Chapter 4 Cost and Production

In the previous two chapters we examined the economics underlying decisions related to
which goods and services a business concern will sell, where it will sell them, how it will
sell them, and in what quantities. Another challenge for management is to determine how
to acquire and organize its production resources to best support those commitments. In
this chapter and in the following chapter we will be discussing key concepts and principles
from microeconomics that guide its organization and production activities to improve
profitability and be able to compete effectively.

Basically, goods and services cannot be produced without utilizing the factors of
production such as land, labor, capital, and entrepreneurship. It is the fundamental
decision of the firm to determine the amount of goods and services to produce and how
much factors of production to apply together with other inputs to generate an output with
the highest level of efficiency.

Theory of Production
It explains the principles in which the business/firm has to take decisions on how much of
each commodity it sells and how much it produces and also how much of raw material i.e.,
fixed capital and labor it employs and how much it will use. It defines the relationships
between the prices of the commodities and productive factors on one hand and the
quantities of these commodities and productive factors that are produced on the other
hand.

What is Production?
• Production is the transformation of inputs into outputs.

Factors of Production
Factors of production are the inputs needed for the creation of a good or service. The
factors of production include land, labor, entrepreneurship, and capital.

Law of Returns to Scale

What is Returns to Scale?
In the long run, 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. Returns
to scale relates the behaviour of total output as all inputs are varied and is a long-run
concept.

The law of returns to scale describes the relationship between variable inputs and output
when all the inputs or factors are increased in the same proportion. Here we find out in
what proportions the output changes when there is proportionate change in the quantities
of all inputs. The answer to this question helps a firm to determine its scale or size in the
long run.
The production and sale of goods and services are always profit-motivated. However,
production depends on certain factors like the law of diminishing marginal returns and
marginal productivity.
Cost is the most important consideration in production. A producer will not just jump into a
particular investment by simply looking at the potential revenue of the business.
Revenue may be substantial but the producer will think twice because of the implication on
the pricing of the commodity. Consumers will not be so enthusiastic in patronizing the
offered product if the price is quite high. Inefficiency in the production process has a direct
impact on cost, because it takes away the incentives being rewarded by the market for
producers that are not wasteful. The market forces the producer to manage cost of
production by finding the least cost in expanding output.

What is Cost?
• Costs are the necessary expenditures that must be made in order to run a business.
Every factor of production has an associated cost. The cost of labor, for example, used in the
production of goods and services is measured in terms of wages and benefits. The cost of a
fixed asset used in production is measured in terms of depreciation. The cost of capital
used to purchase fixed assets is measured in terms of the interest expense associated with
raising the capital.

WHAT ARE THE DIFFERENT TYPES OF COST?

Short-Run Cost Analysis
Short run for a firm is a time horizon when one input is held constant. To analyse the
short-run costs, it is essential to fix the level of capital and study the changes in the quantity
of labor hired.
The following are the types of short-run costs:
The two basic types of costs incurred by businesses are fixed and variable. Fixed costs do
not vary with output, while variable costs do. Fixed costs are sometimes called overhead
costs.

1. Fixed cost are expenses that do not change in proportion to the activity of a business,
within the relevant period or scale of production. For example, a retailer must pay rent and
utility bills irrespective of sales. They are incurred whether a firm manufactures 100
widgets or 1,000 widgets. In preparing a budget, fixed costs may include rent, depreciation,
and supervisors' salaries. Manufacturing overhead may include such items as property
taxes and insurance. These fixed costs remain constant in spite of changes in output. It
stays the same no matter how much output changes.
A cost that does not change with an increase or decrease in the amount of goods or services
produced or sold. It is an expense that must be paid by a company, independent of any
specific business activities. Fixed cost does not change with the volume of production.

*** Examples are rent, salaries of top management, interest payments on borrowed capital,
insurance premiums, interest payments and most of the depreciation allowances of plant
and equipment.
2. Variable costs fluctuate in direct proportion to changes in output. In a production
facility, labor and material costs are usually variable costs that increase as the volume of
production increases. It takes more labor and material to produce more output, so the cost
of labor and material varies in direct proportion to the volume of output. It varies with
output and when output rises, variable cost rises; when output falls, variable cost falls.

***Examples are payment for raw materials, utilities, fuel, shipping/freight costs, wages,
tax payments and the like.
Other types of cost
1. Total Cost is the sum of variable cost and fixed cost. It increases in total cost is due to
the increase in variable cost.
2. Marginal Cost is the cost of producing one additional unit of output. It can be found by
calculating the change in total cost when output is increased by one unit.
3. Average Fixed Cost (AFC). It is the fixed cost per unit of output. As the total number of
units of the good produced increases, the average fixed cost decreases because the same
amount of fixed costs is being spread over a larger number of units of output.
Average Fixed Cost (AFC) = TFC/Q where TFC is Total Fixed Cost, Q is total number of units
produced. Unit fixed costs decline along with volume, following a rectangular hyperbola. As
a result, the total unit cost of a product will decline as volume increases.
4. Average Variable Cost (AVC). It is a firm's variable costs (labor, electricity, etc.) divided
by the quantity of output produced.
Average Variable Cost (AVC) is the TVC of a firm divided by the total units of output (Q).
AVC = TVC/Q where TVC is Total Variable Cost, and total number of units produced
5. Average Cost/Average Total Cost (AC/ATC). Average Cost (AC) is the TC of a firm
divided by the total units of output (Q). AC = TC/Q = AFC + AVC
6. Marginal Cost is the change in total cost that arises when the quantity produced
changes by one unit. In general terms, marginal cost at each level of production includes
any additional costs required to produce the next unit. The additional cost incurred to
produce one additional unit of output is called the Marginal Cost (MC). MC = dC/dQ. It is the
change in the total cost when the quantity produced changes by one unit. It is the cost of
producing one more unit of a good. Marginal cost is not related to fixed costs.

TFC+TVC TFC÷Q TVC÷Q TC÷Q Δ TC

Why does the MC Curve pass through the AVC and ATC curves at their minimum
points?
The Marginal Cost (MC) curve intersects the average total cost (ATC) curve at its lowest
point because once the marginal cost exceeds the average cost, the average cost starts to
increase. When marginal cost is less than average cost, the average cost falls as production
increases. The minimum average cost is reached when the average cost falls to the same
level as the marginal cost. As marginal cost increases above the minimum average cost, the
average cost begins to rise.
Average Total Cost and Marginal Cost are connected because they are derived from the
same basic numerical cost data. The general rules governing the relationship are:
1. Marginal Cost will always cut average total cost from below.
2. When marginal cost is below average total cost, average total cost will be falling, and
when marginal cost is above average total cost, average total cost will be rising.
3. A firm is most productively efficient at the lowest average total cost, which is also where
Average Total Cost (ATC) = Marginal Cost (MC).

Why are the AVC and ATC curved-U Shaped?

Average Total Cost starts off relatively high, because at low levels of output total costs are
dominated by the fixed cost; mathematically, the denominator is so small that average total
cost is large. Average total cost then declines, as the fixed costs are spread over an
increasing quantity of output. In the average cost calculation, the rise in the numerator of
total costs is relatively small compared to the rise in the denominator of quantity produced.
But as output expands still further, the average cost begins to rise. At the right side of the
average cost curve, total costs begin rising more rapidly as diminishing returns kick in.
The nature ‘U’ shaped short-run Average Cost curve can be attributed to the law of variable
proportions. This law tells that when the quantity of one variable factor is changed while
keeping the quantities of other factors fixed, the total output increases with an increasing
rate and then declines with more than proportionate.

Thus, the Average Costs of the firms continue to fall as output increases because it operates
under the increasing returns due to various internal economies. Due to the operation of the
law of increasing returns the firm is able to work with the machines to their optimum
capacity and as a consequence the Average Cost is minimum.
The average variable cost curve is U-shaped. Average variable cost is relatively high at
small quantities of output, then as production increases, it declines, reaches a minimum
value, then rises. This shape of the average variable cost curve is indirectly attributable to
increasing, then decreasing marginal returns (and the law of diminishing marginal
returns).

Why does the AVC curve begin to rise?

The average variable cost (AVC) curve will at first slope down from left to right, then reach
a minimum point, and rise again. AVC is ‘U’ shaped because of the principle of variable
proportions, which explains the three phases of the curve:

1. Increasing returns to the variable factors, which cause average costs to fall, followed by:
2. Constant returns, followed by:
3. Diminishing returns, which cause costs to rise

THE DECISION TO OPERATE OR SHUT DOWN

*A firm will operate in the short run when prospective sales exceed variable costs.
Operational decisions or Operating decisions are decisions made to manage day to day
business.
Any firm which is into any kind of business is faced with 100 decisions they have to take in
a day.
These will be as mundane as refilling the water cooler, to as stressful as fulfilling a
customer’s order within minutes. Naturally, operational decisions have to be taken care of
by a manager in charge of the operations.
However, it is not as easy as it sounds because the number of operations can be mind
boggling.
On any normal day, McDonald’s sells 75 burgers a second, or 64 million burgers a day
across the world. Thing about the number of simple operational decisions that, if not taken
properly, can destroy the experiences of customers visiting the McDonald’s stores.

Typically, operational decisions in any business are of the following types:

1) Pricing – Go to any retail store and you will find customers haggling on price. Now, if the
owner was himself involved in such operational decisions, the firm would go down the
drain soon.
Instead, the owner or the manager gives price levels and margin levels which are to be
maintained and hence the decision is made by the employee.
2) Discounts – In channel sales or in network marketing, the daily sale as well as daily
purchase is so high in quantity, that discounts play a major role on which brand the dealer
will push in the market. And hence, managers should have all information on current
discount levels in the market and what discounts to be given to dealers which are
ultimately given by executives. In short, channel level operations have to be managed
properly.
3) Promotions – Promotions involve a lot of operating decisions, like how to promote the
product, and which areas or mediums will give the best ROI after promotions. Similarly,
getting the promotional material ready and ensuring that the promotions are done
properly in the market are all operational decisions which are to be taken from time to
time.
4) Collecting information – Now this is a task which is huge and can make a big impact in
the altogether running of an organization. If you look at it from the bottom up level, there is
a lot of operational information also collected, which has to be summarized at the manager
level and finally submitted at the director level.
Above 4 are the major operational decisions which have to be taken everyday and hence
are mostly outsourced or are managed via a chain of command in between. Besides the
above, there are other operational decisions also which are made in the day to day running
of a business.

• Maintaining Inventory
• Logistics decisions
• Sales and outreach
• Employee management
• Customer management

Overall, calculating the time spent on operations is important for any organization as you
don’t want to waste your resources. And hence, MBA’s generally have a subject known as
operations management, which emphasizes the importance of time and how to achieve a
task in as less steps as possible.
As a business grows, the operational decisions needed to manage the day to day activities
increases. Hence the business needs to hire employees, or an organization needs to hire
managers to manage such operational decisions.

Economies of scale and economies of scope are both related to cost efficiencies in business
production, but they operate in slightly different ways.

Economies of Scale:
Economies of scale refer to the cost advantages a business can achieve as it increases the
scale or level of production. These advantages occur because certain fixed costs can be
spread over a larger number of units produced. As a result, the average cost per unit
decreases as production volume increases. Here are some key aspects of economies of
scale:

Lower Average Costs: As a business produces more units of a product or provides more
services, it can often reduce the per-unit cost of production. This reduction is due to the
ability to use specialized machinery, take advantage of bulk purchasing discounts, optimize
production processes, and benefit from increased efficiency in various operations.
Cost Reduction: Economies of scale typically lead to cost reduction in areas such as labor,
raw materials, energy, and transportation.

Competitive Advantage: Firms that achieve economies of scale can often offer products or
services at lower prices than their competitors, which can lead to increased market share
and competitiveness.

Examples: Large manufacturing facilities, such as car factories or semiconductor

fabrication plants, often achieve economies of scale by producing a high volume of units.

Economies of Scope:
Economies of scope refer to cost savings and efficiencies that a business can gain when it
produces multiple products or services using shared resources or capabilities. In other
words, it's about producing a variety of related products or services more efficiently than
producing them separately. Here are some key points about economies of scope:

Resource Sharing: Businesses can share common resources, such as production facilities,
distribution networks, marketing efforts, research and development, and management
expertise, across different product lines or services.

Cost Synergies: Producing related products or services under one corporate umbrella can
often lead to cost synergies. For example, a company that produces both laptops and
desktop computers can use the same production facilities for both, reducing duplication of
costs.

Risk Diversification: Diversifying through economies of scope can reduce a company's

reliance on a single product or market, spreading risk.

Cross-Selling Opportunities: Companies with a diverse product or service portfolio can

cross-sell their offerings to their existing customer base, potentially increasing sales and
profitability.

Examples: Conglomerates like General Electric, which manufactures a wide range of

products from jet engines to healthcare equipment, and Procter & Gamble, which offers
various consumer goods, benefit from economies of scope.

THE DECISION TO OPERATE OR SHUTDOWN

Shutdown
*A firm will shut down in the sort run when variable costs exceed prospective sales. A firm
will implement a production shutdown if the revenue from the sale of goods produced
cannot cover the variable costs of production.
• Economic shutdown occurs within a firm when the marginal revenue is below average
variable cost at the profit -maximizing output.
• When a shutdown is required the firm failed to achieve a primary goal of production by
not operating at the level of output where marginal revenue equals marginal cost.
• If the variable cost is greater than the revenue being made (VC>R) then the firm is not
even covering production costs and it should be shutdown.
• The decision to shutdown production is usually temporary. If the market conditions
improve, due to prices increasing or production costs falling, then the firm can resume
production.
• When a shutdown last for an extended period of time, a firm has to decide whether to
continue to business or leave the industry.

Therefore:
- A firm will operate in the short-run when prospective firm sales exceed variable
costs.

Example: If the firm has fixed costs of 5 million, variable costs of 6 million, and total
revenue of 7 million, what must it do in the short run?
The firm must operate.

- A firm will shut down in the short-run when variable costs exceed prospective
sales.
Example: If the firm has fixed costs of 10 million, variable costs of 9 million, and total
revenue of 8 million, what must it do in the short run?
The firm must shut down.

Price is greater than Average Total Cost (P › ATC).