UNIT –I

1. Define managerial economics? Explain

a) Nature of ME
b) Scope of ME

Essay Questions
Answer:
Definition of Managerial Economics:
Spencer and Siegelman define:
It is “the integration of economic theory with business practice for the purpose of facilitating
decision making and forward planning by management.”

Nature of ME:
Managerial Economics is concerned with the economic problems that the management team of
every business needs to solve. A study on the nature of managerial economics is relevant and
helpful for managerial decision-making. The nature of Managerial Economics is studies as
follows:
i. Micro-economics in character: Managerial economics deals with the problems of an
individual firm or single industry, which can be analyzed through the applications of
microeconomics. Thus, managerial economics is close to microeconomics.
ii. Takes the support of macroeconomics: In order to solve the business problems an
economist need to understand the circumstances and environment in which an individual
firm or an industry is operating. For this the manager should have the knowledge of
macroeconomics such as business cycles, taxation policies, industrial policies, price and
distribution policies, anti monopoly policies etc.
iii. Normative statement: Economists frequently distinguish between 'positive' and
'normative' economics. Positive economics is concerned with the development and testing
of positive statements. It is objective and verifiable. Normative statements derive from an
opinion or a point of view. Thus the words 'should', 'ought to' or 'it is better to' frequently
occur. The validity of normative statements can never be tested. Every business concern
with the different should be undertaken to achieve the organizational goals. Thus, the
managerial economics is a normative science.
iv. Prescriptive nature: Managerial economics is an applied discipline. It suggests the
applications of economic principles such as policy formulation, decision-making, and
future planning. It prescribes the ways to achieve the goals of an organization.
v. Pragmatic: Managerial economics is a practical subject. It goes beyond providing rigid
and abstract theoretical framework for managers. While at some it avoids the difficult
issues of economic theory.
 vi. Scientific art: Art represents the best way of doing the things. Managerial economics helps
the managers to utilize the scared resources in an efficient manner. It considers production
costs, demand, price, profit, risk etc and helps the managers in selecting the best
alternative.
vii. Conceptual: Managerial economics is based on sound framework of economic concepts. It
aims to analyze business problems on the basis of established concepts. Thus, it is
conceptual in nature.
viii. Problem solving: Besides analyzing the business problems managerial economics focus on
finding the optimal solutions to the business problems.

SCOPE OF MANAGERIAL ECONOMICS:

Managerial economics is used to solve the business problems almost in all the areas of business.
Some of the specific areas of firm include:
a. Capital management
b. Demand analysis and forecasting
c. Cost analysis
d. Production analysis
e. Pricing decisions
f. Profit management
a. Capital Management:
Capital investment is one of the most complex problem of a firm. Capital management
implies planning, acquisition, disposition and control of capital expenditure. The basic
economic concepts that help to manage capital are sources of capital, cost of capital, capital
budgeting, rate of return.
b. Demand analysis and forecasting:
The performance and profitability of a firm depends on meeting the demand for their goods
in the market. Thus, the managers need to estimate the nature and amount of demand for their
goods both at present and future. The various tools used to forecast the demand are: demand
concepts, demand determinants, law of demand, elasticity of demand, demand forecasting
etc.
c. Cost analysis: In the present competitive economy customers expects quality goods at
reasonable price. Hence, the managers have to control the cost of production in order to meet
customer expectations and to earn maximum profits. The various aspects of cost that the
managers need to consider are: cost concepts, cost behavior in short run and long run, cost
function, cost determinants, cost control and cost reduction.
d. Production analysis: Production relates the physical relation between inputs and output. The
cost of goods and supply of goods in the market depends on the combination of variable
input factors of production and quantity of production. At some level of output the cost of
production increases with increase in input factors and in some other cases it decreases. The
managers should determine the level of production at which the average cost is minimum.
Thus, the managers need to analyze the input factors of production to minimize the cost and
maximize profits of the firm. These decisions can be taken by analyzing the production
concepts like: production determinants, production function, law of returns, isoquants and
isocosts etc.
e. Pricing decision: Price of a good plays an important role in profits and success of a firm.
When the price is too high, it fail to generate demand and if it is too low, leads to losses to
the firm. Thus, the managers need to more careful while fixing price of their products. The
 main aspects under pricing analysis are: pricing policies, pricing methods, approaches,
market structures and price determination under different markets.
f. Profit Analysis: Profit is one of the measurement that represents performance of a business.
Generally every business aims at making profits, without which a firm can’t survive. Profit
management requires that the most efficient techniques should be used for predicting future.
The important aspects that support to plan and manage the profits include: nature and
measurement of profit, profit policies, Break-even analysis, cost-volume-profit analysis etc.

Decision Area Economic tools

Capital Sources of capital, cost of
management capital, capital budgeting
Demand Demand determinants, Law of
decision demand, demand function,
elasticity of demand, demand
estimation, demand
forecasting
Cost analysis Cost concepts cost output
relation in short run & long
run
Production Production determinants,
decision production function, law of
returns, isoquants, isocosts,
MRTS
Pricing decision Market structures – Perfect
competition, monopoly,
duopoly, oligopoly,
monopolistic competition
Pricing methods
Profit related Break even analysis, Cost –
decision volume –profit analysis

2. Write a note on
a) Demand determinants
b) Law of demand with its exceptions
Answer:
Demand:
Generally demand, means the desire for a thing, but in economics the demand for a product can
be considered based on three elements. They are:
 Desire – wishful thinking
Willingness – interested to purchase at given time and price
Ability to pay – money spend to acquire a product
According to 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”.
According to Bobber, “ by demand represents various quantities of a given commodity or service
which consumers would buy in one market in a given period of time at various prices”.
a) DEMAND DETERMINATS:
The demand for a product depends on the various factors, which are known as demand
determinates. The decision maker should analyze the influence the influence of these factors
while predicting or calculating the demand. The demand determinants include:
i. Price of the product
ii. Income of the consumer
iii. Consumer Taste and preferences
iv. Prices of related goods
v. Advertisement cost
vi. Population size
vii. Expected change in future income
viii. Expected change in future price
i. Price of the product: Affects the demand of a product to a large extent.
In case of inferior goods, there is an inverse relationship
between the price of a product and quantity demanded. The
demand for a product decreases with increase in its price, while
other factors are constant, and vice versa.
Whereas in case of luxury goods, the demand and price are in
same direction i.e., increases in the price will increases the
demand and vice versa.
ii. Income: A rise in a person’s income will lead to an increase in
demand (shift demand curve to the right), a fall will lead to a decrease in demand for normal
goods. Goods whose demand varies inversely with income are called inferior goods.
iii. Consumer Taste & Preferences: Favorable consumer taste & preferences leads to an increase
in demand, unfavorable change lead to a decrease in demand.
iv. Price of related goods: The demand for a good not only influenced by its own price but also
prices of other related goods. Depending upon the relation with change in price of other goods
the demand may increases or decreases.
a. Substitute goods (Replacement goods): price of substitute and demand for the other good
are directly related.
Example: If the price of coffee rises, the demand for tea should increase.
b. Complement goods (Joint goods): price of complement good and demand for the other
good are inversely related.
Example: if the price of ice cream rises, the demand for ice-cream toppings will decrease.
v. Number of Buyers: the more buyers lead to an increase in demand; fewer buyers lead to
decrease.
vi. Expectation of future:
a. Future price: consumers’ current demand will increase if they expect higher future prices;
their demand will decrease if they expect lower future prices.
 b. Future income: consumers’ current demand will increase if they expect higher future
income; their demand will decrease if they expect lower future income.
vii. Advertisement cost:
The cost and effectiveness of advertisement helps to attract and inform the customers about
the various features of the product. Thus, the effective advertisement will increases the
demand for the product.  
b) LAW OF DEMAND:
Law of demand explains the relationship between price and quantity demanded for a commodity.
Statement: Law of demand can be stated as “At any given time, the demand for a commodity
will increases with fall in its price and the demand decreases with increase in its price”. Thus, the
price of a commodity and its demand are always inversely related to each other.
i.e, D α 1/Px
Where Dx = Quantity Demanded for a commodity X
Px = Price of the commodity X
Assumptions:
The law of demand can be applicable under the following conditions:
 There should not be any change in income of consumer
 No change in taste and preferences of consumers
 No change in prices of related goods
 No change in expected change in income and price
 There is no change in cost of advertisement
Demand schedule representing law of demand
Price (Rs) Demand (kg)
50 25
40 32
36 46
29 58

Demand curve showing law of demand

Exceptions of law of demand:

Law of demand does not hold good in some cases, which are considered as exceptions of law of
demand. In the exceptions of law of demand, the demand will increases with increase in price or
decrease the demand with decrease in price. They include:
a. Giffin goods: These goods are defined by Sir Robert Giffin so these are known as Giffin
goods. He defined the Giffin goods as – the inferior goods with low price, such as bajra,
rice, jawa, rice etc. The demand for these goods will decreases with decrease in its price and
vice versa.
b. Luxury goods: Luxury goods are the high price goods, which indicate status of an
individual. The law of demand does not hold good in case of luxury goods. It is because,
the fall in price does not attract middle or lower class individuals and due to its fall in price
its existing users search for other prestigious goods. Thus, the demand for the goods
decreases with fall in price and vice versa.
c. Future expectations: When the price of the goods increases and if the individual expect
that in future again its prices are going to be increased they prefer to purchase even at
present increased prices.
When the customer expects that their future income increases they won’t prefer to purchase
the goods even the price of the goods decreases.
d. Ignorance: Customers ignorance is another factor that influences the demand. In some
cases the customers believes that the high price goods are high quality and fall in price
considered as low quality.
e. Limited supply: when the supply of goods are limited due to uncertainties like strikes,
natural accidents etc. the demand for the goods are very high after the occurrence of the
uncertainty still the demand will be very high.
f. Brand loyalty: If a customer is loyal to a specific brand then he/she prefer to use the same
even at high price.
The demand curve in case of exceptional cases

3. Define Elasticity of demand? Explain types of elasticity and its significance?

Answer:
ELASTICITY OF DEMAND:
Prof. Marshall introduced the concept of elasticity of demand to measure the change in demand,
with respect to the changes in demand determinants. Elasticity of demand is the rate at which the
quantity demanded for a commodity changes in response to the given change in its determinants
(Price). It measures the proportionate change in the quantity demanded for a commodity in
response to proportionate change in its demand determinants.
Elasticity of demand, E=
Proportionate change∈quantity demanded for a commodity X
Proportionate change∈its demand determinants
∆Q
∗100
Q
E=
∆D
∗100
D
∆Q
Q
E=
∆D
D
ΔQ D
E= *
ΔD Q
Where ∆Q = Q2-Q1
∆D= D2-D1
Q2 = Quantity demanded before change
Q1 = Quantity demanded after change
D2 = Demand determinant before change
D1 = Demand determinant after change
Q= Initial quantity
D= Initial Demand determinant
TYPES OF ELASTICITY OF DEMAND:
Depending upon the elements on which the quantity demanded changes elasticity of demand can
be divided into four types. They are:
i. Price elasticity of demand
Price Elasticity of demand, EP=
Proportionate change∈quantity demanded for a commodity X
Proportionate change∈its price

ii. Income elasticity of demand

Income Elasticity of demand, EI=
Proportionate change∈quantity demanded for a commodity X
Proportionate change∈the income of a customer

iii. Cross elasticity of demand

Cross Elasticity of demand, EC=
Proportionate change∈quantity demanded for a commodity X
Proportionate change∈ price of commodity Y

iv. Advertisement elasticity of demand

Advertisement Elasticity of demand, EA=
Proportionate change∈quantity demanded for a commodity X
Proportionate change∈advertisement cost
SIGNIFICANCE OF ELASTICITY OF DEMAND:
 i. Business decisions: While taking the decisions related to changes in the prices of a goods, it
is important to consider the price elasticity of demand. If the elasticity of demand is high,
then a decrease in price will lead to an increase in the demand.
ii. Price discrimination: When the demand for the good is inelastic then the firm can offer the
product at different prices to maximize the profits.
iii. Government decisions: The concept of price elasticity of demand is important for
formulating government policies, especially the taxation policy. Government can impose
higher taxes on goods with inelastic demand, whereas, low rates of taxes are imposed on
commodities with elastic demand.
iv. Prices of joint goods: In case of join goods like cotton and cotton seeds, oil and oil –cakes,
goat and its skin and meat etc, the cost of goods can’t be known separately. The producer
will be guided mostly by demand and its nature while fixing its prices. The demand for
cotton is inelastic and that of cotton-seeds elastic, then price for cotton will be fixed more
and that of cotton-seeds less.
v. Factor Pricing: The return on each factor of production depends upon the elasticity of
demand for its goods and services. If the demand for a factor of production is inelastic, the
producer will be prepared to pay a high price for it. On the other hand, if the demand is
elastic, its returns will be lower, therefore the producer will pay less price or at the most the
prevailing price for hiring its services.
vi. Nationalization of Public utilities: Demand for public utilities such as electricity, water
supply, post and telegraph, public transportation etc. is generally inelastic in nature. If the
operation of such utilities is left in the hand of private individuals, they may exploit the
consumers by charging high prices. Therefore, in the interest of general public, the
government owns and runs such services.
The public utility enterprises decide their price policy on the basis of elasticity of demand. A
suitable price policy for public utility enterprises is to charge from consumers according to
their elasticity of demand for public utility.
vii. International trade policy: It helps to calculate the terms of trade and the consequent gain
from foreign trade. If the demand for home product is inelastic, the terms of trade will be
profitable to the home country. However, if demand for such goods in the importing country
is elastic, then the exporting country will have to fix lower prices.
viii. Determination of Wages: The concept of elasticity of demand influences the determination
of wages of a particular type of labour. If the demand of particular type of labour is inelastic
trade union can easily get their wages raised. On the other hand of the demand for labour is
relatively elastic trade union trade unions may not be successful in raising wages.
ix. Demand forecasting: Income elasticity of demand can be used to determine the demand for
the products in future. For planning and management of production the manger need to
determine the effect of income on the demand.

4. Explain the survey methods of demand forecasting?

Answer:
DEMAND FORECASTING:
It can be defined as a “systematic process of estimating the quantity of goods that are purchased
by a customer in future at a specific price and time”.
A. SURVEY METHOD:
 Survey method is generally used where the purpose is to make short run forecast of demand. The
survey can be conducted on consumers, sales representative, experts or market.
i. Consumer survey method: Survey on consumers can be conducted in two ways:
a. Consumer enumeration: In this method, the quantity of demand can be calculated by
including all the potential consumers opinion.
Merits:
 The forecaster just collects the consumer opinion and thus, does not influence the
consumer’s opinion. (unbiased)
 More accurate
 Suitable for small number of consumers.
Demerits:
 More expensive.
 Consumers may not interest to become a part of survey.
 The forecaster may do the mistake while recording the information.
 Not suitable for the firms having large number of consumers
b. Sample survey method:  Under this method only a few potential consumers selected from
relevant market through a sampling method are surveyed, on the basis of the information
obtained, the probable demand can be estimated.
Merits:
 Less expensive
 More accurate result if a sample is properly chosen
Demerits:
 Accuracy depends on the cooperation of selected consumers
 Selection of test market from the total market will be more difficult
ii. Sales force opinion method: Sales representatives are in close touch with consumers;
therefore, they are well aware of the consumers’ future purchase plans, their reactions to
market change, and their perceptions for other competing products. They provide an
approximate estimate of the demand for the organization’s products. This method is quite
simple and less expensive. Thus, sales representatives are requested to give their opinion on
product demand.
Merits:
 Cheaper and easy to handle
 Less time consuming
Demerits:
 The accuracy and reliability of information depends on the analytical skills and
interest of the sales representatives.
 Sometimes the executives may over estimate or under estimate
iii. Delphi method: Here the forecasting can be done by the group of experts. All the experts
are asked to estimate the demand for the product individually. The opinion of all experts
can be analyzed to identify the future demand. An expert opinion can be sent back to all the
others for cross verification and to prepare their opinion and the process ends when all the
experts agreed to a single decision.
Merits:
 Simple to conduct
 More reliable because the of the opinion of experts
  It is inexpensive and less time consuming
Demerits:
 Experts may be biased
 Opinions may be divergent
iv. Market experiments: An alternative method to collect the consumer opinion and analyze
their behaviour is through market experiments. This can be done in two ways.
a. Test market: In this method the forecaster conduct market experiments by changing
prices, advertisement expenditure, quantity, label etc. The consequences the changes in
the demand over a time period can be recorded. On the basis of this collected information
the demand can be forecasted.
b. Laboratory experiments/consumer clinics: Under this method, consumers are given
some money to buy in a stipulated/artificial store goods with varying prices, packages,
display, quantities etc. The results of the experiment reflects the consumer behaviour with
respect to the different prices, quantities, packages, etc.
Limitations:
 More expensive
 The artificial market may not consider all the characteristics of long run market.
5. Explain the statistical methods of demand forecasting?
Answer:
DEMAND FORECASTING:
It can be defined as a “systematic process of estimating the quantity of goods that are purchased
by a customer in future at a specific price and time”.
B. STATISTICAL METHODS:
Statistical methods are complex set of methods of demand forecasting. These methods are used
to forecast demand in the long term. In this method, demand is forecasted on the basis of
historical data and cross-sectional data.
i. Time series method:
Time-series methods make forecasts based solely on historical patterns in the data. Time-series
methods use time as independent variable to produce demand. In a time series, measurements are
taken at successive points or over successive periods. The measurements may be taken every
hour, day, week, month, or year, or at any other regular (or irregular) interval. Time-series
models are adequate forecasting tools if demand has shown a consistent pattern in the past that is
expected to recur in the future. 
Ex:
Time duration Sales
2016 500
2017 700
2018 750
2019 850
2020 1000
2021 ?
Based on the time series data the demand for the product in the year 2017 can be estimated as
more than 1000 unit.
ii. Graphical method: In this the time series data can be plotted in a graph. By observing
the behaviour of the curve or line the future demand can be predicted.
Ex: the above time series data can be represented in a graph as

1200
1000
800
600
400
200
0
2011 2012 2013 2014 2015 2016 2017
By observing the line it can be estimated that the demand in 2017 can be increased.
iii. Least square method:
This method uses statistical formula to find the trend line which best fits the available data. A
linear equation can be formulated based on the past data, which can be used for demand
forecasting. The estimated linear equation is:
S= a+bT
Where, S= Estimated sales
T = year number
a, b = constants
The values of a and b can be determined by using the following equations:
∑S =Na +b∑T
∑ST= a∑T+b∑T2
Where N= number of years
iv. Smoothing methods:
Smoothing techniques are useful when the time series exhibit little trend or seasonal variations
but a great deal of irregular of random variation. The basic assumption of smoothing method is
that the future depends on the most recent past. These methods include:
Moving average method
Exponential smoothing
a. Moving average method: In this method the forecasted value of a time series in a given
period is to the average value of the time series in a number of previous periods.
For example, the moving average for first three years can be calculated then next three years and
so on. It may also be predicted by calculating for five years.
The greater the number of periods used in the moving average, the greater is the smoothing
effect because each new observation receives less weight.
Year Sales Moving average for 3 years
2011 4.6 --
2012 5.3 --
2013 8.1 (4.6+5.3+8.1)/3 =6
2014 6 6.5
2015 6.5 6.9
2016 6.9 6.5

b. Exponential smoothing method: One of the limitation of moving average method is it gives
equal weight to all observations in computing the average. With exponential smoothing, the
 forecast for period t+1, is a weighted average of the actual and forecasted values of the time
serried in period t. The value of the time series at period t is assigned a weight c between 0 to
1 inclusive, and the forecast for the period t is assigned the weight of 1-c. The greater the
value of c the greater is the weight given to the value of the time series in period t as opposed
to previous periods. Thus, the value of the forecast of the time series in period t+1 is
St+1 =cSt+(1-c) Smt
Where St = actual sales
Smt = sales in most recent past
C= constant ( 0 to 1)
v. Barometric method: The basic assumption of barometric method is the future can be
predicted from certain happenings in the present. It involve the use of statistical indicators,
which provide an indication of the direction in which the economy or a particular industry or
product interacts. The economic indicators are of three kinds:
 Leading Series/indicator: The leading series is comprised of indicators which move up or
down ahead of some other series. For example applications for the amount of housing loan
over time is a leading series for the demand of construction material.
 Coincidental Series: The coincidental series include indicators which move up and down
simultaneously with the general level of economic activities. The examples of coincidental
series – the national income is often used as an indicator with employment in an economy.
 Lagging Series: A series of data moves up and down behind the series compared is known
as lagging series. For example, demand for construction is a lagging indicator for prices of
cement.
6. How does demand forecasting influencing by different factors?
ANSWER:
DEMAND FORECASTING:
It can be defined as a “systematic process of estimating the quantity of goods that are
purchased by a customer in future at a specific price and time”.
FACTORS INFLUENCING DEMAND FORECASTING:
 Price of Goods: Demand estimation is highly dependent on the price of goods or
services. The pricing policy and fluctuation in the present price can give an idea of change
in demand for that particular commodity.
 Type of Goods: The kind of commodity, its features and usability determines the
customer base it is going to cater. The demand for existing goods can be easily estimated
by following the previous sales trend, competitors’ analysis and substitutes available.
Whereas, the demand for a new product on the market is difficult to predict.
 Competition: The level of competition in the market supports the process of demand
forecasting. It is easy to predict sales in a less competitive market, whereas the same
becomes difficult in a market where the new firms can freely enter.
 Technology: The demand for any product or service changes drastically with the
advancement in technology. Therefore, it is essential for an organisation to be aware of
technological development while forecasting the demand for any commodity.
 Economic Perspective: Being updated with economic changes and growth is necessary
for demand forecasting. It assists the organisation in preparing for future possibilities and
analyzing the impact of economic development on sales.
7. Explain the measurements of demand.
Answer:
Measurements/ Types of Price elasticity of demand:
A. Perfectly price elastic demand: It refers to the situation where the small change in price
causes an infinite increase in the quantity demanded of the commodity. Thus, the elasticity of
demand is infinity. This extreme case of elasticity of demand is very rarely to be found in
practice. i.e, EP =∞.

B. Perfectly inelastic demand: A perfectly inelastic demand is one when there is no change
produced in the demand of a product with change in its price. The numerical value for
perfectly inelastic demand is zero (ep=0).

C. Unitary Elasticity of demand: When the proportionate change in demand produces the
same change in the price of the product, the demand is referred as unitary elastic demand.
The numerical value for unitary elastic demand is equal to one (ep=1).
D. Relatively Elastic demand: Relatively elastic demand refers to the demand when the
proportionate change produced in demand is greater than the proportionate change in price of
a product. The numerical value of relatively elastic demand ranges between one to infinity.

E. Relatively inelastic demand: Relatively inelastic demand is one when the percentage
change produced in demand is less than the percentage change in the price of a product. The
numerical value of relatively elastic demand ranges between zero to one (EP <1).

Measurements/ Types of Income elasticity of demand:

 Positive income elastic of demand, EI > 0, commodities are known as normal goods
 Negative income elastic of demand, EI < 0, in case of inferior goods
 High income elasticity of demand, EI >1, in case of luxury goods.
 Low income elasticity of demand, EI<1, in case of essential goods.
 Zero income elasticity of demand, EI =0, Neutral goods like salt, matches etc.
Measurements of cross elasticity of demand:
A. Substitute goods: When the Ec is positive then the goods are known as substitute goods. In
this case the demand for the commodity x increase with increase in price of y and demand for
x decrease with fall in price of Y. These goods are also known as replacement goods.
Ex: Tea and coffee, Bicycle and car water and wind (power generation) etc,
B. Complementary goods: When the Ec is negative then the goods are known as
complementary goods. In this case the demand for the commodity x increase with decrease in
price of y and demand for x decrease with increase in price of Y. These are also known as
joint goods.
Ex: bread and butter: car and fuel etc.
C. Independent Goods: When the Ec is zero then the goods are known as independent goods. In
this case the demand for the commodity x does not depends on the price of commodity Y and
vice versa.
Ex: rice and fuel,

UNIT –II
ESSAY QUESTIONS
1. Write a short note on least cost combination?
Answer:
ISOQUANTS:
It is originated from Greek words Iso and Quants which means same quantities.
Iso à same
Quants à quantities
Thus isoquant is a curve with different combinations of two input factors which produces same
quantity of output.It can also be known as isoproduct.

Let us consider table showing different combinations of two input factors which produces 100
units of output:
Combination Labor Capital
A 10 25
B 15 20
C 20 18
Properties of isoquants:
 i. Downward sloping curve
ii. Convex to origin
iii. never touches the axes
iv. no two isoquants intercept each other
v. Higher Iso-curve moves against to origin
i. Downward slope: They slope downward because MTRS of labour for capital diminishes.
When we increase labour, we have to decrease capital to produce a given level of output.

ii. Convex to origin: The downward sloping curve may be a convex curve, concave or even a
straight line. Due to MRTS the shape of an isoquants will be convex to origin.
iii. Never touches axes: The production wont be possible with labour alone or capital alone.
Thus, an isoquant never touches either the axes.

iv. No two isoquants intersect each other: A producer can’t be able to produce two different
quantities of output by using same combination of two input factors. Hence, two isoquants
won’t touch each other.

v. Higher isoqunat moves against to the origin: As the quantity increases the isoquant moves
against to the origin.
ISOCOSTS: Isocost which means same cost. Isocost represents a line with two input factors of
production which cost same to the producer. Thus, it can also be known as budget line.
Now suppose that a producer has a total budget of Rs 1,000 and and for producing a certain level
of output, he has to spend this amount on 2 factors labour and capital. Price of labour and capital
are Rs 15 and Rs. 10 respectively. 
Combination Labour Capital Cost of the project
(i) (ii) (iii) iv=15(ii)+10(iii)
A 40 40 1000
B 30 55 1000
C 18 73 1000

Properties of isocost:
 The higher isocost will moves against to the origin
 It is always a straight line
LEAST COST COMBINATION:
The basic objective of a producer is to maximize the profits of the firm by producing more
output by employing less number of input factors. The combination of two input factors which
gives maximum output by using minimum input factors is known as Least cost combination.
Assumptions:
 There are two factors of production labour and capital
 The input factors of production are homogeneous
 The prices of input factors are kept constant
 The basic objective of the firm is to maximize the profits.

Determination of least cost combination:

 A firm can find out a least cost combination by superimposing the isoquant curve on iso cost
line.
Let us suppose that a firm has a project costing Rs. 1,000. The isoquant and isocost cost
can be represented by:

To determine the least cost

combination let us
superimpose the isoqunat
on isocost.
In the figure the isocost IC1 become a tangent to isoquant IQ2 at the point B. Thus the point B is
considered as least cost combination. Thus, the firm can employ OC capital and OL labour to
produce 2000 units with the budget of Rs.1000.

2. Explain internal and external economies of scale.

Answer:
ECONOMIES OF SCALE:
Economies of scale represents the various factors that reduces the average cost of a commodity.
A firm can reduce the cost of a commodity by using internal and external factors. Thus, the
economies of scale include two types:
A. Internal economies of scale
B. External economies of scale
A. Internal economies of scale: These are the internal factors of an organization which helps the
producer to minimize the cost of production. These factors include:
i. Labour economies: In long run a firm produces more number of units and employ more
specialized employees. They perform their activities more professionally and with little
training they become more productive.
 ii. Financial economies: A larger firm can be able to generate the interest at lesser rate and
get more scope of the expansion and diversification of business.
iii. Marketing economies: The strong marketing activities of a firm helps to buy the input
factors at minimum cost and minimizes the promotional/marketing expenses of the firm.
iv. Risk bearing economies: The investments of a firm involve risk. Larger firms has more
ability to take and tolerate risk which gives more profits to the firm.
v. Economies of R &D: The research and development department of a firm helps the
producer by developing more effective methods of doing the work. These new methods will
minimizes the wastage and increases the efficiency.
vi. Technological economies: Firm with large scale production can be able to include more
technically developed machines, which are more efficient for the production.
vii. Managerial economies: Potential and specialized managers have the ability to control
and use the resources of a firm in a more productive manner. Thus, expertise managers can
reduces the long run cost.
B. External economies of scale: These are the external factors of a firm, which reduces the
long run average cost. They are:
i. Economies of concentration: The long run average cost of a product can be reduced when
many firms are located in a single locality. With the concentration of industries in a place
will helps the firm to get the raw materials and labour at a cheaper cost.
ii. Economies of R &D: The industrial R &D helps all the small industries to adopt the latest
technologies available in the market.
iii. Economies of integration: A firm can lower its cost by integrating the various operations of
producing a product.
DISECONOMIES OF SCALE: Diseconomies of scale leads to increase in the long run
cost of a commodity. The various factors that increases the average cost are:
 Ineffective management
 Lack of technological developments
 Poor communication
 Low financial status/resources
 Poor marketing programmes
 Lack of efforts of R &D
3. Elucidate law of returns?
Answer:
LAW OF VARIABLE PROPORTIONS/ LAW OF RETURNS TO FACTORS/ LAW OF
DIMINISHING RETURNS:
Law of variable proportions represents the input-output relationship or production function with
one variable, while the other factors of production kept constant.
Statement:
In short run, when all the input factors except the labour kept constant, the marginal product
increases with increase in input factor upto the maximum and then decreases to 0 with further
increase in labour, after a beyond point it becomes negative with increase in input factor.
Thus, the law of variable proportions can be explained in three stages. They are:
Stage 1: Law of increasing returns
Stage 2: Law of diminishing returns
Stage 3: Law of negative returns
 No of Total Product Average Marginal Stage
labour Product Product
0 - - -
1 100 100 100
2 220 110 120 Stage -1
3 360 120 140
4 520 130 160
5 650 130 130
6 750 125 100
7 840 120 90 Stage -2
8 880 110 40
9 880 97.7 0
10 830 83 -50
Stage -3
11 770 77 -60

Stage -1: Law of increasing returns:

The basic characteristics of this stage are:
o TP increases with higher growth rate
o AP increases
o MP reaches to maximum
The reasons which cause this stage are:
o Better utilization of resources
o Increased efficiency of variable factors
o Individuality of fixed factor.
Stage –II Law of diminishing returns:
This stage represents:
 TP increases with reduced rate
 AP reaches to maximum
 MP starts decreasing and reaches to 0
Reasons that leads to this stage are:
 Optimum composition of factors
 Imperfect substitution
Stage –III law of negative returns:
The characteristics of this stage are:
 TP starts decreasing
 AP decreases
 MP becomes negative
Reasons:
 Limitations of fixed factors
 Poor coordination between variable and fixed factors
 Decrease in efficiency of variable factors.
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.
Statement:
In long run when all the factors of production changes, the marginal production increases with
higher growth rate of input factors, increases with same rate and decreases with the increase in
input factors.

Factors of production Total Marginal Stage of return to

employed product product scale
1 WORKER+3 hrs 200 200 STAGE OF
INCREASING
2 WORKERS + 6 hrs 500 300 RETURNS

3 WORKERS + 9hrs 900 400

4 WORKERS+ 12 hrs 1400 500

5 WORKERS +15 hrs 1900 500 STAGE OF

CONSTANT
6 WORKERS + 18 hrs. 2400 500 RETURNS

7 WORKERS + 21 hrs 2800 400 STAGE OF

DECREASING
8 WORKERS + 24 hrs 3100 300 RETURNS

9 WORKERS + 27 hrs 3200 100

Stage – I: Law of increasing returns:

There are increasing returns to scale when a given percentage increase in input leads to a greater
relative percentage increase in output. This creates more change in marginal product with
increase in input factors.
Proportionate change in output > proportional change in input.
ΔQ/Q >ΔI/I
ΔQ/Q *I/ΔI >1
Reasons:
o Internal economies of scale 
o Efficiency of labour and capital 
o Improvement in large scale operation 
o Division of labour and specialization 
o Use of better and sophisticated technology 
o Economy of organisation 
o External economies of scale
Stage –II: Law of Constant returns:
Constant returns to scale occur when a given percentage increase in input leads to an equal
percentage increase in output. It shows that if inputs are doubled then the output also gets
doubled.  Thus, the marginal product will be constant with increase in input factors.
Proportionate change in output = proportional change in input.
ΔQ/Q = ΔI/I
ΔQ/Q *I/ΔI = 1
Reasons:
o Internal economics of scale are equal to internal diseconomies of scale.
o Balancing of external economics and diseconomies of scale
o Factors of production are perfectly divisible substitutable, homogenous and their supply is
perfectly elastic at given prices.
Stage –III Law of decreasing returns:
The term 'diminishing' returns to scale refers to scale where output increases in a smaller
proportion than the increase in all inputs. Here the marginal product will decreases with increase
in input factors.
ΔQ/Q <ΔI/I
ΔQ/Q *I/ΔI<1
Reasons:
 Internal diseconomies of scale 
 External diseconomies of scale 
 Increase in business risk 
 Lack of entrepreneurial efficiency 
 Unhealthy management and organization 
 Imperfect factor substitutability 
 Transport bottlenecks and Marketing difficulties.
4. Define BEA? Explain the assumptions and significance of BEA?
Answer:
BREAK EVEN ANALYSIS:
Break even analysis represents the relationship between total cost, total revenue and total
profits at a specific level of output. Break even analysis indicates the specific level of output at
which the total is equal to total revenue. The point where the total cost is equal to total revenue is
known as Break-even point. Thus, at break-even point the total revenue of the firm is equal to its
total costs. The break even analysis can also be known as Cost-volume-profit (CVP) ratio.
The quantity of output or volume of sale below the break-even point gives losses
(TC>TR) and the quantity higher than break even quantity represents the profits (TR>TC) of the
firm.

Assumptions:
 The total revenue of the firm is directly proportional to the volume of sales. Thus, the
average selling price is constant.
 Total cost is combination of fixed and variable cost.
 The variable cost is directly proportional to the quantity of output.
 The production quantity is equal to the volume of sales, there is no closing inventory.
 The cost of production changes only with respect to quantity of production.
Significance of BEA:
 The basic significance of Break-even analysis for the management are:
 To decide the optimum quantity of production or volume of sales that protect from losses.
 It can be used for determining the margin of safety regarding the extent to which the firm
can permit a decline in sales without causing loss.
 To estimate profits at a specific level of output.
 To estimate the quantity of production or volume of sales to be achieved when the firm
want to maintain profit even by reducing the prices of the products
 To take decisions related to make or buy.
 BEA helps to decide the product mix of a firm.
 It also useful to decide add or drop of a product.
5. State cost involved in a firm?
Answer:
COST CONCEPTS:
Cost referred as the expenses incurred to produce certain amount of output which includes the
payments to the factors and non factors of production.
A firm incur different types of cost while producing commodities. The various types f cost
includes:
i. Fixed cost (FC): The cost which does not changes with quantity of production is known as
fixed cost. As some cost is fixed in only in short run this cost can also be known as short run
cost.
Ex: rent of a building, cost of machinery, fixture, furniture etc.
ii. Variable cost (VC) : Cost which depends on the quantity of production can be considered as
variable cost. In long run all the expenses are variable cost. Thus, it can also be known as
short run cost.
Ex: cost of raw material, labour cost, etc.
iii. Semi-variable cost: These are the expenses of a firm where a part of the cost is fixed and
other changes with respect to quantity/ volume of production.
Ex: Electricity charges, minimum wages to the staff/workers, Telephone bill, etc.
iv. Total cost: It includes the fixed and variable cost of producing a commodity.
TC = FC+VC
v. Average cost (AC): Per unit cost of a commodity is known as average cost.
AC= TC/TQ
vi. Marginal cost (MC): It refers to the expenses of producing one more additional unit.
MC =ΔTC/ΔTQ
vii. Explicit cost: The cash payments which firms make to the outsiders for their goods and
services is known as explicit cost. This cost also known as outlay costs or actual costs or out
of pocket cost.
Ex: Wages to the labours, cost of raw material, interest on loans, etc.
viii. Implicit cost: Implicit cost is the costs of self-owned or self-employed resources.
Ex: Salary to the efforts of owner, rent to his own building, etc.
ix. Historical cost: It is the cost of an asset purchased in the past at the prevailing price.
x. Replacement cost: cost incurred for replacing the same asset, at current price.
xi. Future cost: Expenses incurred in the near future.
xii. Incremental cost: The increase in cost due to change in volume of production or nature of
business activity.
Ex: increase in the cost due to change in method of production.
xiii. Avoidable cost: The expenses that can be avoidable like advertisement cost. Also known as
escapable cost.
COST BEHAVIOUR:
Quantit Fixed Variable Total Average Marginal
y cost cost cost cost cost
0 100 0 100 -
10 100 30 130 13 3
20 100 58 158 7.9 2.8
30 100 84 184 6.133 2.6
40 100 106 206 5.15 2.2
50 100 160 260 5.2 5.4
60 100 240 340 5.67 8

6. BEA – Problems?
Problems on BEA
1. From the following information, calculate the break-even point in units and in sales
value:
Output = 3,000 units
Selling price per unit = Rs. 30
Variable cost per unit =Rs. 20
Total fixed cost = Rs. 20,000
Solution:
¿
BEP units =Total ¿ cost Contribution per unit
¿
=Total ¿ cost Selling price−variable cost
 20,000
=
30−20
= 2000 units
¿
BEP value =Total ¿ cost
Contribution marginratio
Selling price – Variable cost
Contribution margin ratio=
selling price

= (30-20)/ 30
= 1/3
20,000
BEP value =
1/3
= Rs. 60,000
2. A firm has a fixed cost of Rs. 10,000, selling price per unit is Rs. 5 and variable cost per unit
is Rs. 3.
Determine Break-even point of terms of volume and sales value
Also calculate the margin of safety considering that the actual production is 8000 units.
Solution:
¿
BEP units =Total ¿ cost Contribution per unit
¿
= Total ¿ cost Selling price−variable cost
10,000
=
5−3
= 5000 units
¿
BEP value =Total ¿ cost Contribution marginratio
Selling price – Variable cost
Contribution margin ratio=
selling price
= (5-3)/5
= 2/5
10,000
BEP value =
2/5
= Rs. 25,000

Margin of safety = Actual production – Break-even units

= 8000- 5000
= 3000 units
3. Srikanth enterprises deals in the supply of hardware parts of computer. The following
cost data is available for two successive periods.
Year I (Rs) Year – II ( Rs)
Sales 50,000 1,20,000
Fixed cost 10,000 20,000
Variable cost 30,000 60,000
Determine Break –even point and margin of safety.
Solution:
 Total ¿ cost ¿
BEP = P
ratio
V
Contribution
P/V Ratio = ⃰ 100
sales
Net profit
Margin of safety = p
ratio
V
Calculation of contribution:
Contribution = Sales – variable cost
Year –I:
Contribution = 50,000-30,000
= 20,000
Year –II
Contribution = 1,20,000 – 60,000
= 60,000
Calculation of P/V ratio:
Contribution
P/V Ratio = ⃰ 100
sales
Year – I:
P/V ration = (20,000/50,000)*100
= 40%
Year –II:
P/V ratio = (60,000/1,20,000) *100
50%
Calculation of net profit:
Net profit = Contribution – fixed cost
Year I:
Net profit = 20,000 – 10,000 = 10,000
Year II:
Net profit = 60,000 – 20,000 = 40,000
Break- even point:
Year I:
10,000
BEP =
40 %
= Rs. 25,000
Year –II
20,000
BEP =
50 %
= Rs. 40,000
Margin of safety:
Year I
Margin of safety = 10,000/40% = 25,000
Year II
Margin of safety = 40,000/ 50% = 80,000
4. A lathe workshop owner uses 150 units of a certain spare part. He buys this from the market
for Rs. 250/-. The same can be manufactured in his workshop with a fixed cost of Rs. 40,000
and a variable cost of Rs. 50. Do you suggest him to make or buy from the market? It is
possible that he can sell 500 units of the same spare part to other lathe shops in the town.
Solution:
¿ cost
BEP =
Purchase price per unit −Variable cost per unit
= 40,000/ 200
= 200 units.
The BEP is 200 units. This means that producing less than this is not economical. The
total demand for the spare parts is 650 units. It is recommended that this can be
manufactured.
5. A machine tool factory has a plant capacity of enough hours 9000. Annual fixed charges are
of Rs. 50,000 per year. It can produce two products X and Y. It has three options: make X or
make Y, or make some units of X and some of Y. From the following data suggest the
product mix that maximizes the net profit of the factory? Calculate the net profit.
X Y
Selling price 250 400
Variable cost 100 200
Demand 2500 units 5000 units
Time taken for 3 hrs 5 hrs
production
Solution:
Since there is a limitation of time in the plant. Decision of production of a product can be taken
based on contribution per unit.
Calculation of contribution per hour:
Contribution of X =Selling price – variable cost
= 250 – 100 = Rs. 150
To get contribution of Rs. 150 from X it takes 3 hrs of production time.
Hence, the contribution of X per hour = 150/3 = Rs. 50
Contribution of y =Selling price – variable cost
= 400 – 200 = Rs. 200
To get contribution of Rs. 200 from Y it takes 5 hrs of production time.
Hence, the contribution of Y per hour = 200/5 = Rs. 40
It is observed that the contribution of Product X is high. Hence, it is profitable to produce X.
Available time = 9000 hrs
Time required for X = 3 hrs
No of units of X that can be produced in 9000 hrs = 3000 units
But the demand for x is only for 2500 units
Hence, Time allotted for X should be 2500*3= 7500 hrs.
Remaining hours = 9000- 7500= 1500
These remaining hours should be spent on producing Y.
No of units produced in 1500 hrs = 1500/5= 300 units.
Thus, the company can produce
2500 units of X and 300 units of Y.
Net profit = Total Contribution – fixed cost
 = [( 150*2500) +(200*300) ] – 50,000
= 3,35,000+60,000-50,000
= Rs. 3,85,000/-

UNIT –III
ESSAY QUESTIONS
1. Define market structures? Explain types of markets based on competition?
Answer:
MARKET STRUCTURE:
Market is derived from a latin word “Marcatus” which means trade or merchandise.
Market is a place where buyers and sellers meet and exchanges the goods and services under
specific conditions.
The various characteristics that influences the Formation of a market is known as market
structure.
TYPES OF MARKET STRUCTURE:
A market can be structured into different types based on the geographical area, time duration,
economic conditions etc. The classification of a market includes:
PERFECT COMPETITION:
A market structure in which there are large number of buyers and sellers, exchanging
homogeneous goods.
Features/ Characteristics:
 Number of seller – Large
 Number of buyer -- Large
  Entry and exit barriers – Low or no

Market
structure

Nature of Economic/
Time period Location Business Importance
goods Competition

Short Run Commodity Wholesale Primary Perfect

Local market
market market market market competition

Long Run National Secondary Imperfect

Capital market Retail market
market market market competition

International Foreign Territorial

market market market

TYPES OF MARKET STRUCTURES BASED ON COMPETITION:

Competition

Perfect Imperfect
competition competition

Sellers Buyers

Monopolistic
Monopoly Duopoly Oligopoly Monopsony Duopsony Oligopsony
competition

 Product differentiation -- all are producing or selling similar products.

 Pricing decision – Price taker
 Perfect information available in the market.
 No government interventions
 AR= MR = Price.
 Demand for the commodities will be perfect elastic.
 Perfect mobilization of resources.
 Output Total Revenue Average Revenue Marginal
Revenue
1 50 50 -

10 500 50 50

50 2500 50 50

100 5000 50 50

IMPERFECT COMPETITION:
A market structure which does not possess the basic characteristics of a perfect competitive
market.
Classified into two types based on number of sellers and number of buyers.
A) Monopoly:
Monopoly is derived from two Greek words.
Mono – Single
Poly – Seller.
Thus, monopoly can be defined as a market structure in which only one seller/producer exist in
the market.
Features of monopoly:
 Number of sellers – Single seller
 Number of buyers – Large number
 Entry and Exit barriers – Very high
 Product differentiation – No because no substitute available in the market.
 Pricing decision – price maker
 Close substitute – Not available
 Firm objective – Maximization of profits
 AR>MR
  Demand will decreases with increases in output. (As the customers search for the

Output Total Revenue Average Revenue Marginal

Revenue
1 50 50 -
substitute products). 10 450 45 44.4
50 2100 42 41.25
100 4000 40 38

B) Duopoly:
A market structure where there are only two sellers who are producing / selling similar type of
goods but not identical.
Features:
 Number of sellers – two
 Number of buyers – large
 Entry and exit barriers – high
 Homogeneous products
 Product differentiation - less
C) Oligopoly:
A market structure dominated by only few sellers is known as oligopoly. Oligopoly
produces/sales same or different type of products.
Types of oligopoly:
Pure oligopoly – Produces homogeneous products (Copper, aluminum, steel…)
Differential oligopoly – produces heterogeneous products (automobiles, soaps, detergents …..)
Features:
 Few sellers
 Large number of buyers
 Entry and exit barriers --high
 Advertisement cost -- high
 Competition – Intensive
 Firm is price taker (Each firm fix the price based on the competitors price).
 AR> MR
 Kinked demand curve.
Kinked demand
The demand for the products of oligopoly firm will be elastic with increase in price up to a point
and then suddenly decreases because the competitors decreases their prices and the demand for
the products will falls. Thus, the demand for the oligopoly will be elastic and then becomes
inelastic in nature.

Monopolistic Competition
Market structure which with large number of sellers and buyers, free to enter and exit, freedom
to fix the prices of their products, and where the product differentiation is very high.
Features:
 Large number of sellers
 Large number of buyers
 Product differentiation – Very high
 Entry and exit barriers – Low
 Pricing decision – Price maker
 Advertisement cost – high
 Profit can be maximum at MR= MC
 AR>MR
 Demand curve is downward sloping curve

2. Explain perfect competition with its features.

Answer:
PERFECT COMPETITION:
A market structure in which there are large number of buyers and sellers, exchanging
homogeneous goods.
Features/ Characteristics:
 Number of seller – Large
 Number of buyer -- Large
 Entry and exit barriers – Low or no
 Market
structure

Nature of Economic/
Time period Location Business Importance
goods Competition

Short Run Commodity Wholesale Primary Perfect

Local market
market market market market competition

Long Run National Secondary Imperfect

Capital market Retail market
market market market competition

International Foreign Territorial

market market market

Output Total Revenue Average Revenue Marginal

Revenue
1 50 50 -

10 500 50 50

50 2500 50 50

100 5000 50 50

 Product differentiation -- all are producing or selling similar products.

 Pricing decision – Price taker
 Perfect information available in the market.
 No government interventions
 AR= MR = Price.
 Demand for the commodities will be perfect elastic.
 Perfect mobilization of resources.
3. Explain monopolistic/monopoly market with features.
Answer:
Monopoly:
Monopoly is derived from two Greek words.
Mono – Single
Poly – Seller.
Thus, monopoly can be defined as a market structure in which only one seller/producer exist in
the market.
Features of monopoly:
 Number of sellers – Single seller
 Number of buyers – Large number
 Entry and Exit barriers – Very high
 Product differentiation – No because no substitute available in the market.
 Pricing decision – price maker
 Close substitute – Not available
 Firm objective – Maximization of profits
 AR>MR
 Demand will decreases with increases in output. (As the customers search for the

Output Total Revenue Average Revenue Marginal

Revenue
1 50 50 -
10 450 45 44.4 substitute
products).
50 2100 42 41.25
100 4000 40 38
 4. What are pricing methods used to fix price of a commodity?
Answer:

PRICING:
Value of a commodity with respect to owner or firm – Cost. The value of a commodity with
respect to customer – Price.
Objectives:
› Maximize profits
› Increase sales
› Satisfy customer
› Competitive leader in the market
› Market share etc.,
Pricing methods:
 Full cost pricing method: Here price will be fixed by covering the entire cost of the product.
Generally this will be used when the demand for the product is high and the competition is
low.
Price = Fixed cost + Variable cost +Profit
 Marginal cost pricing method: In this pricing price will be based on marginal cost of the
product. This will be used when excess of demand is existing for a product.
Price≥ marginal cost.
 Sealed bid pricing /contract pricing: The price of a product will be sent in a sealed cover. The
firm which has coded low will become the final price of the project.
Price = Minimum coded price
 Going rate pricing: This is a competition based pricing, in which the prices of the products
will be fixed according to the market.
Price = Market price
 Price Discrimination: Different prices will be fixed to different products depending on
different characteristics like situation, age, purchase quantity etc.
Price = different price to different customers
 Perceived pricing: price of a product will decided by the customers.
Price = customers decided value
 Skimming pricing -- the initial prices of the products will be kept high as the time passes the
prices will be decreased. Suitable for innovative products.
Prices in case of electronic goods
Initial Price à High
Future priceà Low
 Two- way pricing: In this pricing strategy one part of price will be fixed and the other will
changes depending on the features or services utilized. Ex: prices in exhibition, club
membership etc
 Peak load pricing: In this pricing the prices of the products will increases during the peak
time. Ex: prices of flowers during festivals.
 Bundling pricing: Pricing strategy in which single price will be fixed for group of similar
products. Ex: Pack of lux soaps.
 Commodity pricing: In this a single price will be fixed for set of different products. Generally
this will be used to balance the demand for different products offered by same firm. Ex:
single price will be fixed to a combination of Annapurna salt and Annapurna atta

5. Explain types of business organizations with metrics and demerits?

Answer:
BUSINESS ORGANIZATION:
A business organization is an individual or group of people that collaborate to achieve certain
commercial goals.
FORMS OF BUSINESS ORGANIZATIONS:
PRIVATE SECTOR:
It is a form of business organization which is owned by private individuals and no interference of
any state or central government. These private sector business form are of two types, non –
incorporated and incorporated. Non – incorporated business organization that are started without
any registration.

Type of
business
orgainzations

Private Public Joint sector

undertakings undertakings undertakings

Joint Hindu
Sole trader Joint stock Cooperative Deparmental Public Government
Partnership family
company societies undertaking corporates companies
business
PUBLIC SECTOR:
These are the business organizations established with the interest of public and run by the
government.
JOINT SECTOR:
Business organizations based on the mixed economy. It is partnership between public sector and
private sector.
A. SOLE TRADER:
It implies that there is only one trader who is the owner of the business. He is the boss for
himself. He is the owner, manager and controller. He is responsible for all the business activities.
Features:
 It is easy to start a business and also easy to close.
 own capital
 The owner enjoys all the profits and in case of loss, he alone suffers.
 High degree of flexibility
 Unlimited Liability
 More flexible
 High business secrecy
 Effective control
 Direct relation with customers
Advantages:
• Personal contact with customers
• Secrecy
• Direct motivation
• Total control
• Flexibility
Disadvantages
 Limited capital
 Unlimited liability
 No division of labor
 More competition
 Lack of specialization
 Less scope to expansion of business
B. Partnership:
Indian partnership act, 1932 Defines partnership as “ the relationship between two or more
persons who agree to share the profits of the business carried on by all or any one of them acting
for all”.
Features:
 Association of members:
o Minimum – 2
o Maximum –Banking ≤ 10
- Non banking ≤ 20
 Division of labor: the business activities can be shared among the partners.
 Flexibility: It is more flexible when the partners are like minded.
 Taxation: Less compared with joint stock companies
 Unlimited liability
 Joint and several liability: For the debt of one partner all the other partners are jointly
responsible. The debt of one partner will be considered as the debt of the business.
 No separate legal entity
 Voluntary registration:
 Transfer of share: The share of one partner can’t be transferred to others without the
acceptance of all the other partners.
 Continuity of business: The partnership will exit until the partners have good relation
with each other. The death of one partner may introduce his/her family member in the
business or the business may continue with the existing partners by ending
Advantages:
 Easy formation
 More financial resources
 Effective decision ( >2 involves in decision making)
  Specialized management
 Flexible ( when the partners are like minded)
 Secrecy ( Less compared to sole trader and more than a company)
 personal contact with customers
 Business continuity
Limitations:
 Unlimited liability
 Uncertain existences
 Limited resources
 Transfer of ownership ( until the partner accept won’t allow for the transfer)
 Implied authorities
 Slow decision making ( partners are not like minded)
 Lack of public confidence
Partnership deed:
An agreement made in partnership which includes:
• Nature of business
• Name and address of the business
• Name of the partners and the share of each partner in capital
• if additional amount taken from the partners, its rate of interest
• Accounts preparation, auditing
• Profit sharing among partners
• Dissolution of the business
• Introduction of a new or replacement of a partner
• Disputes handling etc
Types of partners:
 Active partner: A partner who invest and/ or actively involves in the business operations
then they are said to be active partners.
 Sleeping partner: The members of partnership who does not involve in business operations
are sleeping partners.
 Nominal partner – just for namesake. No contribution to capital and share in profit
 Partner by estoppels: A legal, including partnership that may occur where previously, no
formal partnership agreement was in place. A person who exhibits such conduct, or says
words which represent, or allow him to be represented, as a partner in any firm becomes
liable to any loans or credits that are obtained by the firm. 
 Partner by holding out: If partners declare a particular person (having social status) as
partner and this person does not contradict even after he comes to know such declaration, he
is called as partner by holding out and he is liable for the claims of third parties.
 Minor partner: A minor can be admitted for the benefits of the firm. A minor is entitled to
his share of profits of the firm. The liability of a minor is limited to the extent of his
contribution of the capital of the firm.
JOINT STOCK COMPANY:
Company is a business organization established by individuals for earning profit under the
companies Act. Many individuals jointly invest capital in a company and therefore it is called as
Joint Stock Company.
Company is an artificial person created by law (Companies Act, 1956) having separate entity
with a perpetual succession and common seal.
 Features:
i. Incorporated association of persons: According to companies Act, an individual can’t form
a company. A minimum number of 7 persons can form a public company and there no limit
for the maximum number. Whereas minimum 2 persons can formed a private company and
maximum of 50. Thus, a company is an association of persons more than one and registered
under companies Act.
ii. Artificial person: The Company carries on its business activities in its own name. The
company makes purchases, incurs expenses, sells goods, sues against other parties and is also
sued. The company performs all these activities in its own name but it is not a natural person
with human physical construction, so it is called artificial person. It is a distinct legal person,
separate from its members.
iii. Voluntary association- Persons who are willing to form a company can come together
voluntarily for carrying out a business. There is no compulsion on the part of any person to
join as a member in the company. Therefore, a company is a voluntary association of
persons.
iv. Separate legal Entity: Being an artificial person a company has its own legal entity separate
from its members. It can own assets or property, enter into contracts, sue or can be sued by
anyone in the court of law. Its shareholders can not be held liable for any conduct of the
company.
v. Perpetual Existence: A company once formed continues to exist as long as it is fulfilling all
the conditions prescribed by the law. As it exist as an artificial person it does not have natural
death. Its existence is not affected by the death, insolvency or retirement of its members.
vi. Limited liability of shareholders: Shareholders of a joint stock company are only liable to
the extent of shares they hold in a company not more than that. Their liability is limited by
guarantee or shares held by them.
vii. Common Seal: Being an artificial person a joint stock company cannot sign any documents
thus this common seal is the company’s representative while dealing with the outsiders. Any
document having common seal and the signature of the officer is binding on the company.
viii. Transferability of Shares: Members of a joint stock company are free to transfer their
shares to anyone.
ix. Ownership is distinct from management- The Company is owned by the shareholders,
who subscribe for its shares. It is managed by the elected representatives of the shareholders-
i.e. directors.
x. Capital divisible into transferable shares- The Company has to mention its maximum
capital required at any time in the future in its memorandum of association. The capital is
divided into small denominations, known as shares.  These shares are transferable from one
person to other person. Management
Advantages:
i. Financial resources: It is easy to raise a large amount of funds by issuing the shares.
ii. Effective management: As the availability of financial resources are high a company
can appoint more effective managers to conduct business activities.
iii. Growth and expansion: Compared to sole trader and partnership, a company have more
abilities to generate financial resources and generate opportunities to expand and
diversify the business operations.
 iv. Limited liability: Liability of members of Joint Stock Company is limited to the extent
of shares held by them. Hence shareholders assets will not be on stake. This feature
attracts large number of investors to invest in the company. 
v. Perpetual succession: A company is an artificial legal person created by law which has
its own independent legal status. Its existence is not affected by the death or insolvency
of its members. 
vi. Transferability of Shares: In a joint stock company it is easy to transfer shares to
anyone. But the same is not permitted to private limited company. 
vii. Public confidence: A major operations of the company are controlled by the government
according to the companies Act, it creates confidence among the public.
viii. Democratic management: Joint stock companies have democratic management and
control. That is, even though the shareholders are owners of the company, all of them
cannot participate in the management of the company. Normally, the shareholders elect
representatives from among themselves known as ‘Directors’ to manage the affairs of the
company.
Limitations:
a. Difficult to form: The formation or registration of joint stock company involves a
complicated procedure. A number of legal documents and formalities have to be
completed before a company can start its business. It requires the services of specialists
such as Chartered Accountants, Company Secretaries, etc. Therefore, cost of formation of
a company is very high.
b. Delay in policy decisions: Generally policy decisions are taken at the Board meetings of
the company. Further the company has to fulfil certain procedural formalities. These
procedures are time consuming and therefore, may delay action on the decisions.
c. Lack of business secrecy: A company need to provide its details to shareholders and
public, media. Thus, the secrecy will reduces.
TYPES OF JOINT STOCK COMPANIES:
Kinds of companies based on incorporation
 Charted company – created by royal charter of the state.
Ex: British East India company
 Statutory corporation – Created by Act of legislature or parliament.
Ex: APSRTC, FCI, IDBI.
 Registered company-registered under companies Act,1956 or Indian companies Act,
1913.
Kinds of companies based on liability
 Unlimited company
 Limited company
 Companies limited by guarantee
Kinds of companies based on nationality
 Foreign company
 Indian company
Kinds of companies based on public interest
I. Private company
II. Public company
III. Government company
 I) Private company:
A company registered under Companies Act, 1956, which has the following features
(a) It cannot have more than 50 members. Employees of the company are not included in this.
(b) It cannot invite the public to purchase its shares and debentures through open invitation.
(c) It restricts the rights of the members to sell or transfer their shares.
(d) It must have a minimum paid up share capital of One lakh rupees.
A private company contains ‘ Private limited’ at the end of its name.
II) Public company:
A public company means a company, which is not a private company. A public company must
have the following features.
(a) It can invite the public to subscribe to its shares and debentures by open invitation.
(b) A minimum of seven members is required to establish a public company. There is no limit on
the maximum number of its members.
(c) There is no restriction on the transfer of shares i.e., the shareholders are free to sell their
shares to the public.
(d) The public company must have a minimum paid up capital of five lakhs rupees.
A public usually write public limited or limited at the end of its name.
III) Government Company:
In these companies the Government (either state or central government or both) holds a majority
share capital i.e., not less than 51%. However, companies having less than 51% share holding by
the government can also be called Government companies provided control and management lies
with the government. Examples of government companies are: Mahanagar Telephone Nigam
Limited, Bharat Heavy Electricals Limited.
Memorandum of association:
It is also called the charter of the company. It outlines the relation of the company with
the outsiders. It furnishes all its details in six clauses such as:
Name clause
Situation clause
Objects clause
Capital clause
Liability clause
Subscription clause
Articles of association:
Furnishes the bye-law or internal rules governing the internal conduct of the company
CO-OPERATIVE SOCIETIES:
A cooperative society is an association of persons usually of limited means, who have
voluntarily joined together to achieve a common economic end through the formation of
democratically controlled business organization, making equitable contributions to the capital
required and accepting a fair share of risk and benefits of the undertaking.
Features:
a. Voluntary association: The members of cooperative society will join with their interest with
an objective to gain economic status through joint efforts.
b. Open membership: There is no restriction to become members of this society on the basis of
religion, caste etc, everyone has an absolute right to be its member.
c. Equality of voting rights:  Each member of has one vote, irrespective of the number of
shares held by him. Thus, the management of a co-operative society is democratic.
d. Number of members: The minimum number of members required is ten but there is no limit
to the maximum number of members. Any person can become a member of the society
following these rules and regulations.
e. Service motive: Co-operatives are not formed to maximize profit like other forms of
business organizations. The main purpose of a co-operative society is to provide service to its
members. 
f. Distribution of Surplus: Every co-operative society, in addition to providing services to its
members, also generates some profit while conducting business. Profit generated is
distributed to its members not only the basis of the shares held by the members but on the
basis of member’s participation in the business of the society. For example, in a consumer
co-operative society only a small part of the profit is distributed to members as dividend on
their shares; a major part of the profit is paid as purchase bonus to members on the basis of
goods purchased by each member form the society.
g. Compulsory registration: No association of members can use the word cooperative with its
name unless it is registered under The cooperative societies Act, 1912 or under the state
cooperative societies Act.
h. Separate legal entity: After the registration coopetative society becomes a separate entity
with reference to its members, which means that the society can hold assets, enter into
contract, can be sued in a court of law and it can also sue other parties.
i. Sources of finance: In a co-operative society capital is contributed by all the members.
However, it can easily raise loans and secure grants form government after its registration.
j. Transfer of shares: The shares of a co-operative society are not freely transferable. A
member can surrender his shares to the society with the permission of the society’s office
bearers.
k. Cash trading: Co-operative societies conduct business on a cash basis and allow no credit.
Cash trading does not involve bad debts and credit collection expenses. Thus, it helps the
society to have a good wording capital and maintaining short-term solvency.
Advantages:
 Easy to form:
The formation of a cooperative society is very simple as compared to the formation of any other
form of business organisations. Any ten adults can join together and form a cooperative society.
The procedure involves in the registration of a cooperative society is very simple and easy. No
legal formalities are required for the formation of cooperative society.
 Limited liability:
In most cases, the liabilities of the members of the society is limited to the extent of capital
contributed by them. Hence, they are relieved from the fear of attachment of their private
property, in case of the society suffers financial losses.
 Elimination of middlemen.
The cooperative society eliminates the profit earned by middlemen in the supply of commodities
to the consumers. The cooperatives society supplies goods and services to the members at the
whole sale price.
 Equal status:
Each shareholder has one vote in the management of business of the society. All the members
thus stand on equal footing regardless of the number of shares they own.
 Service motive:
In Cooperative society members are provided with better good and services at reasonable prices. 
  Democratic management:
The cooperative society is managed by the elected members from and among themselves. Every
member has equal rights through its single vote but can take active part in' the formulation of the
policies of the society. Thus all member are equally important for the society.
 Stability and continuity:
A cooperative society cannot be dissolved by the death insolvency, lunacy, permanent
incapability of the members. Therefore, it has stable life are continues to exist for a longer
period. 
 Surplus shared by the members:
The society sells goods to its members on a nominal profit. In some cases, the society sells goods
to outsiders. This profit is utilised for meeting the day-to-day administration cost of the society.
The procedure for distribution of profit that some portion of the surplus is spent for the welfare
of the members, some portion kept reserve whereas the balance shared among the members as
dividend on the basis of this purchases.
Disadvantages:
 Limited resources:
Cooperative societies financial strength depend on the cap contributed by its members and loan
raising capacity from state cooperative banks. The membership fee is limited for which they are
unable to raise large amount of resources as their members belong to the lower and middle class.
Thus, cooperative^ are not suitable for the large scale business which require huge capital.
 Inefficient management:
A cooperative society is managed by the members only. They do not possess any managerial and
special skills. This is considered as major drawback of this sector. Inefficiency of management
may not bring success to the societies.
 Lack of secrecy:
The cooperative society does not maintain any secrecy in business because the affairs of the
society is openly discussed in the meetings. But secrecy is very important for the success of a
business organisation. This paved the way for competitors to compete in more better manner.
 Cash trading:
The cooperative societies sell their products to outsiders only in cash. But, they are usually from
the poor sections. These persons require to avail credit facilities which is not possible in the case
of cooperatives. Hence, marketing is a shortcoming for the cooperatives.
 Excessive Government interference:
Government put their nominee in the Board of management of cooperative society. They
influence the decision of the Board which may or may not be favourable for the interest of the
society. Excessive state regulation, interference with the flexibility of its operation affects
adversely the efficiency of the management of the society.
 Absence of motivation:
The members may not feel enthusiastic because the law governing the cooperatives put some
restriction on the rate of return. Absence of relationship between work and reward discourage the
members to put their maximum effort in the society.
 Disputes and differences:
The management of the society constitutes the various types of personnel from different social,
economical and academic background. Many a times they strongly differs from each other on
many important issues. This becomes detrimental to the interest of the society. The different
opinions and disputes may paralyses the effectiveness of the management.
PUBLIC SECTOR/PUBLIC ENTERPRISES:
According to N. N. Malaya, “Public enterprises are autonomous or semi-autonomous
corporations and companies established, owned and controlled by the state and engaged in
industrial and commercial undertakings”.
Types of public enterprises:
I. Departmental undertaking:
It is a traditional form of operating and managing affairs of public enterprise. They are
organized, financed and controlled by the certain department of the government. Budget is
prepared very year.
Ex: Railway, department of post, etc.
Features:
 It is totally financed by treasury and all the revenues are paid into treasury.
 The budgeting, accounting and audit procedures are controlled and managed by the rules
and regulations of the government
 The civil servants are the permanent staff.
 The recruitment, training, promotion, terms and conditions of employment are same for
all civil servants.
 It is managed by the officials of the concerned department of the government.
 The ministry is directly controlled by administrative staff.
 The policy and performance are discussed in parliament.
 It has no separate legal entity.
 Nothing can be done without the permission of government.
II. Public corporate:
Public corporation is created by a special act of parliament. It has separate legal status. Its scope,
objectives, power, duties and operating procedures are specified by the Act. Public corporation is
established to achieve socioeconomic objectives of the country. It is guided by service motive. 
Under public corporation act 1961, statutory companies or public corporation are established.
Ex: LIC, Unit Trust of India, Industrial Finance Corporation of India etc.
Features:
 The act defines the objectives, functions, powers, rights and duties, privileges and
relationship with other department of the government
 It is totally owned by the government
 In some cases, public my hold the portion of share capital.
 It is a separate legal entity.
 It can purchase and sell securities, can enter into any contract, can sue and can be   sued.
 It has independent accounting, auditing and financial system.
 It is established for service motive
 Employees are not civil servants
 Employees are appointed under the terms and conditions of the corporation
 It is managed and controlled by board of directors and boards of directors are appointed
by the government
 They are governed by the special act of the parliament.
 Its main aim is to maximize the social welfare
 Expenditure and revenues are not shown in the budget of department
III. Government Company:
A public enterprise which is established under the prevailing law of the country is called a
government company. In this company, government owns at least 51% of total shares. This type
of company is a popular form of company because it is easy to organize and is considered to be
more efficient. It is incorporated under company law of the country. It doesn’t need any special
act for its incorporation. There are 2 types of Government Company. They are;
1. It is totally owned by government
2. At least 51% of its shares is taken up by government
Features
  It is incorporated under company law of the country.
 At least 7 promoters are required for incorporation
 It has separate legal entity.
 It can purchase and sell securities, can enter into any contract, can sue and can be   sued.
 It is totally owned by government or at least 51% of its shares is taken up by government.
 It is managed and controlled by board of directors and boards of directors are appointed
by the government
 It is financed by the government.
 Expenditure and revenues are not shown in the budget of department
 Employees are not civil servants
 The policies are mentioned in memorandum and articles of association.
 The budgeting, accounting and audit procedures are not controlled and managed by the
rules and regulations of the government
 Activities of the company are accountable to the parliament.

6. How do you determine price –output relationship in perfect and imperfect market
structures?
Answer:
PRICE- OUTPUT RELATIONS:
The price and output relation in different markets can be determined by using the following basic
concepts:
i. cost curve – Average & Marginal
ii. Revenue curves – Average & Marginal
iii. Equilibrium point
Equilibrium point:
It refers to a position where the firm enjoys maximum profits.
In case of perfect competition
 MC=MR
 Marginal cost curve should cut the marginal revenue
curve from below
In case of Monopoly
 MC= MR
Cost curves:
Short run
i. Average cost curve
ii. Marginal cost curve
Relationship between Average and Marginal Revenue:
 Under perfect competition AR= MR.
 Under monopoly AR> MR
PRICE – OUTPUT RELATION UNDER PERFECT COMPETITION
I. Short run:
The equilibrium point is at B.
Thus, the dimensions of B
Represents the quantity &
Price that the firm need to
Produce and sale.
From the figure,
OQ = Equilibrium quantity
OA = Equilibrium price
ABCD = Super profit/ abnormal profits.
II. Long Run:
 The Average cost curve will be tangent to Average revenue.
 Demand is equal Average revenue.
 From the figure
E= Equilibrium point
OQ= Equilibrium Quantity
OP= Equilibrium price
In long run the firm earns normal profits
PRICE OUTPUT RELATIONSHIP IN MONOPOLY
 In Short run
From the figure
E= Equilibrium point
OQ= Equilibrium Quantity
OA= Equilibrium Price
ABCD= Profit

In long run
From the figure
E= Equilibrium point
OQ= Equilibrium Quantity
OP= Equilibrium Price
AR= AC, Thus, the firm will earn
Normal profit.

UNIT-IV
ESSAY QUESIONS
1. Define capital budgeting? Explain techniques of capital budgeting?
Answer:
CAPITAL BUDGETING TECHNIQUES: These techniques are used to evaluate the
investment proposals in take the decision to accept or reject a proposal. There are many methods
for evaluating and ranking the capital investment proposals. They are:
A) Traditional methods
i. Pay Back Period
ii. Accounting Rate of Return
B) Modern methods
i. Net Present Value
ii. Internal Rate of Return
a. PayBack period method: Payback period is one of the most popular and widely recognized
technique of evaluating investment proposals. It can be defined as “the period required to
recover the original cash outflow invested in a project”.
Formulae:
Event cash inflows
Initital investment
Pay back period =
Annual cash inflows
Uneven cash inflows
Unrecoverd ammount
Payback period = Year before full recovery +
Cashinflows∈the next sucessive year
Decision Criteria:
Accept: Calculated PBP < standard PBP
Reject: Calculated PBP > Standard PBP
When the firm has two proposals, proposal with less pay back period can be accepted.
Merits:
 It is very simple to calculate and easy to understand.
 This method is helpful to analyze risk, i.e. to determine how long the investments will be at
risk.
 It is beneficial for the industries where the investments become obsolete very quickly.
 It measures the liquidity of the projects.
Demerits:
 It ignores the Time Value of Money.
 It does not take into consideration the cash flows that occur after the payback period.
 It does not show the liquidity position of the company, but only tells the ability of a
project to return the initial outlay.
 It does not measure the profitability of the entire project since it only focuses on the time
required to recover the initial investment cost.
 This method does not consider the life-span of investment, what if the life of an asset gets
over very much before the initial investment cost is realized.
iii. Average Rate of Return
The Average Rate of Return or ARR, measures the profitability of the investments on the basis
of the information taken from the financial statements rather than the cash flows. It is also called
as Accounting Rate of Return
ARR= Average profits after tax/Average investment
Average investment = (Cost – Scrap)/2 +Scrap on old assets + Additional working capital

If cost, scrap and additional working capital not given it will be considered as 0.
Decision criteria:
If ARR> cost of capital, then the project can be accepted
If ARR< cost of capital, then the project can be rejected
In case of two or more proposal, proposal with higher ARR can be accepted.
Merits:
 It is easy to calculate, simple to understand.
 It consider the complete life period of a project
 Information can easily be drawn from accounting records
Demerits:
 It used accounting profits instead of actual cash flows after taxes, in evaluating the projects.
 It ignores the concept of time value of money
 It does not allow profits to be reinvested
 It does not differentiate between the size of the investment required for each project.
MODERN TECHNIQUES:
These methods consider almost all the deficiencies of the traditional methods. These methods
are based on the concept of discounting value of money. The techniques in this are: NPV, IRR,
PI.
Net Present Value Method:
It is one of the discounted cash flow method, which can be defined as present value of benefits
minus present value of costs.
NPV = PVCFAT - PVC
Decision Criteria:
If NPV > 0, Accept the project
NPV < 0, reject the project
NPV =0, consider.
Advantages:
 It considers the time value of money
  It uses all cash inflows occurring over the entire life period of the project including scrap
value of the old project.
 It can be used to select mutually exclusive projects
 It takes into consideration the changing discount rate
Limitations:
 It is difficult to understand compared to PBP and ARR
 In case of projects involving different cash outlays, NPV method may not give
dependable results
 It does not give satisfactory results when comparing two projects with different life
periods.
Internal Rate of Return (IRR): It is the rate at which the net present value of the investment is
0.
IRR= LRR +NPVLRR / (NPV LRR –NPVHRR) ⃰ ΔR
LRR = Lower Rate of Return
HRR = Higher rate of return
Advantages:
 Consider the time value of money
 It also consider the cash flows throught out the lifeof the project
Limitations:
 IRR method is difficult to understand, complications due to trial and error method.
 The important drawback of IRR is that it recognizes the cash inflows generated by project
is reinvested to internal rate of project, but NPV recognizes such cash inflows are
reinvested to cost of capital of the organization
 Single discount rate ignores the varying future interpret rate.
2. How do you estimate the requirement of working capital and fixed capital?
Answer:
Working capital: The capital which is used to meet the day to day expenses of a business can be
termed as working capital.
Working capital = Current assets – Current liabilities.
Features:
 Short term assets: working capital is used to purchase the current asset of a business.
 High liquidity: the working capital can easily converted into cash. Hence, liquidity is
very high.
 Smooth flow of operations: All the immediate expenses of a business can be made
only from the available working capital.
 Amount of working capital: The amount of working capital required depends on size,
nature of business, business cycle etc.
FACTORS DETERMINING THE REQUIREMENTS OF WORKING CAPITAL:
The various factors that influence the amount of working capital required are:
i. Nature of Business
 The amount of working capital required depends on the kind or nature of business a company
performs:
 In case of public utilities, less capital is required. It is so, since, they don't have any stock in
trade and they sell on a cash basis.
 Companies involved in trading and providing services require more working capital because
they have to keep a lot of stock-in-trade. They also have to maintain a lot of liquid cash, bills
receivable, so on.
 Manufacturing companies need more working capital to continue production if they use
imported and costly raw materials.
 Labour intensive industries also require more working capital because they have to spend a
lot of money on giving wages and salaries to workers or employees.
 Capital intensive industries need less working capital because they have to depends more on
machines and less on the workers.
ii. Size of Business:
A size of business determines the amount of working capital that is needed.
For, e.g., bigger companies require more working capital than smaller ones.
iii. Terms of Purchase and Sales
The working capital requirements of a company depends on its terms of purchase and sales:
 If it makes a purchase on credit and sells on a cash basis, then it requires less working capital.
 Conversely, if it buy with cash and sells on credit, then it will need more working capital.
iv. Market Conditions
The working capital requirements of a company depends on the degree of competition in the
market.
If the competition is intense, then the company has to spend a lot of money on running
advertising campaigns and sales promotion. It will also have to keep more stock and sell on
credit. So, it will require more working capital.
v. Business Cycle
The working capital requirements of a company depends on the business cycle.
Business cycle consists of a boom and recession period:
 During the boom period, the sales are very high. So, in this time, the company has to spend a
lot of money on raw material, wages, etc. So, it requires more working capital.
 But, during the recession period, the sales decline as people tend to buy less. Thus, in this
phase, the company needs less working capital.
vi. Operating Cycle
A service company usually has a short operating cycle or period. It also sells on a cash basis.
So, it requires less working capital. For example, electricity and transport companies.
A manufacturing company usually has a long operating cycle. It also sells on a credit basis.
Therefore, it requires more working capital. For example, machine tools companies.
vii. Growth and Expansion
If a company is growing and expanding its business activities, then it will need more working
capital to maintain its growth.
viii. Conditions of Supply
The working capital requirements of the company depends on the conditions of supply:
 The supply of raw materials is regular, then the company can keep less inventory (stock). So,
it will require less working capital.
 But, if the supply is irregular then the company has to hold more stock. Therefore, in such a
case, it will need more working capital.
ix. Taxes: Taxes are often paid in advance. This also blocks a part of working capital.
Depending on the tax environment of the industry, working capital needs are also affected.
x. Dividend Policy: Dividend policy determines the level of retained profits with the business
and retained profits are also used for working capital. This is how; dividend policy affects the
need for working capital.
xi. Seasonality of Industry and Production Policy: Businesses based on seasons the amount of
working capital depends on its demand. For example, manufacturing of ACs whose demand
peaks in summer and dips in winter. The requirement of working capital will be more in
summer compared to winter if they are produced in the fashion of their demand. The policy
of producing throughout the year can smoothen the fluctuation of working capital
requirement.
xii. Cash Requirements
A company needs cash for paying salaries, rent, taxes, so on. If the company's cash needs are
high, then it requires more working capital. In other words, higher the cash requirement,
greater will be the working capital required and vice versa.
3. Explain different sources of capital.
Answer:
METHODS OF FINANCE / SOURCES OF CAPITAL:
A business can generate the required capital in different ways, which can be considered as
sources of finance. They include:
I) Long –term finance
II) Medium –term finance
III) Short –term finance
I) Long-term finance: Long term finance refer to those requirements of funds which are
for a period exceeding 5-10 years. They include:
i. Own capital: The investment made by the owner irrespective of sole trader, partnership,
or a company will continue with business for a long period of time.
ii. Share capital: Part of the capital is known as share. A business can generate capital by
issuing the shares to the public. That capital generated through the shares can be
considered as share capital. The liability of the shareholders is limited, and the returns
paid to the shareholders is dividend. Share capital is of two types:
A) Preference share capital
B) Equity share capital
 A) Preference share capital: Preference shares are those, which enjoy the following two
preferential rights:
 Dividend at a fixed rate or a fixed amount on these shares before any dividend on
equity shares.
 Return of preference share capital before the return of equity share capital at the
time of winding up of the company.
The preference shareholders will get the dividend first after payment of dues to the
outsiders then the dividend will be paid to the equity shareholders.
Types Of Preference Shares
Following are the major types of preference shares:
a. Cumulative Preference Shares: When unpaid dividends on preference shares are treated as
arrears and are carried forward to subsequent years, then such preference shares are known
as cumulative preference shares. It means unpaid dividend on such shares is accumulated till
it is paid off in full.
b. Non-cumulative Preference Shares: Non-cumulative preference shares are those type of
preference shares, which right to get have fixed rate of dividend out of the profits of current
year only. They do not carry the right to receive arrears of dividend. If a company fails to pay
dividend in a particular year then that need not to be paid out of future profits.
c. Redeemable Preference Shares: Those preference shares, which can be redeemed or repaid
after the expiry of a fixed period or after giving the prescribed notice as desired by the
company, are known as redeemable preference shares. Terms of redemption are announced at
the time of issue of such shares.
d. Non-redeemable Preference Shares: Those preference shares, which can not be redeemed
during the life time of the company, are known as non-redeemable preference shares. The
amount of such shares is paid at the time of liquidation of the company.
e. Participating Preference Shares: Those preference shares, which have right
to participate in any surplus profit of the company after paying the equity shareholders, in
addition to the fixed rate of their dividend, are called participating preference shares.
f. Non-participating Preference Shares: Preference shares, which have no right
to participate on the surplus profit or in any surplus on liquidation of the company, are called
non-participating preference shares.
g. Convertible Preference Shares: Those preference shares, which can be converted into
equity shares at the option of the holders after a fixed period according to the terms
and conditions of their issue, are known as convertible preference shares.
h. Non-convertible Preference Shares: Preference shares, which are not convertible into
equity shares, are called non-convertible preference shares.
B) Equity share capital:
This can be raised through the issue of equity shares. These can also known as ordinary share.
These share does not have priorities like preference shareholders. The equity shareholders has
the voting right depending upon the percentage of share they holds. The dividend to the equity
shareholders can be paid only after payment of dividend to the preference shareholders. In case
of losses the equity shareholder won’t get the dividend. They are risk bearers.
iii. Retained profits: Retained earnings means that part of trading profits which is not
distributed in the form of dividends but retained by directors for future expansion of the
company.
 iv. Debentures: A Debenture is a long-term Debt Instrument issued by governments or a big
institutions for the purpose of raising funds.  Debenture holders are the creditors of a
company. The debenture holder entitled a fixed rate of interest, which can be paid first from
the profits. A Debenture is regarded as an unsecured because there are no pledges (guarantee)
or liens available on particular assets.
b. Convertible Debentures: This is a debenture which can be converted into some other type
of securities (for example stocks).
c. Partly convertible debentures: Part of the debentures can be converted into equity share
and the other part continue as loan.
d. Non-convertible debentures: These debentures can’t be converted into equity shares.
e. Secured debentures: Here the company assets are offered as security towards the
debentures.
f. Partly secured debentures: The part of the debentures can be secured
g. Unsecured debentures: There is no security for this debentures.
h. Redeemable debentures: The debentures can be repaid on a specific date.
i. Non-redeemable debentures: These will be continued with the business.
v. Long term loans: Specific financial institutions offer loan term loans on the basis of assets
of the business as security.
vi. Government grants and loans: For some business organization the government provides
loans, and grants.
II) MEDIUM TERM FIANCE:
Medium term finance is defined as money raised for a period for 1 to 5 years.
The medium term funds are required by a business mostly for the repaired and modernizing
of machinery. The source of medium term finance include:
a) Leasing: It is a contract In which the assets is purchased initially by the lessor (leasing
company) and thereafter leased to the user (leasee company) who pays a specified rent at
periodical intervals.
b) Hire purchase: Hire purchase transaction, the goods are delivered by the owner to another
person the agreement that such person pays the agreed amount in the periodical installment.
c) Bank loans: Banks issue loans to a business at a fixed rate of interest.
III) SHORT TERM FINANCE: Short term finance are required primarily to meet working capital
requirements.
The focus is on maintaining liquidity at a reasonable cost. The source of short term finance
include:
a) Trade credit: Generally, many of the business organizations purchase the rawmaterials from
the suppliers on credit and repay by selling the goods. In some cases the creditior (supplier)
ask the buyer to sign a bill.
b) Bank overdraft: It a special feature provided by banks to withdraw excess of amount
available in the account of an individual. However, the bank charge interest day-to-day basis.
c) Commercial paper: It is promissory note issued by the company to raise short run capital.
d) Debt factoring or credit factoring: Debt factoring is a transaction in which a business sells
its accounts receivable at a discount. The company purchasing the accounts receivable is
known as a factor. The factor then collects the outstanding amounts from the businesses
customers.
4. Write a note on cash budget?
Answer:
CASH BUDGET:
A cash budget is a forecast of estimated cash receipts, estimated cash payments and the resultant
cash position for a certain period of time. Generally it can be done on monthly, quarterly, or
annual basis.
Importance of cash budgeting:
 Allows companies to predict possible cash shortages and take corrective action before a
crisis occurs.
 Allows companies to see if large sums of excess cash are lying idle—could be put to
better use.
 Assists with the identification of when commitments are due.
 Reveals periods of excess funds
 Reveals weaknesses in business’ s debt collection policy
 Adjustments for seasonal fluctuations can be made
 Budget reveals periods when shortages of funds may occur
 Budgets are a form of control.
Preparation of cash budget:
Receipt and payments method- under this method all the cash receipts and payments expected
during the budget period is considered. However care must be taken to ensure that cash
adjustments and accruals are not shown in cash budget.
Receipts / cash inflows:
 Sales and other cash income
 New loans received
 Sales of capital assets
 Nonfarm income
 Beginning cash on hand
Payments/ cash outflows:
 Cash expenses
 Principal payments
 Purchase of capital assets
 Nonfarm expenses
 Ending cash on hand
5. Explain the factors that are influencing the requirement of fixed capital.
Answer:
I) Fixed capital: The investment made to acquire the long term/fixed assets of a business is
known as fixed capital. The fixed assets are like land and building, plant and machinery,
furniture, fixtures, patents, copyrights, etc.
Features:
 Permanent in nature: The fixed capital once made can’t be withdrawn easily. It will
be continued with the business.
  Low liquidity: Anything which is easily saleable in the market and gets an expected
value (price) is said to be liquidable. That is, it has a liquidity. Fixed capital is used to acquire
fixed assets. These assets have a low liquidity because of not easily saleable. K20048
 Amount of capital: The required amount of capital depends on, nature and size of
business, production method, location of business etc.
 Source of profit: A firm generates profit by selling the products. The fixed capital
can’t generate profit directly but the investment made on the factors of production creates the
profits to a business.
 Promotion and expansion of a business: Fixed capital helps to expand and
diversification of a business.
FACTORS DETERMINING THE REQUIREMENTS OF FIXED CAPITAL:
i. Nature of Business: The type of business is involved in is the first factor which helps in deciding the
requirement of fixed capital. A manufacturing company needs more fixed capital as compared to a
trading company, as trading company does not need plant, machinery, etc.
ii. Scale of Operation: The companies which are operating at large scale require more fixed
capital as they need more machineries and other assets whereas small scale enterprises need less
amount of fixed capital.
iii. Technique of Production: Companies using capital-intensive techniques require more fixed
capital whereas companies using labour-intensive techniques require less capital because
capital-intensive techniques make use of plant and machinery and company needs more fixed
capital to buy plants and machinery.
iv. Technology Up-gradation: Industries in which technology up-gradation is fast need more
amount of fixed capital as when new technology is invented old machines become obsolete and
they need to buy new plants and machinery whereas companies where technological up-
gradation is slow they require less fixed capital as they can manage with old machines.
v. Growth Prospects: Companies which are expanding and have higher growth plan require more
fixed capital as to expand they need to expand their production capacity and to expand
production capacity companies need more plant and machinery so more fixed capital.
vi. Diversification: Companies which have plans to diversify their activities by including more
range of products require more fixed capital as to produce more products they require more
plants and machineries which means more fixed capital.
vii. Availability of Finance and Leasing Facility: If companies can arrange financial and leasing
facilities easily then they require less fixed capital as they can acquire assets on easy
installments instead of paying huge amount at one time. On the other hand if easy loan and
leasing facilities are not available then more fixed capital is needed as companies will have to
buy plant and machinery by paying huge amount together.
viii. Level of Collaboration/Joint Ventures: If companies are preferring collaborations, joint
venture then companies will need less fixed capital as they can share plant and machinery with
their collaborators but if company prefers to operate as independent unit then there is more
requirement of fixed capital.
6. Problems on Payback period, Accounting Rate of return, NPV and IRR.
SAMPLE PROBLEMS WITH SOLUTION
1. The cost of a project is Rs. 50,000/- the annual cash inflows for the next 4 years are
Rs.25,000-.What is the payback period of the project.
Solution:
Initial investment = Rs. 50,000
Annual cash inflow = Rs. 25,000
Initital investment
Payback period =
Annual cash inflows
= 50,000/25,000
= 2 years.
Hence, the payback period is 2 years. It is concluded that the initial investment will be
returned in a span of 2 years.
2. An investment of Rs. 2,00,000 is expected to generate the following cash inflows in six
years.
Year Cash inflows (Rs.)
1 70,000
2 60,000
3 55,000
4 40,000
5 30,000
6 25,000
Compute payback period of the investment. Should the investment be made if management want
to recover the initial investment in 3 years or less?
Solution:
Initial Investment = Rs. 2,00,000
Year Cash inflows (Rs) Cumulative cash
inflows (Rs)
1 70,000 70,000
2 60,000 1,30,000
55,000 1,85,000
4 40,000 2,25,000
5 30,000 2,55,000
6 25,000 2,80,000

Payback period =
Unrecoverd ammount
Year before full recovery +
Cashinflows∈the next sucessive year
Year before full recovery = 3
2,00,000−1,85,000
Payback period = 3+
40,000
= 3+ 15,000/40,000
= 3.375 years
Payback period is at 3.375 years, as the management want to recover the investment within 3
years. Hence the project is not desirable.
3. Apple Limited has two project options. Initial investment in both projects Rs. 10,00,000.
Project A has an even inflow of Rs. 1,00,000 every year and project B has uneven cash flows
as follows: Rs.2,00,000, Rs. 3,00,000, Rs. 4,00,000 and Rs.1,50,000. Recommend the project
based on payback period.
Solution:
Calculation of Payback period:
Project –A:
Initial investment = Rs. 10,00,000
Annual cash inflows = Rs.1,00,000
Initital investment
Payback period =
Annual cash inflows
= 10, 00,000/ 1, 00,000
=10 years
Project – B:
Year no Cash flows Cumulative cash
flows
1 2,00,000 2,00,000
2 3,00,000 5,00,000
3 4,00,000 9,00,000
4 1,50,000 10,50,000

As the cash inflows are uneven the payback period can be calculated as:
Payback period =
Unrecoverd ammount
Year before full recovery +
Cashinflows∈the next sucessive year
Year before full recovery = 3rd year ( 10,00,000<9,00,000)
10,00,000−9,00,000
Payback period = 3+
1,50,000
= 3+ 1, 00,000/1, 50,000
= 3+ 0.66
= 3.66 years
The project –B has less payback period than project – A. Hence, project B is recommended.

Problems on Accounting Rate of Return

1. A firm is considering two projects each with an initial investment of Rs. 20,000 and a life of 4
years. The following is the list of estimated cash inflows after taxes:
Year Proposal I Proposal II Proposal III
1 12,500 11,750 13,5000
2 12,500 12,250 12,500
3 12,500 12,500 12,250
4 12,500 13,500 11,750
Determine accounting rate of return on average capital and original capital employed.
Solution:
ARR on Average capital:
ARR= Average profits after tax/Average investment
Average investment = (Cost – Scrap)/2 +Scrap on old assets + Additional working capital.
Proposal I:
Average profits after tax= (12,500+12,500+12,500+12,500)/4
= 12,500
Average investment = (20,000-0)/2+0+0
= 10,000
ARR = 12,500/10,000
= 12.5 =125%
Proposal II:
Average profits after tax= (11,750+12,250+12,500+13,500)/4
= 12,500
Average investment = (20,000-0)/2+0+0
= 10,000
ARR = 12,500/10,000
= 12.5 =125%
Proposal –III:
Average profits after tax= (13,500+12,500+12,250+11,750)/4
= 12,500
Average investment = (20,000-0)/2+0+0
= 10,000
ARR = 12,500/10,000
= 12.5 =125%
ARR on original capital employed:
ARR= Average profits after tax/Average investment
Proposal I: ARR= 12,500/20,000 = 0.625 = 62.5%
Proposal II: ARR= 12,500/20,000 = 0.625 = 62.5%
Proposal III: ARR= 12,500/20,000 = 0.625 = 62.5%
2. Find out the average rate of return from the following data relating to CNC machines I and II.
Cost Rs. 3,00,000 each
Estimated life 3 years each
Estimated scrap 60,000 each
Income tax rate 50%
Additional working capital required 2,50,000 for each machine.
The estimated cash inflows after taxes for each machine are as given below:
Year CNC machine I CNC Machine II
1 1,50,000 2,00,000
2 3,00,000 3,00,000
3 1,50,000 2,50,000
4 - 1,50,000
Total 6,00,000 9,00,000
Solution:
ARR= Average profits after tax/Average investment
Average investment = (Cost – Scrap)/2 +Scrap on old assets + Additional working capital.
Machine I:
Average cash inflows after cash = 6,00,000/3 = 2,00,000
Average investment =
(Cost – Scrap)/2 +Scrap on old assets + Additional working capital.
(3, 00,000- 60,000)/2 + 60,000+ 2, 50,000
=1, 20,000+3, 10,000
= 4, 30, 000.
ARR= 2,00,000/4,30,000 = 0.465 = 46.5%
Machine II:
Average cash inflows after taxes = 9,00,000/4 = Rs. 2,25,000
Average investment =
(Cost – Scrap)/2 +Scrap on old assets + Additional working capital.
(3, 00,000- 60,000)/2 + 60,000+ 2, 50,000
=1, 20,000+3, 10,000
= 4, 30, 000.
ARR = 2,25,000/4,30,000 = 0.523 = 52.3%
The ARR of Machine II is higher than Machine I. Hence Machine II is profitable.
Net Present Value – Sample problems
1. A project requires an initial investment of Rs. 2, 25,000 and is expected to generate the
following net cash inflows:
Year Cash Inflows
1 95,000
2 80,000
3 60,000
4 55,000

Compute net present value of the project if the minimum desired rate of return is 12%.
Solution:
NPV = PVCFAT - PVC
Present value of cash outflows, PVC = Rs. 2, 25,000
Calculation of PV values of cash inflows:
Year Cash inflows PV value at PVCFAT
(Rs) 12%
NPV = 22,62,950- 2,25,000 =
1 95,000 0.893 84835
Rs. 1,295.
2 80,000 0.797 63760 As the NPV value is positive the
project is acceptable.
3 60,000 0.712 42720
2. The management of Fine
4 55,000 0.636 34980 Electronics Company is
Total PVCFAT 22,62,950 considering to purchase an
 equipment to be attached with the main manufacturing machine. The equipment will cost Rs.
6,000 and will increase annual cash inflow by Rs.2,200. The useful life of the equipment is 6
years. After 6 years it will have no salvage value. The management wants a 20% return on all
investments.
Solution:
Cost of the equipment = Rs. 6,000
Life span of the equipment = 6 years
Annual cash inflows = Rs. 2,200
Year Cash inflows PV value at PVCFAT
(Rs) 20%
1 2200 0.833 1832
2 2200 0.694 1526
3 2200 0.579 1273
4 2200 0.4823 1061
5 2200 0.4019 884
6 2200 0.3349 736
Total PVCFAT 7312
NPV= 7312-6000= 1312
Internal Rate of Return – sample Problems
3. A project cost Rs. 1,44,000. The average annual cash inflows are likely to be Rs. 45,000 for a
period of 5 years. Calculate the IRR for the project.
Solution:
Calculation of factor:
Project cost
Factor =
Average Cashinflows
1,44,000
=
45,000
= 3.2
From the cumulative PV table, it is observed that the factor value 3.2 will lies between 16%
and 20%. Hence IRR can be calculated by taking 16% as lower rate of return and 20% as
higher rate of return.
IRR= LRR +[NPVLRR / (NPV LRR –NPVHRR)] ⃰ ΔR
Calculation of NPV at LRR:
NPV= PVCFAT - PVC
= (45,000)(3.2743) – 1,44,000
= 1,47,343 -1,44,000
= 3,343
Calculation of NPV at HRR:
NPV= PVCFAT - PVC
 = (45,000)(2.9906) – 1,44,000
= 1,34,577-1,44,000
= (-9423)
IRR= LRR +[NPVLRR / (NPV LRR –NPVHRR)] ⃰ ΔR
3343
= 16+ 4
3343+9423
= 16+ 1.0474
= 17.0474
Hence, IRR is 17%.
2. Given that a project yields the following cash inflows for six years at an original cost of Rs.
50,000 determine IRR
Year 1 2 3 4 5 6
Cash inflows 0 10,000 16,000 24,000 30,000 30,000
Solution:
Project cost
Factor =
AverageCash inflows
50,000
=
18333
= 2.7273
From the cumulative PV table, it is observed that the factor value 2.7273 will be near to the value
for 6 years at 25%. So let us calculate NPV at 25%
Calculation of NPV at 25%:
Year Cash inflows Factor values PV values
1 0 0.800 0
2 10,000 0.640 6400
3 16,000 0.512 8192
4 24,000 0.410 9830
5 30,000 0.328 9831
6 30,000 0.262 7863
PVCFAT 42,116
NPV= PVCFAT - PVC
=42,116 – 50,000
= -7,884
As the NPV value at 25% is negative. Now let us calculate NPV at the rate of return below 25%
to get Positive NPV value.
Calculation of NPV at 16%:
Year Cash inflows Factor values PV values
1 0 0.8621 0
2 10,000 0.743 7430
3 16,000 0.641 10256
4 24,000 0.552 13248
5 30,000 0.476 14280
6 30,000 0.410 12300
PVCFAT 57514 57514
IRR= LRR +[NPVLRR / (NPV LRR –NPVHRR)] ⃰ ΔR
NPV= PVCFAT - PVC
=57514– 50,000
= 7514
7514
= 16 + 5
7514+7,884
= 16+4.4
= 20.4

UNIT-V
ESSAY QUESTIONS
1. Define accounting? Explain the concepts and conventions of accounting?
Answer:
ACCOUNTING:
American Institute of Certified Public Accountants (AICPA) defines accounting as “an art of
recording, classifying and summarizing in a significant manner, and in terms of money and
events which are, in part at least, of a finance character and interpreting the results thereof”.
The American Accounting Association (AAA) defines accounting as “the process of identifying,
measuring, and communicating economic information to permit informed judgments and
decisions by the users of the information”.
ACCOUNTING PRINCIPLES:
Accounting principles are the norms or rule of actions adopted while recording business
transactions which will ensure the uniformity, clarity and understanding of business. The
accounting principles are mainly classified in to two categories. They are Accounting Concepts
and Accounting Conventions. 
A) Accounting Concepts:
        Accounting concepts are basic assumptions or conditions which the accounting system is
based. The important accounting concepts are Business Entity Concept, Going Concern concept,
Dual Aspect Concept, Cost Concept, Money measurement Concept, Realization Concept,
Accrual Concept and matching Concept.
 Business Entity Concept- Business entity concept states that the business and business man
are two separate entity. Under this, business is treated as a separate unit distinct from its
owner. The transactions between the proprietor and the business will be recorded separately
in the books of business and shown separately under the heading 'Capital account'.
 Going Concern concept- As per this concept business unit has a perpetual succession or a
continued existence and the transactions are recorded from the point of view. The concept
says that the business will continue in operation long enough to charge the cost of fixed
assets over the useful life time against the income from business.
  Dual Aspect Concept- Under this concept each business transaction has two aspects they
are receiving aspects and giving aspects. The receiving aspect is known as Debit aspect and
the giving aspect is known as the Credit aspect of the business.
  Cost Concept- Cost Concept is based on the Going concern concept. According to this
concept, assets purchased will be entered in the business book as per the cost price in which
they are purchased and this will be the base for further accounting of assets.
 Money measurement Concept- This concepts states that, the transactions which will treat
only in the terms of money.
 Realization concept- According to this Revenue is recognized only when the sale is made.
 Matching Concept- This matches the cost along with the revenue.
 Accounting period concept: As per going concern concept an entity is assumed to have
indefinite life. The financial performance of an entity can be measured by dividing the
operations of entity for a specific period, otherwise it’s very difficult to ascertain the
performance of business.
Periodicity concept assumes a small but workable fraction of time period for measuring the
business performance. Generally it assumes 1 year is taken for this purpose.
 Dual Aspect concept :
This concept is base for double entry of a transaction. Under the system, aspects of
transactions are classified into two main types:
i. Debit
ii. Credit
Every transaction should have a Debit and credit. Debit is the portion of transaction that
accounts for the increase in assets and expenses, and the decrease in liabilities, equity and
income. And credit is the portion which is a results of decreases the asset, increases the
liability, income, gains, equity.
Accounting Conventions:
        This is method or custom in which the accountants are following for the preparation of
accounting statements. This includes mainly three types of conventions. They are as follows:-
 Convention of material Disclosure.
 Convention of conservatism
 Convention of consistency
Materiality: Only those transactions, important facts and items are shown which are useful and
material for the business. The firm need not record immaterial and insignificant items.
Conservatism:
As per this concept while accounting one should not anticipate the income but should provide for
all possible losses. When there are many alternative values to account an asset then lesser value
will be considered.
Consistency: The accounting practices and methods should remain consistent from one
accounting period to another. Whatever accounting practice is followed by the business
enterprise, should be followed on a consistent basis from year to year.
2. Write the advantages and disadvantage of double entry book keeping?
Answer:
BOOKING KEEPING: In financial accounting there are two systems of book keeping.
Single entry book keeping
Double entry book keeping
Double entry book keeping: Double entry bookkeeping is a system of accounting in which
every transaction has a corresponding positive and negative entry (debits and credits).
Every transaction involves a debit entry in one account and a credit entry in another account.
This means that every transaction must be recorded in two accounts; one account will
be debited because it receives value and the other account will be credited because it has given
value.
Advantages of Double Entry Book Keeping:
 Double Entry System is Scientific System: This is a scientific system for recording
business transactions as compared to a single entry. It helps to recheck and counter check the
books of accounts.
 Double Entry System Record Complete Transactions: In this system, both sides of a
transaction are recorded as debit and credit, so we record both purchase and payment in
different accounts.
 Recheck the Accounts: In this system, the account is checked automatically when we pass
an entry on both sides. If both sides of the trial balance are not matched we can easily find
the mistake.
 Calculation of Profit or Loss: Profit and Loss Account provides information about the
Profit earned or loss incurred during a period.
 Financial Position: The financial position of the business can be determined at the end of the
year as we prepare profit and loss account & Balance Sheet.
 Comparison becomes Easy: We can compare the profit and loss account & Balance
Sheet of any two or more years as we have the accounting books.
 Helps to Manager: Manager can take decisions on the basis of the financial condition of the
business and make plans accordingly.
 Easily Frauds and Misappropriations: Frauds and misappropriations can be easily found
as every transaction have two records.
Disadvantages of Double entry book keeping:
 Complex in nature: Double-entry system is complex in nature as to take care of lots of rules
and regulations of accounting standard & accounting principles.
 Time and Cost: It requires more time to maintain the accounting books so it involves more
clerk which leads to an increase in cost.
 Not For Small Firms: Small firms cannot hire a person who has proper knowledge of
accounting as their charge is high.
 Expert knowledge: It requires expert knowledge of account to use the Double Entry System
for book-keeping.
 Increase in book size: Every transaction needs to record in two places so the size of books
will increase or who have data in electronic form need a more powerful computer to handle
that data.
3. Type of accounts with rule for journal entry?
Answer:

TYPES OF ACCOUNTS:
i) Personal: Accounts that represents the individuals or companies are known as personal
accounts. These persons may be natural persons like Raj’s account, Rajesh’s account,
Ramesh’s account, Suresh’s account, etc.
Rule for this Account
  Debit the receiver.
 Credit the Giver.
ii) Real: These account types are related to assets or properties. They are further classified
as Tangible real account and Intangible real accounts.
Tangible Real Accounts
 These include assets that have a physical existence and can be touched. For example –
Building A/c, cash A/c, stationery A/c, inventory A/c, etc.
Intangible Real Accounts
 These assets do not have any physical existence and cannot be touched. However, these
can be measured in terms of money and have value. For Example  – Goodwill, Patent,
Copyright, Trademark, etc.
Real Account Rules
 Debit what comes into the business.
 Credit what goes out of business.
iii) Nominal: These accounts types are related to income or gains and expenses or losses. For
example: – Rent A/c, commission received A/c, salary A/c, wages A/c, conveyance A/c, etc.
Rules
 Debit all the expenses and losses of the business.
 Credit the incomes and gains of business.
For Example – Salary paid to employees of the entity. Salary A/c will be debited when the
expenses are incurred. Whereas, when an entity receives any interest, discount, etc these are
credited whenever these are received by the entity.
4. Define ratio? Explain the classification of rations in accounts?
Answer:

RATIO ANALYSIS: The term ‘ratio’ refers to the mathematical relationship between any two
inter-related variables. In other words, it establishes relationship between two items expressed
in quantitative form.
According J. Batty, Ratio can be defined as “the term accounting ratio is used to describe
significant relationships which exist between figures shown in a balance sheet and profit and
loss account in a budgetary control system or any other part of the accounting management.”
Types of Ratio Analysis
Types of ratios are given below:
A. Liquidity Ratios:
This type of ratio helps in measuring the ability of a company to take care of its short-term debt
obligations. A higher liquidity ratio represents that the company is highly rich in cash.
The types of liquidity ratios are: –
1. Current Ratio: The current ratio is the ratio between the current assets and current liabilities
of a company. The current ratio is used to indicate the liquidity of an organization in being able
to meet its debt obligations in the upcoming twelve months. A higher current ratio will indicate
that the organization is highly capable of repaying its short-term debt obligations.
Current Ratio = Current Assets / Current Liabilities
 Standard current Ratio = 2:1
2. Quick Ratio: The quick ratio is used to ascertain information pertaining to the capability of a
company in paying off its current liabilities on an immediate basis.
The formula used for the calculation of a quick ratio is-
 Popular Course in this category
Quick Ratio = Quick Assets / Current Liabilities
Quick assets = current assets – stock – prepaid expenses
i.e., Quick Assets =Cash and Cash Equivalents + Marketable Securities + Accounts
Receivables
Standard quick ratio = 1:1
B. Turnover Ratios/ Activity Ratio:

Turnover ratios are used to determine how efficiently the financial assets and liabilities of an
organization have been used for the purpose of generating revenues.
The types of turnover ratios are: –
i. Inventory Turnover Ratio: Inventory turnover ratio is used to determine the speed of a
company in converting its inventories into sales.
The formula used for calculating inventory turnover ratio is-
Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory
Cost of goods sold = Sales – Gross profit
Opening stock +Closing Stock
Average inventory =
2
Inventory Turnover period = 365 days /inventory turnover ratio.
ii. Debtors turnover ratio: It represents the ratio by which a firm able to collect its debts.
Credits . sales
Debtors turnover ratio =
Average debtors
Opening debtors+closing debtors
Average debtors =
2
365 days
Debt collection period =
Debtors turnover ratio
iii. Creditors turnover ratio: It explains the ability of a firm to pay its creditors.
Credit purchases
Creditors turnover ratio =
Average crditors
Opening creditors+closing creditors
Average debtors =
2
365 days
Credit payment period =
creditors turnover ratio
C. Solvency Ratios

Solvency ratios can be defined as a type of ratio that is used to evaluate whether a company is
solvent and well capable of paying off its debt obligations or not.
The types of solvency ratios are: –
1. Debt Equity Ratio: The debt-equity ratio can be defined as a ratio between total debt and
shareholders fund. The debt-equity ratio is used to calculate the leverage of an organization. An
ideal debt-equity ratio for an organization is 2:1.
The formula for debt-equity ratio is-
Debt Equity Ratio = Total Debts / Shareholders Fund
2. Interest Coverage Ratio: The interest coverage ratio is used to determine the solvency of an
organization in the nearing time as well as how many times the profits earned by that very
organization were capable of absorbing its interest-related expenses.
The formula used for the calculation of interest coverage ratio is-
Interest Coverage Ratio = Earnings Before Interest and Taxes / Interest Expense
Propritors fund
3. Ratio of proprietor’s fund to total assets = *100
Total assets
Current assets
4. Ratio of current assets to proprietor’s fund =
Proprietors fund
D. Profitability Ratios

This type of ratio helps in measuring the ability of a company in earning sufficient profits.
The types of profitability ratios are: –
1. Gross Profit Ratios: Gross profit ratios are calculated in order to represent the operating
profits of an organization after making necessary adjustments pertaining to the COGS or cost of
goods sold.
The formula used for the calculation of gross profit ratio is-
Gross Profit Ratio = (Gross Profit / Net Sales) * 100
2. Net Profit Ratio: Net profit ratios are calculated in order to determine the overall profitability
of an organization after reducing both cash and non-cash expenditures.
The formula used for the calculation of net profit ratio is-
Net Profit Ratio = (Net Profit / Net Sales) * 100
3. Operating Profit Ratio: Operating profit ratio is used to determine the soundness of an
organization and its financial ability to repay all the short term and long term debt obligations.
The formula used for the calculation of operating profit ratio is-
Operating Profit Ratio = (Earnings before Interest and Taxes / Net Sales) * 100
4. Return on Capital Employed (ROCE): Return on capital employed is used to determine the
profitability of an organization with respect to the capital that is invested in the business.
The formula used for the calculation of ROCE is:
ROCE = Earnings Before Interest and Taxes / Capital Employed
4. Profit Earnings Ratio: P/E ratio indicates the profit earning capacity of the company.
The formula used for the calculation of profit earnings ratio is:
Profit Earnings Ratio = Market Price per Share / Earnings per Share
5. Earnings per Share (EPS): EPS signifies the earnings of an equity holder based on each
share.
The formula used for EPS is:
EPS = (Net Income – Preferred Dividends) / (Weighted Average of Outstanding Shares)
(Net profits−Dividends payable¿ preference shareholders)
6. Return on equity =
Equity share capital
 Nominal∨face value of the sahre
7. Dividend yield = * % dividend per annum
Cost ∨market price of the share
5. Problems on Journal/ ledger/ trail balance/ Trading account/ Profit and loss account /
Balance sheet.
Problem 1: From the following particulars taken out from the books of Abdul Hanan & Co.
Prepare Trading account, Profit & Loss account and Balance sheet as at December 31st 2019.
Particulars Amount (Rs)
Sundry Debtors 52,000
Accounts payable 22,000
Insurance premium (paid on 1.10.19) 2,400
Cash at bank 6,200
Cash at hand ` 2,392
Furniture 3,500
Motor car 22,000
Machinery 24,000
Wages 23,600
General Expenses 2,680
Purchases 1,45,000
Sales 2,92,000
Sales Return 2,600
Salaries 8,420
Opening Stock 11,400
Motor car expenses 3,600
Equipment 2,508
Carriage inwards 2,040
Carriage outwards 1,630
Transpiration in 6,430
Owner equity 20,000
Drawing 8,000
Rent and taxes 3,600
Prepaid insurance ` 1,800
Adjustments:
a) Closing stock Rs. 35,000
b) Provision for doubtful debts at 5% of sundry debtors
c) Depreciation furniture and machinery by 10%
d) Commission of Rs. 3,600 has been earned but not received till the closing of accounts.

Solution:
Trading account of Abdul Hanan & Co. as on December 31st 2019
Particulars Amount (Rs) Particulars Amount (Rs)
To Opening Stock 11,400 By Sales 2,92,000
To Purchases 1,45,000 By Sales return 2,89,400
 2,600
To Carriage 2,040 By Closing Stock 35,000
inwards
To Transportation 6,430
in
To Wages 23,600
To Gross Profit c/d 1,35,930
Total 3,24,400 Total 3,24,400

Profit & Loss account of Abdul Hanan & Co. as on December 31st 2019
Particulars Amount Particulars Amount (Rs)
(Rs)
To Insurance premium 600 By Gross profit b/d 1,35,930
24,000
Prepaid Insurance
(1,800)
To General Expenses 2,680 By Commission 3,600
To Motor car expenses 3,600
To Salaries 8,420
To Carriage outwards 1,630 22200
To Rent and taxes 3,600
To Provision for doubtful debts 2,600
To Depreciation on furniture 350
To Depreciation on machinery 2,400
To Net profit c/d 1,13,650
Total 1,39,530 Total 1,39,530

Balance sheet of Abdul Hanan & Co. as on December 31st 2019

Liabilities Amount Asset Amount
(Rs) (Rs)
Owners Equity: Fixed and long term:
Owner equity 20,000 Furniture 3,500
Drawings (8,000) Depreciation (350) 3,150
Profit b/d 1,13,650 1,25,650 Motor car 22,000
Machinery
24,000 21,600
Depreciation 2,508
(2,400)
Equipment
Current Liabilities: Current assets:
Account Payable 22,000 Cash in hand 2,392
Cash at bank 6,200
Sundry Debtors
52,000 49,400
Provision for bad debts 35,000
 (2,600) 3,600
Stock 1,800
Commission receivable
Prepaid insurance
Long Term Liability
Total 1,47,650 Total 1,47,650

Problem 2:
From the following trial balance of Anil & Bros. and additional information, prepare Trading and
Profit & Loss account and Balance sheet for the year ended June 30th, 2019.
Particulars Amount (Rs)
Capital – BS 1,00,000
Furniture- BS 20,000
Purchases – TA 1,50,000
Transportation out – P&L 7,000
Creditors – BS 1,20,000
Provision for bad debts – P&L , BS 6,000
Debtors – BS 2,00,00
Interest earned P & L 4,000
Salaries – P & L 30,000
Sales – TA 3,21,000
Purchases Return – TA 5,000
Wages -TA 20,000
Rent – P &L 15,000
Sales return –TA , 10,000
Printing and Stationery – P &L 8,000
Insurance Expense P&L 12,000
Opening stock – TA 50,000
Office expenses – P & L 12,000
Bank overdraft – BS 2,000
Drawings - BS 24,000

Additional Information

i. Depreciation furniture by 10%.

ii. A provision for doubtful debts is to be created to the extent of 5% on sundry debtors.
iii. Salaries for the month of June, 2019 amounting to Rs. 3,000 were unpaid which must be
provided for. However, salaries included Rs. 2,000 paid in advance. Office expenses
outstanding Rs. 8,000.
iv. Insurance amounting to Rs. 2,000 is prepaid.
v. Stock use for private purpose Rs. 6,000 and closing stock Rs. 60,000.

Solution:
 Trading account of Anil & Bros as on June 30th, 2019.
Particulars Amount (Rs) Particulars Amount (Rs)
To Opening stock 50,000 By Sales 3,21,000
Stock withdrawn 44,000 Sales Return 10,000 3,11,000
(6,000)
To Purchases By Closing stock 60,000
1,50,000 1,45,000
Purchases return 5,000
To Wages 20,000
To Gross profit c/d 1,62,000
Total 3,71,000 Total 3,71,000

Profit and loss account of Anil & Bros as on June 30th, 2019.
Particulars Amount (Rs) Particulars Amount (Rs)
To Transpiration out 7,000 By Gross profit c/d 1,62,000
To Provision for bad debts By Interest earned 4,000
New 10,000
Old (6,000) 4,000
To Salaries 30,000
Outstanding salaries 3,000
Advance (2,000) 31,000
To Rent 15,000
To Printing and Stationery 8,000
To Insurance Expense 12,000
Prepaid insurance 10,000
2,000
To Office expenses 12,000
Outstanding 8,000 20,000
To Depreciation on Furniture 2,000
To Net profit c/d 69,000
Total 1,66,000 Total 1,66,000

Balance sheet of Anil & Bros as on June 30th, 2019.

Liabilities Amount Assets Amount (Rs)
(Rs)
Capital Fixed asset:
1,00,000 Furniture
Drawings 20,000 18,000
(24,000) 1,39,000 Depreciation
Stock (6,000) (2,000)
Profit b/d 69,000
Current Liability: Current asset:
Creditors 1,20,000 Debtors 2,00,000
Outstanding Salaries 3,000 Bad debts 1,90,000
Outstanding expenses 8,000 ( 10,000) 2,000
Bank overdraft 2,000 Advance Salaries 2,000
Prepaid expenses 60,000
Stock
Total 2,72,000 Total 2,72,000

6. Problems on ratio analysis.

Problem 1:
Following is the Balance sheet of a company as on 31st of March:
Liabilities Rs Assets Rs.
Share Capital 2,00,000 Land and Buildings 1,40,000
Profit & loss 30,000 Plant and 3,50,000
Account 40,000 Machinery 2,00,000
General Reserve 4,20,000 Stock 1,00,000
12% Debentures 1,00,000 Sundry Debtors 10,000
Sundry Creditors 50,000 Bills Receivable 40,000
Bills payable Cash at bank
8,40,000 8,40,000
Calculate:
a. Current Ratio
b. Quick Ratio
c. Debt- equity ratio
d. Proprietary Ratio or proprietors fund to total assets
e. Current assets to fixed assets
Solutions:
a. Current Ratio:
Current Assets
Current ration =
Current Liabilities
Current assets:

Stock – 2, 00,000
Sundry debtors - 1, 00,000
Bills Receivables - 10,000
Cash at Bank - 40,000

3, 50,000
Current Liabilities:

Sundry Creditors - Rs. 1,00,000

Bills Payable - Rs. 50,000
Current Assets
Current ration =
Current Liabilities
= 3,50,000/1,50,000
= 2.333: 1
b. Quick Ratio:
 Quick Assets
Quick Ratio =
Current Liabilities
Quick Assets = current assets – stock
= 3,50,000 – 2,00,000
= 1,50,000

Quick Ratio =1,50,000/ 1,50,000

=1:1
c. Debt – Equity Ratio:
Total Debt
Debt Equity Ratio =
Shareholders Fund
Total Debt = Debentures + long term loans
Shareholders fund =Equity share capital + Reserves & Surplus + Preference Share –
Treasury stock
Total Debt = 4,20,000
Shareholders fund = 2,00,000+40,000 + 30,000 = 2,70,000
Total Debt
Debt Equity Ratio =
Shareholders Fund
= 4,20,000/ 2,70,000
= 1.56:1
d. Proprietary Ratio:

Propritors fund
Proprietors fund to total assets =
total assets
Proprietors fund = shareholders fund + reserves+ Profit & loss account
= 2,00,000+40,000 + 30,000 = 2,70,000
Propritors fund
Proprietors fund to total assets =
total assets
= 2,70,000/ 8,40,000
= 0.32:1
e. Current assets to fixed assets:
Current assets
Current assets to fixed assets =
¿ assets
= 3, 50,000/ 4,90,000
= 0.714:1
Problem 2:
Particulars Rs
Cash sales 80,000
Credit sales 2,00,000
Return inward 10,000
Opening stock 25,000
Closing stock 30,000
Gross profit 25% on net sales
Calculate inventory turnover ratio and holding period.
 cost of goods sold
Solution: Inventory turnover ratio =
Average inventory

365 days
Inventory holding period =
Inventory turnover ratio
Net sales = Cash sales + credit sales – sales return
= 80,000+ 2,00,000 – 10,000
=2,70,000
Gross profit = 25% of 2,70,000
= 67,500
Cost of goods sold = sales – gross profit
= 2,70,000 – 67,500
= 2,02,500
Average inventory = (25,000+ 30,000)/2
= 27,500
Inventory turnover ratio = 2,02,500/ 27,500 = 7.36 times
Inventory holding period = 365 / 7.36 = 49.6 days.
7. Write a short note on du pont chart?
Answer:
Du Pont Chart: During 1920s, the management of Dupont Corporation developed a model
called Dupont Analysis for a detailed assessment of the company’s profitability. Dupont
Analysis is a tool that help to avoid misleading conclusion regarding a company’s profitability.
In simple words, it breaks down the ROE to analyze how corporate can increase the
return for their shareholders.
Return on Equity = Net Profit Margin * Asset Turnover Ratio * Financial Leverage
= (Net Income / Sales) * (Sales / Total Assets) * (Total Assets / Total Equity)
The company can increase its Return on Equity if it-
o Generates a high Net Profit Margin.
o Effectively uses its assets so as to generate more sales
o Has a high Financial Leverage
Components of DuPont Analysis:
This analysis has 3 components to consider;
i. Profit Margin– This is a very basic profitability ratio. This is calculated by dividing the net
profit by total revenues. This resembles the profit generated after deducting all the expenses.
The primary factor remains to maintain healthy profit margins and derive ways to keep
growing it by reducing expenses, increasing prices etc, which impacts ROE.
 For example; Company X has Annual net profits of Rs 1000 and Annual turnover of Rs
10000. Therefore the net profit margin is calculated as
Net Profit Margin= Net profit/ Total revenue= 1000/10000= 10%
ii. Total Asset Turnover– This ratio depicts the efficiency of the company in using its assets.
This is calculated by dividing revenues by average assets. This ratio differs across industries
but is useful in comparing firms in the same industry. If the company’s asset turnover
increases, this positively impacts the ROE of the company.
For example; Company X has revenues of Rs 10000 and average assets of Rs 200. Hence the
asset turnover is as follows
Asset Turnover= Revenues/Average Assets = 1000/200 = 5
iii. Financial Leverage- This refers to the debt usage to finance the assets. The companies
should strike a balance in the usage of debt. The debt should be used to finance the
operations and growth of the company. However usage of excess leverage to push up the
ROE can turn out to be detrimental for the health of the company.
For example; Company X has average assets of Rs 1000 and equity of Rs 400. Hence the
leverage of the company is as
Financial Leverage = Average Assets/ Average Equity= 1000/400 = 2.5