Notes of Mgl Economics

8/22/2019 Notes of Mgl Economics

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COST CONCEPTS

Business decisions are generally taken on the basis of money values of

the inputs and outputs. The cost production expressed in monetary

terms is an important factor in almost all business decisions, specially

those pertaining to (a) locating the weak points in production

management; (b), minimising the cost; (c) finding out the optjmum

level of output; and (d) estimating or projecting the cost of business

operations. Besides, the term 'cost' has different meanings under

different settings and is subject to varying interpretations. It is

therefore essential that only relevant concept of costs is used in the

business decisions.

CONCEPT OF COST

The concepts of cost, which are relevant to business operations and

decisions, can be grouped, on the basis of their purpose, under two

overlapping categories such as concepts used for accounting purposes

and concepts used in economic analysis of business activities.

SOME ACCOUNTING CONCEPTS OF COST

Opportunity Cost and Actual Cost

Opportunity cost is the loss incurred due to the unavoidable situations

such as scarcity of resources. If resources were unlimited, there would

be no need to forego any income yielding opportunity and, therefore,

there would be no opportunity cost. Resources are scarce but have

alternative uses with different returns, Resource owners who aim at

maximising of income put their scarce resources to their most

productive use and forego the income expected from the second best

use of the resources. Thus, the opportunity cost may be defined as the

expected returns from the second best use of the resources foregone

due to the scarcity of resources. The opportunity cost is also called the

alternative cost.

For example, suppose that a person has a sum of Rs. lOO,OOO for

which he has only two alternative uses. He can buy either a printing


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machine or, alternatively, a lathe machine. From printing machine, he

expects an annual income of Rs. 20,000 and from the lathe, Rs.

15,000. If he is a profit maximising investor, he would invest his

tnoney in printing machine and forego the expected income from the

lathe. The opportunity cost of his income from printing machine is,

the expected income from the lathe machine, i.e., Rs. l5,000. The

opportunity cost arises because of the foregone opportunities. Thus,

the opportunity cost of using resources in the'Printing business is the

best opportunity ahdthe expected return from the lathe machine is

the second best alternative. In assessing the alternative cost, both

explicit and implicit costs are taken into account.

Associated with the concept of opportunity cost is the concept of

economic rent or economic profit. In our example, economic rent of

the printing machine is the excess of its earning over the income

expected from the lathe machine (i.e., Rs. 20,000 - Rs. 15,000 = Rs.

5,000). The implication of this concept for a businessman is that

investing in printing machine is preferable as long as its economic

rent is greater than zero. Also, if firms have knowledge of the

economic rent of the various alternative uses of their resources, it will

be helpful for them to choose the best Investment A venue. In

contrast to opportunity cost, actual costs are those which are actuallyincurred by the firm in the payment for labour, material, plant,

building, machinery, equipments, travelling and transport,

advertisement, etc. The total money expenditures, recorded in the'

books of accounts are, the actual costs, Therefore, the actual cost

comes under the accounting concept.

Business Costs and Full Costs

Business.costs include all the expenses, which are incurred to carry

out a business. The concept of business costs is similar to the actual

or the real costs. Business costs include all the payments and'

contractual obligations made by the firm together with the book cost

of depreciation on plant and equipment. These cost concepts are used

for calculating business profits and losses, for filing returns for income

tax and for other legal purposes. The concept of full costs, include

business costs, opportunity cost and. normal profit. As stated earlier


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the opportunity cost includes the expected earning from the second

best use of the resources, or the market rate of interest on the total

money capital and the value of entrepreneur's own services, which

are not charged for'in the current business. Normal profit is a

necessary minimum earning in addition to the opportunity cost, which

a firm must get to remain in its present occupation.

Explicit and Implicit or Imputed Costs

Explicit costs are those, which fall under actual or business costs

entered in the books of accounts. For example, the payments for

wages and salaries, materials, licence fee, insurance premium and

depreciation charges etc. These costs involve cash payment and, are

recorded in normal accounting practices. In contrast with these costs,

there are other costs, which neither take the form of cash outlays, nor

do they appear in the accounting system. Such costs are known as

implicit or imputed costs. Implicit costs may be defined as the earning

expected froin thesecond best alternative use of resources. For

example, suppose an entrepreneur does not utilise his services in his

own business and works as a manager in some other firm on a salary

basis. If he starts his own business, he foregoes his salary as a

manager. This loss of salary is the opportunity cost of income from his

business. This is an implicit cost of his business. The cost is implicit,

because the entrepreneur suffers the loss, but does not charge it as

the explicit cost of his own business. Implicit costs are not taken into

account while calculating the loss or gains of the business, but they

form an important consideration in whether or not a factor would

remain in its present occupation. The explicit and implicit costs

together make the economic cost.

Out-of-Pocket and Book Costs

The items of expenditure, which involve cash payments or cash

transfers recurring and non-recurring are known as out-of-pocket

costs. All the explicit costs such as wage, rent, interest and transport

expenditure. On the contrary, there are actual business costs, which

do not involve cash payments, but a provision is made for them in the


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books of account. Thes costs are taken into account while finalising the

profit and loss accounts. Such expenses are known as book costs. In a

way, these are payments that the firm needs to pay itself such as

depreciation allowances and unpaid interest on the businessman's own

fund.

Fixed and Variable CostsFixed costs are those, which are fixed in volume for a given output.

Fixed cost does not vary with variation in the output between zero and

any certain level of output. The costs that do not vary for a certain

level of output are known as fixed cost. The fixed costs include cost of

managerial and administrative staff, depreciation of machinery,

building and other fixed assets and maintenance of land, etc.

Variable costs are those, which vary with the variation in the totaloutput. They are a function of output. Variable costs inclue cost of raw

materials, running cost on fixed capital, such as fuel, repairs, routine

maintenance expenditure, direct labour charges associated with the

level of output and the costs of all other inputs that vary with the

output.

Total, Average and Marginal Costs

Total cost represents the value of the total resource requirement for

the production of goods and services. It refers to the total outlays of

money expenditure, both explicit and implicit, on the resources used to

produce a given level of output. It includes both fixed and variable

costs. The total cost for a given output is given by the cost function.

The Average Cost (AC) of a firm is of statistical nature and is not

the actual cost. It is obtained by dividing the total cost (TC) by the

total output (Q), i.e.,

AC =TC

= average costQ

Marginal cost is the addition to the total cost on account of

producing an additional unit of the product. Or marginal cost is the

cost of marginal unit produced. Given the cost function, it may be

defined as


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These cost concepts are discussed in further detail in the

following section. Total, average and marginal cost concepts are used

in economic analysis of firm's producti on activities.

Short-run and Long-run Costs

Short-run and long-run cost concepts are related to variable and fixed

costs, respectively, and often appear in economic analysi.s

interchangeably. Short-run costs are those costs, which change with

the variation in output, the size of the firm remaining the same. In

other words, short-run costs are the same as variable costs. Long-run

costs, on the other hand, are the costs, which are incurred on the fixed

assets like plant, building, machinery, etc. Such costs have long-run

implication in the sense that these are not used up in the single batch

of production.

Long-run costs are, by implication, same as fixed costs. In the

long-run, however, even the fixed costs become variable costs as the

size of the firm or scale of production increases. Broadly speaking, the

short-run costs are those associated with variables in the utilisation of

fixed plant or other facilities whereas long-run costs are associated

with the changes in the size and type of plant.

Incremental Costs and Sunk Costs

Conceptually, increment natal costs are closely related to the concept

of marginal sot. Whereas marginal cost refers to the cost of the

macgmalunit of output, incremental cost refers to the total additional

cost associated with the marginal batch of output. The concept of

incremental cost is based on a specific and factual principle. In the real

world, it is not practicable for lack of perfect divisibility of inputs to

employ factors for each unit of output separately. Besides, in the long

run, firms expand their production; hire more men, materials,

machinery, and equipments. The expenditures of this nature are the

incremental costs, anq not the marginal cost. Incremental costs also

AC=aTCaQ


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arise owing to the change in product lines, addition or introduction of a

new product, replacement of worn out plan and machinery,

replacement of old technique of production with a new one, etc.

The sunk costs are those, which cannot be altered, increased or

decreased, by varying the rate of output. For example, once it is

decided to make incremental investment expenditure and the funds

are allocated and spent, all the preceding costs are considered to be

the sunk costs since they accord to the prior commitment and cannot

be revised or reversed when there is change in market conditions

orchange in business decisions.

Historical and Replacement Costs

Historical cost refers to the cost of an asset acquired in the past

whereas replacement cost refers to the outlay, which has to be made

for replacing an old asset. These concepts own their sigtlificance to

unstable nature of price behaviour. Stable prices over a period of

time, other things given, keep historical and replacement costs on par

with each other. Instability in asset prices, however, makes the two

costs differ from each other.

Historical cost of assets is used for accounting purposes, in the

assessment of net worth of the firm.

Private and Social Costs

We have so far discussed the cost concepts that are related to the

working of the firm and those which are used in the cost-benefit

analysis of the business decision process. There are, however, certain

other costs, which arise due to functioning of the firm but do not

normally appear in business decisions. Such costs are neither

explicitly borne by the firms. The costs of this category are borne by-

the society. Thus, the total cost generated by a firm's working may be

divided into two categories:

Those paid out or provided for by the firms,

Those not paid or borne by the firm.

The costs that are not borne by the firm include use of resouces

freely available and the disutility created in the process of production.


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The costs of the former category are known as private costs and of the

latter category are known as external or social costs. A few examples

of social cost are: Mathura Oil Refinery discharging its wastage in the

Yamuna River causes water pollution. Mills and factories located in city

cause air pollution by emitting smoke. Similarly, plying cars, buses,

trucks, etc., cause both air and noise pollution; Such pollutions cause

tremendous health hazards, which involve health cost to the society as

it whole Thes'e costs are termed external costs from the firm's point of

view and social cost from the society's point of view. The relevance of

the social costs lies in understandipg the overall impact of firm's

working on the society as a whole and in working out the social cost of

private gains. A further distinction between private cost and social cost

therefore, requires discussion.

Private costs are those, which are actually incurred or provided

by an individual or a firm on the purchase of goods and services from

the market. For a firm, all the actual costs both explicit and implicit are

private costs. Private costs are the internalised cost that is

incorporated in the firm's total cost of production.

Social costs, on thehand refer to the total cost for the society on

account of production ofa commodity. Social cost can be the private

cost or the external cost. It includes the cost of resources for which thefirm is not compelled to pay a price such as rivers and lakes, the

public, utility services like roadways and drainage system, the cost in

the form of disutility created in through air, water and noise pollution.

This category is generally assumed to be equal to total private and

public expenditures. The private and public expenditures, however,

serve only as an indicator of public disutility. They do not give exact

measure of the public disutility or the social costs.

COST-OUTPUT RELATIONS

The previous section discussed the variou cost concepts, which help in

the business decisions. The following section contains the discussion of

the behaviour of costs in relation to the change in output. This is, in

fact, the theory of production cost.

Cost-output relations play an importai)t role in business


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decisions relating to cost minirnisalioil"Of'profiHnaximisation and

optimisation of output. Cost-output relations are specified through a

cost function expressed as

T(C) = f(Q) (1)

where,

TC = total cost

Q = quantity produced

Cost functions depend on production function and market-supply

function of inputs. Production function specifies the technical

relationship between the input, and the output. Production function of

a firm combined with the supply function of inputs or prices of inputs

determines the cost function of the firm. Precisely, cost function is a

function derived from the production function and the market supply

function. 'Depending on whether short or long-run is considered for the

production, there are two kinds of cost functions: such as short-run

cost-function and long-run cost function. Cost-output relations in

relation to the changing level of output will be discussed here u.nder

both kinds of cost-functions.

Short-run Cost Output Relations

The basic analytical cost concepts used in the analysis of costbehaviour are total average and marginal costs. The totalcost (TC) is

defined as the actual cost that must be incurred to produce a given

quantity of output. The short-run TC is composed of two major

elements: total fixed cost (TFC) and total variable cost (TVC). That is,

in the short-run,

TC = TFC + TVC (2)

As mentioned earlier, TFC (i.e" the costof plant, building,equipment, etc.) remains fixed in the short-run, where as TVC varies

with the variation in the output.

For a given quantity of output (Q), the average total cost, (AC),

average fixed cost (AFC) and, average var!able cost (AVC) can 'be

defined as follows:

TC TFC + TVC


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AC = =Q Q

AFC =

TFC

Q

AVC =

TVC

Q

and AC = AFC +AVC (3)

Marginal cost (MC) is defined as the change in the total cost divided by

the change in the total output, i.e.,

MC =TC

or

aTC

Q aQ

(4)

Since TC = TFC + TVC and, in the short-run, TFC = 0,

therefore,TC=TVC

Furthermore, under marginality concept, where Q = 1,MC =

TVC.

Cost Function and Cost-output Relations

The concepts AC, AFC and AVC give only a static relationship between

cost and output in the sense that they are related to a given output.

These cost concepts do not tell us anything about cost behaviour, i.e.,

how AC, A VC and AFC behave when output changes. This can be

understood better with a cost function of empirical nature.

Suppose the cost function (I) is specified as

TC = a + bQ - CQ2 + dQ3 (5)

(where a = TFC and b, c and d are variable-cost parameters)

And also the cost function is empirically estimated asTC = 10 + 6Q - 0.9Q2 + 0.05Q3 (6)

and TVC = 6Q - 0.9Q2 + 0.05Q3 (7)

The TC and TVC, based on equations (6) and (7), respectively, have

been calculated for Q = I to 16 and is presented in Table 3.1. The TFC,

TVC and TC have been graphically presented in Figure 3.1. As the

figure shows, TFC remains fixed for the whole range of output, and

hghce, takes the form of a horizontal line, i.e., TFC. The TVCcurve


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shows that the total variable cost first increases ata'i decreasing rate

and then at an increasing rate with the increase it the total output. The

rate of increase can be obtained from the slope of TVC curve. The

pattemof change in the TVC stems directly from the law of increasing

and diminishing returns to the variable inputs. As output increases,

larger quantities of variable inputs are required to produce the same

quantity of output due to diminishing returns. This causes a

subsequent increase in the variable cost for producing the same

output. The following Table 3.1 shows the cost output relationship.

Table 3.1: Cost Output Relations

Q FC TVC TC AFC AVC AC MC

(I) (2) (3) (4) (5) (6) (7) (8)

0 10 0.0 10.00 - - - -

I 10 5.15 15.15 10.00 5.15 15.15 5.152 10 8.80 18.80 5:00 4.40 9.40 3.653 10 11.25 21.25 3.33 3.75 7.08 2.45

4 10 12.80 22.80 2.50 3.20 5.70 1.555 10 13.75 23.75 2.00 2.75 4.75 0.956 10 14.40 24.40 1.67 2.40 4.07 0.65

7 10 15.05 25.05 1.43 2.15 3.58 0.65

8 10 16.00 26.00 1.25 2.00 3.25 0.959 10 17.55 27.55 1.11 1.95 3.06 1.5510 10 20.00 30.00 1.00 2.00 3.00 2.4511 10 23.65 33.65 0.90 2.15 3.05 3.65

12 10 28,80 38.80 0.83 2.40 3.23 5.1513 10 35.75 45.75 0.77 2.75 3.52 6.9514 10 44.80 54.80 0.71 3.20 3.91 9.0515 10 56.25 66.25 0.67 3.75 4.42 11.45

16 10 70.40 80.40 0.62 4.40 5.02 14.15

From equations (6) and (7), we may derive the behavioural

equations for AFC, AVC and AC. Let us first consider AFC.

Average Fixed Cost (AFC)

As already mentioned, the costs that remain fixed for a certain level of

output make the total fixed cost in the short-run. The fixed cost is

represented by the constant term 'a' in equation (6). We know that

AFC =

TFC (8)Q

Substituting 10 for TFC in equation (8), we get


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AFC =

10 (9)Q

Equation (9) expresses the behaviour of AFC in relation to

change in Q. The behaviour of AFC for Q from 1 to 16 is given in Table

3.1 (col. 5) and is presented graphically by the AFC curve in the

Figure 3.1. The AFC curve is a rectangular hyperbola.

Average Variable Cost (AVC)

As defined above,

AVC =

TVCQ

Given the TVC function in equation 7, we may express AVC as

follows:

AVC =

6Q-0.9Q2+0.05Q3

= 6- 0.9Q+0.05Q3

(10)

Q

Having derived the A VC function (equation 10), we may easily

obtain the behaviour of A VC in response to change in Q. The

behaviour of A VC for Q from I to 16 is given in Table 3.1 (co 1. 6), and

is graphically presented in Figure 3.2 by the A VC curve.


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Critical Value of A VC

From equation (10), we may compute the critical value or Q in respect

of A Vc. The critical value of Q (in respect of A VC) is that value of Q at

which A VCis minimum. The Ave will be minimum when its decreasing

rate of change is equal to zero. This can be accomplished by

differentiating equation (10) and setting it equal to zero. Thus, critical

value of Q can be obtained as

Q=

aAVC

= 0.9+0.10Q=0

(11)

aQ

Q= 9

Thus, the critical value of Q=9. This can be verified from Table3.1

Average Cost (AC)

The average cost in defined as

AC =

TCQ

Substituting equation (6) for TC in above equation, we get

AC =

10+6Q-09Q2+0.05Q3(12a)

Q

=

10

+ 6-0.9Q+0.05Q2Q

The equation (l2a) gives the behaviour of AC in response to

change in Q. The behaviour of AC for Q from I to 16 is given in Table

3.1 and graphically presented in Figure 3.2 by the AC-curve. Note that

AC-curve is U-shaped.

From equation (12a), we may easily obtain the critical value of Q in

respect of AC. Here, the critical valuepf Q in respect of AC is one at

which AC is minimum. This can be obtained by differentiating equation

(l2a) and setting it equal to zero. This, critical vallie of Q in respect of


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AC is given by

aAC

=

10- 0.9 + 0.1Q = 0

(12b)

aQ Q2

This equation takes the form of a quadratic equation as

-10 0.9Q2 + 0.1Q3 = 0

or, Q3 9Q2 = 100 = 0

By solving equation (12b), we get

Q = 10

Thus, the critical value of output in respect of AC is 10. That is,

AC reaches its minimum at Q = 10. This can be verified from Table. 3.1

shows short-run cost curves.

Marginal Cost (MC)

The concept of marginal cost (MC) is particularly useful in economicanalysis. MC is technically the first derivative of TC function. That is,

MC =

aTCaQ

Given the TC function as in equation (6), the MC function can be

obtained as


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aTC

= 6-1.8Q+0.15Q2 (13)aQ

Equation (13) represents the behaviour of MC. The behaviour of MC

for Q from 1 to 16 computed as MC = TCn - TCn- i is given in Table 3.1

(col. 8) and graphically presented by MC-curve in Figure 3'.2. The

critical 'value of Q in respect of MC is 6 or 7. It can be seen from Table

3.1.

One method of solving quadratic equation is to factorise it and find

the solution.

Thus, Q3 9Q2 100 = 0

(Q 10) (Q2 + Q + 10) = 0

For this to hold, one of the terms must be equal to zero,

Suppose (Q2 + Q + 10) = 0

Then, Q 10 = 0 and Q = 10.

COST CURVES AND THE LAWS OF DIMINISHING RETURNS

We now return to the laws of variable proportions and explain it

through the .cost curves. Figures 3.1 and 3.2 clearly bring out the

short-term laws of production, i.e., the laws of diminishing returns. Let

us recall the law: it states that when more and more units of a variable

input are applied to those inputs which are held constant, the returns

from the marginal units of the variable input may initially increase but

will eventually decrease. The same law can also be interpreted in

term's of decreasing and increasing costs. The law can then be stated

as, if more and more units of a variable inputs are applied to the given

amount of a fixed input, the' marginal cost initially decreases, but

eventually increases. Both interpretations of the law yield the same

information: one in terms of marginal productivity of the variable input,

and the other, in terms of the marginal cost. The former is expressed

through production function and the latter through a cost function.

Figure 3.2 represents the short-run laws of returns in terms of

cost of production. As the figure shows, in the initial stage of

production, both AFC and AVC are declining because of internal


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economies. Since AC = AFC + AVC, AC is also declining, this shows the

operation of the law of increasing returns. But beyond a certain level of

output (i.e., 9 units in out example), while AFC continues to fall, AVC

starts increasing because of a faster increase in the TVC.

Consequently, the rate of fall in AC decreases. The AC reaches its

minimum when output increases to 10 units. Beyond this level of

output, AC starts increasing which shows that the law of diminishing

returns comes in operation. The MC, curve represents the pattern of

change in both the TVC and TC curves due to change in output. A

downward trend in the MC shows increasing marginal productivity of

the variable input mainly due to internal economy resulting from

increase in production. Similarly, an upward trend in the MC shows

increase in TVC, on the one hand, and decreasing marginal

productivity of the variable input, on the other.

SOME IMPORTANT COST RELATIONSHIPS

Some important relationships between costs used in analysing the

short-run cost behaviour may now be summed up as follows:

As long as AFC and AVC fall, AC also falls because AC = AFC

+AVC.

When AFC falls but A VC increases, change in AC depends on

the rate of change in AFC and AVC then any of the following

happens:

ifthereisdecrease in AFC and increase in A VC, AC falls,

if the decrease on AFC is equal to increase in Ave, AC remains

constant, and

if the d~crease in AFC is less than increase in A VC, AC

increases.

The relationship between AC and MC is of varied nature. It may

be described as follows:

When MC falls, AC follows, over a certain range of initial

output. When MCis failing, the rate of fall in MC is greater than

that of AC This is because in case of MC the decreasing


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marginal cost is attributed, : to a single marginal unit while; in

case of AC, the decreasing marginal cost is distributed overall

the entire output. Therefore, AC decreases at a lower rate than

MC.

Similarly, when MC increase, AC also increases but at a lower

rate fbr the reason given in'the above point. There is however

a range of output over which this relationship does not exist.

For example, compare the behaviour of MC and AC over the

range of output frbm 6 units to 10 units (see Figure 3.2). Over

this range of ~utput, MC begins to increase while AC continues

to decrease. The reason for this can be seen in Table. 3.1.

When MC starts increasing, it increases at a relatively lower

rate, which is sufficient only to reduce the rate of decrease in

AC, i.e., not sufficient to push the AC up. That is why AC

continues to fall over some range of output even, if MC falls.

MC iJ1tetsects AC at its minimum point. This is simply a

mathematical relationship between MC and AC curves when

both of them are obtained from the same TC function. In

simple words, when AC is at its minimum, then it is neither

increasing nor decreasing it is constant. When AC is constant,

AC = MC.

Optimum Output in Short-run

An optimum level of output is the one, which can be produced at a

minimum or least average cost, given the required technology is

available. Here, the least'tcost' combination of inputs can be

understood with the help of isoquants and isocosts. The least-cost

combination of inputs also indicates the optimum level of output at

given investment and factor prices. The AC and MC cost Curves can

also be used to find the optimum level of output, given the size of the

plant in the short-run. The point of intersection between AC and MC

curves deterinines the minimum level of AC. At this level of output AC

= MC. Production beloW or beyond thislevelwill be in optimal. If

production is less than 10 units (Figure 3.2) it will leave some scope for

reducing AC by producing more, because MC < AC. Similarly, if

production is greater than 10 units, reducing output can reduce AC.


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Thus, the cost curves can be useful in finding the optimum level of

output. It may be noted here that optimum level of output is not

necessarily the maximum profit output. Profits cannot be known unless

the revenue curves of firms are known.

Long-run Cost-output Relations

By definition, in the long-run, all the inputs become variable. The

variability of inputs is based on the assumption that, in the long run,

supply of all the inputs, including those held constant in the short-run,

becomes elastic. The firms are, therefore, in a position to expand the

scale of their production by hiring a larger quantity of all the inputs.

The long-run cost-output relations, therefore, imply the relationship

between the changing scale of the firm and the total output;

conversely in the short-run this relationship is essentially one betweenthe total output and, the variable cost (labour). To understand the

long-run costoutput relations (lnd to derive long-run cost curves it will

be helpful to imagine that a long run is composed of a series of short-

run production decisions. As a' corollary of this, long-run cost curves

are composed of a series of short-run cost curves. We may now derive

the long-run cost curves and study their' relationship with output.

Long-run Total Cost Curve (LTC)

In order to draw the long-run total cost curve, let us begin with a short-

run situation. Suppose that a firm having only one-plant has its short-

mn total cost curve as given-by STC l in panel (a) of Figure 3.3. In this

example if the firm decides to add two more plants to its size over

time, one after the other then in accordance two more short-run total

cost curves are added to STCl in the manner shown by STC2 and STC3

in Figure 3.3 (a):. The LTC can now be drawn through the minimumpoints of STCl, STC2 and STC3 as shown by the LTC curve

corresponding to each STC.

Long-run Average Cost Curve (LAC)

Combining the short-run average cost curves (SACs) derives the long-

run average cost curve (LAC). Note that there is one SAC associated

with each STC. Given the STC1 STC2, and STC3 curves in panel (a) of

Figure 3.3, there are three corresponding SAC curves as given by SAC1


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SAC2 arid SAC3 curves in panel (b) of Figure 3.3. Thus, the firm has a

series of SAC curves, each having a bottom point showing the

minimum SAC. For instance, C1Q1 is the minimum AC when the firm

has only one plant. The AC decreases to C2Q2 when the second plant is

added and then rises to C3Q3after the inclusion of the third plant. The

LAC carl be drawn through the bottom of SAC 1 SAC2 and SAC3 as

shown in Figure3.3 (b) The LAC curve is also known as Envelope

Curve' or 'Planning Curve' as it serves as a guide to the entrepreneur

in his planning to expand production.

The SAC curves can be derived from the data given in the STC

schedule, from STC function or straightaway from the LTC-curve.

Similarly, LAC can be derived from LTC-schedule, LTC function or from

LTC-curve. The relationship between LTC and output, and between

LAC and output can now be easily derived. It is obvious. from the LTC

that the long-run cost-output relationship is similar to the short-run


19/45

cost-output relationship. With the subsequent increase in the output,

LTC first increases at a decreasing rate, and then at an increasing

rate. As a result, LAC initially decreases until the optimum utilisation of

the second plant and then it begins to increase. From these relations

are drawn the 'laws of returns to scale'. When the scale of the firm

expands, unit cost of production initially decreases, but it ultimately

increases as shown in Figure 3.3 (b).

Long-run Marginal Cost Curve

The long-run marginal, cost curve (LMC) is derived from the short-run

marginal cost curves (SMCs). The derivation of LMC is illustrated in

Figure 3.4 in which SAC3'and LAC arethe same as'in Figure 3.3(b). To

derive the LMC3, consider the points of tangency between SAC3 and the

LAC, i.e., points A, Band C. In the long-run production planning, thesepoints determine the output levels at the different levels of production.

For example, if we draw perpendiculars from points A, Band C to the X-

axis, the corresponding output levels will be OQ1 OQ2 and OQ3 The

perpendicular AQ1 intersects the SMC1 at point M. It means that at

output BQ2, LMC, is MQ1. If output increases to OQ2, LMC rises to BQ2.

Similarly, CQ3 measures the LMC at output OQ3. A curve drawn through

points M3B and N, as shown by the LMC, represents the behaviour of

the marginal cost in the long run. This curve is known as the long-run

marginal cost curve, LMC. It shows the trends in the marginal cost in

response to the change in the scale of production.

Some important inferences may be drawn from Figure 3.4. The

LMC must be equal to SMC for the output at which the corresponding

SAC is tangent to the LAC. At the point of tangency, LAC = SAC. For all

other levels of output (considering each SAC separately), SAC > LAC.

Similarly, for all levels of outout corresponding to LAC = SAC, the LMC

= SMC. For all other levels output, i:he LMC is either greater or less

than the SMC. Another important point to notice is that the LMC

intersects LAC when the latter is at its minimum, i.e., point B. There, is

one and only one short-run plant size whose minimum SAC coincides

with the minimum LAC. This point is B where, SAC 2 = SMC2 = LAC =

LMC.


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Optimum Plant Size and Long-run Cost Curves

The short-run cost curves are helpful in showing how a firm can decide

on the optimum utilisation of the plant-which is the fixed factor; or how

it can determine the least-cost output level. Long-run cost curves, on

the other hand, can be used to show how the management can decide

on the optimum size of the firm. An Optimum size of a firm is the one,

which ensures the most efficient utilisation of resources. Given the

state: of technology overtime, there is technically a unique size of the

firm and lever of output associated with the least cost Concept. This

uriique size of the firm can be obtained with the help of LAC and LMCIn

Figur 3.4 the optimum size consists of two plants, which produce OQ 2

units of a produd, at minimum long-run average cost (LAC) of BQ2.

The downtrend in the LAC ihdicates that until output reaches the

level of OQ2, the firm is of non-optimal size. Similarly, expansion of the

firm beyond production capacity OQ2 causes a rise in SMC as well as

LAC. It follows that given the technology, a firm trying to mini mise its

average cost over time must choose a plant which gives minimum LAC

where SAC = SMC = LAC = LMC. This size of plant assures most

efficient utilisation of the resource. Any change in output level, i.e.,

increase or decrease, will make the firm enter the area of in optimality.

ECONOMIES AND DISECONOMIES OF SCALE

Scale of enterprise or size of plant means the amount of investment in

relatively fixed factors of production (plant and fixed equipment).


21/45

Costs of production are generally lower in larger plants than in the

smaller ones. This is so because there are a number of economies of

large-scale production.

Economies of Scale

Marshall classified the economies of large-scale production into two

types:

1. ExternalEconomies

2. Internal Economies

External Economies are those, which are available to all the

firms in an industry, for example, the construction of a railway line in a

certain region, which would reduce transport cost for all the firms, the

discovery of a new machine, which can be purchased by all the firms,

the emergence of repair industries, rise of industries utilising by-

products, and the establishment of special technical schools for

training skilled labour and research institutes, etc. These economies

arise from the expansion in the size of an industry involving an

increase in the number and size of the firms engaged in it.

Internal Ecnomies are the economies, which are available to a

particular firm and give it an advantage over other firms engaged in

the industry. Internal economies arise from the expansion of the size of

a particular firm. From the managerial point of view, internal

economies are more important as they can be affected by managerial

decisions of an individual firm to change its size or scale.

Types of Internal Economies

There are various types of internal economies such as labour,

technical, managerial, marketing and so on. We will discuss the types

of internal economies in detail in the following section:

Labour Economies: If an firm decides to expand its scale of

output, it will be possible for it to reduce the labour costs per

unit by practising division of labour. Economies of division of

labour arise due to increase in the skill of workers, and the

saving of time involved in changing from one operation to the

other. Again, in many cases, a large firm may find it economical

to have a number of operations performed mechanically rather


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than manuaily. These economies will be of great use in firms

where the product is complex and the manufacturing processes

can be sub-divided.

Technical Economies: These are economies derived from the

use of subsize machines and such scientific processes like those

which can be carried out in large production units. A small

establishment cannot afford to use such machines and

processes, because their use would bring a saving only when

they are used intensively. On the other hand, their use will be

quite uneconomical if they were to lie idle over a considerable

part of the time. For example, a large electroplating plant costs a

great deal to keep it in operation. Therefore, the cost per unit will

be low only if the output is large. Similarly, a machine that

facilitates the pressing out a side of a motorcar will take a week

or more to be put ready for operation to produce a particular

design. The greater the output of cars of this particular designs

the lower the cost per unit of getting the machine ready for

operation. Similarly, if a dye is made to produce a particular

model of cars, the cost of dye per unit of cars will depend upon

the output of the cars. Very often large firms may find it

economical to produce or manufacture parts and components for

their products rather than buy them from outside sources. For

example, Hind Cycles, unlike small mariufacturers, produced

parts and components themselves. Moreover, large firms may

find it profitable to utilise their by-products and waste products.

For example, Tata use the smoke from their furnaces to

manufacture coal tar, naphthalene, etc. A small firm's output of

smoke would not be large enough to justifY setting up the.equipment necessary to do so.

Managerial Economies: When the size of the fern increases,

the efficiency of the management usually increases because

there can be greater specialisationin managerial staff. In a large

firm, experts can be appointed to look after the various sections

or divisions of the business, such as purchasing, sales,

production, financing, personnel, etc. But a small firm cannot


23/45

provide full-time employmentto these experts naturally, the

various aspects of the business have to be looked after by few

people only who may not necessarily be experts. Moreover, a

large firm can afford to set up data processing and mechanised

accounting, etc., whereas small firms cannot afford to do so.

Marketing Economies: A large firm can secure economies in its

purchasing and sales. It can purchase its requirements in bulk and

thereby get better terms. It usually receives prompt deliveries,

careful attention and special facilities from its suppliers. This is

sometimes due to the fact that a large buyer can exert more

pressure, at times compulsive in nature, for specially favoured

treatment. It can also get concessions from transport agencies.

Moreover, it can appoint expert buyers and expert salesmen.

Finally, a large firm can spread its advertising cost over bigger

output because advertising costs do not rise in proportion to a

rise in sales.

Economies of Vertical integration: A large firm may decide to

have vertical integration by combining a number of stages of

production. Thisintegration has the advantage that the flow of

goods through various stages in production processes is more

readily controlled. Steady supplies of raw materials, on the one

hand, and steady outlets for these raw materials, on the other,

make production planning more certain and less subject to erratic

and unpredictable changes. Vertical integration may also facilitate

cost control, as most of the costs become controllable costs for the

enterprise. Transport' costs may also be reduced by planning

transportation in such a way that cross hauling is reduced to the

minimum.

Financial Economies: A large firm can offer better security and is,

therefore, in a position to secure better and easier credit facilities

both from its suppliers and its bankers. Due to a better image, it

enjoys easier access to the capital market.

Economies of Risk-spreading: The larger the size of the

business, the greater is the scope for spreading of risks through

diversification. Diversification is possible.on two lines as follows:


24/45

o Diversification of Output: If there are many products,

the loss in the sale of one product may be covered by the

profits from others. By diversification, the firm avoids what

may be called putting all eggs in the same basket. For

example, Vickers Ltd., make aircrafts, ships, armaments,

food-processing plant, rubber, plastics, paints, instruments

arid a wide range of other products. Many of the larger

firms have taken to diversification. ITC diversified to

include marine products and hotel business in its

operations.

o Diversification of Markets: The larger producer is

glenerally in a position to sell his goods in many different

and even far-off places. By depending upon one market,

he runs the risk of heavy loss if sales in that market

decline for one reason or the other.

Sargant Floren'ce and Economies of Scale

Sargant Florence has attributed the economies of scale the three

principles, which are in operation in a large-sized business, namely,

the principle of bulk transactions, the principle of massed reserves,

and the principle of multiples.

Principle of Bulk Transactions: This principle implies that the

cost of dealing with a large batch is often no greater than the cost

of dealing with a small batch, for example,' the cost of placing an

order, large or small; availability of discounts on bulk orders, or

annual purchase contracts; economies in the use or'large

containers such as tanks or trucks of special design, for a

container holding, say, twice as much as the other one, does notcost double the amount.

Principle of Massed Reserves: A large firm has a number of

departments or sections and its overall demand for services, say,

transport services, is likely to be fairly large. But it is unlikely that

all departments will make heavy demands of the particular service

at the saine time. Thus the firm can afford to have its own

transport fleet and fully utilise it and thereby ultimately reduce its


25/45

costs. The larger the firm, the greater are the advantages.

Principle of Multiples: This principle was first raised by Babbage

in 1832 and has also been referred to as 'Balancing of Processes'.

The principle can be better explained through an example.

Suppose a manufacturing, operation involves three processes, first

in which a machine (:an make 30 units a week; second in which an

automatic machine can make 1,000 units per week; and a third in

which a semi-automatic machine can make 400 units per week.

Unles~ the output of the plant is some common multiple of

30,1,000 anti 400, one or more of the processes will have

unutilised capacity. Their LCM is 6,000 and, therefore, to best

utilise all the machines the plant size must be of at least 6,000

units or any of its multiples.

Economies of Scale and Empirical Evidence

According to the surveys conducted by the Pre-investment Survey

Group (FAG) and later on by the NCAER, it has been pf()Ved that in

paper industry, profitability decreases with lower scaly of operations

and bigger plants beneht from economies of scale. The report of the

Pre-investment Survey Group (FAG) reveals that the manufacturing

cost of writing and printing paper would fall from Rs. 1,489 in a 100-

tonne per day plant to Rs. 1,238 in a 200-tonne per day plant and

further to Rs. 1,104 in a 300-tonne per day plant. The following Table

3.2 further shows the capital cost of raw materials and operating cost

per tonne of paper according to the size of the unit, as estimated by

the NCAER.

Table 3.2: Paper Industry: Investment and Other

Costs of Paper Mills according to Size

Size Tonnes Fixed Cost of raw O eratiner da investment cost ma terials er cost er tonne

'. er tonne tonne of a er of a er100 4,473 324 1,307

200 4,070 263 1,116250 3,945 258 1,056

Another study of cement industry by the Economic and Scientific

Research undation-shows that the per unit of capacity capital


26/45

investment of a 3,000 tonne per' day (TPD) capacity cement plant

islower than the plants of 50 TPD size. Thus a single cement plant

producing 3,200 TPD requires 46 per cent less capital investment than

8 plants of 400 TPD productions would. As regards cost of production, a

800 TPD plant has a 15 per cent cost advantage over a 400 TPD plant.

The difference between the cost of production of a tonne of cement by

a 3,000 TPD plant and of a50 TPD plant is as high as Rs. 100 per tonne.

In fact, there has been a perceptible increase in the size of cement

plants in India. For example, the 600 tonnes per day capacity cement

plants during the early 1960s gave way with their size going up to

1,200 tonnes per day. The latest preference is for 3,200 tonnes per day

capacity plants. A significant policy implication of economics of scale is

that in order to earn a reasonable return and at the same time ensure

a fair deal to the consumers, the industry should go in for larger plants

and expand the existing plants to .the optimum level.

The 6/10 Rule

A useful rule that seeks to measure economies of scale is the 6/1 0

rule. According to this rule, if we want to double the volume of a

container, the material needed to make it will have to be increased by

6/10, i.e., 60 per cent. A proofofthe'6/l0 rule is easy and can be given

here with its advantage. Let us begin with the volume of a container

and the material required to make it. Suppose the container is of the

shape of a Gube with its side. The volume of the container then is:

Vo = ao x ao x ao = ao3

Now, to find out the area of material needed, we know that the

container will have six equal square faces, each of area an 2 so, the

area of total material needed IS:

Mo = 6 x ao2 = 6ao2

Suppose now, that the container's dimension increases from an to

all the volume of the container will then increase to al3 and the area

of t~e material needed will increase to 6a12.

Thus, for two containers of dimensions an and al the ratio of the

areas of material needed will be:

M1 6a1/2 a1/2


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= =M0 6a0/2 a0

The corresponding ratio of the volumes will be:

V1

=

a1/3

=

a1/3

V0 a0/3 a0

From the above, it follows that:

M1

=

a1/2

=

a1/3.2/3=

V 1 2/3

M0 a0/2 a0 V0

Now, if we double the volume, i.e., if

V1 = 2V0 or

V1

=2V0

Then,

M1

=

V1 2/3

= (20) 2/3 = 1.59M0 V0

M1 = 1.59 M0

In other words, doubling the volume requires 59 per cent

increase in material. This is rouJded off as 60 per cent, which is the

same as 6/1O. It may be added that, if in place of a cubical container,

we had taken the example of a spherical or a rectangular or a

cylindricai or for that matter a conical container, we would have aijived

at the same relationship, viz.,

M1

=

V12/3

M0 V0

The 6/10 rule is of great practical significance. Its significance can

well be realised if we visualise, for example, blast furnaces as boxes

containing the ingredients needed to produce iron, or tankers as large

boxes containing oil.

Minimum Economic Capacity (MEC) Scheme

Small size firms do not enjoy economies of scale. As such, in

pursuance of government's policy to encourage minimum efficient

capacity in industrial und~i1akings, the Government of India has


28/45

introduced' MEC Scheme to petrochemical industries, for example,

Naphtha / Gas Cracker (3 to 4 lakhs tonnes), Bopp Film (56,000

tonnes), Polyster Film (5,000 tonnes), Polyster Filament Yam (25,000

tonnes), Acrylic Fibre (20,000 tonnes), MEG (One lakh tonnes), PTA

(2lakh tonnes), etc.

World Sdale

With recent trends towards globalisation of industries in India, the

concept of "World Scale" has emerged. The term 'World Scale' refers to

that scale or size of the enterprise, which is large enough to enable the

firm to reap various large-scale economies so as to compete

successfully on the world basis with global rivals. Thus Reliance

Industries Limited has recently announced to build a world scale

polyester facility at Hnzira and a cracker project with capacity

expanding from earlier 40,000 tonnesto the world scale of 7,50,000

tonnes per annum.

Diseconomies of Scale

Economies of increasing size do not continue indefinitely. After a

certain point, any further expansion of the size leads to diseconomies

of scale. For example, after the division of labour has reached its mostefficient point, further increase in the number of workers will lead to a

duplication of workers. There will be too many workers per machine for

really efficient production. Moreover, the problem of co-ordination of

different processes may become difficult. There may be divergence of

views concerning policy problems among specialists in management

and reconciliation may be difficult to arrive. Decision-making process

becomes slow resulting in missed opportunities. There may be too

much of formality, too many individuals between the managers and

workers, and supervision may' become difficult. The management

problems thus get out of hand with consequent adverse effects on

managerial efficiency.

The limit of scale economics is also often explained in terms of the

possible loss of control and consequent inefficiency. With the growth

in the size of the firm, the control by those at the top becomes


29/45

weaker. Adding one more hierarchical level removes the superior

further away from the subordinates. Again, as the firm expands, the

incidence of wrong judgements increases and errors in judgement

become costly.

Last be not the least, is the limitation where the larger the plant,

the larger is the attendant risks of loss from technological changes as

technologies are changing fast in modern times.

Diseconomies of Scale and Empirical Evidence

Large petro-chemical plants achieve economies in both full usage and

in utilisation of a wider range ofby-products, which would otherwise,

be wasted. But above 5,00,000 tonnes, diseconomies of scale sets in

because of the following occurrences:

The plant becomes so large that on-site fabrication of some partsis required which is much more expensive;

Starting up costs are much higher, more capital is tied up and

delays in commissioning can be extremely expensive; and

The technical limit to compressor size has been reached.

There is, however, no substantial evidence of diseconomies of

large-scale production. In the final analysis, however, a significant

test of efficiency is survival. If small firms tend to disappear and large

ones survive, as in the automobile industry, we must conclude that

small firms are relatively inefficient. If small firms survive and large

ones tend to disappear as in the textile industry, then large firms are

relatively inefficient. In reality, we find that in most industries, firms of

very different sizes tend to survive. Hence, it can be concluded that

usually there is no significant advantage or disadvantage to size over

a very wide range of outputs. It may mean, of course, that thebusinessman in his planning decisions determines that beyond a

certain size, plants do have higher costs and, therefore, does not

build them.

Somewhat surprisingly, some Indian entrepreneurs have been

perceptive enough to attempt to derive the advantages of both large

and small-scale enterprises. In the late sixties, the Jay Engineering Co.

Ltd. evolved a strategy of blending large units with small enterprises


30/45

to obtain the best of both worlds. It manufactures its Usha fans in

three different plants (Calcutta, Hyderabad and Agra), with each plant'

manu facturing the same or a similar range of products. Each unit is

autonomous and is free to take operational decisions except in highly

strategic areas. Within each unit, the work-force is kept small to carry

out vital operations such as forgoing, blanking, notching and final

assembly. The rest of the work is sub-contracted to neighbouring

small-scale units, which over a period or time have become almost

integral parts of each plant. Loans for the purchase of machinery are

also advanced and technical know-how and sometimes-eve training is

provided to these ancillary units.

Payments are made promptly. The whole system operates like

families within a larger family. Managers in the US, who are always

quick in innovating, have also begun adopting this blended system

during the past few years. General Motors encourages the creation ofa

cluster of independent enterprises in an area, with adequate

autonomy granted to the company's area chief to encourage their

growth and developm.ent. Consequently, though a giant in the

automobile industry, General Motors enjoys a large number of the

privileges that acerue to small units and also reaps the special benefits

accruing to large business firms.

Economies of Scope

This concept is of recent development and is different from the

concept of economies of scale. Here, the cost efficiency in production

process is brought out by variety rather than volume, that is, the cost

advantages follow from variety of output, for example, product

diversification within the given scale of plant as against increase in

volume of production or scale 6f output. A firm can add new and newer

products if the size of plant and type of technology make it possible.

Here, the firm will enjoy scope-economies instead of scale economies.

COST CONTROL AND COST REDUCTION

Cost Control

The long-run prosperity of a firm depends upon its ability to eam

sustaid profits. Profit depends upon the difference between the selling


31/45

price and the cost of production. Very often, the selling price is not

within the control of a firm but many costs are under its control. The

firm should therefore aim at doing whatever is done at the minimum

cost. In fact, cost control is ail essential element for the successful

operation of a business, Cost control by management means a search

for better and more economical ways of completing each operation. In

effect, cost control would mean a reduction in the percentage of costs

and, in turn, an increase in the percentage of profits. Naturally, cost

control is and will continue to be of perpetual concern to the industry.

Cost control has two aspects' such as a reduction in specific

expenses and a more efficient use of every rupee spent. For example,

if sales can be increased with the same amount of expenditure, say,

on advertising and saTesmen, the cost as a percentage of sales is cut

down. In practice, cost control will ultimately be achieved by looking

into both these aspects and it is impossible to assess the contribution,

which each has made to the overall savings. Potential savings in

individual businesses will, however, vary between wide extremes

depending upon the levels of efficiency already achieved before cost

controls are introduced.

It is useful to bear in mind the following rules covering cost control

activities:

It is easier to keep costs down than it is to bring costs down.

The amount of effort put into cost control tends to increase

when business is bad and decrease when business is good.

There is more profit in cost control when business is. good than

when I business is bad. Therefore, one should not be slack when

conditions are good.

Cost control helps a firm to improve its profitability and

competitiveness. Profits may be drastically reduced despite a large and

increasing sales volume in the absence of cost control. A big sales

volume does not necessarily mean a big profit. On the other hand, it

may create a false sense of prosperity while in reality; increasing costs

are eating up profits. Profit is in danger-when good merchantdising and

cost control do not go hand in hand. Cost control may also help a firm

in reducing its costs and thus reduce its prices. A reduction in prices of


32/45

a firm would lead to an increase in its competitiveness. The aspect is of

particular relevance to Indian conditions because of high costs, India is

being priced out of the world markets.

Tools of Cost Control

Following ar.e the tools that are used for the cost control:

Standard Costs and Budgets: The technique of standard,

costing has been developed to establish standards of performance for

producing gvuus and services. These standards serve "as a goal for the

attainment and as basis of comparison with actual costs in checking

performance. The analysis of variance between actual and standard

costs will: (i) help fix the responsibility for non-standard performance

and (ii) focus attention on areas in which cost improvement should be

sought by pinpointing the source of loss and inefficiency. The principlehere is that or controlling by exception. Instead of attempting to follow

a mass of cost data, the attention of those responsible for cost control

is concentrated on significant variances from the standard. If effective

action is to be taken, the cause and responsibility of a variance, as well

as its amount, must be established.

The prime objective of standard costs is to generate greater cost

consciousness and help in cost control by directing attention to

specific areas where action is needed. To those who are immediately

concerned, variances wou1d indicate whether any action is required

on their part. It must be noted that

Costs are controlled at the points where they are incurred and at

the time of occurrence of events, and

At the same time they may be uncontrolled at some points.

It is, therefore, necessary to understand the difference betweencontrollable and uncontrollable costs. The variances may also be

controllable and uncontrollable. For example, if the material cost

variance is due to rise in prices, it is not within the control of the

production manager. But if the variance is due to greater usage,

control action is certainly possible on his part. The higher management

can also deCide whether or not they should intervene in the matter.

Sometimes, variances may be so significant that a complete


33/45

reapRraisal of the standard costs themselves may be needed.

For example, if the variances are always favourable, it may point

to the fact that the standards have not been properly fixed. Standard

costing can also provide the means for actual and standard cost

comparison by type of expense, by departments or cost centres. Yields

and spoilage can be compared with the standard allowance for loss.

Labour operations and overheads also can be checked for efficiency.

Flexible budgets constitute yet another effective technique of cost

control, especially control of factory overheads. Flexible budgets, also

known as variable budgets; provide a basis for determining costs that

are anticipated at various levels of activity. It provides a flexible

standard for comparing the costs of an actual volume of activity with

the cost that should be or should have been. The variances can then

be analysed and necessary action can be taken in the matter. Table

3.3 gives a specimen flexible budget.

Table 3.3: Finishing Department, Modern Manufacturing Co.

Standard hours of direct labour

35,000 40,000 45,000

Labour cost hour at Rs. 3 per Rs. 1,05,000 Rs. 1,20,000 Rs. 1,35,000Other variable costs 17500 20.000 22,500Semi-variable costs 9,250 10,000 10,250Fixed costs 50,000 50,000 50,000Total Rs.l,81,75Q Rs. 2,00,000 Rs.2,17,750

The scientific establishment of standards of performance through

standard costs and budgets has not only provided better cost control

but has led to cost reduction in a number of companies. This has been

the case especiilIIy in companies where standards were tied to wage-

incentive plans and improyement in control is part of a general

programme of better management. The above table shows three

budgets, one each for 35,000, 40,000 and '45,000 standard hours of

work. In practice, one may come across 50 or more cost items in the

budget and not just four as shown in the table.


34/45

Ratio Analysis

RatIo is a statistical yardstick that provides a measure of the

relationship betweeri two figures. This relationship may be expressed

as a rate (costs per rupee of sales), as a per cent (cost of sales as a

percentage of sales), or as a quotient (sales as a certain number of

time the inventory). Ratios are commonly used in the analysis of

operations because the use of absolute figures might be misleading.

Ratios provide standards of comparison for appraising the performance

of a business firm. They can be used for cost control purposes in two

ways:

A businessman may compare his firm's ratios for the period

under scrutiny with similar ratios of the previous periods. Such a

comparison would help him identify areas that need his

attention.

The businessman can compare his ratios with the standard ratios

in his jndustry. Standard ratios are averages of the results

achieved by thousands, of firms in the same line of business.

If these comparisons reveal any significant differences,

thtYmanagement call analyse the reasons for these differences and

can take appropriate action to remove' the causeS responsible for

increase in costs. Some of the most commonly used ratios for cost

corrtparisons are given below:

Not profits/sales.

Gross profits/sales.

Net profits/total assets.

Sales/totaLassets.

Production costs/costs of sales.

Selling Costs/costs of sales.

Admiriistration costs/costs of sales.

Sahes/iriventory or inventory turnover.

Material costs/prod1, Jction costs.

Labour costs/production costs.

Overhead/prqduction costs.


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Value Analysis: Value analysis is an approach to cost saving

that deals with product design. Here, before making or buying any

equipment or materials, a study is made of the purpose to which these

things serve. Would other lower-cost designs work as well? Could

another less costly item fill the need? Will less expensive material, do

the job? Can scrap be reduced by changing the design or the type of

raw materiaJ? Are the seller's costs as low as they ought to be?

Suppliers of alternative materIals can provide the ample data to make

the appropriate choice. Of course, absorbing and reviewing the data

will need some time. Thus the objective of value analysis is the

identification of such costs in a product that do not in any manner

contribute to its specifications or functional value. Hence, value

analysis is the process of reducing the cost of the prescribed function

without sacrificing the required standard of performance. The

emphasis is, first, on identificatiqn of the required function and,

secondly, on determination of the best way to perform it at a lower

cost. This novel method of cost reduction is not yet seriously exploited,

in our country. Value analysis is a supplementary device in addition to

the con~entional cost reduction methods.

Value analysis is closely related to value engineering, though

they are not identical. Value analysis refers to the work that

purchasing department does in-this direction whereas value

engineering usually refers to what engineers are doing in this area. The

purchasing department raises questions and consults the engineering

department and even the vendor company's department. Value

analysis thus requires wholehearted co-operation of not only the firm's

expertise in design, purchase, production and costing but also that of

the vendor and other company expertise, if necessary. Some examplesof savings through value analysis are given below:

Discarding tailored products where standard components can

do.

Dispensing with facilities not specified or not required by the

customer, for example, doing away with headphone in a radio

set.

Use ofnewly-deyeloped, better and cheaper materials in place of


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traditional materials.

Taking the specific case of TV industry, there are various

components of cost, which can be questioned. The various items are

as under:

Whether to have vertical holding chassis or the chassis should

be tied down horizontally. In case, chassis is held vertically,

additional expenditure in terms of holding clamps is required.

Whether to have plastic cabinet or wooden cabinet.

Whether to have two speakers or one speaker.

Whether to have sliding switches or stationary switches.

Whether to have PVC back cover or wooden back cover.

Whether to have costly knobs or cheaper knobs.

Whether to have moulded mask or extruded plask.

Whether to have Electronic Tuner or Turret Tuner.

Whether to have digital operating unit or noble operating unit.

Cost control is applicable only to such costs, which can be

altered by the management on their own initiative. It may be noted in

this context that, by and large, non-controllable costs exceed far more

than controllable ones thereby restricting the scope of profit

impfoyement through cost, control. Of course, attempts may be made

to convert an uncontrollable cost into a controllable one. Vertical

combinations to secure control over sources of supply provide an

example. So also instead of buying a component, a firm may decide to

make the conversion possible.

AREAS OF COST CONTROL

Folloviing are the areas where the cost can be controlled:

1. Materials

There area number of ways that help in reducing the cost ofmatenals.

Ifbuying is done properly, a firm avails itself of quantity discounts.

While buying from a particular source, in addition to the cost of

materials, consideration should be given to freight charges. In some

cases, lower prices of materials may be offset by higher freiight to the


37/45

firm's godown. Whiie buying, one may attempt to buy from the

cheapbt source by inviting bids. At times, it may be possible to have

more economical substitutes for raw materials that the firm is using.

Many a times, improvell1ent in product design may lead to reduction

in material usage. It is desirable to concentrate attention on the areas

where saving potential is the highest.

Another area, which needs examination in this respect, is

whether to make or buy components from outside source. Very often

firm may find it advantageous to manufacture certain parts and

components in one's own factory rather than buying them. Yet in many

cases there are specific advantages in purchasing spares and

components from outside because suppliers may deliver goods at low

cost with high quality. For example, Ford and Chrysler of the US Auto

Industry purchase their components from outside source. But General

Motors could not do so because the firm has its own departments for

handling the process of production. This type of firm is referred as

vertically integrated firm where it owns the various aspects of making

seIling and delivering a product Hind Cycles, which has now been

taken over by the Government, manufactures all its components. But

manufacturers of Hero and Avon Cycles purchased most of their

components from outside source and successfully competed with HindCycles.

Continuous Research and Development (R & D) may also lead to

a reduction in raw material costs. For example, Asian Paints made high

savings in costs of raw materials by its phenomenal success on

Research and Development front, by manufacturing synthetic resins

for captive consumption. Total materials consumed as a ratio of value

of production fell from 67.66 per cent in 1973 to 60-67 per cent in1977. General Motors have reduced the weight of their cars to make

them more fuel-efficient. Better utilisation of materials' may also save

the cost of materials by avoiding wastes in storing, handling and

processing. Some of the factors, responsible for excessive wastage of

materials are: lack of laid down requirements for raw materials, bad

process planning, rejects due to faulty materials or poor workmanship,

lack of proper tools, jigs and fixtures, poor quality of materials, loose


38/45

packing, careless and negligent handling and careless storage.

Exploration of the possibilities of the use of standardised parts

and components and the utilisation of waste and by-products, may

also lead to a significant reduction in the cost of materials.

Inventory control is yet another area for reducing materials

cost. Thro inventory control, it is possible to maintain the investmentin inventories at lowest amount consistent with the production and

the sales requirements of firm. The cost of carrying inventories

ranges from 15 to 20 per cent per annum account of interest on

capital, insurance, storage and handling charges, spilla breakage,

physical deterioration, pilferage and obsolescence. Again 50 per cent

the gross working capital may be locked up in inventories.

Some important ways of reducing inventories are: Improved production planning.

Having dependable sources of supplies, which can ensure

prompt deliver of materials at short notice.

Elimination of slow-moving stocks and dropping of obsolete items.

Improved flow of part and materials leading to increased machine

utilisation and shorter manufacturing cycles.

Packaging constitutes a significant proportion of raw materials

(9 to 24 per cent) and of the total manufacturing expenses (7 to 22

per cent). Firm should mal attempts to reduce the packaging costs to

the minimum. For example, instead discarding containers that the

materials come in it may be used for shipping tl goods and thus, the

packaging cost can be saved. The manufacturing firms such; cars and

motor bikes may request its customers to return the containers in

whic are goods were sent so that they could be used in future. This isbecause packin of such goods as well as the materials used for

packing is very expensive.

2. Labour

Reduction in wages for reducing labour costs is out of question. On the

other hand, wages might have to be increased to provide incentives to

workers. Yet there is good scope for reduction in the wage cost per

unit. A reduction in labour costs is possible by proper selection and


39/45

training, improvement in productivity and by automation, where

possible. A study by cn (Confederation of Indian Industry) showed that

Hero Cycles improved their productivity per employee by 6.4 per cent.

'Purolators' were able to increase their productivity by 100 per cent.

Work study might result in a lot of savings by reducing overtime and

idle time and providing better workloads. Labour productivity might

increase if frequent change of tools is avoided. Improvement in

working conditions may reduce absenteeism and thus reduce costs per

unit. Scrutiny of overtime may reveal substantial scope for savings.

All efforts must be made to redllce wastage of human effort.

Wastage of human effort may be due to lack of co-ordination among

various departments by having more workers than necessary, under-

utilisation of existing manpower, shortage of materials, improper

scheduling, absenteeism, poor methods and poor morale. For example,

Metal Box adopted a Voluntary Severance Scheme in 197576 to reduce

their work force by 950 workers after they faced a huge operating loss

ofRs. 2.4 crores. General Motors eliminated 14,000 white-collar jobs

through attrition to reduce cost. Japan's big 5 steel producers

announced substantial retrenchment programmes and workers co-

operated with the management. Attempts must be made to secure co-

operation of employees in cost reduction by inviting suggestions fromthem. These suggestions should be carefully examined and

implemented if found satisfactory. Hindustan Lever has a suggestion

box scheme and employees who come out with good suggestions

receive awards. These suggestions may either lead to savings or

improve safety and work convenJence. The basic idea is to motivate

workers and make them perceive working in the firm as a participative

endeavour.

3. Overheads

Factory overheads may be reduced by proper selection of equipment,

effective utilisation of space and .equipment, proper maintenance of

equipment and reduction in power cost, lighting cost, etc. For

example, fluorescent lighting can reduce lighting cost. Faulty designs

may lead to excessive use of materials or multiplicity of components,

waste of steam, electricity, gas, lubricants, etc. A British team invited


40/45

by the Government of India to report on standards of fuel efficiency in

Indian industry found that fuel wastages might be as high as an

average of 25 per cent. Keeping them in check even in the face of

increasing sales may reduce overhead costs per unit. For example,

Metal Box maintained their fixed costs in 1976-77 even when there

was an increase in sales of over 18 per cent.

Taking advantage of truck or wagonloads may reduce

transportation cost. Careful planning of movements may also save

transportation cost. Another point to be examined is whether it would

be economical to use one's own transport or hire a transport. For

reasons of economy, many transport companies hire trucks rather than

owning them. This is because purchase and maintemince of trucks can

be more expensive. By chartering vehicles the problems of

maintenance is left to the owner who in turn Cuts cost for the firm.

Thus by keeping a smaller work force on rolls and by introducing a

contract rate linked to a safe delivery schedule it is possible to ensure

speedy point-to-point delivery of goods. Many firms now prefer to use

private taxis rather than have their own staff cars.

Reduction of wastes in general can also reduce manufacturing

costs considerably. Of course, a certain amount of waste and spoilage

is unavoidable because employees do make mistakes, machines do getout of order and sometimes raw materials are faulty. However,

attempts can be made to reduce these mistakes and faulty handling to

the minimum. The normal figure for the waste and spoilage depends

upon the complexity of the product, the age of the manufacturing

plant, and the skill and experience of the workers. Once normal

wastage is found out, production reports must be watched carefully to

find out whether the wastages are excessive. Wastes can be reduced

considerably by educating operators in the causes and cures of the

wastes. Bad debt losses can be reduced considerably by selecting

customers carefully, and keeping an eye on the receivables.

Concentrating on areas and media can reduce advertising costs, which

give the best results.

Selling costs can be controlled by improving the supervision and

training of salesmen, rearrangement of sales territories, replanting


41/45

salesmen's routes and calls and redirecting of the sales efforts, to

achieve a more economic product mix. It may be possible to save

selling costs by the use of warehouses, making bulk shipments to the

warehouses and giving faster deliveries to the customers.

Centralisation, reduction, clerical and accounting work may also lead to

cost savings. A look at the telephone bills and the communication cost

in general may also reveal areas for substantial savings. For example a

telegram may be sent in place of a trunk call.

(a) Cost Reduction

The Institute of Cost and Works Accounts of London has defined cost

reduction as "the achievement of real and permanent reductions in the

unit costs of goods manufactured or services rendered without

impairing their suitability for the use intended". Thus, cost reduction is

confined to savings in the cost of manufacture, administration,

distribution and selling by eliminating wasteful and unnecessary

elements from the product design and from the techniques and

practices carried out in coilOection with cost reduction?

(b) Cost Contro/and Cost Reduction

According to the Institute of Cost and Works Accounts, London, "cost

control, as generally practised, lacks the dynamic approach to many

factors affecting costs, which determine the need of cost reduction."

For example, under cost control, the tendency is to accept standards

once they are fixed and leave them unchallenged over a period. In cost

reduction, on the other hand, standards must be constantly challenged

for improvement. And there is no phase of business, which is

exempted from the cost reduction. Products, processes, procedures

and personnel are subjected to continuous scrutiny to see where andhow they can be reduced in cost.

To achieve success in cost reduction, the management must be

convinced of the need for cost reduction. The formulation of a detailed

and co-ordinated plan of cost reduction demands a systematic

approach to the problem. The first step would be the institution of a

Cost Reduction Committee consisting of all the departmental heads to

locate the areas of potential savings and to determine the priorities.


42/45

The Committee should review progress and assign responsibilities to

appropriate personnel. Every business operation should be approached

in the belief that it is a potential source of economy and may benefit

from a completely new appraisal. Often, it may be possible to dispense

entirely with routines, which, by tradition, have come to be regarded

as a permanent feature of concern. Cost reduction is just as much

concerned with the stoppage of unnecessary activity as with the

curtailing of expenditure. It is imperative that the cost of administering

any scheme of cost reduction must be kept within reasonable limits.

What is reasonable must be determined in all cases from the

relationship between the expenditure and the savings, which result

from it.

Essentials for the Success of a Cost Reduction Programme

Following are the some of the points that firms should take care in

order to achieve success in the cost reduction programme:

Every individual within the firm should recognise his

responsibility. The co-operation of every individual requires a careful

dissemination of the objectives and interest of the employees in the

achievement of the firm's goals.

Employee resistance to change should be minimised by

disseminating complete information about the proposed changes

and convincing the emplcyees that the changes are concerned

with the problems faced by the firm and that they would

ultimately benefit.

Efforts should be concentrated in the areas where the savings are

likely to be the maximum.

Cost reduction efforts should be continuously maintained.

There should be periodic meetings with the employees to review

the progress made towards cost reduction.

(c) Factors Hampering Cost Control in India

The cost of raw material and other intermediate products is generally

high. In many cases: the cost of raw materials is substantially higher


43/45

than their international prices, which makes it difficult for the Indian

firms to compete in foreign markets. The sharp rise in oil prices in

recent years also gave a severe push to the cost of raw materials with

petrochemical base. Shortages of raw materials are a usual

phenomenon. With a view to insuring against these shortages,

manufacturers keep larger inventories, which result in increase in their

costs. This occurs especially in case of imported raw materials. Wages

are always being linked to cost of living. There are wage boards for

almost every industry and management has little control on wage

rates.

Overheads are also higher in India due to the following reasons:

The size of the plant is very often uneconomic due to the

Government's desire to prevent concentration of economic

power. However, there is now a marked change in the policy. In

1986, the Government announced that 65 industries would be

started with minimum economic capacity so as to 'make India's

products competitive. This process got a boost after the new

Industrial Policy was announced in July 1991.

There is under-utilisation of capacities due to lack of raw

materials and power shortage. However a manufacturer can

exceed his capacity by improving the techniques of production

process. Even after making improvements, a manufacturer lacks

the

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