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

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 actually incurred 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

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

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 Costs Fixed 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 total output. 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 Q = average cost

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

AC=

aTC aQ

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

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 bythe 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.

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 the firm 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

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) 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 cost behaviour 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) (1)

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

AC =

Q TFC Q TVC Q

AFC =

AVC = 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 Q

aTC or 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 (where a = TFC and b, c and d are variable-cost parameters) And also the cost function is empirically estimated as TC = 10 + 6Q - 0.9Q2 + 0.05Q3 and TVC = 6Q - 0.9Q2 + 0.05Q3 (6) (7) (5)

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

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 (I) 0 I 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 FC (2) 10 10 10 10 10 10 10 10 10 10 10 10 10 10 10 10 10 TVC (3) 0.0 5.15 8.80 11.25 12.80 13.75 14.40 15.05 16.00 17.55 20.00 23.65 28,80 35.75 44.80 56.25 70.40 TC (4) 10.00 15.15 18.80 21.25 22.80 23.75 24.40 25.05 26.00 27.55 30.00 33.65 38.80 45.75 54.80 66.25 80.40 AFC (5) 10.00 5:00 3.33 2.50 2.00 1.67 1.43 1.25 1.11 1.00 0.90 0.83 0.77 0.71 0.67 0.62 AVC AC MC (6) (7) (8) 5.15 15.15 5.15 4.40 9.40 3.65 3.75 7.08 2.45 3.20 5.70 1.55 2.75 4.75 0.95 2.40 4.07 0.65 2.15 3.58 0.65 2.00 3.25 0.95 1.95 3.06 1.55 2.00 3.00 2.45 2.15 3.05 3.65 2.40 3.23 5.15 2.75 3.52 6.95 3.20 3.91 9.05 3.75 4.42 11.45 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 TFC Q (8)

AFC =

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

AFC =

10 Q

(9)

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 = TVC Q

Given the TVC function in equation 7, we may express AVC as follows: AVC = 6Q-0.9Q2+0.05Q3 = 6- 0.9Q+0.05Q3 Q (10)

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.

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 aQ = 0.9+0.10Q=0 (11) Q= 9

Thus, the critical value of Q=9. This can be verified from Table 3.1 Average Cost (AC) The average cost in defined as AC = TC Q

Substituting equation (6) for TC in above equation, we get 10+6Q-09Q2+0.05Q3 AC = Q (12a)

10 = Q + 6-0.9Q+0.05Q2

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

AC is given by aAC aQ = 10 Q2 - 0.9 + 0.1Q = 0 (12b) This equation takes the form of a quadratic equation as -10 0.9Q2 + 0.1Q3 = 0 or, Q3 9Q2 = 100 = 0 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. By solving equation (12b), we get

Marginal Cost (MC) The concept of marginal cost (MC) is particularly useful in economic analysis. MC is technically the first derivative of TC function. That is, aTC aQ

MC =

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

aTC aQ

= 6-1.8Q+0.15Q2

(13)

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 Then, (Q2 + Q + 10) = 0 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

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

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.

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 between the 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 shortrun 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 shortrun situation. Suppose that a firm having only one-plant has its shortmn total cost curve as given-by STCl 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 STC l in the manner shown by STC 2 and STC3 in Figure 3.3 (a):. The LTC can now be drawn through the minimum points 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 longrun average cost curve (LAC). Note that there is one SAC associated with each STC. Given the STC 1 STC2, and STC3 curves in panel (a) of Figure 3.3, there are three corresponding SAC curves as given by SAC 1

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 C 2Q2 when the second plant is added and then rises to C 3Q3after 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

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 SAC 3 and the LAC, i.e., points A, Band C. In the long-run production planning, these points determine the output levels at the different levels of production. For example, if we draw perpendiculars from points A, Band C to the Xaxis, the corresponding output levels will be OQ 1 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 OQ 3. 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.

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).

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 byproducts, 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

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

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:

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 not cost 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

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 100tonne 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 per day) '. 100 200 250

Fixed investment cost per tonne 4,473 4,070 3,945

Cost of raw Operating ma terials per cost per tonne tonne of paper of paper 324 1,307 263 1,116 258 1,056

Another study of cement industry by the Economic and Scientific Research undation-shows that the per unit of capacity capital

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 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 al 3 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
2

so, the

M0

6a0/2

a0

The corresponding ratio of the volumes will be: V1 V0 a1/3 a0/3 a1/3 a0

From the above, it follows that: M1 M0 a1/2 a0/2 a1/3.2/3 a0 = V 1 2/3 V0

Now, if we double the volume, i.e., if V1 V1 = Then, M1 V1 2/3 = M0 V0 M1 = 1.59 M0 = (20) 2/3 = 1.59 2V0 or V0 =2

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 M0 = V12/3 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

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 most efficient 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

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 parts is 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 the businessman 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

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

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

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 principle here 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 between controllable 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

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. 1,35,000 Other variable costs 17500 20.000 22,500 Semi-variable costs 9,250 10,000 10,250 Fixed costs 50,000 50,000 50,000 Total 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 wageincentive 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.

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.

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 examples of 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

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

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 Hind Cycles. 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 in 1977. 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

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 investment in 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 is because 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

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, underutilisation 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 cooperated with the management. Attempts must be made to secure cooperation of employees in cost reduction by inviting suggestions from them. 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

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 get out 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

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 and how 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.

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

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 way to completely minimise the possibilities of increase in the overheads. Machinery and equipment obtained under tied credits usually cost 30 to 40 per cent more than what it wouid cost if purchased in the open market. There are delays in the issue of licences and by the time licences are issued, cost of equipment goes up. The number of industries subject to licensing has now been drastically reduced. Increase in administered prices for many items crucial to the industrial production by the Government from time to time also pushes up costs. Finally, there is what lis called by businessmen as 'unseen

overheads' in the nature of demands for illegitl gratification by various Government officials at different administrative levels. There are indirect taxes, which also tend to raise the overall costs of production in India. Excise duties and saies taxes also heighten the impact of indirect taxes on the cost of production. India is perhaps the only country where basic raw materials carry heavy excise duties. According to an estimate by Mr. S. Moolgaokar, Chairman, TELCO, as much as Rs. 25 crores of working capital is locked up in inventories and work-in-progress with TELCO and its suppliers solely due to the present tax structure. Until recent times the Indian industrialists operated in a sheltered domestic market. They were protected against foreign competition by import controls and against domestic competition due to industrial licensing. So long as this sellers' market prevailed competition among sellers was absent and there was no compelling reason for the industrialists to pay any attention to cost reduction. Cost consciousness was thus by and large absent in India. The price fixation for products under price control ensured that the rise in costs was fully reflected in the prices. This made it possible for the industrialists to pass on any increase in costs to the consumers. However, now with the advent of recession tendencies, and liberalisation in licensing policies, the Indian industrialist is compelled to pay greater attention to cost reduction and cost control.

A firm has fixed costs of $60 and variable costs as indicated in the table below. Complete the table. Total fixed cost $_____ _____ _____ _____ _____ Total variable cost $ 0 45 85 120 150 Average Average Average fixed variable total Margina l cost cost cost cost $_____ _____ _____ _____ _____ $_____ _____ _____ _____ _____ $_____ _____ _____ _____ _____ _____ _____ _____ _____ _____

Total product 0 1 2 3 4

Total cost $_____ _____ _____ _____ _____

5 6 7 8 9 10

_____ _____ _____ _____ _____ _____

185 225 270 325 390 465

_____ _____ _____ _____ _____ _____

_____ _____ _____ _____ _____ _____

_____ _____ _____ _____ _____ _____

_____ _____ _____ _____ _____ _____

_____ _____ _____ _____ _____

Fill in the blanks in the following table and use it to answer the next five questions. Total Output Cost 100 560 200 300 400 Total Fixed Cost Total Average Average Variable Fixed Variable Cost Cost Cost 60 4.00 7.00 Average Total Marg. Cost Cost 4.00

1. What is the average fixed cost when 300 units of output are produced? a. $.60 b. $3.00 c. $160 d. $500 e. none of the above 2. What is total fixed cost when 400 units of output are produced? a. $500 b. $2000 c. $25000 d. $5000 e. none of the above 3. What is average total cost when 200 units of output are produced? a. $2.30 b. $2.50 c. $4.00 d. $4.80 above 4. What is the marginal cost of the 300th unit of output? a. $.14 b. $2.40 c. $4.00 d. $7.40 above 5. What is the average variable cost at 200 units of output? a. $4.00 b. $2.30 c. $1.80 d. $1.50 e. none of the

e. none of the

e. $4.60