Demand in economics is the consumer's desire and ability to purchase a good or service.

It's the
underlying force that drives economic growth and expansion. Without demand, no business
would ever bother producing anything.

Determinants of Demand

There are five determinants of demand. The most important is the price of the good or service
itself. The second is the price of related products, whether they are substitutes or
complementary. 

Circumstances drive the next three determinants. These are consumers' incomes, their tastes, and
their expectations.

Law of Demand

The law of demand governs the relationship between the quantity demanded and the price. This
economic principle describes something you already intuitively know. If the price increases,
people buy less. The reverse is also true. If the price drops, people buy more. 

But, price is not the only determining factor. The law of demand is only true if all other
determinants don't change. In economics, this is called ceteris paribus. The law of demand
formally states that, ceteris paribus, the quantity demanded for a good or service is inversely
related to the price.

Elasticity of Demand

Demand elasticity means how much more, or less, demand changes when the price does. It's
specifically measured as a ratio. It's the percentage change of the quantity demanded divided by
the percentage change in price. 

There are three levels of demand elasticity:

1. Unit elastic is when demand changes by the exact same percentage as the price does.
2. Elastic is when demand changes by a greater percentage than the price does.
3. Inelastic is when demand changes by a smaller percentage than the price does.

Aggregate Demand

Aggregate demand, or market demand, is the demand from a group of people. The five
determinants of individual demand govern it. There’s also a sixth: the number of buyers in the
market.

Aggregate demand can be measured for a country. It's the quantity of the goods or services the
country produces that the world's population demands. For that reason, it is composed of the
same five components that make up gross domestic product:
 1. Consumer spending.
2. Business investment spending.
3. Government spending.
4. Exports.
5. Imports, which are subtracted from aggregate demand and GDP.

Definition of 'Law of Supply'

Definition: Law of supply states that other factors remaining constant, price and quantity
supplied of a good are directly related to each other. In other words, when the price paid by
buyers for a good rises, then suppliers increase the supply of that good in the market.

Description: Law of supply depicts the producer behavior at the time of changes in the prices of
goods and services. When the price of a good rises, the supplier increases the supply in order to
earn a profit because of higher prices.

The above diagram shows the supply curve that is upward sloping (positive relation between the
price and the quantity supplied). When the price of the good was at P3, suppliers were supplying
Q3 quantity. As the price starts rising, the quantity supplied also starts rising.
Elasticity of Supply:

Meaning of Elasticity of Supply:

The law of supply indicates the direction of change—if price goes up, supply will increase. But
how much supply will rise in response to an increase in price cannot be known from the law of
supply. To quantify such change we require the concept of elasticity of supply that measures the
extent of quantities supplied in response to a change in price.

Elasticity of supply measures the degree of responsiveness of quantity supplied to a change in

own price of the commodity. It is also defined as the percentage change in quantity supplied
divided by percentage change in price.

It can be calculated by using the following formula:

ES = % change in quantity supplied/% change in price

Symbolically,

ES = ∆Q/Q ÷ ∆P/P = ∆Q/∆P × P/Q

Since price and quantity supplied, in usual cases, move in the same direction, the coefficient of
ES is positive.

Types of Elasticity of Supply:

For all the commodities, the value of Es cannot be uniform. For some commodities, the value
may be greater than or less than one.

Like elasticity of demand, there are five cases of ES:

(a) Elastic Supply (ES>1):

Supply is said to be elastic when a given percentage change in price leads to a larger change in
quantity supplied. Under this situation, the numerical value of E s will be greater than one but less
than infinity. SS1 curve of Fig. 4.17 exhibits elastic supply. Here quantity supplied changes by a
larger magnitude than does price.
(b) Inelastic Supply (ES< 1):

Supply is said to be inelastic when a given percentage change in price causes a smaller change in
quantity supplied. Here the numerical value of elasticity of supply is greater than zero but less
than one. Fig. 4.18 depicts inelastic supply curve where quantity supplied changes by a smaller
percentage than does price.

(c) Unit Elasticity of Supply (ES = 1):

If price and quantity supplied change by the same magnitude, then we have unit elasticity of
supply. Any straight line supply Curve passing through the origin, such as the one shown in Fig.
4.19, has an elasticity of supply equal to 1. This can be verified in this way.
For any straight line positively-sloped supply curve drawn through the origin, the ratio of P/Q at
any point on the supply curve is equal to the ratio ∆ P/∆ Q. Note that ∆ P/∆ Q is the slope of the
supply curve while elasticity is (1/∆P/∆Q = ∆Q/∆P).Thus, in the formula (∆Q/∆P. P/Q), the two
ratios cancel out each other.

(d) Perfectly Elastic Supply (ES = ∞):

The numerical value of elasticity of supply, in exceptional cases, may reach up to infinity. The
supply curve PS1 drawn in Fig. 4.20 has an elasticity of supply equal to infinity. Here the supply
curve has been drawn parallel to the horizontal axis. The economic interpretation of this supply
curve is that an unlimited quantity will be offered for sale at the price OS. If price slightly drops
down below OS, nothing will be supplied.
(e) Perfectly Inelastic Supply (ES = 0):

Another extreme is the completely or perfectly inelastic supply or zero elasticity. SS 1 curve
drawn in Fig. 4.21 illustrates the case of zero elasticity. This curve describes that whatever the
price of the commodity, it may even be zero, quantity supplied remains unchanged at OQ. This
sort of supply curve is conceived when we consider the supply curve of land from the viewpoint
of a country, or the world as a whole.

One important point to note here. Any straight line supply curve that intersects the vertical axis
above the origin has an elasticity of supply greater than one (Fig. 4.17). Elasticity of supply will
be less than one if the straight line supply curve cuts the horizontal axis on any point to the right
of the origin, i.e. the quantity axis (Fig. 4.18).

Measurement of Elasticity of Supply:

Here we will measure the elasticity of supply at a particular point on a given supply curve. This
is shown in Fig. 4.22 where SS’ is the supply curve.

To measure the elasticity of supply at a particular point on the curve SS’, we have drawn a
straight line NT in such a way that it touches the SS’ curve at points A and C. As these two
points lie very close to each other, the slope of the supply curve as well as the slope of the NT
line is the same.
Following is the formula:

ES = ∆Q/∆P.P/Q = AB/BC. OA/OQ

Triangles ABC and NQA are similar triangles.

Thus we can write NQ/QA instead of AB/BC.

Therefore,

ES = NQ/QA. QA/OQ =NQ/OQ

As Fig. 4.22 suggests NQ < OQ, the coefficient of elasticity of supply is less than one i.e.,
inelastic.

If the NT straight line passes through the origin, the elasticity of supply becomes unity and if it
passes through the price or vertical axis, the coefficient will be greater than one, i.e., elastic.

Determinants of Elasticity of Supply:

Here we are concerned with certain factors which affect elasticity of supply viz., the nature of the
good, the definition of the good, the relevance of the time period, and so on.

(a) The Nature of the Good:

As with demand elasticity, the most important determinant of elasticity of supply is the
availability of substitutes. In the context of supply, substitute goods are those to which factors of
production can most easily be transferred. For example, a farmer can easily move from growing
wheat to producing jute. Of course, mobility of factors is very important for such substitution.
(b) The Definition of the Commodity:

As in the case of demand, elasticity of supply also depends on the definition of the commodity.
The narrowly a commodity is defined the greater is its elasticity of supply. For example, it is
easier for a tailor to transfer resources from producing red skirts to green skirts than from skirts
to men’s trousers.

(c) Time:

Time also exerts considerable influence on the elasticity of supply. Supply is more elastic in the
long run than in the short run. The reason is easy to find out. The longer the time period, the
easier it is to shift resources among products, following a change in their relative prices.

Fig. 4.23 shows how time influences the supply of a commodity. If a very short period or
momentary period is considered, the supply curve will be perfectly inelastic (Q 1S1curve), where
quantity supplied does not change even if price changes.

In the short run some degree of elasticity is found since supply can be adjusted to price change
(SS2 curve). SS3 curve is a rather long run supply curve when quantity can be adjusted greatly to
price change. As price increases from OP to OP 1 quantity supplied is unresponsive if the supply
curve is Q1S1.

Quantity supplied increases to OQ2 (> OQ1) when the supply curve is SS2 and quantity supplied
rises to OQ3 (> OQ2 > OQ1) if the supply curve is SS3. Thus the supply of a commodity responds
more, or is more elastic if a long time period is taken into account.

(d) The Cost of Attracting Resources:

If supply is to be increased it is necessary to attract resources from other industries. This usually
involves raising the prices of these resources. As their prices rise, cost of production also
increases. So supply becomes relatively inelastic.
If these resources can be obtained cheaply then supply is likely to be relatively elastic. These
considerations become very important at times of full employment when the only available
factors of production are those which can be attracted from other industries and uses.

(e) The Level of Price:

Elasticity of supply is also likely to vary at different prices. Thus, when the price of a commodity
is relatively high, the producers are likely to be supplying near the limits of their capacity and
would, therefore, be unable to make much response to a still higher price. When the price is
relatively low, however, producers may well have surplus capacity which a higher price would
induce them to use.

Production

Meaning of Production:

Since the primary purpose of economic activity is to produce utility for individuals, we count as
production during a time period all activity which either creates utility during the period or
which increases ability of the society to create utility in the future.

Business firms are important components (units) of the economic system.

They are artificial entities created by individuals for the purpose of organising and facilitating
production. The essential characteristics of the business firm is that it purchases factors of
production such as land, labour, capital, intermediate goods, and raw material from households
and other business firms and transforms those resources into different goods or services which it
sells to its customers, other business firms and various units of the government as also to foreign
countries.

Definition of Production:

According to Bates and Parkinson:

“Production is the organised activity of transforming resources into finished products in the form
of goods and services; the objective of production is to satisfy the demand for such transformed
resources”.

According to J. R. Hicks:

“Production is any activity directed to the satisfaction of other peoples’ wants through
exchange”. This definition makes it clear that, in economics, we do not treat the mere making of
things as production. What is made must be designed to satisfy wants.

Three Types of Production:

For general purposes, it is necessary to classify production into three main groups:

1. Primary Production:

Primary production is carried out by ‘extractive’ industries like agriculture, forestry, fishing,
mining and oil extraction. These industries are engaged in such activities as extracting the gifts
of Nature from the earth’s surface, from beneath the earth’s surface and from the oceans.

2. Secondary Production:

This includes production in manufacturing industry, viz., turning out semi-finished and finished
goods from raw materials and intermediate goods— conversion of flour into bread or iron ore
into finished steel. They are generally described as manufacturing and construction industries,
such as the manufacture of cars, furnishing, clothing and chemicals, as also engineering and
building.

3. Tertiary Production:

Industries in the tertiary sector produce all those services which enable the finished goods to be
put in the hands of consumers. In fact, these services are supplied to the firms in all types of
industry and directly to consumers. Examples cover distributive traders, banking, insurance,
transport and communications. Government services, such as law, administration, education,
health and defence, are also included.

Factors of Production:

Production of a commodity or service requires the use of certain resources or factors of

production. Since most of the resources necessary to carry on production are scarce relative to
demand for them they are called economic resources.

Resources, which we shall call factors of production, are combined in various ways, by firms or
enterprises, to produce an annual flow of goods and services.
Table 5.1: A Classification of Factors of Production:

Each factor gets a reward on the basis of its contribution to the production process, as shown in
the table.

In fact, the resources of any community, referred to as its factors of production, can be classified
in a number of ways, but it is common to group them according to certain characteristics which
they possess. If we keep in mind that the production of goods and services is the result of people
working with natural resources and with equipment such as tools, machinery and buildings, a
generally acceptable classification can readily be derived. The traditional division of factors of
production distinguishes labour, land and capital, with a fourth factor, enterprise, some-times
separated from the rest.

The people involved in production use their skills and efforts to make things and do things that
are wanted. This human effort is known as labour. In other words, labour represents all human
resources. The natural resources people use are called land. And the equipment they use is called
capital, which refers to all man-made resources.

The first three factors—land; labour and capital do not work independently or in isolation. There
is need to combine these factors and co-ordinate their activities. This two-fold function is
performed by the organiser or the entrepreneur.

But this is not the only function of the entrepreneur. In fact, production can never take place
without some risk being involved; the decision to produce something has to be taken in
anticipation of demand and there must be some element of uncertainty about that demand
materialising.

Thus, risk taking or enterprise can be considered as a fourth factor of production, and those
responsible for taking these risks are usually referred to as entrepreneurs (see the box below
which is self-explanatory). We may now study the nature and characteristics of four factors
against this backdrop. But before we proceed further we may make a passing reference to factor
mobility.

(1) Land and Natural Resources:

In economics the term land is used in a broad sense to refer to all natural resources or gifts of
nature. As the Penguin Dictionary of Economics has put it: “Land in economics is taken to mean
not simply that part of the earth’s surface not covered by water, but also all the free gifts of
nature’s such as minerals, soil fertility, as also the resources of sea. Land provides both space
and specific resources”.
(2) Labour:

Like land, labour is also a primary factor of production. The distinctive feature of the factor of
production, called labour, is that it provides a human service. It refers to human effect of any
kind—physical and mental— which is directed to the production of goods and services. ‘Labour’
is the collective name given to the productive services embodied in human physical effort, skill,
intellectual powers, etc.

As such, there are different types of labour input, varying in effort and skill content, and in
particular types of skill content. Thus, like ‘land’, labour is not homogeneous. The term covers
clerical, managerial and administrative functions as well as skilled and unskilled manual work.

(3) Capital:

Capital, the third agent or factor is the result of past labour and it is used to produce more goods.
Capital has, therefore, been defined as ‘produced means of production.’ It is a man-made
resource. In a board sense, any product of labour-and-land which is reserved for use in future
production is capital.

To put it more clearly, capital is that part of wealth which is not used for the purpose of
consumption but is utilised in the process of production. Tools and machinery, bullocks and
ploughs, seeds and fertilizers, etc. are examples of capital. We have already identified certain
things described as capital in our discussion on producers’ goods.

Capital Formation:

People use capital goods like machines, equipment, etc. because capital goods are the creators of
other goods. But this is not the whole truth. People use capital for another important reason to
produce goods with less effort and lower costs than would be the case if labour were not assisted
by capital. But in order to use capital goods people must first produce them. This calls for a
sacrifice of current consumption.

(4) Enterprise (Organization):

Organisation, as a factor of production, refers to the task of bringing land, labour and capital
together. It involves the establishment of co-ordination and co-operation among these factors.
The person in charge of organisation is known as an organiser or an entrepreneur. So, the
entrepreneur is the person who takes the charge of supervising the organisation of production and
of framing the necessary policy regarding business.

Functions or Role of the Entrepreneur:

The entrepreneur in modern business performs the following useful functions:

1. Decision-making:
2. Management Control:

3. Division of income:

4. Risk-taking and uncertainty-bearing:

5. Innovation:

What is Production Possibility Curve?

Since human wants are unlimited and the means to satisfy them are limited, every society is
faced with the fundamental problem of choosing and allocating its scarce resources among
alternative uses. The production possibility curve or frontier is an analytical tool which is used to
illustrate and explain this problem of choice.

The production possibility curve is based on the following Assumptions:

(1) Only two goods X (consumer goods) and Y (capital goods) are produced in different
proportions in the economy.

(2) The same resources can be used to produce either or both of the two goods and can be shifted
freely between them.

(3) The supplies of factors are fixed. But they can be re-allocated for the production of the two
goods within limits.

(4) The production techniques are given and constant.

(5) The economy’s resources are fully employed and technically efficient.

(6) The time period is short.

Explanation:

Given these assumptions, we construct a hypothetical production possibility schedule of such an

economy in Table 6.1.
In this schedule, P and P1 are such possibilities in which the economy can produce either 250
units of Y or 250 units of X with given quantities of factors. But the assumption is that the
economy should produce both the goods. There are many possibilities to produce the two goods.
Such possibilities are В, С and D.

The economy can produce 100 units of X and 230 units of Y in possibility B; 150 units of X and
200 units of Y in possibility C; and 200 units of X and 150 units of Y in possibility D. The
production possibility schedule shows that when the economy produces more units of X, it
produces less units of Y successively.

In other words, the economy withdraws the given quantities of factors from the production of Y
and uses them in producing more of X. For example, to reach the possibility С from B, the
economy produces 50 units more of X and sacrifices 30 units of Y; whereas in possibility D for
the same units of X, it sacrifices 50 units of y.

Table 1 is represented diagrammatically in Figure 2. Units of good X are measured horizontally

and that of Y on the vertical axis. The concave curve PP depicts the various possible
combinations of the two goods, P, В, C, D and P. This is the production possibility curve which
is also known as the transformation curve or production possibility frontier.

Each production possibility curve is the locus of output combinations which can be obtained
from given quantities of factors or inputs.

This curve not only shows production possibilities but also the rate of transformation of one
product into the other when the economy moves from one possibility point to the other. The rate
of transformation on a production possibility curve increases as we move from point В to С and
to D.

The production possibility curve further shows that when the society moves from the possibility
point B to С or to D, it transfers resources from the production of good Y to the production of
good X. 
The Law of Variable Proportions:

If one input is variable and all other inputs are fixed the firm’s production function exhibits the
law of variable proportions. If the number of units of a variable factor is increased, keeping other
factors constant, how output changes is the concern of this law. Suppose land, plant and
equipment are the fixed factors, and labour the variable factor.

When the number of labourers is increased successively to have larger output, the proportion
between fixed and variable factors is altered and the law of variable proportions sets in. The law
states that as the quantity of a variable input is increased by equal doses keeping the quantities of
other inputs constant, total product will increase, but after a point at a diminishing rate.

This principle can also be defined thus:

When more and more units of the variable factor are used, holding the quantities of fixed factors
constant, a point is reached beyond which the marginal product, then the average and finally the
total product will diminish. The law of variable proportions (or the law of non-proportional
returns) is also known as the law of diminishing returns. But, as we shall see below, the law of
diminishing returns is only one phase of the more comprehensive law of variable proportions.

Its Assumption:

The law of diminishing returns is based on the following assumptions:

(1) Only one factor is variable while others are held constant.

(2) All units of the variable factor are homogeneous.

(3) There is no change in technology.

(4) It is possible to vary the proportions in which different inputs are combined.

(5) It assumes a short-run situation, for in the long-run all factors are variable.

(6) The product is measured in physical units, i.e., in quintals, tonnes, etc. The use of money in
measuring the product may show increasing rather than decreasing returns if the price of the
product rises, even though the output might have declined.

The Law of Returns to Scale:

The law of returns to scale describes the relationship between outputs and scale of inputs in the
long-run when all the inputs are increased in the same proportion. In the words of Prof. Roger
Miller, “Returns to scale refer to the relationship between changes in output and proportionate
changes in all factors of production. To meet a long-run change in demand, the firm increases its
scale of production by using more space, more machines and labourers in the factory’.

Assumptions:

This law assumes that:

(1) All factors (inputs) are variable but enterprise is fixed.

(2) A worker works with given tools and implements.

(3) Technological changes are absent.

(4) There is perfect competition.

(5) The product is measured in quantities.

Explanation:

Given these assumptions, when all inputs are increased in unchanged proportions and the scale
of production is expanded, the effect on output shows three stages: increasing returns to scale,
constant returns to scale and diminishing returns to scale. They are explained with the help of
Table 2 and Fig. 5.

1. Increasing Returns to Scale:

Returns to scale increase because the increase in total output is more than proportional to the
increase in all inputs.
The table reveals that in the beginning with the scale of production of (1 worker + 2 acres of
land), total output is 8. To increase output when the scale of production is doubled (2 workers +
4 acres of land), total returns are more than doubled. They become 17. Now if the scale is trebled
(3 workers + о acres of land), returns become more than three-fold, i.e., 27. It shows increasing
returns to scale. In the figure RS is the returns to scale curve where R to С portion indicates
increasing returns.

Causes of Increasing Returns to Scale:

1. Returns to scale increase due to the following reasons:

(i) Indivisibility of Factors:

(ii) Specialisation and Division of Labour:

(iii) Internal Economies:

(iv) External Economies:

2. Constant Returns to Scale:

Returns to scale become constant as the increase in total output is in exact proportion to the
increase in inputs. If the scale of production in increased further, total returns will increase in
such a way that the marginal returns become constant. In the table, for the 4th and 5th units of
the scale of production, marginal returns are 11, i.e., returns to scale are constant. In the figure,
the portion from С to D of the RS curve is horizontal which depicts constant returns to scale. It
means that increments of each input are constant at all levels of output.

Causes of Constant Returns to Scale:

Returns to scale are constant due to:

(i) Internal Economies and Diseconomies:

(ii) External Economies and Diseconomies:

(iii) Divisible Factors.

3. Diminishing Returns to Scale:

Returns to scale diminish because the increase in output is less than proportional to the increase
in inputs. The table shows that when output is increased from the 6th, 7th and 8th units, the total
returns increase at a lower rate than before so that the marginal returns start diminishing
successively to 10, 9 and 8. In the figure, the portion from D to S of the RS curve shows
diminishing returns.

Depreciation:

Meaning: Cost of a fixed asset must be charged to the income statement in a manner that best
reflects the pattern of economic use of assets.

Types of depreciation

Common methods of depreciation are as follows:

Straight Line Depreciation Same depreciation is charged over the entire useful life.

Depreciation expense decreases at a constant rate as the

Reducing Balance Depreciation
life of an asset progresses.

Depreciation charge declines by a constant amount as the

Sum of the Year' Digits Depreciation
life of the asset progresses.

Depreciation charge varies each period in proportion to

Units of Activity Depreciation
the change in level of activity.

Impact of using different depreciation methods

The total amount of depreciation charged over an asset's entire useful life (i.e. depreciable
amount) is the same irrespective of the choice of depreciation method. The adoption of a
particular depreciation method does however effect the amount of depreciation expense charged
in each year of an asset's life.

Following diagram illustrates the effect of using different depreciation methods on yearly
depreciation expense:
The above illustration is based on the following information:

Cost of fixed asset $100,000

Residual Value Nil

Useful Life 4 Years

Total Machine hours 20,000 (for calculating depreciation using units of activity method)

Rate of depreciation 40% (for calculating depreciation using reducing balance method)

For calculation and working, you may view the depreciation worksheet.

Following can be deduced from the diagram:

Straight Line Depreciation Results in an equal expense of $25,000 each year.

Depreciation charge is reduced by 40% in each period (i.e.

Reducing Balance Depreciation the rate used in this example) until the last year in which
the entire un-depreciated amount is charged off.

Sum of the Year' Digits

Depreciation expense decreases each year by $10,000.
Depreciation

Depreciation charge varies in line with the change in

Units of Activity Depreciation
number of machine hours consumed each year.

Comparison of Depreciation Methods

Advantages Disadvantages

Straight Line Easy to calculate May not reflect the true pattern of
asset's economic benefits.
Useful where the pattern of economic
benefits are hard to determine with
precision.

Suitable for depreciating assets that

provide similar level of economic
benefits throughout their useful life
(e.g. buildings).

Reducing Balance Appropriate where the usefulness of The rate of depreciation selected is
an asset declines over its useful life subject to bias
(e.g. IT equipment).

Sum of the Year' Easier to understand More difficult to calculate.

Digits
The effect of decrease in depreciation
expense compared to reducing
balance method.

Units of Activity Most accurately reflects the pattern of Difficult to determine and measure a
consumption of economic benefits. reasonable basis of activity

Suitable in case of fixed assets that

depreciate in proportion to units of
activity rather than just the passage of
 time.

Types of Costs:

Indirect Cost:
Indirect costs, on the other hand, are expenses unrelated to producing a good or service. An
indirect cost cannot be easily traced to a product, department, activity or project. For example,
with Ford Motor Company (F), the direct costs associated with each vehicle include tires
and steel. However, the electricity used to power the plant is considered an indirect cost because
the electricity is used for all the products made in the plant. No one product can be traced back to
the electric bill.

Fixed Costs:

Fixed costs do not vary with the number of goods or services a company produces. For example,
suppose a company leases a machine for production for two years. The company has to pay
$2,000 per month to cover the cost of the lease. The lease payment is considered a fixed cost as it
remains unchanged.

Variable Costs

Variable costs fluctuate as the level of production output changes, contrary to a fixed cost. This
type of cost varies depending on the number of products a company produces. A variable cost
increases as the production volume increases, and it falls as the production volume decreases.
For example, a toy manufacturer must package its toys before shipping products out to stores.
This is considered a type of variable cost because, as the manufacturer produces more toys, its
packaging costs increase. However, if the toy manufacturer's production level is decreasing, the
variable cost associated with the packaging decreases.

Operating Costs:

Operating costs are expenses associated with day-to-day business activities but are not traced
back to one product. Operating costs can be variable or fixed. Examples of operating costs,
which are more commonly called operating expenses, include rent and utilities for a
manufacturing plant. Operating costs are day-to-day expenses, but are not classified as costs of
producing the products. Investors can calculate a company's operating expense ratio, which
shows how efficient a company is in using their costs to generate sales.

Opportunity Cost:

Opportunity cost is the benefit given up when one decision is made over another. In other words,
an opportunity cost represents an alternative given up when a decision is made. This cost is,
therefore, most relevant for two mutually exclusive events. In investing, it's the difference in
return between a chosen investment and one that is passed up. For companies, opportunity
costs do not show up in the financial statements but are useful in planning by management. 

For example, if a company decides to buy a new piece of manufacturing equipment rather than
lease it. The opportunity cost would be the difference between the cost of the cash outlay for the
equipment and the improved productivity versus how much money could have been saved had
the money been used to pay down debt.
Sunk Costs:

Sunk costs are historical costs that have already been incurred and will not make any difference
in the current decisions by management. Sunk costs are those costs that a company
has committed to and are unavoidable or unrecoverable costs. Sunk costs (past costs) are
excluded from future business decisions because the costs will be the same regardless of the
outcome of a decision.

Controllable Costs:

Controllable costs are expenses managers has control over and have the power to increase or
decrease. For example, deciding on how supplies are ordered or the payroll for a manufacturing
company would be controllable, but not necessarily avoidable.

Break-even analysis:

Break-even analysis is a technique widely used by production management and management

accountants. It is based on categorising production costs between those which are "variable"
(costs that change when the production output changes) and those that are "fixed" (costs not
directly related to the volume of production).

Total variable and fixed costs are compared with sales revenue in order to determine the level of
sales volume, sales value or production at which the business makes neither a profit nor a
loss (the "break-even point").

Fixed Costs

Fixed costs are those business costs that are not directly related to the level of production or
output. In other words, even if the business has a zero output or high output, the level of fixed
costs will remain broadly the same. In the long term fixed costs can alter - perhaps as a result of
investment in production capacity (e.g. adding a new factory unit) or through the growth in
overheads required to support a larger, more complex business.

Examples of fixed costs:

- Rent and rates
- Depreciation
- Research and development
- Marketing costs (non- revenue related)
- Administration costs

Variable Costs

Variable costs are those costs which vary directly with the level of output. They represent
payment output-related inputs such as raw materials, direct labour, fuel and revenue-related costs
such as commission.
A distinction is often made between "Direct" variable costs and "Indirect" variable costs.

Direct variable costs are those which can be directly attributable to the production of a particular
product or service and allocated to a particular cost centre. Raw materials and the wages those
working on the production line are good examples.

Indirect variable costs cannot be directly attributable to production but they do vary with output.
These include depreciation (where it is calculated related to output - e.g. machine hours),
maintenance and certain labour costs.

Semi-Variable Costs

Whilst the distinction between fixed and variable costs is a convenient way of categorising
business costs, in reality there are some costs which are fixed in nature but which increase when
output reaches certain levels. These are largely related to the overall "scale" and/or complexity of
the business. For example, when a business has relatively low levels of output or sales, it may
not require costs associated with functions such as human resource management or a fully-
resourced finance department. However, as the scale of the business grows (e.g. output, number
people employed, number and complexity of transactions) then more resources are required. If
production rises suddenly then some short-term increase in warehousing and/or transport may be
required. In these circumstances, we say that part of the cost is variable and part fixed.

Make or Buy Decision:

The make-or-buy decision is the act of making a strategic choice between producing an item
internally (in-house) or buying it externally (from an outside supplier). The buy side of the
decision also is referred to as outsourcing. Make-or-buy decisions usually arise when a firm that
has developed a product or part—or significantly modified a product or part—is having trouble
with current suppliers, or has diminishing capacity or changing demand.

Make-or-buy analysis is conducted at the strategic and operational level. Obviously, the strategic
level is the more long-range of the two. Variables considered at the strategic level include
analysis of the future, as well as the current environment. Issues like government regulation,
competing firms, and market trends all have a strategic impact on the make-or-buy decision. Of
course, firms should make items that reinforce or are in-line with their core competencies. These
are areas in which the firm is strongest and which give the firm a competitive advantage.

The increased existence of firms that utilize the concept of lean manufacturing has prompted an
increase in outsourcing.

David Burt, Donald Dobler, and Stephen Starling present a rule of thumb for out-sourcing. It
prescribes that a firm outsource all items that do not fit one of the following three categories:

(1) The item is critical to the success of the product, including customer perception of important
product attributes;
(2) The item requires specialized design and manufacturing skills or equipment, and the number
of capable and reliable suppliers is extremely limited; and

(3) The item fits well within the firm's core competencies, or within those the firm must develop
to fulfill future plans. Items that fit under one of these three categories are considered strategic in
nature and should be produced internally if at all possible.

Make-or-buy decisions also occur at the operational level. Analysis in separate texts by Burt,
Dobler, and Starling, as well as Joel Wisner, G. Keong Leong, and Keah-Choon Tan, suggest
these considerations that favor making a part in-house:

 Cost considerations (less expensive to make the part)

 Desire to integrate plant operations
 Productive use of excess plant capacity to help absorb fixed overhead (using existing idle
capacity)
 Need to exert direct control over production and/or quality
 Better quality control
 Design secrecy is required to protect proprietary technology
 Unreliable suppliers
 No competent suppliers
 Desire to maintain a stable workforce (in periods of declining sales)
 Quantity too small to interest a supplier
 Control of lead time, transportation, and warehousing costs
 Greater assurance of continual supply
 Provision of a second source
 Political, social or environmental reasons (union pressure)
 Emotion (e.g., pride)

Factors that may influence firms to buy a part externally include:

 Lack of expertise
 Suppliers' research and specialized know-how exceeds that of the buyer
 cost considerations (less expensive to buy the item)
 Small-volume requirements
 Limited production facilities or insufficient capacity
 Desire to maintain a multiple-source policy
 Indirect managerial control considerations
 Procurement and inventory considerations
 Brand preference
 Item not essential to the firm's strategy

The two most important factors to consider in a make-or-buy decision are cost and the
availability of production capacity.