NORTH SOUTH UNIVERSITY

BUS525 | SECTION: 6

Report on: “Cost of Production”

Submission Date: 30th April, 2019

Submitted To-

Dr. K. M. Zahidul Islam

Prepared By-

Name ID
Tasnia Masud 1825246060

Tanzina Amin 1825220060

Shiria Akter 1815062660

Molla Tashrif Hossain 1725040060

Umme Sadia Alam 1825072660

Table of Contents
Introduction .................................................................................................................................... 4
Cost Function: ................................................................................................................................. 5
Economic Costs Vs Accounting Costs .............................................................................................. 6
Other Different Types of Cost ................................................................................................................... 6
Other formulas important for Cost of Production calculations are:......................................................... 7

The structure of costs in the short run ........................................................................................... 8

Graphical Representations of Production and Cost Relationships: .......................................................... 8
AVC, ATC, AFC & MC Function in the short run: ..................................................................................... 10
Relationship of MC and AVC in the short run ......................................................................................... 11

Long Run Production Function......................................................... Error! Bookmark not defined.

Long Run Cost: ........................................................................................... Error! Bookmark not defined.
Long Run Marginal Cost ............................................................................. Error! Bookmark not defined.
Long Run Cost: ........................................................................................... Error! Bookmark not defined.

Returns to Scale: ........................................................................................................................... 17

Learning Curve: ............................................................................................................................. 18
Learning Curve Concept .......................................................................................................................... 18
Learning Curve Example.......................................................................................................................... 19
Learning Curve Long run Average Cost ................................................................................................... 20
Long-Run Average Cost Curve Effects of Learning .................................................................................. 20
Learning Curve on an Arithmetic Scale ................................................................................................... 22
Strategic Implications of the Learning Curve Concept............................................................................ 22

Conclusion ..................................................................................................................................... 24
Letter of Transmittal

30th April, 2019

Professor Dr. K.M. Zahidul Islam

School of Business

North South University

Subject: Cost of Production in Microeconomics

Dear Sir,

With due respect, we would like to submit the Project titled “Cost of Production”, prepared as a
partial requirement of Masters of Business Administration degree of North South University.

The purpose of this case was to discuss and evaluate the objectives. Thank you for giving us the
stupendous opportunity to work on this project. It has been a learning experience that we have
all enjoyed thoroughly. Although utmost care has been taken to make this project as lucid as
possible we hope that this project has been comprehensive enough to achieve the aims and
objectives.

In presenting this project, we have tried our level best effort to include all the relevant
information and the explanation to make this project informative, vivid, and comprehensive.

Lastly, we sincerely wish that the project fulfils the relevant requirement and gets your
acceptance.

Sincerely Yours,

Tanzina Amin
Tasnia Masud
Molla Tashfir Hossain
Shiria Akter
Umme Sadia Alam
 Acknowledgement

We have prepared our group project on: “Cost of Production”. It was really a nice experience for us to do
the project on above topic. While preparing the project various types of things like-assignment points,
class lecture notes helped us lot. In this regard, we would like to give our special thanks to our course
instructor, Professor Dr. K.M. Zahidul Islam, School of Business, North South University. Finally, our
gratitude along with thanks goes to The Almighty for keeping everything on right track.

We want to talk about our limitations that we had to accept during the completion of this project.
However, we believe that we have tried our best to make this project more reliable and acceptable.
 Introduction
Cost of Production is the cost related to making or acquiring goods and services that directly
generates revenue for a firm. It comprises of direct costs and indirect costs. Direct costs are those
that are traceable to the creation of a product and include costs for materials and labor whereas
indirect costs refer to those costs that cannot be traced to the product such as overhead.

A cost of production report details the total cost, including raw materials and operating costs, of
producing a product. Manufacturers who tend to make profits must be apprehensive about both
the revenue (the demand side of the economic problem) and the costs of production. Profits (Π)
are defined as the difference between the total revenue (TR) and the total cost (TC). Thus, cost
is a major concern for earning profit.

(Profit = Total Revenue – Total Cost)

Cost of production has a distinctive meaning in Economics. It is all of the outflows or expenses
required to obtain the factors of production of land, labor, capital and management required to
produce a product. It represents money costs which we want to incur in order to acquire the
factors of production. Cost, in common usage, is the monetary value of goods and services that
producers and consumers purchase.
More conventionally, cost has to do with the relationship between the value of production inputs
and the level of output. Total cost refers to the total expense incurred in reaching a particular
level of output; if such total cost is divided by the quantity produced, average or unit cost is
obtained. A portion of the total cost known as fixed cost—e.g., the costs of a building lease or of
heavy machinery—does not vary with the quantity produced and, in the short run, does not alter
with changes in the amount produced. Variable costs, like the costs of labor or raw materials,
change with the level of output.

An aspect of cost important in economic analysis is marginal cost, or the addition to the total cost
resulting from the production of an additional unit of output. A firm desiring to maximize its
profits will, in theory, determine its level of output by continuing production until the cost of the
last additional unit produced (marginal cost) just equals the addition to revenue (marginal
revenue) obtained from it.

XsCost Function:

Let w be the cost per unit of labor and r be the cost per unit of capital. With the input Labor (L)
and Capital (K), the production cost is:

Production Cost: w × L + r × K
( Cost per unit labor . Input labor + Cost per unit capital . Input capital)

A cost function C(q) is a function of q, which tells us what the minimum cost is for producing q
units of output. We can also split total cost into fixed cost and variable cost as follows:

C(q) = FC + V C(q).

Fixed cost is independent of quantity, while variable cost is dependent on quantity.

Economic Costs Vs Accounting Costs

Economists measure a firm’s economic profit as total revenue minus total cost, including both
explicit and implicit costs. Accountants measure the accounting profit as the firm’s total revenue
minus only the firm’s explicit costs. When total revenue exceeds both explicit and implicit costs,
the firm earns economic profit. Economic profit is smaller than accounting profit.

Other Different Types of Cost

- Sunk Cost: Expenditure that has been made and cannot be recovered.
Such as R&D costs. Because a sunk cost cannot be recovered, it should not influence the
firm’s decisions.

- Opportunity Cost: A firm’s cost of production includes all the opportunity costs of making
its output of goods and services.
 - Explicit and Implicit Costs: A firm’s cost of production includes explicit costs and implicit
costs. Explicit costs are input costs that require a direct outlay of money by the firm.
Implicit costs are input costs that do not require an outlay of money by the firm.

- Fixed Cost: A cost that is actually incurred, but independent of the level of output

- Variable Cost: A cost that is actually incurred, and dependent of the level of output

- Total Cost: Variable Cost + Fixed Cost

- Marginal Cost: Change in TC resulting from producing one more additional unit of
output. MC reflects change in VC. Remember that fixed cost do not change and
therefore do not influence MC. In Principles of Economics texts and courses MC is
usually described as the change in TC associated with a one unit change in output
MC = ∆TC/∆Q

Other formulas important for Cost of Production calculations are:

■ Avg. Total Cost: TC/Q

■ Total Fixed Cost: Total of all costs, does not change even if output zero

■ Avg. Fixed Cost: TFC/Q

■ Total Variable Cost: Total of all costs that vary with output in short run

■ Avg. Variable Cost: TVC/Q

■ Total Revenue: P×Q

■ Marginal Revenue: P = MR (in perfect competition)

 The structure of costs in the short run
Looked at from a short-run perspective, a firm’s total costs can be divided into fixed costs, which a
firm must incur before producing any output, and variable costs, which the firm incurs in the act of
producing. Fixed costs are sunk costs—because they are in the past and cannot be altered, they
should play no role in economic decisions about future production or pricing. Variable costs typically
show diminishing marginal returns, so the marginal cost of producing higher levels of output rises.
Total cost is the sum of fixed and variable costs of production.

Graphical Representations of Production and Cost Relationships:

The short-run, total product function and the price of the variable input(s) determine

The variable cost (VC or TVC) function

In the Figure abive, the production relationship is shown with respect to the variable cost. In the
Y-axis, the TP function is shown.

Q = f(L)

(Given fixed input and technology) TP initially increases at an increasing rate to point A where LA
amount of variable input is used. There is an inflection point at point A, TP then increases at a
decreasing rate to a maximum at point B produced by LB amount of input. Beyond LB amount of
input the TP declines.
Using LA amount of labor, QA amount of output is produced. At input level LB, QB output results.

In the above Figure, the short-run TP function and VC function are shown.

Here, VC is expressed as a function of Q

VC = f(Q)

(Given fixed input and technology) The Y- axis, (TP or Q) in the first figure becomes the X- axis (Q)
in the lower panel.

The X - axis (L) in the first diagram is multiplied by PL and becomes the Y- axis in the lower panel.

So we have proved that:

 When the TP increases at an increasing rate, the VC increases at a decreasing rate.

 When the TP increases at a decreasing rate, VC will increase at an increasing rate.
 When the TP decreases at the quantity of input increases, the VC would increase.
AVC, ATC, AFC & MC Function in the short run:

The fixed cost is determined by the amount of the fixed input and its price. In the short-run, the
fixed cost does not change. As the output (Q) increases, the average fixed cost (AFC) will decline
since it is divided by Q. So as long as Q increases, AFC will decrease and approach the Q axis
"asymptotically."

𝐹𝐼𝑋𝐸𝐷 𝐶𝑂𝑆𝑇
𝐴𝐹𝐶 =
𝑄

The average total cost (ATC) is the total cost per unit of output.

𝑇𝐶
𝐴𝑇𝐶 = = 𝐴𝐹𝐶 + 𝐴𝑉𝐶
𝑄

In the Figure abive, the AFC is shown declining over the range of output. The vertical distance
between the ATC and AVC is the same as AFC. The location or shape of the AVC is not related to
the AFC.

The marginal cost is not related to the AFC but will intersect both the AVC and ATC at their
minimum points.
Relationship of MC and AVC in the short run

MC will be at a minimum at the output level (QA). AVC will be a minimum at QH output. This is
where MC=AVC.

This is at output level QH produced by LH labor.

When MC<AVC, AVC will be decreasing.

When MC>AVC, AVC will increase.

When AVC=MC, AVC is a minimum.

Long Run Production Function
The long run production function is multidimensional, two or more inputs and output changes. It
describes a period in which all inputs (and Q) are variable while technology is constant.
Production in the short run in which the functional relationship between input and output is
explained assuming labor to be the only variable input, keeping capital constant.

In the long run production function, the relationship between input and output is explained
under the condition when both, labor and capital, are variable inputs.

In the long run, the supply of both the inputs, labor and capital, is assumed to be elastic (changes
frequently). Therefore, organizations can hire larger quantities of both the inputs. If larger
quantities of both the inputs are employed, the level of production increases.

Here, two isocost functions are also shown in below Figure.These are TC1 and TC2. “Isocost”
means equal cost. All output combinations that lie on TC1 require the same expenditure. All
output combinations that cost less than TC1 lie inside the isocost. Output combinations that cost
more than TC1 lie outside the isocost. TC2 represents a greater cost than TC1. The isocost
function can be located by finding the intercepts on the K-axis (capital axis) and L-axis (labor axis).
The L-intercept is found by dividing the total cost (TC1 by the price of labor. If TC1 were $200 and
the price of labour were $5 the L-intercept (L*) would be 40 units of labour, i.e. 40 units of labour
at $5 each will cost $200. If the price of capital were $4, the K-intercept for TC1 is K* (200/4 =
50). A straight line between these two intercepts identifies all combinations of labour and capital
that cost $200.
Q1 output could be produced by using KA capital and LJ labour (point J on Q1). Point H (LA labour
and KH capital will also result in Q1 output.

Notice that both points J and H lie outside the isocost TC 1. Since point B lies on TC1, that input
combination cost less than those at point J and H. If Q1 output is desired, TC1 is the lowest cost
of production that can be attained. This is accomplished by using LB labour and KB capital. The
lowest cost of producing Q2 given the price of labour and capital is at point A.

The slope of the isoquant represents the rate at which one input can be substituted for another
and still produce the same output. The slope of the isocost represents relative price so of the
inputs. The lowest cost combination of inputs is at the point of tangency between the isocost and
the isoquant. When the isocost function is tangent to an isoquant, it identifies the combination
of inputs that minimizes the cost per unit for that level of output.

Long Run Cost:

Long run costs are accumulated when firms change production levels over time in response to
expected economic profits or losses. In the long run there are no fixed factors of production. The
land, labor, capital goods, and entrepreneurship all vary to reach the the long run cost of
producing a good or service.

The long run is associated with the long-run average cost (LRAC) curve in microeconomic models
along which a firm would minimize its average cost (cost per unit) for each respective long-run
quantity of output. Long-run marginal cost (LRMC) is the added cost of providing an additional
unit of service or commodity from changing capacity level to reach the lowest cost associated
with that extra output. LRMC equaling price is efficient as to resource allocation in the long run.
The concept of long-run cost is also used in determining whether the firm will remain in the
industry or shut down production there. In long-run equilibrium of an industry in which perfect
competition prevails, the LRMC = LRAC at the minimum LRAC and associated output. The shape
of the long-run marginal and average costs curves is influenced by the type of returns to scale.
Long-run total cost (LTC):

LTC = wL* + rK*

Long-run average cost (LAC):

LTC
LAC 
Q

The long run is a planning and implementation stage. Here a firm may decide that it needs to
produce on a larger scale by building a new plant or adding a production line. The firm may decide
that new technology should be incorporated into its production process. The firm thus considers
all its long-run production options and selects the optimal combination of inputs and technology
for its long-run purposes. The optimal combination of inputs is the least-cost combination of
inputs for desired level of output when all inputs are variable. Once the decisions are made and
implemented and production begins, the firm is operating in the short run with fixed and variable
inputs.
Note in the figure, that each SAC curve corresponds to a particular plant size. This size is fixed but
what can vary is the variable input in the short-run. In the long run, the firm will select that plant
size which can minimize costs for a given level of output.

You can see that till the OM1 level of output it is logical for the firm to operate at the plat size
represented by SAC2. If the firm operates at the cost represented by SAC2 when producing an
output level OM2, the cost would be more.

So in the long run, the firm will produce till OM1 on SAC2. However, till an output level
represented by OM3, the firm can produce at SAC2, after which it is profitable to produce at SAC3
if the firm wishes to minimize costs.

Thus, the choice, in the long run, is to produce at that plant size that can minimize costs.
Graphically, this gives us a LAC curve that joins the minimum points of all possible SAC curves, as
shown in the figure. Thus, the LAC curve is also called an envelope curve or planning curve. The
curve first falls, reaches a minimum and then rises, giving it a U-shape.

We can use returns to scale to explain the shape of the LAC curve. Returns to scale depict the
change in output with respect to a change in inputs. During Increasing Returns to Scale (IRS), the
output doubles by using less than double inputs. As a result, LTC increases less than the rise in
output and LAC will fall.

In Constant Returns to Scale (CRS), the output doubles by doubling the inputs and the LTC
increases proportionately with the rise in output. Thus, LAC remains constant.
In Decreasing Returns to Scale (DRS), the output doubles by using more than double the inputs
so the LTC increases more than proportionately to the rise in output. Thus, LAC also rises. This
gives LAC its U-shape.

Long Run Marginal Cost

Long run marginal cost is defined at the additional cost of producing an extra unit of the output
in the long-run i.e. when all inputs are variable. The LMC curve is derived by the points of
tangency between LAC and SAC.

Note an important relation between LMC and SAC here. When LMC lies below LAC, LAC is falling,
while when LMC is above LAC, LAC is rising. At the point where LMC = LAC, LAC is constant and
minimum.

The LAC curve suggests the long run optimization problem of the firm. The firm can choose a
plant size to operate at in the long-run where all inputs are variable. Thus, the firm shall choose
that plant at which it can minimize costs.

MRTS:

The marginal rate of technical substitution (MRTS) is an economic theory that illustrates the rate
at which one factor must decrease so that the same level of productivity can be maintained when
another factor is increased.

The MRTS reflects the give-and-take between factors, such as capital and labor, that allow a firm
to maintain a constant output. MRTS differs from the marginal rate of substitution (MRS) because
MRTS is focused on producer equilibrium and MRS is focused on consumer equilibrium.
Returns to Scale:
The terms “economies of scale,” Refers “increasing returns to scale,” “constant returns to scale,”
“decreasing returns to scale” and “diseconomies of scale”. These terms involve subtle and
complicated concepts that apply to the long run production process. In principles of economics
they are simplified. Conceptually, returns to scale implies that all inputs are variable. Given a
Cobb-Douglas production function of the form Q = A Lα Kβ. Q is output or quantity, L is quantity
of labour and K is the quantity of capital. A, α and β are parameters that are determined by the
technology of producing a specific product.

When C+L = 1, the production process demonstrates “constant returns to scale.”

If L and K both increased by 20%, output (Q) would also increase by 20%. Here Long Market will
be constant and the function of the slope will be 0 (Zero).

When C+L > 1, production has increasing returns.

A 10% increase in both L and K results in a larger percentage (say 20%) increase in output (Q).
This is consistent with the declining portion of the long run average cost function (LRAC). This
tends to be the result of specialization and division of labour. It is sometimes referred to as
economies of scale or economies of mass production. There may be a variety of forces that cause
the LRAC to decline. Not all these forces are actually economies of scale. A larger firm (or
monopolist) may be able to negotiate lower prices for inputs. This is not economies of scale; it is
a transfer of income or wealth from one group to another.

When C+L < 1, decreasing returns are said to exist.

As both inputs increase 20%, output (Q) will increase by a smaller percentage (say 6%). This
condition is consistent with the rising portion of the long run average cost function (LRAC). As a
firm gets larger it may lack the information about various aspects of the production process and
be unable to coordinate all the processes. That’s why a planned economy does not always
produce optimal results.

Learning Curve:
For many manufacturing processes, average costs decline substantially as cumulative total
output increases. Improvements in the use of production equipment and procedures are
important in this process, as are reduced waste from defects and decreased labor requirements
as workers become more proficient in their jobs.

Learning Curve Concept

When knowledge gained from manufacturing experience is used to improve production
methods, the resulting decline in average costs is said to reflect the effects of the firm’s learning
curve.
The learning curve or experience curve phenomenon affects average costs in a way similar to
that for any technical advance that improves productive efficiency. Both involve a downward
shift in the long-run average cost curve at all levels of output. Learning through production
experience permits the firm to produce output more efficiently at each and every output level.

To illustrate, consider Figure, which shows hypothetical long-run average cost curves for
periods t and t + 1. With increased knowledge about production methods gained through the
experience of producing Qt units in period t, long-run average costs have declined for every
output level in period t + 1, which means that Qtunits could be produced during period t + 1 at
an average cost of B rather than the earlier cost of C. The learning curve cost savings is BC. If
output were expanded from Qt to Qt+1 between these periods, average costs would fall
from C to A. This decline in average costs reflects both the learning curve effect, BC, and the
effect of economies of scale, AB.
To isolate the effect of learning or experience on average cost, it is necessary to identify carefully
that portion of average-cost changes over time that is due to other factors. One of the most
important of these changes is the effect of economies of scale. As seen before, the change in
average costs experienced between periods t and t + 1 can reflect the effects of both learning
and economies of scale. Similarly, the effects of important technical breakthroughs, causing a
downward shift in LRAC curves, and input-cost inflation, causing an upward shift in LRAC curves,
must be constrained to examine learning curve characteristics. Only when output scale,
technology, and input prices are all held constant can the learning curve relation be accurately
represented.
Figure depicts the learning curve relation suggested by Figure. Note that learning results in
dramatic average cost reductions at low total production levels, but it generates increasingly
modest savings at higher cumulative production levels. This reflects the fact that many
improvements in production methods become quickly obvious and are readily adopted. Later
gains often come more slowly and are less substantial.

Learning Curve Example

The learning curve phenomenon is often characterized as a constant percentage decline in
average costs as cumulative output increases. This percentage represents the proportion by
which unit costs decline as the cumulative quantity of total output doubles. Suppose, for
example, that average costs per unit for a new product were $100 during 2001 but fell to $90
during 2002.

Learning Curve Long run Average Cost

Long-Run Average Cost Curve Effects of Learning

Furthermore, assume that average costs are in constant dollars, reflecting an accurate
adjustment for input/price inflation and an identical basic technology being used in production.
Given equal output in each period to ensure that the effects of economies of scale are not
incorporated in the data, the learning or experience rate, defined as the percentage by which
average cost falls as output doubles, is the following:
Thus, as cumulative total output doubles, average cost is expected to fall by 10 percent. If annual
production is projected to remain constant, it will take 2 additional years for cumulative output
to double again. One would project that average unit costs will decline to $81 (90 percent of $90)
in 2004. Because cumulative total output at that time will equal 4 years’ production, at a constant
annual rate, output will again double by 2008. At that time, the learning curve will have reduced
average costs to $72.90 (90 percent of $81).
Because the learning curve concept is often improperly described as a cause of economies of
scale, it is worth repeating that the two are distinct concepts. Scale economies relate to cost
differences associated with different output levels along a single LRAC curve. Learning curves
relate cost differences to total cumulative output. They are measured by shifts in LRAC curves
over time. These shifts result from improved production efficiencies stemming from knowledge
gained through production experience. Care must be exercised to separate learning and scale
effects in cost analysis.
Research in a number of industries, ranging from aircraft manufacturing to semiconductor
memory-chip production, has shown that learning or experience can be very important in some
production systems. Learning or experience rates of 20 percent to 30 percent are sometimes
reported. These high learning rates imply rapidly declining manufacturing costs as cumulative
total output increases. It should be noted, however, that many learning curve studies fail to
account adequately for the expansion of production. Therefore, reported learning or experience
rates sometimes include the effects of both learning and economies of scale. Nevertheless,
managers in a wide variety of industries have found that the learning curve concept has
considerable strategic implications.
Learning Curve on an Arithmetic Scale

Strategic Implications of the Learning Curve Concept

What makes the learning curve phenomenon important for competitive strategy is its possible
contribution to achieving and maintaining a dominant position in a given market. By virtue of
their large relative volume, dominant firms have greater opportunity for learning than do smaller,
non-leading firms. In some instances, the market share leader is able to drive down its average
cost curve faster than its competitors, underprice them, and permanently maintain a leadership
position. Non leading firms face an important and perhaps insurmountable barrier to relative
improvement in performance. Where the learning curve advantages of leading firms are
important, it may be prudent to relinquish non leading positions and redeploy assets to markets
in which a dominant position can be achieved or maintained.

A classic example illustrating the successful use of the learning curve concept is Dallas– based
Texas Instruments (TI). TI’s main business is producing semiconductor chips, which are key
components used to store information in computers and a wide array of electronic products.
With growing applications for computers and “intelligent” electronics, the demand for
semiconductors is expanding rapidly. Some years ago, TI was one of a number of leading
semiconductor manufacturers. At this early stage in the development of the industry, TI made
the decision to price its semiconductors well below then-current production costs, given
expected learning curve advantages in the 20 percent range. TI’s learning curve strategy proved
spectacularly successful.

With low prices, volume increased dramatically. Because TI was making so many chips, average
costs were even lower than anticipated; it could price below the competition; and dozens of
competitors were knocked out of the world market. Given a relative cost advantage and strict
quality controls, TI rapidly achieved a position of dominant leadership in a market that became a
source of large and rapidly growing profits.

To play an important role in competitive strategy, learning must be significant. Cost savings of 20
percent to 30 percent as cumulative output doubles must be possible. If only modest effects of
learning are present, product quality or customer service often plays a greater role in determining
firm success. Learning is also apt to be more important in industries with an abundance of new
products or new production techniques rather than in mature industries with well-known
production methods. Similarly, learning tends to be important in industries with standardized
products and competition based on price rather than product variety or service.

Finally, the beneficial effects of learning are realized only when management systems tightly
control costs and monitor potential sources of increased efficiency. Continuous feedback of
information between production and management personnel is essential.
 CONCLUSION
As the report has elaborately covered, production costs refer to the costs incurred by a
business from manufacturing a product or providing a service. Production costs can include a
variety of expenses, such as labor, raw materials, consumable manufacturing supplies, and
general overhead.

The costs related to making or acquiring goods and services that directly generates revenue for
a firm. It comprises of direct costs and indirect costs. Direct costs are those that are traceable to
the creation of a product and include costs for materials and labor whereas indirect costs refer
to those costs that cannot be traced to the product such as overhead.