PRODUCTION ANALYSIS

Reading Objectives:

At the end of reading of this chapter the reader will be able to understand that production

is a function of land, labour, capital and organisation. The mangers will have to procure the

right level of these factors based on factors like diminishing marginal utility economies of large

scale operations, law of return, scales etc., with a view of maximizing the output with minimum

cost so as to earn larger profit to the firm/ industry.

Lesson Outline:

 Factors of production

 Production function

 Cobb-Douglas production function

 The law of diminishing returns

 Law of returns to scale

 Iso-quant curve

 Expansion path

 Review questions

Introduction:
 Production is an important economic activity which satisfies the wants and needs of the

people. Production function brings out the relationship between inputs used and the resulting

output. A firm is an entity that combines and processes resources in order to produce output that

will satisfy the consumer’s needs. The firm has to decide as to how much to produce and how

much input factors (labour and capital) to employ to produce efficiently. This chapter helps to

understand the set of conditions for efficient production of an organization.

Factors of production include resource inputs used to produce goods and services. Economist

categorise input factors into four major categories such as land, labour, capital and organization.

Land: Land is heterogeneous in nature. The supply of land is fixed and it is a permanent factor

of production but it is productive only with the application of capital and labour.

Labour: The supply of labour is inelastic in nature but it differs in productivity and efficiency

and it can be improved.

Capital: is a man made factor and is mobile but the supply is elastic.

Organization: the organization plans, , supervises, organizes and controls the business activity

and also takes risks.

Production function

Production function indicates the maximum amount of commodity ‘X’ to be produced

from various combinations of input factors. It decides on the maximum output to be produced

from a given level of input, and how much minimum input can be used to get the desired level of

output. The production function assumes that the state of technology is fixed. If there is a change

in technology then there would be change in production function.

 Q = f (Land, Labour, Capital, Organization)
Q = f (L, L, C, O)

The production manager’s responsibility is that of identifying the right combination of

inputs for the decided quantity of output. As a manager ,he has to know the price of the input

factors and the budget allocation of the organization. The major objective of any business

organization is maximizing the output with minimum cost. To achieve the maximum output the

firm has to utilize the input factors efficiently. In the long run, without increasing the fixed

factors it is not possible to achieve the goal. Therefore it is necessary to understand the

relationship between the input and output in any production process in the short and long run.

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 labour (L) and capital (K).The general equilibrium for the production function

is

Q = f (K, L)

There are various functional forms available to describe production. In general Cobb-Douglas

production function (Quadratic equation) is widely used

Q = A Kα Lβ

Q = the maximum rate of output for a given rate of capital (K) and labour (L).
Short run production function:

In the short run, some inputs (land, capital) are fixed in quantity. The output depends on

how much of other variable inputs are used. For example if we change the variable input namely

(labour) the production function shows how much output changes when more labour is used. In

the short run producers are faced with the problem that some input factors are fixed. The firms

can make the workers work for longer hours and also can buy more raw materials. In that case,

labour and raw material are considered as variable input factors. But the number of machines

and the size of the building are fixed. Therefore it has its own constraints in producing more

goods.

In the long run all input factors are variable. The producer can appoint more workers,

purchase more machines and use more raw materials. Initially output per worker will increase

up to an extent. This is known as the Law of Diminishing Returns or the Law of Variable

Proportion. To understand the law of diminishing returns it is essential to know the basic

concepts of production.

Measures of Productivity

Total production (TP): the maximum level of output that can be produced with a given amount of
input.

Average Production (AP): output produced per unit of input AP = Q/L

Marginal Production (MP): the change in total output produced by the last unit of an input
Marginal production of labour = Δ Q / Δ L (i.e. change in the quantity produced to a given
change in the labour)
Marginal production of capital = Δ Q / Δ K (i.e. change in the quantity produced to a given
change in the capital)

Production function:

A production function, like any other function can be expressed and analysed by

any one or more of the three tools namely table, graph and equation. The maximum amounts of

output attainable from various alternative combinations of input factors are given in the table.

The production function expressed in tabular form is as follows.

Table - Production schedule

Labour TP AP MP
1 20 20 0
2 54 27 34
3 81 27 27
4 104 26 23
5 125 25 21
6 138 23 13
7 147 21 9
8 152 19 5
9 153 17 1
10 150 15 -3
 The firm has a set of fixed variables. As long with that it increases the labour force from

1 unit to 10 units. The increase in input factor leads to increase in the output up to an extent.

After that it start declining. Marginal production increases in the initial period and then it starts

declining and it become negative. The firm should stop increasing labour force if the marginal

production is zero- that is the maximum output that can be derived with the available fixed

factors. The 9th labour does not contribute to any output. In case the firm wants to increase the

output beyond 153 units it has to improve its fixed variable. That means purchase of new

machinery or building is essential. Therefore the firm understands that the maximum output is

153 units with the given set of input factors.

The graphical representations of the production function are as shown in the following graph.

Graph - Production curves

180
160
140
120
100 TP
80 AP
60 MP
40
20
0
1 2 3 4 5 6 7 8 9 10
-20
 The graphical presentations of the values are shown in the graph. The ‘X” axis denotes

the labour and the ‘Y’ axis indicates the total production (TP), average production (AP) and

marginal production (MP). From the given table and graph we can understand all the three

curves in the graph increased in the beginning and the marginal product (MP) first fell, then the

average product (AP) finally total production (TP). The marginal production curve MP cuts the

AP at its highest point. Total production TP falls when marginal production curve cuts the ‘X’

axis. The law of diminishing returns states that if increasing quantity of a variable input are

combined with fixed, eventually the marginal product and then average product will decline.

When the production function is expressed as an equation it shall be as follows:

Q = f (Ld, L, K, M, T )

It can be expressed as Q = f1, f2, f3, f4, f5 > 0

Where,
Q = output in physical units of good X
Ld = land units employed in the production of Q
L = Labour units employed in the production of Q
K = Capital units employed in the production of Q
M = Managerial Units employed in the production of Q
T = Technology employed in the production of Q
f = unspecified function
fi = Partial derivative of Q with respect to ith input.

This equation assumes that output is an increasing function of all inputs.

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.

For example with two sewing machines and two tailors, a firm can produce a maximum

of 14 pairs of curtains per day. The machines are used only from 9 AM to 5 PM and the

machines lie idle from 5 pm onwards. Therefore the firm appoints 2 more tailors for the second

shift and the production goes up to 28 units. Then adding two more labour to assist these people

will increase the output to 30 units. When the firm appoints two more people, then there won’t

be any change in their production because their Marginal productivity is zero. There is no

addition in the total production. That means there is no use of appointing two more tailors.

Therefore, there is a limit for output from a fixed input factors but in the long run purchase of

one more sewing machine alone will help the firm to increase the production more than 30 units.
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 labour, 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.

From the graph given below we can see the total production (TP) curve and the marginal

production curve (MP) and average production curve (AP). It is classified into three stages; let us

understand the stages in terms of returns to scale.

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.

Stage III: 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 over all production along with the average and marginal.

In economics, the production function with one variable input is illustrated with the well known

law of variable proportions. (below graph) it shows the input-output relationship or production

function with one factor variable while other factors of production are kept constant. To

understand a production function with two variable inputs, it is necessary know the concept iso-

quant or iso-product curve.

(a)

TP
Output

Stage I Stage II Stage III

O X X1 X2

Input

Increasing Diminishing Negative

returns returns returns
(b)

B
Output

AP
C

O X X1 X2

Input MP
 ISO-QUANTS

To understand the production function with two variable inputs, iso-quant curve is used. These

curves show the various combinations of two variable inputs resulting in the same level of

output. The shape of an Iso-quant reflects the ease with which a producer can substitute among

inputs while maintaining the same level of output. From the graph we can understand that the

iso-quant curve indicates various combinations of capital and labour usage to produce 100 units

of motor pumps. The points a, b or any point in the curve indicates the same quantum of

production. If the production increases to 200 or 300 units definitely the input usage will also

increase therefore the new iso-quant curve for 200 units (Q1) is shifted upwards. Various iso-

quant curves presented in a graph is called as iso- quant map.

Iso-cost: different combination of inputs that can be purchased at a given expenditure level.

Y UNITARY ELASTIC DEMAND

B
Capital

a
C

b
C1
100

O L L1 L X

Labour

The above graph explains clearly that the iso quant curve for 100 units of motor consists of ‘n’

number of input combinations to produce the same quantity. For example at ‘a’ to produce 100
units of motors the firm uses OC amount of capital and OL amount of labour ie., more capital

and less labour force. At ’b’ OC1 amount of capital and OL1 labour force is used to produce the

same that means more labour and less capital.

Optimal input combination: the points of tangency between iso quant and iso cost curves

depict optimal input combination at different activity levels.

Y
UNITARY ELASTIC DEMAND
B2

B1

c
Capital

B
b
300
a
C
200
100

O M L L1 L2
X
Labour

Expansion path: optimal input combinations as the scale of production expand. From the graph

it is clear that the optimum combination is selected based on the tangency point of iso cost

(budget line) and iso- quant ie., a, b respectively. The point ‘a’ indicates that to produce 100

units of motor the best combination of capital and labour are OC and OM which is within the

budget. Over a period of time a firm will face various optimum levels if we connect all points we

derive expansion path of a firm.

Managerial uses of production function:

Production functions are logical and useful. Production analysis can be used as aids in decision

making because they can give guidance to obtain the maximum output from a given set of inputs

and how to obtain a given output from the minimum aggregation of inputs. The complex

production functions with large numbers of inputs and outputs are analyzed with the help of

computer based programmes.

Review Questions

1. List out the major factors of production (input factors used) in a cement factory.
2. Define production function and Cobb-Douglas production function.
3. Write short notes on Marginal Product and Average product.
4. Briefly discuss the concept Returns to scale, increasing and decreasing returns to scale.
5. Explain the Law of variable proportions.
6. What is Iso-quant?
7. What do you mean by an expansion path?
8. Discuss the managerial uses of production function.
 LESSON V

COST ANALYSIS

Reading Objectives:

At the end of reading this chapter the reader will be able to understand the concepts like

fixed cost, variable cost, average cost, and marginal cost. The concept of the marginal costing is

the contribution of the 20th century. The concept like break even analysis, cost volume profit

analysis are the important tools used to take various managerial decisions. The concept like

average revenue decides the level of output to earn profit. At the same time the concept like

marginal cost is the tool available in the hands of the producers to decide that level of output

where MC = AR i.e., the equilibrium position of the suppliers and consumers.

Lesson Outline:

 Cost of determinants
 Types of cost
 Short run cost output relationship
 Cost output relationship in the long run
 Economies of scale / diseconomies of scale
 Factors causing economies of scale
 Break-Even Analysis
 Review questions
Introduction:

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

appliesin 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.

Types of costs
There are various classifications of costs based on the nature and the purpose of

calculation. But in economics and for accounting purpose the following are the important cost

concepts.

Actual cost/ Outlay cost/ Absolute cost / Accounting cost: The cost or expenditure which a

firm incurs for producing or acquiring a good or service. (Eg. Raw material cost)

Opportunity cost: the revenue which could have been earned by employing that good or

service in some other alternative uses. (Eg. A land owned by the firm does not pay rent. Thus a

rent is an income forgone by not letting it out)

Sunk cost: are retrospective (past) costs that have already been incurred and cannot be
recovered.

Historical cost: The price paid for a plant originally at the time of purchase.

Replacement cost: the price that would have to be paid currently for acquiring the same plant.

Incremental cost: is the addition to costs resulting from a change in the nature of level of
business activity. Change in cost caused by a given managerial decision.

Explicit cost: Cost actually paid by the firm. If the factors of production are hired or rented then
it is an explicit cost.

Implicit cost: If the factors of production are owned by a firm then its cost is implicit cost.

Book cost: Costs which do not involve any cash payments but a provision is made in the books
of accounts in order to include them in the profit and loss account to take tax advantages.
Social cost: total cost incurred by the society on account of production of a good or service.
Transaction cost: The cost associated with the exchange of goods and services.

Controllable cost: costs which can be controllable by the executives are called as controllable
cost.

Shut down cost: Cost incurred if the firm temporarily stops its operation. These can be saved
by continuing business.

Economic costs are related to future. They play a vital role in business decisions as the costs
considered in decision - making are usually future costs. They are similar in nature to that of
incremental, imputed explicit and opportunity costs.

Determinants of Short –run cost

Fixed cost: some inputs are used over a period of time for producing more than one batch of
goods. The costs incurred in these are called fixed cost. For example amount spent on purchase
of equipment, machinery, land and building.

Variable cost: when output has increased the firm spends more on these items. For example the
money spent on labour wages, raw material and electricity usage. Variable costs vary according
to the output. In the long run all costs become variable.

Total cost: The market value of all resources used to produce a good or service.
Total Fixed cost: Cost of production remains constant whatever the level of output.
Total Variable cost: Cost of production varies with output.
Average cost: Total cost divided by the level of output.
Average variable cost: Variable cost divided by the level of output.
Average fixed cost: Total fixed cost divided by the level of output.
Marginal cost: Cost of producing an extra unit of output.
Short run cost output relationship
Fixed cost curve is a horizontal line which is parallel to the ‘X’ axis. This cost is constant

with respect to output in the short run. Fixed cost does not change with output. It must be paid

even if ‘0’ units of output are produced. For example: if you have purchased a building for the

business you have invested capital on building even if there is no production. Total fixed cost

(TFC) consists of various costs incurred on the building, machinery, land, etc.. For example if

you have spent Rs. 2 Lakhs and bought machinery and building which is used to produce more

than one batch of commodity, then the same cost of Rs. 2 Lakhs is fixed cost for all batches. The

total variable costs vary according to the output. Whenever the output increases the firm has to

buy more raw materials, use more electricity, labour and other sources therefore the TVC curve

is upward sloping. The total cost consists of fixed (TFC) and variable costs (TVC). The TFC of

Rs. 2 Lakhs is included with the variable cost throughout the production schedule so the total

cost (TC) is above the TVC line.

Graph – Total cost curves

Y
TC
COST OF PRODUCTION

TVC

TFC

O OUTPUT X
 Graph – Average cost curves
MC
Y

AC

AC / MC / AFC

AFC

O X
Out Put

The above set of graphs indicates clearly that the average variable cost curve looks like a

boat. Average fixed cost curve declines as output increases and it is a hyperbola to the origin.

The Marginal cost curve slopes like a tick mark which declines up to an extent then it starts

increasing along with the output. Let us see and understand the nature of each and every curve

with an example. The table and graphs shown below indicates the total costs curves and average

cost curves at various output level.

Table - cost schedule

(Rupees in thousands ‘000)

Output TC TFC TVC AFC ATC AVC MC
0 1200 300 - - - - -
1 1800 300 1500 300 1800 1500 600
2 2000 300 1700 150 1000 850 200
3 2100 300 1800 100 700 600 100
4 2250 300 1950 75 562.5 487.5 150
5 2600 300 2300 60 520 460 350
6 3300 300 3000 50 550 500 700
 Graph – Average cost curves
2000

1800

1600

1400

1200
AFC
1000
ATC
800 MC
600

400

200

0
1 2 3 4 5 6

Graph – Total cost curves

3500

3000

2500

2000
TC

1500 TFC
TVC
1000

500

0
1 2 3 4 5 6 7
 From the above table and set of graphs we can understand that capital is the fixed factor

of production and the total fixed cost will be the same Rs. 300,000. The total variable cost will

increase as more and more goods are produced. So the total variable cost TVC of producing

1 unit is Rs.1500 000, for 2 units 1700 000 and so on.

Total cost = TFC + TVC for 1 unit TC = 300 + 1500 = 1800.

The marginal cost of producing an extra unit is calculated based on the difference in total cost.

MCn = TCn – TC n-1

MC2 = TC2 – TC 2-1 = 2000 – 1800 = 200

MC for 5th unit = TC of 5th unit minus TC of 4th unit, in our example 2600 – 2250 = 350.

AVC also is calculated in the same manner TVC / output = 2600 / 5 = 460
AFC = TFC / output = 300 / 5 = 60.

Relationship between Marginal Cost and Average Cost curve:

The marginal cost and average cost curves are U shaped because of law of diminishing

returns. The marginal cost curve cuts the average cost curve and average variable cost curves at

their lowest point. Marginal cost curve cuts the average variable cost from below. The AC curve

is above the MC curve when AC is falling. The AC curve is below the MC when AC is

increasing. The intersecting point indicates that AC=MC and that is the minimum average cost

with an optimum output. (No more output can be produced at this average cost without

increasing the fixed cost of production)

 Graph – Relationship between Average Cost and Marginal cost

Y
MC

AC
COST OF PRODUCTION

O
Out Put X

Optimum output and minimum cost

The MC and AC curves are mirror image of the MP and AP curves. It is presented in the

graph below.

All organizations aim for maximum output with minimum cost. To achieve this goal they

like to derive the point where optimum output can be produced with the given amount of input

factors and with a minimum average cost. In the graph the MP=AP at maximum average

production. On the other hand MC = AC at minimum average variable cost. Therefore this is the

optimum output to be produced to achieve their managerial goals.

 Graph – Optimum cost and output
INPUT FACTORS

AP

MP
O
MC
COST OF PRODUCTION

AC

O Out Put

The above set of cost curves explain the cost output relationship in the short period but in

the long run there is no fixed cost because all costs vary over a period of time. Therefore in the

long run the firm will have only average cost curve that is called as long run average cost curve

(LAC). Let us see how the average cost curve is derived in the long run. This LAC also slopes

like the short period average cost curve (U shaped) provided the law of diminishing returns

prevails. In case the returns to scale are increasing or constant then the LAC curve will have a

different slope. It will be a horizontal line, which is parallel to the ‘X’ axis.
Cost output relationship in the Long run

In the long run costs fall as output increases due to economies of scale, consequently the

average cost AC of production falls. Some firms experience diseconomies of scale if the average

cost begins to increase. This fall and rise derives a U shaped or boat shaped average cost curve in

the long run which is denoted as LAC. The minimum point of the curve is said to be the

optimum output in the long run. It is explained graphically in the chart given below.

Graph – Long run Average Cost Curve

LAC
SMC1

E
C A SAC1 SAC2
AC / MC /LAC

C1
B
C2

O M M1 M2 X

Out Put

In the long run all factors are variable and the average cost may fall or increase to A, B

respectively but all these costs are above the long run cost average cost. LAC is the lower

envelope of all the short run average cost curves because it contains them all. At point ‘E’ the
SAC1 and SMC1 intersects each other, in case the organization increases its output from OM to

OM1 they have to spend OC1 amount. In case the organization purchases one more machine

(increase in fixed cost) then they will get a new set of cost curves SAC2, and SMC2. But the new

average cost curve reduces the cost of production from OC1 to OC2.That means they can save

the difference of C1C2 which is nothing but AB. Therefore in the long run due to business

expansion a firm can reduce their cost of production. During their business life they will meet

many combinations of optimum production and minimum cost in different short periods. In the

long run due to law of diminishing returns the long run average cost curve LAC also slopes like

boat shape.

Economies of scale

Economies of scale exist when long run average costs decline as output is increased.

Diseconomies of scale exist when long run average cost rises as output is increased. It is

graphically presented in the following graph. The economies of scale occur because of (i)

technical economies: the change in production process due to technology adoption. (ii)

Managerial economies (iii) purchasing economies, (iv) marketing economies and (v) financial

economies.

Economies of scale means a fall in average cost of production due to growth in the size of the

industry within which a firm operates.

Diseconomies of scale: arises due to managerial problems. If the size of the business becomes

too large, then it becomes difficult for management to control the organizational activities

therefore diseconomies of scale arise.

 Graph – Economies of Scale and Diseconomies of scale

LRAC
SMC1 SAC3

SAC1
AC / MC / AFC

SAC2

Diseconomies
Economies of
of scale
scale

O M X

Out Put

Factors causing Economies of Scale:

There are various factors influencing the economies of scale of an organization. They are
generally classified in to two categories as Internal factors and External factors.

Internal Factors:

1. Labour economies: if the labour force of a firm is specialized in a specific skill then the
organization can achieve economies of scale due to higher labour productivity.
2. Technical economies: with the use of advanced technology they can produce large quantities
with quality which reduces their cost of production.
3. Managerial economies: the managerial skills of an organization will be advantageous to
achieve economies of scale in various business activities.
4. Marketing economies: use of various marketing strategies will help in achieving economies
of scale.
5. Vertical integration: if there is vertical integration then there will be efficient use of raw
material due to internal factor flow.
6. Financial economies: the firm’s financial soundness and past record of financial transactions
will help them to get financial facilities easily.
7. Economies of risk spreading: having variety of products and diversification will help them
to spread their risk and reduce losses.
8. Economies of scale in purchase: when the organization purchases raw material in bulk
reduces the transportation cost and maintains uniform quality.

External factors:
1. Better repair and maintenance facilities: When the machinery and equipments are repaired
and maintained, then the production process never gets affected.
2. Research and Development: research facilities will provide opportunities to introduce new
products and process methods.
3. Training and Development: continuous training and development of skills in the managerial,
production level will achieve economies of scale.
4. Economies of location: the plant location plays a major role in cutting down the cost of
materials, transport and other expenses.
5. Economies of Information Technology: advanced Information technology provides timely
accurate information for better decision making and for better services.
6. Economies of by-products: Organizations can increase the economies of scale by
minimizing waste and can be environmental responsible by using the by- products of the
organization.

Factors causing Diseconomies of scale:

1. Labour union: continuous labour problem and dissatisfaction can lead to diseconomies of
scale.
2. Poor team work: Poor performance of the team leads to diseconomies of scale.
3. Lack of co-ordination: lack of coordination among the work force has a major role to play in
causing diseconomies of scale.
4. Difficulty in fund raising: difficulties in fund raising reduce the scale of operation.
5. Difficulty in decision making: the managerial inability, delay in decision making is also a
factor that determines the economies of scale.
6. Scarcity of Resources: raw material availability determines the purchase and price.
Therefore there is a possibility of facing diseconomies in firms.
7. Increased risk: growing risk factors can cause diseconomies of scale in an organization. It is
essential to reduce the same.

Constant returns to scale:

In the long run if the returns to scale are constant then the average cost of production will

be the same. For example : Ananda Vikatan magazine, started 100 years ago and it was sold in

the market for 25 paise but now it is still sold at a nominal cost of Rs.15. The price increased

because raw material cost and printing and labour costs have also increased but in the long run

the price of the commodity has not increased much.

The constant returns to scale curve is graphically presented below which indicates that

the LRAC is not a boat shaped curve.

SMC1
SAC1 SAC2 SAC3 SAC4

C LRAC
AC / MC

O M X

Out Put
From the above graph it is clear that in the long run it is possible to derive a LRAC as a straight
line with constant returns to scale.

Economies of scope: producing variety to get cost advantage. In retail business it is commonly

used. Product diversification within the same scale of plant will help them to achieve success.

Lessons for managers:

 To achieve reasonable return the firm should go for larger plants or expandtheir plant for
optimum utilization of available resources.
 Build market share to achieve the scale which in turn reduces the cost of production.
 All business activities of the organization leads to economies of scale directly or
indirectly.

Review Questions:

1. What is Marginal cost? State its significance in cost analysis.

2. Define opportunity cost and give an example.
2. Explain the concepts: AFC, AVC, ATC and MC.
3. Explain briefly the various types of costs with suitable examples.
4. Discuss the short run cost output relationship with the graph.
5. Derive long run total cost curve.
6. What is the relationship between AC and MC?
7. Give reasons for the U shape of long run AC curve.
8. Distinguish between economies of scale and diseconomies of scale with a graph.
9. List out the factors that cause economies and diseconomies of scale.
 BREAK EVEN ANALYSIS

Break even analysis helps to identify the level of output and sales volume at which the firm

‘breaks even’. It means the revenues are sufficient to cover all costs of production. Various

managerial decisions of firms are taken by the managers based on the break- even point.

It is a study of cost, revenues and sales of a firm and finding out the volume of sales where the

firm’s costs and revenues will be equal. There is no profit and no loss. The total revenue is equal

to the total cost of production. The amount of money which the firm receives by the sale of its

output in the market is known as revenue.

Graph – Break even point

The above graph shows the break- even point of an organization. The total revenue curve (TR)

and total cost curve (TC) is given. When they produce 50 units the total cost and total revenue

are equal that is $ 150’000 which is at the intersecting point of the curves. Break even point

always denotes the quantity produced or sold to equalize the revenue and cost.

When the firm produces less than 50 units the revenue earned is less than the cost of production

(TR<TC) therefore in the initial period the firm incurs loss which is shown in the graph. Through

selling more than 50 units the revenue increases more than the cost of production therefore the

difference increases and provides profit to the organization (TR>TC). It can be calculated with

the help of the following formula.

TFC
Break even quantity = -----------------------
Selling Price - AVC

TFC + targeted profit

To decide a quantity to achieve a targeted profit = --------------------------
Selling price – AVC
Sales - BEP
Safety margin = ---------------------- X 100
Sales
Managerial Uses of Break-Even Analysis:

1. Product planning: it helps the firm in planning its new product development. Decisions
regarding removal or addition of new products in their product line.
2. Activity planning: the firm decides the expansion of production capacity.
3. Profit planning: this helps the firm to plan about their profit well in advance and at the same
time it helps to identify the quantity to be sold to achieve the targeted profit.
4. Target capacity: the targeted sales quantity helps to decide the purchase, inventory and
management.
5. Price and cost decision: Decision regarding how much the price of the commodity should be
reduced or increased to cover their cost of production.
6. Safety margin: it helps to understand the extent to which the firm can withstand their fall in
sales.
7. Price decision: the selling price can be fixed based on its expected revenue or profit.
8. Promotional decision: the firm can decide the kind of promotion required and how much
amount could be spent.
9. Distribution decision: Break even analysis helps to improve the distribution system and for
business expansion.
10. Dividend decision: firm can decide the dividend to be fixed for their shareholders.
11. Make or buy decision: break even analysis helps to decide on whether to make or buy the
product. It means outsourcing or in house production.

We can conclude that the break – even analysis is a useful tool for decision making at various

levels of a business firm in the short and long run. Therefore it is an essential tool to be used by

the Managers.

Review Questions:
1. What is Break- even point?
2. Explain the important managerial uses of break even analysis.