Unit-2

Theory of Production and Cost

Analysis
Theory of Production : Production function-
Isoquants and Isocosts , MRTS , Least Cost
Combination of Inputs.
Cost Analysis: Cost Concepts , Opportunity cost ,
Out of Pocket cost , Imputed Costs , Out of Pocket
cost Vs Imputed Costs.
Breakeven Analysis ( BEA) - (Determination of
Breakeven point ,
Managerial Significance and limitations of BEA.
• Production function: 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.
• it states the relationship between inputs and
outputs. So how much would x number of
inputs be able to produce.
• For example, a firm may have 5 workers
producing 100 pins an hour.
 “That function which defines the maximum
amount of output that can be produced with a
given set of inputs.”
Michael R Baye
• The production function is expressed in the formula:
Q = f(K, L, P, H),
calculates the maximum amount of output you can
get from a certain number of inputs. The factors of
production are: Physical capital (K), including tangible
assets like buildings, machines, computers, and other
equipment. Labor (L), or input of human workers.
where the quantity produced is a function of the
combined input amounts of each factor.
• Not all businesses require the same factors of
production or number of inputs.
• In case of software industry, land is not an input factor
as significant as that in case of an agricultural product.
• What is the law of diminishing returns?
• The law of diminishing returns is an economic
principle stating that as investment in a particular
area increases, the rate of profit from that
investment, after a certain point, cannot continue
to increase if other variables remain at a
constant.
• The law of diminishing returns is an economic
principle stating that as investment in a particular
area increases, the rate of profit from that
investment, after a certain point, cannot continue
to increase if other variables remain at a
constant.
• production with one variable input
(labour) follows the law of increasing returns.
According to this law, output would increase
at an increasing rate as the quantity of labour
increases.
• For example, a factory employs workers to
manufacture its products, at some point, the
company operates at an optimal level.
• With all other production factors constant,
adding additional workers beyond this optimal
level will result in less efficient operations.
• When the Marginal Product (MP) increases,
the Total Product is also increasing at an
increasing rate. This gives the Total product
curve a convex shape in the beginning as
variable factor inputs increase. This continues
to the point where the MP curve reaches its
maximum.
• Total Product
• The total product refers to the total amount
(or volume) of output produced with a given
amount of input during a period of time.
• Therefore, a firm wanting to increase its Total
Product in the short run will have to increase its
variable factors as the fixed factors remain
unchanged (that is why they are ‘fixed’ in the
short run).
• In the long run, as we know that all factors
become variable, the firm can increase its total
product by increasing any of its factors as all
factors become variable. The concept of Total
Product helps us understand what is called the
Marginal Product.
• Marginal Product
• The total product can be calculated by adding
subsequent marginal returns to an input (also
known as the marginal product). The increase
in output per unit increase in input is called
Marginal Product. Thus, if we were to assume
Labour as the input used in the production
process (say)
• For example: In donut shop to produce
additional donuts only one they hire extra
employee.
• Average Product
• Average product is the average output
(or products) Produced by each employee
• Average product, as the name suggests, refers
to the per unit total product of the variable
factor (here, labour). Hence, the calculation of
Average Product is also very simple.
• AP = Total Product/ units of variable factor
input = TP/L
• The TP curve first increases at an increasing rate, after
which it continues to increase but at a decreasing rate,
giving the curve an S-shape. This trend continues till TP
reaches its maximum. Here, MP =0. After the
maximum, TP starts to fall or it declines.
• The MP curve also initially increases, reaches its
maximum and then declines. Note that the maximum
of MP is reached at the point where TP starts to
increase at a diminishing rate. An interesting fact is that
MP can also be negative, whereas TP is always positive
even when it declines.
• The AP curve also shows a similar trend as the MP. It
rises, reaches its maximum and then falls. At the point
where AP reaches its maximum, AP = MP.
• All – TP, MP and AP curves, are inverted U-shaped.
• In short run, it is assumed that capital is a fixed factor
input and labour is variable input. It is also assumed
that technology is given and is not going to change.
Under such circumstances, the firm starts production
with a fixed amount of capital and uses more and more
units of labour.
• In the initial stages, output increases at an increasing
rate because capital is grossly underutilised.
Productivity will increase up to a point A when more
and more units of labour are increased.
• After Point A, output increases at a declining rate till it
reaches maximum at point C, the total output declines
and the marginal point product of labour is negative.
This indicates that the additional units of labour are
not contributing any thing positively to the total
output.
• Even if labour is available free of cost , it is not worth
using it.
• Production Function with two Variable
Inputs. A firm may increase its output by
using more of two variable inputs that are
substitutes for each other, e.g., labour and
capital.
• There may be various technical possibilities of
producing a given output by using different
factor combinations.
 Isoquant
• The term "isoquant," broken down in Latin,
means “equal quantity,” with “iso” meaning
equal and “quant” meaning quantity.
Essentially, the curve represents a consistent
amount of output. The isoquant is known,
alternatively, as an equal product curve or a
production indifference curve.
• An isoquant shows combinations of capital and labor,
and the technological tradeoff between the two—how
much capital would be required to replace a unit of
labor at a certain production point to generate the
same output. Labor is often placed along the X-axis of
the isoquant graph, and capital along the Y-axis.
• Due to the law of diminishing returns—the economic
theory that predicts that after some optimal level of
production capacity is reached, adding other factors
will actually result in smaller increases in output—an
isoquant curve usually has a concave shape. The exact
slope of the isoquant curve on the graph shows the
rate at which a given input, either labor or capital, can
be substituted for the other while keeping the same
output level.
• Features
• An isoquant is a concave-shaped curve on a graph
that measures output, and the trade-off between
two factors needed to keep that output constant.
Among the properties of isoquants:
• An isoquant slopes downward from left to right
• The higher and more to the right an isoquant is
on a graph, the higher the level of output it
represents
• Two isoquants can not intersect each other
• An isoquant is convex to its origin point
• An isoquant is oval-shaped
Isoquant curve
Isoquant where input factors are
perfect substitutes
Isoquant where input factors are not
perfect substitutes
 Isocost
• An isocost line shows all combinations of inputs which
cost the same total amount.
• Although similar to the budget constraint in consumer
theory, the use of the isocost line pertains to cost-
minimization in production, as opposed to utility-
maximization. For the two production inputs labour
and capital, with fixed unit costs of the inputs, the
equation of the isocost line is
• An isocost line shows all combinations of inputs which
cost the same total amount. Although similar to the
budget constraint in consumer theory, the use of the
isocost line pertains to cost-minimization in
production, as opposed to utility-maximization.
• Marginal Rate of Technical Substitution – MRTS?
• The marginal rate of technical substitution (MRTS) is an
economic theory
• That illustrates the rate at which one factor must
decrease so that the same level of productivity can be
maintained when another factor is increased.
• The MRTS reflects the give-and-take between factors,
such as capital and labor, that allow a firm to
maintain a constant output.
• MRTS differs from the marginal rate of
substitution(MRS)
• (the marginal rate of substitution (MRS) is the amount
of a good that a consumer is willing to consume
compared to another good, as long as the new good is
equally satisfying.)because MRTS is focused on
producer equilibrium and MRS is focused on consumer
equilibrium.
• The marginal rate of substitution (MRS) is the
willingness of a consumer to replace one good for
another good, as long as the new good is equally
satisfying.
• The marginal rate of substitution is the slope of
the indifference curve at any given point along
the curve and displays a frontier of utility for each
combination of "good X" and "good Y."
• When the law of diminishing MRS is in effect, the
MRS forms a downward, negative sloping, convex
curve showing more consumption of one good in
place of another.
• For example, a consumer must choose between
hamburgers and hot dogs. To determine the
marginal rate of substitution, the consumer is
asked what combinations of hamburgers and hot
dogs provide the same level of satisfaction.
• When these combinations are graphed, the slope
of the resulting line is negative. This means that
the consumer faces a diminishing marginal rate of
substitution: The more hamburgers they have
relative to hot dogs, the fewer hot dogs they are
willing to consume. If the marginal rate of
substitution of hamburgers for hot dogs is -2,
then the individual would be willing to give up 2
hot dogs for every additional hamburger
consumption.
• The marginal rate of technical substitution
shows the rate at which you can substitute
one input, such as labor, for another input,
such as capital, without changing the level of
resulting output.
• The isoquant,(Equal quantity) or curve on a
graph, shows all of the various combinations
of the two inputs that result in the same
amount of output.
• How to Calculate the Marginal Rate of Technical
Substitution – MRTS
• An isoquant is a graph showing combinations of
capital and labor that will yield the same output.
The slope of the isoquant indicates the MRTS or
at any point along the isoquant how much capital
would be required to replace a unit of labor at
that production point.
• For example, in the graph of an isoquant where
capital (represented with K on its Y-axis and labor
(represented with L) on its X-axis, the slope of the
isoquant, or the MRTS at any one point, is
calculated as dL/dK.
• What Does the MRTS Tell You?
• The slope of the isoquant, or the MRTS, on the graph shows
the rate at which a given input, either labor or capital, can
be substituted for the other while keeping the same output
level. The MRTS is represented by the absolute value of an
isoquant's slope at a chosen point.
• A decline in MRTS along an isoquant for producing the
same level of output is called the diminishing marginal rate
of substitution.
• The figure below shows that when a firm moves down
from point (a) to point (b) and it uses one additional unit of
labor, the firm can give up 4 units of capital (K) and yet
remains on the same isoquant at point (b).
• So the MRTS is 4. If the firm hires another unit of labor and
moves from point (b) to (c), the firm can reduce its use of
capital (K) by 3 units but remains on the same isoquant,
and the MRTS is 3.
MRTS
 Least cost combination principle
• The optimum combination of inputs that is
required to produce output at the least possible
cost is called the least cost combination.
• Least cost combination principle
• A rational firm would combine the various factors
of production its production function in such a
way that with the minimum.
• input and maximum output is obtained at the
minimum cost.
• Assumption of least cost combinations
• There are two factors of production – labour &
capital.
• All units of labour & capital are
homogeneous.( )
• The prices of units of labour (w) & capital (r)
are given & constant.
• The firm aims at profit maximization.
Isoquant curve
 Cost Analysis
• COST CONCEPT : It is used for analyzing the
cost of a project in short and long run. In
other word, cost is the sum total of explicit
cost & implicit cost.
• COST FUNCTION
• It refers to the functional relationship
between cost and output.
• C = f (q)
• where C = cost of production,
• q = quantity of output,
• f = functional relationship
• Types of Cost :
• Total fixed cost (TFC) is that cost which does not
change with a change in the level of output.

• Total variable cost (TVC) : A company's total

variable cost is the expenses that change in
relation to the total production during a given
time period. These costs are directly connected
to a business' volume of production and may
increase or decrease depending on how much a
company produces.
• Total cost (TC) is the minimum dollar cost of
producing some quantity of output.
• For example, suppose a company leases office
space for $10,000 per month, rents machinery
for $5,000 per month, and has a $1,000
monthly utility bill. In this case, the company's
total fixed costs would be $16,000.
• The average fixed cost (AFC) is the fixed cost
that does not change with the change in the
number of goods and services produced by a
company.
• The average variable cost (AVC) is the total variable
cost per unit of output. This is found by dividing total
variable cost (TVC) by total output (Q). Total variable
cost (TVC) is all the costs that vary with output, such as
materials and labour.
• For example, the variable cost of producing 80 haircuts
is $400, so the average variable cost is $400/80, or $5
per haircut.
• Average cost is the cost per unit manufactured in a
production run. It represents the average amount of
money spent to produce a product. This amount can
vary, depending on the number of units produced.
• For instance, for a total cost of $3500, we can produce
1500 chocolate bars. Therefore, the average cost for
the production of 1500 chocolate bars is $2.33.
• Average cost is the cost per unit manufactured in
a production run. It represents the average
amount of money spent to produce a product.
This amount can vary, depending on the number
of units produced.
• Marginal cost (MC) : the marginal cost is the
change in total production cost that comes from
making or producing one additional unit.
• For example, say that to make 100 car tires, it
costs $100. To make one more tire would cost
$80. This is then the marginal cost: how much it
costs to create one additional unit of a good or
service.
 Opportunity cost
• “Opportunity cost is the value of the next-best
alternative when a decision is made; it's what is
given up,”
Example:
• A student spends three hours and $20 at the
movies the night before an exam. The
opportunity cost is time spent studying and that
money to spend on something else. A farmer
chooses to plant wheat; the opportunity cost is
planting a different crop, or an alternate use of
the resources (land and farm equipment).
• opportunity cost.
The two types of opportunity costs are
– Explicit cost (Explicit costs are out-of-pocket costs
for a firm—for example, payments for wages and
salaries, rent, or materials.)- is actual money
expenditure or input or payment made to
outsiders for hiring their factor services.
– Implicit cost ( are the opportunity cost of
resources already owned by the firm and used in
business—for example, expanding a factory onto
land already owned.) - is the estimate value of
inputs supplied by the owners including normal
profit.
• out of pocket costs: Your expenses for
medical care that aren't reimbursed by
insurance. Out-of-pocket costs include
deductibles, coinsurance, and copayments for
covered services plus all costs for services that
aren't covered.
• Examples of work-related out-of-pocket
expenses include airfare, car rentals,
taxis/Ubers , gas, tolls, parking, lodging, and
meals, as well as work-related supplies and
tools.
• An imputed cost is a cost that is incurred by
virtue of using an asset instead of investing it
or the cost arising from undertaking an
alternative course of action. An imputed cost
is an invisible cost that is not incurred directly,
as opposed to an explicit cost, which is
incurred directly.
• For example, if an individual decided to go to
graduate school instead of working at a job,
the imputed cost would be the salary they
gave up during the time they are at school.
 Beakeven Analysis(BEA)
• A break-even analysis is a financial calculation
that weighs the costs of a new business,
service or product against the unit sell price
to determine the point at which you will
break even.
• In other words, it reveals the point at which
you will have sold enough units to cover all of
your costs.
• What Is a Break-Even Point?
• A break-even point is used in multiple areas of
business and finance. In accounting terms, it
refers to the production level at which total
production revenue equals total production
costs.
• In investing, the break-even point is the point
at which the original cost equals the market
price. Meanwhile, the break-even point in
options trading occurs when the market price
of an underlying asset reaches the level at
which a buyer will not incur a loss.
• How Do You Calculate a Break-Even Point?
• Generally, to calculate the break-even point in
business, fixed costs are divided by the gross
profit margin.
• This produces a dollar figure that a company
needs to break even.
• When it comes to stocks, if a trader bought a
stock at $200, and nine months later it
reached $200 again after falling from $250, it
would have reached the break-even point.
• Key terms used in Break- even Analysis
a) Fixed cost: Fixed costs remain fixed in short-run.
Examples: Rent, insurance, director’s salary, etc.
b) Variable cost: The variable cost vary with the volume
of production. The variable costs include cost of direct
material, direct labour, direct expenses
c) Total cost of fixed and variable cost
d) Contribution margin is the difference between the
selling price per unit and the variable cost per unit.
e) Profit = contribution – fixed cost
f) Contribution margin ratio: it is the ratio between
contribution per unit and the selling price per unit.
g) Margin of safety in units: The excess of actual sales (in
units) minus the break – even point ( in rupee)
h) Margin of safety in sales volume: The excess of actual
sales (in rupee) minus the break – even point (in rupee)
 Key terms used in Break- even point
• Selling price = fixed cost + variable cost+ profit
• Selling price – Variable cost= fixed cost
+profit=contribution
• Contribution per unit= selling price per unit-
variable cost per unit
• Determination of break even point in units

Where contribution margin per unit=(selling

price per unit-variable cost per unit)
• Crave Limited has recently entered into the
business of making Table fans. The company’s
management is interested in knowing the
breakeven point at which there will be no
profit/loss. Below are the details about the
cost incurred:
• So, first will find out the No. of units sold by
Crave limited:
• No. of units sold by Crave limited will be:
calculating variable cost per unit
• Variable cost per unit will be:
• We need to find the Contribution per unit, i.e.,
= Selling price per unit- variable cost per unit.
• Contribution margin per unit will be
• we will find the Break-Even Point by using its
formula = (Fixed Cost/Contribution Margin per
unit)
• The Break-Even Point formula will be:
• Thus Crave limited need to sell 1000 units of electric
Table fans to break even at the current cost structure.
At this break-even point of 1000 units, Crave Limited
will succeed in meeting both its Fixed and Variable
expenses of the business. Below the breakeven point
of 1000 units, Crave Limited will make losses on a net
basis if the same cost structure exists.
• Here it is essential to understand that the Fixed Cost (in
this case $60000) is constant and doesn’t vary with the
level of Sales Revenue generated by Crave Limited.
Thus once Crave Limited succeeds in making Break-
Even Point, all Sales over and above that level will lead
to profits as the excess of sales over Variable Cost will
be a positive value since Fixed Cost has already been
fully absorbed by Crave Limited on attaining the
Breakeven Sales Level.
• Advantages
• One of the most critical and primary benefits of
Break-Even Point in accounting is its simplicity of
calculation and helping the business determine
the number of units to be sold to breakeven, i.e.,
no profit, no loss.
• It helps understand the cost structure, i.e., the
proportion of Fixed Costs and Variable Costs.
Since Fixed Cost doesn’t change easily, it helps
business owners to take measures to control the
Variable cost without focusing on the total cost.
• It is vital in forecasting, long-term planning,
growth, and business stability.
• Disadvantages
• The biggest shortcoming of the Break-Even
Point in accounting analysis is the assumption,
which holds that fixed cost remains constant
and Variable cost varies proportionately with
the level of sales, which may not be the case
in the real-world scenario.
• It assumes costs are either fixed or variable;
however, some expenses are semi-fixed in
reality. Example Telephone expenses comprise
a fixed monthly charge and a variable charge
based on the number of calls made.
• Conclusion
• It is difficult for any business to decide its
expected sales volume level accurately. Such
decisions are usually based on past estimates
and market research regarding the demand
for products offered by the business.
• Once a business can know its breakeven point,
it can either reduce the amount of its fixed
cost or increase its contribution margin, which
may be achieved by selling a more significant
proportion of high contribution margin
products.
• Managerial significance means ensuring both the goals
of your organization and the needs of your staff are
met concurrently.
• Here are some other traits of management
effectiveness. An ability to listen:
Effective managers practice active listening when
interacting with staffers.
The break-even analysis helps the company to decide
the least number of sales required to make profits.
With the margin of safety reports, the management
can execute a high business decision.
Monitors and controls cost: Companies' profit margin
can be affected by the fixed and variable cost.