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Module III

Production function production with one variable input, law of variable proportion;
production with two variable inputs; production isoquant; isocost lines; Estimating
production functions; cost concepts and break even analysis

Production : Meaning of Production

In economics, production is the act of creating output, a goods or service

which has value and contributes to the utility of individuals. The act may or may not include
factors of production other than labour. Any effort directed toward the realization of a desired
product or service is a "productive" effort and the performance of such act is production. The relation
between the amount of inputs used in production and the resulting amount of output is called the
production function.

Production can be distinguished into three stages:

1 Primary producers directly extract natural resources.

2 Secondary producers process resources to turn them into intermediate goods.
3 Tertiary producers provide final goods or services to the consumer.

Production Function

A production function is a function that specifies the output of a firm, an industry, or an

entire economy for all combinations of inputs. This function is an assumed technological relationship,
based on the current state of engineering knowledge; it does not represent the result of economic
choices, but rather is an externally given entity that influences economic decision-making.
Production function may be Capital Intensive or Labour Intensive. There are literally millions of
production functions and one specially designed for a specific location and purpose would be useless
anywhere else.
The production function is a mathematical expression which relates the quantity of factor inputs to
the quantity of outputs that result. We make use of three measures of production / productivity. Total
product is simply the total output that is generated from the factors of production employed by a
business. In most manufacturing industries such as motor vehicles, freezers and DVD players, it is
straightforward to measure the volume of production from labour and capital inputs that are used. But
in many service or knowledge-based industries, where much of the output is intangible or perhaps
weightless we find it harder to measure productivityAverage product is the total output divided by
the number of units of the variable factor of production employed (e.g. output per worker employed or
output per unit of capital employed)Marginal product is the change in total product when an
additional unit of the variable factor of production is employed. For example marginal product would
measure the change in output that comes from increasing the employment of labour by one person, or
by adding one more machine to the production process in the short run.

ShortRun and LongRun Production

Our analysis of production and cost makes an important distinction between the short run and the long
run.In the short run one or more of the firms inputs is fixed; that is, they cannot be varied. In the
long run the firm can vary all of its inputs. There is no universal rule for distinguishing between the
short and long run; rather, the dividing line must be drawn on a casebycase basis. For a
petrochemical refinery, the short run might be any period less than five years since it takes roughly
this long to build a new refinery. For a fastfood chain, six months (the time it takes to obtain zoning
approvals and construct new restaurants) may be the dividing line between the short and long run.
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Inputs that cannot be changed in the short run are called fixed inputs. A firms production facility is a
typical example. In the long run, the firm could vary the size and scale of its plant, whereas in the
short run the size of this plant would be fixed at its existing capacity. If a firm operates under
restrictive, longterm labor contracts, its ability to vary its labor force may be limited over the contract
duration, perhaps up to three years. In this case, labor could be a fixed input in the short run.

'Economies Of Scale'

The cost advantage that arises with increased output of a product. Economies of
scale arise because of the inverse relationship between the quantity produced and per-unit fixed costs;
i.e. the greater the quantity of a good produced, the lower the per-unit fixed cost because these costs
are shared over a larger number of goods. Economies of scale may also reduce variable costs per unit
because of operational efficiencies and synergies. Economies of scale can be classified into two main
types: Internal arising from within the company; and External arising from extraneous factors
such as industry size.

PRODUCTION WITH ONE VARIABLE INPUT : The law of returns

(LAW OF VARIABLE PROPORTION/ LAW OF DIMINISHING RETURNS)

The law of variable proportion is one of the fundamental laws of economics. It is the
generalized form of Law of Diminishing marginal return. The law of variable proportion is the study
of short run production function with some factors fixed and some factors variable.In the short run the
volume of production can be changed by altering variable factors only. In the study of production
function (variable proportion) the effect on output is examined by varying factor proportions. When
we increase the quantity of variable factors to the combination of fixed factor, the proportion between
fixed and variable factors change. The change in factor proportion and its effect on output forms the
subject- matter of the law of variable proportions.

The ratio of variable factor to the fixed factor changes as the variable factors are increased in the
combination. Thus the main thing to be noted is the break of proportion between fixed and variable
factors of production. With disproportionate combination of factors, the returns may initially increase
then remain constant for sometime and ultimately diminishes. Therefore, the law of variable
proportion is called non-proportional returns.. The law of variable proportions or diminishing
returns has been stated by Benham in the following manner."As the proportion of one factor in a
combination of factors is increased, after a point, first the marginal and then the average production of
that factor will diminishing.

Marginal Product
Lets consider the production decisions of a firm.. In the short run, this capital input is fixed.
However, labor is a variable input; that is, the firm can freely vary its number of workers. Table
shows the amount of output obtainable using different numbers of workers. (This information is
reproduced from the earlier production function and expanded slightly.) Notice that output steadily
increases as the workforce increases, up to 7 workers. Beyond that point, output declines. It appears
that too many workers within a plant of limited size are counterproductive to the task of producing
parts. (Note : Labour increases, Capital remains constant)
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Number of Amount of Total Average Marginal

Workers (L) Capital(K) Product(TP) Product(APL) Product(MPL)
0 10 0 - -
1 10 10 10 10
2 10 30 15 20
3 10 60 20 30
4 10 80 20 20
5 10 95 19 15
6 10 108 18 13
7 10 112 16 4
8 10 112 14 0
9 10 108 12 -4
10 10 100 10 -8
10 10 388 3.88 2.0
The last column of Table lists the marginal product of labor (abbreviated MP L). This
marginal product is the additional output produced by an additional unit of labor, all other inputs
held constant. The marginal product increases upto 3rd labour and beyond that, it decreases and
reaches zero at 8th labour and becomes negative at 9th labour and beyond. Mathematically, labors
marginal product is MPL = dQ/dL. In other words, labors marginal product is the change in output per
unit change in labor input. The average product also increases upto 3 rd labour and is constant at 4th
labour and it starts decreasing beyond 4th labour

In our example, MPL first rises then declines. Why does MPL rise initially? With a small workforce,
the typical worker must be a jackofalltrades (and master of none). Increasing the number of
workers allows for specialization of laborworkers devoting themselves to particular taskswhich
results in increased output per worker. Furthermore, additional workers can use underutilized
machinery and capital equipment

Law of variable proportion is explained in the diagrams

(Figure 1 )
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Figure 2
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It is only one law of production which has three phases, increasing, diminishing and negative
production. This general law of production was named as the Law of Variable Proportions.

The Law of Variable Proportions which is the new name of the famous law of Diminishing Returns
has been defined by stigler in the following words. As equal increments of one input are added, the
inputs of other productive services being held constant, beyond a certain point, the resulting
increments of produce will decrease i.e., the marginal product will diminish.According to Samuelson,
An increase in some inputs relative to other fixed inputs will in a given state of,technology cause
outputto increase, but after a point, the extra output resulting from the same addition of extra inputs
will become less.

PRODUCTION WITH TWO VARIABLE INPUTS

In the short run, production function is explained with one variable factor and other
factors of productions are held constant. We have called this production function as the Law of
Variable Proportions or the Law of Diminishing returns.

In the long run, production function is explained by assuming all the factors of
production as variable. There are no fixed inputs in the long run. Here the production function is
called the Law of Returns to scale of production. As it is difficult to handle more than two variables
in graph, we therefore, explain the Laws of Returns according to scale of production by assuming
only two inputs i.e., capital and labour and Study how output responds to their use. Production
function is expressed as Q = f(K, L).

There are two methods which are used for explaining the laws of Returns to Scale

(i) Production function with two variable inputs.

(ii) Isoquant- Isocost Approach

These two methods are explained in brief.

THE LAW OF RETURNS TO SCALE

The law of returns ((Law of variable proportions) are often confused with the law of
returns to scale. There were three laws of returns (Law of variable proportions) mentioned in the
history of economic thought up till Alfred Marshalls time. The law of diminishing returns operates in
the short period. It explains the production behaviour of the firm with one factor variable while other
factors are kept constant. Whereas the laws of returns to scale operates in the long period. It explains
the production behaviour of the firm under the conditions when both the inputs (labour and capital)
are variable and they can be increased proportionately and simultaneously.

The laws of Returns to scale is a set of three inter-related and chronological laws (stages):
Law of Increasing Returns to Scale, Law of Constant Returns to Scale, and Law of Diminishing
returns to Scale. If output increases by that same proportional change then there are constant returns
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to scale (CRS). If output increases by less than that proportional change in inputs, there are
decreasing returns to scale (DRS). If output increases by more than that proportional change in
inputs, there are increasing returns to scale (IRS). In mainstream microeconomics, the returns to
scale faced by a firm are purely technologically imposed and are not influenced by economic
decisions or by market conditions (i.e., conclusions about returns to scale are derived from the
specific mathematical structure of the production function in isolation).

The Laws of Return to Scale explains the behaviour of rate of increase in the output/production to the
subsequent increase in the inputs i.e. the factors of production in the long run.In the long run all
factors of production are variable and subject to change due a given increase in size/scale .

The laws of Returns to scale is a set of three inter-related and chronological laws (stages)

1 Law of Increasing Returns to Scale

2 Law of Constant Returns to Scale

3 Law of Diminishing returns to Scale

Formal definitions

Formally, a production function is defined to have:

Constant returns to scale if (for any constant a greater than 0)

Increasing returns to scale if (for any constant a greater than 1)

Decreasing returns to scale if (for any constant a greater than 1)

where K and L are factors of productioncapital and labor, respectively

Dr. Marshall was of the view that the law of diminishing returns applies to agriculture and the law of
increasing returns to industry..

Example
When all inputs increase by a factor of 2, new values for output will be:

Twice the previous output if there are constant returns to scale (CRS)

Less than twice the previous output if there are decreasing returns to scale (DRS)

More than twice the previous output if there are increasing returns to scale (IRS)

Let us take a numerical example to explain the behavior of the law of returns to scale.
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Table 1: Returns to Scale

Unit Scale of Production Total Returns Marginal Returns

1 1 Labor + 2 C 4 4 (Stage I - Increasing Returns)

2 2 Labor + 4 C 10 6

3 3 Labor + 6 C 18 8

4 4 Labor + 8 C 28 10 (Stage II - Constant Returns)

5 5 Labor + 10 C 38 10

6 6 Labor + 12 C 48 10

7 7 Labor + 14 C 56 8 (Stage III - Decreasing Returns)

8 8 Labor + 16 C 62 6

The data of table 1 can be represented in the form of Figure 3

RS = Returns to scale curve

RP = Segment; increasing returns to scale

PQ = segment; constant returns to scale

QS = segment; decreasing returns to scale

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Explanation of Different Stages of Laws of Returns to Scale

1. The Increasing Returns to Scale: There are increasing returns to scale when a given percentage
increase in input leads to a greater relative percentage increase in output. In case of increasing returns
to scale, the production function is homogeneous of degree greater than one.
Causes of Increasing Returns to Scale:

a.Internal economies of scale

b.Efficiency of labour and capital
c.Improvement in large scale operation
d.Division of labour and specialization
e.Use of better and sophisticated technology
f.Economy of organisation
g.External economies of scale

2.Constant Returns to Scale.There are constant returns to scale when a given percentage increase in
input leads to an equal percentage increase in output. It shows that if inputs are doubled then the
output also gets doubled. If inputs are trebled then the output also trebles

Causes of Constant Returns to Scale:

a)Internal economics of scale are equal to internal diseconomies of scale.
b)Balancing of external economics and diseconomies of scale
c)Factors of production are perfectly divisible substitutable, homogenous and their supply is perfectly
elastic at given prices.

3.Decreasing Returns to Scale.There are decreasing returns to scale when a given percentage
increase in input leads to a smaller percentage increase in output.

Causes of Decreasing Returns to Scale

a.Internal diseconomies of scale

b.External diseconomies of scale

c.Increase in business risk
d.Lack of entrepreneurial efficiency
e.Unhealtny management and organization
f.Imperfect factor substitutability
g.Transport bottlenecks and Marketing difficulties.
Returns to scale are important for determining how many firms will populate an
industry. When increasing returns to scale exist, one large firm will produce more cheaply than two
small firms. Small firms will thus have a tendency to merge to increase profits, and those that do not
merge will eventually fail. On the other hand, if an industry has decreasing returns to scale, a merger
of two small firms to create a large firm will cut output, raise average costs, and lower profits. In such
industries, many small firms should exist rather than a few large firms.

If business decision-makers lack information or are incompetent, the firm will not
make the best use of available resources. Or if morale is bad in a firm, people may work poorly and
produce less than they could. In either case, the firm will produce below the maximum that the
production function allows. Economist Harvey Liebenstein called losses of these sorts "X-
inefficiency." Although economists assume that the firm will be on the production function, a major
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challenge of management is to make decisions so that the firm will be on or close to the production
function.

The Laws of Returns to Scale: Production Function with two variable inputs : Isoquant-Isocost
Approach

Long run is a period during which all factors of production can vary. Long run
relationship between inputs and output of a firm is explained by the Laws of returns to scale. The term
returns to scale arises in the context of a firm's Production Function.In the long run production
function, all factors are variable. Therefore in the long run output can be changed by changing all the
factors of production.A firm's production function could exhibit different types of returns to scale in
different ranges of output.Typically, there could be Increasing returns to scale,Constant returns to
scale and Diminishing returns to scale. In this section we will use the isoquants to analyse the input
output relationships under the condition that both the inputs (labour and Capital) are variable and their
quantity is changed proportionately and simultaneously.

The relationship between inputs such as capital, raw materials, land and labor and
outputs, or products, is called the production function. It shows the maximum output that can be
produced per unit of time using given quantities of input. Isoquant curves display production
functions graphically. They are composed of a set of points that represent combinations of capital and
labor yielding the same output. "Iso" means "equal", and "quant" means "quantity." An isoquant curve
is also called an equal product curve and a production indifference curve.

Statement of the Law

"Other things being equal in the long run, as the firm increases the quantities of all factors employed,
the output may rise either more than proportionately, less than proportionately or in exactly same
proportion of the change in quantities of inputs.

Symbolically, the long run production function can be written as:

Two factor model: Q'x = f(L,K)

The laws of returns to scale can also be elucidated in stipulations of the Isoquant approach. The laws
of returns to scale refer to the effects of a change in the scale of factors upon output in the long run
when the combinations of factors are changed in some proportion. If by increasing two factors say
labour and capital in the same proportion, productivity augments in exactly the same proportion there
are invariable returns to the scale.

Increasing Returns to Scale

1 There may be indivisibilities in machines, management, labour, finance etc. A little item of
equipment or some activities have a minimum size and cannot be divided into smaller units.

2 Increasing returns to scale also result from specialisation and division of labour, when the
scale of firm enlarges, there is a broader exposure for specialisation and division of labour.

3 As the firm enlarges, it enjoys internal economies of production. It may be able to install
better machines, sell its products more easily, borrow money cheaply, procure the services of
more efficient manager and workers etc.

Decreasing Returns to Scale

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1 Indivisible factors may become incompetent and less productive.

2 The firm experiences internal diseconomies. Business may become unwieldy and produce
problems of supervision and coordination. Large management creates complexities of control
and rigidities.

3 To these internal diseconomies are additional external diseconomies of scale. These occur
from higher factor price or from diminishing productivity of the factors.

Constant Returns to Scale

1 The returns to scale are invariable when internal economies enjoyed by a firm are neutralised
by internal diseconomies so that productivity amplifies in the same ration.

2 One more reason is the balancing of external economies and external diseconomies.

3 Invariable returns to scale also result when factors of production are perfectly divisible,
substitutable, standardised and their supplies are perfectly elastic at given prices.

Thats why in the case of invariable returns to scale, the production function is homogeneous of
degree one.

ISOQUANT

An isoquant (isoproduct) is a curve on which the various combinations of labour and capital show the
same output. According to Cohen and Cyert, An isoproduct curve is a curve along which the
maximum achievable rate of production is constant. It is also known as a production indifference
curve or a constant product curve. Just as indifference curve shows the various combinations of any
two commodities that give the consumer the same amount of satisfaction (iso-utility), similarly an
isoquant indicates the various combinations of two factors of production which give the producer the
same level of output per unit of time.

Isoquant Properties

Negative Slope
Isoquant curves have a negative or downward slope. For a specific isoquant, the amount of
labor is always inversely related to the amount of capital used. So if capital or labor is
reduced, the other factor should be increased to maintain the same output. Isoquants cannot
slope upward.

No Intersection
Isoquants do not meet with each other or cross each other; they do not intersect. Different
isoquants are created for different outputs for the same production function. Also, each
isoquant relates to a particular rate of output. So an intersection of isoquants would show that
the same amounts of labor and capital with the same efficiency can produce two different
outputs. Similarly, isoquants cannot be tangential to each other.

Convex Toward Origin

Isoquants are usually convex toward the origin. That means every isoquant becomes flatter
farther down its curve. As a result, the curve never can be parallel to the X or the Y axis. The
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isoquant remains part of an oval. If you travel along the isoquant downward and to the right,
the values of labor and capital adjust with each other to keep output constant. So successive
increments of capital result in reduction of labor. This is called the law of diminishing returns.
As a result, the isoquant is convex toward the origin.

Isoquant Map

A family of isoquants can be represented by an isoquant map, a graph combining

a number of isoquants, each representing a different quantity of output. Isoquants are also called equal
product curves. An isoquant map can also indicate decreasing or increasing returns to scale based on
increasing or decreasing distances between the isoquant pairs of fixed output increment, as output
increases. If the distance between those isoquants increases as output increases, the firm's production
function is exhibiting decreasing returns to scale; doubling both inputs will result in placement on an
isoquant with less than double the output of the previous isoquant. Conversely, if the distance is
decreasing as output increases, the firm is experiencing increasing returns to scale; doubling both
inputs results in placement on an isoquant with more than twice the output of the original isoquant

Producers Equilibrium: THE ECONOMICALLY EFFICIENT POINT OF PRODUCTION

Choice of Optimal Factor Combination or Least Cost Combination of Factors

A profit maximisation firm faces two choices of optimal combination of factors (inputs):
First, to minimise its cost for a given output; and second, to maximise its output for a given cost. Thus
the least cost combination of factors refers to a firm producing the largest volume of output from a
given cost and producing a given level of output with the minimum cost when the factors are
combined in an optimum manner.

Assumptions:
This analysis is based on the following assumptions:

1. There are two factors, labour and capital.

2. All units of labour and capital are homogeneous.

3. The prices of units of labour (w) and that of capital (r) are given and constant.

4. The cost outlay is given.

5. The firm produces a single product.

6. The price of the product is given and constant.

7. The firm aims at profit maximisation.

8. There is perfect competition in the factor market.

Given these assumptions, the point of least-cost combination of factors for a given level of output is
where the isoquant curve is tangent to an isocost line.
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Explanation
There are only 2 factors of production, labour and capital. Combining labour and capital produces
output. The given table shows the same quantity of output that can be produced with the different
combinations of these 2 inputs.

Table showing different combinations of 2 inputs producing same level of output

Combinations Labour Capital Units of output

A 3 20 50

B 4 15 50

C 6 10 50

D 10 6 50

E 15 4 50

F 20 3 50

The above table , displayed in the form of a curve would look like (Figure4)

The Graphical representation of all the combinations of 2 inputs , producing same level of output is
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called an isoquant curve.

An isoquant curve is always technically efficient.
ISOCOST

The Isocost Line

The isocost line is an important component when analysing producers behaviour. The isocost line
illustrates all the possible combinations of two factors that can be used at given costs and for a given
producers budget. In simple words, an isocost line represents a combination of inputs which all cost
the same amount. Now suppose that a producer has a total budget of Rs 120 and and for producing a
certain level of output, he has to spend this amount on 2 factors A and B. Price of factors A and B are
Rs 15 and Rs. 10 respectively.

Combinations Units of Units of Total expenditure

Capital Labour

Price = 15Rs Price = 10 Rs ( in Rupees)

A 8 0 120

B 6 3 120

C 4 6 120

D 2 9 120

E 0 12 120

Figure 5
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The isocost line shows all the possible combinations of two factors Labour and capital.

THE ECONOMICALLY EFFICIENT POINT OF PRODUCTION

Cost-Minimisation for a Given Output:

In the theory of production, the profit maximisation firm is in equilibrium when, given the cost-price
function, it maximises its profits on the basis of the least cost combination of factors. For this, it will
choose that combination which minimises its cost of production for a given output. This will be the
optimal combination for it.

The least cost combination of inputs for a given output occurs where the isocost curve is tangent to
the isoquant curve for that output.
This point can be found where the slopes of the theisoquant curve and isoquant line are equal. And
this is equal at the point of tangency.
Figure 6
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The tangency point of Isoquant Map and isocost line gives us the equilibrium position E.
Isoquant map intersects the isocost line at 3 points x , E and Z
. x and z lie on the lower isoquant curve than E lies on and hence gives lesser utility than E. So, E is
the economically Efficient Point of Production

The point of tangency between the isocost line and the isoquant is an important
first order condition but not a necessary condition for the producers equilibrium.
There are two essential or second order conditions for the equilibrium of the firm

1 The first condition is that the slope of the isocost line must equal
the slope of the isoquant curve.

2 The second condition is that at the point of tangency, the isoquant

curve must he convex to the origin.

Relation between Returns to Scale and Returns to a Factor (Law of Returns to Scale and Law of
Diminishing Returns):
Returns to a factor and returns to scale are two important laws of production. Both laws explain the
relation between inputs and output. Both laws have three stages of increasing, decreasing and constant
returns. Even then, there are fundamental differences between the two laws. Returns to a factor relate
to the short period production function when one factor is varied keeping the other factor fixed in
order to have more output, the marginal returns of the variable factor diminish. On the other hand,
returns to scale relate to the long period production function when a firm changes its scale of
production by changing one or more of its factors.

The laws of returns to scale can also be explained in terms of the isoquant approach. The laws of
returns to scale refer to the effects of a change in the scale of factors (inputs) upon output in the long-
run when the combinations of factors are changed in some proportion. If by increasing two factors,
say labour and capital, in the same proportion, output increases in exactly the same proportion, there
are constant returns to scale. If in order to secure equal increases in output, both factors are increased
in larger proportionate units, there are decreasing returns to scale. If in order to get equal increases in
output, both factors are increased in smaller proportionate units, there are increasing returns to scale.

Questions

1 Explain Law of Variable Proportions / Explain production with one

variable input (Figure 1 &2 )

2 Explain Laws of Returns ( Figure 3)

3 Explain Isoquant Isocost approach Or Determine economic

efficiency point of production (Figure 4,5 and 6)

4 Explain production with two variable inputs ( Fig 3 &6)

Profit maximization (Explained in Theory of Markets)

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In economics, profit maximization is the short run or long run process by which a
firm determines the price and output level that returns the greatest profit. There are several approaches
to this problem. The total revenuetotal cost perspective relies on the fact that profit equals revenue
minus cost and focuses on maximizing this difference, and the marginal revenuemarginal cost
perspective is based on the fact that total profit reaches its maximum point where marginal revenue
equals marginal cost.

ANALYSIS OF COSTS

Cost function
Cost function ( the output-cost relationship is the cost function of the firm.)
Certain quantity of output can be produced by different input combinations. With the input prices
given, it will choose that combination of inputs which is least expensive. So, for every level of output,
the firm chooses the least cost input combination.. and this output-cost relationship is the cost
function of the firm.
or
In order to produce output, the firm chooses least cost input combinations. this process of selecting
and producing is called the cost function.

Cost Concepts Defined Cost is the value of the inputs used to produce its output; e.g. the firm hires
labor, and the cost is the wage rate that must be paid for the labor services Total cost (TC) is the full
cost of producing any given level of output, and it is divided into two parts: Total fixed cost (TFC): it
is the part of the TC that doesnt vary with the level of output Total variable cost (TVC): it is the part
of the TC that changes directly with the output
Average Costs Average total cost (ATC) is the total cost per unit of output
Average fixed cost (AFC) is the fixed cost per unit of output.(details given below)
Average variable cost (AVC) is the variable cost per unit of output
Marginal costs(MC): Marginal cost (incremental cost) is the increase in total cost resulting from
increasing the level of output by one unit .Since some of total costs are fixed costs, which do not
change as the level of output changes, marginal cost is also equal to the increase in variable cost, that
results when output is increased by one unit

Variable Costs and Fixed Costs

All the costs faced by companies can be broken into two main categories: fixed costs and variable
costs. Fixed costs are costs that are independent of output. These remain constant throughout the
relevant range and are usually considered sunk for the relevant range (not relevant to output
decisions). Fixed costs often include rent, buildings, machinery, etc. Cost that do not change when
production or sales levels do change, such as rent, property tax, insurance, or interest expense. The
fixed costs are summarized for a specific time period (generally one month).

Variable costs are costs that vary with output. Generally variable costs increase at a constant rate
relative to labor and capital. Variable costs may include wages, utilities, materials used in production,
etc. In accounting they also often refer to mixed costs. These are simply costs that are part fixed and
part variable. An example could be electricity--electricity usage may increase with production but if
nothing is produced a factory still may require a certain amount of power just to maintain itself.
Variable costs are costs directly related to production units. Typical variable costs include direct labor
and direct materials. . The variable cost times the number of units sold will equal the Total Variable
Cost
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Short-Run & Long-RunTotal Cost Function

The short-run and long-run total cost functions relate the cost per unit of output
against the quantity of goods produced. The long run is defined as the period of time in which no
factor units of production are fixed, while the short run involves at least one unit of production as
fixed. The difference between the long-run and short-run functions is that the long run allows for a
variety of capital to labor combinations, while the the short run generally allows a very limited
number of combinations.
"The short run is a period of time in which the quantity of at least
one input is fixed and the quantities of the other inputs can be varied. The long run is a period of time
in which the quantities of all inputs can be varied.There is no fixed time that can be marked on the
calendar to separate the short run from the long run. The short run and long run distinction varies from
one industry to another." The long run and the short run do not refer to a specific period of time such
as 3 months or 5 years. The difference between the short run and the long run is the flexibility
decision makers have. "The short run is a period of time in which the quantity of at least one input is
fixed and the quantities of the other inputs can be varied. The long run is a period of time in which
the quantities of all inputs can be varied.Short Run: Some inputs variable, some fixed. New firms do
not enter the industry, and existing firms do not exit.Long Run: All inputs variable, firms can enter
and exit the market place.

Analysis of Costs
Quantity Fixed Variable Total Cost Marginal Average Cost Average Fixed Average
Q cost Cost(VC) (TC=FC+VC) Cost (MC) (AC=TC/Q) Cost per Variable Cost
(FC) unit(AFC=FC per unit(AVC
/Q =VC/Q)
0 55 0 55 Infinity Infinity Infinity
30
1 55 35 85 85 55 30
25
2 55 55 110 55 27.5 27.5
20
3 55 75 130 43.33 18.33 25
30
4* 55 105 160 40* 40* 13.75 26.25
50
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5 55 155 210 42 11 31
70
6 55 225 280 46.66 9.16 37.5

Note: The starred MC= starred AC . The point where AC cuts MC in the diagram

ATC (Average Total Cost)/AC = Total Cost / quantity

AVC (Average Variable Cost) = Variable cost / Quantity

AFC (Average Fixed Cost) = Fixed cost / Quantity

Mathematically: Calculation of cost functions vary, although most tend to multilply the total fixed
units of production or costs and add them to the variable factors of production.

Total Cost
Total cost is the sum of total variable cost and the total fixed cost.

Fixed Cost - is the cost of fixed factors of production. Fixed Cost remains the same in the short run.

Variable Cost - is the cost of variable factors of production. Variable Cost increases with the increase
in the quantity of production.
TC = TFC + TVC

( Fixed factors of production refers to the factors of production whose supply cannot be increased in
the short run. E.g. Land is a fixed factor of production in the short run.

Variable factors of production refer to the factors of production whose supply can be increased in
the short run as well as long run.

Duration of short run and long run varies according to industry. For some industries like steel
plant 1 year is a short run, but for other industries like plastic factory, 1 year is a long run.)

Average Fixed Cost is the total fixed cost divided by the quantity produced.
AFC = TFC/Q
19

Average Variable Cost is the total variable cost divided by the quantity produced.
AVC = TVC/Q

Average Total Cost is the sum of average variable cost and average fixed cost. or we can say, average
cost is equal to the total cost divided by the number of units produced.
ATC = TC/Q

Marginal Cost is the addition made to the total cost by producing 1 additional unit of output.
Marginal Cost = Total cost of nth unit - Total cost of (n-1)th unit.
MC = TCn TCn-1 (e.g. MC of 6 th unit = Total cost of 6th unit Total cost of 5th unit)

Marginal cost can also be defined as the change in total cost (TC) due to change in quantity
demanded(Q).
MC = TC/Q

BREAK EVEN ANALYSIS (BEA) / COST VOLUME PROFIT(CVP) ANALYSIS

Break-Even Analysis in management

Break-even analysis is used as an important planning and controlling technique.

Breakeven charts and break-even analysis have become widespread and known within no time and
they are extensively employed by executives in organisations, investment agencies, labour unions, and
government agencies. Break-even analysis has become useful in price determination and expense
control in several organisations.

According to Joel Dean, "break analysis produces flexible projections of the impact of the output rate
upon expenses receipts, and profits assuming other things equal. In this way; it provides an important
bridge between business behaviour and theory of firm.Most importantly, break-even analysis, also
known as cost-volume-profit relationship, is designed to assist planning and decision making by
predicting the net effect of change in cost, volume, price, and the level of activity on the profits of the
company".

According to 1CMA, London, "break-even analysis is the summary of the operating costs of the
whole part of the activities of an undertaking for a specific period.Breakeven chart is a convenient
way of demonstrating the profitability or otherwise of an undertaking at various levels of activity.
Incidentally, break-even point' indicates the point at which the profit or loss to a firm is zero. It is also
called no-profit-no loss point.

Why your break-even point is important

A business could be turning over a lot of money, but still be making a loss. Knowing the break-even
point is helpful in deciding prices, setting sales budgets and preparing a business plan. The break-even
point calculation is a useful tool to analyse critical profit drivers of your business including sales
volume, average production costs and average sales price.
20

By understanding where your break-even point is, you are able to work out:

how profitable your present product line is

how far sales can decline before you start to incur losses

how many units you need to sell before you make a profit

how reducing price or volume of sales will impact on your profits

how much of an increase in price or volume of sales you will need to make up for an increase
in fixed costs.

Computation of break-even point:

(1). Use of equation method:

The application of equation method facilitates the computation of break-even point both in units and
in rupees. The sales are equal to total variable and fixed expenses at break-even point, the equation
can therefore be written as follows:

Sp Q = Ve Q + Fe
Or
SpQ = VeQ + Fe
Where;
Sp = Sales price per unit.
Q = Number (quantity) of units to be manufactured and sold during the period.
Ve = Variable expenses to manufacture and sell a single unit of product.
Fe = Total fixed expenses for the period.
Notice that the left hand side of the equation represents the total sales in rupees and the right hand side
of the equation represents the total cost. If the information about sales price per unit, variable
expenses per unit and the total fixed expenses is available, we can solve the equation to find the
number of units to break-even. The number of units required to break-even can then be multiplied by
the sales price per unit to calculate the break-even point in dollars. Suppose, for example, you run a
manufacturing business that is involved in manufacturing and selling a single product. The annual
fixed expenses to run the business are Rs15,000 and variable expenses are Rs7.50 per unit. The sale
price of your product is Rs15 per unit. The number of units to be sold to break even can be easily
calculated using equation method:

Sp Q = Ve Q + Fe
15 Q = 7.5 Q + 15,000
15 Q = 7.5 Q + 15,000
15Q 7.5Q = 15,000
7.5Q = 15,000
Q = 15,000 / 7.5
Q = 2,000 units
The break-even point in units is 2,000 units and the break-even point in rupees is computed as
follows:
= (2,000 units) (Rs15)
= Rs30,000
21

(2). Use of Contribution Margin Method:

The method described above is known as equation method of calculating
break-even point. Some people use another method called contribution margin method .Under this
method, the total fixed expenses are divided by contribution margin per unit. Consider the following
computations:
Total fixed expenses / Contribution margin per unit
= 15,000 / 7.5*
= 2,000 units
OR
= (2,000 units) (Rs15)
= Rs30,000
*Rs15 Rs7.5
(2a). Use of Contribution Margin Ratio Method:

A little variation of this method is to divide the total fixed expenses by the contribution margin ratio
(CM ratio). Doing so results in break-even point in rupees. It is shown below:
Total fixed expenses / Contribution margin ratio
= Rs15,000 / 0.5*
=Rs 30,000
*(Rs15 Rs 17.5)/ Rs 15

3. Graphical presentation (Preparation of break-even chart or CVP graph):

The annual fixed expenses to run the business are Rs15,000 and variable expenses are
Rs 7.50 per unit. The sale price of your product is Rs15 per unit.

The graphical presentation of rupees and unit sales needed to break-even is known as break-even
chart or CVP graph:
22

Explanation of the graph:

1 The number of units have been presented on the X-axis (horizontally) where as rupees have
been presented on Y-axis (vertically).

2 The straight line in red color represents the total annual fixed expenses of Rs 15,000.

3 The blue line represents the total expenses. Notice that the line has a positive or upward slop
that indicates the effect of increasing variable expenses with the increase in production.

4 The green line with positive or upward slop indicates that every unit sold increases the total
sales revenue.

5 The total revenue line and the total expenses line cross each other. The point at which they
cross each other is the break-even point. Notice that the total expenses line is above the total
revenue line before the point of intersection and below after the point of intersection. It tells
us that the business suffers a loss before the point of intersection and makes a profit after this
point. The break-even point in the above graph is 2,000 units or Rs 30,000 that agrees with
the break-even point computed using equation and contribution margin methods above.

6 The difference between the total expenses line and the total revenue line before the point of
intersection (BE point) is the loss area. The loss area has been filled with pink color. Notice
that this area reduces as the number of units sold increases. It means every additional unit sold
before the break-even point reduces the loss.

7 The difference between the total expenses line and the total revenue line after the point of
intersection (BE point) is the profit area. The profit area has been filled with green color.
Notice that this area increases as the number of units sold increases. It means every additional
unit sold after the break-even point increases the profit of the business.

How to Do Break Even Analysis

Step 1. Determine your company's fixed costs.

Step 1 Determine your company's variable costs.

Step 3. Determine the price at which you will sell your product.

Step 4. Calculate your unit contribution margin. (P-AVC)

Or Calculate your unit contribution margin ratio . (P-AVC/P)
Step 5. Calculate your company's break-even point. It is calculated by dividing all your fixed costs
by your product's contribution margin. FC/(P-AVC)
OR Calculate your company's break-even sales in rupees. It is calculated by dividing all your fixed
costs by your product's contribution margin ratio . FC/ (P-AVC/P)
23

Step 6. Determine your expected profits or losses. Once you have determined the break-even
volume, you can estimate your expected profits. Remember that each additional unit sold will produce
revenue equal to its contribution margin. Therefore, each unit sold above the break-even point will
produce a profit equal to its contribution margin, and each unit sold below the break-even point will
generate a loss equal to its contribution margin.
Step 7. Calculate Required sales for targeted profit : FC + targeted profit /(P-AVC)
Step 8. Determine Margin of Safety (MS)

Uses of a break even analysis

Break even analysis enables a business organization to:

1 Measure profit and loses at different levels of production and sales.

2 To predict the effect of changes in price of sales.

3 To analysis the relationship between fixed cost and variable cost.

4 To predict the effect on profitability if changes in cost and efficiency.

Even though break even has these advantages or uses, there are also several demerits of break even
analysis.

Disadvantages of break even analysis

1 Assumes that sales prices are constant at all levels of output.

2 Assumes production and sales are the same.

3 Break even charts may be time consuming to prepare.

4 It can only apply to a single product or single mix of products

Key Concepts

1 Cost Volume Profit Analysis (CVPA ) or BEA

Break even analysis is essentially cost volume profit analysis. It is an analytical technique for
tracing relationship among key business variables such as costs, revenues and profits at
different output levels. BEA diagram is essentially CVPA diagram. CVPA is useful for
analyzing a decision problem
Break-Even Point/Break-Even Quantatity : Break even exists when a business
makes neither a profit nor a loss. This occurs at the level of output where total costs equal
total revenue.ie.TC=TR.Break-even analysis is a technique widely used by production
management and management accountants. It is based on categorising production costs
between those which are "variable" (costs that change when the production output changes)
and those that are "fixed" (costs not directly related to the volume of production).
(Total Variable Cost = Expected Unit Sales x Variable Unit Costs).
(Total Cost = Fixed Cost + Variable Cost).
(Total Expected Revenue = Expected Unit Sales x Unit Price).
(Breakeven point = Fixed Costs / (Unit Sales Price Variable Costs))
2 Break-Even Revenue : The amount of revenue at which the firm reaches BEQ
3 Break even Quantity (BEQ): refers to the level of output that generates neither any profit or
loss
24

4 Safety Margin: It refers to the extent to which the firm can afford a decline in sales before it
starts incurring losses. It measures the difference between a firms sales volume and the
quantity needed to break -even ie. it shows how much demand ( for a product) exceeds the
break even quantity. The existence of a margin of safety is the indication that the sales are
more than the break-even level and the business is earning profit. It does not exist if the sales
are less than break -even level. Margin of safety is very important figure for any business
because it tells management how much reduction in revenue will result in break-even. The
higher the margin of safety, the better it is. A high MOS reduces the risk of business losses.
5 Profit Volume ratio: P/V Ratio (Profit Volume Ratio) is the ratio of contribution to sales
which indicates the contribution earned with respect to one rupee of sales. It also measures
the rate of change of profit due to change in volume of sales. Its fundamental property is that
if per unit sales price and variable cost are constant then P/V Ratio will be constant at all the
levels of activities. A high P/V Ratio indicates that a slight increase in sales without increase
in fixed costs will result in higher profits. A low P/V ratio which indicates low profitability
can be improved by increasing selling price, reducing marginal costs or selling products
having high P/V ratio .A comparison of P/V ratio of different products can be made to find
out which product is more profitable. Higher the P/V ratio the more will be the profit and
lower the P/V ratio the lesser will be the profit

6 Fixed Costs. Fixed costs are those business costs that are not directly related to the level of
production or output. In other words, even if the business has a zero output or high output, the
level of fixed costs will remain broadly the same. In the long term fixed costs can alter -
perhaps as a result of investment in production capacity (e.g. adding a new factory unit) or
through the growth in overheads required to support a larger, more complex business.

Examples of fixed costs:

Rent and rates - Marketing costs (non- revenue

- Depreciation related)
- Research and development - Administration cost

7 Variable Costs.Variable costs are those costs which vary directly with the level of output.
They represent payment output-related inputs such as raw materials, direct labour, fuel and
revenue-related costs such as commission.

8 Selling Price (per unit price) The price that a unit is sold for. Sales Tax is not included the
selling price and sales taxes paid is not included as a cost. The Selling Price times the number
of units sold equals the Total Sales.
9 Total cost: Fixed costs + variable costs at each possible level of output.
10 Profit: The difference between total revenue and total cost (where revenues are higher than
costs.
11 Loss: The difference between total revenue and total cost (where costs are higher than
revenues).
12 Contribution per unit (unit contribution) : is the difference between the selling price of a
product and its variable costs of production. The surplus goes towards paying fixed costs.
The unit contribution margin represents how much money each unit sold brings in after
25

recovering its own variable costs. It is calculated by subtracting a unit's variable costs from its
sales price. Unit Contribution Margin (Unit CM). Contribution Margin can also be calculated
per unit which is called Unit Contribution Margin. It is the excess of sales price per unit (p)
over variable cost per unit (v). Thus: Unit CM = p v
Contribution Margin (CM) is equal to the difference between total sales (S)
and total variable cost or, in other words, it is the amount by which sales exceed total variable
costs (VC). In order to make profit the contribution margin of a business must exceed its total
fixed costs. In short: CM = S VC
13 Contribution Margin Ratio (CM Ratio). Contribution Margin Ratio is calculated by
dividing contribution margin by total sales or unit CM by price per unit.

MANAGERIAL ECONOMICS

A BEP SOLVED PROBLEMS

FORMULAE FOR BEP (COST-VOLUME PROFIT ANALYSIS)

A Contribution Margin Method : P-AVC

BEP in Physical Units
I BEQ= TFC/ (P-AVC)
26

where TFC is total fixed cost and AVC is average variable cost
(P-AVC )is marginal contribution per unit
B Contribution Margin Ratio Method ( PV Ratio ) for BEP in Rupees
BES in Sales Value
I BES= TFC/ Contribution Ratio
II BES= TFC/PV Ratio
III BES= (TFC / (P-AVC) X Price per unit
IV BES= TFC/(P-AVC/P)
V BES= TFC/(S-V/S)
a PV Ratio =S-V/S or P-AVC /P
b PV Ratio = S-V/S x100, where S= sales, V= variable cost
c PV Ratio= Change in Profit/Change in sales x 100
d PV Ratio = Contribution/ Sales x100
e PV Ratio = TFC/BES
f Contribution Ratio = TR-TVC/TR

C Margin of safety(MS) MS= (Profit /Contribution) x Sales

MS= Total sales- BES D Target Profit : Required Sales in

MS =(Actual Sales-BES)/Sales Quantity
MS(%) = (Actual Sales-BES)/Sales x Required Sales= (TFC + Profit
100 required)/(P-AVC)
MS= Profit /PV Ratio Required Sales = (TFC + Profit) /PV
Ratio

E Others Methods to find FC, Profit and Contribution Margin

a Contribution = FC+ Profit e Contribution= S x PV Ratio

f Fixed Cost = BES x PV Ratio
b FC= Contribution Profit g FC= TC- TVC
c Profit = Contribution- FC h Profit = Sales x PV Ratio FC
d Contribution = S- V i Profit= TR-TC

F Useful Hints:

a TR = TVC+ TFC i P= Price

j TVC = Total variable cost
b TR = TVC+TFC k AVC =Average variable cost
c TC= TVC+TFC l TFC= Total Fixed Cost
d TVC= TC- TFC m TC = Total cost
e TR= P x Q n TR = Total revenue
f (P x Q) = (AVC x Q) +TFC o Profit = TR-TC
g (P x Q) (AVC x Q) = TFC p Profit = TR-TVC- TFC
h (AVC x Q) = TVC q Profit = Q (P-AVC) -TFC
 Graphical presentation (Preparation of break-even chart or CVP graph):

The annual fixed expenses to run the business are Rs15,000 and variable expenses are
Rs 7.50 per unit. The sale price of your product is Rs15 per unit.The graphical presentation of rupees
and unit sales needed to break-even is known as break-even chart or CVP graph:

Question 1 : Find BEP,BES.P/V Ratio, MS at $ 35000 and required sale for a target profit of $
1000.00

SOLUTION

1 BEP= FC/P-AVC , 15000/15-7.5 = 2000 units (BEQ)

2 BES = FC/(P-AVC)/P = 15000/(15-7.5)/15 = $ 30000
3 Unit Contribution Margin = FC/P-AVC
4 Unit Contribution Margin Ratio = FC/(P-AVC )/P
5 P/V Ratio = (P-AVC )/P = 7.5/15 = 0.5 (50%)
6 M.S at $ 350000 =35000-30000/35000 = 0.14 = 14%
7 Required sale in units for a target profit of $ 1000 = FC + 1000/P-AVC = 2133 units
8 OR Required sale in dollars for a target profit of $ 1000 = FC + 1000/P-AVC = 2133 units
X $ 15 = 32000.00
9 OR FC + 1000/(P-AVC)P = $32000/15000

QUESTION II
Price per unit : Rs 5.00
Variable cost per unit : Rs 3.00
Total Fixed Cost : Rs 20,000

UNITS TFC TVC TC TR/T.SALES PROFIT/LOS

S
0 20000
5000 20000
10000 20000
15000 20000
20000 20000
25000 20000
30000 20000
35000 20000
40000 20000
1 Find the TVC,TC,TR,PROFIT ,BEP (BEQ) and Break Even Revenue
2 If the required profit is Rs 10000/ , find the required sales,PV ratio and safety margin at
different levels

UNITS TFC TVC TC TR/T.SALES PROFIT/LOS

S
0 20000 0 20000 0 -20000
5000 20000 15000 35000 25000 -10000
10000 BEP 20000 30000 50000 50000 0
15000 20000 45000 65000 750000 10000
20000 20000 60000 80000 100000 20000
25000 20000 75000 95000 125000 30000
30000 20000 90000 110000 150000 40000
35000 20000 105000 125000 175000 50000
40000 20000 120000 140000 200000 60000

Answer
1 BEQ = TFC/P-AVC = 20000/5-3 = 10000 units
2 BES = 10000 units X Rs 5 = Rs 5000.00
3 Or BES = TFC/(P-AVC)/P = 20000/(2/5) = 20000X 5/2= Rs 50000.00
4 CR = 50000-30000/5000= 2/5
5 Required Sales for Rs 10000 profit = TFC+ 10000/ 2 = 20000+ 10000/2 = 15000units
6 MS for 15000 units = Actual Sales BES /Actual sales X 100 = 75000-50000 /750000= 0.33
or 33 %
7 P/V Ratio = TFC/BES or S-V/S x 100 = 20000/50000= 0.4 = 40%
8 or S-V/S x 100 = 5-3 /5 =0.4 = 40%

QUESTION III

Software Firm

Development Costs (Fixed)

a Programme Development : Rs 10000.00

b Manual preparation and type setting : Rs 3000.00
c Advertising : Rs 10000.00
Total Rs 23.00

Volume Cost per unit

d Blank disc Rs 2.00

e Loading Cost Rs 0.50
f Postage and handling Rs 1.25
g Printing of the manual Rs 2.75

Total Rs 6.50

A typical programme of this type including the manual sells for Rs 40.00
1 Determine the break even number of programmes and total revenue (TR) associated with this
volume
2 The company has a minimum profit target of Rs 40000.00 on each new programme it
develops. Determine the unit and volume of sales required to meet this goal
3 If the price declines by 25% (to Rs 30.00) , find the new break even quantity and rupee
volumes(TR)

SOLUTION

1 BEP = 23000/40-6.5 = 686.6 units = 686.6 X Rs 40 = Rs 27464.00

2 23000+ 40000/ 40-6.5 = 1880.6 units . Volume of sales 1880.6 units X Rs 40 = Rs 75224.00
3 23000/30-6.5 = 978.7 units X Rs 30 = Rs 29361

QUESTION IV

A small firm incurs fixed expenses amounting to Rs 12000.00 .Its variable cost of
product X is Rs 5 per unit. Its selling price is Rs 8.00. Determine its Break even quantity (BEQ) and
safety margin for the sales of Rs 5000 units .

SOLUTION

1 BEQ = 12000/8-5 = 4000 units X Rs 8 = Rs 32,000

2 MS = 40000- 32000/40000 = 0.20 = 20%

QUESTION IV

A firm starts its business with fixed expenses of Rs 60000.00 to produce commodity X. Its variable
cost is Rs 2.00 per unit. Prevailing market price of the product is Rs6.00 . How much should firm
produce to earn profit of Rs 20000.00 at this price

SOLUTION

1 BEQ = 60,000/6-2 =15000 units

2 BES =15000 units X Rs 6 = Rs 90,000.00
3 Required produce in quantity = 60000+ 20000 /4 = 20,000 units
4 Required produce in Rupees = 20,000 units X Rs 6 = Rs 1,20,000.00

QUESTION V (KU , MBA 2012)

The sales turnover and profits during two periods were as follows

Period I : Sales Rs 20 lakh, Profit Rs 2 lakhs

Period II : Sales Rs 30 lakh, Profit Rs 4 lakhs

Calculate

1 P/V Ratio
2 Sales required to earn a profit of Rs 500000
3 BEP
4 Margin of Safety

SOLUTION FORMULAE

a P/V Ratio = Change in Profit/ Change in sales X 100

b BEP in sales = FC/ PV ratio
c FC = Contribution Profit
d Contribution = Sales X PV Ratio
e Sales required to earn a profit of Rs 500000 = FC+ Rs 500000/PV Ratio
f MS = (Actual sales BES) / Actual sales for Period I & II
Answer

1 P/V Ratio == Change in Profit/ Change in sales X 100

Change in Profit Rs 4 lakhs Rs 2 lakhs = Rs 2 lakhs
Change in sales Rs 30 lakhs Rs 20 lakhs = Rs 10 lakhs
P/V Ratio = 2/10 = .02 = 20%

2 BES = FC/ PV ratio

FC = Contribution Profit & Contribution = Sales X PV Ratio
Using Period I sales : Rs 20 lakh X 20% = Rs 4 lakhs , Contribution = Rs 4 lakhs
FC = Contribution Profit , Rs 4 lakhs Rs 2 lakhs = Rs 2 lakhs , FC = Rs 2 lakhs
BEP in sales = FC/ PV ratio = Rs 2lakhs / 20% = Rs 100000.00 (Rs 10 lakhs)
3 Sales required to earn a profit of Rs 500000 = Rs 2 lakhs+ Rs 5 lakhs/.20 = Rs 140000.00

4 Margin of Safety = (Actual sales BES) / Actual sales

MS in Period I = 20 lakhs - Rs 10 lakhs = Rs 10 lakhs/20 = 0.5 (50%)
MS in Period II = 30 lakhs - Rs 10 lakhs = Rs 20 lakhs/30 = 0.66( 66%)

Note : The existence of a margin of safety is the indication that the sales are more than the
break-even level and the business is earning profit. It does not exist if the sales are less than
break -even level.

QUESTION VI (KU , MBA 2011)

Sales Rs 200000
Variable Overhead Rs 150000.00
Contribution Rs 50000.00
Fixed Overhead Rs Rs 15000
Net Profit Rs 35000.00
Calculate
1 Find P/V Ratio
2 BEP
3 Sales for 40% of P/V Ratio
4 Margin of Safety from the sale of Rs 300000.00
5 Net Profit from the sale of Rs 300000.00
6 Required sales for the net profit of Rs 70000.00
SOLUTION FORMULAE

a P/V Ratio = Contribution/ sales X 100 ie. P/V ratio (C Sales) (per cent)
b BEP in sales = FC/ PV ratio
c P/V ratio (C Sales) (per cent) Hence Sales = C/ P/V ratio
d MS = (Actual sales BES) / Actual sales
e Net Profit : Profit = Sales X PV Ratio- FC
f Sales required to earn a profit of Rs 70,000 = FC+ Rs 70000/PV Ratio
ANSWER

1 PV Ratio = 50000/200000= 0.25 (25%)

Or PV ratio = (S-V)/S X100 = Rs 2lakhs- Rs 1.5 lakhs/ Rs 2lakhs =50000/200000= 0.25
(25%)
2 BES = FC/PV ratio = 15,000/0.25 =Rs 60,000.00
3 Sales for 40% PV Ratio : Sales = C/ P/V ratio = 50000/ 0.40 = Rs1,25000.00
4 MS from the sale of Rs 300000.00 = Rs 3 lakhs- Rs 60,000 / Rs 3 lakhs = 24,0000/30000
=0.8 (80%)
5 Net Profit from the sale of Rs 300000.00 = Sales X PV Ratio- FC , Rs 300000X 0.25 =
75000- Rs 15000 = Rs 60,000
6 Sales required to earn a profit of Rs 70,000 = FC+ Rs 70000/PV Ratio = 15000+ 70000 /
0.25= Rs 34,000.00
Note : A high P/V Ratio indicates that a slight increase in sales without increase in
fixed costs will result in higher profits

QUESTION VII

From the following information calculate

1 P/V Ratio
2 Break Even Point(BEP)
3 If the selling price is reduced to Rs 80.00, calculate the New BEP and new P/V ratio
Total Sales Rs 50000.00
Selling price per unit Rs 100.00
Variable cost per unit Rs 60.00
Fixed Cost Rs 120000.00

SOLUTION FORMULAE

a P/V Ratio = TFC / BES

b BEP in sales = FC/ PV ratio Or BEQ = FC/ P-AVC
ANSWER

1 BEQ = FC/ P-AVC = Rs 1,20000.00/ Rs 100- Rs 60 = 3000 units ,

3000 units X Rs 100 = Rs 30,0000 (BES)
2 P/V Ratio = TFC / BES = 1,20000/ 30,0000 = 0.4 (40%)
3 New BEP if the selling price is reduced to Rs 80.00 , BEQ = FC/ P-AVC = Rs 120000/ Rs
80- Rs 60 = 120000/20 = 6000 units
4 New BES is 6000 units X Rs 80 .00 = Rs 48,0000.00
5 New P/V ratio is P-AVC/P = 80-60/80 = 0.25 (25%)
QUESTION VIII

From the following particulars calculate Margin of Safety and MS expressed as percentages

FC Rs 100000.00
VC Rs 150000.00
Total Sales Rs 300000.00

SOLUTION FORMULAE

a Margin of Safety = Profit /PV ratio

b MS in % = ( Sales BES)/ Sales
c PV Ratio = S-V/S
d BEP in sales = FC/ PV ratio Or BEQ = FC/ P-AVC
ANSWER

1 Margin of Safety = Profit /PV ratio

Profit = TR-TC , TR = Rs 3,00,000 , TC = (100000+ 150000) = 250000
Profit = Rs 50000.00
2 PV Ratio = S-V/S = 300000-150000/300000 = 0.50 (50%)
3 MS = 50000/0.50 = Rs 100000.00*
4 BES = FC/ PV Ratio = 100000/ 0.50 = Rs 200000.00
5 MS = 300000- 200000/300000= 0.33 (33%)
*another method to compute MS = (profit/Contribution) X sales where Contribution = Sales
VC ie. 300000- 150000 = Rs 150000 Therefore MS = (50000/150000) X 300000= Rs
99999.999 (Rs 100000)
QUESTION IX

Sales Rs 200000.00
Profit Rs 20000
Variable cost 60%
Calculate
1 P/V Ratio
2 FC
3 Sales Volume to earn a profit of Rs 50000.00

SOLUTION FORMULAE

a PV Ratio = S-V/S
b Contribution = S V ( Sales Variable Cost)
c Contribution = FC + Profit
d Sales Volume to earn a profit of Rs 50000 = (TFC + Rs 50000)/ PV Ratio
ANSWER

1 Variable Cost = 200000X 60% = 120000.00

2 PV Ratio = S-V/S = (200000-120000)/200000= 0.40 (40%)
3 Contribution = 2000000-120000 = Rs 80,000.00
4 Contribution = FC + Profit , Rs 80000 = FC+ Rs 20000 , Therefore FC = Rs 60000.00
5 Sales Volume to earn a profit of Rs 50000 = (TFC + Rs 50000)/ PV Ratio
( Rs 60000+ Rs 50000)/ 0.40 = Rs 2,75000.00
QUESTION X

Year Sales (Rs) Profit (Rs)

2010 140000.00 15000.00

2011 160000.00 20,000.00

Calculate

1 P/V RATIO
2 BEP
3 Sales required to earn a profit of Rs 40000.00
4 FC
5 Profit when sales are Rs 120000.00

SOLUTION FORMULAE

a PV Ratio = (Changes in Profit /Changes in Sales) X 100

b BEP in sales value = TFC / PV Ratio
c FC = Contribution Profit
d Contribution= Sales X PV Ratio
e Sales Volume to earn a profit of Rs 40000 = (TFC + Rs 40000)/ PV Ratio
f Profit when sales are Rs 120000.00 , Profit = Contribution - FC

ANSWER

1 PV Ratio = ( 50000/ Rs 20000) X 100 = 25% (.25)

2 BEP in sales value = TFC / PV Ratio
FC = Contribution Profit
Contribution= Sales X PV Ratio
Using 2010 sales , C = 140000X .25 =Rs 35000.00
FC = 35000 15000 = Rs 20000.00
BEP in sales value = Rs 20000/ .25 = Rs 80,000.00
3 Sales required to earn a profit of Rs 40000 = (20000 + 40000)/ .25 = Rs 2,40000.00
4 FC = 35000 15000 = Rs 20000.00
5 Profit when sales are Rs 120000.00
Contribution= Sales X PV Ratio Rs 120000.00 X 0.25 = Rs 30000.00
Profit = Contribution FC , ie. Rs 30000.00- Rs 20000.00 = Rs 10,000.00

B. DEMAND FORCASTING

Trend Series Analysis

Examples of time series are:

Annual yield of a crop in a country for a number of years,
Annual profit before tax of a firm,
Daily temperature of a city,
Annual rainfall of a country,
Total monthly sales receipts in a departmental store,
Daily closing prices of a share on the stock exchange,
Annual balance of trade of a country,
 Weekly consumer price index number, etc.

Basically, there are two objectives of time series:

(a) to examine the patterns of change over time, and

(b) to use these patterns to forecast and predict future values.

Trend Equation Y= a+ bX

Where Y = time series data , X = time (years) and a & b are constants .The parameter b
gives the measure of annual increase in sales. The parameters a & b are estimated by solving the
following two equations

The equation of least square line

Normal Equation for a Y = Na + b X ---- (1)
Normal Equation for b XY = aX + bX2 ----(2)

Eliminate a from equation (1) and (2), multiply equation (1) by a suitable number and subtract
from equation (2), we get the values of a and b.

QUESTION I : Find trend values for the years 2006,2007 ,2008 and 2009

Year
Demand/Sale
s (Y)
2001 120
2002 140
2003 120
2004 150
2005 180
SOLUTION

Year Trend
2
Demand/Sale X XY values
s (Y) X
2001 120 1 1 120
2002 140 2 4 280
2003 120 3 9 360
2004 150 4 16 600
2005 180 5 25 900
N= 5 Y= 710 X= 15 X2=55 XY=2260

The equation of least square line

Normal Equation for a Y = Na + b X ---- (1)
Normal Equation for b XY = aX + bX2 ----(2)

710= 5a + 15b (3) x 3

2260= 15a + 55b (4)
-----------------------------
2130 = 15a + 45 b (5)
2260= 15a + 55b (4) Equation (4) minus (5)
-----------------------------
130 = 10 b , b = 130/10 = 13
2130 = 15a + 585 , 2130-585 = 15 a, ie. 1545= 15a , a= 1545/15 = 103
a = 103 , b = 13

Y 2006 = Y= 103 + 13 (6) = 181

Y 2007 = Y= 103 + 13 (7) = 194
Y 2008 = Y= 103 + 13 (8) = 207

Question 3 : Find Trend Values

Year
Demand/Sale
s (Y)
1991 45
1992 56
1993 78
1994 46
1995 75
N= 5 Y= 300

Solution

Year Trend values

Demand/Sale X X2 XY
s (Y)
1991 45 1 1 45
1992 56 2 4 112
1993 78 3 9 234
1994 46 4 16 184
1995 75 5 25 375
N= 5 Y= 300 X= 15 X2=55 XY = 950

The equation of least square line

Normal Equation for a Y = Na + b X ---- (1)
Normal Equation for b XY = aX + bX2 ----(2)

300= 5a + 15 b (1) X 3
950= 15a + 55b (2)
900 = 15 a+ 45 b (3)
(2) (3)
50 = 10 b , b= 5
300 = 5a + 75 , 300- 75 =225/5 = 45 , a = 45
Y 1996 = 45 + 5 (6) = 75
Question 4

For the following data, calculate the trend values and plot them on a graph using least squares
method by fitting linear equation:

Table III
Pakistans GDP (In Trillion Rs.)

Year 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

GDP 3.10 3.15 3.26 3.40 3.53 3.59 3.71 3.89 4.14 4.48

Solution:

Year GDP (Y) Trend

X2 XY
Y = 2.842 + 0.142 X
X

1996 3.10 1 1 3.10 2.984

1997 3.15 2 4 6.3 3.127

1998 3.26 3 9 9.78 3.269

1999 3.40 4 16 13.6 3.411

2000 3.53 5 25 17.65 3.554

2001 3.59 6 36 21.54 3.696

2002 3.71 7 49 25.97 3.839

2003 3.89 8 64 31.12 3.981

2004 4.14 9 81 37.26 4.123

2005 4.48 10 100 44.8 4.266

 N=10 Y X X2 XY
=36.25 = 55 =385 =211.12

The equation of least square line

Normal Equation for a Y = Na + b X ---- (1)
Normal Equation for b XY = aX + bX2 ----(2)

36.25 =10a +55b (3) x 7

211.12 = 55a + 385 b
------------------------------
253.75 = 70 a + 385 b
211.12 = 55a + 385 b
------------------------------
42.63 = 15 a , a = 42.63/ 15 = 2.842 a= 2.842
Substitute the value of a in equation (3)
36.25 = 28.42 + 55 b ie. 7.83 = 55b , ie . b = 7.83/55 =0.14 , b= 0.14
Y= a+ bX

The equation would be: Y1996 = 2.842 + 0.142 (1) = 2.984

B ELASTICITY OF DEMAND

Question 1
Price per Quantity
Unit (Rs)P Demanded in
Units (Q)

60 100

70 90

Ep =% Change in quantity demanded/% Change in price

Change in Price = 70-60 = Rs 10 (P)

Change in quantity demanded = 90-100 = Rs -10 ( Ignore the negative sign) = Rs 10(Q)

Ep = (Q/ P) X P/Q

Ep= (10/10)X (60/100) = 0.6

Note :
1 Interpretation :A Ep (PED)value of 0.6 can be interpreted as follows, a 1% increase in the
price of the good will result in a 0.6% decrease in the demand for the good .(This means that
for a 10% increase in the price of the commodity, the quantity demanded will fall by 6%. ). It
is clear that with an inelastic demand (Ep = 0.6) then the change in the quantity demanded
changes by proportionately less than the change in the price. If the Ep is relatively inelastic
(less than one) then the quantity demanded will decrease by proportionately less than the
price rise
2 Ignoring the negative sign: This is because of the reason that the relationship between price
and demand is inverse that can yield a negative value of price or demand.

3 Computation of Price Elasticity:

Ep =% Change in quantity demanded/% Change in price
Percentage Change in quantity demanded = (Q/ Q)
Percentage Change in price = (P/ P)
Ep = (Q/Q)/ (P/P)
Ep= (Q/Q)X P/ P
Therefore , Ep = (Q/ P) X P/Q

4 Interpreting the Cross Price Elasticity of Demand (CPED). A CPED value of 0.4 can be
interpreted as follows, a 1% increase in the price of good A will result in a 0.4% increase in
the demand for good B.Alternatively, a CPED value of -1.5 implies that a 1% increase in the
price of good A will result in a fall of 1.5% in the quantity demanded of good B.
5 Interpreting the Income Elasticity of Demand (YED). If the YED has a value of +0.4, it
can be interpreted as follows, a 1% increase in the household income will result in a 0.4%
increase in the demand for the good. Alternatively, a YED value of -1.5 implies that a 1%
increase in household income will result in a fall of 1.5% in the quantity demanded.

Question2 :
An initial advertisement expenditure of Rs 50,000.00 the demand for a firms produce is 80,000 units.
When the advertising budget is increased to Rs 60000.00 the sale volume increases to 90,000 units.
Find the advertising elasticity of demand

A1 = Rs 50000.00 A2 = Rs 60000.00
Q1 = 80,000 units Q2 = 90,000 units
A = Rs 10000.00 Q = 10000 units
EA = (Q/ A) x (A/ Q)
= ( 10000/10000) x (50000/80000) = 0.625

D.PRODUCTION FUNCTION ESTIMATION

Mathematically, the production function can be expressed as

Q=f( K, L)
Q: level of output
K (Capital )and L (Labour): inputs used in the production process
Three most important measures of productivity are

1 Total product (TP)

2 Average product(AP) and
3 Marginal product(MP)

Question 1. For a Short run production function , Calculate Production when 100 units of labor are
used?
Production function Q = F(K,L) = K.5 L.5
K is fixed at 16 units
Short run production function: Q = (16).5 L.5 = 4 L.5
Production when 100 units of labor are used?
Q = 4 (100).5 = 4(10) = 40 units

Question2. Production Function : Q = F(K,L) = K.5 L.5 If the inputs are K = 16 and L = 9,
Measure the output of an average worker.

Answer :
Average Product of Labor
APL = Q/L.
Measures the output of an average worker.
Q = F(K,L) = K.5 L.5
If the inputs are K = 16 and L = 9, then the average product of labor is .
Average product of labor is APL = [(16)0.5(9)0.5]/9 = 1.33

Question 3 : Explain three stages of return of Cobb- Douglas Production Function

Cobb-Douglas Production Function: Q = aLbKc

Both capital and labor inputs must exist for Q to be a positive number
Can be increasing, decreasing, or constant returns to scale
Cobb-Douglas function: exponential for two inputs
Q = aLbKc
if b + c > 1, IRTS
if b + c = 1, CRTS
if b + c < 1, DRTS
Question 4 : Suppose a chair manufacturer is producing in the short run when equipment is fixed.The
manufacturer knows that as the number of laborers used in the production process increases from 1 to
7, the number of chairs produced changes as follows : 10,17,22,25,26,25 and 23
a Calculate the Marginal and Average Product of this production function
b Does this production function exhibit diminishing returns to Labour? Explain
c Explain intuitively what might cause the marginal product of labour to become negative?

Answer

a Calculate the Marginal and Average Product of this production function

The average product of labour, APL is equal to Q/L. The marginal product of labour MPL is
equal to Q/ L , the change in output divided by the change in labour input. For this
production function process , we have

L Q APL MPL
0 0 - -
1 10 10 10
2 17 8.5 7
3 22 7.33 5
4 25 6.25 3
5 26 5.20 1
6 25 4.16 -1
7 23 3.28 -2

b Does this production function exhibit diminishing returns to Labour? Explain

This production process exhibits diminishing returns to labour. The marginal product of
labour , the extra output produced by each additional worker , diminishes as workers are
added , and is actually negative for the 6th and 7th workers.

c Explain intuitively what might cause the marginal product of labour to become negative?
Labours negative marginal product for L< 5 may arise from congestion in the chair
manufactures factory. Since more labourers are using the same, fixed amount capital, it is
possible that they could get in each others way , decreasing efficiency and the amount of
output.
Question 5 :
Production Function Q = aLbKc

Q = 1.3 L0.7 K 0.3 and L= 120 ,K= 60 , find APL,MPL,APK,MPK

APL= Q/L
MPL= b (Q/L)
APK= Q/K
MPK = c (Q/K)

Answer : Q=1.3(120) 0.7 (60) 0.3 = 1.3 x 28.5X 3.4 =126

APL= Q/L = 126/120 =1.05

MPL= b (Q/L) = 0.7 x1.05= 0.74
APK= Q/K = 126/60= 2.1
MPK = c (Q/K) = 0.3 x2.1 =0.63
 E. COST- REVENUE- PROFIT

Quantit Price TR TC Profit MR MC Profit

y Margin

0 10 0 5 -5 - - -
10 10
1 10 7 3 2 8
10 10
2 20 10 10 3 7
10 10
3 30 14 16 4 6
10 10
4 40 19 21 5 5
10 10
5 50 25 25 6 4
10 10
6 60 32 28 7 3
10 10
7 70 40 30 8 2
10 10
8 80 49 31 9 1
10 10
9 90 59 31 10 0
10 10
10 100 70 30 11 -1

F. Total Product , Marginal Product , Average Product

Input TP MP AP

0 0 - -

1 150 150 150

2 400 250 200

3 600 200 200

4 760 160 190

5 910 150 182

6 900 -10 150

 G. ANALYSIS OF COST CURVES

Quantity Fixed Variable Total Cost Marginal Average Cost Average Fixed Average
Q cost Cost(V (TC=FC+VC) Cost (AC=TC/Q) Cost per Variable Cost
(FC) C) (MC) unit(AFC=FC/Q per unit(AVC
=VC/Q)
0 55 0 55 Infinity Infinity Infinity
30
1 55 35 85 85 55 30
25
2 55 55 110 55 27.5 27.5
20
3 55 75 130 43.33 18.33 25
30
4* 55 105 160 40* 40* 13.75 26.25
50
5 55 155 210 42 11 31
70
6 55 225 280 46.66 9.16 37.5

Note: The starred MC= starred AC . The point where AC cuts MC in the diagram