Production and cost analysis : - PowerPoint Presentation

1. Production and cost analysis :Prof Prasanna Shembekar

2. Production Process by which resources are transformed in to more useful goods or servicesProcessing, assembling, producing, manufacturing, extracting, purifying, packaging, storing, transportation, retailing are all productive activities as they add “Value”Inputs to production are : Land labour capital raw material time and technology. Output is goods or service

3. Theory of Production Production is a process that create/adds value or utility It is the process in which the inputs are converted in to outputs.

4. Short run and Long Run In short run time period supply of some factors is fixed or inelastic. Ex: Land , machinery In long run all factors are variable except technology In very long run all factors are variable including technology

5. Production Function Production function means the functional relationship between inputs and outputs in the process of production. It is a technical relation which connects factors inputs used in the production function and the level of outputs Q = f (Land, Labour, Capital, Organization, Technology, etc)

6. Production function Overall production function is expressed as:Q= f (Ld, L, K, M, T, t) Ld= land, L = Labour, K= Capital, M= Machinery, T= Technology, t= time In general form Q = f (K, L) in long run Q=f (L) in shot run

7. Factors of Production

8. Total Product – Total production done till time using given inputs Average Product- Ratio of Total Product and one variable inputs Marginal Product – The marginal change in output as a result changes in one variable input Various concept of production

9. Law of Production Function Laws of Variable proportion- Short run production function with at least one input is variableLaws of Return to scales – Long run production function with all inputs factors are variable.

10. Law of variable proportion: Short run Production Function Production function with at least one variable factor keeping the quantities of others inputs as a Fixed. Usually L is variable. It shows the input-out put relation when one inputs is variable “When one factor of production is gradually increased keeping other factors constant, marginal product increases up to one stage then it starts declining and if the factor is increased further then the marginal product becomes negative”

11. Production with One Variable InputLabour (L) Capital (K)Total Output (TP)Average Product (AP)01234567891010101010101010101010100103060809510811211210810010203020151340-4-8-10152020191816141210Marginal Product (MP)1010101010101010101010 LandFirst StageSecond StageThird StageShort run Production Function with Labour as Variable factor

12. ACB Total ProductLabor per month348843EAverage productMarginal productOutput per month112Labor per month60302010DFirst StageSecond StageThird Stage

13. Stages in Law of variable proportionFirst Stage: Increasing returnTP increase at increasing rate till the end of the stage.AP also increase and reaches at highest point at the end of the stage.MP also increase at it become equal to AP at the end of the stage.MP>APSecond Stage: Diminishing return TP increase but at diminishing rate and it reach at highest at the end of the stage.AP and MP are decreasing but both are positive.MP become zero when TP is at Maximum, at the end of the stageAfter some time MP<AP, from where AP start falling Third Stage: Negative return TP decrease and TP Curve slopes downward As TP is decreased MP is negative. AP is decreasing but positive.

14. Where should rational firm produce?

15. Stage I: MP is above AP implies an increase in input increases output in greater proportion. The firm is not making the best possible use of the fixed factor. So, the firm has an incentive to increase input until it crosses over to stage II.Stage III: MP is negative implies contribution of additional labor is negative so the total output decreases .In this case it will be unwise to employ an additional labor. Where should rational firm produce?

16. Stage II: Till MP is below AP implies increase in input increases output in lesser proportion. A rational producer/firm should produce in stage II.

17. 2. Law of return to scales: Long run Production Function Explain long run production function when the inputs are changed in the same proportion. Production function with all factors of productions are variable..Show the input-out put relation in the long run with all inputs are variable. “Return to scale refers to the relationship between changes of outputs with proportionate changes in the in all factors of production ”

18. Law of return to scales: Long run Production Function LabourCapitalTPMP218842181063301284401010550101266010147688168746189784Increasing returns to scaleConstant returns to scaleDecreasing returns to scale

19. Law of return to scales: Long run Production Function Increasing returns to scaleConstant returns to scaleDecreasing returns to scaleInputs 10% increase – Outputs 15% increaseInputs 10% increase – Outputs 10% increaseInputs 10% increase – Outputs 5% increase

20. Laws of increasing returns to scale When the combination of factors increases, marginal product increases many folds. Factors leading to increasing returns ( economies of scale)Increases degree of specialization Synergy and higher morale Effective utilization of resources

21. Constant returns to scale When the inputs are doubled, outputs are also doubled. Production is moving towards point of saturation due to limits of economies of scale. It may start turning up in to diseconomies of scale.Region of maximum production

22. Decreasing returns to scale This occurs when an increase in all inputs leads to a less than proportional increase in output.This phenomena happens to increasing diseconomies of scale More addition to scale leads to inefficient supervision, shortage of raw material, chaos at workplace, social loafing and rivalry among labour

23. Isoquants The Greek word ‘iso’ means ‘equal’ or ‘same’ and ‘quant’ is the short form of quantity. Thus an isoquant is a curve along which output is the same. For the sake of analysis, we are assuming that a producer employs two inputs—labour (L) and capital (K).A firm can produce a certain amount of a commodity by employing different combinations of labour and capital. When this information is plotted on a graph paper, we obtain an isoquant.

24. Iosquants CombinationLabourCapitalOutput levelA201100 unitB182100 unitC123100 unitD94100 unitE65100 unitF46100 unitAn isoquants represent all those possible combination of two inputs (labour and capital), which is capable to produce an equal level of output .

25. 100 unit outputLabour CapitalIsoquants or equal product curve Iosquants An isoquants represent all those possible combination of two inputs (Labour and Capital), which is capable to produce an equal level of output.

26. 100 unit outputLabour CapitalIsoquants or equal product curve Marginal Rate Technical Substitute(MRTS) The slop of isoquant is known as Marginal Rate of Technical Substitution (MRTS). It is the rate at which one factors of production is substitute with other factor so that the level of the out put remain the same.MRTS = Changes in Capital / changes in Labour

27. Properties of ISOQUANTSNegative slope : The slope is negative because the two factors L and K are partially substitutable for each other. Convex to origin: Due to diminishing marginal rate of substitution D K/ D L goes on reducing at each point Two isoquants do not intersect each other : Because one cant have two different productions with same combination of factorsHigher the production isoquants shift rightwards

28. Ridge Lines: The Economic Region of ProductionNot all points of an isoquant are relevant for production. One should consider only feasible portions of an isoquant, because no rational producer will produce where marginal product of an input is either zero or negative.Only the negatively sloped segment of the isoquant is relevant for production or economically feasible.This is shown in Fig. 3.5 where

29. The Lines R & L are the ridge lines outside which production is not feasible. Thus the area that falls within R, L and the isoquant is called economic region of production

30. Cost concepts Accounting costs Opportunity and actual costsBusiness costs and full costs Explicit and implicit or imputed costs Out of pocket and book costs Analytical costs Fixed and variable costs Total , average and marginal costs Short run and long run costs Incremental and sunk costs Historical and replacement costs Private and social costs

31. Opportunity cost Opportunity cost is the expected returns from the second best use of the resources foregone due to the scarcity of resources. It is also called Alternative cost. It’s an economic cost. Ex: Suppose that a person has a sum of Rs. 1, 00,000 from which he can buy either a printing machine or a lathe machine. From printing machine, he expects an annual income of Rs. 20,000 and from the lathe, Rs. 15,000.If he is a profit maximizing investor, he would invest his money in printing machine and forego the expected income from the lathe. The opportunity cost of his income from printing machine is the expected income from the lathe, i.e., Rs. 15,000.

32. Actual CostActual costs are actually incurred by the firm in payment for labour, material, plant, building, machinery, equipment, travelling and transport, advertisement, etc. The total money expenses, recorded in the books of accounts are, for all practical purposes, the actual costs. Actual cost comes under the accounting concept.

33. Business CostsBusiness costs include all the expenses which are incurred to carry out business. Similar to the actual or real costs. Business costs “include all the payments and contractual obligations made by the firm together with the book cost of depreciation on plant and equipment”.These cost concepts are used for calculating business profits and losses and for filling returns for income-tax and also for other legal purposes.

34. Full costsFull costs include business costs, opportunity cost and normal profit. Normal profit is a necessary minimum earning in addition to the opportunity cost, which a firm must get to remain in its present occupation.

35. EXplicit vs Implicit costs Explicit costs fall under actual or business costs entered in the books of accounts. The payments for wages and salaries, materials, license fee, insurance premium, depreciation charges are the examples of explicit costs. These costs involve cash payments and are recorded in normal accounting practices.Implicit or imputed costs may be defined as the earning expected from the second best alternative use of resources. If an entrepreneur does not utilize his services in his own business and works as a manager in some other firm on a salary basis.Implicit costs are not taken into account while calculating the loss or gains of the business.But they form an important consideration in whether or not a factor would remain in its present occupation. The explicit and implicit costs together make the economic cost.

36. Incremental vs sunk costs Incremental costs are closely related to the concept of marginal cost but with a relatively wider meaningWhile marginal cost refers to the cost of the marginal unit of output, incremental cost refers to the total additional cost associated with the marginal batch of output.Incremental costs arise due to the change in product lines, addition or introduction of a new product, replacement of worn out plant and machinery, replacement of old technique of production with a new one, etc.The Sunk costs are those which cannot be altered, increased or decreased, by varying the rate of output. For example, once it is decided to make incremental investment expenditure and the funds are allocated and spent, all the preceding costs are considered to be the sunk costs since they accord to the prior commitment They cannot be revised or reversed or recovered when there is change in market conditions or change in business decisions.

37. Historical vs replacement costs Historical costs are those costs of an asset acquired in the past whereas replacement cost refers to the outlay which has to be made for replacing an old asset. These concepts own their significance to unstable nature of price behaviour.Stable prices over time, other things given, keep historical and replacement costs on par with each other. Instability in asset prices makes the two costs differ from each other.Historical cost of assets is used for accounting purposes, in the assessment of net worth of the firm. The replacement cost figures in the business decision regarding the renovation of the firm.

38. Private costs are those which are actually incurred or provided for by an individual or a firm on the purchase of goods and services from the market. For a firm, all the actual costs both explicit and implicit are private costs. Private costs are internalized costs that are incorporated in the firm’s total cost of production.Social costs on the other hand, refer to the total cost to the society on account of production of a commodity. Social costs include both private cost and the external cost.a) The cost of resources for which the firm is not compelled to pay a price, i.e., atmosphere, rivers, and also for the use of public utility services like roadways, drainage system, etc.(b) The cost in the form of ‘disutility’ created through air, water and noise pollutions, etc. The costs of category.(b) Total private and public expenditures incurred to safeguard the individual and public interest against the various kinds of health hazards created by the production system.

39. Book costs can be converted into out-of-pocket costs by selling the assets and having them on hire. Rent would then replace depreciation and interest.While undertaking expansion, book costs do not come into the picture until the assets are purchased. Out of pocket costs involve current cash payments to outsidersNot all out-of- pocket costs are variable, e.g., salaries paid to the administrative staff, Neither are they all direct, e.g., the electric power bill.Book costs are such as depreciation do not require current cash payments.Book costs are in some cases variable and in some cases readily traceable, and hence become a part of direct costs. 

40. Fixed costs are those costs which are fixed in volume for a certain given output. Fixed cost does not vary with variation in the output. The costs that do not vary for a certain level of output are known as fixed cost.The fixed costs include:(i) Cost of managerial and administrative staff.(ii) Depreciation of machinery, building and other Fixed assets, and(iii) Maintenance of land, etc. The concept of fixed cost is associated with short-run.Variable costs are those which vary with the variation in the total output. They are a function of output. Variable costs include cost of raw materials, running cost on fixed capital, such as fuel, repairs, routine maintenance expenditure, direct labour charges associated with the level of output, and the costs of all other inputs that vary with output.

41. Total CostTotal cost represents the value of the total resource requirement for the production of goods and services. It refers to the total expenditure, both explicit and implicit, on the resources used to produce a given level of output. It includes both fixed and variable costs. The total cost for a given output is given by the cost function. TC = FC + VC

42. Average cost:Average cost (AC) is of statistical nature, it is not actual cost. It is obtained by dividing the total cost (TC) by the total output (Q), i.e.AC = TC / Q = average costMarginal cost:Marginal cost is the addition to the total cost on account of producing an additional unit of the product. Given the cost function, it may be defined asMC = TCn – TCn-1Total, average and marginal cost concepts are used in economic analysis of firm’s production activities.

43. Short run and long run costs Short-run costs vary with the variation in output, the size of the firm remaining the same. In other words, short-run costs are the same as variable costs. Long-run costs, on the other hand, are the costs which are incurred on the fixed assets like plant, building, machinery, etc. Such costs have long-run implication in the sense that these are not used up in the single batch of production.Long-run costs are, by implication, the same as fixed costs. In the long-run, however, even the fixed costs become variable costs as the size of the firm or scale of production increases. Short-run costs are those associated with variables in the utilization of fixed plant or other facilities whereas long-run costs are associated with the changes in the size and kind of plant.

44. The cost function The relation between cost and its determinants is technically described as the cost function.C= f (S, Q, P, T ….)Where;C= Cost (Unit or total cost)S= Size of plant/scale of productionQ= Quantity of production P= Prices of inputsT= Technology

45. Short Run TableQTFCTVCTC (TFC+TVC)0500501502070250358535060110450100150550145195650190240750237287850284334

46. Short – Run Cost FunctionsOutputCostOTFCBTVCTCThe shape :TFC : horizontal straight lineTVC: Rises upwards, increases at a decreasing rate initially , later on increases at a increasing rate.TC: Same as TVC, the distance between them is constant because of TFC

47. Cost output relation in Short Run Total Cost is the summation of Fixed Costs and Variable Costs.TC=TFC+TVCAverage cost is the total cost per unit. It can be found out as follows.AC=TC/QThe total of Average Fixed Cost (TFC/Q) keep coming down as the production is increased.Marginal Cost is the addition to the total cost due to the production of an additional unit of product. It can be arrived at by dividing the change in total cost by the change in output.In the short-run there will not be any change in Total Fixed Cost. Hence change in total cost implies change in Total Variable Cost only.

48.

49. Shape of SRTC curve AFCATCMCAVCOutputCost

50. Shape of Short Run Total Cost curveThe shape of ATC curve depend upon AVC and AFCIn the beginning both AFC and AVC falls, so ATC fallsAVC rising and AFC falling, ATC still fallsBut as output increases, a sharp rise AVC offset the fall of AFC and AC start to rise

51. Short – Run Cost Functions Marginal Cost MC MC < AC = AC falls ( MC pulls the AC down) MC > AC = AC rises ( MC pulls the AC up) MCAC

52. Long – Run Cost FunctionsA firm can vary all its inputThe entrepreneur has before him number of alternative plant sizes and levels of output.In short run the size of the plant ( capital equipment, machinery, land…) are fixed.In long run the firm can move from one plant to another plantThe LRAC is the least possible average cost production of producing any given level of output when all the inputs are variable.

53. Derivation of Long Run Average Cost CurveABCDKLHGRJSAC1SAC2SAC3Average costOutput

54. In long run firm can vary all its input.The firm moves from one plant to larger plant if it has to increase its output.The long run average cost of production is the least possible average cost of producing any given level of output when all the inputs are variable.The short run average cost curves are called as Plant curves.Suppose there are only three technically possible size of plant.The firm can choose among the three possible sizes of plantUp to OB amount of output, the firm will operate on the SAC1, though it could produce on SAC2.For OA output . It will cost AL per unit cost on SAC1 curve but it will cost AH if on SAC2. (AL < AH).If the firm plans to produce larger output than OB then it has to move to a bigger plant size.Thus OC if produced on SAC2 cost CK per unit which is lower than CJ when produced on SAC1. If the firm produce output between OB and OD it will employ the plant corresponding to SAC2.

55. Long-Run Cost CurveGQACMLACNKFOutputV

56. Long – Run Cost FunctionsThe LAC is the locus of all the tangency points with the short run average cost curve.The long run curve is also called as Envelope curve.LRAC is also called the planning curve: as the firm plans to produce any output in the long run by choosing a plant on the LRAC corresponding to the given output.Point G lies on the falling portion of SAC2, the firm is using the given plant below its full capacity. Point F is the minimum point

57. Iso-cost Curves 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 )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.

58. The isocost line plays a similar role in the firm's decision making as the budget line does in consumer's decision making. The only difference between the two is that the consumer has a single budget line which is determined by the income of the consumer. Whereas the firm faces many isocost lines depending upon the different level of expenditure the firm might make.

59. Economies and diseconomies of scale

60. Economies of Scale The factors which cause the operation of the laws of returns to scale are grouped under economies and diseconomies of scale. Increasing returns to scale operates because of economies of scale and decreasing returns to scale operates because of diseconomies of scale where economies and diseconomies arise simultaneously.

61. Continue…When a firm increases all the factor of production it enjoys the same advantages of economies of production.The economies of scale are classified as:Internal economiesExternal economies

62. Internal Economies of Scale Internal economies are those which arise from the expansion of the plant-size of the firm. Internal economies of scale may be classified as:Economies in productionEconomies in marketingEconomies in managementEconomies in transport and storage

63. Economies in Production It arises fromTechnological advantagesMass Production reduces average costs Use of geographical advantages for production of various parts

64. Economies in Marketing It facilitates through:Advertisement & promotion economiesEconomies in large scale distributionMarketing costs distributed over large scale production leads to very small rise in ATC.

65. Managerial Economies It achieves through: Specialization in management and division of labourSystemization of managerial function

66. Economies in Transport and StorageEconomies in transportation and storage costs arise from fuller utilization of transport and storage facilities. Larger companies can afford multiple hub warehouses (TATA Steel) and their own transportation ( JSW ISPAT) or tie up with larger PSU like Railways for transportation (SAIL)

67. External Economies of Scale External economies to large size firms arise from the discounts available to it due toLarge scale purchase of raw materialsLarge scale acquisition of external finance at low interestLower advertising rate from advertising mediaConcessional transport charge on bulk transportLower wage rates if large scale firm is monopolistic employer of certain kind of specialized labor.

68. Continue…External economies of scale are strictly based on experience of large-scale firms or well managed small scale firms.Economies of scale will not continue for ever.Expansion in the size of the firms beyond a particular limit, too much specialization, inefficient supervision, improper labor relations etc will lead to diseconomies of scale.

69. Diseconomies of scale Larger firms often suffer poor communication because they find it difficult to maintain an effective flow of information between departments, divisions or between head office and subsidiaries. Time lags in the flow of information can also create problems in terms of the speed of response to changing market conditions. For example, a large supermarket chain may be less responsive to changing tastes and fashions than a much smaller, ‘local’ retailer.Co-ordination problems also affect large firms with many departments and divisions, and may find it much harder to co-ordinate its operations than a smaller firm. For example, a small manufacturer can more easily co-ordinate the activities of its small number of staff than a large manufacturer employing tens of thousands.

70. Diseconomies of scale Loss of management efficiency occurs when firms become large. Such loses of efficiency include over paying for resources, such as paying managers salaries higher than needed to secure their services, and excessive waste of resources. Low motivation of workers in large firms is a potential diseconomy of scale that results in lower productivity, as measured by output per worker.

71. Diseconomies of scale Large firms may experience inefficiencies related to the principal-agent problem. This problem is caused because the size and complexity of most large firms means that their owners often have to delegate decision making to appointed managers, which can lead to inefficiencies.  For example, the owners of a large chain of clothes retailers will have to employ managers for each store, and delegate some of the jobs to managers but they may not necessarily make decisions in the best interest of the owners.