PRODUCTION AND COST ANALYSIS

A study of the firm begins with analysis of production. The essence of a firm is to buy inputs, use these inputs to produce outputs and then to sell the outputs.

This is true of competitive firms as well as monopolies, under capitalism as well as communism. Only after understandingthe essential elements of production theory,we can master the cost concepts that underpinbusiness decisions for perfect and imperfect competitors.

Let us begin by considering the case of production of food by a farmer. The farmer will use a number of inputs or factors of production such as land, labour, machinery and fertiliser. These inputs will be applied over the planting and growing season and at harvest time the farmer will reap certain outputs, such as wheat.

In what follows, we assume that the farmer always strives to produce efficiently or at lowest cost. That is, he will always attempt to produce the maximum level of output for a given dose of inputs, avoiding waste wherever possible.

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

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

Sx = f (Px, Py, Pz Pf, O, T), whereSx = Amount supplied of good XPx = Price of good Py, Pz = Prices of other goods in the marketPf = Prices of factors of production needed to produce good xO = Objectives of the producersT = State of technology used by the producer to produce good x

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

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

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

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

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

The supply curve shows the maximum amount of good which the firm would be willing to sell at each possible price of the good, under given conditions of supply. SSYOX800700600500400300PriceOfTyreQty. of tyres5,00010,00015,000

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

PoYOXSoSoS2S2S1S1P1P2Price Of GoodXUnit of good XQoQ2QoQ1QoQoQo

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

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

For example, if 1 per cent change in the price of sugar leads to 5 per cent change in its amount supplied, the supply is said to be elastic.If one per cent change in price of tomatoes, leads to 0.5 per cent change in its quantity supplied, the tomato supply is said to be inelastic.The Theory of ProductionProduction in economics refers to the creation of utilities. Production is the end result of a given production process.

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

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

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

A fixed input is one whose quantity cannot be varied during the period under consideration. Plant and equipment are examples of fixed inputs.An input whose quantity can be changed during the period under consideration, is known as the variable input. Raw materials, labour, power, transportation, etc., whose quantity can often be increased or decreased on short notice are examples of variable inputs.

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

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

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

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

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

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

MPL = Similarly, average product of labour (APL) is defined as total product (TP) per unit of labour. So, APL = TP / L

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

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

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

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

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

An isoquant is defined as the curve passing through the plotted points representing all the combinations of the two factors of production which will produce a given output, a typical isoquant diagram is one which moves upward to the right, since higher levels of output as obtained using larger quantities of inputs. YOX

MachineryLabout q, = 600q.=1000q. = 2000

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

YOXQ1Q2 Q2Q3Q4OilGasLikewise, given a power plantequiped to burn either gas or oil,various amounts of electric powercan be produced by burning gas only or oil only or varying amounts of each other. Gas and oil are perfect substitutes here; hence the isoquantsare straight lines.

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

ChasisYOXWheelsQ3 = 3 scooters Q2 = 2 scootersQ1 = 1 scooter

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

YOXC1C2C3L1L2L3ClothLabourQ1Q2So, while a relatively small additionof labour from L1 to L2 allows the in-put of cloth to be reduced from C1to C2, a very large increase in labour from L1 to L3 is needed to obtain a small reduction in cloth from C2 to C3. Thus, the substitutability of labour for cloth diminishes from L1 to L2 to L3.

Main properties of Isoquants:

An isoquant is downward sloping to the right, ie., negatively inclined. This implies

that for the same level of output, the quantity of one variable has to be reducedto increase the other variable.

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

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

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

Scale Total production in unitsMarginal product or return in unitsIncreasing,constant or decreasingreturns1. 1 L + 2 K 4 42. 2L + 4K 10 63. 3L + 6K 18 84, 4L + 8K 28 10Increasing5. 5L + 10K 38 106. 6L + 12K 7. 7L + 14K 48 56 10 8Constant8. 8L + 16K 62 6Decreasing

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

Increasing returns are attributed to improvement in the large-scale operation, division of labour, use of sophisticated machinery, better technology, etc.

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

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

The combined effect of specialised inputs results in increasing returns to scale. Dimensional advantages: Prof. W.J. Baumol, has put forward dimensional economies as one of the reasons for increasing returns to scale.

For instance, a storehouse with an area of 100 sq.ft. ie., 10 x 10 when doubled, will obtain an area of 20 x 20 = 400 sq.ft. Similarly, when factor inputs are doubled, the output will increase more than proportionately to the increase in input.

Units of CapitalOYXRExpansion pathUnits of labourIQ1Qx1 = 1000Qx2 = 2000Qx3 = 3000IQ2 IQ3IQ4Qx = 4000abcd

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

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

Emergence of Diseconomies of Scale: While increasing returns occur on account of economies of scale outnumbering the diseconomies, constant returns to scale can be attributed to the process of equalisation between the economies and diseconomies of scale.

When the firm expands beyond its optimum limit, diseconomies such as financial, managerial, marketing, technical and risk-taking emerges in equality with the economies of scale that the firm enjoyed in the initial stages.

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

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

When factors of production are perfectly divisible, constant returns to scale are obtained:

ROYIQ1IQ2IQ3IQ4abcdExpansionpathUnits of CapitalUnits of LabourQx1=1000Qx2=2000Qx3=3000Qx4=4000

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

IQ1IQ2IQ3IQ4OYXUnits of CapitalUnits of LabourQx1=1000Qx2=2000Qx3=3000Qx4=4000RExpansion pathabcd

You will notice from the above diagram that the successive distance between any two points on the expansion path or the scale line goes on increasing, thereby suggesting that in order to increase the output by a given fixed proportion, a progressively increasing combination of factor inputs is required. Thus Oa

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

In a given region or city, it is not only a given industry expands, but a number of industries are set up and these expand, results in overcrowding and congestion and transport and communication bottlenecks and reduces efficiency of work force. In addition, the firm may have a large work force with a high degree of specialisation. Control and coordination of various activities, both in management and material management becomes difficult, leading to greater possibilities of inappropriate decisions.

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

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

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

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

The percentage change in output is equal to percentage change in input

ROYIQ1IQ2IQ3IQ4abcdExpansionpathUnits of CapitalUnits of LabourQx1=1000Qx2=2000Qx3=3000Qx4=4000C4L4L3C3L2C2C1L1

The importance of Cobb-Douglas production function:

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Rs.2,100 Rs.2,000 = Rs.100.Total cost increases throughout, though at different rates.Average cost and marginal costs first decline and then rise.Marginal cost rises earlier than average cost.Fixed Costs and Variable Costs: Fixed costs are that part of total cost of the firm, which does not vary with output, e.g., expenditure on depreciation, rent of land and buildings, property taxes, etc.

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

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

However, when the firm expands its scale of operation, the fixed costs become variable costs.

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

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

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

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

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

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

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

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

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

YOXFCTotalFixedCostOutput

VCYOTotalVariable CostOutputX

))))))Variable Cost of ProductionYOXTotalSemi-VariableCostTotal Fixed Cost of productionOutput

YOXAverage Fixed CostOutput

AFC

AverageVariableCostYOXOutput

AVC

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

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

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

YOXCostOutput

AFCAVCATCAverage Cost isalso known as the unit Cost, since it is the cost perunit of output produced

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

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

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

Fixed salary of a foreman will have a sudden jump if another foreman is appointed when the output crosses a limit.A diagram to depict the semi-variable cost is as under:

YOXTotalVariable CostA stair step variablecost.OutputVC

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

TFC will be incurred even if there is no output. Initially, the MC decreases when the output is increased. At the fourth unit of production, the marginal cost increases with the increase in output. The shape of the curve will be U, showing that the marginal cost declines first and increases afterwards.The U shaped marginal cost curve can be depicted by means of a diagram, which is as under:

MCYOX MCOutput

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

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

According to Lipsey, the two curves should start from the same point.

Both the MC and AC curves decline but MC curve declines steeply than the latter.

After a certain stage, both costs rise but MC curve rises steeply while AC will rise smoothly. The MC curve cuts the AC curve from below at the lowest point of AC.

YOXRMCACQAC &MCOutput

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

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

YOX

MCATCAVCAFCCostOutputL

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

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

At that level of output then, all the inputs become variable including the size of the plant.

SAC1SAC2SAC3SAC4SAC5

LACYOQKAverageCostMM1The LAC curve will touch SAC2curve at the least cost point, ie.Q.LAC will touch SAC 3 and SAC4 curves on the right side.This is on the basis of traditional economic analysis.Output

However, modern firms face L-shaped cost curve than U shaped. LACLMCYOABXAverageCostOutputOver AB range, the Curve is perfectly flat.Over this range, all Sizes of plant have the same minimum cost.

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

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

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

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

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

AC1AC2CostYOXBLAC1 is before learning and AC2 is the curve of learning in the sense that the cost reduced after some experience.The unit cost in the first monthis BM. After nx months, the cost gets reduced to LM. The cost steadily declines and ultimately it sets at LM.MOutput

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

Units of OutputCumulative average labour hoursCumulative average labour cost (Rs,) 1 2000.0 20,000 8 1336.5 13,365 16 1115.0 11,150 32 917.4 9,174

If we plot the learning curve, it will be as underUnit Labour Cost(Rs, inthousands)YOX

2015105Output Units (cumulative)C 81632

This is an 80 per cent learning curve. You will notice here that for producing 1 unit of output, the average unit labour cost is Rs.20,000, But, when the output is raised to 16, the cumulative labour cost would be Rs.11,150 and when it is doubled to 32, it was brought down to Rs.9,174.Limitations: It cannot effectively deal with situation where (i) changes are made in the general size of the production run; (ii) rapid expansion of the enterprise;

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

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

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

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

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

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

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

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

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

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

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

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

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

managerial economies, financial economies and marketing economies.

YOXOutputCost &RevenueMCACAR=MR=PriceM

All these forces operate, making for a technical optimum, financial optimum and managerial optimum, etc.

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