Mefa Course Material
Mefa Course Material
Mefa Course Material
Imagine for a while that you have finished your studies and have joined as an engineer in a
manufacturing organization. What do you do there? You plan to produce maximum quantity of
goods of a given quality at a reasonable cost. On the other hand, if you are a sale manager, you have
to sell a maximum amount of goods with minimum advertisement costs. In other words, you want
to minimize your costs and maximize your returns and by doing so, you are practicing the principles
of managerial economics.
Managers, in their day-to-day activities, are always confronted with several issues such as how
much quantity is to be supplied; at what price; should the product be made internally; or whether it
should be bought from outside; how much quantity is to be produced to make a given amount of
profit and so on. Managerial economics provides us a basic insight into seeking solutions for
managerial problems.
Managerial economics, as the name itself implies, is an offshoot of two distinct disciplines:
Economics and Management. In other words, it is necessary to understand what these disciplines
are, at least in brief, to understand the nature and scope of managerial economics.
INTRODUCTION TO ECONOMICS
Economics is a study of human activity both at individual and national level. The economists of
early age treated economics merely as the science of wealth. The reason for this is clear. Every one
of us in involved in efforts aimed at earning money and spending this money to satisfy our wants
such as food, Clothing, shelter, and others. Such activities of earning and spending money are called
“Economic activities”. It was only during the eighteenth century that Adam Smith, the Father of
Economics, defined economics as the study of nature and uses of national wealth’.
Dr. Alfred Marshall, one of the greatest economists of the nineteenth century, writes “Economics is
a study of man’s actions in the ordinary business of life: it enquires how he gets his income and how
he uses it”. Thus, it is one side, a study of wealth; and on the other, and more important side; it is
the study of man. As Marshall observed, the chief aim of economics is to promote ‘human welfare’,
but not wealth. The definition given by AC Pigou endorses the opinion of Marshall. Pigou defines
Economics as “the study of economic welfare that can be brought directly and indirectly, into
relationship with the measuring rod of money”.
Prof. Lionel Robbins defined Economics as “the science, which studies human behavior as a
relationship between ends and scarce means which have alternative uses”. With this, the focus of
economics shifted from ‘wealth’ to human behavior’.
Lord Keynes defined economics as ‘the study of the administration of scarce means and the
determinants of employments and income”.
The study of an individual consumer or a firm is called microeconomics (also called the Theory of
Firm). Micro means ‘one millionth’. Microeconomics deals with behavior and problems of single
individual and of micro organization. Managerial economics has its roots in microeconomics and it
deals with the micro or individual enterprises. It is concerned with the application of the concepts
such as price theory, Law of Demand and theories of market structure and so on.
MACROECONOMICS
The study of ‘aggregate’ or total level of economics activity in a country is called macroeconomics.
It studies the flow of economics resources or factors of production (such as land, labour, capital,
organization and technology) from the resource owner to the business firms and then from the
business firms to the households. It deals with total aggregates, for instance, total national income
total employment, output and total investment. It studies the interrelations among various
aggregates and examines their nature and behaviour, their determination and causes of fluctuations
in the. It deals with the price level in general, instead of studying the prices of individual
commodities. It is concerned with the level of employment in the economy. It discusses aggregate
consumption, aggregate investment, price level, and payment, theories of employment, and so on.
Though macroeconomics provides the necessary framework in term of government policies etc., for
the firm to act upon dealing with analysis of business conditions, it has less direct relevance in the
study of theory of firm.
MANAGEMENT
Management is the science and art of getting things done through people in formally organized
groups. It is necessary that every organisation be well managed to enable it to achieve its desired
goals. Management includes a number of functions: Planning, organizing, staffing, directing, and
controlling. The manager while directing the efforts of his staff communicates to them the goals,
objectives, policies, and procedures; coordinates their efforts; motivates them to sustain their
enthusiasm; and leads them to achieve the corporate goals.
WELFARE ECONOMICS
Welfare economics is that branch of economics, which primarily deals with taking of poverty,
famine and distribution of wealth in an economy. This is also called Development Economics. The
central focus of welfare economics is to assess how well things are going for the members of the
society. If certain things have gone terribly bad in some situation, it is necessary to explain why
things have gone wrong. Prof. Amartya Sen was awarded the Nobel Prize in Economics in 1998 in
recognition of his contributions to welfare economics. Prof. Sen gained recognition for his studies
In the words of Prof. Sen, famines can occur even when the food supply is high but people cannot
buy the food because they don’t have money. There has never been a famine in a democratic
country because leaders of those nations are spurred into action by politics and free media. In
undemocratic countries, the rulers are unaffected by famine and there is no one to hold them
accountable, even when millions die.
Welfare economics takes care of what managerial economics tends to ignore. In other words, the
growth for an economic growth with societal upliftment is countered productive. In times of crisis,
what comes to the rescue of people is their won literacy, public health facilities, a system of food
distribution, stable democracy, social safety, (that is, systems or policies that take care of people
when things go wrong for one reason or other).
MANAGERIAL ECONOMICS
Introduction
Managerial Economics as a subject gained popularity in USA after the publication of the book
“Managerial Economics” by Joel Dean in 1951.
Managerial Economics refers to the firm’s decision making process. It could be also interpreted as
“Economics of Management” or “Economics of Management”. Managerial Economics is also
called as “Industrial Economics” or “Business Economics”.
As Joel Dean observes managerial economics shows how economic analysis can be used in
formulating polices.
Managerial Economics bridges the gap between traditional economics theory and real business
practices in two days. First it provides a number of tools and techniques to enable the manager to
become more competent to take decisions in real and practical situations. Secondly it serves as an
integrating course to show the interaction between various areas in which the firm operates.
C. I. Savage & T. R. Small therefore believes that managerial economics “is concerned with
business efficiency”.
It is clear, therefore, that managerial economics deals with economic aspects of managerial
decisions of with those managerial decisions, which have an economics contest. Managerial
economics may therefore, be defined as a body of knowledge, techniques and practices which give
substance to those economic concepts which are useful in deciding the business strategy of a unit of
management.
Managerial Economics, therefore, focuses on those tools and techniques, which are useful in
decision-making.
Managerial economics is, perhaps, the youngest of all the social sciences. Since it originates from
Economics, it has the basis features of economics, such as assuming that other things remaining the
same (or the Latin equivalent ceteris paribus). This assumption is made to simplify the complexity
of the managerial phenomenon under study in a dynamic business environment so many things are
changing simultaneously. This set a limitation that we cannot really hold other things remaining the
same. In such a case, the observations made out of such a study will have a limited purpose or
value. Managerial economics also has inherited this problem from economics.
Further, it is assumed that the firm or the buyer acts in a rational manner (which normally does not
happen). The buyer is carried away by the advertisements, brand loyalties, incentives and so on,
and, therefore, the innate behaviour of the consumer will be rational is not a realistic assumption.
Unfortunately, there are no other alternatives to understand the subject other than by making such
assumptions. This is because the behaviour of a firm or a consumer is a complex phenomenon.
(a) Close to microeconomics: Managerial economics is concerned with finding the solutions
for different managerial problems of a particular firm. Thus, it is more close to
microeconomics.
(b) Operates against the backdrop of macroeconomics: The macroeconomics conditions of
the economy are also seen as limiting factors for the firm to operate. In other words, the
managerial economist has to be aware of the limits set by the macroeconomics conditions
such as government industrial policy, inflation and so on.
The scope of managerial economics refers to its area of study. Managerial economics refers to its
area of study. Managerial economics, Provides management with a strategic planning tool that can
be used to get a clear perspective of the way the business world works and what can be done to
maintain profitability in an ever-changing environment. Managerial economics is primarily
concerned with the application of economic principles and theories to five types of resource
decisions made by all types of business organizations.
A. OPERATIONAL ISSUES:
Operational issues refer to those, which wise within the business organization and they are under
the control of the management. Those are:
1. Theory of demand and Demand Forecasting
2. Pricing and Competitive strategy
3. Production cost analysis
4. Resource allocation
5. Profit analysis
6. Capital or Investment analysis
7. Strategic planning
1. Demand Analyses and Forecasting:
A firm can survive only if it is able to the demand for its product at the right time, within the right
quantity. Understanding the basic concepts of demand is essential for demand forecasting. Demand
analysis should be a basic activity of the firm because many of the other activities of the firms
depend upon the outcome of the demand fore cost. Demand analysis provides:
1. The basis for analyzing market influences on the firms; products and thus helps in the
adaptation to those influences.
2. Demand analysis also highlights for factors, which influence the demand for a product. This
helps to manipulate demand. Thus demand analysis studies not only the price elasticity but
also income elasticity, cross elasticity as well as the influence of advertising expenditure
with the advent of computers, demand forecasting has become an increasingly important
function of managerial economics.
Pricing decisions have been always within the preview of managerial economics. Pricing policies
are merely a subset of broader class of managerial economic problems. Price theory helps to explain
how prices are determined under different types of market conditions. Competitions analysis
includes the anticipation of the response of competitions the firm’s pricing, advertising and
marketing strategies. Product line pricing and price forecasting occupy an important place here.
4. Resource Allocation:
Managerial Economics is the traditional economic theory that is concerned with the problem of
optimum allocation of scarce resources. Marginal analysis is applied to the problem of determining
the level of output, which maximizes profit. In this respect linear programming techniques has been
used to solve optimization problems. In fact lines programming is one of the most practical and
powerful managerial decision making tools currently available.
5. Profit analysis:
Profit making is the major goal of firms. There are several constraints here an account of
competition from other products, changing input prices and changing business environment hence
in spite of careful planning, there is always certain risk involved. Managerial economics deals with
techniques of averting of minimizing risks. Profit theory guides in the measurement and
management of profit, in calculating the pure return on capital, besides future profit planning.
Capital is the foundation of business. Lack of capital may result in small size of operations.
Availability of capital from various sources like equity capital, institutional finance etc. may help to
undertake large-scale operations. Hence efficient allocation and management of capital is one of the
most important tasks of the managers. The major issues related to capital analysis are:
Knowledge of capital theory can help very much in taking investment decisions. This involves,
capital budgeting, feasibility studies, analysis of cost of capital etc.
7. Strategic planning:
Strategic planning provides management with a framework on which long-term decisions can be
made which has an impact on the behavior of the firm. The firm sets certain long-term goals and
objectives and selects the strategies to achieve the same. Strategic planning is now a new addition to
the scope of managerial economics with the emergence of multinational corporations. The
perspective of strategic planning is global.
The social environment refers to social structure as well as social organization like trade unions,
consumer’s co-operative etc. The Political environment refers to the nature of state activity, chiefly
states’ attitude towards private business, political stability etc.
The environmental issues highlight the social objective of a firm i.e.; the firm owes a responsibility
to the society. Private gains of the firm alone cannot be the goal.
The environmental or external issues relate managerial economics to macro economic theory while
operational issues relate the scope to micro economic theory. The scope of managerial economics is
ever widening with the dynamic role of big firms in a society.
Many new subjects have evolved in recent years due to the interaction among basic disciplines.
While there are many such new subjects in natural and social sciences, managerial economics can
be taken as the best example of such a phenomenon among social sciences. Hence it is necessary to
trace its roots and relation ship with other disciplines.
The relationship between managerial economics and economics theory may be viewed form the
point of view of the two approaches to the subject Viz. Micro Economics and Marco Economics.
Managerial economics has been influenced by the developments in management theory and
accounting techniques. Accounting refers to the recording of pecuniary transactions of the firm in
certain books. A proper knowledge of accounting techniques is very essential for the success of the
firm because profit maximization is the major objective of the firm.
Managerial Economics requires a proper knowledge of cost and revenue information and their
classification. A student of managerial economics should be familiar with the generation,
interpretation and use of accounting data. The focus of accounting within the firm is fast changing
from the concepts of store keeping to that if managerial decision making, this has resulted in a new
specialized area of study called “Managerial Accounting”.
The use of mathematics is significant for managerial economics in view of its profit maximization
goal long with optional use of resources. The major problem of the firm is how to minimize cost,
hoe to maximize profit or how to optimize sales. Mathematical concepts and techniques are widely
used in economic logic to solve these problems. Also mathematical methods help to estimate and
predict the economic factors for decision making and forward planning.
Mathematical symbols are more convenient to handle and understand various concepts like
incremental cost, elasticity of demand etc., Geometry, Algebra and calculus are the major branches
of mathematics which are of use in managerial economics. The main concepts of mathematics like
logarithms, and exponentials, vectors and determinants, input-output models etc., are widely used.
Besides these usual tools, more advanced techniques designed in the recent years viz. linear
programming, inventory models and game theory fine wide application in managerial economics.
4. Managerial Economics and Statistics:
Statistical tools like the theory of probability and forecasting techniques help the firm to predict the
future course of events. Managerial Economics also make use of correlation and multiple
regressions in related variables like price and demand to estimate the extent of dependence of one
variable on the other. The theory of probability is very useful in problems involving uncertainty.
Taking effectives decisions is the major concern of both managerial economics and operations
research. The development of techniques and concepts such as linear programming, inventory
models and game theory is due to the development of this new subject of operations research in the
postwar years. Operations research is concerned with the complex problems arising out of the
management of men, machines, materials and money.
Operation research provides a scientific model of the system and it helps managerial economists in
the field of product development, material management, and inventory control, quality control,
marketing and demand analysis. The varied tools of operations Research are helpful to managerial
economists in decision-making.
The Theory of decision-making is a new field of knowledge grown in the second half of this
century. Most of the economic theories explain a single goal for the consumer i.e., Profit
maximization for the firm. But the theory of decision-making is developed to explain multiplicity of
goals and lot of uncertainty.
As such this new branch of knowledge is useful to business firms, which have to take quick
decision in the case of multiple goals. Viewed this way the theory of decision making is more
practical and application oriented than the economic theories.
Computers have changes the way of the world functions and economic or business activity is no
exception. Computers are used in data and accounts maintenance, inventory and stock controls and
supply and demand predictions. What used to take days and months is done in a few minutes or
hours by the computers. In fact computerization of business activities on a large scale has reduced
the workload of managerial personnel. In most countries a basic knowledge of computer science, is
a compulsory programme for managerial trainees.
Making decisions and processing information are the two primary tasks of the managers.
Managerial economists have gained importance in recent years with the emergence of an
organizational culture in production and sales activities.
A management economist with sound knowledge of theory and analytical tools for information
system occupies a prestigious place among the personnel. A managerial economist is nearer to the
policy-making. Equipped with specialized skills and modern techniques he analyses the internal and
external operations of the firm. He evaluates and helps in decision making regarding sales, Pricing
financial issues, labour relations and profitability. He helps in decision-making keeping in view the
different goals of the firm.
His role in decision-making applies to routine affairs such as price fixation, improvement in quality,
Location of plant, expansion or contraction of output etc. The role of managerial economist in
internal management covers wide areas of production, sales and inventory schedules of the firm.
The most important role of the managerial economist relates to demand forecasting because an
analysis of general business conditions is most vital for the success of the firm. He prepares a short-
term forecast of general business activity and relates general economic forecasts to specific market
trends. Most firms require two forecasts one covering the short term (for nest three months to one
year) and the other covering the long term, which represents any period exceeding one-year. He has
to be ever alert to gauge the changes in tastes and preferences of the consumers. He should evaluate
the market potential. The need to know forecasting techniques on the part of the managerial
economics means, he should be adept at market research. The purpose of market research is to
provide a firm with information about current market position as well as present and possible future
trends in the industry. A managerial economist who is well equipped with this knowledge can help
the firm to plan product improvement, new product policy, pricing, and sales promotion strategy.
The fourth function of the managerial economist is to undertake an economic analysis of the
industry. This is concerned with project evaluation and feasibility study at the firm level i.e., he
should be able to judge on the basis of cost benefit analysis, whether it is advisable and profitable to
go ahead with the project. The managerial economist should be adept at investment appraisal
Another function is security management analysis. This is very important in the case of defense-
oriented industries, power projects, and nuclear plants where security is very essential. Security
management means, also that the production and trade secrets concerning technology, quality and
other such related facts should not be leaked out to others. This security is more necessary in
strategic and defense-oriented projects of national importance; a managerial economist should be
able to manage these issues of security management analysis.
The sixth function is an advisory function. Here his advice is required on all matters of production
and trade. In the hierarchy of management, a managerial economist ranks next to the top executives
or the policy maker who may be doyens of several projects. It is the managerial economist of each
firm who has to advise them on all matters of trade since they are in the know of actual functioning
of the unit in all aspects, both technical and financial.
Another function of importance for the managerial economist is a concerned with pricing and
related problems. The success of the firm depends upon a proper pricing strategy. The pricing
decision is one of the most difficult decisions to be made in business because the information
required is never fully available. Pricing of established products is different from new products. He
may have to operate in an atmosphere constrained by government regulation. He may have to
anticipate the reactions of competitors in pricing. The managerial economist has to be very alert and
dynamic to take correct pricing decision in changing environment.
Finally the specific function of a managerial economist includes an analysis of environment issues.
Modern theory of managerial economics recognizes the social responsibility of the firm. It refers to
the impact of a firm on environmental factors. It should not have adverse impact on pollution and if
possible try to contribute to environmental preservation and protection in a positive way.
The role of management economist lies not in taking decision but in analyzing, concluding and
recommending to the policy maker. He should have the freedom to operate and analyze and must
possess full knowledge of facts. He has to collect and provide the quantitative data from within the
firm. He has to get information on external business environment such as general market conditions,
trade cycles, and behavior pattern of the consumers. The managerial economist helps to co-ordinate
policies relating to production, investment, inventories and price.
He should have equanimity to meet crisis. He should act only after analysis and discussion with
relevant departments. He should have diplomacy to act in advisory capacity to the top executive as
well as getting co-operation from different departments for his economic analysis. He should do
well to have intuitive ability to know what is good or bad for the firm.
He should have sound theoretical knowledge to take up the challenges he has to face in actual day
to day affairs. “BANMOL” referring to the role of managerial economist points out. “A managerial
QUESTIONS
QUIZ
3. Which subject studies the behavior of the firm in theory and practice? ( )
(a) Micro Economics (b) Macro Economics
(c) Managerial Economics (d) Welfare Economics
8. Making decisions and processing information are the two Primary tasks of
the Managers . It was explained by the subject _____________________. ( )
(a) Physics (b) Engineering Science
(c) Managerial Economics (d) Chemistry
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Demand in common parlance means the desire for an object. But in economics demand is
something more than this. According to Stonier and Hague, “Demand in economics means demand
backed up by enough money to pay for the goods demanded”. This means that the demand becomes
effective only it if is backed by the purchasing power in addition to this there must be willingness to
buy a commodity.
Thus demand in economics means the desire backed by the willingness to buy a commodity and the
purchasing power to pay. In the words of “Benham” “The demand for anything at a given price is
the amount of it which will be bought per unit of time at that Price”. (Thus demand is always at a
price for a definite quantity at a specified time.) Thus demand has three essentials – price, quantity
demanded and time. Without these, demand has to significance in economics.
LAW OF DEMAND:
Law of demand shows the relation between price and quantity demanded of a commodity in the
market. In the words of Marshall, “the amount demand increases with a fall in price and diminishes
with a rise in price”.
A rise in the price of a commodity is followed by a reduction in demand and a fall in price is
followed by an increase in demand, if a condition of demand remains constant.
The law of demand may be explained with the help of the following demand schedule.
DEMAND SCHEDULE.
When the price falls from Rs. 10 to 8 quantity demand increases from 1 to 2. In the same way as
price falls, quantity demand increases on the basis of the demand schedule we can draw the demand
curve.
The demand curve DD shows the inverse relation between price and quantity demand of apple. It is
downward sloping.
ASSUMPTIONS:
Some times the demand curve slopes upwards from left to right. In this case the demand curve has a
positive slope.
Price
1. Giffen paradox:
The Giffen good or inferior good is an exception to the law of demand. When the price of an
inferior good falls, the poor will buy less and vice versa. For example, when the price of maize falls,
the poor are willing to spend more on superior goods than on maize if the price of maize increases,
he has to increase the quantity of money spent on it. Otherwise he will have to face starvation. Thus
a fall in price is followed by reduction in quantity demanded and vice versa. “Giffen” first
explained this and therefore it is called as Giffen’s paradox.
‘Veblan’ has explained the exceptional demand curve through his doctrine of conspicuous
consumption. Rich people buy certain good because it gives social distinction or prestige for
example diamonds are bought by the richer class for the prestige it possess. It the price of diamonds
falls poor also will buy is hence they will not give prestige. Therefore, rich people may stop buying
this commodity.
3. Ignorance:
Sometimes, the quality of the commodity is Judge by its price. Consumers think that the product is
superior if the price is high. As such they buy more at a higher price.
4. Speculative effect:
If the price of the commodity is increasing the consumers will buy more of it because of the fear
that it increase still further, Thus, an increase in price may not be accomplished by a decrease in
demand.
5. Fear of shortage:
During the times of emergency of war People may expect shortage of a commodity. At that time,
they may buy more at a higher price to keep stocks for the future.
5. Necessaries:
In the case of necessaries like rice, vegetables etc. people buy more even at a higher price.
The most important factor-affecting amount demanded is the price of the commodity. The amount
of a commodity demanded at a particular price is more properly called price demand. The relation
between price and demand is called the Law of Demand. It is not only the existing price but also the
expected changes in price, which affect demand.
The second most important factor influencing demand is consumer income. In fact, we can establish
a relation between the consumer income and the demand at different levels of income, price and
other things remaining the same. The demand for a normal commodity goes up when income rises
and falls down when income falls. But in case of Giffen goods the relationship is the opposite.
The demand for a commodity is also affected by the changes in prices of the related goods also.
Related goods can be of two types:
(i). Substitutes which can replace each other in use; for example, tea and coffee are
substitutes. The change in price of a substitute has effect on a commodity’s demand
in the same direction in which price changes. The rise in price of coffee shall raise
the demand for tea;
(ii). Complementary foods are those which are jointly demanded, such as pen and ink. In
such cases complementary goods have opposite relationship between price of one
commodity and the amount demanded for the other. If the price of pens goes up,
their demand is less as a result of which the demand for ink is also less. The price
and demand go in opposite direction. The effect of changes in price of a commodity on
amounts demanded of related commodities is called Cross Demand.
The amount demanded also depends on consumer’s taste. Tastes include fashion, habit, customs,
etc. A consumer’s taste is also affected by advertisement. If the taste for a commodity goes up, its
amount demanded is more even at the same price. This is called increase in demand. The opposite is
called decrease in demand.
The amount demanded of commodity is also affected by the amount of wealth as well as its
distribution. The wealthier are the people; higher is the demand for normal commodities. If wealth
is more equally distributed, the demand for necessaries and comforts is more. On the other hand, if
some people are rich, while the majorities are poor, the demand for luxuries is generally higher.
6. Population:
Increase in population increases demand for necessaries of life. The composition of population also
affects demand. Composition of population means the proportion of young and old and children as
well as the ratio of men to women. A change in composition of population has an effect on the
nature of demand for different commodities.
7. Government Policy:
Government policy affects the demands for commodities through taxation. Taxing a commodity
increases its price and the demand goes down. Similarly, financial help from the government
increases the demand for a commodity while lowering its price.
If consumers expect changes in price of commodity in future, they will change the demand at
present even when the present price remains the same. Similarly, if consumers expect their incomes
to rise in the near future they may increase the demand for a commodity just now.
The climate of an area and the weather prevailing there has a decisive effect on consumer’s demand.
In cold areas woolen cloth is demanded. During hot summer days, ice is very much in demand. On
a rainy day, ice cream is not so much demanded.
The level of demand for different commodities also depends upon the business conditions in the
country. If the country is passing through boom conditions, there will be a marked increase in
demand. On the other hand, the level of demand goes down during depression.
ELASTICITY OF DEMAND
In the words of “Marshall”, “The elasticity of demand in a market is great or small according as the
amount demanded increases much or little for a given fall in the price and diminishes much or little
for a given rise in Price”
Elastic demand: A small change in price may lead to a great change in quantity demanded. In this
case, demand is elastic.
In-elastic demand: If a big change in price is followed by a small change in demanded then the
demand in “inelastic”.
Marshall was the first economist to define price elasticity of demand. Price elasticity of demand
measures changes in quantity demand to a change in Price. It is the ratio of percentage change in
quantity demanded to a percentage change in price.
In this case, even a large change in price fails to bring about a change in quantity demanded.
When price increases from ‘OP’ to ‘OP’, the quantity demanded remains the same. In other words
the response of demand to a change in Price is nil. In this case ‘E’=0.
Demand changes more than proportionately to a change in price. i.e. a small change in price loads
to a very big change in the quantity demanded. In this case
E > 1. This demand curve will be flatter.
The change in demand is exactly equal to the change in price. When both are equal E=1 and
elasticity if said to be unitary.
When price falls from ‘OP’ to ‘OP1’ quantity demanded increases from ‘OP’ to ‘OP1’, quantity
demanded increases from ‘OQ’ to ‘OQ1’. Thus a change in price has resulted in an equal change in
quantity demanded so price elasticity of demand is equal to unity.
Income elasticity of demand shows the change in quantity demanded as a result of a change in
income. Income elasticity of demand may be slated in the form of a formula.
Quantity demanded remains the same, even though money income increases. Symbolically, it can
be expressed as Ey=0. It can be depicted in the following way:
When income increases, quantity demanded falls. In this case, income elasticity of demand is
negative. i.e., Ey < 0.
When income increases from OY to OY1, Quantity demanded also increases from OQ to OQ1.
d. Income elasticity greater than unity:
In this case, an increase in come brings about a more than proportionate increase in quantity
demanded. Symbolically it can be written as Ey > 1.
When income increases quantity demanded also increases but less than proportionately. In this case
E < 1.
A change in the price of one commodity leads to a change in the quantity demanded of another
commodity. This is called a cross elasticity of demand. The formula for cross elasticity of demand
is:
a. In case of substitutes, cross elasticity of demand is positive. Eg: Coffee and Tea
When the price of coffee increases, Quantity demanded of tea increases. Both are substitutes.
Price of Coffee
b. Incase of compliments, cross elasticity is negative. If increase in the price of one commodity
leads to a decrease in the quantity demanded of another and vice versa.
c. In case of unrelated commodities, cross elasticity of demanded is zero. A change in the price of
one commodity will not affect the quantity demanded of another.
Quantity demanded of commodity “b” remains unchanged due to a change in the price of ‘A’, as
both are unrelated goods.
Elasticity or in-elasticity of demand depends on the nature of the commodity i.e. whether a
commodity is a necessity, comfort or luxury, normally; the demand for Necessaries like salt, rice etc
is inelastic. On the other band, the demand for comforts and luxuries is elastic.
2. Availability of substitutes:
3. Variety of uses:
If a commodity can be used for several purposes, than it will have elastic demand. i.e. electricity.
On the other hand, demanded is inelastic for commodities, which can be put to only one use.
4. Postponement of demand:
If the consumption of a commodity can be postponed, than it will have elastic demand. On the
contrary, if the demand for a commodity cannot be postpones, than demand is in elastic. The
demand for rice or medicine cannot be postponed, while the demand for Cycle or umbrella can be
postponed.
Elasticity of demand depends on the amount of money spent on the commodity. If the consumer
spends a smaller for example a consumer spends a little amount on salt and matchboxes. Even when
price of salt or matchbox goes up, demanded will not fall. Therefore, demand is in case of clothing
a consumer spends a large proportion of his income and an increase in price will reduce his demand
for clothing. So the demand is elastic.
6. Time:
Elasticity of demand varies with time. Generally, demand is inelastic during short period and elastic
during the long period. Demand is inelastic during short period because the consumers do not have
enough time to know about the change is price. Even if they are aware of the price change, they
may not immediately switch over to a new commodity, as they are accustomed to the old
commodity.
7. Range of Prices:
1. Price fixation:
Each seller under monopoly and imperfect competition has to take into account elasticity of demand
while fixing the price for his product. If the demand for the product is inelastic, he can fix a higher
price.
2. Production:
Producers generally decide their production level on the basis of demand for the product. Hence
elasticity of demand helps the producers to take correct decision regarding the level of cut put to be
produced.
3. Distribution:
Elasticity of demand also helps in the determination of rewards for factors of production. For
example, if the demand for labour is inelastic, trade unions will be successful in raising wages. It is
applicable to other factors of production.
4. International Trade:
Elasticity of demand helps in finding out the terms of trade between two countries. Terms of trade
refers to the rate at which domestic commodity is exchanged for foreign commodities. Terms of
trade depends upon the elasticity of demand of the two countries for each other goods.
5. Public Finance:
Elasticity of demand helps the government in formulating tax policies. For example, for imposing
tax on a commodity, the Finance Minister has to take into account the elasticity of demand.
6. Nationalization:
The concept of elasticity of demand enables the government to decide about nationalization of
industries.
Introduction:
The information about the future is essential for both new firms and those planning to expand the
scale of their production. Demand forecasting refers to an estimate of future demand for the
product.
It is an ‘objective assessment of the future course of demand”. In recent times, forecasting plays an
important role in business decision-making. Demand forecasting has an important influence on
production planning. It is essential for a firm to produce the required quantities at the right time.
It is essential to distinguish between forecasts of demand and forecasts of sales. Sales forecast is
important for estimating revenue cash requirements and expenses. Demand forecasts relate to
production, inventory control, timing, reliability of forecast etc. However, there is not much
difference between these two terms.
Based on the time span and planning requirements of business firms, demand forecasting can be
classified in to 1. Short-term demand forecasting and
2. Long – term demand forecasting.
Short-term demand forecasting is limited to short periods, usually for one year. It relates to policies
regarding sales, purchase, price and finances. It refers to existing production capacity of the firm.
Short-term forecasting is essential for formulating is essential for formulating a suitable price
policy. If the business people expect of rise in the prices of raw materials of shortages, they may
buy early. This price forecasting helps in sale policy formulation. Production may be undertaken
based on expected sales and not on actual sales. Further, demand forecasting assists in financial
forecasting also. Prior information about production and sales is essential to provide additional
funds on reasonable terms.
In long-term forecasting, the businessmen should now about the long-term demand for the product.
Planning of a new plant or expansion of an existing unit depends on long-term demand. Similarly a
multi product firm must take into account the demand for different items. When forecast are mode
covering long periods, the probability of error is high. It is vary difficult to forecast the production,
the trend of prices and the nature of competition. Hence quality and competent forecasts are
essential.
METHODS OF FORECASTING:
Several methods are employed for forecasting demand. All these methods can be grouped under
survey method and statistical method. Survey methods and statistical methods are further
subdivided in to different categories.
1. SURVEY METHOD:
Under this method, information about the desires of the consumer and opinion of exports are
collected by interviewing them. Survey method can be divided into four type’s viz., Option survey
method; expert opinion; Delphi method and consumers interview methods.
This method is also known as sales-force composite method (or) collective opinion method. Under
this method, the company asks its salesman to submit estimate of future sales in their respective
territories. Since the forecasts of the salesmen are biased due to their optimistic or pessimistic
attitude ignorance about economic developments etc. these estimates are consolidated, reviewed
and adjusted by the top executives. In case of wide differences, an average is struck to make the
forecasts realistic.
This method is more useful and appropriate because the salesmen are more knowledge. They can be
important source of information. They are cooperative. The implementation within unbiased or their
basic can be corrected.
Apart from salesmen and consumers, distributors or outside experts may also e used for forecasting.
In the United States of America, the automobile companies get sales estimates directly from their
dealers. Firms in advanced countries make use of outside experts for estimating future demand.
Various public and private agencies all periodic forecasts of short or long term business conditions.
C. Delphi Method:
In this method the consumers are contacted personally to know about their plans and preference
regarding the consumption of the product. A list of all potential buyers would be drawn and each
buyer will be approached and asked how much he plans to buy the listed product in future. He
would be asked the proportion in which he intends to buy. This method seems to be the most ideal
method for forecasting demand.
2. STATISTICAL METHODS:
Statistical method is used for long run forecasting. In this method, statistical and mathematical
techniques are used to forecast demand. This method relies on post data.
A well-established firm would have accumulated data. These data are analyzed to determine the
nature of existing trend. Then, this trend is projected in to the future and the results are used as the
basis for forecast. This is called as time series analysis. This data can be presented either in a tabular
form or a graph. In the time series post data of sales are used to forecast future.
b. Barometric Technique:
Simple trend projections are not capable of forecasting turning paints. Under Barometric method,
present events are used to predict the directions of change in future. This is done with the help of
economics and statistical indicators. Those are (1) Construction Contracts awarded for building
materials (2) Personal income (3) Agricultural Income. (4) Employment (5) Gross national income
(6) Industrial Production (7) Bank Deposits etc.
Regression and correlation are used for forecasting demand. Based on post data the future data trend
is forecasted. If the functional relationship is analyzed with the independent variable it is simple
correction. When there are several independent variables it is multiple correlation. In correlation we
QUESTIONS
1. What is meant by elasticity of demand? How do you measure it? What are determinates of
elasticity of demand?
2. What is the utility of demand forecasting? What are the criteria for a good forecasting
method? Forecasting of demand for a new product? ‘ Economic indicators’
3. What is promotional elasticity of demand? How does if differ from cross elasticity of
demand.
4. Explain in law of demand. What do you mean by shifts in demand curve?
5. What is cross elasticity of demand? Is it positive for substitute or complements? Show in a
diagram relating to the demand for coffee to the price of tea?
6. Income elasticity of demand and distinguish its, various tapes. How does it differ from pure
elasticity of demand?
7. What is meant by demand? Everyone desires a Maruti 800 Car – Does this mean that the
demand for Maruti Car is large?
8. Calculate price elasticity of demand:
Q1= 4000 P1= 20
Q2= 5000 P2= 19
9. What is demand analysis? Explain the factor influencing the demand for a product?
What are the various factors that influence the demand for a computer.
QUIZ
11. When a small change in price leads great change in the quantity demand,
We call it ________. ( )
(a) Inelastic Demand (b) Negative Demand
(c) Elastic Demand (d) None
12. When a great change in price leads small change in the quantity demand,
We call it ________. ( )
(a) Elastic Demand (b) Positive Demand
(c) Inelastic Demand (d) None
14. Consumers Survey method is one of the Survey Methods to forecast the__. ( )
(a) Sales (b) Income
(c) Demand (d) Production
21. When Income Elasticity of demand is Zero (IE = 0), It is termed as ___. ( )
(a) Negative Income Elasticity (b) Unit Income Elasticity
(c) Zero Income Elasticity (d) Infinite Income Elasticity
UNIT - II
PRODUCTION FUNCTION
Q= f (A, B, C, D)
Where “Q” stands for the quantity of output and A, B, C, D are various input factors such as land,
labour, capital and organization. Here output is the function of inputs. Hence output becomes the
dependent variable and inputs are the independent variables.
Y= a+b(x)
Which shows that there is a constant relationship between applications of input (the only factor
input ‘X’ in this case) and the amount of output (y) produced.
IMPORTANCE:
1. When inputs are specified in physical units, production function helps to estimate the level
of production.
2. It becomes is equates when different combinations of inputs yield the same level of output.
3. It indicates the manner in which the firm can substitute on input for another without altering
the total output.
4. When price is taken into consideration, the production function helps to select the least
combination of inputs for the desired output.
5. It considers two types’ input-output relationships namely ‘law of variable proportions’ and
‘law of returns to scale’. Law of variable propositions explains the pattern of output in the
short-run as the units of variable inputs are increased to increase the output. On the other
hand law of returns to scale explains the pattern of output in the long run as all the units of
inputs are increased.
6. The production function explains the maximum quantity of output, which can be produced,
from any chosen quantities of various inputs or the minimum quantities of various inputs
that are required to produce a given quantity of output.
Production function can be fitted the particular firm or industry or for the economy as whole.
Production function will change with an improvement in technology.
ASSUMPTIONS:
Y= (AKX L1-x)
Where Y=output
K=Capital
L=Labour
A, ∞=positive constant
ASSUMPTIONS:
1. The function assumes that output is the function of two factors viz. capital and labour.
2. It is a linear homogenous production function of the first degree
3. The function assumes that the logarithm of the total output of the economy is a linear
function of the logarithms of the labour force and capital stock.
4. There are constant returns to scale
5. All inputs are homogenous
6. There is perfect competition
7. There is no change in technology
ISOQUANTS:
The term Isoquants is derived from the words ‘iso’ and ‘quant’ – ‘Iso’ means equal and ‘quent’
implies quantity. Isoquant therefore, means equal quantity. A family of iso-product curves or
isoquants or production difference curves can represent a production function with two variable
inputs, which are substitutable for one another within limits.
Iqoquants are the curves, which represent the different combinations of inputs producing a
particular quantity of output. Any combination on the isoquant represents the some level of output.
Where ‘Q’, the units of output is a function of the quantity of two inputs ‘L’ and ‘K’.
Thus an isoquant shows all possible combinations of two inputs, which are capable of producing
equal or a given level of output. Since each combination yields same output, the producer becomes
indifferent towards these combinations.
ASSUMPTIONS:
1. There are only two factors of production, viz. labour and capital.
2. The two factors can substitute each other up to certain limit
3. The shape of the isoquant depends upon the extent of substitutability of the two inputs.
4. The technology is given over a period.
Combination ‘A’ represent 1 unit of labour and 10 units of capital and produces ‘50’ quintals of a
product all other combinations in the table are assumed to yield the same given output of a product
say ‘50’ quintals by employing any one of the alternative combinations of the two factors labour
and capital. If we plot all these combinations on a paper and join them, we will get continues and
smooth curve called Iso-product curve as shown below.
PRODUCER’S EQUILIBRIUM:
The tem producer’s equilibrium is the counter part of consumer’s equilibrium. Just as the consumer
is in equilibrium when be secures maximum satisfaction, in the same manner, the producer is in
equilibrium when he secures maximum output, with the least cost combination of factors of
production.
The optimum position of the producer can be found with the help of iso-product curve. The Iso-
product curve or equal product curve or production indifference curve shows different combinations
of two factors of production, which yield the same output. This is illustrated as follows.
Let us suppose. The producer can produces the given output of paddy say 100 quintals by
employing any one of the following alternative combinations of the two factors labour and capital
computation of least cost combination of two inputs.
It is clear from the above that 10 units of ‘L’ combined with 45 units of ‘K’ would cost the producer
Rs. 20/-. But if 17 units reduce ‘K’ and 10 units increase ‘L’, the resulting cost would be Rs. 172/-.
Substituting 10 more units of ‘L’ for 12 units of ‘K’ further reduces cost pf Rs. 154/-/ However, it
will not be profitable to continue this substitution process further at the existing prices since the rate
of substitution is diminishing rapidly. In the above table the least cost combination is 30 units of ‘L’
used with 16 units of ‘K’ when the cost would be minimum at Rs. 154/-. So this is they stage “the
producer is in equilibrium”.
1. When quantities of certain inputs, are fixed and others are variable and
2. When all inputs are variable.
These two types of relationships have been explained in the form of laws.
The law of variable proportions which is a new name given to old classical concept of “Law of
diminishing returns has played a vital role in the modern economics theory. Assume that a firms
production function consists of fixed quantities of all inputs (land, equipment, etc.) except labour
which is a variable input when the firm expands output by employing more and more labour it alters
the proportion between fixed and the variable inputs. The law can be stated as follows:
“When total output or production of a commodity is increased by adding units of a variable input
while the quantities of other inputs are held constant, the increase in total production becomes after
some point, smaller and smaller”.
“If equal increments of one input are added, the inputs of other production services being held
constant, beyond a certain point the resulting increments of product will decrease i.e. the marginal
product will diminish”. (G. Stigler)
“As the proportion of one factor in a combination of factors is increased, after a point, first the
marginal and then the average product of that factor will diminish”. (F. Benham)
The law of variable proportions refers to the behaviour of output as the quantity of one Factor is
increased Keeping the quantity of other factors fixed and further it states that the marginal product
and average product will eventually do cline. This law states three types of productivity an input
factor – Total, average and marginal physical productivity.
Assumptions of the Law: The law is based upon the following assumptions:
i) The state of technology remains constant. If there is any improvement in technology, the
average and marginal out put will not decrease but increase.
ii) Only one factor of input is made variable and other factors are kept constant. This law
does not apply to those cases where the factors must be used in rigidly fixed proportions.
iii) All units of the variable factors are homogenous.
The behaviors of the Output when the varying quantity of one factor is combines with a fixed
quantity of the other can be divided in to three district stages. The three stages can be better
understood by following the table.
Above table reveals that both average product and marginal product increase in the beginning and
then decline of the two marginal products drops of faster than average product. Total product is
maximum when the farmer employs 6th worker, nothing is produced by the 7th worker and its
marginal productivity is zero, whereas marginal product of 8 th worker is ‘-10’, by just creating
credits 8th worker not only fails to make a positive contribution but leads to a fall in the total output.
Production function with one variable input and the remaining fixed inputs is illustrated as below
From the above graph the law of variable proportions operates in three stages. In the first stage,
total product increases at an increasing rate. The marginal product in this stage increases at an
We can sum up the above relationship thus when ‘A.P.’ is rising, “M. P.’ rises more than “ A. P;
When ‘A. P.” is maximum and constant, ‘M. P.’ becomes equal to ‘A. P.’ when ‘A. P.’ starts falling,
‘M. P.’ falls faster than ‘ A. P.’.
Thus, the total product, marginal product and average product pass through three phases, viz.,
increasing diminishing and negative returns stage. The law of variable proportion is nothing but the
combination of the law of increasing and demising returns.
The law of returns to scale explains the behavior of the total output in response to change in the
scale of the firm, i.e., in response to a simultaneous to changes in the scale of the firm, i.e., in
response to a simultaneous and proportional increase in all the inputs. More precisely, the Law of
returns to scale explains how a simultaneous and proportionate increase in all the inputs affects the
total output at its various levels.
The concept of variable proportions is a short-run phenomenon as in these period fixed factors can
not be changed and all factors cannot be changed. On the other hand in the long-term all factors can
be changed as made variable. When we study the changes in output when all factors or inputs are
changed, we study returns to scale. An increase in the scale means that all inputs or factors are
increased in the same proportion. In variable proportions, the cooperating factors may be increased
or decreased and one faster (Ex. Land in agriculture (or) machinery in industry) remains constant so
that the changes in proportion among the factors result in certain changes in output. In returns to
scale all the necessary factors or production are increased or decreased to the same extent so that
whatever the scale of production, the proportion among the factors remains the same.
When a firm expands, its scale increases all its inputs proportionally, then technically there are three
possibilities. (i) The total output may increase proportionately (ii) The total output may increase
more than proportionately and (iii) The total output may increase less than proportionately. If
increase in the total output is proportional to the increase in input, it means constant returns to scale.
If increase in the output is greater than the proportional increase in the inputs, it means increasing
return to scale. If increase in the output is less than proportional increase in the inputs, it means
diminishing returns to scale.
ECONOMIES OF SCALE
Production may be carried on a small scale or o a large scale by a firm. When a firm expands its
size of production by increasing all the factors, it secures certain advantages known as economies of
production. Marshall has classified these economies of large-scale production into internal
economies and external economies.
Internal economies are those, which are opened to a single factory or a single firm independently of
the action of other firms. They result from an increase in the scale of output of a firm and cannot be
achieved unless output increases. Hence internal economies depend solely upon the size of the firm
and are different for different firms.
External economies are those benefits, which are shared in by a number of firms or industries when
the scale of production in an industry or groups of industries increases. Hence external economies
benefit all firms within the industry as the size of the industry expands.
1. Indivisibilities
Many fixed factors of production are indivisible in the sense that they must be used in a fixed
minimum size. For instance, if a worker works half the time, he may be paid half the salary. But he
cannot be chopped into half and asked to produce half the current output. Thus as output increases
the indivisible factors which were being used below capacity can be utilized to their full capacity
thereby reducing costs. Such indivisibilities arise in the case of labour, machines, marketing,
finance and research.
2. Specialization.
INTERNAL ECONOMIES:
Technical economies arise to a firm from the use of better machines and superior techniques of
production. As a result, production increases and per unit cost of production falls. A large firm,
which employs costly and superior plant and equipment, enjoys a technical superiority over a small
firm. Another technical economy lies in the mechanical advantage of using large machines. The cost
of operating large machines is less than that of operating mall machine. More over a larger firm is
able to reduce it’s per unit cost of production by linking the various processes of production.
Technical economies may also be associated when the large firm is able to utilize all its waste
materials for the development of by-products industry. Scope for specialization is also available in a
large firm. This increases the productive capacity of the firm and reduces the unit cost of
production.
These economies arise due to better and more elaborate management, which only the large size
firms can afford. There may be a separate head for manufacturing, assembling, packing, marketing,
general administration etc. Each department is under the charge of an expert. Hence the
appointment of experts, division of administration into several departments, functional
specialization and scientific co-ordination of various works make the management of the firm most
efficient.
The large firm reaps marketing or commercial economies in buying its requirements and in selling
its final products. The large firm generally has a separate marketing department. It can buy and sell
on behalf of the firm, when the market trends are more favorable. In the matter of buying they could
enjoy advantages like preferential treatment, transport concessions, cheap credit, prompt delivery
and fine relation with dealers. Similarly it sells its products more effectively for a higher margin of
profit.
The large firm is able to secure the necessary finances either for block capital purposes or for
working capital needs more easily and cheaply. It can barrow from the public, banks and other
financial institutions at relatively cheaper rates. It is in this way that a large firm reaps financial
economies.
A large firm possesses larger resources and can establish it’s own research laboratory and employ
trained research workers. The firm may even invent new production techniques for increasing its
output and reducing cost.
A large firm can provide better working conditions in-and out-side the factory. Facilities like
subsidized canteens, crèches for the infants, recreation room, cheap houses, educational and medical
facilities tend to increase the productive efficiency of the workers, which helps in raising production
and reducing costs.
EXTERNAL ECONOMIES.
Business firm enjoys a number of external economies, which are discussed below:
When an industry is concentrated in a particular area, all the member firms reap some common
economies like skilled labour, improved means of transport and communications, banking and
financial services, supply of power and benefits from subsidiaries. All these facilities tend to lower
the unit cost of production of all the firms in the industry.
The industry can set up an information centre which may publish a journal and pass on information
regarding the availability of raw materials, modern machines, export potentialities and provide other
information needed by the firms. It will benefit all firms and reduction in their costs.
An industry is in a better position to provide welfare facilities to the workers. It may get land at
concessional rates and procure special facilities from the local bodies for setting up housing
colonies for the workers. It may also establish public health care units, educational institutions both
The firms in an industry may also reap the economies of specialization. When an industry expands,
it becomes possible to spilt up some of the processes which are taken over by specialist firms. For
example, in the cotton textile industry, some firms may specialize in manufacturing thread, others in
printing, still others in dyeing, some in long cloth, some in dhotis, some in shirting etc. As a result
the efficiency of the firms specializing in different fields increases and the unit cost of production
falls.
Thus internal economies depend upon the size of the firm and external economies depend upon the
size of the industry.
Internal and external diseconomies are the limits to large-scale production. It is possible that
expansion of a firm’s output may lead to rise in costs and thus result diseconomies instead of
economies. When a firm expands beyond proper limits, it is beyond the capacity of the manager to
manage it efficiently. This is an example of an internal diseconomy. In the same manner, the
expansion of an industry may result in diseconomies, which may be called external diseconomies.
Employment of additional factors of production becomes less efficient and they are obtained at a
higher cost. It is in this way that external diseconomies result as an industry expands.
INTERNAL DISECONOMIES:
For expanding business, the entrepreneur needs finance. But finance may not be easily available in
the required amount at the appropriate time. Lack of finance retards the production plans thereby
increasing costs of the firm.
As business is expanded, prices of the factors of production will rise. The cost will therefore rise.
Raw materials may not be available in sufficient quantities due to their scarcities. Additional output
may depress the price in the market. The demand for the products may fall as a result of changes in
tastes and preferences of the people. Hence cost will exceed the revenue.
There is a limit to the division of labour and splitting down of production p0rocesses. The firm may
fail to operate its plant to its maximum capacity. As a result cost per unit increases. Internal
diseconomies follow.
As the scale of production of a firm expands risks also increase with it. Wrong decision by the
management may adversely affect production. In large firms are affected by any disaster, natural or
human, the economy will be put to strains.
EXTERNAL DISECONOMIES:
When many firm get located at a particular place, the costs of transportation increases due to
congestion. The firms have to face considerable delays in getting raw materials and sending
finished products to the marketing centers. The localization of industries may lead to scarcity of raw
material, shortage of various factors of production like labour and capital, shortage of power,
finance and equipments. All such external diseconomies tend to raise cost per unit.
QUESTIONS
1. Why does the law of diminishing returns operate? Explain with the help of a diagram.
2. Explain the nature and uses of production function.
3. Explain and illustrate lows of returns to scale.
4. a. Explain how production function can be mode use of to reduce cost of
Production.
b. Explain low of constant returns? Illustrate.
5. Explain the following (i) Internal Economics (ii) External Economics (or)
Explain Economics of scale. Explain the factor, which causes increasing returns to scale.
6. Explain the following with reference to production functions
(a) MRTS
(b) Variable proportion of factor
QUIZ
5. When producer secures maximum output with the least cost combination
Of factors of production, it is known as_______ ( )
(a) Consumer’s Equilibrium (b) Price Equilibrium
(c) Producer’s Equilibrium (d) Firm’s Equilibrium
11. When Proportionate increase in all inputs results in more than equal
Proportionate increase in output, then we call _____________. ( )
(a) Decreasing Returns to Scale (b) Constant Returns to Scale
(c) Increasing Returns to Scale (d) None
12. When Proportionate increase in all inputs results in less than Equal
Proportionate increase in output, then we call _____________. ( )
(a) Increasing Returns to Scale (b) Constant Returns to Scale
(c) Decreasing Returns to Scale (d) None
Profit is the ultimate aim of any business and the long-run prosperity of a firm depends upon its
ability to earn sustained profits. Profits are the difference between selling price and cost of
production. In general the selling price is not within the control of a firm but many costs are under
its control. The firm should therefore aim at controlling and minimizing cost. Since every business
decision involves cost consideration, it is necessary to understand the meaning of various concepts
for clear business thinking and application of right kind of costs.
COST CONCEPTS:
A managerial economist must have a clear understanding of the different cost concepts for clear
business thinking and proper application. The several alternative bases of classifying cost and the
relevance of each for different kinds of problems are to be studied. The various relevant concepts of
cost are:
Out lay cost also known as actual costs obsolete costs are those expends which are actually incurred
by the firm these are the payments made for labour, material, plant, building, machinery traveling,
transporting etc., These are all those expense item appearing in the books of account, hence based
on accounting cost concept.
On the other hand opportunity cost implies the earnings foregone on the next best alternative, has
the present option is undertaken. This cost is often measured by assessing the alternative, which has
to be scarified if the particular line is followed.
The opportunity cost concept is made use for long-run decisions. This concept is very important in
capital expenditure budgeting. This concept is very important in capital expenditure budgeting. The
concept is also useful for taking short-run decisions opportunity cost is the cost concept to use when
the supply of inputs is strictly limited and when there is an alternative. If there is no alternative,
Opportunity cost is zero. The opportunity cost of any action is therefore measured by the value of
the most favorable alternative course, which had to be foregoing if that action is taken.
Explicit costs are those expenses that involve cash payments. These are the actual or business costs
that appear in the books of accounts. These costs include payment of wages and salaries, payment
for raw-materials, interest on borrowed capital funds, rent on hired land, Taxes paid etc.
Implicit costs are the costs of the factor units that are owned by the employer himself. These costs
are not actually incurred but would have been incurred in the absence of employment of self –
Historical cost is the original cost of an asset. Historical cost valuation shows the cost of an asset as
the original price paid for the asset acquired in the past. Historical valuation is the basis for financial
accounts.
A replacement cost is the price that would have to be paid currently to replace the same asset.
During periods of substantial change in the price level, historical valuation gives a poor projection
of the future cost intended for managerial decision. A replacement cost is a relevant cost concept
when financial statements have to be adjusted for inflation.
Short-run is a period during which the physical capacity of the firm remains fixed. Any increase in
output during this period is possible only by using the existing physical capacity more extensively.
So short run cost is that which varies with output when the plant and capital equipment in constant.
Long run costs are those, which vary with output when all inputs are variable including plant and
capital equipment. Long-run cost analysis helps to take investment decisions.
Out-of pocket costs also known as explicit costs are those costs that involve current cash payment.
Book costs also called implicit costs do not require current cash payments. Depreciation, unpaid
interest, salary of the owner is examples of back costs.
But the book costs are taken into account in determining the level dividend payable during a period.
Both book costs and out-of-pocket costs are considered for all decisions. Book cost is the cost of
self-owned factors of production.
Fixed cost is that cost which remains constant for a certain level to output. It is not affected by the
changes in the volume of production. But fixed cost per unit decrease, when the production is
increased. Fixed cost includes salaries, Rent, Administrative expenses depreciations etc.
Variable is that which varies directly with the variation is output. An increase in total output results
in an increase in total variable costs and decrease in total output results in a proportionate decline in
the total variables costs. The variable cost per unit will be constant. Ex: Raw materials, labour,
direct expenses, etc.
Post costs also called historical costs are the actual cost incurred and recorded in the book of
account these costs are useful only for valuation and not for decision making.
Future costs are costs that are expected to be incurred in the futures. They are not actual costs. They
are the costs forecasted or estimated with rational methods. Future cost estimate is useful for
decision making because decision are meant for future.
Traceable costs otherwise called direct cost, is one, which can be identified with a products process
or product. Raw material, labour involved in production is examples of traceable cost.
Common costs are the ones that common are attributed to a particular process or product. They are
incurred collectively for different processes or different types of products. It cannot be directly
identified with any particular process or type of product.
Avoidable costs are the costs, which can be reduced if the business activities of a concern are
curtailed. For example, if some workers can be retrenched with a drop in a product – line, or
volume or production the wages of the retrenched workers are escapable costs.
The unavoidable costs are otherwise called sunk costs. There will not be any reduction in this cost
even if reduction in business activity is made. For example cost of the ideal machine capacity is
unavoidable cost.
Controllable costs are ones, which can be regulated by the executive who is in change of it. The
concept of controllability of cost varies with levels of management. Direct expenses like material,
labour etc. are controllable costs.
Some costs are not directly identifiable with a process of product. They are appointed to various
processes or products in some proportion. This cost varies with the variation in the basis of
allocation and is independent of the actions of the executive of that department. These apportioned
costs are called uncontrollable costs.
Incremental cost also known as different cost is the additional cost due to a change in the level or
nature of business activity. The change may be caused by adding a new product, adding new
machinery, replacing a machine by a better one etc.
Sunk costs are those which are not altered by any change – They are the costs incurred in the past.
This cost is the result of past decision, and cannot be changed by future decisions. Investments in
fixed assets are examples of sunk costs.
Total cost is the total cash payment made for the input needed for production. It may be explicit or
implicit. It is the sum total of the fixed and variable costs. Average cost is the cost per unit of
output. If is obtained by dividing the total cost (TC) by the total quantity produced (Q)
TC
Average cost = ------
Q
Marginal cost is the additional cost incurred to produce and additional unit of output or it is the cost
of the marginal unit produced.
Accounting costs are the costs recorded for the purpose of preparing the balance sheet and profit
and ton statements to meet the legal, financial and tax purpose of the company. The accounting
concept is a historical concept and records what has happened in the post.
Economics concept considers future costs and future revenues, which help future planning, and
choice, while the accountant describes what has happened, the economics aims at projecting what
will happen.
BREAKEVEN ANALYSIS
The study of cost-volume-profit relationship is often referred as BEA. The term BEA is interpreted
in two senses. In its narrow sense, it is concerned with finding out BEP; BEP is the point at which
total revenue is equal to total cost. It is the point of no profit, no loss. In its broad determine the
probable profit at any level of production.
Assumptions:
Merits:
1. Information provided by the Break Even Chart can be understood more easily then those
contained in the profit and Loss Account and the cost statement.
2. Break Even Chart discloses the relationship between cost, volume and profit. It reveals how
changes in profit. So, it helps management in decision-making.
3. It is very useful for forecasting costs and profits long term planning and growth
4. The chart discloses profits at various levels of production.
5. It serves as a useful tool for cost control.
6. It can also be used to study the comparative plant efficiencies of the industry.
7. Analytical Break-even chart present the different elements, in the costs – direct material,
direct labour, fixed and variable overheads.
Demerits:
1. Break-even chart presents only cost volume profits. It ignores other considerations such as
capital amount, marketing aspects and effect of government policy etc., which are necessary
in decision making.
2. It is assumed that sales, total cost and fixed cost can be represented as straight lines. In
actual practice, this may not be so.
3. It assumes that profit is a function of output. This is not always true. The firm may increase
the profit without increasing its output.
4. A major draw back of BEC is its inability to handle production and sale of multiple
products.
5. It is difficult to handle selling costs such as advertisement and sale promotion in BEC.
6. It ignores economics of scale in production.
7. Fixed costs do not remain constant in the long run.
8. Semi-variable costs are completely ignored.
9. It assumes production is equal to sale. It is not always true because generally there may be
opening stock.
10. When production increases variable cost per unit may not remain constant but may reduce
on account of bulk buying etc.
11. The assumption of static nature of business and economic activities is a well-known defect
of BEC.
1. Fixed cost: Expenses that do not vary with the volume of production are known as fixed
expenses. Eg. Manager’s salary, rent and taxes, insurance etc. It should be noted that fixed
changes are fixed only within a certain range of plant capacity. The concept of fixed overhead is
most useful in formulating a price fixing policy. Fixed cost per unit is not fixed.
2. Variable Cost: Expenses that vary almost in direct proportion to the volume of production of
sales are called variable expenses. Eg. Electric power and fuel, packing materials consumable
stores. It should be noted that variable cost per unit is fixed.
3. Contribution: Contribution is the difference between sales and variable costs and it contributed
towards fixed costs and profit. It helps in sales and pricing policies and measuring the
profitability of different proposals. Contribution is a sure test to decide whether a product is
worthwhile to be continued among different products.
4. Margin of safety: Margin of safety is the excess of sales over the break even sales. It can be
expressed in absolute sales amount or in percentage. It indicates the extent to which the sales
can be reduced without resulting in loss. A large margin of safety indicates the soundness of the
business. The formula for the margin of safety is:
Profit
Present sales – Break even sales or
P. V. ratio
Margin of safety can be improved by taking the following steps.
1. Increasing production
2. Increasing selling price
3. Reducing the fixed or the variable costs or both
4. Substituting unprofitable product with profitable one.
5. Angle of incidence: This is the angle between sales line and total cost line at the Break-even
point. It indicates the profit earning capacity of the concern. Large angle of incidence indicates a
high rate of profit; a small angle indicates a low rate of earnings. To improve this angle,
contribution should be increased either by raising the selling price and/or by reducing variable
cost. It also indicates as to what extent the output and sales price can be changed to attain a
desired amount of profit.
Contribution
The formula is, X 100
Sales
7. Break – Even- Point: If we divide the term into three words, then it does not require further
explanation.
Break-divide
Even-equal
Point-place or position
Break Even Point refers to the point where total cost is equal to total revenue. It is a point of
no profit, no loss. This is also a minimum point of no profit, no loss. This is also a
minimum point of production where total costs are recovered. If sales go up beyond the
Break Even Point, organization makes a profit. If they come down, a loss is incurred.
Fixed Expenses
1. Break Even point (Units) = Contribution per unit
Fixed expenses
2. Break Even point (In Rupees) = X sales
Contribution
QUESTIONS
1. What cost concepts are mainly used for management decision making? Illustrate.
2. The PV ratio of matrix books Ltd Rs. 40% and the margin of safety Rs. 30. You are required
to work out the BEP and Net Profit. If the sales volume is Rs. 14000/-
5. Write short notes on: (i) Suck costs (ii) Abandonment costs
13. Describe the BEP with the help of a diagram and its uses in business decision making.
14. If sales in 10000 units and selling price Rs. 20/- per unit. Variable cost is Rs. 10/- per unit
and fixed cost is Rs. 80000. Find out BEP in Units and sales revenue what is profit earned?
What should be the sales for earning a profit of Rs. 60000/-
15. How do you determine BEP in terms of physical units and sales value? Explain the concepts
of margin of safety & angle of incidence.
16. Sales are 1,10,000 producing a profit of Rs. 4000/- in period I, sales are 150000 producing a
profit of Rs. 12000/- in period II. Determine BEP & fixed expenses.
17. When a Mc change does Ac changed (a) at the same rate (b) at a higher rate or (c) at a lower
rate? Illustrate your answer with a diagram.
18. Explain the relationship between MC, AC and TC assuming a short run non-linear cost
function.
19. Sale of a product amounts to 20 units per months at Rs. 10/- per unit. Fixed overheads is Rs.
400/- per month and variable cost is Rs. 6/- per unit. There is a proposal to reduce prices by
107. Calculate present and future P-V ratio. How many units must be sold to earn a target
profit of present level?
2. If we add up total fixed cost (TFC) and total variable cost (TVC),
we get__ ( )
(a) Average cost (b) Marginal cost
(c) Total cost (d) Future cost
3. ________ costs are theoretical costs, which are not recognized by the
Accounting system. ( )
(a) Past (b) Explicit
(c) Implicit (d) Historical
5. _______ costs are the costs, which are varies with the level of output. ( )
(a) Fixed (b) Past
(c) Variable (d) Historical
10. _______ is a point of sales at which there is neither profit nor loss. ( )
(a) Maximum sales (b) Minimum sales
(c) Break-Even sales (d) Average sales
14. What is the break-even sales amount, when selling price per unit
is 10/- , Variable cost per unit is 6/- and fixed cost is 40,000/-. ( )
(a) Rs. 4, 00,000/- (b) Rs. 3, 00,000/-
(c) Rs. 1, 00,000/- (d) Rs. 2, 00,000/-
UNIT III
PRICING STRATEGIES
PRICING
INTRODUCTION
Pricing is an important, if not the most important function of all enterprises. Since every enterprise
is engaged in the production of some goods or/and service. Incurring some expenditure, it must set a
price for the same to sell it in the market. It is only in extreme cases that the firm has no say in
pricing its product; because there is severe or rather perfect competition in the market of the good
happens to be of such public significance that its price is decided by the government. In an
overwhelmingly large number of cases, the individual producer plays the role in pricing its product.
It is said that if a firm were good in setting its product price it would certainly flourish in the
market. This is because the price is such a parameter that it exerts a direct influence on the products
demand as well as on its supply, leading to firm’s turnover (sales) and profit. Every manager
Price
Price denotes the exchange value of a unit of good expressed in terms of money. Thus the current
price of a maruti car around Rs. 2,00,000, the price of a hair cut is Rs. 25 the price of a economics
book is Rs. 150 and so on. Nevertheless, if one gives a little, if one gives a little thought to this
subject, one would realize that there is nothing like a unique price for any good. Instead, there are
multiple prices.
Price concepts
Price of a well-defined product varies over the types of the buyers, place it is received, credit sale or
cash sale, time taken between final production and sale, etc.
It should be obvious to the readers, that the price difference on account of the above four factors are
more significant. The multiple prices is more serious in the case of items like cars refrigerators,
coal, furniture and bricks and is of little significance for items like shaving blade, soaps, tooth
pastes, creams and stationeries. Differences in various prices of any good are due to differences in
transport cost, storage cost accessories, interest cost, intermediaries’ profits etc. Once can still
conceive of a basic price, which would be exclusive of all these items of cost and then rationalize
other prices by adding the cost of special items attached to the particular transaction, in what
follows we shall explain the determination of this basis price alone and thus resolve the problem of
multiple prices.
The price of a product is determined by the demand for and supply of that product. According to
Marshall the role of these two determinants is like that of a pair of scissors in cutting cloth. It is
possible that at times, while one pair is held fixed, the other is moving to cut the cloth. Similarly, it
is conceivable that there could be situations under which either demand or supply is playing a
passive role, and the other, which is active, alone appear to be determining the price. However, just
as one pair of scissors alone can never cut a cloth, demand or supply alone is insufficient to
determine the price.
Equilibrium Price
The price at which demand and supply of a commodity is equal known as equilibrium price. The
demand and supply schedules of a good are shown in the table below.
Of the five possible prices in the above example, price Rs.30 would be the market-clearing price.
No other price could prevail in the market. If price is Rs. 50 supply would exceed demand and
consequently the producers of this good would not find enough customers for their demand, thereby
they would accumulate unwanted inventories of output, which, in turn, would lead to competition
among the producers, forcing price to Rs.30. Similarly if price were Rs.10, there would be excess
demand, which would give rise to competition among the buyers of good, forcing price to Rs.30. At
price Rs.30, demand equals supply and thus both producers and consumers are satisfied. The
economist calls such a price as equilibrium price.
PRICING METHODS
The micro – economic principle of profit maximization suggests pricing by the marginal analysis.
That is by equating MR to MC. However the pricing methods followed by the firms in practice
around the world rarely follow this procedure. This is for two reasons; uncertainty with regard to
demand and cost function and the deviation from the objective of short run profit maximization.
In view of these problems economic prices are a rare phenomenon. Instead, firms set prices for their
products through several alternative means. The important pricing methods followed in practice are
shown in the chart.
There are three versions of the cost – based pricing. Full – cost or break even pricing, cost plus
pricing and the marginal cost pricing. Under the first version, price just equals the average (total)
cost. In the second version, some mark-up is added to the average cost in arriving at the price. In the
last version, price is set equal to the marginal cost. While all these methods appear to be easy and
straight forward, they are in fact associated with a number of difficulties. Even through difficulties
are there, the cost- oriented pricing is quite popular today.
The cost – based pricing has several strengths as well as limitations. The advantages are its
simplicity, acceptability and consistency with the target rate of return on investment and the price
stability in general. The limitations are difficulties in getting accurate estimates of cost (particularly
Some commodities are priced according to the competition in their markets. Thus we have the
going rate method of price and the sealed bid pricing technique. Under the former a firm prices its
new product according to the prevailing prices of comparable products in the market. If the product
is new in the country, then its import cost – inclusive of the costs of certificates, insurance, and
freight and customs duty, is used as the basis for pricing, Incidentally, the price is not necessarily
equal to the import cost, but to the firm is either new in the country, or is a close substitute or
complimentary to some other products, the prices of hitherto existing bands or / and of the related
goods are taken in to a account while deciding its price. Thus, when television was first
manufactures in India, its import cost must have been a guiding force in its price determination.
Similarly, when
maruti car was first manufactured in India, it must have taken into account the prices of existing
cars, price of petrol, price of car accessories, etc. Needless to say, the going rate price could be
below or above the average cost and it could even be an economic price.
The sealed bid pricing method is quite popular in the case of construction activities and in the
disposition of used produces. In this method the prospective seller (buyers) are asked to quote their
prices through a sealed cover, all the offers are opened at a preannounce time in the presence of all
the competitors, and the one who quoted the least is awarded the contract (purchase / sale deed). As
it sound, this method is totally competition based and if the competitors unit by any change, the
buyers (seller) may have to pay (receive) an exorbitantly high (too low) price, thus there is a great
degree of risk attached to this method of pricing.
The demand – based pricing and strategy – based pricing are quite related. The seller knows rather
well that the demand for its product is a decreasing function of the price its sets for product. Thus if
seller wishes to sell more he must reduce the price of his product, and if he wants a good price for
his product, he could sell only a limited quantity of his good. Demand oriented pricing rules imply
establishment of prices in accordance with consumer preference and perceptions and the intensity of
demand.
A firm which products a new product, if it is also new to industry, can earn very good profits it if
handles marketing carefully, because of the uniqueness of the product. The price fixed for the new
product must keep the competitors away. Earn good profits for the firm over the life of the product
and must help to get the product accepted. The company can select either skimming pricing or
penetration pricing.
While there are some firms, which follow the strategy of price penetration, there are some others
who opt for price – skimming. Under the former, firms sell their new product at a low price in the
beginning in order to catch the attention of consumers, once the product image and credibility is
established, the seller slowly starts jacking up the price to reap good profits in future. Under this
strategy, a firm might well sell its product below the cost of production and thus runs into losses to
start with but eventually it recovers all its losses and even makes good overall profits. The Rin
washing soap perhaps falls into this category. This soap was sold at a rather low price in the
beginning and the firm even distributed free samples. Today, it is quite an expensive brand and yet it
is selling very well. Under the price – skimming strategy, the new product is priced high in the
beginning, and its price is reduced gradually as it faces a dearth of buyers such a strategy may be
beneficial for products, which are fancy, but of poor quality and / or of insignificant use over a
period of time.
A prudent producer follows a good mix of the various pricing methods rather than adapting any
once of them. This is because no method is perfect and every method has certain good features
further a firm might adopt one method at one time and another method at some other accession.
Cost-based Pricing:
Cost-plus Pricing:
Refers to the simplest method of determining the price of a product. In cost-plus pricing method, a
fixed percentage, also called mark-up percentage, of the total cost (as a profit) is added to the total
Cost-plus pricing is also known as average cost pricing. This is the most commonly used method in
manufacturing organizations.
In economics, the general formula given for setting price in case of cost-plus pricing is as
follows:
M = Mark-up percentage
Mark-up percentage (M) is fixed in which AFC and net profit margin (NPM) are covered.
ii. For determining average variable cost, the first step is to fix prices. This is done by estimating the
volume of the output for a given period of time. The planned output or normal level of production is
taken into account to estimate the output.
The second step is to calculate Total Variable Cost (TVC) of the output. TVC includes direct costs,
such as cost incurred in labor, electricity, and transportation. Once TVC is calculated, AVC is
obtained by dividing TVC by output, Q. [AVC= TVC/Q]. The price is then fixed by adding the
mark-up of some percentage of AVC to the profit [P = AVC + AVC (m)].
Refers to a pricing method in which the fixed amount or the percentage of cost of the product is
added to product’s price to get the selling price of the product. Markup pricing is more common in
retailing in which a retailer sells the product to earn profit. For example, if a retailer has taken a
c. For example, the product is sold for Rs. 500 whose cost was Rs. 400. The mark up as a
percentage to cost is equal to (100/400)*100 =25. The mark up as a percentage of the selling price
equals (100/500)*100= 20.
Demand-based Pricing:
Demand-based pricing refers to a pricing method in which the price of a product is finalized
according to its demand. If the demand of a product is more, an organization prefers to set high
prices for products to gain profit; whereas, if the demand of a product is less, the low prices are
charged to attract the customers.
The success of demand-based pricing depends on the ability of marketers to analyze the demand.
This type of pricing can be seen in the hospitality and travel industries. For instance, airlines during
the period of low demand charge less rates as compared to the period of high demand. Demand-
based pricing helps the organization to earn more profit if the customers accept the product at the
price more than its cost.
The term differential pricing is also used to describe the practice of charging different prices to
different buyers for the same quality and quantity of a product,[5] but it can also refer to a
combination of price differentiation and product differentiation.[3] Other terms used to refer to price
discrimination include equity pricing, preferential pricing,[6] dual pricing[7] and tiered pricing.[8]
Within the broader domain of price differentiation, a commonly accepted classification dating to the
1920s is:[9][10]
Competition-based Pricing:
The aviation industry is the best example of competition-based pricing where airlines charge the
same or fewer prices for same routes as charged by their competitors. In addition, the introductory
prices charged by publishing organizations for textbooks are determined according to the
competitors’ prices.
Implies a method in which an organization sets the price of a product according to the prevailing
price trends in the market. Thus, the pricing strategy adopted by the organization can be same or
similar to other organizations. However, in this type of pricing, the prices set by the market leaders
are followed by all the organizations in the industry.
In addition to the pricing methods, there are other methods that are discussed as follows:
i. Value Pricing:
Implies a method in which an organization tries to win loyal customers by charging low prices for
their high- quality products. The organization aims to become a low cost producer without
sacrificing the quality. It can deliver high- quality products at low prices by improving its research
and development process. Value pricing is also called value-optimized pricing.
Helps in achieving the required rate of return on investment done for a product. In other words, the
price of a product is fixed on the basis of expected profit.
Penetration Pricing implies a pricing technique in which new product is offered at low price, by
adding a nominal markup to its cost of production, to penetrate the market as early as possible. It
Penetration pricing results in lower profits in the short run, however, in the long run, it results in
higher profits because it increases the market base. The reasons behind adopting penetration pricing
are as under:
New product offered by the firm is already provided by other well-established brands. The
low price will lure customers to switch to the new product, who are already familiar with
other brands.
It can help in increasing sales of the product in short period.
It restricts new entrants from entering the market.
The pricing strategy in which high markup is charged for the new product, leading to the high price,
so as to skim the cream from the market, is known as Skimming Pricing. It entails fixing a high
price for the new product before other competitors step into the market.
This technique is used in case of new product, which faces no to little competition in the market,
and have a great extent of consumer acceptability. Market skimming pricing is adopted by the
company, due to the following reasons:
In the early stages, the demand for the product is inelastic, till the product occupies a good
position in the market.
In the initial phase, the demand for the product is not known, and high price helps in
covering the cost of production.
In the beginning, there is a huge requirement of capital for producing the product, resulting
in high production cost. Further, a huge amount is invested in the promotional activities, that
also adds to its cost. When the product is charged high, it will cover the cost of production
and promotion expenses easily.
1. Penetration Pricing can be described as a pricing method adopted by the firm to attract more
and more customers, in which the product is offered at low price at the early stage.
Conversely, skimming pricing is used to mean a pricing technique, in which high price is
charged at the beginning to earn maximum profit.
2. Penetration pricing aims at achieving a greater market share, by offering the product at low
prices. As against the object of using skimming pricing strategy is to earn maximum profit
from the customers, by offering the product at the highest price.
3. Penetration pricing strategy is put into practice when the demand for the product is relatively
elastic. On the other hand, skimming pricing is used when the demand for the product is
inelastic.
4. In case of penetration pricing, the profit margin is low, whereas, in skimming pricing, the
profit margin is very high.
v) A limit price (or limit pricing) is a price, or pricing strategy, where products
are sold by a supplier at a price low enough to make it unprofitable for other players to enter
the market.
It is used by monopolists to discourage entry into a market, and is illegal in many countries.
[1]
The quantity produced by the incumbent firm to act as a deterrent to entry is usually larger
than would be optimal for a monopolist, but might still produce higher economic profits
than would be earned under perfect competition.
Disadvantages:
The problem with limit pricing as strategic behavior is that once the entrant has entered the
market, the quantity used as a threat to deter entry is no longer the incumbent firm's best
response. This means that for limit pricing to be an effective deterrent (means a thing that
discourages or is intended to discourage someone from doing something.) to entry, the threat
must in some way be made credible. A way to achieve this is for the incumbent firm to
constrain itself to produce a certain quantity whether entry occurs or not. An example of this
would be if the firm signed a union contract to employ a certain (high) level of labor for a
long period of time.[2] Another example is to build excess production capacity as a
commitment device.
It is important to note that due to the often ambiguous nature of cost in production, it may be
relatively easy for a firm to avoid legal difficulties when undertaking such action. Due to
this ambiguous nature, limit pricing may well be a commonly used strategy even in modern
economies. However, it is often very hard to regulate, since limit pricing is often
synonymous with a market monopoly. When a monopoly exists, it becomes very difficult to
compare alternative prices with other, similar firms to confirm claims that limit pricing may
be occurring.
Peak Load Pricing is a pricing strategy that implies price will be set at the highest level during
times when demand is at a peak. The pricing strategy is an attempt to shift demand, or at
least consumption of the good or service, to accomodate supply. The idea is that pricing higher
when demand is at its peak will balance out the supply and demand so that there is no
shortage on either end of the spectrum. If a good is priced at a high cost and many demand it,
a capacity will be balanced. This is a type of price discrimination; a firm discriminates between
high-traffic, high usage or high demand times and low usage time periods. The consumer that
purchases during high usage times has to pay a higher price than that of the consumer that
can delay his purchase or demand.
Graphically, Marginal Cost is constant until the quantity being produced is the maximum that
the firm can produce. At this quantity, Marginal Cost becomes vertical. Since firms optimize
profits when MC=MR, shifts in MR and MC effect the price. As demand shifts outward, Marginal
Revenue increases. As a result, the point where MR=MC increases and higher prices result.
For example,1:
A movie theatre, which charges more for the evening show than for the matinee show because for
theatres, the MC of serving customers during the matinee show is independent of the MC during
the evening. The owner of a movie theatre can determine the optimal prices for the evening and
matinee shows independently, using estimates of demand in each period and of MC.
Example2:
Tourist pricing. In a tourist town, one might see prices of many goods rise during tourist
season.
Example 3:
Pizza prices. On the weekend, there are a limited number of specials, however on Monday and
Tuesday (slow days for pizza shops), many more low cost deals are available.
Example 4:
Telecommunications services firms practice a limited form of peak load pricing. Globe
Telecoms, for instance, charges a lower call rate from10:01 pm to 6:59 am. Long distance
calls made during off-peak periods also cost less. Some “decongestion” results from this
practice.
Example 5:
The same outcome happens when airlines charge higher fares during the tourist season -- the
producers maximize profits and make better use of capacity. This shifting of consumption
creates what economists call “efficiency gains.” If airfares were kept uniform, airlines would
forego profits because they have to turn away passengers when flights are fully booked, while
other flights take off with a lot of empty seats.
Advantages:
1. When a good or service is limited in availability, peak load pricing can effectively reduce consumer
consumption because consumers are swayed by the high prices.
2. On the other hand, when prices are lower, consumers are more likely to purchase more.
3. The high demand at certain hours would compel the producers to install additional
capacity. Producers would have to pump in additional capital, and pass the cost on to
consumers.
Reasons:
1. The rules imposed by regulatory authorities
2. The producer lacks information that allows differential pricing across periods of
consumption.
3. Installing equipment that allows the producer to impose different prices depending on
times of consumption is itself an added
Block pricing is a pricing strategy in which identical products are packaged together in order
to increase profits by forcing customers to make an all or none decision. By packaging the
product and selling it as one unit the firm earns more than if it sold all of the units at a
simple per unit price. The profit maximizing price for a block pricing scheme is the total
amount the consumer receives for the product. This amount also includes the consumer
surplus. This pricing strategy is very similar to the two-part pricing strategy in that it's
purpose is to extract the maximum conumer surplus.
Source: Baye, Michael. Managerial Economics and Business Strategy. 2006. The chart below illustrates the
the block pricing scheme:
Block pricing is frequently used by supermarkets to extract the most value out of the
consumers. An example is a package of toilet paper. Oftentimes the supermarkets will
bundle the toilet paper into units of 24 or 48 to force the consumer to buy the large pack or
not to buy the pack at all. By packaging the toilet paper in this way, the supermarket can
earn a larger profit.
Example 1.
Microsoft Office suite (which is a bundle of applications for word processing, spreadsheets,
presentation, and so on),
Example 2.
McDonalds Happy Meal (which is a bundle of items such as a burger, fries and a cold
drink)
Example3.
bundling of TV channels by cable operators. Product bundling can be used as a means of
differentiation and/or market expansion.
• Exposure: New customers may be attracted and new channels may open up
• Risk: Profitable channels may be cannibalized, resulting on lower sales and lower margins. Care
should be taken to avoid channel conflict.
c) Marginal costs are low; set-up costs for production are high;
f) It usually works very well for high volume; low marginal cost goods.
For Example1:
A company selling men’s garments may sell shirts at lower price, but make up for the lost margins
through selling suiting material at premium prices.
1. Cross subsidization can be a useful strategy to launch new products into a very highly
competitive market.
2. Offering a good quality product, with appropriate customer service and at a low price point,
can lead to rapid increase in sales volume and will help attract consumers spoilt for choice
in a certain product category.
Drawbacks:
1. Although the company may drive up market share for the low priced product, it may
rapidly lose market share for the high priced product if the competitors price it
competitively (they still remain profitable).
2. Larger volumes of business for the low priced product will drive resources towards it, thus
affecting business of the high priced product. This will have a reverse effect on the low
priced product – In order to make for the lost business, the company may be forced to
increase the price of the lower priced product, thus driving away customers.
x) Transfer pricing:
Involves selling of goods and services within the departments of the organization. It is done to
manage the profit and loss ratios of different departments within the organization. One department
of an organization can sell its products to other departments at low prices. Sometimes, transfer
pricing is used to show higher profits in the organization by showing fake sales of products within
departments.
Pricing of goods and services within a multi-divisional organization, particularly in regard to cross-
border transactions.
Transfer pricing describes all aspects of intercompany pricing arrangements between related
business entities, including transfers of intellectual property; transfers of tangible goods; services
and loans and other financing transactions.
Inter-company transactions across borders are growing rapidly and are becoming much more
complex. Compliance with the differing requirements of multiple overlapping tax jurisdictions is a
complicated and time-consuming task.
At the same time, tax authorities from each country are imposing stricter penalties, new
documentation requirements, increased information exchange and increased audit/inspection
activity.
Division managers are provided incentives to maximize their own division's profits. The firm must
set the optimal transfer prices to maximize company profits or each division will try to maximize
their own profits leading to lower overall profits for the firm. Double marginalization is when both
divisions mark up prices in excess of marginal cost and overall firm profits are not optimal.
Example:
Company X produces car engines in a plant in Michigan and puts together the entire car in Indiana.
Each of these locations are a division of the company that has to meet their own profit margins.
Company X tells the engine division in Michigan that they must make a profit of $500 per engine.
They also tell the final assembly division in Indiana that they must make a profit of $2,000. The
engine division in Michigan wants to set a price in which they will make the required profit.
However, if they set this price too high then the Indiana division will not make their required profit
and the total company will have less of a profit. Each division must set a transfer price in which the
company will be the most profitable and not based on each division being the most profitable.
In a monopolistic world, the firm would produce at quantity Qm and price at Pm. This would
create a profit of section B. By charging a per unit price of Pc and a fixed charge of A,B,C, the
firm will actually increase it's profits to A,B,C. Thus, it would extract all of the consumer
surplus and increase its profits by A,C. Charging the fixed fee in this way increases income if
the firm can determine the correct price to charge for the fixed fee. The risk to the firm of
charging too high of a fixed fee is that the firm will be priced out of the market and will not
purchase any of the products.
Another case for two part pricing is when there are two consumers and their demand is not assumed
to be identical. In the case of the chart above, the demand for consumer Y is assumed to be twice
that of consumer X. In other words, we are making the assumption that we cannot discriminate
against the consumers individually. By charging a fixed price equal to A,B, the firm would be
pricing consumer X out of the market. Therefore, one of the firm's options is to charge a fixed price
of A,C and a price of Pc. In this way the firm will be able to secure a surplus of A,B,C,D. However,
In each of these examples the goal of the firm is to extract the largest consumer surplus possible to
receive the largest profits. The firm must be careful not to charge too high of a fixed fee or it may
completely alienate the consumers and receive no profit whatsoever.
PRICING OBJECTIVES:
QUESTIONS
QUIZ
7. Under which pricing method, price just equals the total cost ( )
(a) Marginal cost pricing (b) Cost plus pricing
(c) Full cost pricing (d) Going rate pricing
8. ______ is a place in which goods and services are bought and sold. ( )
(a) Factory (b) Workshop
(c) Market (d) Warehouse
10. Charging Very Low price in the beginning and increasing it gradually
is called ________ ( )
(a) Differential pricing (b) Sealed bid Pricing
(c) Penetration Pricing (d) Skimming Pricing
Introduction
Finance is the prerequisite to commence and vary on business. It is rightly said to be the
lifeblood of the business. No growth and expansion of business can take place without sufficient
finance. It shows that no business activity is possible without finance. This is why; every
business has to make plans regarding acquisition and utilization of funds.
Function of finance
Investment Decision
The investment decision relates to the selection of assets in which funds will be invested by a
firm. The assets as per their duration of benefits, can be categorized into two groups: (i) long-
term assets which yield a return over a period of time in future (ii) short-term or current assents
which in the normal course of business are convertible into cash usually with in a year.
Accordingly, the asset selection decision of a firm is of two types. The investment in long-term
assets is popularly known as capital budgeting and in short-term assets, working capital
management.
1. Capital budgeting: Capital budgeting – the long – term investment decision – is probably
the most crucial financial decision of a firm. It relates to the selection of an assent or
investment proposal or course of action that benefits are likely to be available in future over
the lifetime of the project.
The long-term investment may relate to acquisition of new asset or replacement of old
assets. Whether an asset will be accepted or not will depend upon the relative benefits and
returns associated with it. The measurement of the worth of the investment proposals is,
therefore, a major element in the capital budgeting exercise. The second element of the
capital budgeting decision is the analysis of risk and uncertainty as the benefits from the
investment proposals pertain the future, which is uncertain. They have to be estimated under
various assumptions and thus there is an element of risk involved in the exercise. The return
The third and final element is the ascertainment of a certain norm or standard against which
the benefits are to be judged. The norm is known by different names such as cut-off rate,
hurdle rate, required rate, minimum rate of return and so on. This standard is broadly
expressed in terms of the cost of capital is, thus, another major aspect of the capital;
budgeting decision. In brief, the main elements of the capital budgeting decision are: (i) The
total assets and their composition (ii) The business risk complexion of the firm, and (iii)
concept and measurement of the cost of capital.
Finance Decision
The second major decision involved in financial management is the financing decision, which is
concerned with the financing – mix or capital structure of leverage. The term capital structure
refers to the combination of debt (fixed interest sources of financing) and equity capital
(variable – dividend securities/source of funds). The financing decision of a firm relates to the
choice of the proportion of these sources to finance the investment requirements. A higher
proportion of debt implies a higher return to the shareholders and also the higher financial risk
and vice versa. A proper balance between debt and equity is a must to ensure a trade – off
between risk and return to the shareholders. A capital structure with a reasonable proportion of
debt and equity capital is called the optimum capital structure.
The second aspect of the financing decision is the determination of an appropriate capital
structure, which will result, is maximum return to the shareholders and in turn maximizes the
worth of the firm. Thus, the financing decision covers two inter-related aspects: (a) capital
structure theory, and (b) capital structure decision.
Finance is required for two purpose viz. for it establishment and to carry out the day-to-day
operations of a business. Funds are required to purchase the fixed assets such as plant, machinery,
land, building, furniture, etc, on long-term basis. Investments in these assets represent that part of
firm’s capital, which is blocked on a permanent of fixed basis and is called fixed capital. Funds are
also needed for short-term purposes such as the purchase of raw materials, payment of wages and
other day-to-day expenses, etc. and these funds are known as working capital. In simple words
working capital refers that part of the firm’s capital, which is required for financing short term or
current assets such as cash, marketable securities, debtors and inventories. The investment in these
current assets keeps revolving and being constantly converted into cash and which in turn financed
to acquire current assets. Thus the working capital is also known as revolving or circulating capital
or short-term capital.
Current liabilities are those liabilities, which are intend to be paid in the ordinary course of business
within a short period, normally one accounting year out of the current assets or the income of the
business. Net working capital may be positive or negative. When the current assets exceed the
current liabilities net working capital is positive and the negative net working capital results when
the liabilities are more then the current assets.
1. Bills payable
2. Sundry Creditors or Accounts Payable.
3. Accrued or Outstanding Expanses.
4. Short term loans, advances and deposits.
5. Dividends payable
6. Bank overdraft
7. Provision for taxation etc.
On the basis of concept, working capital is classified as gross working capital and net working
capital is discussed earlier. This classification is important from the point of view of the
financial manager. On the basis of time, working capital may be classified as:
Temporary working capital differs from permanent working capital in the sense that it is
required for short periods and cannot be permanently employed gainfully in the business.
Figures given below illustrate the different between permanent and temporary working
capital.
Working capital is refereed to be the lifeblood and nerve center of a business. Working capital is as
essential to maintain the smooth functioning of a business as blood circulation in a human body. No
business can run successfully with out an adequate amount of working capital. The main advantages
of maintaining adequate amount of working capital are as follows:
The need for working capital arises mainly due to the time gap between production and realization
of cash. The process of production and sale cannot be done instantaneously and hence the firm
needs to hold the current assets to fill-up the time gaps. There are time gaps in purchase of raw
materials and production; production and sales: and sales and realization of cash. The working
capital is needed mainly for the following purposes:
Generally, the level of working capital needed depends upon the time gap (known as operating
cycle) and the size of operations. Greater the size of the business unit generally, larger will be the
There are a large number of factors such as the nature and size of business, the character of their
operations, the length of production cycle, the rate of stock turnover and the state of economic
situation etc. that decode requirement of working capital. These factors have different importance
and influence on firm differently. In general following factors generally influence the working
capital requirements.
SOURCE OF FINANCE
Incase of proprietorship business, the individual proprietor generally invests his own savings to start
with, and may borrow money on his personal security or the security of his assets from others.
Similarly, the capital of a partnership from consists partly of funds contributed by the partners and
partly of borrowed funds. But the company from of organization enables the promoters to raise
necessary funds from the public who may contribute capital and become members (share holders)
of the company. In course of its business, the company can raise loans directly from banks and
financial institutions or by issue of securities (debentures) to the public. Besides, profits earned may
also be reinvested instead of being distributed as dividend to the shareholders.
Thus for any business enterprise, there are two sources of finance, viz, funds contributed by owners
and funds available from loans and credits. In other words the financial resources of a business may
be own funds and borrowed funds.
The ownership capital is also known as ‘risk capital’ because every business runs the risk of loss or
low profits, and it is the owner who bears this risk. In the event of low profits they do not have
adequate return on their investment. If losses continue the owners may be unable to recover even
their original investment. However, in times of prosperity and in the case of a flourishing business
the high level of profits earned accrues entirely to the owners of the business. Thus, after paying
The second characteristic of this source of finance is that ownership capital remains permanently
invested in the business. It is not refundable like loans or borrowed capital. Hence a large part of it
is generally used for a acquiring long – lived fixed assets and to finance a part of the working
capital which is permanently required to hold a minimum level of stock of raw materials, a
minimum amount of cash, etc.
Another characteristic of ownership capital related to the management of business. It is on the basis
of their contribution to equity capital that owners can exercise their right of control over the
management of the firm. Managers cannot ignore the owners in the conduct of business affairs. The
sole proprietor directly controls his own business. In a partnership firm, the active partner will take
part in the management of business. A company is managed by directors who are elected by the
members (shareholders).
Merits:
Arising out of its characteristics, the advantages of ownership capital may be briefly stated as
follows:
Limitations:
There are also certain limitations of ownership capital as a source of finance. These are:
The amount of capital, which may be raised as owners fund depends on the number of persons,
prepared to take the risks involved. In a partnership confer, a few persons cannot provide ownership
capital beyond a certain limit and this limitation is more so in case of proprietary form of
organization.
A joint stock company can raise large amount by issuing shares to the public. Bus it leads to an
increased number of people having ownership interest and right of control over management. This
may reduce the original investors’ power of control over management. Being a permanent source of
capital, ownership funds are not refundable as long as the company is in existence, even when the
funds remain idle.
Borrowed funds and borrowed capital: It includes all funds available by way of loans or credit.
Business firms raise loans for specified periods at fixed rates of interest. Thus borrowed funds may
serve the purpose of long-term, medium-term or short-term finance. The borrowing is generally at
against the security of assets from banks and financial institutions. A company to borrow the funds
can also issue various types of debentures.
Interest on such borrowed funds is payable at half yearly or yearly but the principal amount is being
repaid only at the end of the period of loan. These interest and principal payments have to be met
even if the earnings are low or there is loss. Lenders and creditors do not have any right of control
over the management of the borrowing firm. But they can sue the firm in a law court if there is
default in payment, interest or principal back.
Merits:
From the business point of view, borrowed capital has several merits.
1. It does not affect the owner’s control over management.
2. Interest is treated as an expense, so it can be charged against income and amount of tax
payable thereby reduced.
3. The amount of borrowing and its timing can be adjusted according to convenience and
needs, and
4. It involves a fixed rate of interest to be paid even when profits are very high, thus owners
may enjoy a much higher rate of return on investment then the lenders.
Limitations:
There are certain limitations, too in case of borrowed capacity. Payment of interest and repayment
of loans cannot be avoided even if there is a loss. Default in meeting these obligations may create
problems for the business and result in decline of its credit worthiness. Continuing default may even
lead to insolvency of firm.
Secondly, it requires adequate security to be offered against loans. Moreover, high rates of interest
may be charged if the firm’s ability to repay the loan in uncertain.
Based upon the time, the financial resources may be classified into (1) sources of long term (2)
sources of short – term finance. Some of these sources also serve the purpose of medium – term
finance.
1. Issue of shares
2. Issue debentures
3. Loan from financial institutions
4. Retained profits and
5. Public deposits
1. Trade credit
2. Bank loans and advances and
3. Short-term loans from finance companies.
1. Issue of Shares: The amount of capital decided to be raised from members of the public is
divided into units of equal value. These units are known as share and the aggregate values of
shares are known as share capital of the company. Those who subscribe to the share capital
become members of the company and are called shareholders. They are the owners of the
company. Hence shares are also described as ownership securities.
2. Issue of Preference Shares: Preference share have three distinct characteristics. Preference
shareholders have the right to claim dividend at a fixed rate, which is decided according to
the terms of issue of shares. Moreover, the preference dividend is to be paid first out of the
net profit. The balance, it any, can be distributed among other shareholders that is, equity
shareholders. However, payment of dividend is not legally compulsory. Only when dividend
is declared, preference shareholders have a prior claim over equity shareholders.
Preference shareholders also have the preferential right of claiming repayment of capital in
the event of winding up of the company. Preference capital has to be repaid out of assets
after meeting the loan obligations and claims of creditors but before any amount is repaid to
equity shareholders.
Holders of preference shares enjoy certain privileges, which cannot be claimed by the equity
shareholders. That is why; they cannot directly take part in matters, which may be discussed
at the general meeting of shareholders, or in the election of directors.
Depending upon the terms of conditions of issue, different types of preference shares may
be issued by a company to raises funds. Preference shares may be issued as:
1. Cumulative or Non-cumulative
2. Participating or Non-participating
In the case of cumulative preference shares, the dividend unpaid if any in previous years
gets accumulated until that is paid. No cumulative preference shares have any such
provision.
Participatory shareholders are entitled to a further share in the surplus profits after a
reasonable divided has been paid to equity shareholders. Non-participating preference shares
do not enjoy such right. Redeemable preference shares are those, which are repaid after a
specified period, where as the irredeemable preference shares are not repaid. However, the
company can also redeem these shares after a specified period by giving notice as per the
terms of issue. Convertible preference shows are those, which are entitled to be converted
into equity shares after a specified period.
Merits:
Many companies due to the following reasons prefer issue of preference shares as a source
of finance.
Limitations:
1. Dividend paid cannot be charged to the company’s income as an expense; hence there is no
tax saving as in the case of interest on loans.
2. Even through payment of dividend is not legally compulsory, if it is not paid or arrears
accumulate there is an adverse effect on the company’s credit.
3. Issue of preference share does not attract many investors, as the return is generally limited
and not exceed the rates of interest on loan. On the other than, there is a risk of no dividend
being paid in the event of falling income.
1. Issue of Equity Shares: The most important source of raising long-term capital for a company is
the issue of equity shares. In the case of equity shares there is no promise to shareholders a fixed
dividend. But if the company is successful and the level profits are high, equity shareholders enjoy
very high returns on their investment. This feature is very attractive to many investors even through
they run the risk of having no return if the profits are inadequate or there is loss. They have the right
From the above it can be said that equity shares have three distinct characteristics:
1. The holders of equity shares are the primary risk bearers. It is the issue of equity shares that
mainly provides ‘risk capital’, unlike borrowed capital. Even compared with preference
capital, equity shareholders are to bear ultimate risk.
2. Equity shares enable much higher return sot be earned by shareholders during prosperity
because after meeting the preference dividend and interest on borrowed capital at a fixed
rate, the entire surplus of profit goes to equity shareholders only.
3. Holders of equity shares have the right of control over the company. Directors are elected on
the vote of equity shareholders.
Merits:
From the company’ point of view; there are several merits of issuing equity shares to raise long-
term finance.
Limitations:
Although there are several advantages of issuing equity shares to raise long-term capital.
1. The risks of fluctuating returns due to changes in the level of earnings of the company do
not attract many people to subscribe to equity capital.
2. The value of shares in the market also fluctuate with changes in business conditions, this is
another risk, which many investors want to avoid.
2. Issue of Debentures:
When a company decides to raise loans from the public, the amount of loan is dividend into units of
equal. These units are known as debentures. A debenture is the instrument or certificate issued by a
company to acknowledge its debt. Those who invest money in debentures are known as ‘debenture
holders’. They are creditors of the company. Debentures are therefore called ‘creditor ship’
Debentures carry a fixed rate of interest, and generally are repayable after a certain period, which is
specified at the time of issue. Depending upon the terms and conditions of issue there are different
types of debentures. There are:
It debentures are issued on the security of all or some specific assets of the company, they are
known as secured debentures. The assets are mortgaged in favor of the debenture holders.
Debentures, which are not secured by a charge or mortgage of any assets, are called unsecured
debentures. The holders of these debentures are treated as ordinary creditors.
Sometimes under the terms of issue debenture holders are given an option to covert their debentures
into equity shares after a specified period. Or the terms of issue may lay down that the whole or part
of the debentures will be automatically converted into equity shares of a specified price after a
certain period. Such debentures are known as convertible debentures. If there is no mention of
conversion at the time of issue, the debentures are regarded as non-convertible debentures.
Merits:
Debentures issue is a widely used method of raising long-term finance by companies, due to the
following reasons.
1. Interest payable on Debentures can be fixed at low rates than rate of return on equity shares.
Thus Debentures issue is a cheaper source of finance.
2. Interest paid can be deducted from income tax purpose; there by the amount of tax payable
is reduced.
3. Funds raised for the issue of debentures may be used in business to earn a much higher rate
of return then the rate of interest. As a result the equity shareholders earn more.
4. Another advantage of debenture issue is that funds are available from investors who are not
entitled to have any control over the management of the company.
5. Companies often find it convenient to raise debenture capital from financial institutions,
which prefer to invest in debentures rather than in shares. This is due to the assurance of a
fixed return and repayment after a specified period.
Limitations:
Debenture issue as a source of finance has certain limitations too.
1. It involves a fixed commitment to pay interest regularly even when the company has low
earnings or incurring losses.
Methods of Issuing Securities: The firm after deciding the amount to be raised and the type of
securities to be issued, must adopt suitable methods to offer the securities to potential investors.
There are for common methods followed by companies for the purpose.
When securities are offered to the general public a document known as Prospectus, or a notice,
circular or advertisement is issued inviting the public to subscribe to the securities offered thereby
all particulars about the company and the securities offered are made to the public. Brokers are
appointed and one or more banks are authorized to collect subscription.
Some times the entire issue is subscribed by an organization known as Issue House, which in turn
sells the securities to the public at a suitable time.
The company may negotiate with large investors of financial institutions who agree to take over the
securities. This is known as ‘Private Placement’ of securities.
When an exiting company decides to raise funds by issue of equity shares, it is required under law
to offer the new shares to the existing shareholders. This is described as right issue of equity shares.
But if the existing shareholders decline, the new shares can be offered to the public.
Government with the main object of promoting industrial development has set up a number of
financial institutions. These institutions play an important role as sources of company finance.
Besides they also assist companies to raise funds from other sources.
These institutions provide medium and long-term finance to industrial enterprises at a reason able
rate of interest. Thus companies may obtain direct loan from the financial institutions for expansion
or modernization of existing manufacturing units or for starting a new unit.
Often, the financial institutions subscribe to the industrial debenture issue of companies some of the
institutions (ICICI) and (IDBI) also subscribe to the share issued by companies.
All such institutions also underwrite the public issue of shares and debentures by companies.
Underwriting is an agreement to take over the securities to the extent there is no public response to
the issue. They may guarantee loans, which may be raised by companies from other sources.
Loans in foreign currency may also be granted for the import of machinery and equipment wherever
necessary from these institutions, which stand guarantee for re-payments. Apart from the national
level institutions mentioned above, there are a number of similar institutions set up in different
states of India. The state-level financial institutions are known as State Financial Corporation, State
4. Retained Profits:
Successful companies do not distribute the whole of their profits as dividend to shareholders but
reinvest a part of the profits. The amount of profit reinvested in the business of a company is known
as retained profit. It is shown as reserve in the accounts. The surplus profits retained and reinvested
may be regarded as an internal source of finance. Hence, this method of financing is known as self-
financing. It is also called sloughing back of profits.
Since profits belong to the shareholders, the amount of retained profit is treated as ownership fund.
It serves the purpose of medium and long-term finance. The total amount of ownership capital of a
company can be determined by adding the share capital and accumulated reserves.
Merits:
This source of finance is considered to be better than other sources for the following reasons.
Limitations:
1. Only well established companies can be avail of this sources of finance. Even for such
companies retained profits cannot be used to an unlimited extent.
2. Accumulation of reserves often attract competition in the market,
3. With the increased earnings, shareholders expect a high rate of dividend to be paid.
4. Growth of companies through internal financing may attract government restrictions as it
leads to concentration of economic power.
An important source of medium – term finance which companies make use of is public deposits.
This requires advertisement to be issued inviting the general public of deposits. This requires
advertisement to be issued inviting the general public to deposit their savings with the company.
The period of deposit may extend up to three yeas. The rate of interest offered is generally higher
than the interest on bank deposits. Against the deposit, the company mentioning the amount, rate of
interest, time of repayment and such other information issues a receipt.
Since the public deposits are unsecured loans, profitable companies enjoying public confidence
only can be able to attract public deposits. Even for such companies there are rules prescribed by
government limited its use.
1. Trade credit: Trade credit is a common source of short-term finance available to all
companies. It refers to the amount payable to the suppliers of raw materials, goods etc. after
an agreed period, which is generally less than a year. It is customary for all business firms to
allow credit facility to their customers in trade business. Thus, it is an automatic source of
finance. With the increase in production and corresponding purchases, the amount due to the
creditors also increases. Thereby part of the funds required for increased production is
financed by the creditors. The more important advantages of trade credit as a source of
short-term finance are the following:
It is readily available according to the prevailing customs. There are no special efforts to be
made to avail of it. Trade credit is a flexible source of finance. It can be easily adjusted to
the changing needs for purchases.
Where there is an open account for any creditor failure to pay the amounts on time due to
temporary difficulties does not involve any serious consequence Creditors often adjust the
time of payment in view of continued dealings. It is an economical source of finance.
However, the liability on account of trade credit cannot be neglected. Payment has to be
made regularly. If the company is required to accept a bill of exchange or to issue a
promissory note against the credit, payment must be made on the maturity of the bill or note.
It is a legal commitment and must be honored; otherwise legal action will follow to recover
the dues.
2. Bank loans and advances: Money advanced or granted as loan by commercial banks is
known as bank credit. Companies generally secure bank credit to meet their current
The advantage of bank credit as a source of short-term finance is that the amount can be
adjusted according to the changing needs of finance. The rate of interest on bank credit is
fairly high. But the burden is no excessive because it is used for short periods and is
compensated by profitable use of the funds.
Commercial banks also advance money by discounting bills of exchange. A company having
sold goods on credit may draw bills of exchange on the customers for their acceptance. A
bill is an order in writing requiring the customer to pay the specified amount after a certain
period (say 60 days or 90 days). After acceptance of the bill, the company can drawn the
amount as an advance from many commercial banks on payment of a discount. The amount
of discount, which is equal to the interest for the period of the bill, and the balance, is
available to the company. Bill discounting is thus another source of short-term finance
available from the commercial banks.
3. Short term loans from finance companies: Short-term funds may be available from
finance companies on the security of assets. Some finance companies also provide funds
according to the value of bills receivable or amount due from the customers of the
borrowing company, which they take over.
CAPITAL BUDGETING
Capital Budgeting: Capital budgeting is the process of making investment decision in long-term
assets or courses of action. Capital expenditure incurred today is expected to bring its benefits over
a period of time. These expenditures are related to the acquisition & improvement of fixes assets.
Capital budgeting is the planning of expenditure and the benefit, which spread over a number of
years. It is the process of deciding whether or not to invest in a particular project, as the investment
possibilities may not be rewarding. The manager has to choose a project, which gives a rate of
return, which is more than the cost of financing the project. For this the manager has to evaluate the
worth of the projects in-terms of cost and benefits. The benefits are the expected cash inflows from
the project, which are discounted against a standard, generally the cost of capital.
Capital Budgeting Process:
1. Project generation
2. Project evaluation
3. Project selection
4. Project execution
1. Project generation: In the project generation, the company has to identify the proposal to be
undertaken depending upon its future plans of activity. After identification of the proposals they can
be grouped according to the following categories:
a. Estimation of benefits and costs: These must be measured in terms of cash flows.
Benefits to be received are measured in terms of cash flows. Benefits to be received
are measured in terms of cash in flows, and costs to be incurred are measured in
terms of cash flows.
b. Selection of an appropriate criterion to judge the desirability of the project.
3. Project selection: There is no standard administrative procedure for approving the investment
decisions. The screening and selection procedure would differ from firm to firm. Due to lot of
importance of capital budgeting decision, the final approval of the project may generally rest on the
top management of the company. However the proposals are scrutinized at multiple levels. Some
times top management may delegate authority to approve certain types of investment proposals. The
top management may do so by limiting the amount of cash out lay. Prescribing the selection criteria
and holding the lower management levels accountable for the results.
The capital budgeting appraisal methods are techniques of evaluation of investment proposal will
help the company to decide upon the desirability of an investment proposal depending upon their;
relative income generating capacity and rank them in order of their desirability. These methods
provide the company a set of norms on the basis of which either it has to accept or reject the
investment proposal. The most widely accepted techniques used in estimating the cost-returns of
investment projects can be grouped under two categories.
1. Traditional methods
2. Discounted Cash flow methods
1. Traditional methods
These methods are based on the principles to determine the desirability of an investment project on
the basis of its useful life and expected returns. These methods depend upon the accounting
information available from the books of accounts of the company. These will not take into account
the concept of ‘time value of money’, which is a significant factor to determine the desirability of a
project in terms of present value.
A. Pay-back period method: It is the most popular and widely recognized traditional method of
evaluating the investment proposals. It can be defined, as ‘the number of years required to recover
the original cash out lay invested in a project’.
According to Weston & Brigham, “The pay back period is the number of years it takes the firm to
recover its original investment by net returns before depreciation, but after taxes”.
According to James. C. Vanhorne, “The payback period is the number of years required to recover
initial cash investment.
The pay back period is also called payout or payoff period. This period is calculated by dividing the
cost of the project by the annual earnings after tax but before depreciation under this method the
projects are ranked on the basis of the length of the payback period. A project with the shortest
payback period will be given the highest rank and taken as the best investment. The shorter the
payback period, the less risky the investment is the formula for payback period is
Merits:
1. It is one of the earliest methods of evaluating the investment projects.
2. It is simple to understand and to compute.
3. It dose not involve any cost for computation of the payback period
4. It is one of the widely used methods in small scale industry sector
5. It can be computed on the basis of accounting information available from the books.
Demerits:
1. This method fails to take into account the cash flows received by the
company after the pay back period.
2. It doesn’t take into account the interest factor involved in an investment
outlay.
3. It doesn’t take into account the interest factor involved in an investment
outlay.
4. It is not consistent with the objective of maximizing the market value of
the company’s share.
5. It fails to consider the pattern of cash inflows i. e., the magnitude and timing of cash in
flows.
It is an accounting method, which uses the accounting information repeated by the financial
statements to measure the probability of an investment proposal. It can be determine by dividing the
average income after taxes by the average investment i.e., the average book value after depreciation.
According to ‘Soloman’, accounting rate of return on an investment can be calculated as the ratio of
accounting net income to the initial investment, i.e.,
On the basis of this method, the company can select all those projects who’s ARR is higher than the
minimum rate established by the company. It can reject the projects with an ARR lower than the
expected rate of return. This method can also help the management to rank the proposal on the basis
of ARR. A highest rank will be given to a project with highest ARR, where as a lowest rank to a
project with lowest ARR.
Merits:
Demerits:
The traditional method does not take into consideration the time value of money. They give equal
weight age to the present and future flow of incomes. The DCF methods are based on the concept
that a rupee earned today is more worth than a rupee earned tomorrow. These methods take into
consideration the profitability and also time value of money.
The NPV takes into consideration the time value of money. The cash flows of different years and
valued differently and made comparable in terms of present values for this the net cash inflows of
various period are discounted using required rate of return which is predetermined.
According to Ezra Solomon, “It is a present value of future returns, discounted at the required rate
of return minus the present value of the cost of the investment.”
NPV is the difference between the present value of cash inflows of a project and the initial cost of
the project.
According the NPV technique, only one project will be selected whose NPV is positive or above
zero. If a project(s) NPV is less than ‘Zero’. It gives negative NPV hence. It must be rejected. If
Merits:
Demerits:
The IRR for an investment proposal is that discount rate which equates the present value of cash
inflows with the present value of cash out flows of an investment. The IRR is also known as cutoff
or handle rate. It is usually the concern’s cost of capital.
According to Weston and Brigham “The internal rate is the interest rate that equates the present
value of the expected future receipts to the cost of the investment outlay.
When compared the IRR with the required rate of return (RRR), if the IRR is more than RRR then
the project is accepted else rejected. In case of more than one project with IRR more than RRR, the
one, which gives the highest IRR, is selected.
P1 - Q
IRR = L+ --------- X D
P1 –P2
Merits:
1. It consider the time value of money
2. It takes into account the cash flows over the entire useful life of the asset.
3. It has a psychological appear to the user because when the highest rate of return projects are
selected, it satisfies the investors in terms of the rate of return an capital
4. It always suggests accepting to projects with maximum rate of return.
5. It is inconformity with the firm’s objective of maximum owner’s welfare.
Demerits:
The method is also called benefit cost ration. This method is obtained cloth a slight modification of
the NPV method. In case of NPV the present value of cash out flows are profitability index (PI), the
present value of cash inflows are divide by the present value of cash out flows, while NPV is a
absolute measure, the PI is a relative measure.
It the PI is more than one (>1), the proposal is accepted else rejected. If there are more than one
investment proposal with the more than one PI the one with the highest PI will be selected. This
method is more useful incase of projects with different cash outlays cash outlays and hence is
superior to the NPV method.
Merits:
1. It requires less computational work then IRR method
2. It helps to accept / reject investment proposal on the basis of value of the index.
3. It is useful to rank the proposals on the basis of the highest/lowest value of the index.
4. It is useful to tank the proposals on the basis of the highest/lowest value of the index.
5. It takes into consideration the entire stream of cash flows generated during the useful life of
the asset.
Demerits:
QUESTIONS
1. What do you understand by working capital cycle and what is its importance.
2. Describe the institutions providing long-term finance.
3. What do you understand by NPV method of appeasing long-term investment proposal?
Explain with the help of a proposal of your choice.
4. What is ARR and Payback period? Compare and count ran-the two methods.
5. What are the components of working capital? Explain each of them/ explain the factors
affecting the requirements of working capital.
6. What are the merits & limitations of Pay back period? How does discounting approach
overcome the limitation of payback period?
7. Give various examples of capital budgeting decisions classify them into specific kinds.
8. What is the importance of capital budgeting? Explain the basic steps involved in evaluating
capital budgeting proposals.
9. What is NPV & IRR Compare and contrast the two methods of evaluating capital budgeting
proposals.
10. What are major sources of short-term finance?
11. What is meant by discounting and time value of money? How is it useful in capital
budgeting?
UNIT - V
CONCEPTS
Synopsis:
1. Introduction
2. Book-keeping and Accounting
3. Function of an Accountant
4. Users of Accounting
5. Advantages of Accounting
6. Limitations of Accounting
7. Basic Accounting concepts
As you are aware, every trader generally starts business for purpose of earning profit. While
establishing business, he brings own capital, borrows money from relatives, friends, outsiders or
financial institutions. Then he purchases machinery, plant , furniture, raw materials and other assets.
He starts buying and selling of goods, paying for salaries, rent and other expenses, depositing and
withdrawing cash from bank. Like this he undertakes innumerable transactions in business. Observe
the following transactions of small trader for one week during the month of July, 1998.
1998 Rs.
July 24 Purchase of goods from Sree Ram 12,000
July 25 Goods sold for cash 5,000
July 25 Sold gods to Syam on credit 8,000
July 26 Advertising expenses 5,200
July 27 Stationary expenses 600
July 27 Withdrawal for personal use 2,500
July 28 Rent paid through cheque 1,000
July 31 Salaries paid 9,000
July 31 Received cash from Syam 5,000
The number of transactions in an organization depends upon the size of the organization. In
small organizations, the transactions generally will be in thousand and in big organizations they
may be in lakhs. As such it is humanly impossible to remember all these transactions. Further, it
may not by possible to find out the final result of the business without recording and analyzing
these transactions.
Book – Keeping: Book – Keeping involves the chronological recording of financial transactions in
a set of books in a systematic manner.
Accounting: Accounting is concerned with the maintenance of accounts giving stress to the
design of the system of records, the preparation of reports based on the recorded date and the
interpretation of the reports.
Thus, the terms, book-keeping and accounting are very closely related, through there is a
subtle difference as mentioned below.
1. Object : The object of book-keeping is to prepare original books of Accounts. It is restricted to
journal, subsidiary book and ledge accounts only. On the other hand, the main object of accounting
is to record analyse and interpret the business transactions.
Smith and Ashburne: “Accounting is a means of measuring and reporting the results of
economic activities.”
R.N. Anthony: “Accounting system is a means of collecting summarizing, analyzing and
reporting in monetary terms, the information about the business.
American Institute of Certified Public Accountants (AICPA): “The art of recording, classifying
and summarizing in a significant manner and in terms of money transactions and events, which are
in part at least, of a financial character and interpreting the results thereof.”
Thus, accounting is an art of identifying, recording, summarizing and interpreting business
transactions of financial nature. Hence accounting is the Language of Business.
3. FUNCTIONS OF AN ACCOUNTANT
The job of an accountant involves the following types of accounting works :
1. Designing Work : It includes the designing of the accounting system, basis for
identification and classification of financial transactions and events, forms, methods,
procedures, etc.
2. Recording Work : The financial transactions are identified, classified and recorded in
appropriate books of accounts according to principles. This is “Book Keeping”. The
recording of transactions tends to be mechanical and repetitive.
3. Summarizing Work : The recorded transactions are summarized into significant form
according to generally accepted accounting principles. The work includes the preparation of
profit and loss account, balance sheet. This phase is called ‘preparation of final accounts’
4. Analysis and Interpretation Work: The financial statements are analysed by using ratio
analysis, break-even analysis, funds flow and cash flow analysis.
5. Reporting Work: The summarized statements along with analysis and interpretation are
communicated to the interested parties or whoever has the right to receive them. For Ex.
This is what the accountant or the accounting department does. A person may be
placed in any part of Accounting Department or MIS (Management Information System)
Department or in small organization, the same person may have to attend to all this work.
Different categories of users need different kinds of information for making decisions. The
users of accounting can be divided in two board groups (1). Internal users and (2). External users.
2. Creditors : Lenders are interested to know whether their load, principal and interest, will
be paid when due. Suppliers and other creditors are also interested to know the ability of the firm to
pay their dues in time.
4. Customers : They are also concerned with the stability and profitability of the enterprise.
They may be interested in knowing the financial strength of the company to rent it for further
decisions relating to purchase of goods.
5. Government: Governments all over the world are using financial statements for compiling
statistics concerning business which, in turn, helps in compiling national accounts. The financial
statements are useful for tax authorities for calculating taxes.
6. Public : The public at large interested in the functioning of the enterprises because it may
make a substantial contribution to the local economy in many ways including the number of people
employed and their patronage to local suppliers.
The role of accounting has changed from that of a mere record keeping during the 1 st decade
of 20th century of the present stage, which it is accepted as information system and decision making
activity. The following are the advantages of accounting.
1. Provides for systematic records: Since all the financial transactions are recorded in the
books, one need not rely on memory. Any information required is readily available from these
records.
2. Facilitates the preparation of financial statements: Profit and loss accountant and balance
sheet can be easily prepared with the help of the information in the records. This enables the
trader to know the net result of business operations (i.e. profit / loss) during the accounting
period and the financial position of the business at the end of the accounting period.
3. Provides control over assets: Book-keeping provides information regarding cash in had,
cash at bank, stock of goods, accounts receivables from various parties and the amounts
invested in various other assets. As the trader knows the values of the assets he will have
control over them.
6. LIMITATIONS OF ACCOUNTING
“Book keeping is the system of recording Business transactions for the purpose of
providing reliable information to the owners and managers about the state and
prospect of the Business concepts”.
ADVANTAGE OF ACCOUNTING
1. PROVIDES FOR SYSTEMATIC RECORDS: Since all the financial transactions are
recorded in the books, one need not rely on memory. Any information required is readily
available from these records.
3. PROVIDES CONTROL OVER ASSETS: Book keeping provides information regarding cash
in hand, cash at hand, stack of goods, accounts receivable from various parties and the
amounts invested in various other assets. As the trader knows the values of the assets he will
have control over them.
5. COMPARITIVE STUDY: One can compare present performance of the organization with
that of its past. This enables the managers to draw useful conclusions and make proper
decisions.
6. LESS SCOPE FOR FRAUD OR THEFT: It is difficult to conceal fraud or theft etc. because
of the balancing of the books of accounts periodically. As the work is divided among many
persons, there will be check and counter check.
7. TAX MALTERS: Properly maintained Book keeping records will help in the settlement of
all tax matters with the tax authorities.
9. DOCUMENTARY EVIDENCE: Accounting records can also be used as evidence in the court
of substantial the claim of the Business. Thus records are based on documentary proof.
Authentic vouchers support every entry. As such, courts accept these records as evidence.
LIMITATIONS OF ACCOUNTING
2.DOES NOT REFLECT CURRENT VLAUES: The data available under book keeping is
historical in nature. So they do not reflect current values. For instance we record the values of
stock at cost price or market price, which ever is less. In case of building, machinery etc., we
adapt historical case as the basis. Infact, the current values of Buildings, plant and machinery
may be much more than what is recorded in the balance sheet.
3. ESTIMATES BASED ON PERSONAL JUDGEMENT: The estimates used for determining the
values of various items may not be correct. For example, debtors are estimated in terms of
collectibles, inventories are based on marketability and fixed assets are based on useful working
life. These estimates are based on personal judgment and hence sometimes may not be correct.
PRINCIPLES OF ACCOUNTING :
Principles of accounting is divided into two parts as follows:
A)BASIC ACCOUNTING CONCEPTS
B)ACCOUNTING CONVENTIONS
Accounting is a system evolved to achieve a set of objectives. In order to achieve the goals, we need
a set of rules or guidelines. These guidelines are termed here as “BASIC ACCOUNTING
CONCEPTS”. The term concept means an idea or thought. Basic accounting concepts are the
fundamental ideas or basic assumptions underlying the theory and profit of FINANCIAL
ACCOUNTING. These concepts help in bringing about uniformity in the practice of accounting. In
accountancy following concepts are quite popular.
1. BUSINESS ENTITY CONCEPT: In this concept “Business is treated as separate from the
proprietor”. All the
Transactions recorded in the book of Business and not in the books of proprietor. The proprietor is
also treated as a creditor for the Business.
2. GOING CONCERN CONCEPT: This concept relates with the long life of Business. The
assumption is that business will continue to exist for unlimited period unless it is dissolved due to
some reasons or the other.
4. COST CONCEPT: Accounting to this concept, can asset is recorded at its cost in the books of
account. i.e., the price, which is paid at the time of acquiring it. In balance sheet, these assets appear
not at cost price every year, but depreciation is deducted and they appear at the amount, which is
cost, less classification.
5. ACCOUNTING PERIOD CONCEPT: every Businessman wants to know the result of his
investment and efforts after a certain period. Usually one-year period is regarded as an ideal for this
purpose. This period is called Accounting Period. It depends on the nature of the business and
object of the proprietor of business.
6. DUAL ASCEPT CONCEPT: According to this concept “Every business transactions has two
aspects”, one is the receiving benefit aspect another one is giving benefit aspect. The receiving
benefit aspect is termed as “DEBIT”, where as the giving benefit aspect is termed as “CREDIT”.
Therefore, for every debit, there will be corresponding credit.
7. MATCHING COST CONCEPT: According to this concept “The expenses incurred during an
accounting period, e.g., if revenue is recognized on all goods sold during a period, cost of those
good sole should also
Be charged to that period.
B) ACCOUNTING CONVENTIONS
Accounting is based on some customs or usages. Naturally accountants here to adopt that usage or
custom.
They are termed as convert conventions in accounting. The following are some of the important
accounting conventions.
1.FULL DISCLOSURE: According to this convention accounting reports should disclose fully and
fairly the information. They purport to represent. They should be prepared honestly and sufficiently
disclose information which is if material interest to proprietors, present and potential creditors and
investors. The companies ACT, 1956 makes it compulsory to provide all the information in the
prescribed form.
3.CONSISTENCY: It means that accounting method adopted should not be changed from year to
year. It means that there should be consistent in the methods or principles followed. Or else the
results of a year Cannot be conveniently compared with that of another.
4. CONSERVATISM: This convention warns the trader not to take unrealized income in to account.
That is why the practice of valuing stock at cost or market price, which ever is lower is in vague.
This is the policy of “playing safe”; it takes in to consideration all prospective losses but leaves all
prospective profits.
2.GOODS: Fill those things which a firm purchases for resale are called goods.
4.SALES: Sales means sale of goods, unless it is stated otherwise it also represents these
goods sold.
5.EXPENSES: Payments for the purchase of goods as services are known as expenses.
6.REVENUE: Revenue is the amount realized or receivable from the sale of goods or
services.
7.ASSETS: The valuable things owned by the business are known as assets. These are the
properties owned by the business.
8.LIABILITIES: Liabilities are the obligations or debts payable by the enterprise in future in
the term of money or goods.
11.DRAWINGS: cash or goods withdrawn by the proprietor from the Business for his personal
or Household is termed to as “drawing”.
12.RESERVE: An amount set aside out of profits or other surplus and designed to meet
contingencies.
1.Personal Accounts :Accounts which are transactions with persons are called “Personal Accounts”
.
A separate account is kept on the name of each person for recording the benefits received from ,or
given to the person in the course of dealings with him.
E.g.: Krishna’s A/C, Gopal’s A/C, SBI A/C, Nagarjuna Finanace Ltd.A/C, ObulReddy & Sons
A/C , HMT Ltd. A/C, Capital A/C, Drawings A/C etc.
2.Real Accounts: The accounts relating to properties or assets are known as “Real Accounts” .Every
business needs assets such as machinery , furniture etc, for running its activities .A separate account
is maintained for each asset owned by the business .
E.g.: cash A/C, furniture A/C, building A/C, machinery A/C etc.
Before recording a transaction, it is necessary to find out which of the accounts is to be debited and
which is to be credited. The following three different rules have been laid down for the three classes
of accounts….
1.Personal Accounts: The account of the person receiving benefit (receiver) is to be debited and the
account of the person giving the benefit (given) is to be credited.
Rule: “Debit----The
Receiver
Credit---The
2.Real Accounts: When an asset is coming into the business, account of that asset is to be
debited .When an asset is going out of the business, the account of that asset is to be credited.
Rule: “Debit----What
comes in
Credit---What goes
3. Nominal Accounts: When an expense is incurred or loss encountered, the account representing
the expense or loss is to be debited . When any income is earned or gain made, the account
representing the income of gain is to be credited.
JOURNAL
The first step in accounting therefore is the record of all the transactions in the books of original
entry viz., Journal and then posting into ledges.
JOURNAL: The word Journal is derived from the Latin word ‘journ’ which means a day. Therefore,
journal means a ‘day Book’ in day-to-day business transactions are recorded in chronological order.
LEDGER
All the transactions in a journal are recorded in a chronological order. After a certain period, if we
want to know whether a particular account is showing a debit or credit balance it becomes very
difficult. So, the ledger is designed to accommodate the various accounts maintained the trader. It
contains the final or permanent record of all the transactions in duly classified form. “A ledger is a
book which contains various accounts.” The process of transferring entries from journal to ledger is
called “POSTING”.
Posting is the process of entering in the ledger the entries given in the journal. Posting into ledger is
done periodically, may be weekly or fortnightly as per the convenience of the business. The
following are the guidelines for posting transactions in the ledger.
1. After the completion of Journal entries only posting is to be made in the ledger.
2. For each item in the Journal a separate account is to be opened. Further, for each new item
a new account is to be opened.
3. Depending upon the number of transactions space for each account is to be determined in
the ledger.
4. For each account there must be a name. This should be written in the top of the table. At
the end of the name, the word “Account” is to be added.
5. The debit side of the Journal entry is to be posted on the debit side of the account, by
starting with “TO”.
6. The credit side of the Journal entry is to be posted on the debit side of the account, by
starting with “BY”.
Proforma for ledger: LEDGER BOOK
sales account
cash account
TRAIL BALANCE
The first step in the preparation of final accounts is the preparation of trail balance. In the double
entry system of book keeping, there will be credit for every debit and there will not be any debit
without credit. When this principle is followed in writing journal entries, the total amount of all
debits is equal to the total amount all credits.
A trail balance is a statement of debit and credit balances. It is prepared on a particular date with the
object of checking the accuracy of the books of accounts. It indicates that all the transactions for a
particular period have been duly entered in the book, properly posted and balanced. The trail
balance doesn’t include stock in hand at the end of the period. All adjustments required to be done
at the end of the period including closing stock are generally given under the trail balance.
DEFINITIONS: SPICER AND POGLAR :A trail balance is a list of all the balances standing
on the ledger accounts and cash book of a concern at any given date.
A trail balance is a statement of debit and credit balances extracted from the ledger with a view to
test the arithmetical accuracy of the books.
Thus a trail balance is a list of balances of the ledger accounts’ and cash book of a business concern
at any given date.
Trail Balance
In every business, the business man is interested in knowing whether the business has
resulted in profit or loss and what the financial position of the business is at a given time. In brief,
he wants to know (i)The profitability of the business and (ii) The soundness of the business.
The trader can ascertain this by preparing the final accounts. The final accounts are prepared
from the trial balance. Hence the trial balance is said to be the link between the ledger accounts and
the final accounts. The final accounts of a firm can be divided into two stages. The first stage is
preparing the trading and profit and loss account and the second stage is preparing the balance
sheet.
TRADING ACCOUNT
The first step in the preparation of final account is the preparation of trading account. The
main purpose of preparing the trading account is to ascertain gross profit or gross loss as a result of
buying and selling the goods.
Trading account of MR……………………. for the year ended ……………………
To factory expenses
To other man. Expenses Xxxx
To productive expenses Xxxx
To gross profit c/d
Xxxx Xxxx
Xxxx
Xxxx
The business man is always interested in knowing his net income or net profit.Net profit represents
the excess of gross profit plus the other revenue incomes over administrative, sales, Financial and
other expenses. The debit side of profit and loss account shows the expenses and the credit side the
incomes. If the total of the credit side is more, it will be the net profit. And if the debit side is more,
it will be net loss.
BALANCE SHEET
The second point of final accounts is the preparation of balance sheet. It is prepared often in the
trading and profit, loss accounts have been compiled and closed. A balance sheet may be considered
as a statement of the financial position of the concern at a given date.
J.R.botliboi: A balance sheet is a statement with a view to measure exact financial position of a
business at a particular date.
Thus, Balance sheet is defined as a statement which sets out the assets and liabilities of a business
firm and which serves to as certain the financial position of the same on any particular date. On the
left-hand side of this statement, the liabilities and the capital are shown. On the right-hand side all
the assets are shown. Therefore, the two sides of the balance sheet should be equal. Otherwise, there
is an error somewhere.
Ratio Analysis
Absolute figures are valuable but they standing alone convey no meaning unless compared with
another. Accounting ratio show inter-relationships which exist among various accounting data.
When relationships among various accounting data supplied by financial statements are worked out,
they are known as accounting ratios.
Each method of expression has a distinct advantage over the other the analyst will selected that
mode which will best suit his convenience and purpose.
Ratio Analysis stands for the process of determining and presenting the relationship of items and
groups of items in the financial statements. It is an important technique of financial analysis. It is a
way by which financial stability and health of a concern can be judged. The following are the main
uses of Ratio analysis:
(a) Useful in financial position analysis: Accounting reveals the financial position of the
concern. This helps banks, insurance companies and other financial institution in lending
and making investment decisions.
(ii) Useful in simplifying accounting figures: Accounting ratios simplify, summaries and
systematic the accounting figures in order to make them more understandable and in lucid form.
(iii) Useful in assessing the operational efficiency: Accounting ratios helps to have an idea of
the working of a concern. The efficiency of the firm becomes evident when analysis is based on
accounting ratio. This helps the management to assess financial requirements and the
capabilities of various business units.
(iv) Useful in forecasting purposes: If accounting ratios are calculated for number of years, then
a trend is established. This trend helps in setting up future plans and forecasting.
(v) Useful in locating the weak spots of the business: Accounting ratios are of great assistance in
locating the weak spots in the business even through the overall performance may be efficient.
(vi) Useful in comparison of performance: Managers are usually interested to know which
department performance is good and for that he compare one department with the another
Limitations of Ratio Analysis: These limitations should be kept in mind while making use of
ratio analyses for interpreting the financial statements. The following are the main limitations of
ratio analysis.
1. False results if based on incorrect accounting data: Accounting ratios can be correct only if
the data (on which they are based) is correct. Sometimes, the information given in the
financial statements is affected by window dressing, i. e. showing position better than what
actually is.
2. No idea of probable happenings in future: Ratios are an attempt to make an analysis of the
past financial statements; so they are historical documents. Now-a-days keeping in view the
complexities of the business, it is important to have an idea of the probable happenings in
future.
3. Variation in accounting methods: The two firms’ results are comparable with the help of
accounting ratios only if they follow the some accounting methods or bases. Comparison
will become difficult if the two concerns follow the different methods of providing
depreciation or valuing stock.
4. Price level change: Change in price levels make comparison for various years difficult.
5. Only one method of analysis: Ratio analysis is only a beginning and gives just a fraction of
information needed for decision-making so, to have a comprehensive analysis of financial
statements, ratios should be used along with other methods of analysis.
6. No common standards: It is very difficult to by down a common standard for comparison
because circumstances differ from concern to concern and the nature of each industry is
different.
7. Different meanings assigned to the some term: Different firms, in order to calculate ratio
may assign different meanings. This may affect the calculation of ratio in different firms and
such ratio when used for comparison may lead to wrong conclusions.
8. Ignores qualitative factors: Accounting ratios are tools of quantitative analysis only. But
sometimes qualitative factors may surmount the quantitative aspects. The calculations
derived from the ratio analysis under such circumstances may get distorted.
9. No use if ratios are worked out for insignificant and unrelated figure: Accounting ratios
should be calculated on the basis of cause and effect relationship. One should be clear as to
what cause is and what effect is before calculating a ratio between two figures.
Ratio Analysis: Ratio is an expression of one number is relation to another. It is one of the methods
of analyzing financial statement. Ratio analysis facilities the presentation of the information of the
financial statements in simplified and summarized from. Ratio is a measuring of two numerical
positions. It expresses the relation between two numeric figures. It can be found by dividing one
figure by another ratios are expressed in three ways.
1. Jines method
2. Ratio Method
Classification of ratios: All the ratios broadly classified into four types due to the interest of
different parties for different purposes. They are:
1. Profitability ratios
2. Turn over ratios
3. Financial ratios
4. Leverage ratios
1. Profitability ratios: These ratios are calculated to understand the profit positions of the
business. These ratios measure the profit earning capacity of an enterprise. These ratios can
be related its save or capital to a certain margin on sales or profitability of capital employ.
These ratios are of interest to management. Who are responsible for success and growth of
enterprise? Owners as well as financiers are interested in profitability ratios as these reflect
ability of enterprises to generate return on capital employ important profitability ratios are:
Profitability ratios in relation to sales: Profitability ratios are almost importance of concern.
These ratios are calculated is focus the end results of the business activities which are the
sole eritesiour of overall efficiency of organisation.
gross profit
1. Gross profit ratio: x 100
Nest sales
Note: Higher the ratio the better it is cost of goods sold= opening stock + purchase + wages +
other direct expenses- closing stock (or) sales – gross profit.
Operating expenses:
concern expense
Expenses ratio = X 100
Net sales
Share holders funds = equity share capital + preference share capital + receives & surpluses
+undistributed profits.
Here, capital employed = equity share capital + preference share capital + reserves & surpluses
+ undistributed profits + debentures+ public deposit + securities + long term loan + other long
term liability – factious assets (preliminary expressed & profit & loss account debt
balance)
These ratios measure how efficiency the enterprise employees the resources of assets at its
command. They indicate the performance of the business. The performance if an enterprise is
judged with its save. It means ratios are also laced efficiency ratios.
These ratios are used to know the turn over position of various things in the ___________. The
turnover ratios are measured to help the management in taking the decisions regarding the levels
maintained in the assets, and raw materials and in the funds. These ratio s are measured in ratio
method.
cost of goods sold
1. Stock turnover ratio = average stock
Note: Higher the ratio the better it is working capital = current assets – essential liabilities.
sales
3. Fixed assets turnover ratio =
fixed assets
sales
3 (i) Total assets turnover ratio is :
total assets
Here,
opening debitors closing bebtors
Average debtors =
2
365 (or) 12
6 (i) creditors collection period=
Creditor turnover ratio
Here,
opening closing credetors
Average creditor=
2
QUIZ
12. When a deduction allowed from the gross or catalogue price to traders;
then it is called as ____. ( )
(a) Cash discount (b) Credit discount
(c) Trade discount (d) None
13. “Out standing wages” is treated as _________. ( )
(a) Asset (b) Expense
(c) Liability (d) Income
14. How many types of accounts are maintained to record all types of
business transactions? ( )
(a) Five (b) four
(c) Three (d) Two
15. Which connects the link between Journal and Trial Balance? ( )
(a) Trading Account (b) Profit & Loss account
(c) Ledger (d) Balance sheet
18. Profit and Loss account is prepared to find out the business ____. ( )
(a) Gross result (b) Financial position
(c) Net result (d) Liquidity position
21. The statement reveals the financial positions of a business at any given
date is called __________. ( )
(a) Trading account (b) Profit and loss account
(c) Balance sheet (d) Trial balance
23. Debit what comes in; Credit what goes out is ____ account principle? ( )
(a) Nominal (b) Personal
(c) Real (d) None
25. Debit Expenses and Losses; Credit Incomes and Gains is ___ account
Principle ( )
(a) Personal (b) Real
(c) Nominal (d) None