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Economics of production and costs

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A research report

Feb 21 - 27, 2000

Production is the process of transforming inputs into outputs. For instance, the production of automobiles requires a wide variety of inputs (also called factors of production): raw materials (steel, plastic, rubber, and so on), factories, machines, land, and many different categories of workers. For purpose of analysis, it will be convenient to refer to three main categories of inputs — materials, labour, and capital — with each category broadly defined. Materials include raw materials, intermediate goods (such as parts), water, and electricity and other energy sources. Labour encompasses all categories of workers employed by the firm: production workers, marketers, and managers at all levels. Capital includes buildings, equipment, and inventories.

The firm's production function indicates the maximum level of output the firm can produce for any combination of inputs. The production function is a quantitative relationship that can be expressed equivalently as an equation, a table, or a graph.

The production and cost are closely linked. The main task of the production manager is to determine how to produce a given level of output at minimal total cost. Thus, efficient production requires setting up appropriate facilities and estimating materials and inputs needs. It also means paying close attention to the costs of inputs and continually seeking to find less costly ways to produce the firm's goods and services. To minimize the cost of producing a particular amount of output, the firm should choose an input mix such that the ratio of the marginal product to the input's cost is the same across all inputs. Cost information is a distillation of production information: It combines the information in the production function with information about input prices. The end result can be summarized in the following important concept: the cost function indicates the firm's total cost of producing any given level of output.

Cost is an important consideration in decision making. In deciding among different courses of action, the manager need only consider the differential revenues and costs of the various alternatives. The opportunity cost associated with choosing a particular decision is measured by the forgone benefits in the next best alternatives.

Cost analysis is the bedrock on which many managerial decisions are grounded. Reckoning costs accurately is essential to determining the firm's current level of profitability. Moreover, profit-maximizing decisions depend on projections of costs at other (untried) levels of output. Thus, production managers frequently pose such questions as: What would be the cost of increasing production by 25 percent? What is the impact on cost of rising input prices? What production changes can be made to reduce or at least contain costs? In short, managers must pay close attention to the ways output and costs are interrelated.


The traditional role of both the production manager and the corporate controller have been altered and expended by the faster pace of technological change and continuing growth in the productivity and complexity of industry. The production manager is still primarily responsible for making and shipping products, but he can no longer do so effectively without a more comprehensive understanding and an intense application of financial controls in both day-to-day operations and short and long-term business planning. Given a projected production schedule as a fundamental objective in his planning and control, he must be able to observe and measure performance in terms of customer shipping dates, cost, and expense, but product profitability as well. In a true sense, happily or not, the production manager is now, more than ever before, a full-fledged businessman.

The controller in the same way is still responsible for the many time-honoured essential accounting functions — payroll, accounts receivables, accounts payables, and cashiering. In addition the dynamic business environment today demands that he become deeply involved in the critical area of short-and long-range financial planning, closely oriented to the operations and schedules of the production department, as well as to all other staff and line functions in the company. For the very reason that cost, expenses, and production profitability are now vital measurements of performance to the production manager, the controller no longer concerned only with reporting what happened yesterday must also take an active part in planning what will happen tomorrow.

The production manager continues to make the action needed to meet production schedules and customer commitments but the controller must provide him with the tools to do so: timely, complete, useful information on cost and expense for planning and control in a form geared to management needs and production and financial control requirements. Again, happily or not, the controller must now know more than ever before what is happening on the production floor. Many industries are faced with such rapidly changing technologies that financial decisions made today can be obsoleted at the same pace as production decisions.

The production manager and the controller then, no longer isolated functions on the organization chart, must work together more closely. How should they work together constructively and positively? How can they help each other in setting cost goals and in measuring actual performances against these goals? The specific procedures for planning and control that these functions develop together may be expected to vary widely from company to company, depending on such factors as types and variety of products, size of the company, and top management's overall administrative philosophy. The degree to which the computer has been applied in handling production and financial information, as well as conventional accounting tasks, also strongly influences these procedures. As a matter of fact, the joint participation of the production manager and controller in specifying, contributing to, and benefiting from a corporate data processing system promotes and encourages the day-to-day teamwork that is essential in modern industry. Although the specific procedures may thus vary widely whether or not the compute is involved, the underlying concepts and basic techniques of financial planning and control and the relationship between the production manager and the controller are the same.


Production operations and services: The specific organization of an industrial concern may differ from one company to another, as does terminology for various activities, but the basic operating and services functions reporting to the operations manager and general manager. Although quality control may occasionally report directly to the general manager, all other functions almost always are under the supervision of the plant or operations manager.

Most significantly with regard to the subject of this chapter, each function has specific responsibilities in financial planning and control and, to some degree, must work with the company's financial departments. Work standards, job procedures, manpower planning, and space planning, all primarily tasks of industrial engineering, for example originate information important to the financial department that is not available anywhere else. Conversely, these industrial engineering responsibilities cannot be discharged without the payroll and overhead assignments that are maintained by the controller. Materials management, which includes both inventory control and procurement, certainly must originate much of the information needed in a corporate data processing system.

The production operation are the primary source of both income and expenses, and so the production manager is deeply involved in many phases of financial planning and control from the point of personal commitment as well as accurate planning. The managers of the various service, such as industrial engineering and production engineering, are equally deeply concerned with budgets but within a far narrower scope. References to the production manager alone in the reminder of this chapter, therefore, will often apply also to the managers of production services.

The financial department: Although he certainly knows the development of financial data and its application to production operations, the production manager is often unfamiliar with the responsibilities of the financial department, particularly as it is run in the modern industrial organization. As shown in Figure 4-2, the financial department, under the direction of the corporate controller, has three primary functions: (1) accounting services, (2) plans and operations, and (3) data processing. The last function includes all computer equipment operations, computer programming, and systems and procedures involved in maintaining a corporate data processing system. This responsibility is most likely to be found in financial department, because digital computers were originally devoted entirely to traditional accounting services and so were naturally introduced under the controller's direction.

Traditional accounting services include the ledger, accounting distributions, payroll, labour accounting, and accounts payable. Although these services may occupy the largest proportion of the time of the financial staff and data processing system, the procedures are firmly established and change very little from month to month. The financial controller, then spends only a small fraction of his time in supervising traditional accounting work.

The controller instead tends to concentrate on the plans and operations activities of the financial department. Here, management action and decision become more important than standardized procedures and paperwork mechanization. In addition, plans and operations constitute the financial activity where most of the interaction between production and finance takes place. There are six major activities in financial plans and operations:

1. Cost accounting and control

2. Inventory accounting and control

3. Overhead budget

4. Financial planning (including cash planning)

5. Capital budgets

6. Assets control and appropriations evaluation

Although these financial activities certainly do not seem to indicate any radical change in the controller's responsibilities, the real difference is that planning and control have changed from periodic studies to establish bench marks and operating limits to dynamic, day-to-day activities that are constantly changing to fulfil present and projected needs.


The key planning mechanism in any production organization is the economics of production, and overall plant programme that is essentially a commitment or contract by the plant manager to the general manager and company president. The controller's job is to help the plant manager and production manager fulfil this commitment. In doing so, his responsibility is to coordinate the development of the plan by the various production functions, help set cost and expense ground rules, and trigger reviews in the control activity.

Economics of production logically requires a procedure for performance measurement and operations control. Its content must be specific and identifiable. In measuring performance, there must be timely, accurate information that scribes all production activities with respect to the Economics of production and in forms and terms that are meaningful to the production managers involved. The key management control mechanism might be called a "Plans / Operations Progress Report," a periodic summary of performance measured against the commitment in the Economics of production. A monthly Plans/Operations Progress Report is both frequent enough to maintain satisfactory control and yet not so frequent as to be beyond the capacity of a data processing system consistent with reasonable administrative expense. In addition, too frequent progress reports may require too much personnel and computer time in recording and processing data and may also be unnecessarily sensitive to small changes.

To be continued...