UNIT – I
INTRODUCTION OF MANAGERIAL ECONOMICS
1. What is Managerial Economics? Critically examine its nature and scope?
Ans: Economics is a social science. Its basic function is to study how people- individuals,
households, firms & nations- maximize their gains from their limited resources & opportunities.
In economic terminology, this is called maximizing behavior or, more approximately, optimizing
behavior. Optimizing behavior is, selecting the best out of available options with the objective of
maximizing gains from the limited resources. For most purposes, economics can be divided into
two broad categories: Micro Economics and Macro Economics. Macroeconomics is the study of
the economic system as a whole. It includes changes in total output, total employment, the
unemployment rate and exports and imports. The goal of macroeconomics is to explain the
economic changes that effect many household, firms and markets at once.
Micro economics focuses on the behavior of the individual actors on the economic stage, i.e.,
firms and individuals and their interaction in markets. Economics is thus a social science, which
studies human behavior in relation to optimizing allocation of available resources to achieve the
given ends.
Definitions of Economics
According to Dr. Alfred Marshall ―Economics is a study of man�s action in the ordinary
business of life: it enquires how he gets his income and how he uses it‖
According to Pigou ―Economics is the study of economic welfare that can be brought directly
and indirectly, into relationship with the measuring rod of money‖
The subject matter of economics science consists of logic, tool & techniques of analyzing
economic as well as, evaluating economic options, optimizing techniques and economic theories.
Application of economic science in business decision making is all pervasive. More specifically,
economic laws and tools of economic analysis are now applied a great dealing in the process of
business decision making. This has led, as mention earlier, in the emergence of separate branch
of study called ―managerial economics.‖ Economics principles by themselves don�t offer
readymade solutions applicable in the changing business world. After the Second World War and
particularly after 1950 with the expansion of business all over the world the business managers
faced with many problems due to changing environment and the consequent variability and
unpredictability of their achievements. There is a gap between economic theory and the exact
procedure they have to apply to arrive at correct decisions in the treatment of business problems.
These problems are attracted the attention of academics and resulted in a separate branch of
knowledge for treatment of business problems and this has come to be Managerial Economics.
Managerial economics should be thought of as applied micro economics. It is an application of
the part of micro economics that focuses on the topics that are of greatest interest and importance
to managers. Managerial economics may be viewed as economics applied to problem solving at
the level of the firm. It is a science which deals with the application of economic theory in
managerial functions, It is a study of allocation of resources available to a firm relate to choices
managerial economics implies that the focus of the subject is an identifying and solving the
decision problems faced by the managers all the time. It has gained greater importance in the
recent years mainly because it enables the management to take proper decision in their business
at every stage whether it be allocation of resources, calculation of cost, determination of output,
forecasting, expansion of market of production, profit planning etc..
While economics is concerned with determining the means of achieving given objectives in the
most efficient manner, Managerial Economics is the application of economic theory and
methodology to decision making problems faced by both public and private institutions. The two
major components of managerial economics are decision making and forward planning.
Economics applied in decision making. It fills the gap between Economic Theory and managerial
practice.
In general, managerial economics can be used by the goal oriented manager in two ways. First,
given an existing economic environment, the principles of managerial economics provide a
frame work for evaluating whether resources are being allocated efficiently with in a firm.
Second, these principles help managers respond to various economic signals.
Managerial Economics Definitions
Managerial economics is defined by different authors according to their views. Some of the wellknown definitions are as follows:
Milton H. Spencer and Louis Siegel man:defines Managerial Economics as ―The Integration
of Economic Theory with business practice for the purpose of facilitating Decision Making and
forward planning by management.
According to Edwin Mansfield:―Managerial economics is concerned with the application of
economic concepts and economic analysis to the problem of formulating rational managerial
decisions‖.
According to James Bates and J.R. Parkinson:―Managerial economics orBusiness economics
is a study or the behavior of the firm in theory and practice‖.
The Nature and Scope of Managerial Economics
Nature:
Human needs are unlimited and moreover ever recurring. These wants may be either basic needs
or comforts or even luxuries in respect of food, clothing, shelter, health, education, entertainment
etc... In fact of such needs are endless. However, the means of satisfying these wants are in form
of products and services. The resources are limited (scarce) to produce the products and services
and at the same time all these scarce resource have alternative uses, their employment and
utilization have to optimal and efficient. As in the same, all the enterprise engaged in offering
various products and services to be small or large to allocate its scarce (limited) resources in
most efficient manner for its basic survival and growth. Managerial economics studies about the
firm and scarce resources for maximizing output, finding solutions to the firm to the problem of
the firm for maximizing profit.
Managerial economics is goal oriented. The course of action is chosen from available
alternatives. It uses tools and techniques which are derived from management economics,
statistics, accountancy, sociology and psychology. Economics is the study of economic actions
of individual in daily life. Economic actions are under taken for the direct satisfaction of our
wants Economics is a study of man�s action in relation to the satisfaction of his wants.
Economics thus study of human actions and behavior as a relationship between unlimited wants
and limited means.
Economics as a branch of knowledge is concerned with the study of the allocation of scarce
resources among completions ends. Managerial economics also has inherited this problem from
economics. It is assumed that the firm or the buyer acts in a rational manner. The basic feature of
economics is assuming that, other things remaining the same. This assumption is made to
simplify the complexity of the managerial phenomenon. So many things are changing
simultaneously.
Managerial Economics is also known as business economics since its major focus is on business
problems, is has a blend of features on many a business elated discipline apart from economics
from which it originates primarily. Since this is newly formed discipline no uniform pattern is
adopted and different authors treat the subject in different ways.
Thus, the nature of Managerial Economics can be known through its relation with various other
disciplines such as a micro and macroeconomics, normative and descriptive economics, the
theory of decision making, operation research and statistics. It is said that a successful business
economist will try to integrate the concepts and methods from all the disciplines.
1) Micro-Economic Frame work —
The micro-economic analysis deals with the problem of an individual firm,industry, etc… In the
case of managerial economics micro economics helps in studying what is going on with in the
firm. The micro economic theory is also known as the price theory. It provides various concepts
for the determination of the price of commodities, services and factors of production.
The chief source of concepts and analytical tool for managerial economics is micro economic
theory, some of the popular micro economic concepts are elasticity of demand, production
analysis, cost analysis, opportunity cost, present value, pricing under various market structures
and profit management etc.., It also includes the behavior of the consumer in his individual
capacity. Managerial Economics use some well accepted models in price theory such as the
model for monopoly price, model of price discrimination and behavioral and marginal models
Macro Economics: A successful manager has to acquaint himself with the general business
conditions, which influence supply and price of commodities as well as factors of production.
Especially in forecasting demand, the general economic environment is taken into account,. The
other macro variables like income, general price levels, rate of foreign exchange etc.. Influence
business so closely. Hence, the managers has to grasp the various concepts related to them form
macroeconomics also.
2) Managerial Economics is Normative approach (Normative Vs Descriptive Economics):
Managerial Economics is considered as a part of normative economics. This is because it is
prescriptive in nature rather than descriptive. It is concerned with those decisions which are to be
made keeping in view the objectives of a firm, if profit is taken as the objective of the firm.
Managerial economics proved various alternatives to achieve the desired profit. The descriptive
economics only describes relations and situation. It indicates only the possible consequence
based on certain relations but the best choice amongst them is not made. Normative approach of
managerial economic decide the logic which fits into a given purpose.
Integration of Economic Theory and Business practice:
Managerial economic prefers the practical approach. It is concerned with the application of
economics theories in the business practices. With the help of economics one can understand the
actual business behavior. Managerial Economics attempts to estimate and predict the economic
quantities and relationships It cannot ignore the environment within which they operate.
Scope:
The main focus in managerial economics is to find an optimal solution to a given managerial
problem. The problems are concerned with managerial decisions such as production, reduction or
control of costs, determination of price of a given product or service, make or buy decisions,
inventory decisions, capital management or profit planning and management, investment
decisions or human resource management. To overcome these problems economist makes use of
concepts, tools and techniques of economics and other related disciplines to find an optimal
solution to a given managerial problem.
Concepts,
techniques
and tools of
managerial
economics
Production
Costing
Capital management
Inventory
Profit planning
Human resource
Demand analysis
Investment decisions
Make or buy decisions
Determination of price
of given product or
service
Optimal
solution of
problems
Managerial economics can be used to analyze the demand of a product. The subject also suggests
several ways and methods for estimating the present and future demand of any product.
Managerial economics and its cost concepts can be employed to analyze the cost of a product.
Besides analyzing cost, a manager would also like to know the exact amount of cost. Managerial
economics provides alternative methods for estimating the cost of a product. Another important
aspect of managerial decision making is a price of a product.
Lastly M.E provides a frame work for planning the capital expenditure decisions of a firm. It also
helps a manager to estimate the cost of firm�s capital and the cash flows associated with a
project.
Managerial economics has a close connection with economic theories, OR, statistics,
mathematics and the theory of decision making. It also draws together end relates ideas from
various functional areas of management. Different authors have given different definitions to the
scope of Managerial economics leaving divergence of opinion about the subject matter.
However the following elements accepted in general and provides� scope of managerial
economics:
1)
2)
3)
4)
Area of study (or) subject matter of managerial economics
Managerial economics with other disciplines
Profits
Optimization
1).Area of study (or) subject matter of managerial economics:
Broadly, managerial economics is concerned, the following aspects constitute it:
A)
Demand analysis and forecasting
B)
Cost and production analysis
C)
Pricing decisions and policies, practices
D)
Profit management
E)
Capital management (or) capital budgeting
A) Demand analysis and forecasting:
Demand analysis attempts to understand the consumer behavior. This analysis answers he
questions such as why do consumer buy a commodity? When do they buy or stop consuming a
commodity? How they react if price changes? Thus, knowledge of demand theory and demand
analysis is essential in making decisions in choice of commodities for production. Demand
analysis attempts at finding out the forces determining the sales. It strengthens market position
and also enlarges profits.
Therefore, demand determination, demand distinction and demand forecasting occupy a strategic
role in the subject matter of managerial economic.
Two main managerial purposes in demand analysis are
1)
Forecasting sales
2)
Manipulating demand
B) Production and Cost Analysis:
Production theory describes the cost behavior. It explains how average and managerial cost vary
when production is varied. It forecast the level of output due to the changes made in the factor of
inputs. In brief, it helps in determining the size of the firm, size of the total output, and the factor
proportion.
In decision making cost estimates are very essential, Production, profit planning depend upon
sound pricing practices and accurate cost analysis. The cost analysis makes a manager of a firm
to produce in an ideal way and make it to serve in midst of other competitive producers, while
ensuring considerable profit. Production analysis deals with physical terms of product. Cost
analysis deals with monetary terms
C) Pricing Decisions, Pricing Policies &Practices:
Price theory basically explains the way the prices are determined under different market
structures. The success (or) failure of a firm mainly depends on accurate price decisions. Price
theories determine the price policies of a firm. Price and production theories together, in fact,
help in determining optimum size of the firm.
Thus, the pricing methods, price determinants, price polices and price forecasting are also
dominating the subject contention of managerial economics.
D)Profit Management:
The survival as well as the success of every firm depends on its ability to earn and also maximize
profit. It must also be understood that for maximizing profits, the firm needs to take care of its
long-range decisions i.e. investment decisions. However, a satisfactory level of profit is not
always guaranteed as the firm has to carry out its activities under conditions of uncertainty in
regard to demand for the product, inputs prices in the factor market, degree of competition, price
behavior under changing conditions etc. therefore an element of risk always exist even if most
efficient techniques are used for predicting future.
The firms are therefore supposed to safeguard their interest and avert as far as possible the
possibilities of risk or minimize the risk. Profit theory guides in the measurement and
management of profit, in making allowances for risk premium, in calculating the pure return of
capital and pure profit and also in future profit planning. Profit management thinks the profit
policies, techniques and profit planning like BEP analysis.
E)Capital Management:
Capital is a scare and an expensive factor in firms and it is a foundation of a business. Efficient
capital allocation and management is one of the most important tasks of the managers. The major
issues related to capital are
A) Choice of capital
B)Assessing the efficiency of capital
C)Allocation of capital
Efficient Capital theory can contribute a great deal in investment decision, choice of projects,
maintaining capital intact, capital budgeting etc., has its own vital bearing in the subject code of
managerial economics. Capital budgeting deals with planning and control of capital expenditure,
cost of capital, rate of returns
2) Profits:Profits are primary measure of success of any business; these are the acid test of the
economic strength. Economic theory makes a fundamental assumption that maximizing profit.
Modern firms pursue multiple objectives such as welfare, obligations to the society and
consumers.
3) Optimization:Optimization is a basic to managerial economics in decision making It offers
numerical solutions to problem of making optimum choices. Managerial Economics is concerned
with optimization of certain objective functions of a firm within given constraints. Obviously,
the goals of business have to be determined resources assessed and their use pattern decided
upon, so as to accomplish the goal of business in the best possible manner. In recent years,
optimization researchers have discovered the term ―sub optimization‖
Q2. Define demand? Determine the determinants of demand?
Ans: Demand
Demand is on of crucial requirement for the existence of any business enterprise. Business
executives have to make decision on such matters as what to produce and how much to produce
and demand analysis helps managing to make decisions with respect to production, advertising,
cost allocation, pricing, inventory holding etc. Information on the size and type of demand helps
management in planning its requirement of men, material, machine and money. Similarly,
executives entrusted with the task of selling the produces and promoting its sales, have to make a
choice between alternative prices and between markets. For its successful operation the firm has
to plan for future production, inventor of raw materials and advertising etc. Demand forecasting
attempts to estimate the likely demand for a product in future. Production can be better planned
if future demands are identified.
Every want, supported by the willingness and ability, constitutes demand for a particular product
or service. In other words, if a person wants to buy a car but he cannot pay for it, then there is no
demand for the car from any side. A product or service is said to have demand when three
conditions are satisfied:
•
•
•
Desire on the part of the buyer to buy it
Willingness to pay for it
Ability to pay the specified price for it
Unless all these conditions are fulfilled, the product is not set to have any demand
Meaning of Demand:
Demand for a commodity refers to the desire backed by the necessary, purchasing power. By
demand we mean the various quantities of a given commodity or service which consumer would
buy in one market, in a given period of time, at a various prices or at various incomes or at
various prices of related goods. Demand refers to the quantity of a product or a service that the
consumers are desired, willingness to buy, an ability to purchase during a specified period under
given set of conditions.
Demand for commodity implies
в–Є
в–Є
в–Є
Desire to acquire it
Willingness to pay for it
Ability to pay for it
All the three must be checked to identify and establish demand, It should also note that the
demand for a product or service has no meaning unless it is stated with specific reference to the
time, its price, price of related goods, consumer income and tastes and preferences etc.. Thus is
because demand, is used in economics, varies with fluctuation in these factors. To sum up, the
demand for a product is the desired for that product, backed by willingness as well as ability to
pay for it. It is always defined with reference to a particular time, place, and price and given
values of other variables on which it depends.
Determinants of Demand
The demand for a commodity depends on the individual desire to purchase, and capability to
purchase it. The desire to purchase is revealed by tastes of the individual, the capability to
purchase depends on his purchasing power, his income, price of the commodity. This concept is
a dynamic it means determinants changes in relation to change in the nature of the product. So,
we can say that the amount demanded of a commodity depends upon the following determinants
General
Factors
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пѓ�Income of the
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product
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and
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Factors
Determining
Demand
Additional
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factors
&
luxury goods
durabl
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Consumer’s
future
Consumer’s
expectations of
prices
future
expectations of
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Additional
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and
пѓјPopu
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пѓјSocial,
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1). Change in price of goods (Price of the product) :
The primary determinant for any product is its price. If the price of product changes like low and
high
the demand will be impacted. Obviously demand is affected by the change in the price of a
commodity
i.e. there is an inverse relationship between price of the product and quantity demand i.e.
Increase in price
Decrease in price
Decrease in demand
Increase in demand.
2) Price of other ―related commodities‖ (substitutes and complements)
Substitute goods —The price of one product and the quantity of other products move in the
same direction those products are called as substitute goods for the product. The related goods
are substitute goods that satisfy the same want. When a commodity is substituted for another
commodity, the price of one commodity determines the demand for another commodity.
Ex: 1). An increase in price of Pepsi will create a huge demand for coke and vice versa.
2). An increase in price of Coffee will create a huge demand for Tea and vice versa.
Complementary goods:
The price increase of one product causes quantify of demand decrease in other products. The
price of one commodity and quantity of other product move in the opposite direction. The
compliments that are required together to satisfy the same want.Ex: Pen – Ink, Petrol –
Automobile, Tea – Sugar.
Ex:
1).
An increase in price of Petrol will impact on Automobile sales
2).
An increase in price of Bread price will have a negative impact on the sale of
butter and Jam, they go together. If the price of the petrol falls and as a result you
drive your car more.
This extra driving will increase the demand for motor oil. Conversely an increase in price of
Petrol will diminish a demand for motor oil.
3). Change in the tastes and preferences of consumers:
It has a decisive influence on their pattern of demand. A change in consumer tastes favorable to
the product possibly prompted by advertising fashion changes will mean that more will be
demanded at each price i.e. demand will increase. An unfavorable change in consumer
preferences will cause demand to decrease
4). Money and income of consumers:This is another important influence factor on demand. As
income (Real purchasing capacity) goes up, the demand for the product increases likewise when
income of consumers decreases the demand for the product also decreases. Thus, the income
effect on demand may be positive or negative. Example: The impact of changes in money
income upon demand is a bit more complex. For most commodities a rise in income will cause
an increase in demand. Consumers typically buy more shoes, goggles, and T-shirts. Etc.
As their incomes increase. Conversely the demand for such products will decline in response to a
fall in incomes. Commodities the demand for which varies directly with money income are
called as superior or normal goods. Commodities whose demand varies inversely with a change
in money income are called as poor men / inferior goods.
5)Consumer expectations with respect to future prices and income :
Consumer expectations of higher future prices may prompt them now to buy more in order to
beat the anticipated price rises, and similarly the expectation of rising incomes may induce
consumers to spend more. The demand for these products is known as speculative demand. Thus
the price expectation effect on demand is not certain.
6) Change in money supply:
INFLATION: A general increase in the level of prices accompanied by a fall in the purchasing
power of money caused by an increase in the amount of money in circulation and money in
circulation and credit available.
DEFLATION : A reduction in the amount of money available in an economy resulting in lower
levels of economic activity, industrial output and very low increase in the wage system of
employees.
7). Change in money savings:
Past income or accumulated saving out of that income and expected future income, its
discounted value along with the present income, permanent and transitory (short-lived) all
together determine the nominal stock of wealth of person. The real wealth of consumer will have
an influence on his demand in the market i.e. this savings lead to further improvement of wealth
or new purchases.
8). The number of consumers in the market (Total population):It is equally obvious that an
increase in the number of consumers in the market brought about perhaps improvements in
transportation and population growth will constitute an increase in demand. Few consumers
decrease in demand.
9). Advertising and sales promotion:
In today�s world, advertisement has a major role to play in the demand creation for a product.
Advertisement creates the awareness about product, so the customer will be influenced and the
demand for the product goes up.
10). Physical Environmental conditions:
The demand for commodities will also depend upon climate conditions.
Q3. What are the methods and Objectives of demand forecasting?
Suggested Answer:Demand forecasting:While price and cross elasticity�s are useful for
pricing policy, income elasticity can be used for forecasting demand for the product in future.
Thus, production planning and management in the long run depend significantly upon the
knowledge of income elasticity, as the business man can then find out the impact of changing
income levels on the demand for his commodity.
Concept of demand forecasting: Planning is the most important function of managing. In the
simplest terms, planning thinking before doing. It is done to minimize the risks arising out of an
uncertain future. The risks associated with an uncertain future can be negated if one tries to
make reasonable assumptions about the course that the future is likely to take. Such an
estimation of the future situation is known as forecasting. The future can be predicted in two
ways. As every variable depends upon some other variables, it may be possible to estimate the
value of the dependent variables, while disregarding any action of the firm, which will affect the
independent variables. Such forecasts are known as passive forecasts. On the other hand, if
estimates of future situations are made considering the likely future actions of the firm they are
called active forecasts. Both the active and passive forecasts are important to a manager in order
to ascertain the survival of the firm in the long-run.
Be it the raising of finance, planning of production or setting up of a distribution network,
prediction of demand forms the basis of almost all important managerial decisions. Demand
Forecasting essentially involves ascertaining the expected level of demand during the period
under consideration. Sales is a function of demand. Likewise, even cost of production depends
upon demand. The need for forecasting demand arises because production depends upon
demand. The need for forecasting demand arises because production of any commodity requires
time and resources. One thus has to know future demand in order to plan the level of production
and make arrangements for the resources to be consumed.
Methods of demand forecasting: A number of techniques are available for forecasting
demand. In view of the important role of demand forecasting in managerial decision-making, it
is crucial to use a technique that gives the most accurate forecast with the least possible cost and
the minimum use of other resources. Besides accuracy and cost consideration, the choice of a
forecast technique is also guided by the urgency of a forecasting technique requirements and the
availability of data.
A more accurate forecast will require complex data and be expensive, while a simplest forecast
will be easy to make, use readily available data and be less costly. Forecasts of greater accuracy
will require more resources. The forecasting methods thus range from simple to complex and
from relatively inexpensive to expensive. However, the ranking of forecasts is not universal.
Which forecast is the best in a given situation, depends upon the nature of the concerned
problem. It is very important for a manager to use the right forecasting technique in order to be
more effective.
Thus, while choosing a forecasting method, the manager should ascertain the desired level of
accuracy, availability of data, the length of the forecast period and the associated costs and
benefits. The cost of forecast error also effects the choice of the forecasting method. Where the
cost of error is higher, it would be prudent to use a method with a higher degree of accuracy.
Less accurate forecasts in such cases would lead to erroneous managerial decisions, which can
be critical. Let us now discuss the important forecasting techniques, their advantages and
drawbacks. Since a wide choice of forecasting techniques are available and choosing the right
technique is crucial, it is important for managers to have knowledge of the whole range of
forecasting techniques.
Forecasting techniques can be broadly classified into two categories: Qualitative
techniques and Quantitative techniques. The qualitative techniques obtain information about the
likes and dislikes of consumers, while the quantitative ones forecast future demand by using
quantitative data from the past and extrapolating it to make forecasts of future levels. These
techniques are thus suited to short-term and long-term forecasting, respectively.
Forecasts for new products for which no past data is available can be made only by
qualitative methods because there is no quantitative data available that can be extrapolated.On
the other hand, demand for existing products can be forecasted by employing any of these two
methods.
Expert opinion method:
This technique of forecasting demand seeks the views of experts on the likely level of
demand in the future. Experts are informed persons who know the product very well as they
have been dealing with it and related products for a long time.They thus have a rich experience
of the behavior of demand.
This personal insight of experts is used for developing future expectations. If the
forecasting is based on the opinion of several experts, then it is known as panel consensus. This
kind of forecasting minimizing individual deviations and personal biases. A specialized form of
panel opinion is the Delphi method. Instead of going in for direct identification, this method
seeks the opinion of a group of experts through mail about the expected level of demand.The
responses so received are analyzed by an independent body.
This method thus takes care of the disadvantage of panel consensus where some
powerful individual could have influenced the consensus.
Advantages:
1.
It is simple to conduct
2.
Can be used where quantitative data is not possible.
3.
The forecast is reliable as it is based on the opinion of people who know the product
very well.
4.
It is inexpensive 5. It takes little time
Disadvantages:
1. The results are based on mere hunch of one or more persons and not onscientific analysis.
2. The experts may be biased
3. The method is subjective and the forecast could be unfavorable influenced by persons with
vested interests.
Consumers complete enumeration survey —
This method is based on a complete survey of all the consumers for the commodity under
consideration.
Interviews are used to ask consumers about the quantity of the commodity they would like to
buy in the forecast period. All the data is then collected and added up to arrive at the total
expected demand for that product.
Advantages:
1.
Quite accurate as it surveys all the consumers of the product.
2.
It is simple to use
3.
It is not affected by personnel biases.
4.
It is based on collected data.
Disadvantages:
1.
2.
3.
4.
5.
It is costly.
It is time consuming.
It is difficult and practically impossible to survey all the consumers.
The size of the data increases the chances of faulty recording and wrong
interpretation.
Useful only for products with limited consumers.
Consumers sample survey — This is miniature form of the complete enumeration method.
Here instead of surveying all the consumers of a commodity, only a few consumers are selected
and their views on the probable demand are collected. The sample is considered to be a true
representation of the entire population. The demand of the sample so ascertained is then
magnified to generate the total demand of all consumers for the commodity in the forecast
period. The selection of an optimum sample size is crucial to this method. While a sample
would be easily managed and less costly, it will be susceptible to larger sampling errors. The
converse is true for large samples.
Advantages:
1.
An important tool especially for short term projections.
2.
It is simple and does not cost much.
3.
Since only a few consumers are to be approached, the method works quickly.
4.
The risk of erroneous data is reduced.
5.
This method gives excellent results, if used carefully
Disadvantages:
1.
The conclusions are based on the view of only a few consumers and not all of
them.
2.
The sample may not be a true representation of the entire population
Sales force opinion survey —This method is similar to the expert opinion method. The
difference here is that instead of external experts, employees of the company who are a part of
the sales and marketing teams are asked to predict future levels of demand. The sales force,
which has been selling the product to wholesalers / retailers/consumers over a period of time is
considered to know that product and the demand pattern very well. Moreover, they being
company employees will be less likely to introduce the element of bias in their opinion.
Advantages:
1.
Perhaps the simplest of the forecasting methods.
2.
It is less costly.
3.
Collecting data from its own employees is easier for a firm than to do it from external
parties.
Disadvantages:
1.
Consumer�s tastes and preferences keep changing with time. What held good in the past
may not necessarily continue to do so in the future as well. The opinion of the sales
force may thus be erroneous.
2.
The sales force give biased views as the projected demand affects their future job
prospects.
Consumer’s end use survey — we have seen in the previous chapter that goods can be either
producer goods or consumer goods. They can be also a combination of these two wherein they
may be used for the production of some other consumer goods and can also be used for final
consumption. A commodity that is used for the production of some other finally consumable
goods is also known as an intermediary good.
While the demand for goods used for final consumption can be forecasted using any other
methods, the end use method focuses on forecasting the demand for intermediary goods. Such
goods can also be exported or imported besides being used for domestic production of other
goods. For ex, milk is a commodity which can be used as an intermediary good for the
production of ice-cream, paneer and other dairy products.
Advantages :
1.
2.
3.
The method yields accurate predictions.
It provide sector wise demand forecast from different industries.
It is especially useful for producer�s goods.
Disadvantages :
1.
It requires complex and diverse calculations.
2.
It is costlier as compared to the other survey methods and is more time
consuming.
3.
Industry data may not be readily available..
Statistical techniques:
These are forecasting techniques that make use of historical quantitative data. A statistical
concept is applied to this existing data about the demand for a commodity over the past years, in
order to generate the predicted demand in the forecast period. Due to this reason these
quantitative techniques are also known as statistical methods. Some important quantitative
methods are as follows:
Trend projection methods:
This technique assumes that whatever has been the pattern of demand in the past , will continue
to hold good in the future as well. Historical data can thus be used to predict the demand for a
commodity in the future. In the trend projection method, historical data is collected and fitted
into some kind of trend i.e, repetitive behavior pattern. This trend is then extrapolated into the
future to get the demand for the forecast period. The trend could be linear or curvilinear or have
any other complex shape.
Future demand through the trend method can be found by either of two methods.
•
Graphical method
•
Algebraic method
In the graphical method, the past data will be plotted on a graph and the identified trend will be
extended further in the same pattern to ascertain the demand in the forecast period. The figure
shows the past data in bold lines and the forecasted data in dotted lines.
Advantages:
a.
b.
c.
It is very simple
The method provides reasonably accurate forecast.
It is quick and inexpensive
Disadvantages:
a.
b.
Can be used only if past data is available
It is not necessary that past trends may continue to hold good in the future as
well.
c.
There is no analysis of causal relations between the demand and time series
explaining the whys of it.
Barometric techniques — It has been observed that despite erratic cyclical patterns in most
economic time series, the movements of different economic variables exhibit quite a consistent
relationship over time.
Thus, there is always some time series which is closely correlated with a given time series.
This correlation between two time series can be of 3 types either the second series data can
move ahead or move behind or move aloud with first series data. Accordingly, when the second
series moves ahead after fist series, the second series is known as the leading series while the
first series is called the lagging series. The opposite holds true when the second series moves
behind the first series, the series are called coincidence series if both of them move along with
each other.
For example, the Bhuj earthquake in January 2001, lead to a massive destruction of property and
building in Gujarat. This necessitated construction of buildings to rehabilitate the people of
affected areas. The construction was followed by a spurt in the demand for cement, fans, tube
lights, etc. Thus, one can say that the construction of buildings leads to the demand for cement.
In this case, the construction of buildings is the leading indicator or the barometer.
Forecasting technique that use the lead and lag relationship between economic variables for
predicting the directional changes in the concerned variables are known as barometric
techniques. This techniques requires ascertaining the lead lag relationship between two series
and then keeping a track of the movement of leading indicator.
Advantages :
1.
2.
It is a simple method.
It predicts directional changes quite accurately.
Disadvantages :
1.
2.
3.
4.
It does not predict the magnitude of changes very well.
Finding out a leading indicator for any series is not always feasible.
The lead time is maintained consistently by a veryfew time series.
The method can be used for short term forecasts only.
Econometric techniques —These techniques forecast demand on the basis of systematic
analysis of economic relations by combining economic theory with mathematical and statistical
tools. While economic theory is used to identify those variables on which other variables
depend. The relationship between the dependent and causal variables is estimated through the
mathematical tools. The most commonly used mathematical tool for estimation is the least
square method, as discussed earlier. On the basis of both economic theory and mathematical
tools, the equation that best describes the past causal relationship is selected.
Regression method — Forecasting problems can often be adequately analyzed with single
equation econometric models. This is also called the regression method. The relevant
equation is
: Dx = a + bPx + cI + dA – ePy
Where a,b,c,d and e are constants. Dx is the demand X, Px is the price of X, I is the consumers
income. A is the advertisement outlay and Px is the price of its substitute product Y.
econometric modeling consists of expressing the economic relation in the form of an equation to
be followed by estimating the parameters of the system i.e, the constants a,b,c,d and e. this
usually done with the help of the least square method.
Finally the equation is used to forecast the value of demand in the forecast period.
Advantages:
1.
2.
3.
4.
5.
As the method is based on causal relationships it produces reliable and accurate results.
Besides generating the forecast, it also explains the economic phenomenon.
It is neither as subjective as the qualitative techniques nor as mechanistic as the
quantitative ones.
This method not only forecasts the direction but also the magnitude of the change.
The method is quite consistent.
Disadvantages:
1.
2.
3.
The method uses complex calculations.
It is costly and time consuming.
It requires the use of some other forecasting technique for estimating the value of the
causal variables.
Simultaneous equation method:
When the inter relationship between the economic variables become complex, the use of single
equation regression method become difficult. In such cases forecasting of demand is done using
multiple simultaneous equations. This is a complex statistical method of forecasting where a
complete model is developed explaining the behavior of all the economic variables.
These variables are of two types. Variables whose values are determined within the system are
called endogenous while those are determined outside the model are exogenous. The number of
equations in such a model equals the number of endogenous variables. The model consists of
two basic kinds of equations identities and behavioral equations. While the identity equations
express relations that are true by definition, the behavioral equation. While the identify equation
express relations that are true by definition. The behavioral equation reflects hypotheses about
how the variables in a system interact with each other. These equations are solved through
methods such as the two stages method. A detailed discussion of this method of forecasting is
beyond the scope of this book.
Test Marketing: It is likely that opinions given by buyers, salesmen or other experts may be, at
times, misleading. This is reason why most of the manufacturers favor to test their product or
service in a limited market as test -run before they launch their products nationwide. Based on
the results of test marketing, valuable lessons can be leant on how consumers react to the given
product and necessary changes can be introduced to gain wider acceptability. To forecast the
sales of an new product or the likely sales of an established product in a new channel of
distribution or territory, it is customary to find test marketing in practice.
Automobile companies maintain a panel of consumers who give feedback on the style and
design and specifications of the new models. Accordingly these companies make necessary
changes, if any, and launch the product in the wider markets.
In test marketing, the entire product and marketing programmer is tried out for the first time in a
small number of well-chosen and authentic sale environment. The primary objective, here, is a
know whether the customer will accept the product in the present form or not.
If sales are not encouraging in the markets so tested, it is clear that the product has certain
defects, which are to be looked into seriously. The company can work further to identify these
defects, correct them and then test the product again, if necessary.
One of the factors determining the success of the test marketing is the relevance of small market
chosen. A small market representing all the features of the wide market constitutes an ideal
place conduct test marketing for a given product or service. In other words, should be
representative.
Control Experiments: Controlled experiment refer to such exercises where some of the major
determinants of demand are manipulated to suit to the customers with different tastes and
preferences income groups, and such others. It is further assumed that all other factors remain
the same. In this method, the product is introduced with different packages, different prices in
different markets or same markets to assess which combination appeals to the customer most.
Regression equation can be built upon these price-quantity relationships of different markets.
This method cannot provide better results unless these markets are homogeneous I terms of,
tastes and preferences of the customers, their income and so on.
This method is used to gauge the effect of a change in some demand determinant like price,
product, design, advertisement, packaging, and so on. This method is still in the infancy sage
and not much tried because of the following reasons:
•
•
•
It is costly and time consuming.
It involves elaborate process of studying different markets and different permutations
and combinations that can push the product aggressively.
If it fails in one market, it may affect other markets also.
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. Even when the above
methods are used, the forecasting process is supplemented with the factor of judgment for the
following reasons;
•
Historical data for significantly long period is not available
•
•
•
•
Turning points in terms of policies or procedures or causal factors cannot be precisely
determined
Sales fluctuations are wide and significant
The sophisticated statistical techniques such as regression and so on. May not cover all
the significant factors such as new technology and so on, effecting demand
The results of statistical methods are more reliable at the national level rather than firm
or industry level. In such a case the management has to rely more on its judgment to
assess the validity of such results.
4. How do you measure the Elasticity’s of Demand?
Ans. Elasticity of demand:It is a technique to measure the responsiveness in the quantity
demanded of a commodity to a change in anyone of the determinants in the demand function
vise, price, income, expectations, advertising expenditure etc. This technique provides a
quantitative value for the responsiveness of the quantity demanded to change in each of the
determinants in the demand function.
Definition: Elasticity of demand is defined as the percentage change in quantity demanded
earned by one percent change in the demand determined under consideration, while the other
determinants are held constant. The general equation for the measurement of elasticity of
demand is
Ed=
Percentage change in quantity demanded of Product X
Percentage change in demand determinants
Elasticity’s:
There are various types of elasticity�s of demand. However, the importance ones are given
below,
1.
2.
3.
4.
Income elasticity of demand
Price elasticity of demand
Cross elasticity of demand
Promotional elasticity of demand
Income elasticity of demand:
The income elasticity of demand is the measure of the percentage change in the demand for a
commodity due to a one percent change in the consumer�s income, ceteris paribus
Ei = percentage change in Quantity demand / Percentage change in income of consumer.
In other words elasticity of demand is a measure of the responsiveness of demand to the change
in the variables on which it depends. Demand elasticity shows how sensitive demand is to the
change in the underlying factors in the demand function.
Regardless of whether the underlying factor is within or outside the control of the firm, an effect
of its change by a particular amount and in a particular direction is very useful in managerial
decision making. With this knowledge of elasticity of demand, a manager can use the changes in
the endogenous and exogenous variables to his advantage. Thus, the firm will be able to respond
effectively to the changes in the environment.
From our discussion on the determinants of demand, we know that demand increases with a rise
in consumers income for superior goods and decreases for inferior goods and vice versa.
Likewise, the income elasticity of demand is positive for superior or normal goods and negative
for inferior goods since a person may shift from inferior to superior goods with a rise in income.
I
I
Inferior
Superior
D
D
Demand and consumersincome: Further, the positive income elasticity of demand can be
unity, more than unity or less than unity. It is more than one when the quantity demanded
increases at a faster rate than the rise in consumers income or decrease at a faster rate than the
fall in income. For positive income elasticity to be less than one, the relationship will be just the
opposite. However when the rise in consumer�s income leads to a proportionate increase in
demand of the commodity income elasticity is said to be unity.
Income elasticity : Luxury goods such as cars air conditioners mobile phones etc. are knows to
take away a large share of the consumers income and the consumer buys more of these when his
income increases necessity goods on the other hand becomes less important with rising income
levels. This behavior can be seen in goods like foods and cloth. Semi luxury and comfort goods
witness a direct and proportionate relationship between demand and income.
The concept of income elasticity of demand is very useful in studying the effects of the changes
in national income on the demand for the firm�s products. Companies whose products have high
income elasticity will grow faster when the economy will expand. Such firms are very sensitive
to the level of business activity. The performance of firms having low income elasticity on the
other hand will be less affected by economics changes.
Price elasticity of demand — Price elasticity of demand measures the responsiveness of
demand for products to changes in the price of the products, when all other variables are
constant. Thus the price elasticity of demand is
ep = percentage changes in demand for a commodity / percentages change in price of
commodity
ep = ∆Dx\Dx
∆px \ px
= ∆Dx \∆Px* Px\Dx
Where DDx and DPx are the changes in demand and price of the commodity X while Dx and Px
are the demand and price of the commodity X at a given point on the demand curve. But for
goods that are exceptions to the laws of the demand the price of demand is negative for all
goods. This is because of the facts that the demand for a commodity varies inversely with its
own price and vice versa .
Price elasticity varies between 0 and - a, which will be the respective conditions when the goods
is completely inelastic or perfectly elastic. Between these two extremes the values of the price
elasticity of demand can be clubbed into three ranges using its absolute values. Thus we can
have ep> 1 i .e ep lies between -1 and –a (elastic) ep =1 ,i.eep=-1 (unitary ) and ep<n i.eep lies
between 0 and -1 (inelastic demand )
An elastic demand is where a given changes in price of a commodity induces more than
proportionate changes in the quantity of the commodity demanded. For example when ep= -4.5,
it is a situation which signifies that for every one percent changes in its price, the demanded for
that good changes by 4.5 percent in the opposite direction. Where a price changes leads to a
less than proportionate changes in the demand , it is a case of inelastic demand . for example ep
= -0.6 i.e for every one percent price changes, there is an inverse demand variations of 0.6
percent. with unitary elasticity the quantity demanded changes exactly equal to the changes in s
like price. While necessities like wheat milk have inelastic demanded, luxury goods such as cars
and fashions items like cosmetics have elastic demand. The price elasticity of demand for cheap
goods that are generally consumed in fixed quantities, e.g salt is it zero
Cross elasticity of demand : The cross elasticity of demand measures the responsiveness of
demand for one product to the changes in price of another
Ec = Percentage change in demand of X
Percentage change in price Y
Ec = DDx / Dx
DPy / Py
∆Dx
=
PY
_____ x
∆PyDx
The cross elasticity of demand is positive for substitutes and negative for complements.
Consider the case of pen and pencil. When the price of pencils will go up , people will replace
pencils with pens and will start using fewer pencils and more pens .So the demand for pens will
increase . Thus, the demand for pen increases with a rise in the price of its substitute pencils.
The direct relationship between the two renders the cross elasticity positive. The demand for
pens however varies differently with a change in the price of ink. When the price of ink
increases the consumption of ink will decrease and hence the demand for pens will decrease
.So the demand for pens decrease with the increase in the price of its complement: ink.
Complement thus has a negative cross elasticity of demand.
Looking at the cross elasticity of demand, i.e. its sign and magnitude, one can understand how
the two goods are related and to what extent. Zero cross elasticity would indicate that the goods
are totally unrelated. Elasticity increases with the increasing strength of the relationship. The
concept of cross elasticity enables a firm to understand how the demand for its product will vary
for a given change in the prices of its related products. It thus equips a firm to formulate its
pricing strategy in relation to the pricing strategy of its competitors. Thus, cross elasticity also
helps in measuring the inter – relation among different industries.
Promotional elasticity of demand:
The promotional elasticity of demand is a measure of the responsiveness of demand for a
commodity to the change in outlay on advertisements and other promotional efforts
Percentage change in demand
Ea=
Percentage change in expenditure on Advertisement and other promotional efforts
Ea
=(Q2-Q1) / Q1 / A2-A1 / A1
The promotional or advertisement elasticity of demand plays an important role in the marketing
decisions of any firm. A low promotional elasticity would indicate that demand changes less
compared to a change in the advertisement outlay of a firm . In such cases , for increasing the
demand for its product, the firm will have to incur relatively much higher expenditure on
advertisements . The manager should therefore plan for alternative marketing approaches in
order to promote sales effectively.
Significance of the concept of elasticity of demand:
The understanding of the concept of elasticity of demand is highly useful both from theoretical
and practical points of view. Some of its important uses may be the following:
1. Level of output and price: If production is to be profitable, the volume of goods and services
produced must be in accordance with the demand for the commodity. And note that demand
changes with change in price. Except in perfectly competitive market, seller in every other
market has to know the influence of price on quantity demanded for his product. If price elastic
of demand for his product is elastic, he can charge a high price for it .
1.
2.
Fixation of rewards for factors of production: The concept of elasticity of demand is
also quite important in determining the rewards of various factors of production in the
country. For example , if the demand for the workers is inelastic , the efforts of trade
Unions to raise wages of the workers will meet with success.
Government Policies :
a.
The government can take a lot of help from the knowledge of elasticity of
demand, for example, of a commodity before imposing statutory price control on
it .Similarly, in order to stabilize prices of agricultural goods, the government
must know their level of demand and elasticity coefficients.
b.
The decision about the industries to be declared as ― public utilities ― so as to be
owned and operated by the government depends significantly on the knowledge
of elasticity of demand .
c.
Elasticity of demand is also of great help to the government in its ―taxation
policy‖ since taxes impose burden on taxpayers, that the optimal tax policy must
ensure, these burdens are equitably distributed between groups of the taxpayers.
d.
When fixing a proper ― rate of exchange ― for its currency the government can
take considerable help from the concept of elasticity of demand . When taking a
decision to revalue or devalue the country�s currency, the government has to
carefully study the impact of such a decision.
Multiple Choice Questions
1.
a.
b.
c.
d.
2.
a.
b.
c.
d.
3.
a.
b.
c.
d.
Managerial economics deals with, which of the following.
Managerial economics deals with issues such as inflation and employment
Managerial economics deals with the issues which effect the world economy
Managerial economics deals with the issues which are macro in nature
Managerial economics deals with the issues relating to one single individual for firm.
Managerial economics is the application of.
Economics theory with methodology to businessadministration practice
Economics theory to welfare issues
Economics theory to macro-economic issues
Economics theory to issues such as floods and disasters.
Which of the following is correct?
Managerial economics seeks to understand and analyses the problems of business
decision making.
Managerial economics seeks to identify the issues relating to unemployment and suggest
ways to overcome the problems of unemployment
Managerial economics seeks to underline the development issues
Managerial economics seeks to explore issues relating to the development of the nation.
4. What is the major objective of managerial economics?
a.
It facilitates decision making and forward planning.
b.
It integrates economics theory with business practice
c.
Planning experts mostly use managerial economics
d.
It integrates economics theory with employment theory
5.
Managerial economics is concerned for
a.
b.
c.
d.
Demand analysis and forecasting and cost and production analysis
Pricing decisions and policies, practice
Profit management and capital management
All the above
6. Managerial economics is having a close association with which of the following
a.
Macro economics
b.
Profit management and employment
c.
Theory of Income and supply
d.
Micro economics
7. ―Economics is the science which studies human behavior as relationship between ends
and scarce means which have alternative uses‖ this definition is proposed by
a.
Adam smith
b.
Paul A. Samuelsson
c.
Lionel Robbins
d.
Alfred Marshal
8. ―Economics is a study of mass action in the ordinarybusiness of life; it enquires how he
gets his income and how he uses it‖
a.
Adam smith
b.
Paul A. Samuelsson
c.
Pigou
d.
Alferd Marshal
9. Which of the following is not converted by managerial economics ?
a.
Price - out decision
b.
Profit related decision
c.
Investment decision
d.
Foreign direct investment decision
10. The pre - requisite for rational decision making is
a. Logical analysis of one�s choices without error
b. Rigidity defined choice
c. Choices not involving any trade - offs
d. Consistency between goals and choices
11.
Law of demand emphasis on
a. If price increases the demand decreases & if prices decreases the demand increases
b. If price decreases the demand decreases & if price decrease the demand increases
c. If price increases the demand decreases & if price increases the demand increases
d. If price increases the demand increases & if price decrease the demand decreases
12. The demand curve slope down wards because of
a. Profit maximization, cost reduction, income change
b. Law of diminishing marginal utility
c. Low employment
d. Fear of shortage
13. Which of the following has highest consumer surplus?
Consumer surplus - (consumer ready to pay more or the difference between AR and MR)
a.
b.
c.
d.
Luxury goods
Comforts
Necessities
Conventional necessitates
14. If the quantity for a particular product aa given time depends on the price of a related
product is called
a. Cross demand
b. Derived demand
c. Autonomous demand
d. Marginal demand
15. In case of Giffen’s goods, the demand curve
a. Slops downwards
b. Meets cost curve
c. Intersect supply curve
d. Slopes upwards
16. Change in demand of a commodity due to change in the price of other related good is
________ demand.
(a)
Price
(b)
Income
(c)
17.
(a)
Cross
(d)
Advertising
When e=1 elasticity of demand is __________
Unitary
(b)
Perfect
(c)
Imperfect
(d)
Pure
18. __________ and _______ are the two methods forecasting demand.
(a)
Income and price
(b)
Survey and statistical
(c)
Ratio and arc
19.
_______ is a tabular format which explain relationship between price and demand.
(a)
Demand schedule
Law of demand
(b)
(d)
demand
function
Supply schedule
(c)
20. Demand for plant and machinery is ________ demand.
(a)
Producers goods
(b)
Consumer goods
(c)
21.
(a)
(c)
Industry
(d)
Firm
When e=0 elasticity of demand is ____________.
Perfectly inelastic demand
(b)
perfectly elastic
Unitary
(d)
inelastic
22. There are _____________ types of price elasticity of demand.
(a)
3
(b)
4
(c)
5
(d)
6
23.Demand__________ when a small change in price leads to a large change in demand.
(a)
inelastic
(b)
elastic (c)
stagnant
(d)
fixed
24. Sensitiveness or responsiveness of demand to the change in price_______
(a)
Elasticity of demand (b)
demand
(c)
Price demand
(d)
cross demand
25. ________ is desire backed by willingness and ability to pay.
(a)
Elasticity of demand (b)
demand
(c)
26.
(a)
(c)
Supply
(d)
Production
_________ is exception to law of demand.
Income
(b)
Price
Fashions
(d)
Geffen goods
27. Demand forecasting is relatively easier in case of ________ products.
(a)
New
(b)
old
(c)
Established
(d)
cyclic
28. Where total number of customer in the population is studied _______ method is said to
be employed.
(a)
Moving average method (b) time series
(c)
Census
(d)
accountability
29. In case of producers goods where the number of consumers is __________survey of
buyers intentions method can be advantageously used.
(a)
Limited
(b)
more
(c)
less
(d)
cyclic
30. The market demand for a given marketing effort is called.
(a)
test market
(b)
multiple correlation
(c)
Market forecast
(d)
limited forecast
Multiple Choice Answers
1.
4.
7.
10.
13.
16.
d
a
c
d
c
c
20.
a
24.
26.
28.
30.
2.
5.
8.
11.
14.
a
d
d
a
a
17.
21.
3.
6.
9.
12.
15.
A
a
d
d
b
d
18.
b
19.
a
A
22.
c
23.
b
a
d
c
c
25.
27.
29.
B
c
a
UNIT – II
PRODUCTION AND COST ANALYSIS
1.What is Production ?
Suggested Answer
Production is basically an activity of transformation, which connects factor inputs and outputs.
The process of transforming inputs into outputs can be any of the following kinds:
п‚·
п‚·
п‚·
п‚·
Change in the Form(Raw material transformed to finished goods )
Change in Place( Supply chain, Factory to Retailer)
With these three kinds of transformations, usability of the good or materials increases.
Production is an activity that increases consumer usability of goods and services.
Basic Concepts of Production Theory: Classifications of Inputs
(i) Labour,(ii) Capital,(iii) Land,(iv) Raw Materials and (v) Time.
These variables are measured per unit of time and hence referred to as flow variables.
Entrepreneurship has been added as part of the production inputs, though this can be measured
by the managerial expertise and the ability to make things happen. An input is a good or service
that goes into the production process. As economists refer to it, an input is simply anything
which a firm buys for use in its production process.
An output, on the other hand, is any good or service that comes out of a production process.
Inputs are considered variable or fixed depending on how readily their usage can be changed
п‚·
Fixed input
o An input for which the level of usage cannot readily be changed in economic sense, a
fixed input is one whose supply is inelastic in the short run.
o In technical sense, a fixed input is one that remains fixed (or constant) for certain
level of output.
Variable input
п‚·
A variable input is one whose supply in the short run is elastic, example, labour, raw
materials, and the like. Users of such inputs can employ a larger quantity in the short
run.Technically, a variable input is one that changes with changes in output. In the long run,
all inputs are variable.
- In the short run, at least one input is fixed
-
All changes in output achieved by changing usage of variable inputs
-
In the long run all inputs are variable
-
Output changed by varying usage of all inputs
2. What is Production Function? Explain in the context of short run and long run.
Suggested Answer
Production function is used in explaining the input-output relationship. It describes the technical
relationship between inputs and output in physical terms. In its general form, it holds that
production of a given commodity depends on certain specific inputs. In its specific form, it
presents the quantitative relationships between inputs and outputs. A production function may
take the form of a schedule, a graph line or a curve, an algebraic equation or a mathematical
model. The production function represents the technology of a firm. Maximum amount of output
that can be produced from any specified set of inputs, given existing technology
Technical efficiency
п‚·
Achieved when maximum amount of output is produced with a given
combination of inputs
Economic efficiency
- Achieved when firm is producing a given output at the lowest possible total cost
An empirical production function is generally so complex to include a wide range of inputs: land,
labour, capital, raw materials, time, and technology.
These variables form the independent variables in a firm�s actual production function.
A firm�s long-run production function is of the form:
Q = f(Ld, L, K, M, T, t)
Where
Ld = land and building; L = labour; K = capital; M = materials; T = technology; and, t = time.
Suppose we want to produce apples. We need land, seedlings, fertilizer, water,labour, and some
machinery. These are called inputs or factors of production. The output is apples. In general a
given output can be produced with different combinations of inputs. A production function is the
functional relationship between inputs and output. It shows the maximum output which can be
obtained for a given combination of inputs. It expresses the technological relationship between
inputs and output of a product.
In general, we can represent the production function for a firm as:
Q = f (x1, x2, ….,xn)
Where Q is the maximum quantity of output, x1, x2, ….,xn are the quantities of various inputs,
and f stands for functional relationship between inputs and output. For the sake of clarity, let us
restrict our attention to only one product produced using either one input or two inputs. If there
are only two inputs, capital (K) and labour (L), we write the production function as: Q = f (L, K)
This function defines the maximum rate of output (Q) obtainable for a given rate of capital and
labour input. It may be noted here that outputs may be tangible like computers, television sets,
etc., or it may be intangible like education, medical care, etc. Similarly, the inputs may be other
than capital and labour. Also, the principles discussed in this unit apply to situations with more
than two inputs as well.
3. Explain production function with one variable input.(Short run production function)
Consider the simplest two input production process - where one input with afixed quantity and
the other input with is variable quantity. Suppose that the fixed input is the service of machine
tools, the variable input is labour, and the output is a metal part. The production function in this
case can be represented as:Q = f (K, L)
Where
Q is output of metal parts, K is service of five machine tools (fixed input), and L is labour
(variable input). The variable input can be combined with the fixed input to produce different
levels of output.
Total, Average, and Marginal Products
Total, Average and Marginal Products of labour (with fixed capital at five machine tools)
Two other important concepts are the average product (AP) and the marginal product (MP) of an
input. The AP of an input is the TP divided by the amount of input used to produce this amount
of output. Thus AP is the output-input ratio for each level of variable input usage. The MP of an
input is the addition to TP resulting from the addition of one unit of input, when the amounts of
other inputs are constant. In our example of machine part production process, the AP of labour is
the TP divided by the number of workers. APL = Q/L
As shown in Table, the APL first rises, reaches maximum at 19, and then declines thereafter.
Similarly, the MP of labour is the additional output attributable to using one additional worker
with use of other input (service of five machine tools) fixed. MPL = W Q/WL Where W means
‗the change in�. For example, from Table for MP4 (marginal product of 4th worker) WQ = 76–
54 = 22 and WL = 4–3 =1. Therefore, MP4 = (22/1) = 22. Note that although the MP first
increases with addition of workers, it declines later and for the addition of 8th worker it becomes
negative (–4).
Relationship between TP, MP, and AP curves and the three stages of production
The graphical presentation of total, average, and marginal products for our example of machine
parts production process is shown in Figure. Relationship between TP, MP and AP Curves
Examine Table and its graphical presentation in Figure. We can establish the following
relationship between TP, MP, and AP curves.
1a) If MP > 0, TP will be rising as L increases. The TP curve begins at the origin, increases at an
increasing rate over the range 0 to 3, and then increases at a decreasing rate. The MP reaches a
maximum at 3, which corresponds to an inflection point (x) on the TP curve. At the inflection
point, the TP curve changes from increasing at an increasing rate to increasing at a decreasing
rate.
b) If MP = 0, TP will be constant as L increases. The TP is constant between workers 6 and 7.
c) If MP < 0, TP will be declining as L increases. The TP declines beyond 7. Also, the TP curve
reaches a maximum when MP = 0 and then starts declining when MP < 0.2. MP intersects AP
(MP = AP) at the maximum point on the AP curve. This occurs at labour input rate 4.5. Also,
observe that whenever MP > AP, the AP is rising (up to number of workers 4.5) — it makes no
difference whether MP is rising or falling. When MP < AP (from number of workers 4.5), the
AP is falling. Therefore, the intersection must occur at the maximum point of AP. It is important
to understand why. The key is that AP increases as long as the MP is greater than AP. and AP
decreases as long as MP is less than AP. Since AP is positively or negatively sloped depending
on whether MP is above or below AP, it follows that MP = AP at the highest point on the AP
curve.
This relationship between MP and AP is not unique to economics. Consider a cricket batsman,
say Sachin Tendulkar, who is averaging 50 runs in 10 innings. In his next innings he scores a
100. His marginal score is 100 and his average will now be above 50. More precisely, it is 54 i.e.
(50 * 10 + 100)/(10+1) = 600/11. This means when the marginal score is above the average, the
average must increase. In case he had scored zero, his marginal score would be below the
average, and his average would fall to 45.5 i.e. 500/11 is 45.45. Only if he had scored 50 would
the average remain constant, and the marginal score would be equal to the average.
4. Explain the law of diminishing marginal returns.
The slope of the MP curve in figure illustrates an important principle, the law of diminishing
marginal returns. As the number of units of the variable input increases, the other inputs held
constant (fixed), there exists a point beyond which the MP of the variable input declines. Table
illustrates this law. Observe that MP was increasing up to the addition of 4th worker
(input)beyond this the MP decreases. What this law says is that MP may rise or stay constant for
some time, but as we keep increasing the units of variable input, MP should start falling. It may
keep falling and turn negative, or may stay positive all the time. Consider another example for
clarity. Single application of fertilizers may increase the output by 50%, a second application by
another 30% and the third by 20% and so on. However, if you were to apply fertilizer five to six
times in a year, the output may drop to zero.
Three things should be noted concerning the law of diminishing marginal returns.
1. This law is an empirical generalization, not a deduction from physical orbiological laws.
2. It is assumed that technology remains fixed. The law of diminishing marginal returns cannot
predict the effect of an additional unit of input when technology is allowed to change.
3. It is assumed that there is at least one input whose quantity is being heldconstant (fixed). In other
words, the law of diminishing marginal returnsdoes not applies to cases where all inputs are
variable.
Stages of Production
Based on the behaviour of MP and AP, economists have classified productioninto three stages:
Stage 1: MP > 0, AP rising. Thus, MP > AP.
Stage 2: MP > 0, but AP is falling. MP < AP but TP is increasing (becauseMP > 0).
Stage 3: MP < 0. In this case TP is falling.
These results are illustrated in Figure. No profit-maximizing producer would produce in stages I
or III. In stage I, by adding one more unit of labour, the producer can increase the AP of all units.
Thus, it would be unwise on the part of the producer to stop the production in this stage. As for
stage III, it does not pay the producer to be in this region because by reducing the labour input
the total output can be increased and the cost of a unit of labour can be saved. Thus, the
economically meaningful range is given by stage II. In Figure at the point of inflection (x), we
saw earlier that MP is maximised. At point y, since AP is maximized, we have AP = MP. At
point z, TP reaches a maximum. Thus, MP = 0 at this point. If the variable input is free then the
optimum level of output is at point z where TP is maximized.
5. Explain production function with two variable inputs.
Suggested Answer
Output is a function of labour and capital.Capital is also varying with output.Generally in
long run these two inputs vary.Also these two inputs are substitutable.These inputs are
used in different combinations to produce a level of output.Q=f(L,K).
Production Isoquants
A production isoquant (equal output curve) is the locus of all those combinations of two inputs
which yields a given level of output. With two variable inputs, capital and labour, the isoquant
gives the different combinations of capital and labour, that produces the same level of output.
For example, 5 units of output can be produced using either 15 units of capital (K) or 2 units of
labour (L) or K=10 and L=3 or K=5 and L=5 or K=3 and L=7. These four combinations of
capital and labour are four points on the isoquant associated with 5 units of output as shown in
Figure and if we assume that capital and labour are continuously divisible, therewould be many
more combinations on this isoquant.
Production Isoquant: This isoquant shows various combinations of capital and labour
inputs that can produce 5 units of output.
Isoquant Map: These isoquants shows various combinations of capital and labour inputs that can
produce 10, 15, and 20 units of output.
6.What is marginal rate of technical substitution?
Suggested answer
The production function can be written as Q = f (K,L) The rate, at which one input can be
substituted for another input, if output remains constant, is called the marginal rate of technical
substitution (MRTS). It is defined in case of two inputs, capital and labour, as the amount of
capital that can be replaced by an extra unit of labour, without affecting total output.
The MRTS of labour for capital between points a and b is equal to WK/WL = (4–8) / (4–2)= –
4/2 = –2 or | 2 |. Between points b and c, the MRTS is equal to –2/4 = –½ or | ½ |. The MRTS has
decreased because capital and labour are not perfect substitutes for each other. Therefore, as
more of labour is added, less of capital can be used (in exchange for another unit of labour) while
keeping the output level constant.
Marginal Rate of Technical Substitution
Not at all substitutable,perfectly substitutable,imperfectly substitutable products
7. How do you determine the optimal combination of inputs?
Suggested answer
Any desired level of output can be produced using a number of different combinations of inputs.
As said earlier in the introduction of this unit one of the decision problems that concerns a
production process manager is, which input combination to use. That is, what is the optimal input
combination? While all the input combinations are technically efficient, the final decision to
employ a particular input combination is purely an economic decision and rests on cost
(expenditure). Thus, the production manager can make either of the following two input choice
decisions:
1. Choose the input combination that yields the maximum level of output with a given level of
expenditure.
2. Choose the input combination that leads to the lowest cost of producing agiven level of output.
Isocost Lines
Isocosts are different combinations of inputs which cost the producer same amount of money.
Optimal Combination of Inputs:
This is obtained by superimposing the isocost curve on the corresponding isoquant for a given
level of output.
So for an output 50 optimal combination is at Z.for output 100 optimal combination is at Q
8. What is expansion path of the firm?
Suggested answer;
In addition to above answer, the firm expands through least cost points ie ZQS
9. What are returns to scale?
Suggested answer
Another important attribute of production function is how output responds in the long run to
changes in the scale of the firm i.e. when all inputs are increased in the same proportion (by say
10%), how does output change. Clearly, there are 3 possibilities. If output increases by more than
an increase in inputs (i.e. by more than 10%), then the situation is one of increasing returns to
scale (IRS). If output increases by less than the increase in inputs, then it is a case of decreasing
returns to scale (DRS). Lastly, output may increase by exactly the same proportion as inputs. For
example a doubling of inputs may lead to a doubling of output. This is a case of constant returns
to scale (CRS).
10.What are Economies and diseconomies of scale (Reasons for returns to scale)?
Suggested answer
The advantages of large scale production that result in lower unit (average) costs (cost per unit)
is known as economies of scale.
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AC = TC / Q
Economies of scale – spreads total costs over a greater range of output
Types
Pecuniary Economies: Economies realized from paying lower prices for the factor used in
production and distribution of the product, due to bulk buying by the firm as its size increases
Real Economies: Associated with a reduction in the physical quantity of inputs, raw materials,
various types of labor and various types of capital.
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Production Economies
Selling and Marketing Economies
Managerial Economies
Transport and Storage Economies
Production Economies
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It may arise from the factor 1. Labor 2. Fixed capital 3. Inventory requirement of firm
Production Economies Labor Economies
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1.Specialization 2.Time saving 3.Automation of Production process 4.Cumulative volume
Economies
Technical economies
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At large scale production the firm becomes capital intensive uses sophisticated equipment
and technology which results in decrease in average cost.
Selling and Marketing Economies
Good relations with dealers and customers will decrease average cost
Managerial Economies
Managerial efficiencies like effective planning decrease average cost of production and selling.
Cost of management decreases with increase in scale up to a certain point.
Transport and Storage Economies
Transport cost and storage cost decrease with increase in scale.
External Economies of Scale
The advantages firms can gain as a result of the growth of the industry – normally associated
with a particular area.
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Supply of skilled labour
Reputation
Local knowledge and skills
Infrastructure
Training facilities
Diseconomies of scale
Business can become too large. Unit costs can then tend to rise.
Causes:
Communication
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Hierarchical structure, information overload, formal methods, less face to face, language.
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Co-ordination
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Different departments must work towards same goals.
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Motivation
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Being a small fish in a big pond syndrome. Less contact with senior managers.
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Technical diseconomies
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If a large machine breaks down production costs can rise.
Problems of management
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Lack of effective communication, lack of coordination, demotivation of staff, no
understanding between ownership and management
11.What is Cobb Douglas Production function?
Suggested Answer
Cobb Douglus Production function is a production function representing constant returns to
scale.Mathematically it is represented as
Q=bLaK1-a
Where Q is total output,
L is labour employed
K is fixed capital employed
A and 1-a are labour and capital elasticities of production
A function with values is given below.
Q=1.01L 0.75K 0.25
Here if labour and capital change by 100%,q also changes by 100%.ie if L becomes 2L,K
BECOMES 2K,Q becomes 2Q.
12. Explain concept of cost and various cost concepts.
Suggested answer
Cost Analysis
Analysis of cost is very important. Profit can be made not only by maximizing revenue but also
minimizing cost. So controlling cost is important.
Analysis of cost is to
•
Understand concept of cost
•
Classification of costs
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Cost output relationship in short run and cost output relationship in long run.
Cost involves some type of sacrifice ie to get some benefit some thing is be spent.
Cost is the expenditure incurred in producing a good or a service.Eg.;We go to hotel.We eat
food.We incur some expenditure.
Various costs
Category of cost
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Concepts used for accounting purposes; and,
Analytical cost concepts used in economic analysis of business activities.
Accounting Cost Concepts
Opportunity Cost and Actual or Explicit Cost
Opportunity cost can be seen as the expected returns from the second best use of an economic
resource which is foregone due to the scarcity of the resources
Opportunity Cost and Actual or Explicit Cost
The actual or explicit costs are those out-of-pocket costs of labour, materials, machine, plant
building and other factors of production.
Explicit and Implicit/Imputed Costs These are costs falling under business costs and are those
entered in the books of accounts. Payments for wages and salaries, materials, insurance
premium, depreciation charges are examples of explicit costs. These costs involve cash payments
and are recorded in accounting practices.
Implicit/Imputed Costs
Those costs that do not involve cash outlays or payments and do not appear in the business
accounting system are referred to as implicit or imputed costs.
Implicit costs are not taken into account while calculating the loss or gains of the business
The explicit and implicit costs together (explicit +implicit costs) form the economic cost.
Out-of-Pocket and Book Costs
Expenditure items that involve cash payments or cash transfers, both recurring and nonrecurring, are referred to in economics as out-of pocket costs. All the explicit costs including
wages, rent, interest, cost of materials, maintenance, transport expenditures, and the like are in
this classification.
Some actual business costs which do not involve cash payments, but a provision is made in the
books of account and they are taken into account while finalizing the profit and loss accounts.
Such costs are known as book costs. These are somehow, payments made by a firm to itself.
Fixed and Variable Costs
Costs that are fixed in volume for a certain level of output. They do not vary with output. They
remain constant regardless of the level of output.
Fixed costs include:
i.
Cost of managerial and administrative staff; (ii) Depreciation of machinery; (iii)
Land, maintenance. Fixed costs are normally short-term concepts because, in the
long-run, all costs must vary.
Variable Costs are those that vary with variations in output. It includes: (i) Cost of raw materials;
(ii) Running costs of fixed capital, such as fuel, repairs, routine maintenance expenditure, direct
labour charges associated with output levels; and (iii) The Costs of all other inputs that may vary
with the level of output.
Total, Average, and Marginal Costs
The Total Cost (TC) refers to the total expenditure on the production of goods and services.
Total cost includes fixed cost and variable cost.(TC=FC+VC)
The Average cost (AC) is obtained by dividing total cost (TC) by total output (Q). AC = TC/Q
Marginal Cost (MC) is the addition to total cost on account of producing one additional unit of a
product. It is the cost of the marginal unit produced. MC = Change in TC/ Change in Q = О”TC/
О”Q
Short-Run and Long-Run Costs
Short-Run Costs are costs which change as desired output changes, size of the firm remaining
constant. These costs are often referred to as variable costs. Long-Run costs, on the other hand
are costs incurred on the firm�s fixed assets, such as plant, machinery, building, and the like.
Incremental Costs and Sunk Costs Refers to the total additional cost associated with the
decision to expand output or to add a new variety of product. The concept of incremental cost is
based on the fact that, in the real world, it is not practicable to employ factors for each unit of
output separately due to lack of perfect divisibility of inputs. It also arise as a result of change in
product line, addition or introduction of a new product, replacement of worn out plant and
machinery, replacement of old technique of production with a new one, and the like
The Sunk costs are those costs that cannot be altered, increased or decreased, by varying the rate
of output. once management decides to make incremental investment expenditure and the funds
are allocated and spent, all preceding costs are considered to be the sunk costs since they accord
to the prior commitment and cannot be reversed or recovered when there is a change in market
conditions or a change in business decisions.
Historical and Replacement Costs
Historical cost refers to the cost an asset acquired in the past, whereas, replacement cost refers to
the outlay made for replacing an old asset.
Private and Social Costs
Private and social costs are those costs which arise as a result of the functioning of a firm, but
neither are normally reflected in the business decisions nor are explicitly borne by the firm
Examples of such social costs include:
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water pollution from oil refineries,
air pollution costs by mills and factories located near a city etc
13. Explain short-run cost functions
The distinction between fixed and variable costs is of great significance to the business manager.
Variable costs are those costs, which the business manager can control or alter in the short run by
changing levels of production. On the other hand, fixed costs are clearly beyond business
manager�s control, such costs are incurred in the short run and must be paid regardless of output.
Cost Output Relationship
A cost function is a symbolic statement of the technological relationship between the cost and
output. C = TC = f(Q), and О”Q > 0, The specific form of the cost function depends on the time
framework for cost analysis: in short-or long-run.
Short Run Costs
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Total Variable cost (TVC)
Total amount paid for variable inputs
Increases as output increases
Total Fixed Cost (TFC)
Total amount paid for fixed inputs
Does not vary with output
Total Cost (TC) = TVC + TFC
Short-Run Total Cost Schedules
Total Cost Curves
Average Costs
AVC= TVC/Q
AFC =TFC/Q
ATC=TC/Q=AFC+AVC
Short Run Marginal Cost
Short run marginal cost (SMC) measures rate of change in total cost (TC) as output varies
SMC=пЃ„TC/пЃ„Q=пЃ„TVC/пЃ„Q
Average & Marginal Cost Schedules
Average & Marginal Cost Curves
Behaviour of Costs in Short Run
1. TFC�s are fixed irrespective of increase or decrease in production activity.
2. AFC per unit declines as the volume of production increases. Fixed costs are spread over a
greater number of units. Thus FC per unit will fall. The relationship between FC per unit and
volume of production is inverse.
3. Total variable cost increases proportionately with production. However the rate of increase is
not constant.
4. TC increases with volume of production.
5. Average total cost decrease up to a certain level of production. After this level it increases
sharply. If represented graphically it will result in a flat U-Shaped curve. The lowest point of
average total cost curve denotes the ideal level of production.
6. Marginal cost is the change in total cost resulting from one unit change in output.
7. Marginal cost also decreases up to a certain level and thereafter steeply rises
8. Marginal cost curve cuts ATC and AVC curves at their lowest points.
Relationship between Average cost and Marginal Cost
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Marginal cost is less than average cost when the average cost is falling.
When the average cost is rising, the marginal cost is less than the average cost.
When the average cost is constant, marginal cost is also constant and equals average cost.
MC
AC
AC
MC
Output
Output
(MC<AC)
(MC>AC)
AC=MC
Output (AC=MC)
14.Explain Costs in long run
Suggested answer
Long run is a period, during which all inputs are variable including the one, which are fixes in
the short-run. In the long run a firm can change its output according to its demand. Over a long
period, the size of the plant can be changed, unwanted buildings can be sold staff can be
increased or reduced. The long run enables the firms to expand and scale of their operation by
bringing or purchasing larger quantities of all the inputs. Thus in the long run all factors become
variable.
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Long run costs are incurred by a firm as it Expands its production
Upgrades its production facilities
Enter in to new markets
Initiate necessary changes in the labour force
Import technology
Undertake research and development
Hence long run costs refer to costs of producing different levels of output by changing the scale
of production.
In the long run a firm has a number of alternatives in regards to the scale of operations. For each
scale of production or plant size, the firm has an appropriate short-run average cost curves. The
short-run average cost (SAC) curve applies to only one plant whereas the long-run average cost
(LAC) curve takes in to consideration many plants.
The long-run cost-output relationship is shown graphically with the help of ―LCA� curve.
To draw on ‗LAC� curve we have to start with a number of ‗SAC� curves. In the above figure it
is assumed that technologically there are only three sizes of plants – small, medium and large,
‗SAC�, for the small size, ‗SAC2� for the medium size plant and ‗SAC3� for the large size plant.
If the firm wants to produce ‗OP� units of output, it will choose the smallest plant. For an output
beyond ‗OQ� the firm wills optimum for medium size plant. It does not mean that the OQ
production is not possible with small plant. Rather it implies that cost of production will be more
with small plant compared to the medium plant.
For an output ‗OR� the firm will choose the largest plant as the cost of production will be more
with medium plant. Thus the firm has a series of ‗SAC� curves. The ‗LCA� curve drawn will be
tangential to the entire family of ‗SAC� curves i.e. the ‗LAC� curve touches each ‗SAC� curve at
one point, and thus it is known as envelope curve. It is also known as planning curve as it serves
as guide to the entrepreneur in his planning to expand the production in future. With the help of
‗LAC� the firm determines the size of plant which yields the lowest average cost of producing a
given volume of output it anticipates.
Optimum Plant Size and Long-Run Cost Curves. The optimum size of the firm is one which
ensures the most efficient utilization of the resources. The optimum size of a firm is one in which
the long-run average cost (LAC) is minimised.
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Before optimum point Economies of scale >Diseconomies of scale
At optimum point Economies of scale=Diseconomies of scale
Beyond optimum Economies of scale<Diseconomies of scale
15. Explain breakeven analysis.
Suggested answer
The study of cost-volume-profit relationship is often referred as BEA. The term BEA is
interpreted in two senses. In its narrow sense, it is concerned with finding out BEP; BEP is the
point at which total revenue is equal to total cost. It is the point of no profit, no loss. In its broad
determine the probable profit at any level of production.
Key terms used in Break Even Analysis
1.
2.
3.
4.
Fixed cost
Variable cost
Contribution
Margin of safety
5. Angle of incidence
6. Profit volume ratio
7. Break-Even-Point
1. Fixed cost: Expenses that do not vary with the volume of production are known as fixed
expenses. Eg. Manager�s salary, rent and taxes, insurance etc. It should be noted that fixed
changes are fixed only within a certain range of plant capacity. The concept of fixed overhead is
most useful in formulating a price fixing policy. Fixed cost per unit is not fixed.
2. Variable Cost: Expenses that vary almost in direct proportion to the volume of production of
sales are called variable expenses. Eg. Electric power and fuel, packing materials consumable
stores. It should be noted that variable cost per unit is fixed.
3. Contribution: Contribution is the difference between sales and variable costs and it contributed
towards fixed costs and profit. It helps in sales and pricing policies and measuring the
profitability of different proposals. Contribution is a sure test to decide whether a product is
worthwhile to be continued among different products.
Contribution = Sales – Variable cost
Contribution = Fixed Cost + Profit.
4. Margin of safety: Margin of safety is the excess of sales over the break even sales. It can be
expressed in absolute sales amount or in percentage. It indicates the extent to which the sales can
be reduced without resulting in loss. A large margin of safety indicates the soundness of the
business. The formula for the margin of safety is:
Present sales – Break even sales
or
Profit
P. V. ratio
Margin of safety can be improved by taking the following steps.
1. Increasing production
2. Increasing selling price
3. Reducing the fixed or the variable costs or both
4. Substituting unprofitable product with profitable one.
5. Angle of incidence: This is the angle between sales line and total cost line at the Break-even
point. It indicates the profit earning capacity of the concern. Large angle of incidence indicates a
high rate of profit; a small angle indicates a low rate of earnings. To improve this angle,
contribution should be increased either by raising the selling price and/or by reducing variable
cost. It also indicates as to what extent the output and sales price can be changed to attain a
desired amount of profit.
6. Profit Volume Ratio is usually called P. V. ratio. It is one of the most useful ratios for studying
the profitability of business. The ratio of contribution to sales is the P/V ratio. It may be
expressed in percentage. Therefore, every organization tries to improve the P. V. ratio of each
product by reducing the variable cost per unit or by increasing the selling price per unit. The
concept of P. V. ratio helps in determining break even-point, a desired amount of profit etc.
The formula is,
Contributi on
Sales
X 100
7. Break – Even- Point: If we divide the term into three words, then it does not require further
explanation.
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Break-divide
Even-equal
Point-place or position
Break Even Point refers to the point where total cost is equal to total revenue. It is a point of no
profit, no loss. This is also a minimum point of no profit, no loss. This is also a minimum point
of production where total costs are recovered. If sales go up beyond the Break Even Point,
organization makes a profit. If they come down, a loss is incurred.
Fixed Expenses
1. Break Even point (Units) = Contributi on per unit
Fixed expenses
2. Break Even point (In Rupees) = Contributi on X sales
Numerical problems
16.A firm has a fixed cost of rs.10,000.Selling price per unit is Rs 5.Variable cost per unit is Rs
3.Find out BEP in terms of volume and value.Also find out margin of safety when actual
production is 8,000 units
Suggested answer
BEP=FC/Contribution margin per unit.
Contribution==S.P-V.C/Unit=5-3=2
Hence BEP in units=10,000/2=5,000 units
BEP in value=FC/Contribution Margin ratio
Contribution Margin ratio=(S.P-V.C)/S.P
unit)=10,000/(2/5)=25,000 Rs.
Margin of Safety=8,000-5,000=3,000 Units
16.A rail company can carry a maximum of 10,000 passengers per annum at a fare of Rs 400.The
variable cost per passenger is Rs 150 while the fixed cost is Rs 25,00,000 per year.Find BEP in
number and value.
Suggested answer
Contribution=S.P-V.C=400-150=250
Contribution margin ratio=S.P-V.C/S.P=250/400=5/8
BEP in number=FC/Contribution margin=25,00,000/250=10,000 passengers.
BEP in value=FC/Contribution margin ratio=25,00,000/5/8=40,00,000 Rs
17.Srikanth enterprises has the following cost data for two consecutive years in Rs.
Year 1
Year 2
Sales
50,000
1,20,000
F.C
10,000
20,000
V.C
30,000
60,000
Suggested answer
Here per unit data is not available.We have to use P/V ratio to find out BEP.
P/V Ratio= (Contribution/Sales)
Calculation
Year1
Year 2
Sales
50,000
1,20,000
Less V.C
30,000
60,000
Contribution
20,000
60,000
Less F.C
10,000
20,000
Net Profit
10,000
40,000
P/V Ratio
20,000/50,000=2/5
60,000/1,20,000=1/2
BEP
10,000/(2/5)=25,000
20,000/(1/2)=40,000
safety(Net 10,000/(2/5)=25,000
40,000/(1/2)=80,000
Margin
of
profit/P/V Ratio)
18.Explain Break Even Chart
Suggested Answer
An analytical tool frequently employed by managerial economists is the breakeven chart, an
important application of cost functions. The breakeven chart illustrates at what level of output in
the short run, the total revenue just covers total costs. Generally, a breakeven chart assumes that
the firm�s average variable costs are constant in the relevant output range; hence, the firm�s total
cost function is assumed to be a straight line. Since variable cost is constant, the marginal cost is
also constant and equals to average variable cost.
Figure shows the breakeven chart of a firm. Here, it is assumed that the price of the product will
not be affected by the quantity of sales. Therefore, the total revenue is proportional to output.
Consequently, the total revenue curve is a straight line through the origin. The firm�s fixed cost
is Rs. 500,
Variable cost per unit is Rs. 4 and the unit sales price of output is Rs. 5. The breakeven chart,
which combines the total cost function and the total revenue curve, shows profit or loss resulting
from each sales level. For example, Figure shows that if the firm sells 200 units of output it will
make a loss of Rs. 300. The chart also shows the breakeven point, the output level that must be
reached if the firm is to avoid losses. It can be seen from the figure, the breakeven point is 500
units of output. Beyond 500 units of output the firm makes profit.
Breakeven charts are used extensively for managerial decision process. Under right conditions,
breakeven charts can produce useful projections of the effect of the output rate on costs, revenue
and profits. For example, a firm may use breakeven chart to determine the effect of projected
decline in sales or profits. On the other hand, the firm may use it to determine how many units of
a particular product it must sell in order to breakeven or to make a particular
level of profit.
QUESTIONS
1. What are cost concepts mainly used for in management decision making? Illustrate.
2. The PV ratio of matrix books Ltd Rs. 40% and the margin of safety Rs. 30. You are required to
work out the BEP and Net Profit. If the sales volume is Rs. 14000/3. A Company reported the following results for two period
Period
Sales
Profit
I
Rs. 20,00,000
Rs. 2,00,000
II
Rs. 25,00,000
Rs. 3,00,000
Ascertain the BEP, PV ratio, fixes cost and Margin of Safety.
4. Write short notes on the following
a) Profit – Volume ratio
b) Margin of Safety
5. Write short notes on: (i) Suck costs (ii) Abandonment costs
6. The information about Raj & Co are given below:
P/V ratio
: 20%
Fixed Cost
: Rs. 36,000/-
Selling Price Per Unit: Rs. 150/Calculate (i) BEP in rupees (ii) BEP in Units
(iii) Variable cost per unit
(iv) Contribution per unit
7. Define opportunity cost. List out its assumptions & Limitation.
8.
(a) Explain the utility of BEA in managerial decision making
(b) How do you explain break even chart? Explain.
9. Write short motes on:
(i) Fixed cost & variable cost
(ii) Out of pocket costs & imputed costs
(iii) Explicit & implicit Costs
(iv) Short rum cost
1. Write short note on the following:
a) PV ratio
b) Margin of Safety
c) Angle of incidence
2. Explain Cost/Output relationship in the short run.
3. Appraise the usefulness of BEA for a multi product organization
4. Describe the BEP with the help of a diagram and its uses in business decision making.
5. If sales in 10000 units and selling price Rs. 20/- per unit. Variable cost is Rs. 10/- per unit and
fixed cost is Rs. 80000. Find out BEP in Units and sales revenue what is profit earned? What
should be the sales for earning a profit of Rs. 60000/6. How do you determine BEP in terms of physical units and sales value? Explain the concepts of
margin of safety & angle of incidence.
7. Sales are 1,10,000 producing a profit of Rs. 4000/- in period I, sales are 150000 producing a
profit of Rs. 12000/- in period II. Determine BEP & fixed expenses.
8. When a Mc change does Ac changed (a) at the same rate (b) at a higher rate or (c) at a lower
rate? Illustrate your answer with a diagram.
9. Explain the relationship between MC, AC and TC assuming a short run non-linear cost function.
10. Sale of a product amounts to 20 units per months at Rs. 10/- per unit. Fixed overheads is Rs.
400/- per month and variable cost is Rs. 6/- per unit. There is a proposal to reduce prices by 107.
Calculate present and future P-V ratio. How many units must be sold to earn a target profit of
present level?
QUIZ
1. The cost of best alternative forgone is_______________
(a) Outlay cost (b) Past cost
(c) Opportunity cost (d) Future cost [
]
2. If we add up total fixed cost (TFC) and total variable cost (TVC),We get
(a) Average cost
(b) Marginal cost
(c) Total cost (d) Future cost
[
]
[
]
3. ________ costs are theoretical costs, which are not recognized by Accounting system.
(a) Past
(b) Explicit
(c) Implicit
(d) Historical
4. _____cost is the additional cost to produce an additional unit of output.
(a) Incremental
(b) Sunk
(c) Marginal (d) Total
[
]
[
]
5. _______ costs are the costs, which are varies with the level of output.
(a) Fixed
(b) Past
(c) Variable
(d) Historical
6. _________________ costs are those business costs, which do notInvolve any cash payment.
(a) Past
(b) Historical
(c) Implicit
(d) Explicit
[
]
(d) Variable cost
[
]
7. The opposite of Past cost is ________________________.
(a) Historical (b) Fixed cost
(c) Future cost
8. _____ is a period during which the existing physical capacity of the firm can be changed.
(a) Market period
(b) Short period
(c) Long period
(d) Medium period
[ ]
9. What is the formula for Profit-Volume Ratio?
(a)Sales/Contribution*100
(b)Variable cost/Sales*100
(c)Contribution/Sales*100
(b)Fixed cost/Sales*100
[
]
[
]
[
]
10. _______ is a point of sales at which there is neither profit nor loss.
(a) Maximum sales
(b) Minimum sales
(c) Break-Even sales
(d) Average sales
11. What is the formula for Margin of Safety?
(a) Break Even sales – Actual sales
(b) Maximum sales – Actual sales
(c) Actual sales – Break Even sales
(d) Actual sales – Minimum sales
12. What is the formula for Break-Even Point in Units?
(a) Contribution/Selling Price per unit
(b) Variable cost/Contribution per unit
(c) Fixed Cost/ Contribution per unit
(d) Variable Cost/Selling Price per unit
[
]
14. What is the break-even sales amount, when selling price per unit is Rs.10, Variable cost per
unit is Rs.6 and fixed cost is Rs.40,000.
(a) Rs.4, 00,000
(b) Rs.3, 00,000
(c) Rs.1, 00,000
(d) Rs.2, 00,000
[
]
[
]
15. ‗Contribution‖ is the excess amount of Actual Sales over ______.
(a) Fixed cost
(b) Sales
(c) Variable cost
(d) Total cost
UNIT III
Markets & New Economic Environment:Pricing: Objectives and Policies of Pricing. Methods
of Pricing. Business:Features and evaluation of different forms of Business Organisation: Sole
Proprietorship, Partnership, Joint Stock Company, Public Enterprises and their types,New
Economic Environment: Changing Business Environment in Post-liberalization scenario.
Q. 1. Define Market and Market Structures. Explain the factors determining the Market
Structure.
Suggested Answer
Definition of Market:
Market is defined as a place or point at which buyers and sellers negotiate their exchanges of
well- defined product and service.
Traditionally, market was referred to as a public place in a village or town where provisions and
other objects were brought for sale. Based on the location, markets are classified as rural, urban,
national or world market. Today, with increasing technology and modern facilities, the definition
of market has undergone a sea change. In the modern context, the buyers need not meet the seller
in person. While traditional avenues such as value payable by post (vpp) continued to be popular,
E- commerce through internet, internet – Banking services has been the latest avenue of firm
where on-line negotiations were necessary
Size of markets: The size of market depends on many factors such as nature of products, nature
of their demand, tastes and preferences of the customer, their income level, state of technology,
extent of infrastructure including telecommunications and information technology, time factoring
terms of short- run and long-run so on.
Market structure:
Market structure refers to the characteristics of a market that influence the behavior and
performance of firm that sell in that market. The following features of market structures are
1. The degree of seller concentration: - This refers to the number of sellers and their market
share for a given product or service in the market.
2. The degree of buyer concentration: - This refers to the number of buyers and their extent
of purchase of a given product or service in the market.
3. The degree of product differentiation:- This refers to the extent by which the product of
each trader is differentiated from that of the other product differentiation can take several
forms such as varieties, bonds all of which are sufficiently similar to distinguish them as
a group, from other product (e.g. Cars)
4. The conditions of entry AND EXIT into the market:-There could be large number of
firms, if the number of restrictions to enter the market is low and vice versa, the principle
is ―survival of fittest‖ is applicable.
The main factors, which determine the market structure, are:
1. Number of Buyers and Sellers:
Number of buyers and sellers of a commodity in the market indicates the influence
exercised by them on the price of the commodity. In case of large number of buyers and
sellers, an individual buyer or seller is not in the position to influence the price of the
commodity. However, if there is a single seller of a commodity, then such a seller
exercises great control over the price.
2. Nature of the Commodity (Homogeneous or Differentiated)
If the commodity is of homogeneous nature, i.e. identical in all respects, then it is sold at
a uniform price. However, if the commodity is of differentiated nature (like different
brands of toothpaste), then it may be sold at different prices. Again, if the commodity has
no close substitutes (like Railways), then the seller can charge higher price from the
buyers.
3. Freedom of Movement of Firms:
If there is freedom of entry and exit of firms, then price will be stable in the market.
However, if there are restrictions on entry of new firms and exit of old firms, then a firm
can influence the price as it has no fear of competition from other or new firms.
4. Knowledge of Market Conditions:
If buyers and sellers have perfect knowledge about the market conditions, then a uniform
price prevails in the market. However, in case of imperfect knowledge, sellers are in a
position to charge different prices.
5. Mobility of Goods and Factors of Production:
When the factors of production can move freely from one place to another, then a
uniform price prevails in the market. However, in case of immobility of goods and
factors, different prices may prevail in the market.
Q. 2. Explain the different types of Market Structures. Also Explain features of Perfect
Competition.
Types of Market Structures:
1. Perfect or Pure competition
2. Imperfect competition
п‚·
Monopoly competition
п‚·
Duopoly competition
п‚·
Oligopoly competition
п‚·
Monopolistic competition
Perfect or Pure Competition
п‚·
low barriers to entry, many choices, no business has dominance
п‚·
many companies competing and nobody has a significant advantage examples
o
small bars and restaurants
o
variety stores, convenience stores
o
salons, beauty parlors
o
small grocery stores
o
bakery shops
o
professional services (dentist, doctor, architects)
Oligopoly
п‚·
very similar products, few sellers, small firms follow lead of big firms, fairly inelastic
demand
п‚·
many barriers to establishing a business so only the oldest and biggest businesses are
operating
п‚·
all the businesses are big and of equal size
o
banking industry
o
automotive manufacturers
o
gasoline retail companies
o
insurance companies
o
telecommunications companies
Monopoly
п‚·
one single large seller with no close competition and no alternate substitutes examples
п‚·
the definition of a Monopoly, some say, is that it is bigger than all other competition
combined
o
Software companies like Microsoft
o
Local telephone in Canada (Bell)
o
Water & Electricity Services
o
Indian Railways
Monopolistic Competition
п‚·
sellers feel they do have some competition
п‚·
there is one big company dominating the market with a few medium or smaller sized
companies examples
o
Google (there used to be "pure competition" until Google grew very big and
became dominant)
o
Walmart
Features of Perfect Competition:
1. Existence of very large number of buyers and sellers:

Large number will be there so they cannot combine and influence the market.

No buyer will not influence the price because the quantity purchased by him is
fraction of the total quantity.

The individual firm is only a price taker and not a price maker, so they have no price
policy of own.
2. Homogenous products:

The firm constituting the industry produces homogenous products.

They are identical in character. Hence, no firm can raise its price above the
general level.
3. Free entry and free exit conditions:

There is absolute freedom to firms to get in or get out of the industry.

Under these circumstances all the firms will be earning just normal profits.
4. Perfect mobility of factors of production:

Factors of productions are free to move into any use in order to earn higher
rewards.

If they feel that they are under remunerated, they may come out of the industry.
5. Perfect knowledge of market:

All sellers and buyers will have perfect knowledge of the market.

Sellers cannot influence buyers and buyers cannot influence seller. They will be
independent of their actions.
6. Absence of difference in transport cost:

All firms will have equal access to the market.

Market price charged by the sellers should not vary because of difference in the
cost of transportation.
7. Absence of government control:

Government should not interfere in matters pertaining to supply and price.

It should not place barriers in the way of smooth exchange.
8. Advertisement cost: Due to perfect competition the advertising cost will disappear from
the price, because all the buyers and sellers know the all details regarding product, price,
and availability etc.
Q. 3. Discuss the main differences between Perfect Competition and Monopoly.
Perfect Competition: Perfect competition is said to exist in a market place when all firms face
the highest or most complete degree of competition conceivable and all are price takers, meaning
they can sell as much as they wish at the going market price but not any higher. But for this to
happen, there are four conditions or assumption that have to be fulfilled to guarantee perfect
competition.
First, there must be many sellers and none should be big enough to exert any discerning
perceptible influence on the market price of its products, for example by increasing its product
offering for sale. Second, the goods sold must all be homogenous in nature and not
differentiable, for example, in tomato farming, all farmers will have a homogenous product,
tomatoes unlike, car manufacturing where BMW offers differentiated products from Ford. Third,
there must be perfect information and knowledge of prices and qualities of each firm�s products
in the market without any need for advertising. So if one farmer raises price, the well informed
customers will simply leave and go elsewhere to buy tomatoes as they are homogenous. Fourth,
there must be no barriers to entry such as patents, licensing, as firms have complete freedom of
entry and exit with no restrictions.
Monopoly: A monopoly is a market with a single supplier or firm that dominates supply of a
certain output. The firm and the industry are one and the same. A good example of a monopoly is
Microsoft and its dominance of the PC market with regards to its windows operating system.
Even though other operating systems such as Linux exist, its Windows product controls virtually
90% of market.
Many variables can restrict entry of a firm into a Monopoly market. There may be government
regulations, patents, import/export restrictions or large investment and startup costs. It is the
number of restrictions in place that determines the difference between the two markets.
There is no restriction on entering a perfect competition market. There is complete freedom of
entry for firms and established firms are unable to stop new firms entering the market. On the
other hand, access to a monopoly is completely blocked or restricted. The access to a monopoly
may be restricted for various reasons such as government regulations, legislation or initial set-up
costs.
Because a monopoly is the sole supplier of the market, their demand curve is the same as that of
the market. But that doesn�t mean they can set the price as in Perfect Competition. What they can
is increase output while selling more units at lower prices up to a point where average revenue is
above the average cost, and they will make also make abnormal profits.
In the long run, a monopoly has the option to maintain this position depending on factors such as
barriers to entry which can protect that position and prevent other firms from entering the
industry. Barriers to exit can also create the same effect as barriers to entry if it�s expensive for
competitors to start up. A monopoly can also advertise unlike in Perfect Competition which can
help them continue maximizing profits. A monopoly can also simply force out any competition
that tries to enter the market as a result of abnormal profits by cutting prices which they can do
due to economies of scale.
Conclusion
Although a pure Monopoly can offer advantages to consumers such as lower prices due to
economies of scale, in reality such a market is not healthy. One can argue that in such a market, a
firm will use its resources to invest and innovate but in many cases, this does not happen. What
happen are often higher prices and less efficiency due to low competition?
Perfect Competition seems to be the best choice for consumers as it gives them the power.
Q.4. What are the different types of Monopoly?
Ans. Classification / Kinds / Types of Monopoly
1. Perfect Monopoly
It is also called as absolute monopoly. In this case, there is only a single seller of product having
no close substitute; not even remote one. There is absolutely zero level of competition. Such
monopoly is practically very rare.
2. Imperfect Monopoly
It is also called as relative monopoly or simple or limited monopoly. It refers to a single seller
market having no close substitute. It means in this market, a product may have a remote
substitute. So, there is fear of competition to some extent e.g. Mobile (Cellphone) telcom
industry (e.g. vodaphone) is having competition from fixed landline phone service industry (e.g.
BSNL).
3. Private Monopoly
When production is owned, controlled and managed by the individual, or private body or private
organization, it is called private monopoly. e.g. Tata, Reliance, Bajaj, etc. groups in India. Such
type of monopoly is profit oriented.
4. Public Monopoly
When production is owned, controlled and managed by government, it is called public
monopoly. It is welfare and service oriented. So, it is also called as 'Welfare Monopoly' e.g.
Railways, Defence, etc.
5. Simple Monopoly
Simple monopoly firm charges a uniform price or single price to all the customers. He operates
in a single market.
6. Discriminating Monopoly
Such a monopoly firm charges different price to different customers for the same product. It
prevails in more than one market.
7. Legal Monopoly
When monopoly exists on account of trade marks, patents, copy rights, statutory regulation of
government etc., it is called legal monopoly. Music industry is an example of legal monopoly.
8. Natural Monopoly
It emerges as a result of natural advantages like good location, abundant mineral resources, etc.
e.g. Gulf countries are having monopoly in crude oil exploration activities because of plenty of
natural oil resources.
9. Technological Monopoly
It emerges as a result of economies of large scale production, use of capital goods, new
production methods, etc. E.g. engineering goods industry, automobile industry, software
industry, etc.
10. Joint Monopoly: A number of business firms acquire monopoly position through
amalgamation, cartels, syndicates, etc, it becomes joint monopoly. e.g. Actually, pizza making
firm and burger making firm are competitors of each other in fast food industry. But when they
combine their business, which leads to reduction in competition. So they can enjoy monopoly
power in market.
Q. 5. Define Oligopoly. Discuss the Features of Oligopoly.
Answer
An Oligopoly is a market form in which a market or industry is dominated by a small number of
sellers (oligopolists). Oligopolies can result from various forms of collusion which reduce
competition and lead to higher prices for consumers.
With few sellers, each oligopolist is likely to be aware of the actions of the others. The decisions
of one firm therefore influence and are influenced by the decisions of other firms. Strategic
planning by oligopolists needs to take into account the likely responses of the other market
participants.
Oligopoly is a common market form where a number of firms are in competition. As a
quantitative description of oligopoly, the four-firm concentration ratio is often utilized. This
measure expresses the market share of the four largest firms in an industry as a percentage. For
example, as of fourth quarter 2008, Verizon, AT&T, Sprint, and T-Mobile together control 89%
of the US cellular phone market.
Oligopolistic competition can give rise to a wide range of different outcomes. In some situations,
the firms may employ restrictive trade practices (collusion, market sharing etc.) to raise prices
and restrict production in much the same way as a monopoly. Where there is a formal agreement
for such collusion, this is known as a cartel. A primary example of such a cartel is OPEC which
has a profound influence on the international price of oil.
Firms often collude in an attempt to stabilize unstable markets, so as to reduce the risks inherent
in these markets for investment and product development. There are legal restrictions on such
collusion in most countries. There does not have to be a formal agreement for collusion to take
place (although for the act to be illegal there must be actual communication between
companies)–for example, in some industries there may be an acknowledged market leader which
informally sets prices to which other producers respond, known as price leadership.
In other situations, competition between sellers in an oligopoly can be fierce, with relatively low
prices and high production. This could lead to an efficient outcome approaching perfect
competition. The competition in an oligopoly can be greater when there are more firms in an
industry than if, for example, the firms were only regionally based and did not compete directly
with each other.
Characteristics of Oligopoly Market Structure
a) Profit maximization conditions: An oligopoly maximizes profits.
b) Ability to set price: Oligopolies are price setters rather than price takers.
c) Entry and exit: Barriers to entry are high. The most important barriers are government
licenses, economies of scale, patents, access to expensive and complex technology, and
strategic actions by incumbent firms designed to discourage or destroy nascent firms.
Additional sources of barriers to entry often result from government regulation favoring
existing firms making it difficult for new firms to enter the market.
d) Number of firms: "Few" – a "handful" of sellers. There are so few firms that the actions
of one firm can influence the actions of the other firms.
e) Long run profits: Oligopolies can retain long run abnormal profits. High barriers of entry
prevent sideline firms from entering market to capture excess profits.
f) Product differentiation: Product may be homogeneous (steel) or differentiated
(automobiles).
g) Perfect knowledge: Assumptions about perfect knowledge vary but the knowledge of
various economic factors can be generally described as selective. Oligopolies have
perfect knowledge of their own cost and demand functions but their inter-firm
information may be incomplete. Buyers have only imperfect knowledge as to price, cost
and product quality.
h) Interdependence: The distinctive feature of an oligopoly is interdependence. Oligopolies
are typically composed of a few large firms. Each firm is so large that its actions affect
market conditions. Therefore the competing firms will be aware of a firm's market
actions and will respond appropriately. This means that in contemplating a market action,
a firm must take into consideration the possible reactions of all competing firms and the
firm's countermoves. It is very much like a game of chess or pool in which a player must
anticipate a whole sequence of moves and countermoves in determining how to achieve
his or her objectives.
i) Non-Price Competition: Oligopolies tend to compete on terms other than price. Loyalty
schemes, advertisement, and product differentiation are all examples of non-price
competition.
Examples
In industrialized economies, barriers to entry have resulted in oligopolies forming in many
sectors, with unprecedented levels of competition fueled by increasing globalization. Market
shares in an oligopoly are typically determined by product development and advertising. For
example, there are now only a small number of manufacturers of civil passenger aircraft, though
Brazil (Embraer) and Canada (Bombardier) have participated in the small passenger aircraft
market sector. Oligopolies have also arisen in heavily-regulated markets such as wireless
communications: in some areas only two or three providers are licensed to operate.
India
п‚·
The petroleum and gas industry is dominated by Indian Oil, Bharat Petroleum, Hindustan
Petroleum and Reliance.
п‚·
Most of the telecommunication in India is dominated by Airtel, Vodafone, Idea, Reliance
United States
п‚·
Many media industries today are essentially oligopolies.
o
Six movie studios receive almost 87% of American film revenues.
o
The television and high speed internet industry is mostly an oligopoly of seven
companies: The Walt Disney Company, CBS Corporation, Viacom, Comcast,
Hearst Corporation, Time Warner, and News Corporation. See Concentration of
media ownership.
o
Four wireless providers (AT&T Mobility, Verizon Wireless, T-Mobile, and Sprint
Nextel) control 89% of the cellular telephone service market. This is not to be
confused with cellular telephone manufacturing, an integral portion of the cellular
telephone market as a whole.
Worldwide
The accountancy market is dominated by PriceWaterhouseCoopers, KPMG, Deloitte Touche
Tohmatsu, and Ernst & Young (commonly known as the Big Four)
Three leading food processing companies, Kraft Foods, PepsiCo and NestlГ©, together achieve a
large proportion of global processed food sales. These three companies are often used as an
example of "Rule of three", which states that markets often become an oligopoly of three large
firms.
Boeing and Airbus have a duopoly over the airliner market.
General Electric, Pratt and Whitney and Rolls-Royce plc own more than 50% of the market
share in the airliner engine market.
Three credit rating agencies (Standard & Poor's, Moody's, and Fitch Group) dominate their
market and extend their crucial importance into the financial sector. See Big Three (credit rating
agencies).
NestlГ©, The Hershey Company and Mars, Incorporated together make most of the confectionery
made worldwide.
Microsoft, Sony, and Nintendo dominate the video game console market.
Q. 6. Explain Monopolistic Competition.
Monopolistic competition is different from a monopoly. A monopoly exists when a person or
entity is the exclusive supplier of a good or service in a market.
Markets that have monopolistic competition are inefficient for two reasons. First, at its optimum
output the firm charges a price that exceeds marginal costs. The second source of inefficiency is
the fact that these firms operate with excess capacity.
Monopolistic competitive markets have highly differentiated products; have many firms
providing the good or service; firms can freely enter and exits in the long-run; firms can make
decisions independently; there is some degree of market power; and buyers and sellers have
imperfect information.
Monopolistic competition
A type of imperfect competition such that one or two producers sell products that are
differentiated from one another as goods but not perfect substitutes (such as from branding,
quality, or location).
Monopoly: A market where one company is the sole supplier.
Monopolistic Competition
Monopolistic competition is a type of imperfect competition such that many producers sell
products that are differentiated from one another as goods but not perfect substitutes (such as
from branding, quality, or location). In monopolistic competition, a firm takes the prices charged
by its rivals as given and ignores the impact of its own prices on the prices of other firms.
Unlike in perfect competition, firms that are monopolistically competitive maintain spare
capacity. Models of monopolistic competition are often used to model industries. Textbook
examples of industries with market structures similar to monopolistic competition include
restaurants, cereal, clothing, shoes, and service industries in large cities.
Clothing
The clothing industry is monopolistically competitive because firms have differentiated products
and market power.
Monopolistic competition is different from a monopoly. A monopoly exists when a person or
entity is the exclusive supplier of a good or service in a market. The demand is inelastic and the
market is inefficient.
Monopolistic competitive markets:
п‚·
have products that are highly differentiated, meaning that there is a perception that the
goods are different for reasons other than price;
п‚·
have many firms providing the good or service;
п‚·
firms can freely enter and exits in the long-run;
п‚·
firms can make decisions independently;
п‚·
there is some degree of market power, meaning producers have some control over price;
п‚·
Buyers and sellers have imperfect information.
Sources of Market Inefficiency
Markets that have monopolistic competition are inefficient for two reasons. The first source of
inefficiency is due to the fact that at its optimum output, the firm charges a price that exceeds
marginal costs. The monopolistic competitive firm maximizes profits where marginal revenue
equals marginal cost. A monopolistic competitive firm's demand curve is downward sloping,
which means it will charge a price that exceeds marginal costs. The market power possessed by a
monopolistic competitive firm means that at its profit maximizing level of production there will
be a net loss of consumer and producer surplus.
The second source of inefficiency is the fact that these firms operate with excess capacity. The
firm's profit maximizing output is less than the output associated with minimum average cost.
All firms, regardless of the type of market it operates in, will produce to a point where demand or
price equals average cost. In a perfectly competitive market, this occurs where the perfectly
elastic demand curve equals minimum average cost. In a monopolistic competitive market, the
demand curve is downward sloping. In the long run, this leads to excess capacity.
Q. 7. Explain the Price & Output determination for firm in Perfect Competition in the
short-run and long-run period.
Answer. Price and Output Determination—Under Perfect Competition
In Perfect Competition, there are large number of buyers and sellers and their actions do not
influence the market price. The prevailing price of the product in the market is taken for granted,
the buyers have to make outlay by the price and sellers have to supply by the price. Price under
perfect competition is determined by the interaction of the two faces i.e. demand and supply. So,
individuals, firms, government cannot change the price, the aggregate force of demand and
supply determines the equilibrium price of the product.
Equilibrium Price: - Although no single entity in a perfectly competitive market can affect
price, the aggregate effect of the participants in the market is important in price determination.
Indeed, the interaction of supply and demand determines the equilibrium price of the quantity to
be exchanged.
Equilibrium output: - As price is determined in the market, and the product is homogenous, the
only decision left to the manager of a firm in a perfectly competitive market is how much output
is produced. The profit- maximizing output is determined where the extra revenue generated by
selling the last unit (i.e., the market price) just equals the marginal cost of producing that unit.
Y
MC
AC
C
D
C
AR = MR
F
E
O
output
X
The firms demand curve is horizontal at the price determined in the industry (MR=AR= Price)
i.e. Marginal Revenue= Average Revenue= Price.
This is because if all the units are sold at the same price, on an average the revenue to the firm
equals its prices. When the average revenue is constant (neither falling nor raising), it will
coincide with marginal revenue curve. CC is the demand curve representing price, average
revenue curve and also marginal revenue curve (price =MR=AR). AC (Average cost), MC
(marginal cost) are firms costs.
In the perfect competition the firm has to satisfy two conditions.
1. MR= MC.
2. MC curve must cut MR curve from below.
Price and output determination in long-run
Having been attracted by supernormal profit, more and more firms enter the industry, with the
result there will be a scramble for scarce inputs among the competing firms pushing the input
prices. Hence, the average cost increases. The entry of more and more firms will expand the
supply pulling the market price. As a result, the super normal profits hitherto, enjoyed by the
firms get eroded. The entry of the firms into the industry continues till the super normal profits
are completely eroded. In the long run the firms will be in position to enjoy normal profits but
not supernormal profits. Normal profits are the profits that are just sufficient for the firm to stay
in the business.
CMC
Y
E
CAC
P
AR= MR= Price = AC
O
output
Q
X
From the above figure, long- run equilibrium position of the firm under perfect competition has
to satisfy two conditions.
1. MR = MC.
2. AR = AC. Must be tangential to AR at its lowest point QE, is the price and also long- run
average cost(LAC). Long run marginal cost (LMC) curve pass through the minimum
point of the long-run average cost curve (LAC).
At E, while passing through the marginal revenue curve, E is the equilibrium point and the firm
produces OQ units of output. It can be noted that the normal profits are not visible to the naked
eye since normal profits are included in the average cost.
Q. 8. Explain the features of Monopoly and Monopolistic Competition. Compare &
Contrast price output determination in Monopoly and Monopolistic Competitions.
Answer. Features of Monopoly: 1. There is a single firm dealing in a particular product or service.
2. There is no close substitute and no competitors.
3. The monopolist can decide either the price or quantity, not both.
4. The product and services provided by the monopolist bear inelastic demand.
5. Monopoly may be created through statutory grant of special privileges such as Licenses,
Permits, and Patent rights and so on.
Features of Monopolistic Competition:
1. Existence of large number of firms:
The first important feature of monopolistic competition is that there are a large number of firms
satisfying the market demand for the product. As there are a large number of firms under
monopolistic competition, there exists stiff competition between them. These firms do not
produce perfect substitutes. But the products are close substitute for each other.
(2) Product differentiations:
The various firms under monopolistic competition bring out differentiated products which are
relatively close substitutes for each other. So their prices cannot be very much different from
each other. Various firms under monopolistic competitors compete with each other as the
products are similar and close substitutes of each other. Differentiation of the product may be
real or fancied.
Real or physical differentiation is done through differences in materials used, design, color etc.
Further differentiation of a particular product may be linked with the conditions of his sale, the
location of his shop, courteous behavior and fair dealing etc.
(3) Some influence over the price:
As the products are close substitutes of others any reduction of price of a commodity by a seller
will attract some customers of other products. Thus with a fall in price quantity demanded
increases. It therefore, implies that the demand curve of a firm under monopolistic competition
slopes downward and marginal revenue curve lies below it.
Thus under monopolistic competition a firm cannot fix up price but has influence over price. A
firm can sell a smaller quantity by increasing price and can sell more by reducing price. Thus
under monopolistic competition a firm has to choose a price-output combination that will
maximize price.
(4) Absence of firm's interdependence:
Under oligopoly, the firms are dependent upon each other and can't fix up price independently.
But under monopolistic competition the case is not so. Under monopolistic competition each
firm acts more or less independently. Each firm formulates its own price-output policy upon its
own demand cost.
(5) Non-price competition:
Firms under monopolistic competition incur a considerable expenditure on advertisement and
selling costs so as to win over customers. In order to promote sale firms follow definite -methods
of competing rivals other than price. Advertisement is a prominent example of non-price
competition.
The advertisement and other selling costs by a firm change the demand for his product. The rival
firms compete with each other through advertisement by which they change the consumer's
wants for their products and attract more customers.
(6) Freedom of entry and exit:
In a monopolistic competition it is easy for new firms to enter into an existing firm or to leave
the industry. Lured by the profit of the existing firms new firms enter the industry which leads to
the expansion of output. But there exists a difference.
Price output determination under Monopoly
Under the Monopoly, the average revenue curve for a firm is a downward sloping one. It is
because, if the monopolist reduces the price of his product, the quantity demanded increases and
vice versa. In monopoly, marginal revenue is less than the average revenue. In other words,
marginal revenue below average revenue curves. The monopolist always wants to maximize his
profits. To maximum profits, it is necessary that marginal revenue should be more than marginal
cost.
He can continue to sell as long as the marginal revenue exceeds marginal cost. At the point F,
where MR=MC, profits will be maximized. Profits will be diminishing if the production is
continued beyond this point. Average revenue curve is represented by AR, marginal revenue
curve by MR, average cost by AC, and marginal cost curve by MC. OQ is equilibrium output,
OA is the equilibrium price, QC is the average cost, and BC is the average profit (AR-AC is the
average profit).
Up to OQ output, MR is greater than MC and beyond OQ, MR is less than MC. Therefore, the
monopolist will be in equilibrium at output OQ where MR=MC and profit are maximum. OA is
the corresponding price to the output level of OQ. The rectangle ABCD represents the profits
earned by the monopolist in the equilibrium position in the short run.
Price
Y
MC
AC
A
B
C
D
AR
MR
F
D
Q
Output
X
Price and output discrimination under the Monopolistic Competition
It is common that every firm whether operating under perfect market or imperfect market, wants
to maximize the profits when marginal cost is equal to the marginal revenue. The demand curve
for the firm in case of monopolistic competition is just similar to that of monopolist. As the
products are differentiated, the demand curve has a downward slope. The firms are price makers
as far as given group of customers is concerned. The demand for their products and services is
relatively inelastic. The degree if elasticity of demand of a firm in monopolistic competition
depends upon the extent to which the firm can resort to the product differentiation.
Short Run: - In the short run the firms may experience super normal or even losses. When there
is a fall in cost and increase in demand the firms enjoy super normal profits. The firm has to
satisfy two conditions: MC=MR, Where AR less than AC.
The firms demand curve is a downward sloping curve because of product differentiation at point
F, marginal cost (MC) is equal to marginal revenue (MR), extends F to point B on average
revenue (AR) curve and point Q on x axis.
OQ is the equilibrium output.
OA=OB= equilibrium price and
QC= average cost.
Average profits= average revenue minus average cost. BC is the average profits
Total profit = profits x quantity
The area ABCD represents supernormal profits earned by a firm under monopolistic competition
in the short run.
Long-run
More and more firms entering the market having been attracted by super normal profits enjoyed
by the existing firm in the industry. As a result, competition becomes intensive on one hand; firm
will compete with one another for acquiring scare inputs pushing up the prices of factor inputs.
In order to cope with the competition, the competition, the firms will have to increase the budget
on advertising .The entry of new firms continue till the super normal profits of the firm
completely eroded and ultimately firms in the industry will earn only normal profits.
In long-run to achieve equilibrium position, the firm has to following two conditions.
a. MR=MC
b. AR=AC at the equilibrium level of output.
MC
Price
AC
P
E
F
AR
O
Q
output
x
Thus, the firm has to fulfill dual equilibrium conditions as mentioned above. But when compared
to long –run equilibrium position of a perfect competition firm. Even though AR=AC, AC will
not be at its minimum point at equilibrium level of output and also MR is not equal to either AR
or AC; MR is well below AR in the case of monopolistic competitive firm.
FREQUENTLY ASKED QUESTIONS
1. What is a Market? Explain the features of Markets Structures.
2. What are the factors that determine the selection of a suitable market structure?
3. What are the different types of Market Structures? Explain them.
4. Explain features of Perfect Competition.
5. What is Perfect Competition? Explain the price out – put determination in Perfect
Competition.
6. What is Perfect Competition? How the Price & Output is determined in short run for
industry & firm under Perfect Competition?
7. What is Monopoly? Explain the characteristics of Monopoly Market Structure.
8. What are the different types of Monopoly Market Structure?
9. Compare & Contrast features & price output determination in Monopoly and
Monopolistic Competitions?
10. Determine Price & Output determination for firm & industry in long run in Perfect
Competition.
11. Differentiate between Perfect Competition and Monopoly.
12. What is Oligopoly? Explain the characteristics of Oligopolistic Market Structure.
13. What is Duopoly? Explain the characteristics of Duopoly Market Structure.
14. How some companies like Microsoft are able to do Monopoly for such a long time?
Explain.
15. Which is the ideal market structure? Explain by taking examples of some firms.
1.What is Price?
Suggested Answer:
Price denotes the exchange value of a unit of good expressed in terms of money.
Price of a well-defined product varies over the types of the buyers, place it is received, credit sale
or cash sale, time taken between final production and sale, etc.
It should be obvious to the readers, that the price difference on account of the above four factors
are more significant. The multiple prices is more serious in the case of items like cars
refrigerators, coal, furniture and bricks and is of little significance for items like shaving blade,
soaps, tooth pastes, creams and stationeries. Differences in various prices of any good are due to
differences in transport cost, storage cost accessories, interest cost, intermediaries� profits etc.
Once can still conceive of a basic price, which would be exclusive of all these items of cost and
then rationalize other prices by adding the cost of special items attached to the particular
transaction, in what follows we shall explain the determination of this basis price alone and thus
resolve the problem of multiple prices.
Example;
Thus the current price of a maruti car around Rs. 2,00,000, the price of a hair cut is Rs. 25 the
price of a economics book is Rs. 150 and so on. Nevertheless, if one gives a little, if one gives a
little thought to this subject, one would realize that there is nothing like a unique price for any
good. Instead, there are multiple prices.
2.Explain the concept of Pricing and what are its Objectives?
Suggested Answer:
Pricing:
Pricing is not an exact science. Pricing decisions, more often, are done by trial and error. Most
often we see discounts and concessions offered at the time of purchase. Sometimes certain
schemes are introduced wherein if you buy a Packet of Tea powder, a shining steel table spoon is
free! Why are all this providing? While the main objective of such schemes is to increase sales,
one of the other objectives is to correct pricing strategy
Pricing is an important exercise, under pricing will result in losses and over-pricing will make
the customers run away. To determine pricing in a scientific manner, it is necessary to
understand the pricing objectives, pricing methods, pricing policies, and pricing procedures.
Pricing objectives:
Pricing objectives or goals gives direction to the whole pricing process. Determining what your
objectives are is the first step in pricing. When deciding on pricing objectives you must consider:
1) the overall financial, marketing, and strategic objectives of the company; 2) the objectives of
your product or brand; 3) consumer price elasticity and price points; and 4) the resources you
have available.
Generally, the following are the objectives of pricing.
a) To maximize profits
b) To increase sales.
c) To increase the market share,
d) To satisfy customers, and
e) To meet the competition.
3.Explain the various methods of Pricing?
Suggested Answer:
Pricing Methods.
The following are the different methods of pricing.
1.
Cost -based pricing methods
a.
Cost-plus pricing: is a pricing method used by companies. It is used primarily
because it is easy to calculate and requires little information. There are several varieties, but the
common thread in all of them is that one first calculates the cost of the product, and then includes
an additional amount to represent profit.
b.
Marginal Cost Pricing: Is a pricing method according to which firms set the
prices of their products by taking into consideration the marginal cost of production, which is the
cost of producing one extra unit of the product.
Governments commonly employ marginal cost pricing method when pricing noncompetitive
industries such as public services and utilities where the aim is to maximize the economic
welfare of the state.
2. Competition-Oriented Pricing:
A method of pricing in which a manufacturer's price is determined more by the price of a similar
product sold by a powerful competitor than by considerations of consumer demand and cost of
production.
a.
Sealed bid pricing
Price bidding is a strategy most common with manufacturing, building and construction
services. For example, if a restaurant was to be decorated, then the owner would consult a
number of decorating services for a quote and the best offer (not necessarily the lowest) would
be taken. If this was considered a big job (likely to generate high revenue), then some decorating
businesses would consider cutting their prices as it may account for a large proportion of their
annual revenue.
b.
Going Rate Pricing:
Many businesses feel that lowering prices to be more competitive can be disastrous for
them (and often very true!) and so instead, they settle for a price that is close to their competitors.
Any price movements made by competition is then mirrored by yourself: so long that you can
compensate for any reductions if they lower their price.
3. Demand-oriented Pricing:
a.
Price discrimination:
The practice of selling a commodity at different prices to different buyers, even though
sales costs are the same in all of the transactions. Discrimination among buyers may be based on
personal characteristics such as Income race, or age or on geographic location. For price
discrimination to succeed, other entrepreneurs must be unable to purchase goods at the lower
price and resell them at a higher one.
b.
Perceived Value Pricing:
Perceived Value Pricing is a market-based approach to pricing wherein the price is set by
estimating what the perceptions of potential consumers are regarding the value of the product.
4. Strategy-Based Pricing:
a.
Market skimming:
The practice of ‗price skimming� involves charging a relatively high price for a short
time where a new, innovative, or much-improved product is launched onto a market. The
objective with skimming is to ―skim‖ off customers who are willing to pay more to have the
product sooner; prices are lowered later when demand from the ―early adopters‖ falls.
b.
Penetration pricing:
Penetration pricing involves the setting of lower, rather than higher prices in order to
achieve a large, if not dominant market share. This strategy is most often used businesses
wishing to enter a new market or build on a relatively small market share.
c.
Two-part pricing: is a price discrimination technique in which the price of a
product or service is composed of two parts - a lump-sum fee as well as a per-unit charge. In
general, price discrimination techniques only occur in partially or fully monopolistic markets. It
is designed to enable the firm to capture more consumer surplus than it otherwise would in a
non-discriminating pricing environment.
d.
Peak Load Pricing
Peak-load pricing is a policy of raising prices when the demand for a service is at its
highest. The most recent analysis of this pricing policy stems from American research in the
1960s and 1970s.Peak-load pricing is often used by electricity and telephone utilities as a means
of reflecting the investment they have made to meet peak demand for their services.
e.
Transfer pricing :
Transfer pricing refers to the pricing of contributions (assets, tangible and intangible,
services, and funds) transferred within an organization. For example, goods from the production
division may be sold to the marketing division, or goods from a parent company may be sold to a
foreign subsidiary. Since the prices are set within an organization (i.e. controlled), the typical
market mechanisms that establish prices for such transactions between third parties may not
apply. The choice of the transfer price will affect the allocation of the total profit among the parts
of the company. This is a major concern for fiscal authorities who worry that multi-national
entities may set transfer prices on cross-border transactions to reduce taxable profits in their
jurisdiction. This has led to the rise of transfer pricing regulations and enforcement, making
transfer pricing a major tax compliance issue for multi-national companies.
f.
Cross Subsidies – ―Whenever the demands for two products produced by a firm
are interrelated through costs or demand, the firm may enhance profits by cross-subsidization:
selling one product at or below cost and the other product above cost‖ (Baye, 2006). A good
example of this strategy is the practices of some software companies. For instance, Adobe
produces products such as Adobe Acrobat and Adobe Flash, but provides a form of these
products free of charge to consumers. Adobe Reader and Adobe Flash Player are available for
free, but do not allow the user to create files with them. The full versions of these programs are
available at a cost that pays for the development of both the free versions and the full versions.
With the increased number of people demanding Adobe Reader, there will be a proportional
increase in demand for Adobe Acrobat. This will eventually help to increase the total profits of
the company.
g.
Block pricing:
―The profit-maximizing price on a package is the total value the customer receives for the
package, including consumer surplus‖. A firm uses this in order to get the consumer to pay the
full value of the total amount of units purchased. If a company packages their product in a
package of eight units, the consumer has to decide if they want to purchase all eight units or none
of the units. If the total value of the eight units is $50, the consumer will find it in his/her best
interest to purchase the package as long as the price does not exceed this value. This prevents the
consumer from purchasing only a few of the units, which would decrease the firm�s profits from
this consumer.
h.
Product Bundle Pricing.
Here sellers combine several products in the same package. This also serves to move old
stock. Videos and CDs are often sold using the bundle approach.
4. Explain various strategies in Pricing
Suggested Answer:
Pricing strategies in times of stiff price competition
1.
Price Matching
Many businesses feel that lowering prices to be more competitive can be disastrous for
them (and often very true!) and so instead, they settle for a price that is close to their competitors.
Any price movements made by competition is then mirrored by yourself: so long that you can
compensate for any reductions if they lower their price.
2.
Time-to-time pricing:
When a firm randomly changes the prices of their goods, consumer cannot learn from
experience which firm charges the lowest price in the market. Sometimes firm A might be lowest
and sometimes firm B might be lowest. Since consumers do not have an understanding of where
a company stands on pricing, they have less incentive to shop for the best price. The other
advantage a firm gets with this strategy is it discourages other firms from trying to undercut their
prices. Other firms cannot accurately predict the price set by a randomly priced good, so they are
forced to ignore it when they are setting their prices.
Promotional Pricing. Pricing to promote a product is a very common
3.
application. There are many examples of promotional pricing including approaches such as
BOGOF (Buy One Get One Free).
Target Pricing:
4.
Target pricing method whereby the selling price of a product is calculated to produce a
particular rate of return on investment for a specific volume of production. The target pricing
method is used most often by public utilities, like electric and gas companies, and companies
whose capital investment is high, like automobile manufacturers. Essentially, the selling price is
calculated according to the following formula: Target pricing is not useful for companies whose
capital investment is low because, according to this formula, the selling price will be understated.
Also the target pricing method is not keyed to the demand for the product, and if the entire
volume is not sold, a company might sustain an overall budgetary loss on the product.
FORMS OF BUSINESS ORGANIZATION
5.Explain various charactestic features of Business.
Suggested Answer:
Human activities may be categorized as economic and non-economic.
Economic
activities are related to the production of wealth, they create utilities. Non-economic activities
are like social services. The word business literally means ‗a state of being busy.� According to
L.H. Haney, ―Business may be defined as Human activity directed towards providing or
acquiring wealth through buying and selling‖.
Characteristics of Business
п‚·
Entrepreneur.
п‚·
Economic Activities. Activities relating to production and distribution of goods
A person who takes initiative to establish a business.
and services
п‚·
Profit Motive. Activities undertaken without profit motive are not a business.
п‚·
Risk and Uncertainty. If the concern is stable and exists continuously, it will
attract more investment. They do not have permanent life.
п‚·
Government Regulations. These are another factor that governs all the business
organizations. A business needs to keep its records transparent for the government
every year. A number of formalities are required to be complied with while
incorporating a company.
п‚·
Creation of utility:
Goods are created and services are provided as per the
requirements of the consumers. This is the most important objective of a business
organization.
п‚·
Organization: Business needs an organization for its successful functioning. A
proper structure is formed establishing interrelationships between the people and
functions for smooth functioning of the organization.
п‚·
Financing: Business organizations cannot move a step without finances. There
are many sources of finance available to business organization.
п‚·
Consumer satisfaction is the ultimate aim of a business.
6. Define various Forms of Business Organization
Suggested Answer:
Forms of Business Organization
1.
Private Undertaking
a.
Sole Proprietorship
b.
Partnership
c.
Joint Hindu Family Business
d.
Joint Stock Company
e.
Co-operative societies
2.
Public Undertaking
f.
Departmental Organization
g.
Public Corporations
h.
Government Companies
3.
Joint Sector Undertaking
7. What are the factors influencing the choice of suitable form of business organization?
Suggested Answer:
Capital Requirement. Larger the organization, more will be the capital requirement and
vice versa. The need for capital will depend upon the nature of business and scale of operations.
Liability. There are two types of liability, limited liability and unlimited liability. In
sole proprietorship and partnership, the liability of owners is unlimited. In case of companies,
the liability of the shareholders is limited to the value of the shares they have purchased.
Managerial Needs. Managerial and administrative requirements are also one of the
factors which influence the choice of form of organization.
Continuity.
If the concern is stable and exists continuously, it will attract more
investment. A company form of organization ensures stability and continuity.
Tax Liability. A Joint Stock Company has more tax liability as compared to a sole
proprietorship and a partnership form of organization. A small scale concern will be able to
avoid higher tax liability.
Government Regulations.
Government Regulation is another factor influencing a
decision about the form of organization. A number of formalities are required to be complied
with while incorporating a company.
Ease of Formation. The formalities required at the time of formation of a form of
organization depend upon the nature of business. Sole trader and Partnership are easy to form
but a company requires the services of qualified persons for getting it registered and bringing a
company into existence. It needs to mobilize huge funds.
8. Define sole proprietorship. Explain advantages, disadvantages of sole proprietorship.
Suggested Answer:
SOLE PROPRIETORSHIP
‗Sole� means single and ‗proprietorship� means ownership. It means only one person or
individual becomes the owner of the business. This type of organization is as old as civilization.
A single individual promotes and controls the business and bears the entire risk by himself. This
is a simplest form of organization. It is defined as a business which is owned and managed by a
single person. He enjoys all the profits and bears all the losses of the business. Small shops like
vegetable shops, grocery shops, telephone booths, general stores, chemist shops etc are some
examples of this type of business.
Characteristics of Sole Proprietorship
Single Ownership.
A single individual always owns sole proprietorship form of
business organization. That individual owns all assets and properties of the business.
No sharing of profit and loss. The entire profit arising out of sole proprietorship
business goes to the sole proprietor. If there is any loss it is also to be borne by the sole
proprietor alone.
One Man’s Capital. The capital required by a sole proprietorship form of business
organization is totally arranged by the sole proprietor. He provides it either from his personal
resources or by borrowing from banks or other financial institutions.
Unlimited Liability. The liability of the sole trader is unlimited. He is responsible for
all the losses arising from the business. This liability is not limited only to his investments in the
business but his private property is also liable for business obligations.
Less Legal Formalities. The formation and operation of a sole proprietorship form of
business organization requires almost no legal formalities.
It also does not require to be
registered.
Advantages of sole trading business
1.
Ease of Formation and Dissolution. Very less legal formalities are required to
form this type of business. It is also very easy to wind up the business as there are no legal
formalities.
2.
Quick Decision and Prompt Action. In a sole proprietorship business the sole
proprietor alone is responsible for all decisions.
3.
Direct Motivation. The profits earned belong to the sole proprietor alone and he
bears the risk of losses as well. Thus, there is a direct relationship in efforts and reward.
4.
Secrecy. It refers to the future plans, technical competencies, business strategies,
etc. secret from outsiders or competitors.
5.
Tax benefits
7.
Personal contact with the customers and employees. It enables him to know
the likes and dislikes and tastes of the customers.
8.
Independence, flexibility, self-motivation.
Disadvantages or limitations of sole trader business:
1.
Limited capital. In sole proprietorship business, it is the owner who arranges
the required capital of the business. It is often difficult for a single individual to raise a huge
amount of capital. The owner�s own funds as well as borrowed funds sometimes become
insufficient to meet the requirements of the business for its growth and expansion.
2.
No perpetual existence: If the owner dies, the continuity of business will be in
doubt.
3.Limited managerial skills. A sole proprietor may not be an expert in every aspect of
management and therefore sometimes his decisions may be unbalanced.
4.Unlimited liability: The sole trader is liable for all the debts taken for business
purpose.
5.No Economies of Large Scale and Specialization. A sole trader cannot secure many
economies due to small size of the business and the degree of specialization is very small, the
benefits of specialization or services of experts may not be obtained.
9. Define partnership. Explain advantages, disadvantages of partnership.
Suggested Answer:
Partnership
A Partnership is an association of two or more persons to carry on, as co-owners of a
business and to share its profits and losses. It may come into existence either as a result of
expansion of sole trading or by means of an agreement between two or more persons desirous of
forming a partnership. This form of organization grew essentially out of the failures or
limitations of sole proprietorship.
According to John A Shubin, ―two or more individuals may form partnership by making
a written or oral agreement that they will jointly assume full responsibility for the conduct of
business‖.
Characteristics of Partnership:
1. Association of two or more persons. In Partnership, there must be at least two persons.
According to Section 11 of the Contract Act there is no maximum limit on partners in
Partnership Act, but according to the Companies Act, the maximum number of members should
not exceed 10 in case of banking business and 20 in case of other business.
2. Contractual relationship exists between the persons in this business.
3. Unlimited liability. That means if the assets of the firm are insufficient to meet the liabilities,
the personal properties of the partners, if any, can also be utilized to meet the business liabilities.
4.
There is an implied authority that any partner can act on behalf of the firm.
5.
Restriction on transfer of shares among partners without the consent of others.
6.
Voluntary Registration. It is not compulsory that you register your partnership firm.
Unregistered firms are deprived of some benefits.
Advantages of Partnership Form of Business:
1. Easy to form without any legal formalities. It is not necessary to get registered. A simple
agreement either oral or in writing, is sufficient to create a partnership firm.
2.The possibility of growth and expansion is more.
3.More resources are available and also more managerial skills.
4.The risk can be shared by more number of people
5.Secrecy: A partnership concern is not expected to publish its profits and loss account and
balance sheet as is necessary in the case of a joint stock company.
6.Easy dissolution: The partnership can be dissolved on insolvency, lunacy or death of partner.
Disadvantages of Partnership:
1.Unlimited liability: All partners are jointly as well as separately liable for the debt of the firm
to an unlimited extent. Thus, they can share the liability among themselves or any one can be
asked to pay all the debts even from his personal properties.
2.No transferability of share: If you are a partner in any firm you cannot transfer your share of
interest to outsiders without the consent of other partners. The transfer of share without the
consent of other partners can act as the cause for the dissolution of the firm with the help of the
court.
3.Burden
of
implied
authority:
The
other
partners
will
have
to
meet
the
obligations/difficulties/losses incurred by one partner.
4.Uncertainty of continuity of business: The partnership firm has no legal entity separate from
its partners. It cannot enjoy continuous existence as in case of Joint Stock Company. It comes to
an end with the death, insolvency, incapacity or the retirement of any partner.
10. What are the various types of partnership?
Suggested Answer:
Active Partners : The partners who actively participate in the day-to-day operations of
the business are known as active partners or working partners.
Sleeping Partners or Dormant Partners: Those partners who do not participate in the
day-to-day activities of the partnership firm are known as dormant or sleeping partners. They
only contribute capital and share the profits or bear the losses.
Nominal Partners: These partners only allow the firm to use their name as a partner.
They do not have any real interest in the firm. They do not invest any capital or share profits, or
do not take part in the conduct of the business of the firm. However, they remain liable to the
third parties for the acts of the firm.
Minor as a Partner: A minor i.e., a person under 18 years of age is not eligible to
become a partner. Since a minor does not enjoy the capacity to enter into contracts in his own
right, he cannot be a full-fledged partner in a partnership firm. He can, however be admitted to
the benefits of partnership.
Partner by Estoppels: If a person falsely represents himself as a partner of any firm, or
behaves in a way so that somebody can have an impression that such person is a partner, and on
the basis of this impression transacts with that firm, then that person is held liable to the third
party.
Partner by holding out: If a person is declared to be a partner by another person, the
person concerned should deny it immediately on coming to know of such a declaration. If he
does not, he will be liable to those third parties who lend money or otherwise give credit to the
firm on the basis of his being a partner. Such a partner is known as a partner by holding out.
Partnership Agreement or Partnership Deed. The partnership deed is a must for
partnership. The partnership agreement contains the terms and conditions relating to partnership
and the regulations governing its internal management and organization. Sometimes it is called
the Articles of Partnership.
The partnership deed consists of the following clauses:
1.
The nature of business
2.
The name of the business and the place of its existence
3.
The amount of capital contributed by each partner
4.
The duties, powers and obligations of all the partners
5.
The method of valuation, revaluation, dissolution and arbitration of disputes
11. Define Joint Stock Company.ExplainAdvantages,Disadvantages Of Joint Stock
Company.
Suggested Answer:
JOINT STOCK COMPANY
A company is an association of many persons who contribute money or money�s worth to
a common stock and employs it in some trade or business, and who share the profit or loss
arising there from. These undertakings are managed by elected representatives of shareholders.
The companies may be public or private and registered by shares or by guarantee etc.
You must have heard about Reliance Industries Limited (RIL), Tata Iron and Steel
Company Limited (TISCO), Steel Authority of India Limited (SAIL), MarutiUdyog Limited
(MUL) etc. Who owns them? What is the volume of financial transactions of these companies?
If you think about it, you will find that these organizations are quite large in size and their
activities are spread all over the country. It is not possible for these companies to be formed by a
single person. Then how are they formed and managed? Actually, they are a different form of
business organization and require much more capital and manpower than sole trader and
partnership form of business organization.
Joint Stock Company was started in Italy in the thirteenth century and during seventeenth
and eighteenth centuries it was formed in England under Royal Charter or Acts of parliament.
Enormous capital requirements of business concerns cannot be met by a few persons. So
the need for Joint Stock Company form of business rose.
In India the first companies act was passed in 1850 and the principle or limited liability
was introduced only in 1857. The application of this Act was extended to banking and insurance
companies in 1860. A comprehensive bill was passed in 1956. The firms incorporated under
this act are known as ‗companies�.
Characteristics of Joint Stock Company
1.
Legal Formation. No single individual or a group of individuals can start a
business and call it a joint stock company. A joint stock company comes into existence only
when it has been registered after completion of all formalities required by Indian Companies Act,
1956.
2.
Artificial Person.
Just like an individual takes birth, grows, enters into
relationships and dies, a joint stock company takes birth, grows, enters into relationships and
dies. However it is called an artificial person as its birth, existence and death are regulated by
law and it does not possess physical attributes like that of a normal person.
3.
Separate Legal Entity. Being an artificial person, a joint stock company has its
own separate existence independent of its members.
4.
Common Seal. A joint stock company has a seal which is used while dealing
with others or entering into contracts with outsiders. It is called a common seal as it can be used
by any officer at any level of the organization working on behalf of the company.
Any
document, on which the company�s seal is put and is duly signed by any official of the company,
become binding on the company.
5.
Perpetual (continuous) Existence. As a company is an artificial person enjoying
individuality. Perpetual succession therefore means that the membership of a company may
keep changing from time to time but that does not affect its continuity. Thus, the death, lunacy,
insolvency or retirement of any of its members does not, in any way, affect the corporate
existence of the company.
6.
Limited Liability. In a joint stock company, the liability of a member is limited
to the extent of the value of shares held by him. Even if his company goes into liquidation his
private property is not attachable for the debts of the company and he will lose only his shares.
7.
Transferability of Shares. The shares of a company can be transferred by its
members.Whenever the members want to dispose of the shares, they can do so by following the
procedure devised for this purpose Under Articles of Association, the company can put some
restrictions on the transfer of shares but it cannot altogether stop it.
12.Explain the various ways a company can be incorporated,its advantages and
disadvantages
Suggested Answer:
There are three ways in which companies may be incorporated:
Chartered Companies. A company created by the grant of a charter by the Crown is
called a Chartered Company and is regulated by that Charter. The East India Company and the
Standard Chartered Bank are examples of Standard Chartered Companies.
Statutory Companies. These are constituted by a special Act of Parliament or state
legislature. The objects, powers, rights and responsibilities of these companies are clearly
defined in the Act. Generally, companies for public utility services are formed under special
statutes. Examples of this type are Reserve Bank of India, Life Insurance Corporation of India,
Industrial Finance Corporation of India, State Trading Corporation of India, etc.
Registered Companies. These are the companies which are incorporated under the
Companies Act, 1956. Registered companies may be limited by shares, or limited by guarantee
or unlimited companies.
Unlimited companies.
In this type of company, the members are liable for the
company�s debts in proportion to their respective interests in the company and their liability is
unlimited.
Private Companies. These companies can be formed by at least two individuals but the
maximum number of shareholders cannot exceed 50. They are required to use ‗Private Limited�
after their names.
Public Companies. Section 3(1) (IV) of the Indian Companies Act, 1956 says that all
companies other than private companies are to be called public companies. A minimum of seven
members are required to form a public limited company. There is no restriction on maximum
number of members. The shares allotted to the members are freely transferable
Advantages of a company:
1.Better management and control of business functions.
2.Economies of large scale production: With the availability of large resources, the
company can organize production on a large scale.
3.Transferability of shares is possible.
4.Limited Liability
5.Continuity of existence: The death or insolvency of members does not in any way
affect the corporate existence of the company.
Disadvantages of a company:
1.Excessive state regulations: A large number of rules and regulations are framed for the
working of the companies. They have to follow the rules for even the internal working.
2.Lack of secrecy
3.Concentration of economic power rests in the hands of few people
4.Separation of ownership and management are in the different hands.
5.All important decisions are taken by board of directors or stakeholders, hence decision
making is a time consuming process.
13.Explain Various Characteristic features Of Public Sector Undertakings And Their
Types
Suggested Answer:
PUBLIC SECTOR UNDERTAKINGS
Public enterprises are autonomous or semi-autonomous corporations and companies
established, owned and controlled by the state and engaged in industrial and commercial
activities. The industrial resolutions of 1948 and 1956 have clearly defined the role of these
sectors.
Characteristics of Public Enterprises/ PUBLIC SECTOR UNDERTAKINGS
Financed by Government. Public Enterprises are financed by the government. They
are either owned by the government or majority shares are held by the government.
Government Management.
They are managed by the government.
nominates persons to manage he undertakings.
Government
Even autonomous bodies are directly or
indirectly controlled by the government departments.
Service Motive. The primary aim of public enterprises is to provide service to the
society. Public enterprises serve all sectors of the economy rather than serving only particular
sectors where they earn more profits.
Autonomous or semi-autonomous bodies. These enterprises are autonomous or semiautonomous bodies. In some cases they work under the control of government departments, and
in other cases, they are established under official statutes and under the companies act.
Types of Public Enterprises
I. Departmental Organization:This is the oldest form of government organization. They are
financed by the government. Their management is in the hands of the civil servants. The
Minister of the department is the ultimate in charge of the enterprise. The budget of the
department is passed by the Parliament and or by the legislatures.
Characteristics. The characteristics of departmental form of organization are as follows:
The enterprise is managed by a government department, with a Minister at the top,
responsible to Parliament for its operations.
These undertakings produce largely, if not entirely, for the State itself.
These enterprises are financed by annual appropriations from the Treasury, and the
estimates of expenditure and revenue are shown in the national budget. The revenue, or at least a
major portion thereof, is paid into the Treasury.
As the enterprise is a sub-division of a department of the government, it can be used only
by following the procedure prescribed for filing suits against the government.
II. Public Corporations:A public corporation is a corporate body created by the legislature
under a separate statute of a state or central government, which sets out its powers, purpose,
duties and immunities. It is financially independent and has a clear-cut jurisdiction over a
specified area or a particular type of industrial activity.
According to the President Roosevelt, ―A public corporation is clothed with the powers
of the government but possessed of the flexibility and initiative of a private enterprise. It is a
separate legal entity created for a specific purpose. Examples are The Reserve Bank of India,
Damodar Valley Corporation, Industrial Development Bank of India, State Trading Corporation.
A public corporation is very much like a public company except in two cases. A
company is incorporated by registration under the Companies Act, while a public corporation is
created by an Act of Parliament or any state legislature.
Since it is a separate legal entity, the employees of a public corporation are not
government servants and are not governed by Civil Service Rules. They are employed and
remunerated independently by each public corporation.
It enjoys complete internal autonomy and is free from parliamentary or political control
in the internal and routine management. It has flexibility of operations, accountability to the
Parliament but no bureaucracy.
III. Government Companies
According to Indian Companies Act 1956, ―Government company means 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 partly by the state and central governments.‖ They are registered
both as public limited and private limited companies but the management remains with the
government in both the cases.
All or a majority of the directors are nominated by the government. Its employees,
excluding the officers taken from government departments on deputation, are not civil servants.
It is free from the budget, audit and accounting laws applicable to other departments.
The concerned ministry performs the functions of shareholders and exercises ultimate control
over the entire operations of the company.
Its funds are obtained from the government, and in some cases, from private
shareholders, and through revenues derived from the sale of its goods and services.
JOINT SECTOR UNDERTAKINGS
Joint Sector Undertakings is a form of partnership between the private sector and the
Government, where the management will generally be in the hands of the private sector and
overall supervision will be with the Board of Directors giving adequate representation to
Government representatives. The business enterprise which is owned and managed jointly by
the private and public sector undertakings are known as Joint Sector Undertakings. No single
private party shall be allowed to hold more than 25% of the paid-up capital without the
permission of the Central Government. Private enterprises 25% and investing public 49% is the
share of paid-up capital in this business.
14.Explain the steps involved in Formation of Joint Stock company,its advantages and
disadvantages
Suggested Answer:
There are two stages in the formation of a joint stock company. They are:
(a)To obtain Certificates of Incorporation
(b)To obtain certificate of commencement of Business
Certificate of Incorporation: The certificate of Incorporation is just like a ‗date of birth�
certificate. It certifies that a company with such and such a name is born on a particular day.
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 vision of the promoters forms the backbone for the company
in the future to reckon with.
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 clause such as (ii) Name clause (II) situation clause (iii) objects clause (iv)
Capital clause and (vi) subscription clause duly executed by its subscribers.
(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. The
declaration has to be duly signed by any one of the following: Company secretary in whole
practice, the proposed director, legal solicitor, chartered accountant in whole time practice 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 with the information furnished, he will register the
documents and then issue a certificate of incorporation, if it is private company, it can start its
business operation immediately after obtaining certificate of incorporation.
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.Liquidity of investments: By providing the transferability of shares, shares can be converted
into cash.
6.Inculcates the habit of savings and investments: Because the share face value is very low,
this promotes the habit of saving among the common man and mobilizes the same towards
investments in the company.
7.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, as they perceive, The directors respond
to the issue raised by the shareholders and have to justify their actions.
8.Economics of large scale production: Since the production is in the scale with large funds at
9.Continued existence: The Company has perpetual succession. It has no natural end. It
continues forever and ever unless law put an end to it.
10.Institutional confidence: Financial Institutions prefer to deal with companies in view of their
professionalism and financial strengths.
11.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.
12.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.
All that shines is not gold. The company from of organization is not without any
disadvantages. The following are the disadvantages of joint stock companies.
Disadvantages
1.Formation of company is a long drawn 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. Sometimes, so-called professionals do not
respond to the urgencies as required. It promotes delay in administration, which is referred to
‗red tape and bureaucracy�.
4.Lack or 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 lose the revenue.
6.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. Where managers do not show up willingness to take responsibility, they
cannot be considered as committed. They will not be able to handle the business risks.
15.Explain the different features of Government Limited Company & Departmental
Undertakings.
Suggested Answer:
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‖.
A government company is the right combination of operating flexibility of privately organized
companies with the advantages of state regulation and control in public interest.
Government companies differ in the degree of control and their motive also.
Some government companies are promoted as
п‚·
industrial undertakings (such as Hindustan Machine Tools, Indian Telephone
Industries, and so on)
п‚·
Promotional agencies (such as National Industrial Development Corporation,
National Small Industries Corporation, and so on) to prepare feasibility reports for promoters
who want to set up public or private companies.
п‚·
Agency to promote trade or commerce. For example, state trading corporation,
Export Credit Guarantee Corporation and so such like.
п‚·
A company to take over the existing sick companies under private management
(E.g. Hindustan Shipyard)
п‚·
A company established as a totally state enterprise to safeguard national interests
such as Hindustan Aeronautics Ltd. And so on.
п‚·
Mixed ownership company in collaboration with a private consult to obtain
technical know how and guidance for the management of its enterprises, e.g. Hindustan Cables)
Features
The following are the features of a government company:
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. The
provisions of the Indian Companies Act apply for all matters relating to formation,
administration and winding up. However, the government has a right to exempt the application
of any provisions of the government companies.
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, It is
also common that the collaborators and allotted some shares for providing the transfer of
technology.
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. Government may consider the requirements of the company in terms of necessary
specialization and appoints the directors accordingly.
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 and he can call for information related to the progress and affairs of the 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. Which is relatively easier?
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. It retains its independence in respect of large financial resources, recruitment of
personnel, management of its affairs, and so on.
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. Government can, if necessary, change the provisions of the Companies Act. If
found restricting the freedom of the government company. The form of Government Company is
so flexible that it can be used for taking over sick units promoting strategic industries in the
context of national security and interest.
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 seldom leaves
the government company to function on its own. Government is the major shareholder and it
dictates its decisions to the Board. The Board of Directors gets these approved in the general
body. There were a number of cases where the operational polices were influenced by the whims
and fancies of 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 attachment or commitment: The members of the Board of
Management of government companies and from the ministerial departments in their ex-officio
capacity. The 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 government
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. The government companies are rarely allowed to exercise their flexibility and
independence.
Departmental Undertaking
This is the earliest from of public enterprise. Under this form, the affairs of the public
enterprise are carried out under the overall control of one of the departments of the government.
The government department appoints a managing director (normally a civil servant) for the
departmental undertaking. He will be given the executive authority to take necessary decisions.
The departmental undertaking 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.
Examples for departmental undertakings are Railways, Department of Posts, All India
Radio, Doordarshan, Defence undertakings like DRDL, DLRL, ordinance factories, and such.
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: At times, 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.
Any business organization to be more successful needs to be more dynamic, flexible, and
responsive to market conditions, fast in decision marking and prompt in actions. None of these
qualities figure in the features of a departmental undertaking. It is true that departmental
undertaking operates as a extension to the government. With the result, the government may miss
certain business opportunities. So as not to miss business opportunities, the government has
thought of another form of public enterprise, that is, Public corporation.
16.What are the Objectives of Public Sector Undertakings?
Suggested Answer:
PUBLIC ENTERPRISES
Public enterprises occupy an important position in the Indian economy. Today, public
enterprises provide the substance and heart of the economy. Its investment of over
Rs.10,000crore is in heavy and basic industry, and infrastructure like power, transport and
communications. The concept of public enterprise in Indian dates back to the era of preindependence.
Genesis of Public Enterprises
In consequence to declaration of its goal as socialistic pattern of society in 1954, the
Government of India realized that it is through progressive extension of public enterprises only,
the following aims of our five years plans can be fulfilled.
п‚·
Higher production
п‚·
Greater employment
п‚·
Economic equality, and
п‚·
Dispersal of economic power
The government found it necessary to revise its industrial policy in 1956 to give it a
socialistic bent.
Need for Public Enterprises
The Industrial Policy Resolution 1956 states the need for promoting public enterprises as
follows:
п‚·
To accelerate the rate of economic growth by planned development
п‚·
To speed up industrialization, particularly development of heavy industries and to
expand public sector and to build up a large and growing cooperative sector.
п‚·
To increase infrastructure facilities
п‚·
To disperse the industries over different geographical areas for balanced regional
development
п‚·
To increase the opportunities of gainful employment
п‚·
To help in raising the standards of living
п‚·
To reducing disparities in income and wealth (By preventing private monopolies
and curbing concentration of economic power and vast industries in the hands of a small number
of individuals)
Achievements of public Enterprises
The achievements of public enterprise are vast and varied. They are:
1.
Setting up a number of public enterprises in basic and key industries
2.
Generating considerably large employment opportunities in skilled, unskilled,
supervisory and managerial cadres.
3.
Creating internal resources and contributing towards national exchequer for funds
for development and welfare.
4.
Bringing about development activities in backward regions, through locations in
different areas of the country.
5.
Assisting in the field of export promotion and conservation of foreign exchange.
6.
Creating viable infrastructure and bringing about rapid industrialization (ancillary
industries developed around the public sector as its nucleus).
7.
Restricting the growth of private monopolies
8.
Stimulating diversified growth in private sector
9.
Taking over sick industrial units and putting them, in most of the vases, in order,
10.
Creating financial systems, through a powerful networking of financial
institutions, development and promotional institutions, which has resulted in social control and
social orientation of investment, credit and capital management systems.
11.
Benefiting the rural areas, priority sectors, small business in the fields of industry,
finance, credit, services, trade, transport, consultancy and so on.
Let us see the different forms of public enterprise and their features now.
Forms of public enterprises
Public enterprises can be classified into three forms:
(a)
Departmental undertaking
(b)
Public corporation
(c)
Government company
Disadvantages
Though Public Enterprises are meant for the good of the society sometimes the face
losses due to the over involvement of the Government for its political gains.
17. Differentiate Sole trader & Partnership.
Suggested Answer:
Partnership is owned by two or more Sole trade is owned and controlled by
persons known as Partners.
single person.
To constitute a partnership an agreement is There is no need for agreement in this
required either in writing or oral.
business.
Registration is not compulsory but non- No registration required.
registration bars it from taking legal
remedies.
All Partners have equal rights and all of This business is controlled and managed by
them can participate in management
single owner
Business risk is shared by all parties
Total risk is shared by the trader
All partners contribute capital
Only resources of one person are used in
business
Secrets of business are known to all There is complete secrecy in the business
partners, so there is danger of leakage.
because
only
one
person
manages
business.
Partners divide the work and can achieve Division of work is not feasible.
efficiency.
18. Differentiate Public and Private Companies
Suggested Answer:
Number of members ranges between 2-50
A public company can be started by 7
persons and there is no max limit
Business can be started immediately after The business can be started only after
its incorporation.
getting the certificate of commencement of
business.
Transfer of shares is restricted by articles
Transfer of shares is freely allowed
Private company cannot issue a prospectus A public company must issue prospectus
for issue of shares
for purchase of its share or debentures.
Quorum for a meeting of a private Five members constitute a quorum
company is two.
Minimum two directors. can be increased Min of three directors must be there. and
with permission from central govt.
all must be intimated to registrar of
companies
Private company need not send the list of Should send the list of directors to roc
directors to roc
Pvt. Must be used at the end of the Limited is used with the name of a public
company
company.
PREVIOUS QUESTIONS
1.
Differentiate Sole trader & Partnership. Refer Q.NO-17
2.
What are the Objectives & Limitations of Public Sector Undertakings? Refer Q.NO-16
3.
Explain briefly any four methods of pricing. Refer Q.NO-3
4.
Define Joint Stock Company.Explain advantages of Joint Stock Company.Refer Q.NO-14
5.
Differentiate Private & Public Limited Companies. Refer Q.NO-18
6.
Explain the different features of Government Limited Company & Departmental
Undertakings. Refer Q.NO-15
7.
Explain the features of Partnership forms of Business. Refer Q.NO-9
8.
Explain types of Partnership. Refer Q.NO-10
Unit IV
Capital Budgeting
1. What is capital and explain the significance of capital.
Answer: Meaning of Capital:
Capital is wealth in the form of money or other assets owned by a person or
organization or available for a purpose such as starting a company or investing.
Significance of/ need for capital:
a. To promote a business: capital is required at the promotion stage. A large variety of
expenses have to be incurred on project reports, feasibility studies and reports,
preparation and filing of various documents, and for meeting various other expenses
in connection with the raising of capital from the public.
b. To conduct business operations smoothly: business firms also need capital for the
purpose of conducting their business operations such as research and development,
advertising, sales promotion, distribution and operating expenses.
c. To expand and diversify: the firm requires a lot of capital for expansion and
diversification purposes. This includes development expense such as purchase of
sophisticated machinery and equipment and also payment towards sophisticated
technology.
d. To meet contingencies: a firm needs funds to meet contingencies such as sudden fall
in sales, major litigation (legal cases), natural calamities lke fire.
e. To pay taxes: the firm has to meet its statutory commitments such as income tax and
sales tax, excise duty.
f. To pay dividends and interests: the business has to take payment towards dividends
and its interests to shareholders and financial institutions respectively.
g. To replace the assets: The business needs to replace its assets like plant and
machinery after a certain period of use. For this purpose the firm needs funds to make
suitable replacement of assets in place of old and worn-out assets.
h. To support welfare programmes: the company may also have to take up social
welfare programmes such as literacy drive, and health camps. It may have to donate
to charitable trusts, educational institutions or public service organisations.
i. To wind up the company, it may need funds to meet the liquidation expenses.
2. Explain the types of capital and method of estimating it.
Answer: TYPES OF CAPITAL
Capital can broadly be divided into two types : fixed capital and working capital
FIXED Capital
Is that portion of capital which is invested in acquiring long-term assets such as land buildings
plant and machinery furniture and fixtures and so on.
Estimation of fixed capital
The amount of fixed capital of a company depends on a number of factors such as
Size of the company, nature of business, method of production and so on
Size of the company - Larger the size of the company higher is the amount of fixed capital
required
Nature of business - A manufacturing firm requires more amount of fixed capital
Whereas a retail firm requires less amount of fixed capital
Method of production - If it is a capital intensive company it requires more amount
of fixed capital
Working Capital
It is that portion of capital that makes a company work. It is used to meet regular or recurring
needs of the business. The regular needs refer to the purchase of materials payment of
wages and salaries, expenses like rent advertising and power.
FACTORS DETERMINING THE REQUIREMENTS OF WORKING Capital
Promotional stage – The business may require more funds
Position of business cycle – The economy is subject to ups and downs. The upward swing
is associated increase in sales followed increase in inventories.
During the downward swing sales volume will be low
1.
2.
3.
4.
Nature of business – In general manufacturing companies less working capital when
compared to the trading organizations
The length of manufacturing cycle – Longer the manufacturing cycle is, more is the
requirement of working capital.
PROCESS INVOLVED IN ESTIMATING WORKING CAPITAL REQUIREMENTS
Step 1) Factors Involved
1)
2)
3)
4)
5)
6)
7)
8)
9)
The level of production
The length of time for which raw materials are to remain in stores
The time taken for the conversion of raw materials into finished goods
The length of time taken to convert finished goods into sales
The average period of credit allowed to customers
The amount of cash required to pay day to day expenses of the business and make
advances
The average credit period expected to be allowed by suppliers
Time-lag in the payment of wages and other expenses
The prices of factors of production
Step 2) :
Find the amount of investment in current assets such as raw materials ,WIP , FG , debtors and
cash balance
Step 3) :
Liabilities such as creditors , lag in payment of expenses are to be deducted from the total
Current asset
3. Explain the methods and sources of raising capital/ finance
Answer: Method of finance is the type of finance used – such as a loan or a mortgage.
The source of finance would be where the money was obtained from.
METHODS OF FINANCE
The following are the common methods of finance :
-
Long term finance
Medium term finance
Short term finance
Now we will discuss each of these methods identifying the sources under each method
Sources of finance
1. LONG TERM FINANCE
Long-term finance refers to the finance available for a long period say three years and above.
The long term methods outlined below are used to purchase fixed assets such as land and
buildings , plant and so on.
Own Capital
Money invested by the owners , partners or promoters is permanent and will stay with business
throughout the life of the business.
Share Capital
Normally in the case of a company , the capital is raised by issue of shares. The capital so raised
is called share capital.
Preference Share Capital
Capital raised through issue of preference shares is called preference share capital.
Preference share
A preference shareholder enjoys two rights over equity shareholders :
(a) right to receive fixed rate of dividend
(b) right to return of capital
Equity Share Capital
Capital raised through issue of equity share is called equity share capital. An equity shareholder
does not enjoy any priorities such as those enjoyed by a preference shareholder. But an equity
shareholder is entitled to voting rights as many as the number of shares he holds. The profits
after paying all claims belong to the equity shareholders.
Retained profits
These are the profits remaining after all the claims. Retained profits form a good source of
working capital.
Long term loans
There are specialized financial institutions offering long term loans.
Debentures
Are loans taken by the company. It is a certificate or letter issued by the company under the
common seal . A debenture is entitled to a fixed rate of interest on the debenture amount.
II MEDIUM-TERM FINANCE
Refers to such sources of finance where the repayment is normally over one year and less than
three years. The sources of medium term finance are as given below:
Bank Loans
Bank loans are extended at a fixed rate of interest.
Hire-purchase
It is a facility to buy a fixed asset while paying the price over a long period of time. The
possession of the asset can be taken by making a down payment of a part of the price and the
balance will be repaid with a fixed rate of interest in agreed number of instalments.
Leasing
Where there is a need for fixed assets, the asset need not be purchased, it can be taken on leas or
rent for a specified number of years.
Venture Capital
This form of finance is available only for limited companies. It is normally provided in such
projects where there is relatively a higher degree of risk. For such projects additional sources
may not be available. Many banks offer such finance through their merchant banking divisions
which offer advice and financial assistance
III SHORT TERM FINANCE
Is that finance which is available for a period of less than one year.
Commercial Paper
It is a new money market instrument introduced in India in recent times. CP�s are issued usually
in large denominations by the leading nationally reputed, highly rated and credit worthy, large
manufacturing and finance companies in the public and private sector.
Bank Overdraft
This is a special arrangement with the banker where the customer can draw more than what he
has in his savings/current account subject to a maximum limit
Trade credit
This is a short term credit facility extended by the creditors to the debtors. It is common for the
traders to buy the materials and other supplies from the suppliers on credit basis.
Advance from customers
It is customary to collect full or part of the order amount from customers in advance
Internal Funds
Are generated by the firm by way of secret reserves namely depreciation provisions, taxation
provisions, retained profits and so on
4. What is capital budgeting and explain the features and scope of capital budgeting
decisions.
Ans: Capital budgeting is the process of evaluating the relative worth of long term investment
proposals on the basis of their respective profitability. Long term investment proposals involve
larger cash outlays. This requires a careful analysis of cash outflows and inflows associated
with each of these proposals.
FEATURES OF CAPITAL BUDGETING DECISIONS
1)Since the results of CB decision continue for many years , the firm looses some of its
flexibility
2) An erroneous forecast can have serious consequences
3) Capital assets must be available when they are needed
4) Effective CB can improve both the timing and the quality of asset acquisitions
SCOPE OF CAPITAL BUDGETING DECISIONS
The various decisions which can be grouped as Capital Budgeting Decisions are as follows
1) Replacement : maintenance of business
The expenditures to replace worn-out or damaged equipment used in the production of
profitable projects
2) Replacement : Cost reduction
Expenditures to replace serviceable but obsolete equipment
3) Expansion of existing products / markets
Expenditures to increase output of existing products or to expand retail outlets in markets
now being served
4) Expansion into new products / markets
These are investments to produce a new product or to expand into a new geographic area not
currently being used
5) Safety and environmental projects
Expenditures which comply with government orders, labor agreements or insurance policy
falls into this category
6) Research and Development
R & D constitutes the largest and most important type of capital expenditure
5. Explain the importance and process of capital budgeting
Answer: The Investment decision is one of the important decisions taken by a financial manager.
Investment decisions involve decisions related to investment in fixed as well as current assets.
Capital budgeting is the process of evaluating decisions related to fixed assets. The investment
made in fixed assets is known as capital expenditure. Hence capital budgeting involves the
process of making long term investment decisions related to capital expenditure. Capital
expenditure may be defined as an expenditure, the benefits from which are enjoyed for more than
one year. The important characteristic of the capital expenditure decision is that the expenditure
is incurred at the present period but the benefits are realized in the future period.
Charles T. Horngreen defines capital budgeting as, ―Capital Budgeting is long term planning for
making and financing proposed capital outlays.‖
In the words of Lynch, ―Capital Budgeting consists in planning development of available capital
for the purpose of maximizing the long term profitability of the concern.‖
Importance of Capital Budgeting
The capital budgeting decisions are of supreme importance in every organization. The
importance of the capital budgeting can be understood from the following points :
(a) Huge Investments : The capital budgeting decisions generally involves huge amount of
funds. This itself emphasizes the importance of capital budgeting decisions.
(b) Long term Implication : The effect of capital budgeting decisions will be felt by a firm
for a long period of time. Hence the capital budgeting decisions will determine the future
prospects of the company.
(c) Irreversible : The capital expenditure decisions cannot be reverted back. The reversion
of capital budgeting decision involves huge loss to the company.
(d) Complexity : The capital budgeting decisions are taken based on the forecasting of the
future cash inflows. As future is always uncertain, it is very difficult to quantify the
future cash inflows. But the capital budgeting decisions should be taken comparing the
present expenditure with the uncertain future cash inflows.
Process of Capital Budgeting
The entire capital budgeting decisions can be divided into following steps :
Step 1: Identification of potential investment opportunities : The process of capital budgeting
begins with identifying potential investment opportunities. This involves estimation of the
required investment and also the future income expected from such investment.
Step 2: Evaluation of investment Opportunities : The next step in capital budgeting process is
the evaluation of investment opportunities. For this purpose, the various capital budgeting
techniques can be employed. The investment opportunities which create wealth for the
shareholders should be considered for investment.
Step 3 : Decision Making : After identification of the profitable investment opportunities, the
next step involves prioritizing the selected alternatives. Based on the requirements of the
organization, the selected alternatives should be prioritized. A system of rupee gateways usually
characterizes capital investment decision-making. Under such system, different executives are
vested with the authority to approve investment proposals to certain limits. Fox example capital
investment decisions which involve an outlay of less than Rs.5,00,000 can be approved by the
works manager. Any decisions above the mentioned level needs the approval of the top level.
Step 4 : Preparation of the Capital Expenditure Budget : The next step involves preparation
of the capital expenditure budget. This budget shows the amount of estimated capital expenditure
to be incurred during the budgeting period.
Step 5 : Implementation : After preparation of the capital expenditure budget, the next step
involves implementation of the project. Using techniques like CPM, PERT ensures effective
implementation and monitoring of projects.
Step 6 : Performance Review : The last and the most important step in capital budgeting
process is the review of the performance of the project. It compares the actual performance with
the projected performance. Based on the review, corrective steps can be taken.
The capital budgeting process can be diagrammatically represented as under :
Identification of potential investment opportunities
Evaluation of investment opportunities
Decision Making
Preparation of Capital Expenditure Budgets
Implementation
Performance Review
Capital Budgeting Process
6.. Briefly explain capital budgeting techniques
Ans: Based on the concept of time value of money, the capital budgeting techniques are divided
into two types viz., Traditional techniques and Discounted Cash Flow techniques.
Capital Budgeting Techniques
Traditional Techniques
Discounting Cash Flow Techniques
Traditional Techniques
These techniques don�t consider time value of money. This category of techniques include (i)
Accounting Rate of Return and (ii) Pay Back Period
Accounting Rate of Return
This technique is also known as Average rate of return (ARR).The name itself indicates that this
technique is based on the accounting profits. The ARR is computed as under
ARR =
Average Profit After Tax
п‚ґ 100
Average Investment
Average Profit after Taxes =
Total Expected Profit after Taxes during life of the project
Life of the project (in years)
Average Investment = Salvage Value +
1
(Initial Investment - Salvage Value)
2
Accept – Reject Criteria
For Single Proposal
The ARR of the project is compared with the minimum desired rate of return. If the ARR of the
project is higher than the minimum desired rate of return, the project has to be accepted.
Otherwise the project will be rejected.
ARR > Minimum Desired Rate of return – Accept the Project
ARR < Minimum Desired Rate of return – Reject the Project
For Mutually Exclusive Projects
The ARR of the projects will be compared and the project with higher ARR will be accepted.
Pay Back Period
The Pay back period measures the time required for a project to repay the initial investment. It is
the period in which the Cash Flows After Tax (CFAT) generated by the project equals to the
initial investment. The pay back period is computed as under
For projects generating uniform CFAT
Pay Back Period =
Initial Investment
Annual Uniform CFAT
Discounting Cash Flow (DCF) Techniques
These techniques take into consideration the time value of money for evaluating the capital
budgeting proposals. This category of techniques include (i) Net Present Value (ii) Internal Rate
of Return and (iii) Profitability index
Net Present Value
The Net Present Value (NPV) is the difference between the present value of cash inflows and
present value of cash outflows.
NPV = PV of cash inflows – PV of cash outflows
It can also be represented as
пѓ¦ CF1
CF3
CFn пѓ¶
CF2
CF4
пѓ· пЂ­ CF0
пЂ«
пЂ«
пЂ«
пЂ«
..........
..........
.....
пЂ«
NPV = пѓ§пѓ§
1
2
3
4
n пѓ·
(
1
пЂ«
k
)
(
1
пЂ«
k
)
(
1
пЂ«
k
)
(
1
пЂ«
k
)
(
1
пЂ«
k
)
пѓЁ
пѓё
Where
CF0 represents initial cash outlay/ cash outflow
CF1, CF2, CF3, CF4……………………. CFn represents CFAT generated by the project at the end of year
1, 2, 3, 4…………..n respectively.
n represents life of project in years
k represents the cost of capital
Accept – Reject Criteria
For Single Proposal
If the NPV of the project is greater than zero, the project has to be accepted. And if the NPV of
the project is less than zero, the project will be rejected.
NPV > 0 – Accept the Project
NPV < 0 – Reject the Project
NPV = 0, the project may be accepted or rejected.
For Mutually Exclusive Projects
The NPV of the projects will be compared and the project with higher NPV will be accepted.
Internal Rate of Return
The Internal Rate of Return (IRR) is the rate of return generated by the project. It can also be
defined as the discount rate which equates the present value of cash inflows and present value of
cash outflows (or) it is the discount rate where NPV of the project is zero.
The IRR can be represented by ‗k� where
пѓ¦ CF1
CF3
CFn
CF2
CF4
CF0 пЂЅ пѓ§пѓ§
пЂ«
пЂ«
пЂ«
пЂ« ......................... пЂ«
1
2
3
4
(1 пЂ« k )
(1 пЂ« k )
(1 пЂ« k )
(1 пЂ« k ) n
пѓЁ (1 пЂ« k )
пѓ¶
пѓ·пѓ·
пѓё
(or)
пѓ¦ CF1
CF3
CFn
CF2
CF4
пѓ§пѓ§
пЂ«
пЂ«
пЂ«
пЂ« ......................... пЂ«
1
2
3
4
(1 пЂ« k )
(1 пЂ« k )
(1 пЂ« k )
(1 пЂ« k ) n
пѓЁ (1 пЂ« k )
пѓ¶
пѓ·пѓ· пЂ­ CF0 = 0
пѓё
where
CF0 represents initial cash outlay/ cash outflow
CF1, CF2, CF3, CF4……………………. CFn represents CFAT generated by the project at the end of year
1, 2, 3, 4…………..n respectively.
n represents life of project in years
k represents the internal rate of return
Computation of IRR
The following steps are to be adopted for computing IRR of the project.
Step 1: Calculate NPV at some assumed discount rate.
Step 2 : If NPV is positive, calculate NPV at a higher discount rate and if NPV is negative,
calculate NPV at a lesser discount rate.
Step 3 : By using the technique of interpolation, IRR will be computed.
Accept – Reject Criteria
For Single Proposal
If the IRR of the project is greater than cost of capital, the project has to be accepted. And if the
IRR of the project is less than cost of capital, the project will be rejected.
IRR > Cost of Capital
– Accept the Project
IRR < Cost of Capital – Reject the Project
IRR = Cost of Capital, the project may be accepted or rejected.
For Mutually Exclusive Projects
The IRR of the projects will be compared and the project with higher IRR will be accepted.
Profitability Index
It is also called as Benefit – Cost Ratio. It is the ratio between the present value of cash inflows
and present value of cash outflows.
Profitability Index ( PI) =
Present Value of Cash Inflows
Present Value of Cash Outflows
Accept – Reject Criteria
For Single Proposal
If the PI of the project is greater than one, the project has to be accepted. And if the PI of the
project is less than one, the project will be rejected.
PI > 1
– Accept the Project
PI < 1
– Reject the Project
PI = 1, the project may be accepted or rejected.
For Mutually Exclusive Projects
The PI of the projects will be compared and the project with higher PI will be
accepted.
7. A company is considering an investment proposal which has in investment outlay of
Rs.50,000. The project has a life of 6 years with a salvage value of Rs.4,000. The Project is
expected to generate profit after tax (PAT) of Rs.5,000, Rs.8,000, Rs.9,000, Rs.8,000 and
Rs.7,000 at the end of year 1, 2, 3, 4 and 5 respectively. Advise the firm whether the project
has to be accepted or not if the firm adopts ARR technique for evaluating capital budgeting
proposals. Assume the firm’s minimum expected rate of return is 15%
Solution
Average Profit after Taxes =
Total Expected Profit after Taxes during life of the project
Life of the project (in years)
Average Profit after taxes
=
5,000 пЂ« 8,000 пЂ« 9,000 пЂ« 8,000 пЂ« 7,000
5
= Rs. 7,400
Average Investment
= Salvage Value +
1
(Initial Investment - Salvage Value)
2
1
(50,000-4,000)
2
= Rs. 27,000
= 4,000 +
ARR
=
ARR
=
Average Profit After Tax
п‚ґ 100
Average Investment
7,400
п‚ґ 100
27,000
= 27.40%
Decision : As the ARR of the project (27.40%) is higher than the minimum required rate of
return (15%) the project has to be accepted.
8. A project requires an investment of Rs. 1,00,000 and has zero scrap value after 4 years.
The project is expected to yield profit after taxes amounting to Rs. 12,000, Rs. 15,000, Rs.
18,000 and Rs.23,000 at the end of year 1, 2, 3 and 4 respectively. Compute the ARR of the
project.
Solution
Average Profit after Taxes =
Average Profit after taxes =
Total Expected Profit after Taxes during life of the project
Life of the project (in years)
12,000 пЂ« 15,000 пЂ« 18,000 пЂ« 23,000
4
= Rs. 17,000
Average Investment
= Salvage Value +
1
(Initial Investment - Salvage Value)
2
1
(1,00,000-0)
2
= Rs. 50,000
=0+
ARR
ARR
=
Average Profit After Tax
п‚ґ 100
Average Investment
17,000
п‚ґ 100
50,000
= 34%
=
9. A project requires an initial investment of Rs.50,000 and is expected to generate annual
Cash Flows After Tax (CFAT) of Rs.20,000 for five years. Compute Pay back period.
Solution
Pay Back Period =
Initial Investment
Annual Uniform CFAT
50,000
20,000
=
=
2.5 years
For projects generating uniform CFAT The pay back period will be the time period where the
cumulative CFAT will become equal to the initial investment.
10. A company is considering two mutually exclusive projects A and B which requires an
initial investment of Rs. 50,000 each. Project A is expected to generate annual CFAT of Rs.
10,000 for 8 years and Project B is expected to generate CFAT of Rs. 12,500 for 8 years.
Advise the firm which project has to be accepted if the firm adopts Pay back period
technique for evaluating capital budgeting proposals.
Solution:
Project A
Initial Investment
Annual Uniform CFAT
50,000
10,000
5 years
Pay Back Period =
=
=
Project B
Initial Investment
Annual Uniform CFAT
50,000
12,500
4 years
Pay Back Period =
=
=
Decision : As the pay back period of project B is less than project A, the project B has to be
accepted.
11. A Petroleum company is considering purchase of new machine for its future expansion.
The new machine requires an investment outlay of Rs.2,00,000. The machine has an
expected life of 5 years. The machine is expected to generate CFAT of Rs. 40,000, Rs.
50,000, Rs. 60,000, Rs. 80,000 and Rs. 90,000 at the end of year1, 2, 3,4 and 5 respectively.
If the firm’s cost of capital is 12%, advise the company whether to purchase the machine or
not.
Solution
Calculation of present value of cash inflows
Year CFAT
PVIF @ 12% PV of CFAT
1 40,000
0.893
35,720
2 50,000
0.797
39,850
3 60,000
0.712
42,720
4 80,000
0.636
50,880
5 90,000
0.567
51,030
Present value of Cash Inflows
2,20,200
PVIF : Present Value Interest Factor
NPV
= PV of cash inflows – PV of cash outflows
= 2,20,200 – 2,00,000
= Rs. 20,200
Decision : As the NPV of the project is greater than zero, the company should
purchase the new machine.
12. A company is considering two mutually exclusive projects. The following information is
available related to the two projects.
Project A
Project B
Initial Investment
Rs. 5,00,000
Rs. 5,00,000
CFAT at the end of Year 1
Rs.
50,000
Rs. 3,00,000
2
Rs. 1,00,000
Rs. 2,50,000
3
Rs. 2,00,000
Rs. 2,00,000
4
Rs. 2,50,000
Rs. 1,00,000
5
Rs. 3,00,000
Rs.
50,000
If the firm�s minimum expected rate of return is 10%, advise the company which
project has to be accepted.
Solution:
Calculation of NPV of Project A
Year
CFAT
PVIF @ 10%
PV of CFAT
0 (5,00,000)
1.000
(500000)
1
50,000
0.909
45450
2
100,000
0.826
82600
3
200,000
0.751
150200
4
250,000
0.683
170750
5
300,000
0.621
186300
NPV =
135300
Calculation of NPV of Project B
Year CFAT
PVIF @ 10%
PV of CFAT
0 (5,00,000)
1.000
(500000)
1
300,000
0.909
272700
2
250,000
0.826
206500
3
200,000
0.751
150200
4
100,000
0.683
68300
5
50,000
0.621
31050
NPV =
228750
Decision : As the NPV of Project B is higher than Project A, Project B should be accepted.
12. PQR Ltd is planning to purchase a new machine to meet the increasing demand for its
products. The new machine costs Rs. 1,00,000 and has a salvage value of Rs.10,000. The
expected life of the machine is 6 years. The new machine is expected to generate additional
CFAT of Rs. 20,000, Rs. 30,000, Rs. 45,000, Rs. 32,000, Rs. 25,000 and Rs.15,000 at the end
of the year 1,2,3,4,5 and 6 respectively. The company’s cost of capital is 12%. Advise the
firm whether to purchase the new machine or not if the company adopts IRR technique for
evaluating capital budgeting proposals.
Solution:
Calculation of NPV at 10% discount rate :
Year
CFAT
PVIF @ 10%
PV of CFAT
0
(1,00,000)
1.000
(100000)
1
20,000
0.909
18180
2
30,000
0.826
24780
3
45,000
0.751
33795
4
32,000
0.683
21856
5
25,000
0.621
15525
6
15,000
0.564
8460
6 (Salvage Value)
10,000
0.564
5640
NPV =
28236
As NPV >0 at 10% discount rate, let us calculate NPV a higher discount rate i.e. at
12%.
Year
CFAT
PVIF @ 12%
PV of CFAT
0
(1,00,000)
1.000
(100000)
1
20,000
0.893
17,860
2
30,000
0.797
23,910
3
45,000
0.712
32,040
4
32,000
0.636
20,352
5
25,000
0.567
14,175
6
15,000
0.507
7,605
6 (Salvage Value)
10,000
0.507
5,070
NPV =
Calculation of NPV at 12% discount rate :
21,012
By using the technique of Interpolation :
At 10 % : NPV = Rs. 28,236
At 12% : NPV = Rs. 21,012
2 % Change – Change in NPV is 7,224
? % change – Change in NPV will be 28,236
% Change
=
28,236 x 2
7224
= 7.82 %
So, IRR = 10+7.82
= 17.82 %
Decision : As the IRR of the new machine (17.82%) is greater than the cost of
capital (12%), the company should be purchase the new machine.
13. The Great India Ltd is planning to replace its old machine with a new machine. The
new machine costs Rs. 1,00,000 and the machine has an expected economic life of 5 years
with zero salvage value. The new machine is expected to generate CFAT of Rs. 10,000, Rs.
20,000, Rs. 25,000, Rs. 40,000 and Rs.50,000 at the end of the year 1,2,3,4 and 5
respectively. If the Company’s cost of capital is 13% advise the company whether to
purchase the new machine or not if the company adopts PI technique for evaluating capital
budgeting proposals.
Solution:
Calculation of Present Value of Cash Inflows
Year CFAT
PVIF @ 13%
PV of CFAT
1
10,000
0.885
8,850
2
20,000
0.783
15,660
3
25,000
0.693
17,325
4
40,000
0.613
24,520
5
50,000
0.543
27,150
Present Value of Cash Inflows =
93,505
Profitability Index ( PI) =
Present Value of Cash Inflows
Present Value of Cash Outflows
93,505
1,00,000
= 0.935
=
Decision: As the PI<1 , the company should be not purchase the new machine.
FREQUENTLY ASKED QUESTIONS
1. What are the factors influencing Working Capital? (refer Q.no. 2)
2. Explain methods of capital budgeting.(refer Q.no 6)
3. A firm has two investment opportunities, each costing Rs 1,00,000 and expected cash
inflows are as follows1
2
3
4
YEAR
50000
40000
30000
10000
PROJECT -A
20000
40000
50000
60000
PROJECT -B
Compute NPV at 10% cost of capital and suggest the course of action if both are mutually
exclusive.
4. What different sources & methods of raising Capital? (refer Q.no 3)
5. Determine Pay Back Period & Accounting Rate of Return
Description
Adjusted Cash Inflows(Rs.)
Initial Cash Outflow
350000
1st Year
100000
2nd Year
80000
3rd Year
70000
4th Year
95000
5th Year
115000
Scrap Value 5th Year
65000
Note: Company Follow Straight Line Method of Depreciation
6. Determine Net Present Value & Profitability Index
Description
Cash Inflows(Rs.)
10% PV Factor
Initial Cash Outflow
300000
1.000
1st Year
90000
0.909
2nd Year
100000
0.826
3rd Year
125000
0.751
4th Year
75000
0.683
5th Year
110000
0.621
Scrap Value 5th Year
25000
0.621
7. What is Capital Budgeting? Explain methods of Capital Budgeting. (refer Q. No. 6)
8. A company has an investment opportunity costing Rs. 1, 50,000 with the following
expected net cash flow
Year
CFAT
1
16,000
2
34,000
3
44,000
4
54,000
5
54,000
Using 10% as the rate of discount, determine the following
1. a) Payback Period
b) Net present value
UNIT V
1. Define Accounting and state its objectives?
Accounting is the science of recording and classifying business transactions and events,
primarily of financial in character, and the art of making significant summaries, analysis and
interpretations of those transactions and events, and communicating the results to persons who
must make decisions or form judgments�.‖
--Smith and Ashburn
―Accounting is the art of recording, classifying and summarizing in significant manner and in
terms of money, transactions and events which are, in part at least, of a financial character and
interpreting the results there of.‖
-- American Institute of Certified Public Accountants
Objectives of Accounting:
i. Keeping Systematic Records: Accounting is done to keep a systematic record of financial
transactions.
ii. Protecting and Controlling Business Properties: Accounting helps in seeing to it that there
is no unauthorized use or disposal of any assets or property belonging to the firm, because proper
records are maintained. Accounting will furnish information about money due from various
persons and money due to various parties. The firm can see that all amounts due to it are
recovered in due time and that no amount is paid unnecessarily
iii. Ascertaining the operational profit or loss: Accounting is used to show the results of the
activities in a given period, usually a year, i.e. to show how much profit has been earned or how
much loss has been incurred. This is done by keeping a proper record of revenues and expenses
of a particular period.
iv. Ascertaining the financial position of the business: Balance sheet is prepared to ascertain
the financial position of the firm at the end of a particular period. It shows the value of the firms�
possessions and the amount the firm is owing to others.
v. Facilitating rational; decision making : Accounting has taken upon itself the task of
collection, analysis and reporting of information at the required point of time to the required
levels of authority in order to facilitate rational decision making.
2. What is Accounting principles (or) what are accounting concepts and conventions?
Accounting principles concepts and conventions:
Accounting principles have been defined as ―the body of doctrines commonly associated with
the theory and procedure of accounting, serving as an explanation of current Practices and as a
guide for the selection
These principles can be classified into two categories
i. Accounting concepts
ii. Accounting conventions
Accounting Concepts:
i. Business Entity Concept:
Accountants assume that an enterprise is separate from its owners. It is treated to have a distinct
accounting entity which controls the resources of the concern and is accountable there for.
Accounts are kept for a business entity as distinguished from the persons associated with it. They
will record transactions between the owner and the firm; for instance, when capital is provided
by the owner, the accounting record will show that the firm as having received so much money
and as owing it to the proprietor. This concept is based on the sense that proprietors entrust
resources to the management; the management is expected to use these resources to the best
advantage of the firm and to account for the resources placed at its disposal. The concept of
separate entity is applicable to all forms of business organizations.
ii. Money Measurement Concept:
Only those transactions and events as can be interpreted in terms of money are recorded. Events
or transactions which cannot be expressed in money do not find place in the books of account
though they may be very useful for the business.
iii. Cost Concept: Transactions are entered in the books of account at the amount actually
involved. The personal views of people are not considered as the basis for making the record.
iv. Going Concern Concept:
According to this concept it is assumed that the business will continue for a fairly long time to
come. Transactions are, therefore, recorded in such a manner that the benefits likely to accrue in
future from money spent now or the further consequences of events occurring now are taken into
consideration. It is on this basis that a clear distinction must be made between assets and
expenses. It is because of this concept that fixed assets are recorded at their original cost and are
depreciated in a systematic manner without reference to their current realizable value. However,
if it is certain that the business will last only for a limited period; the accounting record will keep
the expected life in view, probably treating all expenditure, capital and revenue alike.
v. Dual Aspect Concept: Every transaction entered into by a firm or institution will have two
aspects; if any event occurs, it is bound to have double effect.
vi. Realization Concept:
According to this concept revenue is recognized when a sale is made. Consequently unless
money has been realized, i.e. either cash has been received or a legal obligation to pay has been
assumed by the customer no sale can be said to have taken place and no profit can be said to
have arisen. It prevents business firms from inflation their profits by recording sales and incomes
that are likely to accrue i.e. expected incomes or gains are not recorded.
vii. Accrual Concept:
If a transaction has been entered into or an event has occurred its consequences must follow, i.e.
the amount of assets and liabilities will be affected by the various transactions and events even if
settlement in cash will be only at a later time. To ignore any transaction or vent would mean
station assets or liabilities and capital wrongly. Hence all transactions and events should be
recorded. This concept is called accrual concept. The system of accounting that is based on it is
called the mercantile system.
Accounting conventions:
The term ‗accounting conventions� refer to the customs or traditions which are used as a guide in
the preparation of accounting reports and statements. The following are the important accounting
conventions in use.
i. Consistency: According to this convention the accounting practice should remain unchanged
from one period to another. It requires that working rules once chosen should not be changed
arbitrarily and without notice of the effects of change to those who use the accounts.
ii. Disclosure: Apart from statutory requirements good accounting practice also demands that
significant information should be disclosed in financial statements. Such discloses can also be
made through footnotes. Purpose of this convention is to communicate all material and relevant
facts concerning financial position and results of operations to the users.
iii. Conservatism: Financial statements are usually drawn up on a conservative basis.
Anticipated profits are ignored but anticipated losses are taken into account while drawing the
statements. Valuing inventory at cost or market price whichever is less and creating provision for
doubtful debts are the good examples of the application of this convention.
iv. Materiality: According to this convention, the accountant should attach importance to
material details and ignore insignificant details in the financial statements. This is because
otherwise accounting will be unnecessarily overburdened with minute details.
3. What is book keeping and explain double entry system?
Book-keeping and accounting:
Book-keeping and accounting are often used interchangeably but they are different from each
other. Book-keeping is mainly concerned with recording of financial data relating to the business
operations in a significant and orderly manner. It is the science and art of correctly recording in
books of account all those business transactions that result in the transfer of money or money�s
worth. It is mechanical and repetitive. This work is usually entrusted to junior employees f
accounts section of a business house. Accounting is a broader and more analytical subject. It
includes the design of accounting systems which the book-keepers use, preparation of financial
statements, audits, cost studies, income-tax work and analysis and interpretation of accounting
information for internal and external end-users as an aid to taking business decisions. This work
requires more skill, experience and imagination. The larger the firm, the greater is the
responsibility of the accountant. It can be said that accounting begins where bookkeeping ends.
Book-keeping provides the basis for accounting.
Double Entry System:
There are two systems of keeping records i.e. (i) single entry system and (ii) double entry
system. The single entry system appears to be time saving and economical but it is unscientific
as under this system some transactions are not recorded at all whereas some other transactions
are recorded only partially. On the other hand, the double entry system is based on scientific
principles and is, therefore, used by most of the business houses. The system recognizes the fact
that every transaction has two aspects and records both aspects of each and every transaction.
Under this system in every transaction an account is debited and some other account is credited.
The crux of accountancy lies in finding out which of the two accounts are affected by a particular
transaction and out of these two accounts which account is to be debited and which account is to
be credited.
Merits of Double Entry System:
1. It keeps a complete record of business transactions. Both personal accounts and
impersonal accounts are kept.
2. The entire information regarding the value of assets and profits earned during the year
can be easily obtained. It provides a check on the arithmetical accuracy of the both of
accounts, since every debit has corresponding credit to it and vice-versa.
3. The detailed profit and loss account can be prepared to show profits earned or loss
Suffered during any given period.
4. The system makes possible the comparison of purchases as well as sales, expenditure,
income etc. of a current year with those of the previous years, thus enabling a
businessman to control his business activities.
5. The balance sheet can be prepared at any specified point of time or any date showing
the actual amount of assets, liabilities and capital.
6. The system being a scientific one, it prevents commission of fraud and if a fraud is
committed it can be easily detected.
7. The accurate details with regard to any account can be easily obtained.
4. What are basic accounting rules?
An account is an individual record of a person, firm, or thing, an item of income or an expense.
According to Kohler�s Dictionary for Accountants, an account has been defined as a formal
record of a particular type of transaction expressed in money.
Classification of Accounts:
Accounts are broadly classified into two classes: (i) Personal Accounts and (ii) Impersonal
Accounts. The latter are further sub-divided into a) Real Accounts and b) Nominal Accounts.
Thus all accounts can be classified into Personal, Real and Nominal Accounts. Personal
Accounts: Personal accounts are the accounts relating to persons with whom the business deals.
Such accounts can take the following forms:
i. Natural person’s accounts: e.g. Mohan�s Account, Sheena�s Account, Raj�s Account etc.
ii. Artificial person’s or body of person’s account : e.g. Bank Account, Firm Account,
Company Account, Club Account etc.
iii. Representative personal accounts: e.g. Outstanding Wages Account, Prepaid Rent Account,
Unexpired Insurance Account etc.
Real Accounts: Real Accounts may be of the following types:
i. Tangible Real Accounts: Tangible real accounts are the accounts of such things which can be
touched, felt, measured, purchased, sold etc. e.g. Land Account, Furniture Account, Stock
Account, and Cash Account etc.
ii. Intangible Real Accounts: These accounts represent such things which cannot be touched.
Of course they can be measured in terms of money e.g. Goodwill Account, Trade Mark Account,
Patent Account etc.
Nominal Account: Accounts of incomes, expenses, gains and losses are called nominal
accounts. Interest received, wages, salaries, rent, postage, profit and loss are such items, and a
separate account is opened for each of these items.
Basic Accounting Rules
Personal Accounts
Debit The Receiver
Credit The Giver
Real Accounts
Debit What comes in
Credit What goes out
Nominal Accounts
Debit Expenses and Losses
Credit Incomes and Gains
5. Give journal entries for the following transactions in the books of Raju
1.
2.
3.
4.
5.
Raju commenced business with Rs. 1,00,000
Purchased furniture for cash Rs. 50,000
Purchased machinery from Mahesh on credit Rs. 40,000
Received cash from Goyal Rs. 80,000 on account.
Paid rent to landlord Rs. 5,000
Journal Entries in the books of Raju
Date
Particulars
L.
F
Debit
Amount
(Rs.)
Credit
Amount
(Rs.)
...Dr.
1
Cash a/c
To Capital a/c
(being capital brought into business)
...Dr
50,000
2
Furniture a/c
To Cash a/c
( being furniture purchased for cash )
Machinery a/c
...Dr.
To Mahesh a/c
( being machinery purchased from Mahesh on credit)
40,000
Cash a/c
To Goyal
(being cash received from Goyal )
...Dr.
80,000
Rent a/c
To cash a/c
( being rent paid to landlord )
...Dr.
3
4
5
6.
1,00,000
1,00,000
50,000
40,000
80,000
5,000
5,000
Journalise the following transactions:
April, 12007
April, 2
April, 4
April, 5
April, 9
April, 11
April, 16
April, 19
April, 21
April, 25
April, 30
Rajesh stars business with cash
He buys goods for cash
He buys goods from Malhotra on credit
Furniture is purchased for cash
Cash sales made
Goods sold on credit to Satya Dev
Payment made to Malhotra
Cash sales
Purchases of stationery for cash
Sales on credit to Yusuf
Rent for the month paid in cash
20,000
15,000
6,000
1,000
1,500
4,000
6,000
4,300
20
1,770
500
Journal Entries
Date
2007
April, 1
April,2
Particulars
Cash a/c
...Dr.
To Rajesh�s capital a/c
( being cash brought in by Rajesh)
_______________________________
Purchases a/c
...Dr.
L
F
Debit
Credit
Amount
20,000
Amount
20,000
15,000
April,4
April,5
April,9
April,11
April,16
April,19
April,21
April,25
April,30
To cash a/c
( being goods purchased for cash)
_______________________________
Purchases a/c
...Dr.
To Malhotra
( being goods purchased on credit)
_______________________________
Furniture a/c
...Dr.
Cash a/c
( being furniture purchased for cash)
_______________________________
Cash a/c
...Dr.
To sales a/c
(being cash sales made )
Satya Dev
...Dr.
To sales a/c
( being goods sold on credit )
_______________________________
Malhotra a/c
...Dr.
To cash a/c
( being payment made to Malhotra )
_______________________________
Cash a/c
...Dr.
To sales a/c
( being cash sales made )
_______________________________
Stationery a/c
...Dr.
To cash a/c
( being stationery purchased for cash)
_______________________________
Yousuf
...Dr.
To sales a/c
( being sales made to Yusuf on credit)
_______________________________
Rent a/c
...Dr.
To cash a/c
( being rent paid in cash )
7. Journalize the following transactions.
Jan 1. Pankaj commenced business with a capital Rs. 5, 00,000
15,000
6,000
6,000
1,000
1,000
1,500
1,500
4,000
4,000
6,000
6,000
4,300
4,300
20
20
1,770
1,770
500
500
2 . Deposited in bank Rs. 4, 00,000
Purchased goods from Krishna on credit Rs. 1,00,000
7.
Sold goods to Rama on credit
Rs. 80,000
9.
Purchased goods from Manish for cash Rs. 50,000
12. Sold goods for cash to Sailesh Rs. 8,500
15. Purchased machinery from Ajay Engg. & Payment made by cheque Rs. 20,000
18. Issued cheque to Krishna Rs. 75,000 Received interest from Ashok Rs. 500
22. Cash withdrawn from bank for office use Rs.2 0,000
24. Amount withdrawn from bank for personal use Rs. 8,000
27. Took loan from Rajiv Varma
Rs.1, 50,000
29. Cash withdrawn from office for personal use Rs.10,000
30.
Goods withdrawn for personal use Rs. 20,000
31. Paid rent to landlord by cheque Rs.6,000
JOURNAL
Date
2007
Jan 1
Particulars
Cash a/c
Dr.
To Capital a/c
( being cash brought into business as capital )
2
L.F
Debit
Amount
(Rs.)
5,00,000
5,00,000
4,00,000
4,00,000
Bank a/c
Dr.
To cash a/c
( being cash deposited in bank)
5
7
12
Credit
Amount
(Rs.)
Goods/ Purchases a/c
Dr.
To Krishna a/c
( being goods purchased from Krishna on Credit )
Rama a/c
Dr.
To Goods / Purchases a/c
( being goods sold to Rama on credit )
9
Goods / Purchases a/c
Dr.
To cash a/c
( being goods purchased for cash )
Cash a/c
1,00,000
1,00,000
80,000
80,000
50,000
50,000
8,500
8,500
Dr.
To Goods/ Purchases a/c
( being goods sold for cash)
20,000
20,000
15
18
20
22
Machinery a/c
Dr.
To Bank a/c
( being machinery purchased payment made by
cheque)
Krishna a/c
Dr.
To Bank a/c
( being interest received )
Cash a/c
Dr.
To Interest a/c
( being cash withdrawn from bank for office use)
24
Cash a/c
Dr.
To Bank a/c
( being cash withdrawn from bank for personal
use )
27
Drawings a/c
Dr.
To Bank a/c
( being amount withdrawn from bank for personal
use)
29
Cash a/c
Dr.
To Rajiv Varma Loan a/c
( being loan taken from Rajiv Varma )
30
Drawings a/c
Dr.
To cash a/c
(being cash taken for personal use )
31
Drawings a/c
Dr.
To Goods a/c
(being goods withdrawn for personal use)
75,000
75,000
500
500
20,000
20,000
8,000
8,000
1,50,000
1,50,000
10,000
10,000
20,000
20,000
6,000
6,000
Rent a/c
Dr.
To Bank a/c
( being rent paid by cheque)
8. Record the following transactions in the Journal and post them into Ledger of Mr. Aditya Raj:
2008
March 1
Purchase of goods from Ramautar
3,20,000
March 10
Paid rent for the month
March 11
Purchase of Plant
1,00,000
March 12
Paid salaries
12,000
March 15
Paid Ramautar
1,00,000
March 20
Sold goods to Shyam
20,000
March 25
Received from Shyam
30,000
March 31
Received cash from cash sales
March 31
Wages paid
2,000
2,50,000
5,000
Journal Entries in the books of Aditya Raj
Date
2008
Particulars
L.F.
Debit
Amount
(Rs.)
Credit
Amount
(Rs.)
Mar-01 Purchases a/c
To Ramautar
( being purchase of goods on
credit )
3,20,000
3,20,000
Mar-10 Rent a/c
To Cash a/c
( being payment of rent )
2,000
2,000
Mar-11 Plant a/c
To Cash a/c
( being purchase of plant )
1,00,000
1,00,000
Mar-12 Salaries a/c
To Cash a/c
( being payment of salaries )
12,000
12,000
Mar-15 Ramautar a/c
To Cash a/c
( being payment to Ramautar )
Date Particulars
1,00,000
1,00,000
L.F.
Debit Credit
Mar-20 Shyam a/c
To Sales a/c
( being goods sold on credit )
20,000
Mar-25 Cash a/c
To Shyam a/c
( being receipt of cash )
30,000
20,000
30,000
Mar-31 Cash a/c
To Sales a/c
( being cash sales made )
2,50,000
Mar-31 Wages a/c
To Cash a/c
(being payment of wages )
5,000
LEDGER
2,50,000
5,000
CASH ACCOUNT
Date
Particulars
2008
Mar-25 To Shyam
Mar-31 To Sales a/c
J.F.
Debit Rs. Date
30,000
2,50,000
2008
Mar-10
Mar-11
Mar-12
Mar-15
Mar-31
Mar-31
Particulars
By Rent a/c
By Plant a/c
By Salaries a/c
By Ramautar a/c
By Wages a/c
By Balance c/d
2,80,000
2008
Apr-01 To Balance b/d
Credit
J.F. Rs.
2,000
1,00,000
12,000
1,00,000
5,000
61,000
2,80,000
61,000
PURCHASES ACCOUNT
Date
Particulars
2008
Mar-01 To Ramautar
J.F.
Debit Rs. Date
3,20,000
3,20,000
2008
Apr-01 To Balance b/d
Particulars
Mar-31 By Balance c/d
Credit
J.F. Rs.
3,20,000
3,20,000
3,20,000
RAMAUTAR'S ACCOUNT
Date
Particulars
2008
Mar-15 To Cash a/c
Mar-31 To Balance c/d
J.F.
Debit Rs. Date
1,00,000
2,20,000
3,20,000
Particulars
Credt
J.F. Rs.
Mar-01 By Purchase a/c
3,20,000
Apr-01 By Balance b/d
3,20,000
2,20,000
RENT
ACCOUNT
Date
Particulars
2008
Mar-10 To Cash a/c
2008
J.F.
Debit Rs. Date
2,000
2,000
Particulars
Mar-31 By Balance c/d
Credt
J.F. Rs.
2,000
2,000
Apr-01 To Balance b/d
2,000
PLANT ACCOUNT
Date
Particulars
2008
Mar-11 To Cash a/c
J.F.
Debit Rs. Date
1,00,000
1,00,000
2008
Apr-01 To Balance b/d
Particulars
Mar-31 By Balance c/d
Credit
J.F. Rs.
1,00,000
1,00,000
1,00,000
SALARIES
ACCOUNT
Date
Particulars
2008
Mar-12 To Cash a/c
J.F.
Debit Rs. Date
12,000
12,000
2008
Apr-01 To Balance b/d
Particulars
Mar-31 By Balance c/d
Credt
J.F. Rs.
12,000
12,000
12,000
SHYAM'S ACCOUNT
Date
Particulars
2008
Mar-20 To Sales a/c
Mar-31 To Balance b/d
J.F.
Debit Rs. Date
20,000
10,000
30,000
Particulars
Credit
J.F. Rs.
Mar-31 By cash a/c
30,000
Apr-01 By Balance b/d
30,000
10,000
SALES
ACCOUNT
Date
Particulars
2008
Mar-01 To Balance b/d
J.F.
Debit Rs. Date
2,70,000
Particulars
Mar-20 By Shyam
Credit
J.F. Rs.
20,000
Mar-31 By Cash a/c
2,50,000
2,70,000
2,70,000
2,70,000
Apr-01 By Balance b/d
WAGES ACCOUNT
Date
Particulars
2008
Mar-31 To Cash a/c
J.F.
Debit Rs. Date
5,000
5,000
5,000
Apr-01 To Balance b/d
Credit
J.F. Rs.
Particulars
Mar-31 By Balance c/d
5,000
5,000
9. Prepare a format of Trading, profit & loss account & Balance sheet?
Trading Account
Trading account is the comparison of sales and purchase. This account is prepared to determine
the amount of gross profit or gross loss on sales.
Performa of Trading Account
Trading Account
(For the year ending............)
Particulars
Rs.
To Opening stock
To
Purchases
xxxxxx
Less: Purchase returns
xxxx
To Wages & Salaries
To Carriage inwards
To Cartage
To Freight
To Light power & Heating
in
Factory
To Factory insurance
To
Works
Manager's
salary
To Foreman's salary
To Factory rent & taxes
Xxxxxx
Xxxxxxx
Xxxx
Xxx
Xxx
Xxx
Xxx
Xxx
Xxxxx
Xxxx
Xxx
Particulars
By
xxxxxx
Less:
Sales
xxx
Rs.
Sales
returns
By Closing stock
By Gross Loss (if any )
(Transferred to P/L a/c)
Xxxxxxx
Xxxxx
Xxxx
To Motive power
To Factory repairs
To Factory expenses
To Octroi duty
To Customs duty
To
Manufacturing
expenses
To Consumable stores
To Gross profit
(Transferred to P/L a/c)
Xxx
Xxx
Xxx
Xxx
Xxx
Xxx
Xxx
xxxxx
xxxxxxxx
Xxxxxxxx
Profit & Loss Account
Profit & Loss Account is the second part of Trading & Profit & Loss Account. Trading
Account depicts the gross profit which is the difference of sales and cost of sale. Thus the gross
profit cannot treated as net profit while the businessman wants to know how much net profit he
has earned from the operating activities during a period. For this purpose P&L a/c is prepared
keeping in mind all the operating and non-operating incomes and losses of the business. In the
debit side all the expenses and losses are disclosed and in the credit side all incomes are
disclosed. The excess of credit side over debit side is called net profit while the excess of debit
side over credit side shows net loss. Net profit increases the net worth of the business; therefore,
it is added to the capital of owner. Net loss decreases the net worth of business so it is subtracted
from capital.
Profit & Loss Account
For the year ending.........
Dr.
Particulars
Rs.
To Gross loss (if any )
transferred from Tradin a/c
To Staff salaries
To Office Rent
To Office lighting and heating
To Printing & Stationery
To Bank charges
To Insurance
To Telephone charges
xxxx
To Legal expenses
To Repairs
To Postage & Stamps
To Trade expenses
To Establishment expenses
To Audit fees
xxxxx
xxxxx
xxxx
xxxx
xxxx
Xxx
xxxx
xxxx
xxxx
xxxxx
xxxx
xxxx
xxxxx
Particulars
By Gross profit (transferred
from
Trading a/c
By Discount received
By Commission received
By Dividend
By Interest received
By Rent from tenant
By Interest from bank
By Interest on drawings
By Profit on sale of
investment
By Provision for discount on
creditors
By Bad debts recovered
By Profit on sale of assets
By other incomes
Cr.
Rs.
Xxxx
Xxxx
Xxxx
Xxxx
Xxxx
Xxxx
Xxxx
Xxxx
Xxxx
Xxxx
Xxxx
Xxxx
Xxxxx
Xxxx
To Charity & Donations
To Management expenses
To Depreciation on
Land & Buildings
Furnitures
Plant & Machinery
To Directors fee
To Interest on loan
To Interest on capital
To Sales Tax
To Advertisement
To Bad Debts
To Agents' commission
To Travelling expenses
To Free samples distributed
To Warehouse expenses
To Packing expenses
To Brokerage
To Distribution expenses
To Delivery van expenses
To Provision for bad & doubtful
debts
To Entertainment expenses
To Carriage outwards
To Licence fees
To Net Profit ( transferred to capital
a/c)
xxxx
xxxx
Xxx
Xxx
xxxx
Xxx
Xxx
xxxx
xxxx
xxxx
Xxx
xxxx
xxxx
xxxx
Xxx
Xxx
xxxx
Xxx
xxxx
xxx
By Net Loss ( if any )
transferred to capital a/c
Xxxx
xxx
xxx
xxx
xxxx
xxxx
xxxx
Xxxx
Balance Sheet prepared in Liquidity Order
Here liquidity means conversion of assets into cash. When a Balance Sheet is prepared on the
basis of liquidity order, more easily convertible assets into cash are shown first and those assets
which cannot be easily converted into cash are shown later and so on. In the case of liabilities,
first those liabilities are shown which are payable earlier and then those liabilities are shown
which are payable later.
Proforma of Balance sheet in order of liquidity
(as on ...................)
Liabilities
Amt.
Assets
Current Liabilities
Current Assets
Sundry Creditors
Xxxxx
Cash in hand
Bank Overdraft
Xxxxx
Cash at bank
Short term loan
Xxxxx
Short term investment
Amt.
xxxxx
xxxxx
xxxxx
Outstanding expenses
Income received in advance
Bills payable
Long term liabilities
Capital
xxxxxx
Add: Net profit
xxxx
Add: Interest on capital xxxx
xxxxx
Less: Drawings
Long term loans
Contingent Liabilities
Xxxxx
Xxxxx
Xxxxx
xxxxx Xxxxxx
Xxxxx
Xxxx
Prepaid expenses
Bills receivable
Accrued incomes
Debtors
xxxxx
xxxxx
xxxxx
xxxxx
Closing stock
Fixed Assets
Land& Building
xxxxx
Plant & Machinery
Furniture
Investments (long term )
Goodwill
Patents & Trademarks
xxxxx
xxxxx
xxxxx
xxxxx
xxxxx
xxxxxxxx
Xxxxxxxx
xxxxx
b) Balance Sheet prepared in Permanency Order
Balance Sheet prepared under this order is the reverse of the Balance Sheet prepared in liquidity
order. In this case first those assets are shown which are more permanent means fixed assets and
then less permanent assets (Current Assets) are shown. Similarly, first long-term liabilities
(more permanent) are shown then less permanent liabilities are shown.
Proforma of Balance Sheet in Permanency Order
Liabilities
Long term liabilities
Capital
xxxxxxx
Add: Net profit
xxxx
Add: Interest on capital
xxxx
Xxxxx
Less: Drawings
xxxxx
Current Liabilities
Sundry Creditors
Bank Overdraft
Short term loan
Outstanding expenses
Income received in advance
Bills payable
Amt.
Xxxxxx
Xxxxx
Xxxxx
Xxxxx
Xxxxx
Xxxxx
Xxxxx
Xxxxx
Xxxxxxxx
Assets
Fixed Assets
Land& Building
Plant & Machinery
Furniture
Investments (long term )
Goodwill
Patents & Trademarks
Current Assets
Cash in hand
Cash at bank
Short term investment
Prepaid expenses
Bills receivable
Accrued incomes
Debtors
Closing stock
Amt.
xxxxx
xxxxx
xxxxx
xxxxx
xxxxx
xxxxx
xxxxx
xxxxx
xxxxx
Xxxxx
Xxxxx
Xxxxx
Xxxxx
Xxxxx
Xxxxxxxx
11. From the following information prepare Trading and Profit and Loss account for the year
ended 31st Dec. 2007 and Balance Sheet as on that date.
Capital
30,000
duty and clearing charges
3,500
Drawings
6,000
Sales
1,28,000
sundry creditors
43,000
Salaries
9,500
bills payable
4,000
returns from customers
1,000
sundry debtors
51,000
returns to creditors
1,100
bills receivable
5,000
commission and travelling exp.
4,700
loans and advances
12,000
general exp.
2,500
fixtures& fittings
8,500
rent paid
2,000
opening stock
47,000
commission received
4,000
cash in hand
900
O.D with bank
6,000
cash at bank
12,500
Purchases
50,000
Adjustments:
1). Closing stock Rs. 50,000 2). Interest to be received Rs. 200 3). Outstanding salaries Rs.
500 4). Depreciation of fixtures& fittings by 10% 5). Commission received in advance Rs. 600
6). Allow interest on capital 8%
Particulars
To opening stock
To purchases
Less: returns
To duty& clearing
Charges
To gross profit c/d
Trading and Profit and Loss Account
For the year ended 31st Dec. 2007
Amt .
Particulars
47,000
By sales
50,000
less: returns
1,100 48,900
By closing stock
3,500
To salaries
9,500
add: o/s salaries
500
To commission and
travelling expenses
To general expenses
To rent paid
To interest on capital
( 30,000 x 8 % )
To depreciation on
fixtures & fittings
( 8,500 x 10 % )
To net profit
(transferred to capital a/c)
Amt .
1,28,000
1,000
1,27,000
50,000
77,600
1,77,000
10,000
4,700
2,500
2,000
2,400
By gross profit b/d
By commission
less: commission
received in advance
By accrued interest
1,77,000
77,600
4,000
600
3,400
200
850
58,750
81,200
Balance Sheet
81,200
As on 31st Dec. 2007
Liabilities
Capital
add: net profit
add: interest on capital
less : drawings
O.D with bank
sundry creditors
bills payable
o/s salaries
commission received in
Advance
Amt .
30,000
58,750
88,750
2,400
91,150
6,000 85,150
6,000
43,000
4,000
500
600
1,39,250
Assets
fixtures & fittings
less: depreciation
loans & advances
sundry debtors
bills receivables
closing stock
accrued interest
cash in hand
cash at bank
Amt .
8,500
850
7,650
12,000
51,000
5,000
50,000
200
900
12,500
1,39,250
12. What are ratios? Explain uses and significance of ratio analysis?
A ratio is simple arithmetical expression of the relationship of one number to another. It is
defined as the indicate quotient of two mathematical expression.
Definition:
According to accountant handbook by Wixon, cell and bedford a ratio is an expression of the
quantative relationship b/w two numbers. In simple language ratio is one number expressed in
terms of another and can be worked out by dividing one number by another number.
Uses and significance of ratios analysis —The ratio analysis is one of the most important tools
for financial analysis. they draw attention on strength, weakness, soundness, status of
organization which is an important tool for financial managers. A ratio is stand to be a blood
pressure or pulse rate on the body temperature of an individual�s, which helps a financial
manager to take a clear decision for analyzing the financial position of a concern.
Ratio analysis help the financial analysts especially for managerial purpose like decision making
process, planning, forecasting, communication, coordinating and controlling purpose of the
organization and also helpful to share holders/ Investors - for Investments in a particular
organization. They are also helpful to a creditor for lending short term constant help useful to the
employees and to the government for leving taxes.
13. Explain the Classification of Ratios.
Classification of Ratios
Liquidity Ratio
Solvency Ratios
Turn Over Ratios
Current Ratio
Quick Ratio
Absolute Quick Ratio
Debit – equity Ratio
Interest coverage
Ratio
Inventory
Ratio
Debtors
Ratio
Creditors
Ratio
Profitability Ratios
turnover General Profitability
Ratios
turnover
Gross profit Ratio
turnover Net profit Ratio
Operating Ratio
Operating Profit
Expenses Ratio
Overall Profitability
Earnings per share
Price – earnings Ratio
ROI
Liquidity ratio:
Liquidity ratio expresses the ability of the firm to meet its short term commitments as and when
they fall due. If the firm is not in a position to meet the short term commitment such as payments
to creditors, taxes, wages and salaries so on, then it cannot continue in business for long time
despite its strong capital base liquidity ratio helps in identifying the danger signals to the firm in
advances.
1. Current ratio — Thus ratio establishes a relationship between current assets and current
liabilities.
2. Objective — The objectives of computing the ratio are to measure the ability of the firm to
meet its short term obligations and to reflect the short term financial strength and solvency of
firm computations. Thus ratio is computed by dividing the current assets by the current
liabilities, the ratio is usually expressed as proportion. The ideal ratio for current ratio is 2:1
Current ratio
=
current asset
Current liabilities
Quick ratio —
Meaning — This ratio establishes a relationship between quick assets and current liabilities.
Objectives — The objective of computing the ratio is to measure the ability of the firm to meet
its short term obligations as and when due with relying upon the realization of short.
Computation — The ratio is computed by dividing the quick assets by the current liabilities. thus
ratio is usually expressed as proportion. 1:1
Quick ratio =
Quick assets
Current liabilities
Quick assets = Current assets – (Stock + prepaid expenses)
3. Absolute liquid ratio or absolute quick ratio — Although receivables, debtors and Bill
Receivables are more liquid than inventories. Yet they may be doubts regarding their realization
into cast immediately in time. An absolute liquid asset includes cash in hand, cash at bank and
marketable securities. The normal standards are 1:2
Absolute quick assets = Absolute quick assets
Current liabilities
Absolute quick ratio = Absolute quick ratio + Current liabilities + Absolute quick assets Cash in
hand cash at bank marketable securities
Current Assets
1. Cash in hand
2. Cash at bank
3. Marketable securities (Short term)
4. Short term investments
5. Bills receivables
6. Sundry debtors
7. Inventories
8. Work in process
9. Prepaid exp.
10. Accrued income.
Current Liabilities
1. Outstanding exp
2. Bills payable.
3. Sundry creditors
4. Bank loans(short term)
6. Income tax payables
7. Bank overdraft
8. Dividend payable
Activity ratios —
Activity ratio measures the efficiency and effectiveness with which a firm manager the resources
on assets, these ratios are also called as turnover ratio, indicates the speed with which the assets
are converted or into sales.
These ratios are —
1. Net working capital turnover ratio
2. Stock / Inventory turnover ratio
3. Debtors turnover ratio
4. Creditors turnover ratio
Inventory turnover ratio or stock turnover ratio:
Meaning: This ratio establishes a relationship between cost of goods and average inventory the
objectives of computing this ratio is to determine the efficiency with which the inventory is
utilized.
Inventory turnover ratio = Cost of goods sold
Average stock
Cost of good sales = Op. stock + purchases + direct exp - closing stock OR
Net sales - gross profit
Average Inventory= (op.st +cl.st)/2
Debtor – turnover Ratio:DTR is also known as receivable turnover ratio is a relationship of sales, with O/S amount due
from Debtors to whom goods were sold on credit.
DTR = Sales
Average Debtors
or
Credit Sales
Average Debtors
For Computation of this ratio, Debtors includes sundry Debtors and B/R, and are preferably
taken as Avg. of the value at the beginning & at the end.
Debtors collection period = 365 days or 12 months
DTR
Creditors� turnover ratio:
In the course of business operations, a firm has to make credit purchases and incur short – term
liabilities. A supplier of goods, i.e., creditor is naturally interested in finding out how much time
the firm is likely to take in repaying its trade creditors.
Creditors turn over / payable turnover ratio =
Net credit purchases
Avg. Creditors
Avg creditors = Open creditors + Open closing Bill payable + closing creditors +
Closing Bill payable
2
Average Payment Period = (365 days or 12 months)
CTR
Working capital turnover ratio —
Indicate the velocity of the utilization of Net working capital. This ratio indicates the no. of times
the working capital turn over in the course of a year. The higher the ratio is better.
Working capital turnover ratio = Cost of sales
Average working capital
Average working capital =
If the of cost of sales is not given then sales can be used instead.
Profitability Ratio:Every business enterprise operates with an objective to earn profit. It can be related sales or
capital to ascertain margin on sales or profitability of capital employed.
1. Gross Profit Ratio =
Gross Profit *100
Sales
2. Net Profit Ratio =
Net Profit *100
Sales
3. Operating Profit Ratio = Operating Profit *100
Sales
Operating Profit = Net sales – Operating cost
Operating cost = Net sales – ( Cost of goods Sold + administration exp+ Selling exp + financial
exp +
Repairs).
OR
Net Profit + non. Operating Exp – non. Operating Income.
4. Operating Ratio
= Operating Cost *100
Sales
Operating cost = COGS + S&DEXP. + Adm. exp + fin exp. + Repairs
Overall Profitability Ratio:1 Return on share holders Investments or Net worth:- ROI is the relationship b/w Net
profit (after Int. & Tax) and share holder funds. Higher the ratio is better.
ROI = Net profit (after Int. & Tax)
Share holder�s funds
Share holders� funds = [Equity share capital + Pref. share capital + Reserves & surplus]
Minus accumulated loss by any
1. Return on Equity Capital:=
Net profit after tax – pref. dividend
Equity share capital (Paid – up)
2. Earnings per share:= Net profit after tax – Pref. dividend
No. of Equity shares
SOLVENCY RATIOS
Solvency refers to the ability of a business honours Long – term obligations like interest
and instalment associated with Long – term debts. Lenders, like financial institution, Debenture
holders, bank who give term Loans to the enterprise.
(i) Interest Coverage Ratio:This Ratio refers interest obligations to the profit (before interest and tax) for the
period and indicates the number of times; interest obligation is covered by the profit for the
period. It is always desirable to have profit more than the interest payable; otherwise position of
lenders is unsafe.
Interest Coverage Ratio = Profit before Interest and Tax
Interest
The Ratio is expressed in number and not in percentage.
Debit – Equity Ratio: - A general norm for this Ratio is 2:1
The ratio related Debt to equity or owner�s funds Debt here refer to longer term
Liabilities which mature after one year and includes Long – term Loans from financial
institutions, bank, public deposit and debentures. Equity is taken as Owner�s funds and includes
equity share capital, preference share capital, general reserve, capital reserve, balance in share –
premium account and other reserves available to equity share holders, P*C a/c
Debit – Equity Ratio = Debit
Equity
Price Earnings Ratio:P/E Ratio is the relationship b/w market price per equity shares and earnings per
shares. This ratio is calculated to makes an estimate of appreciation in the value of a share of a
company, and widely used to decide whether to buy or not to buy in particular company. Higher
the Ratio is advisable
P/E ratio = Market price per equity share
Earnings per share
SOLVENCY RATIOS
Solvency refers to the ability of a business honours Long – term obligations like interest
and instalment associated with Long – term debts. Lenders, like financial institution, Debenture
holders, bank who give term Loans to the enterprise.
(i) Interest Coverage Ratio:This Ratio refers interest obligations to the profit (before interest and tax) for the
period and indicates the number of times; interest obligation is covered by the profit for the
period. It is always desirable to have profit more than the interest payable; otherwise position of
lenders is unsafe.
Interest Coverage Ratio = Profit before Interest and Tax
Interest
The Ratio is expressed in number and not in percentage.
14. Calculate liquidity ratio from the following balance sheet a company computes current ratio
and quick ratio, absolute quick ratio. Also interpret the ratios.
Land and Buildings
Plant and Machinery
Furniture and fixtures
Closing stock
Sundry debtors
Wages prepaid
Sundry creditors
Rent outstanding
50000
100000
25000
25000
12500
2500
8000
2000
Solution:
Current assets: Closing stock + sundry debtors + wages prepaid
Closing stock
Sundry debtors
Wages prepaid
Total
25000
12500
2500
40000
Current Liabilities: Sundry creditors + Rent Outstanding
Sundry creditors
Rent outstanding
Total
8000
2000
1000
Current Ratio =
Crurent assets
Current liabilities
= 40000/10000 = 4:1
Quick Assets – Current Assets – (Stock + prepaid Exp)
40000 – (25000 + 2500) = 12500
Quick Assets = 12500/10000 = 1.25:1
15. From the following balance sheet a company computes current ratio and quick ratio, Also
interpret the ratios.
Land and Buildings
Plant and Machinery
Furniture and fixtures
Closing stock
Sundry debtors
Wages prepaid
Sundry creditors
Rent outstanding
50000
100000
25000
25000
12500
2500
8000
2000
Solution:
Current assets: Closing stock + sundry debtors + wages prepaid
Closing stock
25000
Sundry debtors
12500
Wages prepaid
2500
Total
40000
Current Liabilities: Sundry creditors + Rent Outstanding
Sundry creditors
8000
Rent outstanding
2000
Total
1000
Curent Ratio =
Current assets
Current liabilities
= 40000/10000 = 4:1
Quick Assets – Current Assets – (Stock + prepaid Exp)
40000 – (25000 + 2500)
12500
Quick Assets = 12500/10000 = 1.25
16. The profit of a company after tax and interest is Rs.250000 provision for taxation is
Rs.4,00,000 and interest payable is Rs.110000. Find interest coverage ratio
Profit after taxes
+ Interest payment
Tax provision
250000
110000
400000
510000
760000
Interest coverage ratio = PBIT
Interest
= 760000
110000
6.9 times.
17. The following information relates to Disco Electrical for the year ending 31/12/03.
Equity Capital (80,000 shares @ 20/- each)
16, 00,000.
10% preference share capital @ 20/- each)
6, 00,000.
Profit after tax @ 10%
5, 40,000.
Depreciation
1, 20,000.
Equity dividend paid @ 20% market price for equity share.
Calculate:
a. Earnings per share. b) Price Earning Ration.
1. Earnings per share:
Net profit to equity shareholders
No. of Shares
= 5, 40,000 = Rs. 6.75
80,000
2. Price –Earnings Ratio:Market price of equity share
Earning per share
= 80 =11.85
6.25
18. From the following information calculate stock turnover ratio.
Particulars
To Opening Stock
To Purchases
To Carriage
Inwards
To Wages
To Gross Profit
Amount
18,000
67,700
3,000
8,000
26,800
Particulars
By Sales
By Closing Stock
Solution:
Cost of Goods sold can arrived in two ways.
1. Sales
98,500
(-) Gross Profit
26,800
71,700
2. Opening Stock
(+) Purchases
(+) Direct Expenses
Carriage Inwards
Wages
(-) Closing Stock
Cost of Goods Sold
18,000.
67,700.
3,000
8,000
96,700
25,000
71,700
Average Stock = Opening stock + Closing Stock
2
Amount
98,500
25,000
= 18,000+25,000
2
= 21,500
Stock Turnover ratio = Cost of Goods Sold
Average Stock
= 71,700 = 3.33
21,500
Stock Velocity =
12 months/52 weeks/365 days
Stock turnover ratio
=
365
3.3
110 days.
19. From the following information calculate debtor�s turnover ratio and sales for 2012
Credit
Cash
Opening Balance
Sundry debtors
Bills Receivable
Closing Balances
Sundry Debtors
Bills Receivables
58,000
40,500
28,000
7,000
25,000
15,000
Average Debtors = Opening Sundry debtors
(+) Opening Bills Receivable
Closing Stock of Debtors
(+) Closing Bills Receivable
Average Debtors = 75,000
2
Debtors Turnover ratio =
Debtors Collection Period =
= 37,500
Credit Sales
Average Debtors
= 58,000
37,500
= 1.55 times
365
Turnover ratio
= 365 = 235 days
1.55
28,000
7,000 35,000
25,000
15,000 40,000
75,000
20. Following is the profit loss account Electro Matrix Ltd, for the year ended 31/12/08.
Particulars
To opening stock
To purchases
To wages
To gross profit
To administration exp
To selling and distribution
Amount
100000
350000
9000
201000
20000
89000
Particulars
By sales
By closing stock
To non-operating ex
To net profit
30000
80000
219000
By sale of investments
By gross profit
201000
By interest on investments 10000
Your are required to calculate
Gross profit ratio, net profit ratio, operating ratio, operating profit ratio,
Solution:
Gross profit ratio: Gross profit /sales * 100
201000/560000*100 = 35.9%
Net profit ratio:
Amount
560000
100000
Net profit/sales*100
80,000/560000 = 14.28%
Operating ratio: operating cost/sales *100
4,68,000/560000 = 83.5%
Operating profit ratio: operating profit/sales *100
92000/560000 = 16.4%
8000
219000

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