PRODUCTION AND COST ANALYSIS

A study of the firm begins with analysis of

production. The essence of a firm is to buy
inputs, use these inputs to produce outputs
and then to sell the outputs.
This is true of competitive firms as well as
monopolies, under capitalism as well as
communism. Only after understanding
the essential elements of production theory,
we can master the cost concepts that underpin
business decisions for perfect and imperfect
competitors.

Let us begin by considering the case of

production of food by a farmer. The farmer
will use a number of inputs or factors of
production such as land, labour, machinery
and fertiliser. These inputs will be applied
over the planting and growing season and at
harvest time the farmer will reap certain
outputs, such as wheat.
In what follows, we assume that the farmer
always strives to produce efficiently or at
lowest cost. That is, he will always attempt
to produce the maximum level of output for a
given dose of inputs, avoiding waste
wherever possible.

Production Function: We have spoken of

inputs like land and labour and output like
wheat.
The relationship between the amount of input
required and the amount of output that can
be obtained is called the production
function.
The production function is the technical name
given to the relationship between the
maximum amount of output that can be
produced and the inputs required to make
that output.

The Law of Supply: Supply of a commodity

refers to the various quantities of the
commodity, which a seller is willing and
able to sell at different prices in a given
market, at a point of time, other things
remaining the same.
Supply is related to scarcity. It is only the
scarce goods which have a supply price.
The goods which are freely available have
no supply price.
The determinants of supply: The supply of a
commodity depends upon a number of
factors. These can be stated as under:

Sx = f (Px, Py, Pz Pf, O, T), where

Sx = Amount supplied of good X
Px = Price of good
Py, Pz = Prices of other goods in the market
Pf = Prices of factors of production needed
to produce good x
O = Objectives of the producers
T = State of technology used by the producer
to produce good x

Let us discuss these determinants in detail:

(i) Price of the good: Since higher money
income is necessary to induce producers to
produce more, the amount supplied therefore
increases when producers get a higher price
for their produce.
(ii) Prices of other goods: Change in the prices of
other goods in the market in the market also
has influence in the supply of a commodity. For
example, if the price of good Y rises, the
produce of good X will start switching his
production of good Y as it is more attractive to
produce Y than before.

(iii) Prices of factors of production: We

know that different commodities use factors
in different proportions. An increase in the
price of a factor, say, labour may lead to a
larger increase in the costs of making those
commodities that use relatively more
labour, but only a smaller rise in the costs of
producing those commodities that use a
small amount of labour.
(iv) Producers Objectives: There may be
many objectives of a firm, like profit
maximisation, sales revenue maximisation,
goodwill, etc.

Amount supplied of a commodity is often

influenced by the specific objective of the
firm.
A sales revenue maximiser or a goodwill
maximiser will sell greater amount of good
than a profit maximising seller.
(v) State of technology: A change in
technology may result in lower costs and
greater supply of goods.
Other things remaining constant, more of a
commodity is supplied at a higher price and
less of its is supplied at a lower price.

Higher revenue from sales is necessary to

induce producers to increase their supply of
the commodity.
The law of supply can be depicted with the
help of both a supply schedule and a supply
curve.
A hypothetical supply schedule tyres is given
in the following table. As is evident from the
table, as the price of tyre increases, the
seller will supply greater number of tyres and
vice versa. In other words, the price of a
commodity and its quantity supplied move in
the same direction.

Price of Tyres
Quantity supplied
(Rs.)
(Nos.)
800
15,000
700
12,000
600
10,000
500
8,000
400
6,000
300
5,000
The supply schedule when represented
diagramatically is known as the supply curve.
Each point on the supply curve depicts the pricequantity supplied combinations of the firm.

The supply curve shows the maximum amount

of good which the firm would be willing to
sell at each possible price of the good,
under given conditions of supply.
S

Y
800
Price
Of
Tyre

700
600
500
400
300

S
5,000
Qty. of tyres

10,000

X
15,000

Shift in supply and change in supply:

Shift in supply means increase or decrease
in quantity supplied at the same price. In
the figure given below, increase in supply is
shown by a shift in the supply curve to the
right (from SoSo to S1S1) while a decrease
in supply by a shift in the supply curve to
the left (from SoSo to S2S2). For example,
at Po price, OQo quantity is supplied when
supply curve is SoSo while OQo and OQo
quantities are supplied when supply curves
are S1S1 and S2S2 respectively.

S2

Price
Of
Good
X

So

S1

P1
Po
P2
S2
So
O

S1
Qo

Unit of good X

Q2 Q1
X
Qo
Q
Qo
Qo
o

Change in supply is, in fact, the extension and

contraction of supply. When more units are
supplied at a higher price (OQ1 at P1 price),
it is called the extension of supply and when
less units of the good are supplied at a
lower price (OQ2 at P2 price), it is called
contraction of supply. In other words, a
movement of supply curve upwards
indicates extension in supply and a
movement downward shows contraction in
supply.

Elasticity of supply: Elasticity of supply of a

commodity is defined as the
responsiveness of quantity supplied to a
unit change in price of that commodity.
When the quantity supplied changes more
than proportionately to the change in price,
the supply tends to be elastic.
On the other hand, if the change in price
leads to less than proportionate change in
quantity supplied, the supply tends to be
inelastic.

For example, if 1 per cent change in the price

of sugar leads to 5 per cent change in its
amount supplied, the supply is said to be
elastic.
If one per cent change in price of tomatoes,
leads to 0.5 per cent change in its quantity
supplied, the tomato supply is said to be
inelastic.
The Theory of Production
Production in economics refers to the
creation of utilities. Production is the end
result of a given production process.

Utilities are created when resources are

converted into usable goods and services.
To produce a given quantity 9of goods and
services, a definite quantity of a
combination of resources are required.
These resources are known as inputs and
the resultant goods and services are
known as the output.
The functional relationship between input
and output is known as production function.

Production function can, therefore, be

explained as the relationship between
physical units of inputs and physical units of
output.
Factors affecting production: There are
wide variety of inputs used by the firms like
various raw materials, labour services of
different kinds, machine tools, buildings,
etc.
All inputs used in production are broadly
classified into four categories, viz., land,
labour, capital and entrepreneurship.

Land is all that is gifted by nature, while the

physical and mental human effort spent in
producing goods and services is labour.
Capital is the man-made means of production
like machinery, factory, building, etc., and
the entrepreneur coordinates the input and
takes risk in business.
Each of these categories can be further subdivided. For example, we have skilled,
unskilled and semi-skilled labour.
Broadly, the inputs are divided into two main
groups fixed and variable inputs.

A fixed input is one whose quantity cannot be

varied during the period under
consideration. Plant and equipment are
examples of fixed inputs.
An input whose quantity can be changed
during the period under consideration, is
known as the variable input.
Raw materials, labour, power, transportation,
etc., whose quantity can often be increased
or decreased on short notice are examples
of variable inputs.

Technology: A firms production behaviour is

fundamentally determined by the state of
technology.
Existing technology sets upper limit for the
production of the firm, irrespective of the
nature of output, size of the firm or the kind
of management.
Time period of production: The fixity or the
variability of an input depends on the length
of time period under consideration. Shorter
the time period, more difficult it becomes to
vary the inputs.

Economists classify time period into two

categories: short run and the long run.
The short run is that period of time in which
some of the firms inputs are fixed. These
fixed inputs act as a limiting factor on change
in output.
In practice, the short run is generally understood
to mean the length of time during which the
firms plant and equipment are fixed.
On the other hand, long run is that period of time
in which there are no limiting factors on input
change.

In other words, in the long run, all inputs can

be changed.
The production function is purely a
technological relationship which expresses
the relation between output of a good and
the different combinations of inputs used in
its production.
It indicates the maximum amount of output
that can be produced with the help of each
possible combination of inputs.
Algebraically, the production function of a firm
for commodity X can be stated as under:

Qx = f (L, K)
where Qx is the quantity of commodity x
produced per unit of time, L = units of labour
input and K = units of capital input.
This production function is a simple one
assuming that the firm employs only two
inputs labour and capital in production of
commodity x.
However, in the short run, a combination of
fixed and variable factors are used.
Since capital is lumpy and indivisible, it is a
fixed factor in the short run.

The firm can, therefore, increase its output by

increasing the labour inputs. Labour ,
therefore, becomes a variable factor.
Short run analysis of Production function:
Before a more detailed analysis of short run
production function, certain key terms used
in the analysis have to be clarified. There
are total product (TP), marginal product
(MP) and average product (AP).
The total product is the amount of output
resulting from the use of different quantities
of inputs.

We assume labour (L) to be a variable input

(capital K held constant), then the
marginal product of labour (MPL) is
defined as the change in total output (TP)
per unit of change in the variable input,
say Labour (L), ie.,
TP

MPL =

Similarly, average product of labour (APL) is defined

as total product (TP) per unit of labour.
So, APL = TP / L

The Law of Variable Proportions: When the

inputs like plant, machinery, floor space, etc.,
of a firm are fixed, only the amont of labour
services (L) vary, that means any increase or
decrease in output is achieved with the help
of changes in the amount of L.
When the firm changes only the amount of
labour, it alters the proportion between the
fixed input and the variable input. As the firm
keeps on altering this proportion by changing
the amount of labour, it invariably experiences
the law of diminishing marginal returns which
is the same as law of variable proportions

The law states that as more and more of one

factor input is employed, all other input
quantities remaining constant, a point will
eventually be reached where additional
quantities of the varying input will yield
diminishing marginal contributions to the
total product.
Production function with two variable
inputs:
We can see a more general case where the
firm increases its output by using more of
two inputs that are substitutes for each
other, say, capital and labour.

The two variable input case may be taken

either as a short-run or a long-run analysis
of production process, depending on what
assumption is made about the nature of the
firms inputs.
If the firm uses only two inputs and both of
them are variable, then this is a case of
long-run analysis.
While if more than two inputs are used but
only two of them are variable (and the
others are fixed), then this would be taken
as a short run analysis.

ISOQUANT: An isoquant is a curve

representing the various combinations of
two inputs that produce the same amount of
output.
An isoquant is also known as iso-product
curve, or production indifference curve.
As isoquant may, therefore, be defined as a
curve which shows the different
combinations of the two inputs producing a
given level of output.
The table below shows how different pairs of
labour and capital result in the same output.

Labour (units) Capital (units) Output (units)

1
5
10
2
3
10
3
2
10
4
1
10
5
0
10
The output above is the same either by
employing 4L+1K or 5L+0K and so on.
This relationship when shown grphically
results in an Isoquant.

An isoquant is defined as the curve passing

through the plotted points representing all
the combinations of the two factors of
production which will produce a given
output, a typical isoquant diagram is one
which moves upward to the right, since
higher levels of output as obtained using
largerYquantities of inputs.
Machinery
q. = 2000
q.=1000
q, = 600
O

X
Labout

An important assumption in the isoquant

diagram is that the inputs can be
substituted for each other. If the quantity of
labour (X) is reduced, the quantity of
machinery (Y) must be increased in order
to produce the same output.
Types of Isoquants: Linear isoquants: Here
there is a perfect substitutability of inputs.
For example, a given output, say 100 units
can be produced by using only capital or
only labour or by a number of combinations
of labour and capital say, 1 units of labour,
5 units of capital or 2 units of labour and 3
units of capital and so on.

Y
Likewise, given a power plant
equiped to burn either gas or oil,
various amounts of electric power
can be produced by burning gas only
or oil only or varying amounts of
each other. Gas and oil are perfect
substitutes here; hence the isoquants
are straight lines.

Oil

Q1
Gas

Q2

Q2 Q3

Q4

Right Angle Isoquant: Here there is a

complete non-substitutability between the
inputs (or strict complementarity).
For example, exactly two wheels and one
frame are required to produce a bicyle and
in no way can wheels be substituted for
frames or vice versa.
Likewise, two wheels and one chassis are
required for a scooter. This is also known
as Leontief Isoquant or input-output
isoquant.

ChasisY

Q3 = 3 scooters

Q2 = 2 scooters

Q1 = 1 scooter

X
O

Wheels

Convex Isoquant: This form assumes

substitutability of inputs but the
substitutability is not perfect. For example, a
shirt can be made with relatively small
amount of labour (L1) and a large amount of
cloth (C1). The same shirt can as well be
made with less amount of cloth (C2), if more
labour (L2) is used, because the tailor will
have to cut the cloth more carefully and
reduce wastage. Finally, the shirt can be
made with still less cloth (C3) but the tailor
must take extreme pains so that the labour
input requirement increases to L3.

Y
So, while a relatively small addition
of labour from L1 to L2 allows the input of cloth to be reduced from C1
to C2, a very large increase in labour
from L1 to L3 is needed to obtain
a small reduction in cloth from C2
to C3. Thus, the substitutability
of labour for cloth diminishes from L1
to L2 to L3.

C1
Cloth

C2
Q2
C3
Q1
O

L1 L2 L3

Labour
Main properties of Isoquants:
An isoquant is downward sloping to the right, ie., negatively inclined. This implies
that for the same level of output, the quantity of one variable has to be reduced
to increase the other variable.

 A higher isoquant represents a larger output.

That is,with the same quantity of one input
and larger quantity of the other input, larger
output will be produced.
No two isoquants intersect or touch each
other (as two inputs cannot produce two
different levels of output).
Isoquant is convex to the origin. This means
the slope declines from left to right along the
curve. When we go on increasing the
quantity of one input, say labour, by reducing
the quantity of the other input, say, capital,
we see that less units of capital are sacrificed
for the additional amount of labour.

The Laws of Returns to Scale:

The laws of returns to scale explains the
behaviour of total output and the causes of
change in the behaviour of output which
takes place on account of expansion.
The laws of returns to scale explains the
manner in which proportionate increase in
input combinations influences total output at
various points on the path of expansion.
Returns to scale denotes the output
behaviour in the long run in relation to
variations in factor inputs.

In the short run, we have returns to variable

factors and in the long run we have returns
to scale.
As the firm increases the quantities of all
factors employed, other things being equal,
the output may rise initially at a more rapid
rate than the rate of increase in inputs, then
the output may increase in the same
proportion of input and ultimately output
increases less than proportionately. Let us
explain this by means of an hypothetical
table on returns to scale:

Scale

Total
production
in units

Marginal
product or
return in
units

Increasing,
constant or
decreasing
returns

1. 1 L + 2 K
2. 2L + 4K
3. 3L + 6K
4, 4L + 8K
5. 5L + 10K
6. 6L + 12K
7. 7L + 14K

4
10
18
28
38
48
56

4
6
8
10
10
10
8

Increasing

8. 8L + 16K

62

Decreasing

Constant

The law however, assumes the technique of

production unchanged, all units of actors are
homogeneous and returns are measured in
physical terms.
The increasing returns to scale are mainly due
to the realisation of the internal economies of
scale such as labour economies, managerial
economies, technical economies, etc.
Marshall says that increasing returns arise due
to increased efficiency of labour and capital
in the improved organisation with the
expanding scale of output and employment
of factor input.

 Increasing returns are attributed to

improvement in the large-scale operation,
division of labour, use of sophisticated
machinery, better technology, etc.
Technical and managerial indivisibilities: Both
managerial skills and machinery are available
at a certain irreducible size. These inputs
cannot be divided further to obtain a smaller
output.
Hence, when the scale of production expands by
increasing all the factor inputs, the productivity
of indivisible factors increases more than
proportionately, resulting in increasing returns
to scale.

Economists like Robinson, Kaldor, Lerner and

Knight have attributed increasing returns to
scale to the indivisibility or lumpiness of
certain factor inputs.
Higher degree of specialisation of human
resources and machinery: With the increase
in scale of production or expansion, it
becomes possible to introduce greater
specialisation of human resources and more
efficient machinery. The use of advanced
machinery and highly specialised human
resources increases marginal productivity of
factor inputs.

The combined effect of specialised inputs

results in increasing returns to scale.
Dimensional advantages: Prof. W.J. Baumol,
has put forward dimensional economies as
one of the reasons for increasing returns to
scale.
For instance, a storehouse with an area of 100
[Link]. ie., 10 x 10 when doubled, will obtain
an area of 20 x 20 = 400 [Link].
Similarly, when factor inputs are doubled, the
output will increase more than proportionately
to the increase in input.

Units of
Capital

IQ3

IQ4

IQ2
Expansion path

IQ1

Qx = 4000
Qx3 = 3000

Qx2 = 2000
Qx1 = 1000

X
Units of labour

In the above figure of increasing returns to

scale there are four isoquants, IQ1, IQ2,
IQ3 and IQ4, each representing 1000,
2000, 3000 and 4000 units of output,
respectively. The OR shows the expansion
path of the firm.
You may notice above that the incremental
output of 1000 units of commodity x is
obtained by a progressively smaller input
combination of both the factors viz., labour
and capital. This is evident from the
progressive fall in the distance between the
isoquants.

Thus, Oa>ab>bc>cd, which means a

progressively diminishing rate of factor
input is yielding equal increase in output
which further proves the fact that the firm is
enjoying increasing returns to scale.
Since the proportionate change in output is
greater than the proportionate change in
input, the production function coefficient is
greater than one.
Constant Return to Scale occurs on
account of the following:

 Emergence of Diseconomies of Scale:

While increasing returns occur on account
of economies of scale outnumbering the
diseconomies, constant returns to scale
can be attributed to the process of
equalisation between the economies and
diseconomies of scale.
When the firm expands beyond its optimum
limit, diseconomies such as financial,
managerial, marketing, technical and risktaking emerges in equality with the
economies of scale that the firm enjoyed in
the initial stages.

As a result, proportionate change in output is

found to be equal to the proportionate
change in input. Both the internal and
external diseconomies of scale are known to
limit the large-scale production.
As the process of increasing returns to scale
cannot go on for ever, it is followed with
constant returns to scale.
As the firm continues to expand its scale of
operation, it gradually exhausts the
economies responsible for the increasing
returns. Then the constant returns occurs.

Constant returns to scale occurs when a

given percentage increase in inputs leads
to the same percentage increase in output.
Marshall would say that the laws of constant
returns tends to operate when the action of
the laws of increasing returns and
decreasing returns are balanced out or in
other words economies and diseconomies
are exactly in balance over a range of
output.
Perfect divisibility of factor inputs and
constant capital-labour ratio.

When factors of production are perfectly

divisible, constant returns to scale are
obtained:
R
IQ4
Y

IQ3
IQ2
Units of
Capital

Expansion
path

IQ1
d
c
Qx4=4000

b
a

Qx3=3000
Qx1=1000

Units of Labour

Qx2=2000

You will notice here that the distance between

any two Isoquant map is equal, ie.,
Oa=ab=bc=cd. This means that the
combination of factor inputs are increased
proportionately on the expansion path and
the output increases in the same or equal
proportion.
Decreasing Returns to Scale: When
proportionate change in output is less than
the proportionate change in input,
decreasing return to scale is said to have
begun.

IQ4

IQ3

Expansion
path
d

IQ2

Units of
Capital

IQ1

Qx4=4000

Qx3=3000

a
Qx2=2000
Qx1=1000
X

O
Units of Labour

You will notice from the above diagram that the

successive distance between any two points
on the expansion path or the scale line goes
on increasing, thereby suggesting that in
order to increase the output by a given fixed
proportion, a progressively increasing
combination of factor inputs is required. Thus
Oa<ab<bc<cd.
As the firm expands, it may encounter growing
diseconomies of the factors employed.
When powerful diseconomies are met by
feeble economies of certain factors,
decreasing returns to scale set in.

Decreasing returns to scale arise when the

percentage increase in output is less than
the percentage increase in inputs.
Decreasing returns to scale are attributed to
increased problems of organisation and
complexities of large-scale management
which may be physically very difficult to
handle.
The following can be said to be the main
causes for the decreasing returns:

(i) Diseconomies outnumbering economies of

scale: When the firm expands beyond the
point of constant returns, the diseconomies
of scale outnumber the economies the firm
enjoyed in the earlier stages of expansion.
(ii) Limited reserves of natural resources:
Natural resources such as coal, gas, oil,
metal ores, etc., are given and fixed.
Beyond a point of exploration, these
reserves exhaust and if the firm expands its
plant capacity in such a situation, the rate
of return would be less than proportionate.

Causes for decreasing returns to scale:

(a) Though all physical factor inputs are
increased proportionately, organisation and
management as a factor cannot be
increased in equal proportion.
(b) Business risks increase more than
proportionately when the scale of
production is enhanced. An entrepreneur
has his own physical limitations.
(c) When scale of production increases
beyond a limit, growing diseconomies of
large scale production set in.

(d) The increasing difficulties in managing a

big enterprise the complex nature of
supervision and coordination in large-scale
production would make the enterprise more
unwieldy to manage.
(e) Imperfect substitutability of factors of
production causes diseconomies resulting in
a declining marginal output.
In short, the decreasing returns to scale is
attributed to the growing diseconomies of
scale caused by internal inefficiencies of
management of a large-scale enterprise.

Economies and Diseconomies of Scale:

Changes in returns to scale are caused by
cost reducing and cost increasing factors.
These factors are either internal or external
to the firm.
In the long run, when the firm expands its
scale of production, some internal factors
indigenous to the firm starts operating so
that the cost of production falls. These
factors are called internal economies of
scale and the advantages of these factors
are exclusively enjoyed by the firm in which
they arise.

Similarly, when a given industry expands, ie.,

when the number of firms operating in an
industry in a specific location expands, all
the constituent firms begin to enjoy certain
advantages due to certain factors operating
in the industry. These factors external to
the firm are called external economies of
scale.
While there are internal and external
economies of scale, there are also internal
and external diseconomies of scale.

These diseconomies both internal and

external to the firm are responsible for the
rise in the cost of production and the
operation of the returns to scale.
Increasing returns are caused by the fact that
the economies of scale outnumber
diseconomies.
Constant returns are obtained due to the
equality of economies and diseconomies
and negative returns are obtained because
diseconomies of scale outnumber the
economies of scale.

Internal Economies: Advantages arising due

to the expansion in the scale of output
imparts competitive edge to the firm over
others. From the managerial point of view,
it is important to identify these economies
and take advantage to improve the
operational efficiency of the firm. These
internal economies are as under:
(i) Labour economies: Expansion of labour
employment, job analysis, job description,
job specification and person specification
helps the firm to put the right person at the
right place and at the right time.

This exercise leads to division of labour which

in turn leads to specialisation and increases
the efficiency of the work force of the firm.
Specialised employees develop more efficient
tools and techniques and increase the
speed of work.
Increased productivity on account of division
of labour results in improved production
function and lower cost of production.
(ii) Technological economies: Most efficient
and advanced technologies can only be
sued, if the scale of production is large
enough to optimise them.

Technological economies are obtained when

modern machines and scientific technical
processes are adopted and used in
producing on a large scale.
The cost of operating large and advanced
machines is less than that of operating
small and outdated machines.
When the firm expands, it can link all the
stages of output by setting up composite
production processes and reap advantages
of cost reduction.

For instance, a composite textile mill can set up

plants for spinning, weaving, bleaching, dyeing,
printing, pressing and packaging the fabric.
Technological economies are also obtained when
a large firm is able to use its waste to produce
by-products in other industries. For instance,
the use of sugarcane pulp obtained from a
sugar factory can be used as a raw material in
paper manufacturing.
(iii) Managerial economies: When more and more
people are employed, in the course of
expansion, managerial specialisation can also
be undertaken.

And specialised managerial staff can be placed

to perform various managerial functions. For
instance, human power requirements,
planning, placement, compensation, etc., can
be handled by a specialised personnel
manager.
The activities of training and development can
be looked after by a human resource
development manger. Other key areas of an
organisation such as production, purchase,
finance, marketing, etc., can be handled by
respective specialists.

Expertise obtained from the specialised functions,

heads of management can bring about reduction
in the cost of production, increased sales and
higher profits.
(iv) Marketing economies: When various material
inputs are obtained in a large scale and sold on a
large scale, economies of marketing are realised.
A large firm, for instance, will have its own
specialised marketing department which will be
capable of exploring new sources of supply,
obtain raw material and other inputs at lower
rates and also expand the size of the market
through marketing research.

When large purchases are made, the firm can

obtain advantages such as preferential
treatment, cheap transport, preferential
credit, timely delivery and good relation with
the dealers.
(v) Economies of Vertical Integration: Vertical
integration refers to the control of the
different stages of a product as it moves from
raw materials to production and to final
distribution. This imparts the necessary
attitude to production planning and cost
control.

(vi) Financial Economies: A big firm has a

relatively easy access to the capital market.
While debt capital can be raised on easier
terms, ownership capital can be sold at a
premium, thus generating savings or profits.
Further, when financial resources are raised
on a big scale, the cost of mobilising
resources is also low.
(vii) Risk-bearing Economies: A big firm can
easily divide and spread its risks through
diversification.

While concentrating on core competencies, a

firm can diversify its operations along
products and markets and substantially
reduces its risks and survive under all
circumstances. All major companies like
ITC, HUL and industrial houses are
diversified in their business operations.
Diversification of output helps to offset losses
in certain lines of business by the profits
gained in others. Market diversification not
only helps to remain in business but also
continually expand the scale of operations.

External Economies of Scale: These are

external to the firm and such economies
are available to all the firms operating in a
given industry so also other firms and
industries located in a given geographical
region.
To put it briefly, external economies arise due
to growing industrialisation which may be
specialised or diversified.
The following external economies can be
enjoyed by a firm if it is located in a highly
industrialised region.

(i) Economies of concentration: Easy and

cheap access to all the facilities emanating
out of concentration reduces the
operational costs of the firm.
Skilled, trained and technically competent
labour, better transport and
communication, banking and financial
services, better infrastructure, easily
accessible repair and maintenance
services, uninterrupted power supply, etc.,
are the benefits of concentration.

Further, industry-specific research and

development work can be undertaken on a
cooperative basis and benefits of such
research can be enjoyed by all the
constituent member firms of a given
industry.
ii) Economies of Information and market
intelligence: Timely information helps the
firms to make appropriate and timely
business decisions and reduce anxiety and
increase the productive efficiency of the
firm.

(iii) Economies of Specialisation: Firm level

specialisation helps to increase the
productive efficiency of the firm. Various
stages of the value chain can be
disintegrated and handled by a subsidiary
firm or other firms. Each production
facility can maximise the economies of
scale and reduce the cost of production.
Diseconomies of Scale: When a firm
expands beyond its optimum size, it
begins to lose the advantages it made
during the course of its expansion.

The disadvantages of supra-optimal

expansion are known as diseconomies of
scale.
When an industry expands, ie., when the
number of firms of the industry are more
than what is required according to market
or demand conditions, there will not only be
competition for factor inputs but also
competition in the market.
Both on account of price and non-price
competition, the firm may experience loss
of market share and profits in the long run.

In a given region or city, it is not only a given

industry expands, but a number of
industries are set up and these expand,
results in overcrowding and congestion and
transport and communication bottlenecks
and reduces efficiency of work force.
In addition, the firm may have a large work
force with a high degree of specialisation.
Control and coordination of various
activities, both in management and
material management becomes difficult,
leading to greater possibilities of
inappropriate decisions.

Wrong decisions and want of control and

coordination translates into costs to the
firm.
Production Function as applicable to
Service and Manufacturing Sectors
The Cobb-Douglas Production Function
[Link] and P.H. Douglas have explained
the input-output relationship with the help of
statistical techniques. They carried out
their study on the relationship between
input and output in the American
manufacturing industry in 1899 and 1922.

In its original form, this production function

applies not to an individual firm but to the
whole of manufacturing sector in the USA.
The production function, as originally
suggested by Cobb and Douglas was in
the following form:
Q = ALb K1-b
Where Q = total output, L= units of Labour
and K = units of Capital, A = a constant and
b = a parameter

Properties of Cobb-Douglas Production

function:
(i) Both L and K should be positive for Q to
exist. If either of these is zero, Q will be
zero. This implies both labour and capital
are to be combined to get output.
(ii) If we look at the parameters, we find that
their sum [(b) + (1-b)] is equal to 1. This
means that the function in the original form
assumes constant returns to scale.
Constant returns to scale implies that
economies and diseconomies are absent.

And that irrespective of the scale of production,

the profitability of manufacturing firm would
be equal or that the average cost of
production and marginal cost of production
will remain constant.
The conclusion drawn in this famous statistical
study is that labour contributed about 3/4 th
and capital contributed about 1/4 th of the
increase in production in the manufacturing
sector. The function is linear and
homogeneous. Constant returns can be
explained with the help of iso-quant curves,
as under:

The percentage change in output is equal to

percentage change in input
R

IQ4

Y
IQ3
IQ2
Units of
Capital

Expansion
path

IQ1
d

C4
c
C3
C2

Qx4=4000

b
a

Qx3=3000

C1
Qx1=1000
O

L4
L1 L2 L3
Units of Labour

Qx2=2000

The importance of Cobb-Douglas production

function:
The Cobb-Douglas production function is
convenient for international and interindustry comparisons.
It captures the essential non-linearities of
production process and has the benefit of
simplification of calculations by
transforming the function into a linear form
with the help of logarithms.

This can be used to investigate the nature of

long-run production function, whether it is
on the increasing, constant and decreasing
returns to scale.
A significant point that could be arrived at
from the Cobb-Douglas production function
is that small and large scale plants were
equally profitable in the US manufacturing
industry.
With labour held constant, a one per cent
change in capital brings about 0.25%
change in output.

The limitations of the Cobb-Douglas

production function are:
Production function, being a micro economic
concept has been used for explaining the
macro economic phenomenon of
estimating production for the economy as a
whole, without adequate justification. Its
finding would therefore be inaccurate.
Moreover, here only labour was measured by
the actual quantity used in production while
capital was measured in terms of capital
investment, which is theoretically incorrect
except in the case of full employment.

Managerial Use of Production function: The

concept of production function can be used to
compute the least cost input combination for a
given output or the optimum input-output
combination for a given cost.
The managers can decide on the value of
employing a variable input on the basis of the
marginal revenue productivity of a given factor
input.
Ie., if the MRP of a given unit of factor input is
greater than the cost, the firm can continue to
employ the given factor until input cost and
revenue becomes equal.

The managers should know the stage of

returns in which the firm is operating. If
the firm is operating on increasing
returns, it is wiser on the part of the
management to optimise output and
minimise the cost of production.
Thus, it helps in decision making.
Production function has immense utility to
the managers and executives in decision
making at the firm level. It aids in two
ways, viz.,
(i) How to obtain the optimum output for a
given set of inputs.

(ii) How to obtain a given output from the

minimum set of inputs.
The value of utility of a variable input factor in
the production can be better judged with the
help of the production function.
Additional employment of the variable input is
desirable only when the marginal revenue
productivity of a variable factor is more than
its price.
It is rational to stop the additional employment
of the variable factor at a point where the
marginal revenue productivity equals its
price.

The production function, where all factors are

variable, is highly useful in making long run
decisions.
When the firm experiences the increasing
returns to scale, it is profitable to increase
the output. Thus, the production function
helps in making long run as well as short
run decisions.
Optimisation of Factor Combinations: The
most important factor exerting profound
influence on the production function is the
price.

In fact, it is the price of factors that gives practical

shape to the entire theory of optimisation and
factor combination.
If the element of price is introduced, the
theoretical production function becomes
practical oriented indicating least cost
combinations or optimal combination.
When the price is taken into consideration, the
optimum combination of inputs is obviously that
combination where the marginal rate of
substitution between the inputs is equal to the
ratio between prices and inputs. This is studied
through Iso-quant curves.

To conclude, production is an organised activity of

transforming inputs into outputs.
Inputs not only refer to factors of production but also
other things purchased by the firms and spent in
the process of production.
It also includes the rendering of the various kinds of
services, such as banking, insurance and transport.
The process of production adds to the valoues or
creation of utilities.
According to James Bates and J.R. Parkinson,
Production is the organised activity of transforming
resources into finished product in the form of goods
and services and therefore, the objective of
production is to satisfy the demand of such
transformed resources.

The money expenses incurred in the process

of production, ie., transforming resources
into finished products constitute the cost of
production.
The cost of production is an important variable
determining the decision making process at
the firm level.
It is the cost of production which forms the
basis of pricing, quantity to be supplied, etc.
Firms which are not able to produce at the
least cost or the firms which are not capable
of covering the cost of production will have
to abandon production.

The cost of production, therefore, determines

the very existence of the firm.
Cost Concepts for Business Decisions:
As the productive resources are scarce with
any firm and have alternative uses, and use
of these resources involves sacrifice and
therefore cost. The firm will have to
analyse these sacrifices or costs, whenever
it uses the resources.
The study of cost is, thus essential for making
a choice from among the competing
production plans.

Cost and revenue are the two major factors

with which the profit maximising firms need
to deal carefully with. It is the difference
between the revenue and cost that
determines the firms overall profitability.
The long run prosperity of the firm depends
upon its ability to earn sustained profits.
Profit depends upon the difference between
the selling price and the cost of production.
Very often, the selling price is not within the
control of the firm but many costs are under
its control.

The firm should, therefore, aim at controlling

costs to survive and prosper in its business,
particularly in the present day competitive
business environment.
Cost control by management means a search
for better and more economical ways of
completing each operation.
In effect, it would mean that a reduction in the
percentage of costs and in turn increase in
the percentage of profit.
Naturally, cost control is and will continue to
be a perpetual concern for the industry.

In order to make effective business decisions,

the business managers need to be aware
of a number of cost concepts and their
respective uses.
There are several types of costs that a firm
may consider relevant under various
circumstances.
Such costs include future costs, accounting
costs, opportunity costs, implicit costs, final
costs, variable costs, semi-variable costs,
private costs, social costs, common costs,
etc.

For the purpose of decision making, it is

essential to know the fundamental difference
between the main cost concepts along with
the conditions of their use in decision
making.
Actual (or Acquisition or Outlay) Costs and
Opportunity Cost: Actual costs are the costs
which the firm incurs while producing or
acquiring a good or service like the cost on
raw material, labour, rent, interest, etc.
The books of accounts generally record this
information.

The actual costs are also called the outlay

costs or acquisition costs, or absolute costs.
On the other hand, opportunity costs or
alternative costs are the return from the
second best use of the firms resources
which the firm foregoes in order to avail of
the return from the best use of the resources.
Suppose a businessman can buy either a lathe
machine or a paper pressing machine with
his limited resources and he can earn
annually Rs.50,000 and Rs.70,000,
respectively from the two alternatives.

A rational businessman will certainly buy a

paper pressing machine which gives him a
higher return.
But, in the process of earning Rs.70,000 he
has foregone the opportunity to earn
Rs.50,000 annually from the lathe machine.
Thus, Rs.50,000 is the opportunity cost or
alternative cost.
The difference between the actual cost and
the opportunity is called the economic rent
or economic profit.

For example, economic profit from the paper

pressing machine in the above case is
Rs,70,000 Rs.50,000 = Rs.20,000.
As long as economic profit is above zero, it is
rational to invest resources in paper
pressing machine.
The cost of opportunity cost is useful to
managers in decision making or in choosing
the best opportunity.
Opportunity costs or imputed costs are not
actually incurred and hence they are not
recorded in the books of accounts.

Sunk Costs and Outlay Costs: Outlay costs

mean the actual expenditure incurred for
producing or acquiring a good or service.
These actual expenditures are recorded in the
books of accounts of the business unit, e.g.,
wage bill. These costs are also known as
actual costs or absolute costs.
Sunk costs are those which cannot be altered
by changing the rate of output and cannot
be recovered, e.g., depreciation. Such
costs remain the same irrespective of the
level of business activity.

Explicit Cost (or paid out costs) and Implicit

(or imputed costs):
Explicit costs are those expenses which are
actually paid by the firm. They are paid out
costs.
These costs appear in the accounting
records of the firm.
On the other hand, implicit or imputed costs
and theoretical costs in the sense that they
go unrecognised by the accounting system.
These costs may be defined as the earnings
of those employed resources, which belong
to the owner himself.

For example, the interest payment on

borrowed funds is an explicit cost and
enters the accounting records but the
amount of interest which the employer could
have earned (and which he foregoes when
he uses his own capital in his firm) is his
implicit cost.
Similarly, the amount of rent, wages, utility
expenses, etc., which are paid out are the
explicit costs of the firm, while wages, rent,
etc., which are due to the entrepreneur for
employing his own resources in the firm are
all implicit costs.

The explicit costs are important for

calculation of profit and loss account but
for economic decision making the firm
takes into account both the explicit as well
as implicit costs.
Accounting Costs and Economic Costs:
Accounting costs are the actual or outlay
costs. These costs point out how much
expenditure has already been incurred on
a particular process or on production as
such. Since these costs relate to the past,
these are generally sunk costs.

The accounting costs are useful for managing

taxation needs, as well as to calculate profit
and loss of the firm.
On the other hand, economic costs relate to
the future. They are in the nature of
incremental costs both the imputed and
the explicit costs as well as the opportunity
costs.
As what matters for decision making is future
costs, it is the economic costs that are used
for decision making.

Private Costs and Social Costs: Economic

costs can be calculated at two levels: micro
level and macro level.
Micro level economic sots relate to
functioning of a firm as a production unit,
while the macro level economic costs are
the ones that are generated by the
decisions of the firm but are paid by the
society and not the firm.
For example, if the decision of the firm to
expand its output leads to increase in its
costs, this would form part of private costs.

If it also leads to certain costs to the society,

(may be in the nature of greater pollution,
greater conjestion, etc.), these costs which
are external to the firm are social costs from
the societys point of view.
Thus, private costs are those which are
actually incurred by the firm and are
provided for by an individual or a firm for its
business activity, while social costs are the
total cost to the society on account of
production of a good.

Thus, economic costs include both the private

costs and social costs. However, the net
social cost is the total cost minus the
private costs.
Historical (original) Costs and Replacement
Costs: Historical cost of an asset states the
cost of the plant, equipment and materials
at the price paid originally for them while
the replacement cost states the cost the
firm would have to incur if it wants to
replace or acquire the same assets now.

The difference between the historical cost and

replacement cost results from the price
changes over time.
Suppose a machine was purchased for
Rs.10,000 in 1991 and the same machine is
now priced at Rs.25,000, the former is the
historical cost and the latter is the
replacement cost.
Marginal Cost, Average Cost and Total Cost:
The total cost represents the money value of
the total resources required for production of
goods and services by the firm.

Average cost is the cost per unit of output,

assuming that production of each unit of
output is incurs the same cost, ie., AC =
TC / the number of units.
Marginal costs are the incremental or
additional cost incurred when there is
addition to the existing output of goods and
services.
For example, if the total cost increases from
Rs.2,000 to Rs.2,100 when production
increases from 10 units to 11 units, the
marginal cost of the 11th unit is equal to

Rs.2,100 Rs.2,000 = Rs.100.

Total cost increases throughout, though at
different rates.
Average cost and marginal costs first decline
and then rise.
Marginal cost rises earlier than average cost.
Fixed Costs and Variable Costs: Fixed costs
are that part of total cost of the firm, which
does not vary with output, e.g., expenditure
on depreciation, rent of land and buildings,
property taxes, etc.

Fixed costs are also known as overhead

costs.
Fixed costs are, therefore, defined as the
costs which are incurred in hiring the fixed
factors of production, whose amount cannot
be changed in the short run.
Variable costs, on the other hand, varies with
the level of output.
Variable costs involve payment of wages to
the labour employed, cost of raw materials,
fuel, power, transportation, etc.

Variable costs are incurred when the

production process begins. They are,
therefore, known as Prime Costs or direct
costs.
Total cost is the sum of fixed and variable
costs.
Short run and long-run costs: Short run costs
are those costs which changes with the
level of output. All variable costs are
incurred in the short run.
Long run costs are incurred on the fixed
assets, such as plant, machinery, buildings,
etc. They are the long run costs.

However, when the firm expands its scale of

operation, the fixed costs become variable
costs.
Cost-Output relationship: Cost
determinants differ from firm to firm and
also from problem to problem.
In modern manufacturing enterprises, there
are certain forces which are considered as
cost determinants. They are:
(a) Rate of output (utilisation of fixed plant)

(b) Size of plant

(c) Prices of input factors (materials and
labour)
(d) Technology
(e) Stability of output
(f) Efficiency of management and labour.
Of these, the first one, viz., the rate of output
occupies a strategic role as the behaviour
of cost is mainly determined by this force,
viz., the output.
The cost is determined to a very large extent
directly by the changes in size of output.

Hence, a detailed study of cost-output

relationship has to be made.
The relation between the cost and output is
technically described as cost function. In
economic theory there are two types of cost
functions, viz., (i) short run cost function and
(ii) the long-run cost function.
The cost output relationship has to be studied
for the short period and the long period
separately.
In the short run, there is no scope to vary
plant and machinery and management.

With fixed plant and machinery, cost varies

with changes in the rate of output.
In the long run cost, there is complete change
as the time is long enough to effect total
change because there is ample scope for
changing all input factors.
Long run costs are useful in deciding the
optimum size of the plant. They are useful
for starting a new plant and expanding old
ones.
Fixed costs and variable costs are not two
distinct categories.

They are the two ends of a continuum.

In the long run all costs become variable and
hence this distinction prevails mainly for a
short period.
The distinction is useful in evaluating the
effect of short run changes in volume, upon
costs and profits.
Fixed costs which are incurred in the fixed
capital of the firm, e.g., equipment,
machinery, land, building, permanent staff
of the company, arise because certain
factors of production are indivisible.

And they have to be engaged in a certain size

for technical reasons and can be used over
a period of time.
The inputs which are exhausted for a single
use, e.g., raw materials, fuel, etc., would fall
in the variable costs.
Fixed costs will not vary with the changes in
output, as these costs have to be incurred
even if the plant is in a standstill.
Rent on buildings, interest on capital, salaries
to the permanent staff, insurance premium
or certain taxes are the fixed costs.

Variable costs which vary according to the

changes in output would include payments
to labour, raw material, fuel, power, etc.
Fixed costs are also known as constant
costs, supplementary costs or overhead
expenses.
Variable costs are known as Prime costs or
Direct costs.
Since fixed costs are not affected by the
changes in the volume of output, there
exists an inverse relationship between the
volume of production and fixed cost per
unit.

The per unit fixed costs are known as the

Average Fixed Cost.
AFC = TFC / q, where q represents the
number of units of output.
The greater the output of the firm, the smaller
will be the average fixed cost.
The average fixed cost diminishes as the
output increases.
The AFC curve is the downward sloping
curve to right through its entire length and it
is a rectangular hyperbola, since AFC and
quantity produced are constant.

Average variable cost refers to the variable

cost per unit of output.
AVC = TVC / q.
Average variable cost will generally be Ushaped. The AVC will fall as the output
increases from zero to normal capacity
output due to the operation of increasing
returns. But, beyond the normal capacity
output, AVC will rise steeply due to the
operation of diminishing returns.
The completely fixed cost and completely
variable cost curves would be as under:

FC

Total
Fixed
Cost

X
Output

VC

Total
Variable
Cost

O
Output

Y
)
)
)
)
)
)

Total
SemiVariable
Cost

Variable Cost of
Production

Total Fixed Cost of production

X
Output

Average
Fixed
Cost

AFC

X
Output

Average
Variable
Cost

AVC

Output

Total cost of production is the money

expenses incurred for buying the input
required for producing a commodity or a
service.
It includes all payments made in cash to
various factors of production and all those
charges paid to the owners of factors of
production.
For example, the total cost of producing a
table will include the amount spent on
wood, nails, varnish, labour, rent for the
premises, interest on capital, etc.

In economic parlance, the total cost includes

the remuneration for the organiser or the
entrepreneur, which may be called profit.
ATC is the sum of average fixed cost and
average variable cost. As the output
increases, the AFC becomes smaller and
smaller and the vertical distance between
the ATC curve and AVC curve goes on
declining.
When the AFC approaches the X axis, the
AVC approaches the average total cost
curve.

The ATC is simply called the average cost,

which is the total cost divided by the
number of units produced.
ATC = TC / q
TC is the sum of TFC and TVC and the ATC
is the sum of AVC and AFC.
TC = TVC + TFC
ATC = TVC + TFC / q = TVC / q + TFC / q
ATC = AVC + AFC
ATC is equal to AVC + AFC, which is the
average cost.

Y
ATC

Average Cost is
also known as the
unit Cost, since
it is the cost per
unit of output
produced

AVC

Cost

AFC
O

Output

From the diagram, it is evident that the

behaviour of ATC curve depends upon the
behaviour of AVC and AFC curves.
In the beginning, both AVC and AFC have
fallen. When the AVC curve starts rising,
AFC curve falls steeply. But ATC curve
continues to fall because the fall in the AFC
is heavier than the AVC.
But as output increases further, there is a
sharp rise in AVC which more than offsets
the fall in AFC.

Therefore, the ATC curve rises after a point.

The ATC curve, like AVC falls first, reaches
the minimum value and then rises. Hence it
has taken a U shape.
Semi-Variable Cost: There are some costs
which are neither perfectly variable nor
absolutely fixed in relation to the changes in
the size of the output.
For example, electricity charges include both a
fixed charge and a charge based on
consumption.
.

Salesmens salary includes commission

based on the quantum of sales, which
is variable, along with salary, which is
fixed.
Some costs may increase in a stair step
fashion
That is, they remain fixed over a certain
level of output but suddenly jump to a
new higher level when output goes
beyond a given limit.

Fixed salary of a foreman will have a sudden

jump if another foreman is appointed when
the output crosses a limit.
A diagram to depict the semi-variable cost is
as under:
Y

VC A stair step variablecost.

Total
Variable
Cost

Output

Marginal Cost: The computation of marginal

cost is as under:
Output in Total Cost
Marginal Cost
Units
(Rs.)
(Rs.)
0
200
1
250
50
2
290
40
3
320
30
4
360
40
5
412
52

TFC will be incurred even if there is no

output. Initially, the MC decreases when the
output is increased. At the fourth unit of
production, the marginal cost increases with
the increase in output. The shape of the
curve will be U, showing that the marginal
cost declines first and increases afterwards.
The U shaped marginal cost curve can be
depicted by means of a diagram, which is
as under:

MC

MC

X
Output

Three important points to be noted here.

First, the shape of the curve is determined by
the law of variable proportion.
As increasing returns is in operation, the MC
curve will be declining as the cost will be
decreasing with the increase in output.
When the diminishing return is in operation,
the MC will be ascending as it is a situation
of increasing cost.
Second, the changes in the MC is due to
changes in the VC when the output is
increased or decreased.

And so, MC is independent of fixed cost.

Increase in variable cost will cause an
increase in MC and a decrease in VC will
cause decrease in MC.
Third, the price of the variable factor remains
constant as the firm expands its output.
Otherwise , a change in price will disturb our
conclusion.
Relation between MC and AC: The
relationship is more a mathematical one
rather than economical.

According to Lipsey, the two curves should

start from the same point.
Both the MC and AC curves decline but MC
curve declines steeply than the latter.
After a certain stage, both costs rise but MC
curve rises steeply while AC will rise
smoothly. The MC curve cuts the AC curve
from below at the lowest point of AC.

Y
MC
AC &
MC

AC

X
Output

At the point of intersection Q where AC

curve and MC curve meet, both are equal.
When MC curve cuts the AC curve at the
latters minimum point, the MC will be rising
too. But beyond point R and up to point Q,
the MC curve lies below the average cost
curve and the AC is also falling.
Though the MC is rising between R & Q, it is
below the AC .
It is clear that when AC is falling, MC may be
falling or rising. But when AC is rising, MC
should necessarily be rising.

Short-run Cost-Output Relationship:

During the short period, the variable factors of
production can be changed but the fixed
factors of production cannot be changed.
An increase in supply can be achieved by
having additional shifts or by using the
existing equipment more intensively.
Since the fixed equipment of the firm cannot
be altered during the short period, the extra
output can be had only incurring a higher
marginal cost.

MC

ATC

AVC

Cost

AFC

X
O

Output

In the short run, the average cost of the firm

declines to a minimum and then rises.
To what extent it declines, depends on the
proportion of fixed cost to total cost.
The average cost curve is U-shaped in the
short run.
AFC is a rectangular hyperbola. It falls as
the output rises.
AVC first falls and then rises so also the ATC
curve.
AVC curve starts rising earlier than the ATC
curve.

The least cost level of output corresponds to

the point L on ATC curve.
The MC curve intersects both AVC curve and
the ATC at their minimum curve.
In the short run, the firm is tied with a given
plant.
But, in the long run, the firm moves from one
plant to another. As the scale of operation is
altered, a new plant is added.
The long run cost of production is the least
possible cost of production of producing any
given level of output.

At that level of output then, all the inputs

become variable including the size of the
plant.
LAC
Y
SAC1
SAC2
Average
Cost

SAC3
K

M1
Output

SAC4

SAC5

The LAC curve will touch SAC2

curve at the least cost point, ie.Q.
LAC will touch SAC 3 and SAC4
curves on the right side.
This is on the basis of traditional
economic analysis.

However, modern firms face L-shaped cost

curve than U shaped.
LMC
Y
Over AB range, the
Curve is perfectly flat.
Over this range, all
Sizes of plant have the
same minimum cost.

Average
Cost

LAC

A
Output

In modern business, the economists

emphasize another important factor, known
as learning.
Learning and Costs: In addition to the
economies of scale, both internal and
external, one of the important factors that
determine the gradual fall in the average
cost of production is the progressive
accumulation of learning by all concerned in
an enterprise.
Learning is cumulative through time and
enhances the efficiency , accuracy and
profitability of human resources.

Human resources would include labour of all

categories.
Learning and costs are inversely related with
each other.
The more the organisation learns through
experience and the application of mind and
the more the environment is conducive to
such application of minds, greater and
greater will be the productivity of the people
and lower will be the cost of production.

The reduction in cost due to this learning

process is known as the learning curve
effect, where learning curve graphically
depicts the relationship between the labour
cost and additional units of output.
Learning contribution to increased productivity
through progressive and simultaneous
improvements in the processes and
techniques of production.
In modern business organisation, learning is
not merely a natural process ie., people
learn through experience.

And that they are naturally pre-disposed to

learning but also a deliberate effort.
In fact, deliberate learning is more scientific,
time-bound and result-oriented.
Deliberate learning can be quantified and
assessed for its results.
Both deliberate and spontaneous learning
brings about a fall in the average cost of
production in a number of ways.
Some of these are as under:
(a) Job familiarisation and reduced time
required to instruct the subordinates.

(b) Mechanical and skilful movement of

employees;
(c) Improved sequential operating process,
machine speeds and feeds;
(d) Reduced rate of rejection and resultant
reworking efforts;
(e) Improvements in machines and tooling;
(f) Larger manufacturing lots and reducing
set up time.
(g) Better coordination and managerial
controls, etc.

Y
AC1 is before learning and
AC2 is the curve of learning
in the sense that the cost
reduced after some experience.
The unit cost in the first month
is BM. After nx months, the cost
gets reduced to LM. The cost
steadily declines and ultimately
it sets at LM.

Cost
L

AC2

M
Output

AC1

It is found that the rate of learning is about 80

per cent, ie., when the output is doubled,
the time required to produce the given
output is only 80 per cent of the former
level.
For instance, if the first 100 units of output
require an average of 100 person hours
each and when the output is doubled to
200 units, the average person hours
required to produce 200 units of output is
only 80 person hours

Units of
Output

Cumulative
average labour
hours

Cumulative
average labour
cost (Rs,)

2000.0

20,000

1336.5

13,365

16

1115.0

11,150

32

917.4

9,174

If we plot the learning curve, it will be as under

Y
Unit
20
Labour
Cost
(Rs, in
thousands)15

10
C
5

16
Output Units (cumulative)

32

This is an 80 per cent learning curve. You will

notice here that for producing 1 unit of
output, the average unit labour cost is
Rs.20,000, But, when the output is raised to
16, the cumulative labour cost would be
Rs.11,150 and when it is doubled to 32, it
was brought down to Rs.9,174.
Limitations: It cannot effectively deal with
situation where (i) changes are made in the
general size of the production run; (ii) rapid
expansion of the enterprise;

(iii) Learning by the newly recruited

employees is faster than the old ones; (iv)
difference in the rates of production are
substantial and (v) improvements in the
direct labour content of production
Notwithstanding the limitations of learning
curve theory, it is generally agreed that a
substantial part of gains made through
improvement in productivity are on account
of learnings.

Cost Control and Optimum Firm:

Modern business world is not only highly
complex but also competitive.
The success and survival of a firm depends on
so many factors and the competence of the
firm mainly depends on the price of its
products and the quality of its products.
The competitive ability of the firm depends
upon the ability to produce the commodity at
the minimum cost.

Hence, cost structure, reduction of cost and

cost control have to occupy an importance
place in business decisions.
Business decisions, as thy are about the
future, require the businessmen to choose
between alternatives and to do this, it is
necessary to know the cost involved.
Cost control involves discovering better and
economical ways of doing each operation. It
aims at keeping the costs down, thereby
increasing the profitability and competence
of the firm.

And making best use of every rupee spent in

producing a commodity.
In the absence of cost control, profits would
come down due to increasing costs, even
though the quantum of sales may be
increasing. Hence, it is necessary for the
modern firms to exercise control on costs.
There is more profit in cost control when the
business is good than when the business is
bad. Therefore, one should not be slack
when conditions are good.

Techniques of Cost Control: There are two

distinct and inter-related techniques of cost
control. They are: (1) Budgetary control and
(2) Standard Costing.
Budgetary control is concerned with the cost
of running individual departments within the
company.
Standard costing is concerned with the cost of
making particular products.
Once the departmental budgets are prepared,
they can be aggregated to produce a Master
Budget

showing the overall effect which will

incorporate a planned P & L A/c and
Balance Sheet and serve to show what profit
will be earned and what will be the end-year
asset position.
When the actual budget period starts, the
actual data must be collected for
comparison with the budgets to facilitate
cost control. If there is an excess of actual
cost due to a rise in material prices, rather
than excess usage of materials, then the
budget itself may have to be revised.

Standard costing would facilitate to isolate

the causes which have risen to higher
costs and who is responsible for this in
the organisation.
Other techniques for cost reduction:
(a) value analysis;
(b) work study and O & M;
(c) Standardisation and
(d) simplication and variety reduction.
Value Analysis is in essence, a procedure
which specified the functions of products,

or components, establishes an appropriate

cost, creates alternatives and evaluates
them.
This technique finds useful where very large
quantities of an item is being produced so
that fractional amounts saved on
manufacturing cost can result in substantial
savings.
Method Study: It is a systematic recording
and critical examination of existing and
proposed way of doing work, as a means of
developing and applying easier and more
effective methods of reducing costs.

The primary object of work study is analysis of

all the factors which affect the performance of
a taste to develop and install work methods
which make optimum use of the human and
material resources available and also to
establish suitable standards by which the
performance of this work can be measured.
Method study is the creative aspect of work
study. By means of a defined procedure,
either improved methods of doing existing
jobs or efficient methods of doing new jobs
are developed in order to achieve near
optimum use of men, materials &machines.

Work measurement is required frequently to

compare alternative work methods.
Standardisation: Standardisation reduces
cost through reduction of capital
investment (by elimination of unnecessary
stock), reliability of product and
improvement in quality.
Simplification and Variety Reduction also
result in lower costs due to a number of
reasons, viz., (a) concentration on
administration, sales, advertising and
distribution for fewer products and

(b) Reduced inventory of raw materials,

components and finished goods.
Optimum Firm: In production, the firm while
increasing the output reaps economies of
scale and thereby reduces the cost of
production.
But, after a certain stage, expansion of
output reaps economies of scale and
thereby reduces the cost of production.
But, after a certain stage, expansion of
output becomes uneconomical.

At the initial stages, cost of production will go

on reducing as the firm works the expansion
of plants.
The long-run average cost curve will be falling
down as the firm takes up to new plants one
after the other.
But, after a stage, the long run cost curve will
go up showing that any expansion will result
in higher cost of production.
When the cost of production comes to the
lowest point, then the firm is said to be of
optimum size.

The optimum firm means the best or the most

efficient size of the firm. Its cost of production
per unit is at the minimum.
According to Prof. Robinson, The optimum firm
is one which in existing conditions of
techniques and organising ability, has the
lowest average cost of production per unit
when all those costs which must be covered
in the long run are included.
According to [Link], the optimum size
of a firm depends, mainly upon the
economies of scale like technical economies,

managerial economies, financial economies

and marketing economies.
Y

MC

AC
Cost &
Revenue
AR=MR=Price

O
Output

All these forces operate, making for a

technical optimum, financial optimum and
managerial optimum, etc.
The optimum size of the firm is largely
determined by the economies and
diseconomies of scale of production, along
with the other factors such as factor
proportions and the availability of capital.