CONCEPTS AND TECHNIQUES OF MANAGERIAL ECONOMICS • Resources are limited and wants are unlimited. • Therefore, problem arises of choosing between alternative uses of the resources. • Economics deals with the problem of choice and evaluation on larger or macro scale.
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CONCEPTS AND TECHNIQUES OF MANAGERIAL
ECONOMICS
• Resources are limited and wants are unlimited. • Therefore, problem arises of choosing between
alternative uses of the resources.• Economics deals with the problem of choice and
evaluation on larger or macro scale.
• The firm or any business is a microeconomic unit. Here again, because of scarcity of resources there arises the problem of choice between the alternative and competing demands and the evaluation of the benefits and thus taking the most beneficial decision.
• The economic theories provide necessary tool at the micro level and these tools when applied to a micro-economic unit is called the managerial economics.
• Managerial Economics constitutes that part of economic theories and analytical tools that are widely applied to business decision-making and forward planning.
What is Economics? Economics is a social science. Its basic function is to study how people- individuals, households, firms, and nations- maximise their gains from their limited resources.
• Micro vs. Macro analysis: In micro-economics, the focus is on single individual entities like a consumer, a producer etc. in macro-analysis the problem is approached from the angle of totality or aggregates like national income, national consumption etc.
• Main contributions of economic theory to managerial
Economics – Building analytical models that help to recognise the
structure of the managerial problems, eliminate the minor details that might obstruct decision-making and help to concentrate on main issue.
– ‘A set of analytical methods’ which may not be applied directly to specific business problems, nevertheless, they enhance the analytical capabilities of the business analyst.
– Clarity to the various concepts used in business analysis, which enables the managers to avoid conceptual pitfalls.
• Business decisions may be of different nature like, financial decisions. production decisions, personnel decisions, marketing decisions, or miscellaneous decisions.
• Depends on other disciplines like Accountancy, Mathematics, Statistics, Operations Research, Psychology and organizational behaviour.
Nature of Managerial Economics
• Micro-economic in character
• Normative Science
• Prescriptive rather than Descriptive
• Pragmatic
• Science as well as Art
• The Scope (subject matter) of managerial economics can now be lined up as follows:
• Concepts and techniques Topics of ME Demand Analysis Demand Decision
Production and cost analysis Input-output decisionMarket structure analysis Price-output decisions
Firm behaviour analysis Profit maximisation and alternative hypothesis
Project Appraisal Investment Decisions Risk and uncertainty analysis Economic forecasting and
planning Environmental Issues Business cycle, Economic
system of the country, all trade related policies of the country
Importance of ME
• Reconciling traditional theoretical concepts to the actual business behavior and conditions
• Estimating economic relationships
• Predicting relevant economic quantities
• Understanding Significant External forces
• Basis of all business policies
Some fundamental concepts of Managerial Economics:
• Scarcity: “Scarcity” may be defined as “excess demand”. It is thus, a relative concept linked to demand.
• Marginalism: is used to study impact of small variations in inputs on costs, outputs or return like marginal output of labour, or marginal cost, or marginal return.
• Incrementalism: Very often it is not possible to change the inputs in small units and the changes may be done in chunks. In such a situation the word marginal is replaced by “incremental” like incremental cost, incremental return etc.
• Equimarginalism: Relative Activity Level Principle- MR1=MR2 or MC1=MC2 or MR=MC
• Opportunity Cost: Because of the limited resources and competing demands, only the best alternative is selected at the cost of others. Opportunity cost is the benefit of the sacrificed next best alternative that has been sacrificed. of “Y”.
• Time Perspective: Decision-making is the act of co-ordination along the time dimension- past, present and future.
• Discounting: for comparing the values of two time periods we have to discount the future inflows/outflows to bring at the same time horizon. This is called discounting. It is also used for risk hedging.
• Risk and Uncertainty: Future is always unknown and uncertain, the business decisions always have future implications and thus have an element of uncertainty and the business manager has to take some risk.
– Risk- can be statistically determined
– Uncertainties- cannot be statistically determined are termed as uncertainties.
– The risks can be got insured through an insurance company but the uncertainties cannot be insured.
• In fact profit is the reward of successful management of these uninsurable risks or uncertainties.
• Profit: Profit= Total revenue- Total costs.
Objectives of A Firm• The ultimate objective of a firm is to
maximise its profit.
• A firm faced with several alternatives having different profit outcomes will select the alternative with the greatest expected profit.
Alternative objectives of a firm
– Revenue maximisation
– Market share
– Technological excellence
– Growth rate
– Customer satisfaction
– Best employer status.
– Social Responsibility of business
• Hey! What about Money Value of Time?
Time Value of Money!
DEMAND DECISIONS
• Demand Concepts
• All decision-making by the management in any functional area- production planning, inventory planning, cost budgeting, purchase planning or market research – always hinges on the analysis of demand.
• Demand analysis seeks to identify and measure the forces that determine the sales and reflects the market condition for the products.
• Demand for a product may be defines as ”the desire for that product backed by willingness to pay and ability to pay”.
• Unless the desire is backed by willingness and ability to pay it may not be demand. All the conditions must be satisfied
Determinants of demand
• Its own price• Price of the related goods
-Substitute
-Complements• Budget of the purchaser• Income level of the purchaser• Advertisement for the product• Price expectation of the user• Taste and preference of the user• Demonstration Effect• Consumer credit facility• Population of the country• Distribution of income
Types of demand
• Direct and Derived demand:
– Direct demand e.g. food, clothes, shelter etc. – Derived demand- out of a demand for some
other commodity(parent commodity) e.g. demand for steel, bricks, fertilisers etc.
• Domestic and Industrial demand:• Autonomous and Induced demand
• Perishable and Durable goods demand: Perishable or non-durable goods (e.g. food items). Durable goods (e.g. clothes, shoes, houses, automobiles etc.)
• New and Replacement demand
• First and Intermediate demand
• Individual and Market demand
• Total market and Market segment demand.
• Short-run and long run demand: Short- run demand (e.g. fashion goods, goods for seasonal use etc.) Long-term demand, (e.g. demand for consumers and durable goods, producer goods etc.)
• Demand for firm’s product and demand for Industry’s products
Law of Demand• The law of demand states “the quantity demanded of
any product varies inversely with its price, other factors remaining constant”.
• Exceptions of law of demand Inferior Goods An inferior good is one for which the quantity demand varies inversely with the income
• In case of inferior Giffen Goods Generally the substitution effect of a price change is larger
enough to offset a negative income effect. But in case of the giffen goods, the income effect is so strong that, it offsets the substitution effect.
• As price rises the purchaser’s demand extends for commodities like staple (basic) food items.
●Expectations regarding future prices:When consumers expect a continuous
increase in the price of a durable commodity, they buy more of it despite the increase in price with a view to avoid a pinch of much higher prices in the future.
● Status Goods
ELASTICITY OF DEMAND
• In general, the elasticity of demand may be defined as the responsiveness of change in the quantity demanded with respect to a change in any of the factors affecting demand.
Types of Elasticity of demand• Price Elasticity of demand
– It is the ratio of proportionate change in quantity demanded to the proportionate change in the price of the product.
– If its value is one it is said to be unitary elastic
– If its value is more than one, it is said to me relatively more elastic (luxury and fashion goods, cars etc.)
– Its value may be from zero(inelastic) (e.g. salt).
– It is less than in one, case of necessities.
• Demand for necessities is generally inelastic.
• Demand for luxury goods is highly elastic.
• Durable goods have higher elasticity than non-durable goods.
• A commodity having a variety of uses will have higher elasticity.
• Goods having specific uses will have comparatively inelastic demand.
• Larger the substitute a commodity has higher is the price elasticity of demand.
• The price elasticity for a branded commodity is higher than that of a generic commodity e.g. wills cigarette and cigarettes in general.
Uses in Decision Making
• Price Discrimination• In Public Utilities• Super Markets• Use of Machines : Fear of Unemployment• Factor pricing• Shifting of Tax Burden• Taxation Policy
• Cross Elasticity of demand – It is the ratio of proportionate change in
quantity demanded to the proportionate change in the price of a related product.
– The related product may be a substitute ( tea and Coffee) or a complement ( tea and sugar)
– Elasticity for a substitute will be positive– Elasticity for a complement will be negative.– Important with the view of the pricing policies
of the competitors.
Uses in Decision Making
• If cross elasticity in response to the price of the substitutes is greater than one , it would be advisable to increase the price
• In case of complementary goods, reducing the price may be helpful in maintaining the demand in case the price of the complementary goods is rising
Contd..
• The firm can forecast the demand for its products and can adopt the necessary safeguards against fluctuating price of related goods
• Income Elasticity of demand– It is the ratio of proportionate change in quantity
demanded to the proportionate change in the income of the purchaser.
– It is positive for superior goods and negative for inferior goods.
– It is greater than 1 for luxury goods (e.g. car, CTV, fridge etc.)
– It is positive and equal to 1 for semi-luxury and comfort items (good quality of foods and clothing).
– It is less than one for necessities (foods, clothes etc.)– It is negative for inferior goods (bidi to cigarette)– It is higher for durables than for non-durables.
Uses in Decision Making
• Significant during the period of business cycle
• Used in estimating future demand if income and rate of change in income is known
• Helps in avoiding over and under production
• Helps to define normal and inferior goods
• Promotional (Advertisement ) Elasticity of Demand– It is the ratio of proportionate change in
quantity demanded to the proportionate change in the advertisement expenditure.
– The advertisement elasticity of demand is always positive for both informative and persuasive types of advertisements.
– The higher the elasticity, the more it pays the firm to spend on promotional activities
• Elasticity is determined by the following factors:– The extent of substitutability between goods;– The nature of the goods;– The price of the product itself;– The importance of the goods;– Whether the demand can be postponed or not;– Price expectation of the buyer;– Time allowed for making adjustment in
consumption pattern.
Determining Price Elasticity
Percentage Change in Quantity
Ep =
Percentage Change in Price
Change in Quantity
Quantity
Ep =
Change in Price
Price
Ep (a --- b) = (10/8)/(-2/10) = -6.25
Ep (c ---d ) = (10/80)/(-2/4) = -.25
P
Q
D
ab
cd2
4
8
10
8 18 80 90
What does the elasticity “measure” really measure?
• The elasticity measure is a ratio between two percentage measures: the percentage change in one variable over the percentage change in another variable
• A price elasticity of -6.25 means that for each one percent change in price the quantity demanded will change by 6.25 percent.
Arc (Price) Elasticity
P
Q
D24
Note that if we increased the price,
(from 8 to 10 or 2 to 4)
the original P and Q would be 2 and 8 and 18 and 90, respectively.
Ep = (-10/18)/(2/8) = -2.22
Ep = (-10/90)/(2/2) = -.11
810
8 18 80 90
a
b
c
d
Arc Elasticity
To get the average elasticity between two points on a demand curve we take the average of the two end points (for both price and quantity) and use it as the initial value:
Q2-Q1 10
(Q1+Q2) 8+18
Ea = = -3.49
P2-P1 -2
(P1+P2) 10+8
Point Elasticity Q
---------
Q1+Q2 Q P1+P2 Q P
E = ------------ = ------- . ------- = ------- . ------
P P Q1+Q2 P Q
---------
P1+P2
dQ P
Or, = ------ . -----
dP Q
Demand Forecasting – A special type
of economic activity • Need for demand forecasting:
– Sales constitute the primary sources of revenue. – Production for sales constitutes major source of
costs incurred by the firm. – Thus, sales forecast is needed for production
planning, inventory planning, manpower planning, financial planning, profit planning etc.
• Production itself requires the support of men, materials, machines and money. In fact, all the decisions are based on the sales forecast.
• No choice between forecasting and no forecasting, the choice lies only with the concepts and techniques that we employ.
• The forecasting projects the most likely future and the actual future because no forecast can be actual.
Techniques of demand forecasting • Economic and non-economic forecast
– Social, technological, political forecasts (crime rate, election forecasts etc.).
– Technological forecasts may, however, have economic relevance to. New technologies may create demands for a new product.
• Macro and Micro forecastAt the firm level, sales forecast s a micro forecast. At economy or industry level the same forecast is macro forecast.
• Active and passive forecast – Extrapolation of the past year’s demand for the
future year is ‘passive forecast’.– If the firm on the other hand, tries to
manipulate demand by changing product quality, promotional efforts etc. then it is example of ‘active forecast’.
– The expected sales, when planned actions and strategies are undertaken, result into active forecast.
• Conditional and non-conditional forecast – By way of ‘conditional forecasting’, we
estimate the likely impact of the certain known or assumed changes in the independent variables on the dependent variable.
– ‘Non-conditional forecasts’ in contrast, require the estimation of changes in the independent variables themselves. Such forecasting involves all risks of conditional forecasting.
• Short-run and long -run forecasts
• Approaches of Demand Forecasting
– Simple Survey Method– Complex Statistical Method.
Simple Survey method
• Expert Opinion poll method
• Reasoned Opinion Method (or Delphi Technique)
• Consumer Survey or Complete Enumeration method
• Sample Survey Method
• Consumer Clinics Method
• End-use method of consumers survey method- – A survey of the end users of the product. – The product may be used for final
consumption, or intermediate consumption or exports.
Complex Statistical Methods
• Time Series or Trend Analysis method– Time series data is used to fit a trend line or
curve either graphically or through statistical method of least square (QT).
– The trend may be linear, exponential, logarithmic or double logarithmic.
– The method is very simple.
Trend of LCV sales
0
20
40
60
80
100
120
140
160
1975 1980 1985 1990 1995 2000 2005
• It is assumed that past rate of change in the dependent variable will persist in the future also.
• It cannot be used for short-run or where trend is cyclical and abrupt changes are observed.
• This method does not bring out the measure of relationship between the dependent and independent variable.
Limitations
Barometric Technique or Lead-lag Indicator method
• Leading Indicators,• Coincidental indicators• Lagging indicators.
Ay/St
Ay
St
Time
Agricultural Income/ Sale of Tractors
Income/sales
sales
income
Simultaneous Equations Method
• This is very complex method • Used in macro level forecasting for the economy as a
whole. • It involves development of a complete model, which
can explain the behaviour of all the variables, which the decision unit can control.
• The number of equation in such a model equals the number of dependent (controllable) variables.
• Inevitably certain outside forces (exogenous variables) also affect the behaviour of independent variables (endogenous) variables.
• For example, the cigarette industry can determine the prices of cigarettes and the advertisement outlay but not the income of the consumers.
• Can forecasts be Accurate?
• If not then, why the exercise?
Supply Analysis
• Elasticity of Supply (Es)
• Determinants of Price Elasticity of Supply
• When Government Taxes Products
• For Next Time
Price Elasticity of Supply
• A measure of the extent to which the quantity supplied of a good changes when the price of the good changes, and all other influences on seller’s plans remain the same (cateris paribus)
• Price Elasticity of Supply (Es)
= % Change in Qs
% Change in Price
Computing Price Elasticity of Supply
• Percentage change in quantity supplied
Percentage change in price
• If Price Elasticity of Supply > 1, Supply is elastic
• If Price Elasticity of Supply = 1, Supply is unit elastic
• If price elasticity of supply< 1, Supply is inelastic
Price Elasticity of Supply
• Perfectly Elastic Supply – When the quantity supplied changes by a very large percentage in response to an almost zero increase in price
• Elastic Supply – When the % change in the quantity supplied > the % change in the price
• Unit Elastic Supply – When the % change in the quantity supplied = the % change in price
• Inelastic Supply – When the % change in the quantity supplied is < the % change in price
• Perfectly Inelastic Supply – When the quantity supplied remains the same as the price changes
Influences of Price Elasticity of Supply
• Storage Possibilities
The better the storability, the more elastic is the price elasticity of supply
Think of farm produce vs fertilizer as an example
• Price of the good
• Prices of factors
• Prices of other commodities
Influences on Price Elasticity of Supply
• Production Possibilities
-- Opportunity Costs
constant or gently rising opportunity costs
> the elasticity of price
-- Fixed Production < the elasticity of price
-- Time Elapse – longer time, > the elasticity of price
• Objectives of the firm
• Number of producers
• Government supply
• Future price expectation
Elasticity over Time
• Remember, supply grows more elastic over time, especially when enough time has passed for new firms to enter the industry and for existing firms to increase their output
• Economists have identified three distinct time periods
– The market period
– The short run
– The long run
The Market Period
• The market period is the time immediately after a change in market price during which the sellers can’t respond by changing the quantity supplied– During this period the supply curve may be
perfectly inelastic or with some positive slope because firms have limited ability to increase output
The Short Run
• In the short run a firm has an essentially fixed productive capacity but labor flexibility– A firm has some ability to increase output
• A firm could go from two 8-hour shifts to three 8-hour shifts
• Store hours could probably be extended
• And so, an increase in demand will result in more output
The Long Run
• In the long run there is sufficient time for a firm to alter its productive capacity– The firm can leave the industry– New firms can enter the industry– When a rise in demand is considered to be long
lasting, some existing firms will add to their plant and equipment
– If demand falls, some or all firms will cut back on their plant and equipment, while others may leave the industry
CHAPTER - 4COST CONCEPTS AND ANALYSIS • The aim of the business is to maximise
profits (Price- Cost).
• For this managers have to increase their revenues and minimise costs.
• The cost of production provides floor to pricing.
Types of Costs
1. Direct and Indirect Costs2. Explicit and Implicit (or imputed)
Costs3. Private Costs and Social Costs4. Relevant and Irrelevant Costs5. Economic Costs and Economic Profit6. Separable and Common Costs7. Fixed and variable Costs8. Out-of-Pocket Costs and book costs.
Economic Costs and Profits
• Accountants definition of profit is total revenue – total explicit costs
• Economists definition of profit is total revenue- total explicit costs- implicit costs.
• Or Economic profit = Accounting Profit – implicit costs.
Example
Sales
Cost of
goods sold
Salaries
Depreciation
Total Cost
Accounting Profit
Rs.
600,000
40,000
10,000
Rs.
800,000
650.000
150,000
Example
Sales
Cost of
goods sold
Salaries
Depreciation
Imputed salary of owner manager
Imputed interest cost of capital (equity)
Total Cost
Economic Profit
Rs.
600,000
40,000
10,000
50,000
25,000
Rs.
800,000
725,000
75,000
• · Prices are related as follows: TVC= Pr. V
AVC= Pr. V/Q MC=TVC/ Q =Pr. V/Q
Where, Pr is the price of input factor, V is the quantity, TVC is the Total Variable Cost, Q is the output quantity, MC is the marginal cost.
Cost Relationships• · In short run, Total Cost=Total Fixed Cost +Total
variable costs
• ·The variable cost, and thus, the total cost typically first increases at decreasing rate and then at increasing rate due to Principle of Diminishing Marginal Productivity. · The principle states that as we increase any variable
input factor of production, the marginal product (MP) first increases and then declines.
• The variable cost, average cost, and the marginal cost first decrease then increase.
• Once the marginal product increases, the average variable cost (AVC), marginal cost (MC), and the average total cost (ATC) decrease.
• When the marginal product decreases, the average variable cost (AVC), marginal cost (MC), and the average total cost (ATC) increase.
• The rate of change in the marginal cost is higher as compared to the average variable cost or average total cost.
• The AVC, MC and the ATC curves are all U-shaped curves.
• MC curve is however, more steeper than AVC.
Cost Relationships(1)
Total Production
(Q)
(2) Total Fixed Cost
(TFC)
(3) Total
Variable Cost
(TVC)
(4) Total Cost
(TC)
(5) Average
Fixed Cost (2/1)
(AFC)
(6) Average variable
Cost (3/1)
(AVC)
(7) Average
Total Cost (4/1)
(ATC)
(8) Marginal
Cost
(TC/Q) (MC)
0 100 0 100
1 100 90 190 100.0 90.0 190.0 90
2 100 170 270 50.0 85.0 135.0 80
3 100 240 340 33.3 80.0 113.3 70
4 100 300 400 25.0 75.0 100.0 60
5 100 370 470 20.0 74.0 94.0 70
6 100 450 550 16.7 75.0 91.7 80
7 100 540 640 14.3 77.1 91.4 90
8 100 650 750 12.5 81.3 93.8 110
9 100 780 880 11.1 86.7 97.8 130
10 100 930 1030 10.0 93.0 103.0 150
Cost Curves
0
500
1000
1500
1 2 3 4 5 6 7 8 9 1011Quantity
C o s t s
Total Fixed CostTVC
TC
Average & Marginal Costs
0.0
50.0
100.0
150.0
200.0
1 2 3 4 5 6 7 8 9 10
Output
Cos
ts
AFC
AVC
ATC
MC
• How much of input should be employed ?• An additional input of any factor, say labour (L)
can be employed, if additional output (revenue) is more than the additional cost. Marginal revenue product of labour (MRPL)
MRPL = M PL * M R • Where, M PL is the marginal product of
labour and M RL is the marginal revenue. • The optimum number of labour is determined by
the condition, MRCL = MRPL .
Long Run Total Cost CurveTC4
TC3 TC5
TC2TC1
TC
Q
LTC
• The long run total cost may also first increase at a decreasing rate and then at increasing rate.
• LTC curve starts from origin implying that all costs in long run are variable ( the business will cease to exist ).
• Thus, it is analogous to short run TVC except in the shape.
LAC CurveCost
SAC1 SAC5 F SAC2 SAC4
A SAC3
B E LACSMC4
Q QQ1 Q2 Q3
LMC
C D
Economies and Diseconomies of scale
Cost
Economies Diseconomies
Quantity
• Economies and diseconomies of scale are concerned with the behaviour of the average cost as the plant size changes.
• The U-shaped LAC curve is explained by the economies of scale. The point at which LAC is minimum is the point where economies and diseconomies are just equal
• Marshal classified economies and diseconomies of large scale into two types: Internal and External.
• Internal economies and diseconomies are due to the firm’s own expansion
• External economies and diseconomies may arise due to the expansion of the industry as a whole.
• Since internal economies (diseconomies) are available to particular firm only, they give it an advantage (disadvantage) over other firms in the industry. In contrast to the, external economies do not discriminate between firms.
• From managerial point of view, internal economies are more important than external ones, because while the former one can be affected by managerial decisions of an individual firm changing its size or scale, the latter are not subjected to such influence.
Usefulness of LAC Curve
• A given output at the minimum cost. • LAC curve helps to decide the size of the plant to be
adopted for producing a given output. • In increasing returns to scale, it is more economical to
under- utilise a larger at a slightly lower than the minimum cost output level than to over-utilise a smaller plant.
• Conversely, at outputs beyond the optimum level (under decreasing returns to scale) it is better to slightly over-utilise a smaller plant than under-use a larger plant
Determinants of Cost
• The general determinants of cost are:
• Output level
• Prices of factors of production
• Productivities of factors of production
• Technology
Importance of estimation of Cost Function
• The decisions such as : whether to increase the output, whether the plant is of optimal size etc. would largely depend upon increase in total costs a firm should know the cost function facing it.
• The knowledge of cost function is also essential for future planning. The exact future cost-output relationship may not be available until the firm goes for actual expansion of its output.
• The approximate cost-output relationship can be worked out using the following three methods:
• Engineering Method• Accounting method• Statistical method
Problems of measurement
• The cost and output data must be correctly paired- Cost data corresponding to the output data.
• The data should be obtained for a period when the output has been produced at relatively even rate
• All explicit as well as implicit costs have been properly taken into account and that all costs are properly identified by time period in which they were incurred.
• For multi-product firms it may not be possible to separate costs according to output in a meaningful way, cost allocation among various products on relative proportion of each output product in total output. Not accurate
Managerial uses of estimated cost function
• The estimated cost function is very useful to the managers to make meaningful decisions with regard to:
• Determination of optimum plant size – minimum LAC
• Determination of optimum output for a given plant –SAC is minimum
• Determination of a firm’s supply curve- cost function and the objectives of the firm
Production Theory
• Deals with quantitative relationships between inputs, technical and technological
• Least cost combination of inputs
• Relationship between input and output
• Role of technology in reducing the cost
• Rate of return when there is change in the scale of production
Production Process
• A transformation process
• Input and output
• Fixed and variable inputs
• Production function: describes technological relationship between input and output in physical terms
Production Function
• Q= f ( Ld, L, K, M, T, t)
• Applicable Function- Q= f (L, K)
• Short Run Production Function- Q=f (L)
• Long Run Production Function-Q= f (L, K)
Laws of Production
• Short run law of production or The law of returns to a variable input or The law of diminishing returns
• When more and more units of variable input are applied to a given quantity of fixed inputs, the given output initially increase at an increasing rate, then at a constant rate and eventually increase at diminishing rates.
Laws of Production
• Long run laws of production or The laws of returns to scale
• Three kinds of returns to scale:
-Increasing returns to scale
-Constant returns to scale
-Diminishing returns to scaless
CHAPTER-5PRICING DECISION POLICIES
• Price affects the profit through its effect both on total revenue and total cost. Total revenue equals price per unit multiplied by the quantity sold.
• The quantity sold varies with the variations in price, and the total as well as the average costs depend upon the volume of output.
• Thus, price plays very important role in profit planning.
• If the prices are set too high, the seller may not find enough buyers to buy his product. If the price is too low, the costs will not be recovered. Furthermore, since what is a good price today may not be a good price tomorrow. Hence, the pricing decision needs to be reviewed and reformulated from time to time.
• Apart from the buyers and sellers, certain other parties are also involved in pricing process. They are competitors and the Government.
DETERMINANTS OF PRICE
• Demand for it;
• Cost of production and capacity;
• Objectives of the producers;
• Nature of the product;
• Nature of the competition in the market;
• Environment policy or the Government policy pertaining to it.
• Competitors: Price of competing products (e.g. colour TV),New firms entering the market,Pricing policy changes by the competitors.
• Government PolicyCustom and excise duties and other taxesLicensed capacityControlled and duel pricing
• Substitutes and ComplementsColour TV and VCRCompeting demand on limited income of
consumers (e.g. CTV or scooter)
• Product characteristicsMany substitutes for the product like detergent
powder (bar soaps, chips, cakes, liquid etc.)More violent competition like rail and road
transportPhysical characteristics of a product can also
influence the competitive structure of its market. If the distribution cost is a major element in the cost of a product, competition would tend to be localised or location of several plants around all the major markets. Similarly competition is local for perishable goods.
Conflict between physical characteristics and minimum economical size (e.g. cement plant near mines where demand is low and heavy transportation cost of cement hence different costs in different markets.
This may, however, be partly offset by mechanism of levy price which is the same throughout the county.
FORMS OF MARKET STRUCTURE AND PRICING
• Forms of Market Structure
– Market may be defined as “ a group of people and firms, that are in contact with one other for the purpose of buying and selling some product”. It is not necessary that each one contacts with each other.
– Market Structure may be defined as “ the number and size distribution of the firms in a market”.
– Implicit in the concept is that the market structure for a product includes not only the firms and individuals currently engaged in buying or selling but also the potential entrants.
• Markets are traditionally classified into two broad and four main categories as below:
– Perfect competition– Imperfect competition
• Monopoly• Monopolistic Competition• Oligopoly
Perfect CompetitionCharacteristics:• A large number of buyers and sellers• Essentially identical product or are so perceived by
the buyers• Any single firm is so insignificantly small as
compared to the total market that it cannot influence the price of the product.
• Perfect mobility of resources• Members of the market have perfect knowledge
about the market• Free entry and free exit• Indifference
Monopoly
Characteristics:• A single seller of the product• The firm and industry coincide by definition• The firm has substantial control over the
price• The firm can control either the output or the
price but not both• The product may or may not be
differentiated.
Monopolistic Competition
Characteristics:• A large number of firms• Products are differentiated. The differentiation
may be real or perceived by the customer.• The firm has some control over the price. By and
large the firm is not able to earn excessive profits in long run because the entry of new firms cannot be rules out.
• The competition is not restricted to variation in price but extends to promotion, research and development.
Oligopoly• Oligopoly market is characterised by:
• Small number of firms account for the entire industry output. For example, 5-6 integrated steel plants account for almost 100% of the county’s steel production.
• The product may or may not be differentiated.
• The firms do not resort to price reduction wars and the competition is in the form of newer brands, models and advertisement.
• Interdependence of pricing decisions.
• There is vigorous competition where the firms manipulate both prices and volumes in an attempt to outsmart their rivals.
Monopsony:
• Many sellers but only one buyer. • For example, Indian railways are the buyers of
railway coaches but many suppliers.• Here the buyer can influence the prices and the
prices are determined through negotiations. Oligopsony:
• Few suppliers and few buyers. • For example, the explosives are produced by
only few and also purchased by a few for defence, road and bridge construction and mining purposes etc.
Factors affecting nature of competition
• Effect of buyers– Monopsony- Many sellers and one buyer (e.g. railway
wagons are manufactured by six firms but there is only one buyer i.e. I. R.)
– Oligopsony- Few larger buyers (e.g. explosives are purchased by CIL, Irrigation and PWD, Govt. deptts. /agencies working on roads and buildings)
– Most industries manufacturing heavy engineering equipment in India are characterised by few sellers and few buyers. In this case prices are negotiated across table.
• Production characteristics
Minimum efficient scale of production in relation to the industry output and market requirements sometime play a major role in shaping the market structure. That is why we have only five or six integrated steel plants (even five or ten in USA), since minimum economic size is few million tonnes.
Further, the economic size changes drastically with technological advancements. The number of firms declines if technology pushes the economic size up (e.g. synthetic fibres). Conversely, technological innovations make it possible for smaller size plants to become economically viable resulting in more entries and competition (computer market).
Raw materials availability, availability of skilled labour can also mould the market structure.
PRICING UNDER PERFECT COMPETITION
• In short run, in the perfect competition market, the prices are determined by the market forces of supply and demand. For the firm, the equilibrium point is determined at the point where the MC curve intersects the MR curve from below. AR and MR curves will coincide.
Pricing Under Perfect Competition
P
P
S
PP
P’
P
P
AR=MR
AR’=MR’D
D
D’S D’
AVC
MC
b
Q’QQ Q’
c
a
c
Industry Firm
• P=MC=MR=AR.
• In the long run, all costs are variable i.e ATC=AVC=MC and no firm will earn any profit.
PRICING UNDER Monopolistic Competition
• Since products are similar but not identical, there will be no unique price.
• There will be a cluster of market prices reflecting consumers’ opinion of the comparative qualities of differentiated products.
• The price of an individual firm’s product is determined by its cost function, demand, its own objectives and the government regulations, if any.
• The demand curve of the firm has a downward slope because of product differentiation and attachment of consumers to particular brand names.
• As larger and larger price the firm institutes reductions, more and more customers from its rivals will come to it.
• However, the demand curve is highly elastic. The cost function of a firm under such a market structure would be similar to that of other types of markets.
• The equilibrium in this case also determined in the manner equilibrium is determined in case of perfect competition.
PC
P
B
Q
A AVC
MC
ARMR
P
AVC
MC
ARMR
Short run equilibrium Long run equilibrium
P
QQQ
• In the long run, equilibrium output is less than the optimal output.
• The positive difference between the optimum output and the equilibrium output is termed as ‘excess capacity’ and so there exists an excess capacity in the monopolistic market.
• For similar, reasons, the price is much higher than the average total cost in such a market.
PRICING UNDER MONOPLY
• Monopoly– Monopoly is also very rare.– It exists when the firm is the sole producer of a
product, which has no close substitute.– The monopolist can either decide the price or the
volume.– In the short run a monopolist may earn profit or incur
loss.– However the firm must cover his all variable costs
and so his losses will be equal to the total fixed cost. – Monopoly Power: The difference between the
optimum volume (no profit no loss) and the actual production is known as monopoly power of the firm.
PC
P
B
Q
A AVC
MC
ARMR
P
AVC
MC
ARMR
Short run equilibrium Long run equilibrium
P
Q Q
PRICING UNDER Oligopoly
• In oligopoly market the prices are not determined by the supply and demand conditions.
• Firms are large enough to influence the supply conditions the pricing decision taken by one firm also affects other firms in the industry.
• The oligopolists do not resort to competition through price reductions as it will start a price war reduce their profits.
Price determination theories
• Augustine Cournot model- According to this model, every firm tries to maximise its profit.
• Collusion Model or the Cartel Model: The firms form a cartel and decide the prices and the output of each firm on the basis of their existing market share.
Leader follower model• Price leadership may emerge out of technical
reasons or out of tacit or explicit agreement to assign a leadership role to one of the firms.
• The leadership role is normally played by the most dominant firm in the industry.
• Company as their leader and follow its pricing decisions
Kinked demand curve. • Prices appear to have exhibited a remarkable degree
of stability particularly in their resistance toward downward change.
• Competitors follow price decreases by their rivals but they do not follow price increases.
• For this reason the demand curve of an oligopolist is a composite of two demand curves-(1) for the price increases (more elastic) and (2) price decrease (less elastic).
• In the presence of a kinked demand curve of this type, the firm would have no motive to change its price.
• Equilibrium price remains at OP
Kinked demand Curve
Pri
ce/C
ost
MRD
D’
MCMC’
Quantity
A
R’
R
B
C
E
O
P
Demand curve for price increase
Demand curve for price decrease
• Duopoly: a special case of oligopoly with only two sellers in the market.
Pricing Polices and Practices
• Target Return Pricing: predetermined return to the firm from the sale of specified product or group of products.
Pricing Methods
• 1) Cost Plus Pricing:
Price=AVC+AVC (m)AVC (m)= AFC+NPM
Where AVC =Average variable costAVC (m) = Mark up or gross profit
margin (GPM) AFC = Average Fixed CostNPM = Net profit margin
• Limitations• The method uses optimal allocation of resources and
the standard cost is comparable with the industry standards.
• The assumption of cost may be over or under estimated. In this method historical cost data are used.
• If the current situation varies, there may be under-pricing or over-pricing, if the costs go up or down
• If variable costs fluctuate frequently and significantly, this may not be useful.
• It ignores demand.• It does not reflect competitive forces
• Cost plus pricing is useful in the following cases:
• (i) Public utility pricing
• (ii) Product tailoring
• (iii) Pricing products that are designed to the specifications of a single buyer.
• The method is widely used in India too for two specific reasons:
(i) The prevalence of sellers’ market till recently made it possible for the producer to pass on the increases in costs to consumers.
• (ii) In the cost-plus method a reasonable profit is taken for the fixation of the price in price controlled industries. Thus, the method has the tacit approval of the government.
• To conclude, the cost plus pricing is a pricing convention relying primarily on arbitrary costs and mark-up it is adopted because it is simple to apply
• Penetration Pricing
• start with a low price initially and subsequently increased when the demand for the product is established.
• If, however, the prices are set too low, the consumers may think that the prices have been kept low at the cost of the quality of the product.
Price Skimming
• Higher prices (three or four times the ex-factory price) of new product to take advantage of the consumer behaviour(to take advantage of liking of elite group of customers.)
• The prices may be subsequently reduced when competitors come in.
Market leader pricing
• Low price of a product of the product line low, even if negative contribution with the aim to earn profit from other products of the product line or the same product in future. (camera price low and higher prices on films so that the two combined give profit.)
Pricing of skills• Demand and supply of skills in the market. The
concept of opportunity cost becomes more relevant in case of pricing of services.
Pricing of spares• The spares, which are easily available, may be
priced low and the parts, which are not easily available, and the proprietary item may be priced slightly high.
• The general thumb of rule is that the total price of all the assembled parts should not be more than the price of the assembled whole.
Pricing of leases and licences
• The pricing strategy is based upon the utility the consumer or user perceives in the lease or license. The price is set accordingly.
Multiple Product pricing
• The point of equilibrium is determined by the point where the MC =CMR.
• A vertical line drawn from the point of intersection will intersect various MR curves at different points, which will determine their prices.
Other Principles• Prices are proportional to full cost
(including a target rate of return)- • Each product assumes its allocated share
of common overhead expenses.• The method is thus, arbitrary and no
consideration of demand. • They produce a fixed percentage of net
profit margins.
Prices, which are proportional to incremental costs (including a fixed percentage rate of profit) –
• Same percentage of net margin over incremental costs for all products.
• Thus, this method also suffers from the same limitations.
Prices, which are proportional to conversion costs-
• Conversion costs, are costs of converting raw materials to finished product i.e. labour and overheads.
• This method also does not get much support.
Illustration
Cost Structure
1. Material Cost
2.Labour Cost
3. Overhead Cost
Full Cost (1+2+3)
Incremental costs (1+2)
Conversion Costs (2+3)
Soap 1
2.00
1.00
0.50
3.50
3.00
1.50
Soap 2
1.00
1.50
1.00
3.50
2.50
2.50
S.N.
1.PRICING METHOD
Full cost Pricing
Incremental cost Pricing
Conversion Cost Pricing
MARK-UP
10%
20%
90%
SOAP 1 (Rs.)
3.85
3.40
2.85
SOAP 2 (Rs.)
3.85
3.00
4.75
Prices are set differently in different markets (i.e. price discrimination and product differentiation continued)
• Depending upon elasticity of demand of different market sectors/segments – buyers with high income are less sensitive to prices (luxury cars).
Prices are related to the stage in the life cycle of the product
• A product may start as a novelty, later become a speciality and finally degenerate into a common product. Prices are decreased accordingly
Prices are set with a view to maximise the net revenue than from a specific product within the product line.
• (cheaper camera and costlier films).
A multiple product firm faces four kinds of general problems, which a single product firm does not face:
• Intensity of competition each product meets in the market.
• Intensity of competition, which each product faces from the other products of its own product line.
• Allocation of joint costs of production, distribution, selling and advertisement.
• Shifting of economic resources from one product to another to attain an optimal rate of return for the firm.
• These will, however, depend upon nature of product
Specific problems of product line pricing• Problems relating to pricing of products,
which differ in size. – There are two different alternatives- different
sizes for different sizes and uniform prices for all sizes.
– Much depends on whether or not the buyer has choice to substitute one product size for another size.
– Price setting below becomes easier if a new non-substitutable size is added to the product line.
Relating to pricing of products of special order.
• The firm has to find out what the is the highest price that can be quoted without risk of loosing the order and also the lowest price it can accept.
• The first question arises- is there any long run benefit?
Relating pricing of repair parts or spare parts.
• Normally low prices are kept for easily available parts and higher prices for rare parts.
• Pricing of spare parts must be consistent with the pricing of the whole product (rule of thumb is that the price of spares combined is not more than double the price of the complete product.
Problem relating pricing leases and licenses-
• Price discrimination can be easily practiced for equipment on lease. Different users may get different benefits.
• The principal consideration in pricing leases and licenses should be the worth pf the process to the licensee.
• This sets the maximum limit for fixing the royalty.
Pricing related goods-
• Price can be set to get largest contribution margin according to separate market elasticities of the market segment (e.g. films and camera)
Situations requiring major pricing decisions
• In actual practice, firms adopt various pricing tactics and strategies. The act of pricing decision is full of complexities and MR = MC is too simple way of looking at the pricing problem.
• Pricing becomes major problem in essentially the following types of situations:
• New product introduction or setting the price for the first time.
– Setting the first price is a major decision. When the company launches a new product for the first time, the future depends heavily on the soundness of the initial pricing decision.
– Every time a new product is added to the product line or existing product is modified, the firm has to look carefully at same issues.
– The nature of the modification, its relation to the existing product and several other aspects are to be considered.
– In case the new product is a close substitute for the company’s existing products, there is always a danger of the existing products getting killed by a faulty pricing of the new one.
• Should we ever Charge price lower than the average total cost of a product?
Point to ponder
PROFIT POLICIES & PLANNING
Nature of Profit Net profit is a sum over and above the
ordinary costs of business including contracted outlays on land, labour and capital.
No body contracts to pay the entrepreneur the profit. Business profits are consequent upon successful management of risks and uncertainties.
• Business is faced with a number of uncertainties:
1. Technical uncertainties- those relating to physical process of production.
2. Cost uncertainties- changes in the prices of are materials, labour, rent etc. or due to technology changes.
3. Demand uncertainties- changes in consumer preferences or introduction of new products and obsolescence of old products (gramophone records and cassettes).
4. Market uncertainties- future prices of products or volume of sales.
• The entrepreneur receives a reward for combining the factors of production to meet the economic needs of the world faced with uncertainties.
• He takes a risk which others do not want to, and if he successfully manages the risks he receives a profit.
• Thus, a business man has to do two things:1. Select the risk which he wishes to take,
and2. Manage them successfully.
• Since risks and uncertainties are because of changes in the dynamic world, the profits vary from year to year.
• Profits are affected by the level of business activity.• Profits are likely to be high in industries in which :
– methods of production are constantly changing so that there is continuous adoption of new technologies,
– in nascent industries which are rather uncertain, in industries in which there is along gestation period, and
– in industries in which resources are committed to a narrowly specialised tasks.
Profit Theories
Profit is the reward for bearing risks and uncertainties. • According to Prof. Frank H. Knight, risks inherent in any
business are of two types- insurable and non-insurable risks. • Risks which can be statistically calculated and thus insured
with an insurance firm are of two types: – (a) risks of loss of property due to earthquakes, fires,
flood or other natural calamities; and – (b) risks of dishonesty such as loss due to theft, robbery,
burglary etc. these risks are borne by the insurance company and the insurance premium is charges to cost of production and hence enters into the price of the product.
• However, there are certain risks which cannot be insured and are necessarily to be borne by the business entrepreneur himself, like:
a. Risks of competition,b. Technical risks – obsolescence,c. Business cycle risks- depressions,d. Risks arising from government actions-
price control, tax policy, import and export restrictions etc.
• According to Prof. Knight, pure economic profit is related to uncertainty.
Profit as a consequence of market imperfections and monopoly
• A monopolist can restrict output and obtain a higher profit. Profit is the result of contrived scarcity and consumers are deprived of the alternate sources of supply.
• Contrived scarcity must be distinguished from natural scarcity (e.g. urban plots and good farming land).
• Profit is the reward for successful innovation. • Innovation refers broadly to any purposeful
change in production methods or consumer tastes that increase the output more than the increase in costs.
• The increase in net output is the profit that comes from innovation. In includes not only new products such as synthetic fibres, but also new organisations, new markets, new promotion and new raw materials.
• To an important degree, innovation has been built into the competitive system complete with research and advertising itself.
• The innovator can earn high profits by bringing their new revolutionary products in the market, the public is attracted by the apparently superior product and is willing to pay a higher price.
• Thus, the innovator reaps a high profit for it. Following a successful innovation comes a period of adjustment when new competitors come in and sooner or later innovational products die out.
• Meanwhile, in dynamic economy, other innovations are hitting the market.
• No one of these theories is necessarily correct. All are in
some sense complimentary.
Measurement of Profit • Accountants’ Concept of profit• The accountant is concerned with the
historical data. In accounting terms, the profit can be defined as under:
=R - T - W – I
Where, R = Total revenue, T = Total Costs, W= Taxes, and I =Interest.
• Economists’ concept of profit
Economists do not agree with the accountants’ approach. Economist would deduct implicit costs or opportunity costs or the imputed costs from the accounting profit to arrive at economic profit. Thus, the economic profits would be:
* = - Oc =R - T - W – I – Oc
Where, Oc is the opportunity cost.
• Difficulty in measurement of profit • The distinction between the accounting profit
and the economic profit makes the measurement of profit a difficult task.
• The economists’ opportunity cost is not easily identifiable and measurable.
• On the other hand, accounting costs, both direct and indirect, are easily identifiable and recorded.
• A fundamental principle of accounting is that the assets of the business are subject to claim by two parties0 owners and creditors.
• Thus, Assets = Liabilities + Proprietorship
Or, Assets – Liabilities = Proprietorship= Net assets
The balance sheet of the firm indicates the value of the firms’ assets corresponding to claims of creditors and owners at a given time.
The ‘Income & Expenditure’ or ‘Profit & Loss’ statement records the changes in these items resulting from business transactions over a period of one year.
The ‘ Funds Flow Statement’ records the sources and uses of funds.
In preparing these statements, accountants normally show assets valued at original (historical costs).
• By contrast economists try to assess the present value of future cash flows which existing assets might bring. Traditional financial accounting finds it unsatisfactory because it is somewhat speculative.
• There are three basic aspects of profit measurement where the use of accounting and economic methods gives different results.
• These aspects are (a) Depreciation,
(b) Inventory valuation and
(c) Unaccounted value changes
(A) Depreciation Depreciation is normal wear and tear in fixed assets like
machines through continuous use, over a period of time. Accountants employ several methods to compute depreciation. Some of these are:
• Straight Line Depreciation Method: In this method a fixed percentage of original value of assets is charged to the revenues. Depreciation is computed as
D= [ (F –S)/N] Where, F= Original Cost of fixed cost of assets,
S= Salvage value of assets,N= Life of the asset, andD= Annual Depreciation charge.
• Diminishing balance Depreciation Method: It provides for a constant percentage annual depreciation charge.
D= [ 1-(S –F)/1/N]
• Annuity Method: • This method requires the cost to be recovered
equal to the fixed cost of assets plus an interest rate (r) equal to the cost of capita, covering annual fixed instalment over the estimated life of the asset.
D= [ (F+r)/N]
• Service Unit Method
• It is appropriate where the life of an asset depends upon its uses rather than time. In its simplest for, the difference between the original cost and the salvage value is divided by the life time capacity (Q) so that
D= [ (F-S)/Q]
• For an economist all above methods are of no use. • The economist looks at depreciation in terms of
opportunity costs and uses the asset replacement costs (R) rather than the original costs (F). R is the difference between the new investment (I) and salvage value (S) of the old asset.
R = I – S
R> F during inflation, and
R< F during the period of falling prices.
Inventory valuation• Inventory refers to stock i.e. goods in pipe line i.e.
difference between production and consumption. • The stocks pile up and vice versa. • Such inventory build-up or stock pile-up would have
posed no problem of valuation, had prices been constant. In practice, prices do not remain constant, material cost changes, and different prices might have been paid for different lots of the same material purchased at different points of time.
• The valuation of inventory, must, therefore, change at different points of time.
• Three following three methods of inventory valuation are popular:
• First – in- first- out (FIFO) method
Materials are withdrawn from the stock in the same order as they are acquired such that the manufacturing costs are based on the cost of the newest materials in stock.
• Last –in – First – Out(LIFO) method
The most recently purchased materials are withdrawn from the stock such that the current manufacturing costs are based on the cost of newest materials in stock.
• The Weighted Average Cost (WAC) method
A weighted average of different costs, corresponding to different lots of materials purchased at different periods is used for valuation of inventory.
• The recorded value of business incomes in periods of rising or falling prices may differ considerably depending upon the choice of inventory valuation methods.
• For example, FIFO method will increasingly high profits during inflation and low profits during deflation.
• LIFO may be a better choice because it will show relatively more accurate costs of manufacturing during inflation or deflation.
• Economists feel that neither of these provide the measure of business income at different prices.
• Thus, the economist would like to adjust the accountant’s data at constant prices so that they can compare the levels of profit over time, reference being ‘economic profit’ net of operating costs.
• Unaccounted Value changes• There may be certain items of business expenditure
which may not may have any impact on current business income, but which may increase the future income of the firm.
• Accountant does consider the future value of current expenditure on items like research and development.
• Advertisement, recruitment of successful managers etc. in the process, accountant may understate current profits and overstate future profits.
• The economist would like to take care of intangible assets and liabilities and the opportunity gains and costs involved therein so that a time measure of economic profitability is estimated.
• It thus, follows that the management accounting techniques and conventions of measuring profit do not appeal to the economist, though both agree that the measurement of profit is necessary for business decisions.
• Most of the economic decisions of the firm are ultimately based on profit decisions involving opportunity cost calculations.
BREAK EVEN ANALYSIS
Business is faced with a number of uncertainties
created by the dynamic nature of consumer needs,
the diverse nature of competition,
The uncontrollable nature of most elements of cost, and
the continuous technological development.
A healthy business has to make
profit consistent with the various risks that it has to face. The business has, therefore, to be prepared to face the uncertainties created by these risks, and firm has to plan for profits and not left to chance. In this respect a thorough understanding of the relationships of costs, price and volume is extremely helpful. Break-even analysis or cost-volume-profit (CVP) analysis is the most important method for this purpose.
• Break-even point (BEP)
Defined as that level of sales at which total revenues equal total costs and the net income is zero. This is also known as no-profit no-loss point.
Determination of Break-even point: It be determined either in terms of sales volume
(units) or sales value (Rupees)Break-even point in terms of sales volume or
physical units: Break-even volume is the number of physical units
of product which must be sold to earn revenue just enough to cover all costs- fixed and variable.
The selling price covers not only the variable costs but also leaves a margin (contribution margin) to contribute towards the fixed costs.
The break-even point is reached when sufficient number of units have been sold so that the contribution margin of the units is equal to the fixed costs.
Method is convenient for single product.
Break-even point = Fixed cost
Contribution margin per unit
Where,
Contribution margin = sale price – variable cost per unit
Ex. 1: Given that
(a) fixed cost = Rs. 10000 per year,
(b) Variable cost = Rs. 2.00 per unit and
(c) sale price = Rs. 4.00 per unit,
(d) calculate the BEP.
Solution:
Contribution Margin per unit
=Sales price – variable cost per unit
= Rs. 4.00- Rs. 2.00
= Rs. 2.00
Break-even point = Fixed cost/ Contribution Margin per unit
= 10,000/ 2= 5,000 unit.
At this sales volume there will be no profit or loss.
Break-even point in terms of sales value
• Multi-product firms cannot measure b. e. p. in terms of sales volume but in terms of total value of sales i.e. rupee sales.
• Here again, the breakeven point would be the point where the contribution margin ( sales value – variable costs) would equal the fixed costs. Contribution margin is, however, as ratio to sales.
• If sales are Rs. 200, and variable costs for these sales is Rs. 140, the contribution ratio will work out to [(200-140}/200] 0.3
Break-even point = Fixed cost
Contribution ratio
Where,
Contribution ratio = [(sales – variable costs)/sales]
• Example 2: Given sales= Rs. 10,000, variable costs= Rs. 6000 and fixed costs=Rs. 3000 calculate breakeven point.
Solution: Contribution ratio = [(sales – variable costs)/sales] = (10,000-6,000)/10,000 = 0.4 Break-even point = Fixed costs/ contribution ratio = 3,000/0.4= Rs. 7,500
• Example 3:
Sales of Rs. 15,000 provide a profit of Rs. 400 in a week.
In the next week, sales amounted to Rs. 19,000 and profit was Rs. 1200. Find B. E. P.
Solution:
Increase in Sales = Rs. 19,000- 15,000 = Rs. 4,000
Increase in profit = Rs. 1200- 400 = Rs. 800
Increase in variable cost= Rs. 4,000 – 800 = Rs. 3,200
So, for sales of Rs. 4,000, the variable cost = Rs. 3200
Or, Variable cost per unit = 3,200/4,000 = Rs. 0.8
Hence, for a given sales of Rs. 15,000 variable cost can be worked out as under:
Variable cost = Rs. 15,000 x 0.8 = 12,000
Profit = Rs. 400
Variable cost +Profit = Rs. 12,400
Sales Value = Rs. 15,000
Fixed Cost = sa0les value-v. c.–profit
=Rs. 15,000- 12,400
=Rs. 2,600
Contribution ratio= (Sales- V.C. )/ Sales
= Rs. (15,000-12,000)/15,000
=3,000/15,000 =0.2
Break-even point =F.C./Contribution ratio
=2,600/0.2 =Rs. 13,000
Break-even point as a percentage of full capacity
• Full capacity may be defined as the maximum possible volume of production available with the firm’s existing fixed assets, operating policies and practices.
• Break-even point is usually expressed as a percentage of full capacity. Supposing full capacity in example 1 is 10,000 units, the B. E. P. at 5,000 units can be expressed as 50% of full capacity.
Multi-product manufacturing and Break-even Analysis
• Example 4: A manufacturer manufactures tables, chairs and lamps. The cost accounting department has supplied the following data:
Product Selling price p.u.
v.c. p.u. % of rupee sales value
Tables 40 30 20
Lamps 50 40 30
Chairs 70 50 50
Capacity of the firm Rs. 150,000 of total sales value
Actual fixed cost Rs. 20,000 Calculate (1) Break-even point(2) Profit if firm
works at 80% of capacity Solution: The contribution towards fixed cost in each case is as
follows: Tables Rs. 10Lamps Rs. 10Chairs Rs. 20
The percentage contribution by each product works out as follows:
Contribution* 100/ selling price Tables 10*100/40 = 25%Lamp 10*100/50= 20%Chairs 20*100/70= 28.57%Now, we multiply the contribution percentage of each
product by the percentage sales volume for that particular product and add the figures so obtained. This gives the total contribution per rupee of sales volme for these products.
Product Contribution %
% of sales Contribution % * % of
sales
Tables 25 20 5%
Lamps 20 30 6%
Chairs 28.57 50 14.28%
Total 25.28% Say 25%
This 25% is the total contribution given the present sales mix per rupee of overall sales.
(1) Break-even point = Fixed Cost/ Contribution ratio= 20,000/ 25% = Rs. 80,000
(2) Profit: If the produces 80% of its full capacity, assuming the same product mix, the profit can be calculated as under.
Profit = Total Revenue – Total Cost = 80% of 150,000-Fixed cost- variable
cost(=sales –contribution)=120,000-20,00-(100-25)% of 120,000=120,000-20,000-90,000=Rs 10,000
• Break-even Charts• The break-even
analysis can also be done with the help of break-even charts.
• A break-even chart based on Example 1 is given in Fig. 1. BEP corresponds to the point
• where Total revenue (TR)• and Total cost (TC)
intersect each other A perpendicular to X-axis from this point gives physical units of BEPA line perpendicular to the Y-axis gives BEP in rupees
Quantity
Y
TR
TC
FC
BEP
O
Cos
ts/ R
even
ue
X
Break-even chart – A variation
• Facing Fig. is a variation of traditional break-even chart This chart has been prepared With variable cost line starting at O. This graph shows more clearly the contribution to fixed cost and profit
Quantity
Y
TR
TC
FC
BEP
O
Cos
ts/ R
even
ueVC
PROFIT
• It is similar to the break –even chart and is based on the analysis of the relationships of profit to sales volume. Total profit or loss is shown on Y-axis (profit above x-axis). The sales volume is measures on x-axis and is drawn at the point of ‘zero-profit’ Volume is usually expressed as Percentage of full capacity The maximum loss will be at zero Sales volume and is equal to the And is shown on Y-axis below the X-axis. The two points of maximum profit and maximum loss are joined together by a line which is known as ‘contribution line’.
The point where, this line intersects the X-axis is the break-even point.
Sales Volume
Q
Y
Y’
Pro
fit
Los
s
Contribution Line
Loss
Profit
Maximum Profit
Maximum Loss
BEP
This graph shows at a glance the profit or loss earned by working at different levels of its full capacity.
• Assumptions underlying Break-even analysis• All costs are either perfectly variable or fixed,
which may not hold good during actual practice.• All revenues are perfectly variable with physical
volume of production. This may not hold good in many cases e.g. quantity discounts.
• Volume of sales and the volume of production are equal i.e. no change in the inventory. In practice they may differ significantly
• In the case of a multi-product firm, the product mix should be stable. If different products have different contribution ratios, a shift in the product mix may shift the Break even point. In reality stability of product mix is unrealistic
• But, these limitations do not impair the usefulness of break-even analysis.
Managerial use of Break-even Analysis It presents a macroscopic picture of the
profit structure of the business. It highlights areas of strengths and
weaknesses. It sharpens focus on leverages which can
be increase profitability. It is possible to examine profit
vulnerability of a business conditions e.g. sales prospects, changes in cost structure etc.
LAW OF SUPPLY Meaning of Supply By supply of a commodity we mean the
amount of that commodity which producers are willing to offer for sale at a given price.
The total sum of the amount supplied at any given price is the amount that the industry can supply at that given price.
Law of Supply
“Other things remaining the same, as the price of a commodity rises its supply increases and as the price falls the supply declines.”
Thus, the quantity offered for sales varies directly with the price, i.e. higher the price, longer is the supply and vice versa. This can be explained by two reasons:– Higher price
– Higher profits
• Higher profits offer increased quantities. Higher profitability attracts new producers/suppliers increased output.
Elasticity of Supply
Elasticity can be defined as “the degree of responsiveness of supply to a given change in the price of a commodity, other factors remaining the same.”
Elasticity of supply can be mathematically defined as :
es = [∆Q/Q] / [∆P/P]
Proportionate change in quantity supplied
Or =
Proportionate change in price
• The elasticity of supply nay vary from zero to infinity. Diagrammatically three types of elasticities have been shown Fig. 1 below.
(1) Zero (2) Infinite (3) Unit elasticity elasticity elasticity
Fig. 1: Elasticity of supply
OO O
Q Q Qa
b
S S1
SS2
Y YY
Pri
ce
Pri
ce
Pri
ce
• In case of zero elasticity, the quantity supplied does not change as the price changes. Suppliers persist in producing a given quantity Oa and dumping into the market.
• The elasticity of supply is infinite at a price Ob. Nothing will be supplied at price lower than Ob but a small increase in price to the price Ob causes supply to rise from zero to indefinitely large amount indicating that the producers will supply any amount demanded at that price.
• Any straight line supply curve drawn through the origin has a unit elasticity.
Elasticity of supply is useful but not as much as the elasticity of demand as the latter has the major additional function of showing what is happening to total revenue.
There is, however, an important fact that elasticity of supply is able to explain.
A given change in price will have a greater and greater impact on the quantity supplied as one moves from momentary situation to a short-run period and on to the long-run period.
Elasticity of supply tends to be greater in the long-run when adjustments to the higher price have been made than in the shorter period of time.
1.0 Increase and Decrease in Supply ‘ Increase’ and ‘Decrease’ in supply would mean
change in quantity supplied without change in price. Shift in the supply schedule to the right means increase and to the left means decrease in supply.
An increase in supply involving willingness to make and supply more at each price may be caused by
(i) improvements in technology, (ii) decrease in price of some other
commodities, or (iii) decrease in the prices of factors of
production used in producing the commodity.
A decrease in supply involving reluctance on the part of sellers to sell as much as before at each price may be due to
increase in the price of other commodities, or increase in prices of factors of production used in
producing the concerned commodity.Factors in influencing supply There are five possible hypotheses about the
most important factors influencing supply: • The supply of a commodity depends upon the
goals of the firms.
o If a drug manufacturer prefers to produce medicines rather than rat poison because it makes them more important in the society, we expect more medicines to be produced and less of rat poison rather than the case when producers hold all commodities in equal regard.
o If producers want to sell as much quantity of a commodity as possible, even if at a lower profit, more will be sold of that commodity than they would have wanted to make maximum profits.
o If producers are reluctant to take risk we expect smaller production of goods whose production is risky.
• The supply of any commodity depends
upon the price of the commodity. • Higher the prices, higher will be
willingness to supply.• The supply of a commodity depends upon
the prices of al other commodities. • The supply of one commodity will fall if
the prices of other commodities rise.
The supply of a commodity depends upon prices of factors of production.
The supply of a commodity depends upon the state of technology.
Discoveries of chemistry ( plastic and synthetic fibres), electronics (transistors, IC chips) are the glaring examples.
Over time, knowledge changes and so do the supply of individual commodities.
Expectations about future level of prices. Natural factors such as failure of monsoon,
floods, pastes etc. Government control.
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