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Costs of production©
Unit 03
1RASHAIN PERERA CIMA Adv. Dip. MA, UOR (Mgt)
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Prepared by; RASHAIN PERERA077 059 37 [email protected]
RASHAIN PERERA CIMA Adv. Dip. MA, UOR (Mgt)
2
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INTRODUCTION Section 01
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Business objectives Profit maximization is the fundamental
objective of a business Profit is the excess of income over
expenses Income is mainly through selling goods
and services There are various components of costs
such as variable costs, fixed costs and overhead costs.
4RASHAIN PERERA CIMA Adv. Dip. MA, UOR (Mgt)
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Other business objectives Maximizing earning per share Satisfying customers Quality products Continuous improvement Satisfactory service Business social responsibility (CSR) Growth and development Research and development AND other financial and non financial
objectives5RASHAIN PERERA CIMA Adv. Dip. MA,
UOR (Mgt)
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The production process Conversion of raw materials to finished
goods could be simply known as the production process.
Conversion process, transformation process are some of the similar terms that are used by various parties for production process
6RASHAIN PERERA CIMA Adv. Dip. MA, UOR (Mgt)
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Production process involves inputs and its outcome could be termed as output
Therefore it is clear that there’s a direct relationship between inputs and outputs
This relationship could be shown in terms of the production function
7RASHAIN PERERA CIMA Adv. Dip. MA, UOR (Mgt)
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Production Function The production function shows the
relationship between the inputs and the outputs of a particular production process.
The production function can be presented as below
8RASHAIN PERERA CIMA Adv. Dip. MA, UOR (Mgt)
Q = f{L/M, K}
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In some processes some inputs might be fixed.
For example if capital is fixed the production function could be re stated as
RASHAIN PERERA CIMA Adv. Dip. MA, UOR (Mgt)
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Q = f { L/M, K }
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Short run Vs Long run
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Short Run Short run is a time period in which both variable
factors and fixed factors exists. In the short run some factors remain fixed while
some of the factors can be changed in line with the requirement.
For example suppose that you need to park 4 cars in your garden but you don’t have enough space to do so. In the short run you garden space remains fixed while in the long run you can change it either by buying the land next to your house or by building an underground car park
11RASHAIN PERERA CIMA Adv. Dip. MA, UOR (Mgt)
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Long Run In the long run all factors are variable
and no fixed factors can be seen
12RASHAIN PERERA CIMA Adv. Dip. MA, UOR (Mgt)
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Variable factors Vs Fixed factors
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Variable Factors Variable factors are the inputs/ factors
which change if the activity level or output changes
For example if we consider a tuition class, the tutorial cost would be variable
14RASHAIN PERERA CIMA Adv. Dip. MA, UOR (Mgt)
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Fixed Factors These are the factors or inputs that stay
the same or constant regardless of the output produced or activity level
Considering the same example mentioned in the previous slide, the fixed factor is the building that is being used to deliver the lecture
15RASHAIN PERERA CIMA Adv. Dip. MA, UOR (Mgt)
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SHORT RUNSection 02
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Short run production function
17RASHAIN PERERA CIMA Adv. Dip. MA, UOR (Mgt)
Q = f { L/M, K }
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RASHAIN PERERA CIMA Adv. Dip. MA, UOR (Mgt)
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TP
MP
AP
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Law of diminishing marginal returns This says that proportion of one factor
in a combination of factors is increased, after a certain point first the marginal then the average product of that factor will diminish
In other words total output will increase at a decreasing rate when more and more variable factors are assigned to a fixed input
Refer notes for graphical presentation19RASHAIN PERERA CIMA Adv. Dip. MA,
UOR (Mgt)
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Short run revenue functions Revenue is the income gained by selling
goods and services Key formulas;
20RASHAIN PERERA CIMA Adv. Dip. MA, UOR (Mgt)
TR = P X Qty
AR= TR/Qty
MR= change in TR/change in Qty
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Short run cost functions There are 7 types of short run costs
Fixed costs Variable costs Total costs Average fixed cost Average variable cost Average total cost Marginal cost
21RASHAIN PERERA CIMA Adv. Dip. MA, UOR (Mgt)
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Fixed costs This is the cost that stays a same
regardless of the output level
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TFC
Cost
Qty
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Variable costs The costs that changes with the activity
level or output level
RASHAIN PERERA CIMA Adv. Dip. MA, UOR (Mgt)
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Cost
Qty
TVC
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Total costs This is the totality of variable and fixed
costs
RASHAIN PERERA CIMA Adv. Dip. MA, UOR (Mgt)
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TC = VC + FC
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Average fixed costs
RASHAIN PERERA CIMA Adv. Dip. MA, UOR (Mgt)
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AFC = TFC / QtyCost
Qty
TFC
AFC
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Average variable costs
RASHAIN PERERA CIMA Adv. Dip. MA, UOR (Mgt)
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AVC = TVC / QtyCost
Qty
AVC
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Average total costs
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ATC = AFC + AVC Cost
Qty
AVC
ATC
AFC
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Marginal costs
RASHAIN PERERA CIMA Adv. Dip. MA, UOR (Mgt)
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MC = Chg TC/Chg QCost
Qty
AVC
ATCMC
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Cost functions VS production functions
29RASHAIN PERERA CIMA Adv. Dip. MA, UOR (Mgt)
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Short run profit functions Profit the excess of revenue over
expenditure
Where TR is a function of price and quantity sold
TC is a function of variable, fixed costs and overheads
31RASHAIN PERERA CIMA Adv. Dip. MA, UOR (Mgt)
Profit = TR - TC
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Types of profits Accountants profit
Economists profit
32RASHAIN PERERA CIMA Adv. Dip. MA, UOR (Mgt)
= TR – explicit costs
= TR – implicit – explicit costs
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Explicit costs Explicit costs are the costs that can be
accountant in monetary terms. For example electricity paid 10 000
Implicit costs These are the opportunity costs or
unseen decision costs.
33RASHAIN PERERA CIMA Adv. Dip. MA, UOR (Mgt)
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Types of economic profits Normal profit
The minimum required by a firm to be in operation
Here the economic profit = 0 Abnormal profit/supernormal profit
This is an excess Here economic profit > 0
Subnormal profit Is an actual loss Here economic profit < 0
34RASHAIN PERERA CIMA Adv. Dip. MA, UOR (Mgt)
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LONG RUNSection 03
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Long run production function Is a time period where only variable
factors exists Long run production function can be
explained with the help of economies of scale
Economies of scale refers to an advantageous situation derived by a firm with increase in capacity, size and production
36RASHAIN PERERA CIMA Adv. Dip. MA, UOR (Mgt)
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Envelop curve It is said that LRAC is made of several
SRAC curves. LRAC is derived by joining the optimums of those SRAC curves as shown below.
37RASHAIN PERERA CIMA Adv. Dip. MA, UOR (Mgt)
LRAC
SRAC 1 SRAC 2
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Economies of scale and LRAC curve
38RASHAIN PERERA CIMA Adv. Dip. MA, UOR (Mgt)
Optimum level
EOSDEOS
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Returns to scale and LRAC curve
39RASHAIN PERERA CIMA Adv. Dip. MA, UOR (Mgt)
Increasing returns to scale
constant returns to
scale
Decreasing returns to scale
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Increasing returns to scale Firms experience this if their average cost
per unit in production falls as the firms expand in size/ activity level
Reasons Bulk buying Spreading overheads Risk bearing economies Financial economies Marketing economies of scale Specialization
40RASHAIN PERERA CIMA Adv. Dip. MA, UOR (Mgt)
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Decreasing returns to scale Reasons
Depreciation of resources Stress Lack of control Poor communications in the large firm Weaknesses in the management and
coordination.
41RASHAIN PERERA CIMA Adv. Dip. MA, UOR (Mgt)
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MARKET STRUCTURES Section 04
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Characterization of markets Number of firms? Size of firms? Type of product? Barriers to entry and exit? Information availability?
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Perfect competition Characteristics
Large number of small firms Homogenous or identical product No/low barriers to entry and exit Perfect information available for both
consumers and producers No advertising can be seen A price taker Faces a perfectly elastic demand curve No/low competition Ex; paddy farmers, wheat farmers etc
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Industry VS firms demand curve (price taker)
45RASHAIN PERERA CIMA Adv. Dip. MA, UOR (Mgt)
Industry Firm
P
S
D
P=D=AR=MR
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Price = demand = AR = MR
46RASHAIN PERERA CIMA Adv. Dip. MA, UOR (Mgt)
Price Demand
TR AR MR
10 1 10 10 1010 2 20 10 1010 3 30 10 1010 4 40 10 10
P=D=AR=MR 10
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47RASHAIN PERERA CIMA Adv. Dip. MA, UOR (Mgt)
D=AR=MR=P
MC
AC
Short run equilibrium- abnormal profit
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48RASHAIN PERERA CIMA Adv. Dip. MA, UOR (Mgt)
D=AR=MR=P
MC
AC
Short run equilibrium-sub normal profit
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49RASHAIN PERERA CIMA Adv. Dip. MA, UOR (Mgt)
D=AR=MR=P
MC
AC
Long run equilibrium- normal profit
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50RASHAIN PERERA CIMA Adv. Dip. MA, UOR (Mgt)
D=AR=MR=P
MC
AC
Shut down point- case 1since AVC can be covered the firm will continue its operations
AVC
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51RASHAIN PERERA CIMA Adv. Dip. MA, UOR (Mgt)
D=AR=MR=P
MC
AC
Shut down point- case 2since AVC can not be covered the firm will shut down or discontinue
AVC
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52RASHAIN PERERA CIMA Adv. Dip. MA, UOR (Mgt)
D=AR=MR=P
MC
AC
Supply curve of a perfect competitive firm- case 1
AVC
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53RASHAIN PERERA CIMA Adv. Dip. MA, UOR (Mgt)
MC
AC
AVC
Supply curve of a perfect competitive firm- case 2
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Monopoly Characteristics
Only one firm Sells a unique product High entry and exit barriers Less or no information available for customers No need to advertise Faces a normal downward sloping demand
curve A price maker No competition Ex; CGR
54RASHAIN PERERA CIMA Adv. Dip. MA, UOR (Mgt)
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MR=0.5AR
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Short/long run equilibrium-abnormal profit
56RASHAIN PERERA CIMA Adv. Dip. MA, UOR (Mgt)
D=ARMR
MC
AC
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Monopolistic competition Characteristics
Large number of small and large firms Homogenous or heterogeneous product Barriers to entry and exit are comparatively high Imperfect information Faces a normal downward sloping demand curve Advertising can be seen Can be a price taker or a maker Brand competition can be seen Ex; soft drinks, soap, tooth paste
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Short run equilibrium-abnormal profit
58RASHAIN PERERA CIMA Adv. Dip. MA, UOR (Mgt)
D=ARMR
MC
AC
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Long run equilibrium-normal profit
59RASHAIN PERERA CIMA Adv. Dip. MA, UOR (Mgt)
D=ARMR
MC
AC
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Oligopoly Characteristics
Few large firms Differentiated inter dependent product High barriers to entry and exit Mutually interdependent Advertising can be seen Faces a kinked demand curve High competition Ex; television broadcasting, newspaper
publishers60RASHAIN PERERA CIMA Adv. Dip. MA,
UOR (Mgt)
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Kinked demand curve
61RASHAIN PERERA CIMA Adv. Dip. MA, UOR (Mgt)
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Competition methods Price competition
Decreasing the price to increase sales discounts
Non price competition Advertising Internet shopping Extension of opening hours Home delivery Cash on delivery COD
62RASHAIN PERERA CIMA Adv. Dip. MA, UOR (Mgt)
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Price leadership When one firm has a dominant position
in the industry, that firm will be able to control the prices of other firms in the industry up to a certain extent. The dominant firm is named as price leader.
63RASHAIN PERERA CIMA Adv. Dip. MA, UOR (Mgt)
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The bad of oligopolies Inefficient in allocation of resources In equal distribution of income
The good of oligopolies Widen the product range Benefits the customer with innovative
products Can take advantage of economies of
scales
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Types of barriers to entry and exit Barriers to entry
Economies of size Capital intensive Intellectual property High switching cost of barriers Established brand loyalty Legal requirements Government standards
Barriers to exit Investment in specialized equipment Specialized skills High fixed costs
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END
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