers to the
behaviour of output as the quantity of one
Factor is increased Keeping the quantity of
other factors fixed and further it states that
the marginal product and average product
will eventually do cline. This law states three
types of productivity an input factor – Total,
average and marginal physical productivity.

Assumptions of the Law: The law is based

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

Three stages of law:

The behaviors of the Output when the varying quantity of one factor is combines with a fixed
quantity of the other can be divided in to three district stages. The three stages can be better
understood by following the table.

In the first stage, total product increases at an increasing rate. The marginal product in this
stage increases at an increasing rate resulting in a greater increase in total product. The
average product also increases. This stage continues up to the point where average product is
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equal to marginal product. The law of increasing returns is in operation at this stage. The law
of diminishing returns starts operating from the second stage awards. At the second stage
total product increases only at a diminishing rate. The average product also declines.
The second stage comes to an end where total product becomes maximum and marginal
product becomes zero. The marginal product becomes negative
In the third stage. So the total product also declines. The average product continues to
decline.
We can sum up the above relationship thus when „A.P.‟ is rising, “M. P.‟ rises more than “ A.
P; When „A. P.” is maximum and constant, „M. P.‟ becomes equal to „A. P.‟ when „A. P.‟
starts falling, „M. P.‟ falls faster than „ A. P.‟Thus, the total product, marginal product and
average product pass through three phases, viz., increasing diminishing and negative returns
stage. The law of variable proportion is nothing but the combination of the law of increasing
and demising returns.

PRODUCTION FUNCTION WITH TWO VARIABLE INPUTS:

Refers to the relationship between the output resulting in production by varying the two or
more inputs. There may be various technical possibilities of producing a given output by
using different factor combinations. Which particular factor combination will be actually
selected by the firm depends both on the technical possibilities of factor substitution as well
as on the prices of the factors of production.
Production Function with two Variable Inputs explains the production behavior of the firm
with all variable factors. We are restricting our analysis to two variable inputs because it
simply allows us the scope for graphical analysis.\

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II. Law of Returns of Scale:
The law of returns to scale explains the behavior of the total output in response to change in
the scale of the firm, i.e., in response to a simultaneous to changes in the scale of the firm,
i.e., in response to a simultaneous and proportional increase in all the inputs. More precisely,
the Law of returns to scale explains how a simultaneous and proportionate increase in all the
inputs affects the total output at its various levels.
When a firm expands, its scale increases all its inputs proportionally, then technically there
are three possibilities. (i) The total output may increase proportionately (ii) The total output
may increase more than proportionately and (iii) The total output may increase less than
proportionately.
Assumptions of Law of returns to scale:
 All inputs or factors of production are variable
 Production technology remains constant
 Product produce is measure in physical units

Total
Unit Scale of Production Marginal Returns
Returns
4 (Stage I - Increasing
1 1 abor + 2 Acres of Land 4
Returns)
2 2 Labor + 4 Acres of Land 10 6
3 3 Labor + 6 Acres of Land 18 8
10 (Stage II - Constant
4 4 Labor + 8 Acres of Land 28
Returns)
5 5 Labor + 10 Acres of Land 38 10
6 6 Labor + 12 Acres of Land 48 10
8 (Stage III - Decreasing
7 7 Labor + 14 Acres of Land 56
Returns)
8 8 Labor + 16 Acres of Land 62 6

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Stage 1: Increasing Returns to Scale In figure,
stage I represents increasing returns to scale.
During this stage, the firm enjoys various internal
and external economies such as technical
economies, managerial economies and marketing
economies. Economies simply mean advantages for
the firm. Due to these economies, the firm realizes
increasing returns to scale. This stage is also
explained saying increasing returns in terms of
“increased efficiency” of labor and capital in the improved organization with the expanding
scale of output and employment factor unit. It is referred to as the economy of organization in
the earlier stages of production.
Increasing Return to Scale: If increase in the output is greater than the proportional
increase in the inputs, it means increasing return to scale
Stage 2: Constant Returns to Scale
In figure, the stage II represents constant returns to scale. During this stage, the economies
accrued during the first stage start vanishing and diseconomies arise. Diseconomies refers to
the limiting factors for the firm‟s expansion. Emergence of diseconomies is a natural process
when a firm expands beyond certain stage. In the stage II, the economies and diseconomies of
scale are exactly in balance over a particular range of output. When a firm is at constant
returns to scale, an increase in all inputs leads to a proportionate increase in output but to an
extent.
Constant returns to scale: If increase in the total output is proportional to the increase
in input, it means constant returns to scale.

Stage 3: Diminishing Returns to Scale

In figure, the stage III represents diminishing returns or decreasing returns. This situation
arises when a firm expands its operation even after the point of constant returns. Decreasing
returns mean that increase in the total output is not proportionate according to the increase in
the input. Because of this, the marginal output starts decreasing. Important factors that
determine diminishing returns are managerial inefficiency and technical constraints.
Diminishing Returns to Scale: If increase in the output is less than proportional increase
in the inputs, it means diminishing returns to scale.

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ISOQUANTS:
The term Isoquants is derived from the words „iso‟ and „quant‟ – „Iso‟ means equal and
„quant‟ implies quantity. Isoquant therefore, means equal quantity. A family of iso-product
curves or isoquants or production difference curves can represent a production function with
two variable inputs, which are substitutable for one another within limits.
Isoquants are the curves, which represent the different combinations of inputs producing a
particular quantity of output. Any combination on the Isoquant represents the some level of
output.
For a given output level firm‟s production become,
Q= f (L, K)
Where „Q‟, is the units of output is a function of the quantity of two inputs „L‟ and „K‟.
Thus an Isoquant shows all possible combinations of two inputs, which are capable of
producing equal or a given level of output. Since each combination yields same output, the
producer becomes indifferent towards these combinations.
Assumptions:
1. There are only two factors of production, viz. labour and capital.
2. The two factors can substitute each other up to certain limit
3. The shape of the Isoquant depends upon the extent of substitutability of the two inputs.
4. The technology is given over a period.

Marginal Rate of Technical Substitution:

Marginal rate of technical substitution in the theory of production is similar to the concept of
marginal rate of substitution in the indifference curve analysis of consumer‟s demand.
Marginal rate of technical substitution indicates the rate at which factors can be substituted at
the margin without altering the level of output.
PROPERTIES OF ISOQUANTS
Property 1: An isoquant curve slopes downward, or is negatively sloped. This means that
the same level of production only occurs when increasing units of input are offset with lesser

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units of another input factor. This property falls in line with the principle of the Marginal
Rate of Technical Substitution (MRTS). As an example, the same level of output could be
achieved by a company when capital inputs increase, but labor inputs decrease.
Property 2: An isoquant curve, because of the MRTS effect, is convex to its origin. This
indicates that factors of production may be substituted with one another. The increase in one
factor, however, must still be used in conjunction with the decrease of another input factor.
Property 3: Isoquant curves cannot be tangent or intersect one another. Curves that
intersect are incorrect and produce results that are invalid, as a common factor combination
on each of the curves will reveal the same level of output, which is not possible.
Property 4: Isoquant curves in the upper portions of the chart yield higher outputs. This
is because, at a higher curve, factors of production are more heavily employed. Either more
capital or more labor input factors result in a greater level of production.
Property 5: An isoquant curve should not touch the X or Y axis on the graph. If it does,
the rate of technical substitution is void, as it will indicate that one factor is responsible for
producing the given level of output without the involvement of any other input factors.
Property 6: Isoquant curves do not have to be parallel to one another; the rate of technical
substitution between factors may have variations.
Property 7: Isoquant curves are oval-shaped, allowing firms to determine the most
efficient factors of production.

TYPES OF ISOQUANT:
Isoquants are differentiated on the basis of substitutability of the factors of production and
they are as below
1. Linear Isoquant:
This type of isoquant are depicted by a straight line sloping downward from left to right, as
shown in Figure-(a). It indicated a perfect and unlimited substitutability between two factors
implying that the product may be produced even by using only capital or labour or by infinite
combinations of the two factors.
2. Right angled Isoquant:
are L-shaped curve Figure-(b) and also known as Leontief isoquants. They assume a perfect
complementary nature between factors implying zero substitutability. Factors are jointly used
in a fixed proportion. It means that there is only one method of production to produce a
commodity. Hence, to increase output, both factors are to be increased holding the proportion
constant.
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3. Convex Isoquant:
In this the inputs can be substituted but not perfectly. The curve of this type is convex to
origin as we always consider for the isoquant curve.

ISO-COST CURVE:
Isocost line shows all combinations of inputs which cost the same total amount. The use of
the Isocost line pertains to cost-minimization in production, as opposed to utility-
maximization. An Isocost line shows the maximum amount which a firm is willing to expend
on production.
Slope of iso cost line: With the change in the factor prices the slope of iso cost lien will
change. If the price of labour falls the firm could buy more of labour and the line will shift
away from the origin. The slope depends on the prices of factors of production and the
amount of money which the firm spends on the factors. When the amount of money spent by
the firm changes, the isocost line may shift but its slope remains the same. A change in factor
price makes changes in the slope of isocost lines as shown in the figure.

INDIFFERENCE CURVE:

INDIFFERENCE CURVE: An indifference curve connects points on a graph representing

different quantities of two goods, points between which a consumer is indifferent. An
indifference curve is a graph showing combination of two goods that give the consumer equal

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satisfaction and utility. Each point on an indifference curve indicates that a consumer is
indifferent between the two and all points give him the same utility.
Graphically, the indifference curve is drawn as a downward sloping convex to the origin.
The graph shows a combination of two goods that the consumer consumes. The above
diagram shows the U indifference curve showing
bundles of goods A and B. To the consumer, bundle
A and B are the same as both of them give him the
equal satisfaction. In other words, point A gives as
much utility as point B to the individual. The
consumer will be satisfied at any point along the
curve assuming that other things are constant.
LEAST COST COMBINATION FACTOR:
Producer‟s equilibrium or optimization occurs when he earns maximum profit with optimal
combination of factors. A profit maximization firm faces two choices of optimal combination
of factors
1. To Maximize its output for a given cost

2. To minimize its cost for given output

Thus the least cost combination of factors refers to a firm producing the largest volume of
output from a given cost and producing a given level of output with the minimum cost when
the factors are combined in an optimum manner.
Assumptions made for to understand this concept are:
1. There are two factors, labour and capital.
2. All units of labour and capital are homogeneous.
3. The prices of units of labour (w) and that of capital (r) are given and constant.
4. The cost outlay is given.
5. The firm produces a single product.
6. The price of the product is given and constant.
7. The firm aims at profit maximisation.
8. There is perfect competition in the factor market.

1. To maximize output for given cost:

The firm maximizes its profits by maximizing its output, given its cost outlays, and the prices
of the two factors. This analysis is based on the same assumptions, as given above From the
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fig, the firm can reach the optimal factor combination level
of maximum output by moving along the iso-cost line CL
from either point E or F to point P. This movement involves
no extra cost because the firm remains on the same iso-cost
line the firm is maximising its output level of 200 units by
employing the optimal combination of OM of capital and
ON of labour, given its cost outlay CL.
But it cannot be at points E or F on the iso-cost line CL, since both points give a smaller
quantity of output, being on the isoquant 100, than on the isoquant 200. The firm cannot
attain a higher level of output such as isoquant 300 because of the cost constraint. The firm is
in equilibrium at point P where the isoquant curve 200 is tangent to the iso-cost line CL Thus
the equilibrium point has to be P with optimal factor combination OM + ON.

2. To minimize cost for given output:

Given these assumptions, the point of least-cost combination
of factors for a given level of output is where the isoquant
curve is tangent to an iso-cost line. The iso-cost line GH is
tangent to the isoquant 200 at point M. The firm employs the
combination of ОС of capital and OL of labour to produce
200 units of output at point M with the given cost-outlay GH.
At this point, the firm is minimising its cost for producing 200 units.
Any other combination on the isoquant 200, such as R or T, is on the higher iso-cost line KP
which shows higher cost of production. The iso-cost line EF shows lower cost but output 200
cannot be attained with it. Therefore, the firm will choose the minimum cost point M which is
the least-cost factor combination for producing 200 units of output.
M is thus the optimal combination for the firm. The point of tangency between the iso-cost
line and the isoquant is an important first order condition but not a necessary condition for the
producer‟s equilibrium.

ECONOMIES & DISECONOMIES OF SCALE: Economies of scale are defined as the

cost advantages that an organization can achieve by expanding its production in the long run.
In other words, these are the advantages of large scale production of the organization. The
cost advantages are achieved in the form of lower average costs per unit.

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It is a long term concept. Economies of scale are achieved
when there is an increase in the sales of an organization.
Economies of scale are the cost advantages that enterprises
obtain due to their scale of operation, with cost per unit of
output decreasing which causes scale increasing.
Figure illustrates that average cost falls as output increases,
with the result that large firms may enjoy lower costs that
smaller competitors. This competitive cost advantage allows
large firms to have larger profit margins and have more options in pricing policy.
Reason for Economies of Scale:
1. Managerial - managers are on a fixed salary
2. Marketing - advertising, endorsements promotional events do not directly depend on
quantity produced
3. Techinical - machinery, buildings etc are paid for as a fixed amount
4. Bulk buying - remember it is the cost per unit of buying in bulk not the total cost (Great
example is supermarkets and local shop)
5. Financial - similar in principle to buying in bulk but this time interest rates a more
favorable.
The economies of scale are divided in to internal economies and external economies:

INTERNAL ECONOMIES:
As a firm increases its scale of production, the firm enjoys several economies named as
internal economies. Basically, internal economies are those which are special to each firm.
For example, one firm will enjoy the advantage of good management; the other may have the
advantage of specialisation in the techniques of production and so on.
“Internal economies are those which are open to a single factory, or a single firm
independently of the action of other firms. These result from an increase in the scale of output
of a firm and cannot be achieved unless output increases.” Cairncross
Refer to real economies which arise from the expansion of the plant size of the organization.
These economies arise from the growth of the organization itself.
A. Technical Economies of Scale: Technical economies have their influence on the size of
the firm. Generally, these economies accrue to large firms which enjoy higher efficiency
from capital goods or machinery. Bigger firms having more resources at their disposal are

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able to install the most suitable machinery. Therefore, a firm producing on large scale can
enjoy economies by the use of superior techniques.

Technical economies are of three kinds:

(i) Economies of Dimension:
A firm by increasing the scale of production can enjoy the technical economies. When a firm
increases its scale of production, average cost of production falls but its average return will be
more.
(ii) Economies of Linked Process:
A big firm can also enjoy the economies of linked process. A big firm carries all productive
activities. These activities get economies. These linked activities save time and transport
costs to the firm.
(iii) Economies of the Use of By-Products:
All the large sized firms are in a position to use its by-products and waste-material to produce
another material and thus, supplement to their income. For instance, sugar industries make
power, alcohol out of the molasses.
B. Marketing Economies of Scale:
When the scale of production of a firm is increased, it enjoys numerous selling or marketing
economies. In the marketing economies, we include advertisement economies, opening up of
show rooms, appointment of sole distributors etc. Moreover, a large firm can conduct its own
research to effect improvement in the quality of the product and to reduce the cost of
production. The other economies of scale are advertising economies, economies from special
arrangements with exclusive dealers. In this way, all these acts lead to economies of large
scale production.
C. Labor Economies of Scale:
As the scale of production is expanded their accrue many labour economies, like new
inventions, specialization, time saving production etc. A large firm employs large number of
workers. Each worker is given the kind of job he is fit for. The personnel .officer evaluates
the working efficiency of the labour if possible. Workers are skilled in their operations which
save production, time and simultaneously encourage new ideas.
D. Managerial Economies of Scale:
Managerial economies refer to production in managerial costs and proper management of
large scale firm. Under this, work is divided and subdivided into different departments. Each
department is headed by an expert who keeps a vigil on the minute details of his department.
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A small firm cannot afford this specialisation. Experts are able to reduce the costs of
production under their supervision. These also arise due to specialization of management and
mechanisation of managerial functions.
E. Economies of Transport and Storage:
A firm producing on large scale enjoys the economies of transport and storage. A big firm
can have its own means of transportation to carry finished as well as raw material from one
place to another. Moreover, big firms also enjoy the economies of storage facilities. The big
firm also has its own storage and go down facilities. Therefore, these firms can store their
products when prices are unfavorable in the market.

EXTERNAL ECONOMIES:
the firms operating in a
given industry. Generally, these economies accrue due to the expansion of industry and other
facilities expanded by the Government.

number of firms or industries when the scale of production in any industry increases.”
Moreover, the simplest case of an external economy arises when the scale of production
function of a firm contains as an implicit variable the output of the industry. A good example
is that of coal mines in a locality.

organizations. When an industry expands, organizations may benefit from better

transportation network, infrastructure, and other facilities. This helps in decreasing the cost of
an organization.
A. Economies of Concentration:
As the number of firms in an area increases each firm enjoys some benefits like, transport and
communication, availability of raw materials, research and invention etc. Further, financial
assistance from banks and non-bank institutions easily accrue to firm. We can, therefore,
conclude that concentration of industries lead to economies of concentration.
B. Economies of Information:
When the number of firms in an industry expands they become mutually dependent on each
other. In other words, they do not feel the need of independent research on individual basis.
Many scientific and trade journals are published. These journals provide information to all
the firms which relates to new markets, sources of raw materials, latest techniques of
production etc.
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C. Economies of Disintegration
As an industry develops, all the firms engaged in it decide to divide and sub-divide the
process of production among themselves. Each firm specializes in its own process. For
instance, in case of moped industry, some firms specialize in rims, hubs and still others in
chains, pedals, tires etc. It is of two types-horizontal disintegration and vertical disintegration.
In case of horizontal disintegration each firm in the industry tries to specialize in one
particular item whereas, under vertical disintegration every firm endeavors to specialize in
different types of items. Material of one firm may be available and useable as raw materials
in the other firms. Thus, wastes are converted into by-products.
The selling firms reduce their costs of production by realizing something for their wastes.
The buying firms gain by getting other firms‟ wastes as raw materials at cheaper rates. As a
result of this, the average cost of production declines.

SIGNIFICANCE OF ECONOMIES OF SCALE:

The significance of economies of scale is discussed as under:
(a). Nature of the Industry:
The foremost significance of economies of scale is that it plays an important role in
determining the nature of the industry i.e. increasing cost industry, constant cost industry or
decreasing cost industry.
(b). Analysis of Cost of Production:
When an industry expands in response to an increase in demand for its products, it
experiences some external economies as well as some external diseconomies. The external
economies tend to reduce the costs of production and thereby causing an upward shift in the
long period average cost curve, whereas the external diseconomies tend to raise the costs and
thereby causing an upward shift in the long period average cost curve. If external
diseconomies outweigh the external economies, that is, when there are net external
diseconomies, the industry would be an Increasing costindustry.
Diseconomies of scale are when the cost per unit of production (Average cost) increases
because the output (sales) increases. Reasons for diseconomies of scale
1. Communication - becomes more complex
2. Coordination - between departments
3. X- Inefficiency - management costs increase (non-productive costs)
4. Principle agent problem - delegating to employees who are not as committed as the owner

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Cost analysis:
Cost Analysis refers to the measure of the cost – output relationship, i.e. the economists are
concerned with determining the cost incurred in hiring the inputs and how well these can be
re- arranged to increase the productivity (output) of the firm.

Cost refers to the money value that is incurred in acquiring the resources and producing the
product.
Determinants of Cost:
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.
Price of input factors: A rise in the cost of input factors will increase the total cost of
production.
Productivities of factors of production: When the productivity of the input factors is high then
the cost of production will fall.
Size of plant: The cost of production will be low in large plants due to mass production with
mechanization.
Time period: In the long run cost of production will be stable.
Technology: When the organization follows advanced technology in their process then the
cost of production will be low.

TYPES OF COST
Fixed Costs (FC): The costs which don‟t vary with changing output. Fixed costs might
include the cost of building a factory, insurance and legal bills. Even if your output changes
or you don‟t produce anything, your fixed costs stay the same.
Costs (VC): Costs which depend on the output produced. For example, if you produce more
cars, you have to use more raw materials such as metal. This is a variable cost.
Marginal Costs (MC): is the cost that incurred due to the production of an extra or
additional unit.
Opportunity Cost: Opportunity cost is the next best alternative foregone. “It is cost incurred
due to one‟s own choice”, i.e the opportunity an individual loose by choosing other.
Incremental cost: Incremental cost is the total cost incurred due to an additional unit of
product being produced.
Explicit costs: these are costs that a firm directly pays for and can be seen on the accounting
sheet. Explicit costs can be variable or fixed and it is a clear amount.
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Implicit costs: these are opportunity costs, which do not necessarily appear on its balance
sheet but affect the firm. For example the assets of the owner used for the purpose of
business.
Sunk Cost: these are costs that have been incurred and cannot be recouped. Depreciation is
considered as one of the best example for sunk cost. Example if you spend money on
advertising to enter an industry, you can never claim these costs back.
Future Cost: It is a type of cost, where the cost incurred to estimate the future data or
forecasting of the organization. It is a type of cost which cannot be exceptional in nature.
Social Cost: This is the total cost to society. It will include the private costs plus also the
external cost (cost incurred by a third party). May also be referred to as „True costs‟ where
the company spends on betterment of the society.

COST CURVES:
Total fixed costs: Given that total fixed costs (TFC) are constant as output increases, the
curve is a horizontal line on the cost graph.
In economic analysis, the following types of costs are considered in studying cost data
of a firm:
□ Total Cost (TC),
□ Total Fixed Cost (TFC),
□ Total Variable Cost (TVC),
□ Average Fixed Cost (AFC),
□ Average Variable Cost (AVC),
□ Average Total Cost (ATC), and
□ Marginal Cost (MC).
Total Fixed Cost (TFC). It is the cost pertaining to all fixed inputs like machinery,
etc., at any given level of output.
□ Total Variable Cost (TVC). It is the cost pertaining to all variable inputs like raw
materials, etc., at any given level of output.
Total Cost (TC). 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.
Thus, TC = TFC + TVC.

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COST – OUTPUT RELATIONSHIP IN SHORT RUN:

.
Units Total Total Total Average Average Average Marginal
of fixed cost variable cost variable cost fixed cost cost cost MC
Output TFC cost (TFC + (TVC / Q) (TFC / Q) (TC/Q)
Q TVC TVC) AVC AFC AC
TC
0 60 – 60 – – – –
1 60 20 80 20 60 80 20
2 60 36 96 18 30 48 16
3 60 48 108 16 20 36 12
4 60 64 124 16 15 31 16
5 60 90 150 18 12 30 26
6 60 132 192 22 10 32 42
Behaviour of Total Costs
Examining cost schedules in Table 9.1, we may observe the following interesting points
about the behaviour of various total costs:
□ TFC remains constant at all levels of output. It is the same even when the output is nil.
Fixed costs are thus independent of output.
□ TVC varies with the output. It is nil when there is no output. Variable costs are, thus,
direct costs of the output.
TVC does not change in the same proportion. Initially, it is increasing 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 or non-proportional output, which suggests that initially to obtain a

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given amount of output relatively, variations in factors are needed in less proportion, but after
a point when the diminishing phase operates, variable factors, are to be employed in a greater
proportion to increase the same „level‟ of output.
□ TC varies in the same proportion as the TVC. Thus, in the short period, the changes
in total cost are entirely due to changes in the total
THE BEHAVIOUR OF SHORT-RUN AVERAGE COST CURVES
The behaviour patterns and relations of short-run unit costs become more explicit when
we plot the cost data on a graph and draw the respective cost curves.

Average Fixed Cost in Short Run: The average fixed cost is the total fixed cost divided by
the volume of output. There is an inverse relation between output and average fixed cost.
With the increase in output average fixed cost decreases and with the decrease in output the
average fixed cost will increase.
It is calculated from the following formula:
AFC = TFC/Q

2. Average Variable Cost (AVC): The average variable cost is total variable cost divided by
the volume of output. Average variable cost falls with the increase in output, reaches at its
minimum and then starts rising. By the operation of law of increasing returns the AVC
decreases, and by the operation of constant returns leads to constancy in AVC and the law of
diminishing returns leads to increase in AVC. The shape of AVC is U-shaped because of the
operation of the laws of returns during short period.

The AVC is calculated by the formula given below:

AVC = TVC/Q
AVC and TVC are average variable cost and total variable cost while Q is the volume of
output.
3. Average Total Cost (ATC): Average Total Cost (ATC) is the aggregate of AFC and
AVC. ATC can be calculated from total cost (TC) divided by the volume of output or by
aggregating AVC and AFC.

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The ATC curve decreases with the increase in output and remains constant up to a point and
thereafter it increases with the increase in output. Its shape is U-shaped because of the
operation of the laws of return during short period.
The following is the formula of calculating AC:
ATC = TC/Q or ATC = AFC + AVC
ATC and TC are average total cost and total cost while Q is the volume of output.
4. Marginal Cost (MC): It is an addition to total cost by producing an additional unit of
output. It can be calculated as the change in total cost divided by an additional unit change in
the output.

Marginal Cost changes with the change in average variable cost (AVC) and it is independent
of average fixed cost (AFC). Initially, MC Falls, reaches the minimum and thereafter
continuously increases. MC is also U-shaped curve. MC curve cuts the ATC and AVC curves
at their minimum points.
MC = Change in ATC/ Change in Q
**Note:
(1) AFC declines continuously, approaching both axes asymptomatically (as shown by the
de- creasing distance between ATC and AVC) and is a rectangular hyperbola.
(2) AVC first declines, reaches a minimum at Q2and rises thereafter. When AVC is at its
minimum, MC equals AVC.
(3) ATC first declines, reaches a minimum at Q3, and rises thereafter. When ATC is at its
minimum, MC equals ATC.
(4) MC first declines, reaches a minimum at Q1, and rises thereafter. MC equals both AVC
and ATC when these curves are at their minimum values.
Cost – Output Relationship in Long Run:
Long period gives sufficient time to business managers to change even the scale of production.
All the factors of production are variable. All the costs are variable costs and there is no fixed
cost. The supply of goods can be adjusted to their demands because scale of production and
factors of production can be changed.
Log Run Average Cost (LAC): In the long run, all the factors of production are variable and the
firm has a variety of choices to select the size of the plants and the factors of production to be
employed. Various short run average cost curves represent the various sizes of the plants
available to a firm. We can get the long run average cost curve with the help of all the short run

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average cost curves. The long run average
cost curve envelopes all the short run
average cost curves in it. It is also called an
‘Envelope Curve’ or ‘Planning Curve’.
From the above figure long run cost
represented on OY-axis and output on OX-
axis. SAC, SAC1, SAC2, SAC3 and SAC4 are short
run average cost curves which represent the
different size of plants. LAC has been drawn
by combining all those points of least cost of
producing the corresponding output. The least per unit cost of production is OQ, OQ 1, OQ2, OQ3,
OQ4, and OQ5 respectively.

BREAK-EVEN ANALYSIS
The BEA is an important technique to trace the
relationship between costs, revenue and profits at the
varying levels of output or sales
In BEA, the break-even point is located at that level of
output or sales at which the net income or profit is zero. At
this point, total cost is equal to total revenue. Hence, the
breakeven point is the no-profit-no-loss zone.
However, the object of the BEA is not just to determine the break-even point (BEP), but to
understand the functional relationship among cost, revenue and the rate of output.

ASSUMPTIONS OF BREAK-EVEN ANALYSIS

The validity of the BEA is conditioned by a number of assumptions as follows:
1. The cost function and the revenue function are linear.
2. The total cost is divided into fixed and variable costs.
3. The selling price is constant.
4. The volume of sales and the volume of production are identical.
5. Average and marginal productivity of factors are constant.
6. The product-mix is stable in the case of a multi-product firm.
7. Factor price is constant.

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LIMITATIONS OF BEA
The break-even analysis has certain major limitations as follows:
 It is static. In the BEA, everything is assumed to be constant. This implies a static
condition. It is not suited to a dynamic situation.
 It is unrealistic. It is based on many assumptions which do not hold good in
practice. Linearity of cost and revenue function are true only for a limited range of
output.
 It has many shortcomings. The BEA regards profit as a function of output only. It
fails to consider the impact of technological change, better management, division of
labour, improved productivity and such other factors influencing profits.
 Its scope is limited to the short-run only. The SEA is not an effective tool for a
long-run analysis.
 It assumes horizontal demand curve with the given price of the product. But this
is not so in the case of a monopoly firm.
 It is difficult to handle selling costs in the BEA. Selling costs do not vary with
output. They manipulate sales and affect the volume of output.
 The traditional BEA is very simple. It makes no provision for corporate income-tax,
etc.
Managerial Use of Break Even Analysis:
(i) Safety Margin: The break-even chart helps the management to know at a glance the
profits generated at the various levels of sales. The safety margin refers to the extent to which
the firm can afford a decline before it starts incurring losses.
The formula to determine the sales safety margin is:
Safety Margin= (Sales – BEP)/ Sales x 100
(ii) Target Profit: The break-even analysis can be utilised for the purpose of calculating the
volume of sales necessary to achieve a target profit.

(iii) Change in Price: The management is often faced with a problem of whether to reduce
prices or not. Before taking a decision on this question, the management will have to consider
a profit. A reduction in price leads to a reduction in the contribution margin.
This means that the volume of sales will have to be increased even to maintain the previous
level of profit. The higher the reduction in the contribution margin, the higher is the increase
in sales needed to ensure the previous profit.

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(iv) Change in Costs:
When costs undergo change, the selling price and the quantity produced and sold also
undergo changes.
Changes in cost can be in two ways:
(i) Change in variable cost, and
(ii) Change in fixed cost.
(i) Variable Cost Change: An increase in variable costs leads to a reduction in the
contribution margin. This reduction in the contribution margin will shift the break-even point
downward. Conversely, with the fall in the proportion of variable costs, contribution margins
increase and break-even point moves upwards.
(ii) Fixed Cost Change: An increase in fixed cost of a firm may be caused either due to a tax
on assets or due to an increase in remuneration of management, etc. It will increase the
contribution margin and thus push the break-even point upwards. Again to maintain the
earlier level of profits, a new level of sales volume or new price has to be found out.
(v) Decision on Choice of Technique of Production: The breakeven analysis is the most
simple and helpful in the case of decision on a choice of technique of production. For low
levels of output, some conventional methods may be most probable as they require minimum
fixed cost. For high levels of output, only automatic machines may be most profitable. By
showing the cost of different alternative techniques at different levels of output, the break-
even analysis helps the decision of the choice among these techniques.
(vi) Make or Buy Decision: Firms often have the option of making certain components or
for purchasing them from outside the concern. Break-even analysis can enable the firm to
decide whether to make or buy.
(vii) Plant Expansion Decisions: The break-even analysis may be adopted to reveal the
effect of an actual or proposed change in operation condition. This may be illustrated by
showing the impact of a proposed plant on expansion on costs, volume and profits. Through
the break-even analysis, it would be possible to examine the various implications of this
proposal.
(viii) Plant Shut Down Decisions: In the shut down decisions, a distinction should be made
between out of pocket and sunk costs. Out of pocket costs include all the variable costs plus
the fixe cost which do not vary with output. Sunk fixed costs are the expenditures previously
made but from which benefits still remain to be obtained e.g. depreciation.

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(ix) Advertising and Promotion Mix Decisions: The break-even point concept helps the
management to know about the circumstances. It enables him not only to take appropriate
decision but by showing how these additional fixed cost would influence BEPs. The
advertisement pushes up the total cost curve by the amount of advertisement expenditure.
(x) Decision Regarding Addition or Deletion of Product Line: If a product has outlive
utility in the market immediately, the production must be abandoned by the management and
examined what would be its consequent effect on revenue and cost. Alternatively, the
management may like to add a product to its existing product line because it expects the
product as a potential profit spinner. The break-even analysis helps in such a decision.

Practical problems on break even analysis

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