2130004-Engineering Economics & Management

2. Theory of Production

 Variable costs change w ith the output. Examples of variable costs include employee w ages and costs
of raw materials. The short run costs increase or decrease based on variable cost as w ell as the rate
of production.
 If a firm manages its short run costs w ell over time, it w ill be more likely to succeed in reaching the
desired long run costs and goals.

Compar ison between Shor t Run and Long Run Cost

 The main difference betw een long run and short run costs is that there are no fixed factors in the
long run; there are bot h fixed and variable factors in the short run.
 In the long run the general price level, contractual w ages, and expectations adjust fully to the state
of the economy. In the short run these variables do not alw ays adjust due to the condensed time
period.
 In order to be successful a firm must set realistic long run cost expectations. How the short run costs
are handled determines w hether the firm w ill meet its future production and financial goals.
 This graph show s the relationship betw een long run and short run costs.

Fixed Cost / indir ect costs / over heads

 In economics, fixed costs are business expenses that are not dependent on the level of goods or
services produced by the business. They tend to be time-related, such as salaries or rents being paid
per month, and are often referred to as overhead cost s.
 Fixed costs are not permanently fixed; they w ill change over time, but are fixed in relation to the
quantity of production for the relevant period.
 For example, a company may have unexpected and unpredictable expenses unrelated to
production, and w arehouse costs and the like are fixed only over the time period of the lease.
 By definition, there are no fixed costs in the long run, because the long run is a sufficient period of
time for all short-run fixed inputs to become variable.

12 Prof. Vijay M . Shekhat (9558045778)| Department of Computer Engineering

 2130004-Engineering Economics & Management
2. Theory of Production

Var iable Cost

 Variable costs are costs that change in proportion to t he good or service that a business produces.
 Variable costs are also the sum of marginal costs over all units produced.
 They can also be considered normal costs. Fixed costs and variable costs make up the tw o
components of total cost.
 For example, variable manufacturing overhead costs are variable costs that are indirect costs, not
direct costs. Variable costs are sometimes called unit-level costs as they vary w ith the number of
units produced.

Example
Assume a business produces clothing. A variable cost of this product w ould be the direct material, i.e.,
cloth, and the direct labor. If it takes one laborer 10 ft. of cloth and 5 hours to make a garment, then the
cost of labor and cloth increases if tw o garments are produced.

1 Garment 2 Garment 3 Garment

Cloth (Direct M aterials) 10 ft. 20 ft. 30 ft.
Labor (Direct Labor) 5 hrs 10 hrs 15 hrs

The amount of materials and labor that goes into each garment increases in direct proportion to the
number of garments produced. In this sense, the cost " varies" as production varies.

Total Fixed Cost

 Total cost for all fixed inputs of the firm per time is called total fixed cost.
 For example firm taking land on lease Rs. 1 lack per month and borrow ed money from other for that
they have to pay interest Rs. 2oooo per month w hich is not change w ith production it is fixed
w hether production is increasing or decreasing. So total fixed cost per month is Rs. 120000 per
month

Total Var iable Cost

 Total variable cost is calculated by adding variable cost of all variable inputs.
 It is varies w ith output.
 For example if material required for construction of one building is double if w e construct tw o
building.

Total Cost
 Total cost is sum of t otal fixed cost and t otal variable cost.
( ) = ( )+ ( )

13 Prof. Vijay M . Shekhat (9558045778)| Department of Computer Engineering

 2130004-Engineering Economics & Management
2. Theory of Production

 Note that change in total cost is influenced by the change in variable cost only.

Aver age Cost

 The average cost is the average obtained by dividing the total cost of producing a given volume of a
product by the volume of production of that product. This is the average cost of a product per unit.
Aver age Cost ( AC) = Total Cost ( TC) / Total Volume Pr oduced ( TVP)
 For example if a company requires Rs. 100000 for producing 10 machine than the average cost is Rs.
10000.

Mar ginal Cost

 The benefit of mass production can be seen in marginal cost.
 If V1 volume of product is manufactured in X1 cost and it requires X2 cost for producing V1 + 1
volume then the marginal cost of production is X2 – X1 w ith reference to production volume V1.
 For example if 1000 toy is manufactured in Rs. 50000 and 1001 toy requires Rs. 50030 then the
marginal cost is 30.

Oppor tunity Cost

 In real practice if alternative (X) is selected from a set of competing alternatives (X, Y), then the
corresponding investment in the selected alternative is not available for any other purpose. If the
same money is invested in some other alternative (Y) it may fetch some return. Since the money is
invested in the selected alternative (X), one has to forget the return from the other alternatives
(Y).the amount that is forgotten by not investing in the other alternative (Y) is know n as the
opportunity cost of the selected alternative (X).
 For example if you have Rs. 50000 to invest and have tw o option share market and real estate and
you selected share market and got Rs, 4000 return in one year and same time if you invest it in real
estate then it w ill give Rs. 5000 return then you have to forget Rs. 1000 due to not selecting real
estate this 1000 is called Opportunity Cost.

Br eak-Even Analysis
 The main objective of break-even analysis is to find the cut-off production volume from w here a firm
w ill make profit. Let
=
=
=
Q = volume of pr oduction
 Total sales revenue (S) of the firm is given by the follow ing formula:
S= s ∗ Q

14 Prof. Vijay M . Shekhat (9558045778)| Department of Computer Engineering

 2130004-Engineering Economics & Management
2. Theory of Production

 Total cost (TC) of the firm for a given production volume is given by:
= +
TC = v ∗ Q + FC
 The linear plot of above tw o equations is:

Sales (S)
Profit
Loss

Total Cost (TC)

Break-even Variable Cost (VC)

Sales
Fixed Cost (FC)

*
BEP (Q )
Production quantity

Fig.:- Break-even chart

 The intersection point of the total sales revenue line and the t otal cost line is called the break-even
point.
 On X-axis volume of production at BEP is called break-even sales quantity and on Y-axis at BEP w e
get break-even sales.
 At break-even point revenue is equals to total cost and so it is also called No profits No loss
situation.
 Quantity less then break-even quantity w ill put firm in loss as total cost is more than t otal revenue.
Similarly quantity greater than break-even quantity w ill make profit.
 Profit is calculated as follow s:
Pr ofit = Sales − ( Fixed cost + Var iable costs)
Pr ofit = s ∗ Q − ( FC+ v ∗ Q)
 Break-even quantity and break-even sales can be calculated as follow s:
Fixed Cost
Br eak even quantity =
Selling pr ice/ unit − Var iable cost/ unit
FC
Br eak even quantity = ( in units)
s−v
Fixed Cost
Br eak even sales = ∗ Selling pr ice/ unit
Selling pr ice/ unit − Var iable cost/ unit
FC
Br eak even sales = ∗ s ( in Rs.)
s− v
 The contribution is the difference betw een the sales and the variable cost.

15 Prof. Vijay M . Shekhat (9558045778)| Department of Computer Engineering

 2130004-Engineering Economics & Management
2. Theory of Production

Contr ibution = Sales − Var iable costs

Contr ibution/ unit = Selling pr ice/ unit − Var iable cost/ unit
 The margin of Safety (M . S.) is the sales over and above the break-even sales. It can be calculated by
tw o methods and one can be derived from other.
 M ethod I:
Pr ofit
M.S. = ∗ sales
Contr ibution
 M ethod II derived from method I:
Pr ofit
M.S. = ∗ sales
Contr ibution
s ∗ Q − ( FC + v ∗ Q)
M.S. = ∗ sales
Sales − Var iable costs
s ∗ Q − ( FC+ v ∗ Q)
M.S. = ∗ ( s ∗ Q)
( s ∗ Q) − ( v ∗ Q)
( s ∗ Q − v ∗ Q − FC)
M.S. = ∗ ( s ∗ Q)
( s ∗ Q) − ( v ∗ Q)
( s ∗ Q − v ∗ Q) − ( FC)
M.S. = ∗ ( s ∗ Q)
( s ∗ Q) − ( v ∗ Q)
FC
M.S. = ( s ∗ Q) − ∗s
s−v
M.S. = Sales − Br eak even sales
 Now M .S. as a percent of sales:
M. S.
M.S. as a per cent of sales = ∗ 100
Sales

Example
Alpha Associates has the follow ing details:
Fixed cost = Rs. 20,00,000
Variable cost per unit = Rs. 100
Selling price per unit = Rs. 200
Find
(a) The break-even sales quantity
(b) The break-even sales
(c) If the actual product quantity is 60,000, find (i) contribution; and (ii) margin of safety by all methods.

Solution
Fixed cost (FC) = Rs. 20,00,000
Variable cost per unit (v) = Rs. 100
Selling price per unit (s) = Rs. 200
, ,
(a) Br eak even quantity = = = 20,000
, ,
(b) Br eak even sales = ∗s= ∗ 200 = 40,00,000

16 Prof. Vijay M . Shekhat (9558045778)| Department of Computer Engineering

 2130004-Engineering Economics & Management
2. Theory of Production

(c) (i) Contr ibution = Sales − Var iable costs = s ∗ Q − v ∗ Q = 200 ∗ 60,000 − 100 ∗ 60,000
Contr ibution = 60,00,000
(c) (ii) margin of safety
M ethod I
Pr ofit Sales − ( FC+ v ∗ Q)
M.S. = ∗ sales = ∗ sales
Contr ibution Contr ibution
60,000 ∗ 200 − ( 20,00,000 + 100 ∗ 60,000)
M.S. = ∗ 1,20,00,000 = 80,00,000
60,00,000
M ethod II
M.S. = Sales − Br eak even sales = 60,000 ∗ 200 − 40,00,000 = 80,00,000

M. S. 80,00,000
M.S. as a per cent of sales = ∗ 100 = ∗ 100 = 67%
Sales 1,20,00,000

17 Prof. Vijay M . Shekhat (9558045778)| Department of Computer Engineering