Managerial Economics

(CCRDC11)

Prepared By

S.Vanitha Rani, M.Com., M.Phil.,

Asst.Professor,

Dept of Commerce,

Parvathys Arts and Science College,

Dindigul-624 002

MANAGERIAL ECONOMICS

UNIT- 1

Definition of Economics-Definition of Managerial Economics-Nature and

Scope of Managerial Economics-Difference between Economics and Managerial

Economics-Role of Managerial Economist

Unit-2

Objectives of a Modern firm-Five Fundamental Concepts-Incremental

Concept-Time Perspective Concept-Discounting Principle-Opportunity Cost Concept-

Equi-Marginal Concept.

Unit-3

Law of Demand-Factors affecting Demand-Exceptions to Demand-Demand

Forecasting-Factors involved in Demand Forecasting-Advantages-Methods of Forecasting

the demand for an established product and new product-Criteria for a good forecasting

method.

Unit-4

Pricing-objectives of Pricing-Policies and Methods-Pioneer Pricing-

Skimming Pricing-Penetration Pricing-Price lining-Pricing over the life cycle of a Product.

Unit-5

Profit Planning and Control-Profit Budget-Break Even Analysis-Managerial

application of Break Even Approach-Its uses and limitations-Profit Forecasting.

UNIT-1

Definition of Economics:

Economics is the study of human activities in the ordinary course of business. It studies

how man attains his income and how he utilizes it. In this way, it studies wealth, on one hand and

on the other hand, it is a part of the study of man, which is more important.

According to this definition, it becomes the science of human activities instead of science of

wealth.

Definition of Managerial Economics

“Managerial Economics is the integration of Economic theory with business practice to

facilitating decision making and forward planning by management” – W.W. Haynes

“Economics decision making and forward planning” – Spencer & Siegelman

“Managerial economics consists of the use of economic modes of thought to

analyze business situations” – problems in business economics – McNair & Meriam

Nature of Managerial economics:

Managerial Economics requires Art

Managerial economist is required to have an art of utilising his capability, knowledge and

understanding to achieve the organizational objective. Managerial economist should have an art

to put in practice his theoretical knowledge regarding elements of economic environment.

Managerial Economics for administration of organization

Managerial economics helps the management in decision making. These decisions are

based on the economic rationale and are valid in the existing economic environment.

Managerial economics is helpful in optimum resource allocation

The resources are scarce with alternative uses. Managers need to use these limited

resources optimally. Each resource has several uses. It is manager who decides with his

knowledge of economics that which one is the preeminent use of the resource.

Managerial Economics has components of micro economics

Managers study and manage the internal environment of the organization and work for

the profitable and long-term functioning of the organization. This aspect refers to the micro

economics study. The managerial economics deals with the problems faced by the individual

organization such as main objective of the organization, demand for its product, price and output

determination of the organization, available substitute and complimentary goods, supply of

inputs and raw material, target or prospective consumers of its products etc.

Managerial Economics has components of macro economics

None of the organization works in isolation. They are affected by the external

environment of the economy in which it operates such as government policies, general price

level, income and employment levels in the economy, stage of business cycle in which economy

is operating, exchange rate, balance of payment, general expenditure, saving and investment

patterns of the consumers, market conditions etc. These aspects are related to macro economics.

Managerial Economics is dynamic in nature

Managerial Economics deals with human-beings (i.e. human resource, consumers,

producers etc.). The nature and attitude differs from person to person. Thus to cope up with

dynamism and vitality managerial economics also changes itself over a period of time.

Scope of Managerial Economics

Managerial economics has emerged as a new branch of knowledge and Managerial

economics is currently undergoing development.

Therefore, there was not much known about its area, but I am going to explain the areas

which are usually seen. Which prove to be very helpful to you.

1. Production and Cost Analysis

Managerial economics determines the quantity of production and analyzing. so the needs

of its (product, planning of quantity of profit, pricing policy) are crucial for effective control of

the firm.

Thus, under the assumptions of cost-average marginal cost expansion and variable costs,

2. short-term and long-term costs, 3. considerations of measuring procedures, 4. costs and

relationships in production quantities, 5. the process of the production process and equation point

analysis etc.

2. Demand Analysis and Forecasting

All the economic theories and perceptions related to the demand of the firm are studied

and the means of production are imposed in production work by making future projections of the

demand.

Thus, 1. Demand rules, 2. The elasticity of demand and interpretation of income-effect, 3.

Replacement effects and price impact, 4. Along with economic theory and psychological

perception and 5. External circumstances, the effect of demand is taken care.

3. Price Policies and Practices

Pricing is a matter of paramount importance for any firm. Because of the success of the

firm’s benefit, the demand for the product depends a lot on it. including pricing, principles are

examined in different conditions of the market like 1. Full competition, 2. Incomplete

competition, 3. One right, non-negotiable and 4. Monopolistic competition, value related

forecasts, and sales problems are also analyzed under it.

Therefore, It also involves short-term and long-term pricing policies.

Thus, Useful in showing the path of economic well-being- Business economics inspires

managers to operate the business in such a way that the path of maximum economic welfare is

paved.

4. Profit Maximization or Profit Management

The purpose of each producer and the business firm is to maximize profit. The amount of

profit depends on the cost and cost.

Thus, the managerial economics 1. The benefits of maximization and profit planning for

the benefits, 2. The nature of the assumptions and benefits, 3. The measurement of profit 4. The

appropriate benefits policy comes into the ordered zone.

5. Capital Management

Capital is the life of the modern business. For the 1. proper planning of capital loss, 2.

proper planning of capital loss, and 3. effective control of the cost of capital to the managers. the

calculation of the rate of profit received on it.

Thus, the evaluation of the discretion for the full election from the alternative expenditure of

capital. and expenditure and Study of topics etc. so that is the important part of capital

management in the managerial economics.

6. Project Evolution

When business projects are evaluated, the utility and poets of different schemes of business are

traced. So that those deficiencies and utilities should be adjusted and used by making new rules.

7. Industry and Trade Policies of Govt.

The government changes its business policies whether the central government, state govt., This

change affects every business, firm. That’s why it affects the managerial economy, it comes

under this.

Conclusion

Thus, The areas of managerial economics are now going through a developing phase and

many of these students are there. Those who are still hidden from us. But the managerial

economics influence many facts of the profession and provide help in their development.

Management Economics teaches us that any business is required to make proper

management to move forward.

Difference between Managerial Economics and Economics

The difference between managerial economics and economics can be understood with the

help of the following points:

Managerial economics involves application of economic principles to the problems of a

business firm whereas; economics deals with the study of these principles only.

Economics ignores the application of economic principles to the problems of a business

firm.

Managerial economics is micro-economic in character, however, Economics is both

macro-economic and micro-economic.

Managerial economics, though micro in character, deals only with a firm and has nothing

to do with an individual’s economic problems. But microeconomics as a branch of

economics deals with both economics of the individual as well as economics of a firm.

Under microeconomics, the distribution theories, viz., wages, interest and profit, are also

dealt with. Managerial economics on the contrary is mainly concerned with profit theory

and does not consider other distribution theories. Thus, the scope of economics is wider

than that of managerial economics.

Economic theory assumes economic relationships and builds economic models.

Managerial economics adopts, modifies and reformulates the economic models to suit the

specific conditions and serves the specific problem solving process. Thus, economics

gives the simplified model, whereas managerial economics modifies and enlarges it.

Economics involves the study of certain assumptions like in the law of proportion where it is

assumed that “The variable input as applied, unit by unit is homogeneous or identical in amount

and quality”. Managerial economics on the other hand, introduces certain feedbacks. These

feedbacks are in the form of objectives of the firm, multi-product nature of manufacture,

behavioral constraints, environmental aspects, legal constraints, constraints on resource

availability, etc. Thus managerial economics, attempts to solve the complexities in real life,

which are assumed in economics. this is done with the help of mathematics, statistics,

econometrics, accounting, operations research, etc

Role of a Managerial Economist

One of the principal objectives of any management in its decision-making process is

to determine the key factors, which will influence the business over the period ahead. In general,

these factors can be divided into two categories:

External

Internal

The external factors lie outside the control of management because they are external to

the firm and are said to constitute business environment. The internal factors lie within the scope

and operations of a firm and hence within the control of management, and they are known as

business operations. To illustrate, a business firm is free to take decisions about what to invest,

where to invest, how much labour to employ and what to pay for it, how to price its products,

and so on. But all these decisions are taken within the framework of a particular business

environment, and the firm’s degree of freedom depends on such factors as the government’s

economic policy, the actions of its competitors and the like.

Environmental Studies of a Business Firm

An analysis and forecast of external factors constituting general business conditions, for

example, prices, national income and output, volume of trade, etc., are of great significance since

they affect every business firm. Certain important relevant factors to be considered in this

connection are as follows:

The outlook for the national economy, the most important local, regional or worldwide

economic trends, the nature of phase of the business cycle that lies immediately ahead.

Population shifts and the resultant ups and downs in regional purchasing power.

The demand prospects in new as well as established markets. Impact of changes in social

behaviour and fashions, i.e., whether they will tend to expand or limit the sales of a

company’s products, or possibly make the products obsolete?

The areas in which the market and customer opportunities are likely to expand or contract

most rapidly.

Whether overseas markets expand or contract and the affect of new foreign government

legislations on the operation of the overseas plants?

Whether the availability and cost of credit tend to increase or decrease buying, and

whether money or credit conditions ahead are likely to easy or tight?

The prices of raw materials and finished products.

Whether the competition will increase or decrease.

The main components of the five-year plan, the areas where outlays have been increased

and the segments, which have suffered a cut in their outlays.

The outlook to government’s economic policies and regulations and changes in defence

expenditure, tax rates tariffs and import restrictions.

Whether the Reserve Bank’s decisions will stimulate or depress industrial production

and consumer spending and how will these decisions affect the company’s cost, credit,

sales and profits.

Reasonably accurate data regarding these factors can enable the management to chalk out

the scope and direction of their own business plans effectively. It will also help them to

determine the timing of their specific actions. And it is these factors, which present some of the

areas where a managerial economist can make effective contribution. The managerial economist

has not only to study the economic trends at the micro-level but also must interpret their

relevance to the particular industry or firm where he works. He has to digest the ever-growing

economic literature and advise top management by means of short, business-like practical notes.

In mixed economy like that of India, the managerial economist pragmatically interprets the

intentions of controls and evaluates their impact. He acts as a bridge between the government

and the industry, translating the government’s intentions and transmitting the reactions of the

industry. In fact, the government policies emerge out of the performance of industry, the

expectations of the people and political expediency.

Business Operations

A managerial economist can also be helpful to the management in making decisions

relating to the internal operations of a firm in respect of such problems as price, rate of

operations, investment,

expansion or contraction. Certain relevant questions in this context would be as follows:

What will be a reasonable sales and profit budget for the next year?

What will be the most appropriate production schedules and inventory policies for the

next six months?

What changes in wage and price policies should be made now?

How much cash will be available next month and how should it be invested?

Specific Functions

The managerial economists can play a further role, which can cover the following specific

functions as revealed by a survey pertaining to Brittain conducted by K.J.W. Alexander and

Alexander G. Kemp:

Sales forecasting.

Industrial market research.

Economic analysis of competing companies.

Pricing problems of industry.

Capital projects.

Production programmes.

Security / Investment analysis and forecasts.

Advice on trade and public relations.

Advice on primary commodities.

Advice on foreign exchange.

Economic analysis of agriculture.

Analysis of underdeveloped economics.

Environmental forecasting.

The managerial economist has to gather economic data, analyse all relevant information

about the business environment and prepare position papers on issues facing the firm and the

industry. In the case of industries prone to rapid theological advances, the manager may have to

make continuous assessment of tl1e impact of changing technology. The manager' may need to

evaluate the capital budget in the light of short and long-range financial, profit and market

potentialities. Very often, he also needs to prepare speeches for the corporate executives. It is

thus clear that in practice, managerial economists perform many and various functions. However,

of all these, the marketing functions, i.e., sales force listing an industrial market research, are the

most important.

Economic Intelligence

Besides these functions involving sophisticated analysis, managerial economist may also

provide general intelligence service. Thus the economist may supply the management with

economic information of general interest such as competitors

prices and products, tax rates, tariff rates, etc.

Participating in Public Debates

Many well-known business economists participate in public debates. The government

and society alike are seeking their advice and views. Their practical experience in business and

industry adds prestige to their views. Their public recognition enhances their protégé in the .firm

itself.

Indian Context

In the Indian context, a managerial economist is expected to perform the following

functions:

Macro-forecasting for demand and supply.

Production planning at macro and micro levels.

Capacity planning and product-mix determination.

Economics of various production lines.

Economic feasibility of new production lines / processes and projects.

Assistance in preparation of overall development plans.

Preparation of periodical economic reports bearing on various matters such as the

company's product-lines, future growth opportunities, market pricing situation, general

business,. and various national/international factors affecting industry and business.

Preparing briefs; speeches, articles and papers for top management for various chambers,

Committees, Seminars, Conferences, etc

Keeping management informed of various national and

International Developments on economic/industrial matters.

Responsibilities of a Managerial Economist

Besides considering the opportunities that lie before a managerial economist it is necessary to

take into account the services that are expected by the management. For this, it is necessary for a

managerial economist to thoroughly recognise the responsibilities and obligations. A managerial

economist can serve the management best by recognising that the main objective of the business,

is to make a profit on its invested capital. Academic training and the critical comments from

people outside the business may lead a managerial economist to adopt an apologetic or defensive

attitude towards profits. There should be a strong personal conviction on part of the managerial

economist that profits are essential and it is necessary to help enhance the ability of the firm to

make profits. Otherwise it is difficult to succeed in serving management.

Most management decisions necessarily concern the future, which is rather uncertain. It is,

therefore, absolutely essential that a managerial economist recognises his responsibility to make

successful forecast. By making the best possible forecasts and through constant efforts to

improve, a managerial' ng, the risks involved in uncertainties. This enables the management to·

follow a more orderly course of business planning.

UNIT-2

OBJECTIVES OF A MODERN FIRM:

The following economic objectives are explained in detail:

a. Profit:

The primary objective of every business is to earn profit. Profit is the lifeblood of

business, without which no business can survive in a competitive-market. Profit is the financial

gain or excess of return over investment.

It is the reward for bearing risk and uncertainty in the business. It is a lubricant, which

keeps the wheels of business moving. Profit is essential for the survival, growth and expansion of

the business.

b. Creating and retaining customers:

Consumer is a king of the market. All the business activities revolve around the

consumers. The success of the business depends upon its customers. It is not only necessary to

make customers but also to hold the customers.

Competition is intensely rising. Hence to face this stiff competition, it is necessary for the

businessman to come out with new concepts and products for attracting the new customers and

retaining the old one.

c. Innovation:

Innovation is the act of introducing something new. It means creativity i.e. to come up

with new ideas, new concepts and new process changes, which bring about improvement in

products, process of production and distribution of goods.

Innovation helps in reducing the cost by adopting better methods of production.

Reduction in the cost and quality products increase the sales thereby increasing the economic

gain of the firm. Hence to survive in the competitive world, the business has to be innovative.

d. Optimum utilisation of the scarce resources:

Resources comprises of physical, human and capital that has to optimally utilise for

making profit. The availability of these resources is usually limited. So the firm should make

best possible use of these resources, wastage of the limited resource should be avoided.

III. Social Objectives:

Social objective means objective relating to the society. This objective helps to shape the

character of the company in the minds of the society. The obligation of any business to protect

and serve public interest is known as social responsibility of business.

Society comprises of the consumers, employees, shareholders, creditors, financial

institutions, government, etc. Business has some responsibility towards the society. Businessmen

engage themselves in research for improving the quality of products; some provide housing,

transport, education and health care to their employees and their families.

In some places businessmen provide free medical facility to poor patients. Sometimes

they also sponsor games and sports at national as well as international level etc.

a. Towards the Employees:

Employee of a business firm contributes to the success of the business firm. They are the

most important resource of the business. Every business is responsible towards their employees

in respect of wages, working conditions, etc. The interest of the employees should be taken care

of. The authorities should not exploit the employees.

b. Towards the Consumers:

Business has some obligation towards the consumers. No business can survive without

the support of customers. Now-a-days consumers have become very conscious about their rights.

They protest against the supply of inferior and harmful products.

This has made it obligatory for the business to protect the interest of the consumers by

providing quality products at the most competitive price. They should charge the price according

to the quality of the goods and services provided to the consumers. There must be regularity in

supply of goods and services

c. Towards Shareholders:

Shareholders are the owners of the company. They provide finance by way of investment

in debentures, bonds, deposits etc. They contribute capital and bear the business risks. The

primary responsibilities of business towards.

It is the responsibility of the business to safeguard the capital of the shareholders and

provide a reasonable dividend. Business and Society are interdependent. Society depends on

business for meeting its needs and welfare, whereas, Business depends on society for its

existence and growth.

d. Towards the Creditors/financial institutions

e. Towards the Suppliers:

Suppliers supply raw material, spare parts and equipment’s necessary for the business. It

is the responsibility of the business to give regular orders for the purchase of goods, avail

reasonable credit period and pay dues in time. The business should maintain good relations with

the supplier for regular supply of quality raw material.

f. Towards the government:

Government frame certain rules and regulations with in which the business has to act.

These are the following responsibilities of the business towards government are:

i. Paying taxes regularly

ii. Conducting business in a lawful manner

iii. Setting up business enterprise as per the government guidelines

iv. Avoiding indulgence into monopolistic and restrictive trade practices,

v. Avoiding indulgence into corruption and unlawful practices.

g. Towards the environment:

The business is also responsible towards the environment. It is the responsibility of the

business to keep the environment pollution free by producing pollution free products. Business is

also responsible to conserve natural resources and wild life and hence promote the culture.

IV. Human Objectives:

Human objective refers to the objectives aimed at well being of the employees in the

organisation. It includes economic well-being of the employees and their psychological

satisfaction.

Hence the human objectives of the business organisation can be explained with the

following points:

a. Economic well-being of the employees:

Employees should be given fair wages and incentives for their work done. They should

also be provided with the benefits of provident fund, pension and other amenities like medical

facilities, housing facilities etc.

b. Human Resource development:

The organisation should undertake necessary human resource development programmes.

Employees always want to grow and prosper. Employees to grow, the firm must conduct proper

training and development programmes to improve their skills and competencies.

c. Motivating employees:

Employees need continuous motivation to improve their performance in their job. It is the

job of the organisation and managers to motivate their employees by providing them monetary

and non-monetary incentives like bonus, increments, promotions, job-enrichment, proper

working conditions, appreciations etc. motivated employees put efforts and are dedicated

towards their job.

d. Social and psychological satisfaction of the employees:

This is the most important objective of the organisation towards their employees. The

business should provide social and psychological satisfaction to their employees. Employees can

feel satisfied if they are put on the right job according to their skill, talent and qualification.

The firm should give prompt attention to the employee grievances and necessary

suggestions should be provided. Psychologically satisfied employees put best efforts in their

work.

V. National Objectives:

The business enterprise contributes for the upliftment of the nation. Every business has an

obligation towards nation to fulfill national goal: and aspirations. The goal can be increase

employment opportunities, earn foreign revenue, promote social justice etc. The following

national objectives are explained in detail:

a. Employment opportunities:

Public benefit is the basic national objective of a business firm. Business creates

employment opportunities directly or indirectly. People can be employed in production and

distribution activities by establishing new business units, expanding markets, widening

distribution channels, transportation, insurance etc.

b. Developing backward areas:

Business undertakes projects in the backward region and thereby develops the backward

areas of the nation. Business also helps in providing infrastructure facilities in the backward

regions of the country like transportation, banking, communication etc.

Opening of small-scale industries in those backward areas also provide employment

opportunities to the people and results into balanced regional development.

c. Promoting social justice:

The term social justice indicates uniform rights and equality to all the sections of the

society. Business can do justice with the society by providing them better quality products and

services at reasonable prices.

They should not undertake any malpractices and prevent the customers from being

exploited. The business should also provide equal opportunities to all the employees to work and

progress.

d. Raising standard of living:

Business can raise the standard of living of the people of the country by making quality

goods and services available at reasonable prices. Consuming quality products enhances the

standard of living of the people.

e. Contributes revenue to the government:

Business helps in earning more foreign exchange to the government by undertaking

export activities. The revenue of the government also increases by payment of taxes by the

business entities, which can further be used for the development of the nation.

Concepts of Managerial Economics (With Diagram)

The Incremental Concept:

It is easy to describe incremental reasoning. But it is very difficult to apply it. As T.J.

Coyne has put it, “It involves estimating the impact of decision alternatives on costs and

revenues, stressing the changes in total cost and total revenue that result from changes in

prices, products, procedures, investments or whatever may be at stake in the decision”.

Two basic concepts lie at the heart of incremental analysis, viz., incremental cost and

incremental revenue. The former refers to the change in total cost resulting from a decision.

Likewise, the latter may be defined as the change in total revenue resulting from a decision.

4. It decreases costs more than it decreases revenue.

We may now consider some of the implications of incremental reasoning which appears

to be too elementary. In general, businessmen think that in order to make an overall profit they

must make a profit on every activity (or job).

Consequently they refuse orders that do not cover cost (labour, materials and overhead)

and make a provision for profit. This is an unproved and probably a false belief. Incremental

reasoning makes it clear that this rule may be inconsistent with short-rim profit maximization.

A refusal to accept a job below cost may imply rejection of a possibility of adding more

to revenue than to cost. Here the relevant cost for decision-making is not the full cost but rather

the incremental cost. The following example clarifies the point. Consider a new order which is

supposed to bring Rs. 9,000 additional revenue.

The costs are estimated as follows:

It apparently seems that the order is unprofitable. But suppose there is idle capacity in the

short run. This could be used to produce the order. Suppose acceptance of the order will add only

Rs. 900 of overhead.

However, the term ‘incremental cost’ may be used to refer to the change in cost brought

about by the changes in production process or activity.The following diagram may be used to

compare the marginal and incremental approaches. In Fig 1.1 the MC curve is rising over most

of its range.

Suppose the production manager is considering an increase in output from 2,000 to 3,000

units. In this case it is very difficult to measure the marginal cost of change. No single MC cost

figure will suffice. The MC is initially low, but subsequently it rises rapidly.

However, another pattern of costs is common in industry. Several empirical studies have

discovered relatively constant marginal costs over wide range of outputs, as in Fig 1.2. Here MC

does not change dramatically with the changes in output. Hence a single MC cost figure can be

used over the whole range.

For the firm illustrated in Fig 1.2, we assume that total fixed cost is Rs. 4,000 per unit of

time. The average variable cost is Rs. 2.50 per unit. The MC is also Rs. 2.50 per unit. Suppose,

the production manager has to choose between an output of 2,000 units and one of 3,000 units. In

this case MC is Rs. 250 but incremental cost is Rs. 2,500.

The pertinent question here is whether or not marginal costs are in fact constant and

justify the substitution of incremental cost measurements over large changes in output, for

measurements of cost changes for small (marginal) changes in output. If the short run cost curves

were linear throughout, the decision-making problem would be greatly simplified.

The Concept of Time Perspective:

In economics, we often draw a distinction between the short-run and the long-run. This

distinction is not based on any calendar period, say, a month, a quarter or a year. It is based in the

speed with which decisions can be made and factors of production varied.

The period during which it is possible to vary some factors and not others is called the

short run. But the period during which all factors can be varied is called the long-run. For

example, more output can be produced in the short- run by using more labour and raw materials.

This is basically a short-term decision. But setting up a new factory or building an entirely new

plant is a long-term decision.

In reality, however, the distinction between the two often gets blurred. What remains is

an estimate of those costs that vary and those that do not by the decision under consideration. In

managerial economics we are concerned with the short-run and long-run effects of decisions on

revenues as well as on costs.

The line between the short-run and long-run revenue (or demand) is even less transparent

than that for costs. What is really important for managerial decision making is maintaining the

right balance among various runs, i.e., the long-run, short-run and intermediate-run perspectives.

A decision may be made on the basis of certain short-term considerations but it may have

various long-term repercussions which, in turn, may make it more or less profitable than it

appeared at the first sight. A simple example will make this point clear.

Suppose there is a firm with temporary idle capacity. It now gets an order for 10,000

units. The prospective customer is willing to pay Rs. 3 per unit, or Rs. 30,000 for the whole lot.

The short-term incremental cost (which ignores the fixed cost is) is only Rs. 2.50. So the

contribution to overhead and profit is 50 paise per unit (or Rs. 5,000 in all).

But the following two long-term repercussions must be taken into account:

1. If the management commits itself to a series of repeat orders at the same price, the

fixed costs (which are ignored temporarily) will become variable cost. For instance, sooner or

later it will become necessary to replace the machinery and equipment which wear out. True

enough, the gradual accumulation of orders may require an addition to capacity, with added

depreciation and added top-level supervision.

2. If lower price is charged for the extra order, old customers who pay higher price for the

same product may become annoyed. This practice will appear to be unethical and may destroy

the company image. This will be damaging in the long-run.

Now on the basis of our above discussion we can state the above principle — the

principle of time perspective — in the following words:

A decision should always take into consideration both the short-term and long-term

effects on revenues and costs, giving proper weight to the most relevant time periods.

The Concept of Discounting Principle:

There is a famous proverb that a bird in the hand is worth two in the bush’. This proverb,

like many others, contains an element of truth. And one of the fundamental propositions of

economic theory is that a rupee to be received tomorrow is worth less than the same rupee

received today.

The above proverb is, however, slightly misleading in this context, implying that the

reason for discounting the future rupees is uncertainty about receiving them. Even in the absence

of uncertainty, it is necessary to discount future rupees to make them equivalent to present day

rupees.

A simple example will make clear the rationale of discounting. If an individual is offered

to choose between a gift of Rs. 1,000 today or Rs. 1,000 to be received after one year, he would

surely prefer the former (even if there is no uncertainty regarding the receipt of either gift).

This is because in a world where the rate of interest is not zero there is scope for

investing Rs. 1,000 at the market rate of interest and accumulate interest on the principal. If the

rate of interest is 5%, today’s Rs. 1,000 will become Rs. 1,050 after one year.

There is another way of illustrating the discounting principle. One may ask how much

money today would be equivalent to Rs. 100 a year from now.

If the rate of interest is 5% the present value of Rs. 100 to be received after one year is:

Where PV = present value and

i = rate of interest

As a cross check one may multiply the PV of Rs. 95.24 by 1.05 to determine how much

money will have accumulated during the year at 5%. The answer is Rs. 95.24 x 1.05 = Rs.100. In

other words, Rs. 95.24 plus the interest on it will accumulate to an amount exactly equal to Rs.

100.

An individual who can earn 5% on his (or her) money should be indifferent between

receiving Rs. 95.24 today and Rs. 100 after one year. So the present value of Rs. 100 is Rs.

95.24.

The same analysis can be extended to any number of periods.

A sum of Rs. 100 two years from now is worth:

The Opportunity Cost Concept:

The opportunity cost of a decision means sacrificing alternatives. Opportunity cost

measures the value of the most valuable of the options that we have to forego in choosing from a

set of alternative options. Suppose a shipbuilder gets a contract to be called Contract A.

After making the correct assessment of the associated incremental costs and revenues he

arrives at an estimated profit of Rs. 25,000 from the contract. Suppose, in the meantime, two

other contracts, B and C, have been brought to his attention.

These two are expected to give a profit of Rs. 15,000 and Rs. 20,000, respectively. However, his

yard’s capacity is so limited that he can accept only one of these. So, in the absence of any other

consideration, he would accept contract A, the most profitable one.

His opportunity cost would then be Rs. 20,000, the sacrifice he must make of the profit

for the next best option. Had he chosen either B or C, his opportunity cost would have been Rs.

25,000 profit that A would have earned.

An opportunity cost has arisen here only because some essential input, the yard’s

capacity, is scarce, i.e., grossly insufficient to take up all the options that are open and desirable.

In the absence of such a constraint no such sacrifice and hence no opportunity cost would have

arisen.

We will come across various examples of opportunity cost in this title because all

business activity is carried on within constraint (‘scarcities’) which force choices and consequent

sacrifices to be made.

The following examples help in understanding the meaning of the term:

1. The opportunity cost (O.C.) of using a machine is the most profitable alternative

sacrificed by employing the machine in its present use.

2. The O.C. of buying a colour TV is the interest or profit that could be earned by

investing the purchase money.

3. The O.C. of working for oneself in one’s own factory is the salary that one could earn

in others occupations.

4. The O.C. of funds tied in one’s own business is the interest (or profits adjusted for

difference in risk) that could be earned on those funds in other ventures.

The Concept of Equi-marginal Principle:

The cornerstone of the economists’ marginal analysis is that purchases, activities, or

productive resources should be allocated so as to ensure that the marginal utilities, benefits, or

value- added accruing from each, are identical in all uses. Optimality requires that it should not

be possible to increase the total benefit or reduce the total cost by moving one unit from one

application to another.

If this equimarginal condition is violated, the system is operating below its optimum and

it is possible to gain some improvement by reallocation of inputs or purchases. The key

assumption underlying this result is the law of diminishing returns or variable proportions. For

the equimarginal principle to operate, the law of diminishing returns is held to apply.

The law implies that the marginal product will decline as more of one resource is

combined with fixed amounts of another. This proposition, in fact, holds good over a wide range

of economic activity. For example, successive applications of fertilizer tend to raise cereal yields

per acre, but increasing quantities of fertilizer are successively required to give equal output

increases.

The micro-economic theory of the demand for labour asserts that the profit: maximising

entrepreneur will continue to employ labour so long as the resulting addition to his costs is

covered by the addition to his receipts from the sale of his products.

One of the fundamental principles of economics is the proposition that in input such as

labour it should be so allocated among different activities or lines of production that the value

added by the last unit is the same in all uses. This generalisation is known as the equimarginal

principle.

Consider a simple situation where a firm has 100 units of labour at its disposal. If this

remains fixed in the short-run, the total wage bill can be determined in advance. For example, if

each worker gets Rs. 300 per month the total payroll will be Rs. 30,000 per month.

Suppose there are five different activities in the factory: A, B, C, D and E. Each activity

requires labour as an input. With limited supply of labour it is possible to expand any one of

these activities by employing more labour only by reducing the level of other activities.

Suppose when one unit of labour is added to activity A, total output increases by, say, 10

units. By selling this output in the market at a price of Rs. 5 per unit the firm makes a gain of Rs.

50. The value of this added output is called ‘the value of the marginal product (V.M.P.) of

labour’ in activity A.

In the same way, we can estimate the value of the marginal product of labour in other

activities, viz., B, C, D and E. If V.M.P. in activity A is greater than that in another activity, an

optimum has not been reached. Now it would be profitable for the firm to shift labour from low-

marginal value to high- marginal value uses.

This will surely raise the total value of all products taken together. For example, if

V.M.P. in activity A is Rs. 50 and that in activity B is Rs. 55, it will pay the firm to expand

activity B and reduce activity A. The optimum is reached when V.M.P. is the same in all the five

activities. In terms of symbol

VM PLA = VMPLB = … = VMPLE

The Contribution Concept:

The various concepts developed so far are interdependent. For example, in measuring

opportunity cost of capital we use a discount factor by following the discounting principle. The

same thing is true of the contribution concept.

Consider a simple product whose price is determined either by the market forces the

forces of demand and supply, or by some government agency like the Bureau of Costs and

Industrial Prices (Govt, of India, New Delhi). Assume this price is Rs. 93.

The total cost including allocated overheads is Rs. 105, but the incremental cost is only

Rs. 74. The loss on the item seems to be Rs. 12. So at first sight the firm may think of dropping

the product. However, if the contribution to overhead and profits is Rs. 19 = (Rs. 93 – Rs. 74),

further analysis is required before arriving at a decision.

It is not always worthwhile to retain a product simply because its contribution is positive.

If the company is having a package of orders on products (say, B, C or D) requiring the same

scarce resources per unit — production time or machine time and labour — and if these products

make larger contributions, viz., Rs. 50 or Rs. 40 or Rs. 30, there is no point in sacrificing these

larger contribution in favour of product A.

However, what is important is the comparison of contributions, not the comparison of

profits or losses based on full costs.

Suppose the only production constraint in a multi-product firm is machine-hours

available. Now we can convert the contribution per unit of output into contributions per

machine-hour. Table 1.1 illustrates such a situation in case of a company producing five

products.

At first sight product B appears to be the best. Since its contribution is the highest, it

deserves the top priority in allocation of capacity. But product B’s demand on capacity is also

maximum. By converting the contributions into contributions per hour of machine time, we get

the following results.

Now it is clear that the product E, which initially appeared to be the least profitable, is

now the largest contributor. Therefore, the principle should be almost the opposite to those that

appeared at first glance.

If there are more constraints, i.e., more than one capacity bottleneck and all products pass

through, say, four or five different processes, it will no longer be possible to compute

contributions in terms of one of the bottlenecks. We have to make use of linear programming to

reach an optimum solution (i.e., to choose an optimum product mix).

So long we assumed that demand for each product remained unchanged as also its price.

Now suppose the quantity demanded of product E increases at a lower price. Now we can

compare product E’s contribution of Rs. 2.50 at a price of Rs. 6 with its contribution of Rs. 3 at a

price of Rs. 5.50.

If sales at a higher price are 8,000 units and at the lower prices 15,000 units, the total

contribution from product E increases from Rs. 28,000 to Rs. 45,000. So, it is in the Tightness of

things to accept the lower unit contribution to obtain the higher volume, even if other higher unit

contribution products are sacrificed.

The contribution concept is often used in product- mix decisions, also in pricing

decisions. It is also applicable in make or buy decisions. Finally, in a discussion on capital

budgeting, it is usually discovered that the cash flows estimated by financial analysis are closely

related to the contribution concept.

UNIT-3

Definition of 'Law of Demand'

Definition: The law of demand states that other factors being constant (cetris peribus),

price and quantity demand of any good and service are inversely related to each other.

When the price of a product increases, the demand for the same product will fall.

Description: Law of demand explains consumer choice behavior when the price changes.

In the market, assuming other factors affecting demand being constant, when the price of

a good rises, it leads to a fall in the demand of that good. This is the natural consumer

choice behavior. This happens because a consumer hesitates to spend more for the good

with the fear of going out of cash.

The above diagram shows the demand curve which is downward sloping. Clearly when

the price of the commodity increases from price p3 to p2, then its quantity demand comes down

from Q3 to Q2 and then to Q3 and vice versa.

1. Price of the Given Commodity:

It is the most important factor affecting demand for the given commodity. Generally,

there exists an inverse relationship between price and quantity demanded. It means, as price

increases, quantity demanded falls due to decrease in the satisfaction level of consumers.

2. Price of Related Goods:

Demand for the given commodity is also affected by change in prices of the related

goods. Related goods are of two types:

(i) Substitute Goods:

Substitute goods are those goods which can be used in place of one another for

satisfaction of a particular want, like tea and coffee. An increase in the price of substitute leads to

an increase in the demand for given commodity and vice-versa. For example, if price of a

substitute good (say, coffee) increases, then demand for given commodity (say, tea) will rise as

tea will become relatively cheaper in comparison to coffee. So, demand for a given commodity is

directly affected by change in price of substitute goods.

(ii) Complementary Goods:

Complementary goods are those goods which are used together to satisfy a particular

want, like tea and sugar. An increase in the price of complementary good leads to a decrease in

the demand for given commodity and vice-versa. For example, if price of a complementary good

(say, sugar) increases, then demand for given commodity (say, tea) will fall as it will be

relatively costlier to use both the goods together. So, demand for a given commodity is inversely

affected by change in price of complementary goods.

Examples of Substitute and Complementary Goods:

Substitute Goods 1. Tea and Coffee 2. Coke and Pepsi 3. Pen and Pencil

4. CD and DVD 5. Ink pen and Ball Pen 6. Rice and Wheat

Complementary Goods:

1. Tea and Sugar 2. Pen and Ink 3. Car and Petrol

4. Bread and Butter 5. Pen and Refill 6. Brick and Cement

For detailed discussion on substitute goods and complementary goods, refer Section 3.11.

3. Income of the Consumer:

Demand for a commodity is also affected by income of the consumer. However, the

effect of change in income on demand depends on the nature of the commodity under

consideration.

i. If the given commodity is a normal good, then an increase in income leads to rise in its

demand, while a decrease in income reduces the demand.

ii. If the given commodity is an inferior good, then an increase in income reduces the demand,

while a decrease in income leads to rise in demand.

Example:

Suppose, income of a consumer increases. As a result, the consumer reduces consumption of

toned milk and increases consumption of full cream milk. In this case, ‘Toned Milk’ is an

inferior good for the consumer and ‘Full Cream Milk’ is a normal good. For detailed discussion

on normal goods and inferior goods, refer Section 3.12.

4. Tastes and Preferences:

Tastes and preferences of the consumer directly influence the demand for a commodity.

They include changes in fashion, customs, habits, etc. If a commodity is in fashion or is preferred

by the consumers, then demand for such a commodity rises. On the other hand, demand for a

commodity falls, if the consumers have no taste for that commodity.

5. Expectation of Change in the Price in Future:

If the price of a certain commodity is expected to increase in near future, then people will

buy more of that commodity than what they normally buy. There exists a direct relationship

between expectation of change in the prices in future and change in demand in the current

period. For example, if the price of petrol is expected to rise in future, its present demand will

increase.

Exceptions to the Law of Demand

1. Giffen Goods:

Giffen goods are the inferior goods whose demand increases with the increase in its

prices. There are several inferior commodities, much cheaper than the superior substitutes

often consumed by the poor households as an essential commodity. Whenever the price of

the Giffen goods increases its quantity demanded also increases because, with an increase in

the price, and the income remaining the same, the poor people cut the consumption of

superior substitute and buy more quantities of Giffen goods to meet their basic needs.

For Example,

Suppose the minimum monthly consumption of food grains by a poor household is 20 Kg

Bajra (Inferior good) and 10 Kg Rice (superior good). The selling price of Bajra is Rs 5 per kg,

and the rice is Rs 10 per kg, and the household spends its total income of Rs 200 on the purchase

of these items. Suppose, the price of Bajra rose to Rs 6 per kg then the household will be forced

to reduce the consumption of rice by 5 Kg and increase the quantity of Bajra to 25 Kg in order to

meet the minimum monthly requirement of food grains of 30 kg.

2. Veblen Goods:

Another exception to the law of demand is given by the economist Thorstein Veblen, who

proposed the concept of “Conspicuous Consumption.” According to Veblen, there are a certain

group of people who measure the utility of the commodity purely by its price, which means, they

think that higher priced goods and services derive more utility than the lesser priced

commodities.

For example, goods like a diamond, platinum, ruby, etc. are bought by the upper

echelons of the society (rich class) for whom the higher the price of these goods, the

higher is the prestige value and ultimately the higher is the utility or desirability of them.

3. Expectation of Price Change in Future:

When the consumer expects that the price of a commodity is likely to further increase in

the future, then he will buy more of it despite its increased price in order to escape himself

from the pinch of much higher price in the future.

On the other hand, if the consumer expects the price of the commodity to further fall in

the future, then he will likely postpone his purchase despite less price of the commodity

in order to avail the benefits of much lower prices in the future.

4. Ignorance:

Often people are misconceived as high-priced commodities are better than the low-priced

commodities and rest their purchase decision on such a notion. They buy those commodities

whose price are relatively higher than the substitutes.

5. Emergencies:

During emergencies such as war, natural calamity- flood, drought, earthquake, etc., the law

of demand becomes ineffective. In such situations, people often fear the shortage of the

essentials and hence demand more goods and services even at higher prices.

6. Change in fashion and Tastes & Preferences:

The change in fashion trend and tastes and preferences of the consumers negates the effect

of law of demand. The consumer tends to buy those commodities which are very much ‘in’ in the

market even at higher prices.

7. Conspicuous Necessities:

There are certain commodities which have become essentials of the modern life. These are

the goods which consumer buys irrespective of an increase in the price. For example TV,

refrigerator, automobiles, washing machines, air conditioners, etc.

8. Bandwagon Effect:

This is the most common type of exception to the law of demand wherein the consumer tries

to purchase those commodities which are bought by his friends, relatives or neighbors. Here, the

person tries to emulate the buying behavior and patterns of the group to which he belongs

irrespective of the price of the commodity.

For example, if the majority of group members have smart phones then the consumer

will also demand for the smartphone even if the prices are high.

Objectives of Demand Forecasting:

Demand forecasting constitutes an important part in making crucial business decisions.

The objectives of demand forecasting are divided into short and long-term objectives,

which are shown in Figure-1:

The objectives of demand forecasting (as shown in Figure-1) are discussed as follows:

i. Short-term Objectives:

Include the following:

a. Formulating production policy:

Helps in covering the gap between the demand and supply of the product. The demand

forecasting helps in estimating the requirement of raw material in future, so that the regular

supply of raw material can be maintained. It further helps in maximum utilization of resources as

operations are planned according to forecasts. Similarly, human resource requirements are easily

met with the help of demand forecasting.

b. Formulating price policy:

Refers to one of the most important objectives of demand forecasting. An organization

sets prices of its products according to their demand. For example, if an economy enters into

depression or recession phase, the demand for products falls. In such a case, the organization sets

low prices of its products.

c. Controlling sales:

Helps in setting sales targets, which act as a basis for evaluating sales performance. An

organization make demand forecasts for different regions and fix sales targets for each region

accordingly.

d. Arranging finance:

Implies that the financial requirements of the enterprise are estimated with the help of

demand forecasting. This helps in ensuring proper liquidity within the organization.

ii. Long-term Objectives:

Include the following:

a. Deciding the production capacity:

Implies that with the help of demand forecasting, an organization can determine the size

of the plant required for production. The size of the plant should conform to the sales

requirement of the organization.

b. Planning long-term activities:

Implies that demand forecasting helps in planning for long term. For example, if the

forecasted demand for the organization’s products is high, then it may plan to invest in various

expansion and development projects in the long term.

Factors Influencing Demand Forecasting:

Demand forecasting is a proactive process that helps in determining what products are

needed where, when, and in what quantities. There are a number of factors that affect demand

forecasting.

Some of the factors that influence demand forecasting are shown in Figure-2:

The various factors that influence demand forecasting are explained as follows:

i. Types of Goods:

Affect the demand forecasting process to a larger extent. Goods can be producer’s goods,

consumer goods, or services. Apart from this, goods can be established and new goods.

Established goods are those goods which already exist in the market, whereas new goods are

those which are yet to be introduced in the market.

Information regarding the demand, substitutes and level of competition of goods is known only

in case of established goods. On the other hand, it is difficult to forecast demand for the new

goods. Therefore, forecasting is different for different types of goods.

ii. Competition Level:

Influence the process of demand forecasting. In a highly competitive market, demand for

products also depend on the number of competitors existing in the market. Moreover, in a highly

competitive market, there is always a risk of new entrants. In such a case, demand forecasting

becomes difficult and challenging.

iii. Price of Goods:

Acts as a major factor that influences the demand forecasting process. The demand

forecasts of organizations are highly affected by change in their pricing policies. In such a

scenario, it is difficult to estimate the exact demand of products.

iv. Level of Technology:

Constitutes an important factor in obtaining reliable demand forecasts. If there is a rapid

change in technology, the existing technology or products may become obsolete. For example,

there is a high decline in the demand of floppy disks with the introduction of compact disks

(CDs) and pen drives for saving data in computer. In such a case, it is difficult to forecast

demand for existing products in future.

v. Economic Viewpoint:

Play a crucial role in obtaining demand forecasts. For example, if there is a positive

development in an economy, such as globalization and high level of investment, the demand

forecasts of organizations would also be positive.

Apart from aforementioned factors, following are some of the other important factors that

influence demand forecasting:

a. Time Period of Forecasts:

Act as a crucial factor that affect demand forecasting. The accuracy of demand

forecasting depends on its time period.

Forecasts can be of three types, which are explained as follows:

1. Short Period Forecasts:

Refer to the forecasts that are generally for one year and based upon the judgment of the

experienced staff. Short period forecasts are important for deciding the production policy, price

policy, credit policy, and distribution policy of the organization.

2. Long Period Forecasts:

Refer to the forecasts that are for a period of 5-10 years and based on scientific analysis

and statistical methods. The forecasts help in deciding about the introduction of a new product,

expansion of the business, or requirement of extra funds.

3. Very Long Period Forecasts:

Refer to the forecasts that are for a period of more than 10 years. These forecasts are

carried to determine the growth of population, development of the economy, political situation in

a country, and changes in international trade in future.

Among the aforementioned forecasts, short period forecast deals with deviation in long period

forecast. Therefore, short period forecasts are more accurate than long period forecasts.

4. Level of Forecasts:

Influences demand forecasting to a larger extent. A demand forecast can be carried at

three levels, namely, macro level, industry level, and firm level. At macro level, forecasts are

undertaken for general economic conditions, such as industrial production and allocation of

national income. At the industry level, forecasts are prepared by trade associations and based on

the statistical data.

Moreover, at the industry level, forecasts deal with products whose sales are dependent

on the specific policy of a particular industry. On the other hand, at the firm level, forecasts are

done to estimate the demand of those products whose sales depends on the specific policy of a

particular firm. A firm considers various factors, such as changes in income, consumer’s tastes

and preferences, technology, and competitive strategies, while forecasting demand for its

products.

5. Nature of Forecasts:

Constitutes an important factor that affects demand forecasting. A forecast can be

specific or general. A general forecast provides a global picture of business environment, while a

specific forecast provides an insight into the business environment in which an organization

operates. Generally, organizations opt for both the forecasts together because over-generalization

restricts accurate estimation of demand and too specific information provides an inadequate basis

for planning and execution.

Steps of Demand Forecasting:

The Demand forecasting process of an organization can be effective only when it is

conducted systematically and scientifically.

It involves a number of steps, which are shown in Figure-3:

The steps involved in demand forecasting (as shown in Figure-3) are explained as follows:

1. Setting the Objective:

Refers to first and foremost step of the demand forecasting process. An organization

needs to clearly state the purpose of demand forecasting before initiating it.

Setting objective of demand forecasting involves the following:

Deciding the time period of forecasting whether an organization should opt for short-term

forecasting or long-term forecasting

Deciding whether to forecast the overall demand for a product in the market or only- for

the organizations own products

Deciding whether to forecast the demand for the whole market or for the segment of the

market

Deciding whether to forecast the market share of the organization

2. Determining Time Period:

Involves deciding the time perspective for demand forecasting. Demand can be

forecasted for a long period or short period. In the short run, determinants of demand may not

change significantly or may remain constant, whereas in the long run, there is a significant

change in the determinants of demand. Therefore, an organization determines the time period on

the basis of its set objectives.

3. Selecting a Method for Demand Forecasting:

Constitutes one of the most important steps of the demand forecasting process Demand

can be forecasted by using various methods. The method of demand forecasting differs from

organization to organization depending on the purpose of forecasting, time frame, and data

requirement and its availability. Selecting the suitable method is necessary for saving time and

cost and ensuring the reliability of the data.

4. Collecting Data:

Requires gathering primary or secondary data. Primary’ data refers to the data that is

collected by researchers through observation, interviews, and questionnaires for a particular

research. On the other hand, secondary data refers to the data that is collected in the past; but can

be utilized in the present scenario/research work.

5. Estimating Results:

Involves making an estimate of the forecasted demand for predetermined years. The

results should be easily interpreted and presented in a usable form. The results should be easy to

understand by the readers or management of the organization.

The criteria of a good demand forecasting method in economics:

1. Accuracy:

Accuracy denotes near to actual demand. A firm should forecast its demand very close to

the actual market demand so that required quantities could be made available for the market.

Inaccurate forecast may cost huge to the firm. It may create over or under production. Forecast

should be explicit. For example, there would be an increase in sales in the next year than the

current is not a good forecast but there would be an increase in sales by 20% in the next year is

an accurate forecast.

2. Longevity or Durability:

Demand forecast generally takes huge time, money and planning. Since a forecast takes

a lot of time and money, it should be usable for longer span of time or multiple years. A forecast

for short span of time may not be effective for the organization.

3. Flexibility or Scale-ability

A demand forecast should be flexible and adaptable to any kind of changes. Now a days

there is a rapid change in the tastes and preferences of consumers. This affects the demand for

different products up to a great extent. Therefore, the demand forecasts made by a firm should

be able to reflect those changes accordingly. Apart from this, a business firm, while making

forecasts, should consider various business risks that may take place in the future.

4. Acceptability and Simplicity:

Acceptability is one of the most important criterion of a good demand forecasting

method. That means a forecast should be acceptable to all. It should also be as simple as

possible. A business firm should forecast its market demand by using simple and easy methods

so that the organizations do not face any complexities. However, some companies generally

prefer advanced statistical methods, which may prove difficult and complex.

5. Availability:

A good a good demand forecasting method should have adequate and up-to-date data

available. The forecasts should be done in timely manner so that necessary arrangements could

be made related to the market demand. Data should be available to the decision makers at all

time.

6. Plausibility and Possibility:

It denotes that the demand forecasts should be reasonable, so that they are easily

understood by individuals who will use it. Again, it should have the quality of application in the

changing business conditions.

7. Economy:

A good demand forecasting method should have a relationship with costs and benefits.

It should be economically effective. The forecasting should be made in such a way that the costs

do not exceed the benefits that will be derived from it. Costs should be less and benefits should

be high.

8. Yielding quick results:

A good demand forecasting method should yield quick result rather than taking longer

period to respond. It should match with the changing business environment.

9) Maintenance of timeliness:

It should take care of timelines. Data should be available to users as and when requires so

that decision making does not hamper.

Unit-4

Pricing Meaning:

Pricing is the method of determining the value, a producer will get in the exchange of

goods and services.It usually depends upon the firms average costs, and on the customers

perceived value of the product.

Objectives of Pricing:

Five main objectives of pricing are:

Achieving a Target Return on Investments

Price Stability

(iii) Achieving Market Share

(iv) Prevention of Competition and

(v) Increased Profits

Before determining the price of the product, targets of pricing should be clearly stated.

Objectives of a properly planned pricing policy should be logically related to overall managerial

goals.

(i) Achieving a Target Return on Investments:

This is the most important objective which every concern wants to achieve. The objective

is to achieve a certain rate of return on investments and frame the pricing policy in order to

achieve that rate. For example, the concern may have a set target of 20% return on investment

and 10% return on investments after taxes. The targets may be a short term (usually for a year) or

a long term. It is advisable to have a long term target.

Sometimes, it is observed that the actual profit rates may be more than the target return. This is

because the targets already fixed are low and new opportunities and demand of the product

exceeding the return rate already fixed.

(ii) Price Stability:

This is another important objective of an enterprise. Stability of prices over a period

reflects the efficiency of a concern. But in practice, on account of changing costs from time to

time, price stability cannot be achieved. In the market where there are few sellers, every seller

wants to maintain stability in prices. Price is set by one producer and others follow him. He acts

as a leader in price fixation.

(iii) Achieving Market Share:

Market share refers to the share of the company in the total sales of the product in the

market. Some of the concerns when introduce their product in the competitive market want to

achieve a certain share in the market in the initial stages. In the long run the concern may aim at

achieving a sizeable portion of the market by selling its products at lower prices.

The main objective of achieving larger share in the market is to enjoy more reputation

and goodwill among the people. The other consideration of widening the markets by lowering

prices is to eliminate competitors from the market.

It has been observed that companies may not like to increase the size of their share on

account of fear of Govt, intervention and control. General Motors, America, capturing about

50% of the automobile market, passed through this situation. Some companies like General

Electric and Johns-Mauville preferred to have relatively small market say 20% rather than 50%.

(iv) Prevention of Competition:

Modern industrial set up is confronted with cut throat competition. Pricing can be used as

one of the effective means to fight against the competition and business rivalries. Lesser prices

are charged by some firms to keep their competitors out of the market. But a firm cannot afford

to charge fewer prices over a long period of time.

(v) Increased Profits:

Maximisation of profits is one of the main objectives of a business enterprise. A firm can

adopt such a price policy which ensures larger profits. However, such enterprises are also

expected to discharge certain social obligations also.

Methods of Pricing: Cost-Oriented Method and Market-Oriented Method

The two methods of pricing are as follows: A. Cost-oriented Method B. Market-oriented

Methods.

There are several methods of pricing products in the market. While selecting the method

of fixing prices, a marketer must consider the factors affecting pricing. The pricing methods can

be broadly divided into two groups—cost-oriented method and market-oriented method.

A. Cost-oriented Method:

Because cost provides the base for a possible price range, some firms may consider cost-

oriented methods to fix the price.

Cost-oriented methods or pricing are as follows:

1. Cost plus pricing:

Cost plus pricing involves adding a certain percentage to cost in order to fix the price. For

instance, if the cost of a product is Rs. 200 per unit and the marketer expects 10 per cent profit on

costs, then the selling price will be Rs. 220. The difference between the selling price and the cost

is the profit. This method is simpler as marketers can easily determine the costs and add a certain

percentage to arrive at the selling price.

2. Mark-up pricing:

Mark-up pricing is a variation of cost pricing. In this case, mark-ups are calculated as a

percentage of the selling price and not as a percentage of the cost price. Firms that use cost-

oriented methods use mark-up pricing.

Since only the cost and the desired percentage markup on the selling price are known, the

following formula is used to determine the selling price:

Average unit cost/Selling price

3. Break-even pricing:

In this case, the firm determines the level of sales needed to cover all the relevant fixed

and variable costs. The break-even price is the price at which the sales revenue is equal to the

cost of goods sold. In other words, there is neither profit nor loss.

For instance, if the fixed cost is Rs. 2, 00,000, the variable cost per unit is Rs. 10, and the

selling price is Rs. 15, then the firm needs to sell 40,000 units to break even. Therefore, the firm

will plan to sell more than 40,000 units to make a profit. If the firm is not in a position to sell

40,000 limits, then it has to increase the selling price.

The following formula is used to calculate the break-even point:

Contribution = Selling price – Variable cost per unit

4. Target return pricing:

In this case, the firm sets prices in order to achieve a particular level of return on

investment (ROI).

The target return price can be calculated by the following formula:

Target return price = Total costs + (Desired % ROI investment)/ Total sales in units

For instance, if the total investment is Rs. 10,000, the desired ROI is 20 per cent, the total

cost is Rs.5000, and total sales expected are 1,000 units, then the target return price will be

Rs. 7 per unit as shown below:

5000 + (20% X 10,000)/ 7000

Target return price = 7

The limitation of this method (like other cost-oriented methods) is that prices are derived

from costs without considering market factors such as competition, demand and consumers’

perceived value. However, this method helps to ensure that prices exceed all costs and therefore

contribute to profit.

5. Early cash recovery pricing:

Some firms may fix a price to realize early recovery of investment involved, when

market forecasts suggest that the life of the market is likely to be short, such as in the case of

fashion-related products or technology-sensitive products.

Such pricing can also be used when a firm anticipates that a large firm may enter the

market in the near future with its lower prices, forcing existing firms to exit. In such situations,

firms may fix a price level, which would maximize short-term revenues and reduce the firm’s

medium-term risk.

B. Market-oriented Methods:

1. Perceived value pricing:

A good number of firms fix the price of their goods and services on the basis of

customers’ perceived value. They consider customers’ perceived value as the primary factor for

fixing prices, and the firm’s costs as the secondary.

The customers’ perception can be influenced by several factors, such as advertising, sales

on techniques, effective sales force and after-sale-service staff. If customers perceive a higher

value, then the price fixed will be high and vice versa. Market research is needed to establish the

customers’ perceived value as a guide to effective pricing.

2. Going-rate pricing:

In this case, the benchmark for setting prices is the price set by major competitors. If a

major competitor changes its price, then the smaller firms may also change their price,

irrespective of their costs or demand.

The going-rate pricing can be further divided into three sub-methods:

a. Competitors ‘parity method:

A firm may set the same price as that of the major competitor.

b. Premium pricing:

A firm may charge a little higher if its products have some additional special features as

compared to major competitors.

c. Discount pricing:

A firm may charge a little lower price if its products lack certain features as compared to

major competitors.

The going-rate method is very popular because it tends to reduce the likelihood of price

wars emerging in the market. It also reflects the industry’s coactive wisdom relating to the price

that would generate a fair return.

3. Sealed-bid pricing:

This pricing is adopted in the case of large orders or contracts, especially those of

industrial buyers or government departments. The firms submit sealed bids for jobs in response

to an advertisement.

In this case, the buyer expects the lowest possible price and the seller is expected to

provide the best possible quotation or tender. If a firm wants to win a contract, then it has to

submit a lower price bid. For this purpose, the firm has to anticipate the pricing policy of the

competitors and decide the price offer.

4. Differentiated pricing:

Firms may charge different prices for the same product or service.

The following are some the types of differentiated pricing:

a. Customer segment pricing:

Here different customer groups are charged different prices for the same product or

service depending on the size of the order, payment terms, and so on.

b. Time pricing:

Here different prices are charged for the same product or service at different timings or

season. It includes off-peak pricing, where low prices are charged during low-demand tunings or

season.

c. Area pricing:

Here different prices are charged for the same product in different market areas. For

instance, a firm may charge a lower price in a new market to attract customers.

d. Product form pricing:

Here different versions of the product are priced differently but not proportionately to

their respective costs. For instance, soft drinks of 200,300, 500 ml, etc., are priced according to

this strategy.

UNIT-V

Process of Profit Planning and Control

Profit is considered as a significant element of a business activity. According to Peter

Drucker, “profit is a condition of survival.

It is the cost of the future, the cost of staying in a business.” Thus, profit should be

planned and managed properly.

An organization should plan profits by taking into consideration its capabilities and

resources. Profit planning lays foundation for the future income statement of the organization.

The profit planning process begins with the forecasting of Les and estimating the desired level of

profit taking in view the market conditions.

The steps involved in Profit Planning Process

1. Establishing profit goals:

Implies that profit goals should be set in alignment with the strategic plans of the

organization. Moreover, the profit goals of an organization should be realistic in nature based on

the capabilities and resources of the organization.

2. Determining expected sales volume:

Constitutes the most important step of the profit planning process. An organization needs

to forecast its sales volume so that it can achieve its profit goals. The sales volume can be

anticipated by taking into account the market and industry trends and performing competitive

analysis.

3. Estimating expenses:

Requires that an organization needs to estimate its expenses for the planned sales volume.

Expenses can be determined from the past data. If an organization is new, then the data of similar

organization in same industry can be taken. The expense forecasts should be adjusted to the

economic conditions of the country.

4. Determining profit:

Helps in estimating the exact value of sales.

It is calculated as:

Estimated Profit = Projected Sales Income – Expected Expenses

After planning profit successfully, an organization needs to control profit. Profit control

involves measuring the gap between the estimated level and actual level of profit achieved by an

organization. If there is any deviation, the necessary actions are taken by the organization.

Profit control involves two steps, which are as follows:

1. Comparing estimates with the goal:

Involves comparing the estimated profit with the expected profit. If there is a large gap

between the estimated profits and the expected profits, the measures should be taken.

2. Using alternatives to achieve the desired profit:

Includes the following:

Making changes in planned sales volume by increasing sales promotion,

improving product quality, providing better service, and providing after sales

support to customers.

Reducing planned expenses by minimizing losses, implementing better control

systems, improving product quality, and increasing the productivity of human

resource and machines.

Break Even Analysis:

The break-even point (BEP) or break-even level represents the sales amount—in either

unit (quantity) or revenue (sales) terms—that is required to cover total costs, consisting of both

fixed and variable costs to the company. Total profit at the break-even point is zero. It is only

possible for a firm to pass the break-even point if the dollar value of sales is higher than the

variable cost per unit. This means that the selling price of the good must be higher than what the

company paid for the good or its components for them to cover the initial price they paid

(variable costs). Once they surpass the break-even price, the company can start making a profit.

The break-even point is one of the most commonly used concepts of financial analysis,

and is not only limited to economic use, but can also be used by entrepreneurs, accountants,

financial planners, managers and even marketers. Break-even points can be useful to all avenues

of a business, as it allows employees to identify required outputs and work towards meeting

these.

The break-even value is not a generic value and will vary dependent on the individual

business. Some businesses may have a higher or lower break-even point. However, it is

important that each business develop a break-even point calculation, as this will enable them to

see the number of units they need to sell to cover their variable costs. Each sale will also make a

contribution to the payment of fixed costs as well.

For example, a business that sells tables needs to make annual sales of 200 tables to

break-even. At present the company is selling fewer than 200 tables and is therefore operating at

a loss. As a business, they must consider increasing the number of tables they sell annually in

order to make enough money to pay fixed and variable costs.

If the business does not think that they can sell the required number of units, they could

consider the following options:

Reduce the fixed costs. This could be done through a number or negotiations, such as

reductions in rent payments, or through better management of bills or other costs.

Reduce the variable costs, (which could be done by finding a new supplier that sells

tables for less).

Either option can reduce the break-even point so the business need not sell as many tables

as before, and could still pay fixed costs.

Three assumptions of the break-even analysis

The break-even analysis depends on three key assumptions:

1. Average per-unit sales price (per-unit revenue):

This is the price that you receive per unit of sales. Take into account sales discounts and

special offers. Get this number from your sales forecast.

For non-unit based businesses, make the per-unit revenue one dollar and enter your costs

as a percent of a dollar. The most common questions about this input relate to averaging many

different products into a single estimate.

The analysis requires a single number, and if you build your sales forecast first, then you

will have this number. You are not alone in this, the vast majority of businesses sell more than

one item, and have to average for their break-even analysis.

2. Average per-unit cost:

This is the incremental cost, or variable cost, of each unit of sales. If you buy goods for

resale, this is what you paid, on average, for the goods you sell. If you sell a service, this is what

it costs you, per dollar of revenue or unit of service delivered, to deliver that service.

If you are using a units-based sales forecast table (for manufacturing and mixed business types),

you can project unit costs from the sales forecast table. If you are using the basic sales forecast

table for retail, service and distribution businesses, use a percentage estimate, e.g., a retail store

running a 50 percent margin would have a per-unit cost of .5, and a per-unit revenue of 1.

3. Monthly fixed costs:

Technically, a break-even analysis defines fixed costs as costs that would continue even

if you went broke. Instead, we recommend that you use your regular running fixed costs,

including payroll and normal expenses (total monthly operating expenses). This will give you a

better insight on financial realities.

If averaging and estimating is difficult, use your profit and loss table to calculate a

working fixed cost estimate—it will be a rough estimate, but it will provide a useful input for a

conservative break-even analysis.

Top 10 Managerial Uses of Break-Even Analysis

The following points highlight the top ten managerial uses of break-even analysis. the

managerial uses are:

Safety Margin

Target Profit

Change in Price

Change in Costs

Decision on Choice of Technique of Production

Make or Buy Decision

Plant Expansion Decisions

Plant Shut Down Decisions

Advertising and Promotion Mix Decisions

Decision Regarding Addition or Deletion of Product Line.

1. Safety Margin:

The break-even chart helps the management to know at a glance the profits generated at

the various levels of sales. The safety margin refers to the extent to which the firm can afford a

decline before it starts incurring losses.

The formula to determine the sales safety margin is:

Safety Margin = (Sales – BEP)/Sales x 100

From the numerical example at the level of250 units of output and sales, the firm is

earning profit, the safety margin can be found out by applying the formula

Safety Margin = 250 – 150/250 x 100 = 40%

This means that the firm which is now selling 250 units of the product can afford to

decline sales upto 40 per cent. The margin of safety may be negative as well, if the firm is

incurring any loss. In that case, the percentage tells the extent of sales that should be increased in

order to reach the point where there will be no loss.

2. Target Profit:

The break-even analysis can be utilised for the purpose of calculating the volume of sales

necessary to achieve a target profit.

When a firm has some target profit, this analysis will help in finding out the extent

of increase in sales by using the following formula:

Target Sales Volume = Fixed Cost + Target Profit/Contribution Margin Per Unit.

By way of illustration, we can take Table 1 given above. Suppose the firm fixes the profit

as Rs. 100, then the volume of output and sales should be 250 units. Only at this level, it gets a

profit of Rs. 100. By using the formula, the same result will be obtained.

3. Change in Price:

The management is often faced with a problem of whether to reduce prices or not. Before

taking a decision on this question, the management will have to consider a profit. A reduction in

price leads to a reduction in the contribution margin.

This means that the volume of sales will have to be increased even to maintain the

previous level of profit. The higher the reduction in the contribution margin, the higher is the

increase in sales needed to ensure the previous profit.

The formula for determining the new volume of sales to maintain the same profit, given a

reduction in price, will be

New Sales Volume = Total Fixed Cost + Total Profit/New Selling Price –

Average Variable Cost

For example, suppose a firm has a fixed cost of Rs. 8,000 and the profit target is

Rs.20,000. If the sales price is Rs.8 and the average variable cost is Rs. 4, then the total volume

of sales should be 7,000 units on the basis of the formula given under target price.

Suppose the firm decides to reduce the selling price from Rs.8 to Rs. 7, then the new

sales volume should be on the basis of the above formula:

New Sales Volume = 8,000 + 20,000/7-4.

= Rs. 9,330

From this, we can infer that by reducing the price from Rs. 8 to Rs. 7, the firm has to

increase the sales from Rs. 7,000 to Rs 9,330 if it wants to maintain the target profit of Rs.

20,000. In the same way, the sales executive can calculate the new volume of sales if it increases

the price.

4. Change in Costs:

When costs undergo change, the selling price and the quantity produced and sold also

undergo changes.

Changes in cost can be in two ways:

Change in variable cost, and

Change in fixed cost.

(i) Variable Cost Change:

An increase in variable costs leads to a reduction in the contribution margin. This

reduction in the contribution margin will shift the break-even point downward. Conversely, with

the fall in the proportion of variable costs, contribution margins increase and break-even point

moves upwards.

Under conditions of changing variable costs, the formula to determine the new quantity or

the new selling price are:

(a) New Quantity or Sales Volume = Contribution to Margin/Present Selling Price – New

Variable Cost Per Unit

(b) New Selling Price = Present Sale Price + New Variable Cost-Present Variable Cost

Example:

The contribution margin is Rs. 64,000, the present sale price is Rs.10 and the present

variable cost is Rs.6. If the variable cost per unit goes up from Rs.6 to Rs. 7, what will be the

new sales volume and price?

New Sales Volume = 64,000 /10-7 = 64,000 /3 = 21,300 units

New Sales Price = (10+7-6) = Rs.11.

(ii) Fixed Cost Change:

An increase in fixed cost of a firm may be caused either due to a tax on assets or due to

an increase in remuneration of management, etc. It will increase the contribution margin and thus

push the break-even point upwards. Again to maintain the earlier level of profits, a new level of

sales volume or new price has to be found out.

New Sales Volume = Present Sale Volume + (New Fixed Cost + Present Fixed

Costs)/(Present Selling Price-Present Variable Cost)

New Sale Price = Present Sale Price + (New Fixed Costs – Present Fixed Costs)/Present

Sale Volume

Example:

The fixed cost of a firm increases from Rs. 5,000 to Rs. 6,000. The variable cost is Rs. 5

and the sale price is Rs. 10 and the firm sells 1,000 units of the product

New Sales Volume = 1,000 + 6,000 – 5,000/10-5=1,000+1,000/5 = 1,000+200 = 1,200 units

New Sale Price =10 + 6,000-5,000/1,000 = 10 + 1,000/1,000 = Rs.10 + Re 1

= Rs. 11

5. Decision on Choice of Technique of Production:

A firm has to decide about the most economical production process both at the planning

and expansion stages. There are many techniques available to produce a product. These

techniques will differ in terms of capacity and costs.

The breakeven analysis is the most simple and helpful in the case of decision on a choice

of technique of production. For example, for low levels of output, some conventional methods

may be most probable as they require minimum fixed cost.

For high levels of output, only automatic machines may be most profitable. By showing

the cost of different alternative techniques at different levels of output, the break-even analysis

helps the decision of the choice among these techniques.

6. Make or Buy Decision:

Firms often have the option of making certain components or for purchasing them from

outside the concern. Break-even analysis can enable the firm to decide whether to make or buy.

Example:

A manufacturer of car buys a certain components at Rs. 20 each. In case he makes it

himself, his fixed and variable cost would be Rs. 24,000 and Rs.8 per component respectively.

BEP = Fixed Cost/Purchase Price – Variable Cost

=24,000/20-8 = 24,000/12 = 2,000 units

From this, we can infer that the manufacturer can produce the parts himself if he needs

more than 2,000 units per year.

However, certain considerations need to be taken account of in a buying decision, such as:

(i) Is the required quality of the product available?

(ii) Is the supply from the market certain and timely?

(iii) Do the supplies of the components try to take any monopoly advantage?

7. Plant Expansion Decisions:

The break-even analysis may be adopted to reveal the effect of an actual or proposed

change in operation condition. This may be illustrated by showing the impact of a proposed plant

on expansion on costs, volume and profits. Through the break-even analysis, it would be possible

to examine the various implications of this proposal.

Example:

A company has the capacity to produce goods worth of Rs. 40 crores a year. For this, it

has incurred a fixed cost of Rs. 20 crores, the variable costs being 60% of the sales revenue.

Now the company is planning to incur an additional Rs. 6 crores in fixed costs to expand

its production capacity from Rs. 40 crores to Rs.60 crores. The survey shows that the firm’s sales

can be increased from Rs. 40 crores to Rs. 50 crores. Should the firm go in for expansion?

BEP at present capacity = Fixed Cost/Margin Contribution %

= Rs. 10 crores/40% = Rs. 25 Crores

BEP at the proposed capacity = Rs. 16 crores/40% = Rs. 40 Crores

Increase in break-even point = Rs 40 crores-Rs. 25 crores

= Rs. 15 crores.

Thus we can infer that the firm should go in for expansion only if its sales expand by

more than Rs. 15 crores from its earlier level of Rs. 40 crores.

8. Plant Shut Down Decisions:

In the shut-down decisions, a distinction should be made between out of pocket and sunk

costs. Out of pocket costs include all the variable costs plus the fixed cost which do not vary with

output. Sunk fixed costs are the expenditures previously made but from which benefits still

remain to be obtained e.g., depreciation.

9. Advertising and Promotion Mix Decisions:

The main objective of advertisement is to stimulate or increase sales to all customers—

former, present and future. If there is keen competition, the firm has to undertake vigorous

campaign of advertisement. The management has to examine those marketing activities that

stimulate consumer purchasing and dealer effectiveness.

The break-even point concept helps the management to know about the circumstances. It

enables him not only to take appropriate decision but by showing how these additional fixed cost

would influence BEPs. The advertisement cost pushes up the total cost curve by the amount of

advertisement expenditure.

10. Decision Regarding Addition or Deletion of Product Line:

If a product has outlived its utility in the market immediately, the production must be

abandoned by the management and examined what would be its consequent effect on revenue

and cost. Alternatively, the management may like to add a product to its existing product line

because it expects the product as a potential profit spinner. The break-even analysis helps in such

a decision.

Uses of Break-Even Analysis:

It helps in the determination of selling price which will give the desired profits.

It helps in the fixation of sales volume to cover a given return on capital employed.

It helps in forecasting costs and profit as a result of change in volume.

It gives suggestions for shift in sales mix.

It helps in making inter-firm comparison of profitability.

It helps in determination of costs and revenue at various levels of output.

It is an aid in management decision-making (e.g., make or buy, introducing a product

etc.), forecasting, long-term planning and maintaining profitability.

It reveals business strength and profit earning capacity of a concern without much

difficulty and effort.

Limitations of Break-Even Analysis:

1. Break-even analysis is based on the assumption that all costs and expenses can be

clearly separated into fixed and variable components. In practice, however, it may not be

possible to achieve a clear-cut division of costs into fixed and variable types.

2. It assumes that fixed costs remain constant at all levels of activity. It should be noted

that fixed costs tend to vary beyond a certain level of activity.

3. It assumes that variable costs vary proportionately with the volume of output. In

practice, they move, no doubt, in sympathy with volume of output, but not necessarily in direct

proportions..

4. The assumption that selling price remains unchanged gives a straight revenue line

which may not be true. Selling price of a product depends upon certain factors like market

demand and supply, competition etc., so it, too, hardly remains constant.

5. The assumption that only one product is produced or that product mix will remain

unchanged is difficult to find in practice.

6. Apportionment of fixed cost over a variety of products poses a problem.

7. It assumes that the business conditions may not change which is not true.

8. It assumes that production and sales quantities are equal and there will be no change in

opening and closing stock of finished product, these do not hold good in practice.

9. The break-even analysis does not take into consideration the amount of capital

employed in the business. In fact, capital employed is an important determinant of the

profitability of a concern.

Profit forecasting means projection of future earnings after considering all the factors affecting

the size of business profits, such as firm’s pricing policies, costing policies, depreciation policy,

and so on. A thorough study including a proper estimation of both economic as well as non-

economic variables may be necessary for a firm to project its sales volume, costs and

subsequently the profits in future.

Approaches to Profit Forecasting in Managerial Economics

According to Joel Dean, a famous economist, there are three approaches to profit forecasting,

which are as follows:

Spot Projection: Spot projection includes projecting the profit and loss statement of a

business firm for a specified future period. Projecting of profit land loss statement means

forecasting each important element separately. Forecasts are made about sales volume,

prices and costs of producing the expected sales. The prediction of profits of a firm is

subject to wide margins of error, from forecasting revenues to the inter-relation of the

various components of the income statement.

Break-Even Analysis: It helps in identifying functional relations of both revenues and

costs to output rate, keeping in consideration the way in which output is related to

the profits. It also helps in doing so by relating profits to output directly by the usual data

used in break-even analysis.

Environmental Analysis: It helps in relating the company’s profits to key variable, in

the economic environment such as the general business activity and the general price

level. These variables are not considered by a business firm.

All those factors that control profits move in regular and related patterns such as the rate of

output, prices, wages, material costs and efficiency, which are all inter-related by their

connections with the national markets and also by their interactions in business activity. Theories

of business cycles are based on the hypothesis, which is shown by the national values of

production, employment, wages and prices during any fluctuation in business activities. There is

no clear pattern in detailed analysis. These patterns helps in increasing the possibility that

the profits of a business firm, can be forecast directly by finding a relation to key variables. The

need is to find a direct functional relation between profits of a business firm and activities at

national level that shows statistical significance.