Production Theory and Cost Estimation

Managers must understand the fundamental principles of production and cost to reduce costs successfully. Many
costly errors have been made by managers seeking to “reengineer” or “restructure” production. Most of these
errors could have been avoided had the managers possessed an understanding of the fundamentals of production
and cost that we will now set forth. Managers make production decisions in two different decision-making time
frames: short-run production decisions and long-run production decisions. In short-run decision-making
situations, a manager must produce with some inputs that are fixed in quantity. In a typical short-run situation, the
manager has a fixed amount of plant and equipment with which to produce the firm’s output. The manager can
change production levels by hiring more or less labor and purchasing more or less raw material, but the size of
the plant is viewed by the manager as essentially unchangeable or fixed for the purposes of making production
decisions in the short run.
Long-run decision making concerns the same types of decisions as the short run with one important distinction:
A manager can choose to operate in any size plant with any amount of capital equipment. Once a firm builds a
new plant or changes the size of an existing plant, the manager is once more in a short run decision-making
framework. Sometimes economists think of the short run as the time period during which production actually
takes place and the long run as the planning horizon during which future production will take place. As you will
see, the structure of costs differs in rather crucial ways depending on whether production is taking place in the
short run or whether the manager is planning for a particular level of production in the long run.

SOME GENERAL CONCEPTS IN PRODUCTION AND COST

Production is the creation of goods and services from inputs or resources, such as labor, machinery and other
capital equipment, land, raw materials, and so on. when a company such as Ford makes a truck or car or when
Exxon- Mobil refines a gallon of gasoline, the activity is production. But production goes much further than that.
A doctor produces medical services, a teacher produces education, and a singer produces entertainment. So
production involves services as well as making the goods people buy. Production is also undertaken by
governments and non profit organizations. A city police department produces protection, a public school produces
education, and a hospital produces health care.

Production Functions

A production function is a schedule (or table or mathematical equation) showing the maximum amount of output
that can be produced from any specified set of inputs, given the existing technology or state of knowledge
concerning available production methods. Many different inputs are used in production. So, in the most general
case, we can define maximum output Q to be a function of the level of usage of the various inputs X. That is,
Q = f (X1, X2, . . . , Xn)
However, in our discussion we will generally restrict attention to the simpler case of a product whose production
entails only one or two inputs. We will normally use capital and labor as the two inputs. Hence, the production
function we will usually be concerned with is
 Q = f (L, K)
where L and K represent, respectively, the amounts of labor and capital used in production. However, we must
stress that the principles to be developed apply to situations with more than two inputs and, as well, to inputs other
than capital and labor.

Technical and Economic Efficiency

Production engineers, who are responsible for designing and managing processes for transforming inputs into
goods or services, frequently speak of “efficiency”in a way that differs from managers, who are responsible for
maximizing the profit generated from producing goods or services. To understand the nature and importance of
this difference, we must distinguish between two types of efficiency: technical efficiency and economic efficiency.
Technical efficiency is achieved when a firm produces the maximum possible output for a given combination of
inputs and existing technology. Since production functions show the maximum output possible for any particular
combination of inputs, it follows that production functions are derived assuming inputs are going to be employed
in a technically efficient way. When a firm is technically efficient, every input is being utilized to the fullest extent
possible, and there is no other way to get more output without using more of at least one input. And thus, for a
technically efficient firm, reducing the usage of any input will necessarily cause output to fall.
Amergen Inc., a firm manufacturing electric generators, provides an excellent example of how engineers strive to
achieve technical efficiency in production. Amergen’s assembly-line process begins with workers manually
performing five steps before the generator reaches a computer-controlled drill press. Here, the computer-
controlled machine drills 36 holes in the generator, and, in doing so, two pounds of iron are removed. Using this
procedure, 10 assembly-line workers and one computer-controlled drill press were producing 140 generators each
day. Recently, however, a production engineer at Amergen discovered that moving the computer-controlled drill
press to the beginning of the assembly line, ahead of the five steps performed manually, would save a significant
amount of labor energy because each generator would weigh two pounds less as it moves downstream on the
assembly line. The production engineer was unable to find any other change that would further increase output.
Thus, Amergen’s production became technically efficient: 150 generators was the maximum number of generators
that could be produced using 10 laborers and one drill press.
Like the Amergen example above, engineers at most firms focus on ensuring that production takes place in a
technically efficient manner. Business managers, however, are not only interested in technical efficiency but also
plan to achieve economic efficiency in production. Economic efficiency is achieved when the firm produces its
chosen level of output at the lowest-possible total cost. The reason managers focus on economic efficiency is
simple: profit cannot be maximized unless the firm’s output is produced at the lowest-possible total cost.

The relationship between technical and economic efficiency.

When a firm is economically efficient it must also be technically efficient, because minimizing total cost cannot
happen if the amount of any input could be reduced without causing output to fall. However, it is possible to
produce in a technically efficient way without achieving economic efficiency. Typically there are numerous
technically efficient input combinations capable of producing any particular output level. While production
engineers might be satisfied using any one of the technically efficient combinations of inputs, managers want to
use only the combination with the lowest total cost—the economically efficient one. The input combination that
turns out to be economically efficient depends crucially on the prices of the inputs. For a different set of input
prices, a different technically efficient input combination will become the economically efficient one.

Inputs in Production

A variable input is one for which the level of usage may be readily varied in order to change the level of output.
Many types of labor services as well as raw materials and energy to run production facilities are variable inputs.
Payments for variable inputs are called variable costs. Producing more output is accomplished by using greater
amounts of the variable inputs, and output is reduced by using smaller amounts of the variable inputs. Thus,
variable costs are directly related to the level of output.
In contrast to variable inputs, the usage of some inputs remains constant or fixed as the level of output rises or
falls. There are two primary reasons why input usage may be fixed as output varies. First, when the cost of
adjusting the level of input usage is prohibitively high, a manager will treat the level of usage of that input as fixed
at its current level of usage. No matter how much output the firm produces—even when output is zero—the firm
uses a constant amount of the input and must pay for the input even if the firm ceases production. This kind of
input is called a fixed input, and payments for fixed inputs are called fixed costs.
The second reason for input fixity arises when, in order to produce any positive amount of output, a necessary
input must be purchased in some fixed size or lump amount. Because of the inherent lumpiness or indivisibility
of such inputs, producing the first unit of output requires the firm to pay for an entire “lump” of the indivisible
input. Further expansion of output can be accomplished without using any more of the lumpy input. This type of
fixed input is called a quasi-fixed input to distinguish it from an ordinary fixed input, and payments for quasi-
fixed inputs are called quasi-fixed costs. Although fixed and quasi-fixed inputs are both used in constant amounts
as output varies, fixed inputs must be paid even if output is zero while quasi-fixed inputs need not be purchased
if output is zero.

Short-Run and Long-Run Production Periods

Short run
Current time span during which at least one input is a fixed input.

Long run
Time period far enough in the future to allow all fixed inputs to become variable inputs. Using the simplified
production function discussed previously for a firm using only two inputs, labor (L) and capital (K), we can
view the production function Q = f (L, K) as the long-run production function, because output in the long run
varies by changing the amounts of the variable inputs L and K. Once a firm chooses to purchase and install a
particular amount of capital, K the firm then begins operating in a short-run situation with the chosen fixed
amount of capital. The short-run production function can be expressed as
Q = f (L,K ), where capital is fixed at the current level. In the short run, with capital fixed at its current level,
output varies only as the level of labor usage varies, and we can express the short-run production function more
simply as Q = f (L), where we have dropped the term K because capital usage cannot vary. The firm will continue
to operate with this particular short-run production function until a time in the future is reached when it is possible
to choose a different amount of capital. The length of time it takes to make a change in K (i.e., the length of the
short-run period) varies widely across firms and industries. Consequently, we cannot give you a particular amount
of time for the short-run production period. The short-run period lasts as long as it takes for the firm to be able to
change the current levels of usage of its fixed inputs.

PRODUCTION IN THE SHORT RUN

We begin the analysis of production in the short run with the simplest kind of short-run situation: only one variable
input and one fixed input
Q = f (L,K

The firm has chosen the level of capital (made its investment decision), so capital is fixed in amount. Once the
level of capital is fixed, the only way the firm can change its output is by changing the amount of labor it employs.
Total Product, Average Product and Marginal Product calculations are done in the class, please refer that.
Law of Diminishing Marginal Product

As the number of units of the variable input increases, other inputs held constant, there exists a point beyond
which the marginal product of the variable input declines. When the amount of the variable input is small relative
to the fixed inputs, more intensive utilization of fixed inputs by variable inputs may initially increase the marginal
product of the variable input as this input is increased. Nonetheless, a point is reached beyond which an increase
in the use of the variable input yields progressively less additional output. Each additional unit has, on average,
fewer units of the fixed inputs with which to work. The law of diminishing marginal product is a simple statement
concerning the relation between marginal product and the rate of production that comes from observing real-world
production processes.
The diagram and the stages are discussed in the class in detail please refer that.
Production in the Long Run

An important tool of analysis when two inputs are variable is the production isoquant or simply isoquant. An
isoquant is a curve showing all possible combinations of the inputs physically capable of producing a given
(fixed) level of output. Each point on an isoquant is technically efficient; that is, for each combination on the
isoquant, the maximum possible output is that associated with the given isoquant. The concept of an isoquant
implies that it is possible to substitute some amount of one input for some of the other, say, labor for capital,
while keeping output constant.
Diagram of the isoquant and its explanation is done clearly in the class pls refer that .
Cost

A sunk cost in production is a payment for an input that, once made, cannot be recovered should the firm no
longer wish to employ that input. To keep matters clear, you should think of the firm’s production occurring over
a series of time periods: days, weeks, months, quarters, or years, for example. An input payment made in any
particular time period is a sunk cost if that input payment cannot be recovered if it turns out in later time periods
the firm no longer needs that input. For this reason, fixed costs are sunk costs of production. After a business
makes a sunk payment for an input, the cost of using the input thereafter is zero, because the input cannot be
returned for a refund nor can it be sold, rented, or leased to some other business to recover the sunk cost. Under
some circumstances, a portion of the payment can be recovered, either as a refund or by renting or subleasing the
input to another firm. In that case, only the non-recoverable portion of the input payment
is a sunk cost.

An avoidable cost in production is an input payment that a firm can recover or avoid paying should the
manager no longer wish to use that input. Avoidable costs do matter in decision making and should not be
ignored.

Implicit cost

The opportunity cost of using an owner-supplied resource is the best return the owners of the firm could have
received had they taken their own resource to market instead of using it themselves. These nonmonetary
opportunity costs of using a firm’s own resources are called implicit costs because the firm makes no monetary
payment to use its own resources

Explicit cost

The opportunity costs of using market-supplied resources are the out-of-pocket monetary payments made to the
owners of resources. The monetary payments made for market-supplied inputs are also known as explicit costs.
Calculation of Total cost, Total Variable cost, Total fixed cost and Marginal Cost is done in the class pls refer
that.