Cost and Production Analysis

7/21/2019 Cost and Production Analysis

1/51

What is a frm?

A frm is an entity concerned with thepurchase and employment of resources inthe production of various goods and

services. Assumptions:

the rm aims to maximize its prot with theuse of resources that are substitutable to a

certain degree the rm is" a price taker in terms of the

resources it uses.


2/51

The Theory o the Firm


3/51

The Production Function

The production functionrefers to thephysical relationship between the inputsor resources of a rm and their output of

goods and services at a given period oftime.

The production function is dependentondierent time frames. !irms can producefor a brief or lengthy period of time.


4/51

Production Function

Inputs Process Output

Land

Labour

Capital

Product orservice

generated

value added


5/51

Production Function

tates the relationship between inputs andoutputs

Inputs # the factors of production classied

as: Land# all natural resources of the earth . $rice paid to ac%uire land & Rent

Labour # all physical and mental humaneort involved in production $rice paid to labour &Wages

Capital # buildings' machinery ande%uipmentnot used for its own sake but for the

contributionit makes to production


6/51

Production Function


7/51

Fixed s! "ariable Inputs

!ixed inputs (resources used at a constantamount in the production of a commodity.

)ariable inputs ( resources that can

change in %uantity depending on the levelof output being produced.

The longer planning the period' thedistinction between xed and variableinputs disappears' i.e.' all inputs are

variable in the long run.


8/51

#nalysis o Production

Function$%hort Run *n the short run at least one factor xed

in supply but all other factors capableof being changed

+e,ects ways in which rms respond tochangesin output -demand

/an increase or decrease output usingmore or less of some factors but some

likely to be easier


9/51

#nalysis o Production

Function$%hort Run

In times of rising

sales (demand)firms canincrease labourand capital butonly up to a

certain level they will belimited by theamount of space.In this eample!

land is the fixedfactorwhich


10/51

"nalysis of Production #unction$%hort &un

If demandslows down!the firm canreduce itsvariablefactors in

this eample!it reduces itslabour andcapital butagain! land is

the factorwhich stays


11/51

#nalysing the ProductionFunction$ Long Run

The long run is dened as the period of

time taken to vary all factors ofproduction 0y doing this' the rm is able to

increase its total capacity# not 1ust

short term capacityAssociated with a change in the

scale o production

The period of time varies according


12/51

"nalysis of Production #unction$Long &un

In the long run, the firm can change all its factors ofproduction thus increasing its total capacity. In thisexample it has doubled its capacity.


13/51

Production Function

2athematical representationof the relationship:

& ' ()* L* La+ 3utput -4 is dependent upon the

amount of capital -5' 6and -6 and6abour -6a used


14/51

Production #nalysis ,ith -ne"ariable Input

Total product (Q) refers to the totalamount of output produced in physicalunits -may refer to' kilograms of sugar'

sacks of rice produced' etc The marginal product (MP) refers to the

rate of change in output as an input ischanged by one unit' holding all other

inputs constant.

L

L

TPMPL

=


15/51

Total s! .arginalProduct

Total $roduct -T$x & total amount ofoutput produced at dierent levels ofinputs

2arginal $roduct -2$x & rate of changein output as input 7 is increased by oneunit.

X

X

TPMP

X

=


16/51

Production Function o a RiceFarmer

8nits of 6 Total $roduct-46or T$62arginal $roduct-2$6

9 9 (

; ;

; < =

> ; ; ;

? >; 9

B >9 (;

9 ;< (=


17/51

FIGURE 5.1. Total product curve. The total product curve shows the behavior of total product vis-a-vis an input

(e.g., labor) used in production assuming a certain technological level.

L

QL

QL

2

6

2

2!

26

"!

"2

Labor

Totalproduct

! 2 # 6 $ !%&'"


18/51

.arginal Product

The marginal product refers to the rateof change in output as an input ischanged by one unit' holding all other

inputs constant. !ormula:

L

L

TPMP

L

=


19/51

.arginal Product

3bserve that the marginal productinitially increases' reaches a maximumlevel' and beyond this point' the marginalproduct declines' reaches zero' andsubse%uently becomes negative.

The law of diminishing returns statesthat "as the use of an input increases-with other inputs xed' a point willeventually be reached at which theresulting additions to output decrease"


20/51

Total and .arginalProduct

-!

-'

!

'

!

'

2!

2'

"!

"'

! 2 " # ' 6 & $ %

TL

L


21/51

La, o /iminishing .arginalReturns

As more and more of an input isadded -given a xed amount of otherinputs' total output may increaseC

however' as the additions to totaloutput will tend to diminish.


22/51

#erage Product (#P+

Average product is a concept commonlyassociated with eiciency.

The averageproduct measures the totaloutput per unit of input used. The "productivity" of an input is usually

expressed in terms of its average product.

The greater the value of average product' thehigher the eiciency in physical terms.

!ormula:L

L

TPAP

L=


23/51

TABLE 5.2. Average product of labor.

Labor (L

Total product of

labor (T!L

Average product of

labor (A!L

! ! !

2 2

2 6 "

" 2 ## 2! '

' 26 '.2

6 "! '

& "2 #.'$ "2 #

% "! "."

! 26 2.6


24/51

C-%T% -F PR-/0CTI-1

3pportunity /ost $rinciple ( theeconomic cost of an input used in aproduction process is the value of output

sacriced elsewhere. The opportunitycost of an input is the value of foregoneincome in best alternative employment.

*mplicit vs. Dxplicit /osts Dxplicit costs # costs paid in cash *mplicit cost # imputed cost of self(owned or

self employed resources based on theiropportunity costs.


25/51

2 Cost Concepts (%hort3run+

. Total !ixed /ost -T!/

;. Total )ariable /ost -T)/

>.

Total /ost -T/&T)/ET!/=. Average !ixed /ost

-A!/&T!/F4

@. Average )ariable /ost-A)/&T)/F4


26/51

%hort Run #nalysis

Total xed cost(TFC) is morecommonly referred to as "sunk

cost" or "overhead cost." Dxamples: include the payment orrent for land' buildings andmachinery.

The xed cost is independent of thelevel of output produced. Hraphically' depicted as a horizontal

line


27/51

%hort Run #nalysis

Total variable cost (TVC) refers tothe cost that changes as the amountof output produced is changed. Dxamples ( purchases of raw materials'

payments to workers' electricity bills'fuel and power costs.

Total variable cost increases as theamount of output increases. *f no output is produced' then total variable

cost is zeroC

the larger the output' the greater the total


28/51


29/51

Total Costs o Production

*nits ofLabor

Totalroduct

Total+iedost

Totalariable

ostTotalost

arginalost

/verageost

L TL T+ T T /

! ! !! ! !! - -

6 !! "! "! "! "!

2 ! !! '! '! 2! &'

" 2 !! 6! 6! ! '"."

# " !! 6' 6' ' #.2'

' ' !! &' &' ! "'

6 % !! %' %' 2! "2.'

& 2' !! 2' 22' "! "2.#

$ "" !! 6' 26' #! "".2

% #" !! 2' "' '! "'

! '' !! 2&' "&' 6! "&.'


30/51

49

TFC

-Total !ixed /ost

T"C

-Total )ariable /ost

TC-Total /ost

IT3TA6J /3T /8+)D


31/51

49

#FC

-Average !ixed/ost

A!/&T!/F4.

As more output is produced'the Average !ixed /ostdecreases.


32/51

49

$esos

T"C-Total )ariable /ost

%

The#erage"ariable Costat apoint on the T)/curve is measuredby the slope of theline from the originto that point.

A)/&T)/F4

2inimum A)/


33/51

49

$esos

#"C-Average )ariable/ost

%

The Average )ariable /ostis 8 shaped. !irst it

decreases' reaches aminimum and thenincreases.

2inimum A)/


34/51

49

$esos

#"C-Average )ariable/ost

%

The 2arginal /ost curvepasses through theminimum point of theA)/ curve.

*t is also 8(shaped. !irstit decreases' reaches aminimum and thenincreases.

2inimum A)/

.C -2arginal/ost


35/51

49

$esos

#"C

%

.C

#FC

#C

The I$D+ 8K*TJ /3T


36/51

Table 5." Average #o$t of !roduct%o&

(Q (T# (A#

! !! -

"! "!.!!

2 '! &'.!!

" 6! '".""

# 6' #.2'

' &' "'.!!

6 %' "2.'!

& 22' "2.#

$ 26' ""."

% "' "'.!!

! "&' "&.'!


37/51

Total roduct(Q)

Total ariable ost(/)

/verage ariable ost(/)

! ! !

"! "!.!

2 '! 2'.!

" 6! 2!.!

# 6' 6."

' &' '.!

6 %' '.$& 2' &.%

$ 6' 2!.6

% 2' 2".%

! 2&' 2&.'

Table '.' /verage ariable osts of roduction


38/51

6ong+unTotal/o

st

6T/

6T/

4Total $roduct

All inputs are variable inthe long run. There are

no xed costs.

L-143R01 T-T#L C-%T C0R"5


39/51

The L#C

The 6A/ curve is an envelop curveof all possible plant sizes. Alsoknown as Iplanning curveJ

*t traces the lowest average cost ofproducing each level of output.

*t is 8(shaped because of Dconomies of cale Liseconomies of cale


40/51

6A/

A/

49

/3T

A/;

L-143R01 #"5R#45 C-%T

C0R"5


41/51

6A/

49

/3T

A/

%

9


42/51

6A/

49

/3T

A/

%

9

A/;

0uilding a larger sizedplant -size ; will result in alower average cost of

producing %9


43/51

6A/

49

/3T

A/

%

9

A/;

6ikewise' a larger sizedplant -size > will result to

a lower average cost ofproducing %

%

A/>


44/51

5conomies and /iseconomieso %cale

Dconomies of cale( long runaverage cost decreases as outputincreases.

Technological factors pecialization

Liseconomies of cale: ( long runaverage cost increases as outputincreases. $roblems with management # becomes

costly' unwieldy


45/51

6A/

A/

49

/3T

A/;

L-143R01 #"5R#45 C-%T

C0R"5

4

Dconomies of

cale

Liseconomies of

cale


46/51

6A/

A/

49

/3T

L'G)RU A*ERAGEa&d +ARGIAL #',T#UR*E,

4

62

/

2/

2/;

A/;


47/51

L#C and L.C

Long3run #erage Cost (L#C+cure is 03shaped! the enelope o all the short3run

aerage cost cures6 drien by economies and

diseconomies o si7e! Long3run .arginal Cost (L.C+

cure

#lso 03shaped6 8

9 : 5 # l i d


48/51

9rea: 5en #nalysis andCost Control

0DA analysis is an importanttechni%ue to trace the relationshipbetween costs'revenue and prots at

the varying levels of output or sales. *n 0DA 'the break(even point is

located at that level of output or

sales at which the net income orprot is zero.At this point total costis e%ual to total revenue.Mence'the

break(even point is the no(prot(no(


49/51

0D$ in terms of physical units( 0D$&T!/F$( A)/ where '

0D$& break even point

T!/&total xed cost

$&the selling price

A)/&the avg.variable cost.$(A)/ is the contribution margin per

unit.


50/51

0D$ in terms of sales value(

0D$&Total xed costFcontributionratio

/ontribution ratio&T+(T)/FT+


51/51

End

Cost and Production Analysis

Documents