Module-3

Production analysis and

Cost analysis
Production :
 It can be defined as an organized activity of transforming physical inputs into
output which will satisfy the products needs of the society.
 Production is an act of creating value that satisfies the wants of the individuals
 Production is a process in which economic resources or inputs (composed of
natural resources like labour, land and capital equipment) are combined by
entrepreneurs to create economic goods and services (outputs or products).
Firms are required to take different but interrelated production decisions like:
1. Whether or not to actually produce or shut down?
2. How much to produce?
3. What input combination to use?
4. What type of technology to use?
Factors of Production:
Factors of production include resource inputs used to produce goods and
services. Economist categorizes input factors into four major categories such as
land, labor, capital and organization.
1. Land
 Land refers to all natural resources which are employed in the production
process.
 It includes not only physical land but also everything that comes with it, such
as minerals, water bodies, forests, and other natural assets.
 The availability and quality of land can significantly impact the productivity of
an economy.
 For example, countries rich in fertile soil may have a comparative advantage
in agricultural production.
2. Labor
 Labor represents the human effort involved in producing goods or providing
services.
 It encompasses both physical and mental work contributed by individuals at
various skill levels.
 The quantity and quality of labor available within an economy can greatly
influence its productivity levels.
 Skilled workers have an edge over those unskilled ones when it comes to
production due to their specialized knowledge and expertise.
3. Capital
 Capital refers to all man-made resources used in the production process.
 Capital is a factor among the factors of production that. It can be divided into
physical and financial capital.
 Physical capital includes things like factories, vehicles, all the machines and
tools buildings required for production
 Financial capital includes cash, investments, and funding that businesses
need to grow.
 A business must have enough capital to buy modern technology and make it
more efficient and productive.
 Capital plays a vital role in enhancing productivity by enabling more
efficient methods of production.
 For instance, advanced machinery can automate tasks or increase output
per worker hour.
4. Entrepreneurship
 Behind every innovation and economic growth, the role of entrepreneurship is
unavoidable.
 Entrepreneurs are individuals who take risks to create new businesses or
improve existing ones.
 They identify opportunities for profit and allocate resources accordingly.
 Production Analysis
 It refers to analyzing the inputs or resources that are used to produce a firm's
final product.
 Production analysis basically is concerned with the analysis in which the
resources such as land, labor, and capital are employed to produce a firm's
final product
To produce the goods the basic inputs are classified into two divisions:
1. Fixed inputs:
 These are those factors who's quantity remains constant irrespective of level
of output produced by a firm.
 The number of fixed factors always remains constant even when is zero
production
Ex. Land, Building, Machine etc.
2. Variable inputs
 These are those factors who’s quantity varies with variation in the levels of
output produced by a firm.
 An increase in variable factors leads to more production and vice-versa
Ex. Raw material, Power, Transport, fuel etc.
Production Function
 Production Function is the relationship between physical inputs (land,
labour, capital, etc.) and physical outputs (quantity produced).
 It is a technical relationship (not an economic relationship) that studies
material inputs on one hand and material outputs on the other hand.
 Material inputs include variable and fixed factors of production.
 In a standard equation, the Production function is represented by Q, Labour
(Variable element) is represented by L, and Capital (Fixed element) is
represented by K.
Q = f(L,K)
 Types of Production Function
1. Short Run Production Function:
 Short Run is a period of time where output can only be changed by changing
the level of variable inputs
 Fixed factors remain constant in the short run like land, capital, plant,
machinery
 Production can be raised by only increasing the level of variable inputs like
labour.
 Therefore, the situation where the output is increased by only increasing the
variable factors of input and keeping the fixed factors constant is termed as
Short Run Production Function.
For example,
if there is a sudden increase in demand for a specific model due to a marketing
campaign or a change in consumer preferences, the manufacturer may
struggle to meet this increased demand immediately. They might have to
operate their factories at maximum capacity, potentially leading to overtime for
workers and increased pressure on the supply chain to deliver components on
time.
2. Long Run Production Function:
 Long Run is a span of time where the output can be increased by increasing
all the factors of production whether it is fixed (land, capital, plant, machinery,
etc.) or variable (labour).
 Long run is enough time to alter all the factors of production.
 All factors are said to be variable in the long run.
 Therefore, the situation where the output is increased by increasing all the
inputs simultaneously and in the same proportion is termed Long Run
Production Function.
For example,
In the long run, the automobile manufacturer has more flexibility to adjust its
production capacity, upgrade its technology, and expand its market reach.
They could invest in building new manufacturing facilities, implementing
automation to improve efficiency, or developing new models to cater to
changing consumer trends
Concept of Product
Product or output refers to the volume of the goods that the company produces
using inputs during a specified period of time.
The concept of product can be looked at from three different angles:
i. Total Product
ii. Marginal Product
iii. Average Product
i. Total Product:
 Total Product (TP) refers to the total quantity of goods that the firm produced
during a given course of time with the given number of inputs.
 Total Product is also known as Total Physical Product (TPP) or Total Output
or Total Return.
 For example, if 6 labours produce 10 kg of wheat, then the total product is 60
kg
ii. Average Product:
 Average Product refers to output per unit of a variable input.
 AP is calculated by dividing TP by units of the variable factor.
 Average Product= Total Product / Units of variable factor
 For example, if the total product is 60 kg of wheat produced by 6 labours
(variable inputs), then the average product will be 60/6, i.e., 10 kg.
iii. Marginal Product:
 It refers to the addition to the total product when one more unit of a variable
factor is employed.
 It calculates the extra output per additional unit of input while keeping all
other inputs constant.
 MPn = TPn – TPn-1
Here,
MPn = Marginal product of nth unit of the variable factor,
TPn = Total product of n units of the variable factor, and
TPn-1 = Total product of (n-1) units of the variable factor
Production function with one variable input:
It typically represents the relationship between the quantity of output produced
and the quantity of a single input used in the production process.
Law of Variable Proportions:
 It is referred to as the law which states that when the quantity of one factor of
production is increased, while keeping all other factors constant, it will result
in the decline of the marginal product of that factor.
 The law of variable proportion can be understood in the following way,
When variable factor is increased while keeping all other factors constant, the
total product will increase initially at an increasing rate, next it will be
increasing at a diminishing rate and eventually there will be decline in the rate
of production.
Assumptions of Law of Variable Proportion
Law of variable proportion holds good under certain circumstances, which will
be discussed in the following lines.

1. Constant state of Technology:

It is assumed that the state of technology will be constant and with
improvements in the technology, the production will improve.

2. Variable Factor Proportions:

This assumes that factors of production are variable. The law is not valid, if
factors of production are fixed.
3. Homogeneous factor units:
This assumes that all the units produced are identical in quality, quantity and
price. In other words, the units are homogeneous in nature.

4. Short Run:
This assumes that this law is applicable for those systems that are operating for
a short term, where it is not possible to alter all factor inputs.
The Law of Variable proportions has three stages, which are discussed below.

1. First Stage or Stage of Increasing returns:

 First stage starts from point 'O' and ends up to point F. At point F average
product is maximum and is equal to marginal product.
 In this stage, total product increases initially at increasing rate up to point E.
between 'E' and 'F' it increases at diminishing rate Similarly marginal product
also increases initially and reaches its maximum at point ‘H’.
 Later on, it begins to diminish and becomes equal to average product at point
T.
 In this stage, marginal product exceeds average product (MP > AP). In this
stage, the total product increases at an increasing rate.
 This happens because the efficiency of the fixed factors increases with
addition of variable inputs to the product.
 It occurs as a result of the initial variable input quantity being too small in
comparison to the fixed input.
 Due to the division of labour, efficient use of the fixed input during
manufacturing increases the productivity of the variable input.
2. Second Stage or Constant returns:
 It begins from the point F.
 In this stage, total product increases at diminishing rate and is at its maximum
at point 'G' correspondingly marginal product diminishes rapidly and becomes
"zero" at point "C" Average product is maximum at point "I' and thereafter it
begins to decrease.
 In this stage, marginal product is less than average product (MP < AP).
 In this stage, the total product increases at a diminishing rate until it reaches
the maximum point.
 The marginal and average product are positive but diminishing gradually.
 This occurs as a result of pressure on fixed inputs that results in a decline
in variable input productivity after a certain level of output
3. Third Stage or Stage of Negative Returns:
 This stage begins beyond point “G”.
 Here total product starts diminishing.
 Average product also declines.
 Marginal product turns negative.
 Law of diminishing returns firmly manifests itself.
 In this stage, no firm will produce anything.
 This happens because marginal product of the labour becomes negative.
 The employer will suffer losses by employing more units of labourers.
 It occurs when the amount of variable input exceeds the fixed input by a great
difference, which causes TP to decrease.
 However, of the three stages, a firm will like to produce up to any given point
in the second stage only.
 In this stage, the total product declines and the marginal product becomes
negative.
 It occurs when the amount of variable input exceeds the fixed input by a great
difference, which causes TP to decrease.
 Total Product Marginal Product Average Product

Stage I Increases in the beginning then First increases, continues to

reaches a maximum and begins to increase and becomes maximum.
First increases at increasing rate decrease.
then at diminishing rate.

Stage II Continues to diminish and Becomes equal to MP and then

becomes equal to zero. begins to diminish.
Continues to increase at
diminishing rate and becomes
maximum

Stage III Becomes negative Continues to diminish but will

always be greater than zero.
Diminishes
What is the Law of Returns to Scale?
 Returns to scale refer to the change in output that results from a change in
the factor inputs simultaneously in the same proportion in the long run.
 Simply put, when a firm changes the quantity of all inputs in the long run, it
changes the scale of production for the goods.
 According to the Law of Returns to Scale, when all the factor inputs are
varied in the same proportions, then the scale of production may take three
forms; viz
1. Increasing Returns to Scale
2. Constant Return to Scale
3. Diminishing Returns to Scale
1. Increasing Returns to Scale:
In the first stage of Returns to Scale, the proportionate increase in total output is
more than the proportionate increase in inputs. In simple terms, if all the inputs
increase by 100%, then the increase in output will be more than 100%.
For Ex:

Inputs (Units) Percentage Percentage

Output
(K = Capital, L = Increase Increase
(Units)
Labour) in Inputs in Outputs
2K + 4L 200 – –
4K + 8L 450 100% 160%
6K + 12L 600 100% 120%
The main reason behind Increasing Returns to Scale is Economies of Large
Scale.
Economies mean the benefits because of the large scale of production.
Economies of scale are of two types; which is,
1. Internal Economies
2. External Economies.
1. Internal Economies:
Internal Economies means the benefits of large-scale production available to an
organisation within its own operation.
For example, Managerial Economies are achieved by dividing labour and
specialisation.
2. External Economies:
External Economies mean the benefits of large-scale production shared by all the
firms of an industry when the industry as a whole expands.
For example, better infrastructural facilities, better transportation, etc.
2. Constant Return to Scale:
In the second stage of Returns to Scale, the proportionate increase in the total
output is equal to the proportionate increase in inputs. In simple terms, if all the
inputs increase by 100%, then the increase in output will also be 100%.
For example,

Inputs (Units) Percentage Percentage

Output
(K = Capital, L = Increase Increase
(Units)
Labour) in Inputs in Outputs
6K + 12L 600 – –
8K + 16L 1,000 100% 100%
10K + 20L 2,300 100% 100%
Once the firm has achieved the point of optimum capacity, it operates on
Constant Returns to Scale.
After the point of optimum capacity, the economies of production are
counterbalanced by the diseconomies of production.
3. Diminishing Returns to Scale:
In the third stage of Returns to Scale, the proportionate increase in the total
output is less than the proportionate increase in inputs. In simple terms, if all the
inputs increase by 100%, then the increase in output will be less than 100%.
For Example:

Inputs (Units) Percentage Percentage

Output
(K = Capital, L = Increase Increase
(Units)
Labour) in Inputs in Outputs
10K + 20L 2,300 – –
12K + 24L 4,600 100% 80%
14K + 28L 6,000 100% 75%
The main reason behind Diminishing Returns to Scale is Diseconomies of Large
Scale.
Diseconomies of Scale mean that the firm has now become so large that it has
become difficult to manage its operations.
Diseconomies of Scale are of two types; which is
1. Internal Diseconomies
2. External Diseconomies.
1.Internal Diseconomies:
Internal Diseconomies means the disadvantages of the large-scale production
that a firm has to suffer because of its own operations.
For example, Technological Diseconomies because of the heavy cost of wear
and tear.

2. External Diseconomies:
External Diseconomies mean the disadvantages of large-scale production that
all the firms of the industry have to suffer when the industry as a whole expands.
For example, stiff competition, etc.