Cost Analysis

&
Production analysis
 INTRODUCTION
Production implies provision of goods and services, often described as
‘commodities.’
In technical sense, production is the transformation of resources into
commodities overtime and/or space.
To put it simply, production is the act of converting or transforming
input into output. The act of production is technically carried out by a
firm.
A firm is a business unit which undertakes the activity of transforming
inputs into outputs of goods and services. In the production process, a
firm combines various inputs in different quantities and proportions to
produce different levels of outputs.
Production is a flow concept. It is measured as a rate of output per unit
of time.
 THE CONCEPT OF PRODUCTION
FUNCTION
The rate of output of a commodity functionally depends on the
quantity of inputs used per unit of time. The technological-
physical relationship between inputs and outputs is referred to as
the production function.

“The production function is the name given to the relationship

between rates of input of productive services and the rate of
output of product. It is the economist’s summary of technical
knowledge”
(Stigler, 1966: p. 136)
Definition.
A production function refers to the functional
relationship, under the given technology,
between physical rates of input and output of a
firm, per unit of time.
The concept of production function is a
summarised description of technological
possibilities. It shows for a given technique of
production output that can be obtained from
various levels of factor inputs.
Westbrook and Tybout (1993: p. 87) states that
“the relationship between input and output flows
in manufacturing is determined by the
technology employed and by the economic
behaviour of the producers.”
Algebraic Statement of Production Function In algebraic
terms, the production function may be written as:

Q = f(a, b, c, d, … , n, T–)

Q represents the physical quantity of output (commodity

produced) per unit of time.
f denotes functional relationship.
a, b, c, d, n represent the quantities of various inputs
(productive factors) per employed time period.
T– refers to the prevailing state of technology or ‘know-how.’
The bar (–) is placed on T– just to indicate that technology is
assumed to be constant.
Often economists present a simple production
function, assuming a two-factor model, as under:

Qx = f (K, L)

where, Qx is the rate of output of commodity X

per unit of time.
K refers the units of capital used per unit of time,
and
L is the labour units employed per unit of time.
Isoquants
An isoquant is the locus of all the combinations
of two factors of production that yield the same
level of output.

Let us understand the concept of an isoquant

with the help of an example. Suppose a firm
wants to produce 100 units of commodity X and
for that purpose can use any one of the six
processes indicated in Table
Types of Isoquants Depending upon the
degree of substitutability of the factors,
Isoquants can assume three shapes
categorised as:
1) Convex isoquant
2) Linear isoquant
3) Input-output isoquant
 Features of Isoquants
1. Downward sloping
2. Convex to origin
3. Do not intersect
4. Do not touch axes
 Iso-cost
isocost curves are very similar to indifference
curves, its just they are from producer's point of
view. They show all the combinations of two
inputs in the production process that costs the
same. Lower the isocost curve, better it is since
the producer would like to minimise the cost.
 Law of Returns to Scale
In the long run all factors of production are variable. No
factor is fixed. Accordingly, the scale of production can be
changed by changing the quantity of all factors of
production.

“The term returns to scale refers to the changes in output

as all factors change by the same proportion.”
Koutsoyiannis

“Returns to scale relates to the behaviour of total output as

all inputs are varied and is a long run concept”.
Leibhafsky
 Returns to scale are of the
following three types:

1. Increasing Returns to scale.

2. Constant Returns to Scale

3. Diminishing Returns to Scale

• In the long run, output can be increased by
increasing all factors in the same proportion.
Generally, laws of returns to scale refer to an
increase in output due to increase in all factors
in the same proportion. Such an increase is
called returns to scale.
1. Increasing Returns to Scale:
Increasing returns to scale or diminishing cost
refers to a situation when all factors of
production are increased, output increases at a
higher rate. It means if all inputs are doubled,
output will also increase at the faster rate than
double. Hence, it is said to be increasing returns
to scale. This increase is due to many reasons
like division external economies of scale.
2. Diminishing Returns to Scale:

Diminishing returns or increasing costs refer to

that production situation, where if all the factors
of production are increased in a given
proportion, output increases in a smaller
proportion. It means, if inputs are doubled,
output will be less than doubled. If 20 percent
increase in labour and capital is followed by 10
percent increase in output, then it is an instance
of diminishing returns to scale.
• 3. Constant Returns to Scale:
• Constant returns to scale or constant cost refers to the
production situation in which output increases exactly in
the same proportion in which factors of production are
increased. In simple terms, if factors of production are
doubled output will also be doubled.

• In this case internal and external economies are exactly

equal to internal and external diseconomies. This situation
arises when after reaching a certain level of production,
economies of scale are balanced by diseconomies of scale.
This is known as homogeneous production function. Cobb-
Douglas linear homogenous production function is a good
example of this kind.
 Economies of Scale
The concept “economies of scale” may be viewed in two senses: broad and
narrow.

Definition. In a broad sense, anything which serves to minimise

average cost of production in the long-run as the scale of output
increases is referred to as “economies of scale.”

It is measured in money terms.

In a narrow sense, however, the term ‘economies of scale’

relates to the characteristics of the production process by which
average productivity is enhanced with the expanding scale of
output. Real economies are measured in physical terms.
Increasing returns to scale are caused by these real economies.
The economies of scale may be classified as:
(i) internal economies, and
(ii) external economies.

Internal Economies
Internal economies are those economies which are open to an
individual firm when its size expands. They emerge within the
firm itself as its scale of production increases. Internal
economies in the scale of its output cannot be realised unless
the firm increases its output, i.e., expands its size. Thus,
internal economies are the function of the size of a firm. These
are solely enjoyable by the firm itself when its scale of
production increases, independently
of the actions of other firms.
External Economies
External economies are those economies which
are shared by all the firms in an industry or in a
group of industries when their size expands.
They are available to all firms from outside,
irrespective of their size and scale of production.
They are the result of the growth and expansion
of any particular industry or a group of industries
as a whole.
 FORMS OF INTERNAL ECONOMIES

1. Labour Economies
2. Technical Economies
3. Managerial Economies
4. Marketing Economies
5. Financial Economies
6. Risk-Minimising Economies
FORMS OF EXTERNAL ECONOMIES

1. Economies of Localisation
2. Economies of Information or Technical and
Market Intelligence
3. Economies of Vertical Disintegration
4. Economies of By-products
 DISECONOMIES OF
SCALE
1) Difficulties of Management
2) Difficulties of Coordination
3) Difficulties in Decision-making
4) Increased Risks
5) Labour Diseconomies
6) Scarcity of Factor Supplies
7) Financial Difficulties
8) Marketing Diseconomies
 Technological Progresses and the
Production Functions
• As knowledge of new and more efficient methods of
production become available, technology changes.

• Furthermore new inventions may result in the

increase of the efficiency of all methods of
production. At the same time some techniques may
become inefficient and drop out from the production
function.

• These changes in technology constitute

technological progress.
Graphically the effect of innovation in processes is shown with an
upward shift of the production function (figure 3.27), or a downward
movement of the production isoquant (figure 3.28). This shift shows
that the same output may be produced by less factor inputs, or more
output may be obtained with the same inputs.
 Types of Cost
REAL COST
The term “real cost of production” refers to the physical quantities
of various factors used in producing a commodity. For example,
real cost of a table is composed of a carpenter’s labour, two cubic
feet of wood, a dozen of nails, half a bottle of varnish paint,
depreciation of carpenter’s tools, etc., which go into the making of
the table. Real cost, thus, signifies the aggregate of real productive
resources absorbed in the production of a commodity (or a
service).

Definition. The real cost of production of a commodity refers to

the exertion of labour, sacrifice involved in the abstinence from
present consumption by the savers to supply capital, and social
effects of pollution, congestion, and environmental distortions.
OPPORTUNITY COST OR ALTERNATIVE COST

Since the real production cost cannot be measured in an absolute

sense, the concept of opportunity cost is evolved to measure it in
an objective sense. The concept of opportunity cost is based on
the scarcity and versatility (alternative applicabilities)
characteristics of productive resources. It is the most fundamental
concept in economics.
MONEY COST
Cost of production measured in terms of money is called the
money cost.
“Money cost” is the monetary expenditure on inputs of various
kinds — raw materials, labour, etc., required for the output. It is
the money spent on purchasing the different units of factors of
production needed for producing a commodity. Money cost is,
obviously the payment made for the factors in terms of money.
Money cost is the outlay cost, i.e., actual financial expenditure of
the firm.

Explicit and Implicit Costs

While analysing total money costs, the economists speak of
explicit and implicit money costs. To determine total costs, they
include both explicit as well as implicit money costs.
Explicit costs
Definition. Explicit costs are direct contractual monetary payments incurred
through market transactions.

Explicit costs refer to the actual money outlay or out of pocket expenditure
of the firm to buy or hire the productive resources it needs in the process of
production. It is referred to as out-of-pocket costs.
The following items of a firm’s expenditure are explicit money costs:
• Costs of raw materials;
• Wages and salaries;
• Power charges;
• Rent of business or factory premises;
• Interest payments of capital invested;
• Insurance premiums;
• Taxes like property tax, duties, licence fees, etc.;
• Miscellaneous business expenses like marketing and advertising
expenses (selling costs), transport cost, etc.
Implicit costs
Definition: Implicit costs are the opportunity costs of the use of factors
which a firm does not buy or hire but already owns.

Thus, implicit money costs are as follows:

• Wages of labour rendered by the entrepreneur himself.
• Interest on capital supplied by him.
• Rent of land and premises belonging to the entrepreneur himself and
used in his production.
• Normal returns (profits) of entrepreneur, a compensation needed for his
management and organisational activity.

These items are to be valued at current market rates for estimating the
implicit money cost. These are implicit money costs, because these go to
the entrepreneur himself. These are self-recipient payments. And they are,
in practice, unrecorded expenditure of production.
ACCOUNTING AND ECONOMIC COSTS
An economist’s idea of cost of production differs from that of an
accountant. In economics, the cost of production consists of
remuneration to all the factors of production, viz., wages to labour,
rent to land, interest to capital and normal profits to the
entrepreneur.
An accountant on the other hand would include in the cost of
production only the cash payments to the factors of production,
made by the entrepreneur, for the services rendered by these factors
in the productive process. These cash payments are called the
explicit costs. Thus, an accountant will include only explicit costs
in his cost calculations.

In sum, while an accountant includes only explicit costs in his cost

calculations, an economist includes in it explicit and implicit costs.
FIXED AND VARIABLE COSTS
Fixed costs are the amount spent by the firm on fixed inputs in the short-
run. Fixed costs are, thus, those costs which remain constant, irrespective of
the level of output. These costs remain unchanged even if the output of the
firm is nil. Fixed costs, therefore, are known as “supplementary costs” or
“overhead costs.”

Fixed costs, in the short-run, remain fixed because the firm does not change
its size and amount of fixed factors employed. Fixed or supplementary
costs usually include:
• Payments of rent for building.
• Interest paid on capital.
• Insurance premiums.
• Depreciation and maintenance allowances.
• Administrative expenses — salaries of managerial and office staff, etc.
• Property and business taxes, licence fees, etc.
Fixed costs may be classified into two categories:
(i) Recurrent, and (ii) Allocable.

Recurrent fixed costs are those which give rise to cash

output as certain explicit payments like rent, interest on
capital, general insurance premiums, salaries of
permanent irreducible staff, etc., are to be made at a
regular time-interval by the firm.

The allocable fixed costs refer to implicit money costs

like depreciation charges which involve no direct cash
outlays but are to be reckoned on the basis of time rather
than usage
Variable Costs (Or Prime Costs)
Variable costs are those costs that are incurred on variable factors. These
costs vary directly with the level of output. In other words, variable costs
are those costs which rise when output expands and fall when output
contracts. When output is nil, they are reduced to zero.

Variable costs are frequently referred to as direct costs or prime costs.

Briefly, variable costs or prime costs represent all those costs which can
be altered in the short-run as the output alters. These are regarded as
“avoidable contractual costs” (when output is nil).
The short-run variable costs include:
• Prices of raw materials,
• Wages of labour,
• Fuel and power charges,
• Excise duties, sales tax,
• Transport expenditure, etc.
Variable costs may be classified into:
(i) fully variable costs, and
(ii) semi-variable costs.

The former vary more or less at the same rate of

output, e.g., cost of raw materials, power, etc.
Semi-variable costs are, however, those costs
which do not change with output, but they will
be completely eliminated when output is nil.