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Chapter: Engineering Economics and Financial Accounting : Production Function and Cost Anaysis

Important Questions and Answers: Production Function and Cost Analysis

Engineering Economics and Financial Accounting - Production Function and Cost Analysis - Important Questions and Answers: Production Function and Cost Analysis


1.     Say some of the main cost concepts.

1)     Actual costs and opportunity costs

2)     Incremental costs and sunk costs

3)     Explicit costs and implicit costs

4)     Past costs and future costs

5)     Accounting costs and economic costs

6)     Direct cost and indirect cost

7)     Private costs and social costs

8)     Controllable costs and non controllable costs

9)     Replacement costs and original costs

10)            Shutdown costs and abandonment costs

11)            Urgent costs and postponable costs

12)            Bussiness costs and full sosts

13)            Fixed costs and variable costs

14)            Short run and long run costs


15)            Incremental costs and marginal costs


2.     What are actual costs and opportunity costs ?

Actual costs which a firm incurs for producing or acquiring a product or a service. As example for this is


the cost on raw materials, labor, rent, interest.


3.     What are incremental costs and sunk costs ?


Incremental cost is the additional cost due to change in the level of nature or business activity. Sunk costs are the costs that are not altered by a change in quantity produced and cannot be recovered.


4.     What are Explicit costs and implicit costs ?


Explicit or paid out costs are those expenses which are actually paid by the firm. Implicit costs are the theoretical costs in the sense that they go unrecognized by the accounting system.


5.     What are past costs and future costs ?


Past costs are the actual costs incurred in the past are generally contained in the financial accounts. Future costs are costs that are expected to occur in some future period or periods.


6.     What are accounting costs and economic costs ?

Accounting costs are the actual outlay costs. Economic cost relate to the future,


7.     What is direct and indirect cost ?


Direct cost are traceable cost or assignable cost are the ones that have direct relationship with a unit of operation like a product, a process or a product, or a department of the firm. On the otherhand, indirect costs or non traceable costs or common or non assignable costs are the costs whose course cannot be easily and definitely traced to the plant.


8.     What are private costs and social costs ?


Private costs are those which are actually incurred or provided for the business activity by an individual or the business firm. Social costs on the otherhand are the total costs to the society on account of production of a good.


9.     What are controllable and non controllable costs ?


Controllable costs are those which are capable of being controlled or regulated by the managers ant = d it can be used to assess the managerial efficiency in controlling the cost in his department. Non controllable costs are those which cannot be subjected to administrative controls and supervision.


10.What are replacement costs and original costs ?


Original costs or the historical costs are the costs paid for assets such as land, building, cost of plant, equipment and materials. Replacement costs are the costs that the firm incurs if it wants to replace or acquire the same assets now.


11.What is shut down cost and abandonment cost ?


Shutdown costs are costs in which the firm incurs if it temporarily stop its operation. Abandonment costs are the costs of retiring altogether a fixed asset from use.


16)what are incremental cost and marginal cost?


Incremental cost is important when dealing with decisions where discrete alternatives are to be compared.marginal cost deals with unity unit output.


17)what are the determinants of cost?


1) level of output


2) price of inputs.


3) size of plant


4) output stability


5) production lot size


6)level of capability utilization


7) technology


8) learning effect


9) breadth of product range.


10)geographical location


18)what are the two aspects in cost output relationships?


1) cost output relationship in short run.


2)cost output  relationship in long run.


19)what are the terms involved in cost output relationship?


1) Average fixed cost.


2) Average variable cost.


3) Average total cost.


20)what is level of capacity utilization?



The higher the capacity utilization fixed cost per unit of output in bound to be low.


21) what is output stability?


Stability of output leads to savings in various kinds of hidden cost interruption and learning.


22)what is size of plants?


Production costs are usually lower in bigger plants than smaller plants.


23)what is cost?


Cost is the money spent on producing and selling a product to the customers.the cost of a product starts from the raw materials through production costs till selling costs include the cost in maintaining outlets.


24)what is the significance of cost in managerial decision making?


Study of costs is essential for making a choice from among the competing production plans.production decisions are not possible without their respective cost considerations.


25)what is price of input?


If the price of the raw materials labor,power increases then naturally the cost of production goes up.this cost of productions varies directly with the prices of inputs.






1. Briefly explain about types of production function with illustration



production function with one variable input

Ø    Increasing return


Ø    Negative return


Ø    Decrasing return



production function with two variable input


Ø   iso quants


Ø    2 factors of production vs capital & labour


Ø    It slope downwards from left to right


Ø    It can’t be horizontal or vertical


Ø    Iso quants all convex to the origin


Ø    Never touch x axis


Ø    Never touch y axis


production function with all variable input

Ø    increasing return to scale


Ø    Decreasing return to scale


Ø    constant return to scale


      Production function with 2 variable input Iso quant curve:


It represent the different combination of inputs producing a particular quantity of output.



Ø    Two factor of production vs capital &labour


Ø    Two factor can substitute each other up to a certain limit


Ø    Shape of ISO quant depends upon the extent of substitutability of 2 inputs


Ø    Technology is given over  a period of time


Isoquant map


An isoquant map is a set of isoquants that shows the maximum attainable output from any given combination inputs.


Types of iso quants


Linear Isoquant:


This type assumes perfect substitutability of factors of production: a given commodity may be produced by using only capital, or only labour, or by an infinite combination of K and L.


Input-Output Isoquant:


This assumes strict complement [that is, zero substitutability] of the factors of production. The isoquant take the shape of a right angle. This type of isoquant is also called 'Leontief isoquant' after Leontief, who invented the input-output analysis.


Smooth , Convex Isoquant:


This form assumes continuous substitutability of K and L only over a certain range, beyond which factors cannot substitute each other. The isoquant appears as a smooth curve convex to the origin.


Long run production function with all variable (Laws of return to scale)


Return to scale refers to the relationship between changes in output and proportionate changes in all factors of production





·        All factors are variable

·        Workers work with given tools and implementation

·        Technical changes are absent


·        There is perfect competition

·        Product is measured in quantities.


Increasing Returns to Scale


Increasing returns to scale is closely associated with economies of scale.


It occurs when a firm increases its inputs, and a more-than-proportionate increase in production




For example, in year one a firm employs 200 workers, uses 50 machines, and produces 1,000 products. In year two it employs 400 workers, uses 100 machines (inputs doubled), and produces 2,500 products (output more than doubled).


Decreasing Returns to Scale


Decreasing returns to scale is closely associated with diseconomies of scale. Decreasing returns to scale happens when the firm's output rises proportionately less than its inputs rise.


For example, in year one, a firm employs 200 workers, uses 50 machines, and produces 1,000 products. In year two it employs 400 workers, uses 100 machines (inputs doubled), and produces 1,500 products (output less than doubled).


Constant Returns to Scale


Constant returns to scale occurs when the firm's output rises proportionate to the increase in




Constant or same output.






2.  Briefly explain about the types of cost concepts.


—    Types of cost concepts


Actual costs and Opportunity Costs


—    Actual costs are also called as outlay costs, absolute costs and acquisition costs.


—    They are those costs that involve financial expenditures at some time and hence are recorded in the books of accounts.

—    o They are the actual expenses incurred for producing or acquiring a commodity or service by a firm.


—    o For example, wages paid to workers, expenses on raw materials, power, fuel and other types of inputs. They can be exactly calculated and accounted without any difficulty.


Opportunity cost of a good or service is measured in terms of revenue which could have been earned by employing that good or service in some other alternative uses.


Direct costs are those costs which can be specifically attributed to a particular product, a department, or a process of production.

indirect costs are those costs, which are not traceable to any one unit of operation. They cannot be attributed to a product, a department or a process


Explicit costs are those costs which are in the nature of contractual payments and are paid by an entrepreneur to the factors of production [excluding himself] in the form of rent, wages, interest and profits, utility expenses, and payments for raw materials etc.


Implicit or imputed costs are implied cost.They do not take the form of cash outlays and as such do not appear in the books of accounts. They are the earnings of owner employed resources.


Accounting costs are those costs which are already incurred on the production of a particular commodity.It includes only the acquisition costs.


Economic costs are those costs that are to be incurred by an entrepreneur on various alternative programs.


It involves the application of opportunity costs in decision makin


ii). How to estimate the cost?

Ø    accounting concept


Ø    engineering concept


Ø    statistical cost








3.  Explain about cost out put relation in short run &long run with neat sketch.


Ø    Short-run cost curves are normally based on a production function with one variable factor of production that displays first increasing and then decreasing marginal productivity.Increasing marginal productivity is associated with the negatively sloped portion of the marginal cost curve, while decreasing marginal productivity is associated with the positively sloped portion. The average fixed cost (AFC) curve is the cost of the fixed factor of production divided by the quantity of units of the output, while the average variable cost (AVC) curve cost traces out


Ø    the per unit cost of variable factor of production.The U-shaped average total cost (ATC) curve is derived by adding the average fixed and variable costs. The marginal cost (MC) intersects both the AVC and ATC curves at their minimum points. Declining average total costs are explained as the result of spreading the fixed costs over greater quantities and, at low quantities, the result of the increasing marginal productivity, in addition. Increasing average costs occur when the effect of declining marginal productivity overwhelms the effect of spreading the fixed costs.




Ø    The long-run cost curves, usually presented in a separate diagram, are also expressed most commonly in their average, or per unit, form, represented here in Figure 2. The long-run average


Ø    cost (LRAC) curve is shown to be an envelope of the short-run average cost (SRAC) curves, lying everywhere below or tangent to the short-run curves.


Ø    The firm is constrained in the shortrun in selecting the optimal mix of factors of production and so will never be able to find a cheaper mix than can be found in the long-run when there are no constraints. If there are a discrete number of plant sizes available, the LRAC will be the scalloped curve obtained by joining those parts of the SRAC curves that represent the lowest cost of production for a given quantity.


4.     Explain in detail about Total, Average & Marginal Costs.


The cost concepts made use of in the cost behavior are Total cost, Average cost, andMarginal cost. TC=TFC+TVC



Marginal Cost is the addition to the total cost due to the production of an additional unit of product. -If both AFC and 'AVC' fall, 'ATC' will also fall.

Ø    'ATC' will fall where the drop in 'AFC' is more than the raise in 'AVC'.


Ø    'ATC' remains constant is the drop in 'AFC' = rise in 'AVC'


Ø    'ATC' will rise where the drop in 'AFC' is less than the rise in 'AVC'


Long Run Costs


The long run is a planning and implementation stage for producers. They analyze the current and projected state of the market in order to make production decisions.


Examples : changing the quantity of production, decreasing or expanding a company, and entering or leaving a market.


Estimation of costs


Accounting approaches


It is classified as fixed, variable and semi variable on the basis of judgment and inspection Fluctuation in output


Maintenance of proper accounts


Engineering Approaches


It includes the physical units of various inputs as plant size, materials etc.,


Statistical Approaches


It includes

Ø    multiple correlations


Ø    Queuing theory


Ø    Input and output analysis



5.  Calculate the Total, Average and Marginal Costs for the following data.




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