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UNIT VI- THEORY OF PRODUCTION AND COST ANALYSIS

UNIT VI- Theory of Production and Cost Analysis: Production Function- Iso-quants and Iso-costs,
MRTS, Law of variable proportions- Law of returns to scale- Least Cost Combination of Inputs, Cobb-
Douglas Production function - Economies of Scale;
COST ANALYSIS: Cost concepts, Opportunity cost, Fixed Vs Variable costs, Explicit costs Vs. Implicit
costs, Out of pocket costs vs. Imputed costs.-Determination of Break- Even Point (simple problems) -
Managerial Significance and limitations of BEP.
PRODUCTION FUNCTION
Introduction: The production function expresses a functional relationship between physical inputs and
physical outputs of a firm at any particular time period. The output is thus a function of inputs.
Mathematically production function can be written as

Q= f (A, B, C, D)

Where “Q” stands for the quantity of output and A, B, C, D are various input factors such as land,
labour, capital and organization. Here output is the function of inputs. Hence output becomes the dependent
variable and inputs are the independent variables.

The above function does not state by how much the output of “Q” changes as a consequence of
change of variable inputs. In order to express the quantitative relationship between inputs and output,
Production function has been expressed in a precise
mathematical equation i.e.

Y= a+b(x)

Which shows that there is a constant relationship between

applications of input (the only factor input „X‟ in this case) and
the amount of output (y) produced.

A production function is a table or a mathematical equation

showing the maximum amount of output that an be produced
from any specified set of inputs, given the existing technology.
The total product curve for different technology is given below.

Importance:

1. When inputs are specified in physical units, production function helps to estimate the level of
production.
2. It becomes is equates when different combinations of inputs yield the same level of output.
3. It indicates the manner in which the firm can substitute on input for another without altering the total
output.
4. When price is taken into consideration, the production function helps to select the least combination
of inputs for the desired output.
5. It considers two types‟ input-output relationships namely „law of variable proportions‟ and „law of
returns to scale‟. Law of variable propositions explains the pattern of output in the short-run as the
units of variable inputs are increased to increase the output. On the other hand law of returns to scale
explains the pattern of output in the long run as all the units of inputs are increased.
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6. The production function explains the maximum quantity of output, which can be produced, from
any chosen quantities of various inputs or the minimum quantities of various inputs that are
required to produce a given quantity of output.
Assumptions:

Production function has the following assumptions.

1. The production function is related to a particular period of time.

2. There is no change in technology.
3. The producer is using the best techniques available.
4. The factors of production are divisible.
5. Production function can be fitted to a short run or to long run.
ISO-QUANTS

Isoquants are the curves, which represent the different combinations of inputs producing a particular
quantity of output. Any combination on the isoquant represents the some level of output.
For a given output level firm‟s production become,
Q= f (L, K)

Where „Q‟, the units of output is a function of the quantity of two inputs „L‟ and „K‟.

Thus an isoquant shows all possible

combinations of two inputs, which are
capable of producing equal or a given level
45
An isoquant
a
40
Units Units Point on
of output. Since each combination yields of K of L diagram
35 40 5 a
same output, the producer becomes 20 12 b
Units of capital (K)

10 20 c
indifferent towards these combinations. 30
6 30 d
25 4 50 e
Assumptions: b
20

1. There are only two factors of 15

c
production, viz. labour and capital. 10 d
2. The two factors can substitute each 5
other up to certain limit 0
3. The shape of the isoquant depends 0 5 10 15 20 25 30 35 40
fig
45 50
Units of labour (L)
upon the extent of substitutability of
the two inputs.
4. The technology is given over a period.
◼ Slope of an isoquant indicates the rate at which factors K and L can be substituted for each other
while a constant level of production is maintained.
◼ The slope is called Marginal Rate of Technical Substitution (MRTS)
Properties of Isoquants

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◼ Isoquants do not intersect. Since each isoquant refers to a specific rate of output, an intersection
would indicate that the same combination of resources could, with equal efficiency, produce two
different amounts of output

◼ Isoquants are usually convex to the origin ➔ any isoquant gets flatter as we move down along the
curve.

Isocost Lines
Isocost lines show different combinations of inputs which give the same cost.

Marginal Rate of Technical Substitution (MRTS)

The absolute value of the slope of the isoquant is the

Marginal Rate of Technical Substitution, MRTS,
between two resources.

Thus, the MRTS is the rate at which labor substitutes

for capital without affecting output .
➔ when much capital and little labor are used, the
marginal productivity of labor is relatively great and
the marginal productivity of capital relatively small
➔ one unit of labor will substitute for a relatively
large amount of capital

LAW OF PRODUCTION

Production analysis in economics theory considers two types of input-output relationships.

1. When quantities of certain inputs, are fixed and others are variable and
2. When all inputs are variable.
These two types of relationships have been explained in the form of laws.
i) Law of variable proportions
ii) Law of returns to scale
I. Law of variable proportions:
`The law of variable proportions which is a new name given to old classical concept of “Law of
diminishing returns has played a vital role in the modern economics theory. Assume that a firms production
function consists of fixed quantities of all inputs (land, equipment, etc.) except labour which is a variable
input when the firm expands output by employing more and more labour it alters the proportion between
fixed and the variable inputs. The law can be stated as follows:

“When total output or production of a commodity is increased by adding units of a variable input
while the quantities of other inputs are held constant, the increase in total production becomes after some
point, smaller and smaller”.

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“If equal increments of one input are added, the inputs of other production services being held
constant, beyond a certain point the resulting increments of product will decrease i.e. the marginal product
will diminish”. (G. Stigler)

“As the proportion of one factor in a combination of factors is increased, after a point, first the
marginal and then the average product of that factor will diminish”. (F. Benham)

The law of variable proportions refers to the behaviour of output as the quantity of one Factor is
increased Keeping the quantity of other factors fixed and further it states that the marginal product and
average product will eventually do cline. This law states three types of productivity an input factor – Total,
average and marginal physical productivity.

Assumptions of the Law: The law is based upon the following assumptions:

i) The state of technology remains constant. If there is any improvement in technology, the average
and marginal out put will not decrease but increase.
ii) Only one factor of input is made variable and other factors are kept constant. This law does not
apply to those cases where the factors must be used in rigidly fixed proportions.
iii) All units of the variable factors are homogenous.
Three stages of law:

The behaviors of the Output when the varying quantity of one factor is combines with a fixed quantity of the
other can be divided in to three district stages. The three stages can be better understood by following the
table.

Fixed factor Variable factor Total product Average Marginal

(Labour) Product Product

1 1 100 100 - Stage

I
1 2 220 120 120

1 3 270 90 50

1 4 300 75 30 Stage
II
1 5 320 64 20

1 6 330 55 10

1 7 330 47 0 Stage
III
1 8 320 40 -10

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Above table reveals that both average product and marginal product increase in the beginning and then
decline of the two marginal products drops of
faster than average product. Total product is
maximum when the farmer employs 6th worker,
nothing is produced by the 7th worker and its
marginal productivity is zero, whereas marginal
product of 8th worker is „-10‟, by just creating
credits 8th worker not only fails to make a
positive contribution but leads to a fall in the
total output.

Production function with one variable

input and the remaining fixed inputs is
illustrated as below

From the above graph the law of variable proportions operates in three stages. In the first stage, total
product increases at an increasing rate. The marginal product in this stage increases at an increasing rate
resulting in a greater increase in total product. The average product also increases. This stage continues up
to the point where average product is equal to marginal product. The law of increasing returns is in
operation at this stage. The law of diminishing returns starts operating from the second stage awards. At the
second stage total product increases only at a diminishing rate. The average product also declines. The
second stage comes to an end where total product becomes maximum and marginal product becomes zero.
The marginal product becomes negative in the third stage. So the total product also declines. The average
product continues to decline.

We can sum up the above relationship thus when „A.P.‟ is rising, “M. P.‟ rises more than “ A. P;
When „A. P.” is maximum and constant, „M. P.‟ becomes equal to „A. P.‟ when „A. P.‟ starts falling, „M. P.‟
falls faster than „ A. P.‟.

Thus, the total product, marginal product and average product pass through three phases, viz.,
increasing diminishing and negative returns stage. The law of variable proportion is nothing but the
combination of the law of increasing and demising returns.

II. Law of Returns of Scale:

The law of returns to scale explains the behavior of the total output in response to change in the scale
of the firm, i.e., in response to a simultaneous to changes in the scale of the firm, i.e., in response to a
simultaneous and proportional increase in all the inputs. More precisely, the Law of returns to scale explains
how a simultaneous and proportionate increase in all the inputs affects the total output at its various levels.

The concept of variable proportions is a short-run phenomenon as in these period fixed factors can
not be changed and all factors cannot be changed. On the other hand in the long-term all factors can be
changed as made variable. When we study the changes in output when all factors or inputs are changed, we
study returns to scale. An increase in the scale means that all inputs or factors are increased in the same
proportion. In variable proportions, the cooperating factors may be increased or decreased and one faster
(Ex. Land in agriculture (or) machinery in industry) remains constant so that the changes in proportion
among the factors result in certain changes in output. In returns to scale all the necessary factors or

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production are increased or decreased to the same extent so that whatever the scale of production, the
proportion among the factors remains the same.

When a firm expands, its scale increases all its inputs proportionally, then technically there are three
possibilities.

(i) The total output may increase proportionately

(ii) The total output may increase more than proportionately and

(iii) The total output may increase less than proportionately.

If increase in the total output is proportional to the increase in input, it means constant returns to scale.

If increase in the output is greater than the proportional increase in the inputs, it means increasing
return to scale.

If increase in the output is less than proportional increase in the inputs, it means diminishing returns
to scale.

Cobb-Douglas production function

Production function of the linear homogenous type is invested by Junt wicksell and first tested by C.
W. Cobb and P. H. Dougles in 1928. This famous statistical production function is known as Cobb-Douglas
production function. Originally the function is applied on the empirical study of the American
manufacturing industry. Cabb – Douglas production function takes the following mathematical form.

Y= (AKX L1-x)

Where Y=output K=Capital L=Labour A, ∞=positive constant

Assumptions:

It has the following assumptions

1. The function assumes that output is the function of two factors viz. capital and labour.
2. It is a linear homogenous production function of the first degree
3. The function assumes that the logarithm of the total output of the economy is a linear function of the
logarithms of the labour force and capital stock.
4. There are constant returns to scale
5. All inputs are homogenous
6. There is perfect competition
7. There is no change in technology
ECONOMIES OF SCALE

Production may be carried on a small scale or o a large scale by a firm. When a firm expands its size
of production by increasing all the factors, it secures certain advantages known as economies of production.
Marshall has classified these economies of large-scale production into internal economies and external
economies.

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Internal economies are those, which are opened to a single factory or a single firm independently of
the action of other firms. They result from an increase in the scale of output of a firm and cannot be
achieved unless output increases. Hence internal economies depend solely upon the size of the firm and are
different for different firms.

External economies are those benefits, which are shared in by a number of firms or industries when
the scale of production in an industry or groups of industries increases. Hence external economies benefit all
firms within the industry as the size of the industry expands.

Internal Economies
Internal economies may be of the following types.

A). Technical Economies: Technical economies arise to a firm from the use of better machines and superior
techniques of production. As a result, production increases and per unit cost of production falls. A large
firm, which employs costly and superior plant and equipment, enjoys a technical superiority over a small
firm. Another technical economy lies in the mechanical advantage of using large machines. The cost of
operating large machines is less than that of operating mall machine. More over a larger firm is able to
reduce it‟s per unit cost of production by linking the various processes of production. Technical economies
may also be associated when the large firm is able to utilize all its waste materials for the development of
by-products industry. Scope for specialization is also available in a large firm. This increases the productive
capacity of the firm and reduces the unit cost of production.

B). Managerial Economies: These economies arise due to better and more elaborate management, which
only the large size firms can afford. There may be a separate head for manufacturing, assembling, packing,
marketing, general administration etc. Each department is under the charge of an expert. Hence the
appointment of experts, division of administration into several departments, functional specialization and
scientific co-ordination of various works make the management of the firm most efficient.

C). Marketing Economies: The large firm reaps marketing or commercial economies in buying its
requirements and in selling its final products. The large firm generally has a separate marketing department.
It can buy and sell on behalf of the firm, when the market trends are more favorable. In the matter of buying
they could enjoy advantages like preferential treatment, transport concessions, cheap credit, prompt delivery
and fine relation with dealers. Similarly it sells its products more effectively for a higher margin of profit.

D). Financial Economies: The large firm is able to secure the necessary finances either for block capital
purposes or for working capital needs more easily and cheaply. It can barrow from the public, banks and
other financial institutions at relatively cheaper rates. It is in this way that a large firm reaps financial
economies.

E). Risk bearing Economies: The large firm produces many commodities and serves wider areas. It is,
therefore, able to absorb any shock for its existence. For example, during business depression, the prices fall
for every firm. There is also a possibility for market fluctuations in a particular product of the firm. Under
such circumstances the risk-bearing economies or survival economies help the bigger firm to survive
business crisis.

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F). Economies of Research: A large firm possesses larger resources and can establish it‟s own research
laboratory and employ trained research workers. The firm may even invent new production techniques for
increasing its output and reducing cost.

G). Economies of welfare: A large firm can provide better working conditions in-and out-side the factory.
Facilities like subsidized canteens, crèches for the infants, recreation room, cheap houses, educational and
medical facilities tend to increase the productive efficiency of the workers, which helps in raising
production and reducing costs.

External Economies
Business firm enjoys a number of external economies, which are discussed below:

A). Economies of Concentration: When an industry is concentrated in a particular area, all the member
firms reap some common economies like skilled labour, improved means of transport and communications,
banking and financial services, supply of power and benefits from subsidiaries. All these facilities tend to
lower the unit cost of production of all the firms in the industry.

B). Economies of Information: The industry can set up an information centre which may publish a journal
and pass on information regarding the availability of raw materials, modern machines, export potentialities
and provide other information needed by the firms. It will benefit all firms and reduction in their costs.

C). Economies of Welfare: An industry is in a better position to provide welfare facilities to the workers. It
may get land at concessional rates and procure special facilities from the local bodies for setting up housing
colonies for the workers. It may also establish public health care units, educational institutions both general
and technical so that a continuous supply of skilled labour is available to the industry. This will help the
efficiency of the workers.

D). Economies of Disintegration: The firms in an industry may also reap the economies of specialization.
When an industry expands, it becomes possible to spilt up some of the processes which are taken over by
specialist firms. For example, in the cotton textile industry, some firms may specialize in manufacturing
thread, others in printing, still others in dyeing, some in long cloth, some in dhotis, some in shirting etc. As a
result the efficiency of the firms specializing in different fields increases and the unit cost of production
falls.

Thus internal economies depend upon the size of the firm and external economies depend upon the
size of the industry.

DISECONOMIES OF LARGE SCALE PRODUCTION

Internal and external diseconomies are the limits to large-scale production. It is possible that
expansion of a firm‟s output may lead to rise in costs and thus result diseconomies instead of economies.
When a firm expands beyond proper limits, it is beyond the capacity of the manager to manage it efficiently.
This is an example of an internal diseconomy. In the same manner, the expansion of an industry may result
in diseconomies, which may be called external diseconomies. Employment of additional factors of
production becomes less efficient and they are obtained at a higher cost. It is in this way that external
diseconomies result as an industry expands.

The major diseconomies of large-scale production are discussed below:

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Internal Diseconomies:

A). Financial Diseconomies: For expanding business, the entrepreneur needs finance. But finance may not
be easily available in the required amount at the appropriate time. Lack of finance retards the production
plans thereby increasing costs of the firm.

B). Managerial diseconomies: There are difficulties of large-scale management. Supervision becomes a
difficult job. Workers do not work efficiently, wastages arise, decision-making becomes difficult,
coordination between workers and management disappears and production costs increase.

C). Marketing Diseconomies: As business is expanded, prices of the factors of production will rise. The
cost will therefore rise. Raw materials may not be available in sufficient quantities due to their scarcities.
Additional output may depress the price in the market. The demand for the products may fall as a result of
changes in tastes and preferences of the people. Hence cost will exceed the revenue.

D). Technical Diseconomies: There is a limit to the division of labour and splitting down of production
p0rocesses. The firm may fail to operate its plant to its maximum capacity. As a result cost per unit
increases. Internal diseconomies follow.

External Diseconomies:

When many firm get located at a particular place, the costs of transportation increases due to
congestion. The firms have to face considerable delays in getting raw materials and sending finished
products to the marketing centers. The localization of industries may lead to scarcity of raw material,
shortage of various factors of production like labour and capital, shortage of power, finance and equipments.
All such external diseconomies tend to raise cost per unit.

COST ANALYSIS
Profit is the ultimate aim of any business and the long-run prosperity of a firm depends upon its
ability to earn sustained profits. Profits are the difference between selling price and cost of production. In
general the selling price is not within the control of a firm but many costs are under its control. The firm
should therefore aim at controlling and minimizing cost.

COST CONCEPTS:

A managerial economist must have a clear understanding of the different cost concepts for clear
business thinking and proper application. The several alternative bases of classifying cost and the relevance
of each for different kinds of problems are to be studied. The various costs are:

1. Opportunity costs and outlay costs:

Out lay cost also known as actual costs obsolete costs are those expends which are actually incurred
by the firm these are the payments made for labour, material, plant, building, machinery traveling,
transporting etc., These are all those expense item appearing in the books of account, hence based on
accounting cost concept.
On the other hand opportunity cost implies the earnings foregone on the next best alternative, has the
present option is undertaken. This cost is often measured by assessing the alternative, which has to be
scarified if the particular line is followed.
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The opportunity cost concept is made use for long-run decisions. This concept is very important in
capital expenditure budgeting. This concept is very important in capital expenditure budgeting. The concept
is also useful for taking short-run decisions opportunity cost is the cost concept to use when the supply of
inputs is strictly limited and when there is an alternative. If there is no alternative, Opportunity cost is zero.
The opportunity cost of any action is therefore measured by the value of the most favorable alternative
course, which had to be foregoing if that action is taken.

2. Explicit and implicit costs:

Explicit costs are those expenses that involve cash payments. These are the actual or business costs
that appear in the books of accounts. These costs include payment of wages and salaries, payment for raw-
materials, interest on borrowed capital funds, rent on hired land, Taxes paid etc.

Implicit costs are the costs of the factor units that are owned by the employer himself. These costs
are not actually incurred but would have been incurred in the absence of employment of self – owned
factors. The two normal implicit costs are depreciation, interest on capital etc. A decision maker must
consider implicit costs too to find out appropriate profitability of alternatives.

3. Historical and Replacement costs:

Historical cost is the original cost of an asset. Historical cost valuation shows the cost of an asset as
the original price paid for the asset acquired in the past.

A replacement cost is the price that would have to be paid currently to replace the same asset.

4. Out-of pocket and books costs(imputed cost):

Out-of pocket costs also known as explicit costs are those costs that involve current cash payment.
Book costs also called implicit/imputed costs do not require current cash payments. Depreciation, unpaid
interest, salary of the owner is examples of back costs.

But the book costs are taken into account in determining the level dividend payable during a period.
Both book costs and out-of-pocket costs are considered for all decisions. Book cost is the cost of self-owned
factors of production.

5. Fixed and variable costs:

Fixed cost is that cost which remains constant for a certain level to output. It is not affected by the
changes in the volume of production. But fixed cost per unit decrease, when the production is increased.
Fixed cost includes salaries, Rent, Administrative expenses depreciations etc.

Variable is that which varies directly with the variation is output. An increase in total output results
in an increase in total variable costs and decrease in total output results in a proportionate decline in the total
variables costs. The variable cost per unit will be constant. Ex: Raw materials, labour, direct expenses, etc.

Cost Curves
curves are drawn with the quantity of a specific product along the horizontal axis and money cost on the
vertical. For an analysis of perfect competition, the assumption is that each firm faces identical input prices
and choices of technology. Under this assumption, the curves can be interpreted to correspond either to the
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industry as a whole, or to a representative firm. They can represent the total cost of the quantity, the average
(per unit) cost, or the marginal cost.
For the short-run, total and average costs can be broken down into the portion reflecting the amount spent
on factors of production whose quantities can be varied, and the portion reflecting the sunk costs of the
fixed factors of production.
Further, one can consider long-run cost curves drawn under the assumption that the quantities of all factors
can be varied.
Short Run Average Cost (SAC)

The Short run average cost function is the

short run total cost function divided by
output, Q.

That is, the SAC function tells us the firm‟s

short run cost per unit of output.

SAC(Q,K0) = STC(Q,K0)/Q

Long Run Average Cost (LAC)

The short-run cost curves are normally

based on a production function with one
variable factor of production that displays
first increasing and then decreasing marginal
productivity. Increasing marginal productivity is
associated with the negatively sloped portion of
the marginal cost curve, while decreasing marginal
productivity is associated with the positively
sloped portion.
The average fixed cost (AFC) curve is the cost of
the fixed factor of production divided by the
quantity of units of the output, while the average
variable cost (AVC) curve cost traces out the per
unit cost of variable factor of production. The U-
shaped average total cost (ATC) curve is derived
by adding the average fixed and variable costs.
The marginal cost (MC) intersects both the AVC
and ATC curves at their minimum points.
Long Run Average Cost (LAC)
The Long-run Average Cost (LAC) curve is shown to be an envelope of the short-run average cost (SRAC)
curves, lying everywhere below or tangent to the short-run curves. The firm is constrained in the short- run
in selecting the optimal mix of factors of production and so will never be able to find a cheaper mix than can
be found in the long-run when there are no constraints. If there are a discrete number of plant sizes
available, the LRAC will be the scalloped curve obtained by joining those parts of the SRAC curves that
represent the lowest cost of production for a given quantity.

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BREAKEVEN ANALYSIS

The study of cost-volume-profit relationship is often referred as BEA. The term BEA is interpreted
in two senses. In its narrow sense, it is concerned with finding out BEP; BEP is the point at which total
revenue is equal to total cost. It is the point of no profit, no loss. In its broad determine the probable profit at
any level of production.

Assumptions:

1. All costs are classified into two – fixed and variable.

2. Fixed costs remain constant at all levels of output.
3. Variable costs vary proportionally with the volume of output.
4. Selling price per unit remains constant in spite of competition or change in the volume of
production.
5. There will be no change in the general price level.
6. Volume of production is the only factor affecting the cost.
7. Volume of sales and volume of production are equal. Hence there is no unsold stock.
Merits:

1. Information provided by the Break Even Chart can be understood more easily then those contained
in the profit and Loss Account and the cost statement.
2. Break Even Chart discloses the relationship between cost, volume and profit. It reveals how changes
in profit. So, it helps management in decision-making.
3. It is very useful for forecasting costs and profits long term planning and growth
4. The chart discloses profits at various levels of production.
5. It serves as a useful tool for cost control.
6. It can also be used to study the comparative plant efficiencies of the industry.
7. Analytical Break-even chart present the different elements, in the costs – direct material, direct
labour, fixed and variable overheads.
Demerits:

1. Break-even chart presents only cost

volume profits. It ignores other
considerations such as capital amount,
marketing aspects and effect of
government policy etc., which are
necessary in decision making.
2. It is assumed that sales, total cost and
fixed cost can be represented as straight
lines. In actual practice, this may not be
so.
3. A major drawback of BEC is its inability to handle production and sale of multiple products.

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4. It is difficult to handle selling

costs such as advertisement and
sale promotion in BEC.
5. It ignores economics of scale in
production.
6. Fixed costs do not remain
constant in the long run.
7. It assumes production is equal
to sale. It is not always true
because generally there may be
opening stock.
8. The assumption of static nature
of business and economic
activities is a well-known
defect of BEC.
Important Aspects in BEP
1. Fixed cost: Expenses that do not vary with the volume of production are known as fixed expenses. Eg.
Manager‟s salary, rent and taxes, insurance etc. It should be noted that fixed changes are fixed only
within a certain range of plant capacity. The concept of fixed overhead is most useful in formulating a
price fixing policy. Fixed cost per unit is not fixed.
2. Variable Cost: Expenses that vary almost in direct proportion to the volume of production of sales are
called variable expenses. Eg. Electric power and fuel, packing materials consumable stores. It should be
noted that variable cost per unit is fixed.
3. Contribution: Contribution is the difference between sales and variable costs and it contributed towards
fixed costs and profit. It helps in sales and pricing policies and measuring the profitability of different
proposals. Contribution is a sure test to decide whether a product is worthwhile to be continued among
different products.
Contribution = Sales (Revenue) – Variable cost

Contribution = Fixed Cost + Profit.

4. Margin of safety: Margin of safety is the excess of sales over the break even sales. It can be expressed
in absolute sales amount or in percentage. It indicates the extent to which the sales can be reduced
without resulting in loss. A large margin of safety indicates the soundness of the business. The formula
for the margin of safety is:
Profit
Margin of safety = Present sales – Break even sales or
P. V. ratio

Margin of safety can be improved by taking the following steps.

1. Increasing production
2. Increasing selling price
3. Reducing the fixed or the variable costs or both
4. Substituting unprofitable product with profitable one.

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5. Profit Volume Ratio is usually called P/V. ratio. It is one of the most useful ratios for studying the
profitability of business. The ratio of contribution to sales is the P/V ratio. It may be expressed in
percentage. Therefore, every organization tries to improve the P. V. ratio of each product by reducing
the variable cost per unit or by increasing the selling price per unit. The concept of P. V. ratio helps in
determining break even-point, a desired amount of profit etc.
Contribution
The formula is, X 100
Sales

6. Break – Even- Point: Break Even Point refers to the point where total cost is equal to total revenue. It is
a point of no profit, no loss. This is also a minimum point of no profit, no loss. This is also a minimum
point of production where total costs are recovered. If sales go up beyond the Break Even Point,
organization makes a profit. If they come down, a loss is incurred.
Fixed Exp enses
Break Even point (Units) =
Contribution p er unit

Fixed exp enses

Break Even point (In Rupees) = X sales
Contribution

SPACE TO PRACTICE MODEl PROBLEMS on BEP:

Important Questions
1. Define Production Function. Discuss the different types of Production Functions.
2. Explain the following with reference to production function.
a. Iso-Quants b. Iso-costs c. Least cost combination of Input factors d. MRTS
PVPSIT………………..□ □ □ ► 2022 14 7382219990
 ENGINEERING ECONOMICS ►►

3. Explain the Cobb-Douglas Production function.

4. Explain the principle of Least cost combination of input factors with reference to production function.
i. Explain i. Law of returns ii. Law of returns to scale
5. Discuss the economies of scale that occurs to a firm.
6. Define cost. Explain the different cost concepts used in the process of cost analysis.
7. Define Break-even point. How do you determine it. Show the graphical representation of BEA.
8. What is the significance of BEP or BEA.
9. State the assumptions of BEA. Explain how break even analysis is used by the manager day-to-day transaction.
QUIZ
1. How many types of input-output relations discussed by the Law of production.
(a) Five (b) Four (c) Two (d) Three
2. How many stages are there in „Law of Variable Proportions‟?
(a) Five (b) Two (c) Three (d) Four
3. Congregation of body of persons assembling together to work at a certain Time and place is called
(a) Firm (b) Industry (c) Plant (d) Size
4. When a firm expands its Size of production by increasing all factors, It secures certain advantages, known as
(a) Optimum Size (b) Diseconomies of Scale (c) Economies of Scale (d) None
5. When producer secures maximum output with the least cost combination Of factors of production, it is known as_...
(a) Consumer‟s Equilibrium (b) Price Equilibrium (c) Producer‟s Equilibrium (d) Firm‟s Equilibrium
6. The „Law of Variable Proportions‟ is also called as …..
(a) Law of fixed proportions (b) Law of returns to scale (c) Law of variable proportions (d) None
7. Is a „group of firms producing the same are slightly different products for the same market or using same raw
material‟. (a) Plant (b) Firm (c) Industry (d) Size
8. When proportionate increase in all inputs results in an equal proportionate increase in output, then we call……
a) Increasing Returns to Scale (b) Decreasing Returns to (c) Constant Returns to Scale (d) None
9. When different combinations of inputs yield the same level of output known as ….
(a) Different Quants (b) Output differentiation (c) Isoquants (d) Production differentiation
10. Conversion of inputs in to output is called as (a) Sales (b) Income (c) Production (d) Expenditure
11. When Proportionate increase in all inputs results in more than equal proportionate increase in output, then we call….
(a) Decreasing Returns to Scale (b) Constant Returns to Scale (c) Increasing Returns to Scale (d) None
12. When Proportionate increase in all inputs results in less than Equal proportionate increase in output, then we call….
(a) Increasing Returns to Scale (b) Constant Returns to Scale (c) Decreasing Returns to Scale (d) None
13. A curve showing equal amount of outlay with varying Proportions of two inputs are called …
(a) Total Cost Curve (b) Variable Cost Curve (c) Isocost Curve (d) Marginal Cost Curve
14. The cost of best alternative forgone is…. (a) Outlay cost (b) Past cost (c) Opportunity cost (d) Future cost
15. If we add up total fixed cost (TFC) and total variable cost (TVC), we get
(a) Average cost (b) Marginal cost (c) Total cost (d) Future cost
16. costs are theoretical costs, which are not recognized by the accounting system.
(a) Past (b) Explicit (c) Implicit (d) Historical
17. cost is the additional cost to produce an additional unit of output.
(a) Incremental (b) Sunk (c) Marginal (d) Total
18. costs are the costs, which are varies with the level of output (a) Fixed (b) Past (c) Variabl (d) Historical
18. costs are those business costs, which do not involve any cash payment
(a) Past (b) Historical (c) Implicit (d) Explicit
19. The opposite of Past cost is ……. (a) Historical (b) Fixed cost (c) Future cost (d) Variable cost
20. is a period during which the existing physical capacity of the firm can be changed
(a) Market period (b) Short period (c) Long period (d) Medium period
22. is a point of sales at which there is neither profit nor loss
(a) Maximum sales (b) Minimum sales (c) Break-Even sales (d) Average sales
23. What is the formula for Margin of Safety?
(a) Break Even sales – Actual sales (b) Maximum sales – Actual sales (c) Actual sales – Break Even sales (d) Actual sales –
Minimum sales
24. What is the formula for Break-Even Point in Units………………………
25. What is the Other Name of Profit Volume Ratio?
(a) Cost-Volume-Profit Ratio (b) Margin of safety Ratio (c) Marginal Ratio (d) None
26. What is the break-even sales amount, when selling price per unit is 10/- , Variable cost per unit is 6/- and fixed cost is 40,000/-
(a) Rs. 4, 00,000/- (b) Rs. 3, 00,000/- (c) Rs. 1, 00,000/- (d) Rs. 2, 00,000/-
27. „Contribution” is the excess amount of Actual Sales over .
(a) Fixed cost (b) Sales (c) Variable cost (d) Total cost

Note: Answer is “C” for all the above questions.

PVPSIT………………..□ □ □ ► 2022 15 7382219990