MEFA (2014-15)

UNIT II
Unit-II : Theory of Production and Cost Analysis: Production Function- Isoquants and
Isocosts, MRTS, Law of variable proportions- Law of returns to scale- Least Cost
Combination of Inputs, Cobb-Douglas Production function - Economies of Scale.
Cost Analysis: Cost concepts, Opportunity cost, Fixed Vs Variable costs, Explicit costs Vs.
Implicit costs, Out of pocket costs vs. Imputed costs.-Determination of Break-Even Point
(simple problems) - Managerial Significance and limitations of BEP.
PRODUCTION FUNCTION
Introduction: The production function expresses a functional relationship between physical
inputs and physical outputs of a firm at any particular time period. The output is thus a
function of inputs. Mathematically production function can be written as :
Q= f (A, B, C, D)
Where Q stands for the quantity of output and A, B, C, D are various input factors such as
land, labour, capital and organization. Here output is the function of inputs. Hence output
becomes the dependent variable and inputs are the independent variables.
Importance of Production Function:
1. When inputs are specified in physical units, production function helps to estimate the
level of production.
2. It indicates the manner in which the firm can substitute one input for another without
altering the total output.
3. When price is taken into consideration, the production function helps to select the
least combination of inputs for the desired output.
4. The production function explains the maximum quantity of output, which can be
produced, from any chosen quantities of various inputs or the minimum quantities of
various inputs that are required to produce a given quantity of output.
The production function varies for different firms or industries. Production function will
change with an improvement in technology.
Assumptions:
A production function has the following assumptions.
1. The production function is related to a particular period of time.
2. There is no change in technology.
3. The producer is using the best techniques available.
4. The factors of production are divisible.
5. Production function can be fitted to a short run or to a long run.
Cobb-Douglas production function:
Production function of the linear homogenous type was developed by C. W. Cobb and P. H.
Douglas in 1928. This famous statistical production function is known as Cobb-Douglas
production function. Originally the function is applied on the empirical study of the American
manufacturing industry.

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Cobb Douglas production function takes the following mathematical form.

Y= (AKX L1-X)
Where Y=output; K=Capital; L=Labour; A, X=positive constant
Assumptions:
1. The function assumes that output is the function of two factors viz. capital and labour.
2. It is a linear homogenous production function of the first degree
3. The function assumes that the logarithm of the total output of the economy is a linear
function of the logarithms of the labour force and capital stock.
4. There are constant returns to scale
5. All inputs are homogenous
6. There is perfect competition
7. There is no change in technology
ISOQUANTS:
The term Isoquant is derived from the words iso and quant Iso means equal and quant
implies quantity. Isoquant therefore, means equal quantity. A family of iso-product curves or
isoquants or production difference curves can represent a production function with two
variable inputs, which are substitutable for one another within limits. Isoquants are the
curves, which represent the different combinations of inputs producing a particular quantity
of output. Any combination of the inputs on the isoquant represents the same level of output.
Q= f (L, K)
Where Q, the units of output is a function of the quantity of two inputs L and K.
Thus an isoquant shows all possible combinations of two inputs, which are capable of
producing equal or a given level of output. Since each combination yields same output, the
producer becomes indifferent towards these combinations.
Assumptions:
1. There are only two factors of production, viz. labour and capital.
2. The two factors can substitute each other up to certain limit
3. The shape of the isoquant depends upon the extent of substitutability of the two
inputs.
4. The technology is given over a period.
An isoquant may be explained with the help of an arithmetical example.
Combinations
A
B
C

Labour (units)
1
2
3

Capital (Units)
10
7
4
2

Output (quintals)
50
50
50

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D
E

4
5

2
1

50
50

Combination A represent 1 unit of labour and 10 units of capital and produces 50 quintals
of a product all other combinations in the table are assumed to yield the same given output of
a product say 50 quintals by employing any one of the alternative combinations of the two
factors labour and capital. If we plot all these combinations on a paper and join them, we will
get continues and smooth curve called Iso-product curve as shown below.

Labour is on the X-axis and capital is on the Y-axis. IQ is the ISO-Product curve which
shows all the alternative combinations A, B, C, D, E which can produce 50 quintals of a
product.
LAW OF PRODUCTION:
Production analysis in economics theory considers two types of input-output relationships.
1. When quantities of certain inputs are fixed and others are variable and
2. When all inputs are variable.
These two types of relationships have been explained in the form of laws.
i)
Law of variable proportions
ii)
Law of returns to scale
I. Law of variable proportions:
The law of variable proportions which is a new name given to old classical concept of Law
of diminishing returns has played a vital role in the modern economics theory. Assume that a
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firms production function consists of fixed quantities of all inputs (land, equipment, etc.)
except labour which is a variable input when the firm expands output by employing more and
more labour it alters the proportion between fixed and the variable inputs. The law can be
stated as follows:
When total output or production of a commodity is increased by adding units of a variable
input while the quantities of other inputs are held constant, the increase in total production
becomes after some point, smaller and smaller.
If equal increments of one input are added, the inputs of other production services being
held constant, beyond a certain point the resulting increments of product will decrease i.e. the
marginal product will diminish. (G. Stigler)
The law of variable proportions refers to the behaviour of output as the quantity of one Factor
is increased. Keeping the quantity of other factors fixed and further it states that the marginal
product and average product will eventually do cline. This law states three types of
productivity an input factor Total, average and marginal physical productivity.
Assumptions of the Law: The law is based upon the following assumptions:
i)

The state of technology remains constant. If there is any improvement in

technology, the average and marginal output will not decrease but increase.
Only one factor of input is made variable and other factors are kept constant. This
law does not apply to those cases where the factors must be used in rigidly fixed
proportions.
All units of the variable factors are homogenous.

ii)

iii)

Three stages of law:

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

Fixed factor
1
1
1
1
1
1

Variable factor
(Labour)
1
2
3
4
5
6

Total product

Average Product

100
220
270
300
320
330

100
120
90
75
64
55

Marginal
Product
Stage I
120
50
30
Stage
II
20
10

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1
1

7
8

330
320

47
40

0
-10

Stage
III

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

From the above graph the law of variable proportions operates in three stages. In the first
stage, total product increases at an increasing rate. The marginal product in this stage
increases at an increasing rate resulting in a greater increase in total product. The average
product also increases. This stage continues up to the point where average product is equal to
marginal product. The law of increasing returns is in operation at this stage. The law of
diminishing returns starts operating from the second stage awards. At the second stage total
product increases only at a diminishing rate. The average product also declines. The second
stage comes to an end where total product becomes maximum and marginal product becomes
zero. The marginal product becomes negative in the third stage. So the total product also
declines. The average product continues to decline.
We can sum up the above relationship thus when A.P. is rising, M. P. rises more than A.
P; When A. P. is maximum and constant, M. P. becomes equal to A. P. when A. P. starts
falling, M. P. falls faster than A. P..

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Thus, the total product, marginal product and average product pass through three phases, viz.,
increasing diminishing and negative returns stage. The law of variable proportion is nothing
but the combination of the law of increasing and demising returns.
II. Law of Returns to Scale:
The law of returns to scale explains the behavior of the total output in response to change in
the scale of the firm, i.e., in response to a simultaneous to changes in the scale of the firm,
i.e., in response to a simultaneous and proportional increase in all the inputs. More precisely,
the Law of returns to scale explains how a simultaneous and proportionate increase in all the
inputs affects the total output at its various levels.
The concept of variable proportions is a short-run phenomenon as in these period fixed
factors cannot be changed and all factors cannot be changed. On the other hand in the longterm all factors can be changed and made variable. When we study the changes in output
when all factors or inputs are changed, we study returns to scale.
An increase in the scale means that all inputs or factors are increased in the same proportion.
In variable proportions, the cooperating factors may be increased or decreased and one faster
(Ex. Land in agriculture (or) machinery in industry) remains constant so that the changes in
proportion among the factors result in certain changes in output. In returns to scale all the
necessary factors or production are increased or decreased to the same extent so that whatever
the scale of production, the proportion among the factors remains the same.
Laws of Returns to Scale
Let us now explain the laws of returns to scale with the help of isoquants for a two-input and
single output production system.
When a firm expands, its scale increases all its inputs proportionally, then technically there
are three possibilities. (i) The total output may increase proportionately (ii) The total output
may increase more than proportionately and (iii) The total output may increase less than
proportionately. If increase in the total output is proportional to the increase in input, it means
constant returns to scale. If increase in the output is greater than the proportional increase in
the inputs, it means increasing returns to scale. If increase in the output is less than
proportional increase in the inputs, it means diminishing returns to scale.

ECONOMIES OF SCALE
Production may be carried on a small scale or on a large scale by a firm. When a firm
expands its size of production by increasing all the factors, it secures certain advantages
known as economies of production. Marshall has classified these economies of large-scale
production into internal economies and external economies.
Internal economies are those, which are opened to a single factory or a single firm
independently of the action of other firms. They result from an increase in the scale of output

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of a firm and cannot be achieved unless output increases. Hence internal economies depend
solely upon the size of the firm and are different for different firms.
External economies are those benefits, which are shared in by a number of firms or industries
when the scale of production in an industry or groups of industries increases. Hence external
economies benefit all firms within the industry as the size of the industry expands.
Causes of internal economies:
Internal economies are generally caused by two factors
1. Indivisibilities
2. Specialization.
1. Indivisibilities
Many fixed factors of production are indivisible in the sense that they must be used in a fixed
minimum size. For instance, if a worker works half the time, he may be paid half the salary.
But he cannot be chopped into half and asked to produce half the current output. Thus as
output increases the indivisible factors which were being used below capacity can be utilized
to their full capacity thereby reducing costs. Such indivisibilities arise in the case of labour,
machines, marketing, finance and research.
2. Specialization.
Division of labour, which leads to specialization, is another cause of internal economies.
Specialization refers to the limitation of activities within a particular field of production.
Specialization may be in labour, capital, machinery and place. For example, the production
process may be split into four departments relation to manufacturing, assembling, packing
and marketing under the charge of separate managers who may work under the overall charge
of the general manger and coordinate the activities of the for departments. Thus specialization
will lead to greater productive efficiency and to reduction in costs.
Internal Economies:
Internal economies may be of the following types.
A). Technical Economies.
Technical economies arise to a firm from the use of better machines and superior techniques
of production. As a result, production increases and per unit cost of production falls. A large
firm, which employs costly and superior plant and equipment, enjoys a technical superiority
over a small firm. Another technical economy lies in the mechanical advantage of using large
machines. The cost of operating large machines is less than that of operating mall machine.
More over a larger firm is able to reduce its per unit cost of production by linking the various
processes of production. Technical economies may also be associated when the large firm is
able to utilize all its waste materials for the development of by-products industry. Scope for
specialization is also available in a large firm. This increases the productive capacity of the
firm and reduces the unit cost of production.

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B). Managerial Economies:

These economies arise due to better and more elaborate management, which only the large
size firms can afford. There may be a separate head for manufacturing, assembling, packing,
marketing, general administration etc. Each department is under the charge of an expert.
Hence the appointment of experts, division of administration into several departments,
functional specialization and scientific co-ordination of various works make the management
of the firm most efficient.
C). Marketing Economies:
The large firm reaps marketing or commercial economies in buying its requirements and in
selling its final products. The large firm generally has a separate marketing department. It can
buy and sell on behalf of the firm, when the market trends are more favorable. In the matter
of buying they could enjoy advantages like preferential treatment, transport concessions,
cheap credit, prompt delivery and fine relation with dealers. Similarly it sells its products
more effectively for a higher margin of profit.
D). Financial Economies:
The large firm is able to secure the necessary finances either for gross capital purposes or for
working capital needs easily and cheaply. It can borrow from the public, banks and other
financial institutions at relatively cheaper rates.
E). Risk bearing Economies:
The large firm produces many commodities and serves wider areas. It is, therefore, able to
absorb any shock for its existence. For example, during business depression, the prices fall
for every firm. There is also a possibility for market fluctuations in a particular product of the
firm. Under such circumstances the risk-bearing economies or survival economies help the
bigger firm to survive business crisis.
F). Economies of Research:
A large firm possesses larger resources and can establish its research laboratory and employ
trained research workers. The firm may even invent new production techniques for increasing
its output and reducing cost.
G). Economies of welfare:
A large firm can provide better working conditions in-and out-side the factory. Facilities like
subsidized canteens, crches for the infants, recreation room, cheap houses, educational and
medical facilities tend to increase the productive efficiency of the workers, which helps in
raising production and reducing costs.

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External Economies.
A business firm enjoys a number of external economies, which are discussed below:
A). Economies of Concentration:
When an industry is concentrated in a particular area, all the member firms reap some
common economies like skilled labour, improved means of transport and communications,
banking and financial services, supply of power and benefits from subsidiaries. All these
facilities tend to lower the unit cost of production of all the firms in the industry.
B). Economies of Information
The industry can set up an information centre which may publish a journal and pass on
information regarding the availability of raw materials, modern machines, export
potentialities and provide other information needed by the firms. It will benefit all firms and
reduction in their costs.
C). Economies of Welfare:
An industry is in a better position to provide welfare facilities to the workers. It may get land
at concessional rates and procure special facilities from the local bodies for setting up
housing colonies for the workers. It may also establish public health care units, educational
institutions both general and technical so that a continuous supply of skilled labour is
available to the industry. This will help the efficiency of the workers.
D). Economies of Disintegration:
The firms in an industry may also reap the economies of specialization. When an industry
expands, it becomes possible to split some of the processes which are taken over by specialist
firms. For example, in the cotton textile industry, some firms may specialize in manufacturing
thread, others in printing, still others in dyeing, some in long cloth, some in dhotis, some in
shirting etc. As a result the efficiency of the firms specializing in different fields increases
and the unit cost of production falls.
Thus internal economies depend upon the size of the firm and external economies depend
upon the size of the industry.

DISECONOMIES OF LARGE SCALE PRODUCTION

Internal and external diseconomies are the limits to large-scale production. It is possible that
expansion of a firms output may lead to rise in costs and thus result diseconomies instead of
economies. When a firm expands beyond proper limits, it is beyond the capacity of the
manager to manage it efficiently. This is an example of an internal diseconomy. In the same
manner, the expansion of an industry may result in diseconomies, which may be called
external diseconomies. Employment of additional factors of production becomes less efficient
and they are obtained at a higher cost. It is in this way that external diseconomies result as an
industry expands.
The major diseconomies of large-scale production are discussed below:
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Internal Diseconomies:
A). Financial Diseconomies:
For expanding business, the entrepreneur needs finance. But finance may not be easily
available in the required amount at the appropriate time. Lack of finance retards the
production plans thereby increasing costs of the firm.
B). Managerial diseconomies:
There are difficulties of large-scale management. Supervision becomes a difficult job.
Workers do not work efficiently, wastages arise, decision-making becomes difficult,
coordination between workers and management disappears and production costs increase.
C). Marketing Diseconomies:
As business is expanded, prices of the factors of production will rise. The cost will therefore
rise. Raw materials may not be available in sufficient quantities due to their scarcities.
Additional output may depress the price in the market. The demand for the products may fall
as a result of changes in tastes and preferences of the people. Hence cost will exceed the
revenue.
D). Technical Diseconomies:
There is a limit to the division of labour and splitting down of production processes. The firm
may fail to operate its plant to its maximum capacity. As a result cost per unit increases.
Internal diseconomies follow.
E). Diseconomies of Risk-taking:
As the scale of production of a firm expands risks also increase with it. Wrong decision by
the management may adversely affect production. In large firms are affected by any disaster,
natural or human, the economy will be put to strains.
External Diseconomies:
When many firm get located at a particular place, the costs of transportation increases due to
congestion. The firms have to face considerable delays in getting raw materials and sending
finished products to the marketing centers. The localization of industries may lead to scarcity
of raw material, shortage of various factors of production like labour and capital, shortage of
power, finance and equipments. All such external diseconomies tend to raise cost per unit.
COST ANALYSIS
Profit is the ultimate aim of any business and the long-run prosperity of a firm depends upon
its ability to earn sustained profits. Profits are the difference between selling price and cost of
production. In general the selling price is not within the control of a firm but many costs are
under its control. The firm should therefore aim at controlling and minimizing cost. Since
every business decision involves cost consideration, it is necessary to understand the meaning
of various concepts for clear business thinking and application of right kind of costs.
Cost refers to the expenditure incurred to produce a particular product or service.
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(1) Fixed Costs: Costs that are fixed and do not vary with the volume of production up to
a certain level.
Ex: (i) rent for the factory or office building; (ii) Insurance for the machinery; (iii)
Interest on money borrowed.
(2) Variable Costs: Costs that vary with the volume of production.
Ex: (i) costs of raw material; (ii) wages paid to the workers.
These costs are incurred only when there is production.
(3) Semi-fixed Costs / Semi-variable Costs: Costs that are fixed to some extent, beyond
which they are variable.
Ex: (i) Telephone charges; (ii) Electricity charges.
(4) Marginal Costs: The additional cost incurred for producing an additional unit.
(5) Incremental Costs: Added costs of a change in the level or nature of activity. This
change in the level/nature of activity can be adding a new product to the existing
product mix, changing the channel of distribution, or adding a new plant etc.
(6) Controllable Costs: Costs that can be controlled by the organization.
Ex: Research & development costs, Advertising costs, salaries of top executives etc.
(7) Non-controllable Costs: Costs that cannot be controlled by the organization.
Ex: Costs of material, wages of labour, electricity charges, taxes etc.
(8) Outlay costs (Explicit Costs) : Costs that involve cash flows. Ex: costs of material,
salaries & wages, rent, interest paid on borrowed capital, taxes paid etc.
(9) Opportunity Costs (Implicit Costs): Earnings foregone from foregoing other
opportunities (alternatives). Ex: Interest on own funds, rent of own building etc.
(10) Historical Costs: Costs that have been originally spent to acquire the assets such as
building, machines etc.
(11) Replacement Costs: Costs that are to be paid currently if a new asset is to be
acquired to replace the old asset.
(12) Past Costs (Committed Costs) : Costs that have been already spent in the past.
They can not be controlled or minimized.
(13) Future Costs: Costs that will be spent in the future. These have to be determined
now and can be controlled by using techniques such as budgetary control.
(14) Urgent Costs: Costs that can not be postponed. They are costs such as cost of raw
material, wages etc., which are required to maintain the production activity.
(15) Postponable Costs: Costs which are not urgent and can be postponed to a future
date. They include costs such as white-washing the building etc.
(16) Separable Costs: Costs which can be traced or identified directly with a a particular
unit, department or product etc. Ex: cost of raw material, wages etc.
(17) Joint Costs: Costs which can not be traced to a particular unit, department or a
process of production. Ex: Rent, Electricity, R & D expenses, Office salaries etc.
(18) Short-run Costs: Costs that reflect changes in costs due to changes in inputs and in
the variation in the utilization of capacity.
(19) Long-run Costs: Costs that cover the changes in the size and kind of the plant.

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COST-OUTPUT RELATIONSHIP
A proper understanding of the nature and behavior of costs is a must for regulation and
control of cost of production. The cost of production depends on many forces and an
understanding of the functional relationship of cost to various forces will help us to take
various decisions. Output is an important factor, which influences the cost.
The cost-output relationship plays an important role in determining the optimum level of
production. Knowledge of the cost-output relation helps the manager in cost control, profit
prediction, pricing, promotion etc. The relation between cost and its determinants is
technically described as the cost function.
C= f (S, O, P, T .)
Where;
C= Cost (Unit or total cost)
S= Size of plant/scale of production
O= Output level
P= Prices of inputs
T= Technology
Considering the period the cost function can be classified as (a) short-run cost function and
(b) long-run cost function. In economics theory, the short-run is defined as that period during
which the physical capacity of the firm is fixed and the output can be increased only by using
the existing capacity allows to bring changes in output by physical capacity of the firm.
(a) Cost-Output Relation in the short-run:
The cost concepts made use of in the cost behavior are total cost, Average cost, and marginal
cost.
Total cost is the actual money spent to produce a particular quantity of output. Total cost is
the summation of fixed and variable costs.
TC=TFC+TVC
Up to a certain level of production total fixed cost i.e., the cost of plant, building, equipment
etc, remains fixed. But the total variable cost i.e., the cost of labour, raw materials etc., vary
with the variation in output. Average cost is the total cost per unit. It can be found out as
follows.
TC

AC= Q
Q

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The total of average fixed cost (TFC/Q) keeps coming down as the production is increased
and average variable cost (TVC/Q) will remain constant at any level of output.
Marginal cost is the addition to the total cost due to the production of an additional unit of
product. It can be arrived at by dividing the change in total cost by the change in total output.
In the short-run there will not be any change in total fixed cost. Hence change in total cost
implies change in total variable cost only.
Cost output relations
Units of
Output Q

Total
fixed
cost TFC

Total
variable
cost
TVC

Total
cost
(TFC +
TVC) TC

0
1
2
3
4
5
6

60
60
60
60
60
60
60

20
36
48
64
90
132

60
80
96
108
124
150
192

Average
variable
cost
(TVC /
Q) AVC
20
18
16
16
18
22

Average
fixed
cost
(TFC /
Q) AFC
60
30
20
15
12
10

Average
cost
(TC/Q)
AC

Marginal
cost
MC

80
48
36
31
30
32

20
16
12
16
26
42

The above table represents the cost-output relation. The table is prepared on the basis of the
law of diminishing marginal returns. The fixed cost Rs. 60 may include rent of factory
building, interest on capital, salaries of permanently employed staff, insurance etc. The table
shows that fixed cost is same at all levels of output but the average fixed cost, i.e., the fixed
cost per unit, falls continuously as the output increases. The expenditure on the variable
factors (TVC) is at different rate. If more and more units are produced with a given physical
capacity the AVC will fall initially, as per the table declining up to 3rd unit, and being constant
up to 4th unit and then rising. It implies that variable factors produce more efficiently near a
firms optimum capacity than at any other levels of output.
. In the table AVC starts rising from the 5th unit onwards whereas the AC starts rising from
the 6th unit only. So long as AVC declines AC also will decline. AFC continues to fall
with an increase in output. When the rise in AVC is more than the decline in AFC, the
total cost again begins to rise.
Thus the table shows an increasing returns or diminishing cost in the first stage and
diminishing returns or diminishing cost in the second stage and followed by diminishing
returns or increasing cost in the third stage.
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The short-run cost-output relationship can be shown graphically as follows.

The relationship between AVC, AFC and ATC can be summarized as follows:
1. If both AFC and AVC fall, ATC will also fall.
2. When AFC falls and AVC rises
a. ATC will fall where the drop in AFC is more than the raise in AVC.
b. ATC remains constant is the drop in AFC = rise in AVC
c. ATC will rise where the drop in AFC is less than the rise in AVC
b. Cost-output Relationship in the long-run:
Long run is a period, during which all inputs are variable including the ones, which are fixed
in the short-run. In the long run, a firm can change its output according to its demand. Over a
long period, the size of the plant can be changed, unwanted buildings can be sold, and staff
can be increased or reduced. The long run enables the firms to expand and scale of their
operation by bringing or purchasing larger quantities of all the inputs. Thus in the long run all
factors become variable.
The long-run cost-output relations therefore imply the relationship between the total cost and
the total output. In the long-run cost-output relationship is influenced by the law of returns to
scale.
In the long run a firm has a number of alternatives in regards to the scale of operations. For
each scale of production or plant size, the firm has an appropriate short-run average cost
curves. The short-run average cost (SAC) curve applies to only one plant whereas the longrun average cost (LAC) curve takes in to consideration many plants.
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The long-run cost-output relationship is shown graphically with the help of LCA curve.

To draw one
LAC curve we have
to start with a
number
of
SAC
curves. In the
above figure it is
assumed
that
technologically there
are only three
sizes of plants small,
medium
and
large, SAC, for the
small
size,
SAC2 for the medium
size plant and
SAC3 for the large
size plant. If the
firm wants to produce
OP units of
output, it will choose
the smallest plant. For an output beyond OQ the firm wills optimum for medium size plant.
It does not mean that the OQ production is not possible with small plant. Rather it implies
that cost of production will be more with small plant compared to the medium plant.
For an output OR the firm will choose the largest plant as the cost of production will be
more with medium plant. Thus the firm has a series of SAC curves. The LCA curve drawn
will be tangential to the entire family of SAC curves i.e. the LAC curve touches each
SAC curve at one point, and thus it is known as envelope curve. It is also known as
planning curve as it serves as guide to the entrepreneur in his planning to expand the
production in future. With the help of LAC the firm determines the size of plant which
yields the lowest average cost of producing a given volume of output it anticipates.

BREAKEVEN ANALYSIS
The study of cost-volume-profit relationship is often referred as BEA. The term BEA is
interpreted in two senses. In its narrow sense, it is concerned with finding out BEP; BEP is
the point at which total revenue is equal to total cost. It is the point of no profit- no loss. In its
broad sense, it determines the probable profit at any level of production.
Assumptions:
1. All costs are classified into two fixed and variable.
2. Fixed costs remain constant at all levels of output.
3. Variable costs vary proportionally with the volume of output.
4. Selling price per unit remains constant in spite of competition or change in the volume
of production.
5. There will be no change in operating efficiency.
6. There will be no change in the general price level.
7. Volume of production is the only factor affecting the cost.
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8. Volume of sales and volume of production are equal. Hence there is no unsold stock.
9. There is only one product or in the case of multiple products. Sales mix remains
constant.
Merits:
1. Information provided by the Break Even Chart can be understood more easily than
those contained in the Profit and Loss Account and the Cost statement.
2. Break Even Chart discloses the relationship between cost, volume and profit. It
reveals how changes in profit. So, it helps management in decision-making.
3. It is very useful for forecasting costs and profits for long term planning and growth
4. The chart discloses profits at various levels of production.
5. It serves as a useful tool for cost control.
6. It can also be used to study the comparative plant efficiencies of the industry.
Demerits:
1. Break-even chart presents only cost volume profits. It ignores other considerations
such as capital amount, marketing aspects and effect of government policy etc., which
are necessary in decision making.
2. It is assumed that sales, total cost and fixed cost can be represented as straight lines.
In actual practice, this may not be so.
3. It assumes that profit is a function of output. This is not always true. The firm may
increase the profit without increasing its output.
4. A major drawback of BEC is its inability to handle production and sale of multiple
products.
5. It is difficult to handle selling costs such as advertisement and sale promotion in BEC.
6. It ignores economics of scale in production.
7. Fixed costs do not remain constant in the long run.
8. Semi-variable costs are completely ignored.
9. It assumes production is equal to sale. It is not always true because generally there
may be opening stock.
10. When production increases variable cost per unit may not remain constant but may
reduce on account of bulk buying etc.
11. The assumption of static nature of business and economic activities is a well-known
defect of BEC.
1.
2.
3.
4.
5.
6.
7.

Fixed cost
Variable cost
Contribution
Margin of safety
Angle of incidence
Profit volume ratio
Break-Even-Point
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1. Fixed cost: Expenses that do not vary with the volume of production are known as fixed
expenses. Eg. Managers salary, rent and taxes, insurance etc. It should be noted that fixed
changes are fixed only within a certain range of plant capacity. The concept of fixed
overhead is most useful in formulating a price fixing policy. Fixed cost per unit is not
fixed.
2. Variable Cost: Expenses that vary almost in direct proportion to the volume of production
of sales are called variable expenses. Eg. Electric power and fuel, packing materials
consumable stores. It should be noted that variable cost per unit is fixed.
3. Contribution: Contribution is the difference between sales and variable costs and it
contributed towards fixed costs and profit. It helps in sales and pricing policies and
measuring the profitability of different proposals. Contribution is a sure test to decide
whether a product is worthwhile to be continued among different products.
Contribution = Sales Variable cost
Contribution = Fixed Cost + Profit.
4. Margin of safety: Margin of safety is the excess of sales over the break even sales. It can
be expressed in absolute sales amount or in percentage. It indicates the extent to which
the sales can be reduced without resulting in loss. A large margin of safety indicates the
soundness of the business. The formula for the margin of safety is:
Present sales Break even sales

Profit
P. V. ratio

or

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

1. Increasing production
2. Increasing selling price
3. Reducing the fixed or the variable costs or both
4. Substituting unprofitable product with profitable one.
5. Angle of incidence: This is the angle between sales line and total cost line at the Breakeven point. It indicates the profit earning capacity of the concern. Large angle of
incidence indicates a high rate of profit; a small angle indicates a low rate of earnings. To
improve this angle, contribution should be increased either by raising the selling price
and/or by reducing variable cost. It also indicates as to what extent the output and sales
price can be changed to attain a desired amount of profit.
6. Profit Volume Ratio is usually called P. V. ratio. It is one of the most useful ratios for
studying the profitability of business. The ratio of contribution to sales is the P/V ratio. It
may be expressed in percentage. Therefore, every organization tries to improve the P. V.
ratio of each product by reducing the variable cost per unit or by increasing the selling
price per unit. The concept of P. V. ratio helps in determining break even-point, a desired
amount of profit etc.

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The formula is,

Contribution
X 100
Sales

7. Break Even- Point: If we divide the term into three words, then it does not require
further explanation.
Break-divide
Even-equal
Point-place or position
Break Even Point refers to the point where total cost is equal to total revenue. It is a
point of no profit, no loss. This is also a minimum point of no profit, no loss. This is
also a minimum point of production where total costs are recovered. If sales go up
beyond the Break Even Point, organization makes a profit. If they come down, a loss
is incurred.
Fixed Expenses

1.

Break Even point (Units) = Contribution per unit

2.

Break Even point (In Rupees) =

Fixed expenses
X sales
Contribution

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