Management

Management is the science and art of getting things done through people in formally
organized groups. It is necessary that every organization is well managed to enable it to achieve
its desired goals. Management includes a number of functions planning, organizing, staffing,
directing, and controlling. The manager, while directing the efforts of his staff, communicates to
them the goals, objectives, polices, and procedures, coordinates their efforts, motivates them to
sustain their enthusiasm, and leads them to achieve the corporate goals.

Economics

Economics is the science of making decisions in the presence of scarce resources.

Resources are simply anything used to produce a good or service to achieve a goal. Economic
decisions involve the allocation of scarce resources so as to best meet the managerial goal. The
nature of managerial decision varies depending on the goals of the manager.

Economics is a study of human activity both at individual and national level. The
economists of early age treated economics merely as the science of wealth. The reason for this
is clear. Every one of us in involved in efforts aimed at earning money and spending this money
to satisfy our wants such as food, Clothing, shelter, and others. Such activities of earning and
spending money are called “Economic activities”.

According to Adam Smith

“Economics as the study of nature and uses of national wealth”

According to Dr. Alfred Marshall

“Economics is a study of man’s actions in the ordinary business of life: it enquires how he gets
his income and how he uses it”.

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 UNIT-I
INTRODUCTION TO MANAGERIAL ECONOMICS

Managerial economics is the study of how scarce resources are directed most
efficiently to achieve managerial goals. It is a valuable tool for analyzing business situations to
take better decisions.

Managerial Economics refers to the firm’s decision making process. It could be also
interpreted as “Economics of Management”. Managerial Economics is also called as “Industrial
Economics” or “Business Economics”.

Managerial Economics bridges the gap between traditional economics theory and real
business practices in two days. First it provides a number of tools and techniques to enable the
manager to become more competent to take decisions in real and practical situations. Secondly
it serves as an integrating course to show the interaction between various areas in which the
firm operates

Definition:

According to the Spencer and Siegelman

“Managerial Economics is the integration of economic theory with business practice for
the purpose of facilitating decision making and forward planning by management”.

According to the Pappas

“the application of economic theory and methodology to business administration
practice”

Nature of Managerial Economics

(a) Close to microeconomics: Managerial economics is concerned with finding the solutions
for different managerial problems of a particular firm. Thus, it is more close to
microeconomics.
(b) Operates against the backdrop of macroeconomics: The macroeconomics conditions of
the economy are also seen as limiting factors for the firm to operate. In other words, the
managerial economist has to be aware of the limits set by the macroeconomics conditions
such as government industrial policy, inflation and so on.
(c) Normative statements: A normative statement usually includes or implies the words
‘ought’ or ‘should’. They reflect people’s moral attitudes and are expressions of what a
team of people ought to do. For instance, it deals with statements such as ‘Government of
India should open up the economy. Such statement are based on value judgments and

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 express views of what is ‘good’ or ‘bad’, ‘right’ or ‘ wrong’. One problem with normative
statements is that they cannot to verify by looking at the facts, because they mostly deal
with the future. Disagreements about such statements are usually settled by voting on
them.
(d) Prescriptive actions: Prescriptive action is goal oriented. Given a problem and the
objectives of the firm, it suggests the course of action from the available alternatives for
optimal solution. If does not merely mention the concept, it also explains whether the
concept can be applied in a given context on not. For instance, the fact that variable costs
are marginal costs can be used to judge the feasibility of an export order.
(e) Applied in nature: ‘Models’ are built to reflect the real life complex business situations
and these models are of immense help to managers for decision-making. The different
areas where models are extensively used include inventory control, optimization, project
management etc. In managerial economics, we also employ case study methods to
conceptualize the problem, identify that alternative and determine the best course of
action.
(f) Offers scope to evaluate each alternative: Managerial economics provides an
opportunity to evaluate each alternative in terms of its costs and revenue. The managerial
economist can decide which is the better alternative to maximize the profits for the firm.
(g) Interdisciplinary: The contents, tools and techniques of managerial economics are drawn
from different subjects such as economics, management, mathematics, statistics,
accountancy, psychology, organizational behavior, sociology and etc.
(h) Assumptions and limitations: Every concept and theory of managerial economics is
based on certain assumption and as such their validity is not universal. Where there is
change in assumptions, the theory may not hold good at all.

SCOPE OF MANAGERIAL ECONOMICS

The main focus in managerial economics is to find an optimal solution to a given

managerial problem, the problem may related to production, reduction or control of cost,
determination of price of a given product or service, make or decisions, inventory decisions,
capital management or profit planning and management, investment decisions or human
resource management. While all these are the problems, the managerial economics makes use of
the concepts, tools and techniques of economics and other related discipline to find an optimal
solution to a given managerial problem.

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 applied for

to

Demand Analysis

Demand

Demand means the ability and willingness to buy a specific quantity of a commodity at
the prevailing price in a given period of time. Therefore, demand for a commodity implies the
desire to acquire it, willingness and the ability to pay for it.

Demand in common parlance means the desire for an object. But in economics demand
is something more than this. According to Stonier and Hague, “Demand in economics means
demand backed up by enough money to pay for the goods demanded”. This means that the
demand becomes effective only it if is backed by the purchasing power in addition to this there
must be willingness to buy a commodity.

Every want supported by the willingness and ability to but constitutes demand for a
particular product or services. In other words, if I want a car and I cannot pay for it, there is no
demand for the car from my side

A product or services is said to have demand when three conditions are satisfied:
 Desire on the part of the buyer to buy
 Willingness to pay for it
 Ability to pay the specified price for it.

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Demand Determinants
1. Price of the product:

Demand for a product is inversely related to its price. In other words, if price
rises, the demand falls and vice versa. This is the price demand function showing the
price effect o demand.

2. Income of the consumer:

As the income of the consumer or the household increases, there is tendency to

but more and more up to a particular limit. The demand for product x is directly related
to the income of the consumer.

3. Prices of substitutes or complementary :

The demand for product x is determined by the price of its related products:
substitutes or complementary. If there is an increase in the price of a substitute, the
demand for product x will go up and vice versa. Similar, if the price of complementary
goods ( to product x) goes up, the demand for product x will fall.

4. Tastes and preferences:

If the tastes and preferences of the consumers changes, then there is change in
the product demanded also. Most of the companies keep changing their products and
services, as and when the customer’s tastes and preferences change. In some case the
companies take advantage of technological changes and upgrade their product and
services. Such changes in the technology can be advantageously used to meet the
specific requirements of the customers, thus they try to change the tastes and preferences
of the consumers through public awareness campaigns, advertisements in the media.

Demand function

Demand function is a mathematical expression of relation between the quantity

demanded and its determinants. It can be expressed as follows

QD = F( P, I, Psc, T,EP,EI, A)
Where
Qd = quantity demand
F = functional relational between input
P = price of the product
I = income of the consumer
Psc= price of substituted or complementary
T = taste and preference
EP= expected price in future
EI= expected income in future
A = advertisement

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DEMAND NATURE AND TYPES

1. Consumer goods: consumer goods refers to such products and services which are
capable of satisfying human need.
2. producer goods, also called intermediate goods, in economics, goods manufactured
and used in further manufacturing, processing, or resale. Producer goods either
become part of the final product or lose their distinct identity in the manufacturing
stream.
3. derived demand: refers to demand for goods which are needed for further production;
it is the demand for producers’ goods like industrial raw materials, machine tools and
equipments.
4. Autonomous demand: independent of the other product or main product. it’s not
linked or tie-up with the other goods or commodity.eg: food artical, cloths.
5. Durable goods : A category of consumer goods, durables are products that do not have
to be purchased frequently. Some examples of durables are appliances, home and
office furnishings, lawn and garden equipment, consumer electronics, toy makers, small
tool manufacturers, sporting goods, photographic equipment, and jewelry.
6. Perishable goods: the life of perishable goods is very less, may be in hours or days. For
example milk, vegetables, fish and rice
7. Short –run demand : In economics, it is the concept that within a certain period of
time, in the future, at least one input is fixed while others are variable. The short run is
not a definite period of time, but rather varies based on the length of the firm's
contracts. For example, a firm may have entered into lease contracts which fix the
amount of rent over the next month, year or several years.
8. Long run demand: A period of time in which all factors of production and costs are
variable. In the long run, firms are able to adjust all costs, whereas in the short run
firms are only able to influence prices through adjustments made to production levels.
Additionally, whereas firms may be a monopoly in the short-term they may expect
competition in the long-term.

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Law of Demand
Law of demand states the relationship between price and quantity demanded. As per the
law when price is increased demand will decrease, and similarly, when price is decrease demand
will increase, this law assumed that, other things remaining constant, the change in price will
inversely affect demand, thus the relationship between price and demand is inverse, the law of
demand may be explained with the help of demand schedule,

Price of Appel (In. Rs.) Quantity Demanded

10 1
8 2
6 3
4 4
2 5

Exceptions of the law of demand.

exceptions to the law of Demand :

There are certain exceptions to the law of demand in other words, the law of
demand is not applicable in the following cases.

(1) Giffen Goods:

People whose incomes are low purchase more of a commodity such broken
rice, bread, potato (which is their staple food) when its prices rises. Inversely when its
price falls, instead of buying more, they buy less of this commodity and use the savings for

7
the purchase of better goods such as meat. This phenomenon is called Giffens paradox
and such goods are giffen goods.

(2) Veblen Goods:

Products such as jewels, diamonds and so on confer distinction on the part of
the user. In such case, the consumers tend to buy more goods when price increased, and
less purchase when price decreased. Such goods are called Veblen Goods.

(3) Where there is a shortage of necessities :

If the consumers fear that these could be shortage of necessities, then this law of
demand does not applicable. They may tend to buy more than what they require
immediately, even if the price of the product increases.

(4) In case of ignorance of price changes :

When the customer is not familiar with the changes in the price, he tends to buy
even if there is increase in price.

ELASTICITY OF DEMAND

Elasticity of demand explains the relationship between a change in price and consequent
change in amount demanded. “Marshall” introduced the concept of elasticity of demand.
Elasticity of demand shows the extent of change in quantity demanded to a change in price.

In the words of “Marshall”, “The elasticity of demand in a market is great or small

according as the amount demanded increases much or little for a given fall in the price and
diminishes much or little for a given rise in Price”

Types of Elasticity of Demand:

There are three types of elasticity of demand:

1. Price elasticity of demand

2. Income elasticity of demand
3. Cross elasticity of demand
4. Advertising elasticity of demand

Price elasticity of demand:

Elasticity of demand in general refers to price elasticity of demand. In other words, it

refers to the quantity demanded of a commodity in response to a given change in price. Price
elasticity is always negative which indicates that the customer tends to buy more with every fall
in the price, the relationship between the price and the demand is inverse.

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 Proportionate change in the quantity demand of commodity

Price elasticity = ------------------------------------------------------------------

Proportionate change in the price of commodity

Q2 - Q1/ Q1
Edp = ----------------
P2 – P1 /P1

Where:
Q1 = quantity demand price before change
Q2 = quantity demand price after change
P1 = price before change
P2 = price after change

Income elasticity of demand:

Income elasticity of demand refers to the quantity demand of a commodity in response

to a given change in income of the consumer.

Proportionate change in the quantity demand of commodity

Income Elasticity = ------------------------------------------------------------------
Proportionate change in the income of the people

Q2 - Q1/ Q1
EdI = ----------------
I2 – I1 /I1
Where:
Q1 = quantity demand price before change
Q2 = quantity demand price after change
I1 = income before change
I2 = income after change

Cross elasticity of demand:

Cross elasticity of demand refers to the quantity demanded of a commodity in response

to a change in the price of a related good, which may be substitute or complement.

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 Proportionate change in the quantity demand of commodity “X”
Cross elasticity = -----------------------------------------------------------------------
Proportionate change in the price of commodity “Y”

Q2 - Q1/ Q1
EdP = ----------------
P2 – P1 /P1

Where:
Q1 = quantity demand price before change
Q2 = quantity demand price after change
P1 = price before change
P2 = price after change

Advertising elasticity of demand:

It refers to increase in the sales revenue because of change in the advertising

expenditure. In other words, there is a direct relationship between the amount of money spent
on advertising and its impact on sales. Advertising elasticity is always positive.

Proportionate change in the quantity demand of product “X”

Advertising elasticity = ----------------------------------------------------------------------
Proportionate change in advertisement costs.

Q2 - Q1/ Q1
EdP = ----------------
A2 – A1 /A1

Where:
Q1 = quantity demand price before change
Q2 = quantity demand price after change
A1 = advertising before change
A2 = advertising after change

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Measurement Elasticity of Demand

1. Perfectly elasticity of demand

2. Perfectly inelasticity of demand
3. Relatively elasticity of demand
4. Relatively inelasticity of demand
5. Unity elasticity of demand

Perfectly elasticity of demand:

When any quantity can be sold at a given price, and when there is no need to reduce
price, the demand is said to be perfectly elastic. In such cases, even a small increase in price will
lead to complete fall in demand.

Perfectly inelasticity of demand:

When a significant degree of change in price leads little or no change in the quantity
demanded, then the elasticity is said to be perfectly inelasticity. In other words, the demand is
said to be perfectly inelasticity when there is no change in the quantity demanded even though
there is a big change in the price.

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Relatively elasticity of demand:

The demand is said to be relatively elasticity when the change in demand is more then
the change in the price.

Relatively inelasticity of demand:

The demand is said to be relatively inelasticity when the change in demand is less than
the change in the price.

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Unity elasticity:

The elasticity in demand is said to be unity when the change in demand is equal to the
change in price.

Significance Of Elasticity Of Demand

a. Price of factors of production:

The factors of production are land, labour, capital, organizations and technology.
These have a cost; we have to pay rent, wages, interest, profits and price for these factors
of production.

b. Price fixation:

the manufacturer can decide the amount of price that can be fixed for his product
based on the concept of elasticity, if there is no competition, in other words in the case of
a monopoly, the manufacture is free to fix his price as long as it does not attract the
attention of the government, when there are close substitutes, the product is such that its
consumption can be postponed, it cannot be put to alternative uses and so on, then the
price of the product cannot be fixed very highly.

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 c. Government policies

1. Tax policies: government extensively depends on this concept to finalize its polices
relating to taxes and revenues. Where the product is such that the people cannot
postpone its consumptions, the government tends to increase its, price, such as petrol
and diesel, cigarettes, and so on.

2. Raising bank deposits : if the government wants to mobilize larger deposits from
the consumer it propose to raise the rates of fixed deposits marginally and vice versa.

3. Public utilities: government uses the concept of elasticity in fixing charges for the
public utilities such as elasticity tariff, water charges, ticket fare in case of road or
rail transport .

d. Forecasting demand:

Income elasticity is used to forecast demand for a particular product or services.

The demand for the products can be forecast at a give income level. The trader can
estimate the quantity of goods to be sold at different income levels to realize the targeted
revenue.

e. Planning the levels of output and price:

The knowledge of price elasticity is very useful to producers. The producer can
evaluate whether a change in price will bring in adequate revenue or not. In general, for
items whose demand is elastic, it would benefit him to charge relatively low price. On
the other hand, if the demand for the product is inelastic, a little higher price may be
helpful to him to get huge profits without losing sales.

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 DEMAND FORECASTING

Demand forecasting refers to an estimate of future demand for the product. It is an

objective assessment of the future course of demand, in recent times, forecasting plays an
important role in business decision – making. The survival and prosperity of a business firm
depend on its ability to meet the consumer’s needs efficiently and adequately. Demand
forecasting has an important influence on production planning. It is essential for a firm to
produce the required quantities at the right time.

It is also essential to distinguish between forecasting of demand and forecast of sales,

sales forecasts are important for estimating revenue, cash requirements and expenses whereas,
demand forecasting relate to production, inventory control, timing, reliability of forecast etc.
however, there is not much difference between these terms.

METHODS OF DEMAND FORECASTING

1. Survey methods
2. Statistical methods
3. Expert opinion methods

4. Test marketing

5. Controlled experiments

6. Judgmental approach

STATISTICAL METHODS
Statistical method is used for long run forecasting. In this method, statistical and
mathematical techniques are used to forecast demand. This relies on past data.

1. Trend projection method: these are generally based on analysis of past sales patterns.
These methods dispense with the need for costly market research because the necessary
information is often already available in company files. This method is used in case the sales
data of the firm under consideration relate to different time periods, i.e., it is a time – series data.
There are five main techniques of mechanical extrapolation.

a. Trend line by observation: this method of forecasting trend is elementary, easy and
quick. It involves merely the plotting of actual sales data on a chart and them estimating
just by observation where the trend line lies. The line can be extended towards a future
period and corresponding sales forecast is read form the graph.

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 b. Least squares methods: this technique uses statistical formulae to find the trend line
which best fits the available data. The trend line is the estimating equation, which can be
used for forecasting demand by extrapolating the line for future and reading the
corresponding values of sales on the graph.

c. Time series analysis: where the surveys or market tests are costly and time –
consuming, statistical and mathematical analysis of past sales data offers another
methods to prepare the forecasts, that is, time series analysis.

d. Moving average method: this method considers that the average of past events
determine the future events. In other words, this method provides consistent results
when the past events are consistent and unaffected by wide changes.

e. Exponential smoothing: this is a more popular technique used for short run forecasts.
This method is an improvement over moving averages method, unlike in moving
averages method, all time periods here are given varying weight, that is , value of the
given variable in the recent times are given higher weight and the values of the given
variable in the distant past are given relatively lower weights for further processing.

f. Barometric Technique: Simple trend projections are not capable of forecasting turning
paints. Under Barometric method, present events are used to predict the directions of
change in future. This is done with the help of economics and statistical indicators.
Those are (1) Construction Contracts awarded for building materials (2) Personal
income (3) Agricultural Income. (4) Employment (5) Gross national income (6)
Industrial Production (7) Bank Deposits etc.

g. Simultaneous equation method: in this method, all variable are simultaneously

considered, with the conviction that every variable influence the other variables in an
economic environment. Hence, the set of equations equal the number of dependent
variable which is also called endogenous variables.

h. Correlation and regression methods: correlation and regression methods are statistical
techniques. Correlation describes the degree of association between two variable such as
sales and advertisement expenditure. When the two variable tend to change together,
then they are said to be correlated.

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Expert opinion methods:
Well informed persons are called experts; experts constitute yet another source of
information. These persons are generally the outside experts and they do not have any vested
interest in the results of a particular survey. As expert is good at forecasting and analysis the
future trend in a give product or service at a given level of technology. The service of an expert
could be advantageously used when a firm uses general economic forecasting or special
industry fore casting prepared outside the firm.

Test marketing:
It is likely that opinions given by buyers, salesman or other experts may be, at times,
misleading. This is the reason why most of the manufactures favour to test their product or
service in a limited market as test – run before they launch their product nationwide.

Controlled experiments:
Controlled experiment refer to such exercise where some of the major determinants of
demand are manipulated to suit to the customers with different tastes and preferences, income
groups, and such others, it is further assumed that all other factors remain the same.

Judgmental approach:
When none of the above methods are directly related to the given product or service, the
management has no alternative other than using its own judgment. Even when the above
methods are used, the forecasting process is supplemented with the factor of judgment for the
following reasons

 Historical data for significantly long period is not available

 Turning point in terms of policies or procedures or causal factors cannot be precisely

determined

 Sale fluctuation are wide and significant

 The sophisticated statistical techniques such as regression and so on, may not cover all
the signing.

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18
Factors Governing Demand Forecasting

a) Functional nature of demand: market demand for a particular product or service is not
a single number but it is a function of a number of factors, for instance, higher volumes
of sales can be realized with higher levels of advertising or promotion efforts.

b) Types of forecasting: based on the period under forecast, the demand forecast can be of
two types1) shport – run forecasting and 2) long – run forecasting. Short run forecasts
cover a period of one year whereas long- run forecasting any period ranging from one
year to 20 years.

c) Forecasting level: the forecasting ,au ne at the firm level, industry level, national level
or at the global level.

1. Firm level: firm level means estimating the demand for the products and services
offered by a single firm

2. Industry level: the aggregate demand estimated for the good and service of all the
firms constitutes the industry level forecast. The total estimate of different trade
associations can also be view as industry level forecast.

3. National level : national level forecasting is for the whole economy, national level
forecasts are worked out based on the levels of income, savings of the consumers.

4. Global level: globalization and deregulation , the entrepreneurs have started

exploring the foreign markets for which the global level forecasts are utilized.

d) Degree of orientation: demand forecasts can be worked out based on total sales or
product or service wise sales for a given time period. Forecasting in terms of total sales
can be viewed as general forecast whereas product or service – wise or region or
customer segment – wise forecast is referred is referred to as specific forecast.

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 e) New product: it is relatively easy to forecast demand for established products or
products which are currently in use. The new product in consideration can be analyzed
as a substitute for some existing product. Assess the demand through a sampled or total
survey of consumers intentions over the new product features and price.

f) Nature of good: the good are classified into producer goods, consumer goods,
consumer durables and services. The patterns of forecasting in each of these differ.

g) Degree of competition: there may be a single trader or a few traders depending upon
the nature of goods and services

MANAGERIAL ECONOMICS A POSITIVE OR NORMATIVE SCIENCE

Positive economics explains the economic phenomenon as “what is, what was and
what it will be. Normative economics prescribes what it ought to be”. Positive sciences
simply describe, while normative sciences simply prescribe.

According Prof. Robbins, economics is a positive science. Science is, after all, a
search for truth and therefore, economics should study the truth as it is and not as it ought
to be. This is because when we say that this ought to be like this, we presume that out
point of view is correct. In a study of a problem at a given point of time, not only economic
considerations but also many other considerations such as ethical, political etc. must be
considered. A policy decision is taken after weighing the relative importance of all these
factors. There are bound to be difference in respect of policy prescription and it is better to
keep away from areas which are controversial and study the facts as they are.

According to economists like Marshall and Pigou, the ultimate object of the study of
any science is to contribute to human welfare. Thus economics should be a normative
science. It should be able to suggest policy measure to the politicians. It should be able to
prescribe guidelines for the conduct of economic activities. Not only economists should
build up the economic theory but also at the same time they should provide policy
measures.

We must strike a balance between these two extreme views. As Keynes put it, “The
main function of economics is not to provide a body of settled conclusions immediately
applicable to policy. It provides a methods or a technique of thinking, which enables its
possessor to draw correct conclusion.”

Managerial economics is a blending of pure or positive science with applied or

normative science. It is positive when it is confined to statements about causes and effects
and to functional relations of economics variables. It is normative when it involves norms
and standards, mixing them with cause effect analysis.

One cannot disregard the normative functions of managerial economics, though the
discipline may be treated primarily as a positive science. Normative approach in managerial
economies has ethical considerations and involves value judgments based on philosophical,
cultural and religious positions of the community.

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The value judgment and normative aspect and counseling in managerial economics studies
can never be dispensed with altogether.

UNIT – II
THEORY OF PRODUCTION AND COST ANALYSIS
Samuelson define the production function as “the technical relationship which reveals the
maximum amount of output capable of being produced by each and every set of inputs”
Michael define production function as “ that function which defines the maximum amount of
output that can be produced with a given set of inputs”.
The production function expresses a functional relationship between physical inputs
and physical outputs of a firm at any particular time period. The output is thus a
function of inputs. Mathematically production function can be written as

Q = F(L1,L2,C,O,T)
Where Q is the quantity of production, F explains the functions, that is, the type of
relation between inputs and outputs , L1,L2,C,.O,T refer to land, labout, capital, organization
and technology respectively. These inputs have been taken in conventional terms. In reality,
material also can be included in a set of inputs.
A manufacturer has to make a choice of the production function by considering his
technical knowledge, the process of various factors of production and his efficiency level to
manage. He should not only select the factors of production but also should work out the
different permutations and combinations which will mean lower cost of inputs for a given level
of production.
In case of an agricultural product, increasing the other factors of production can increase
the production, but beyond a point, increase output can be had only with increased use of
agricultural land, investment in land forms a significant portion of the total cost of production
for output, whereas, in the case of the software industry, other factor such as technology , capital
management and others become significant. With change in industry and the requirements the
production function also needs to be modified to suit to the situation.

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Production Function With One Variable Input
The laws of returns states that when at least one factor of production is fixed or factor
input is fixed and when all other factors are varied, the total output in the initial stages will
increase at an increasing rate, and after reaching certain level or output the total output will
increase at declining rate. If variable factor inputs are added further to the fixed factor input, the
total output may decline. This law is of universal nature and it proved to be true in agriculture
and industry also. The law of returns is also called the law of variable proportions or the law of
diminishing returns.
Definition According to G. Stigler
“If equal increments of one input are added, the inputs of other production services being held
constant, beyond a certain point the resulting increments of product will decrease i.e. the
marginal product will diminish”.
According to F. Benham
“As the proportion of one factor in a combination of factors is increased, after a point, first the
marginal and then the average product of that factor will diminish”.
Units of Total Marginal Average Stages
labour production(tp) product product
(mp) (ap)
0 0 0 0
1 10 10 10 Stages 1
2 22 12 11
3 33 11 11
4 40 7 10 Stages 2
5 45 5 9
6 48 3 8
7 48 0 6.85 Stages 3
8 45 -3 5.62

From the above graph the law of

variable proportions operates in three stages. In the first stage, total product increases at an
increasing rate. The marginal product in this stage increases at an increasing rate resulting in a
greater increase in total product. The average product also increases. This stage continues up to
the point where average product is equal to marginal product. The law of increasing returns is in

22
operation at this stage. The law of diminishing returns starts operating from the second stage
awards. At the second stage total product increases only at a diminishing rate. The average
product also declines. The second stage comes to an end where total product becomes maximum
and marginal product becomes zero. The marginal product becomes negative in the third stage.
So the total product also declines. The average product continues to decline.
Production Function With Two Variable Inputs And Laws Returns
Production process that requires two inputs, capital (C) and labour (L) to produce a
given output (Q). There could be more than two inputs in a real life situation, but for a simple
analysis, we restrict the number of inputs to two only. In other words, the production function
based on two inputs can be expressed as
Q = f(C, L)
Where C= capital, L = labour,
Normally, both capital and labour are required to produce a product. To some extent,
these two inputs can be substituted for each other. Hence the producer may choose any
combination of labour and capital that gives him the required number of units of output, for any
one combination of labour and capital out of several such combinations. The alternative
combinations of labour and capital yielding a given level of output are such that if the use of
one factor input is increased , that of another will decrease and vice versa. How ever, the units
of an input foregone to get one unit of the other input changes, depends upon the degree of
substitutability between the two input factors, based on the techniques or technology used, the
degree of substitutability may vary.

ISO - QUANTS
The term Isoquants is derived from the words ‘iso’ and ‘quant’ – ‘Iso’ means equal and
‘quent’ implies quantity. Isoquant therefore, means equal quantity. Isoquant are also called
isopridcut curves, an isoquant curve show various combinations of two input factors such as
capital and labour, which yield the same level of output.
As an isoquant curve represents all such combinations which yield equal quantity of output, any
or every combination is a good combination for the manufacturer. Since he prefers all these
combinations equally , an isoquant curve is also called product indifferent curve.
An isoquant may be explained with the help of an arithmetical example
Combinations Labour (units) Capital (Units) Output (quintals)
A 1 10 50
B 2 7 50
C 3 4 50
D 4 4 50

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 E 5 1 50
Combination ‘A’ represent 1 unit of labour and 10 units of capital and produces ‘50’
quintals of a product all other combinations in the table are assumed to yield the same given
output of a product say ‘50’ quintals by employing any one of the alternative combinations of
the two factors labour and capital. If we plot all these combinations on a paper and join them,
we will get continues and smooth curve called Iso-product curve as shown below.

Labour is on the X-axis and capital is on the Y-

axis. IQ is the ISO-Product curve which shows all the alternative combinations A, B, C, D, E
which can produce 50 quintals of a product
Features of isoquant
1.downward sloping: isoquant are downward sloping curves because , if one input increase, the
other one reduces. There is no question of increase in both the inputs to yield a given output. A
degree of substitution is assumed between the factors of production. In other words, an isoquant
cannot be increasing, as increase in both the inputs does not yield same level of output. If it is
constant, it means that the output remains constant through the use of one of the factor is
increasing, which is not true, isoquant slope from left to right.
2. Convex to origin: isoquant are convex to the origin. It is because the input factors are not
perfect substitutes. One input factor can be substituted by other input factor in a diminishing
marginal rate. If the input factors were perfect substitutes , the isoqunt would be a falling
straight line. When the inputs are used infixed proportion, and substitution of one input for the
other cannot trake place, the isoquant will be L shaped
3. do not intersect: two isoquant do not intersect with each other. It is because, each of these
denote a particular level of output. If the manufacturer wants to operate at a higher level of
output, he has to switch over to another isoquant with a higher level of output and vice versa.
4. do not axes: the isoquant touches neither X-axis nor Y- axis, as both inputs are required to
produce a given product.
ISO COST
Iso cost refers to that cost curve that represent the combination of inputs that will cost
the producer the same amount of money. In other words, each isocost denotes a particular level
of total cost for a given level of production. If the level of production changes, the total cost
changes and thus the isocost curve moves upwards, and vice verse.
Isocost curve is the locus traced out by various combinations of L and K, each of which
costs the producer the same amount of money (C ) Differentiating equation with respect to L,

24
we have dK/dL = -w/r This gives the slope of the producer’s budget line (isocost curve). Iso cost
line shows various combinations of labour and capital that the firm can buy for a given factor
prices. The slope of iso cost line = PL/Pk. In this equation , PL is the price of labour and Pk is
the price of capital. The slope of iso cost line indicates the ratio of the factor prices. A set of
isocost lines can be drawn for different levels of factor prices, or different sums of money. The
iso cost line will shift to the right when money spent on factors increases or firm could buy
more as the factor prices are given.

With the change in the factor prices the slope of iso cost lien will change. If the price of
labour falls the firm could buy more of labour and the line will shift away from the origin. The
slope depends on the prices of factors of production and the amount of money which the firm
spends on the factors. When the amount of money spent by the firm changes, the isocost line
may shift but its slope remains the same. A change in factor price makes changes in the slope of
isocost lines as shown in the figure.

Least Cost Combination Of Inputs

The manufacturer has to produce at lower costs to attain higher profits. The isocost and
isoquants can be used to determined the input usage that minimizes the cost of production.
Where the slope of isoquant is equal to that of isocost, there lies the lowest point of cost of

25
production. This can be observed by superimposing the isocosts on isoproduct curves. It is
evident that the producer can, with a total outlay.

The firm can achieve maximum profits by choosing that combination of factors which
will cost it the least. The choice is based on the prices of factors of production at a particular
time. The firm can maximize its profits either by maximizing the level of output for a given cost
or by minimizing the cost of producing a given output. In both cases the factors will have to be
employed in optimal combination at which the cost of production will be minimum. The least
cost factor combination can be determined by imposing the isoquant map on isocost line. The
point of tangency between the isocost and an isoquant is an important but not a necessary
condition for producer’s equilibrium. The essential condition is that the slope of the isocost line
must equal the slope of the isoquant. Thus at a point of equilibrium marginal physical
productivities of the two factors must be equal the ratio of their prices. The marginal physical
product per rupee of one factor must be equal to tht of the other factor. And isoquant must be
convex to the origin. The marginal rate of technical substitution of labour for capital must be
diminishing at the point of equilibrium.

Marginal Rate Of Technical Substitution

The marginal rate lof technical substitution (MRTS) refers to the rate at which one input
factor is substituted with the other to attain a given level of output. In other words, the lesser
units of one input must be compensated by increasing amounts of another input to produce the
same level of output.
Isoquants are typically convex to the origin reflecting the fact that the two factors are
substitutable for each other at varying rates. This rate of substitutability is called the “marginal
rate of technical substitution” (MRTS) or occasionally the “marginal rate of substitution in
production”. It measures the reduction in one input per unit increase in the other input that is
just sufficient to maintain a constant level of production. For example, the marginal rate of
substitution of labour for capital gives the amount of capital that can be replaced by one unit of
labour while keeping output unchanged.
To move from point A to point B in the diagram, the amount of capital is reduced from
Ka to Kb while the amount of labour is increased only from La to Lb. To move from point C to

26
point D, the amount of capital is reduced from Kc to Kd while the amount of labour is increased
from Lc to Ld. The marginal rate of technical substitution of labour for capital is equivalent to
the absolute slope of the isoquant at that point (change in capital divided by change in labour). It
is equal to 0 where the isoquant becomes horizontal, and equal to infinity where it becomes
vertical.
The opposite is true when going in the other direction (from D to C to B to A). In this
case we are looking at the marginal rate of technical substitution capital for labour (which is the
reciprocal of the marginal rate of technical substitution labour for capital).
It can also be shown that the marginal rate of substitution labour for capital, is equal to
the marginal physical product of labour divided by the marginal physical product of capital.
In the unusual case of two inputs that are perfect substitutes for each other in production,

the isoquant would be linear (linear in the sense of a function ). If, on the other
hand, there is only one production process available, factor proportions would be fixed, and
these zero-substitutability isoquants would be shown as horizontal or vertical lines.

LAW OF RETURNS TO SCALE

There are three laws of returns governing production function. They are
1. Law of increasing returns to scale

This law states that the volume of output keeps on increasing with every increase in the
inputs,. Where a given increase in inputs leads to a more than proportionate increase in
the output, the law of increasing returns to scale is said to operate. We can introduce
division of labour and other technological means to increase production. Hence, the total
product increases at an increasing rate.
2. Law of constant returns to scale

When the scope for division of labour gets restricted, the rate of increase in the total
output remains constant, the law of constant returns to scale is said to operate, this law

27
 states that the rate of increase/decrease in volume of output is same to that of rate of
increase/decrease in inputs.
3. Law of decreasing returns to scale

Where the proportionate increase in the inputs does not lead to equivalent increase in
output, the output increases at a decreasing rate, the law of decreasing returns to scale is
said to operate. This results in higher average cost per unit.

These laws can be illustrated with an example of agricultural land. Take one acre of land. If you
till the land well with adequate bags of fertilizers and sow good quality seeds, the volume of
output increases the following table illustrates further
Capital Labor( % of increase Output(in % of Law applicable
(in units) in in both inputs units) increase in
units) output

1 3 --- --- --- ---

2 6 100 120 140 Law of increase returns to scale
4 12 100 240 100 Law of constant returns to scale
8 24 100 360 50 Law of decrease returns to scale

INTERNAL AND EXTERNAL ECONOMIES OF SCALE

INTERNAL ECONOMIES refer to the economies introduction costs which accrue to the firm
alone when it expands its output. The internal economies occur as a result of increase in the
scale of production.
a. Managerial Economics: as the firm expands, the firm needs qualified managerial
personnel to handle each of its functions marketing, finance, production, human
resources and others in a professional way. Functional specialization ensure minimum
wastage and lowers the cost of production in the long –run.

b. Commercial Economics: the transaction of buying and selling raw material and other
operating supplies such as spares and so on will be rapid and the volume of each
transaction also grows as the firm grows, there could be cheaper savings in the
procurement, transportation and storage cost, this will lead to lower costs and increased
profits.

c. Financial Economics: The large firm is able to secure the necessary finances either for
block capital purposes or for working capital needs more easily and cheaply. It can
barrow from the public, banks and other financial institutions at relatively cheaper rates.
It is in this way that a large firm reaps financial economies.

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 d. Technical Economies: Technical economies arise to a firm from the use of better
machines and superior techniques of production. As a result, production increases and
per unit cost of production falls. A large firm, which employs costly and superior plant
and equipment, enjoys a technical superiority over a small firm. Another technical
economy lies in the mechanical advantage of using large machines. The cost of
operating large machines is less than that of operating mall machine. More over a larger
firm is able to reduce it’s per unit cost of production by linking the various processes of
production. Technical economies may also be associated when the large firm is able to
utilize all its waste materials for the development of by-products industry. Scope for
specialization is also available in a large firm. This increases the productive capacity of
the firm and reduces the unit cost of production.

e. Marketing Economies: The large firm reaps marketing or commercial economies in

buying its requirements and in selling its final products. The large firm generally has a
separate marketing department. It can buy and sell on behalf of the firm, when the
market trends are more favorable. In the matter of buying they could enjoy advantages
like preferential treatment, transport concessions, cheap credit, prompt delivery and fine
relation with dealers. Similarly it sells its products more effectively for a higher margin
of profit.

f. Risk Bearing Economies: The large firm produces many commodities and serves wider
areas. It is, therefore, able to absorb any shock for its existence. For example, during
business depression, the prices fall for every firm. There is also a possibility for market
fluctuations in a particular product of the firm. Under such circumstances the risk-
bearing economies or survival economies help the bigger firm to survive business crisis.

g. Economics Of Larger Dimension: large – scale production is required to take

advantage of bigger size plant and equipment. For example, the cost of a 1.00.000 units
capacity plant will not be double that of 50.000 units capacity plant. Likewise the cost of
a 10.000 ton oil tanker will not be double that of a 5000 ton oil tanker. Engineers go by
what is called two by three rule wherein when the volume is increase by 100%, the
material required will increase only by two – thirds. Technical economies are available
only from large size, improved methods of production processes and when the products
are standardized.

h. Economics Of Research And Development: large organizations such as Dr.Reddy’s

labs, Hindustan Lever spend heavily on research and development and bring out several
innovative products. Only such firms with a strong research and development base can
cope with competition globally.

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EXTERNAL ECONOMICS:
External economics refer to all the firms in the industry, because of growth of the industry as a
whole or because of growth of ancillary industries, external economics benefit al the firms in
the industry as the industry expands. This will lead to lowering the cost of production and
thereby increasing the profitability. The external economics can be grouped under three types:
A). Economies of Concentration: When an industry is concentrated in a particular area, all the
member firms reap some common economies like skilled labour, improved means of transport
and communications, banking and financial services, supply of power and benefits from
subsidiaries. All these facilities tend to lower the unit cost of production of all the firms in the
industry.
B) Economics Of Research And Development: all the firms can pool resources to finance
research and development activities and thus share the benefits of research. There could be a
common facility to shares journals, newspapers and other valuable reference material of
common interest.
C) Economics Of Welfare: there could be common facilities such as canteen, industrial
housing, community halls, schools and colleges, employment burearu, hospitals and so on,
which can be used in common by the employees in the whole industry.
COST ; the institute of cost and management accountants (ICMA) has define cost as “ the
amount expenditure, actual or notional, incurred on or attributable to a specified thing or
activity”. It is the amount of resources sacrificed to achieve a specific objective. A cost must be
with reference to the purpose for which it is used and the conditions under which it is computed.
To take decision, managers wish to know the cost of something.
cost refer to the expenditure incurred to produce a particular product or services. All cost
involve a sacrifice of some kind or other to acquire some benefit. For example , if I want to eat
food, I should be prepared to sacrifice money.
Cost refers to the amount of expenditure incurred in acquiring something. In business firm, it
refers to the expenditure incurred to produce an output or provide service. Thus the cost
incurred in connection with raw material , labour, other heads constitute the overall cost of
production.
COST CONCEPTS :
A managerial economist must have a clear understanding of the different cost concepts for clear
business thinking and proper application. The several alternative bases of classifying cost and
the relevance of each for different kinds of problems are to be studied. The various relevant
concepts of cost are:
OPPORTUNITY COST:
In simple terms, it is the earning from the second is alternative. It represents the maximum
possible alternative income that was have been earned if the resources were put to alternative
use.
Opportunity cost can be distinguished from outlay costs based on the nature of sacrifice. Outlay
costs are those costs that involve cash outflow at sometime and hence they are recorded in the

30
book of account. Opportunity cost refers to earnings/profits that are foregone form alternative
ventures by using gives limited facilities for a particular purpose.
FIXED COST VS VARIABLE COST
Fixed cost is that cost which remains constant for a certain level to output. It is not affected by
the changes in the volume of production. But fixed cost per unit decrease, when the production
is increased. Fixed cost includes salaries, Rent, Administrative expenses depreciations etc.
Variable is that which varies directly with the variation is output. An increase in total output
results in an increase in total variable costs and decrease in total output results in a proportionate
decline in the total variables costs. The variable cost per unit will be constant. Ex: Raw
materials, labour, direct expenses, etc
EXPLICIT AND IMPLICIT COSTS:
Explicit costs are those expenses that involve cash payments. These are the actual or business
costs that appear in the books of accounts. These costs include payment of wages and salaries,
payment for raw-materials, interest on borrowed capital funds, rent on hired land, Taxes paid
etc.
Implicit costs are the costs of the factor units that are owned by the employer himself. These
costs are not actually incurred but would have been incurred in the absence of employment of
self – owned factors. The two normal implicit costs are depreciation, interest on capital etc. A
decision maker must consider implicit costs too to find out appropriate profitability of
alternatives.
SHORT – RUN AND LONG – RUN COSTS:
Short-run is a period during which the physical capacity of the firm remains fixed. Any increase
in output during this period is possible only by using the existing physical capacity more
extensively. So short run cost is that which varies with output when the plant and capital
equipment in constant.
Long run costs are those, which vary with output when all inputs are variable including plant
and capital equipment. Long-run cost analysis helps to take investment decisions.

OUT-OF POCKET AND BOOKS COSTS:

Out-of pocket costs also known as explicit costs are those costs that involve current cash
payment. Book costs also called implicit costs do not require current cash payments.
Depreciation, unpaid interest, salary of the owner is examples of back costs.
But the book costs are taken into account in determining the level dividend payable during a
period. Both book costs and out-of-pocket costs are considered for all decisions. Book cost is
the cost of self-owned factors of production.

BREAKEVEN ANALYSIS
A business is said to break even when its total sales are equal to its total costs. It is a point of no
profits no loss. Break even analysis is defined as analysis of costs and their possible impact on
revenues and volume of the firm. Hence, it is also called the cost – volume- profit analysis. A
firm is said to attain the bep when its total revenue is equal to total cost.

31
Assumptions:
1. All costs are classified into two – fixed and variable.
2. Fixed costs remain constant at all levels of output.
3. Variable costs vary proportionally with the volume of output.
4. Selling price per unit remains constant in spite of competition or change in the volume
of production.
5. There will be no change in operating efficiency.
6. There will be no change in the general price level.
7. Volume of production is the only factor affecting the cost.
8. Volume of sales and volume of production are equal. Hence there is no unsold stock.
9. There is only one product or in the case of multiple products. Sales mix remains
constant.
10. All the goods produced are sold. There is no closing stock.

Significance of BEA
 To ascertain the profit on a particular level of sales volume or a given capacity of
production

 To calculate sales required to earn a particular desired level of profit.

 To compare the product lines, sales area, methods of sales for individual company

 To compare the efficiency of the different firms

 To decide whether to add a particular product to the existing product line or drop one
from it

 To decide to “make or buy” a given component or spare part

 To decide what promotion mix will yield optimum sales

 To assess the impact of changes in fixed cost, variable cost or selling price on BEP and
profits during a given period.

Limitations of BEA
 Break – even - point is based on fixed cost, variable cost and total revenue.

 A change in one variable is going to affect the BEP

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  All cost cannot be classified into fixed and variable costs. We have semi-variable costs
also

 In case of multi-product firm, a single chart cannot be of any use. Series of charts have
to be made use of..

 It is based on fixed cost concept and hence holds good only in the short – run.

 Total cost and total revenue lines are not always straight as shown in the figure. The
quantity and price discounts are the usual phenomena affecting the total revenue line.

 Where the business conditions are volatile, BEP cannot give stable results

Merits:
1. Information provided by the Break Even Chart can be understood more easily then those
contained in the profit and Loss Account and the cost statement.
2. Break Even Chart discloses the relationship between cost, volume and profit. It reveals
how changes in profit. So, it helps management in decision-making.
3. It is very useful for forecasting costs and profits long term planning and growth
4. The chart discloses profits at various levels of production.
5. It serves as a useful tool for cost control.
6. It can also be used to study the comparative plant efficiencies of the industry.
7. Analytical Break-even chart present the different elements, in the costs – direct material,
direct labour, fixed and variable overheads.

Demerits:
1. Break-even chart presents only cost volume profits. It ignores other considerations such
as capital amount, marketing aspects and effect of government policy etc., which are
necessary in decision making.
2. It is assumed that sales, total cost and fixed cost can be represented as straight lines. In
actual practice, this may not be so.
3. It assumes that profit is a function of output. This is not always true. The firm may
increase the profit without increasing its output.
4. A major drawback of BEC is its inability to handle production and sale of multiple
products.
5. It is difficult to handle selling costs such as advertisement and sale promotion in BEC.
6. It ignores economics of scale in production.
7. Fixed costs do not remain constant in the long run.
8. Semi-variable costs are completely ignored.
9. It assumes production is equal to sale. It is not always true because generally there may
be opening stock.
10. When production increases variable cost per unit may not remain constant but may
reduce on account of bulk buying etc.

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 11. The assumption of static nature of business and economic activities is a well-known
defect of BEC.

Determination of break even point

1. Fixed cost
2. Variable cost
3. Contribution
4. Margin of safety
5. Angle of incidence
6. Profit volume ratio

Fixed cost: Expenses that do not vary with the volume of production are known as fixed
expenses. Eg. Manager’s salary, rent and taxes, insurance etc. It should be noted that fixed
changes are fixed only within a certain range of plant capacity. The concept of fixed overhead is
most useful in formulating a price fixing policy. Fixed cost per unit is not fixed
Variable Cost: Expenses that vary almost in direct proportion to the volume of production of
sales are called variable expenses. Eg. Electric power and fuel, packing materials consumable
stores. It should be noted that variable cost per unit is fixed.

Contribution: Contribution is the difference between sales and variable costs and it contributed
towards fixed costs and profit. It helps in sales and pricing policies and measuring the
profitability of different proposals. Contribution is a sure test to decide whether a product is
worthwhile to be continued among different products.
Contribution = Sales – Variable cost
Contribution = Fixed Cost + Profit.
Margin of safety: Margin of safety is the excess of sales over the break even sales. It can be
expressed in absolute sales amount or in percentage. It indicates the extent to which the sales
can be reduced without resulting in loss. A large margin of safety indicates the soundness of the
business. The formula for the margin of safety is:
Present sales – Break even sales or
Margin of safety can be improved by taking the following steps.
1. Increasing production
2. Increasing selling price
3. Reducing the fixed or the variable costs or both
4. Substituting unprofitable product with profitable one.

Angle of incidence: This is the angle between sales line and total cost line at the Break-even
point. It indicates the profit earning capacity of the concern. Large angle of incidence indicates a
high rate of profit; a small angle indicates a low rate of earnings. To improve this angle,
contribution should be increased either by raising the selling price and/or by reducing variable

34
cost. It also indicates as to what extent the output and sales price can be changed to attain a
desired amount of profit.

Profit Volume Ratio is usually called P. V. ratio. It is one of the most useful ratios for studying the
profitability of business. The ratio of contribution to sales is the P/V ratio. It may be expressed in percentage.
Therefore, every organization tries to improve the P. V. ratio of each product by reducing the variable cost per
unit or by increasing the selling price per unit. The concept of P. V. ratio helps in determining break even-
point, a desired amount of profit etc.

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 Unit – 3
INTRODUCTION TO MARKET AND PRICING STRATEGIES

MARKET
Market is a place where buyer and seller meet, goods and services are offered for the
sale and transfer of ownership occurs. A market may be also defined as the demand made by a
certain group of potential buyers for a good or service. The former one is a narrow concept and
later one, a broader concept. Economists describe a market as a collection of buyers and sellers
who transact over a particular product or product class (the housing market, the clothing market,
the grain market etc.). For business purpose we define a market as people or organizations with
wants (needs) to satisfy, money to spend, and the willingness to spend it. Broadly, market
represents the structure and nature of buyers and sellers for a commodity/service and the
process by which the price of the commodity or service is established. In this sense, we are
referring to the structure of competition and the process of price determination for a commodity
or service. The determination of price for a commodity or service depends upon the structure of
the market for that commodity or service (i.e., competitive structure of the market). Hence the
understanding on the market structure and the nature of competition are a pre-requisite in price
determination.
MARKET STRUCTURES
Market structure describes the competitive environment in the market for any good or
service. A market consists of all firms and individuals who are willing and able to buy or sell a
particular product. This includes firms and individuals currently engaged in buying and selling a
particular product, as well as potential entrants.
The determination of price is affected by the competitive structure of the market. This is
because the firm operates in a market and not in isolation. In marking decisions concerning
economic variables it is affected, as are all institutions in society by its environment.

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PERFECT COMPETITION
Perfect competition refers to a market structure where competition among the sellers and
buyers prevails in its most perfect form. In a perfectly competitive market, a single market price
prevails for the commodity, which is determined by the forces of total demand and total supply
in the market.
A market structure in which all firms in an industry are price takers and in which there is
freedom of entry into and exit from the industry is called perfect competition. The market with
perfect competition conditions is known as perfect market.
Features of perfectly competition
1. A large number of buyers and sellers: The number of buyers and sellers is large and
the share of each one of them in the market is so small that none has any influence on
the market price.

There should be significantly large number of buyers and sellers in the market. The
number should be so large that it should not make any difference in terms of price of
quantity supplied even if one enters the market or one leaves the market.
2. Homogenous products or services: the products and services of each seller should be
homogeneous. They cannot be differentiated from that of one another. It makes no
difference to the buyer whether he buys from firm X or firm Z. in other words, the buyer
does not have any particular preference to buy the goods from a particular trader or
supplier. The price is one and the same in every firm. There are no concessions or
discounts.

3. Freedom to enter or exit the market: there should not be restrictions on the part of the
buyers and sellers to enter the market or leave the market. There should not be any
barriers. The buyers can enter the market or leave the market whenever they want.

4. Prefect information available to the buyers and sellers: each buyer and seller has total
knowledge of the prices prevailing in the market at every given point of time, quantity
supplied, costs, demand, nature of product, and other relevant information. There is no
need for any advertisement expenditure as the buyers and sellers are fully informed.

37
 5. Perfect mobility of factors of production: there should not be any restrictions on the
utilization of factors of production such as land , labour, capital and so on. In words, the
firm or buyer should have free access to the factors of production. Whenever capital or
labor is required, it should instantly be made available.

6. Each firm is a price taker: an individual firm can alter its rate of production or sales
without significantly affecting the market price of the product, a firm in a perfect market
cannot influence the market through its own individual actions. It has no alternative
other than selling its products at the price prevailing in the market. It cannot sell as
much as it wants at its own set price

Monopoly
The word monopoly is made up of two syllables, Mono and poly. Mono means single while
poly implies selling. Thus monopoly is a form of market organization in which there is only one
seller of the commodity. There are no close substitutes for the commodity sold by the seller.
Pure monopoly is a market situation in which a single firm sells a product for which there is no
good substitute.
Features of monopoly
1. Single person or a firm: A single person or a firm controls the total supply of the
commodity. There will be no competition for monopoly firm. The monopolist firm is the
only firm in the whole industry.
2. No close substitute: The goods sold by the monopolist shall not have closely
competition substitutes. Even if price of monopoly product increase people will not go
in far substitute. For example: If the price of electric bulb increase slightly, consumer
will not go in for kerosene lamp.
3. Large number of Buyers: Under monopoly, there may be a large number of buyers in
the market who compete among themselves.
4. Price Maker: Since the monopolist controls the whole supply of a commodity, he is a
price-maker, and then he can alter the price.
5. Supply and Price: The monopolist can fix either the supply or the price. He cannot fix
both. If he charges a very high price, he can sell a small amount. If he wants to sell
more, he has to charge a low price. He cannot sell as much as he wishes for any price he
pleases.
6. Downward Sloping Demand Curve: The demand curve (average revenue curve) of
monopolist slopes downward from left to right. It means that he can sell more only by
lowering price.

Monopolistic competition

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 Monopolistic competition is said to exist when there are many firms and each one produces
such goods and services that are close substitutes to each other. They are similar but not
identical. Product differentiation is the essential feature of monopolistic. Products can be
differentiated by means of unique facilities, advertising, brand loyalty, packaging, pricing, terms
of credit, superior maintenance services, convenient location and so on.

Features of Monopolistic
1. Existence of Many firms: Industry consists of a large number of sellers, each one of
whom does not feel dependent upon others. Every firm acts independently without
bothering about the reactions of its rivals. The size is so large that an individual firm has
only a relatively small part in the total market, so that each firm has very limited control
over the price of the product. As the number is relatively large it is difficult for these
firms to determine its price- output policies without considering the possible reactions of
the rival forms. A monopolistically competitive firm follows an independent price
policy.
2. Product Differentiation: Product differentiation means that products are different in
some ways, but not altogether so. The products are not identical but the same time they
will not be entirely different from each other. IT really means that there are various
monopolist firms competing with each other. An example of monopolistic competition
and product differentiation is the toothpaste produced by various firms. The product of
each firm is different from that of its rivals in one or more respects. Different toothpastes
like Colgate, Close-up, Forehans, Cibaca, etc., provide an example of monopolistic
competition. These products are relatively close substitute for each other but not perfect
substitutes. Consumers have definite preferences for the particular verities or brands of
products offered for sale by various sellers. Advertisement, packing, trademarks, brand
names etc. help differentiation of products even if they are physically identical.
3. Large Number of Buyers: There are large number buyers in the market. But the buyers
have their own brand preferences. So the sellers are able to exercise a certain degree of
monopoly over them. Each seller has to plan various incentive schemes to retain the
customers who patronize his products.
4. Free Entry and Exist of Firms: As in the perfect competition, in the monopolistic
competition too, there is freedom of entry and exit. That is, there is no barrier as found
under monopoly.
5. Selling costs: Since the products are close substitute much effort is needed to retain the
existing consumers and to create new demand. So each firm has to spend a lot on selling
cost, which includes cost on advertising and other sale promotion activities.
6. Imperfect Knowledge: Imperfect knowledge about the product leads to monopolistic
competition. If the buyers are fully aware of the quality of the product they cannot be
influenced much by advertisement or other sales promotion techniques. But in the
business world we can see that thought the quality of certain products is the same,

39
 effective advertisement and sales promotion techniques make certain brands
monopolistic. For examples, effective dealer service backed by advertisement-helped
popularization of some brands through the quality of almost all the cement available in
the market remains the same.
7. The Group: Under perfect competition the term industry refers to all collection of firms
producing a homogenous product. But under monopolistic competition the products of
various firms are not identical through they are close substitutes. Prof. Chamberlin
called the collection of firms producing close subset
OLIGOPOLY

The term oligopoly is derived from two Greek words: ‘oligi’ means few
and ‘polein’ means to sell. Oligopoly is a market structure in which there are
only a few sellers (but more than two) of the homogeneous or differentiated
products. So, oligopoly lies in between monopolistic competition and
monopoly.

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Features of Oligopoly:
1. Few firms: Under oligopoly, there are few large firms. The exact number of firms is not
defined. Each firm produces a significant portion of the total output. There exists severe
competition among different firms and each firm try to manipulate both prices and
volume of production to outsmart each other. For example, the market for automobiles
in India is an oligopolist structure as there are only few producers of automobiles.
2. Interdependence: Firms under oligopoly are interdependent. Interdependence means that
actions of one firm affect the actions of other firms. A firm considers the action and
reaction of the rival firms while determining its price and output levels. A change in
output or price by one firm evokes reaction from other firms operating in the market.
For example, market for cars in India is dominated by few firms (Maruti, Tata, Hyundai, Ford,
Honda, etc.). A change by any one firm (say, Tata) in any of its vehicle (say, Indica) will induce
other firms (say, Maruti, Hyundai, etc.) to make changes in their respective vehicles.
3. Non-Price Competition: Under oligopoly, firms are in a position to influence the prices.
However, they try to avoid price competition for the fear of price war. They follow the
policy of price rigidity. Price rigidity refers to a situation in which price tends to stay
fixed irrespective of changes in demand and supply conditions. Firms use other
methods like advertising, better services to customers, etc. to compete with each
other.
4. Barriers to Entry of Firms: The main reason for few firms under oligopoly is the barriers,
which prevent entry of new firms into the industry. Patents, requirement of large
capital, control over crucial raw materials, etc, are some of the reasons, which prevent
new firms from entering into industry. Only those firms enter into the industry which
is able to cross these barriers. As a result, firms can earn abnormal profits in the long
run.
5. Role of Selling Costs: Due to severe competition ‘and interdependence of the firms, various
sales promotion techniques are used to promote sales of the product. Advertisement
is in full swing under oligopoly, and many a times advertisement can become a matter
of life-and-death. A firm under oligopoly relies more on non-price competition.
6. Group Behaviour: Under oligopoly, there is complete interdependence among different
firms. So, price and output decisions of a particular firm directly influence the
competing firms. Instead of independent price and output strategy, oligopoly firms
prefer group decisions that will protect the interest of all the firms. Group Behaviour
means that firms tend to behave as if they were a single firm even though individually
they retain their independence.
7. Nature of the Product: The firms under oligopoly may produce homogeneous or
differentiated product.

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i. If the firms produce a homogeneous product, like cement or steel, the industry is called a
pure or perfect oligopoly.
ii. If the firms produce a differentiated product, like automobiles, the industry is called
differentiated or imperfect oligopoly.
8. Indeterminate Demand Curve: Under oligopoly, the exact behaviour pattern of a producer
cannot be determined with certainty. So, demand curve faced by an oligopolist is
indeterminate (uncertain). As firms are inter-dependent, a firm cannot ignore the
reaction of the rival firms. Any change in price by one firm may lead to change in
prices by the competing firms. So, demand curve keeps on shifting and it is not
definite, rather it is indeterminate.

Duopoly:
Duopoly is a special case of the theory of oligopoly in which there are only two sellers.

Both the sellers are completely independent and no agreement exists between them. Even

though they are independent, a change in the price and output of one will affect the other, and

may set a chain of reactions. A seller may, however, assume that his rival is unaffected by what

he does, in that case he takes only his own direct influence on the price.

If, on the other hand, each seller takes into account the effect of his
policy on that of his rival and the reaction of the rival on himself again, then
he considers both the direct and the indirect influences upon the price.
Moreover, a rival seller’s policy may remain unaltered either to the amount
offered for sale or to the price at which he offers his product. Thus the
duopoly problem can be considered as either ignoring mutual dependence
or recognising it.

PRICE OUTPUT DETERMINATION INCASE OF PERFECT COMPETITION

SHORT RUN:
The price and output of the firm are determined, under perfect competition, based
on the industry price and its own costs. The industry price has greater say in this process
because the firm own sales are very small and insignificant. The process of price output
determination in case of perfect competition.
The firm demand curve is horizontal at the price determined in the industry (MR =
AR = price). This demand curve is also known as average revenue curve. This is because if
all the units are sold at the same price, on an average , the revenue to the firm equal its
price.

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 LONG RUN UNDER PERFECT COMPETITION

Having been attracted by supernormal profits, more and more firms enter the
industry. With the result, there will be a scramble for scarce inputs among the
competing firms pushing the input prices. Hence, the average cost increases. The
entry of more and more firms will expand the supply pulling down the market price.
The entry of the firms into the industry continues till the supernormal profit is
completely eroded. In the long run, the firms will be in the position to enjoy only
normal profits but not supernormal profit. Normal profits are the profit that is just
sufficient for the firms to stay in the business.

PRICE OUT PUT DETERMINATION IN MONOPOLY

Under monopoly the average revenue curve for a firm is a downward sloping one. It
is because, of the monopolist reduces the price of his product, the quantity

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 demanded increase and vice versa. In monopoly, marginal revenue is less than the
average revenue.

The monopolist always wants to maximize his profits. To achieve maximum profits,
it is necessary that the marginal revenue should be more than the marginal cost.

PRICING METHODS

COST – BASED PRICING PRICING METHODS

1. Cost plus pricing: This is also called full cost or mark up pricing. Here the average
cost normal capacity of output is ascertained and then a conventional margin of profit is
added to the cost to arrive at the price. In other words, find out the product unit’s total
cost and add percentage of profit to arrive at the selling price.

This method is suitable where the cost keep fluctuating from time to time. It is commonly
followed in departmental stores and other retail shops. This method is simple to be administered
but it does not consider the competition factor. The competitor may produce the same product at
lower cost and thus offer it at a lower price.
2. Marginal cost pricing : in marginal cost pricing, selling price is fixed in such a way that
it covers fully the variable or marginal cost and contributes towards recovery of fixed
costs fully or partly, depending upon the market situations. In times of stiff competition,
marginal cost offers a guideline as to how far the selling price can be lowered. This is
also called break – even pricing or target profit pricing. How break – even analysis helps
in taking pricing decisions.

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COMPETITION – ORIENTED PRICING:
Some commodities are priced according to the competition in their markets. Thus we have the
going rate method of price and the sealed bid pricing technique. Under the former a firm prices
its new product according to the prevailing prices of comparable products in the market.
a. Sealed bid pricing: this method is more popular in tenders and contracts. Each
contracting firm quotes its price in a sealed cover called tender. All the tenders are
opened on a scheduled date and the person who quotes the lowest prices, other things
remaining the same, is awarded the contract.

b. Going rate pricing: here the price charged by the firm is in tune with the price charged
in the industry as a whole. In other words, the prevailing market price at a given point of
time is the guiding factor. When one wants to buy or sell gold, the prevailing market
rate at a given point of time is taken as the basis to determine the price, normally the
market leaders keep announcing the prevailing prices at a given point of time based on
demand and supply positions.

DEMAND – ORIENTED PRICING

The higher the demand, the higher can be the price. Cost is not the consideration here. The
key to pricing here is the value as perceived by the consumer. This is a relatively modern
marketing concept.
a. Price discrimination: price discrimination refer to the practice of charging different
prices to customers for the same good. The firm uses its discretion to charge differently
the different customer. It is also called differential pricing. Customers of different profile
can be separated in various ways, such as by different consumer requirement by nature
of product itself , by geographical areas, by income group and so on.

b. Perceived value pricing: perceived value pricing refers to where the price is fixed on the
basis of the perception of the buyer of the value of the product.

STRATEGY – BASED PRICING:

1. Market skimming: when the product is introduced for the first time in the market, the
company follows this method. Under this method, the company fixes a very high price
for the product. The main idea is to charge the customer maximum possible. For
example Sony introduces a particular TV model , it fixed a very high price and other
company.

2. Market penetration: this is exactly opposite to the market skimming method. Here the
price of the product is fixed so low that the company can increase its market share. the
company attains profits with increasing volumes and increase in the market share. More
often , the companies believe that it is necessary to dominate the market in the long –run
making profit in the short-run.

3. Two – part pricing : the firms with market power can enhance profits by the strategy of
two – part pricing. Under this strategy, a firm charges a fixed fee for the right to

45
 purchase its goods, plus a per unit charge for each unit purchased. Entertainment houses
such as country clubs, athletic clubs, golf courses, health clubs usually adopt this
strategy. They charge a fixed initiation fee plus a charge, per month or per visit, to use
the facilities.

4. Block pricing: block pricing is another way a firm with market power can enhance its
profits. We see block pricing in out day – to – day life very frequently. Six lux soaps in a
single pack or five magi noodles in a single pack.

5. Commodity bundling: commodity bundling refers to the practice of bundling two or

more different products together and selling them at a single bundle price, the package
deals offered by the tourist companies, airlines hold testimony to this practice. The
package includes the airfare, hotel, meals, sight seeing and so on.

6. Peak load pricing: during seasonal period when demand is likely to be higher, a firm
may enhance profits by peak load pricing. The firm philosophy is to charge a higher
price during peak times than is charged during off – peak times. Apsrtc, air india, jet air
etc,.

7. Cross subsidization: in case where demand for two products produced by a firm is
interrelated through demand or costs, the firm may enhance the profitability of its
operation through cross subsidization .

8. Transfer pricing: transfer pricing is an internal pricing technique. It refers to a price at

which inputs of one department are transferred to another, in order to maximize the
overall profits of the company. For example kinetic Honda, hero Honda,

PRICING STRATEGIES IN TIMES OF STIFF PRICE COMPETITION

1. Pricing matching: price matching is a strategy in which a firm promise to match a
lower price offered by any competitor, while announcing its own price. It is necessary
that one should be confident, before this strategy is adopted, that the price cannot be
lower in the market than one offered.

2. Promoting brand loyalty: this is an advertising strategy where the customers are
frequently reminded by the brand value of given product or services. The conviction
here is that the customers, once they are loyal to the given branded product or services,
will not slip away when the competitors come out with products at lower prices.

3. Time – to – time: this is also called randomized pricing strategy where the firm varies
its prices form time- to – time, say hour – to – time, say hour – to – hour or day – to –
day. This methods offers two advantages , the rival firms can no more play with price
cuts. Also customers cannot learn form experience which firm charges the lowers price
in the market.

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 4. Promotional pricing: to promote a particular product, at time, the firm may offer the
product at the most competitive price. Some time, the price of a particular product is
kept intentionally lower to attract the attention f the customer to other products of the
firm.

5. Target pricing: the company operates with a particular targeted profit in mind.
Normally the cost of capital will be one of the yardsticks to guide the targeted rate of
return. How much is the rate of return the other companies are achieving also could be
another yardstick to determine the price. The higher the risk and investment, the higher
is the targeted profit and so is the price.

Unit – IV
CAPITAL AND CAPITAL BUDGETING
Capital is defined as wealth, which is created over a period of time through abstinence to
spend. There are different forms of capital property, cash or titles to wealth. It is the aggregate
of funds used in the short run and long run. An economist views capital as the value total assets
available with the business. An accountant sees the capital as the different between the assets
and liabilities.
Significance of capital
1. To promote a business: capital is required at the promotion stage. A large variety of
expenses have to be incurred on project reports, feasibility studies and reports,
preparation and filing of various documents, and for meeting various other expenses in
connection with the raising of capital from the public.

2. To conduct business operations smoothly: business firms also need capital for the
purpose of conducting their business operations such as research and development,
advertising, sales promotion, distribution and operation expenses.

3. To expand and diversify: the firm requires a lot of capital for expansion and
diversification purposes. This includes development expense such as purchase of
sophistical machinery and equipment and also payment towards sophisticated
technology.

4. To meet contingencies: a firm needs funds to meet contingencies such as sudden fall in
sales, major litigation, nature calamities like fire, and so on.

5. To pay taxes: the firm has to meet its statutory commitments such as income tax and
sales tax, excise duty and so on.

6. To pay dividends and interests: the business has to make payment towards dividends and
its interest to shareholders and financial institutions respectively.

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 7. To replace the assets: the business needs to replace its assets like plant and machinery
after a certain period of use. For this purpose the firm needs funds to make suitable
replacement of assets in place of old and worn out assets.

8. To support welfare programmes: the company may also have to take up social welfare
programmes such as literacy drive, and health camps, It may have to donate to charitable
trusts, educational institutions or public services organizations.

9. To wind up: at the time of winding up, the company may need funds to meet liquidation
expenses

Types of capital
A) Fixed capital

B) Working capital

FIXED CAPITAL
Fixed capital is that portion of capital which invested in acquiring long term assets such
as land and buildings, plant and machinery, furniture and fixtures, and so on, fixed capital forms
the skeleton of the business. It provides the basic assets as per the business needs.
Features of fixed assets:
1. Permanent in nature: fixed capital is more or less permanent in nature, it is generally
not withdrawn as long as the business carries on its business.

2. Profit generation: fixed asset are the sources of profits but they can never generate
profits by themselves. They use stocks, cash and debtors to generate profits.

3. Low liquidity: the fixed assets cannot be converted into cash quickly. Liquidity refers to
conversion of assets into cash.

4. Amount of fixed capital : the amount of fixed capital of a company depends on a

number of factors such as size of the company, nature of business, method of production
and so on. A manufacturing company such as steel factory may require relatively large
finance when compared to a service organization such as a software company.

5. Utilized for promotional and expansion: the fixed capital is mostly needed at the time
of promoting the company to purchase the fixed assets or at the time of expansion. In
other words, the need for fixed capital arises less frequently.

Types of fixed assets

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 1. Tangible fixed assets : these are physical items which can be seen and touched. Most of
the common fixed assets are land, buildings, machinery, motor vehicles, furniture and so
on.

2. Intangible fixed assets : these do not have physical form. They cannot be seen or
touched. But these are very valuable to business. Examples are goodwill, brand names,
trademarks, patents, copy rights and so on.

3. Financial fixed assets : these are investments in shares, foreign currency deposits,
government bonds , shares held by the business in other companies and so on.

WORKING CAPITAL
Working capital is the flesh and blood of the business. It is that portion of capital that
makes a company work. It is not just possible to carry on the business with only fixed
assets. Working capital is a must, working capital is also called circulating capital. It is used
to meet regular or recurring needs of the business. The regular needs refer to the purchase of
materials, payment of wages and salaries, expenses like rent, advertising, power and so on.
In short , working capital is the amounts needed to cover the cost of operating the business.
Definition of working capital
Working capital define as a current assets excess of current liabilities
Its also define in mathematically formula as
working capital = current assets – current liabilities
features of working capital
1. Short life span: working capital changes in its form cash to stock, stock to debtors,
debtors to cash, the cash balances may be kept idle for a week or so, debtors have a life
span of a few months , raw materials are held for a short – time until they go into
production, finished goods as held for a short – time until they are sold.

2. Smoothly flow of operations: adequate amount of working capital enables the business
to conduct its operations smoothly. It is there fore, called the flesh and blood of the
business.

3. Liquidity: the assets represented by the working capital can be converted into cash
quickly within a short period of time unlike fixed assets.

4. Amount of working capital: the amount of working capital of a business depends on

many factors such as size and nature of the business, production and marketing policies,
business cycles and so on.

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 5. Utilized for payment of current expenses: the working capital is used to pay for current
expenses such as suppliers of raw materials, payment of wages and salaries, rent and
other expenses and so on.

Components of working capital:

Current assets: current assets are those assets which are converted into cash with in accounting
period or within the year. For example, cash in hand, cash at bank, sundry debtor, bill
receivable, prepaid expenses etc.
Current liabilities: current liabilities are those liabilities to pay outside with in the year. For
example sundry creditor, bill payable, bank overdraft, outstanding expenses.
Gross working capital:
In the broader sense, the term working capital refers to the gross working capital. The
notion of the gross working capital refers to the capital invested in total current assets of the
enterprise. Current assets are those assets, which in the ordinary course of business, can be
converted into cash within a short period, normally one accounting year.
Net working capital:
In a narrow sense, the term working capital refers to the net working capital. Networking
capital represents the excess of current assets over current liabilities.
WORKING CAPITAL CYCLE

Factors determining the working capital requirements

1. Nature or character of business: The working capital requirements of a firm basically
depend upon the nature of its business. Public utility undertakings like electricity, water
supply and railways need very limited working capital as their sales are on cash and are
engaged in provision of services only. On the other hand, trading firms require more
investment in inventories, receivables and cash and such they need large amount of
working capital. The manufacturing undertakings also require sizable working capital.
2. Size of business or scale of operations: The working capital requirements of a concern
are directly influenced by the size of its business, which may be measured in terms of
scale of operations. Greater the size of a business unit, generally, larger will be the
requirements of working capital. However, in some cases, even a smaller concern may

50
 need more working capital due to high overhead charges, inefficient use of available
resources and other economic disadvantages of small size.
3. Production policy: If the demand for a given product is subject to wide fluctuations due
to seasonal variations, the requirements of working capital, in such cases, depend upon
the production policy. The production could be kept either steady by accumulating
inventories during stack periods with a view to meet high demand during the peck
season or the production could be curtailed during the slack season and increased during
the peak season. If the policy is to keep the production steady by accumulating
inventories it will require higher working capital.
4. Manufacturing process/Length of production cycle: In manufacturing business, the
requirements of working capital will be in direct proportion to the length of
manufacturing process. Longer the process period of manufacture, larger is the amount
of working capital required, as the raw materials and other supplies have to be carried
for a longer period.
5. Seasonal variations: If the raw material availability is seasonal, they have to be bought
in bulk during the season to ensure an uninterrupted material for the production. A huge
amount is, thus, blocked in the form of material, inventories during such season, which
give rise to more working capital requirements. Generally, during the busy season, a
firm requires larger working capital then in the slack season.
6. Working capital cycle: In a manufacturing concern, the working capital cycle starts
with the purchase of raw material and ends with the realization of cash from the sale of
finished products. This cycle involves purchase of raw materials and stores, its
conversion into stocks of finished goods through work–in progress with progressive
increment of labour and service costs, conversion of finished stock into sales, debtors
and receivables and ultimately realization of cash. This cycle continues again from cash
to purchase of raw materials and so on. In general the longer the operating cycle, the
larger the requirement of working capital.
7. Credit policy: The credit policy of a concern in its dealings with debtors and creditors
influences considerably the requirements of working capital. A concern that purchases
its requirements on credit requires lesser amount of working capital compared to the
firm, which buys on cash. On the other hand, a concern allowing credit to its customers
shall need larger amount of working capital compared to a firm selling only on cash.
8. Business cycles: Business cycle refers to alternate expansion and contraction in general
business activity. In a period of boom, i.e., when the business is prosperous, there is a
need for larger amount of working capital due to increase in sales. On the contrary, in
the times of depression, i.e., when there is a down swing of the cycle, the business
contracts, sales decline, difficulties are faced in collection from debtors and firms may
have to hold large amount of working capital.
9. Rate of growth of business: The working capital requirements of a concern increase
with the growth and expansion of its business activities. The retained profits may

51
 provide for a part of working capital but the fast growing concerns need larger amount
of working capital than the amount of undistributed profits.

METHODS AND SOURCES OF FINANCE

Methods of finance
1. Long term finance

2. Medium term finance

3. Short term finance

SOURCES OF FINANCE
1. Long term finance: long term finance available for a long period say five years and
above. The long term methods outlined below are used to purchase fixed assets such as
land and buildings, plant and so on.

a) Own capital : irrespective of the form of organization such as soletrader, partnership or

a company, the owners of the business have to invest their own finances to start with.
Money invested by the owners, partners or promoters is permanent and will stay with
the business throughout the life of business.

b) Share capital : normally in the case of a company, the capital is raised by issue of
shares. The capital so raised is called share capital. The share capital can be of two
types, preference share capital and equity share capital.

c) Debentures: debentures are the loans taken by the company. It is a certificate or letter
by the company under its common seal acknowledging the receipt of loan. A debenture
holder is the creditor of the company. A debenture holder is entitled to a fixed rate of
interest on the debenture amount.

d) Government grants and loans: government may provide long term finance directly to
the business houses or by indirectly subscribing to the shares of the companies. The
government gives loans only if the project satisfies certain conditions, such as setting up
a project in a notified area, or ventures into projects which are beneficial for the society
as a whole.

2. Medium term finance

a. Bank loans ; bank loans are extended at a fixed rate of interest. Repayment of the loan
and interest are scheduled at the beginning and are usually directly debited to the current
account of the borrower. These are secured loans.

52
 b. Hire purchase: it is a facility to buy a fixed asset while paying the price over a long
period of time. In other words , the possession of the asset can be taken by making a
down payment of a part of the price and the balance will be repaid with a fixed rate of
interest in agreed number of installments.

c. Leasing or renting: where there is a need for fixed assets, the asset need not be
purchased. It can be taken on lease or rent for specified number of years. The company
who owns the assets is called lessor and the company which takes the asset on lease is
called lessee. The agreement between the lessor and lessee is called a lease agreement.

d. Venture capital: this form of finance is available only for limited companies. Venture
capital is normally provided in such projects where there is relatively a higher degree of
risk. For such projects, finance through the conventional sources may not be available.
Many banks offer such finance through their merchant banking divisions, or specialist
banks which offer advice and financial assistance. The financial assistance may take
form of loans and venture capital.

3. Short term finance

a. Commercial paper: it is new money market instrument introduced in india in recent

times. Cps are issued in large denominations by the leading, nationally reputed, highly
rated and credit worthy, large manufacturing and finance companies in the public and
private sector. The proceeds of the issue of commercial paper are used to finance current
transactions and seasonal and interim needs for funds.

b. Bank overdraft: this is special arrangement with the banker where the customer can draw
more than what he has in his saving/ current account subject to a maximum limit.
interest is charged on a day to day basis on the actual amount overdrawn .

c. Trade credit: this is short term credit facility extended by the creditors to the debtors,
normally, it is common for the traders to buy the materials and other supplies from the
suppliers on credit basis. After selling the stocks the traders pay the cash and buy fresh
stocks again on credit. Sometimes , the suppliers may insist on the buyer to sign a bill.

CAPITAL BUDGETING
Capital budgeting is the process of making investment decision in long-term assets or
courses of action. Capital expenditure incurred today is expected to bring its benefits over a
period of time. These expenditures are related to the acquisition & improvement of fixes assets.
Capital budgeting is the planning of expenditure and the benefit, which spread over a
number of years. It is the process of deciding whether or not to invest in a particular project, as
the investment possibilities may not be rewarding. The manager has to choose a project, which
gives a rate of return, which is more than the cost of financing the project. For this the manager
has to evaluate the worth of the projects in-terms of cost and benefits. The benefits are the

53
expected cash inflows from the project, which are discounted against a standard, generally the
cost of capital.

Significance of capital budgeting

1. 1 ) s ubs ta ntia l expen di ture : ca pital budge ting decis ion involv es the
inves tm ent of s ubs tantial am ount of f unds and is thus it is ne ces s ary f or a
f irm to m ake such decis ion aft er a though tf ul cons id eration, s o as to res ult
in prof itable us e of s carce res ources . H as ty and incorrec t decis ions w ould not
only res ult in huge los s es but w ould als o a ccount f or failure of th e firm .
2. l o ng tim e peri o d : ca pital budge ting decis ion has its ef f ect over a long
period of tim e, the y af f ec t the f uture benef its and als o th e firm and inf luen ce
the rat e and direction of grow th of the f irm .
3. i rrev e rsi bi l i ty : mos t of s uch de cis ions are irrevers ibl e, onc e taken, the f irm
m ay not been in a pos ition to rev ers e its im pa ct. This m ay be due to the
reas on, that it is dif f icult to f ind a buyer f or s econd -hand capi tal item s .
4. co m pl ex deci s i o n : ca pital inves tm en t decis ion involv es an as s es s m ent of
f uture even ts , w hich in f ac t are dif f icult to predi ct, further, it is dif f icult to
es tim at e in quanti tativ e term s all benef its or cos ts relating to a par ticular
inves tm ent decis ion.

Nature of capital budgeting:

1. generating investment proposals
2. estimating cash for the proposals
3. evaluating cash flows
4. selection of projects
5. monitoring and re-evaluating

scope of capital budgeting:

1. substantial capital outlays
2. long term implication
3. strategic in nature
4. Irreversibility.

Methods of capital budgeting

The capital budgeting appraisal methods are techniques of evaluation of investment
proposal will help the company to decide upon the desirability of an investment proposal
depending upon their; relative income generating capacity and rank them in order of their
desirability. These methods provide the company a set of norms on the basis of which either it
has to accept or reject the investment proposal. The most widely accepted techniques used in
estimating the cost-returns of investment projects can be grouped under two categories.
1. Traditional methods
2. Discounted Cash flow methods
1. Traditional methods

54
These methods are based on the principles to determine the desirability of an investment project
on the basis of its useful life and expected returns. These methods depend upon the accounting
information available from the books of accounts of the company. These will not take into
account the concept of ‘time value of money’, which is a significant factor to determine the
desirability of a project in terms of present value.

A. Pay-back period method: It is the most popular and widely recognized traditional method
of evaluating the investment proposals. It can be defined, as ‘the number of years required to
recover the original cash out lay invested in a project’.
According to Weston & Brigham, “The pay back period is the number of years it takes the firm
to recover its original investment by net returns before depreciation, but after taxes”.
According to James. C. Vanhorne, “The payback period is the number of years required to
recover initial cash investment.

The pay back period is also called payout or payoff period. This period is calculated by
dividing the cost of the project by the annual earnings after tax but before depreciation under
this method the projects are ranked on the basis of the length of the payback period. A project
with the shortest payback period will be given the highest rank and taken as the best investment.
The shorter the payback period, the less risky the investment is the formula for payback period
is
Merits:
1. It is one of the earliest methods of evaluating the investment projects
2. It is simple to understand and to compute.
3. It dose not involve any cost for computation of the payback period
4. It is one of the widely used methods in small scale industry sector
5. It can be computed on the basis of accounting information available from the books.

Demerits:
1. This method fails to take into account the cash flows received by the company after the pay
back period.
2. It doesn’t take into account the interest factor involved in an investment outlay.
3. It doesn’t take into account the interest factor involved in an investment outlay.
4. It is not consistent with the objective of maximizing the market value of the company’s share.
5. It fails to consider the pattern of cash inflows i. e., the magnitude and timing of cash in flows.

Cash outlay (or) original cost of project

Pay-back period = -------------------------------------------
Annual cash inflow

Pay back methods = cost of the project – accumulate annual cash inflow
lower year + -------------------------------------------------------------------

55
 Accumulate annual cash - accumulate annual cash inflow
Inflow of next year

B. Accounting (or) Average rate of return method (ARR):

It is an accounting method, which uses the accounting information repeated by the financial
statements to measure the probability of an investment proposal. It can be determine by dividing
the average income after taxes by the average investment i.e., the average book value after
depreciation.
According to ‘Soloman’, accounting rate of return on an investment can be calculated as the
ratio of accounting net income to the initial investment, i.e.,
Average rate of return= average annual profit after tax
---------------------------------------- x 100
Average investment

Average annual profit after tax = sum of profit after tax

----------------------------------
No. of the years

Average investment = cost – scrap value

--------------------- + additional working capital + scrap value
2

Merits:
1. It is very simple to understand and calculate.
2. It can be readily computed with the help of the available accounting data.
3. It uses the entire stream of earning to calculate the ARR.

Demerits:
1. It is not based on cash flows generated by a project.
2. This method does not consider the objective of wealth maximization
3. IT ignores the length of the projects useful life.
4. It does not take into account the fact that the profits can be re-invested.

II: Discounted cash flow methods:

The traditional method does not take into consideration the time value of money. They
give equal weight age to the present and future flow of incomes. The DCF methods are based on
the concept that a rupee earned today is more worth than a rupee earned tomorrow. These
methods take into consideration the profitability and also time value of money.
A. Net present value method (NPV)
The NPV takes into consideration the time value of money. The cash flows of different
years and valued differently and made comparable in terms of present values for this the net
cash inflows of various period are discounted using required rate of return which is
predetermined.

56
 According to Ezra Solomon, “It is a present value of future returns, discounted at the
required rate of return minus the present value of the cost of the investment.”
NPV is the difference between the present value of cash inflows of a project and the initial cost
of the project.
According the NPV technique, only one project will be selected whose NPV is positive
or above zero. If a project(s) NPV is less than ‘Zero’. It gives negative NPV hence. It must be
rejected. If there are more than one project with positive NPV’s the project is selected whose
NPV is the highest.
NPV = PRESENT VALUE OF CASH INFLOW – PRESENT VALUE OF CASH OUTFLOW
Merits:
1. It recognizes the time value of money.
2. It is based on the entire cash flows generated during the useful life of the asset.
3. It is consistent with the objective of maximization of wealth of the owners.
4. The ranking of projects is independent of the discount rate used for determining the
present value.
Demerits:
1. It is different to understand and use.
2. The NPV is calculated by using the cost of capital as a discount rate. But the concept of
cost of capital. If self is difficult to understood and determine.
3. It does not give solutions when the comparable projects are involved in different
amounts of investment.
4. It does not give correct answer to a question whether alternative projects or limited
funds are available with unequal lines.

PROFITABILITY INDEX (PI)

It is a capital budgeting technique to evaluate the investment projects for
their viability or profitability. Discounted cash flow technique is used in
arriving at the profitability index. It is also known as a benefit-cost ratio.
Calculation of profitability index is possible with a simple formula with inputs
as – discount rate, cash inflows and outflows. PI greater than or equal to 1
is interpreted as a good and acceptable criterion.

Profitability index = present value of cash inflow / present value of cash

outflow

Internal Rate of Return Method (IRR)

Internal Rate of Return Method is also called as "Time Adjusted Rate of Return
Method." It is defined as the rate which equates the present value of each cash inflows with
the present value of cash outflows of an investment. In other words, it is the rate at which
the net present value of the investment is zero.

57
 Horngren and Foster define Internal Rate of Return as the rate of interest at which
the present value of expected cash inflows from a project equals the present value of
expected cash outflows of the project.
The Internal Rate of Return can be found out by Trial and Error Method. First,
compute the present value of the cash flow from an investment, using an arbitrarily
selected interest rate, for example 10%. Then compare the present value so obtained with
the investment cost.

Lower discount factor - original investment

Present value
Internal rate of return = lower discount +
------------------------------------------------------------------- (HDF – LDF)
Factor lower discount factor – high discount
factor
Present value present
value

ADVANTAGES OF INTERNAL RATE OF RETURN:

 Time Value of Money: The first and the most important thing is that it considers the
time value of money in evaluating a project which is a big lacking in accounting rate of
return.

 Simplicity: The most attractive thing about this method is that it is very simple to
interpret after the IRR is calculated.

 Hurdle Rate: he hurdle rate is a difficult and subjective thing to

decide. In IRR, the hurdle rate or the required rate of return is not
required for finding out IRR.

 Required Rate of Return is a Rough Estimate: A required rate of return

is a rough estimate being made by the managers and the method of
IRR is not completely based on required rate of return.

DISADVANTAGES OF INTERNAL RATE OF RETURN:

 Economies of Scale Ignored: One pitfall in the use of IRR method is
that it ignores the actual dollar value of benefits.
 Impractical Implicit Assumption of Reinvestment Rate: While
analyzing a project with IRR method, it implicitly assumes that the
positive future cash flows are reinvested at IRR. If a project has low
IRR, it will assume reinvestment at a low rate of return and on the
contrary if the other project has very high IRR, it will assume
reinvestment rate at the very high rate of return.

58
  Dependent or Contingent Projects: Many times, finance managers
come across a situation when the project under evaluation creates a
compulsion of investing in other projects.

 Mutually Exclusive Projects: Sometimes investors come across

mutually exclusive projects which mean if one is accepted other
cannot be accepted. Building a hotel or a commercial complex on a
particular plot of land is an example of mutually exclusive projects.

UNIT - V
INTRODUCTION TO FINANCIAL ACCOUNTING AND RATIO ANALYSIS

DOUBLE ENTRY SYSTEM:

Every transaction has two aspects. When we receive something, we give something else
in return. For example, when we purchase goods for cash, we receive goods and give cash in
return. Similarly when goods are sold on credit, goods are given and the customer becomes
debtor. This method of writing every transaction in two accounts is knows as double entry
systems of accounting.
Stages of double entry system:
1. All transaction are first recorded in journal or books of original entry known as
subsidiary books as and when they take place.

2. All entries in the journal or subsidiary books are posted in the ledger.

3. All the accounts are closed or balanced and final accounts are prepared.

Advantages of double- entry book – keeping

1. Information about every account: under double entry systems, both aspects of a
transaction are being recorded in the books of accounts. Hence information about every
account is available in the books of account as all accounts are to be found in the ledgers
under double entry system.

2. Helps to know the receivables and payables: it helps to know how much is owed to the
creditors and how much is due from the debtors, also it focuses on the bills payable and
receivables.

3. Arithmetical accuracy: the arithmetical accuracy can be ascertained by preparing a

statement of debits and credits called trial balance and this is possible because both debit
aspects and credit aspects of every transaction are recorded.

4. Helps to locate errors: trial balance can reveal the errors that creep in account while
recording the business information.

5. Helps to ascertain profit / loss: the profit and loss statement can be prepared without
much difficulty under double entry system.

59
 6. Helps to know the financial position: double entry system helps to prepare balance sheet
that reveals the financial position of the business as on a particular date.

7. Monitoring and auditing made easier: with double entry system the scope for frauds and
misappropriations is less, provided proper internal audit system is in place.

INTRODUCTION TO ACCOUNTING

Accounting is the science of recording and classifying business transactions and events
primarily of financial character, and the art of making significant, summaries, analysis and
interpretations of those transaction and events, and communicating the results to persons who
must make decisions or form judgment.
Meaning and Scope of Accounting

Accounting is the language of business. The main objectives of Accounting is to

safeguard the interests of the business, its proprietors and others connected with the
business transactions. This is done by providing suitable information to the owners,
creditors, shareholders, Government, financial institutions and other related agencies.
Definition of Accounting
The American Accounting Association defines accounting as "the process of
identifying, measuring and communicating economic information to permit informed
judgements and decisions by the users of the information."

According to AICPA (American Institute of Certified Public Accountants) it is defined

as "the art of recording, classifying and summarizing in a significant manner and in terms
of money, transactions and events which are in part at least of a financial character and
interpreting the result thereof."

Steps of Accounting
The following are the important steps to be adopted in the accounting process:
1. Recording: Recording all the transactions in subsidiary books for purpose of future
record or reference. It is referred to as "Journal."
2. Classifying: All recorded transactions in subsidiary books are classified and posted to
the main book of accounts. It is known as "Ledger."
3. Summarizing: All recorded transactions in main books will be summarized for the
preparation of Trail Balance, Profit and Loss Account and Balance Sheet.
4. Interpreting: Interpreting refers to the explanation of the meaning and significance of
the result of final accounts and balance sheet so that parties concerned with business can
determine the future earnings, ability to pay interest, liquidity and profitability of a sound
dividend policy.

Functions of Accounting
From the definition and analysis of the above the main functions of accounting can be
summarized as: (1) Keeping systematic record of business transactions.
(2) Protecting properties of the business.
(3) Communicating the results to various parties interested in or connected with the
business.
(4) Meeting legal requirements.

60
 Objectives of Accounting
(1) Providing suitable information with an aim of safeguarding the interest of the business
and its proprietors and others connected with it.
(2) To emphasis on the ascertainment and exhibition of profits earned or losses incurred in
the business.
(3) To ascertain the financial position of the business as a whole.
(4) To ensure accounts are prepared according to some accepted accounting concepts and
conventions. (5) To comply with the requirements of the Companies Act, Income Tax Act,
etc.

Limitations of Accounting
(1) Accounting provides only limited information because it reveals the profitability of the
concern as a whole.
(2) Accounting considers only those transactions which can be measured in terms of money
or quantitatively expressed. Qualitative information is not taken into account.
(3) Accounting provides limited information to the management.
(4) Accounting is only historical in nature. It provides only a post mortem record of
business transactions.

Significance of accounting:
1. Maintain its own records of business

2. Monitor the business acitivities

3. Calculate profit or loss for a given period

4. Fulfill legal obligations

5. Show financial position for a given period

6. Communicate the information to the interested parties

Accounting terms
 Business transactions: any exchange of money or money worth is called business
transaction. Events like purchase and sale of goods, receipts and payments of cash for
services.

 Debtor : a debtor is a person who owes something to the business.

 Creditor: a creditor is a person to whom something is Owings by the business

 Capital : it is the amount invested by the proprietor in the business. For the business,
capital is a liability towards the owner. Some times it in called owner equity i.e, owners
claim against the assets. Owner’s equity or capital is always equal to assets minus
liabilities.

 Drawing: it is the value of cash or goods withdrawn from the business by the owner for
his personal uses.

61
  Goods : it includes all commodities or articles in which a trader deals.

 Assets : these are the material things or possessions or properties of the business
including the amount due to it. Examples are cash and bank balances, land and
buildings, plant and machinery.

 Liabilities : the term liabilities denote the amount which the business owes to others
such as loan from bank, creditors for goods supplied, for outstanding expenses.

Accounting principles:
Accounting Principles Various accounting systems and techniques are designed to meet the
needs of the management. The information should be recorded and presented in such a
way that management is able to arrive at right conclusions. The ultimate aim of the
management is to increase profitability and losses. In order to achieve the objectives of the
concern as a whole, it is essential to prepare the accounting statements in accordance with
the generally accepted principles and procedures. The term principles refers to the rule of
action or conduct to be applied in accounting. Accounting principles may be defined as
"those rules of conduct or procedure which are adopted by the accountants universally,
while recording the accounting transactions."
The accounting principles can be classified into two categories:
I. Accounting Concepts.

II. Accounting Conventions.

Accounting Concepts Accounting concepts mean and include necessary assumptions or

postulates or ideas which are used to accounting practice and preparation of financial
statements. The following are the important accounting concepts:
 Entity Concept;
 Dual Aspect Concept;
 Accounting Period Concept;
 Going Concern Concept;
 Cost Concept;
 Money Measurement Concept;
 Matching Concept;
 Realization Concept;
 Accrual Concept;
 Rupee Value Concept
II. Accounting Conventions Accounting Convention implies that those customs, methods
and practices to be followed as a guideline for preparation of accounting statements. The
accounting conventions can be classified as follows:
(1) Convention of Disclosure.
(2) Convention of Conservatism.
(3) Convention of Consistency.
(4) Convention of Materiality.

I. Accounting Concepts
1. Entity Concept: Separate entity concept implies that business unit or a company is a
body corporate and having a separate legal entity distinct from its proprietors. The
proprietors or members are not liable for the acts of the company. But in the case of the
partnership business or sole trader business no separate legal entity from its proprietors.
Here proprietors or members are liable for the acts of the firm. As per the separate entity
concept of accounting it applies to all forms of business to determine the scope of what is

62
to be recorded or what is to be excluded from the business books. For example, if the
proprietor of the business invests Rs.50,000 in his business, it is deemed that the
proprietor has given that much amount to the business as loan which will be shown as a
liability for the business. On withdrawal of any amount it will be debited in cash account
and credited in proprietor's capital account. In conclusion, this separate entity concept
applies much larger in body corporate sectors than sole traders and partnership firms.
2. Dual Aspect Concept: According to this concept, every business transaction involves two
aspects, namely, for every receiving of benefit and. there is a corresponding giving of
benefit. The dual aspect concept is the basis of the double entry book keeping. Accordingly
for every debit there is an equal and corresponding credit. The accounting equation of the
dual aspect concept is:
Capital + Liabilities = Assets (or) Assets = Equities (Capital)
(3) Accounting Period Concept: According to this concept, income or loss of a business can
be analysed and determined on the basis of suitable accounting period instead of wait for a
long period, Le., until it is liquidated. Being a business in continuous affairs for an indefinite
period of time, the proprietors, the shareholders and outsiders want to know the financial
position of the concern, periodically. Thus, the accounting period is normally adopted for
one year. At the end of the each accounting period an income statement and balance sheet
are prepared. This concept is simply intended for a periodical ascertainment and reporting
the true and fair financial position of the concern as a whole.
(4) Going Concern Concept: It is otherwise known as Continue of Activity Concept. This
concept assumes that business concern will continue for a long period to exit. In other
words, under this assumption, the enterprise is normally viewed as a going concern and it
is not likely to be liquidated in the near future. This assumption implies that while valuing
the assets of the business on the basis of productivity and not on the basis of their
realizable value or the present market value, at cost less depreciation till date for the
purpose of balance sheet. It is useful in valuation of assets and liabilities, depreciation of
fixed assets and treatment of prepaid expenses.
(5) Cost Concept: This concept is based on "Going Concern Concept." Cost Concept implies
that assets acquired are recorded in the accounting books at the cost or price paid to
acquire it. And this cost is the basis for subsequent accounting for the asset. For accounting
purpose the market value of assets are not taken into account either for valuation or
charging depreciation of such assets. Cost Concept has the advantage of bringing
objectivity in the preparation and presentation of financial statements. In the absence of
cost concept, figures shown in accounting records would be subjective and questionable.
But due to inflationary tendencies, the preparation of financial statements on the basis of
cost concept has become irrelevant for judging the true financial position of the business.
(6) Money Measurement Concept: According to this concept, accounting transactions are
measured, expressed and recorded in terms of money. This concept excludes those
transactions or events which cannot be expressed in terms of money. For example, factors
such as the skill of the supervisor, product policies, planning, employer-employee
relationship cannot be recorded in accounts in spite of their importance to the business.
This makes the financial statements incomplete.
(7) Matching Concept: Matching Concept is closely related to accounting period concept.
The chief aim of the business concern is to ascertain the profit periodically. To measure the
profit for a particular period it is essential to match accurately the costs associated with the
revenue. Thus, matching of costs and revenues related to a particular period is called as
Matching Concept.
(8) Realization Concept: Realization Concept is otherwise known as Revenue Recognition
Concept. According to this concept, revenue is the gross inflow of cash, receivables or
other considerations arising in the course of an enterprise from the sale of goods or
rendering of services from the holding of assets. If no sale takes place, no revenue is
considered. However, there are certain exceptions to this concept. Examples, Hire Purchase
/ Sale, Contract Accounts etc.

63
 (9) Accrual Concept: Accrual Concept is closely related to Matching Concept. According to
this concept, revenue recognition depends on its realization and not accrual receipt.
Likewise cost are recognized when they are incurred and not when paid. The accrual
concept ensures that the profit or loss shown is on the basis of full fact relating to all
expenses and incomes.
(10) Rupee Value Concept: This concept assumes that the value of rupee is constant. In
fact, due to inflationary pressures, the value of rupee will be declining. Under this
situations financial statements are prepared on the basis of historical costs not considering
the declining value of rupee. Similarly depreciation is also charged on the basis of cost
price. Thus, this concept results in underestimation of depreciation and overestimation of
assets in the balance sheet and hence will not reflect the true position of the business.
II. Accounting Conventions
(1) Convention of Disclosure: The disclosure of all material information is one of the
important accounting conventions. According to this conventions all accounting statements
should be honestly prepared and all facts and figures must be disclosed therein. The
disclosure of financial information’s are required for different parties who are interested in
the welfare of that enterprise. The Companies Act lays down the forms of Profit and Loss
Account and Balance Sheet. Thus convention of disclosure is required to be kept as per the
requirement of the Companies Act and Income Tax Act.
(2) Convention of Conservatism: This convention is closely related to the policy of playing
safe. This principle is" often described as "anticipate no profit, and provide for all possible
losses." Thus, this convention emphasise that uncertainties and risks inherent in business
transactions should be given proper consideration. For example, under this convention
inventory is valued at cost price or market price whichever is lower. Similarly, bad and
doubtful debts is made in the books before ascertaining the profit.
(3) Convention of Consistency: The Convention of Consistency implies that accounting
policies, procedures and methods should remain unchanged for preparation of financial
statements from one period to another. Under this convention alternative improved
accounting policies are also equally acceptable. In order to measure the operational
efficiency of a concern, this convention allows a meaningful comparison in the performance
of different period.
(4) Convention of Materiality: According to Kohler's Dictionary of Accountants Materiality
may be defined as "the characteristic attaching to a statement fact, or item whereby its
disclosure or method of giving it expression would be likely to influence the judgment of a
reasonable person." According to this convention consideration is given to all material
events, insignificant details are ignored while preparing the profit and loss account and
balance sheet. The evaluation and decision of material or immaterial depends upon the
circumstances and lies at the discretion of the Accountant.

ACCOUNTING RULES:
Personal Account: these are the accounts of natural persons such as ram account, gopal
account. Artificial person such as udayltd, syndicate bank. And representative personal account.

Real Accounts: accounts relating to properties or assets of a trader are known as real accounts.
It includes tangible assests such as buildings, furniture,. Cash, etc and also intangible assets
such as goodwill, trade marks, patent rights.

64
Nominal Accounts : account dealing with expenses, losses, gains and incomes are called
nominal accounts, eg. Salaries, wages commission account etc.

USERS OF ACCOUNTING INFORMATION:

1. Proprietors: a business is done with the objective of making profit. Its profitability and
financial soundness are, therefore, matter s of prime importance to the proprietors who
have invested their money in the business.

2. Managers: in a sole proprietary business, usually the proprietor is the manager. In case of a
partnership business either some or all the partners participate in the management of the
business.

3. Creditors: creditors are the persons who have extended credit to the company. They are also
interested in the financial statement because they will help them in asscertainting whether
the enterprise will be in a position to meet its commitment towards the both regarding
payment of interest and principal.

4. Prospective investors: a person who is contemplating an investment in a business will like

to known about its profitability and financial position. A study of the financial statements
will help him in this respect.

5. Government: the government is interested in the financial statements of business enterprise

on account of taxation, labour and corporate laws. If necessary, the government may ask its
officials to examine the accounting records of a business.

6. Employees: the employees are interested in the financial statements on account of various
profit sharing and bonus schemes. Their interest may further increase in case they purchase
shares of the companies in which they are employed.

JOURNAL
Journal means a daily record of business transactions. Journal being a book of original
entry. The transaction is first written in the journal from which it is posted to the ledger. The
transactions will be recorded as and when they occur and in the order in which they occur.

Date Particular LF Debit Credit

Cash a/c----------------------------DR 20,000

65
 To ram a/c 20,000

( narration )

Where: ledger folio . in this column the pages numbers on which the various accounts appear
in the ledger are entered.
Narration : an explanation of the entry in the particular column.
Note : Dr mean a amount transfer to debit column

Ledger:
Ledger is a book in which various accounts such as personal, real and nominal account are
opened. Every transaction is first recorded in the journal, and from it, transferred to the
concerned account in the ledger. This process of transferring the transaction from the journal to
the ledger is called posting.

Dr ledger a/c
Cr
Date Particular JF Amount Date Particular JF Amount

Note:
Dr means debit side it is always start with TO, Cr means credit side it is always start with By
Balancing an account: after all transaction have been posted and the various accounts prepared
they are balanced. The procedure for balancing ledger accounts is as follows.
1. Take the totals of the two sides of the account on a rough sheet.

2. Ascertain the difference between the totals of two sides . the difference is called
“balance”

3. Enter the difference in the amount column of the side showing less total. If the credit
side total is less , write in the particulars column on the credit side of the account , By
balance c/d. similarly if the debit side is less , write on the debit side of the account To
balance c/d.

TRAIL BALANCE
The first step in the preparation of final accounts is the preparation of trail balance. In the
double entry system of book keeping, there will be credit for every debit and there will not be
any debit without credit. When this principle is followed in writing journal entries, the total
amount of all debits is equal to the total amount all credits.
A trail balance is a statement of debit and credit balances. It is prepared on a particular date
with the object of checking the accuracy of the books of accounts. It indicates that all the
transactions for a particular period have been duly entered in the book, properly posted and
balanced. The trail balance doesn’t include stock in hand at the end of the period. All

66
adjustments required to be done at the end of the period including closing stock are generally
given under the trail balance.

DEFINITIONS: SPICER AND POGLAR :A trail balance is a list of all the balances
standing on the ledger accounts and cash book of a concern at any given date.
J.R.BATLIBOI:
A trail balance is a statement of debit and credit balances extracted from the ledger with a view
to test the arithmetical accuracy of the books.
Thus a trail balance is a list of balances of the ledger accounts’ and cash book of a business
concern at any given date
PROFORMA FOR TRAIL BALANCE:
Trail balance for MR…………………………………… as on …………
N NAME OF ACCOUNT DEBIT CREDIT
O (PARTICULARS) AMOUNT(RS.) AMOUNT(RS.)

FINAL ACCOUNT
In every business, the business man is interested in knowing whether the business has
resulted in profit or loss and what the financial position of the business is at a given time. In
brief, he wants to know (i)The profitability of the business and (ii) The soundness of the
business.
The trader can ascertain this by preparing the final accounts. The final accounts are prepared
from the trial balance. Hence the trial balance is said to be the link between the ledger accounts
and the final accounts. The final accounts of a firm can be divided into two stages. The first
stage is preparing the trading and profit and loss account and the second stage is preparing the
balance sheet.
1. Trading account

2. Profit and loss account

3. Balance sheet.

Trading account
Trading account is a part of profit and loss account . trading account is prepared for
ascertaining Gross profit or gross loss. The difference between the sales and the cost of the
goods sold is gross profit. Cost of good sold can be ascertained by adding opening stock ,
purchases, direct expenses for purchase of goods and deduction there from closing stock and
sales.
PROFORMA OF TRADING ACCOUNT

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Trading account of ------------- for the year ended 31 march ----
Particular Amount Particular Amount
To opening stock Xxxx By Sales
xxxxx Xxxx
To Purchase Less; Sales return
xxxx Xxxx xxxxx
Less: purchase return
xxxx

To carriage inwards Xxx By closing stock Xxxx

To wage Xxxx
To freight , duty clearing charges Xxxx
To fuel and power Xxxx
To coal, gas, and water Xxxx
To motive power Xxxx
To factory rent Xxxx
To manufacturing expenses Xxxx
To direct expenses Xxxx
To factory lighting Xxxx
To gross profit Xxxx
Xxxxxxx xxxxxxx

PROFIT AND LOSS ACCOUNT

Profit and loss account is prepared to ascertain the net profit or net loss of the business
for a particular period. All indirect expenses such as management and office expenses, financial
expenses, selling and distribution expenses are taken on the debit side. Gross profit and other
items of incomes such as interest received , discount received, etc. are taken on credit side. The
different between two sides is either net profit or net loss which is transferred to capital account.
The business man is always interested in knowing his net income or net profit.Net profit
represents the excess of gross profit plus the other revenue incomes over administrative, sales,
Financial and other expenses. The debit side of profit and loss account shows the expenses and
the credit side the incomes. If the total of the credit side is more, it will be the net profit. And if
the debit side is more, it will be net loss.
PROFORMA OF PROFIT AND LOSS ACCOUNT
Profit and loss of --------------- for the year ended 31 march xxx
Particular Amount Particular Amount
To Salaries By gross profit Xxx
xxx Xxx
Add : outstanding salaries
xxx
To Rent Xxx By Discount receive Xxx
To Discount allowed Xxx By Interest receive Xxx
To Office expenses Xxx By Commission receive Xxx
To Rate and tax Xxx
To Lighting Xxx

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To Printing and stationery Xxx
To Postage and telegrams Xxx
To Telephone charges Xxx
To Legal expenses Xxx
To Telephone charges Xxx
To Audit fee Xxx
To General expenses Xxx
To Advertisement Xxx
To Insurance Xxx
To interest on capital Xxx
To deprecation on Xxx
assets( machinery , building ,
furniture, land.etc)
To repair Xxx
To carriage outward Xxx
To written off bad debts Xxx
To travelling expenses Xxx
To interest on loan Xxx
To net profit Xxx
Xxxxxx Xxxxxx

BALANCE SHEET:
The second point of final accounts is the preparation of balance sheet. It is prepared
often in the trading and profit, loss accounts have been compiled and closed. A balance sheet
may be considered as a statement of the financial position of the concern at a given date.
DEFINITION: A balance sheet is an item wise list of assets, liabilities and proprietorship of a
business at a certain state.
J.R.botliboi: A balance sheet is a statement with a view to measure exact financial position of a
business at a particular date.
Thus, Balance sheet is defined as a statement which sets out the assets and liabilities of a
business firm and which serves to as certain the financial position of the same on any particular
date. On the left-hand side of this statement, the liabilities and the capital are shown. On the
right-hand side all the assets are shown. Therefore, the two sides of the balance sheet should be
equal. Otherwise, there is an error somewhere.

PROFORMA OF BALANCE SHEET

Balance sheet of Mr.------------------------------ for the year ending on 31 march xxxxx
Liabilities Amount Assets Amount
Capital xxxx Plant and machinery
Add: interest on capital xxxx Xxx Xxx
Net profit xxxx Less: depreciation on plant machinery
------ xxx
Xxxx Xxx
Less: drawings xxxx Building
Net loss xxxx Xxx xxx Xxx
Less : depreciation on building

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 xxx
Land
xxx
Less ; depreciation on land
xxx
Sundry creditor xxx Sundry debtor
xxx Xxx
Less : written of bad debts
xxx
Bank overdraft Xxx Cash in hand Xxx
Outstanding expenses Xxxx Cash at bank Xxx
Reserves Xxx Investment Xxx
Long term loans Xxx Bill receivable Xxxx
Bill payable Xxx Prepaid expenses Xxx
Prepaid expenses Xxx
Vehicle Xxx
Closing stock Xxx
Xxxxx Xxxxx

Advantages: The following are the advantages of final balance .

1. It helps in checking the arithmetical accuracy of books of accounts.
2. It helps in the preparation of financial statements.
3. It helps in detecting errors.
4. It serves as an instrument for carrying out the job of rectification of entries.
5. It is possible to find out the balances of various accounts at one place.

Difference between trading account and profit and loss account

Trading account Profit and loss account
It is the first stage of final accounts it is the second stage of the final accounts
It shows the gross profit and gross loss result It shows the net profit and net loss results
of the business.
All direct expenses are considered in it. All expenses connected with sales and
administration of business are considered.
It does not start with the balance of any It always starts with the balance of a trading
account account
Its balance transferred to profit and loss Its balance is transferred to capital account in
account as gross profit or gross loss balance sheet as net profit and net loss.

Difference between trial balance and balance sheet

Trial balance Balance sheet
It is prepared to verify the arithmetical It is prepared to disclose the true financial

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accuracy of books of accounts position of the business
It is prepared with balances of all the ledger It is prepared with the balances of assets
accounts and liabilities accounts.
It is not a part of final accounts It is an important part of final accounts.
It is prepared before the preparation of final It is prepared after the preparation of
accounts
trading and profit and loss account.
It may be prepared a number of time in an It is generally prepared once at the end of
accounting year.
accounting year.
Generally, it includes opening stock but not It always includes closing stock but not
closing stock.
opening stock.
There is no rule for arranging the ledger Assets and liabilities must be shown in it
balances in it.
according to the rule of marshaling
It is not required to be filed to anybody. It must be filed with the registrar of
companies if the business is a company.
Auditor need not to sign it. Auditor must sign it.

FINAL ACCOUNTS -- ADJUSTMENTS

We know that business is a going concern. It has to be carried on indefinitely. At the end
of every accounting year. The trader prepares the trading and profit and loss account and
balance sheet. While preparing these financial statements, sometimes the trader may come
across certain problems .The expenses of the current year may be still payable or the expenses
of the next year have been prepaid during the current year. In the same way, the income of the
current year still receivable and the income of the next year have been received during the
current year. Without these adjustments, the profit figures arrived at or the financial position of
the concern may not be correct. As such these adjustments are to be made while preparing the
final accounts.
The adjustments to be made to final accounts will be given under the Trial Balance. While
making the adjustment in the final accounts, the student should remember that “every
adjustment is to be made in the final accounts twice i.e. once in trading, profit and loss account
and later in balance sheet generally”. The following are some of the important adjustments to be
made at the time of preparing of final accounts:-

1. CLOSING STOCK :-
(i)If closing stock is given in Trail Balance: It should be shown only in the balance sheet
“Assets Side”.
(ii)If closing stock is given as adjustment :

1. First, it should be posted at the credit side of “Trading Account”.

2. Next, shown at the asset side of the “Balance Sheet”.

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2.OUTSTANDING EXPENSES :-
(i)If outstanding expenses given in Trail Balance: It should be only on the liability side of
Balance Sheet.
(ii)If outstanding expenses given as adjustment :
1. First, it should be added to the concerned expense at the
debit side of profit and loss account or Trading Account.
2. Next, it should be added at the liabilities side of the
Balance Sheet.

3.PREAPID EXPENSES :-
(i)If prepaid expenses given in Trial Balance: It should be shown only in assets side of the
Balance Sheet.
(ii)If prepaid expense given as adjustment :
1. First, it should be deducted from the concerned expenses at the debit side of profit and
loss account or Trading Account.
2. Next, it should be shown at the assets side of the Balance Sheet.

4.INCOME EARNED BUT NOT RECEIVED [OR] OUTSTANDING INCOME [OR]

ACCURED INCOME :-
(i)If incomes given in Trial Balance: It should be shown only on the assets side of the Balance
Sheet.
(ii)If incomes outstanding given as adjustment:
1. First, it should be added to the concerned income at the credit side of profit and loss
account.
2. Next, it should be shown at the assets side of the Balance sheet.

5. INCOME RECEIVED IN ADVANCE: UNEARNED INCOME:-

(i)If unearned incomes given in Trail Balance : It should be shown only on the liabilities side of
the Balance Sheet.
(ii)If unearned income given as adjustment :
1. First, it should be deducted from the concerned income in the credit side of the profit
and loss account.
2. Secondly, it should be shown in the liabilities side of the
Balance Sheet.
6.DEPRECIATION:-
(i)If Depreciation given in Trail Balance: It should be shown only on the debit side of the profit
and loss account.
(ii)If Depreciation given as adjustment
1. First, it should be shown on the debit side of the profit and loss account.
2. Secondly, it should be deduced from the concerned asset in the Balance sheet assets side.

7.INTEREST ON LOAN [OR] CAPITAL :-

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(i)If interest on loan (or) capital given in Trail balance :It should be shown only on debit side
of the profit and loss account
(ii)If interest on loan (or)capital given as adjustment :
1. First, it should be shown on debit side of the profit and loss account.
2. Secondly, it should added to the loan or capital in
the liabilities side of the Balance Sheet.
8.BAD DEBTS:-
(i)If bad debts given in Trail balance :It should be shown on the debit side of the profit and loss
account.
(ii)If bad debts given as adjustment:
1. First, it should be shown on the debit side of the profit and loss account.
2. Secondly, it should be deducted from debtors in the assets side of the Balance Sheet.

9.INTEREST ON DRAWINGS :-
(i)If interest on drawings given in Trail balance: It should be shown on the credit side of the
profit and loss account.
(ii)If interest on drawings given as adjustments :
1. First, it should be shown on the credit side of the profit and loss account.
2. Secondly, it should be deducted from capital on liabilities
side of the Balance Sheet.
10.INTEREST ON INVESTMENTS :-
(i)If interest on the investments given in Trail balance :It should be shown on the credit side of
the profit and loss account.
(ii)If interest on investments given as adjustments :
1. First, it should be shown on the credit side of the profit and loss account.
2. Secondly, it should be added to the investments on assets side of the Balance Sheet.

FINANCIAL ANALYSIS THROUGH RATIOS

Ratio Analysis
Absolute figures are valuable but they standing alone convey no meaning unless compared with
another. Accounting ratio show inter-relationships which exist among various accounting data.
When relationships among various accounting data supplied by financial statements are worked
out, they are known as accounting ratios.
Accounting ratios can be expressed in various ways such as:
1. a pure ratio says ratio of current assets to current liabilities is 2:1 or
2. a rate say current assets are two times of current liabilities or

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 3. a percentage say current assets are 200% of current liabilities.
Each method of expression has a distinct advantage over the other the analyst will selected that
mode which will best suit his convenience and purpose.
Uses or Advantages or Importance of Ratio Analysis
Ratio Analysis stands for the process of determining and presenting the relationship of items
and groups of items in the financial statements. It is an important technique of financial
analysis. It is a way by which financial stability and health of a concern can be judged. The
following are the main uses of Ratio analysis:
(i) Useful in financial position analysis: Accounting reveals the financial position of the
concern. This helps banks, insurance companies and other financial institution in lending
and making investment decisions.
(ii) Useful in simplifying accounting figures: Accounting ratios simplify, summaries and
systematic the accounting figures in order to make them more understandable and in lucid
form.
(iii) Useful in assessing the operational efficiency: Accounting ratios helps to have an idea
of the working of a concern. The efficiency of the firm becomes evident when analysis is
based on accounting ratio. This helps the management to assess financial requirements and
the capabilities of various business units.
(iv) Useful in forecasting purposes: If accounting ratios are calculated for number of years,
then a trend is established. This trend helps in setting up future plans and forecasting.
(v) Useful in locating the weak spots of the business: Accounting ratios are of great
assistance in locating the weak spots in the business even through the overall performance
may be efficient.
(vi) Useful in comparison of performance: Managers are usually interested to know which
department performance is good and for that he compare one department with the another
department of the same firm. Ratios also help him to make any change in the organisation
structure.

Limitations of Ratio Analysis: These limitations should be kept in mind while making use
of ratio analyses for interpreting the financial statements. The following are the main
limitations of ratio analysis.
1. False results if based on incorrect accounting data: Accounting ratios can be correct only
if the data (on which they are based) is correct. Sometimes, the information given in the
financial statements is affected by window dressing, i. e. showing position better than
what actually is.
2. No idea of probable happenings in future: Ratios are an attempt to make an analysis of
the past financial statements; so they are historical documents. Now-a-days keeping in
view the complexities of the business, it is important to have an idea of the probable
happenings in future.
3. Variation in accounting methods: The two firms’ results are comparable with the help of
accounting ratios only if they follow the some accounting methods or bases. Comparison

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 will become difficult if the two concerns follow the different methods of providing
depreciation or valuing stock.
4. Price level change: Change in price levels make comparison for various years difficult.
5. Only one method of analysis: Ratio analysis is only a beginning and gives just a fraction
of information needed for decision-making so, to have a comprehensive analysis of
financial statements, ratios should be used along with other methods of analysis.

Types of ratios:
1. Liquidity ratios

2. Activity ratios

3. Capital structure ratios

4. Profitability ratios

Liquidity ratios:
Liquidity ratios express the ability of the firm to meet its short term commitments as and
when they become due. Creditor are interested to know whether the firm will be in a
position to meet its commitment on time or not. Liquidity ratio help in identifying the
danger signals for the firm in advance. Apart form the firm itself, all the financing
companies offering short term finances are interested in these ratios.
Liquidity ratios can be classified into two types:
1. Current ratio: current ratio is the ratio between current assets and current liabilities. The
firm is said to be comfortable in its liquidity position if the current ratio2:1.

Current ratio =
WHERE :
current assets are whose assets with are converted in to cash with the accounting period or one
year. For example of current assets are sundry debtors, bill receivable, cash in hand , cash at
bank, closing stock, prepaid expenses, etc.
current liabilities: current liabilities are whose which have to pay in the year or pay with in
account period for example, sundry creditor, bill payable, bank overdraft, outstanding
expenses, etc.
2. Quick ratio: quick ratio is also called acid test ratio. It measures the firm’s ability to
convert us current assets quickly into cash in order to meet its current liabilities. It is the
ratio between liquid assets and liquid liabilities. It supplements the information given by
current ratio.

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 Quick ratio or liquid ratio or acid test ratio:
Where:
Quick assets= current assets – (stock + prepaid expenses)

Turnover ratios
It ratios express how active the firm is in terms of selling its stocks collecting its receivables
and paying its creditors. 1. Inventory turnover ratio 2. Debtors turnover ratio.
Inventory turnover ratio; It is also called stock turnover ratio. It indicates the number of times
the average stock is being sold during a given accounting period. It establishes the relation
between the cost of goods sold during a given period and the average amount of inventory
outstanding during that period.
1. Inventory turnover ratio =

Average stock =

Where : cost of goods sold = sales – gross profit

Cost of goods sold = opening stock+ purchase+ wages+ direct express

2. Debtors turnover ratio: detor turnover ratio reveals the number times the average debtors
are collectied during a given accounting period. In other words. It shows how quickly
the firm is in position to collect its debts. It is necessary to keep close monitoring of
realization of debts because it directly affect the working capital position .
Debtors turnover ratio=

Where :
Credit sales : credit sales refer to goods sold on credit
Average debtors is the average of opening and closing balance of debtors for the given
accounting period

Activity ratios:
the financial ratio, which focuses on the long term solvency of the firm. The long term
solvency of the firm is always reflected in its ability to meet its long term commitments such as
payment of interest periodically without fail, repayment of principal as and when due.
1. Debt - equity ratio
2. Interest coverage ratio.

Debt - equity ratio: debt equity ratio is the ratio between outsiders funds and insider funds this
is used to measure the firm obligations to creditors in relations to the owners funds. It is a
measure of solvency.

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 Debt – equity ratio = debt / equity
Where :
Debt or outsider funds: debentures + long term loan
Equity or inside funds: preference share capital + equity share capital + general reserve + profit
and loss account

Interest coverage ratio;

Interest coverage ratio is calculated to judge the firms capacity to pay the interest on debit it
borrows. It gives idea of the extent the firm earning may contract before it is unable to pay
interest payments out of current earnings.it is very important ratio for the financial institutions
to judge the ability of the borrower to service the loan from the current year profit.

Interest coverage ratio = net profit before interest and taxes /fixed charges

PROFITABILITY RATIO:
Profitability ratios throw light on how well the firm is organizing its activities in a profitable
manner. The owners expect reasonable rate of return on their investment. The firm should
generate enough profit not onlyto meet expectations of the owners, but also finance the
expansion activities.

1. Gross profit
2. Net profit ratio
3. Operating ratio
4. Earning per share(EPS)
5. Price/ earning ratio(p/e ratio)

Gross profit
Gross profit ratio is the ratio between gross profit to sales during a given period. It is expressed
in terms of percentage. Gross profit is the difference between the net sales and the cost of good
sold.

Gross profit = gross profit

__________ X 100
net sales
where :

gross profit = cost of goods sold – net sales

cost of goods sold= opening stock + purchase + wage + direct expenses.

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Net profit
Net profit ratio is the ratio between net profit after taxes and net sales. It indicates what portion
of sales is left to the owners after operating expenses .

Net profit ratio = net profit

________ X 100
Net sales
Operating ratio
Operating ratio is the ratio between costs of goods plus operating expenses and the net sales.
This is expressed as a percentage to net sales. The higher the operating ratio, the lower is the
profitability and vice versa

Operating ratio = operating expenses

________________X 100
Net sales

Earning per share (EPS):

Earning per share is the relationship between net profits and number of shares outstanding at the
ends of the given period. This can be compared with previous years to provide a basis for
assessing the company performance.

EPS = net profit after taxes

________________
Number of shares outsanding

Price / earning ratio

This is share price divided by the earning per share

Price / earning ratio = market price

__________
Earning per share

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