MODULE III

THEORY OF PRODUCTION AND COST

Production function, Factors of Production, Law of Variable Proportion and Returns to Scale
04 hours, Blooms level: Application

Cost and its classification, short and long run cost curves, cost behavior, cost concepts and decision
making, breakeven analysis Calculation of costs and Break even point. 06 hours Analysis
 MODULE 3
THEORY OF PRODUCTION AND COST
 THEORY OF PRODUCTION

Meaning of production -The term production means transformation of physical “inputs” into physical
“outputs” . The term “inputs” refers to all those things which are required by a firm to produce a
particular product.

In addition to four factors or production, inputs also includes raw materials, power, fuel, transport
Warehousing, banking, etc. Thus the term “inputs” has a wider meaning in economics. What we get
At the end of the productive process is called as “Outputs”. In short output refers to finished products.

Meaning of Production Function- production function expresses the technological or engg relationship
between physical inputs and physical outputs.

A production function can be expressed in the form of a mathematical model Q = f (L1,L2, C,O,T, etc)
Where Q = Quantity of output
L1,L2,C,O,T, etc = various factor inputs like land, labour, capital, Organization and Technology etc.

The rate of output Q is thus a function of the factor inputs LNK etc. employed by firm per unit of time.
 Laws of production

Short run
Long run
Law of Variable Proportion
(only labour input is made variable)
Assumptions : Isoquant Analysis Returns to Scale
1. Only one factor is variable while (two variable inputs) (all inputs are variable)
others are constant. Assumptions: Assumptions:
1. There are only 2 1. All factor inputs are
2. All units of variable factor are factor inputs i.e. variable but
homogenous. Labour and Capital enterprise is fixed
3. Technology is constant 2. Technology is 2. Technology is
constant constant
The Law of Variable Proportion
This is one of the most fundamental laws of production. It gives us one
of the key insights to the working out of the ideal combination of Fixed
inputs and Variable inputs.
Additional units of the variable inputs on the fixed inputs certainly mean
a variation in output.

Statement of the Law

As the quantity of different units of only one factor input are increased
to a given quantity of fixed inputs, the Total, Average and Marginal
output varies in different proportions.

The old name of this law is the Law of Diminishing Returns.

BASIS OF Law of Variable proportion Law of Returns to scale

DIFFERENCE
Time period Applies in the short run Applies in the Long run
Variable & Fixed Factors Only one variable input factor is All factor inputs are changed
changed all other input factors are simultaneously. No distinction
unchanged like fixed factor inputs and
variable factor inputs.

Stages 1. Increasing returns to factor 1. Increasing returns to scale

2. Diminishing returns to factor 2. Constant returns to scale
3. Negative returns to factor 3. Decreasing returns to scale

Optimum stage Stage 2 is considered to be the There is no stage which is the

optimum stage of production. best in the long run.
TOTAL PRODUCT (TP) is defined as the total quantity of
goods produced with a given inputs.
in short run TP can be increased by employing more
units of a variable factor, where as in the long run
all input factors can be increased.
AVERAGE PRODUCT (AP) is defined as the amount of output
produced per unit of variable factor
AP=total product/input of variable factor.
MARGINAL PRODUCT (MP) is defined as the change in TP
resulting from the employment of additional
unit of a variable factor.
symbolically
MP = CHANGE IN TOTAL PRODUCT/CHANGE IN VARIABLE INPUT
SYMBOLICALLY MP = TPn – TPn-1 difference between TP of the
Present and TP of the previous.
 Y
STAGE- 2
STAGE- 3
Units Total Avera Marginal 70 - STAGE- 1
DIMINISHING
RETURNS NEGATIVE
of Produ ge product (MP) INCREASING RETURNS
variabl ct (TP) Produ
71 - RETURNS
e input ct
(Labou (AP)

LEVEL OF OUTPUT
r) Stage I 72 -
1 10 10 10
Increasing
Returns 73 -
2 24 12 14 To Factor
TP
3 39 13 15 Stage I I 74 -
4 52 13 13 Diminishing
Returns 75 -
5 61 12.2 9 To Factor
AP
6 66 11 5 10 -
7 66 9.1 0 Stage III O I I I I I I I I I I X
Negative
8 64 8 -2 Returns 1 2 3 4 5 6 7 8 9 10
To Factor McGraw-Hill/Irwin
UNITS OF VARIABLE FACTOR
Colander, Economics
MP
 Behaviour of TP, AP and MP – Law of Variable Proportions
TOTAL PRODUCT (TP) MARGINAL PRODUCT AVERAGE PRODUCT (AP)
(MP)
Stage I : Increases at an Increases and reaches its Increases (but slower
increasing rate. maximum than MP)
Stage II : Increases at a Starts diminishing and Starts diminishing
diminishing rate and becomes equal to zero
becomes maximum.
Stage III : Reaches its Keeps on declining and Continues to diminish but
maximum, becomes becomes negative. must always be greater
constant and then starts than zero.
declining.
 PRACTICAL IMPORTANCE OF THE LAW

1. It helps to work out the most ideal combination of factor inputs or the least
cost combination of factor inputs.

2. It is useful to a businessman in the short run production planning at the micro

level.

3. The law give guidance that by making continuous improvements in science and
technology, the producer can postpone the occurrence of diminishing returns.
 LAWS OF RETURNS TO SCALE
The law of returns to scale refers to long run production function wherein all factors
of production becomes Variable. There is no distinction between fixed inputs and
variable inputs.

Statement of the law

As a firm in the long run increases the quantities of all factors of production the
output may rise initially at a more rapid rate the than rate of increase in input,
then the output may increase in the same proportion of input and ultimately the
output increases less than proportionately.

This law has three stages as shown in the table:

1. Increasing Returns to Scale
2. Constant Returns to Scale
3. Decreasing Returns to Scale
STAGE 1 – INCREASING RETURNS TO SCALE
When the increase in output is more than proportional to the increase in input, it is referred as
law of increasing to scale.
For example, if labour and capital are increased by 15% and output increases by 25%.

This increase is due to the expansion of the business firm with large scale production and it enjoys
economies of scale.

STAGE 2 – CONSTANT RETURNS TO SCALE

When the increase in output is proportional to the increase in inputs, it is referred as law of
constant returns to scale.
For example, 10% increase in labour and capital will result in an equal proportion of 10% increase
in the output.

This is due to the reason that as a firm expands its output, a stage comes when all economies have
been fully exploited.
STAGE 3 – LAW OF DECREASING RETURNS TO SCALE
When an increase in the output is less than proportional to the increase in inputs, it is referred as
Decreasing
Returns to Scale.
For example, if all factors inputs are increased by 5% the output will increase by 3%.

This is due to diseconomies of scale, lack of coordination, difficulties of management, etc. Hence due
to diseconomies of scale, the management has to use inputs in greater proportions, thus giving rise
to decreasing returns to scale.
 LAW OF RETURNS TO SCALE
SCALE LAWS
TOTALOF RETURNS TO SCALE
PRODU MP
CT
(TP)
1L + 3C 2 2
I Stage
2L + 6C 5 3
INCREASING RETURNS
3L + 9C 9 4
4L + 12C 14 5
5L + 15C 19 5
II Stage
CONSTANT RETURNS
6L + 18C 24 5
7L + 21C 28 4 III Stage
8L + 24C 31 3 DECREASING RETURNS
9L + 27C 33 2
McGraw-Hill/Irwin Colander, Economics 14
 Y
7—

6—
MARGINAL PRODUCT

5— CONSTANT
ING B C
4---

DE
AS

CR
3---
RE

EA
INC

SI
MP

NG
2--- Curve
A D
1---
O X
2 I 3I 4I 5 I 6 I 7 I 8 I 9
SCALE
McGraw-Hill/Irwin Colander, Economics 15
 ECONOMIES OF SCALE
Economies of scale can be defined as “anything which serves to minimize average cost of production
in the long run as the scale of output increases is known as “Economies of Scale”.
Economies of Scale is classified into two broad categories

INTERNAL ECONOMIES EXTERNAL ECONOMIES

1) Labor Economies 1) Economies of Localisation
2) Technical Economies 2) Economies of Information
i) Economies of superior technique 3) Economies of disintegration
ii) Economies of Linked Process
iii) Economies of by-products
3) Managerial Economies
4) Market Economies
5) Financial Economies
6) Risk Minimising Economies
i) By diversification of output
ii) By diversification of market
 From Point A to B E>D (Economies is Greater than Diseconomies)
At Point B E=D (Economies = Diseconomies)
From Point B to C E<D (Economies is Lesser than Diseconomies)

C
A
LAC (Rs.)

10,000 Long Run Average Cost Curve

E>D E<D (LAC Curve)
8,000
E=D
7500 * B

X
100 150 300
Output (units)
Meaning of Internal Economies: Internal Economies are those economies which are open to an individual
firm when its size expands.

They emerge within the firm itself as its scale of production expands.

Internal economies are the function of the size of the firm.

Meaning of External Economies: External Economies are those economies which are shared by all the
firms in an industry when their size expands.

They are available for all firms from outside, irrespective of their size and scale of production.

They are the result of the growth and expansion of any particular industry or a group of industries as a whole.

External Economies are function of the size of the industry.

 FACTORS OF PRODUCTION
There are mainly four factors of production which help in the production process.

They are LAND, LABOUR, CAPITAL & ENTERPRISE/ORGANISATION.

LAND – refers to soil or earth’s surface. It includes all the free gifts of nature like natural resources,
Fertility of soil, etc.

Its features:

1. Land is free gift of nature

2. Land is limited in area
3. Land lacks mobility
4. Land varies in quality
5. Land differs in value
6. Land is the primary and passive factor of production
LABOUR-refers to all kinds of human efforts (both physical and intellectual) which result in the production
For which monetary paymants are made. Thus the services of a doctor, engineer, lawyer, accountant, etc
Are all considered to be labour.

Its features:

1. Labour is perishable
2. It is inseparable from the labourer
3. It differs in efficiency
4. Labour has imperfect mobility
CAPITAL-refers to all man made goods which can be used for further production. For example, plant, machinery
Dams and canals, equipment, etc. are all known as capital. Capital has been defined as ‘produced means of
Production’. This is because unlike land and labour which are primary factors of prodn, capital is produced by man
To help in the production of further goods.
Money is regarded as capital because it can be used to buy rawmaterials, tools, machinery, equipments, etc. for
Production.

The terms capital and wealth are not synonyms.

Capital is that part of wealth which is used for further production of wealth.

Thus, all wealth is not capital, but all capital is wealth.

Its types:
1. Fixed capital- refers to durable capital goods which used in prodn again and again till they wear out.
example, Machinery, Tools, etc.
2. Working capital-refers to capital used to buy rawmatersls and to meet the day to day expenses.
3. Human Capital-refers skills, knowledge and abilities possessed by individuals
4. Intangible capital-refers to some benefits and rights, which cannot be perceived by senses.
example, copyright, patent, etc.
ENTREPRENEUR or ENTERPRISE- An entrepreneur is a person who combines the three factors of
production Land, Labour and Capital in the right proportion and initiates the process of production
and also bears the risk Involved in it. The entrepreneur is also called as an ‘Organiser’.

Functions of an Entrepreneur:

1. Starting a business and resource mobilization-an entrepreneur collects the different factors of
production like land, labour and capital and coordinates them in order to initiate a business
Enterprise.

2. Risk and Uncertainty – an enterprise operates in a constantly changing environment. Thus it

depends on the ability of entrepreneur to bear risks. An entrepreneur has to bear risks because of
uncertainty of the future.

3. Innovations-the actual function of an entrepreneur is to bring innovations. Innovation includes

introduction of new production methods, utilization of new sources of raw materials, introduction
of New products, opening of new markets, etc.
 Problem on production theory
M/s Reliable Enterprises has found that the most profitable output occurs when they produce
Rs. 17,200 worth of output of a particular product. They can choose from three possible
Techniques A, B and C that will produce the desired level of output. The table below shows
The amount of inputs these techniques use along with each input price.
Price of input Input Production Techniques
per unit
A (units) B (units) C (units)
Rs. 100 Land 70 40 10
Rs. 20 Labour 60 70 180
Rs.150 Capital 20 60 30
Rs. 80 Entrepreneurship 10 20 20

If Reliable Enterprises chooses technique ‘C’ for production, is this choice correct?
What will be the maximum profit?

If the price of labour increases to Rs. 40 per unit, which technique now they should choose?
How will their profit be affected?
 Theory of cost
Cost of production refers to total money expenses incurred by the producer in the process
Of transforming inputs into outputs.
In other words, it refers to the total money expenses incurred to produce a particular
Quantity of output by the producer.
The knowledge of various cost concepts in cost analysis is important for a business manager/Production
engineers.
Uses of cost analysis
1. To findout the most profitable rate of operation.
2. To determine the quantity of output to be produced.
3. To locate weak points in production management to minimize cost.
4. To fix the price for the product.
5. To have a clarity about various concepts.
Cost-output relationship
Cost and output are correlated. Cost output relations play an important role in almost all
Business decisions. It throws light on cost minimization and profit maximization.
Cost output relationship is studied in two forms; short run and long run.
In producing products a firm has to use various inputs like fixed inputs and variable Inputs.
Fixed inputs are those which remain unchanged over a period of time. Example land,
Building, machinery etc.

Variable inputs are those which varies along with the level of output. Example
Raw material, direct labour, etc.

The cost incurred on fixed inputs are known as Fixed cost. These costs never varies with the level
Of outputs.
Example, rent, licence fee, interest on borrowed funds, managers salary, etc.
The cost incurred on variable inputs are known as variable cost. These cost varies along with the
Level of output.
Example, raw material, direct labour, etc.
In the cost analysis only in the short run we classify inputs into fixed and variable.
In the long run all inputs are considered as variable inputs.
 Short run cost schedule
OUTPUT TOTAL TOTAL TOTAL AVERAGE AVERAGE AVERAGE MARGINAL
(Q) FIXED COST VARIABLE COST (TC) FIXED COST VARIABLE TOTAL COST (MC)
(TFC) COST (TVC) (AFC) COST (AVC) COST (ATC)
0 300 0 300 300 0 300 -
1 300 300 600 300 300 600 300
2 300 400 700 150 200 350 100
3 300 450 750 100 150 250 50
4 300 500 800 75 125 200 50
5 300 600 900 60 120 180 100
6 300 720 1020 50 120 170 120
7 300 890 1190 42.9 127.1 170 170
8 300 1100 1400 37.5 137.5 175 210
9 300 1350 1650 33.3 150 183.3 250
10 300 2000 2300 30 200 230 650
 Y TC TVC

Cost of production formulas

TC = TFC + TVC

TFC = TC – TVC or AFC X Q

COST
TVC = TC – TFC or AVC X Q

AFC = AC – AVC or TFC/Q

AVC = AC – AFC or TVC/Q

Rs.300 TFC
AC = AFC + AVC or TC/Q

MC = TCn – TCn-1 O X
OUTPUT
AVERAGE FIXED COST (AFC) is the fixed cost per unit of output. When TFC is divided by total units of output, we
Get AFC

AFC and output have inverse relationship. It is higher at smaller level of output and lower at the higher
Level of output.

It is pure mathematical result that the numerator remaining unchanged the increasing denominator causes
Diminishing product.

COST
AFC
OUTPUT
 AVERAGE VARIABLE COST (AVC)

AVC is variable cost per unit of output. AVC can be

Computed by dividing the TVC by total units of output.
Thus, AVC=TVC/Q. AVC CURVE IS ‘U’ SHAPED
AVC will come down in beginning and then rise as more
A C

COST OF PRODUCTION
units of output are produced with a given plant.
This is because as we add more units of variable
factors in a fixed plant, the efficiency of inputs first
increases and then it decreases.

>
AVC curve is “U” shaped and it has 3 phases.

>
1. Decreasing Phase – in the graph from A to B, AVC
decreases. As output expands, AVC decreases because

.
when we add more units of variable factors to a given B
Fixed factors output increases more efficiently and
More than proportionately due to increasing returns. OUTPUT
2. Constant Phase – in the graph at point “B” AVC reaches its minimum point. When the proportion of
both fixed and variable factors are the most ideal, the output will be the optimum.
3. Increasing phase – in the graph from B to C, AVC rises. This is because additional units of variable
factors will not result in more than proportionate output. Hence greater output is obtained at higher
AVC
 AVERAGE TOTAL COST (ATC) / AVERAGE COST (AC)

ATC can be obtained by dividing the TC by total

Output. Thus AC=TC/Q.
In the short run AC tends to be ‘U’ shaped.
The combined influence of AFC and AVC curves
Will shape the nature of AC curve.

Cost of production
As long as the falling effect of AFC is much more
than the rising effect of AVC, the AC tends to fall.
At this stage increasing returns and economies
Of scale operate.

>

>
When the firm produces optimum output, AC will
Become minimum. Again at the point where the

.
Rise in AVC exactly counter balances the fall in AFC,
The balancing effect causes AC to remain constant.
In third stage when the rise in AVC is more than drop output
in AFC, then AC shows a rise. When output is
expanded beyond the optimum level diminishing returns set in and diseconomies of scale starts
operating. The short-run AC curve is also called as “plant curve”
 RELATION BETWEEN AVERAGE COST (AC) AND MARGINAL COST (MC)
1. Both AC and MC fall at a certain range of output and rise
afterwards. Y
2. When AC falls, MC also falls but at certain range of output.
MC tends to rise even though AC continues to fall. AC
However, MC would be less than AC. This is because MC
is attributed to a single marginal unit whereas in case of AC MC
the decreasing AC is distributed over all the units of

COST
output produced.
3. So long as AC is falling, MC is less than AC. Hence, MC curve
lies below AC curve, which indicates that fall in MC is more
than the fall in AC.
4. When AC is rising, after the point of intersection, MC will
be greater than AC.
5. So long as AC is rising, MC is greater than AC. Hence MC curve
lies to the left side of the AC curve, which indicates that MC is
O X
OUTPUT
more than the rise in AC.
6. MC cuts AC curve at minimum point of the AC curve only. This is because when MC decrease, it pulls AC
down and when MC increases, it pushes AC up. When AC is at its minimum it is neither being pulled
down nor being pushed up by MC. MC=AC. The point of intersection is least cost combination.
 Complete the following table

OUTPUT TC MC TFC TVC AFC AVC AC

0 250
1 100
2 210
3 220
4 510
5 60
6 100
7 60
8 590

FOR SOLUTION SEE NEXT SLIDE

OUTPUT TC MC TFC TVC AFC AVC AC
0 250 0 250 0 250 0 0
1 350 100 250 100 250 100 350
2 420 70 250 170 125 85 210
3 470 50 250 220 83.3 73.3 156.6
4 510 40 250 260 62.5 65 127.5
5 550 40 250 300 50 60 110
6 600 50 250 350 41.6 58.3 100
7 660 60 250 410 35.7 58.5 94.28
8 840 180 250 590 31.25 73.75 105
 COMPLETE THE FOLLOWING TABLE

OUTPUT AFC ATC AVC MC

1 140 50
2 45
3 45
4 48
5 18 52

FOR SOLUTION SEE NEXT SLIDE

 COMPLETE THE FOLLOWING TABLE

OUTPUT AFC ATC AVC MC

1 90 140 50 50
2 45 90 45 40
3 30 75 45 45
4 22.5 70.5 48 57
5 18 70 52 68
 SAMPLE PROBLEMS ON COST ANALYSIS
PROBLEM 1
Excel engineers have provided the following information:
Output 0 1 2 3 4 5 6 7 8
(in units)
Total Cost (Rs.) 400 480 550 590 620 650 730 820 950
Calculate TVC, AFC, AVC, and MC

PROBLEM 2
A manufacturing firm incurs a TFC of Rs. 120. with the help of the information given below calculate:
TVC, AVC, TC, AFC, AC
Output 0 1 2 3 4 5 6
(in units)
Marginal -- 60 20 10 15 35 70
Cost
(Rs.)
Solution to Problem 1

(TFC+TVC) (TC-TVC) (TFC/Q) (TC-TFC) (TVC/Q) (TCn – TCn-1))

OUTPUT TOTAL COST TOTAL FIXED AVERAGE TOTAL AVERAGE MARGINAL
(Q) (TC) COST (TFC) FIXED COST VARIABLE VARIABLE COST (MC)
(AFC) COST (TVC) COST (AVC)
0 400 400 - - - -

1 480 400 400 80 80 80 (480-400)

2 550 400 200 150 75 70 (550-480)

3 590 400 133.3 190 63.3 40 (590-550)

4 620 400 100 220 55 30 (620-590)

5 650 400 80 250 50 30 (650-620)

6 730 400 66.6 330 55 80 (730-650)

7 820 400 57.14 420 60 90 (820-730)

Solution for problem 2

Output (Q) TOTAL MARGINAL AVERAGE TOTAL AVERAGE TOTAL AVERAGE

FIXED COST (MC) FIXED VARIABLE VARIABLE COST (TC) TOTAL
COST COST COST (TVC) COST COST (ATC)
(TFC) (AFC) (AVC)

0 120 - - - - 120 -

1 120 60 120 60 60 180 180

2 120 20 60 80 40 200 100

3 120 10 40 90 30 210 70

4 120 15 30 105 26.25 225 56.25

5 120 35 24 140 28 260 52

6 120 70 20 210 35 330 55

Problem 3
Problem 4
With the help of the following
Find out the TC, AFC, AVC, AC,and MC of a firm
data calculate TFC, TVC, TC, AFC
With the help of the given data below.
AVC and MC
OUTPUT AVERAGE OUTPUT TFC TVC
COST (AC)
0 100 0
0 300 1 100 50
1 350 2 100 90
2 190 3 100 120
3 180 4 100 140
4 180 5 100 175
5 190 6 100 230
6 200 7 100 310
Solution For Problem 3
TFC TVC TC AFC AVC MC
300 - 300 - - -
300 50 350 300 50 50
300 80 380 150 40 30
300 240 540 100 80 160
300 420 720 75 105 180
300 650 950 60 130 230
300 900 1200 50 150 250
Solution for problem 4

TC AVC AFC AC MC
100 - - - -
150 50 100 150 50
190 45 50 95 40
220 40 33.3 73.3 30
240 35 25 60 20
275 35 20 55 35
330 38.3 16.6 55 55
410 44.28 14.2 58.5 80
Problem 5
The Fixed cost is Rs. 20. TVC is as follows:

OUTPUT TVC (Rs.)

(UNITS)
1 30
2 56
3 75
4 80
5 105
6 132
7 182

Calculate TC, AFC, AVC, AC and MC

Solution for problem 5

TFC (Rs.) TC (Rs.) AFC (Rs.) AVC (Rs.) AC (Rs.) MC (Rs.)

20 50 20 30 50 -
20 76 10 28 38 26
20 95 6.67 25 31.6 19
20 100 5 20 25 5
20 125 4 21 25 25
20 152 3.3 22 25.3 27
20 202 2.85 26 28.8 50
PROBLEM 4 PROBLEM 5
XYZ Engineers provided the following M/s. Instrumentation Engineers have
information. provided the following cost data.
Calculate TFC, TVC, AC and MC. Calculate TVC, AFC,AVC, AC and MC.
Give a graphic illustration
to explain the relationship between OUTPUT TC
Output and TC. (Rs.)

OUTPUT TC (Rs.) 0 360

0 150 1 540
1 200 2 600
2 240 3 630
3 270 4 675
4 360 5 780
5 400 6 990
 Solution for problem 4

OUTPUT TOTAL TFC TVC AC MC

COST
0 150 150 - - -
1 200 150 50 200 50
2 240 150 90 120 40
3 270 150 120 90 30
4 360 150 210 90 90
5 400 150 250 80 40
SOLUTION FOR PROBLEM 5

OUTPUT TC TFC TVC AFC MC AC AVC

(Rs.)

360 - - - - -
0 360
360 180 360 180 540 180
1 540
360 240 180 60 300 120
2 600
360 270 120 30 210 90
3 630
360 315 90 45 168.75 78.75
4 675
360 420 72 105 156 84
5 780
360 630 60 210 165 105
6 990
 LONG RUN AVERAGE COST CURVE (LAC CURVE)

Y SAC 1., SAC 2, SAC 3 ARE PLANT CURVES

LAC CURVE IS KNOWN AS ENVOLOPE CURVE

COST OF PRODUCTION

SAC 2 SAC 3
SAC 1
LAC Curve

O X
Q1 Q2 Q3
OUTPUT
In the Long run all costs are considered as variable costs. There is no dichotomy of total costs
Into Fixed Costs and Variable Costs.
In the short run a firm has to carry on its production within the existing plant capacity, but in the long run
It is not tide up to a particular plant capacity.
If the demand increases, it can expand output by enlarging its plant capacity by acquiring new buildings,
Install new machines, employ administrative and permanent staff. It can make use of the existing as well as
New staff in the most efficient way and there is lot of scope for making indivisible factors to become
Divisible factors. LTC
Long run average cost is the long run total cost divided by the level of output. Thus, LAC =
Q

In the diagram the LAC curve is drawn on the basis of 3 possible plant sizes. We have three SAC curves.
They represent 3 different scales of output. The firm can produce OQ2 units of output with the least cost.
The LAC curve is tangential to the SAC curves. It is drawn to cover them.. LAC curve is popularly known as
“Envelope Curve” as no SAC curve can be below the LAC curve.
SAC curves as known as “Plant Curve”
In the diagram OQ2 is regarded as optimal scale of output as it has the least per unit cost.
 BREAK EVEN ANALYSIS (BEA)
 The BEA helps in understanding the relationship between revenues and costs of a
firm in relation to its volume of sales.
 It helps in determining the volume at which the firm’s cost and revenue are in
equilibrium.
 It is a technique which helps to analyse the effect of change in the level of
production and total profit of a company.
 The BEA establishes the relationship between cost, volume and profits. Hence it
is also known as “Cost-Volume-Profit analysis”.
 In BEA more prominence to identify the Break Even Point (BEP).
 BEP refers to that level of sales volume at which there is neither profit nor loss,
 Costs being equal to its sales value and the contribution is equal to fixed costs.
 BEP is defined as “that level of sales at which the total revenue is equal to total
costs and the net income is equal to zero.
 Break even chart and diagrammatic representation

Selling Price is Rs. 4 per unit

Output Total Revenue Total Fixed Total Variable Total Cost
(TR) Cost (TFC) Cost (TVC) (TC)
0 0 300 0 300
100 400 (100 x 4) 300 300 600
200 800 (200 x 4) 300 600 900
300 1200 (300 x 4) 300 900 1200
400 1600 (400 x 4) 300 1200 1500
500 2000 (500 x 4) 300 1500 1800
600 2400 (600 x 4) 300 1800 2100

It is clear from this table that when the output is 100 units the firm incurs a loss of Rs.200 (TC-TR) and when
Output is 200 units it incurs a loss of Rs. 100. At the level of output of 300 units, Total Revenue is equal to
Total Cost (Rs.1200). At this point there is no profit no loss. This is the Break Even Point. From the level of 301
Unit the firm will be earning profit. Hence this firm has to make 300 units minimum with the given
TFC, TVC and Selling Price to reach the BEP.
 TR This is the Break Even Chart.
TFC is the Total Fixed Cost TR is
Y the Total Revenue
TC is the Total Cost.
TC
TFC is constant at all levels of output
and it is parallel to OX axis as shown.
PROFIT ZONE Variable Costs are represented by the
LOSS ZONE
BEP vertical distance between TFC and
Total Cost and Total

1200-- Total Variable TC lines.

Cost From this diagram we can observe
that the Break Even Point lies at
300 -- TFC 300 units of output.
Revenue

Upto 300 units the firm is incurring

Total Fixed Cost losses as TC is at a higher level than
TR. But at 300 units of output, the
O I I I I I i X firm is neither incurring losses nor
100 200 300 400 500 earning any profit. It is the Break even
600 Point, the point of production where
Output there is No loss and no profit.
FORMULAS TO REMEMBER FOR CALCULLATION BEP IN PHYSICAL UNITS, BEP IN SALES VALUE,
TARGET PROFIT SALES, PROFIT VOLUME RATIO AND SAFETY MARGIN

TFC TFC
BEP IN PHYSICAL UNITS = =
SP-VC CM

TFC
BEP IN SALES VALUE = (CR=TR-TVC/TR)
CR

TFC+TARGETTED SALES
TARGET PROFIT SALES =
CM

CONTRIBUTION TFC + PROFIT

PROFIT VOLUME RATIO = X 100 OR
SALES SALES
 CALCULATION OF BREAK EVEN POINT
The two methods of calculation of BEP are 1) BEP in terms of physical units 2) BEP in terms of sales value BEP in
terms of physical units is suitable for a firm producing a single product.
BEP in terms of sales value is suitable for a firm producing multi products.

Illustration for calculating BEP in terms of physical units

Selling Price Rs. 15 per engg component

Variable cost Rs. 10 per engg component
Total Fixed cost (TFC) Rs. 1,50,000

First step is to calculate Contribution Margin (CM)

Selling Price – Variable cost per unit.
Rs. 15 – Rs. 10 = Rs. 5 is the CM
TFC Rs. 1,50,000
=
Now, BEP = CM =Rs.
30,000
5
Units
Hence, the firm reaches BEP by producing 30,000 units
Illustration for calculating BEP in terms of sales value
This method is useful for a firm producing multi products

Total Sales Value Rs. 10,000 (TR)

Total Variable Costs Rs. (TVC)
6,000
Total Fixed Cost Rs. (TFC)
3,000
First step is to calculate Contribution Ratio

TR – TVC Rs. 10,000 – Rs.

6,000 = 0.4 (CR)
=
TR Rs. 10,000

It implies that for every one rupee sales value the TFC is 0.40 paise
TFC Rs.
Now BEP = 3,000 = = Rs. 7,500
CR 0.4
Hence it is clear from this calculations that at sales value of Rs. 7500 (BEP),
there is no profit and no loss.
 BREAK EVEN CONCEPT HELPS IN 'MAKE' OR 'BUY'
DECISIONS
Some firms often make certain components or ingredients which may be a part of their finished
product
The break even concept helps the firm to take a decision whether it will be more profitable to produce
or purchase from outside manufacturer or supplier for final assembly of the finished product.

PROBLEM 1
A firm purchases certain components at Rs. 10 each. In case it makes itself, its TFC is Rs. 12,000 and
Variable Cost is Rs. 4 per unit, should a firm Make or Buy.
TFC Rs. 12,000
BEP = = = 2000
Price – VC (CM) Rs. 10 - 4

Hence, if the firms requirements is less than 2000 units then it is profitable to buy than to manufacture them
PROBLEM 2
An engineering firm buys certain components for producing a component at Rs. 20 per unit. If he has
to make these components, it would require a TFC Rs. 15,000 and VC Rs. 5. His present requirement
is 1000 units of these components.
Advise him whether he should make or buy them, if he intents to double the
output.

Solution

TFC Rs. 15000

= = 1,000
BEP =
Price - VC Rs. 20 – Rs. 5

Hence, at 1,000 units requirement it makes no difference whether the firm buys or makes the components
But when requirement increases, it is profitable to make the components.
 PROBLEM 3
A manufacturer of car buys certain component at Rs. 20 each. In case, he makes himself, his fixed
cost and variable cost would be Rs. 24,000 and Rs. 8 per component respectively.
Advice him whether he has to make or buy the component.

PROBLEM 4
Premier Batteries Ltd. makes 10000 batteries per month; it has to pay Rs. 2000 per month towards
Rent of factory and Rs. 5000 per month towards electricity. It also incurs a cost of Re.0.05 per
battery. It sells a battery at Rs. 4 per piece. Find Break Even Point.
 SAMPLE PROBLEMS FOR CALCULATING BREAK
EVEN POINT
PROBLEM 5
A firm incurs fixed cost of Rs. 4000 and variable cost of Rs. 10000 and its total sales receipts are
Rs.15000. determine Break even point.

PROBLEM 6
M/s. Gayatri Engineering furnishes the following information.. On the basis of the information
a) Find BEP in physical units and in terms of sales value in rupees.
b) Show the amount of Variable Cost at BEP
c) Profit made by the company at 20,000 units when the selling price is increased by 25%.

Annual Sales 20,000 units

Selling Price Rs. 8.00
VC Rs. 6.00
TFC Rs. 60,000
PROBLEM 7
M/s. Honeywell Engineering furnishes the following information.. On the basis of the
information
a) Find BEP in physical units and in terms of sales value in rupees.
b) Show the amount of Variable Cost at BEP
c) Profit made by the company at 30,000 units

Annual Sales 30,000

units Selling Price
VC Rs.
Rs. 9.00
12.00
TFC Rs. 80,000

PROBLEM 8
M/s. Zenith Engineering furnishes the following information.. On the basis of the
information
a) Find BEP in physical units and in terms of sales value in rupees.
b) Show the amount of Variable Cost at BEP
c)Profit made by the company at 10,000 units
Annual Sales 10,000 units
Selling Price Rs. 12.00
VC 15.00
TFC Rs. 20,000
Solution for Problem 6 CM = Contribution Margin
TFC Rs. 60000
a) BEP in Physical unit = = 30000 units (CM is the difference between Selling Price and
CM Rs. 2
= Variable Cost =Rs.8– Rs6 = Rs.2)
Rs. 60000
BEP in Sales Value = TFC = = Rs. 240000
0.25 CR = Contribution Ratio
CR (CR can be calculated thus,
TR – TVC Rs. 160000 – Rs. 120000 = 0.25
TR
Rs. 160000

b) Amount of VC at BEP = BEP in physical units X Variable Cost per

unit
30000 units X Rs. 6 = Rs. 180000
c) Profit made by the company at 20000 units when selling price is increased by
Old Price Rs. 8 per unit
25%
New Price by adding
Total Revenue (TR) = 20000 units X Rs. 10.00 (Selling Price per unit) = Rs. 200000
25% to Rs. 8 = Rs. 10.
Total Fixed Cost (TFC) =
Total Variable Cost Rs. 60000
(TVC) = Rs.
Total (TC) = Rs. 180000 Deduct TC = Rs. 180000
Cost 120000
Profit Rs. 20000
PROBLEM 9
ABC Enterprises with annual sales of small ball bearings 8000 units. It is selling at Rs. 9.50 per
unit. The TFC of the company is Rs. 18000 and VC per unit is Rs. 6.50. on the basis of above
calculate:
a) BEP in physical units and sales value in rupees.
b) Show the amount of VC at BEP.
c) Profit made by the company at 8000 units.

PROBLEM 10
Expert Engineering Pvt. Ltd. Manufactures automobile lamps and sells them at Rs. 25 per unit.
And average Variable cost is Rs. 13 per unit.
Determine a) Break even sales
b) Firm’s profit is if its normal production capacity of 2000 lamps.

PROBLEM 11
Premier Engineering Co. incurs a FC of Rs. 4000 and VC of Rs. 10000 and its total sales
receipts Are Rs.15000. Determinine Break Even point
Solution for Problem 9 CM = Contribution Margin
TFC Rs.18,00 (CM is the difference between Selling Price and
a) BEP in Physical units = 6000 Units
CM = 0 Rs. 3 Variable Cost =Rs.9.50 – Rs.6.50 = Rs.3)
=

TFC = Rs. 18000 CR = Contribution Ratio

BEP in Sales Value = = Rs. 57142.8
CR 0.315 (CR can be calculated thus,
TR – TVC = Rs. 76000 – Rs. 52000 = 0.315
TR Rs. 76000

b) Amount of VC at BEP = BEP in physical units X Variable Cost per

unit
6000 units X Rs. 6.50 = Rs. 39000

c) Profit made by the company at 8000 units

Total Revenue (TR) = 8000 units X Rs. 9.50 (Selling Price per = Rs.
Total Fixed Cost unit)
(TFC) = 76000

Total Variable Cost Rs. 18000

(TVC) = Rs.
Total (TC) = Rs. 70000 Deduct Rs. 70000
Cost 52000
Profit is TR – = Rs. 6000
TC
 Calculation of Target Profit Sales in Break Even Concept (TPS)
TPS is about finding out the estimated business activities to perform to earn a Target Profit.
Management is Interested to find Sales Volume required to generate profit.

Problem 1
Acme Engineers provide the following information: TFC= Rs.40,000, Selling Price (SP)=Rs.80,
Variable Cost (VC)=50.
In order to earn a profit of Rs.80,000, how many units has to be sold?
Solution:
TPS = TFC+Targeted Profit
Contribution Margin (CM)

Rs.40,000+Rs.80,000
Rs.30

=4,000

4,000 units has to be sold for a target profit of Rs.80,000

Problem 2
National Engineers have provided the following data, TFC=Rs.4,00,000, SP=Rs.140, VC=Rs.90. in order to
Earn a profit of Rs.2,00,000, how many units they have to sell?

Solution:
TFC+Targetted Profit
TPS= CM

Rs.4,00,000+Rs.2,00,000
Rs.50

Rs.6,00,000
Rs.50

12,000 units has to be sold to earn a profit of Rs.2,00,000

Problem 3
Hindustan engg components furnished the following data: TFC = Rs. 80,000, SP=Rs.7, VC=Rs.2
1. What is BEP if Rs.4000 spent on advertisement?
2. If profit expected Rs40,000, how many units to be sold?

Solution: 1. BEP if Rs.4000 spend on advertisement

we know TFC is Rs.80,000, now we have to add Rs.4000 (advertisement charges) since it is also comes under
TFC.
Now TFC is Rs.80,000+Rs.4,000=Rs.84,000
TFC Rs.84,000
Hence BEP= = =16,800 units
CM Rs.5

2. if profit expected Rs.40,000 how many units to be sold?

TFC+Targeted Profit Rs.80,000+Rs.40,000
TPS= = = 24,000 units
CM Rs.5
 Problems on Profit-Volume Ratio (PV Ratio)
PV Ratio is also known as Contribution Ratio or Marginal Ratio, which expresses the relation of
Contribution to sales.

Problem 1 PV RATIO INDICATES

SLN Softwares have provided the data as below: TFC=Rs.48,000, SP=Rs.1200, VC=Rs.960. THE RELATIONSHIP;
Calculate PV Ratio, Calculate BEP in physical units and Calculate BEP in Sales Value. BETWEEN CONTRIBUTION
Solution: AND SALES AND USUALLY
Contribution Margin (CM) 16 EXPRESSED IN PERCENTAGE.
PV Ratio = X 100 = X 100 = 40% THE RATIO SHOWS THE
Selling Price (SP) 40 AMOUNT OF CONTRIBUTION
PER RUPEE OF SALES.
TFC Rs.48,000
BEP in Physical units = = = 200 units
SP-VC Rs.240

BEP in Sales Value = BE units X Selling Price (SP) = 200 units X Rs.1200 = Rs.2,40,000
Problem 2
Suppose, Sales Rs.10,00,000, VC Rs.4,00,000 TFC Rs.4,00,000, what is the Profit-Volume Ratio?

Problem 3
If the Sales are Rs.2,00,000, VC Rs.1,20,000 and FC Rs.40,000, Calculate Profit-Volume Ratio

Problem 4
If the sales are 10,000 units at Rs.10 per unit, Variable Cost (VC) per unit is Rs.6 and TFC is Rs.80,000,
Calculate Profit-Volume Ratio.

Problem 5
Calculate Profit-Volume Ratio when the Sales are 10,000 units at Rs.10 per unit,
TFC Rs.80,000
Profit Rs.5,000
 Problems on Calculation of Margin of Safety
Margin of Safety (MS) is the difference between actual sales and break even sales.
For example, if actual sales for the month of Jan. 2020 is Rs.2,50,000 and the break even sales are Rs.1,50,000,
Here the difference is Rs.1,00,000 and that is the Margin of Safety.

In Accounting, the Margin of Safety is calculated by substracting the Break Even Point amount from
actual/budgeted sales and then dividing by sales and the result is expressed as percentage.

Sales-BEP Example, Suppose Actual Sales is Rs.1,10,000

Thus, MS= X 100. BEP Sales is Rs.65,000
Sales
Rs.1,10,000-Rs.65,000
Now MS = X 100
Rs.1,10,000

Rs.45,000
= X 100
Rs.1,10,000

= 40.90%
Problem 1
Suppose TFC is Rs.12,000, SP is Rs.8 and VC is Rs.5, calculate BE Quantity and Safety Margin at 5000 units

Solution: Calculation of BE quantity

= TFC Rs.12,000 Rs.12,000 = 4,000 units

= =
SP-VC Rs.8-Rs.5 Rs.3

Calculation of Safety Margin for 5000 units

Sales-BEP 5,000-4,000
SM = X 100 = X 100 =20%
Sales 5,000
 Computation of Actual Sales when Break Even Sales (BEP) and Margin of Safety
(MS) is given

Suppose BEP is Rs.65,000, MS is Rs.45,000, then Actual Sales is

Solution:
MS=Actual Sales-Break Even Sales
Rs.45,000=Actual Sales-Rs.65,000
Actual Sales=Rs.45,000+Rs.65,000=Rs.1,10,000

Computation of BE Sales when Actual Sales and MS is given

Suppose, Actual Sales is Rs.75,000, MS is Rs.15,000, then BE sales is

Solution:
MS=Actual Sales-BE Sales
Rs.15,000=Rs.75,000-BE Sales
BE Sales=Rs.75,000-Rs.15,000
Rs.60,000
 MISCELLANEOUS PROBLEMS ON BEP
Problem 1
From the data given below calculate Selling Price if Break Even should be brought down to 6,000 units.
TFC=Rs.54,000
SP =Rs.20
VC =Rs.15

Solution: Firstly we have to calculate BE in physical units

CM=SP-VC=Rs.20-Rs.15=Rs.5 Hence, BEP=TFC/CM=10,800 units.

What is the new price if Break Even is 6000 units?

BEP=TFC/CM = 6,000=Rs.54,000/CM OR CM=Rs.54,000/6,000 = 9
CM = SP – VC
Verification
9 = SP – 15
TFC = Rs.54,000
SP = --9 – 15 CM = Rs.24 – 15
= Rs. 24 NEW PRICE Rs.9

BEP units = TFC/CM

= 54,000/9
= 6,000 units
Problem 2
You are required to calculate BEP from the following data provided by Zenith Engg company.
Sales 550 units
Sales Receipts Rs.28,875
TFC Rs.16,000
TVC Rs.11,000
Solution:
First let us find out Selling Price (SP) per unit
SP= Total Sales/Total Units
= Rs.28,875/550
= Rs.52.50
Next let us calculate Variable Cost (VC) per unit
VC= TVC/Total Units
= Rs.11,000/550
= Rs.20
Now, BEP in physical units
BEP=TFC/SP-VC
= Rs.16,000/Rs.52.50-Rs.20
= 492.30 units.
Problem 3
With the help of following data calculate : 1) BEP in physical units 2) BEP in sales value 3)Margin of Safety if
sales is 5,500 units.
TFC=Rs.15,000
VC = Rs.5/-
SP = Rs.8/-

Solution
BEP in Physical units = TFC/CM
= Rs,15,000/3
= 5,000 units

BEP in Sales Value = BEP units X Selling Price (SP)

= 5,000 X Rs.8
= Rs.40,000

Margin of Safety if sales is 5,500 units = Sales – BEP/Sales X 100

= 5,500 – 5,000/5,500 X 100
= 500/5,500 X100
= 9%
Problem 4
The Fixed Expenditure of a firm is Rs.24,000, Variable Cost (VC) Rs.5/-, Selling Price
(SP) Rs.8/-
1. Determine Break Even Quantity
2. Safety Margin for sales of 10,000 units

Solution:
BEP in Quantity = TFC/CM
= Rs.24,000/Rs.3
= 8,000 units

Safety Margin for sales of 10,000 units = Sales – BEP/Sales X 100

= 10,000-8,000/10,000 X 100
= 2,000/10,000 X 100
= 20%
Calculation of BEP when Total Revenue (TR) and Total Cost (TC) functions are given

Problem 1
Given the TC and TR functions, determine the Break Even Point Alternate method
Firstly we set TR equal TC
TC=480+10Q, TR=50Q
480+10Q=50Q
Solution 480= -10Q+50Q
We know that TC=TFC+TVC 480=40Q
Here TFC=Rs.480 and AVC=Rs.10 Q=480/40
TR=P X Q 12
TR=50Q
Which implies that Selling Price is Rs.50
Now, BEP=TFC/SP-VC = 480/40 =12 units Therefore when 12 units are produced there no

profit and no loss.

Thus, TC=480+120 (AVC=10 X 12) Rs.600

TR=50 X 12 (SP X BE volume) Rs.600

Hence TR=TC, No profit No loss

Problem 2
You are provided with the TR and TC functions, Determine the Break Even Point
TC=300+3Q
TR=4Q

Solution
Setting TR equals TC = 300+3Q=4Q
300=-3Q+4Q
300=1Q
Q=300/1
=300 IS THE BREAK EVEN POINT
Problem 3
Given the following data with TR and TC functions, calculate Break Even Point
TC=54,000+15Q
TR=20Q

Solution
Setting TR equals TC = 54,000=15Q+20Q
= 54,000=-15Q+20Q
Q=54,000/5
10,800 units is the BE quantity..
1. Pepsi Company produces a single article. Following cost data is given about its product:‐
Selling price per unit Rs.40
Marginal cost per unit Rs.24
Fixed cost per annum Rs. 16000

Calculate:
(a)P/V ratio (b) break even sales (c) sales to earn a profit of Rs. 2,000 (d) Profit at sales of Rs. 60,000 (e)
New break even sales, if price is reduced by 10%.
Solution:
(A) PV Ratio
=CM/SP X 100 = 16/40 X 100 =40%
(B) Break even sales Calculation of
Break even Quantity
Break Sales = Break Even Quantity X Selling Price
1000 units X Rs.40 =TFC/CM
Rs.40,000
=Rs.16,000/Rs.16

=1,000 units
(C) The sales to earn a profit of Rs. 2,000
Targetted Profit = TFC+Targetted Profit/CM
=Rs.16,000+Rs.2,000/Rs.16
=1,125 units (1,125 X Rs.40 Selling Price = Rs.45,000)
(D)Profit at sales of 60,000
Total Revenue Rs.60,000 (1500 Units X Rs.40)
TFC Rs.16,000 Rs.60,000/Rs.40 = 1500 units
TVC Rs. 36,000 (Less) Rs.52,000 TVC for 1500 units = 1500 X Rs.24
Rs. 8,000 =Rs.36,000
(E) New break even sales, if sale price is reduced by10%
New sales price = 40‐10% = 40‐4 = 36
Marginal cost = Rs. 24
Contribution = Rs. 12

BEP=TFC/CM
= Rs.16,000/12
= 1333.3 units
1333.3 X Rs.36
=Rs.47,999.9
2. From the following information's find out:
a. P/V Ratio
b. Sales &
c. Margin of Safety
Fixed Cost = Rs.40, 000
Profit = Rs. 20,000
B.E.P. = Rs. 80,000
Solution:
a. P/V Ratio.
We know that S – V = F + P OR S(S – V)/S = F + P
B.E.S. x P/V Ratio = F (Value of P is zero at BE Sales) OR P/V Ratio = F/BES
Putting the value,
P/V Ratio = 40,000/80,000 = 50/100 OR 50%
b. Sales.
We know that Sales x P/V Ratio = F+ P OR Sales x P/V Ratio = Contribution
OR Sales = Contribution/P/V Ratio
So, = (40,000 + 20,000)/50/100
= (60,000 x 100)/50
=Rs.1, 20,000
c. Margin of Safety.
Margin of Safety = Sales – B.E.P Sales
So, MOS = 1, 20,000 – 80,000
MOS = Rs.40, 000
3. Bansi company manufactures a single product having a marginal cost of Rs. 1.50 per unit.
Fixed cost is Rs. 30,000 per annum. The market is such that up to 40,000 units can be sold at a price of Rs. 3.00 per
unit, but any additional sale must be made at Rs. 2.00 per unit. Company has a planned profit of Rs. 50,000. How
many units must be made and sold?
Solution:
a. Contribution desired = Fixed cost + Desired Profit
= 30,000 + 50,000 = 80,000
b. Calculation of contribution by producing 40,000 units.
Contribution per unit = Selling price – Marginal cost
= 3.00 – 1.50
= 1.50
c. Contribution for producing 40,000 units.
= 1.50 x 40,000 units
= Rs.60, 000
d. Additional units to be produced and sold at Rs. 2.00 per unit after 40,000 units.
=Rs.80, 000 –Rs. 60, 000
=Rs.20, 000
e. Units to be produced for contribution of Rs. 20, 000 after change in price.
Contribution per unit = Rs. 2.00 – Rs. 1.50= Rs. 0.50
f. Additional units to be produced for contribution of Rs. 20, 000.
= (20, 000 x 100)/50 = 40, 000 units.
Total units to be produced to earn planned profit = 40, 000 + 40, 000 = 80, 000 units.