UNIT – II

THEORY OF PRODUCTION AND COST ANALYSIS

Introduction to Production Cost:-

Production cost refers to the expenses incurred in creating goods or services. It includes costs related to
raw materials, labor, equipment, utilities, and overhead. Understanding production costs is essential for
businesses to determine pricing, manage profitability, and make informed decisions about their
operations. Different industries and businesses have varying production cost structures based on factors
like economies of scale, technology, and market conditions.

Nature of production cost:-

The nature of production costs can be classified into several categories:
1. Interdisciplinary Nature:
This analysis draws from various fields such as economics, accounting, finance, and operations
management. It combines economic theories, financial principles, and operational concepts to
provide a comprehensive understanding of production and cost dynamics.
2. Short-term and Long-term Perspectives:
Production and cost analysis takes into account both short-term and long-term perspectives.
Short-term analysis focuses on immediate decisions like pricing and output adjustments, while
long-term analysis considers factors like capital investments, technology upgrades, and
economies of scale.
3. Cost Classification:
One of the foundational aspects of this analysis is the classification of costs. Costs are categorized
into fixed costs (remain constant regardless of production levels), variable costs (change with
production quantities), and semi-variable costs (partly fixed and partly variable).
4. Comparative Analysis:
Businesses often compare different production methods, technologies, or input combinations to
identify the most cost-efficient approach. Comparative analysis helps in making choices that
optimize resources.
5. Decision Support:
Production and cost analysis provides crucial information for managerial decision-making. It
aids in choosing production levels, pricing strategies, cost reduction measures, and investment
decisions.
6. Cost-Volume-Profit Relationship:
The interaction between production volume, costs, and profit is at the heart of this analysis.
Understanding how changes in these variables impact each other helps businesses determine their
break-even points and profit potential.
7. Profit Maximization:
Ultimately, the goal of production and cost analysis is to help businesses maximize profits. By
finding the optimal production levels that balance revenue and costs, organizations can work
toward achieving their financial objectives.
Significance of production cost:-
The significance of production costs is paramount for businesses and decision-makers due to several
reasons:

1. Pricing Strategy: Production costs are a fundamental factor in setting prices for goods and
services. Businesses need to ensure that the prices they charge cover their production expenses
while remaining competitive in the market.
2. Profitability Analysis: By accurately calculating production costs, businesses can determine their
profit margins on products or services. This information is crucial for evaluating the financial
health of the company and making informed decisions.
3. Cost Control and Efficiency: Understanding production costs helps identify areas where cost-
saving measures can be implemented. This might involve optimizing processes, reducing waste,
or negotiating better deals with suppliers.
4. Budgeting and Financial Planning: Accurate knowledge of production costs enables effective
budgeting and financial forecasting. Businesses can allocate resources more effectively and plan
for future growth and investment.
5. Resource Allocation: With insights into production costs, businesses can allocate resources, such
as labor and materials, more efficiently to maximize productivity and minimize waste.
6. Investment Decisions: When considering new equipment, technology, or expansion,
understanding production costs helps assess the potential return on investment and the impact on
overall operations.
7. Competitive Strategy: Businesses can gain a competitive advantage by strategically analyzing
production costs. This might involve differentiating based on cost leadership or focusing on
value-added services.
8. Negotiation Power: Knowledge of production costs empowers businesses when negotiating with
suppliers, vendors, and contractors, leading to more favorable terms and agreements.
9. Risk Management: Accurate cost analysis allows businesses to assess the impact of external
factors like fluctuations in raw material prices or changes in market demand, helping to mitigate
risks.

Advantages of production cost:-

Production costs offer several advantages to businesses and decision-makers:

Pricing Accuracy: Production costs provide a solid foundation for setting accurate and competitive
prices for products or services, ensuring that they cover expenses and contribute to profitability.

Profitability Assessment: By comparing production costs with revenues, businesses can gauge the
profitability of individual products, services, or projects, aiding in effective resource allocation.

Cost Control: Understanding production costs helps identify areas where costs can be reduced or
eliminated, leading to increased efficiency, lower expenses, and improved margins.

Budgeting and Planning: Accurate production cost data allows for better budgeting and financial
planning, helping businesses allocate resources effectively and make informed investment decisions.
Resource Allocation: Knowledge of production costs assists in allocating labor, materials, and other
resources more efficiently, leading to improved productivity and reduced waste.

Performance Evaluation: Monitoring actual production costs against projected costs enables businesses
to evaluate the effectiveness of management decisions and operational strategies.

Risk Management: Understanding production costs helps assess the impact of external factors on
operations, enabling better risk mitigation and contingency planning.

Strategic Decision-Making: Production cost data informs strategic choices such as expansion, market
entry, and technology adoption, contributing to better-informed decisions.

Negotiation Power: Armed with accurate production cost information, businesses can negotiate better
terms with suppliers, contractors, and vendors, leading to cost savings.

Competitive Advantage: Effective cost management based on production cost analysis can lead to a
cost leadership advantage in the market, making a business more competitive.

Innovation and Efficiency: Knowledge of production costs can inspire innovation by encouraging the
development of new products, processes, or technologies that reduce costs or improve quality.

Investment Evaluation: When considering investments, production costs provide insights into potential
returns and risks, aiding in decision-making.

FACTORS OF PRODUCTION:-
Land
Land has a broad definition as a factor of production and can take on various forms, from agricultural
land to commercial real estate to the resources available from a particular piece of land. Natural
resources, such as oil and gold, can be extracted and refined for human consumption from the land.

Cultivation of crops on land by farmers increases its value and utility. While land is an essential
component of most ventures, its importance can diminish or increase based on industry. For example, a
technology company can easily begin operations with zero investment in land. On the other hand, land is
the most significant investment for a real estate venture.

Labor
Labor refers to the effort expended by an individual to bring a product or service to the market. Again, it
can take on various forms. For example, the construction worker at a hotel site is part of labor, as is the
waiter who serves guests or the receptionist who enrolls them into the hotel. Skilled and trained workers
are called “human capital” and are paid higher wages because they bring more than their physical
capacity to the task.

For example, an accountant’s job requires the analysis of financial data for a company. Countries that
are rich in human capital experience increased productivity and efficiency. The difference in skill levels
and terminology also helps companies and entrepreneurs create corresponding disparities in pay scales.
This can result in a transformation of factors of production for entire industries. An example of this is
the change in production processes in the information technology (IT) industry after jobs were
outsourced to countries with lower salaries.

Capital
In economics, capital typically refers to money. However, money is not a factor of production because it
is not directly involved in producing a good or service. Instead, it facilitates the processes used in
production by enabling entrepreneurs and company owners to purchase capital goods or land or to pay
wages. For modern mainstream (neoclassical) economists, capital is the primary driver of value.

It is important to distinguish personal and private capital in factors of production. A personal vehicle
used to transport family is not considered a capital good, but a commercial vehicle used expressly for
official purposes is. During an economic contraction or when they suffer losses, companies cut back on
capital expenditure to ensure profits. However, during periods of economic expansion, they invest in
new machinery and equipment to bring new products to market.

As a factor of production, capital refers to the purchase of goods made with money in production. For
example, a tractor purchased for farming is capital. Along the same lines, desks and chairs used in an
office are also capital.

Entrepreneurship
Entrepreneurship is the secret sauce that combines all the other factors of production into a product or
service for the consumer market. An example of entrepreneurship is the evolution of the social media
behemoth Meta (META), formerly Facebook.

Mark Zuckerberg assumed the risk for the success or failure of his social media network when he began
allocating time from his daily schedule toward that activity. When he coded the minimum viable product
himself, Zuckerberg’s labor was the only factor of production. After Facebook, the social media site,
became popular and spread across campuses, it realized it needed to recruit additional employees. He
hired two people, an engineer (Dustin Moskovitz) and a spokesperson (Chris Hughes), who both
allocated hours to the project, meaning that their invested time became a factor of production.

Technology

Though technology isn’t the fifth factor officially, many consider it to be one. In the current world,
technology plays a very important role in coming up with a product or service.

Technology is a very broad term. It could include software, hardware, or a combination of two to make
the production process more efficient. So, it won’t be wrong to say that technology helps in the efficient
utilization of all four factors of production. For instance, the use of robots in production can help a
company to raise productivity, as well as reduce costs. Technology also helps an entrepreneur to make
better decisions.

PRODUCTION FUNCTION:-

Samuelson define the production function as “the technical relationship which reveals the
maximum amount of output capable of being produced by each and every set of inputs”

Michael define production function as “that function which defines the maximum amount of output that
can be produced with a given set of inputs”.
 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)

Where Q is the quantity of production, F explains the functions, that is, the type of relation
between inputs and outputs , L1,L2,C,.O,T refer to land, labout, capital, organization and technology
respectively. These inputs have been taken in conventional terms. In reality, material also can be included
in a set of inputs.

A manufacturer has to make a choice of the production function by considering his technical
knowledge, the process of various factors of production and his efficiency level to manage. He should not
only select the factors of production but also should work out the different permutations and
combinations which will mean lower cost of inputs for a given level of production.

In case of an agricultural product, increasing the other factors of production can increase the
production, but beyond a point, increase output can be had only with increased use of agricultural land,
investment in land forms a significant portion of the total cost of production for output, whereas, in the
case of the software industry, other factor such as technology , capital management and others
become significant. With change in industry and the requirements the production function also needs to
be modified to suit to the situation.

Production Function with One Variable Input :-

The laws of returns states that when at least one factor of production is fixed or factor input is fixed
and when all other factors are varied, the total output in the initial stages will increase at an increasing rate,
and after reaching certain level or output the total output will increase at declining rate. If variable factor
inputs are added further to the fixed factor input, the total output may decline. This law is of universal nature
and it proved to be true in agriculture and industry also. The law of returns is also called the law of variable
proportions or the law of diminishing returns.

Definition According to G. Stigler

“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”.

According to F. Benham

“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”.
 Marginal
Units of
Total product Average
labour Stages
production(tp) (mp) product (ap)

0 0 0 0
1 10 10 10
Stages 1
2 22 12 11
3 33 11 11
4 40 7 10
Stages 2
5 45 5 9
6 48 3 8
7 48 0 6.85
Stages 3
8 45 -3 5.62

From the above graph the law of variable proportions operates in three stages. 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 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.
Production Function With Two Variable Inputs And Laws Returns:-
Production process that requires two inputs, capital and labour (L) to produce a given output (Q).
There could be more than two inputs in a real life situation, but for a simple analysis, we restrict
the number of inputs to two only. In other words, the production function based on two inputs can be
expressed as

Q = f( C,L)

Where C= capital , L = labour,

Normally, both capital and labour are required to produce a product. To some extent, these two
inputs can be substituted for each other. Hence the producer may choose any combination of labour and
capital that gives him the required number of units of output, for any one combination of labour and
capital out of several such combinations. The alternative combinations of labour and capital yielding a
given level of output are such that if the use of one factor input is increased , that of another will decrease
and vice versa. However, the units of an input foregone to get one unit of the other input changes,
depends upon the degree of substitutability between the two input factors, based on the techniques or
technology used, the degree of substitutability may vary.

Functions of the Production Function:

1. Input-Output Relationship: It defines the relationship between inputs (like labor, capital, and raw
materials) and the output produced. This relationship helps businesses understand how much output can
be generated with varying levels of inputs.

2. Efficiency Measurement: The production function allows firms to assess how efficiently they are
utilizing their resources. By analyzing this function, businesses can identify areas where they can
improve efficiency.

3. Cost Analysis: It plays a crucial role in understanding production costs. Firms can evaluate how
changes in output levels affect their costs, which is essential for pricing strategies and budgeting.

4. Optimal Resource Allocation: The production function helps firms determine the best combination of
inputs to maximize output, guiding decisions on how to allocate resources effectively.

5. Forecasting Production: It can be used to predict future production levels based on anticipated
changes in input usage, aiding businesses in planning for growth.

Advantages of the Production Function:

1. Decision-Making Tool: It serves as a framework for making informed production decisions. Firms
can analyze various scenarios and choose the most efficient production methods.

2. Understanding Returns to Scale: The production function helps firms comprehend how output
changes when all inputs are increased proportionally, which is vital for scaling operations.

3. Identifying Bottlenecks: By examining inputs and outputs, businesses can pinpoint bottlenecks in
their production processes and make adjustments to enhance efficiency.
4. Profit Maximization: A clear understanding of the production function enables firms to optimize
production processes, which helps in minimizing costs and maximizing profits.

5. Economic Analysis: It is a key element in economic theories, aiding economists in understanding and
predicting market behaviors and economic dynamics.

ISO - QUANTS

The term Isoquants is derived from the words iso and quant – Iso means equal and quent
implies quantity. Isoquant therefore, means equal quantity. Isoquant are also called iso-product curves, an
isoquant curve show various combinations of two input factors such as capital and labour, which yield
the same level of output.

As an isoquant curve represents all such combinations which yield equal quantity of output, any or every
combination is a good combination for the manufacturer. Since he prefers all these combinations equally
an isoquant curve is also called product indifferent curve.

An isoquant may be explained with the help of an arithmetical example

Capital
Combinations Labour (units) Output (quintals)
(Units)
A 1 10 50

B 2 7 50

C 3 4 50

D 4 2 50

E 5 1 50

Combination A represent 1 unit of labour and 10 units of capital and produces 50 quintals of a
product all other combinations in the table are assumed to yield the same given output of a product say
50 quintals by employing any one of the alternative combinations ofthe two factors labour and capital.
If we plot all these combinations on a paper and join them, we will get continues and smooth curve
called Iso-product curve as shown below.
 Labour is on the X-axis and capital is on the Y-axis. IQ is the ISO-Product curve, which
shows all the alternative combinations A, B, C, D, E which can produce 50 quintals of a product.

Features of isoquant:-
1. Downward sloping: isoquant are downward sloping curves because , if one input increase, the
other one reduces. There is no question of increase in both the inputs to yield a given output. A degree of
substitution is assumed between the factors of production. In other words, an isoquant cannot be
increasing, as increase in both the inputs does not yield same level of output. If it is constant, it means that
the output remains constant through the use of one of the factor is increasing, which is not true, isoquant
slope from left to right.

2. Convex to origin: isoquant are convex to the origin. It is because the input factors are not perfect
substitutes. One input factor can be substituted by other input factor in a diminishing marginal rate. If the
input factors were perfect substitutes, the isoquant would be a falling straight line. When the inputs are
used in fixed proportion, and substitution of one input for the other cannot take place, the isoquant will be
L shaped

3. Do not intersect: two isoquant do not intersect with each other. It is because, each of these denote a
particular level of output. If the manufacturer wants to operate at a higher level of output, he has to
switch over to another isoquant with a higher level of output and vice versa.

4. Do not axes: the isoquant touches neither X-axis nor Y- axis, as both inputs are required to produce
a given product.

ISO COST:-

Iso cost refers to that cost curve that represents the combination of inputs that will cost the
producer the same amount of money. In other words, each isocost denotes a particular level of total cost
for a given level of production. If the level of production changes, the total cost changes and thus the
isocost curve moves upwards, and vice verse.

Isocost curve is the locus traced out by various combinations of L and K, each of which costs the
producer the same amount of money (C ) Differentiating equation with respect to L, we have dK/dL =
-w/r this gives the slope of the producer’s budget line (isocost curve). Iso cost line shows various
combinations of labour and capital that the firm can buy for a given factor prices. The slope of iso cost
line = PL/Pk. In this equation, PL is the price of labour and Pk is the price of capital. The slope of
iso cost line indicates the ratio of the factor prices. A set of isocost lines can be drawn for different levels
of factor prices, or different sums of money. The iso cost line will shift to the right when money spent on
factors increases or firm could buy more as the factor prices are given.

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 ofisocost lines as shown in the figure.
Least Cost Combination of Inputs
The manufacturer has to produce at lower costs to attain higher profits. The isocost and isoquants
can be used to determine the input usage that minimizes the cost of production. Where the slope of
isoquant is equal to that of isocost, there lies the lowest point of cost of production. This can be
observed by superimposing the isocosts on iso-product curves. It is evident that the producer can, with a
total outlay.

The firm can achieve maximum profits by choosing that combination of factors whichwill cost
it the least. The choice is based on the prices of factors of production at a particular time. The firm
can maximize its profits either by maximizing the level of output for a given cost or by minimizing
the cost of producing a given output. In both cases the factors will have to be employed in optimal
combination at which the cost of production will be minimum. The least cost factor combination can
be determined by imposing the isoquant map on isocost line. The point of tangency between the
isocost and an isoquant is an important but not a necessary condition for producer’s
equilibrium. The essential condition is that the slope of the isocost line must equal the slope of the
isoquant. Thus at a point of equilibrium marginal physicalproductivities of the two factors must be equal
the ratio of their prices. The marginal physical product per rupee of one factor must be equal to that of
the other factor. And isoquant must be convex to the origin. The marginal rate of technical substitution
of labour for capital must bediminishing at the point of equilibrium.
Cobb-Douglas production function
The Cobb-Douglas production function is based on the empirical study of the American manufacturing
industry made by Paul H. Douglas and C.W. Cobb. It is a linear homogeneous production function of
degree one which takes into account two inputs, labour and capital, for the entire output of the
manufacturing industry.

The Cobb-Douglas production function is expressed as:

Q = A.LαKβ
Where Q is output and L and K are inputs of labour and capital respectively. A, α and β are positive
parameters where = α> 0, β > 0.

The conclusion drawn from this famous statistical study is that labour contributed about 3/4 th and capital
about 1/4th of the increase in the manufacturing production.

α + β = 1 (Constant Returns to scale)

α + β > 1 (Increasing Returns to scale)

α + β < 1 (Decreasing Returns to scale)

Assumptions:

It has the following assumptions

1. The function assumes that output is the function of two factors viz. capital and labour.
2. It is a linear homogenous production function
3. There are constant returns to scale
4. All inputs are homogenous
5. There is perfect competition
6. There is no change in technology

Marginal Rate of Technical Substitution

The marginal rate of technical substitution (MRTS) refers to the rate at which one input factor is
substituted with the other to attain a given level of output. In other words, the lesser units of one input
must be compensated by increasing amounts of another input to produce the same level of output.

Isoquants are typically convex to the origin reflecting the fact that the two factors are substitutable
for each other at varying rates. This rate of substitutability is called the “marginal rate of technical
substitution” (MRTS) or occasionally the “marginal rate of substitution in production”. It measures the
reduction in one input per unit increase in the other input that is just sufficient to maintain a constant
level of production. For example, the marginal rate of substitution of labour for capital gives the amount
of capital that can be replaced by one unit of labour while keeping output unchanged.
 To move from point A to point B in the diagram, the amount of capital is reduced from Ka to Kb
while the amount of labour is increased only from La to Lb. To move from point C to point D, the
amount of capital is reduced from Kc to Kd while the amount of labour is increased from Lc to Ld. The
marginal rate of technical substitution of labour for capital is equivalent to the absolute slope of the
isoquant at that point (change in capital divided by change in labour). It is equal to 0 where the isoquant
becomes horizontal, and equal to infinity where it becomes vertical.

The opposite is true when going in the other direction (from D to C to B to A). In this case we are
looking at the marginal rate of technical substitution capital for labour (which is the reciprocal of the
marginal rate of technical substitution labour for capital).

It can also be shown that the marginal rate of substitution labour for capital, is equal to the
marginal physical product of labour divided by the marginal physical product of capital.

LAW OF RETURNS TO SCALE

There are three laws of returns governing production function. They are

1. Law of increasing returns to scale

This law states that the volume of output keeps on increasing with every increase in the inputs,.
Where a given increase in inputs leads to a more than proportionate increase in the output, the law of
increasing returns to scale is said to operate. We can introduce division of labour and other
technological means to increase production. Hence, the totalproduct increases at an increasing rate.
2. Law of constant returns to scale
When the scope for division of labour gets restricted, the rate of increase in the total output remains
constant, the law of constant returns to scale is said to operate, this law states that the rate of
increase/decrease in volume of output is same to that of rate of increase/decrease in inputs.
3. Law of decreasing returns to scale
Where the proportionate increase in the inputs does not lead to equivalent increase in output, the
output increases at a decreasing rate, the law of decreasing returns to scale is said to operate. This
results in higher average cost per unit.
 INPUTS TOTAL PRODUCT MARGINAL PRODUCT
1 4 4
2 10 6
3 18 8
4 28 10
5 38 10
6 48 10
7 56 8
8 62 6
9 66 4

ECONOMIES OF SCALE:
Economies of scale are cost advantages reaped by companies when production becomes efficient.
Companies can achieve economies of scale by increasing production and lowering costs. This happens
because costs are spread over a larger number of goods. Costs can be both fixed and variable.
Advantages or benefits that acquire to a firm as a result of increasing in the scale of production or
maximization of profits.
Economies of Scale is of two types
1. Internal Economies of Scale
2. External Economies of Scale

INTERNAL ECONOMIES OF SCALE

INTERNAL ECONOMIES refer to the economies all the development which you do inside your
company. The internal economies occur as a result of increase in the scale of production. Enjoy the
benefits by the large firms.

1. Managerial Economies: as the firm expands, the firm needs qualified managerial personnel to
handle each of its functions marketing, finance, production, human resources and others in a
professional way. Functional specialization ensure minimum wastage and lowers the cost of
production in the long –run.
2. Commercial Economies: the transaction of buying and selling raw material and other
 operating supplies such as spares and so on will be rapid and the volume ofeach transaction also
grows as the firm grows, there could be cheaper savings in the procurement, transportation and storage cost,
this will lead to lower costs and increased profits.
3. Financial Economies: The large firm is able to secure the necessary finances either for block capital
purposes or for working capital needs more easily and cheaply. It can barrow from the public, banks
and other financial institutions at relatively cheaper rates. It is in this way that a large firm reaps
financial economies.
4. Technical Economies: Technical economies arise to a firm from the use of better machines
and superior techniques of production. As a result, production increases and per unit cost of
production falls. A large firm, which employs costly and superior plant and equipment, enjoys a
technical superiority over a small firm. Another technical economy lies in the mechanical advantage
of using large machines. The cost of operating large machines is less than that of operating mall
machine. More over a larger firm is able to reduce it‟s per unit cost of production by linking the
various processes of production. Technical economies may also be associated when the large firm is
able to utilize all its waste materials for the development of by-products industry. Scope for
specialization is also available in a large firm. This increases the productive capacity of the firm and
reduces the unit cost of production.
5. Marketing Economies: The large firm reaps marketing or commercial economies in buying its
requirements and in selling its final products. The large firm generally has a separate marketing
department. It can buy and sell on behalf of the firm, when the market trends are more favorable. In
the matter of buying they could enjoy advantages like preferential treatment, transport concessions,
cheap credit, prompt delivery and fine relation with dealers. Similarly it sells its products more
effectively for a higher margin of profit.
6. Risk Bearing Economies: The large firm produces many commodities and serves wider areas. It is,
therefore, able to absorb any shock for its existence. For example, during business depression, the
prices fall for every firm. There is also a possibility for market fluctuations in a particular product of
the firm. Under such circumstances the risk- bearing economies or survival economies help the
bigger firm to survive business crisis.
7. Economics of Research And Development: large organizations such as Dr.Reddys labs, Hindustan
Lever spend heavily on research and development and bring out several innovative products. Only
such firms with a strong research and development base can cope with competition globally.

EXTERNAL ECONOMIES OF SCALE:

External economics refer to all the firms in the industry, because of growth of the industry as a whole or
because of growth of ancillary industries, advantages or benefits obtained by our firm because of other
firms of similar products. External economies benefit all the firms in the industry as the industry
expands. This will lead to lowering the cost of production and thereby increasing the profitability.

1. Locational Economies: Firms often locate in areas where they can easily access the inputs they need
for production. As mentioned earlier, external economies of scale can result from businesses clustering
together in a certain location. This can lead to cost savings and increased efficiency for individual firms
due to shared infrastructure, skilled labor.
2. Economies of Concentration: When an industry is concentrated in a particular area, all the member
firms reap some common economies like skilled labour, improved means of transport and
communications, banking and financial services, supply of power and benefits from subsidiaries. All
these facilities tend to lower the unit cost of production of all the firms in the industry.
3. Economies of Research And Development: all the firms can pool resources to finance research and
development activities and thus share the benefits of research. There could be a common facility to shares
journals, newspapers and other valuable reference material of common interest.
4. Economies of Welfare: there could be common facilities such as canteen, industrial housing,
community halls, schools and colleges, employment burearu, hospitals and so on, which can be used in
common by the employees in the whole industry.
5. Economies of Information: When several firms are located close to each other, they can access
perfect information on the prices of inputs. Since all firms purchase inputs from the same suppliers, the
latter cannot charge different prices from different firms. The elimination of discriminatory pricing
ensures that no firm pays a higher amount for inputs, and it reduces the overall average cost.
6. Economies of Innovation: Many firms prefer to set up their premises close to centers engaged in
research and development of efficient production methods. Firms can then quickly adapt to all
innovations developed by these centers in order to achieve greater efficiency in production and, therefore,
lower their costs.

Diseconomies of scale

Diseconomies of scale occur when an additional production unit of output increases marginal costs,
which results in reduced profitability. Instead of production costs declining as more units are produced
(which is the case with economies of scale), the opposite happens, and costs increase with the production
of each additional unit.

Causes of Diseconomies of Scale

Diseconomies of scale may result from several factors, including communication breakdown, lack of
motivation, lack of coordination, and loss of focus by the management and employees.

The cause of diseconomies of scale can rarely be attributed to one specific factor, but the following list
outlines the most common catalysts that often initiate a “domino effect” that negatively affects the
financial state of a company.
 Strategic Mistakes by Management Team

 Loss of Control in Organizational Structure

  Technical Difficulties

 Misalignment in Production Capacity and Market Demand (i.e. Capacity Constraint)

 Operational Disruption (“Bottlenecks”)

 Ineffective Communication Between Divisions

 Overlap in Business Functions (or Divisions)

 Loss of Employee Morale

 Reduction in Overall Workplace Productivity

While external factors, such as the prevailing economic conditions, can contribute to the occurrence of
diseconomies of scale, internal factors are more frequently the source of the problem.
For example, suppose a company’s management team decides to prioritize growth and achieving
scalability to reach new markets (and customers), without much consideration for the risks posed by such
corporate actions.
Occasionally, adopting that sort of mindset can work, but only if the management team truly understands
the risks beforehand and takes the precautionary measures to mitigate the risk.
Conclusion:
Economies of scale exist when long run average total cost decreases as output increases, Diseconomies of
scale occur when long run average total cost increases as output increases, and Constant returns to scale
occur when costs do not change as output increases.

COST:
Cost refers to the expenditure incurred to produce a particular product or services. All cost involves a
sacrifice of some kind or other to acquire some benefit. For example , if I want to eat food, I should be
prepared to sacrifice money.

Cost refers to the amount of expenditure incurred in acquiring something. In business firm, it refers to the
expenditure incurred to produce an output or provide service. Thus the cost incurred in connection with
raw material , labour, other heads constitute the overall cost
of production.

COST CONCEPTS:

A managerial economist must have a clear understanding of the different cost concepts for clear business
thinking and proper application. The several alternative bases of classifying cost and the relevance of
each for different kinds of problems are to be studied. The various relevant concepts of cost are:
1. Opportunity costs and outlay costs:

Out lay cost also known as actual costs obsolete costs are those expends which are actually incurred by
the firm these are the payments made for labour, material, plant, building, machinery traveling,
transporting etc., These are all those expense item appearing in the books of account, hence based on
accounting cost concept.

On the other hand opportunity cost implies the earnings foregone on the next best alternative, has the
present option is undertaken. This cost is often measured by assessing the alternative, which has to be
scarified if the particular line is followed. The opportunity cost concept is made use for long-run
decisions. This concept is very important in capital expenditure budgeting. This concept is very important
in capital expenditure budgeting.

2. Explicit and implicit costs:

Explicit costs are those expenses that involve cash payments. These are the actual or business costs that
appear in the books of accounts. These costs include payment of wages and salaries, payment for raw
materials, interest on borrowed capital funds, rent on hired land, Taxes paid etc.

Implicit costs are the costs of the factor units that are owned by the employer himself. These costs are not
actually incurred but would have been incurred in the absence of employment of self – owned factors.
The two normal implicit costs are depreciation, interest on capital etc. A decision maker must consider
implicit costs too to find out appropriate profitability of alternatives.

3. Historical and Replacement costs:

Historical cost is the original cost of an asset. Historical cost valuation shows the cost of an asset as the
original price paid for the asset acquired in the past. Historical valuation is the basis for financial
accounts.

A replacement cost is the price that would have to be paid currently to replace the same asset. During
periods of substantial change in the price level, historical valuation gives a poor projection of the future
cost intended for managerial decision. A replacement cost is a relevant cost concept when financial
statements have to be adjusted for inflation.

4. Short – run and long – run costs:

Short-run is a period during which the physical capacity of the firm remains fixed. Any increase in output
during this period is possible only by using the existing physical capacity more extensively. So short run
cost is that which varies with output when the plant and capital equipment in constant.

Long run costs are those, which vary with output when all inputs are variable including plant and capital
equipment. Long-run cost analysis helps to take investment decisions.

5. Fixed and variable costs:

Fixed cost is that cost which remains constant for a certain level to output. It is not affected by the
changes in the volume of production. But fixed cost per unit decrease, when the production is increased.
Fixed cost includes salaries, Rent, Administrative expenses depreciations etc.
Variable is that which varies directly with the variation is output. An increase in total output results in an
increase in total variable costs and decrease in total output results in a proportionate decline in the total
variables costs. The variable cost per unit will be constant. Ex: Raw materials, labour, direct expenses,
etc.

6. Past and Future costs:

Past costs also called historical costs are the actual cost incurred and recorded in the book of account
these costs are useful only for valuation and not for decision making.

Future costs are costs that are expected to be incurred in the futures. They are not actual costs. They are
the costs forecasted or estimated with rational methods. Future cost estimate is useful for decision
making because decision are meant for future.

7. Traceable and common costs:

Traceable costs otherwise called direct cost, is one, which can be identified with a products process or
product. Raw material, labour involved in production is examples of traceable cost.

Common costs are the ones that common are attributed to a particular process or product. They are
incurred collectively for different processes or different types of products. It cannot be directly identified
with any particular process or type of product.

8. Incremental and sunk costs:

Incremental cost also known as different cost is the additional cost due to a change in the level or nature
of business activity. The change may be caused by adding a new product, adding new machinery,
replacing a machine by a better one etc.

Sunk costs are those which are not altered by any change – They are the costs incurred in the past. This
cost is the result of past decision, and cannot be changed by future decisions. Investments in fixed assets
are examples of sunk costs.

9. Total, average and marginal costs:

Total cost is the total cash payment made for the input needed for production. It may be explicit or
implicit. It is the sum total of the fixed and variable costs.

Average cost is the cost per unit of output. If is obtained by dividing the total cost (TC) by the total
quantity produced (Q)

Average cost = TC
Q

Marginal cost is the additional cost incurred to produce and additional unit of output or it is the cost of
the marginal unit produced.
DIFFERENCE BETWEEN FIXED COST AND VARIABLE COST

Fixed Cost Variable Cost

Fixed costs are costs that do not change with the Variable costs change with the change in the
changing volume of production of a firm. The volume of production. There is a change in
volume, when increases, show better productivity productivity with changing volume in the
though. case of variable costs.

Fixed cost is based on time. It is time-dependent Variable costs are dependent on the volumes
and changes after a certain period of time. These manufactured. The costs change depending
costs are therefore made daily, weekly, monthly, on the production volume and there is
or on a yearly basis depending on the nature of nothing related to time in the case of variable
the cost. costs.

Fixed costs are costs of total production. They

Variable costs are costs per unit of
don’t have anything to do with the number of
production. It is the cost of each unit that is
units produced. This means that the cost of
produced. That is why, when production goes
production stays the same even when the number
up, the costs also go up.
of units produced is increased.

Fixed costs usually go down with an increase in Variable costs do not change with an
the number of production. As the production increase in volume. It will remain the same
goes up, the per unit cost comes down which per unit even when the production goes up.
decreases the total cost of the process.

The profitability does not change in the case

In the case of fixed costs, higher production leads
of variable costs even when production goes
to more profitability as the cost per unit comes
up. This happens because the per unit cost
down.
remains the same.

Examples of variable costs include the cost

Some examples of fixed costs are salaries, rent, of raw materials, labor costs, and sales
and property taxes. commissions.
 BREAK-EVEN ANALYSIS

A business is said to break even when its total sales are equal to its total costs. It is a point of no profits
no loss. Break even analysis is defined as analysis of costs and their possible impact on revenues and
volume of the firm. Hence, it is also called the cost – volume- profit analysis. A firm is said to attain the
BEP when its total revenue is equal to total cost.

Determination of Break Even Point

1. Fixed cost
2. Variable cost
3. Contribution
4. Margin of safety
5. Angle of incidence
6. Profit volume ratio

Fixed cost: Expenses that do not vary with the volume of production are known as fixed expenses. Eg.
Manager‟s salary, rent and taxes, insurance etc. It should be noted that fixed changes are fixed only
within a certain range of plant capacity. The concept of fixed overhead is most useful in formulating a
price fixing policy. Fixed cost per unit is not fixed
Variable Cost: Expenses that vary almost in direct proportion to the volume of production of sales are
called variable expenses. Eg. Electric power and fuel, packing materials consumable stores. It should be
noted that variable cost per unit is fixed.
Contribution: Contribution is the difference between sales and variable costs and it contributed
towards fixed costs and profit. It helps in sales and pricing policies and measuring the profitability of
different proposals. Contribution is a sure test to decide whether a product is worthwhile to be continued
among different products.
Contribution = Sales – Variable cost

Contribution= Fixed Cost+ Profit.

Margin of safety: Margin of safety is the excess of sales over the break even sales. It can beexpressed
in absolute sales amount or in percentage. It indicates the extent to which the sales can be reduced without
resulting in loss. A large margin of safety indicates the soundness of the business.
The formula for the margin of safety is:

Profit

Present sales – Break even sales or PV ratio

Margin of safety can be improved by taking the following step

1. Increasing production
2. Increasing selling price
3. Reducing the fixed or the variable costs or both
4. Substituting unprofitable product with profitable one.
Angle of incidence: This is the angle between sales line and total cost line at the Break-even point. It
indicates the profit earning capacity of the concern. Large angle of incidence indicates a high rate of
profit; a small angle indicates a low rate of earnings. To improve this angle, contribution should be
increased either by raising the selling price and/or by reducing variable cost. It also indicates as to what
extent the output and sales price can be changed to attain a desired amount of profit.
Profit Volume Ratio: It is usually called P. V. ratio. It is one of the most useful ratios for studying
the profitability of business. The ratio of contribution to sales is the P/V ratio. It may be expressed in
percentage. Therefore, every organization tries to improve the P. V. ratio of each product by reducing the
variable cost per unit or by increasing the selling price per unit. The concept of P. V. ratio helps in
determining break even-point, a desired amount of profit etc.

Assumptions:
Break-even analysis is based on three following assumptions:-
1. Total cost should be fixed.
2. All the elements of cost are divided into fixed or variable cost.
3. The stock valuation is restricted to a certain cost.
4. There is always coordination between production and sale.
5. Sales price per unit should be constant.
6. The cost is influenced by the volume of production.

Significance of BEA
Break-even Analysis is essential because of the following reasons:
1. Set the number of units to be sold: With the help of break-even analysis, a manager can set a target
for the number of units to be sold in order to cover the costs. Variable costs, fixed costs, and the selling
price are generally used in the calculation of the break-even point.
2. Pricing Strategy: Break-even Analysis tells the company about the selling price; i.e., What selling
price can be charged per unit in order to cover the expenses. Also, if the selling price of a commodity is
increased, then the number of units of that product to be sold to achieve the break-even point will be
reduced. Similarly, if the selling price of a commodity is reduced, then the company will have to sell
extra to achieve the break-even point.
3. Setting Targets: The target being set under break-even analysis acts as the goal of the sales team so
that they can plan on how and when to sell the units in order to reach the target.
4. Monitors and Controls Costs: Break-even Analysis helps in monitoring the costs occurring in the
production process and then control them by cutting down the useless expenses.
5. Manages the Margin of Safety: During financial breakdown, a company’s sales tend to fall. Under
those circumstances, break-even analysis helps in deciding the least number of sales that the company
needs to make profits. Besides, with the help of margin of safety reports, the management of a
company can easily execute high business decisions.
Merits:
1. Information provided by the Break Even Chart can be understood more easily then those contained in
the profit and Loss Account and the cost statement.
2. Break Even Chart discloses the relationship between cost, volume and profit. It reveals how changes
in profit. So, it helps management in decision-making.
3. It is very useful for forecasting costs and profits long term planning and growth
The chart discloses profits at various levels of production.
4. It serves as a useful tool for cost control.
5. Analytical Break-even chart present the different elements, in the costs – direct material, direct
labour, fixed and variable overheads.

Limitations of BEA
 Break – even - point is based on fixed cost, variable cost and total revenue. A change in one variable
is going to affect the BEP
 All cost cannot be classified into fixed and variable costs. We have semi-variable costs also.
 In case of multi-product firm, a single chart cannot be of any use. Series of charts have to be made
use of.
 Total cost and total revenue lines are not always straight as shown in the figure. The quantity
and price discounts are the usual phenomena affecting the total revenue line.
 Where the business conditions are volatile, BEP cannot give stable results

Marginal Costing Formulae:-

1. Contribution = Sales-Variable cost
= Fixed Cost + Profit
= P/V Ratio × Sales
100
2. BEP (in units) = Total fixed cost
Contribution

3. BEP (in sales)= BEP(in units) ×Selling price per unit

= Total fixed cost × 100
P/V Ratio
= Sales – Margin of safety

4. Margin of Safety = Sales – BEP Sales

= Profit × 100
 P/V Ratio
= Sales × Margin of safety ratio

5. Sales when desired profit given = Fixed cost + Desired Profit

P/V Ratio

6. Units when desired profit given = Fixed cost + Desired Profit

Contribution

7. Profit = (Contribution × Number of units sold) – Total Fixed Cost

8. P/V Ratio = Contribution × 100

Sales
= Fixed cost × 100
BEP Sales
= Profit × 100
Margin of Safety
= Changes in Profit × 100
Changes in Sales
 PROBLEMS

1. From the following information find out a)BEP in Units b)P/V Ratio c) BEP in value d)Number
of units to be sold to achieve a target profit of Rs.1,20,000 e)Profit at sale of 8000 units.
Selling Price/Unit- Rs.50,
Variable Cost/ Unit-Rs.30
TFC- Rs.1, 00,000.

Given the information:

Selling Price/Unit: Rs. 50
Variable Cost/Unit: Rs. 30
Total Fixed Costs (TFC): Rs. 1,00,000
a) BEP in Units:
BEP (in units) = Total fixed cost
Contribution
Contribution = Selling Price per Unit - Variable Cost per Unit
Contribution = Rs. 50 - Rs. 30 = Rs. 20
BEP (in units) = Rs. 1,00,000 / Rs. 20 = 5000 units
b) P/V Ratio:
P/V Ratio = Contribution × 100
Sales
Contribution = Selling Price per Unit - Variable Cost per Unit = Rs. 20
Sales = Selling Price per Unit = Rs. 50
P/V Ratio = (20 / 50) × 100 = 40%
c) BEP in Value:
BEP (in value) = BEP (in units) × Selling Price per Unit
BEP (in value) = 5000 units × Rs. 50 = Rs. 2,50,000
d) Number of Units to Achieve Target Profit of Rs. 1,20,000:
Units when desired profit given = Fixed cost + Desired Profit
Contribution
= 1,00,000 + 1,20,000
20
= 2,20,000
20
= 11,000 units
e) Profit at Sale of 8000 Units:
Profit = (Contribution Margin per Unit × Number of Units Sold) - Total Fixed Costs
Profit = (Rs. 20 × 8000) - Rs. 1,00,000
Profit = Rs. 1,60,000 - Rs. 1,00,000 = Rs. 60,000
2. The information about Raj & Co. is given below.
P/V Ratio is 20%
TFC is Rs.36,000
Selling Price/ Unit is Rs.150
Compute a) Contribution/Unit b) Variable Cost/Unit c) BEP in Units & Rupees.
Given the information:
P/V Ratio: 20%
Total Fixed Costs (TFC): Rs. 36,000
Selling Price/Unit: Rs. 150
a) Contribution per Unit:
Contribution = P/V Ratio × Sales
100
= 20 % × 150
100
= 20 × 150
100
= Rs. 30
b) Variable Cost per Unit:
Contribution per Unit = Selling Price per Unit - Variable Cost per Unit
Rs. 30 = Rs. 150 - Variable Cost per Unit
Solving for Variable Cost per Unit:
Variable Cost per Unit = Rs. 150 - Rs. 30 = Rs. 120
c) BEP in Units:
BEP (in units) = Total Fixed Costs / Contribution per Unit
BEP (in units) = Rs. 36,000 / Rs. 30 = 1200 units
BEP in Rupees:
BEP (in rupees) = BEP (in units) × Selling Price per Unit
BEP (in rupees) = 1200 units ×Rs. 150 = Rs. 1,80,000
3. If actual sales are 10,000 units, Selling price is Rs. 20/Unit, Variable Cost is Rs. 10/Unit and
Fixed Cost is Rs.80, 000, Find out a) BEP in units and value b) What should be the sales
required for earning a profit of RS.60,000.
Selling Price/Unit: Rs. 20
Variable Cost/Unit: Rs. 10
Fixed Costs (TFC): Rs. 80,000
Actual Sales: 10,000 units
a) BEP (Break-Even Point) in Units:
BEP (in units) = Total Fixed Costs / Contribution per Unit
Contribution per Unit = Selling Price per Unit - Variable Cost per Unit
Contribution per Unit = Rs. 20 - Rs. 10 = Rs. 10
BEP (in units) = Rs. 80,000 / Rs. 10 = 8000 units
BEP in Value:
BEP (in value) = BEP (in units) × Selling Price per Unit
BEP (in value) = 8000 units × Rs. 20 = Rs. 1,60,000
b) Sales Required for Earning a Profit of Rs. 60,000:
Sales when desired profit given = Fixed cost + Desired Profit
P/V Ratio

P/V Ratio = Contribution × 100

Sales
= 10 × 100
20
= 50 %
Sales when desired profit given = 80,000 + 60,000
50 %
= 1,40,000
0.5
= Rs. 2,80,000
4. a) Break-even point in terms of sales value and in units.
b) Number of units that must be sold to earn a profit of Rs. 80,000.
Fixed Factory Overheads cost – 70,000
Fixed Selling Overheads cost – 15,000
Variable Manufacturing Cost per unit – 15
Variable Selling Cost per unit – 5
Selling Price per unit – 30
a) Breakeven point = Fixed cost/Selling price per unit-Variable cost per unit
Variable cost per unit = 15+5 = 20

Total Fixed Cost = 70,000+15000 = 85,000

= 85,000/30-20

Breakeven point(in units) = 8,500

Breakeven point(in sales value) = 8,500 ×30 = 2,55,000

b) Number of units that must be sold to earn a profit of Rs. 80,000.

Units when desired profit given = Fixed cost + Desired Profit

Contribution
= 85,000 + 80,000
20
= 1,65,000
10
= 16,500 units
5. You are given the information about 2 companies in 2000
Particulars Company A Company- B

Sales 50 00 000 50 00 000

F.E 12 00 000 17 00 000
V.E 35 00 000 30 00 000
You are required to calculate, p/v ratio, BEP, margin of safety.
Sol:-
Company-A
Sales = 50, 00, 000
F.E = 12, 00, 000
V.E = 35, 00, 000
a) P/V Ratio = Contribution × 100
Sales
P/V Ratio = 50,00,000 – 35,00,000 × 100
50,00,000
 = 15,00,000 × 100
50,00,000
= 30%
b) BEP( in units)= Total fixed cost
Contribution
= 12,00,000
15,00,000
= 0.8 units

BEP( in sales)= BEP(in units) × Sales

= 0.8 × 50,00,000
= Rs. 40,00,000

c) Margin of sales = Sales - BEP sales

= 50,00,000 - 40,00,000
= Rs. 10,00,000/-

Company-B
Sales = 50,00,000
F.E = 17,00,000
V.E = 30,00,000
a) P/V Ratio = Contribution × 100
Sales
P/V Ratio = 50,00,000 – 30,00,000 × 100
5000000
= 20,00,000 × 100
50,00,000
= 40%
b) BEP( in units)= Total fixed cost
Contribution
= 17,00,000
20,00,000
= 0.85 units

BEP( in sales)= BEP(in units) × Sales

= 0.85 × 50,00,000
= Rs. 42,50,000

c) Margin of sales = Sales - BEP sales

= 50,00,000 - 42,50,000
= Rs.7,50,000/-
 2 MARKS QUESTIONS

1. Define production function and write formula for production function?

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)

Where Q is the quantity of production, F explains the functions, that is, the type of relation
between inputs and outputs , L1,L2,C,.O,T refer to land, labout, capital, organization and
technology respectively. These inputs have been taken in conventional terms. In reality, material
also can be included in a set of inputs.

2. What is the meaning of Iso-quant?

The term Isoquants is derived from the words „iso‟ and „quant‟ – „Iso‟ means equal and
„quent‟ implies quantity. Isoquant therefore, means equal quantity. Isoquant are also called iso-
product curves, an isoquant curve show various combinations of two input factors such as capital
and labour, which yield the same level of output.

As an isoquant curve represents all such combinations which yield equal quantity of output, any
or every combination is a good combination for the manufacturer. Since he prefers all these
combinations equally , an isoquant curve is also called product indifferent curve.

3. What is the meaning of Iso-cost?

Iso cost refers to that cost curve that represents the combination of inputs that will cost the
producer the same amount of money. In other words, each isocost denotes a particular level of
total cost for a given level of production. If the level of production changes, the total cost changes
and thus the isocost curve moves upwards, and vice verse.
Isocost curve is the locus traced out by various combinations of L and K, each of which costs the
producer the same amount of money (C ) Differentiating equation with respect to L,we have dK/dL
= -w/r This gives the slope of the producer‟s budget line (isocost curve). Isocost line shows
various combinations of labour and capital that the firm can buy for a given factor prices. The slope of
iso cost line = PL/Pk.

4. Explain cobb –douglas production function?

The Cobb-Douglas production function is based on the empirical study of the American
manufacturing industry made by Paul H. Douglas and C.W. Cobb. It is a linear homogeneous
production function of degree one which takes into account two inputs, labour and capital, for the
entire output of the .manufacturing industry.

The Cobb-Douglas production function is expressed as:

Q = A.LαKβ

where Q is output and L and K are inputs of labour and capital respectively. A, α and β are
positive parameters where = α> 0, β > 0.

The conclusion drawn from this famous statistical study is that labour contributed about 3/4 th and
 capital about 1/4th of the increase in the manufacturing production.

α + β = 1 (Constant Returns to scale)

α + β > 1 (Increasing Returns to scale)
α + β < 1 (Decreasing Returns to scale)

5. What is MRTS?
The marginal rate of technical substitution (MRTS) refers to the rate at which one input factor is
substituted with the other to attain a given level of output. In other words, the lesser units of one
input must be compensated by increasing amounts of another input to produce the same level of
output.
Isoquants are typically convex to the origin reflecting the fact that the two factors are substitutable
for each other at varying rates. This rate of substitutability is called the “marginal rate of technical
substitution” (MRTS) or occasionally the “marginal rate of substitution in production”.
It can also be shown that the marginal rate of substitution labour for capital, is equal to the
marginal physical product of labour divided by the marginal physical product of capital.

6. Define cost?
Cost refers to the expenditure incurred to produce a particular product or services. All cost
involves a sacrifice of some kind or other to acquire some benefit. For example , if I want to eat
food, I should be prepared to sacrifice money.

Cost refers to the amount of expenditure incurred in acquiring something. In business firm, it
refers to the expenditure incurred to produce an output or provide service. Thus the cost incurred
in connection with raw material , labour, other heads constitute the overall cost of production.

7. Explain about BEA point?

A business is said to break even when its total sales are equal to its total costs. It is a point of no
profits no loss. Break even analysis is defined as analysis of costs and their possible impact on
revenues and volume of the firm. Hence, it is also called the cost – volume- profit analysis. A firm
is said to attain the BEP when its total revenue is equal to total cost.

8. Explain Explicit cost and Implicit cost?

 Explicit costs are those expenses that involve cash payments. These are the actual or
business costs that appear in the books of accounts. These costs include payment of wages
and salaries, payment for rawmaterials, interest on borrowed capital funds, rent on hired
land, Taxes paid etc.
 Implicit costs are the costs of the factor units that are owned by the employer himself.
These costs are not actually incurred but would have been incurred in the absence of
employment of self – owned factors. The two normal implicit costs are depreciation,
interest on capital etc. A decision maker must consider implicit costs too to find out
appropriate profitability of alternatives.
9. Explain Out of pocket cost and Book cost?
 Out-of pocket costs also known as explicit costs are those costs that involve current cash
payment. Book costs also called implicit costs do not require current cash payments.
Depreciation, unpaid interest, salary of the owner is examples of back costs.
 The book costs are taken into account in determining the level dividend payable during a
period. Both book costs and out-of-pocket costs are considered for all decisions. Book cost
 is the cost of self-owned factors of production.

10. Explain Fixed cost and Variable cost.

 Fixed cost is that cost which remains constant for a certain level to output. It is not
affected by the changes in the volume of production. But fixed cost per unit decrease,
when the production is increased. Fixed cost includes salaries, Rent, Administrative
expenses depreciations etc.
 Variable is that which varies directly with the variation is output. An increase in total
output results in an increase in total variable costs and decrease in total output results in a
proportionate decline in the total variables costs. The variable cost per unit will be
constant. Ex: Raw materials, labour, direct expenses, etc.

11. Write formulas of breakeven point?

BEP (in units) = Total fixed cost
Contribution

BEP (in sales)= BEP(in units) ×Selling price per unit

= Total fixed cost × 100
P/V Ratio
= Sales – Margin of safety

12. What are the merits of BEA?

 Information provided by the Break Even Chart can be understood more easily then those
contained in the profit and Loss Account and the cost statement.
 Break Even Chart discloses the relationship between cost, volume and profit. It reveals how
changes in profit. So, it helps management in decision-making.
 It is very useful for forecasting costs and profits long term planning and growth
 The chart discloses profits at various levels of production.
 It serves as a useful tool for cost control.
 Analytical Break-even chart present the different elements, in the costs – direct material, direct
labour, fixed and variable overheads.

13. What are the demerits of BEA?

 Break – even - point is based on fixed cost, variable cost and total revenue. A change in one
variable is going to affect the BEP
 All cost cannot be classified into fixed and variable costs. We have semi-variable costs also.
 In case of multi-product firm, a single chart cannot be of any use. Series of charts have to be
made use of.
 Total cost and total revenue lines are not always straight as shown in the figure. The
quantity and price discounts are the usual phenomena affecting the total revenue line.
 Where the business conditions are volatile, BEP cannot give stable results

14. What is the meaning of contribution?

Contribution is the difference between sales and variable costs and it contributed towards fixed
 costs and profit. It helps in sales and pricing policies and measuring the profitability of different
proposals. Contribution is a sure test to decide whether a product is worthwhile to be continued
among different products.
 Contribution = Sales – Variable cost

 Contribution= Fixed Cost+ Profit.

15. What is margin of safety?

Margin of safety is the excess of sales over the break even sales. It can be expressed in absolute
sales amount or in percentage. It indicates the extent to which the sales can be reduced without
resulting in loss. A large margin of safety indicates the soundness of the business.
The formula for the margin of safety is:
Profit
 Present sales – Break even sales or
P. V. ratio

16. What is angle of incidence?

This is the angle between sales line and total cost line at the Break-even point. It indicates the
profit earning capacity of the concern. Large angle of incidence indicates a high rate of profit; a
small angle indicates a low rate of earnings. To improve this angle, contribution should be
increased either by raising the selling price and/or by reducing variable cost. It also indicates as to
what extent the output and sales price can be changed to attain a desired amount of profit.