Production & Cost Analysis

 Meaning: production is an activity that transforms inputs into outputs.

 Definition: According to Michael R Baye defines production function as “that function

which defines the maximum amount of output that can be produced with a given set of
inputs

 Production is the result of the combinations of factors for the creation of values and utility to
the corresponding commodities. The factors of production are namely Land, Labour,
Capital, Organization and Technology.
 Production Function

Samuelson defines 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. It is defined for a given state of technical knowledge
 Production Function: The function for the production is stated as:

Q = f {L1, L2, C, O, T}
 Where Q = Quantity of Production, F = Relation between Inputs and Outputs,
 L1 = land, L2= Labour, C = Capital, O = Organization, T = Technology.

The level of output of a firm can be increases in to two ways:

 1. By increasing only one factor and keeping the other factors constant.
 2. By increasing all factors of Production.
 COST ANALYSIS:

 The Managerial economist is concerned with making Managerial decisions. Different business proposals are
evaluates of their costs and revenues.

 Concept and Nature of Cost: Cost refers to the expenditure incurred to produce a particular product or
service. All costs involve a sacrifice of some kind or other or acquire some benefits.

 Eg: I want to eat food; I should be prepared to sacrifice Money.

 The cost of production normally includes the cost of raw materials, labour and other expenses. These are
called Total cost (TC). This is compared with the total revenues (TR) realized on the sale of the products
manufactured. The difference between total revenues and total cost is known as Profit (P)

Profit (p) = TR-TC

 An understanding of the meaning of various cost concepts is essential for clear business thinking. They
facilitate clear understanding of the management problem and also of the concept of cost that is relevant to it.
 OPPORTUNITY COST: Opportunity cost refers to the earning / profits that are foregone from alternatives
ventures by using given limited facilities for a particular purpose.

Opportunity cost refers to the “cost for the next best alternatives foregone”.

Ex: If the firm owns land there is no cost of using the land (i.e rent) in the firms account. But the firm has an
opportunity cost of using this land, which is equivalent to the rent foregone by not letting the land out on rent.
 ACTUAL COST: Actual cost is defined as the cost or expenditure which a firm incurs for producing or
acquiring a good or service and they are recorded in the books of accounts of a business unit.

 Example: cost of raw material, rent, interest, wages, etc.

 Incremental cost is the total cost incurred due to an additional unit of product being produced.
Incremental cost is calculated by analyzing the additional expenses involved in the production process, such as
raw materials, for one additional unit of production.
 EXPLICIT COSTS: The costs of using resources in production involve both implicit & explicit costs.
Explicit costs involve payment of cash. The rent for the land lord, wages for the laborer, interest paid are the
explicit cost.

Other examples of explicit costs are: Cost of raw material, Salaries, Power charges, Rent of business,
insurance premium

 IMPLICIT COSTS: These are also called imputed costs do not involve payment of cash as they are not
actually incurred. They do not take the form of cash outlays, nor they do not appear in the accounting system.
Eg: wages of labour rendered by the entrepreneur himself, Interest on capital supplied by him.

 OUT-OF-POCKET COSTS: The costs that involve an immediate outflow of cash. These are spent in the
day- to-day life of the business, such as purchase of raw material, payment of salaries interest on loans and so
on. Out of pocket costs are also called explicit costs because they are incurred in reality.
 FIXED COST: Fixed costs are that part of the total cost of the firm which does not vary with output. Eg:
Expenditure depreciation rent of land and building, property taxes etc. The fixed costs no longer remain
fixed.
 Variable Costs: It directly dependent on the volume of output or service, variable costs increase but not
necessarily in the same proportion as the increase in output. Ex: Electricity Bills, wages on Labour.
 IMPUTED/ BOOK COST: Sometimes book costs is also known as imputed cost. Book costs are those
business costs which don’t involve any cash payment but a provision is made in the books of accounts.
Books costs are imputed costs or the payments made by the firm itself.
 Example: Cost of using owners money, depreciation of fully-written-off-property, the firm own capital
equipment etc.
 MARGIN OF SAFETY: It is the excess of sales over the break even sales. It can be expressed in
percentage or in absolute sales amount. A large margin of safety indicates the soundness of the business. The
formula for the margin of safety is:
 MOS = Actual sales (present sales – break even sales)
Replacement Costs vs Historical Costs:
 Replacement cost are those costs that are to be paid currently if the asset were to
be replaced.
 Historical costs are those costs that have been originally spent to acquire the
assets. The financial statements are generally based on the historical costs.
Past costs vs future costs:
 Past costs are those that have been spent already in the past.it is also called
committed costs or historical costs. They cannot be controlled or minimised.
 Future costs: Future costs are those costs that will be spent in the future and
these have to be well ascertained now.
 Sunk Cost:
A sunk cost, sometimes called a retrospective cost, refers to an investment already
incurred that can't be recovered. Examples of sunk costs in business include marketing,
research, new software installation or equipment, salaries and benefits, or facilities expenses.
 COST-OUTPUT RELATIONSHIP:

A proper understanding of the nature and behavior of costs is a must for regulation and
control of cost of production.
 The cost-output relationship plays an important role in determining the optimum level of
production. Knowledge of the cost-output relation helps the manager in cost control, profit
prediction, pricing, promotion etc. The relation between cost and its determinants is
technically described as the cost function.

C= f (S, O, P, T ….) Where

C= Cost (Unit or total cost) S= Size of plant/scale of production

O= Output level

P= Prices of inputs T= Technology

 Considering the period the cost function can be classified as (1) short-run cost function and (2)
long-run cost function.
 1. Cost-Output Relationship in the Short-Run

 The Cost Concepts made use of in the cost behavior are Total Cost, Average Cost, and Marginal Cost.

 Total cost is the actual money spent to produce a particular quantity of output. Total Cost is the summation of
Fixed Costs and Variable Costs.

TC=TFC+TVC
 Up to a certain level of production Total Fixed Cost i.e., the cost of plant, building, equipment etc, remains
fixed. But the Total Variable Cost i.e., the cost of labor, raw materials etc., vary with the variation in output.
Average cost is the total cost per unit. It can be found out as follows.­­

AC=TC/Q
 . 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 total 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.
Units of Total fixed Total Total cost Average Average Average cost Marginal
Output Q cost TFC variable (TFC + TVC) variable cost fixed cost (TC/Q) AC cost MC
cost TVC TC (TVC / Q) AVC (TFC / Q) AFC

0 – – 60 – – – –

1 60 20 80 20 60 80 20

2 60 36 96 18 30 48 16

3 60 48 108 16 20 36 12

4 60 64 124 16 15 31 16

5 60 90 150 18 12 30 26

6 60 132 192 22 10 32 42
 The above table represents the cost-output relationship. The table is prepared on the basis of the Law of
Diminishing Marginal Returns. The fixed cost Rs. 60 May include rent of factory building, interest on capital,
salaries of permanently employed staff, insurance etc.
 Thus the table shows an increasing returns or diminishing cost in the first stage and diminishing returns or
diminishing cost in the second stage and followed by diminishing returns or increasing cost in the third stage.
 The short-run cost-output relationship can be shown graphically as follows.
 2. Cost-output Relationship in the Long-Run

Long run is a period, during which all inputs are variable including the one, which are fixes in
the short-run. In the long run a firm can change its output according to its demand. Over a long
period, the size of the plant can be changed, unwanted buildings can be sold staff can be increased or
reduced. The long run enables the firms to expand and scale of their operation by bringing or
purchasing larger quantities of all the inputs. Thus in the long run all factors become variable.
 BREAK EVEN ANALYSIS (BEP)/ COST VOLUME PROFIT ANALYSIS (CVP)
 Introduction: Break even analysis refers to analysis of the breakeven point. The BEP is defined as a no
profit or no loss point. It is necessary to determine the BEP when there is neither profit nor loss. It is
important because it denoted the minimum volume of production to be undertaken to avoid losses. BEP equal
to TC=TR.
 Break Even Chart: The graphical representation of breakeven point in a breakeven chart is Output is shown
on Horizontal axis and Revenues on Vertical axis
Applications of Breakeven Analysis:
 Make or Buy Decision:. The necessary components or spare parts, where the consumption is larger
making.

 Choosing a product mix when there is a limiting factors: It is very likely that the company may be

dealing in more than one product and company wants to know, in view of the limited plant capacity .

 Drop or Add Decision

Significance of Break Even Analysis:

 To ascertain the profit on a particular level of sales volume or a given capacity of production.
 To calculate sales required to earn a particular desired level of profit.
 To compare the product line, sales area, method of sale for individual company.
 To compare the efficiency of the different firms.
 To decide whether to add a particular product to the existing product line or drop one from it.
 To decide to “Make or Buy” a given component or spare part.
 PRICING STRATEGIES
 Definition: Price is the value that is put to a product or service and is the result of a complex set of
calculations, research and understanding and risk taking ability. A pricing strategy takes into account
segments, ability to pay, market conditions, competitor actions, trade margins and input costs,
amongst others.

OBJECTIVES OF PRICING:

A. Maximum Current Profit

B. Sales Growth
C. Increase in Market Share
D. To Face Competition
E. To Remove Competitors from the Market
F. To Satisfy Customers
 PRICING STRATEGIES
 Definition: Price is the value that is put to a product or service and is the result of a complex set of
calculations, research and understanding and risk taking ability. A pricing strategy takes into account
segments, ability to pay, market conditions, competitor actions, trade margins and input costs,
amongst others.

OBJECTIVES OF PRICING:

A. Maximum Current Profit

B. Sales Growth
C. Increase in Market Share
D. To Face Competition
E. To Remove Competitors from the Market
F. To Satisfy Customers
 Pricing Objectives:

1.Profit Maximisation
2. Revenue Maximization
3.Maximise quality
4.Quality leadership
5.Survival
Pricing Policies:
Different types of Pricing Policies followed by Companies are:
1. Geographical Pricing 2. Price Discounts and Allowances
3. Competitive Bidding in Competitive Markets as a Strategy.

1. Geographical Pricing:
This involves the industrial unit in deciding how to price its products to different
customers in different locations and countries.

2. Price Discounts and Allowances:

Cash Discounts: A period of 30 to 45 or 60 days
Quantity Discounts: A quantity discount is a price reduction to those customers
who buy in large volumes.
3. Competitive Bidding in Competitive Markets as a Strategy:

In competitive bidding, the government undertaking and public sector companies invite
tenders of potential suppliers through newspapers and internet.

1. Cost Based Pricing: These are two types

Cost Plus pricing: This is also called as “Mark up” pricing. The average cost at normal
capacity of output is ascertained and then a conventional margin of profits is added to
the cost to arrive at the price.

Marginal Cost pricing: In Marginal Cost pricing, selling pricing is fixed in such a way
that it covers fully the variables or marginal cost and contributes towards recovery of
fixed costs fully or partly depending up on the market situations.
2. Competition Oriented Pricing: The pricing is a very complex task. The price of a product is set
based on the competition charges for a similar product. These are various types mainly:

A. Sealed Bid Pricing: This method is more popular in tenders and contracts. Each contracting firm
quotes its price in a sealed cover called “Tender”. All the tenders are opened on a scheduled date
and the person, who quotes the lowest price, is awarded the contract. Any price quoted less than the
marginal price results in loss.

B. Going rate pricing: The price charged by the firm is in tune with the price charged in the industry
as a whole. When one wants to buy and sell gold, the prevailing market rate at a given point of time
is taken as the basis to determine the price. Normally the market leaders keep announcing the
prevailing prices at a given point of time based on demand and supply positions.

C. Ex:The Indian Bullion Jewellers Association or the IBJA as it is known plays a key role in
determining day to day gold rates in the country.
4. Demand based pricing methods: Demand-based pricing, also known as customer-based pricing, is
any pricing method that uses consumer demand - based on perceived value - as the central element. These
include:

Price discrimination means that producer Charges different prices for different consumers for the same
goods and service. Price discrimination occurs when prices differ even though costs are same. For Ex:
doctor charges different fees for different customers. In case they charge different prices in different
markets, people go to the market where price is low. Then it gets equalised in the long run. There are
various types of price discrimination.
1.Personal discrimination
2.Place discrimination
3. Use Discrimination
 By charging different prices to different customers, the firm tries to increase its profits by reducing the
consumer surplus.

1) Personal price discrimination: In this some product is sold at different process to different kinds of buyers.
Ex: Railway ticket is cheaper to senior citizens as compared to young citizens.
2) Place Discrimination: Under same product is sold at different prices on the basis of different places.
Ex: Electricity charges are lower for rural market.
3) Use price Discrimination: In this type same product is sold different price on the basis of different users.
Ex: Electricity charges are lower for residential use of compared to commercial use.
 0bjectives of Price Discrimination
 Dispose the surpluses
 Develop new market
 Earn monopoly profit
 Increase sales
 To Maximise use of unutilized capacity
 To retain exports
1. Strategy Based Pricing: The various types of pricing are

A. Market Skimming: when the product is introduced for the first time in the market, the company
follows this method. Under this method the company fixes High price for the product. The main
idea is to change the customer maximum possible. This strategy is mostly found in case of
technological products.

Eg: when Sony introduces a particular TV model, it fixes a very high price.

B. Penetration price: This is exactly opposite to the market skimming method. The price of the
product is fixed at low price that the company can increase its market share. The company attains
profits with increasing volumes and increase in market share. The companies believe that it is
necessary to dominate the market in the long run than making profits in the short run. Ex:
Launching a new product.

C. Two-Part Pricing: The firms with market power can enhance profits by the strategy of two part
pricing. Under this strategy, a firm charges a fixed fee for the right to purchase its goods, plus a per
unit charges for each unit purchased. Ex: Electricty. Cinema hall
LIMIT PRICING: limit pricing refers to the pricing by incubent firms to deter or inhibit the entry or the expansion or the fringe firms.
Limit pricing implies that firms sacrifice current profits in order to deter entry of new firms and earn future profits.

FLAT RATE PRICING:

The internet user is required to pay a fee to connect for a fixed period during which one is not charged on the basis of bits sent or received
each time.

USAGE SENSITIVE PRICING: This model looks like a two part tariff. That utilities have a part of the bill is for the connection
.and the other part is a price per unit of bit sent or received.

TRANSACTION BASED PRICING: This model is a variant of the usage sensitive pricing.
In this model the pricing is transaction based and not usage based. In this we cannot distinguish between different qualities of service.
Ex:common transaction costs are labor, transportation, broker fees, bank charges, commissions, etc.
PRIORITY PRICING:
In this model the users pay according to the quality of service chosen by them. This comes close to the price discrimination model.
Ex: Electricity pricing where the user pays a fixed amount for the first block of units, a higher amount for the next block and so on.
 TRANSFER PRICING: Transfer pricing is an internal pricing technique. It refers to a price
at which inputs are transferred to another to maximise the overall profits of the company.
 In case of a company having multiple processes, the output of one process is the output of
the next process. Till the production reaches the last stage, the output of each process is
termed as work in progress.

 Ex: the engine department Honda Activa makes the scooter engines and forward these to the
assembly department. The assembly department in turn assembles the scooter. Here the price
at which the engine department forwards each engine affects the price of the scooter.

Factors involved in Pricing Policy:

 Costs
 Demand and consumer psychology
 Competition
 Profits
 Government policy
 Demand supply schedule

Price Demand Supply

50 100 200

40 120 180

30 150 150

20 200 110

10 300 50
Demand supply schedule
 INTRODUCTION OF MARKET STRUCTURE

Introduction: Market constitutes an important phase in the economic activity. All the goods and services that
are produced need to be sold to the consumer for a price.

Definition: It is defined as it is a place or point at which buyer and sellers negotiate their exchange of well
defined products or services.

Nature of the market

1. It has the boundaries

2. Different organizations are their

3. Different products are available

4. Different prices

5. Competition
The structure of market is based on its following features:

 The degree of seller Concentration: This refers to the number of sellers and their market share
 The degree of buyer concentration: Number of buyers and their extent of purchases of a given product or
service in the market.
 The degree of product differentiation: This refers to the extent by which the product of each trader is
differentiated from that of the other.
 The conditions of entry into the market: There could be certain restrictions to enter or exit from the
markets.

TYPES OF COMPETITION: Based on the degree of competition, the market can be divided into

1. Perfect market Competition: A market in which all firms in an industry are price takers and in which there
is freedom of entry into and exit from the industry.

2. Imperfect market Competition: Based on the number of buyers and sellers, the imperfect markets are
classified as explained
 PERFECT COMPETITION:

A market in which all firms in an industry are price takers and in which there is freedom of entry into
and exit from the industry. The business motive of the entire firm under perfect competition is profit
maximization.

Features:
 Large number of buyers and sellers:
 Homogenous products or services:
 Freedom to enter or exit the market:
 Perfect information available to the buyer and sellers:
 Each firm is a price taker:
 Perfect Mobility of factors of production
  MONOPOLISTIC COMPETITION

 Monopolist competition is said to exist when there are many firms and each one produces such goods and
services that are close substitutes to each other. They are sustain but not identical.

 Ex: In the hotel industry some hotels have long and spacious pools, attached gymnasium, beauty parlors,
separate restaurants for vegetarians and non-vegetarians cultural programmed and so on.

 FEATURES OF MONOPOLISTIC COMPETITION:

 Large Number of Buyers and Sellers.

 Product Differentiation.
 Selling Cost.
 Lack of Perfect Knowledge.
 Less Mobility.
 More Elastic Demand.
 MONOPOLY
Monopoly refers to a situation where a single firm is in a position to control either supply or price of
an particular product or service. It cannot control both the price and supply.

FEATURES OF MONOPOLY

 Single seller and large number of buyers

 There is no close substitute goods

 Price maker

 In monopoly there is no difference between company and industry

 In monopoly restrictions are more

 Demand is inelastic

 In monopoly the seller control either price and supply

 OLIGOPOLY:
 Oligopoly was defined at that form of market organized, where there are few sellers of a homogenous or
differentiated products is oligopoly.
 Two or more firms existing in an industry each with a significant market share can be called oligopoly.

The following are some of the characteristics or features of an oligopoly:

Only a few sellers: the number of sellers in an oligopoly industry in only few.

 Inter-dependence: In this each firm closely watches the moves of the other firm and reacts carefully to their moves.
The firms may frequently anticipate the moves of the rival and out accordingly.
 Price rigidity:
 Price leadership: one of the firms in the industry has the highest market share and therefore is called dominant price
leadership.

 Advertising and selling cost: firms in an oligopoly market in incur heavy expenditure on advertising and other

promotional activities.
 Innovations: oligopoly firms continually innovate and improve the quantity of the product, reduce the cost of
production and improve the brand image customer care etc.
 KINKED DEMAND THEORY OF OLIGOPOLY:

 Many economists observed that prices in an oligopoly industry are surprisingly stable or rigid. paul sweezy

explained very convincingly the reasons for price rigidity in any oligopoly industry through his kinked

demand curve model.

The model is based on two assumptions:

a) If an oligopoly firm increases the prices, its rivals will not increase the price because they believe that they
can gain more customers by keeping status quo.

b) In an oligopoly firm reduces the prices with an intention of increasing the volume of sales, other rival firms
also follows the same strategy.
 The firm somehow fixed the price originally and once the price is fixed, it remains stable or rigid at that

level. The upper part of the demand curve is relatively elastic demand indicating that any small increases in

price will result in more than a proportionate fall in sales revenue.