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Managerial Economics and Financial Analysis 1
UNIT – I
Introduction to Managerial Economics and Demand Analysis
Introduction
Managerial economics is an offshoot of two distinct disciplines: Economics
and Management. Economics is a study of human activity both at individual and
national level. Every one of us in involved in efforts aimed at earning money and
spending this money to satisfy our wants such as food, Clothing, shelter, and others.
Such activities of earning and spending money are called “Economic activities”.
Economics is defined on the basis of four major concepts:
1. Wealth - Definition/concept: It was during the eighteenth century that Adam
Smith, the Father of Economics, defined economics as the study of nature and
uses of national wealth’. Economics is the subject which studies as to how the
wealth is produced and consumed as the wealth is the main objective and
purpose of every human activity.
2. Welfare - Definition/concept: Dr. Alfred Marshall, one of the greatest
economists of the nineteenth century, writes “Economics is a study of man’s
actions in the ordinary business of life: it enquires how he gets his income and
how he uses it”. Thus, it is one side, a study of wealth; and on the other
‘human welfare’.
3. Scarcity - Definition/concept: Prof. Lionel Robbins defined Economics as “the
science which studies human behaviour as a relationship between ends and
scarce means which have alternative uses”. With this, the focus of economics
shifted from ‘wealth’ to human behaviour’. The essential features are:
unlimited human wants, availability of limited or scarce resources and choice
of alternative uses.
4. Growth - Definition/concept: Lord Keynes & Prof. A.Samuelson defined
economics as ‘the study of the administration of scarce means and the
determinants of employments and income”. This is also called Development
Economics.
Micro Economics
The study of an individual consumer or a firm is called microeconomics (also
called the Theory of Firm). Micro means ‘one millionth’. Microeconomics deals with
behavior and problems of single individual and of micro organization. It is concerned
with the application of the concepts such as price theory, Law of Demand and
theories of market structure and so on.
Macro Economics
The study of ‘aggregate’ or total level of economic activity in a country is
called macroeconomics. It studies the flow of economics resources or factors of
production (such as land, labour, capital, organization and technology) from the
resource owner to the business firms and then from the business firms to the
Dr.O.Narayana Murthy. M.com.,M.B.A.,Ph.d.

households. It deals with total aggregates, for instance, total national income, total
employment, output and total investment.
Management
Management is the science and art of getting things done through people in
formally organized groups. It is necessary that every organization be well managed to
enable it to achieve its desired goals. Management includes a number of functions
like planning, organizing, staffing, directing, and controlling.
Definition
M. H. Spencer and Louis Siegelman explain the “Managerial Economics is the
integration of economic theory with business practice for the purpose of facilitating
decision making and forward planning by management”.
The Economic Principles, Concepts, tools and techniques that can be applied
practically to solve the problems of business is known as Managerial Economics.
Here two aspects are involved i.e.,
Decision Making: It involves selection of best alternative, estimating the cost.
Forward Planning: It is a projected blue print of operations with their costs and
benefits.
Characteristics / Nature of Managerial Economics

As it originates from Economics, it has the basis features of economics, such as
assuming that other things remaining the same. The features of managerial
economics are explained as below:
1. Close to Micro Economics: Managerial economics is concerned with finding
the solutions for different managerial problems of a particular firm. It studies
how the firm can use resources to produce more output with minimum cost
and maximum profit.
2. Operates against the backdrop of Macro economics: The managerial
economist has to be aware of the limits set by the macroeconomics conditions
such as government industrial policy, inflation and so on.
3. Concerned with Normative Economics: A normative statement usually
includes or implies the words ‘ought’ or ‘should’. It suggests the business firm
to do certain things which will benefit them and not to do certain things which
leads to losses.
4. Prescriptive actions: Prescriptive action is goal oriented. Given a problem and
the objectives of the firm, it suggests the course of action from the available
alternatives for optimal solution.
5. Application Oriented: Managerial Economics solves complicated problems and
decision making skills can be improved by applying some principles and
concepts. We also employ case study methods to conceptualize the problem,
identify that alternative and determine the best course of action.
6. Interdisciplinary: The tools and techniques of managerial economics are
drawn from different subjects such as economics, management, mathematics,
statistics, accountancy, psychology, organizational behavior, sociology and etc.

7. Assumptions and limitations: Every concept and theory of managerial

economics is based on certain assumption and as such their validity is not
universal. If there is change in assumptions, the theory may not hold good.
Scope of Managerial Economics

The scope of managerial economics refers to its area of study. The main focus
of Managerial economics is to find an optimal solution to a given managerial
problem. The managerial economist makes used of concepts, tools and theories of
economics and other related disciplines to find the solution to given problems.
Managerial Problems
Production Decisions
Make-Buy Decisions
Concepts, Inventory Decisions
Tools & applied Investment Decisions for Optimum
Techniques to Profit planning & management Solutions
Determination of price of goods
Reduction or control costs
Human Resource Management
1. Demand Decisions: Demand analysis should be a basic activity of the firm

because many of the other activities of the firms depend upon the outcome of
the demand forecast. The implications are like need of customers, change in
price or supply. The impacts of these are assessed and the decisions are taken
to maximize the profits.
2. Profit related Decisions: Profit making is the major goal of firms. There are
several techniques such as Break-Even analysis, cost reduction, cost control
and ratio analysis to ascertain level of profits. In BEP we are concerned with
profit planning and control. If a firm produces less than BEP it gets losses.
3. Pricing – Output Decisions: Pricing decisions have been always within the
preview of managerial economics. Here the production is ready and the task is
to determine the price in different market situations as perfect and imperfect
market ranging from monopoly, duopoly and oligopoly. The pricing policies,
methods, strategies and practices constitute part of the study.
4. Input – Output Decisions: The costs of inputs in relation to output are studied
to optimize profits. The behaviors of costs at different levels of production are
assessed here. Some costs are fixed, semi-variable and variable. It is necessary
to know the relationship between costs and output both in short and long run.
5. Capital or investment Decisions: Capital is the foundation of business. Lack of
capital may result in small size of operations. Availability of capital from
various sources like equity capital, banks, institutional finance etc. may help to
undertake large-scale operations. Hence efficient allocation and management
of capital is one of the most important tasks of the managers.
6. Economic forecasting & Planning: Economic forecasting leads to forward
planning. The firm operates in an environment dominated by external and

internal factors. External factors include government policies, competition,

employment, price and income levels. Internal factors include policies and
procedures relating to production, finance and marketing. This will minimize
the risk & uncertainty about the future.
Links with other disciplines

Many new subjects have evolved in recent years due to the interaction among
basic disciplines. It is necessary to trace its roots and relationship with other
disciplines. A successful managerial economist must be a mathematician, a
statistician and an economist.
1. Economics: Managerial Economics if the offshoot of economics. Economics
deals with theoretical concepts where as Managerial economics deal with
application of these in real life. The relationship between them may be viewed
from the point of view of the two approaches to the subject Viz. Micro
Economics and Marco Economics. Managerial economics is rooted in Micro
Economic theory.
2. Management and Accounting: Managerial economics has been influenced by
the developments in management theory and accounting techniques.
Accounting refers to the recording of transactions of the firm in certain books.
It provides information relating to costs, revenues, receivables, payables,
profit & loss, etc. It is known as Managerial Accounting.
3. Mathematics: Mathematical concepts and techniques are widely used in
economic logic to solve these problems. Also mathematical methods help to
estimate and predict the economic factors for decision making and forward
planning. The concepts like logarithms, exponentials, geometry, Algebra and
calculus vectors etc., are widely used. Advanced techniques like linear
programming, inventory models and game theory are also used.
4. Statistics: Managerial Economics needs the tools of statistics in more than one
way. A successful businessman must correctly estimate the demand for his
product. Statistical tools like probability, averages correlation, regression, time
series, etc are used in collecting data and analyzing them to help in the
decision making process.
5. Operations Research: Managerial Economics focuses on problems on decision
making. It is a tool for finding the solutions for managerial problems such as
linear programming, queuing, transportation, optimization techniques. The
varied tools of operations Research are helpful to managerial economists in
decision-making.
6. Computer Science: Computers have changes the way of the world functions
and economic or business activity is no exception. Computers are used in data
and accounts maintenance, inventory and stock controls and supply and
demand predictions.
7. Psychology: Consumers psychology is the basis on which managerial
economist acts upon i.e. how the customer reacts when there is a change in
price, supply, income, etc.

Basic economic tools in Managerial economics

Economic theory offers a variety of concepts and analytical tools which can
give assistance to the managers in decision making. These tools are helpful for
managers in solving their business related problems. These tools are taken as guide
in making decision. Following are the basic economic tools for decision making:
1) Opportunity Cost principle:
By the opportunity cost of a decision is meant the sacrifice of alternatives
required by that decision. For e.g. the opportunity cost of holding Rs.500 as cash in
hand for one year is equal to the 10% rate of interest, which would have been earned
had the money been kept as fixed deposit in a bank. Thus, it is clear that opportunity
costs require the ascertaining of sacrifices. If a decision involves no sacrifice, its
opportunity cost is nil.
2) Incremental principle:
Incremental concept involves estimating the impact of decision alternatives
on costs and revenue, emphasizing the changes in total cost and total revenue
resulting from changes in prices, products, procedures, investments or whatever may
be at stake in the decisions. The two basic components of incremental reasoning are:
1. Incremental cost 2. Incremental Revenue
“A decision is obviously a profitable one if –
 it increases revenue more than costs or it reduces cost more than revenues.
 it decreases some costs to a greater extent than it increases others.
 it increases some revenues more than it decreases others”.
3) Time Perspective principle:

Managerial economists are also concerned with the short run and the long run
effects of decisions on revenues & costs. “A decision should take into account both
the short run and long run effects on revenues and costs and maintain the right
balance between long run and short run perspective”.
For Ex: An order for 500 units comes to management’s attention. The
customer is willing to pay Rs.4/- unit or Rs.2000/- for the whole lot but not more. The
short run incremental cost (ignoring fixed cost) is only Rs.3/- Therefore profit is Rs.1/-
per unit. If the other customers come to know about this low price, they may
demand a similar low price. Such customers may complain of being treated unfairly
and feel discriminated against.
4) Discounting Principle:
One of the fundamental ideas in Economics is that a rupee tomorrow is worth
less than a rupee today. Suppose a person is offered a choice to make between a gift
of Rs.100/- today or Rs.100/- next year. Naturally he will choose Rs.100/- today.
5) Equi – Marginal Principle:
This principle deals with the allocation of an available resource among the
alternative activities. According to this principle, an input should be so allocated that
the value added by the last unit is the same in all cases. Suppose a firm has 100 units
of labor at its disposal. The firm is engaged in four activities which need labors

services, viz, A,B,C and D. it can enhance any one of these activities by adding more
labor but only at the cost of other activities.
Demand
Demand means the quantity of goods or service which the consumer would
buy in the market at a given time and given place. Every want supported by the
willingness and ability to buy constitutes demand for a product or service a product
or service is said to have demand when three conditions are satisfied:
 Desire for specific commodity
 Willingness to pay for it
 Ability to pay for certain price, place & time.
Definition:
According to Benham, “The demand for anything, at a given price, is the
amount of it, which well be bought per unit of time at that price.
 Demand Schedule: The tabular presentation of relationship between price
and demand for a commodity is known as Demand Schedule.
 Demand Curve: The graphical representation of demand schedule or
relationship between price and demand for a product is known as Demand
Curve
(1) Individual Demand:

It shows the quantities of demand for a commodity by a particular consumer
at various prices of that commodity. Ex: Mohan’s demand for milk and Sohan’s
demand for milk represent individual demand schedule and curve.
Price of Milk Mohan’s Demand
15 2
14 3
13 5
Y
D
Price
0 Demand X
(2) Market Demand:

The demand of the whole market at various prices of the commodity is known
as market demand. It is shown by market demand schedule and demand curve. By
adding individual demand schedules we get market demand schedule.
Ex: X’s & Y’s demand for milk

Price of Milk X’s Demand Y’s Demand Market Demand

15 2 1 3
14 3 2 5
13 5 4 9
12 6 5 11
Y D
Price
0 Demand X
Market Demand Curve
(3) Income Demand:

It indicates the relationship between income of the consumer and the quantity of
commodity demanded, other things remaining constant like price, taste, nature, etc.
(a) Demand for Normal Goods:
Normal goods are those goods whose demand increases with rise in income
and decreases with fall in income. The income demand curve has a positive slope. It
is an upward sloping curve. Normal goods are price negative, with increase in price
demand falls and vice-versa. Ex: bread, wheat, milk, etc.
Income Demand
10,000 100
20,000 200
Y
D
Income
I1
I
D
0 D D1 X
Demand
(b) Demand for Inferior Goods:
The demand for these goods decreases with the rise in consumer’s income. In
this case, there is inverse relation between income and demand. The income
demand curve has negative slope. Ex: ghee, grain, etc.
Income Demand
10,000 100
20,000 50

Y
D
Income
0 Demand X
(4) Cross Demand:
When a change in the price of one commodity results in the change of
demand of other commodity, it is known as Cross Demand. It indicates how the
prices of related goods are effected by the changes in demand.
(a) Demand for Substitute or Competitive goods:
Commodities which can be used in place of other goods are known as
substitute goods. With a rise in price of product A the demand for it decreases and
demand for product B increases.
Ex: Tea & Coffee, bread & rice, etc.
Price of Coffee Demand for Tea
100 20
200 25
Y
D
Price
P1
P
D
0 D D1 X
Demand
(b) Demand for Complementary Goods:

Commodities which are required jointly are termed as complementary goods.
A fall in price of commodity A brings rise I demand for commodity B. These products
have joint demand.
Ex: Pen & paper, car & petrol, printer & cartridge, etc.
Price of petrol Demand for car
100 10
200 20

Y
D
Price
0 Quantity X
Demand Distinctions
1. Consumer goods Vs. Producer goods:
Consumer goods refer to such products and services which are capable
of satisfying human needs. These are available for ultimate consumption.
These give direct and immediate satisfaction. Ex: bread, apple, rice, milk, etc.
Producer goods are those which are used for further process of
production of goods or services to earn income. Ex: machinery, tractor, etc.
2. Durable goods Vs. Perishable goods:
Durable goods are those which give service relatively for a long time.
Ex: TV, refrigerator, etc.
Perishable goods are those which have short life time, it may be in
hours or days. Ex: milk, vegetables, fish, etc.
3. Short-run Demand Vs. Long-run Demand:
The demand for a product or service in a given region for a particular
day is short-run demand. The demand which has immediate reaction to
changes in price, income is called short-run.
The demand for a longer period for the same region can be viewed as
long-run. The demand which will ultimately exist as a result of changes in
price, promotion or product improvement is long run demand.
4. Firm Demand Vs. Industry Demand:
The firm is a single business unit. The quantity of goods demanded by a
single firm is called firm demand.
Industry refers to a group of firms carrying on similar business activity.
The quantity demanded by the industry as a whole is called Industry demand.
5. Autonomous Demand Vs. Derived Demand:
Autonomous refers to the demand for products directly. Ex: Hospitals,
schools, etc.
Derived refers to the demand for a product arises out of purchase of
parent product. Ex: Hotels, etc.
Demand for house is autonomous and demand for units like brick,
sand, cement, iron etc are derived.
6. New Demand Vs. Replacement Demand:

New refers to the demand for new products and it is addition to
existing stock. Ex: cars, bikes, etc.
Replacement refers to the item purchased to maintain the asset in
good condition or replacing the existing one. Ex: TC, washing machine, etc.
7. Total Market Demand Vs. Segment Market Demand:
The total demand for a product in a region in known as total market
demand. Ex: sugar, etc.
The demand for a product for a firm or industry from this region is
segment market demand.
Ex: demand for sugar for sweet making industry.
Demand Function
It is a function which describes a relationship between one variable and its
determinants. It describes how much quantity of goods are brought at alternative
prices of goods and its related goods, alternative income levels, alternative values of
other variables. Thus the above factors can be built up into a demand function.
Mathematically, the demand function for a product can be explained as:
Qd = f (P, I, T, PR, EP, EI, SP, DC, A, O)
Where, Qd refers to quantity of demand and it is a function of the various
determinants
Demand Determinants
1. Price of the product (P): The price of the product and its quantity demanded
is inversely related. If there is a fall in the price of the product, there is a rise in
the demand for that product and vice-versa.
2. Income of the consumer (I): A consumer with an average income spends to
buy some commodities. As he becomes richer he spends his money to buy
adequate quantities so that he becomes satisfied quantitatively. Once he is
satisfied quantitatively he spends his increased income to improve quality
consumption. The former type of goods are called inferior goods and latter
are called superior goods.
3. Tastes & Preferences (T): Taste and preference depend on the changing life-
style, customs, religious values attached to a good, habit of the people, the
general levels of living of the society and age and sex of the consumers.
Change in these factors changes consumer's taste and preferences.
4. Prices of related goods (PR): Goods and services have two kinds of
relationships - substitute goods or complementary goods. When there is a fall
in the price of a commodity x, the demand for it (x) goes up. This further leads
to a fall in the demand for its substitute goods and vice versa. With a fall in the
price of x, increases the demand for its complementary goods.
5. Expected change in future Income (EI): If the consumer expects that his
income will be higher in the future the consumer may buy the good now. In

other words positive expectations about future income may encourage

present consumption.
6. Expected change in future Prices (EP): If consumers expect a rise in the price
of a storable good, they would buy more of it at its current price with a view
to avoiding the possibility of price rise future. If he expects a fall in the price of
certain goods, they postpone their purchase to take advantage of lower prices
in future.
7. Size of Population (SP): As the consumption habits vary from region to region
the demand for a product depends positively upon the size of population i.e.
children and adults, male and female, rich and poor.
8. Distribution to Customers (DC): The distribution changes from region to
region which depends on the demand for a product and it also changes with
the needs of children and adults, and rich and poor. Thus demand is affected
by various sections of a community.
9. Advertisement (A): Advertisement costs are incurred with the objective of
promoting sale of the product. It helps in increasing the demand for the
product through various media like T.V, radio, newspapers, etc.
10. Other factors (O): With a change in other factors like nature, quality and
quantity also the demand for the product changes from time to time.
Law of Demand
Law of demand shows the relation between price and quantity demanded of a
commodity in the market with an assumption that all the other demand
determinants remain same or do no change. In the words of Marshall, “the amount
demand increases with a fall in price and diminishes with a rise in price”.
The demand curve slopes downward from left to right and with a fall in price
of a product the demand goes on increasing and vice-versa.
Assumptions: Law is demand is based on certain assumptions:
1. No change in consumers income or remain constant.
2. No change in consumers taste and preferences.
3. No change in Prices of other related goods.
4. There should be no substitute for the commodity.
5. No change in the size of population.
Exceptions of Law of Demand

There are certain exceptions to this law:
1) Giffen Paradox or Inferior Goods: When the price of an inferior good falls, the
demand may not increase, instead they buy the same quantity and use the
savings for purchase of better goods like meat, etc. Thus a fall in price is
followed by reduction in quantity demanded and vice versa. “Giffen” first
explained this and therefore it is called as Giffen’s paradox.
Ex: bread, cloth, broken rice, etc.
2) Veblen Effect or Conspicuous consumption: This law will not apply in case of
costly items. Rich people buy certain good because it gives social distinction or

prestige. It the price of diamonds falls poor also will buy is hence they will not
give prestige. These products have demand even if the prices go higher. This
effect is called Veblen effect. Ex: Diamond, Gold, etc.
3) Ignorance: If the consumer is not aware of the competitive price of the
product that is prevailing in the market, he may purchase more even at a
higher price.
4) Expected changes in prices: We purchase larger quantity of goods inspite of
their rising price, if we anticipate that the price will go higher in future and
purchase less quantity when we anticipate the price will decrease.
5) Extra ordinary situations: Wars, famines, riots, floods, strikes, etc are extra
ordinary situations. Consumer becomes abnormal and buys products at any
price available in the market.
6) Change in tastes and preferences: Such changes in fashions, tastes, and
preferences are also responsible to make the law ineffective.
UNIT – II
Elasticity of Demand and Demand Forecasting
Introduction
Elasticity of demand explains the relationship between a change in price and
consequent change in amount demanded. “Marshall” introduced the concept of
elasticity of demand. Elasticity of demand shows the extent of change in quantity
demanded to a change in price.
In the words of “Marshall”, “The elasticity of demand in a market is great or
small according as the amount demanded increases much or little for a given fall in
the price and diminishes much or little for a given rise in Price”.
 Elastic demand: A small change in price may lead to a great change in quantity
demanded. In this case, demand is “elastic”.
 In-elastic demand: If a big change in price is followed by a small change in
demanded or no change in demand then the demand in “inelastic”.
Factors Affecting the Elasticity of Demand

1. Nature of the Commodity: Based on their nature, the products and services
are classified as Necessaries, Comforts and Luxuries. Necessaries imply basic
things like food, clothing and shelter. Comforts imply TV, DVD players, etc.
Luxuries refer to gold, diamonds, etc. These change from person to person,
time to time and place to place.
2. Time period: The demand for a commodity is always related to same period of
time, say a day, a week, a month, etc. Elasticity of demand varies with the
length of time periods. Generally longer the duration of period, greater will be
the elasticity of demand and vice-versa.

3. Change in Income: The demand for various commodities are affected in

different degrees due to change in income. The change in income in case of
comforts is less elastic and incase of necessaries it is probably inelastic.
4. Postponement of Consumption: The demand for commodities, whose
consumption can be postponed for sometime, is elastic Ex: VCR, TV, etc. if
prices are higher. The demand for necessities such as food grains are inelastic,
they cannot be postponed.
5. Availability of Substitutes: The demand for commodities having substitutes is
elastic, because if there is increase in price of a product, we use other
products. Ex: gas, kerosene, coal, electricity, etc. The commodities having no
substitutes are inelastic.
6. Tastes and Preferences: When a customer is particular about his taste and
preference, the product is said to be in elastic. Ex: Colgate, Tate Tea, etc.
7. Complementary products: In case of complementary goods having joint
demand the elasticity is low.
8. Price level: Generally the demands for very costly or very cheap goods are
inelastic. Ex: Car and salt. The increase in price of car by Rs.10,000 will not
make any difference in its demand. Similarly changes in very cheap goods do
not have any effect on demand.
9. Durability of the product: Where the product is durable in case of consumer
durables such as TC, the demand is elastic. In case of perishable goods it is
inelastic.
10. Government Policy: When the policy is liberal, the demand for the product is
elastic demand and vice-versa.
Measures of Elasticity of Demand

The Measures of Elasticity of Demand are divided in to five categories:
1. Perfectly Elastic demand or Infinite Elasticity of demand (Ed=∞)
When small change in price leads to an infinitely large change is quantity
demand, it is called perfectly or infinitely elastic demand. In this case Ed=∞.
y
P D
Price
0 Q Q1 Quantity x
The demand curve DD is horizontal straight line or parallel to X-axis. It shows

the at “OP” price any amount is demand and if price increases, the consumer will not
purchase the commodity.
2. Perfectly Inelastic Demand or Zero Elasticity of demand (Ed=0)
In this case, even a large change in price fails to bring about a change in
quantity demanded or demand remains constant. Ex: Salt. In this case Ed=0.

Y D
Price
P1
0 Q Quantity x
The demand curve DD is parallel or vertical to Y-axis. When price increases
from ‘OP’ to ‘OP1’, the quantity demanded remains the same. In other words the
response of demand to a change in Price is nil.
3. Unitary Elasticity of Demand (Ed=1):
The change in demand is exactly equal to the change in price. When both are
equal Ed=1 and elasticity is said to be unitary.
Y
D
P
P1
Price
D
0 Q Q1 Quantity X
The demand curve DD is in the shape of Rectangular Hyperbola. When price
falls from ‘OP’ to ‘OP1’ quantity demanded increases from ‘OQ’ to ‘OQ1’. Thus a
change in price has resulted in an equal change in quantity.
4. Relatively Elastic Demand or More than unitary Elasticity of demand (Ed>1):
Demand changes more than proportionately to a change in price. i.e. a small
change in price leads to a very big change in the quantity demanded. Here Ed>1.
Y
D
P
D
P1
Price
0 Q Q1 X
Quantity
Here the demand curve is inclined to X-axis or curve will be flatter. When price
falls from ‘OP’ to ‘OP1’, amount demanded increase from ‘OQ’ to ‘OQ1’ which is
larger than the change in price.
5. Relatively In-Elastic Demand (Ed<1):
Quantity demanded changes less than proportional to a change in price. A
large change in price leads to small change in amount demanded. Here Ed<1.

Y
D
P
P1
Price
0 Q Q1 X
Quantity
Here the demand curve is inclined towards Y-axis or the curve will be steeper.
When price falls from ‘OP’ to ‘OP1‘, amount demanded increases from OQ to OQ1,
which is smaller than the change in price.
Types of Elasticity of Demand

There are four types of Elasticity of Demand:
1. Price Elasticity of Demand:
Marshall was the first economist to define price elasticity of demand. Price
elasticity of demand measures changes in quantity demand to a change in Price. It is
the ratio of percentage change in quantity demanded to a percentage change in
price. Price elasticity is always negative which indicates that the consumer tends to
buy more with every fall in price.
/ 'X'
=
/percentage change in price of product 'X'
The formula is mathematically presented as:

(Q2 - Q1)/Q1 ∆Q P
Ed = or ×
(P2 - P1)/P1 ∆P Q
where, ∆Q = change in quantity demanded or difference in Q2 - Q1
∆P = change in price or difference in P2 - P1
P = price of product
Q = quantity demanded
Ex:
Price Quantity ∆Q = 2
8 10 ∆P = 4
4 12 P=8
Q = 10
2/10 2 8
Ed = or × = 0.4 (Inelastic)
4/8 4 10
The demand is said to be elastic with respect to price if the change in quantity
demanded is more than the change in price. This implies that the elasticity is more
than one (e > I).

The demand is said to be inelastic with respect to price when the change in
quantity demanded is less than the proportionate change in price. This implies that
the elasticity is less than one (e < 1).
The demand is said to be unity with respect to price when the change in
quantity demanded is equal to the change in price (e = I).
The demand elasticity is zero when a change in price causes no change in
quantity demanded and the demand elasticity is said to be infinity when no
reduction in price is needed to cause an increase in demand.
2. Income Elasticity of Demand:

It refers to the quantity demanded of a product in response to given change in
income of the consumer. It is normally positive, which indicates the consumer tends
to buy more and more with every increase in income.
'X'
=

(Q2 - Q1)/Q1 ∆Q I
Ed = (I - I )/I or ∆I × Q
2 1 1
where, ∆Q = change in quantity demanded or difference in Q2-Q1

∆I = change in income or difference in I2 - I1
I = income of the consumer
Ex:
Income Quantity ∆Q = 5
4000 20 ∆I = 1000
5000 25 I = 4000
Q = 20
5/20 5 4000
Ed = or × = 1 (unitary)
1000/4000 1000 20
The income elasticity of demand is positive for superior goods and negative
for inferior goods. Positive income elasticity of demand can be of three kinds – more
than unity elasticity, unity elasticity and less than unity elasticity.
1. The income elasticity of demand is positive and more than unity when change
in income leads to a direct and more than proportionate change in quantity
demanded. Ex: Luxury articles.
2. The income elasticity of demand is positive and unity when a change in
income results into a direct and proportionate change in quantity demanded.
Ex: semi-luxury.
3. Income elasticity of demand is positive and less than unity when an increase in
consumer's income causes a less than proportionate increase in quantity
demanded and vice-versa. Ex: food, clothing etc.
The income elasticity of demand is negative, when an increase in income leads

to decrease in quantity demanded.
3. Cross Elasticity of Demand:

It refers to the quantity demanded of a product in response to a change in
price of related goods, which may be substitute or complimentary goods.
'X'
=
'Y'
(Qx2 - Qx1)/Qx1 ∆Qx Py
Ed = or ×
(Py2 - Py1)/Py1 ∆Py Qx
where, ∆Qx = change in quantity demanded or difference in Qx2 - Qx1
∆Py = change in price or difference in Py2 - Py1
Py = price of product y
Qx = quantity demanded for product x
Ex:
Price of Y Quantity of X ∆Qx = 20
20 100 ∆Py = 10
30 120 Py = 20
Qx = 100
20/100 20 20
Ed = or × = 0.4 (inelastic)
10/20 10 100
Cross elasticity is always positive for substitute and negative for complements.
It should be noted that greater the cross elasticity, the more related the two goods
are. The cross elasticity will be zero, if the two goods have no relationship.
4. Advertising Elasticity of Demand:
It refers to the relationship between amount of money spent on advertising
and its impact on sales. Advertising elasticity is always positive.
ty demanded for product 'X'
=
(Q2 - Q1)/Q1 ∆Q A
Ed = or ∆A × Q
(A - A )/A
2 1 1
where, ∆Q = change in quantity demanded or difference in Q2 - Q1

∆A = change in advertisement cost or difference in A2 - A1
A = Advertisement costs
Ex:
Advertisement Quantity∆Q = 100
10000 300 ∆A = 5000
5000 200 A = 10000
Q = 300
100/300 100 10000
Ed = or × = 0.66 (Inelastic)
5000/10000 5000 300

Measurement of Price Elasticity of Demand

There are three
Price Quantity Total Expenditure
methods of measuring price elasticity of
demand: 10 30 Pens 300
(1) 5 60 Pens 300 Total Outlay Method or Total
Expenditure or Total Revenue Method
(2) Geometrical Method or Point Elasticity Method
(3) Arc Method
1. Total Outlay Method:
It is also known as Total Expenditure or Total Revenue Method. The price
elasticity can be measured by noting the changes in total expenditure brought about
by changes in price and quantity demanded.
(i) When with a percentage fall in price,
20 10 Pens 200
10 30 Pens 300
the quantity demanded increases so
much that it results in the increase in
total expenditure, the demand is said
to be elastic (Ed >1).
Since OEFG is greater than OABC, it implies that change in quantity

demanded is proportionately more than the
change in price. Hence the demand is elastic
(more than one). Ed > 1.
(ii) When a percentage fall in price raises the
quantity demanded so much as to leave the
total expenditure unchanged, the elasticity
of demand is said to be unitary (Ed = 1).
Since OABC = OEFG, it implies that the change in quantity demanded is

proportionately equal to change in price. So the price elasticity of demand is
equal to one, i.e., Ed = 1.

(iii) When a percentage fall in price raises the quantity demanded of a good so as
to cause the total expenditure to decrease, the demand is inelastic or less
than one ( Ed < 1).
5 60 Pens 300
2 100 Pens 200
Since OEFG is smaller than OABC,
this implies that the change in quantity
demanded is proportionately less than the
change in price. Hence price elasticity of
demand is less than one or inelastic.
2. Geometric Method/Point Elasticity Method:

"The measurement of elasticity at a point of the demand curve is called Point
elasticity". The point elasticity of demand is defined as: "The proportionate change
in the quantity demanded resulting from a very small proportionate change in price".
(i) Measurement of Elasticity on a Linear Demand Curve:
If the demand curve is linear (straight line) it has a unitary elasticity at the
midpoint. The total revenue is maximum at this point. Any point above the midpoint,
has an elasticity greater than 1 (Ed>1) and below the midpoint the elasticity is less
than 1 (Ed<1).
Y
800 A (E=∞)
600 B (E>1)
Price
400 C (E=1)
200 D (E<1)
E (E=0)
0 200 400 600 800 x
Quantity
Formula:
%∆Q P
Ed = ×
%∆P Q
The elasticity at each point on the demand curve can be traced as:
lower segment
Ed =
upper segment
(1) Elasticity of demand at point D = DG = 400 = 1 (Unity)
DA 400
(2) Elasticity of demand at point E = GE = 200 = 0.33 (<1)
EA 600
(3) Elasticity of Demand at point C = GC = 600 = 3 (>1)
CA 200
(4) Elasticity of Demand at point A is infinity
(5) At point G, the elasticity of demand is zero
(ii) Measurement of Elasticity on a Non Linear Demand Curve:

If the demand curve is non linear, then elasticity at a point can be measured
by drawing a tangent at the particular point.
From above the elasticity on DD demand curve is measured at point C by
drawing a tangent. At point C:
%∆Q BM BC 400
Ed = × = = = 2 (Elastic)
%∆P MO CA 200
Y
600 D
400 C
Price
200 D
0 200 400 600 X

Quantity
Here elasticity is greater than unity. Point C lies above the midpoint of the
demand curve DD/. In case the demand curve is a rectangular hyperbola, the change
in price will have no effect on the total amount spent on the product. As such, the
demand curve will have a unitary elasticity at all points.
3. Arc Elasticity:
If we are to measure elasticity between any two points on the demand curve
it is Arc Elasticity Method. It is defined as: "The average elasticity of a range of points
on a demand curve". It is calculated by formula:
∆Q P1 + P2
Ed = ×
∆P Q1 + Q2
∆Q denotes change in quantity Q2 denotes new quantity
∆P denotes change in price P1 stands for initial price
Q1 signifies initial quantity P2 denotes new price
Y D
8 M
6
Price
4 N
D
2
0 2 4 6 8 10 x
Quantity

It is shown that at a price of Rs.10, the quantity of demanded of apples is 5kg.

per day. When its price falls from Rs.10 to Rs.5, the quantity demanded increases to
12Kgs of apples per day.
7 10 + 5
Ed = × = 1.23 (Elasticity)
5 5 + 12
The arc elasticity is more than unity.
Significance of Elasticity of Demand

1) Taxation Policy: When a finance minister levies a tax on a certain commodity, he
has to see whether the demand for that commodity is elastic or inelastic. If the
demand is inelastic, he can increase the tax and thus can collect larger revenue.
But if the demand of a commodity is elastic, he is not in a position to increase the
rate of a tax.
2) Price discrimination: If the monopolist finds that the demand for his commodities
is inelastic, he will at once fix the price at a higher level in order to maximize his
net profit. In case of elastic demand, he will lower the price in order to increase
his sale and derive the maximum net profit.
3) Importance to businessmen: The concept of elasticity is of great importance to
businessmen. When the demand of a good is elastic, they increases sale by
towering its price. In case the demand' is inelastic, they are then in a position to
charge higher price for a commodity.
4) Help to trade unions: The trade unions can raise the wages of the labor in an
industry where the demand of the product is relatively inelastic. On the other
hand, if the demand, for product is relatively elastic, the trade unions cannot
press for higher wages.
5) International trade: The term of trade between two countries are based on the
elasticity of demand of the traded goods.
6) Rate of foreign exchange: The rate of foreign exchange is also considered on the
elasticity of imports and exports of a country.
7) Distribution: Elasticity provides a guideline to the producers for the amount to be
spent on advertisement. If the demand for a commodity is elastic, the producers
shall have to spend large sums of money on advertisements to increase sales.
8) Production: The factors of production which have inelastic demand can obtain a
higher price in the market then those which have elastic demand. This concept
explains the reason of variation in factor pricing.
Demand Forecasting
It is necessary to measure demand accurately in terms of quantity and its
value for several purposes. Demand forecasting is helpful not only at firm level but
also at national level. It is the key driver for success or failure. It is an essential
element to make business decisions to foresee the future and act accordingly.
The factors governing demand forecasting are:
1. Nature of goods: Demand forecasting differs on basis of the fact that goods
may be producer goods, consumer goods, durable or non-durable goods.

2. Level of competition: Market competition affects the demand forecasting.

High competitive market, the forecast is conservative taking into account the
actions of competitions.
3. Price factor: It is deeply influenced by firms pricing policy. High prices in future
may influence future demand of a product.
4. Technology: Rapid changes in technology have the potential of rendering
existing products obsolete in future.
5. Economic outlook: Future economic development plays an important role to
forecast demand in future. Positive economic development due to high level
of investment, globalization gives enough reason to have optimistic demand
forecasting for future.
Methods of Demand Forecasting

The methods of demand forecasting are broadly classified as follows:
1. Survey of Buyers’ Intentions:
Individuals and companies plan in advance for their future purchases. For this it is
important that buyers should be approached and asked as how much they intend to
buy a particular product, at a particular point of time. This is the most effective
method as the buyer is the ultimate decision- maker, so we are collecting the
information directly from him. It is classified into two categories:
 Census Method: When the total population of potential buyers in a nation or
region is surveyed it is known as census method.
 Sample Method: When only a portion/group of total population of potential
buyers in a region is surveyed it is called sample method.
2. Sales force opinion method or Collective Opinion Method:

In this method, the firm will extract opinion about sales or demand for a given
product is a group of people who sell the same. The sales people are those who are
in constant touch with large buyers of a particular market. They express their
opinions about the future about the future demand for the product. It is less
expensive and more reliable.
3. Delphi Method or Expert opinion Method:
Experts are the outside persons and they do not have any interest in results of
particular survey. It is used for predicting the demand under conditions of
technological changes. It is under conditions of non-existence of data or when a new
product is launched.
4. Barometric Method or Economic Indicators:
In this one set of data is used to predict another set. It focuses on cyclical
variations caused due to changes in economic environment (i.e. boom, depression
and recovery). That is why, this method it called barometric method. It evolves over
a period of time which is driven by changes in government policies, prices, inflation,
employment, income, etc.

5. Controlled Experiments:
It refers to such exercises where some of the major determinants of demand
are manipulated to suit to the customers with different tastes, preferences, incomes,
etc. In this a product is introduced with different packages, prices, etc. It is costly &
time consuming.
6. Judgmental Approach:
When none of the above methods are directly related to the given product or
service, the management has no alternative other than using its own judgment. This
is used for the reasons like lack of availability of data, sales fluctuations, etc.
7. Time Series Analysis:
Where the surveys or market tests are costly and time consuming, statistical
analysis provides another method to prepare forecasts, i.e. time series analysis. In
this the product should have been traded in the market in the past i.e. data on
performance should be available. It can forecast future values of time series by
examining past observations only. There are four major:
1. Trend (T): It results in developments in population, capital and technology. It
refers to increase or decrease in time series data. It relates to over a period of
long time say five to 10 years.
2. Cyclic Trend (C): These are variations caused by economic cycles like boom,
depression, recovery. These economic changes causes severely the firms sales
graph move upward and downward depending on the economic cycle the firm
is operating.
3. Seasonal Trend (S): It refers to a consistent pattern of sales movements within
a year. More goods are sold during festival seasons. It may be related to
weather factors, holidays, etc.
4. Erratic Trend (E): It results from occurrence of strikes, riots, wars, natural
disasters, etc. These make forecasting process more complex or difficult.
Time series involves process of decomposing original sales series (y) in to
components T,C,S,E. There are different models while one model states Y=T+C+S+E,
another states that Y=T*C*S*E. It can be projected in a graph i.e. sales on Y axis and
time on X axis.
Demand Forecasting For a New Product

Demand forecasting for new products is quite different from that for
established products. Here the firms will not have any past experience or past data
for this purpose. Professor Joel Dean, however, has suggested a few guidelines to
make forecasting of demand for new products.
1) Evolutionary approach: The demand for the new product may be considered
as an outgrowth of an existing product. For e.g., Demand for new Tata Indica,
which is a modified version of Old Indica can most effectively be projected
based on the sales of the old Indica, the demand for new Pulsar can be
forecasted based on the sales of the old Pulsar. Thus when a new product is
evolved from the old product, the demand conditions of the old product can
be taken as a basis for forecasting the demand for the new product.

2) Sales experience approach: Offer the new product for sale in a sample
market; Say supermarkets or big bazaars in big cities, which are also big
marketing centers. The product may be offered for sale through one super
market and the estimate of sales obtained may be ‘blown up’ to arrive at
estimated demand for the product.
3) Substitute approach: If the new product developed serves as substitute for
the existing product, the demand for the new product may be worked out on
the basis of a ‘market share’. The growths of demand for all the products have
to be worked out on the basis of intelligent forecasts for independent
variables that influence the demand for the substitutes. For e.g., A moped as a
substitute for a scooter, a cell phone as a substitute for a land line. In some
cases price plays an important role in shaping future demand for the product.
4) Opinion Poll approach: Under this approach the potential buyers are directly
contacted, or through the use of samples of the new product and their
responses are found out. These are finally blown up to forecast the demand
for the new product.
5) Growth Curve approach: According to this, the rate of growth and the
ultimate level of demand for the new product are estimated on the basis of
the pattern of growth of established products. For e.g., An Automobile Co.,
while introducing a new version of a car will study the level of demand for the
existing car.
6) Vicarious approach: A firm will survey consumers’ reactions to a new product
indirectly through getting in touch with some specialized and informed
dealers who have good knowledge about the market, about the different
varieties of the product already available in the market, the consumers’
preferences etc.
Criteria for Good Demand Forecasting

Apart from being technically efficient and economically ideal a good method
of demand forecasting should satisfy a few broad economic criteria:
1. Accuracy: Accuracy is the most important criterion of a demand forecast, even
though cent percent accuracy about the future demand cannot be assured. It
is generally measured in terms of the past forecasts on the present sales and
by the number of times it is correct.
2. Plausibility: The techniques used & assumptions made should be intelligible to
the management. It is essential for a correct interpretation of the results.
3. Simplicity: It should be simple, reasonable and consistent with the existing
knowledge. A simple method is always more comprehensive than the
complicated one.
4. Durability: Durability of demand forecast depends on the relationships of the
variables considered and the stability underlying the relation between price
and demand, advertisement and sales, level of income and volume of sales.
5. Flexibility: There should be scope for adjustments to meet the changing
conditions. This imparts durability to the technique.

6. Availability: Immediate availability of required data is of vital importance to

business. It should be made available on an up to date basis.
7. Economy: It should involve lesser costs as far as possible. Its costs must be
compared against the benefits of forecasts
8. Quickness: It should be capable of yielding quick and useful results. This helps
the management to take quick and effective decisions.
UNIT - III
Theory of Production and Cost Analysis
Production function
The term Production function refers to the relationship between the inputs
and outputs produced by them in physical terms. The production function may be
defined as the functional relationship between physical inputs (i.e. the factors of
production) and physical outputs (i.e. the quantity of goods produced).
Definition:
According to Watson - “Production function is the relation between physical
inputs and outputs of a firm”.
A production function includes a wide range of inputs like Land, Labour,
Capital, Organization and Technology. Symbolically the production function can be
denoted as follows:
Q = f (L , La ,C ,O ,T)
Where, Q is quantity of production, f is the function which gives the relation between
inputs and outputs.
In specific situations, all the variables may not be important, therefore the
economists have reduced the number of variables to only two i.e. capital and labour.
It is expressed as: α = f (K, L)
It explains in what proportion, factor inputs should be combined to increase
the production with lower costs.
Cobb-Douglas Production Function

The American Ex-senator and Economist Paul H.Douglas and the
Mathematician Charles W.Cobb made a statistical study in 1920 to find out the actual
production function in the whole of the American manufacturing industry. The inputs
are capital and labour.
Formula: P=bLaC1-a
Where, P = Total output
L = Labour/Labour employed
C = Capital
a and 1-a = Elasticities of Production
The function estimate for USA by Cobb and Douglas is:
P = 1.01 L0.75 C0.25

R2 = 0.9409
The production function shows that 1% change in labour input, capital
remaining constant is associated with a 0.75% change in output, similarly a 1%
change in capital, labour remaining constant, is associated with a 0.25% change in
output.
The coefficient of determination (R2) means 94% of the variations on
dependent variable p are accounted by variations in Labour and Capital.
Iso – Quants
The term ‘Iso’ is derived from a Greek work which means ‘Equal’ and the term
‘Quant’ is derived from a Latin word which means ‘Quantity’. Iso-Quant means equal
quantity throughout the production process. It is defined as a curve which shows
different combinations of two inputs producing same level of output. It is also called
‘Iso-Product Curve’.
The producer is indifferent as to which combination he uses for producing the
same level of output, so it is also known as ‘Product Indifference Curve’ or ‘Equal
Product Curve’ or ‘Production function with two variables’.
Iso-Quant Schedule
Combinations Labour Capital Output (units)
A 1 14 100
B 2 10 100
C 3 7 100
D 4 5 100
E 5 4 100
The table shows different combinations of input factors to yield an output of

100 units of output. The graphical representation of an Iso-Product schedule is Iso-
Quant Curve.
Iso-Quant Map:
A group or a set of Iso-Product curves representing different levels of output
shown on a graph is called Iso-Quant Map. A higher Isoquant shows a higher level of
output and a lower Isoquant represents a lower level of output.

Features:
1. Slopes downwards from left to right.
2. Do not intersect each other.
3. Do not touch the axes.
4. Convex to point of origin.
Linear Iso-Quants:
A linear Iso-Quant implies perfect substitutability between the two inputs K
and L. this is possible only when the two factors K & L are substitutes for one
another. Hence the Iso-Quants are straight lines.
y
Capital
IQ300 units
IQ200 units
IQ100 units
0 Labour x
L – Shaped Iso-Quant:
When a production function has no scope for substitutability and a fixed
proportion of inputs i.e. capital and labour is employed the Iso-Quants take L-Shape.
y
Capital R
IQ300 units
IQ200 units
IQ100 units
0 Labour x

Kinked Iso-Quant:
When there is limited substitutability of two inputs and where the firm may a
choice to choose between processes only, the Iso-Quant takes a Kinked shape.
y
P1
A P2
Capital P3
B
C P4
D IQ100 units
0 Labour x
Iso - Costs
Iso-Cost line represents different combinations of two factors which the
producer can get for a certain amount of given money at given prices of the factors.
If production changes, the total cost also changes.
Ex: Suppose a producer is having Rs.500. If the price of units of labour is Rs.10, he can
buy 50 units of labour. If the price of unit of capital is Rs.5, he can buy 100 units of
capital. Thus Iso-Cost curve moves upwards.
Combinations Labour Capital Cost (Rs.)
A 1 20 1000
B 2 15 1000
C 3 11 1000
D 4 8 1000
Capital
Ic3000
Ic2000
Ic1000
0 Labour x

Marginal Rate of Technical Substitution

It refers to the rate at which one input factor is substituted with other to
attain given level of output i.e. lesser units of one input must be combined with
increasing amount of other input.
Combinations Capital Labour MRTS
A 1 20 -
B 2 15 5:1
C 3 11 4:1
D 4 8 3:1
The table presents the ratio of MRTS between two input factors, capital and
labour. 5 units of decrease in labour are compensated by an increase of 1 unit of
capital i.e. 5:1.
change in one input ∆K
MRTS = =
change in other input ∆L
2−1 1
MRTS = = = 1: 5
20 − 15 5
Least Cost Combination of Inputs

Maximizing profits by combining the factors of production in such a way that
the cost involved in inputs is minimum or least and get maximum return is known as
least cost combination. The Iso-costs and Iso-quants can be used to determine the
input usage that minimizes the cost of production.
When an Iso-quant curve is equal to Iso-cost, there lies the lowest point of cost of
production. This can be observed by improving Iso-costs and Iso-quant curves.
The points A,B,C on each curve represent the least cost combination of inputs,
yielding maximum level of output. Any output lower or higher will result in higher
cost of production. So, the obvious choice for the producer is ‘Q’ combination of
inputs on IQ2.
y
C
Capital B
IQ300 units
A
IQ200 units
IQ100 units
0 Ic1000 Ic2000 Ic3000 x

Labour

Laws of Production
Production analysis consists of two types of input-output relationships:
1. When quantities of certain inputs are fixed and others are variable.
2. When all inputs are variable.
These two types of relationships have been explained in the form of two laws. Law of
variable proportions and Law of returns to scale:
1. Law of Variable Proportions

The relationship between one variable input and output, keeping the
quantities of other inputs are fixed are called Law of Variable proportions. It is also
known as ‘Law of Diminishing Returns’. This operates in short run when fixed factors
cannot be changed. This law states three types of productivity an input factor –
 Total Productivity means the total goods produced during the period.
 Average Productivity means total productivity / No. of goods produced.
 Marginal Productivity means additional units produced during the period or
change in total productivity.
Three stages of law:
The behaviors of the output when the varying quantity of one factor is
combines with a fixed quantity of the other can be divided in to three stages. The
three stages can be better understood by following the table:
Fixed factor Variable factor Total Average Marginal
Stage
(Capital) (Labour) Product Product Product
1 1 100 100 -
1 2 220 120 120 Stage I
1 3 270 90 50
1 4 300 75 30
1 5 320 64 20 Stage II
1 6 330 55 10
1 7 330 47 0
Stage III
1 8 320 40 -10
Above table reveals that
both average product and marginal
product increase in the beginning
and then decline of the two
marginal products drops of faster
than average product.
Stage-I: The total product increases at an increasing rate, the marginal product
increases at an increasing rate resulting in a greater increase in total product. The

average product also increases. This stage continues up to the point where average
product is equal to marginal product. It is known as Stage of Increasing Returns.
Stage-II: The total product increases only at a diminishing rate. The average product
also declines. The second stage comes to an end where total product becomes
maximum and marginal product becomes zero. It is stage of Diminishing Returns.
Stage-III: The marginal product becomes negative, the total product also declines.
The average product continues to decline. This is stage of Negative Returns.
2. Law of Returns to Scale

The relationship between quantities of output and scale of production in long
run, when all inputs are increased in the same proportion, is called law of returns to
scale. In order to meet a long-run change in demand the firm increases its scale of
production by increasing quantaties of all factors of production.
Scale of production Total Marginal
scale
L + C production production
1+2 4 4
2+4 10 6 Increasing
3+6 18 8
4+8 28 10
5 + 10 38 10 Constant
6 + 12 48 10
7 + 14 56 8
Decreasing
8 + 16 62 6
y
Output B Constant C
Increasing Decreasing
A D
0 scale of production x
It consists of three stages:

Increasing Returns to Scale:
It state that the volume of output keeps on increasing with every increase in
input. Where a given increase in input leads to a more proportionate increase in
output, it is increasing returns to scale i.e. total product increases at increasing rate.
Constant Returns to Scale:
It states that the rate of increase or decrease in volume of output is same to
that of increase or decrease in input. When the scope of labour gets restricted, the
rate of increase in the total output remains constant i.e. Constant returns to scale.
Decreasing Returns to Scale:
When a proportionate increase in inputs does not lead to equivalent increase
in output, i.e. output increases in decreasing rate it is Diminishing returns to scale.

Economies of Scale
The Economies of scale result due to increase in scale of production. Marshall
has classified these economies of large-scale production into two groups:
A. Internal Economies:
It occurs as a result of increase in scale of production. It refers to the
economies in cost of production which occur to the firm when it expands its output.
These are as follows:
1. Managerial Economies: The business firm needs qualified managerial personnel
to handle each department like marketing, finance, production, human resource,
inventory, etc. Hence the appointment of experts, division of administration into
departments, functional specialization and scientific co-ordination of various
works make the management of the firm most efficient.
2. Financial Economies: The large firm is able to secure the necessary finances more
easily and cheaply. It can barrow from the public, banks and other financial
institutions at relatively cheaper interest. So it reduces the cost and thus net
profit is increased.
3. Marketing Economies: The firms generally have a separate marketing
department. It can buy and sell the goods, when the market trends are more
favorable and enjoy advantages like preferential treatment, transport
concessions, cheap credit, prompt delivery and fine relation with dealers.
Similarly it sells its products more effectively for a higher margin of profit.
4. Technical Economies: Technical economies arise to a firm from the use of better
machines and superior techniques of production. As a result, production
increases and per unit cost of production falls. This increases the productive
capacity of the firm and reduces the unit cost of production.
5. Commercial Economies: The transactions of buying and selling raw materials and
other operating supplies like spares will be rapid and each transaction grows as
the firm grows. There could be cheaper savings in procurement, transportation,
storage costs which lead to lower costs and increased profits.
6. Risk bearing Economies: The large firm produces many commodities and serves
wider areas. During business depression, the prices fall for every firm. There is
also a possibility for market fluctuations in a particular product of the firm. To
avoid or lower the risk, management has to follow the principle of ‘no to keep all
eggs in one basket’, so that they can spreads risk with insurance companies, etc.
7. Research & Development Economies: A large firm possesses larger resources and
can establish its own research laboratory and employ trained research workers.
The firm may even invent new production techniques for increasing its output
and reducing cost.
8. Welfare Economies: A large firm can provide better working conditions in-and
out-side the factory. Facilities like subsidized canteens, crèches for the infants,
recreation room, cheap houses, educational and medical facilities tend to
increase the productive efficiency of the workers, which helps in raising
production and reducing costs.

B. External Economies:
It refers to all the firms in the industry, because of growth of the industry as a
whole. It benefits all the firms in industry as it expands. It is grouped as follows:
1. Economies of Concentration: When an industry is concentrated in a particular
area, all the member firms reap some common economies like skilled labour,
improved means of transport and communications, banking and financial
services, supply of power and benefits from subsidiaries. All these facilities tend
to lower the unit cost of production of all the firms in the industry.
2. Economies of Information: The industry can set up an information centre which
may publish a journal and pass on information regarding the availability of raw
materials, modern machines, export potentialities and provide other information
needed by the firms. It will benefit all firms to reduce their costs.
3. Economies of Welfare: An industry may provide welfare facilities to the workers.
It may get land at concessional rates for setting up housing colonies for the
workers. It may also establish public health care units, educational institutions,
canteens, hospitals, etc. It will help the efficiency of the workers.
4. Economies of Research & Development: All the firms can pool resources
together to finance research and development activities and thus share the
benefits of research.
Cost Analysis
Cost refers to the expenditure incurred to produce a particular product or
service. The costs may be monetary or non-monetary, tangible or intangible etc. The
cost of production includes cost of raw materials, labour, and other expenses. This
cost is known as Total Cost (TC) and it is compared with Total Revenue (TR) which is
realized on sale of products and the difference is Profit (P).
P = TR – TC
Profit is the ultimate aim of any business. The firm should therefore aim at
controlling and minimizing cost.
Cost Concepts
A managerial economist must have a clear understanding of the different cost
concepts for clear business thinking and proper application. The various relevant
concepts of cost are:
1. Opportunity Cost:
It refers to the expected benefit foregone in sacrificing one alternative for
another. It exists when resources are scarce and there are alternative uses for
them. When they are no alternative, there is o opportunity cost.
Ex: If one acre of land produces rice worth Rs.5000 and when of Rs.8000, so the
producer will forego rice for wheat.
This concept is useful for long run decisions. The amount of opportunity
cost is determined by comparing the benefits or advantages of a choice with

those of the next best alternative. When one is selected it means that
opportunity cost of gaining benefits from other alternatives.
2. Fixed Cost: Fixed cost is that cost which remains constant for a certain level to
output in short run. These are incurred even the production is stopped. It is not
affected by the changes in the volume of production. But fixed cost per unit
decrease when the production is increased. Fixed cost includes salaries, Rent,
Administrative expenses, taxes, depreciations etc.
3. Variable Cost: Variable is that which varies directly with the variation is output. It
exists only when there is production. An increase in total output results in an
increase in total variable costs and decrease in total output results in a
proportionate decline in the total variables costs. The variable cost per unit will
be constant. Ex: Raw materials, labour, direct expenses, etc.
4. Explicit Cost or Out-of-Pocket Cost: Explicit costs are those expenses that involve
cash payments. These are the actual or business costs that appear in the books of
accounts. These costs include payment of wages and salaries, payment for raw-
materials, interest on borrowed capital funds, rent on hired land, Taxes paid etc.
5. Implicit Cost or Imputed Cost or Book Cost: Implicit costs are the costs of the
factor units that are owned by the employer himself. It does not involve payment
of cash as they are not actually incurred. It is incurred in the absence of
employment of self – owned factors. The implicit costs are depreciation, interest
on capital, rent of own premises, savings from salary, etc.
6. Total Cost, Average Cost & Marginal Cost:

Total cost is the total cash payment made for the input needed for
production. It is the sum total of the fixed and variable costs. TC = FC + VC
Average cost is the cost per unit of output. If is obtained by dividing the
total cost (TC) by the total quantity produced (Q).
Marginal cost is the additional cost incurred to produce and additional unit
of output or it is the cost of the marginal unit produced. It is ascertained for one
additional product.
Break Even Analysis

It refers to the analysis of Break Even Point (BEP) i.e. no profit or no loss point.
It is defined as analysis of costs and their possible impact on revenue of the firm.
Hence, it is also called as Cost-Volume-Profit analysis. A firm is said to attain the BEP
when its Total Revenue is equal to Total Cost (TR – TC).
It is a technique for profit planning and control. It is useful to denote the
minimum level of production to be undertaken to avoid losses. The objective of BEP
is the relationship between cost, revenue and output. It is usually presented in the
form of charts.
Output Total Total Total

Total Cost
(units) Revenue Fixed Cost Variable Cost
0 0 300 0 300

100 400 300 300 600

200 800 300 600 900
300 1200 300 900 1200
400 1500 300 1200 1500
Significance or Importance of Break Even Analysis

Break Even Analysis is an important tool for a business for decision making. It helps in
identifying various components of costs and their impact on product of a firm:
1. It helps in determining contribution of each product.
2. It helps in determining required sales at a given level of profit.
3. To compare efficiency of different firm.
4. To decide whether to add a product to the existing or drop one from it.
5. To access the impact of changes in Fixed Cost, Variable Cost & Selling price on
BEP and profits during a period.
Limitations of Break Even Analysis
1. Break Even Point is based on Fixed Cost, Variable Cost and Total Revenue. A
change in one variable effects BEP.
2. All costs cannot be classified as Fixed & variable as there are certain semi
variable costs.
3. It is based on fixed cost, so it is applicable only in short run.
4. If business conditions are volatile, BEP cannot give stable results.
5. It is applicable to single product firm, there are problems in application of
multi product firms.
Determination of Break Even Point

Sales = Fixed cost + Variable cost + Profit
Contribution = S – V (or) F + P
Contribution per unit = Sales per unit – VC per unit
Contribution Ratio = (S – V / S) x % of sales
Total Contribution = Total sales (Rs.) x Total Contribution Ratio
P/V Ratio = Contribution / Sales x 100

BEP (Rs.) = FC / PV Ratio (or) F C / Contribution ratio

BEP (units) = FC / Contribution per unit (or)
Margin of Safety (Rs.) = Actual Sales (Rs.) – Sales at BEP (Rs.)
Margin of Safety (units) = Actual Sales (units) – Sales at BEP (units)
Sales when profit is ‘x’ = Sales – Variable cost = Fixed cost + Profit
Calculation of Profit = S – VC – FC (or)
Sales (No. of units x selling price per unit) = xxx
(-) VC (No. of units x variable cost per unit) = xxx
Contribution = xxx
(-) Fixed Cost = xxx
Profit / Loss = xxx
Problems
1. If sales are 10,000 units and selling price is Rs. 20 per unit, variable cost Rs. 10 per
unit and fixed cost is Rs. 80,000. Find out BEP in units and sales revenue. What is
profit earned? What should be the sales for earning a profit of Rs. 60,000/-.
Solution:
(a) BEP (units) = FC / Contribution
= 80000 / 10 = 8000 units
Contribution = Sales – VC = 20 – 10 = 10
(b) Sales = BEP (units) x Selling price per unit
= 8000 units x Rs.20 = Rs.160000
(c) Profit = Sales – VC – FC
= 280000 – (14000 x 10) – 80000
= 280000 – 140000 – 80000 = 60000
(d) Sales when profit is Rs.60000
S=F+P/S-V
= 80000 + 60000 / 20 - 10
= 140000 / 10 = 14,000 units
Sales = 14,000 units x 20 = Rs.2,80,000
2. If sales are 20,000 units and selling price is Rs 15 per unit, variable cost Rs. 10 per
unit and fixed cost is Rs. 1,00,000. Find out BEP in units and in sales rupee value.
What is profit earned? What should be the sales for earning a profit of Rs. 50,000.
Solution:
(a) BEP (units) = FC / Contribution
= 100000 / 5 = 20000 units
Contribution = Sales – VC = 15 – 10 = 5
(b) Sales = BEP (units) x Selling price per unit

= 20000 units x Rs.15 = Rs.300000

(c) Profit = Sales – VC – FC
= 300000 – (20000 x 10) – 100000
= 300000 – 200000 – 100000 = 0
(d) Sales when profit is Rs.50000
S=F+P/S-V
= 100000 + 50000 / 15 - 10
= 150000 / 5 = 30000 units
Sales = 30000 units x 20 = Rs.6,00,000
3. A company estimates its fixed costs for the year at Rs. 8, 00,000 and its profit
target at Rs.2,00,000. Each unit of product is sold at Rs. 10 and variable cost per
unit is Rs.8. What sales level must the company achieve in order to realize its
profit goal?
Solution:
Sales to get a profit of Rs.200000
S=F+P/C
= 800000 + 200000 / (10-8)
= 1000000 / 2 = 500000 units
Sales = 500000 units x 10 = Rs.5000000
Verify:
Profit = Sales – VC – FC
= 5000000 – (500000 x 8) – 800000
= 5000000 – 4000000 – 800000
= 200000
4. XYZ Company has supplied you the following information.

Selling price per unit Rs. 30, No. of units sold 20,000 units
Fixed cost Rs. 2, 40, 000, Variable cost per unit Rs. 15
Find out: (i) BEP in units & Rs. (ii) Margin of safety
(iii) Sales to get a profit of Rs. 2,00,000
(iv) Verify the results in all the above cases
Solution:
(i) BEP (Units) = Fixed Cost / Contribution per unit
= 240000 / (30-15) = 16000 units
BEP (Rs.) = Fixed Cost / PV Ratio
= 240000 / 0.50 = Rs.480000
= 15 / 30 x 100 = 0.50 or 50%
(ii) Margin of Safety (units) = Actual Sales – BEP Sales (units)
= 20000 – 16000 = 16000 units

Margin of Safety (Rs.) = Actual Sales – BEP Sales (Rs.)

= (20000 units x 30) - 480000
= 600000 – 480000 = Rs.120000
(iii) Sales to get a profit of Rs.200000
S=F+P/C
= 240000 + 200000 / 15
= 440000 / 15 = 29333.33 units
Sales = 29333.33 units x 30 = Rs.880000
(iv) Verification:
i) Contribution at BEP – FC = 0
(16000 units x 15) – 240000 = 0
ii) Sales – BEP sales = (20000 units x 30) – (16000 x 30) = Rs.120000
iii) Profit = C – FC = (880000 x 50%) - 240000 = Rs.200000
5. From the following data calculate the break-even point:

Fixed cost Rs. 9000, Selling price Rs. 5 per unit, Variable cost Rs. 3 per unit
Suppose the price reduces to Rs. 2 per unit, what would you say about the break-
even position?
Solution:
BEP (units) = FC / C = 9000 / (5-3) = 4500 units
BEP (Rs.) = FC / PV Ratio = 9000 / 0.4 = Rs.22500
PV Ratio = C / S = 2 / 5 = 0.4 or 40%
Calculation after price reduction:

BEP (units) = FC / C = 9000 / (3-1) = 4500 units
BEP (Rs.) = FC / PV Ratio = 9000 / 0.4 = Rs.13500
PV Ratio = C / S = 1 / 3 = 0.667 or 66.667%
6. ABC Company has supplied the following data:

No. of units sold 30,000 Fixed cost Rs. 1,50,000
Variable cost per unit Rs. 10 Selling price per unit Rs. 20
Find out: (a) BEP in units and in Rupees (b) Margin of safety
(c) Sales to get a profit of Rs. 3,00,000
(d) Verify the results in all the above cases
Solution:
(a) BEP (Units) = Fixed Cost / Contribution per unit
= 150000 / (20-10) = 15000 units
BEP (Rs.) = Fixed Cost / PV Ratio
= 150000 / 0.50 = Rs.300000
= 10 / 20 x 100 = 0.50 or 50%
(b) Margin of Safety (units) = Actual Sales – BEP Sales (units)

= 30000 – 15000 = 15000 units

(c) Sales to get a profit of Rs.300000
S=F+P/C
= 150000 + 300000 / 10
= 450000 / 10 = 45000 units
Sales = 45000 units x 20 = Rs.900000
Verification:
(a) Contribution at BEP – FC = 0
(15000 units x 20) – 150000 = 0
(b) Margin of Safety (Rs.) = Actual Sales – BEP Sales (Rs.)
= (30000 units x 20) - 300000
= 600000 – 300000 = Rs.300000
(c) Profit = C – FC = 900000 - (45000 x 10) - 150000
= 900000 – 450000 – 150000 = 300000
UNIT – IV
Introduction to Markets, Managerial Theories of Firm & Pricing Policies
Market
Market is defined as a place at which buyers and sellers negotiate their
exchange of products goods and services. In Economic terms market refers to a
group of sellers and buyers spread over a town, region or country and have contract
with each other for the purpose or buying or selling products at an agreed price.
The size of market depends on factors like nature of products, tastes and
preferences of customers, demand, income, etc.
Market Structures:
Market structure refers to the characteristics of a market that influence the
behavior and performance of firms and describes the competition environment in
the market for any good or services. The structure is based on the following features:
1. Sellers Concentration: This refers to the number of sellers and their market
share for a particular product or service in the market.
2. Buyer Concentration: This refers to the number of buyers and their extent of
purchases of a product in the market.
3. Product Differentiation: This refers to differentiating of product from the
point vies of varieties and brands of one firm from another firm.
4. Restrictions to enter into a market: In most cases, there would be certain
restrictions to enter into a market. This regulates the number of firms to enter
or exit from a market. If there are fewer restrictions there will be more firms.

Classification of Markets:
a) Area: It takes place in local, regional, national and international market.
b) Time period: short period, very short period, long period and very long period
market.
c) Quantity: Whole sale and Retail market.
d) Legality: Open and Black market.
Types of Competition:
Competition refers to a drive for the market which consists of similar
customers. A firm which influences the market by offering its products for sale at a
better or attractive terms and conditions to customers, it influences the market. It is
divided in to two categories: Perfect Competition and Imperfect Competition
Perfect Competition
Perfect competition refers to a market structure where competition among
the sellers and buyers prevails in its most perfect form. In a perfectly competitive
market, a single market price prevails for the commodity, which is determined by the
forces of total demand and total supply in the market.
Features:
1. Large number of buyers and sellers: The number of buyers and sellers is large
and the share of each one of them in the market is so small that none has any
influence on the market price.
2. Homogeneous product: The products must be undifferentiated from that of the
other products. All firms produce same type of products at same price.
3. Free entry and exit: Any buyer and seller are free to enter or leave the market
of the commodity whenever they want.
4. Perfect knowledge: All buyers and sellers have perfect knowledge about the
market for the commodity.
5. Indifference to buy or sell: No buyer has a preference to buy from a particular
seller and no seller has a preference to sell to a particular buyer.
6. Non-existence of transport costs: Perfectly competitive market also assumes
the non-existence of transport costs.
7. Perfect mobility of factors of production: Factors of production must be in a
position to move freely into or out of industry and from one firm to the other.
Pricing under Perfect Competition:
Under such a market, the price is determined by the industry as a whole
consisting of both buyers and sellers. Hence all the customers total demand at
various prices constitutes of industry demand curve and all sellers’ total quantity
constitute of supply curve. However, the demand curve for an individual firm is
horizontal and perfectly elastic. The cost function of different firms depends upon
factors of production. Revenue function is:
 Total Revenue: It refers to the earnings earned by producing and selling 'n'
number of units. Total Revenue (TR) = Price per unit (P) x No. of units sold (Q)

 Average revenue: It is the revenue earned per unit sold. AR=TR/Q

 Marginal Revenue: MR refers to a change in revenue because of producing
and selling one more unit. Therefore, Price = AR = MR
Price Output Determination
Price is determined by the interaction of demand and supply. In this there are
large number of buyers and sellers. Each seller supplies a small portion of demand
and each buyer creates some quantity of demand in the market. Hence both
together determine the price.
Equilibrium:
In Perfect Competition the Individual firm has no control over price. It has to
accept the price given by the market and adjust its output to given price and
maximize his profits. Hence the demand curve for the output of individual firm is
horizontal i.e. Price=AR=MR.
Y
Price
Price=AR=MR
0 Quantity x
In case of an industry the price is determined by the market i.e. demand &
supply for a product. The firm has to charge the same price as the other firms charge.
The industry demand curve slopes downwards and supply curve moves upwards It is
the price that determines the quantity demanded & supplied. The price that prevails
in market is one at which demand=supply.
Price per unit Demand Supply Pressure on price
5 20 40 Fall
4 25 35 Fall
3 30 30 Neutral
2 32 27 Rise
1 35 25 Rise
y
D S
Price E
S D
0 Quantity x
Short Run
In short run the firms cannot alter their level of output by increasing or
decreasing variable factors but fixed costs remain same. The firms will be in
equilibrium either by making profits or minimizing losses. The firm earns profits
when AC & MC are less than price.

y
MC
AC
Price
C D P=AR=MR
F E
0 Q x
Output
The firms demand curve is horizontal at price determined by industry

(Price=MR=AR) known as Average Revenue Curve because all the goods are sold at
same price on an average, the revenue is equal to zero.
When AR is constant it will coincide with MR.
CC is the demand curve representing Price=AR=MR.
AC & MC are firms Average and Marginal cost curves.
The firm get profits as long as P=MR=AR
OC = QD = Price
OF = QE = Average Cost
OQ = FE = Equilibrium output
Average Profit = Price – AC
Long Run
A firm can make necessary changes in factors of production in long run.
Further a new firm can enter and an existing firm can leave the industry. The firm
attains equilibrium when AC & MC = AR & MR i.e. (Price=AR=AC=AC=MR).
Y
LAC
LMC
Price E
C P=AR=MR=AC=MC
0 Q x
Output
In long run equilibrium position of firm satisfied two conditions:

(a) MR = MC (b) AR = AC
AC must be tangential to AR at lowest point. QE is the price and also long run
average cost (LAC). The Long run Marginal Cost (LMC) passes through minimum point
of LAC curve. E is equilibrium point that produces OQ. Therefore, if the market price
is below LAC of firm, it is better to leave the industry.

Monopoly
Mono means ‘Single’ and Poly means ‘Seller’. It means Single Seller. A single
firm in the industry can control either supply or price of a product but cannot control
demand. If it decides price it cannot determine supply, vice versa. Monopoly exists
where there are restrictions on entry of other firms in to business or where there are
no close substitutes for a product. Interpretation can be made by two approaches:
1. When there is only one supply it is pure monopoly. Ex: RBI
2. Where the firm is supplying half of the total market may have greater market
power, rest of market is shared by other firms.
Features:
1. Single person or a firm: Here the total supply of the product is controlled by a
single person or a firm. It deals with a particular product.
2. No close substitutes: There should be no close substitutes and no competitors
in the market for the product. Ex: Electric bulb and Railway.
3. Large Number of Buyers: There may be large number of buyers to buy the
products under monopoly.
4. Poly Market: Since there is only one in the industry he is the Price Maker.
5. Supply and Price: The Monopolist can decide either the price of a product or
the quantity for the product, not both.
6. Downward Sloping Curve: The demand curve of monopolist slopes downward
from left to right.
7. Inelastic Demand: The Products and services provided by the monopolist bear
inelastic demand.
8. Easy Creation: Monopoly can be created through statutory grant of special
privileges such as licenses, permits, patent rights and so on.
Pricing under Monopoly:
Monopoly refers to a market situation where there is only one seller. He has
complete control over the supply of a commodity. He is therefore in a position to fix
any price. Under monopoly there is no distinction between a firm and an industry.
This is because the entire industry consists of a single firm.
In monopoly MR is always less than AR because of discounts or concessions
given by the seller to the buyer (MR < AR).
y
Price
AR
MR
0 Output x
Ex: The selling price of pen is Rs.12. If one buys 10 pens together, it costs Rs.120. To
increase sales a discount of 10% is provided. The AR selling price per unit is Rs.12.
The MR is price received on additional sale i.e. 11th pen is Rs.10.80.

Price-Output Determination
In monopoly, the AR curve for a firm is downward sloping because, if a firm
reduces the price of a product, the demand increases, vice versa. Here MR < AR i.e.
MR curve lies below AR curve. To achieve maximum profits, it is necessary that MR
curve should be more than marginal cost.
Y
MC AC
Price=MR=MC=AR=AC
P Q
S R
AR
E
MR
0 M X
Output
From the above figure:

Cost/Price = AC = MC = AR = MR
OM = Equilibrium output
OP = Equilibrium price
MR = Average Cost
QR = Average Profit (AR – AC)
PQRS = Profit
Monopolistic Competition
It is a mixture of perfect competition and monopoly. Edward. H. Chamberlain
developed the theory of monopolistic competition, which presents a more realistic
picture of the actual market structure and the nature of competition.
It exists when there are many firms and each one produces such products that
are close substitutes to each other or if many sellers produce a differentiated
product.
Features:
1. Existence of Many firms: Industry consists of many sellers who are
independent. A Monopolistic competition form follows an independent price
policy.
2. Product Differentiation: Products can be differentiated by means of unique
facilities, advertising, brand loyalty, and so on. Through heavy advertisement
budgets, Pepsi and Coco Cola make it very expensive for a third competitor to
enter the cola market.
3. Large Number of Buyers: There are a large number of buyers in the market.
But the buyers have their own brand preferences. Each seller has to plan
various incentive schemes to retain the customers who patronize his products.
4. Free Entry and Exit of Firms: There is freedom of entry and exit. That is, there
is no barrier as found under monopoly.

5. Selling costs: Since the products are close substitutes much effort is needed to
retain the existing consumers and to create demand. So each firm has to
spend a lot on selling cost, which includes cost on advertising & sales
promotion activities.
6. Imperfect Knowledge: Imperfect knowledge about the product leads to
monopolistic competition. If the buyers are fully aware of the quality of the
product they cannot be influenced much by advertisement or other sales
promotion techniques.
7. Non-Identical Products: Under monopolistic competition, the products of
various firms are not identical though they are close substitutes. Prof.
Chamberlain calls these collections of firms producing close substitute
products as a group.
Price – Output Determination:
Under monopolistic competition different firms produce different varieties of
products at different prices which will be determined in the market depending upon
the demand and cost conditions. Each firm will set the price and output of its own
product. Here the profit will be maximized when MR = MC.
Short Run:
The monopolist always desires to make maximum profits. He makes maximum
profits when MC=MR. He produces up to that point where additional cost is equal to
the additional revenue (MR=MC). Thus point is called equilibrium point. In short run
firms may experience super normal or normal profits or losses.
(i) When there is fall in price or increase in demand, firms enjoy supernormal
profits i.e. if it satisfied two conditions:
(b) Where MC = MR (b) Where AR < AC
(ii) When cost rises or demand decreases the firm may be in losses.
Y
SMC SAC
A B
D C
Cost/Price
E AR
MR
0 Q Output X
In the diagram AC and MC are the average cost and marginal cost curves. AC
and MC and U shaped curves. AR and MR curves slope downwards from left to right.
The monopolistic firm attains equilibrium when its marginal cost is equal to
marginal revenue (MC=MR) i.e. at point E. Under monopoly, the MC curve may cut
the MR curve from below or from a side.
Equilibrium output = OQ
Average revenue = OA or OB
Average cost = AC
Profit per unit = Average Revenue - Average cost = QB - QC = CB
Super normal Profit = ABCD

Long Run:
Many firms enter into industry because of abnormal profits enjoyed by
existing firms. Hence, competition becomes intensive and firms will compete with
each other for acquiring scarce inputs pushing up their prices. On the other hand due
to entry of several firms, the supply of products in the market will increase pulling
down their selling price. Hence the firm will earn only normal profit which is
sufficient to stay in the business.
To get equilibrium, the firm has to fulfill two conditions:
(i) MR = MC (ii) AR = AC
Y
LMC
LAC
P E
F
Price
K AR
MR
0 Q X
Output
From the diagram, the AC curve will be tangential to downward sloping AR
curve at point ‘E’. At point ‘K’ the MR = MC.
The AC curve is tangential to AR curve at higher than its minimum point ‘F’.
OQ = Equilibrium output and OP = Equilibrium price
A firm under monopolistic competition will get equilibrium price and output
when both conditions of equilibrium MR=MC and AR=AC are satisfied.
Oligopoly
The term oligopoly is derived from two Greek words, oligos means a few and
poly means seller. Oligopoly is the form of imperfect competition where there are a
few firms in the market, producing either a homogeneous product or producing
products, which are close but not perfect substitute of each other.
Each firm will have control over market supply and each seller’s actions and
reactions are more important to each other. Ex: Cars, Newspapers, Transportation,
Cell Networks, Refrigerator industry, etc.
Features:
1. Few Firms: There are only a few firms in the industry. Each firm contributes a
sizeable share of the total market. Any decision taken by one firm influence the
actions of other firms in the industry.
2. Indeterminate Demand Curve: The interdependence of the firms makes their
demand curve indeterminate. When one firm reduces price other firms also
reduce their prices. So a firm cannot be certain about demand for its product.
3. Interdependence: As there are only very few firms, any steps taken by one firm
to increase sales, by reducing price or change product design or increase
advertisement expenditure will naturally affect the sales of other firms in the
industry. So the decisions of all the firms in the industry are interdependent.

4. Advertising and selling costs: Advertising plays a greater role in the oligopoly
market when compared to other market systems. A huge expenditure on
advertising and sales promotion techniques is needed both to retain the present
market share and to increase it.
5. Price Rigidity: In the oligopoly market price remain rigid. If one firm reduced price
it is with the intention of attracting the customers of other firms in the industry.
In order to retain their consumers they will also reduce price. Thus the pricing
decision of one firm results in a loss to all the firms in the industry.
Price-Output Determination:
1. Independent pricing: Where there is product differentiation each firm can fix
independent price, aiming at maximum profits. There is a scope for price war by
each firm to sell at lower prices.
2. Collusive pricing: To avoid competition the firms may form a curtel to regulate
price & output of all firms. The control board will determine output & price to be
charged by each firm. Every firm gets profit on basis of quota assigned.
3. Price Leadership: A dominant firm takes the sole leadership and fixes the price of
the product for the entire industry. There is an agreement between the firms to
sell the products at a price set by the leader in the industry.
Due to rival consciousness any reduction in the price by one firm will be
retailed by competitive price cuts by other firms. All individual firms have a Kinked
demand curve. The kink appears where the price stickiness exists. The demand curve
is derived from two demand curves of differing elasticity i.e. more elastic demand
curve for a price increase and less elastic demand curve for price fall.
Y MC1
D MC2
A
Price
P K
B
D1
AR
MR
0 Q X
Output
From the figure,
DKD1 is the demand curve.
Between DK the demand is more elastic and KD1 it is less elastic.
OP is the price.
MR curve is also discontinuous as it cannot ascertain where the kink in the
demand curve appears.

Marris Growth Maximization Model

Profit maximization is a traditional objective of a firm. Prof. Marris has
developed growth maximization model in recent years. It is a common factor to
observe that each firm aims at maximizing its growth rate.
Growth depends on the volume of investment. Investment depends on
capital availability. Capital may come from either internal or external source. External
source of capital is costly where as internal generation of funds is economical and
depends on profit making capacity of a firm. Hence, profit maximization would
automatically lead to growth maximization.
Marris assumes that the ownership and control of the firm is in the hands of
two groups of people, ie, owners and managers.
Managers have a utility function in which the amount of salary, status,
position, power, prestige and security of job etc are the most important variables.
Owners are more concerned about the size of output, volume of profits,
market share and sales maximization etc.
Utility function of the managers and that the owners are expressed as follows:
Uo= f [size of output, market share, volume of profit, capital, etc]
Um = f [salaries, power, status, prestige, job security etc]
In view of Marris the realization of these two functions would depend on the
size of the firm. Larger the firm, greater would be the realization of these functions
and viceversa. Size of the firm according to Marris depends on the amount of
corporate capital which includes total volume of assets, inventory levels, cash
reserves etc. He further points out that the managers always aim at maximizing the
rate of growth of the firm rather than growth in absolute size of the firm.
Marris identifies two constraints in the rate of growth of a firm:
1. There is a limit up to which output of a firm can be increased more
economically, limit to manage the firm efficiently, limit to employ highly
qualified and experienced managers, limit to research and development and
innovation etc.
2. The ambition of job security puts a limit to the growth rate of the firm itself
deliberately. If growth reaches the maximum, then there would be no
opportunity to expand further and as such the managers may lose their jobs.
Maximum growth rate [g] is equal to two important variables:
 The rate of demand for the products [gd]
 Growth rate of capital[gc]
Hence, Max g = gd = gc.
The growth rate of the firm depends on two factors
a] the rate of diversification [d]
b] the average profit margin.
The diversification rate depends on the number of new products introduced
per unit of time and the rate of success of new products in the market. The success
of new products is determined by its changes in fashion styles, consumption habits,
the range of products offered etc.

The Marris model states that in order to maximize balanced growth rate or
reach equilibrium position, there should be equality between the growth rate in
demand for the products and growth rate in supply of capital.
This implies the satisfaction of three conditions:
1. The management has to maintain a low liquidity ratio i.e. liquid asset/total assets.
2. The management has to maintain a high ratio between a debt/asset.
3. The management has to keep a high level of retained profits for further
expansion.
Demerits:
1. It is doubtful whether both managers and owners would maximize their utility
functions simultaneously always
2. The assumption of constant price and production costs are not correct.
3. It is difficult to achieve both growth and profit maximization together.
Williamson’s Managerial Discretionary Theory

Prof. O.Williamson has developed a highly useful and most practical
managerial utility model to explain goals of a business firm in recent years. In many
organizations we come across that when once a firm achieves a certain amount of
growth, the top mangers concentrate their attention on maximizing their self interest
and allow the growth rate to continue. Thus, profit maximization and managers’
utility maximization go together.
Assumptions of the model
1. Existence of imperfect markets.
2. Ownership and management is separated.
3. A minimum level of profit is to be achieved by a firm to pay dividends to share
holders.
The model
Williamson is of the opinion that managers, aim at maximizing their
managerial utility functions rather than maximizing total profits of the company.
They feel that a firm is making profit on account of the efforts of top management
and as such they are entitled to certain special privileges and eligible to enjoy special
benefits. The various kinds of managerial satisfaction includes the degree of
freedom, their status, prestige, power enjoyed by them, dominance, professional
excellence, security of their jobs, salary and other perquisites etc. Out of these
variables, only salary is measurable and all other variables are non-measurable.
In order to measure other variables, Williamson introduces the concept of
“expense preference”. The managers’ utility function is expressed as U = f [S, M, Id]
Where, S = Additional expenditure of staff
M = Managerial Emoluments
Id = Discretionary investment
a) Staff expenditure [S] includes the wages and salaries paid to employees who
have to work under the top management. The mangers enjoy more powers to
control their subordinates. Higher wages or salaries are paid in accordance
with their productive ability and professional excellence which certainly would
motivate the workers to work more.
b) Managerial emoluments [M] include expenses on entertainment, luxurious

air-conditioned office, cars and other allowances, given to managers. This
would motivate the managers to do their work in a free manner.
c) Discretionary power of investment expenditure [Id] includes those
investment expenses which confer certain personal benefits and satisfaction
to managers. For example: expenditure on latest equipments, furniture,
decoration materials, etc. These expenses are expected to elevate the status
and esteem of managers. They satisfy their ego and sense of pride.
Williamson has distinguished between the concepts of profits;
1. Actual Profits (π): It is the difference between total revenue (R) less the
production costs (C) and expenditure of staff (S). π = R – C - S
2. Reported Profits (πr): it is the difference between actual profits (π) and non
essential managerial expenditure (M). πr = π - M
3. Minimum Profits (π0): It is the difference between total revenue (R) and total
costs (C). π0 = R – C
4. Discretionary Profits (πD): It is the difference between actual profits (π) minus
minimum profits (π0) and tax to be paid (T). It is the amount left after profits.
πD = π – π0 – T
Discretionary profits should be carefully distinguished from discretionary
investment. Discretionary investment (ID) equals reported profits (πr) minus
minimum profits (π0) after tax (T). ID = πr – π0 – T
All the expenses are included in total cost of operations of a firm. A minimum
amount of profits are required to distribute to share holders. Otherwise, they
demand for a change in management. This would create job insecurity to the
managers. Hence they can maximize their utility functions only when they ensure
reasonable profits to a company.
In this price is regarded as a function of output, the expenditure of staff and
demand shift parameter. P = P(X, S, e)
Where, P = price function
X = output level in a period
S = expenditure on staff
E = demand shift parameter
Pricing
Pricing is a key issue on which depend the prosperity of business firm and
rupee-worth of goods or services to consumers i.e. over-pricing will make the
consumers run away from purchasing and under-pricing will result in loss. The
amount of money paid for the product or service is called Price. To fix a price of a
product on scientific approach, understanding of pricing objectives, methods, policies
and procedures is essential.
Joel Dean defined Pricing as “Pricing Policy is a systematic approach to pricing
decisions that are individual pricing situations generalized and codified into policy
coverage of all the principal pricing problems”.

Objectives: It refers to general and specific objectives which a firm sets for itself in
establishing the price of the products.
1. Maximizing profits 4. Satisfying customers
2. Increasing sales 5. Meet the competition
3. Increasing market share
Pricing Methods
1. Marginal cost pricing: It is also called Break-Even pricing or Target Profit
pricing. The selling price is fixed in such a way that it covers the variable or
marginal cost and contributes towards recovery of fixed costs depending upon
market situations. In time of competition MC offers a guideline as how far the
selling price can be lowered.
2. Market Skimming: When a product is introduced for the first time in the
market, this method is followed. The firm fixes a very low price for the
product to get maximum profit. This method can be followed when demand
for a product is inelastic, no threat from competitors and high quality.
3. Market Penetration: The price of a product is fixed so low that the firm can
increase its share. It is opposite to skimming. This system is suitable in price
sensitive market and where the cost if likely to fall with rise in output i.e. low
price may avoid competition.
4. Bundle pricing: Bundling two or more different products together and selling
them at a single price is called bundling price. This is useful when consumers
are willing to pay for multiple products offered by a firm. Ex: tourist firms,
airlines, etc., with a package deal which consists of travel, lodging, meals,
sight-seeing, etc., at a bundled price instead of pricing separately.
5. Peak Load pricing: It refers to charging of higher price for the products during
peak times than during off-peak times. This system helps the firms not to lose
its business to competitors and gets profit at peak times which cover the loss
during off peak times. Ex: Air India, Jet Airways, etc.
6. Limit pricing: A limit price is the price set by a monopolist to discourage
economic entry into a market, and is illegal in many countries. The limit price
is the price that the entrant would face upon entering as long as the
incumbent firm did not decrease output. The limit price is often lower than
the average cost of production or just low enough to make entering not
profitable.
Internet Pricing Models

Access to internet is provided by number of commercial entities known as
Internet Service providers (ISPs). The role of ISP is that of a mediator between user
and internet. The ISPs is to adopt a most appropriate pricing strategy. The following
are the basic internet access pricing models practiced by various ISPs:
1. Flat Rate Pricing: To start with more number ISPs adopted this pricing
strategy. A flat rate for a certain period of time. Individual bits sent/received
are not priced. The user does not pay any additional amount for usage of any

new applications. It worked well in the beginning but it became difficult to

continue as the internet usage has increased which affected the flow of
internet traffic.
2. Usage-sensitive pricing: In this model the fee paid by the user is divided into
two portions. The first portion of fee is for the connection and second portion
of fee is for the usage of each bit sent or received.
3. Transaction based pricing: Like usage sensitive pricing in this model also first
portion of fee is for connection and second portion of fee is charges on the
characteristics (bandwidth) of transaction no by volume of bits sent or
received.
4. Priority pricing: In this method the user pay according to the quality of service
chosen by them. This pricing allows the ISPs to charge more for important
items by depends on the paying capacity of users i.e. a fixed amount for first
block of units, a higher amount for next block and so on.
5. Charging on basis of Social Cost: This is similar to peak load pricing. The users
during the peak period pay for imposing a congestion cost on the network.
This system of pricing paradoxically makes the congestion actually happen
because it is the interest of the ISPs to create shortage by reducing capacities,
where ISPs are private parties, this congestion will be created in all likelihood.
6. Precedence Model: This model is developed by Bohn in 1994. In this the
existing users are protected by determining the priority of different
applications. Network priority will be assigned to packets based on their
precedence numbers. When there is congestion, the sequence of sending the
packets is decided by the priority assigned.
7. Smart Market mechanism model: Varian and Mackie-Mason in 1995
proposed this model, wherein there is a dynamic bidding system whereby the
price changes by the minute depending on the degree of network congestion.
Each user specified the bit price on each packet and at the time of congestion,
the highest bidder will get the top.

UNIT – V
Types of Industrial Organization & Introduction to Business Cycles
Introduction to Industrial Organisation

Imagine you want to do business. Which are you interested in? For example, you
want to get into InfoTech industry. What can you do in this industry? Which one do you
choose? The following are the alternatives you have on hand:
 You can buy and sell
 You can set up a small/medium/large industry to manufacture
 You can set up a workshop to repair
 You can develop software
 You can design hardware
If you choose any one or more of the above, you have chosen the line of activity. The next
step for you is to decide whether.
 Sole Trader (It means you what to be the only owner).
 Partnership (It means you what to take some more professionals as co-owners).
 Joint Stock Company (It means you want to bring all like-minded people to share the
benefits of the common enterprise).
 Public Enterprises (It means you want to involve government in the IT business).
To decide this, it is necessary to know how to evaluate each of these alternatives.
Characteristic features of Industrial organization

There are certain parameters against which we can evaluate each of the
available forms of business organizations:
1. Easy to start and easy to close: The form of business organization should be
such that it should be easy to close. There should not be hassles or long
procedures in the process of setting up business or closing the same.
2. Division of labour: There should be possibility to divide the work among the
available owners.
3. Large amount of resources: Large volume of business requires large volume
of resources. Some forms of business organization do not permit to raise
larger resources. Select the one which permits to mobilize the large
resources.
4. Liability: The liability of the owners should be limited to the extent of money
invested in business. It is better if their personal properties are not brought
into business to make up the losses of the business.
5. Secrecy: The form of business organization you select should be such that it
should permit to take care of the business secrets. The business units are still
surviving only because they could successfully guard their business secrets.
6. Ownership, Management and control: If ownership, management and
control are in the hands of one or a small group of persons, communication
will be effective and coordination will be easier.
7. Transfer of ownership: There should be simple procedures to transfer the
ownership to the next legal heir.

8. Continuity: The business should continue forever and ever irrespective of the
uncertainties in future.
9. Quick decision-making: Select such a form of business organization, which
permits you to take decisions quickly and promptly. Delay in decisions may
invalidate the relevance of the decisions.
10. Personal contact with customer: Most of the times, customers give us clues
to improve business. So choose such a form, which keeps you close to the
customers.
11. Flexibility: In times of rough weather, there should be enough flexibility to
shift from one business to the other. The lesser the funds committed in a
particular business, the better it is.
12. Taxation: More profit means more tax. Choose such a form, which permits
to pay low tax.
Sole Trader
The sole trader is the simplest, oldest and natural form of business
organization. It is also called sole proprietorship. ‘Sole’ means one. ‘Sole trader’
implies that there is only one trader who is the owner of the business.
It is a one-man form of organization wherein the trader assumes all the risk of
ownership carrying out the business with his own capital, skill and intelligence. He
has total freedom and flexibility. He can take his own decisions. He can choose or
drop a particular product or business based on its merits. He need not discuss this
with anybody. This form of organization is popular all over the world.
Ex: Restaurants, Supermarkets, pan shops, medical shops, etc.
Features:
1. It is easy to start a business under this form and also easy to close.
2. He introduces his own capital. Sometimes, he may borrow, if necessary
3. He enjoys all the profits and in case of loss, he alone suffers.
4. He has unlimited liability which implies that his liability extends to his personal
properties in case of loss.
5. He has a high degree of flexibility to shift from one business to the other.
6. Business secretes can be guarded well.
7. There is no continuity. The business comes to a close with the death, illness or
insanity of the sole trader.
8. He can be directly in touch with the customers.
9. He can take decisions very fast and implement them promptly.
10. Rates of taxes i.e., income tax and so on are comparatively very low.
Advantages
The following are the advantages of the sole trader from of business organization:
1. Easy to start and easy to close: Formation of a sole trader form of
organization is relatively easy even closing the business is easy.
2. Direct contact with customers: Based on the tastes and preferences of the
customers the stocks can be maintained.

3. Prompt decision-making: To improve the quality of services to the customers,

he can take any decision and implement the same promptly. He is the boss
and he is responsible for his business decisions relating to growth or
expansion.
4. Flexibility: Based on the profitability, the trader can decide to continue or
change the business. He has the flexibility to shift from one business to other.
5. Secrecy: Business secrets can well be maintained because there is only one
trader.
6. Low rate of taxation: The rate of income tax for sole traders is relatively very
low.
7. Total Control: The ownership, management and control are in the hands of
the sole trader and hence it is easy to maintain the hold on business.
8. Interference from government: Except in matters relating to public interest,
government does not interfere in the business matters of the sole trader. The
sole trader is free to fix price for his products/services if he enjoys monopoly
market.
9. Transferability: The legal heirs of the sole trader may take the possession of
the business.
10. Direct motivation: If there are profits, all the profits belong to the trader
himself. In other words. If he works more hard, he will get more profits. At the
same time, if he does not take active interest, he may stand to lose badly also.
Disadvantages
The following are the disadvantages of sole trader form:
1. Unlimited liability: The liability of the sole trader is unlimited. It means that
the sole trader has to bring his personal property to clear off the loans of his
business. From the legal point of view, he is not different from his business.
2. Limited amounts of capital: The resources a sole trader can mobilize cannot
be very large and hence this naturally sets a limit for the scale of operations.
3. No division of labour: All the work related to different functions such as
marketing, production, finance, labour and so on has to be taken care of by
the sole trader himself. There is nobody else to take his burden.
4. Uncertainty: There is no continuity in the duration of the business. On the
death, insanity of insolvency the business may be come to an end.
5. No growth and expansion: This from is suitable for only small size, one-man-
show type of organizations. This may not really work out for growing and
expanding organizations.
6. More competition: Because it is easy to set up a small business, there is a high
degree of competition among the small businessmen and a few who are good
in taking care of customer requirements along can service.
7. Low bargaining power: The sole trader have to compromise many times
regarding the terms and conditions of purchase of materials or borrowing
loans from the finance houses or banks.
8. Low bargaining power: The sole trader is the in the receiving end in terms of
loans or supply of raw materials. He may have to compromise many times

regarding the terms and conditions of purchase of materials or borrowing

loans from the finance houses or banks.
Partnership
Partnership is an improved from of sole trader in certain respects. Where
there are like-minded persons with resources, they can come together to do the
business and share the profits/losses of the business in an agreed ratio. Persons who
have entered into such an agreement are individually called ‘Partners’ and
collectively called ‘firm’. The relationship among partners is called a 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
1. Relationship: Partnership is a relationship among persons. It is relationship
resulting out of an agreement.
2. Two or more persons: There should be two or more number of persons.
3. There should be a business: Business should be conducted.
4. Agreement: Persons should agree to share the profits/losses of the business
5. Carried on by all or any one of them acting for all: The business can be
carried on by all or any one of the persons acting for all. This means that the
business can be carried on by one person who is the agent for all other
persons. All the partners are agents and the ‘partnership’ is their principal.
6. Unlimited liability: The liability of the partners is unlimited. The partnership
and partners, in the eye of law, and not different but one and the same.
Hence, the partners have to bring their personal assets to clear the losses of
the firm, if any.
7. Number of partners: According to the Indian Partnership Act, the minimum
number of partners should be two and the maximum is 10 partners is case of
banking business and 20 in case of non-banking business.
8. Division of labour: Because there are more than two persons, the work can be
divided among the partners based on their aptitude.
9. Personal contact with customers: The partners can continuously be in touch
with the customers to monitor their requirements.
10. Flexibility: All the partners are likeminded persons and hence they can take
any decision relating to business.
11. Transferability of share/interest: The partners cannot transfer their
share/interest in partnership in the firm to others without the consent of the
other partners.
12. Taxation: The profits of partnership and individual incomes of partners are
taxed separately.
13. Dissolution: The closure of partnership is called dissolution. When any of the
partners die, becomes insolvent, the partnership can be dissolved or restart
with a new name.

Advantages:
The following are the advantages of the partnership from:
1. Easy to form: Once there is a group of like-minded persons and good business
proposal, it is easy to start and register a partnership.
2. Availability of larger amount of capital: More amount of capital can be raised
from more number of partners.
3. Division of labour: The different partners come with varied backgrounds and
skills. This facilities division of labour.
4. Flexibility: The partners are free to change their decisions, add or drop a
particular product or start a new business or close the present one and so on.
5. Personal contact with customers: There is scope to keep close monitoring
with customers requirements by keeping one of the partners in charge of
sales and marketing. Necessary changes can be initiated based on the merits
of the proposals from the customers.
6. Quick and prompt action: If there is consensus among partners, it is enough
to implement any decision and initiate prompt action. Sometimes, it may
more time for the partners on strategic issues to reach consensus.
7. Tax rate: When compared to a company form, the tax rate is low.
Disadvantages:
The following are the disadvantages of partnership:
1. Formation of partnership is difficult: Only like-minded persons can start a
partnership. It is sarcastically said,’ it is easy to find a life partner, but not a
business partner’.
2. Liability: The partners have joint and several liabilities beside unlimited
liability. Joint and several liability puts additional burden on the partners,
which means that even the personal properties of the partner or partners can
be attached. Even when all but one partner become insolvent, the solvent
partner has to bear the entire burden of business loss.
3. Lack of harmony or cohesiveness: It is likely that partners may not, most
often work as a group with cohesiveness. This result in mutual conflicts, an
attitude of suspicion and crisis of confidence. Lack of harmony results in delay
in decisions and paralyses the entire operations.
4. Instability: The partnership form is known for its instability. The firm may be
dissolved on death, insolvency or insanity of any of the partners.
5. Limited growth: The resources when compared to sole trader, a partnership
may raise little more. But when compare to the other forms such as a
company, resources raised in this form of organization are limited.
6. High tax rate: When compared to the sole trader the tax rate is higher.
7. Lack of Public confidence: Though registration of the firm under the Indian
Partnership Act is a solution of such problem, this cannot revive public
confidence into this form of organization overnight. The partnership can
create confidence in other only with their performance.

Partnership Deed:
The written agreement among the partners is called ‘Partnership Deed’. It
contains the terms and conditions governing the working of partnership. The
following are contents of the partnership deed:
1. Names and addresses of the firm and partners.
2. Nature of the business proposed.
3. Duration of the business.
4. Amount of capital and the ratio of contribution by each of the partners.
5. Their profit sharing ratio (this is used for sharing losses also).
6. Rate of interest charged on capital contributed, loans taken from the
partnership and the amounts drawn, by the partners from their respective
capital balances.
7. The amount of salary or commission payable to any partner.
8. Procedure to value good will of the firm at the time of admission of a new
partner, retirement of death of a partner.
9. Allocation of responsibilities of the partners in the firm.
10. Procedure for dissolution of the firm.
11. Name of the arbitrator to whom the disputes, can be referred for settlement.
12. Special rights, obligations and liabilities of partners(s), if any.
Kinds of Partners:
1. Active Partner: Active partner takes active part in the affairs of the
partnership. He is also called working partner.
2. Sleeping Partner: Sleeping partner contributes to capital but does not take
part in the affairs of the partnership.
3. Nominal Partner: Nominal partner is partner just for namesake. He neither
contributes to capital nor takes part in the affairs of business. Normally, the
nominal partners are those who have good business connections, and are well
places in the society.
4. Partner by Estoppel: Estoppels means behavior or conduct. Partner by
estoppels gives an impression to outsiders that he is the partner in the firm. In
fact be neither contributes to capital, nor takes any role in the affairs of the
partnership.
5. Partner by Holding out: If partners declare a person having social status as
partner and this person does not contradict even after he comes to know such
declaration, he is called a partner by holding out and he is liable for the claims
of third parties. However, the third parties should prove they entered into
contract with the firm in the belief that he is the partner of the firm.
6. Minor Partner: Minor has a special status in the partnership. 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 partner is limited to the extent of his
contribution of the capital of the firm.

Joint Stock Company

The Joint Stock Company emerges from the limitations of partnership such as
joint and several liability, unlimited liability, limited resources and uncertain duration
and so on. Normally, to take part in a business, it may need large money and we
cannot foretell the fate of business. It is not literally possible to get into business with
little money. The main principle is to provide opportunity to take part in business
with a low investment as possible say Rs.1000. Here the capital is divided in to
certain units. Each unit is called a share. The price of each share is so low, that a
common man can afford.
The word ‘ company’ has a Latin origin, com means ‘come together’, pany
means ‘ bread’, joint stock company means, people come together to earn their
livelihood by investing in the stock of company jointly.
Definition:
Companies Act, 1956: defines a company as a company formed and registered under
the act or an existing company.
Lord justice Lindley explained the concept of the joint stock company form of
organization as ‘an association of many persons who contribute money or money’s
worth to a common stock and employ it for a common purpose.
Features:
This definition brings out the following features of the company:
1. Artificial person: The Company has no form or shape. It is an artificial person
created by law. It is intangible, invisible and existing only, in the eyes of law.
2. Separate legal existence: It has an independence existence, it separate from
its members. It can acquire the assets. It can borrow for the company. It can
sue other if they are in default in payment of dues, breach of contract with it,
if any. Similarly, outsiders for any claim can sue it.
3. Voluntary association of persons: The Company is an association of voluntary
association of persons who want to carry on business for profit. To carry on
business, they need capital. So they invest in the share capital of the company.
4. Capital is divided into shares: The total capital is divided into a certain
number of units. Each unit is called a share. The price of each share is priced
so low that every investor would like to invest in the company. The companies
promoted by promoters of good standing are likely to attract huge resources.
5. Limited Liability: The shareholders have limited liability i.e., liability limited to
the face value of the shares held by him. In other words, the liability of a
shareholder is restricted to the extent of his contribution to the share capital
of the company. The shareholder need not pay anything, even in times of loss
for the company, other than his contribution to the share capital.
6. Transferability of shares: In the company form of organization, the shares can
be transferred from one person to the other. A shareholder of a public
company can cell sell his holding of shares at his will. A private company
restricts the transferability of the shares.

7. Perpetual succession: ‘Members may come and members may go, but the
company continues forever and ever’. A company has uninterrupted existence
because of the right given to the shareholders to transfer the shares.
8. Common Seal: As the company is an artificial person created by law has no
physical form, it cannot sign its name on a paper; so, it has a common seal on
which its name is engraved. The common seal should affix every document or
contract; otherwise it is not bound by such a document or contract.
9. Ownership and Management separated: The shareholders are spread over
the country, and sometimes, they are from different parts of the world. To
facilitate administration, the shareholders elect some among themselves or
the promoters of the company as directors to a Board, which looks after the
management of the business. The Board recruits the managers and employees
at different levels in the management.
10. Winding up: Winding up refers to the putting an end to the company. Because
law creates it, only law can put an end to it in special circumstances such as
representation from creditors of financial institutions, or shareholders against
the company that their interests are not safeguarded. The company is not
affected by the death or insolvency of any of its members.
11. The name of the company ends with ‘limited’: it is necessary that the name
of the company ends with limited (Ltd.) to give an indication to the outsiders
that they are dealing with the company with limited liability and they should
be careful about the liability aspect of their transactions with the company.
Advantages:
The following are the advantages of a joint Stock Company
1. Mobilization of larger resources: A joint stock company provides opportunity
for the investors to invest, even small sums, in the capital of large companies.
The facilities rising of larger resources.
2. Separate legal entity: The Company has separate legal entity. It is registered
under Indian Companies Act, 1956.
3. Limited liability: The shareholder has limited liability in respect of the shares
held by him. In no case, does his liability exceed more than the face value of
the shares allotted to him.
4. Transferability of shares: The shares can be transferred to others. However,
the private company shares cannot be transferred.
5. Democracy in management: The shareholders elect the directors in a
democratic way in the general body meetings. The shareholders are free to
make any proposals, question the practice of the management, suggest the
possible remedial measures.
6. Continued existence: The Company has perpetual succession. It has no
natural end. It continues forever and ever unless law put an end to it.
7. Institutional confidence: Financial Institutions prefer to deal with companies
in view of their professionalism and financial strengths.
8. Professional management: With the larger funds at its disposal, the Board of
Directors recruits competent and professional managers to handle the affairs
of the company in a professional manner.

9. Growth and Expansion: With large resources and professional management,

the company can earn good returns on its operations, build good amount of
reserves and further consider the proposals for growth and expansion.
Disadvantages:
1. Formation of company is a long procedure: Promoting a joint stock company
involves a long drawn procedure. It is expensive and involves large number of
legal formalities.
2. High degree of government interference: The government brings out a
number of rules and regulations governing the internal conduct of the
operations of a company such as meetings, voting, audit and so on, and any
violation of these rules results into statutory lapses, punishable under the
companies act.
3. Inordinate delays in decision-making: As the size of the organization grows,
the number of levels in organization also increases in the name of
specialization. The more the number of levels, the more is the delay in
decision-making.
4. Lack of initiative: In most of the cases, the employees of the company at
different levels show slack in their personal initiative with the result, the
opportunities once missed do not recur and the company loses the revenue.
5. Lack of responsibility and commitment: In some cases, the managers at
different levels are afraid to take risk and more worried about their jobs
rather than the huge funds invested in the capital of the company.
6. Higher Taxes: The rate of income tax is very high when compared to the other
forms of organizations.
FORMATION OF JOINT STOCK COMPANY:

There are two stages in the formation of a joint stock company. They are:
1. Certificate of Incorporation: The certificate of Incorporation is just like a ‘date of
birth’ certificate. It certifies that a company is born on a particular day.
2. Certificate of commencement of Business: A private company need not obtain
the certificate of commencement of business. It can start its commercial
operations immediately after obtaining the certificate of Incorporation.
The persons who conceive the idea of starting a company and who organize
the necessary initial resources are called promoters. The promoters have to file the
following documents, along with necessary fee, with a registrar of joint stock
companies to obtain certificate of incorporation:
(a) Memorandum of Association: The Memorandum of Association is also called
the charter of the company. It outlines the relations of the company with the
outsiders. If furnishes all its details in six clauses such as: Name clause,
Situation clause, Objects clause, Capital clause, Liability clause and
Subscription clause.
(b) Articles of association: Articles of Association furnishes the byelaws or
internal rules government the internal conduct of the company.
(c) The list of names and address of the proposed directors and their willingness,
in writing to act as such, in case of registration of a public company.

(d) A statutory declaration that all the legal requirements have been fulfilled. It
has to be duly signed by any one of the following: Company secretary, the
director, legal solicitor, chartered accountant or advocate of High court.
The registrar of joint stock companies peruses and verifies whether all these
documents are in order or not. If he is satisfied, he will register the documents and
issue a certificate of incorporation. In case of private company, it can start its
business operations immediately after obtaining certificate of incorporation. If it is a
public company needs further details are to be furnished:
a) Seek permission from Securities Exchange Board of India (SEBI): The
promoters have to make an application furnishing the details of certificate of
incorporation, seeking permission to issue prospectus.
b) File prospectus with Registrar: After seeking permission from SEBI, file the
prospectus with the registrar of Joint Stock Company. Prospectus is a notice,
letter or circular inviting the public to subscribe the share capital of company.
c) Collecting minimum subscription: It refers to minimum amount of capital
required to start the business operations.
d) Allotting Shares: Shares are allotted as applied for with the consultation of
stock exchange on lottery basis.
e) Apply to registrar for certificate of commencement of business: The registrar
will verify the details and if he is satisfied, he will issue Certificate of
Commencement of Business.
KINDS OF COMPANIES:
The companies are based on 5 different categories:
1. On the basis of Incorporation:
1. Chartered companies: Companies which are incorporated under special
character granted by a king or queen or by a royal charter of state are known
as chartered companies. Ex: East India Company
2. Statutory companies: Companies which are created by a special Act of the
state legislature or Parliament are known as statutory companies. Ex: Reserve
Bank of India, Unit Trust of India and Industrial Finance Corporation of India.
3. Registered companies: Companies which are formed and registered under the
Companies Act 1956 or were registered under any of the earlier Companies
Act are known as registered companies. Ex: Public Ltd. Co., Private Ltd. Co.
2. On basis of Nationality:
1. Foreign Company: Companies incorporated outside India but established a
part of business in India & which comes under the Indian Companies Act 1956.
2. Indian Company: The Company incorporated in India under Indian Companies
Act 1956 is called as Indian Companies.
3. On the basis of Liability:
1. Companies limited by shares: In case of such a company the liability of the
shareholder is limited to the amount unpaid on the shares held by him. The
liability can be enforced by the company during its existence or during the
winding up of the company.

2. Company limited by guarantee: A company in which the liability of the

members is limited to the amount which they undertake to contribute to the
assets of the company. In other words, the liability of the members is limited
to the amount guaranteed by them.
3. Companies with unlimited liability: These are companies in which the
numbers have an unlimited liability. Every member of such a company is liable
for the debts of the company, as in an ordinary partnership firm.
4. On the basis of Controlling Interest:
1. Holding companies: A holding company is a company, which has control over
other company. A company is a holding company if it:
(a) controls the composition of the Board of Directors of another company
(b) controls more than half the total voting power of such company
(c) it holds more than half in nominal value of its equity share capital.
2. Subsidiary companies: A subsidiary company is a company, which is
controlled by another company.
5. On the basis of Ownership/Public Interest:
1. Government Company: A Government company is a company in which not
less than 51 percent of the paid-up share capital is held by the Central
government and/or by the State Government or partly by Central Government
and partly by one or more State governments.
2. Private company: It means a company that has a minimum paid-up capital of
one lakh or higher paid up capital. The number of members is limited to 50.
The name must end with words private limited (Pvt. Ltd.).
3. Public company: As per the Companies Act, 1956 a company means, which is
not a private company. The minimum paid up capital is 5 lakh or above. It
allows transferring their shares. It can be formed by a minimum of 7 members
although there is not maximum limit to its membership. It must have the word
"limited" (Ltd.) in its name.
Public Enterprises and their Types

Public enterprise is one of the government participant businesses. There are
certain areas such as defence, infrastructure, heavy industries, etc where private
participation was not possible and hence government had to enter the business.
Many basic and key industries have been set up, employment opportunities at
different levels have been generated, generated funds for the government,
stimulating growth in private sector, taking over of sick units & putting them in order,
creating a powerful network of financial institutions by nationalization and so on.
Features for Public Enterprises:
The Industrial Policy Resolution 1956 states the need for promoting public
enterprises as follows:
 To accelerate the rate of economic growth by planned development.
 To speed up industrialization, particularly development of heavy industries
and to expand public sector and to grow cooperative sector.
 To increase infrastructure facilities.

 To disperse the industries over different geographical areas for balanced

regional development.
 To increase the opportunities of employment.
 To help in raising the standards of living.
 To reducing disparities in income and wealth.
Forms of public enterprises
Public enterprises can be classified into three forms:
(a) Departmental undertaking
(b) Public corporation
(c) Government company
Departmental Undertaking
This is the earliest from of public enterprise. Under this form, the affairs are
carried out under the overall control of one of the departments of the government.
The government appoints a managing director and he will be given the executive
authority to take necessary decisions. It does not have a budget of its own. As and
when it wants, it draws money from the government exchequer and when it has
surplus money, it deposits it in the government exchequer. However, it is subject to
budget, accounting and audit controls.
Ex: Railways, Postal Department, All India Radio, Doordarshan, Defence, etc.
Features
1. Under the control of a government department: The departmental
undertaking is not an independent organization. It has no separate existence.
It is designed to work under close control of a government department. It is
subject to direct ministerial control.
2. More financial freedom: The departmental undertaking can draw funds from
government account as per the needs and deposit back when convenient.
3. Like any other government department: The departmental undertaking is
almost similar to any other government department
4. Budget, accounting and audit controls: The departmental undertaking has to
follow guidelines (as applicable to the other government departments)
underlying the budget preparation, maintenance of accounts, and getting the
accounts audited internally and by external auditors.
5. More a government organization, less a business organization . The set up of
a departmental undertaking is more rigid, less flexible, slow in responding to
market needs.
Advantages
1. Effective control: Control is likely to be effective because it is directly under
the Ministry.
2. Responsible Executives: Normally the administration is entrusted to a senior
civil servant. The administration will be organized and effective.
3. Less scope for mystification of funds: Departmental undertaking does not
draw any money more than is needed, that too subject to ministerial sanction
and other controls. So chances for mis-utilisation are low.

4. Adds to Government revenue: The revenue of the government is on the rise

when the revenue of the departmental undertaking is deposited in the
government account.
Disadvantages
1. Decisions delayed: Control is centralized. This results in lower degree of
flexibility. Officials in the lower levels cannot take initiative. Decisions cannot
be fast and actions cannot be prompt.
2. No incentive to maximize earnings: The departmental undertaking does not
retain any surplus with it. So there is no inventive for maximizing the
efficiency or earnings.
3. Slow response to market conditions: Since there is no competition, there is
no profit motive; there is no incentive to move swiftly to market needs.
4. Redtapism and bureaucracy: The departmental undertakings are in the
control of a civil servant and under the immediate supervision of a
government department. Administration gets delayed substantially.
5. Incidence of more taxes: In case of losses, these are made up by the
government funds only. To make up these, there may be a need for fresh
taxes, which is undesirable.
Public Corporation
The Government of India, in 1948, decided to organize some of its enterprises
as statutory corporations. Public corporation is a ‘right mix of public ownership,
public accountability and business management for public ends’.
A public corporation is defined as a ‘body corporate create by an Act of
Parliament or Legislature and notified by the name in the official gazette of the
central or state government. It is a corporate entity having perpetual succession, and
common seal with power to acquire, hold, dispose off property, sue and be sued by
its name”. Ex: LIC, UTI, IFCI, etc.
Features
1. A body corporate: It has a separate legal existence. If can raise resources, buy
and sell properties, by name sue and be sued.
2. More freedom and day-to-day affairs: It is relatively free from any type of
political interference. It enjoys administrative autonomy.
3. Freedom regarding personnel: The employees of public corporation are not
government civil servants. The corporation has absolute freedom to formulate
its own personnel policies and procedures, and these are applicable to all the
employees including directors.
4. Perpetual succession: A statute in parliament or state legislature creates it. It
continues forever and till a statue is passed to wind it up.
5. Financial autonomy: Through the public corporation is fully owned
government organization and the initial finance are provided by the
Government, it enjoys total financial autonomy.

6. Commercial audit: Except in the case of banks and other financial institutions
where chartered accountants are auditors, in all corporations, the audit is
entrusted to the comptroller and auditor general of India.
Advantages
1. Independence, initiative and flexibility: The Corporation has an autonomous
set up. So it is independent, take necessary initiative to realize its goals, and it
can be flexible in its decisions as required.
2. Public interest protected: Public interests are protected because every policy
of the corporation is subject to ministerial directives and board parliamentary
control.
3. Employee friendly work environment: Corporation can design its own work
culture and train its employees accordingly. It can provide better amenities
and better terms of service to the.
4. Competitive prices: the corporation is a government organization and hence
can afford with minimum margins of profit, It can offer its products and
services at competitive prices.
5. Economics of scale: By increasing the size of its operations, it can achieve
economics of large-scale production.
6. Public accountability: It is accountable to the Parliament or legislature; it has
to submit its annual report on its working results.
Disadvantages:
1. Continued political interference: the autonomy is on paper only and in reality,
the continued.
2. Misuse of Power: In some cases, the greater autonomy leads to misuse of
power. It takes time to unearth the impact of such misuse on the resources of
the corporation. Cases of misuse of power defeat the very purpose of the
public corporation.
3. Burden for the government: Where the public corporation ignores the
commercial principles and suffers losses, it is burdensome for the government
to provide subsidies to make up the losses.
Government Company
Section 617 of the Indian Companies Act defines a government company as
“any company in which not less than 51 percent of the paid up share capital” is held
by the Central Government or by any State Government or Governments or partly by
Central Government and partly by one or more of the state Governments and
includes and company which is subsidiary of government company as thus defined”.
Ex: HMT, Indian Telephone Industries, NIDC, Hindustan Shipyard/cables, etc.
Features:
1. Like any other registered company: It is incorporated as a registered company
under the Indian companies Act 1956. Like any other company, the

government company has separate legal existence. Common seal, perpetual

succession, limited liability, and so on.
2. Shareholding: The majority of the share are held by the Government, Central
or State, partly by the Central and State Government(s), in the name of the
President of India.
3. Directors are nominated: As the government is the owner of the entire or
majority of the share capital of the company, it has freedom to nominate the
directors to the Board.
4. Administrative autonomy and financial freedom: A government company
functions independently with full discretion and in the normal administration
of affairs of the undertaking.
5. Subject to ministerial control: Concerned minister may act as the immediate
boss. It is because it is the government that nominates the directors, the
minister issue directions for a company any time.
Advantages:
1. Formation is easy: There is no need for an Act in legislature or parliament to
promote a government company. A Government company can be promoted
as per the provisions of the companies Act.
2. Separate legal entity: It retains the advantages of public corporation such as
autonomy, legal entity.
3. Ability to compete: It is free from the rigid rules and regulations. It can
smoothly function with all the necessary initiative and drive necessary to
complete with any other private organization.
4. Flexibility: A Government company is more flexible than a departmental
undertaking or public corporation. Necessary changes can be initiated, which
the framework of the company law. The form of Government Company is so
flexible that it can be used for taking over sick units.
5. Quick decision and prompt actions: In view of the autonomy, the government
company take decision quickly and ensure that the actions and initiated
promptly.
6. Private participation facilitated: Government company is the only from
providing scope for private participation in the ownership. The facilities to
take the best, necessary to conduct the affairs of business, from the private
sector and also from the public sector.
Disadvantages:
1. Continued political and government interference: Government is the major
shareholder and it dictates its decisions to the Board. The Board of Directors
gets these approved in the general body and these were influenced by the
civil servants and the ministers.
2. Higher degree of government control: The degree of government control is so
high that the government company is reduced to mere adjuncts to the
ministry and is, in majority of the cases, not treated better than the
subordinate organization or offices of the government.

3. Evades constitutional responsibility: A government company is creating by

executive action of the government without the specific approval of the
parliament or Legislature.
4. Poor sense of commitment: The members of the Board and from the
ministerial departments lack the sense of attachment and do not reflect any
degree of commitment to lead the company in a competitive environment.
5. Divided loyalties: The employees are mostly drawn from the regular
government departments for a defined period. After this period, they go back
to their departments and hence their divided loyalty dilutes their interest
towards their job in the government company.
6. Flexibility on paper: The powers of the directors are to be approved by the
concerned Ministry, particularly the power relating to borrowing, increase in
the capital, appointment of top officials, entering into contracts for large
orders and restrictions on capital expenditure.
Introduction to business cycles

Business cycles are a part of the capital economic system. An economy never
runs smoothly, there are upwards swings and then downward swings in the business.
Business cycles are associated with sweeping fluctuations in economic activity such
as production prices, employment, etc.
Meaning:
According to W.C.Mitchell, “Business cycles are a species of fluctuations in the
economic activities of organized communities.”
According to Keynes, “A trade cycle is composed of periods of good trade
characterized by rising prices and low unemployment percentages altering with
periods of bad trade characterized by falling prices and high unemployment
percentages”.
Phases of Business Cycles

Business cycles are fluctuations in the economic activities. The phases of
Business Cycles are divided in to five categories:
.
1. Depression: Depression is characterized a sharp reduction of production, mass

unemployed, low employed, falling prices, falling profits, low wages, contraction
of credit, a high rate of business failures and as atmosphere of all around. A
general decline in economic activity leads to a fall in bank deposits. A decline in
output is accompanied by a reduction in the volume of unemployment.
2. Recovery: Recovery implies in urge in business activity after a lowest point of the
depletion has reached. During this phase, there is a slight improvement in
economic activity. This leads to further expansion of business activity the
industrial production picks up slowly and gradually. The volume of employment
increases, small rise in profits, wages also rise. The banks also expand credit.
Ultimately revival enters the prosperity phase.

3. Prosperity: In this stage the demand, output, employment and income are at a
high level. They tend to raise prices. But wages, salaries, interest rates, rental and
taxes do not rise in proportion to the rise in prices. The gap between the prices
and costs increases in the margin of profit. They lead to considerable expansion in
economic activity by increasing the demand for consumer goods and further
raising the price level.
4. Boom: It is the stage of rapid expansion in business activity to new high marks
resulting in high stocks and commodity prices, high profits and overall
employment. The continuance on investment even after the stage of full
employment results is a sharp inflation may raise the prices. Boom is a situation
develops in which the number of jobs exceeds the number of workers available in
the market. The rising profits, increases their capital which leads to rise in price
level.
5. Recession: The feeling of optimism in the boom period is replaced now by over
pessimism by fear on part of the businessman. The failure of some business
creates panic among businessmen. The prices collapse, unemployment leads to
fall in income, and profits.
Features of Business Cycles

Business Cycles posses the following characteristic features:
1. Cyclical fluctuations are wave like shifts.
2. Fluctuations are recurring in nature.
3. They are non-periodic or uneven. In other words the peaks and channel do
not occur at usual intervals.
4. They transpire in such total variables as productivity, earnings, employment
and prices.
5. These variables move at about the same period in the same course but at
diverse rates.
6. Business cycles are not seasonal variations such as upswings in retail trade
during festive seasons.
7. They are not secular trends such as long run growth or decline in fiscal
performance.
8. Upswings and downswings are collective in their effects.
Therefore, business cycles are recurring fluctuations in total employment,
earnings, productivity and price level.

UNIT – VI
Introduction to Financial Accounting
Introduction to Double Entry System

Every trader generally starts business for the purpose of earning profit. So he
establishes business with capital, purchases machinery, raw materials, etc., buys and
sells goods and incurs some expenses. So at the end of the period he wants to know
whether his business has made profit or loss. For this purpose he prepares profit and
loss account and also to know what he owns (assets) and what he owes (liabilities),
he prepares Balance Sheet. Hence accounting is the Language of Business.
Accountancy means the compilation of accounts in such a way that one is in a
position to know the state of affairs of the business.
American Institute of Certified Public Accountants (AICPA): “The art of
recording, classifying and summarizing in a significant manner and in terms of money
transactions and events, which are in part at least, of a financial character and
interpreting the results thereof.”
Objectives:
1. To maintain the records of business systematically.
2. To calculate profit or loss for a specific period.
3. To ascertain financial position by preparing Balance sheet.
4. To communicate financial information to various interested parties.
Branches of Accounting:
The important branches of accounting are:
1. Financial Accounting: The purpose of Accounting is to ascertain the financial
results i.e. profit or loss during a specific period and know the financial position,
i.e. assets, liabilities and equity position at the end of the period.
2. Cost Accounting: The purpose of this branch of accounting is to ascertain the
cost of a product / operation / project and the costs incurred for carrying out
various activities. It also assists the management in controlling the costs.
3. Management Accounting: Its aim to assist the management in taking correct
policy decision and to evaluate the impact of its decisions and actions. The data
required for this purpose are drawn accounting and cost-accounting.
Users of Accounting Information:

Different categories of users need different kinds of information for making
decisions. The users of accounting can be divided in two board groups:
Internal Users:
1. Owners: To know the profit and loss of their business and the financial status
of the business.
2. Managers: These are the persons who manage the business. Accounting
information also helps the managers in appraising the performance of

subordinates. As such Accounting is termed as “the eyes and ears of

management.”
External Users:
1. Investors: Those who are interested in buying the shares of company are
naturally interested in the financial statements to know how safe the
investment already made is and how safe the proposed investments will be.
2. Creditors: Lenders are interested to know whether their loan, principal and
interest, will be paid when due. Suppliers and other creditors are also
interested to know the ability of the firm to pay their dues in time.
3. Workers: In our country, workers are entitled to payment of bonus which
depends on the size of profit earned. Hence, they would like to be satisfied
that he bonus being paid to them is correct. This knowledge also helps them in
conducting negotiations for wages.
4. Customers: They are also concerned with the stability and profitability of the
enterprise. They may be interested in knowing the financial strength of the
company to rent it for further decisions relating to purchase of goods.
5. Government: Governments all over the world are using financial statements
for compiling statistics concerning business which, in turn, helps in compiling
national accounts. The financial statements are useful for tax authorities for
calculating taxes.
Accounting Terminology:
1. Transactions: Any sale or purchase of goods or services is called the transaction.
Transactions are two types.
a) Cash transaction: cash transaction is one where cash receipt or payment is
involved in the exchange.
b) Credit transaction: Credit transaction will not have cash, either received
or paid, for something given or received respectively.
2. Account: A summarized statements of transactions relating to a particular
person, thing, Expense or income.
3. Expenses: These are payments for the purchase of goods and services.
a) Revenue Expenditure: It refers to expenses incurred for running the
business. Ex: wages, salaries, rent, etc.
b) Capital Expenditure: It refers to expenses incurred to acquire fixed assets.
4. Revenue: It is the amount receivable from the sale of goods or services.
a) Revenue Receipts: It refers to those receipts from customers for goods
supplied or fees received. Ex: rent, commission, discount received, etc.
b) Capital Receipts: It refers to receipts from sale of fixed assets.
5. Assets: These are the properties owned by the business. It is of two types:
a) Fixed Assets: It is of two types:
i. Tangible Assets: The assets which can be seen, touch or felt and which are
fixed & permanent in nature. Ex: land, buildings, machinery, furniture, etc.
ii. In-tangible Assets: The assets which cannot be felt or touched. Ex:
goodwill, patents, copyrights, etc.

b) Current Assets: These are expected to be realized in cash or consumed during

business operations. Ex: debtors, stock, bills receivable, etc.
6. Liabilities: Liabilities are the obligations or debts payable by the firm in future in
the term of money or goods. It refers to what the firm owes to outsiders.
7. Debtors: Debtors means a person who owes money to the trader.
8. Creditors: A creditor is a person to whom something is owned by the business.
9. Drawings: cash or goods withdrawn by the proprietor from the Business for his
personal or household is termed to as “drawing”.
10. Reserve: An amount set aside out of profits or other surplus to meet
contingencies.
11. Discount: There are two types of discounts:
a) Cash discount: An allowable made to encourage frame payment or before the
expiration of the period allowed for credit.
b) Trade discount: A deduction from the gross or catalogue price allowed to
traders who buys them for resale.
Basic Accounting Concepts

There are certain guidelines in identifying the events and transactions to be
accounted for measuring, recording, summarizing and reporting them to the
interested parties. These rules and conventions are termed as Generally Accepted
Accounting Principles. These principles are also referred as standards, assumptions,
concepts, conventions doctrines, etc. These are broadly classified in to two
categories: Accounting Concepts and Accounting Conventions.
Accounting Concepts:
1. Business Entity Concept: In this concept “Business is treated as separate from
the proprietor”. All the transactions recorded in the book of Business and not
in the books of proprietor i.e. he is also treated as a creditor for the Business.
2. Going Concern Concept: This concept relates with the long life of Business.
The assumption is that business will continue to exist for unlimited period
unless it is dissolved due to some reasons or the other.
3. Money Measurement Concept: In this concept “Only those transactions are
recorded in accounting which can be expressed in terms of money, those
transactions which cannot be expressed in terms of money are not recorded
in the books of accounting”.
4. Cost Concept: In this concept an asset is recorded at its cost in the books of
account. i.e., the price at which is paid at the time of acquiring it. In balance
sheet, these assets appear not at cost price every year, but depreciation is
deducted and they appear at the amount, which is cost, less classification.
5. Accounting Period Concept: every Businessman wants to know the result of
his investment and efforts after a certain period. Usually one-year period is
regarded as an ideal for this purpose. This period is called Accounting Period.
It depends on the nature of the business and object of the business.
6. Matching Cost Concept: According to this concept “The expenses incurred
during an accounting period, e.g., if revenue is recognized on all goods sold
during a period, cost of those good sole should also be charged to that period.
7. Realization Concept: According to this concept revenue is recognized when a

sale is made. Sale is Considered to be made at the point when the property in
goods posses to the buyer and he becomes legally liable to pay.
8. Dual Aspect Concept: According to this concept “Every business transactions
has two aspects”, one is the receiving benefit aspect termed as DEBIT and
another one is giving benefit aspect termed as CREDIT. Therefore for every
debit there will be corresponding credit.
Accounting Conventions:
1. Full Disclosure: According to this convention accounting reports should disclose
fully and fairly the information. They should be prepared honestly and sufficiently
disclose information which is if material interest to proprietors, present and
potential creditors and investors.
2. Materiality: Under this convention the trader records important factor about the
commercial activities. In the form of financial statements if any unimportant
information is to be given for the sake of clarity it will be given as footnotes.
3. Consistency: It means that accounting method adopted should not be changed
from year to year. There should be consistent in the methods or principles
followed or else the results of a year cannot be compared with that of another.
4. Conservatism: This convention warns the trader not to take unrealized income in
to account. That is why the practice of valuing stock at cost or market price,
whichever is lower is in vague. This is the policy of “playing safe”; it takes in to
consideration all prospective losses but leaves all prospective profits.
Types of Accounts and Rules

The accounts are maintained for recording all business transactions. They are
divided in to 3 types:
1. Personal Accounts: Accounts which shows transactions related to persons are
called Personal Accounts. Ex: Gopal’s A/C, SBI A/C, X Finanace Ltd. A/C, Capital
A/C, Drawings A/C, etc.
Rule: The account of the person receiving benefit (receiver) is to be debited
and the account of the person giving the benefit (given) is to be credited.
“Debit----The Receiver and Credit---The Giver”
2. Real Accounts: The accounts relating to properties or assets are known as Real
Accounts. Every business needs assets such as machinery, furniture, etc, for
running its activities. Ex: cash A/C, furniture A/C, building A/C, machinery A/C etc.
Rule: When an asset is coming into the business is to be debited. When an
asset is going out of the business the account is to be credited.
“Debit----What comes in and Credit---What goes out”
3. Nominal Accounts: Accounts relating to expenses, losses, incomes and gains are
known as Nominal Account”. Ex: Salaries A/C, stationery A/C, wages A/C, postage
A/C, rent received A/C, etc.

Rule: When an expense is incurred or loss encountered, the account is to be

debited. When any income is earned or gain made, the account is to be
credited.
“Debit----All expenses and losses and Credit---All incomes and gains”

JOURNAL
The word Journal is derived from the Latin word ‘journ’ which means “a day”.
Journal is the first book in which transactions are recorded in chronological order
(date wise), the moment they take place in the business. It is also called Day Book,
Book of original entry, First entry and Prime Entry book.
The process of recording a transaction in the journal is called “Journalising”.
The entries made in the book are called “Journal Entries”. The Performa of Journal:
Journal Entries in the Books of ……….
L.F. Debit Credit
Date Particulars
No Rs. Rs.
2008 Cash A/c Dr. 500
Jan-10 To Capital A/c 500
(Being started business with cash)
1. Date: To write the date of the transaction.
2. Particulars: To write the names of the accounts and its description. Every
entry has two aspects i.e. Debit and Credit. The name of the account to be
debited is written on left side followed by “Dr.” (indicates Debit). The name of
the account to be credited is written in next line using “To” before the account
name. In next line the description of the transaction is written within brackets,
starting with the word “Being”.
3. Ledger Folio (L.F. No.): To write the page number of the account in ledger.
4. Debit (Rs.): To write the amount to be debited.
5. Credit (Rs.): To write the amount to be credited.
LEDGER
“A ledger is a book which contains various accounts.” After a certain period, if
we want to know whether a particular account is showing a debit or credit balance,
ledger is prepared. The process of transferring entries from journal to ledger is called
“Posting”. Posting into ledger is done periodically, may be weekly or fortnightly as
per the convenience of the business. The format of ledger A/c is “T” shape. The left
hand side is debit side (Dr.) and right hand side is credit side (Cr.).
Dr. Particulars A/c Cr.
JF. Amount JF. Amount
Date Particulars Date Particulars
No Rs. No Rs.
1. Date: Write here the date of the transaction as noted in Journal.

2. Particulars: Every entry on the debit side of this column must begin with the
word 'To' and on credit side with the word 'By'.

a) On the debit side of the account after the word 'To' write "Name of the
Credit Part of the Journal entry.
b) On the credit side of the account, after the word' By' write 'Name of the
Debit Part of the Journal entry'.
3. Journal Folio: Write page number of Journal from where the entry is posted.
4. Amount: Write here the amounts of the transaction on debit & credit side.
Balancing an Account:
Accounts are balanced with a view to prepare the final accounts. Take the
totals of the two sides of account and enter the higher balance on both the sides.
Enter the difference amount and write “To/By balance c/d” against the balance. The
balance is brought forward at the beginning of next period written as “To/By balance
b/d”. If the debit and credit balance are equal it implies nil balance.
Trail Balance
The first step in the preparation of final accounts is the preparation of trail
balance. In the double entry system of book keeping, there will be credit for every
debit. A trail balance is a statement of debit and credit balances. It is prepared on a
particular date with the object of checking the accuracy of the books of accounts.
Spicer and Poglar: A trail balance is a list of all the balances standing on the ledger
accounts and cash book of a concern at any given date.
Trail balance for Mr…………………………… as on …………
No. Name of account (Particulars) Debit Amount (Rs.) Credit Amount(Rs.)
Final Accounts
Every business man is interested in knowing whether the business has
resulted in profit or loss and what the financial position of the business is at a given
time. The final accounts are prepared from the trial balance. Hence the trial balance
is said to be the link between the ledger accounts and the final accounts. The final
accounts of a firm can be divided into two stages:
1. The first stage is preparing the Trading A/c and Profit & Loss A/c.
2. The second stage is preparing the Balance Sheet.
Trading Account
The main purpose of preparing the trading account is to ascertain gross profit
or gross loss as a result of buying and selling the goods.
Dr. Trading A/c of Mr.…………………. for the year ended ……………… Cr.
Particulars Amount Particulars Amount

To Opening Stock Xxxx By Sales xxxx

To Purchases xxxx Less: Returns xxx Xxxx
Less: Returns xx Xxxx By Closing Stock Xxxx
To Carriage Inwards Xxxx
To Wages Xxxx
To Freight Xxxx
To Customs Duty, Octroi Xxxx
To Gas, Fuel, Coal, Water Xxxx
To Factory Expenses Xxxx
To Other Mfg. Expenses Xxxx
To Gross Profit c/d Xxxx
Xxxx Xxxx
Profit And Loss Account
The business man is always interested to know his Net Profit. It represents the
excess of gross profit plus the other revenue. The debit side of Profit & Loss A/c
shows the expenses and the credit side the incomes. If the total of the credit side is
more, it will be the Net Profit. And if the debit side is more, it will be Net Loss.
Dr. Profit & Loss A/c of Mr…………………….for the year ended………… Cr.
To Gross Loss b/d Xxxx By Gross Profit b/d Xxxx
To Office Salaries Xxxx By Interest received Xxxx
To Rent, Rates, Taxes Xxxx By Discount received Xxxx
To Printing & Stationery Xxxx By Commission received Xxxx
To Legal Charges, Audit fee Xxxx By Investments Xxxx
To Insurance, Interest Xxxx By Dividend on shares Xxxx
To General Expenses Xxxx By Rent received Xxxx
To Administrative Expenses Xxxx By Net Loss ------- 
To Advertisements Xxxx (transferred to capital a/c)
To Bad Debts Xxxx
To Carriage Outwards Xxxx
To Repairs Xxxx
To Depreciation Xxxx
To Interest on Capital, Loans Xxxx
To Discount Allowed Xxxx
To Commission Allowed Xxxx
To Net Profit ------ Xxxx
(transferred to capital a/c) Xxxx
Xxxxx Xxxxx
Balance Sheet
It is prepared often after the Trading A/c and Profit & Loss A/c have been
compiled and closed. A balance sheet may be considered as a statement of the
financial position of the concern at a given date. On the left-hand side of this
statement, the liabilities and the capital are shown. On the right-hand side all the
assets are shown. Therefore, the two sides of the balance sheet should be equal.
Otherwise, there is an error somewhere.
Definition:
According to J.R.Botliboi - “A balance sheet is a statement with a view to
measure exact financial position of a business at a particular date”.
Balance Sheet of Mr. …………………… as on ………………………

Liabilities Amount Assets Amount
Capital Xxxx Cash in Hand Xxxx
Add: Net Profit Xxxx Cash at Bank Xxxx
Xxxx Bills Receivable Xxxx
Less: Drawings Xxxx Debtors Xxxx
Net Loss Xxxx Xxxx Less: Bad Debts Xxxx Xxxx
Creditors Xxxx Investments Xxxx
Bills Payable Xxxx Furniture & Fittings Xxxx
Bank Overdraft Xxxx Plant & Machinery Xxxx
Loans Xxxx Less: Depreciation Xxxx Xxxx
Mortgage Xxxx Land & Buildings Xxxx
Reserve fund Xxxx Less: Depreciation Xxxx Xxxx
Outstanding Expenses Xxxx Patents, Copyrights Xxxx
Goodwill, Trade Marks Xxxx
Prepaid Expenses Xxxx
Outstanding Incomes Xxxx
Closing Stock Xxxx
XXXX XXXX
Final Accounts – Adjustments:

The adjustments to be made to final accounts will be given under the Trial
Balance. Every adjustment is to be made in the final accounts twice: once in Trading
A/c and Profit & Loss A/c and other in Balance Sheet. The following are some of the
important adjustments to be made at the time of preparing of final accounts:
Item If given in Trail Balance If given in Adjustment
Closing Stock Shown only in balance 1. Posted in credit side of Trading A/c.
sheet “Assets Side”. 2. Shown in asset side of Balance Sheet.
Outstanding Shown only in liability 1. Added to the concerned expense in
Expenses side of Balance Sheet. debit side of P&L A/c or Trading A/c.
2. Shown in liability side of Balance
Sheet.
Prepaid Shown only in assets 1. Deducted from concerned expenses in
Expenses side of the Balance debit side of P&L a/c or Trading a/c.
Sheet. 2. Shown at the assets side of the
Balance Sheet.
Depreciation Shown only in debit side 1. Shown in debit side of P&L A/c.
of the P&L A/c. 2. Deduced from concerned asset in
Balance sheet assets side.

Bad Debts Shown in debit side of 1. Shown in debit side of P&L A/c.
P&L A/c. 2. Deducted from debtors in the assets
side of the Balance Sheet.
Interest On Shown only in debit side 1. Shown on debit side of the P&L A/c.
Loan [Or] of the P&L A/c. 2. Added to loan or capital in liabilities
Capital side of the Balance Sheet.
Problems
1. Enter the following data in the journal of Praveen.
Pradeep commenced business with a cash of Rs. 500000/-
Deposited cash with bank Rs. 10000/-
Purchased goods from Kiran Rs. 20000/-
Goods sold for cash Rs. 5000/-
Purchases Rs. 2000/-
Returned goods to Kiran Rs. 600/-
Paid Wages Rs. 1000/-
Paid for advertisement Rs. 1500/-
Paid cash to Kiran Rs. 19000/-
Solution:
Journal Entries in the books of Praveen
L.F. Debit Credit
Date Particulars
No Rs. Rs.
1 Cash A/c Dr. 5,00,000
To Capital A/c 5,00,000
(Being commenced business with
cash by Pradeep)
2 Bank A/c Dr. 10,000
To Cash A/c 10,000
(Being deposited cash with bank)
3 Purchases A/c Dr. 20,000
To Kiran A/c 20,000
(Being Purchased goods from Kiran)
4 Cash A/c Dr. 5,000
To Sales A/c 5,000
(Being Goods sold for cash)
To Cash A/c 2,000
(Being goods purchased)
6 Kiran A/c Dr. 600
To Purchase Returns A/c 600
(Being Returned goods to Kiran)
7 Wages A/c Dr. 1,000
To Cash A/c 1,000

(Being Paid Wages)
8 Advertisement A/c Dr. 1,500

To Cash A/c 1,500
(Being Paid for advertisement)
9 Kiran A/c Dr. 19,000
To Cash A/c 19,000
(Being Paid cash to Kiran)
2. Prepare Journals and cash account (Ledger) from the following transactions as on
2010 Dec’1st Mr. Srinivas started business with capital Rs. 5,00,000
Dec’3 Purchased goods from Kumar Rs. 30,000
Dec’12 Salaries paid to employees Rs. 50,000
Dec’15 Sold goods to Sudhakar Rs. 50,000
Dec’18 Paid wages Rs. 2,000
Dec’20 Cash paid to Sirisha Rs. 3,000
Dec’22 Cash received from Raju Rs. 20,000
Dec’25 Amount deposited into Bank Rs. Rs. 25,000
Dec’26 Cash withdrawn from Bank Rs. 10,000
Dec’31 Paid stationery expenses Rs. 15,000
Solution:
Journal Entries
L.F.
Date Particulars Debit(Rs.) Credit(Rs.)
No
2010 Cash A/c Dr. 5,00,000
st 5,00,000
Dec-1 To Capital A/c
(Being started business with capital)
Dec-3rd Purchases A/c Dr. 30,000
To Kumar A/c 30,000
(Being Purchased goods from Kumar)
Dec-12th Salaries A/c Dr. 50,000
To Cash A/c 50,000
(Being Salaries paid to employees)
Dec-15th Sudhakar A/c Dr. 50,000
To Sales A/c 50,000
(Being Sold goods to Sudhakar)
Dec-18th Wages A/c Dr. 2,000
To Cash A/c 2,000
(Being Paid wages)
Dec-20th Sirisha A/c Dr. 3,000
To Cash A/c 3,000
(Being Cash paid to Sirisha)
nd
Dec-22 Cash A/c Dr. 20,000
To Raju A/c 20,000
(Being Cash received from Raju)

Dec-25th Bank A/c Dr. 25,000

To Cash A/c 25,000
(Being Amount deposited into Bank)
Dec-26th Cash A/c Dr. 10,000
To Bank A/c 10,000
(Being Cash withdrawn from Bank)
Dec-31st Stationery A/c Dr. 15,000
To Cash A/c 15,000
(Being Paid stationery expenses)
Dr. Cash A/c Cr.
JF. Amount JF. Amount
Date Particulars Date Particulars
No Rs. No Rs.
2010 2010
Dec-1st To Capital A/c 5,00,000 Dec-12th By Salaries A/c 50,000
Dec-22 nd To Raju A/c 20,000 Dec-18th By Wages A/c 2,000
Dec-26 th To Bank A/c 10,000 Dec-20th By Sirisha A/c 3,000
Dec-25th By Bank A/c 25,000
Dec-31st By Stationery 15,000
Dec-31st By Balance c/d 4,35,000
5,30,000 5,30,000
2011
Jan-1st To Balance b/d 4,35,000
3. Enter the following transactions in journal format:

Paid salaries Rs. 5000
Sold goods to Venkat Rs. 10000
Sold machinery Rs. 30000
Commission received Rs. 2000
Allowed discount Rs. 1000
Brought goods from Raghava Rs. 4000
Sold goods to X for cash Rs. 6000
Solution:
Journal Entries
Date Particulars L.F. No Debit (Rs.) Credit (Rs.)
1 Salaries A/c Dr. 5,000
To Cash A/c 5,000
(Being salaries paid)
2 Venkat A/c Dr. 10,000
To Sales A/c 10,000
(Being goods sold to venkat)
3 Cash A/c Dr. 30,000
To Machinery A/c 30,000
(Being machinery sold)
To Commission A/c 2,000
(Being commission received)

5 Discount A/c Dr. 1,000

To Cash A/c 1,000
(Being discount allowed)
To Raghava A/c 4,000
(Being goods brought from raghava)
To Sales A/c 6,000
(Being goods sold to X for cash)
4. From the following trail balance of Mr. Surya & co as on 31st December 2008.
Prepare the Trading account, profit& Loss account and Balance sheet as on date.
Particulars Debit(Rs.) Credit(Rs.)
Capital 70,000
Purchases 40,000
Sales 75,000
Returns 1,000 2,000
Opening stock 20,000
Wages 1,000
Coal & Power 1,500
Carriage Inwards 3,000
Salaries 2,000
Sundry Debtors 15,000
Sundry Creditors 10,000
Bills Payable 5,000
Bills Receivable 10,000
Plant & Machinery 7,500
Cash in Hand 27,000
Cash at Bank 15,000
Discount 500
Discount received 2,000
Loans 5,000
Bank Overdraft 5,000
Buildings 33,000
Total 1,74,000 1,74,000
Adjustments:
a) Closing stock Rs. 30,000
b) Bad debts on sundry debtors Rs. 1,000
c) Deprecation on buildings Rs. 3,000
d) Outstanding salaries Rs. 500

Solution:
Dr. Trading and Profit & Loss A/c of Mr. Surya & co. for year ending 31-12-2008 Cr.
To Opening stock 20,000 By Sales 75,000
To Purchase 40,000 (-) Returns 1,000 74,000
(-) Returns 2,000 38,000 By Closing Stock 30,000
To Wages 1,000
To Coal & Power 1,500
To Carriage Inwards 3,000
To Gross Profit c/d 40,500
1,04,000 1,04,000
To Salaries 2,000 By Gross Profit b/d 40,500
(+) outstanding 500 2,500 By Discount 2,000
To Discount 500
To Bad debts 1,000
To Depreciation on buildings 3,000
To Net Profit 35,500
(transferred to Capital a/c)
42,500 42,500
Balance Sheet of Mr. Surya & Co. as on 31-12-2008

Sundry Creditors 10,000 Cash in Hand 27,000
Bills Payable 5,000 Cash at Bank 15,000
Bank Overdraft 5,000 Bills Receivable 10,000
Loads 5,000 Debtors 15,000
Outstanding Salaries 500 (-) Bad debts 1,000 14,000
Capital 70,000 Closing stock 30,000
(+) Net profit 35,500 1,05,500 Buildings 33,000
Suspense a/c 2,500 (-) Depreciation 3,000 30,000
Plant 7,500
1,33,500 1,33,500
5. From the following trail balance to prepare Trading account, Profit and loss
account and Balance sheet as on 31-3-2007.
Sales 4,00,000 Sundry debtors 1,20,000
Capital 50,000 Carriage inwards 2,500
Land 50,000 Bad debts 10,000
Opening stock 20,000 Carriage outwards 75,000
Wages 5,000 Salaries 60,000
Purchase Returns 10,000 Rent (credit) 20,000
Interest 5,000 Bills payable 30,000
Sundry Creditors 60,000 Buildings 70,000
Furniture 60,000 Purchases 1,00,000
Rent 10,000 Bills Receivable 50,000
Adjustments:

1. Closing stock Rs. 60,000 2. Outstanding wages Rs. 1000

3. Doubtful debts on sundry debtors @ 5%
4. Depreciation on furniture @ 10% and on buildings @ 10%
Solution:
Dr. Trading and Profit & Loss A/c for year ending 31-03-2007 Cr.
To Opening stock 20,000 By Sales 4,00,000
To Purchase 1,00,000 By Closing Stock 60,000
(-) Returns 10,000 90,000
To Wages 5,000
(+) outstanding 1,000 6,000
To Carriage Inwards 2,500
To Gross Profit c/d 3,41,500
4,60,000 4,60,000
To Salaries 60,000 By Gross Profit b/d 3,41,500
To Rent 10,000 By Rent 20,000
To Bad debts 10,000
(+) New Bad debts 6,000 16,000
To Interest 5,000
To Depreciation on Buildings 7,000
To Depreciation on Furniture 6,000
To Carriage Outwards 75,000
To Net Profit
(transferred to Capital a/c) 1,82,500
3,61,500 3,61,500
Balance Sheet as on 31-03-2007

Sundry Creditors 60,000 Land 50,000
Bills Payable 30,000 Bills Receivable 50,000
Outstanding wages 1,000 Debtors 1,20,000
Capital 50,000 (-) Bad debts 6,000 1,14,000
(+) Net profit 1,82,500 2,32,500 Buildings 70,000
Suspense a/c 67,500 (-) Depreciation@10% 7,000 63,000
Furniture 60,000
(-) Depreciation@10% 6,000 54,000
Closing stock 60,000
3,91,000 3,91,000

UNIT – VII
Interpretation and analysis of Financial Statement
Ratio Analysis
Ratio Analysis is a process of determining and interpreting numerical
relationships based on financial statements. It is a technique which is used to
evaluate the financial conditions, strength or weakness and performance of a
business. A numerical relationship between two digits or two numbers is known as
Ratio. “The relationship of one item to another expressed in simple mathematical
form is known as Ratio.”
Objectives:
i. To simplify the comparative picture of financial statements.
ii. To assist the management in decision making.
iii. To gauge the profitability, solvency and efficiency of an enterprise.
iv. To ascertain the rate and direction of change and future potentiality.
Limitations of Ratio Analysis:
A lot of care, caution and intelligence are needed in using these ratios, because
there are number limitations in using these ratios:
1. Accounting ratios are retrospective: The ratios are computed based on the
past data or previous performance. They may not necessarily hold good in the
future and may not be helpful in decision making projections into future.
2. Accounting methods, policies and procedures are not common: Where
accounting data is generated following different accounting methods the
ratios are not strictly comparable. The difference in accounting methods or
policies may lead to distorted conclusions.
3. Inflationary tendencies cannot be highlighted: In times of inflation, the
accounting data of several years cannot be compared. An analysis of such data
based on ratios cannot be meaningful.
4. Concepts of ratios are not the same: Based on the needs of the firm, the
ratios are built upon. The formula may have been different. Inter firm
comparison cannot be realistic in such a case.
5. Ratio by itself has no utility: Ratios to be meaningful have to be read along
with the other ratios. Any single ratio is meaningless by itself.
6. Ratios can be manipulated: During festival season, there will be good
turnover of stocks when compared to the earlier periods. If this inventory
turnover ratio is considered for decision making, the results get distorted. It is
necessary to consider the average inventories to present a fair view of the
business activity.
7. Factors weakening ratio analysis: Sudden changes in the economy such as
economic crisis, lack of uniform data, identifying the right type of ratio for
analysis and interpretation and so forth are some of the factors that threaten
the utility of ratio analysis

Despite the limitations, it continues to be a power tool for analysis and

comparison of financial statements.
Classification of Ratio’s:
Different ratios are use for different purpose. These ratios’ can be grouped
into four broad categories according to the financial activity:
1. Liquidity Ratios
2. Activity Ratios
3. Profitability Ratios
4. Capital Structure Ratios
Liquidity Ratio:
Liquidity ratio measures the firm’s ability to meet its current obligations. If the
firm is not in a position to meet its short term commitments like payment of taxes,
wages, salaries, etc, it cannot continue the business. It helps in identifying the danger
signals for the firm in advance. It is classified as follows:
 Current Ratio:
Current ratio is the ratio, which express relationship between current
assets and current liabilities. Current assets are those which can be converted
into cash within a short period of time, normally not exceeding one year. Current
liabilities are short-term maturing to be met.
Current Ratio = Current Assets / Current Liabilities
Note: Answer must be 2 or more than 2 (i.e 2:1); otherwise company performance is
not satisfactory.
Current Assets = Closing Stock (stock), Debtors, Bills Receivable, Cash at bank, Cash in
hand, Prepaid expenses, Income yet to be received, etc.
Current Liabilities = Creditors, Bank Over Draft, Bills payable, outstanding expenses,
Incomes received in advance, all provisions, Dividends payable, long term debts, etc.
 Quick or Acid test Ratio:

The acid test ratio is a measure of liquidity designed to overcome the
defect of current ratio. It is a measurement of firm’s ability to convert its current
assets quickly into cash in order to meet its current liabilities.
Quick ratio =
Current assets – (Prepaid expenses + Closing stock) / Current Liabilities
Note: Answer must be 1 or more than 1 (i.e. 1:1)

Activity / Turn over / Efficiency Ratios

Activity ratios are sometimes called as efficiency ratios. Activity ratios are
concerned with how efficiency the assets of the firm are managed. These ratios
express relationship between level of sales and the investments in various assets
inventories, receivables, fixed assets etc. These are of 3 types:
 Inventory Turnover Ratio:
It is also called stock turnover ratio. It indicates the number of times the
average stock is being sold during a given accounting period. It establishes the
relation between the cost of goods sold during a given period and the average
amount of inventory outstanding during that period. The higher the inventory
turnover ratio, the better is the performance of the firm in selling its stock.
Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory
Note: Answer must end with times for Eg: if answer is 9. Write it as 9 times
Cost of goods sold = Sales - Gross profit (or)
= Opening stock + Purchases + Mfg expenses – Closing stock
Average Inventory/ Average Stock = Opening stock + Closing Stock / 2
 Debtor’s Turnover Ratio:

It reveals the number of times the average debtors are collected during a
given accounting period. In other words, it shows how quickly the firm is in a
position to collect its debts.
Debtors Turnover Ratio = Credit Sales / Average Debtors
(or)
Debtors Turnover Ratio = Total Sales / Debtors
Credit sales = It refers to goods sold on credit.
Average Debtors = Opening Debtors + Closing Debtors / 2
Debt / Average Collection Period: It refers to the time taken to collect the debts. The
lesser the time, the more is the efficiency.
Debt / Average Collection Period = Debtors / Sales x Days in a year
 Creditor’s Turnover Ratio:

It reveals the number of times the average creditors are paid during a
given accounting period.
Creditors Turnover Ratio = Credit Purchases / Average Creditors
(or)
Creditors Turnover Ratio = Purchases / Creditors
Credit Purchases = It refers to goods purchased on credit.
Average Debtors = Opening Creditors + Closing Creditors / 2
Credit Collection Period: It refers to the time taken to collect the debts. The lesser
the time, the more is the efficiency.
Credit Collection Period = 365 days / Credit Turnover Ratio

Solvency / Capital Structure / Leverage Ratios

Leverage or Capital Structure ratios are the ratios, which indicate the
relative interest of the owners and the creditors in an enterprise. These ratios
indicate the funds provided by the long term creditors and owners.
 Debt-Equity Ratio:
Debt Equity ratio expresses the relationship between debt (Outsider’s
funds) and Equity (Owner’s funds). This ratio explains how far owned funds are
sufficient to pay outside liabilities.
Debt Equity Ratio = Outsiders’ funds / Insiders’ funds
(or)
Debt Equity Ratio = Debt / Equity
Note: Answer must be 1(exactly); otherwise the company is in bad condition
Outsiders Funds= Debentures, Bonds, Long term loans, current liabilities, etc.
Insider funds= Equity & Preference Share capital, Reserves & Surplus, Retained
Earnings, Net profit, etc.
 Interest Coverage Ratio:

Interest coverage ratio is calculated to judge the firm’s capacity to pay the
interest on debt it borrows.
Interest Coverage Ratio=Net Profit Before interest & Taxes (EBIT) / Fixed interest
Note: Answer must end with times for Eg: if answer is 9. Write it as 9 times
Net Profit before Interest & Tax = Net profit After Tax + Tax + Interest on debentures
or Long Term loans
Fixed Interest charges = Interest on debentures or long term loans
 Proprietary Ratio / Proprietors’ Funds to Total Assets Ratio:

It establishes relationship between proprietors’ funds and the total assets.
Proprietary Ratio = Owners’ funds / Total Assets x 100
Note: Answer must end with a percentage value.
Owners’ funds= Equity & Preference Share capital, Reserves & Surplus, Retained
Earnings, Net profit, etc.
Total Assets = Current Assets + Fixed Assets (except Intangible assets)
Profitability Ratio’s
Profitability ratios throw light on how well the firm is organizing its activities in
a profitable manner. The owners expect reasonable rate of return on their
investment. The firm should generate enough profits not only to meet the
expectations of the owners, but also to finance the expansion activities.

 Gross Profit Ratio:

Gross profit ratio is the ratio between gross profits to sales during a given
period. It is expressed in terms of percentage.
Gross Profit Ratio = (Gross Profit / Net Sales) X 100
Note: The higher the ratio the better is profitability.
Gross Profit = Net Sales – Cost of goods sold
Net Sales = Sales – Sales Returns
 Net Profit Ratio:

Net Profit is the ratio between net profits after taxes and net sales. It
indicates what portion of sales is left to the owners after operating expenses.
Net Profit Ratio = (Net profit after taxes / Net sales) X 100
 Operating Ratio:
Operating ratio is the ratio between costs of goods sold plus operating
expenses and the net sales. This is expressed as a percentage to net sales. The
higher the operating ratio, the lower is the profitability and vice-versa.
Operating Ratio = (Operating Expenses / Net sales) X 100
Operating Expenses= Cost of goods sold + Administrative expenses + Office
expenses + Selling & Distribution Expenses.
 Earnings per Share:
EPS is the relationship between net profits and the number of shares
outstanding at the end of the given period. This can be compared with previous
years to provide a basis for assessing the company’s performance.
EPS = (Net Profit after Taxes / No. of Shares outstanding)
 Price/ Earnings ratio:

This is the share price divided by the earnings per share
Price/ Earnings Ratio = (Market price per share / Earnings Per share)
 Return on Investment (ROI):

It is one of the very important parameters affecting business plans. The
profitability of the firm is measured in terms of return on investment. It refers to
total assets, capital employed or owners’ equity.
ROI = Net Profit after taxes / Total Investment or owners equity
 Return on Equity (ROE):

This relates to the net profits available to equity share holders to amount
invested by them. The higher the ROE the more is profitability and vice versa.
ROE = Net Profits – Dividends payable to Pref. shareholders / Equity share capital

Funds Flow Analysis

By the term funds, we mean cash. But from the point of view of accountants
and finance managers, funds mean working capital or net working capital. In the
context of funds flow statements, the term funds, it means working capital only.
There are two concepts of working capital:
 Gross Working Capital: It refers to amount of investment made in current assets.
 Net Working Capital: It refers to the difference between current assets and
current liabilities (i.e. CA – CL).
The funds flow statement is prepared to identify different sources and
application of funds i.e. the sources of raising funds and how the same has been
utilized. There are certain transactions that influence the flow of funds. Some
transactions result in increase in working capital is treated as sources of funds and a
decrease in working capital is treated as application of funds. Some do not have any
effect i.e., neither increase nor decrease in working capital.
The preparation of funds flow statement involves three stages:
1. Statement (or schedule) of changes in working capital
2. Funds from Operations
3. Funds flow statement (or) Statement of Sources and Application of funds
Preparation of Statement (or schedule) of changes in working capital:
We can deduce the following rules for preparation of Statement of Changes in
Working Capital:
1. Increase in current asset will result in increase in working capital.
2. Decrease in current asset will result in decrease in working capital.
3. Increase in current liability will result in decrease in working capital.
4. Decrease in current liability will result in increase in working capital.
Statement of changes in Working Capital

Previous Year Current Year Change
Description
(Rs.) (Rs.) Increase Decrease
Current Assets:
Cash in Hand Xxx Xxx
Cash at Bank Xxx Xxx
Sundry Debtors Xxx Xxx
Bills Receivable Xxx Xxx
Prepaid Expenses Xxx Xxx
Accrued Expenses Xxx Xxx
Closing Stock Xxx Xxx
Investments Xxx Xxx
Marketable Securities Xxx Xxx
XXX XXX
Current Liabilities:
Sundry Creditors Xxx Xxx
Bills Payable Xxx Xxx
Bank Overdraft Xxx Xxx

Outstanding Expenses Xxx Xxx

Unearned Income Xxx Xxx
XXX XXX
Net Increase/Decrease in XXX XXX
Working Capital
Funds from Operations / Funds lost from operations:

Statement of Funds from Operations
Description Amount (Rs.) Amount (Rs.)
Net Profit in the current Year Xxx
Add: Depreciation Xxx
Amortization of fixed assets Xxx
Goodwill written off Xxx
Patents written off Xxx
Preliminary expenses written off Xxx
Interim dividend paid Xxx
Premium on redemption of debentures Xxx
Premium on redemption of preference shares Xxx
Loss on sale of fixed assets Xxx
Discount on issue of debentures Xxx
Transfer to general reserve Xxx Xxx
XXX
Less: Profit from sale of fixed assets Xxx
Decrease in general reserve Xxx
Income from investments Xxx
Net Profit in the previous Year Xxx Xxx
Funds from Operations XXX
Funds flow statement (or) Statement of Sources and Application of funds:
Statement of Sources and Applications of Funds
Sources Amount Application or Uses Amount
(Rs.) (Rs.)
Funds from operations Xxx Funds lost from operations Xxx
Issue of equity shares Purchase of fixed assets Xxx
(including share premium) Xxx Purchase of investments Xxx
Issue of preference shares Xxx Redemption of pref. shares Xxx
Issue of debentures Xxx Redemption of debentures Xxx
Sale of fixed assets Xxx Interim dividend paid Xxx
Sale of investments Xxx Taxes paid Xxx
Decrease in Working Capital Xxx Dividend paid Xxx
Increase in Working Capital Xxx
XXX XXX

Problems
1. The following is the balance sheet of ABC Ltd. as on 31-3-2011.
Calculate the following ratios:

a) Current ratio
b) Quick ratio
C) Debt-equity ratio
d) Stock turnover ratio
Solution:
a) Current Ratio = current assets / current liabilities
= 556000 / 130000
= 4.28:1
Current assets = 100000+175000+10000+15000+256000 = 556000
Current liabilities = 75000+30000+25000 = 130000
b) Quick Ratio = quick assets / current liabilities

= 531000 / 130000
= 4.08:1
Quick assets = 100000+175000+256000 = 531000
Current liabilities = 75000+30000+25000 = 130000
c) Debt – equity ratio = Debt / Equity [or] Outsiders funds / Shareholders funds
= 605000 / 800000
= 0.76:1
Debt = 325000 + 150000 + 75000 + 30000 + 25000 = 605000
Equity = 500000 + 300000 = 800000
d) Stock turnover ratio = cost of goods sold / average inventory at cost

= 600000 / 200000
= 3 times
Average inventory at cost = (opening stock + closing stock) / 2
= (144000 + 256000) / 2 = 200000

2. The following is the balance sheet of XYZ Co. as on 31-3-2010.
Calculate the following ratios:

a) Gross profit ratio
b) Net profit ratio
c) EPS
d) Price Earning ratio
e) Operating ratio
Solution:
a) Gross profit ratio = Gross profit / sales x 100
= 150000 / 300000 x 100
= 50%
b) Net profit ratio = Net profit after tax / Net sales x 100
= 300000 / 250000 x 100
= 120%
Net sales = sales – sales returns
= 300000 – 50000 = 250000
c) Earnings per share (EPS) Ratio =

(Net profit after tax − Preference dividend) / No. of equity shares
= (300000 - 50000) / 15000
= 166.67 per share
d) Price Earnings Ratio = Market price per equity share / Earnings per share
= 10 / 166.67
= 0.60
e) Operating Ratio = [(Cost of goods sold + Operating expenses) / Net sales] × 100
= [(60000 + 35000) / 250000] x 100
= (95000/250000) x 100
= 38%
Operating expenses = office expenses + selling expenses
= 20000 + 15000 = 35000
Net sales = sales – sales returns
= 300000 – 50000 = 250000

3. From the following Balance sheets for the year ending 31st Mach 210 and 2011,
you are required to prepare funds flow statement.
2010 2011 2010 2011
Liabilities Assets
Rs. Rs. Rs. Rs.
Share Capital 50000 60000 Buildings 30000 40000
Profit & Loss A/c 12500 17000 Furniture 10000 8000
General Reserve 10000 12500 Machinery 25000 25000
Provision for Tax 3000 3500 Cash 3000 2500
Proposed Dividend 2000 2500 Bank 10000 17000
Bank Overdraft 3500 4500 Sundry Debtors 8000 13600
Outstanding Exp. 600 400 Preliminary Exp. 2100 1500
Sundry Creditors 6500 7200
88100 107600 88100 107600
Solution
31-03-2010 31-03-2011 Change
Description
Current Assets:
Cash 3000 2500 500
Bank 10000 17000 7000
Sundry Debtors 8000 13600 5600
Sundry Creditors 6500 7200 700
Bank Overdraft 3500 4500 1000
Outstanding Expenses 600 400 200
Increase in Working Capital 10600
12800 2200
Increase in Working Capital = 12800 – 2200 = 10600
Statement of Funds from operations

Description Amount Amount
Profit & Loss A/c as on 31-03-2011 17000
Add:
Increase in General Reserve 2500
Preliminary expenses written off 600
Provision for tax 3500
Proposed dividend 2500 9100
26100
Less:
Funds from Operations 13600

Funds Flow Statement

Sources Amount Applications Amount
Funds from Operations 13600 Increase in Working Capital 10600
Sale of Furniture 2000 Purchase of Buildings 10000
Issue of Share Capital 10000 Tax paid 3000
Dividend paid 2000
25600 25600
4. From the following Balance sheets for the year ending 31st March 2010 and 2011,
prepare funds flow statement.
2010 2011 2010 2011
Liabilities Assets
Rs. Rs. Rs. Rs.
Equity share capital 150000 200000 Stock in hand 30000 40000
Pref. share capital 75000 100000 Sundry debtors 27500 36000
Reserves & Surplus 25000 20000 Cash in hand 5000 8000
P & L A/c 35500 48500 Cash at bank 25000 22500
Bills payable 6000 4000 Goodwill 20000 15000
Sundry creditors 25000 35000 Plant & Machinery 125000 150000
Outstanding Exp. 2500 3000 Land & Buildings 75000 100000
Furniture 11500 39000
319000 410500 319000 410500
Additional Information:
1. Depreciate Plant & Machinery by 10%
2. Interim dividend of Rs.15000 was paid during the year 2010
3. During the year part of furniture or Rs.5000 (accumulated depreciation there
on Rs.3000) sold for Rs.1500.
Solution:
31-03-2010 31-03-2011 Change
Description
Current Assets:
Stock in hand 30000 40000 10000
Sundry debtors 27500 36000 8500
Cash in hand 5000 8000 3000
Cash at bank 25000 22500 2500
Bills Payable 6000 4000 2000
Sundry creditors 25000 35000 10000
Outstanding Exp. 2500 3000 500
Increase in Working Capital 10500
23500 23500
Increase in Working Capital = 23500 - 13000 = 10500

Dr. Plant & Machinery A/c Cr.

To Balance b/d 125000 By Depreciation 12500
To Cash (Bal. fig.) 37500 By Balance c/d 150000
162500 162500
Dr. Furniture A/c Cr.
To Balance b/d 11500 By Cash 1500
To Cash (Bal. fig.) 32500 By Depreciation 3000
By P& L A/c 500
By Balance c/d 39000
44000 44000
Statement of Funds from operations

Description Amount Amount
Add:
Depreciation on Plant & Machinery 12500
Depreciation on Furniture 3000
Loss on sale of furniture 500
Interim dividend paid 15000
Goodwill written off 5000 36000
Less: 84500
Decrease in General Reserve 5000
Profit & Loss A/c as on 31-03-2010 35500 40500
Funds from Operations 44000
Funds Flow Statement
Sources Amount Applications Amount
Funds from Operations 44000 Increase in Working Capital 10500
Sale of furniture 1500 Purchase of P & M 37500
Issue of Equity Share Capital 50000 Purchase of L & B 25000
Issue of Pref. Share capital 25000 Purchase of Furniture 32500
Dividend Paid 15000
120500 120500

UNIT – VIII
Capital and Capital Budgeting
Meaning of Capital Budgeting

Capital budgeting is the process of making investment decision in long-term
assets. Capital expenditure incurred today is expected to bring its benefits over a
period of time. It is the process of deciding whether or not to invest in a particular
project. The manager has to choose a project which gives a rate of return, more than
the cost of financing the project. The benefits are the expected cash inflows from the
project which are discounted against a standard generally the cost of capital.
Definition:
According to Charles T. Horngreen has defined capital budgeting as, "Capital
budgeting is long-term planning for making and financing proposed capital outlays".
Need for capital budgeting

1. Long-Term effect on business operations: Capital budgeting decisions have long
term implications on business operations. The investment decision taken today
not only affects the present earnings but also the growth and profitability of the
firm in the future.
2. Large amount as investments: Capital budgeting decisions involve large amount
of funds, but the funds available with the firm are always limited. Therefore it is
necessary to take the decisions carefully and control its capital expenditure.
3. Irreversible: The capital budgeting decisions are of irreversible nature as it is
difficult to find the market for such capital goods. Once the decision for
acquiring a permanent asset is taken, it becomes very difficult to dispose off,
these assets and the only way is to scrap these assets which involve huge losses.
4. Difficulties of investment decisions: The long - term investment decisions are
difficult to make because it involves the assessment of future events which are
difficult to ascertain. The investments are required to be made immediately but
the returns are expected over a number of years.
5. Ability to compete: It has been observed that many firms fail not because they
have too much capital equipment but because they have too little ability to
compete. Hence it must consider the investment in capital assets so that the
company can face and meet the competition from other.
Capital budgeting decisions

The capital budgeting process involves generation of investment, estimation
of cash-flows, evaluation of cash-flows and selection of projects based on acceptance
criterion. The steps involved in capital budgeting process are as follows:
1. Project generation: A company has to identify the proposal to be undertaken
depending upon its future plans of activity. After identification of the proposals
they can be grouped according to the following categories:

a) Replacement of equipment: In this case the existing outdated equipment and

machinery may be replaced by purchasing new and modern equipment.
b) Expansion: The Company can go for increasing additional capacity in the
existing product line by purchasing additional equipment.
c) Diversification: The Company can diversify its product by producing various
products and entering into different markets.
d) Research and Development: Where the company can go for installation of
research and development suing by incurring heavy expenditure with a view
to innovate new methods of production new products etc.
2. Project evaluation: In involves two steps.
a) Estimation of benefits and costs: Benefits to be received are measured in
terms of cash inflows and costs to be incurred in terms of cash flows.
b) Selection of an appropriate criterion to judge the desirability of the project.
3. Project selection: The selection procedure would differ from firm to firm. Due to
lot of importance of capital budgeting decision, the final approval of the project
may generally rest on the top management of the company.
4. Project Execution: In the project execution the top management is responsible
for effective utilization of funds allocated for the projects. The funds must be
spent only after obtaining the approval of the finance controller.
Examples:
1. Construction of a new building or renovation of existing buildings.
2. Purchase of technology from foreign country.
3. Making a new product or Starting a new business.
4. Expansion decisions of existing plant and equipment.
5. Sponsoring a football or cricket team.
Methods of Capital Budgeting

The capital budgeting methods or techniques of evaluation will help the
company to decide the desirability of an investment proposal depending on their
income generating capacity and rank them in order of their desirability. It is the basis
on which a proposal can be accepted or rejected. The criteria for the appraisal of
investment proposals are grouped into two types:
1. Traditional Methods:
(a) Pay Back Period Method (PBP) (b) Accounting Rate of Return (ARR)
2. Time-Adjusted method / Discounted cash Flow Method:
(a) Net Present Value (NPV) (b)Internal Rate of Return (IRR)
(c)Profitability Index (PI)
Pay-back period method

It is the most popular and widely recognized traditional method of evaluating
the investment proposals. It can be defined as the number of years required to
recover the original cash invested in a project. According to James C. Vanhorne “The
payback period is the number of years required to recover initial cash investment”.
Formula:
1. When cash flows are even:

Cash Outlay (or) Original cost of project
Pay Back period =
Annual Cash inﬂow
2. When cash flows are uneven:
Take the cumulative cash inflows and see how much time it takes to get back
the original investment.
Accept or Reject Criteria:
Under this method the projects are ranked on the basis of the length of the
payback period. A project with the shortest payback period will be given the highest
rank and taken as the best investment.
Merits:
1. It is one of the earliest methods of evaluating the investment projects.
2. It is simple to understand and to compute.
3. It does not involve any cost for computation of the payback period.
4. It is one of the widely used methods in small scale industry sector.
5. It can be computed on the basis of accounting information.
Demerits:
1. This method fails to take into account the cash flows received by the company
after the payback period.
2. It doesn’t take into account the interest factor involved in investment outlay.
3. It ignores the length of the projects useful life.
Accounting (or) Average rate of return method (ARR):

It is an accounting method, which uses the accounting information repeated
by the financial statements to measure the probability of an investment proposal. It
can be determined by dividing the average income after taxes by the average
investment i.e., the average book value after depreciation.
According to ‘Soloman’, accounting rate of return on an investment can be
calculated as the ratio of accounting net income to the initial investment.
Formula:
(ARR)= x100
Net Investment
(Or)
Average Rate of Return (ARR)= x100
Average Investment
Total
=
No. of Years
Total investment
Average investment =
2
The projects are selected when the ARR is higher than the minimum rate fixed
by the company. In case of several projects, the project with high ARR is selected.
Merits:
1. It is very simple to understand and calculate.

2. It can be readily computed with the help of the available accounting data.
3. It uses the entire stream of earning to calculate the ARR.
Demerits:
1. It is not based on cash flows generated by a project.
2. It ignores the length of the projects useful life.
3. It does not take into account the fact that the profits can be re-invested.
Net Present Value Method (NPV)

The NPV takes into consideration the time value of money. NPV is the
difference between the present value of cash inflows of a project and the initial cost
of the project. According to Ezra Solomon, “It is a present value of future returns,
discounted at the required rate of return minus the present value of the cost of the
investment.”
Steps to calculate NPV:
1. Calculation of cash inflows and outflows during life of the project.
2. Determination of discount rate or cost of capital.
3. Computation of present value of cash inflows and outflows by discounting
them with discounting rate.
4. Calculation of NPV by subtracting present value of cash outflows from inflows.
5. Projects are selected when present value of cash inflow is more or equal to
present value of cash outflows.
Formula:
NPV= Present value of cash inflows – investment
CF1 CF2 CFn
NPV = [ + 2 + ……. + ]-I
(1+k)1 (1+k) (1+k)n O
where, IO = Investment or cash outflows
CF1, CF2, … CFn = cash inflows in different years
K= Cost of the Capital (or) Discounting rate
t = No. of Years
The project will be selected when NPV is positive or above zero. If a project(s)
NPV is less than ‘Zero’, it gives negative NPV hence it must be rejected. If there is
more than one project, the project with positive NPV and which is higher is selected.
Merits:
1. It recognizes the time value of money.
2. It is based on the entire cash flows generated during the life of the asset.
3. It is consistent with the objective of maximization of wealth of the owners.
4. The ranking of projects is independent of the discount rate used for
determining the present value.
Demerits:
1. It is different to understand and use.

2. The concept of cost of capital is difficult to understood and determine.

3. It does not give solutions when the comparable projects are involved in
different amounts of investment.
Internal Rate of Return Method (IRR)

The IRR for an investment proposal is that discount rate which equates the
present value of cash inflows with the present value of cash out flows of an
investment. The IRR is also known as cutoff or handle rate and Trial or Error method.
Steps to calculate IRR:
1. Estimation of cash inflows and outflows during the life of the project.
2. Identifying the discounting factor (IRR), through trial and error method that
can equate cash flows.
3. It implies that one has to start with a discounting rate to calculate the present
value of cash inflows. If the obtained present value is higher than the initial
cost of the project, try with a lower rate. Likewise if it is lower, try with a
higher. The process is continued till the net present value becomes Zero.
4. Comparing IRR with ‘K’ (Cost of capital) and determining the acceptability of
the project.
Formula:
IRR = Present value of cash inflows = Investment
CF1 CF2 CFn
IRR = [ + 2 + ……. + (1+k)n
] = IO
(1+k)1 (1+k)
where, IO = Investment
CF1, CF2, … CFn = cash inflows in different years
K= Cost of the Capital (or) Discounting rate
t = No. of Years
If the present value of the project lies between two discount rates:
NPVL
IRR = L + X H-L
PL - PH
where, L = Lower discount rate
H = Higher discount rate
NPVL = Net Present value at lower discount rate
PL = Present value of cash inflows at lower rate
PH - Present value of cash inflows at higher rate
The project with IRR more than Required Rate Return is accepted and in case
of several projects, the project with higher discount rate is selected.
Merits:
1. It considers the time value of money.
2. It takes into account the cash flows over the entire useful life of the asset.
3. It is the actual rate of return generated by the project.
4. It enables to evaluate true profitability.
Demerits:

1. It is very difficult to understand and use.

2. It involves a very complicated computational work.
3. It may not give unique answer in all situations.
Problems
1. Consider the case of the company with the following two investment alternatives
each costing Rs. 9, 00,000/-. The details of the cash flows are as follows.
Cash flows (in Rs.)
Year
Project-I Project-II
1 3,00,000 6,00,000
2 5,00,000 4,00,000
3 6,00,000 3,00,000
The cost of capital is 10 percent per year. Which one will you choose?
i) Under DCF method. ii) Under NPV method.
Solution:
(a) DCF Method
Project - I Project - II
Year PV@10%
Cash Flows PVCI Cash Flows PVCI
1 0.909 3,00,000 2,72,700 6,00,000 5,45,400
2 0.826 5,00,000 4,13,000 4,00,000 3,30,400
3 0.751 6,00,000 4,50,600 3,00,000 2,25,300
Total PVCF 11,36,300 11,01,100
Project – I is chosen as its Total PVCF is higher than Project – II
(b) NPV Method
NPV = PVCF – Investment
Project – I = 11,36,300 – 9,00,000 = 2,36,300
Project – II= 11,01,100 – 9,00,000 = 2,01,100
Project – I is chosen as its NPV is higher than Project – II
2. Consider the case of the company with the following two investment alternatives
each costing Rs. 9, 00,000/-. The details of the cash flows are as follows.
Cash flows (in Rs.)
Year
Project-I Project-II
1 3,00,000 6,00,000
2 5,00,000 4,00,000
3 6,00,000 3,00,000
Which one will you choose under IRR method?
Solution:
Calculation of IRR for Project-I:
Year Cash Inflows PV @ 15% PVCI PV @ 25% PVCI
1 3,00,000 0.870 2,61,000 0.800 2,40,000
2 5,00,000 0.756 3,78,000 0.640 3,20,000
3 6,00,000 0.658 3,94,800 0.512 3,07,200

Total PVCI 10,33,800 8,67,200
(-) Investment 9,00,000 9,00,000
NPV 1,33,800 - 32,800
1,33,800
IRR = 15 + X 25-15
10,33,800 – 8,67,200
1,33,800
= 15 + X 10
1,66,600
= 15 + 0.803 X 10
= 15 + 8.03 = 23.03%
3. ABC Co. ltd. is proposing to mechanize their operations. Two proposals A and B in
the form of quotations have been received from two different vendors. The
proposal in each case cost Rs. 5, 00,000/-. A discount factor of 14% is used to
compare the proposals. Cash flows after taxes are likely to be as under.
Cash flows after taxes (in Rs.)
Year Proposal ‘A’ Proposal ‘B’
1 1,50,000 50,000
2 2,00,000 1,50,000
3 2,50,000 2,00,000
4 1,50,000 3,00,000
5 1,00,000 2,00,000
Which one do you recommend under Payback period and Net Present
Value Index methods?
Solution:
Proposal - A Proposal - B
Year PV@12%
Cash Flows PVCF Cash Flows PVCF
1 0.893 1,50,000 1,33,950 50,000 44,650
2 0.797 2,00,000 1,59,400 1,50,000 1,19,550
3 0.712 2,50,000 1,78,000 2,00,000 1,42,400
4 0.635 1,50,000 95,250 3,00,000 1,90,500
5 0.567 1,00,000 56,700 2,00,000 1,13,400
Total PVCF 6,23,300 6,10,500
( - ) Investment 5,00,000 5,00,000
NPV 1,23,300 1,10,500
Proposal – A is recommended as its NPV is higher than that of Proposal - B

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Managerial Economics and Financial Analysis 1

Dr.O.Narayana Murthy. M.com.,M.B.A.,Ph.d.

Characteristics / Nature of Managerial Economics

Dr.O.Narayana Murthy. M.com.,M.B.A.,Ph.d.

7. Assumptions and limitations: Every concept and theory of managerial

Scope of Managerial Economics

1. Demand Decisions: Demand analysis should be a basic activity of the firm

Dr.O.Narayana Murthy. M.com.,M.B.A.,Ph.d.

internal factors. External factors include government policies, competition,

Links with other disciplines

Dr.O.Narayana Murthy. M.com.,M.B.A.,Ph.d.

Basic economic tools in Managerial economics

3) Time Perspective principle:

Dr.O.Narayana Murthy. M.com.,M.B.A.,Ph.d.

(1) Individual Demand:

(2) Market Demand:

Dr.O.Narayana Murthy. M.com.,M.B.A.,Ph.d.

Price of Milk X’s Demand Y’s Demand Market Demand

(3) Income Demand:

Dr.O.Narayana Murthy. M.com.,M.B.A.,Ph.d.

(b) Demand for Complementary Goods:

Dr.O.Narayana Murthy. M.com.,M.B.A.,Ph.d.

6. New Demand Vs. Replacement Demand:

Dr.O.Narayana Murthy. M.com.,M.B.A.,Ph.d.

other words positive expectations about future income may encourage

Exceptions of Law of Demand

Dr.O.Narayana Murthy. M.com.,M.B.A.,Ph.d.

Factors Affecting the Elasticity of Demand

Dr.O.Narayana Murthy. M.com.,M.B.A.,Ph.d.

3. Change in Income: The demand for various commodities are affected in

Measures of Elasticity of Demand

The demand curve DD is horizontal straight line or parallel to X-axis. It shows

Dr.O.Narayana Murthy. M.com.,M.B.A.,Ph.d.

Dr.O.Narayana Murthy. M.com.,M.B.A.,Ph.d.

Types of Elasticity of Demand

The formula is mathematically presented as:

Dr.O.Narayana Murthy. M.com.,M.B.A.,Ph.d.

2. Income Elasticity of Demand:

The formula is mathematically presented as:

where, ∆Q = change in quantity demanded or difference in Q2-Q1

The income elasticity of demand is negative, when an increase in income leads

3. Cross Elasticity of Demand:

where, ∆Q = change in quantity demanded or difference in Q2 - Q1

Dr.O.Narayana Murthy. M.com.,M.B.A.,Ph.d.

Measurement of Price Elasticity of Demand

Since OEFG is greater than OABC, it implies that change in quantity

Since OABC = OEFG, it implies that the change in quantity demanded is

Dr.O.Narayana Murthy. M.com.,M.B.A.,Ph.d.

2. Geometric Method/Point Elasticity Method:

(ii) Measurement of Elasticity on a Non Linear Demand Curve:

0 200 400 600 X

Dr.O.Narayana Murthy. M.com.,M.B.A.,Ph.d.

It is shown that at a price of Rs.10, the quantity of demanded of apples is 5kg.

Significance of Elasticity of Demand

Dr.O.Narayana Murthy. M.com.,M.B.A.,Ph.d.

2. Level of competition: Market competition affects the demand forecasting.

Methods of Demand Forecasting

2. Sales force opinion method or Collective Opinion Method:

Dr.O.Narayana Murthy. M.com.,M.B.A.,Ph.d.

Demand Forecasting For a New Product

Dr.O.Narayana Murthy. M.com.,M.B.A.,Ph.d.

Criteria for Good Demand Forecasting

Dr.O.Narayana Murthy. M.com.,M.B.A.,Ph.d.

6. Availability: Immediate availability of required data is of vital importance to