SYLLABUS

Course Title : Management Concepts & Behaviour

Course Code : MSPS 11

Course Credit : 4

Course Objective :

CO 1. Develop basic perspective of all the concepts, principles, functions and

specialized areas of Management.
CO 2. Discuss the elements of the management process, Barriers to communication
and the system of effective control in an organisation.
CO 3. State the importance of individual human behaviour. Describe how and why
people behave under different conditions with context to individual personality
and attitudes.
CO 4. Explain group behavioural influence in the organisation. Review the
conceptual framework and theories underlying organisational behavioural.

CO 5. Enumerate the need for change, why organisation change or fail to change
and how to plan for, manage and measure change.

Course Syllabus :

BLOCK 1 Overview of Management

Evolution of Management thoughts – Management Theories – Approaches to
Management– Management roles –skills for managers – Current trends in
Management Practices Management functions: Planning – Process –Types of
Planning and Techniques-Decision Making- Organisation: Organisation structure
and design – Departmentation, Delegation and Decentralisation – Span of
Management .
BLOCK 2 Management Process

Staffing – Recruitment, Selection and training – Directing: Motivation–Leadership in

Management -Communication – Process – Barriers and breakdown in
communication –Control: process, techniques and types.
BLOCK 3 Organisation Behaviour

Organisation Behaviour an overview - Individual behaviour – Personality -

Determinants of Personality-Influence of Personality on Behaviour-– Perception and
learning – Motivation – theories and applications – Attitudes – Theories of attitudes
– Job satisfaction and its effect on employee performance and its Determinants.
BLOCK 4 Group Behaviour & Leadership

Definition and classification of groups- Stages of group development-Group

structure-Difference between groups and teams- Types of teams- Leadership and
theories of leadership: Trait theories, Behavioural theories, Contingency theories.
BLOCK 5 Organisational Change & Development

Organisation change – Manager as a change agent – Organisation Development –

O.D. interventions – Organisational Culture and Climate -Organisation Behaviour in
global scenario – Future trends in Organisation Behaviour.
References:

1. Aswathappa.K ,(2017), Organisation Behaviour Text, Cases& Games, 12th

Edition, Himalaya Publishing House, Mumbai
2. Gupta, C.B., (2017), Management Theory and Practice, latest Edition, Sultan
Chand & Sons, New Delhi
3. Heinz Weihrich, and Mark V. Cannice, Harold Koontz, (2013), Management,
14th edition, McGraw Hill publication.
4. John Newstrom, Keith Davis, (2006) Organizational Behavior – Human
Behaviour at work , McGraw Hill Higher Education
5. Ramasamy. T., (2010), Principles of Management, latest Edition, Himalaya
Publishing House, Mumbai
6. Rao, V.S.P, (2016), Management Text and Cases Excel Books India, Third
Edition, New Delhi, Taxmann Publications Pvt. Ltd.
7. Stephen P. Robbins, Timothy Judge, (2007) Organizational Behavior, latest
Edition, PHI Learning, New Delhi.

8. Stoner J., (2012), Management, latest Ed., Prentice Hall of India, New Delhi
9. Thomas Kalliath, Paula Brough, Michael O’Driscoll, Mathew J Manimalla,
(2011),Organizational Behavior, latest Edition, Tata McGraw Hill, New Delhi.
10. https://www.businessmanagementideas.com/management/useful-notes-on-
management-introduction-and-concept-of-management/2587

11. https://archive.nptel.ac.in/courses/110/105/110105146/
12. https://epgp.inflibnet.ac.in/Home/ViewSubject?catid=ahLCajOqz6/GWFCSpr/X
Yg==

13. https://www.tutorialspoint.com/organizational_behavior/organizational_behavio
r_leadership.htm
14. https://www.geektonight.com/14-od-interventions-type-meaning-process-
importance-examples/
Course Outcome :

CLO 1. Apply the management concepts and principles to real-life managerial

environments
CLO 2. Appraise the role of communication in the management functions and
differentiate between typical channels of business communication.
Enumerate the effective control system of the organisation.

CLO 3. Critically analyse the influence of individual personality traits and

attitudes in the workplace. Also assess the relationship between job
satisfaction and employee performance.

CLO 4. Comprehend the intrapersonal and interpersonal relations in the

business organisation. Examine the group and team dynamics in an
organisation.

CLO 5. Recall the types of OD interventions and identify when and why they are
applied. Point out the benefits of organizational culture and diversity.
 CONTENT

BLOCK 1 OVERVIEW OF MANAGEMENT

UNIT 1 NATURE AND PURPOSE OF MANAGEMENT 2

1.1 Definition and Meaning of Management 3

1.2 Evolution of management thought 4

1.3 Functions of Management 5

1.4 Management Roles 7

1.5 Managerial Role Constellation 8

1.6 Management Skills 9

1.7 Management theories 10

1.8 Current Trends in Management 11

UNIT 2 EVOLUTION OF MANAGEMENT THEORY 16

2.1 Evolution of management theory 17

2.2 Approaches of management 18

2.3 Types of approaches 18

2.4 Contemporary Trends in Management 25

UNIT 3 PLANNING 31

3.1 Planning 32

3.2 Process of Planning 33

3.3 Types of planning and techniques 35

3.4 Decision making 36

UNIT 4 ORGANISATIONAL STRUCTURE AND DESIGN 44

4.1 Meaning of Organisation 45

4.2 Organisation Structure and Design 45

 4.3 Departmentation 46

4.4 Department- Delegation and Decentralization 53

4.5 Delegation of Authority 54

4.6 Decentralization of Authority 57

4.7 Span of management 60

BLOCK 2 MANAGEMENT PROCESS

UNIT 5 STAFFING 69

5.1 Staffing 70

5.2 Recruitment 71

5.3 Selection 74

5.4 Training 78

UNIT 6 DIRECTING 85

6.1 Introduction to Directing 86

6.2 Importance of Directing Function of Management 86

6.3 Meaning and Nature of Leadership 88

6.4 Leadership and Management 88

6.5 Need for Leadership 89

6.6 Leadership Styles 89

6.7 Motivation 91

UNIT 7 COMMUNICATION 94

7.1 Meaning and Characteristics of Communication 94

7.2 Communication Process 95

7.3 Barriers and Breakdowns in Communication 96

 7.4 Importance of Communication in Management 98

7.5 Types of Communication 99

7.6 Electronic Media in Communication 101

UNIT 8 CONTROL 105

8.1 coordination 106

8.2 control process 109

8.3 Pre-Requisites of Control System 109

8.4 Objectives of Control 110

8.5 Importance of Control 110

8.6 Steps in Control Process 111

8.7 Control Techniques 112

8.8 Role of Information Technology in Control Process 117

BLOCK 3 ORGANIZATIONAL BEHAVIOUR

UNIT 9 ORGANISATION BEHAVIOUR 122

9.1 Organisation Behaviour an overview 123

9.2 Organizational Participants 123

9.3 Foundations of Individual Behaviour 126

9.4 Implications of Individual Behaviour 130

9.5 Personality 130

9.6 Determinants of personality 130

9.7 Influence of Personality on Behaviour 132

9.8 Major Personality Traits Influencing Organizational 132

Behaviour

UNIT 10 PERCEPTION AND LEARNING 143

 10.1 Perception and Learning 144

10.2 Factors Influencing Perception 148

10.3 Learning 149

10.4 Theories of Learning 149

10.5 Principles of Learning 152

10.6 Learning Curve 153

10.7 Learning and Organizational Behaviour 154

UNIT 11 MOTIVATION 157

11.1 Definition and Meaning of Motivation 157

11.2 Theories of Motivation 158

11.3 Motivational Techniques 167

UNIT 12 ATTITUDES AND JOB SATISFACTION 171

12.1 Definition and Meaning 172

12.2 Formation of Attitudes 172

12.3 Types of Attitudes 173

12.4 Functions of Attitudes 174

12.5 Changing Attitudes 174

12.6 Job Satisfaction 175

BLOCK 4 GROUP BEHAVIOUR AND LEADERSHIP

UNIT 13 GROUP BEHAVIOUR 180

13.1 Introduction 181

13.2 Stages of Group Development 186

13.3 Group Structure 187

 13.4 Group Dynamics 188

13.5 Group Characteristics 190

13.6 Group Decision Making 191

UNIT 14 TEAM DEVELOPMENT 194

14.1 Meaning of team 195

14.2 Features of team 195

14.3 Types of team 196

14.4 Team Norms and Cohesiveness 197

14.5 Team Development over Time 197

14.6 Roles within Teams 201

14.7 Action Check List 203

UNIT 15 LEADERSHIP 210

15.1 Meaning and Nature of Leadership 211

15.2 Leadership and Management 211

15.3 Need for Leadership 212

15.4 Leadership Styles 212

15.5 Theories of Leadership 214

15.6 Qualities of a Good Leader 219

BLOCK 5 ORGANIZATIONAL CHANGE & DEVELOPMENT

UNIT 16 ORGANISATIONAL CHANGE 224

16.1 Meaning of organization change 225

16.2 Levels of change 225

16.3 Reasons for change 226

 16.4 Resistance to change 226

16.5 Symptoms of resistance 228

16.6 Benefits of Resistance 229

16.7 implementation of change 229

16.8 Manger as change agent 229

16.9 Organizational Change Drivers 230

16.10 Types of organizational change 231

16.11 Organizational Change – Failure 233

UNIT 17 ORGANISATIONAL DEVELOPMENT 236

17.1 Meaning of Organisational Development 237

17.2 Characteristics of Organisational Development 237

17.3 Organisation Development Process 238

17.4 Organisational Development Techniques 239

17.5 Benefits of Organizational Development 242

17.6 Steps in Organisational Development 243

17.7 Modern Organization Development Techniques 245

UNIT 18 ORGANISATION CULTURE AND CLIMATE 249

18.1 Concept of Organization 250

18.2 Concept of Organizational Culture 251

18.3 Concept of Organizational Climate 253

18.4 Elements of Organisation Climate 253

18.5 Organisational Behaviour Across Cultures 254

18.6 An International Perspective 255

 18.7 Managing International Work Forces 256

UNIT 19 FUTURE TRENDS IN ORGANISATION BEHAVIOUR 261

19.1 Trends In Organizational Change 262

19.2 Future Trends in Organisational Behaviour 270

19.3 Emergence Of E-Organisation / Virtual Offices 270

19.4 Work Force Diversity 271

19.5 Coping With Temporariness 272

19.6 Improving Ethical Behaviour 272

19.7 Motivating Professionals and Diversified Workers 272

19.8 Trends Influencing the Way Businesses Organise 272

Plagiarism Report 279

 BLOCK 1

OVERVIEW OF MANAGEMENT

Unit 1 : Nature and purposes of Management

Unit 2 : Evolution of Management Theory

Unit 3 : Planning

Unit 4 : Organizational structure and design

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Unit 1

NATURE AND PURPOSE OF

MANAGEMENT
STRUCTURE

Overview
Learning Objectives
1.1 Definition and Meaning of Management

1.2 Evolution of management thought

1.3 Functions of Management

1.3.1 Planning
1.3.2 Organizing
1.3.3 Staffing
1.3.3 Directing

1.3.4 Controlling
1.4 Management Roles

1.4.1 Management of work

1.4.2 Management of people
1.4.3 Management of operations
1.5 Managerial Role Constellation
1.6 Management Skills
1.7 Management theories

1.8 Current Trends in Management

Let Us Sum Up
Check Your Progress

Glossary

Suggested Readings
Answers to check your progress

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OVERVIEW
Management is a universal phenomenon. It is a very popular and widely
used term. All organizations – business, political, cultural or social are
involved in management because it is the management which helps and
directs the various efforts towards a definite purpose. We have accounts
in Banks, are educated in schools, and are employed by corporations,
worship in temples, mosques or churches, vote for political parties and
belong to professional organizations. No matter what the organization is
or what its goals might be, every organization has two essential
ingredients – management and managers. In this unit an attempt is made
to explain the meaning of management, the steps involved in the
management process, the multifarious roles played by the managers and
the skills they are supposed to have to run the organizations effectively
and efficiently.

LEARNING OBJECTIVES
After completing this unit, you should be able to,
• describe the importance of management
• classify the functions of management
• outline the various roles of management
• identify the skills to be possessed by manager
• discuss how management theory has evolved over the period of
time.

1.1 DEFINITION AND MEANING OF MANAGEMENT

The term Management has been defined in various ways. In the following
paragraphs the term is explained in detail.
“Management is the process of designing and maintaining an environment
in which individuals, working together in groups, accomplish their aims
effectively and efficiently”.

It is defined as “the process of planning, organising, leading and

controlling the resources of an organization in the efficient and effective
pursuit of specified organizational goals”.

In the process of clarifying these definitions, an analysis of the terms

‘efficient’ and ‘effective’ would be appropriate. An efficient manager does
things right, while an effective manager does the right things.

An efficient manager uses resources carefully and expertly, maximizing,

their application to the task at hand.

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The efficient manager achieves greater output at lower costs. The
effective manager, on the other hand, understands the priorities of the
organization and places emphasis on those things that are the most
critical for success.

Good management combines both efficiency and effectiveness.

Management is seen as a process of activities that can be divided into
four distinct, but inter-related activities:

Planning (deciding what is to be done)

Organizing (deciding how it will be done and who will do it)

Directing (influencing behaviour)

Staffing (insisting on choosing right person for right job) and

Controlling (being certain that plans are carried out)

As the Manager is engaged in these processes, efficiency is integrated
with the management of organizational resources, which may be
categorized into four groups.
Human Resources
Financial Resources
Physical Resources and
Information Resources

Who is a manager?
After having understood the meaning of management now we may define
a manager as follows:
“A manager is a person who plans, organizes, leads, and controls, human,
financial, physical and information resources in the efficient and effective
pursuit of specified organizational goals”.

1.2 EVOLUTION OF MANAGEMENT THOUGHT

It is interesting as well as worthwhile to know about the evolution of
management concepts. Today’s manager benefits from the time-honored
practice of assimilating management experience and management theory
into a body of successful management practice. Over the years,
management thought has evolved under the pressure of variety of forces,
mainly political, social and economic forces. A brief description about
these forces is given below:
1) Political Forces: Management thought has been shaped by the
political forces manifested through the administration of political
institutions and government agencies.

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2) Social Forces: Social forces are those that evolve from the values and
beliefs of a particular culture of a people. These forces formulate a
people’s contract, which is an unwritten but understood set of rules that
govern the behavior of people in their day-to-day interrelationships.

3) Economic Forces: Management thought is also influenced by the

economic forces that determine the scarcity, transformation, and
distribution of goods and services in a society. Every social institution
competes for a limited number of resources – human, financial, physical
and information resources.
1.3 MANAGEMENT FUNCTIONS

The definition of Management indicates a management process of four

major functions - planning, organizing, leading and controlling warrants a
brief description now. These functions are generally best understood in
the order presented here, suggesting that the manager first plans, then
organizes, then leads and finally controls. However, in reality, managers
seldom have the luxury of addressing these functions in such a simplified
step-by-step sequence. At any time, the typical manager is engaged in a
number of different activities at the same time. Furthermore, a situation
that occurs in operations can result in changes to the plan, organization,
and leadership function and to the control technique, or any combination
of these. Now we will discuss the management functions in detail.
1.3.1 Planning

Planning is defined as the Management function of developing a futuristic

frame of reference from which to identify opportunities and threats that lie
in the future and to take action now to exploit the opportunities and to
defend against the threats.
Planning involves forecasting and predicting the future, which in turn
requires the ability to know the customer’s needs and the variety of ways
to satisfy them. It also involves the determining of organizational goals
and the means of achieving them most efficiently and effectively.
Moreover, planning demands creative decision making in order to
maximize the selection of appropriate courses of corporate action. Failure
to plan carefully or correctly can result in the loss of lucrative market
opportunities to the competition.

1.3.2 Organizing
Organizing is defined as the management function of assigning duties,
grouping tasks, establishing authority and allocating resources required
to carry out a specific plan.

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Once a specific plan has been established for the accomplishment of an
organizational goal, the organizing function examines the activities and
resources required to implement the plan. It determines what activities
and resources are required. It decides who will do certain tasks, where
they will be done and when they will be done. Organizing involves the
grouping of the required tasks into manageable departments or work units
and the establishment of authority and reporting relationships within the
corporate hierarchy.
Failure to organize properly may make the best plans useless and create
confusion.

1.3.3 Staffing
Staffing may be defined as “function of management, which is concerned
with selecting, developing, maintaining and utilizing the manpower such
that the objectives of the organisation are achieved economically and
effectively. The objectives of individual employees of the organisation are
accomplished to the highest degree possible, serving in the process the
objectives of the community at large.”
Staffing is the traditional management function of attraction and selection
of the best people and putting them on job where their talents and skills
can be best utilized, and retention of these people through incentives, job
training and job enrichment programmes, in order to achieve both
individual and organizational objectives.

1.3.4 Directing
Leading is defined as the management function of influencing, motivating
and directing human resources towards the achievement of organizational
goals.
First of all, leadership function involves the management of human
resources through such activities such as recruitment, selection,
placement and training of personnel. Second, leadership deals with the
interpersonal task of motivating the individual employee. Third, leadership
must deal with and motivate the work unit, work group, department as a
complexity of individuals. Fourth, leadership involves the management of
organizational power, political forces and organizational culture. Lastly,
leadership requires the management of organizational communication
processes.
Outstanding leadership has the capacity to achieve organizational
success in spite of poor plans and/or poor organizations. On the contrary,
the best of plans and/or organizations will fail under poor leadership.

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1.3.5 Controlling
Controlling is defined as the Management function of monitoring
organizational performance towards the attainment of organizational
goals.

Controlling entails the establishment of the performance standards

required to achieve goals, the measurement of performance against those
standards, and the taking of required corrective action. Here, the
management must determine what activities and/or outputs are critical to
success, how and where they can be measured with reasonable cost-
effectiveness and who should have corrective action authority. It is also
essential that the corporate management information system be co-
ordinated with the control function to assure that necessary and timely
information is available to those with hands on control authority.

The champions of controlling functions are the Japanese, who have truly
mastered such control related tasks such as quality and inventory control.
1.4 MANAGEMENT ROLES
After having understood the functions of management, let us try to
understand the roles of management.
The modern manager faces many problems in today’s dynamic and
fiercely competitive environment, but the basic management challenge is
the management of work. Above all else, management is responsible for
the work performance of an organization. All organizational resources –
human, financial, physical and information resources – must be managed
efficiently and effectively. The bottom line, however, is quite simply, “get
the job done!”
Getting the job done is a challenge that can be best be examined in three
parts:
1. Management of Work

2. Management of People
3. Management of Operations
1.4.1 Management of Work

In a factory, the product must be manufactured. In a retail store, the

customers need must be satisfied. In the hospital, the patient must be
treated. Management must decide what need is to be served, what goals
must be established, and what means will be used for the conduct of work.
Problems must be solved, decisions must be made, plans must be
established, budgets must be prepared, responsibilities must be

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assigned, and authority must be delegated. All of these tasks are involved
in the management of work.

1.4.2 Management of People

No matter how good the plans, how flexible the budget, or how clever the
organization, the work of an organization must ultimately be accomplished
by people. Despite all the new labour-saving technology and robotic
equipment, ‘getting work done through people’ is still a major task for the
manager. Human resources should still be considered the single most
important organizational asset. Managing the people of the organization
is, in fact, two tasks in one:

(i)The task of dealing with each employee as an individual with

a uniquely different set of needs and behaviors.
(ii) The task of dealing with each work group as a different group with
uniquely different needs and behaviors.

1.4.3 Management of Operations

No matter what the organization, it has some basic products or service
that it must provide in order to survive. Every organization has an
operations process by which a product or service is produced and/or
provided for the customer. The management of this production operation
entails the flow of input materials and the technology of transforming those
inputs into the desired outputs for consumption. Obviously, the
management of operations is inextricably interwoven with both the
management of work and the management of people.

1.5 MANAGERIAL ROLE CONSTELLATION

Here it is pertinent to mention the various roles of managers as prescribed
by Mintzberg (1973). He developed a model of related roles that he called
the ‘Managerial Role Constellation’.
a) Interpersonal role: The first three managerial roles are classified as
interpersonal roles, because they deal with interpersonal relationships
both inside and outside the firm.
b) Figurehead role: It deals largely with ceremonial and symbolic
activities that may or may not have real substance. Conducting tours for
visiting dignitaries and attending grand opening ceremonies are examples
of figurehead role activity. The manager uses the above interpersonal
roles to seek information from many sources, both inside and outside the
corporation.

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g) Disseminator role: This role entails the transmission of relevant
information to those in the workplace that ‘have a need to know’. The
dissemination may be written or oral, formal or informal.
h) Spokesperson role: This role deals with the dissemination of
information to those outside the company. Such information is usually
related to corporate plans, strategies, policies, actions, performance and
other issues of community interest.

i) Decisional role: As the manager performs the interpersonal and

informational roles, certain decisional roles emerge as a part of the
manager’s day to day activities.

j) Entrepreneur role: It is the process by which the manager seeks and

identifies opportunities to promote improvement and needed change. In
this role, the manager is also involved in the development and
implementation of change in strategy.
k) Disturbance handler role: This role equips the manager to take
corrective action needed to resolve important, unexpected disturbances.
In this role, the manager must handle utility service problems, strikes and
natural disasters.
l) Resource allocator role: This role entails the allocation of scarce
resources to the many requests for those resources. Specific activities
might include developing and monitoring budgets, predicting future
resource needs, and forecasting future resource problems.

m) Negotiator role: It requires that the manager negotiate resolutions to

important disputes, both inside and outside, of the company. For example,
a manager might represent the corporation to negotiate a trade union
contract, a joint venture, or a trade agreement.
It is important to recognize that these ten roles are highly inter-related. At
any given point of time, the manager is apt to be engaged in several
different role activities simultaneously.
1.6 MANAGEMENT SKILLS
You would agree that a successful manager must possess a wide variety
of expert skills and abilities appropriate to the nature of the job being
performed. Katz (1974) categorized and compared these types of
managerial skills as follows:

a) Technical Skills

b) Human Skills and

c) Conceptual Skills

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a) technical skills: A technical skill is the ability to perform a specific task
or function. An accounting manager needs the basic technical skills of the
accounting profession. A manufacturing manager needs the technical
skills to deal with the equipment, technology, and methods of production.

b) Human skills: Human skills are needed to get along with people, to
get work done through people, or to motivate individual or work group
performances. Human skills include interpersonal skills, such as
communication, negotiation, and bargaining, leading, influencing,
motivation, discipline and conflict resolution. Human skills are very
important at all levels of management.

c) Conceptual skills: Conceptual skills reflect the manager’s ability to

organize information and to judge relationships within a complex whole.
That is, the manager must be able to view the total organization,
appreciate the functional interrelationships of the many organizational
units, and to understand how a change in one unit will impact the other
units. A conceptual skill is often called the ability to see the ‘big picture’.
The importance of conceptual skill increases as the manager is promoted,
higher in the organization. Certainly, the conceptual skills are usually the
most difficult to develop and are most critical for top management.

1.7 MANAGEMENT THEORIES

Management theories can be classified into three types.
• Classical Management Theory

• Behavioural Management Theory

• Modern Management Theory

The Classical Management Theory
This based on the belief that workers only have physical and economic
needs and prescribes specialization of labour. Classical theories
recommend centralized leadership and decision-making and focus on
profit maximization. Three streams of classical management theory are
• Bureaucracy (Weber)
• AdministrativeTheory (Fayol)

• Scientific Management(Taylor)

The behavioural Management theory

The behavioural Management theory is based on human aspects of work,
they are also referred to as human relations movement. Those theories
aspire to gain a better understanding of human behaviour at work to

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improve productivity. It focuses on behavioural aspects like motivation,
conflict etc.

Modern Management Theory

Modern management theory emphasizes the use of systematic
mathematical techniques to analyse and understand the inter-relationship
of management and workers in all aspects. Three streams of modern
management theories are - Quantitative Approach, System Approach,
and Contingency Approach.

1.8 CURRENT TRENDS IN MANAGEMENT

Flattening organization structures

The days of the “hero” leader, or “the smartest person in the room” who
must know everything and micromanage his or her direct reports will be a
thing of the past. Organizations are moving towards flatter structures and
they will need leaders who can thrive in a collaborative and cross-
functional environment.
‘Flatter’ organizations tend to benefit from improved communication
between employees, increased morale, less bureaucracy, and the ability
to make decisions and changes faster. Typically, employees'
responsibility levels tend to be much higher in flatter organizations, thus
improving job satisfaction and reducing the need for excess levels of
management. As we move through 2021 and towards next year, we will
begin to see a shift in the hierarchy structure of many companies,
particularly those in creative industries, and startups.

Increasing need to develop self & others

To keep on top of the rapidly changing technological environment, leaders
can no longer sit back and say “I know everything I need to know” as what
they do know today will be outdated tomorrow. There is now a greater
need to develop their self and their teams.

When comparing job culture to that of 10 years ago, there is less loyalty
amongst employees to their employers, meaning employers need to do
everything they can to keep the employees in the company as long as
possible to improve staff turnover. A popular method is through offering
additional development and training alongside the role.
Approaching the “Talent Cliff”

Firms must prepare as the largest workforce in history moves into

retirement. Mentoring, coaching, and job shadowing are examples of how
organizations can manage the transition of the millennial leader.

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Many companies teetering on the edge of the talent cliff take the approach
of hiring apprentices, and enrolling in apprenticeship programmes, to
allow those interested in the industry to gain hands on experience, and for
companies to be able to increase their workforce in a way that
inexpensively gives back to the community, but also positively impacts the
business.
Striving for gender balance

Strong women’s representation in leadership teams has been proven to

bring organizations better results. A successful leadership development
program thus needs to tap into an often woefully underutilized resource -
its female managers.
Achieving gender equality is important for workplaces not only because it
is ‘fair’ and ‘the right thing to do,’ but because it is also directly linked to a
country’s overall economic performance and therefore growth. Workplace
gender equality is associated with:
Improved national productivity and economic growth
Increased organizational performance

Enhanced ability of companies to attract talent and retain employees

Enhanced organizational reputation.

Many workplaces are actively striving to reach equality but also complete
diversity amongst their workforce, a movement pushed forward largely by
generation Z and millennial.

Shifting focus to development on soft skills

As the role of a leader migrates towards managing teams of diverse
members who have different technical skills and areas of expertise, there
will be greater emphasis on the need for leaders to develop their “soft
skills".
Whilst the focus in the past has been on ‘hard skills’ These types of skills
include emotional intelligence, creativity, adaptability and time
management. Employees can be taught “hard skills” such as the specific
skills needed to carry out their role, however soft skills are learnt over
time, and an employee failing in areas like time management could be
detrimental to the business. Investing in the development of
employees’ soft skills training courses will result in an increase of
leadership potential, satisfaction in the workplace, and work performance.
Adopting a blended approach to leadership and management
development

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Leadership and management learning journeys will also need to evolve
and use a wide variety of modalities to prepare the modern leader with the
skills they need to thrive.
Using a blended approach to leadership development allows leaders to
break up their courses into more manageable sessions of one to one/class
tutoring, with some transportable materials such as online webinars, and
on the go tutorials that leaders can easily fit into their day with little
disruption. The flexibility of blended learning makes it much easier to keep
up as your business scales and grows, particularly nowadays when
working from home and remote working is much more common.

Remote and flexible working

It’s quite likely that at least one member of your team works remotely,
whether they’re a contractor or just somebody who needs to due to factors
such as child care. Harnessing the power of the latest technology, social
media and communication platforms early on, will allow your company to
transition smoothly into remote working, should the time come. Remote
working offers better flexibility, and better work life balance to your
employees, it also opens up the ability to employ people from different
backgrounds, and even countries, making the talent pool you’re fishing
from much richer, which in turn will help to grow your business.
LET US SUM UP
Management is the act or function of putting into practice the policies and
plans decided upon by the administration. Management is a process
involving planning, organizing, leading and controlling. Human, financial,
physical and information resources are efficiently handled in the
organization with the help of good managerial skills. Managers play
various roles such as interpersonal roles, figure head roles, leader role,
liaison role etc., A successful manager must possess technical skills,
human skills and conceptual skills at the desired level. It is essential that
a manager understands the various stages and evolutions of
management to apply in real time environment.
CHECK YOUR PROGRESS
Choose the Correct Answer
1. “A ----------------- is a person who plans, organizes, leads, and controls,
human, financial, physical and information resources in the efficient and
effective pursuit of specified organizational goals”.
a) Manager b) supervisor

c) Planner d) executive

13
2. A---------- is often called the ability to see the ‘big picture’.
a) Manager b) conceptual skill

c) Human skill d) executive skill

3.A manufacturing manager needs --------------- to deal with the equipment,
technology, and methods of production.
a) technical skill b) conceptual skill
c) Human skill d) executive skill

4. -----------------include interpersonal skills, such as communication,

negotiation, and bargaining, leading, influencing, motivation, discipline
and conflict resolution.

a) technical skill b) conceptual skill

c) Human skill d) executive skill

5. This role deals with the dissemination of information to those outside
the company.

a) Spokesperson role b) Disseminator role

c) Entrepreneur role d) Executive role

GLOSSARY

Management : The act or art of conducting or

supervising

Resource : A supply of something, a piece of

equipment,

Bureaucracy : The system of official rules that an

organization

Organising : To plan or arrange an event,

activity, etc

SUGGESTED READINGS
1. DinkarPagare (2015) Principles of Management, Sultan Chand &
Sons, New Delhi.
2. Harold Koontz, Cyril O'Donnell and Heinz Weihrich (2017)
Essentials of Management (5th Revised edition), McGraw-Hill Inc.,
US, (ISE Editions).
3. Prasad L.M. (2015) Principles and Practice of Management,
Sultan Chand & Sons, New Delhi.

14
 4. Sherlekar S.A. &Sherlekar V.S 3rd Edition (2014) Principles of
Business Management, Himalaya Publishing House Pvt. Ltd,
Mumbai.
5. Tripathi, Sixth edition (2017) Principles of Management,Tata
McGraw Hill Education Private Limited, 7 thWest Patel Nagar, New
Delhi.
6. Tripathi, P C, Reddy, P N, 5 edition (2012) Principles of
Management, Tata McGraw Hill Education private limited, 7 th west
Patel Nagar, New Delhi.
7. https://www.teamwork.com/blog/the-four-functions-of-
management-overview-examples/
8. https://epgp.inflibnet.ac.in/Home/ViewSubject?catid=ahLCajOqz6
/GWFCSpr/XYg==
9. https://smallbusiness.chron.com/management-theories-concepts-
workplace-17693.html
ANSWERS TO CHECK YOUR PROGRESS
1) a 2) b 3) b 4) c 5) a

15
Unit 2

EVOLUTION OF MANAGEMENT THEORY

STRUCTURE
Overview
Learning Objectives

2.1 Evolution of management theory

2.2 Approaches of management

2.3 Types of approaches

2.4Contemporary Trends in Management

Let Us Sum Up
Check Your Progress
Glossary

Suggested Readings
Answers to check your progress

OVERVIEW
Too often, managers fail to recognize that one of the best ways to learn is
to study the past. Proponents of contemporary thought argue that history
has no relevance to the problems faced by the manager in modern times.
Still others oppose the study of management theory on the grounds that
it is too abstract and has no practical application to the real world. But the
truth is that today’s manager benefits from the time-honored practice of
assimilating management experience and management theory into a
body of successful management practice. An effort is also made to explain
the evolution of management theory and the various approaches to
management such as classical, behavioral, and scientific and systems
approach. The path breaking Hawthorne studies and their implications are
also discussed in this unit.
LEARNING OBJECTIVES
After completing this unit, you should be able to,

• explain the tenets of classical approach

• explain the salient aspects of scientific approach
• explain the features of systems approach.

16
 2.1 EVOLUTION OF MANAGEMENT THEORY
It can truly be said that management is as old as civilization. Organisations
may be the distinguishing feature that separate civilized societies from
uncivilized ones. The first recorded civilizations have left a legacy of rules
and regulations that are an evidence of their managerial practices. Table
(2.1) reflects some of the earlier examples of the practice of management.

Time Period Group Management Practice

3000-2400 BC Sumerians Developed written records

3000-1000 BC Egyptians Developed first national government and

extensive civilization; built massive
buildings and monuments

2700-500 BC Babylonians The code of Hammurabi, the oldest set

of laws.

1000-200 BC Greeks Developed strong form of local

government, the polis, or city state later
introduced constitutional democracy

800BC-500AD Romans The senate advised consuls and the

emperor

1500 BC-1300 AD Chinese Developed capable government and a

civilization rich in science and art.

450-1500 AD Venetians Centre of commercial sea power,

developed laws of commerce

1500 AD Machiavelli Guidelines for the use of persons power.

1776 AD Adam Smith Division of Labour

1800 AD Eli Whitney Parts interchangeability

17
2.2 APPROACHES OF MANAGEMENT
In order to achieve the aim and objective of a project in an organization,
the best way to determine an effective organization is to apply a suitable
management approaches. This part is to describe and outline the major
trends in management approaches which people are always
implementing in their project organization.
There are four types of management approaches will be mention clearly
in this report include classical approach, human relation approach, system
approach and contingency approach. From the management approaches
analysis shall be carry out at the same time in order to choose and clarify
the most effective in promoting a good organizational structure and
organizational relationships. Besides, a good leader is also important to
leading the team in achieving the organization goals. Thus, the attributes
to be a good leader will be discussing and identified as well.

2.3 TYPES OF MANAGEMENT APPROACHES

Management plays a crucial role in the making of the organization and
therefore effective management is required to ensure every organization
is working towards a common objective or goal. Hence, it is essential to
produce a good organization structure and organization relationship. The
four different major types of management approaches will discuss in the
following.
2.3.1 Classical Approach

a) The classical or empirical approach is based on the following

tenets:
b) Management is a process consisting of interrelated functions
performed to achieve the desired goals.
c) From the experience of managers in different organizations,
principles or guidelines can be derived.
d) These principles are basic truths which can be applied in different
organizations to improve managerial efficiency.
e) Managers can be developed through formal education and
training.
f) People are motivated mainly by incentives and penalties.
Therefore managers use and control economic rewards.
g) Theoretical research into management helps to develop a body of
knowledge which is necessary to improve the art of management.
The classical approach offers a convenient framework for the education
and training of future managers. It views management as distinct
discipline based on certain principles. Another merit of this approach is

18
that it focuses attention on what managers actually do i.e. functions of
management. It highlights the universal nature of management. It
provides a foundation for further research in management.
The classical approach however, suffers from several limitations. First, it
is a mechanical approach which undermines the role of human factor in
management. The focus is on technical and economic aspects, at the
cost of socio-psychological issues in management. Secondly, the validity
and universality of management principles is doubtful due to
environmental changes. Thirdly, there is a danger in relying too much on
past experience as two managerial situations are never identical.

F.W. Taylor, Henri Fayol, Max Weber, L.F. Urwick, J.D. Mooney, A.C.
Reiley and several other pioneers made significant contributions towards
the development of the Classical approach.

2.3.2 Scientific Approach

This school of thought emerged in the late 1800’s and early 1900’s and
were based on the management belief that people were rational,
economic creatures who would rationally choose a course of action that
provided the greatest economic gain.
Scientific management is that kind of management which conducts a
business or affairs by standards established by facts or truths gained
through systematic observation, experiment or reasoning.
The main contributors to scientific management school were Charles
Babbage, Fredrick W. Taylor, Frank and Lillian Gilbreth and Henry Gantt.
The contribution of F.W. Taylor is worth mentioning.
F.W. Taylor (1856-1915) is widely known as the father of scientific
management. As an engineer and consultant, Taylor observed and
reported on what he found to be inexcusably inefficient work practices,
especially in the steel industry. According to him scientific management
implies the application of the following two-fold techniques:
i. The discovery of the best method of performing a particular work.
ii. The best method or the fruitful method for meeting a given situation.

He defined scientific management as “knowing exactly what you want

men to do and seeing that they do it in the best and the cheapest way”.
He suggested the following things for enhancing the productivity of the
workers:
• Science, not rule of thumb.
• Harmony, not discord.

19
 • Co-operation, not individualism.
• Maximum output, in place of restricted output.
• The development of each man to his greatest efficiency and
prosperity.

The responsibilities of the management clearly reveal basic elements of

scientific management. The various elements are broadly classified as
follows:

◼ Scientific determination of the task.

◼ Time and motion studies.

◼ Standardization of materials, tools and equipment etc.,

◼ Scientific selection and training of the employees.

◼ Modification of the organisation.

◼ Mental revolution or labour management co-operation.
The basic components of scientific management are:
a) Separation of Planning from Doing: Taylor emphasized that planning
function should be separated from actual performance and should be
given to specialists.
b) Functional Foremanship: In this system eight persons are involved
to direct the activities of workers. Out of these, four persons, (i) Route
Clerk (ii) Instruction Card Clerk (iii) Time and Cost Clerk (iv) Disciplinarian
are related with the planning function and remaining four (i) Speed Boss
(ii) Inspector (iii) Maintenance foreman and (iv) Gang Boss are concerned
with the operating function.
c) Determining ‘fair day’s work’ and one best way of doing it: There
is one way of doing a job which requires least movement, less time and
cost. His main efforts were to increase the efficiency of human beings
and machines through time and motion study, which have been referred
to as the corner stones of the scientific management.

d) Differential Piece work system of wage payment: Taylor realized

that workers were not producing as much as they were capable of. This
he described as ‘systematic soldiering’. To get over these problems, he
introduced differential piece rate system which is of a highly motivating
nature. He pleaded that the rate should be fixed on accurate knowledge
and not on estimates.

e) Bilateral mental revolution: Taylor advocated complete mental

revolution on the part of the workers on one side and the part of the
owners and management on the other side. Management must create

20
congenial working conditions for optimum efficiency of the workers. The
workers should also change their attitude towards the management. Both
management and the workers should trust each other and co-operate in
achieving maximum production.

An Appraisal of Scientific Management

Some of the merits of scientific management are:
a) More production and higher profits - Scientific management
makes for a more systemized way of managing – enabling
employers, to have more production at the minimum cost; and
ultimately reap higher profits.
b) Job Satisfaction - Under scientific management, a standardized
work environment is provided to workers which would enable them
to derive what is known as a job satisfaction.
c) Personality Development - One of the basic principles of scientific
management is the ‘development of each person to the greatest of
his capabilities. Workers get the opportunity, under scientific
management, to develop themselves fully according to their
potential.
d) Higher Standards of Living - Scientific Management is oriented
towards maximum production which would lead to more
consumption of goods on the part of people, in the society. This
naturally, would mean an increase in the standard of living.
e) Scientific Management has come in for severe criticism as follows:
f) Unsuitable for the small employers - Scientific Management is
wholly unsuitable for the small employers. Techniques like Time and
Motion studies, introduction of managerial specialization, etc., are
too costly to be afforded to by the small employers.
g) Unemployment - Scientific management leads to unemployment of
workers especially when mechanical devices are introduced to
replace manual labour.
h) Retarding Human Development - In fact, under scientific
management, workers are reduced to the status of machines, totally
deprived of the thinking function. It totally takes away initiative from
the workers.

2.3.3 Behavioral Sciences Approach

The Hawthorne Experiments conducted by Elton Mayo and his team laid
the foundations of behavioral sciences approach. Several pioneers such
as A.H. Maslow, Douglas McGregor, Frederick Herzberg, and
RensisLikert expanded the findings of Hawthorne Experiments and

21
launched the Human Relations Movement. Later on, Keith Davis, Chester
Barnard, Kurt Lewin and others developed the fields of Group Dynamics
and Organizational Behaviour.

Behavioral science approach involves the application of knowledge drawn

from behavioral sciences (Psychology, Sociology, Anthropology etc) to
managerial problems. The main propositions of this approach are:
a) A business organisation is not merely a techno-economic system. It
is much more a social system of interpersonal and intergroup
relations.
b) The attitudes and performance of an employee are dominated by the
social group to which he belongs. Members of an organisation
behave not as individuals but as members of some group.
c) Social and Psychological incentives exercise a greater influence on
employee motivation than working conditions and economic
rewards.
d) Management must understand and develop harmonious
interpersonal relations among his subordinates. There should be
harmony between human needs and organizational goals.
e) Employees are capable of self-direction and control. Therefore,
participative leadership is more productive than task centered
leadership.
f) Management requires social skills to make employees feel a part of
the organisation.

Human relations movement focused attention on human factor in industry.

It corrected the imbalance in management theory caused by over
emphasis on technical and economic aspects under the classical theory.
Attention shifted from machines and jobs to men and their interpersonal
relations. However, human relations movement has been criticized on the
following points:
i) Human relations movement seeks to manipulate and exploit the
emotions of employees for the benefit of the organisation by
providing a false sense of happiness or satisfaction.

22
 ii) It ignores the wider environmental issues inside and outside an
organisation. Social environment may fail to motivate employees
if they find their jobs highly structured and monotonous.
iii) Human relations movement is based on the assumption - that
happy workers are more productive workers. There is, in fact, no
correlation between job satisfaction and productivity.
The movement undermines the role of economic rewards. Despite cordial
interpersonal relations, employee motivation may be low if they feel
underpaid.
Behavioral approach is very much disciplinary. It has made significant
contributions to our understanding of people at work and groups in
organizations. It recognizes an organisation as a social organism subject
to the attitudes and culture of people. Motivation, leadership, work
designs, group dynamics and participation are the main concepts of
behavioral sciences approach.

Behavioral approach has contributed new ideas for more effective

management. It is however, not free from limitations. First, it lacks the
precision of classical theory because human behavior is unpredictable.
Secondly, its conclusions lack scientific validity and suffer from a clinical
bias. Its findings are tentative. Thirdly, management is much wider than
organizational behavior. Fourthly, its application in practice is very difficult
because it requires fundamental changes in the thinking and attitudes of
both management and workers. Lastly, the linkage between an
organisation and the world outside has been overlooked in the neo-
classical theory.

Hawthorne Experiments: An Overview

Elton Mayo was a Psychologist and an Associate Professor at the Harvard
Business School. Elton Mayo and his group conducted a series of studies
between the years 1924 and 1932 at the Hawthorne plant of the Western
Electric Company. The experiments conducted by the group of Mayo and
others can be summarized as follows:
a) Illumination Experiments: These experiments were conducted to
determine the relationship between the intensity of illumination and the
efficiency of workers measured by output. It was found that variables
other than physical conditions might be affecting output. Psychological

23
and sociological factors might have an important bearing not only upon
worker motivation and attitude but upon output as well.
b) The Relay Assembly Test room experiment: This involved the
continuous observation of six girls engaged in the telephone assembly.
Several new elements such as shorter working hours, appropriate rest
periods, friendly supervision, improved physical working conditions etc.,
were introduced in the work atmosphere of the group. And it was found
that productivity and morale increased consistently during the experiment
period. Hence the experiment concluded that socio-psychological factors
namely recognition, feeling of being important, attention, participation,
small informal cohesive work group, non-directive supervision were now
seen as being of major importance in determining worker satisfaction and
productivity.

c) Interviewing Programme: This involved an in-depth interview of over

21,000 people for eliciting information on their perceptions and
orientations on the working life. The interview indicated the importance of
human and social factors in the total work situation.
d) Bank wiring observation Room Experiment: This study was
conducted to observe and record the group behavior of workers. A group
consisting of 14 workers was observed as regards their work behavior.
The observations indicated the strength of the informal social organisation
which was based upon sentiments and feelings, status roles and social
interactions which were often removed from the formal organizational
policies and procedures.
The various concepts developed about human behavior in organizations
by Mayo, Roethlisberger and Whitehead is summarized below:
i)The business organisation was considered both as a social system and
as a techno-economic system.

ii)In addition to economic incentives, social and psychological factors also

motivate an individual.
iii)Democratic leadership was much emphasized.

iv) The informal work group was given much importance because they
play an important role in determining the attitudes and performance of
individual workers.

v) Management needs technical as well as social skills.

vi)It was considered that increased satisfaction would lead to increased
effectiveness.

24
2.3.4 SYSTEMS APPROACH
The major contributions to this approach have come from Kenneth
Boulding, R.A. Johnson, F.E. Cast, Rosenzweig and Trist.
According to the systems school, an organisation is a system with its parts
(sub systems) interacting and interdependent. It is an open and organic
system which continuously interacts with its environment. Moreover, the
system as a whole should be in harmony with the environment. As a
system, an organisation draws inputs from its environment, transforms
these inputs and returns the output back to the environment.
Management is concerned with regulating and adjusting the system to
maximize performance. Under this school, management is expected to
perform maintenance and adaptation activities. Maintenance activities
are concerned with ensuring the efficiency and stability of the system.
Adaptation activities are concerned with adjusting the system to suit its
environment and altering the environment so as to make it more in tune
with organizational goals.
The systems approach emphasizes the study of the various parts in their
inter-relationship rather than in isolation from each other. It points out the
complexity of real life management problems.

The systems school has an edge over other schools in so far as it is closer
to reality. It takes a multi-dimensional approach as compared to uni-
dimensional view of other schools. It views an organisation as interacting
with its environment. But the conceptual framework of the systems school
is too abstract and complex. It complicates the task of a practicing
manager who is expected to analyze interdependencies between various
subsystems and the systems and the supra system. It is very difficult for
him to determine how a change in one part is going to affect other parts
and what to do to affect the system in the desired manner.

2.4 CONTEMPORARY TRENDS IN MANAGEMENT

Top Priorities for HR Leaders in 2021
Before pandemic

During the years 2018 and 2019, the topic of discussion was VUCA world.
A world that is volatile, uncertain, complex, and ambiguous. The fourth
industrial revolution and its impact on the industries and HR strategies
were also in prime focus. Organizations and HR professionals were trying
to adjust their policies and practices to align with the needs of the VUCA
world.

25
The prime goal was to retain the best talent in the organization and also
to attract external talent to succeed in the long term plans the companies
have worked on. The little we knew, the whole world is going to be altered
suddenly and more significantly than any of us could have ever imagined.

During pandemic
Last year, talent leaders and industry experts had anticipated the trends
that could reshape the HR industry in 2020 and in the near future.
However, it was beyond anybody’s imagination that the COVID19
pandemic is going to create unprecedented challenges disrupting the
traditional work culture.

During the initial days of the lockdown period, everyone was struggling to
understand how to react to this unprecedented situation. The industry had
no option but to move away from the traditional way of working from
physical office spaces. In some parts of the world, the challenge was to
build the IT infrastructure and ensure data security. But eventually, it
became the new normal. HR professionals played a crucial role in making
their people stay motivated, productive, and engaged during work from
home and they still continue to do that.
“There is a lot that changed in 2020. From commuting restrictions to
staying at home in isolation, the COVID19 pandemic has left a profound
impact on the way businesses function, and it may stay here for long. This
pandemic turned the world upside down, forced leaders to think out of the
box, organizations had no option but, to amend their policies and
processes to suit the new normal and bring more ease in the execution.”
This led to a significant impact on the priorities set by the organizations
and in many cases, they had to add or replace new priorities to sustain
and grow in the coming years. The most notable aspect here is that it not
only impacted HR as a function but, every function within the organization
including business operations and support services.
While the 2021 year came with a bright hope of vaccine against corona
virus, there is still time to see the results and its execution will take a long
time. So, the industry experts have started predicting and highlighting the
priorities in the new normal which may shortly become normal.
Home as the New Office

During this pandemic, the definition of the workplace has changed and it
will continue for a long time. Even, governments had to look into this
aspect and change their rules to support work from home. Home has
become the new office place for which employees and the companies are

26
getting adapted to. Traditionally, many organizations were not allowing
their employees to work from home for various reasons including data
security, productivity monitoring, etc. This has changed and now
organizations are not only allowing work from home but, making it a
permanent option.
HR Policies and Processes
Revising HR policies and practices to align with the emerging needs of
time has become very crucial. Communication, engagement, productivity
monitoring has taken a different turn. Managers are being empowered and
they are becoming as the first level of HR connect. Flexible working hours
are being followed and HR technology will gain high importance. The
policies and rules will be viewed with more empathy than strict adherence.
Employee Experience

Employee experience was always on the agenda of HR in recent times

however, it has gained the top priority during this pandemic. Employees
are also keen about the way they are being treated and expecting a lot to
keep themselves engaged. In view of this, organizations are now
reinventing the employee experience strategies which include more
employee interaction, emotional connect, and family bonding. Informal
ways of team building and socializing will increase. Work-life balance and
physical/emotional wellbeing of employees will be at the peak. Instead of
publicizing the company’s products, business, and office amenities, HR
leaders and branding professionals are focusing to showcase the
company’s efforts to support its employees and its customers too.
Employee Health and Wellbeing

Organizations have already taken steps to support their employees during

these difficult times. From providing IT equipment or a table or a chair or
even going beyond to give allowances. Uncertainties in the professional
and personal life resulted in a lot of stress impacting the physical and
mental health of employees. As a result, engaging with doctors or
Employee Assistance Program (EAP) providers have increased
considerably. HR policies are being revised to encourage more physical
and mental wellbeing of employees. Even when we go back to offices,
organizations will promote programs to support this critical aspect.

Diversity
We have been talking about different generations at the workplace and
designing workforce strategies as per their needs. However, with the
flexibility in working conditions, availability of agile workforce, and virtual
learning methodologies, companies may look at having multiple

27
generations of the workforce and design their strategies accordingly. The
reward, retention, and compensation policies would need to reflect this
change.
Virtual Learning Methods

This pandemic has taught all of us that, people can be trained and
retrained to achieve business objectives. The methodology of learning
has already been shifted from in-person to virtual and that will continue as
everyone is getting used to it. On the go, learning will become popular as
it gives flexibility to employees and is easier to manage for companies.
Involvement of HR

This is a very debatable topic and there are different viewpoints, however,
it cannot be denied that during this pandemic, HR was at the forefront and
supported its employees as well as business. With this, the involvement
of HR in business decisions will increase. As many of the business
decisions are now more focused on the employee base, HR can be part
of business strategies and these decisions will be taken based on the
inputs provided from HR. Changing business models basis the availability
of human resources could be one of the example.
This does not end here and there is a lot that will change or even suddenly
become a priority. The most important aspect this pandemic has taught
us is about life. Nothing is permanent and the whole world can change
overnight. It is also leading some organizations to think of a purpose and
build a ‘purpose-driven organization’ in the coming years.

LET US SUM UP
The origin of management concept dates back to 5000 BC and since then
it has travelled a fairly long distance and underwent a lot of morphological
changes. From the above discussion it is clear that the contributions to
the Management thought have come from various parts of the world, from
various civilizations and at various points of time. Even today, keeping
pace with the trend of the business world, new management thoughts are
constantly emerging. This unit enlightens with the different approaches of
management.
CHECK YOUR PROGRESS
Choose the Correct Answer

1. In ----------------- Management is a process consisting of interrelated

functions performed to achieve the desired goals.
a) The Classical approach b) The Scientific Approach

28
 c) The behavioural approach d) The Systems Approach
2. A ---------- is "knowing exactly what you want men to do and seeing that
they do it in the best and the cheapest way”.
a) The Classical approach b) The Scientific Approach

c) The behavioural approach d) The Systems Approach

3. An organization is a system with its parts (sub systems) interacting
and interdependent in -----------------

a) The Classical approach b) The Scientific Approach

c) The behavioural approach d) The Systems Approach

4. The Hawthorne Experiments conducted by Elton Mayo and his team

laid the foundations of -------------------

a) The Classical approach b) The Scientific Approach

c) The behavioural approach d) The Systems Approach
5. ---------------- are those that evolve from the values and beliefs of a

particular culture of a people.

a) Social forces b) political forces

c) Entrepreneur forces d) economic forces

GLOSSARY

Diversity : The practice or quality of including

or involving people from a range of
different social and ethnic
backgrounds and of different
genders, sexual orientations, etc.

Virtual : Not physically existing as such but

made by software to appear to do
so.

Negotiator : A person who conducts

negotiations.

Allocator : The person who involves action or

process of allocating or sharing out
something.

29
 Spokesperson : A spokesperson is a person who
speaks as the representative of a
group or organization.

SUGGESTED READINGS

1. DinkarPagare (2015) Principles of Management, Sultan Chand &

Sons, New Delhi.
2. Harold Koontz, Cyril O'Donnell and Heinz Weihrich (2017)
Essentials of Management (5th Revised edition), McGraw-Hill Inc.,
US, (ISE Editions).
3. Prasad L.M. (2015) Principles and Practice of Management,
Sultan Chand & Sons, New Delhi.
4. Sherlekar S.A. &Sherlekar V.S 3rd Edition (2014) Principles of
Business Management, Himalaya Publishing House Pvt. Ltd,
Mumbai.
5. Tripathi, Sixth edition (2017) Principles of Management, Tata
McGraw Hill Education Private Limited, 7thWest Patel Nagar, New
Delhi.
6. Tripathi, P C, Reddy, P N, 5 edition (2012) Principles of
Management, Tata McGraw Hill Education private limited, 7 th west
Patel Nagar, New Delhi.
7. https://www.economicsdiscussion.net/management/classical-
approach-to-management/32332
8. https://www.yourarticlelibrary.com/management/4-phases-of-
hawthorne-experiments-discussed-business-management/27888
9. https://www.yourarticlelibrary.com/management/system-
approach-to-management-definition-features-and-
evaluation/27897
ANSWERS TO CHECK YOUR PROGRESS

1) a 2) b 3) d 4) c 5) d

30
Unit 3

PLANNING
STRUCTURE
Overview
Learning Objectives

3.1 Planning

3.1.1 Importance of Planning

3.2 Process of Planning

3.3 Types of planning and techniques

3.4 Decision making

3.4.1 Concept of Decision Making
3.4.2 Features of Decision Making

3.4.3 Importance of Decision Making

3.4.4 Process or Techniques of Decision Making

3.4.5 Decision Making Techniques

Let Us Sum Up
Check Your Progress

Glossary
Suggested Readings
Answers to check your progress

OVERVIEW
You are now familiar with basic management theory and have been
introduced to the essential managerial functions: Planning, Organizing,
Leading and Controlling. This unit deals with planning, organizing,
departmentation and decision making in detail. Planning bridges the gap
from where we are to where we want to go. It is the most basic of all the
managerial functions and it is of various types and as a process has many
steps. In this unit we will discuss the various stages and concepts involved
in planning and the process of decision making.

31
LEARNING OBJECTIVES
After completing this unit, you should be able to,
• define Planning
• discuss the importance of planning
• explain the planning process
• list out the different types of Plans
• tell the steps involved in Planning.

3.1 PLANNING
Planning is ascertaining prior to what to do and how to do. It is one of the
primary managerial duties. Before doing something, the manager must
form an opinion on how to work on a specific job. Hence, planning is firmly
correlated with discovery and creativity. But the manager would first have
to set goals. Planning is an essential step what managers at all levels take.
It needs holding on to the decisions since it includes selecting a choice
from alternative ways of performance.
3.1.1 Importance of Planning
Planning is definitely significant as it directs us where to go, it furnishes
direction and decreases the danger of risk by making predictions. The
significant advantages of planning are provided below:

a) Planning provides directions: Planning assures that the objectives

are certainly asserted so that they serve as a model for determining
what action should be taken and in which direction. If objects are well
established, employees are informed of what the company has to do
and what they need do to accomplish those purposes.
b) Planning decreases the chances of risk: Planning is an activity
which permits a manager to look forward and predict changes. By
determining in prior the tasks to be completed, planning notes the way
to deal with changes and unpredictable effects.

c) Planning decreases overlapping and wasteful activities: Planning

works as the foundation of organising the activities and purposes of
distinct branches, departments, and people. It assists in avoiding
chaos and confusion. Since planning guarantees precision in
understanding and action, work is conducted on easily without delays.
d) Planning encourages innovative ideas: Since it is the primary
function of management, new approaches can take the form of actual
plans. It is the most challenging project for the management as it
leads all planned actions pointing to growth and of the business.

32
e) Planning aids decision making: It encourages the manager to look
into the future and make a decision from amongst several alternative
plans of action. The manager has to assess each option and pick the
most viable plan.

3.2 PLANNING PROCESS

As planning is an activity, there are certain reasonable measures forever
manager to follow:

Figure.3.1 Planning Process

(1) Setting Objectives
• This is the primary step in the process of planning which specifies
the objective of an organization, i.e. what an organization wants to
achieve.

• The planning process begins with the setting of objectives.

• Objectives are end results which the management wants to
achieve by its operations.

• Objectives are specific and are measurable in terms of units.

• Objectives are set for the organization as a whole for all
departments, and then departments set their own objectives within
the framework of organizational objectives.
(2) Developing Planning Premises
• Planning is essentially focused on the future, and there are certain
events which are expected to affect the policy formation.
• Such events are external in nature and affect the planning
adversely if ignored.

33
 • Their understanding and fair assessment are necessary for
effective planning.
• Such events are the assumptions on the basis of which plans are
drawn and are known as planning premises.

(3) Identifying Alternative Courses of Action

• Once objectives are set, assumptions are made.
• Then the next step is to act upon them.

• There may be many ways to act and achieve objectives.

• All the alternative courses of action should be identified.

(4) Evaluating Alternative Course of Action

• In this step, the positive and negative aspects of each alternative

need to be evaluated in the light of objectives to be achieved.
• Every alternative is evaluated in terms of lower cost, lower risks,
and higher returns, within the planning premises and within the
availability of capital.
(5) Selecting One Best Alternative

• The best plan, which is the most profitable plan and with minimum
negative effects, is adopted and implemented.
• In such cases, the manager’s experience and judgment play an
important role in selecting the best alternative.

6) Implementing the Plan

• This is the step where other managerial functions come into the
picture.

• This step is concerned with “DOING WHAT IS REQUIRED”

• In this step, managers communicate the plan to the employees
clearly to convert the plans into action.
• This step involves allocating the resources, organizing for labour
and purchase of machinery.

(7) Follow up Action

• Monitoring the plan constantly and taking feedback at regular
intervals is called follow-up.

• Monitoring of plans is very important to ensure that the plans are

being implemented according to the schedule.

34
 • Regular checks and comparisons of the results with set standards
are done to ensure that objectives are achieved.

3.3 TYPES AND TECHNIQUES OF PLANNING

Many different methods for planning exist, each with their own benefits
and drawbacks in different situations. No one technique will be suitable
for every situation, in fact, a number of these techniques will usually be
required for a successful overall strategy. Different methods are used to
cover different timeframes, areas of the business and utilize different skill-
sets.
a) Strategic Planning: Strategic planning aims to ensure employees
and other stakeholders are all working towards a common goal and
their energy, focus and resources are all aligned towards this.
Agreements are made about the direction the organization wants to
move in and how every contributor can ensure this happens. As well
as the overall goal and how they are going to get there, a strategic
plan also often lays out how the success of the strategy will finally be
measured.
b) Action Planning: Unlike strategic planning, this type of planning is
far more focused on day-to-day activities. Individual, team or project
activities are organized and set out in a timetable. This helps to focus
attention on the task at hand, rather than focusing on the bigger
picture. This increases levels of motivation and efficiency, as well as
providing a useful tool for monitoring and evaluation after the task has
been completed. Specific details are planned for to the level of who
will be where, when and the exact number of resources they will
require.
c) Tactical Planning: This type of planning builds on the strategic plan
already set out, by breaking the tasks down into short-term actions
and plans. It is usually drawn up by lower-level managers as they
have better knowledge of their departments and day-to-day running
of the business. The extra level of detail in a tactical plan increases
efficiency and helps individuals and teams to know exactly what is
required of them.
d) Operational Planning: This type of planning aligns different
functions of the business, for example HR or marketing, with the
overall goals and objectives of an organization. This includes planning
levels of resources, processes, where people are needed and
department budgets. This is important for each individual department
but also overall integration within the business, ensuring every area

35
 of a strategy is covered and no two departments are working on the
same project. Simplicity and clarity are key as the plan must be easily
understood and distributed across the organization.
e) Assumption-based Planning (ABP): All plans make assumptions
about the future and identifying these assumptions is crucial to any
plan. In the scenario of any assumption not occurring the organization
must have plans for how to react to this. Once these assumptions
have been identified it is then important to identify which will have the
biggest impact on the business if they were to fail. ‘Signposts’ can
then be set up to monitor any potential issues and actions can be
taken to manage the assumptions made. Finally, hedging actions can
be taken to prepare for the instance where assumptions fail. As the
business environment becomes more unpredictable and volatile ABP
has become more crucial to strategies.
f) Contingency Planning: This type of planning involves preparing for
the worst-case scenario to occur. All strategies have the potential to
fail when they are affected by internal or external factors. This may be
a supplier suddenly closing down, damage or loss of property or a
change in government legislation. These events are often
unavoidable, and hence instead of attempting to block them, plans
need to be made for the event of them occurring. Firstly, a risk
assessment should take place, highlighting the greatest potential risk
to the business. Once risks have been highlighted plans can be made
for if they occur, laying out the actions required, the triggers to the
events, timeframes for action and budgeting. Contingency plans are
often unused by the completion of the strategy, and hence ignored by
many companies, but to initiate a strategy without one poses a
serious risk to any business. Although they are rarely called upon,
when they are they often save companies vast amounts of money.

3.4 DECISION MAKING

Decision making is the process of making choices by identifying
a decision, gathering information, and assessing alternative resolutions.
Using a step-by-step decision-making process can help you make more
deliberate, thoughtful decisions by organizing relevant information and
defining alternatives.

3.4.1 Concept of Decision Making

Decision Making is the process of selecting the best alternative course of
action from among a number of alternatives given to management or
developed by it – after carefully and critically examining each alternative.

36
Decision Making is a process and a decision is the outcome of this
process. Accordingly, the better the decision-making process the better
would be the decisions emerging out of it, leading to an efficient
commitment of precious organizational resources.

3.4.2 Features of Decision Making

Following are the major features of Managerial Decision Making.
i) Decision making is goal oriented: Each and every decision of
management – major or minor – must make, at least some contribution
towards the attainment of organizational objectives.
ii) Decision Making is pervasive: There are three dimensions of the
pervasiveness of decision making viz.,

a) All managers in the management hierarchy take decisions,

b) within the limits of their authority, pertaining to their areas of

functioning.

c) Decision-making is done in all functional areas of management

eg., Production, Marketing, Finance, Personnel, Research

and Development etc.,

d) Decision-making is inherent in all functions of management i.e.,
Planning, Organising, Staffing, Directing and Controlling.

iii) Decision Making is an Intellectual exercise: Decision making calls

for creativity and imagination on the part of managers. In fact, the more
intelligent a manager is, the better would be the decision making done by
him.
iv) Decision making involves a problem of choice: Decision making is
fundamentally a choosing problem i.e. a problem of choosing the best
alternative, from out of a number of alternatives, in a rational and scientific
manner.
v) Decision making is a continuous process: Decision making process
commences since the inception of business and continues throughout the
organizational life. All managers take decisions for organizational
purposes, so long as the enterprise is in existence.

vi) Decision making is the basis of action: All actions of people

operating the enterprise are based on the decisions taken by
management vis-à-vis organizational issues. In fact, the quality of actions
by people well depends on the quality of decisions taken by management.

37
vii) It implies a commitment of organizational resources: Commitment
of organizational resources, viz time, efforts, energies, physical resources
etc., is implied both during the process of taking decisions and more
particularly, at the time of implementation of decisions. Right decisions,
accordingly imply a right commitment of resources and wrong decisions
imply a wrong commitment of precious organizational resources.
viii) Decision making is situational: Decision making depends much on
the situation facing the management at the time when a decision-making
problem crops up. Whenever the situation changes decision making also
changes.

3.4.3 Importance of Decision Making

• Management is essentially a process of decision making and
managers at various levels are mainly concerned with decision making.

• Without decisions the functions of management cannot take place and

the entire process of management cannot exist.
• For performing various aspects of management functions like planning,
organizing, control etc., decisions must be made because it helps to set
objectives, prepare plans of action, introduce innovations, and determine
organizational structure of the concern and so on.

3.4.4 Process of Decision Making

The process of decision making is concerned with adoption of a series of
steps viz

Figure.3.2 Decision Making Process

38
These steps can be explained as under:
a) Defining the problem: The first and the foremost step in the decision-
making process is to find and define the real problem. A problem can be
explained as a question for appropriate solution. The manager should
consider critical or strategic factors or factor in defining the problem.
b) Analysing the problem: After the problems have been defined the
next important step is systematic analysis of the available data or
information. Sound decisions are based on proper collection,
classification and analysis of facts and figures.
c) Developing alternative solutions: The main aim of developing
alternative solutions is to have the best possible decision out of the
available alternative courses of action. In developing alternative solutions,
the manager comes across creative or original solutions to the problems.
In modern times, the techniques of operations research and computer
appliances are immensely helpful in the development of alternative
courses of action.
d) Selecting the best type of alternative: Selecting the best type of
alternative is not an easy task. There are four important points to be kept
in mind in selecting the best from various alternatives. These points are:

i) Risk element involved in each course of action against the expected

gain.
ii) Economy of effort involved in each alternative i.e. securing desired
results with least efforts.
iii) Proper timing of the decision and action should also be taken into
consideration.
iv) Final selection of decision is also affected by limitation of resources at
our disposal.
e) Implementation of the Decision: Under this step a manager has to
put the selected decision into action. For proper and effective execution
of the decision three things are very important i.e., (a) Proper and effective
communication of decision to the subordinates is very important.
Decisions should be communicated in clear, concise and understand able
manner. (b) Acceptance of decision by the subordinates is important.
Group participation and involvement of the employees will facilitate the
smooth execution of decisions. (c) Correct timing in the execution of
decision minimizes the resistance to change.

39
vi) Follow-Up: A follow up system ensures the achievement of the
objectives. It is exercised through control. Follow up is indispensable to
modify and improve decisions at the earliest opportunity.
vii) Monitoring and Feedback: Feedback provides the means of
determining the effectiveness of the implemented decision. If possible, a
mechanism should be built into the process which would give periodic
reports on the success of implementation. In many situations, computers
are very successfully used in monitoring since the information retrieval
process is very quick and accurate and, in some instances, the self-
correcting is instantaneous.

3.4.5 Decision Making Techniques

Before going into the details of Decision-making techniques, it is pertinent
to know about the types of decisions. The decisions made by the manager
usually fall into one of the two main categories – Programmed decisions
and non-programmed decisions.
Programmed decisions are those that are applied to routine situations that
have occurred often and for which decision rules and procedures have
been developed and used again and again. These rules and procedures
are frequently recorded and placed in the organization’s Standard
Operating Manual (SOM).
Non-Programmed decisions are applied to non-routine situations that are
new and different from situations experienced in the past. Thus, there are
no standard methods that appear to be appropriate. So managers must
apply judgment, intuition and creative thinking to the development of
alternatives that are compatible with past operating procedures and
organizational policy.
The important aids (techniques) for routine, repetitive or programmed
decisions are as follows:

i) Habit: Many complicated but repetitive jobs are done just by practice.
ii) Standard Procedures and Methods: Pre-determined standards like
output and performance standards serve as good aids in routine decisions.

iii) Policies: Policies prescribed by the top management give standing

answers to recurrent questions or problems. Hence, they can guide
decisions and encourage management by exception.

iv) Organizational Structure: Organization structure offers invaluable

aid in routine decisions. For instance, delegation and decentralization
enable the subordinates to take routine decisions, on their own account.

40
The aids for the non-programmed decisions are as follows.
i) Intuition: Intuition includes guess work and common-sense views
based on a keen and quick insight. Previous experience and training also
contribute a lot in this regard. Managers having a strong power of intuition
can generally take prompt and appropriate decisions. However, decisions
based on intuition are subjective and cannot be objective. Moreover, they
have no scientific basis.

ii) Experience: Personal experience gives any manager the requisite

breadth of vision that trains him to apply the knowledge he has acquired
to the best of its uses.

iii) Considered Opinion: Democratic participative management relies

upon the considered opinions based on group decisions, as they provide
maturity and rationalization in the decision-making process.

iv) Facts: Relevant, adequate and up-to-date facts and figures provide
the social basis for decision making. The factual data has assumed
unique importance in decision making particularly in the era of computer
technology.
v) Quantitative decision-making tools: The quantitative decision
making tools such as Operations Research, Simulation, Monte Carlo
Technique, Linear programming, Queuing theory, Game theory,
Probability theory, Programme Evaluation Review Technique (PERT),
Break-even Analysis, and Sequence Analysis and soon have proved to be
good decision making tools.

LET US SUM UP
Planning is the primary managerial function. It involves selecting missions
and objectives. There is close relationship between planning and
controlling. The plans are of many types such as Missions, Objectives,
Strategies, Policies, Procedures, Rules, Programmes and Budgets.
Planning involves many steps. Organization denotes both structure and
process and it is to have certain elements to be successful. Sound
organization is essential for the continuity and success of every enterprise
and as a process it also involves a few steps.
CHECK YOUR PROGRESS
Choose the Correct Answer

1. ----------- gives any manager the requisite breadth of vision that trains
him to apply the knowledge he has acquired to the best of its uses.
a) The Classical approach b) Personal experience

41
 c) The behavioral approach d) The Systems Approach
2. ------------------- are applied to non-routine situations that are new and
different from situations experienced in the past.
a) Non-Programmed decisions b) Programmed decisions

c) Policies d) Procedures
3. --------------------system ensures the achievement of the objectives.
a) Follow up b) Policies

c) Rules d) Procedures

4. The planning process begins with the setting of ---------------------.

a) Objectives b) Policies

c) Rules d) Procedures

5. Programmed Evaluation Review Technique (PERT) is a --------

a) Quantitative tools b) political tool
c) Analysis tool d) economic tool

GLOSSARY

Derivative Plan : Secondary plans which help in

achieving main plan.

Missions : An Important assignment given to a

group of people

Objectives : Short term and long term goals of

the concern

Strategies : A strategy describes how the ends

will be Achieved by the means

SUGGESTED READINGS
1. DinkarPagare (2015) Principles of Management, Sultan Chand &
Sons, New Delhi.
2. Harold Koontz, Cyril O'Donnell and Heinz Weihrich (2017)
Essentials of Management (5th Revised edition), McGraw-Hill Inc.,
US, (ISE Editions).

42
3. Prasad L.M. (2015) Principles and Practice of Management,
Sultan Chand & Sons, New Delhi.
4. Sherlekar S.A. &Sherlekar V.S 3rd Edition (2014) Principles of
Business Management, Himalaya Publishing House Pvt. Ltd,
Mumbai.
5. Tripathi, Sixth edition (2017) Principles of Management, Tata
McGraw Hill Education Private Limited, 7 thWest Patel Nagar, New
Delhi.
6. Tripathi, P C, Reddy, P N, 5 edition (2012) Principles of
Management, Tata McGraw Hill Education private limited, 7 th west
Patel Nagar, New Delhi.
7. https://www.geeksforgeeks.org/features-importance-and-limitations-
of-planning/
8. https://epgp.inflibnet.ac.in/Home/ViewSubject?catid=ahLCajOqz6/G
WFCSpr/XYg==
9. https://www.accipio.com/eleadership/mod/wiki/view.php?id=1639
ANSWERS TO CHECK YOUR PROGRESS

1) b 2) a 3) a 4) a 5) a

43
Unit 4

ORGANIZATIONAL STRUCTURE AND

DESIGN
STRUCTURE

Overview
Learning Objectives
4.1 Meaning of Organization

4.2 Organization Structure and Design

4.3 Departmentation

4.3.1 Need and Importance of Departmentation

4.3.2 Types of Departmentation
4.4 Department- Delegation and Decentralization
4.5 Delegation of Authority

4.6 Decentralization of Authority

4.7 Span of management

Let Us Sum Up
Check Your Progress
Glossary
Suggested Readings
Answers to check your progress

OVERVIEW

This unit comprises of various aspects of departmentation such as need

for departmentation, different bases of departmentation and factors
influencing the basis of departmentation are discussed. As the features of
decision making, types of decisions, steps involved in decision making
and decision support system a clear knowledge on departmentation will
be an add on advantage for the managing executives.

44
LEARNING OBJECTIVES
After completing this unit, you should be able to,
• describe the need for departmentation
• describe the different bases of departmentation
• discuss the factors influencing the basis of departmentation
• explain the nature of authority and power.
4.1 MEANING OF ORGANIZATION

The term organization is used in management literature in two different

senses (i) Organization structure and (ii) Organizing process.
4.2 ORGANIZATION STRUCTURE AND DESIGN

Organization is systematic integration of inter dependent parts to form a

united whole. It is a structure of relationship, among various positions or
jobs. This structure or entity comprises horizontal and vertical authority
relationships. It is a system of co-operative activities of two or more
persons for the attainment of a common purpose. It is the framework
through which people work together for the accomplishment of desired
results.
The components of organization structure include men, materials,
machine, money, methods, functions, authority and responsibility. Each
organization structure is characterized by,
(a) Distinct purpose to accomplish
(b) Composed of people and

(c) Formal relationships among its members.

Organization structure is designed to clarify who is to do what and who is
responsible for what results. But this is known as the static or classical
concept of organization because the emphasis here is on the positions or
roles rather than on the people who have to fill the structure. It is a work
centered concept designed to employ people to suit the roles meant for
them. Authority and responsibility of each position rather than the person
holding that position is defined. Moreover, organization is viewed as
something permanent which need not be changed every now and then.

ii) Organization as a Process

The term organization is also used as a function of management or as a
process carried out for arranging the tasks into manageable units and
defining the formal relationships among the people working on different
tasks. It involves putting things and persons in their proper places and in

45
relation to each other. It is the process of structuring or arranging the
different parts, e.g. people, work, technology etc.,
In the words of Louis Allen, “Organizing is the process of identifying and
grouping the work to be performed defining and delegating responsibility
and authority, and establishing relationship for the purpose of enabling
people to work most effectively together in accomplishing objectives”.
Organizing is viewed as a continuing process wherein relationships
among people are constantly reviewed and adjusted depending on the
requirements of the situation.
4.3 DEPARTMENTATION

Departmentation is an element of the organizing process. It is a means of

dividing the large and complex organization into smaller and flexible
administrative units. A department is a distinct area, unit or subsystem of
organization over which a manager has authority for performance of
specified activities.
4.3.1 Need and Importance of Departmentation
Departmentation is required due to the following reasons:
i)Specialization: Departmentation enables an enterprise to take
advantage of specialization. When every department looks after one
major function of business, division of work becomes possible.
ii) Expansion: One manager can manage only a limited number of
subordinates. In the absence of departmentation, the size of the
enterprise remains limited. Grouping of activities and personnel into
departments makes it possible to expand an organization to an indefinite
degree.
iii) Autonomy: Departmentation results in the division of the enterprise
into semi-autonomous units. In these units, every manager is given
adequate freedom. The feeling of autonomy provides job satisfaction and
motivation which in turn leads to higher efficiency of operations.
iv) Fixation of Responsibility: Departmentation enables each person to
know the specific part he is to play in the total organization. It provides a
basis for building up loyalty and commitment. The responsibility for results
can be defined more precisely and an individual can be held accountable
for performance.

v) Appraisal: Appraisal of managerial performance becomes easier when

specific tasks are assigned to departmental personnel. The sources of

46
information, the skills and competence required for total managerial
decision can be located.
vi) Management Development: Departmentation facilitates
communication, co-ordination and control. It simplifies the training and
development of executives by providing them opportunity to take
independent decisions and to exercise initiative.
vii) Administrative Control: Grouping of activities and personnel into
manageable units facilitates administration control. Standards of
performance for each and every department can be precisely determined.
4.3.2 Types of Departmentation

The following patterns may be used for grouping activities into

departments:
a) Departmentation by Functions

b) Departmentation by Products

c) Departmentation by Territory
d) Departmentation by Customers

e) Departmentation by Process or Equipment

f) Departmentation by Time and Numbers.
a) Functional Departmentation: Under functional departmentation each
major or basic function is organized as a separate department. Basic or
organic functions are the functions the performance of which is vital and
essential to the survival of the organization. For example, production,
sales, financing and personnel are basic functions in a manufacturing
enterprise. On the other hand, in a retail store buying, selling and finance
are the major functions.
Thus, the process of functional differentiation takes place through
successive levels in the hierarchy.

Figure. 4.1 Departmentation by Function

47
Advantages
The main advantages of functional departmentation are as follows:
a) It is the most logical, time proven and natural form of
b) departmentation.
c) It provides specialization which makes optimum utilization of man
power.
d) It ensures the performance of all activities necessary for achieving
organizational objectives.
e) It facilitates delegation of authority.
f) It permits effective control over performance.

g) It eliminates costly duplication of effort.

h) It makes management easier because managers have to be

i) experts only in a narrow range of skills.
Disadvantages
a) There is too much emphasis on specialization. When each
Employee specializes only in a small part of the job he cannot
develop a balanced attitude towards the job as a whole.

b) There may be conflicts between departments as the

c) Responsibilities are interdependent and cannot always be clearly
delineated.

d) Functional departments may grow in size to justify their costs.

e) Managers may try to build their functional empires.

f) There may be difficulties in coordinating the activities of different

departments.
Eg: The sales department may fail to honor delivery schedule due

to problems in the production department.

b) Product Departmentation: In product departmentation, every major
product is organized as a separate department. Each department looks
after the production, sales and finance of one product. It is generally
employed when the product is relatively complex and a great deal of
capital is required for plant and equipment such as in automobile and
electronic industries.

48
 Figure 4.2 Product Departmentation

Advantages
i. Product departmentation can reduce the problem of co-ordination

ii. between departments. All activities concerning a particular

iii. product line is integrated together.

iv. It focuses individual attention on each product line which facilitates
product expansion and diversification.

v. It leads to specialization of physical facilities.

vi. The performance of each product division and its contribution to

vii. overall results can be easily evaluated.

viii. As each product division is semi-autonomous and contains

ix. Different functions, product departmentation provides an excellent

x. training ground for managerial personnel.

xi. It is more flexible and adaptable to change.

Disadvantages

a) There is duplication of physical facilities and functions. Each

b) product division maintains its own facilities and personnel due to

c) which operating costs may be high.

d) Advantage of centralization of certain activities like financing,

e) accounting, distribution etc., are not available.

f) There may be under utilisation of plant capacity when the demand

49
for a particular product is not adequate.
c) Territorial Departmentation: Territorial departmentation is very useful
to a large-scale enterprise whose activities are geographically spread.
Banks, Insurance Companies, Transport Companies, Distribution
Agencies are examples of such enterprises. Under territorial or
geographical departmentation activities are divided into zones, divisions
and branches.

Figure 4.3 Territorial Departmentation

Advantages

a) It helps in achieving the benefits of local operations.

b) It results in savings in freight, rents and labour costs. There are

savings in time and money.

c) There is better co-ordination of activities in a locality through the
setting up of regional divisions. It provides for effective span of
control.

d) It facilitates the expansion of business to various regions.

e) It provides opportunity to train managers as they look after the

complete operations of a unit.

Disadvantages
a) Due to geographical distance, there is problem of communication.

b) Co-ordination and control of different branches from the head

c) office become less effective.

50
 d) Customer Departmentation: Under this basis of departmentation,
activities are grouped according to the type of customers. For instance,
a large cloth store may be divided into wholesale, retail and export
divisions. This type of departmentation is useful for banks, departmental
stores etc., each department specializes in saving a particular class of
customers.

Figure.4.4 Customer Departmentation

Advantages

a) Special attention can be given to the particular tasks and

b) preferences of each class of customers. Customers’ satisfaction
enhances the goodwill and sales of the enterprise.

c) The benefits of specialization can be derived

d) The enterprise gains intimate knowledge of the needs of each

category of customers.
Disadvantages
i. As such departmentation is applied only to sales function there

Maybe difficulties in coordinating the activities of different

functions.
ii. There may be under utilization of facilities and manpower,
Particularly during periods of low demand.

51
 iii. Managers of customer departments may put pressures for special
facilities and benefits.

It may lead to duplication of activities.

e) Process or Equipment Departmentation: Under this basis, activities
are grouped on the basis of production process or equipment involved
(Figure.4.5). This is generally used in manufacturing enterprise and at
lower levels of organization. For example, a textile mill may be organised
into ginning, spinning, weaving and dyeing departments. Similarly, a
printing press may consist of composing, proof reading, printing and
binding departments.

Figure 4.5 Process Departmentation

Advantages
Process departmentation provides the advantages of specialization,
proper maintenance of equipment and effective utilization of manpower.
The machines are arranged in such a way that a series of operations on
materials is feasible making operations economical.
Disadvantages
There may be difficulty in coordinating different process departments.
Conflicts among managers of different processes may arise. Volume of
production must be large enough to justify a separate department.

f) Time Based Departmentation: When activities are grouped on the

basis of time of their performance, it is called time based departmentation
(Figure 4.6). For example, a factory operating twenty-four hours may
have three departments, one each for morning, day and night shifts.
Hospitals and other public utility companies, which work around the clock
are generally departmentalized on the basis of time shifts. For each shift,
a different department may exist, although all departments are alike in
terms of objectives and functions.

52
 Figure. 4.6 Time Based Departmentation
Advantages

i. Services can be provided beyond the typical eight-hour day often

extending up to 24 hours a day.
ii. Costly capital equipment can be most effectively utilized as people
working in different shifts make use of the same machines and
other facilities.
iii. Evening and night shift departments provide employment to people
iv. who or one reason or the other cannot work during the day.

Disadvantages
a) Supervision may be difficult during night shift making staff lazy and
careless.
b) There may be lack of co-operation among persons working in
different shifts. For example, night shift people may not properly
clean up machines etc., to be used by morning shift people.
g) Simple Number Based Departmentation: Under this basis of
departmentation, a specific number of persons (making for a suitable
group) who perform the same duties are separated out and put under the
supervision of a manager. For example, in army soldiers are grouped into
squads, battalions, companies, brigades and regiments needed there on
the basis of the number prescribed for each unit.
h) Combined Departmentation: Departmentation is not an end in itself
but a means for achieving organizational objectives. Each basis of
departmentation has its own merits and demerits. Therefore, the relative
advantages and limitations of various types of departmentation should be
analyzed in the light of the needs and circumstances of the particular
enterprise. That basis of departmentation is the best which facilitates the
achievement of organizational objective most economically and efficiently.
4.4 DELEGATION AND DECENTRALISATION

Concept of Authority
Authority is the right vested in a managerial position which enables the
manager occupying the managerial position to command subordinates to

53
take decisions and to use organizational resources – all for the purpose
of facilitating and ensuring the attainment of enterprise objectives.

The following are the salient features of the concept of authority:

i) Authority lies in managerial positions, and not in managers, in their
personal capacities.
ii) Authority is the key to a manager’s job without which no manager is
enabled to command and instruct subordinates, for ensuring the
attainment of enterprise objectives.
iii) Authority is hierarchical in nature i.e. the extent or amount of
authority goes on declining as we come down the management hierarchy.

Authority and Power Distinguished

In general usage, the two terms authority and power are used
interchangeably. However, a distinction between these two can be made
as follows.

Concept of Responsibility
Responsibility is the reverse of authority. It is the obligation or duty or
liability owed by a subordinate to the superior (who grants authority to the
former) for the proper and efficient discharge of the job for which authority
has been granted to the former i.e. the subordinate.

The following are the salient features of responsibility.

a) responsibility is a corollary of authority and cannot exist
independently.
b) it is a natural and logical duty of a subordinate to explain his

c) performance to the superior from whom the former derives

d) authority.

e) it proceeds from subordinates to superiors.

f) it is something fixed or absolute and can never be delegated by
g) any superior to any subordinate.

4.5 DELEGATION OF AUTHORITY

No individual can perform all the activities himself. Therefore, the total
work of an organization is divided among different persons. Every
individual is given some authority so that he can accomplish his task.
Every manager shares his authority with his subordinates because he
alone cannot exercise all the authority himself. After assigning duty and

54
granting authority to subordinates, a manager holds them accountable for
proper discharge of duty.

How Authority Is Delegated

Authority is delegated when a superior gives a subordinate discretion to
make decisions. Clearly, superiors cannot delegate authority they do not
have, whether they are board members, presidents, vice-presidents, or
supervisors.

The process of delegation involves (1) Determining the results expected

from a position (2) Assigning tasks to a position (3) Delegating authority
for accomplishing these tasks and (4) Holding the person in that position
responsible for the accomplishment of the tasks.

The following are the salient features of delegation of authority:

No manager can delegate his total authority to a subordinate. He

can pass on only a portion of his authority to the subordinate.

For Example, in case of Indian Administration, the Prime Minister has
virtually all the powers for the administration of the Indian Economy.
However, certain emergency powers are reserved for the President of
India.
No manager can give that authority to a sub-ordinate, which the former
himself does not possess.
The idea behind delegation of authority is that of representation of the
superior by the subordinate who is supposed to behave and act in a
manner, in which the superior, himself, would have behaved and acted.
Delegation of authority is made by a superior to subordinate, only for
organizational purposes and not the fulfillment of the personal purposes
of the superior.
Delegation of authority does not imply a reduction in the power of the
superior. It is something like knowledge which is still retained by teacher
ever after imparting it to pupils.
Process of Delegation of Authority
The entire process of delegation of authority entails the following steps:

a) Determination of the results expected of the subordinates.

b) Assignment of duties/tasks/jobs to the subordinates.

c) Delegation of authority to the subordinate

d) Fixation of responsibility on the subordinate.

55
The following is brief comment on each of the above steps:
a) Determination of the results expected of the subordinates: While
planning to delegate authority, first of all, the superior has to make a
determination of what results could be expected of the subordinate and
who is to be delegated authority. This step naturally requires an estimate
of the apparent competence of the subordinate. Delegation of authority,
without due regard to the competence of the subordinate, in all good
probability, would lead to poor delegation incapable of yielding the desired
results.
b) Assignment of Duties / Tasks / Job to the subordinate: In view of
the competence of the subordinates, duties or tasks or job is assigned to
him. The duties assigned to the subordinate might concern some specific
job or certain functions or a certain target to be attained.

c) Delegation of authority to the subordinate: In the next step,

necessary authority is granted or delegated to the subordinate to enable
the subordinate perform the assigned work effectively and without
interruption.
d) Fixation of responsibility on the subordinate: Delegation of
authority would remain not only incomplete but also ineffective, unless and
until, the subordinate to whom authority is delegated is made answerable
to the superior for the proper and efficient discharge of the assigned work.
Principles of Delegation

The following principles lead to the betterment of the process of delegation

and ensure the attainment of the results expected of delegation of
authority.
i) Principle of non – delegation of personalized matters: There are
certain matters which must be handled by the superior alone in his
personal capacity because he happens to be the fittest person for this
purpose in view of his placement in the organization. Therefore, authority
for deciding personalized matters must not be delegated to any
subordinate.

ii) Principle of delegation by the results expected: While undertaking

the process of delegation, the superior must delegate the requisite
authority to the subordinate i.e. as much authority as is necessary for the
subordinate in view of the results expected of the latter.
iii) Principles of Unity of Command: According to this principle, at one
time, one and only one superior must delegate authority to a particular
subordinate.

56
iv) Principle of Scalar Chain: The delegation of authority must take place
via the scalar chain or the management hierarchy. i.e. it must be the most
immediate superior who delegates authority to the most immediate
subordinate.

v) Principle of parity of authority and responsibility: According to this

principle, authority and responsibility are co-extensive terms. i.e. the two
go together. As such, the management slogan is – “more authority and
more responsibility” “less authority and less responsibility” and finally, “no
authority and hence no responsibility”.
vi) Principle of absolute responsibility: According to this principle,
responsibility is something, which is fixed or absolute and no superior, in
any manner and to any extent can delegate his own responsibility to any
of his subordinates. Even after delegation of authority, the superior
delegating authority, continuous to be responsible to his own superior, for
the total authority, originally possessed by the former.
4.6 DECENTRALISATION OF AUTHORITY
The previous section deals with the various aspects of Delegation of
Authority. This section emphasizes the dispersion of authority in the
organization.

The Nature of Decentralization

Decentralization is the tendency to disperse decision-making authority in
an organized structure. Decentralization is a fundamental aspect of
delegation. To the extent, the authority is not delegated, it is centralized.
Decentralization of authority is that philosophy of the top management of
an enterprise under which maximum authority for the management of the
enterprise is dispersed or distributed among managers of middle and
specially, lower levels, and minimum authority is kept by the top
management, in reserve, to be exercised by itself.

Dalton E. McFarland defined Decentralization of authority as the degree

to which an organization places authority and responsibility for decisions
as far down in the organization as efficient management permits.

Measurement of Decentralization / Centralization

In the management context there may be more centralization or more of
decentralization but cannot exactly measure these tendencies. However,
the degree of centralization or decentralization could be judged on the
basis of following criteria.

57
i) Quantity of Decisions: The larger is the number of decisions made at
lower levels of management, the higher is the degree of decentralization
and vice-versa.
ii) Quality of Decisions: The more significant are the decisions made at
lower levels of management, the higher is the degree of decentralization
and vice-versa.
iii) Functional areas affected by decisions: The more are the functional
areas of management (eg : Finance, Marketing, Personnel, etc.,) affected
by decisions made at lower levels of management the higher is the degree
of decentralization and vice-versa.

iv) Amount of control over decision making: The lesser is the amount
of control exercised over the decisions made at lower levels of
management, the higher is the degree of decentralization and vice-versa.

Factors Favoring Decentralization

Major factors which favour a policy of decentralization are

i) Optimum size of the enterprise: In order to achieve optimum size of
business enterprise, it is imperative that productive and marketing
operations are conducted on a large scale. As such some minimum
decentralization does become necessary to cope with the larger volume
of decision making in a large enterprise.
ii) Management by Exception: When the top management wishes to
adhere to the policy management by exception decentralization becomes
necessary. In fact, management by exception requires top management
to concentrate its attention only on strategic issues – leaving all
operational details to be taken care of by subordinates.
iii) Decentralized Performance: Where, the performance of the
organization is geographically dispersed some minimum decentralization
of authority becomes necessary to managers of decentralized units of
smooth functioning of their departments or divisions.
iv) To impart freedom to subordinates: Subordinates, at lower levels of
management desire freedom in decision – making concerning their areas
of operation. Such freedom is a great motivation for them. When, top
management plans to motivate subordinates by imparting freedom in
decision-making decentralization of authority becomes imperative.

Degree of Decentralization

The degree of decentralization is determined by :

a) Nature of the authority delegated

58
 b) How far down in the organization, it is delegated.
c) How consistently it is delegated
So, the degree of decentralization is determined by the authority given.
For example, Manager A in a company is given the authority to buy certain
material worth Rs.1500 whereas Manager B is allowed to do similar type
of work to the extent of Rs. 4500. It is pertinent that the degree of
decentralization is less in case of A.

How to decentralize?
Decentralization is an art. We can establish definite sequence for
accomplishing effective decentralization in an enterprise. It calls for the
following steps:
i) Establishing appropriate centralization: There should be centralized
management which becomes the nerve centre of the enterprise. The
centralized management makes decision while the operation and routine
decisions are left to be made by lower levels.
ii) Developing Managers: Companies that favour decentralization will
face shortage of managers making effective decisions with adequate
preliminary preparation, so there is a need for the development of
managers who possess independent thinking and capabilities for making
decentralization effective.
iii) Providing for Communication and Co-ordination: Managers are
required to know the thinking of both centralized and other decentralized
managers, only then they will be in a position to achieve uniform places in
an organization. As such there is need for communication and co-
ordination.
iv) Establishing adequate controls: In the decentralized arrangement a
manager is given authority to act independently to the extent which can
be checked by the centralized management. In order to make
decentralization effective, management must develop systems to
evaluate their performance.
v) Providing appropriate dispersion: When there is dispersion or
physical separation of headquarter office from the product plant,
interference by central staff and top management can be considerably
avoided.

Distinction between Delegation and Decentralization

The points of distinction between delegation and decentralization are as
under:

59
i. In delegation a superior delegate or transfers some rights and duties to
a subordinate but his responsibility in respect of the work does not end.
On the other hand, decentralization relieves him from responsibility and
the subordinate becomes liable for that work.

ii. Delegation is a process while decentralization is the end result of a

deliberate policy of making delegation of authority to the lowest levels in
managerial hierarchy.

iii. Delegation is almost essential for management to get things done in

the organization. Decentralization may or may not be practiced as a
systematic policy in the organization.

iv. In delegation the final control over the activities of organization lies with
the top executive while in decentralization the power of control is
exercised by the unit head to which the authority has been delegated.

v. Decentralization is effective only in big organizations, whereas

delegation is required and gives good results in all types of organizations
irrespective of their size.
vi. Delegation is the result of human limitations to the span of
management. Decentralization on the other hand, is the result of big size
and multifarious functions of the enterprise.

4.7 SPAN OF MANAGEMENT

Definition
The Span of Management refers to the number of subordinates who can
be managed efficiently by a superior. Simply, the manager having the
group of subordinates who report him directly is called as the span of
management.
The Span of Management has two implications

1) Influences the complexities of the individual manager’s job

2) Determine the shape or configuration of the Organization

The span of management is related to the horizontal levels of the

organization structure. There is a wide and a narrow span of management.
With the wider span, there will be less hierarchical levels, and thus, the
organizational structure would be flatter. Whereas, with the narrow span,
the hierarchical levels increase, hence the organizational structure would
be tall.

60
Depending on the number of employees that can be supervised or
controlled by managers, there can be two kinds of structures in the
organization:
I. Tall structures, and

II. Flat structures.

Figure. 4.7 Tall and Flat Span of Control

I. Tall structures
These structures are found in classical bureaucratic organizations. In this
structure, a manager can supervise less number of subordinates. He can,
therefore, exercise tight control over their activities. This creates large
number of levels in the organization. This is also known as narrow span
of control.

Merits

1. Managers can closely supervise activities of the subordinates.

2. There can be better communication amongst superiors and
subordinates.

3. It promotes personal relationships amongst superiors and subordinates.

4. Control on subordinates can be tightened in a narrow span.
Limitations
1. It creates many levels in the organization structure which complicates
co-ordination amongst levels.

61
2. More managers are needed to supervise the subordinates. This
increases the overhead expenditure (salary etc.). It is, thus, a costly form
of structure.
3. Increasing gap between top managers and workers slows the
communication process.
4. Decision-making becomes difficult because of too many levels.
5. Superiors perform routine jobs of supervising the subordinates and
have less time for strategic matters.
6. Employees work under strict control of superiors. Decision-making is
primarily centralized. This restricts employees’ creative and innovative
abilities.
7. Strict control leads to low morale and job satisfaction. This can affect
productivity in the long-run.

To overcome the limitations of a tall structure, many organizations reduce

the number of levels in the hierarchy by downsizing the organization.
Downsizing is “the process of significantly reducing the layers of middle
management, expanding spans of control and shrinking the size of the
work force.”
Many companies downsize their work force through the process of
restructuring. Restructuring is “the process of making a major change in
organization structure that often involves reducing management levels
and also possibly changing some major components of the organizations
through divestiture and/or acquisition.”
“The most common and most serious symptom of mal-organization is
multiplication of the number of management levels. A basic rule of
organization is to build the least possible number of management levels
and forge the shortest possible chains of command.” — Peter F. Drucker.
II. Flat Structures

These structures have a wide span of control. When superior supervises

a larger number of subordinates, flat structure is created with lesser
number of hierarchical levels. A departure was made from tall structures
to flat structures by James C. Worthy who was a consultant in the L. Sears,
Roebuck and company.
To illustrate, if organizations A and B, both have 256 workers and the span
of control for each managerial position is 2 for company A and 4 for
company B, there will be 9 levels in company A (requiring 128 supervisors
at the lowest level, 64 at the next higher level and so on) and 5 levels in

62
company B. A narrow span of control creates more levels in the
organizational hierarchy than the wide span of control.
For the sake of simplicity, the figure represents the span for only one
functional area and one level.

Merits
1. There is low cost as a smaller number of managers can supervise
organizational activities.

2. The decision-making process is effective as superior’s delegate

authority to subordinates. They are relieved of routine matters and
concentrate on strategic matters. The decision-making is decentralized.

3. Subordinates perform the work efficiently since they are considered

worthy of doing so by the superiors.
4. There is effective communication as the number of levels is less.

5. It promotes innovative abilities of the top management.

Limitations
1. Superiors cannot closely supervise the activities of employees.

2. Managers may find it difficult to co-ordinate the activities of

subordinates.
3. Subordinates have to be trained so that dilution of control does not
affect organizational productivity.
Both tall and flat structures have positive and negative features and it is
difficult to find the exact number of subordinates that a manager can
effectively manage. Some management theorists like David D. Van Fleet
and Arthur G. Bedeian assert that span of control and organizational
efficiency are not related and many empirical studies have proved that
span of control is situational and depends on a variety of factors.
Some studies proved that flat structures produce better results as
decentralized decision making has less control from the top, promotes
initiative and satisfaction at work. Large number of members in a group
can better solve the complex problems as group decision making is based
on greater skill variety.

Other studies proved that people working in tall structures produce better
results as less number of members in a group can come to consensus of
opinion and evaluate their decisions more thoroughly. Group
cohesiveness is high and, thus, commitment to decisions is also high.
Members feel satisfied with their decisions and conflicts are reduced.

63
Factors Affecting Span of Management
The following factors help in determining the suitable span of
management
1. Competence of managers: If managers are competent in their jobs,
they can have a wide span of management. Competence of managers is
judged by their ability to make decisions related to motivational plans,
leadership styles, communication channels and chains, techniques of
control etc. Managers who rank high on these parameters can effectively
supervise larger number of subordinates.
2. Nature of work: If employees perform similar and repetitive work,
managers can supervise large number of subordinates and, thus, have a
wide span of control. Non-repetitive and challenging work requires narrow
span of control. Changes in the nature of work also affect the span of
management.
Frequent changes as a result of dynamic environment support a narrow
span as superiors frequently have to direct the activities of subordinates.
Stability in the nature of work supports a wide span of management as
superiors’ directions are not frequently required to carry out the work
processes.

3. Assistance to managers: If managers have access to technical or

secretarial assistance, a larger group of subordinates can be managed.
Span of control can, therefore, be wide. Staff assistance can be useful for
collecting and processing information related to various decisions and
issuing orders to the subordinates. Managers save time in communicating
with subordinates, direct the activities of larger number of subordinates
and focus on other strategic organizational matters.
4. Competence of subordinates: If subordinates are competent to
manage their jobs without much assistance from the superiors, span of
control can be wide. Competent subordinates do not require frequent
directions from the superiors with respect to various organizational
activities. Superiors can thus, manage a larger group of subordinates.

5. Plans and policies: If plans clearly define the organizational/individual

goals and policies, superiors can supervise a larger group of subordinates
and have a wide span of control. Clearly defined plans include well-
formulated policies procedures, methods etc. Particularly, if standing
plans are well defined, subordinates know the broad guidelines within
which they have to make decisions in similar and repetitive situations.

64
They do not approach the superiors every time they face similar problem-
solving situations. Superiors can, thus, manage a larger group of
subordinates. However, if most of the decisions are made by resorting to
single use plans (programmes, budgets, projects etc.), managers have to
be frequently approached and the span can, thus, be narrow.
6. Organizational level: The top executives look after important and
specialized activities and, therefore, the span is narrow at the top level but
at lower levels the span can be wide, since supervisors are mainly
concerned with routine jobs. According to J.C. Worthy, a manager can
supervise as many as 20 subordinates at the lower levels.

7. Authority-responsibility structure: If authority-responsibility structure

is well-defined and understood, superiors can supervise larger number of
subordinates. People work within the confines of their responsibility and
take directions from superiors only when required. Lack of clarity in
authority-responsibility structure will create confusion in the organization.
Jobs and who will perform which job, which is accountable to whom will
not be clear. In such a situation, managers cannot supervise a large group
of subordinates. The span of management will, thus, be narrow.
8. System of control: Effective techniques of control can enable the
manager to supervise larger number of subordinates. Effective system of
control promotes decentralization. Superiors are not actively involved in
the decision-making processes as decisions are taken at the levels where
they are required. There is extensive delegation, clarity of jobs, authority-
responsibility relationships and freedom to take decisions. The span of
control can, thus, be wide.
9. Financial factors: Both narrow and wide structures have financial
constraints. A narrow span requires more managers and is, thus, a costly
form of structure. Wide span, on the other hand, may result into
organizational inefficiencies. Proper balance has to be maintained
between the costs and benefits of the span that a manager can effectively
supervise.

These factors are situational in nature and the span of management is

also, thus, situational. Sometimes it can be narrow and sometimes wide.
For the same organization, it can be different for different functional areas
and different levels. The span is usually narrow in the finance department
and wide in the marketing department for the same level. It may be
different in different organizations for the same functional areas and levels.

65
LET US SUM UP
Departmentation is a part of organizing process and it is needed for
various reasons. There are several patterns of forming departments with
each pattern having some advantages as well as disadvantages.
Authority relationships facilitate departmental activities and bring co-
ordination to an enterprise. Delegation of authority and decentralization
make the organization more vibrant and all these will lead to better
decision making in the organization. This unit has given a clear view on
the various departmentation and the aspects associated to it.
CHECK YOUR PROGRESS

Choose the Correct Answer

1. Under ___________ departmentation each major or basic function is
organized as a separate department

a) Functional b) Products

c) Process d) Customers
2. ___________ is an element of the organising process

a) Departmentation b) Planning
c) Staffing d) Territory
3. Departmentation enables an enterprise to take advantage of

___________

a) Process b) Specialization
c) Functions d) Territory
4.___________is almost essential for management to get things done

in the organization
a) Process b) Specialization

c) Functions d) Delegation
5. The centralized management makes decision while the operation
and routine decisions are left to be made by ________

a) Upper levels b) Middle levels

c) Lower levels d) All of them

66
GLOSSARY

Delegation : To give a particular job, duty, right,

etc. to someone else so that they do
it for someone.

Policies : A deliberate system of principles to

guide decisions and achieve
rational outcomes

Procedures : A series of actions conducted in a

certain order or manner

Programmed Decisions : Decisions are that are based on

criteria that are well understood

SUGGESTED READINGS
1. DinkarPagare (2015) Principles of Management, Sultan Chand &
Sons, New Delhi.
2. Harold Koontz, Cyril O'Donnell and Heinz Weihrich (2017)
Essentials of Management (5th Revised edition), McGraw-Hill Inc.,
US, (ISE Editions).
3. Prasad L.M. (2015) Principles and Practice of Management,
Sultan Chand & Sons, New Delhi.
4. Sherlekar S.A. &Sherlekar V.S 3rd Edition (2014) Principles of
Business Management, Himalaya Publishing House Pvt. Ltd,
Mumbai.
5. Tripathi, Sixth edition (2017) Principles of Management, Tata
McGraw Hill Education Private Limited, 7 thWest Patel Nagar, New
Delhi.
6. Tripathi, P C, Reddy, P N, 5 edition (2012) Principles of
Management, Tata McGraw Hill Education private limited, 7 th west
Patel Nagar, New Delhi.
7. https://www.economicsdiscussion.net/management/types-of-
departmentation-methods-and-basics/31573
8. https://businessjargons.com/span-of-management.html
9. https://www.managementstudyguide.com/delegation_decentraliza
tion.htm

ANSWERS TO CHECK YOUR PROGRESS

1) a 2) a 3) b 4) c 5) c

67
 BLOCK 2

MANAGEMENT PROCESS

Unit 5 : Staffing

Unit 6 : Directing

Unit 7 : Communication

Unit 8 : Coordination and Control

68
Unit 5

STAFFING
STRUCTURE
Overview
Learning Objectives

5.1 Staffing

5.1.1 Nature of Staffing

5.1.2 Need for Staffing

5.2 Recruitment

5.2.1 Sources for Recruitment

5.3 Selection
5.3.1 Process for Selection

5.4 Training
5.4.1 Purposes for Training

5.4.2 Methods and Techniques of Training

Let Us Sum-Up
Check Your Progress

Glossary
Suggested Readings
Answers to check your progress

OVERVIEW
Among all factors of production, the human factor is the only active factor
of production. Managers often say that people are their most important
asset. Hence, staffing is recognized as a crucial function of managers
and that may well determine the success or failure of an enterprise.
Staffing is a part of personnel management. This function pertains to the
recruitment, selection, development, training and compensation of
personnel. Selection of a suitable candidate is the most important function
of the Human Resources Department. If a right candidate is not selected,
such an error can prove to be very costly for any undertaking. Hence in
this unit the process of recruitment, selection, development, training is
explained.

69
LEARNING OBJECTIVES
After completing this unit, you should be able to,
• describe the nature and need for staffing
• list out the steps involved in staffing process
• discuss the different sources of recruitment
• elaborate the process of selection .
5.1 STAFFING

Staffing might be defined as manning each organizational position – that

of managers and operators with the most competent personnel; obtaining
a perfect matching of jobs and personnel so as to convert a material and
technical organization into a human organization full of efficiency and
happiness.
Koontz and O’ Donnel have defined staffing as follows:

“The managerial function of staffing involves manning the organization

structure through proper and effective selection, appraisal and
development of personnel to fill the roles designed into the structure”.
The essence of staffing is the placement of the right man on the right job
and at the right time. It includes identifying work-force requirements,
inventorying the people available and recruiting, selecting, placing,
promoting, appraising, planning the careers of compensation and training
or otherwise developing both candidates and current job holders to
accomplish their tasks effectively and efficiently.

5.1.1 Nature of Staffing

It is concerned with the acquisition, utilization and maintenance of the
human factor.
• The crux of staffing is to put the right man at the right job, at the
right time.
• Staffing gives a finishing touch to the process of organizing.

• It is the key to the managerial functions of directing and controlling.

• It has a multiplier effect on the efficiency of the whole organization.
• It is a continuous managerial exercise.

• It is crucial for the successful functioning of the enterprise.

• It is affected, to some extent, by external factors Eg : Reservation
policy of the Government.

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5.1.2 Need for Staffing
The basic need for staffing arises for reasons of the maintenance of a
satisfactory and satisfied work-force. The following are the factors
requiring emphasis on staffing:

i) Preparations for Human Resource in advance: It is imperative to

make preparations for the acquisition of the human factor, in advance as
requisite number of personnel of the desired type might not be available,
to the enterprise just in the nick of time.
ii) best realization of enterprise objectives: Adequate staffing ensures
a best realization of enterprise objectives in terms of - the quantity of
production, quality of production, minimization of costs, maximization of
profits, optimum utilization of physical facilities, technology and machines
etc.,

iii) best utilization of the human factor: best utilization of the human
factor is necessary both at the micro and macro levels. At the micro level
(enterprise level) best utilization of the human factor implies a
minimization of labour costs while at the macro level (society level) it
would help, contribute to the growth of society.
iv) Development of Personnel: Staffing ensures the development of
personnel to the fullest of their potential. Such development of personnel
not only benefits the individual and organization but also is instrumental
in the growth of the society by providing it with the best of the human asset.

v) Job Satisfaction: The staffing function would do well to plan for

offering ‘job satisfaction’ to personnel with a view to ensuring a loyal and
stable work force, in the long-run interests of both the individual and the
organization.
vi) Healthy Personnel Relations: Staffing ensures healthy personnel
relations. It comprises relations among superiors and subordinates,
subordinates inter-sec t etc.,
5.2 RECRUITMENT
Recruitment is a positive process of searching for prospective employees
and stimulating them to apply for the jobs in the organization.
In simple words, the term recruitment stands for discovering the sources
from where potential employee will be available.

The scientific recruitment leads to greater productivity, better wages, high

morale, reduction in labour turn over and better reputation. It stimulates
people to apply for a job and hence it is a positive process.

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5.2.1 Sources of Recruitment
Basically there are two sources of recruitment;

a) Internal
b) External

A) Internal Sources
Good employees can be found within the organization. When a vacancy
arises in the organization, it is offered to an employee who is already on
the pay roll.

The following are the internal sources:

• Promotions

• Demotions (Very rarely)

• Transfers
• Layoff
Advantages

The following are the advantages of Internal Sources:

Improves Morale: When an employee from inside the organization is
given a higher post, it helps in increasing the morale of all employees.
Generally, every employee expects promotion to a higher post if he fulfills
the requirements.

No error in selection: When an employee is selected from inside, there

is no possibility of errors in selection since every company maintains a
complete record of its employees and can judge them in a better manner.
Promotes loyalty: It promotes loyalty among the employees as they feel
secure on account of chances of advancement.
No hasty decision: The chances of hasty decisions are completely
avoided as the existing employees are well tried and can be relied upon.
Economy in training costs: The existing employees are fully aware of
the operating procedures and policies of the organization. The existing
employees require little training and it results in economy in training costs.
Self–development: It encourages self-development among the
employees since they can look forward to occupy higher posts.

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Disadvantages
• It discourages capable persons from outside to join the concern.
• It is possible that the requisite number of persons possessing
qualification for the vacant posts may not be available in the
organization.
• For posts requiring innovations and original thinking, this method
of recruitment cannot be followed.

• If only seniority is the criterion for promotion then the person filling
the vacant post may not be really capable.
B) External Sources

All organizations have to depend on external sources for recruitment.

These include the following:
a) Advertisement: It is a method of recruitment frequently used for skilled
workers, clerical and higher level staff. Advertisements can be given in
newspapers and professional journals. These advertisements attract
applicants in great numbers and also of highly variable quality.

b) Employment Exchanges: Employment exchanges in India are run by

the Government. For unskilled, semi-skilled, skilled, clerical posts etc., it
is often used as a source of recruitment. In certain cases it has been
obligatory for the business concerns to notify their vacancies to the
employment exchange.
c) Schools, Colleges and Universities: Direct recruitments from
educational institutions for certain jobs which require technical or
professional qualification has become a common practice
d) Recommendation of existing employees: The present employees
know both the company and the candidate being recommended. Hence
some companies encourage their existing employees to assist them in
getting applications from persons who are known to them.

e) Factory gates: Certain workers present themselves at the factory gate

every day for employment. This method of recruitment is very popular in
India for unskilled and semi-skilled labour. The desirable candidates are
selected by the first line supervisors.
f) Casual applicants: Those personnel who casually come to the
company for employment may also be considered for the vacant post. It
is the most economical method of recruitment.

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g) Central Application File: A file of past applicants who were not
selected earlier may be maintained. In order to keep the file alive,
applications on the files must be checked at periodical intervals.
h) Labour Unions: In certain occupations like building, construction,
hotels, maritime industry etc., all recruits usually come from unions.
i) Labour Contractors: The labour contractors keep in touch with the
labour and bring the workers to the places where they are required. They
get a commission for the number of persons supplied by them.
j) Former Employees: In case employees have been laid off or leave the
concern on their own, they may be taken back if they are interested in
joining the concern, provided their record is good.

5.3 SELECTION
The selection process starts immediately after recruitment. It is a negative
process i.e. rejection of those candidates who do not qualify the selection
procedure.
Selection process requires exactness. A candidate will be selected after
he clears all the steps laid down in the selection process.

5.3.1 Steps in Selection Process

The following steps are involved in the selection process:

i) Reception of Applicants
ii) Scrutiny of Applications
iii) Preliminary Interview
iv) Application Blank

v) Employment Tasks
vi) Interview

vii) Checking References

viii) Approval of the Supervisor
ix) Physical Examination

x) Selection and Placement

xi) Induction
All these steps are explained in the diagram below:

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 Figure. 5.1 Selection Process
i) Reception of Applicants: The various departments send requisition to
Personnel Department stating the number of vacancies existing in those
departments. The selection process starts when an application is
received by the Personnel Department. If the applicant personally comes
to deposit his application, he may be interested in getting some specific
information regarding the company. The receptionist’s attitude towards
the applicant must be positive.
ii) Scrutiny: All applications received have to be scrutinized by the
Personnel Department in order to eliminate those applicants who do not
fulfill job requirements. The candidates may be informed of their rejection.
iii) Preliminary Interview: The basic purpose of preliminary interview is
to screen out the unsuitable or unqualified candidates. It is generally very
brief. The personality of the candidate can be immediately evaluated and
if found suitable, an application blank may be given to him.
iv) Application Blank: It is an application form to be filled in by the
candidate who clears the preliminary interview. It should be designed in
such a manner that just by reviewing its contents, an application may be
rejected. Generally, the application blank contains the following
particulars:
• Identifying information such as name, address, sex, marital
status, number of children, other dependents, height, weight,
birth place etc.,
• Education, Eg: School, College, Professional; Languages
known and extent of proficiency in speaking, reading, writing
etc.,

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 • Experience
• Health

• Extra Curricular Activities

• References

• Psychological Factors
Eg: Reasons for leaving jobs, journals read, likings and disliking etc.
Normally, the candidates are required to fill up the application forms in
their own handwriting.
v) Employment Tests: These tests provide information about a candidate
not available from application blank or interview. It is a selection device
whereby an effort is made at the selection stage to see whether the
candidate is capable of doing his prospective job or not.
The following tests are usually applied in the selection process:
Personality Tests - These tests measure certain characteristics such as
emotional maturity, sentiments, conflicts, ascendency, sociability,
objectivity, etc., of a candidate. Whether a candidate is having a sick
personality or healthy personality can be determined by these tests.
Achievement Tests - These tests are also known as proficiency tests. The
skill already acquired by the candidate either through his education or
experience can be judged through these tests. Example: A candidate for
the post of a stenographer may be given a test in typing and shorthand.
Aptitude Tests - Tests designed to measure the learning capacity of the
candidates are known as aptitude tests. Aptitude tests measure whether
an individual has the latent ability to learn a given job, if he is given
adequate training.
Intelligence Tests - These tests measure the mental ability or alertness of
an applicant. These include verbal and written tests.
Interest Tests - These tests are designed to know the interests of the
candidates in terms of his likings and dis-likings. The interests which have
occupational significance include intellectual, social, aesthetic, religious,
literature, music etc.

vi) Interview: The most delicate aspect of the selection procedure is the
“Interview”. The employment interview is for the purpose of determining
the suitability of the applicant for the job and of the job for the applicant.

The information about the candidate which cannot be obtained from the
application blank, tests and group discussion may be secured easily if the

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interview is planned well in advance and is conducted by the interviewer
tactfully.

Types of Employment Interview

i) Preliminary Interview: It is of a few minutes duration to assess the
worth of a candidate. It must be conducted very carefully by an expert as
many desirable applicants may be eliminated at the outset if conducted
improperly.

ii) Stress Interview: The applicant is intentionally put under stress by

interrupting him, criticizing his view points and keeping silent after he has
finished speaking. It also requires that the interviewer must be tactful and
skillful.
iii) Background Information Interview: This type of interview is
conducted when the history of applicant has to be known in terms of his
experience, education, health, interests, likes, dislikes etc.,
iv) Discussion Interview: It is a non-directive interview conducted
informally by giving an opportunity to the interviewee to speak his mind
freely.
v) Group Interview: It is an interview of certain applicants in a group. It
saves time for the busy executive. Interaction of the applicants with each
other can also be observed by the interviewer.
vii) Checking References: An applicant may be asked in the application
blank to supply two types of references.

a) Character reference

b) Experience reference
It provides information regarding behaviors of the applicants. References
may be checked by mail or by telephone or a personal visit may be
arranged.
viii) Approval of the Supervisor: The candidate is then sent to the line
manager for approval. The Personnel Department cannot take a final
decision regarding selection because the candidate has to actually work
under the line managers.

ix) Physical Examination: The Physical Examination should disclose the

physical characteristics of the individual that are significant from the stand
point of his efficient performance of the job he may enter or of those jobs
to which he may reasonably expected to be transferred or promoted.
After a candidate is finally selected, a notification is sent to the pay roll
department for inclusion of his name in the pay roll. Usually an

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appointment is made on probation in the beginning. If the work and
conduct of the employee is found satisfactory, he may be confirmed. It is
also in the interest of the organization to prepare a waiting list and inform
the candidates. In case a person does not join after being selected, the
next person on the waiting list may be called.
x) Selection and Placement: After the physical examination is
satisfactorily completed the employee is selected adn suitably placed. An
appropriate department, which the candidate can fit in is chosen and the
candidate is placed there. The key issue here is person-job fit.
xi) Induction: This is also called as orientation. In this phase the
candidate is gradually introduced to the job, the organization and its
culture. The process acclimatizes the employee to the new work setting.
The idea is to make the employee fell comfortable and become productive
at the earliest.

5.4 TRAINING
After selecting an employee, the most important and established part of
the personnel programme is to impart training to the newcomer. In the
modern world of technological changes, the need for training employees
is being increasingly recognized so as to keep the employees in touch
with the new developments.
According to Edward B. Flippo “Training is the act of increasing the
knowledge and skill of an employee for doing a particular job”.

Training can thus be defined as a systematic procedure for transferring

technical know-how to the employees so as to increase their knowledge
and skill for doing particular jobs.
5.4.1 Need for Training
Training is necessary both for existing and new employees. It increases
the skill of the employees. The factors usually indicating the training need
are given below:
• Frequent accidents
• Low quality

• Higher production cost

Management can also discover training needs of employees by taking the
following steps:

If the employees’ performance is below standard, training is immediately

required.

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Certain production problems also indicate training needs. These
indicators include frequent accidents, low productivity and quality, higher
production cost, excessive gossip, high rate of labour turnover and
absenteeism, excessive grievance etc.,

By conducting interviews and giving questionnaires, views of employees

and executives can be obtained regarding training needs.
The expansion of business in nature, installation of new plants, new
technology etc., require the planning of man power training in advance so
that requirements of the new jobs are met well in time.
Designing Training and Development Programme

Every training and development programme must address certain vital

issues such as,
1) Who participates in the programme?

2) Who are the trainers?

3) What methods and techniques are to be used for training?

4) What should be the level of training?

5) What learning principles are needed?

6) Where is the programme conducted?
Who are the trainees?

Trainees should be selected on the basis of self-nomination,

recommendation of superiors or by the human resource development
department. Whatever the basis, it is advisable to have two or more target
audiences. For example rank-and-file employees and their supervisors
may effectively learn together about a new work process and their
respective roles.

Who are the trainers?

Training and Development programmes may be conducted by the
following people.

a) Immediate supervisors
b) Co-workers
c) Members of the personnel staff

d) Specialists in other parts of the company

e) Outside consultants
f) Industry associations

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g) Faculty members at universities.
Which of these people are selected to teach, often depends on where the
programme is held and the skill that is being taught. Large organizations
generally maintain their own training departments whose staff conducts
the programme.
5.4.2 Methods and Techniques of Training
A multitude of methods of training are used to train employees. The most
commonly used methods are categorized as follows:

i) On-the-job methods and

ii) Off-the-job methods

On-the-job methods refer to methods that are applied in the workplace,

while the employee is actually working. Off-the-job methods are used
away from workplaces.

Training techniques represent the medium of imparting skills and

knowledge to employees. At this point it is worthwhile to elaborate on
important techniques of training such as lecturers, audio-visuals, on-the-
job training, programmed instruction, computer-aided instruction,
simulation and sensitivity training.
Lecture - Lecture is a verbal presentation of information by an instructor
to a large audience. This method is mainly used in colleges and
universities, though its application is restricted in training factory
employees. The method violates the principle of learning by practice. It
constitutes a one-way communication. There is no feedback from the
audience. Continued lecturing is likely to bore the audience. The lecture
method can be made effective if it is combined with other methods of
training.
Audio-Visuals -Audio-Visuals include television, slides, overheads,
video-tapes and films. These can be used to provide wide range of
realistic examples of job conditions and situations in the condensed period
of time.
On the Job-Training (OJT) - OJT is conducted at the work site and in the
context of the job. It is the most effective method as the trainee learns by
experience, making him highly competent. It is also free from the artificial
situation of a classroom.

Programmed Instruction - This is a method where training is offered

without the intervention of a trainer. Information is provided to the trainee
in blocks, either in book form or through a teaching machine. After reading

80
each block of material, the learner must answer a question about it. Feed
back in the form of correct answers is provided after each response. Thus
Programmed Instructions (PI) involve;
1 Presenting questions, facts or problems to the learner.

2. Allowing the person to respond.

3. Providing feedback on the accuracy of his or her answers.
4. If the answers are correct, the learner proceeds to the next block. If
not, he or she repeats the same.
Computer Assisted Instruction (CAI) -This is an extension of
programmed instruction. CAI provides for accountability as tests are
taken on the computer so that the management can monitor each
trainee’s progress and needs. It can also be modified easily to reflect
technological innovations in the equipment for which the employee is
being trained.
This tends to be more flexible and the trainees can use the computer
almost any time they want, and thus get training when they prefer.
Simulation - A simulator is any kind of equipment or technique that
duplicates as nearly as possible the actual conditions encountered on the
job. It is an attempt to create a realistic decision-making environment for
the trainee. The more widely held simulation exercises are case study,
role playing and vestibule training.
Case Study - It is a written description of an actual situation in business
which provokes in the reader the need to decide what is going on, what
the situation really is, or what the problems are and what can and should
be done. Taken from the actual experiences of organizations, these cases
represent attempts to describe, as accurately as possible, real problems
that managers have faced. Trainees study the cases to determine
problems, analyses causes, develop alternative solutions, select the best
one, and implement it.
Role Playing -It generally focuses on emotional issues rather than actual
ones. The essence of role playing is to create a realistic situation, as in
the case study, and then have the trainees assume the parts of specific
personalities in the situation. Role playing helps promote interpersonal
relations.

Vestibule Training - A special area or room is set aside from the main
production area and is equipped with furnishings similar to those found in
the actual production area. The trainee is then permitted to learn under
stimulated conditions without disrupting ongoing operations.

81
Sensitivity Training - It uses small numbers of trainees, usually fewer
than 12 in a group. The objectives of sensitivity training are to provide the
participants with increased awareness of their own behaviour and how
others perceive them, greater sensitivity to the behaviour of others and
increased understanding of group processes.
Sensitivity training can go by a variety of names – laboratory training,
encounter groups or T-group (Training group).

LET US SUM-UP
In the organization, the employment of a suitable human force is
necessary. Proper staffing facilitates preparations of human resources in
advance and helps achieve the enterprise objectives. Man Power
Planning helps in estimating manpower requirements, which leads to
achievement and maintenance of production levels. Scientific recruitment
leads to greater productivity, high morale and reduction in labour turnover.
This unit encompasses Both external and internal sources of recruitment
are available and by adopting proper selection procedure, an organization
is able to get the right men for the jobs. After selecting the employee, the
most important part of the staffing programme is training the new comers
and the organization decides on the nature and methods of training to be
adopted.
CHECK YOUR PROGRESS
Choose the Correct Answer

1). Higher position awarded in the level of job is called ---------------

a) Promotion b) demotion
c) Transfer d) layoff
2). Changing from higher to lower position in job is called----------------

a) promotion b) demotion
c) Transfer d) layoff

3). Change of job from one location to another is called --------------

a) promotion b) demotion
c) Transfer d) layoff

4). The planning process begins with the setting of -------------------.

a) Objectives b) policies
c) Rules d) procedures

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5) In __________phase the candidate is gradually introduced to the job,
the organization and its culture.

a) Selection b) placement
c) Recruitment d) orientation

GLOSSARY

Staffing : Staffing refers to the continuous

process of finding, selecting
evaluating and developing a
working relationship with current or
future employees.

Recruitment : Recruitment is the process of

actively seeking out, finding
and hiring candidates for a specific
position or job.

Role Playing : The acting out of the part of a

particular person or character, for
example as a technique in training
or psychotherapy.

Vestibule Training : A form of training in which new

employees learn the job in a setting
that approximates as closely as is
practicable to the actual working
environment.

SUGGESTED READINGS

1. DinkarPagare (2015) Principles of Management, Sultan Chand &

Sons, New Delhi.
2. Harold Koontz, Cyril O'Donnell and Heinz Weihrich (2017)
Essentials of Management (5th Revised edition), McGraw-Hill Inc.,
US, (ISE Editions).
3. Prasad L.M. (2015) Principles and Practice of Management,
Sultan Chand & Sons, New Delhi.
4. Sherlekar S.A. &Sherlekar V.S 3rd Edition (2014) Principles of
Business Management, Himalaya Publishing House Pvt. Ltd,
Mumbai.

83
 5. Tripathi, Sixth edition (2017) Principles of Management, Tata
McGraw Hill Education Private Limited, 7 thWest Patel Nagar, New
Delhi.
6. Tripathi, P C, Reddy, P N, 5 edition (2012) Principles of
Management, Tata McGraw Hill Education private limited, 7 th west
Patel Nagar, New Delhi.
7. https://www.managementstudyguide.com/staffing-function.htm
8. https://www.yourarticlelibrary.com/human-resources/recruitment-
meaning-and-sources-of-recruitment-with-diagram/32353
9. https://www.businessmanagementideas.com/human-resource-
management-2/types-of-interviews/types-of-interviews/20222
ANSWERS TO CHECK YOUR PROGRESS

1) a 2) b 3) c 4) a 5) d

84
Unit 6

DIRECTING
STRUCTURE
Overview
Learning Objectives

6.1 Introduction to Directing

6.2 Importance of Directing Function of Management

6.3 Meaning and Nature of Leadership

6.4 Leadership and Management

6.5 Need for Leadership

6.6 Leadership Styles
6.7Motivation

Let Us Sum Up
Check Your Progress

Glossary
Suggested Readings
Answers to check your progress

OVERVIEW
Direction is a management function that is carried out primarily at higher
levels of management and on the basis of which permeates down into the
lower levels. It is a continuous process that exists as long as the business
exists and is that function that initiates and commences action towards a
set objective or goal. It gives meaning to organization and planning by
bringing together the entire organization to the task of achieving a goal.
LEARNING OBJECTIVES
After completing this unit you should be able to

• explain the theories of leadership

• describes the nature of leadership
• explain the importance of directing.

85
6.1 INTRODUCTION TO DIRECTING
Directing is a key element in the process of management. After
formulating the plans for accomplishing the pre-determined goals, the
organizational structure is prepared and suitable persons are designated
to appropriate roles, and the organization commences its operations.
However, necessary actions will only initiate after a command in chief
provides direction to the higher-level management.

Direction as a function is composed of 4 important and interdependent

elements:
Supervision

Supervision refers to a process by which a superior oversees and ensures

the work done by his subordinates conform to predetermined
requirements and standards. Supervision is done

Especially at lower levels of management when there are functions such

as Factory Overseeing etc to be done.
Motivation
Motivation is that process of inducing in a person the will to do something
in return for something he wants. Motivation often lies at the basis of
direction as people do not act unless they have a good reason to and
motivation gives them that much required reason.
Leadership
Not everyone can do everything in the beginning. Sometimes you need
an extra push to do it. That extra push is often given by leaders.
Leadership plays a key role in performing the above-mentioned elements
of direction. It revolves the personal quality of a person and is something
that cannot be taught but learnt.

Communication
Communication is something that is pertinent to most managerial
functions including direction. If the employee is not able to communicate
his needs, a manager cannot motivate him. If the upper-level
management doesn’t communicate the current status of operations the
lower level manager will fail in getting his things sorted. The importance
of communication cannot be overstated
6.2 IMPORTANCE OF DIRECTING FUNCTION OF MANAGEMENT

Directing or Direction function is usually considered the central point for

any organization around which objectives are achieved. Being at the

86
center of all enterprise activities, it ensures numerous benefits to any
organization, which are as follows.

Makes the organization goal oriented

Planning as we all know lays down goals. But the mere laying down of
goals isn’t enough. It is directing in terms of those goals that gets them
achieved. It is that process that retains the goal oriented-ness with which
the business process begins. If not for direction the business will proceed
in hap hazard manners thereby making all other processes difficult and
also making the business fragile.
Creates a motivated workforce

As already discussed above, motivation acts a sub set of the broader

function of direction. Direction ensures that the workforce is motivated and
remains motivated. This is so because the process will be successful only
with the effort of motivated people and motivated people is the secret of a
budding effective business. Thus, managers pay extra attention to
motivating workers while directing the business.
Ensures conformity and facilitates Controlling and Coordination
Direction as stated above deals with specifying what to do. Thus, direction
lays down the benchmark on what is to be expected from a person or a
process. This instruction or direction given ensures such tasks and effort
conform to goals. The benchmark so created allows for coordination
whereby other tasks can aligned to make a congruous whole and
controlling whereby one better understands where and what went wrong
in the entire framework.
Initiates Action
Direction is the process that kicks the plan into motion by using the
resources organized and humans staffed to achieve what is envisioned in
the plan. It is the stepping stone to carrying out business processes which
till then remain only on paper.
It creates adaptability
A business has to cope with constant changes in its environment.
Direction plays a key role in ensuring that a business is capable of
adjusting and adapting to such changes by understanding the
environment and by relaying suitable information. Such instruction at the
right point of time allows for meeting various contingencies and ensures
the business isn’t knocked off its feet.

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Ensures Employee Discipline
Direction goes a long way in ensuring employee discipline. It involves the
process of giving an instruction and the instruction being unconditionally
followed. Such conformity with instructions is ensured by controlling;
however it cannot exist in isolation without direction which is the source of
the instruction. This ensures that the employee doesn’t stray away from
what is to be done and keeps him disciplined.

6.3 MEANING AND NATURE OF LEADERSHIP

The following are some of the important definitions of leadership:

According to Peter Drucker, “Leadership is the lifting of man’s visions to
higher sights, the raising of a man’s performance to a higher standard, the
building of a man’s personality beyond its normal limitations”.
In the words of George Terry, “The will to do is triggered by leadership
and lukewarm desire for achievement is transformed into burning passion
for successful accomplishment by the skillful use of leadership “.
Alford and Beatty define leadership as the ability to secure desirable
actions from a group of followers voluntarily without the use of coercion.
According to Keith Davis leadership is the ability to persuade others to
seek defined objectives enthusiastically. It is the human factor which
binds a group together and motivates it towards goals.
The essence of leadership can be summarized as follows:
• Leadership is a group phenomenon. It involves interaction
between two or more people.
• It refers to the ability of one individual to influence others.
• The influence is exercised to change the behavior of others.
• Behaviour is changed through non-coercive means.
• Change of behavior is caused with an objective of achieving
shared goals.
• The person influencing others (leader) possesses a set of qualities
or characteristics which he uses to influence others.
6.4 LEADERSHIP AND MANAGEMENT

Management, managership and leadership are terms which are closely

related. Management is a process of planning, organizing, co-
coordinating, directing and controlling the activities of others.

Managership is the authority to carry out these functions.

Leadership, as mentioned above, is the process of influencing for the
purpose of achieving shared goals.

88
Managers, by virtue of being in a managerial position, have managership,
but they may not possess leadership or the ability to influence other
people.
The following are some of the differences between leaders and Managers;

• Leaders have followers, but managers do not have.

• Leaders have emotional appeal whereas managers are expected
to be rational decision makers and problem solvers.
• Leaders give priority to follower’s needs, but managers give
importance to organizational goals.
6.5 NEED FOR LEADERSHIP

i) The incompleteness of formal organizational design: The formal

organization is generally incomplete and imperfect. Leadership helps
overcome the deficiency.

ii) Changing environment conditions: A leadership of high order would

be needed for the organization to cope with the technological, legal,
cultural and other changes.
iii) The internal dynamics of the organization: As the organization
grows new complexities of structure are created, new needs for co-
ordination arise, and new policies must be invented. Good leadership is
required to cope with these situations.
iv) The nature of human membership in organizations: Human
membership in an organization is segmental in nature. The organization
expects the person to adapt to its requirements. A leader is helpful for
such adaptation.
6.6 LEADERSHIP STYLES
Leadership style is the typical approach a particular person uses to lead
people. The familiar three-way classification of leadership styles is as
follows;

1) Authoritarian style
2) Participative style and
3) Free-rein style

i) Authoritarian Style: In this type of leadership the leader alone

determines policy and makes plans. He tells others what to do and how
to do it. He demands strict obedience and relies on the power of his
position to reward and punish others. People have little freedom under
him. He shows greater concern for work than for his workers.

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Merits
• This type of leadership can increase efficiency and get quick
results in a crisis or emergency situation.
• This style of leadership works well with the employees who have
a low tolerance for ambiguity, feel insecure with freedom and even
minor decision-making requirements, and thrive under clear,
detailed and achievable directives.
• Chain of command and division of work are clear and fully
understood by all in this type or leadership.
Demerits

• One way communication, without feedback, typically leads to

misunderstandings, communication breakdowns and costly
errors.
• This leadership style excludes the people from involvement and
reduces them to machine-like cogs without human dignity or
importance.
ii) Participative style: In this type of leadership the entire group is
involved in and accepts responsibility for goal setting and achievement.
Subordinates have considerable freedom of action. The leader shows
greater concern for his people than for high production.
Merits
• When people participate in and help formulate a decision, they
support it and work hard to make it work because it is their idea
and now, part of their life and their ego.
• The leader consistently receives the benefit of the best
information, ideas, suggestions, talent and operating experience
of his people.
• This style of leadership permits and encourages people to
develop, grow and rise in the organization.
Demerits
This style needs a lot of time and human relations skill which are not
widely possessed.
• This style very often results in watered down solutions.
• This style may cause embarrassment and nervousness to certain
employees who are coming from authoritarian culture and family
background.

90
 • This style may alienate certain individuals whose opinions have
been rejected. These persons may join hands to oppose
management.
• This style, if not exercised properly, may degenerate into a
complete loss of leader’s control. Some leaders may use this style
as a way of avoiding responsibility.
iii) Free-rein or Laissez Faire style: In this type of leadership, the leader
exercises absolutely no control. He only provides information, materials
and facilities to his men to enable them to accomplish group objectives.
This type of leadership can be a disaster if the leader does not know well
the competence and integrity of his people and their ability to handle this
kind of freedom.
6.7 MOTIVATION

The increased attention towards motivation is justified by several reasons.

Motivation acts as a driven force that influences a worker to work
efficiently in an organization. The main significance of motivation are listed
below

First, motivated employees are always looking for better ways to do a job.
Second, a motivated employee generally is more quality oriented.

Third, highly motivated workers are more productive than apathetic

workers.
Fourth, every organization requires human resources, in addition to the
need for financial and physical resources for its functioning. Three
behavioral dimensions of human resources are significant to the
organization. They are (1) people must be attracted not only to join the
organization but also to remain in it; (2) People must perform the tasks for
which they are hired, and must do so in a dependable manner; and (3)
People must go beyond this dependable role performance and engage in
some form of creative, spontaneous and innovative Behaviour at work.
Fifth, an understanding of the topic of motivation is essential in order to
comprehend the concepts such as leadership, performance, satisfaction,
etc.

LET US SUM UP
Only after understanding a few concepts related to organization, effective
direction can be ensured. These concepts relate to (i) Aims, objectives,
and plans of the organization by each individual manager; (ii) The
organization and its elements; (iii) Policies, procedures and rules under

91
which the organization will operate, and the reasons thereof; (iv) Major
problems that are faced by the concern and particularly what each
manager can do to solve the problem; and (v) Complete and up-to-date
information on significant factors such as business forecasts, changes in
policies, procedures etc. this unit described the importance of leadership
and directing and its theories.
CHECK YOUR PROGRESS

Choose the Correct Answer

1. Certain organizations also appoint -------------- who act as a link between
two individuals or departments and co-ordinate the activities of different
individuals.

a) Liaison officers b) safety officer

c) Welfare officer d) executive officer

2. ------------is synchronisation of group efforts for achieving objectives of

an enterprise.
a) Liaison officers b) coordination

c) Placement d) recruitment
3. ------------ Lay down the general philosophy of the organization and
serve as a guide to the understanding of the business and appreciation of
the role of each section or department.
a) Organization manuals b) polices
c)Rules d) procedures
4. Effective-------------- is essential for co-ordination.

a) Communication b) authority
c) Delegation d) departmentation

5. The ultimate aim of co-ordination is to achieve -------- of action of group

efforts and attain the objectives of an enterprise.
a) Teleconferencing b) unity

c) Recruitment d) orientation

GLOSSARY

Directions : The Act of the management or

guidance of someone or
something.

92
 Forecasts : A calculation or estimate of future
events, especially coming weather
or a financial trend.

Leadership : Leadership is the art of motivating a

group of people to act toward
achieving a common goal.

Communication : The imparting or exchanging of

information by speaking, writing, or
using some other medium.

SUGGESTED READINGS
1. DinkarPagare (2015) Principles of Management, Sultan Chand &
Sons, New Delhi.
2. Harold Koontz, Cyril O'Donnell and Heinz Weihrich (2017)
Essentials of Management (5th Revised edition), McGraw-Hill Inc.,
US, (ISE Editions).
3. Prasad L.M. (2015) Principles and Practice of Management,
Sultan Chand & Sons, New Delhi.
4. Sherlekar S.A. &Sherlekar V.S 3rd Edition (2014) Principles of
Business Management, Himalaya Publishing House Pvt. Ltd,
Mumbai.
5. Tripathi, Sixth edition (2017) Principles of Management, Tata
McGraw Hill Education Private Limited, 7 thWest Patel Nagar, New
Delhi.
6. Tripathi, P C, Reddy, P N, 5 edition (2012) Principles of
Management, Tata McGraw Hill Education private limited, 7 th west
Patel Nagar, New Delhi.
7. https://www.managementstudyguide.com/directing_function.htm
8. https://emeritus.org/in/learn/different-types-of-leadership/
ANSWERS TO CHECK YOUR PROGRESS
1) a 2) b 3) d 4) c 5) d

93
Unit 7

COMMUNICATION
STRUCTURE
Overview
Learning Objectives

7.1 Meaning and Characteristics of Communication

7.2 Communication Process

7.3 Barriers and Breakdowns in Communication

7.4 Importance of Communication in Management

7.5 Types of Communication

7.6 Electronic Media in Communication
Let Us Sum Up

Check Your Progress

Glossary

Suggested Readings
Answers to check your progress

OVERVIEW

No business organization can work without an effective communication

network. It is an important human skill. No manager can be successful
without communicating effectively with his subordinates, superiors and
outsiders. Although communication applies to all phases of managing, it
is particularly important in the function of leading. Communication process
is and from and to process and which is discussed in this unit and the
barriers of communication are detailed in this unit.
LEARNING OBJECTIVES
After completing this unit, you should be able to,

• explain the flow of communication and barriers of communication

• discuss the role of electronic media in communication.
7.1 MEANING AND CHARACTERISTICS OF COMMUNICATION

• Communication is the process through which two or more persons

exchange ideas among them.

94
 • According to Newman & Summer, “Communication is an
exchange of facts, ideas, opinions or emotions by two or more
persons”.
• Theo Haiman defines communication as “the process of passing
information and understanding from one person to another, it is the
process of imparting ideas and making oneself understood by
others”.

• The following are the characteristics of communication:

• It involves more than one person.

• It deals with the transmission of facts.

• Media of communication may be numerous.

• Since a business organization has continuity, the process of
communication is also a continuous process.

• It involves both information and understanding.

• It includes all means by which meaning is conveyed from one
person to another.

• It is the basis for action and co-operation.

• It travels up and down and also from side to side.
• Its primary purpose is to motivate a response.

• It is universal in nature.

7.2 COMMUNICATION PROCESS

A communication process involves the following elements.

Figure. 7.1 communication process

i) Sender: The person who intends to convey the message with the
intention of passing information and ideas to others is known as sender
or communicator.

95
ii) Ideas: This is the subject matter of communication. This might be an
opinion, attitude, feelings, views, orders or suggestions etc.,
iii) Encoding: Since the subject matter of communication is theoretical
and intangible, its further passing requires use of certain symbols such as
words, actions or pictures etc., Conversion of subject matter into these
symbols is the process of encoding.
iv) Communication Channel: The person who is interested in
communicating has to choose the channel for sending the required
information, ideas etc., This information is transmitted to the receiver
through certain media. It may be either formal or informal.

v) Receiver: Receiver is the person who receives the message or for

whom the message is meant for. It is the receiver who tries to understand
the message in the best possible manner in achieving the desired
objectives.
vi) Decoding: The person who receives the message or symbol from the
communicator tries to convert the same in such a way so that he may
extract its meaning to his complete understanding.
vii) Feedback: Feedback is the process of ensuring that the receiver
has received the message and understood it in the same sense as sender
meant it.
7.3 BARRIERS AND BREAKDOWNS IN COMMUNICATION
It becomes imperative for the communicator that he should know the
various barriers (obstacles) that can impede not only transmission of
information but also understanding and acceptance of it. There are
barriers which tend to distort the messages that pass between the sender
and receiver. These barriers often cause breakdown and
misunderstanding in communication leading to poor human relations. In
order to achieve effective communication in the organization, it is
desirable to analyses the obstacles or barriers to communication and
removes them.
Following is some of the barriers which are common in communication

Systems:
i)Organizational Structure: The organizational structure has an
important influence on the ability of the members of the organization to
communicate effectively. These days the organizations / structure of big
enterprises is complex involving many layers / channels. “Every layer cuts
off a bit of information” is a common complaint.

96
The very existence of many layers is a stumbling block to communication.
In both upward and downward communication, intermediaries may
withhold information for a variety of reasons. In order to overcome these
difficulties, management should make improvements in the organization
structure.
ii) Semantic or Language Problem: The name “Semantic” indicates the
systematic study of the meanings of words. When communication takes
place between two persons, the meaning of communication intended by
the sender may be interpreted or understood completely in a reverse
manner. The language symbols used in communication may be
interpreted in terms of the receivers’ own behaviors and experiences,
creating thereby a chaotic condition.
iii) Status and position: One important barrier in effective
communication arises due to status relationship in organization. A
subordinate may feel that he may commit some mistakes while
communicating with his boss. So, he does not communicate. Thus, it is
status that brings about a stand-still position to communication, prohibiting,
thereby, the conveyance of vital information to the boss.
iv) Unsound objectives: Any communication programmed which is likely
to affect the interest of workers is bound to fail.
v) Lack of interest: One of the most common obstacles to
communication has been stated to be the lack of attention to the interests
of the people with whom management wants to communicate.
vi) Emotional attitude: Sometime barriers to communication also arise
on account of emotional attitudes of the sender and receiver of the
communication. There are some persons who are emotional and tend to
lose their temper easily and quickly.
vii) Neglect in listening: A good deal of trouble in communication arises
on account of the neglect in listening on the part of the manager. It is
wrong on the part of the listener to evaluate in terms of his own than the
sender’s frame of mind.

viii) Perception: Everyone perceives the world and approaches the

problems of life differently. A person’s perception is determined by his
needs, level of education, cultural factors, social environment etc.,
everyone tries to understand the information he receives from his own
angle or point of view. This may create complexities in the process of
communication.

97
How to Ensure Effective Communication
Although perfect communication may not be possible, yet considerable
degree of perfection can be achieved in communication by overcoming
the barriers of communication. The following are the essentials for
ensuring effective communication.
Clarity of information: Communication should always be in common
and easily understandable language so that it may not be misunderstood
by the persons receiving it.
Adequacy of message: The message to be communicated should be
adequate and complete in all respects since incomplete information turns
out to be dangerous from the view point of business.
Consistency of message: The message to be communicated should not
be mutually conflicting; rather should be in line with the overall objectives,
policies, programmes and procedures of the organization.
Feedback: Feedback refers to the confirmation of the idea
communicated whether the message has been understood by the
receiver in the same sense in which the sender intended or whether the
recipient has agreed or disagreed to the proposal of the communicator,
makes it essential on the part of the sender to confirm it from the receiver.

Tone and content: The communicator must be careful about the

languages he uses while speaking or writing. His tone, expression and
emotion will have a definite impact on the effectiveness or otherwise of
what he is trying to communicate.
Listening: A very important aspect of effective communication is that
executives and supervisors should be good listeners. It is dangerous to
be inattentive or indifferent when others are attempting to communicate.

7.4 IMPORTANCE OF COMMUNICATION IN MANAGEMENT

Now-a-days communication is considered to be an important human skill.
The ability to communicate effectively has become one of the major skills
of a successful manager. An organization without the network of
communication is inadequate and incomplete. The importance of
communication in management can be judged from the following.
i) Basis of Co-ordination: The work of the organization can be carried
out without interruption only through co-ordination. Co-ordination requires
mutual understanding about the organizational goals, the mode of their
achievement and the inter relationships between the work being
performed by various individuals and all this can be achieved through
communication only.

98
ii) Smooth working of an enterprise: Communication makes possible
the smooth and unrestricted running of the enterprise. All the
organizational interactions depend upon communication. If the persons
engaged in performing the various tasks understand exactly the task
which is required to perform, it can help in the smooth running of an
enterprise.
iii) Basis of Decision Making: Communication is a primary requirement
for making decisions. Information must be received before any
meaningful decision can be made. Again, to implement the decision
effectively it becomes necessary to have a good communication system.

iv) Increases managerial efficiency: Communication is essential for

quick and systematic performance of managerial functions. In the modern
day, the skill of communication has become an essential component of
successful management.
v) Promotion of co-operation and industrial peace: two way
communications promote co-operation and mutual understanding
between both parties. Efficient downward communication helps the
management to tell the subordinates what the management actually
expects from them. Upward communication helps the workers in putting
their grievances, suggestions and reactions before the management
which ultimately helps in achieving the desired goals.
vi) Establishment of effective leadership: Communication is the basis
of direction and leadership. By developing the skill of communication, a
manager can be a real leader of his subordinates.
vii) Morale-building and motivation: An efficient system of
communication enables the management to mold the attitude of the
subordinates. Proper and timely communication between the interested
parties reduces the points of friction and minimizes those that inevitably
arise. Communication improves the human relations in any industry.
7.5 TYPES OF COMMUNICATION
According to Organizational Structure

i)Formal Communication: Formal Communication is that which is

associated with the formal organization structure and the official status or
the position of the communicator and the receiver. It travels through the
formal channels (officially recognized positions) in the organization chart.

99
 Figure. 7.2 Types of Communication
The forms of formal communication are as under:
1. Departmental meetings
2. Conference
3. Telephone calls
4. Company News Bulletins
5. Special Interviews and Special Purpose Publications and
Messages.
ii) Informal Communication: It is also known as the “Grapevine”. It is
free from all sorts of formalities, because it is used in informal relationships
between the parties, such as friendship, membership in the same club or
association. Such communication includes comments, suggestions etc.,
It may be conveyed by a simple glance, gesture, smile or mere silence.
According To Direction
i) Downward Communication: Communication which flows from the
superiors to subordinates is referred to as downward communication.
Under this, immediate performance of a job is expected; hence it is highly
directive.
ii) Upward Communication: In upward communication, the persons from
the lower levels are expected to have communication with those who are
above them. This sort of communication includes reactions and

100
suggestions from workers, their grievances etc., Contents of upward
communication are reports, reaction, suggestions, statements and
proposals prepared for submission to the boss.
iii) Horizontal Communication: When communication takes place
between two or more persons who are subordinates of the same person
or those who are working at the same level in an organization the
communication is known as horizontal communication. The
communications between functional managers or among subordinates
working under one boss, the communication of managers of various
factories are the examples of such communication.

According To Way of Expression

i) Oral or Verbal Communication: In oral communication both the parties
i.e. sender and receiver exchange their ideas through oral words either in
a face to face conversation or through any mechanical or electrical device
such as telephone etc., Meetings and Conferences, lectures and
interviews are the other media of such communication.
ii) Written Communication: When communication is reduced to writing,
it is called as written communication. This includes written words, graphs,
diagrams, pictures etc. Written communication is extensively used in
organizations. Sometimes, this form of communication becomes
indispensable as in the case of rules, orders, schedules or policy matters
etc., Circulars, magazines, notes and manuals are some common forms
of written communication.

7.6 ELECTRONIC MEDIA IN COMMUNICATION

Of late, electronic devices play a major role in communication. Electronic
equipment includes Mainframe Computers, Mini Computers, Personal
Computers, Electronic Mail Systems, and Electronic Typewriters as well
as Cellular Phones for making telephone calls from cars and beepers for
keeping in contact with the office.
Here, the role of Telecommunication and Teleconferencing is worth
mentioning.

Telecommunication
Telecommunication is fast emerging as a major factor and a number of
companies have already utilized the new technology in a variety of ways,
as shown below:
• Large banks supply hardware and software to their customers so
that they can easily transfer funds to their suppliers.

101
 • Several banks now make bank-by-phone services available even
to individuals.
• Facsimile mail service ensures delivery of a document across the
country and the globe within hours.
• Many firms now have detailed personnel information - including
performance appraisals and career development plans - in a data
bank.

Teleconferencing
Teleconferencing involves a wide variety of systems, including audio
systems; audio systems with snapshots displayed on the video monitor,
and live video systems. When a group of people interact with each other
by means of audio and video media with moving or still pictures, the group
is said to be “teleconferencing”.

Full motion video is frequently used to hold meetings among managers.

Not only do they hear each other, but they can also see each other’s
expressions or discuss some visual display.
Use of Computers for Information Handling
Electronic data processing now makes it possible to handle large amounts
of data and to make information available to a large number of people.
Thus, one can obtain, analyse and organise timely data quite
inexpensively. Computer graphics can inform visually, displaying
important company information.

Communication applies to all phases of managing and there are various

types of communication. There are some barriers which are common in
communication systems and of late, electronic devices have played a
major role in communication.

LET US SUM UP
This unit explained the process of communication in detail as
communication applies to all phases of managing and there are various
types of communication. There are some barriers which are common in
communication systems and of late, electronic devices have played a
major role in communication which is essentially required for an effective
management.
CHECK YOUR PROGRESS

Choose the Correct Answer

1. Person who intends to convey the message with the intention

of passing information and ideas to others is known as ______

102
 a) Sender b) Receiver
c) Subordinates d) Superiors

2. __________ is the person who receives the message or for whom

the message is meant for.

a) Sender b) Receiver
c) Subordinates d) Superiors
3. ___________ is the basis of direction and leadership.

a) Sender b) Receiver

c) Communication d) Superiors
4. When communication is reduced to writing, it is called as _______

a) Vocabulary b) Oral Communication

c) Distance Communication d) Written Communication

5. __________ is fast emerging as a major factor and a number
of companies have already utilized

a) Vocabulary b) Oral Communication

c) Tele Communication d) Written Communication

GLOSSARY

Semantic : Semantics is the study

of meaning in language.

Encoding : Convert into a coded form.

Feedback : Information about reactions to a

product, a person's performance of
a task, etc

Channels of Communication : The channel or medium used

to communicate a message affects
how the audience will receive the
message.

103
SUGGESTED READINGS
1. DinkarPagare (2015) Principles of Management, Sultan Chand &
Sons, New Delhi.
2. Harold Koontz, Cyril O'Donnell and Heinz Weihrich (2017)
Essentials of Management (5th Revised edition), McGraw-Hill Inc.,
US, (ISE Editions).
3. Prasad L.M. (2015) Principles and Practice of Management,
Sultan Chand & Sons, New Delhi.
4. Sherlekar S.A. &Sherlekar V.S 3rd Edition (2014) Principles of
Business Management, Himalaya Publishing House Pvt. Ltd,
Mumbai.
5. Tripathi, Sixth edition (2017) Principles of Management, Tata
McGraw Hill Education Private Limited, 7 thWest Patel Nagar, New
Delhi.
6. Tripathi, P C, Reddy, P N, 5 edition (2012) Principles of
Management, Tata McGraw Hill Education private limited, 7 th west
Patel Nagar, New Delhi.
7. https://www.tutorialspoint.com/effective_communication/effective
_communication_process.htm
8. https://theknowledgereview.com/importance-electronic-media-
mass-communication/
9. https://www.geektonight.com/types-of-communication/
ANSWERS TO CHECK YOUR PROGRESS
1) a 2) b 3) c 4) d 5) a

104
Unit 8

COORDINATION AND CONTROL

STRUCTURE
Overview
Learning Objectives

8.1 Co-ordination

8.1.1 Definition and features of co-ordination

8.1.2 Importance and need of co-ordination

8.1.3 Principles of co-ordination

8.1.4 Techniques of co-ordination

8.2 Control process
8.2.1 Nature of managerial control

8.3 Pre-requisites of control system

8.4 Objectives of control

8.5 Importance of Control

8.6 Steps in Control Process
8.7 Control Techniques

8.8 Role of Information Technology in Control Process

Let Us Sum-Up
Check Your Progress

Glossary

Suggested Readings
Answers to check your progress

OVERVIEW
Control is a universal and important function of management. It is to guide
somebody or something in the direction in which it is intended to go. In
this sense, control means the power or authority to direct, order or
restrain. It also implies a standard of comparison for the results of any
operation or experiment. In terms of managerial functions, control
consists of the steps taken to ensure that the performance of the
organization conforms to the plans.

105
Although the basic nature and purpose of management control do not
change, a variety of tool and techniques have been used over the years
to help managers control. This unit also examines the newer information
technology and its challenge, as well as the use of computers.

LEARNING OBJECTIVES
After completing this unit, you will be able to,
• explain non-budgeting control devices
• explain the importance of coordination
• describe the applications and importance of information
technology in control process
• discuss the role of IT in control process.

8.1 CO-ORDINATION
8.1.1 Definition and Features of Co-Ordination

According to Mooney and Reilley, “Co-ordination is an orderly

arrangement of group effort to provide unity of action in the pursuit of a
common purpose”.
The following are the features of co-ordination:
• Co-ordination is synchronization of group efforts for achieving
objectives of an enterprise.
• Responsibility for co-ordination rests with management and
managers at all levels and they must try to secure co-ordination of
people working under them.
• It is a continuous and dynamic activity carried on by managers.
• The ultimate aim of co-ordination is to achieve unity of action of
group efforts and attain the objectives of an enterprise.
8.1.2 IMPORTANCE AND NEED OF CO-ORDINATION
The need for co-ordination arises only when two or more persons work
together for achieving common objectives. The following points bring out
the importance of co-ordination.
i) Specialization: An organization is divided into various departments and
each department is headed by a specialist. Co-ordination of diverse
activities of various departments is of utmost importance otherwise there
may be utter confusion and chaos.
ii) Conflicting individual and organization goals: It is very important for
every enterprise to bring about co-ordination between organization goals
and individual goals. If an individual is diverting from the path of

106
organization goals, he may be told immediately to mend his ways and try
to achieve the objective of the organization.
iii) Line and Staff Structure: The creation of line and staff structure in an
organization also creates problems of co-ordination. The staff officers
may confuse their authority with line officers. Thus, co-ordination is
necessary between line and staff officers for achieving the goals of
enterprise.

iv) Personal politics: In every enterprise rival groups of people can be

formed. There is a need for bringing about co-ordination among the rival
groups which sometimes tend to sabotage the co-ordination process.

v) Different outlook: Each individual in an organization is a complex and

unique personality. Individuals assess and interpret organization goals
from their own view points. Hence, management has to co-ordinate the
activities of these individuals.
vi) Increase in efficiency: Co-ordination ensures a proper tempo for the
whole organization. A co-ordinated group effort helps to make an
optimum use of all the resources. It therefore increases the efficiency.

8.1.3 PRINCIPLES OF CO-ORDINATION

The following are the main principles of co-ordination.

i) Early beginning: Co-ordination must begin at the planning stage itself.

It is difficult to co-ordinate the plans which have already started.
ii) Direct contact among parties: It is very important for co-ordination
that there is a direct and personal contact so that all doubts, confusions
and other such problems are removed.
iii) Reciprocity: According to this principle, reciprocal relationships must
be established among the managers of different departments viz.,
production, sales, finance, etc., as activity of one department affects the
activities of other departments.

iv) Continuity: Co-ordination is a continuous process and is not like

solving a problem once for all. There must be a regular exchange of ideas
through a good communication system.

8.1.4 TECHNIQUES OF CO-ORDINATION

i) Defining clearly authority and responsibility: Confusion regarding
authority increases the problems of co-ordination manifold because
responsibility can be fixed only when the authority and its source is clearly
demarcated.

107
ii) Formulation of clear cut policies and procedures: Co-ordination
becomes very easy if there are clear cut and well defined policies and
procedures. It will ensure unity of action.
iii) Mutual communication: Effective communication is essential for co-
ordination. Direct communication helps to resolve the individual and
departmental difference. Through discussion, mutual exchange of ideas
takes place and it helps in bringing harmony among the different
departments of an enterprise.
iv) Existence of community of interest: In order to have an effective co-
ordination, it is essential that there should be a common understanding of
the main objectives of the organization.
v) Effective leadership: A good leader creates confidence among his
subordinates and effectively resolves differences, if any, of the people
working under him. Effective leadership is sure to promote co-ordination
at all levels beginning from the planning stage to the implementation
stage.
vi) Effective control: When an integrated control system is in existence,
it automatically ensures co-ordinated group efforts. With the help of
control charts, management can immediately come to know the degree to
which the various activities have been co-ordinated.
vii) Voluntary co-operation: Voluntary co-operation facilitates co-
ordination. If all the members of the organization work as a team the
results will automatically follow. Whenever conditions are ideal,
management should try to secure voluntary co-operation from the
members of the organization.
viii) Sound organization structure: It is very essential for co-ordination
that there should be a sound organization structure. There should be
organization charts, job descriptions, work manuals etc., as these help to
a great extent in securing co-ordination.
ix) Organization Manuals: Organization manuals lay down the general
philosophy of the organization and serve as a guide to the understanding
of the business and appreciation of the role of each section or department.
x) Appointment of Liaison Officers: Certain organizations also appoint
liaison officers who act as a link between two individuals or departments
and co-ordinate the activities of different individuals.

108
8.2 CONTROL PROCESS
8.2.1 Meaning and Nature of Managerial Control
According to Brech, “Control is the process of checking actual
performance against the agreed standards or plans, with a view to
ensuring adequate progress or satisfactory performance and also
recording such experience as if gained as contribution to possible future
needs.

Managerial control seeks to compile events to conform to plans as closely

as possible. Control is applicable to all activities of business finance,
purchasing, production, marketing, personnel, cost, quality, materials, etc.

8.2.2 Nature of Managerial Control

Important management function - Control is an indispensable function
of management. It is a follow up action taken to achieve the efficiency of
other managerial functions. Control is affected by other functions and in
turn it affects the other functions of management.
Continuous process - It is a continuous or regular process.
Management has to be continuously vigilant to ensure that the enterprise
is following a right path.
Mechanism - It is a mechanism according to which something or
somebody is directed to follow the predetermined course. In a business
enterprise it is the job of a manager to control performance of work and
workers placed under his charge.

Dynamic process - Control is not static but it is flexible. A control system

can be effective only when it goes on changing according to the needs
and conditions of the enterprise.
Forward looking - Control is forward looking because one can control
future happenings and not the past. It seeks to improve future events
through past experience.

Action oriented - The essence of control is the corrective action that

brings plans and performance close to each other. To arrive at
organizational objectives, actions and further actions are necessary.
Each time there may be corrections and changes in the actions depending
upon the information provided by control procedure.
8.3 PRE-REQUISITES OF CONTROL SYSTEM

The existence of the following factors is essential to the operation of the

control system:

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i) Planning: Planning and control are closely linked with each other.
Planning without control is meaningless and control without planning is
blind. Planning provides the basis of control. Control brings to light all
bottlenecks to work performance and operates as a straight pointer to the
need of the situation.
ii) Action: Control implies that actions can be taken to correct the
variations that may occur between standards and actual results.
Deviations may occur in spite of the best of guidance from the manager.
In such a situation, the manager should be quick to act.
iii) Delegation of Authority: A manager cannot exercise control without
adequate authority. The authority is delegated to operate within a
prescribed limit.
iv) Information: For effective control, there must be a prompt flow of
information to the manager. An effective feedback helps the manager to
know where and when deviation from any plan has taken place. He can
then initiate prompt corrective action. Promptness in reporting is vital to
quick remedial action.

8.4 OBJECTIVES OF CONTROL

The various purposes of controlling are discussed below:

• To find out what is happening or what has actually happened in

the enterprise;
• To assure that the work is performed according to the pre-
determined standards, and the desired results are achieved;
• To increase the efficiency of operations by minimizing irrelevant
and wasteful actions;
• To decide the corrective actions, if any, needed for the attainment
of goals with minimum of time, effort and expense; and
• To co-ordinate different activities and effort.

8.5 IMPORTANCE OF CONTROL

The various reasons for the needs and importance of control are given
below:

i) Efficient execution: Control is an important pre-requisite for an

effective and efficient implementation of the pre-determined plans. It
assists in determining variations, pinpointing the factors responsible for
them and taking remedial measures.
ii) Helps delegation: Control can be meaningful only when it is preceded
by proper delegation of authority and duties. Thus it promotes delegation
of authority to the employees at lower levels.

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iii) Aid to decentralization: Under decentralization, the authority of
decision making is dispersed throughout the organization. Management
must keep control in its hands to know whether the authority is being used
properly. Without adequate control, decentralization cannot succeed.

iv) Assists Co-ordination: The size of modern business enterprises is

increasing. This creates the problems of adequate control as there are
many divisions producing and distributing different products and services.
In order to co-ordinate their activities, an efficient system of control is
required.
v) Simplifies supervision: Control simplifies supervision by pinpointing
significant deviations. It keeps the employees under check and brings
discipline among them.
vi) Aids to efficiency: Basically, control is concerned with ensuring that
all the important factors in the enterprise move alone the right lines and
the right place. This assists in promoting efficiency all rounds.
8.6 STEPS IN CONTROL PROCESS
The main steps in the control process are given below:
1) Fixing Standards
2) Measurement of Performance
3) Comparison between actual and standard performance and
4) Correction of deviations from standards.

Figure. 8.1 Control Process

i) Fixing Standards: In the context of a business enterprise, standards
refer to the objectives to be achieved. Standards become the criteria by
which performance is measured in the control process. Standards must
be precise and easy to understand. They should be expressed in
numerical terms, Eg: Quantities of goods to be produced, costs to be
incurred, profits to be earned and so on.

111
ii) Measurement of Performance: This involves the laying down of
methods of evaluating performance.

Eg: Observation, Inspection and Reporting.

Performance is measured either in quantitative terms or in qualitative
terms.
Eg: Quantitative terms : Size, thickness, colour etc.,
Qualitative terms : Attitude, Morale etc.,

iii) Comparing actual and standard performance: It involves two steps:

• Finding out the extent of deviations and
• Identifying the causes of such deviations. The evaluation will show
deviations from the fixed standards and identify the causes
responsible for these.
iv) Correcting the deviation from standards: After the causes of
deviations are known, suitable steps are taken to avoid deviation in the
future. This will involve taking certain decisions by the management like
modification of plans, refining of goals or standards, reassignment or
clarification of duties.

8.7 CONTROL TECHNIQUES

i) Budget and Budgetary Control: A widely used device for managerial
control is the budget. Budgeting is the formulation of plans for a given
future period in numerical terms. As such, budgets are statements of
anticipated results, either in financial terms

(Eg: Revenue and Expense and Capital Budgets) or in non-financial

terms
(Eg: Budgets of direct labour hours, materials, physical sales volume or
units of production)

Types of Budgets
Now, we will discuss some of the important budgets:

i) Sales Budget - A sales budget is an estimate of expected total sales

revenue and selling expenses of the firm. It is known as the nerve centre
of the enterprise. It is the starting point on which other budgets are also
based. It is a forecasting of sales for the period both in quantity and value.
It shows what products will be sold in what quantities and what prices.
The responsibility for preparing sales budget lies with the sales manager
who takes into account several factors for making the sales budget. Some
of the factors are,

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a) Past sales figure and trend;
b) Estimates and reports by salesman;

c) General economic conditions;

d) Orders on hand;

e) Seasonal fluctuations;
f) Competition and
g) Government Control.

ii) Production Budget: Production budget is prepared on the basis of

the sales budget. It also takes into account the stock levels required to
be maintained. It contains the manufacturing programme of the
enterprise. It is helpful in anticipating the cost of production. It is made
by the production manager by keeping in view the following factors:
1. The Sales Budget
2. Plant capacity

3. Inventory Policy and

4. Availability of raw materials, labour, power, etc.,

iii) Financial Budget: This budget shows the requirement of capital for
both long-term and short-term needs of the enterprise at various points of
time in future. Its objective is to ensure regular supply of adequate funds
at the right time. An important part of the financial budget is the Cash
Budget.
Cash Budget contains estimated receipts and payments of cash over the
specified future period.
iv) Overheads Budget: It includes the estimated costs of indirect
materials, indirect labour and indirect factory expenses needed during the
budget period for the attainment of budgeted production targets.
v) Personnel Budget: It lays out manpower requirements of all
departments for the budget period. It shows labour requirements in terms
of labour hours, cost and grade of workers.
vi) Master Budget: Master Budget is prepared by consolidating
departmental or functional budgets. It is the summary of the budget
incorporating all functional budgets. It generally includes sales,
production, costs-materials, labour, factory overhead, profit, appropriation
of profit and major financial ratios.

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vii) Zero Based Budget: In zero base budgeting, every year is taken as
a new year and the previous year is not taken as a base. Zero is taken
as a base and future activities are decided as per the present situations.
Budgetary Control

Use of budgets for controlling activities is known as budgetary control. It

involves the following three steps:
i) Preparation of budgets;

ii) Continuous comparison of actual results with the planned ones; and

iii) Revision of plans or budgets in the light of changed circumstances.

The comparison of budgeted and actual figure will enable the manager to
find out discrepancies and take remedial measures at a proper time.

Cost Accounting and Cost Control

Control through costing involves the control over costs in the light of
certain predetermined costs usually known as standard costs. Standard
costs is a method of cost accounting in which standard costs are used in
recording certain transactions and the actual costs are compared with the
standard costs to find out the amount of and the reasons for variation from
the standard.
Statistical Data

Statistical Data are being widely used for the purpose of managerial
control. These may be presented in the form of statistical tables and
graphical charts. Analysis in terms of averages, percentages, ratios,
correlations provide help for control.

Special Reports and Analysis

Special reports and analysis from specially trained analysts help in
investigating and analyzing some special problems. The very non-routine
nature of such special analysis may highlight the unusual things.
Internal or Operational Audit

Internal audit ensures that accounts properly reflect the facts and
appraises one of the policies, procedures, use of authority, quality of
management, effectiveness of methods etc.,It also feeds managers with
a perennial supply of control information.

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Personal Observation
Personal Observation of experienced managers is always quite useful in
revealing certain surprising information even when he is casually passing
through a plant or an office.

Break-Even Analysis
It is basically concerned with the cost-volume profit relationship. It
magnifies a set of relationships of fixed costs, variable costs, price, level
of output and sales mix to the profitability of the organization. It indicates
the breakeven point which is the volume of activity when the revenue
generated is exactly equal to the total costs. (i.e. Both fixed and variable
costs) and there is neither a profit nor a loss.

Mathematically it can be represented as follows:

Fixed Costs
Break Even Point = ---------------------------
Contribution per unit
Contribution = Sales price per unit - Variable costs per unit
In the above diagram sales volume is shown on the X-axis and costs and
revenue is shown on the Y-Axis. Fixed cost is represented by a horizontal
line. The total cost line moves upward proportionately with the volume.
The sales revenue is represented by the line moving upward uniformly
from the origin of the axes. The point of interaction of the total cost line
with revenue line is the break-even point.

The main advantage of breakeven analysis is that it tells the manager

about the probable level of profits at different levels of output.

PERT and CPM as Tools of Control

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PERT and CPM are techniques of Project Management, useful in the
basic managerial functions of Planning, Scheduling and Control. PERT
stands for “Programme Evaluation and Review Technique” and CPM is
the abbreviation of “Critical Path Method”.

The techniques of PERT and CPM help greatly in completing the various
jobs on schedule. They minimize production delays, interruptions and
conflicts. These techniques are very helpful in coordinating various jobs
of the total project and thereby expedite and achieve completion of project
on time and are used in addition to traditional devices of control.
PERT is a sophisticated tool used in planning, scheduling and controlling
large projects consisting of a number of activities independent of one
another with uncertain completion time. The following steps are required
for using CPM and PERT for planning and scheduling:

i) All the jobs or activities of a project must be separately listed.

ii) The order of precedence for these jobs has to be determined.
iii) A picture or graph to be drawn portraying each of these jobs and
showing the predecessor and successor relations among them.

10 Days 4 10 Days
14 Days b
1 2 e
a c d 4 Days
5
7 Days
3

In this figure jobs are shown as arrows leading from one circle to another.
Thus the arrow connecting the two circles represents a job. Circles 1 and
2 represent job ‘a’ which would take 14 days. Circles 2 and 4 represent
job ‘b’ which would take 10 days and so on. Once we reduce the project
to network of activities and events we estimate activity durations and we
are in a position to determine the minimum time required for completion
of the whole project. To do so, we must find the longest path or sequence
connecting the activities through the network. This is called as the ‘Critical
Path’ of the project. The longest path is the critical path. In this case a-
c-d-e is the critical path. (14+7+4+10 = 35 days)
What we have basically described above is the very useful technique of
CPM and PERT which consists of decomposing a project into activities
and then ordering activities according to their relationships to find out the
shortest time required to carry out an activity.

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8.8 ROLE OF INFORMATION TECHNOLOGY IN CONTROL
PROCESS
The system model of management shows that communication is needed
for carrying out the managerial functions and for linking the organization
with its external environment. The Management Information System (MIS)
provides the communication link that makes managing possible. MIS is a
formal system of gathering, integrating, comparing, analysing and
dispersing information both internal and external to the enterprise in a
timely, effective and efficient manner.
MIS has to be tailored to specific needs and may include routine
information, such as monthly reports, information that points out
exceptions, especially at critical points and information necessary to
predict the future.

Use of Computers in Controlling

The computer can store, retrieve and process information at a very rapid
pace. The following are the various kinds of computers.
Mainframe: The mainframe is a full scale computer, often costing million
of dollars, that is capable of handling huge amounts of data. These “Super
Computers” are used for engineering, simulation and the manipulation of
large data bases.
Mini Computer: The minicomputer has less memory and is smaller than
the mainframe. This kind of computer is often connected with peripheral
equipment.
Micro Computer: The microcomputer is even smaller and may be a desk
computer, home computer, personal computer, portable computer or a
small computer for a business system.
But the distinction between the various classes of computer is
disappearing. With the introduction of the new micro computers with large
memory and high computing speed, these computers have become very
powerful.
Among the many business applications of the computer are material
requirements planning, manufacturing, resource planning, computer-
aided control of manufacturing machinery project costing, inventory
control and purchasing. There are many uses in processing financial
information such as accounts receivable and accounts payable, pay roll,
capital budgeting and financial planning.

117
Executive Information Systems: EIS provides up-to-date information to
support decision making by managers. It provides a top-down analysis
instead of raw data and presents data graphically as well as numerically,
making it easier for the user to spot trends and relationships.

Geographical Information System: A GIS relates data to maps.

National sales shown by country, state, or region using colors for various
ranges of sales, making it easy to spot, where sales are high and low.
Management then has knowledge of where sales are lower than
expected.
LET US SUM-UP

Control is a universal and important function of management. It helps in

efficient execution of plans, in delegation, decentralization, co-ordination
and supervision. Control involves a few steps and both budgetary and
non-budgetary control techniques are used in the organizations. The
various budgeting techniques are also detailed in this unit.
CHECK YOUR PROGRESS
Choose the correct answer
1. A ------------- relates data to maps. National sales shown by country,
state, or region using colors for various ranges of sales.

a) Employment b) GIS
c) Mini Computer d) micro computer
2. ---------------provides up-to-date information to support decision making
by managers.

a) EIS b) internet
c) Personal Computer d) micro computer
3.The ------------ is even smaller and may be a desk computer, home
computer, personal computer, portable computer
a) Pen - drive b) GPS

c) Mini Computer d) micro computer

4. The----------- has less memory and is smaller than the mainframe.
a) EIS b) floppy disk

c) Mini Computer d) mainframe

5. The---------- is a full scale computer, often costing millions of dollars,

that is capable of handling huge amounts of data.

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 a) EIS b) geographical information system
c) Mini Computer d) mainframe

GLOSSARY

Coordination : The organization of the different

elements of a complex body or
activity so as to enable them to
work together effectively

Control : The power to influence or direct

people's behaviour or the course of
events.

Efficiency : Efficiency signifies a peak level of

performance that uses the least
amount of inputs to achieve the
highest amount of output.

Supervision : The action of monitoring someone

or something.

SUGGESTED READINGS
1. DinkarPagare (2015) Principles of Management, Sultan Chand &
Sons, New Delhi.
2. Harold Koontz, Cyril O'Donnell and Heinz Weihrich (2017)
Essentials of Management (5th Revised edition), McGraw-Hill Inc.,
US, (ISE Editions).
3. Prasad L.M. (2015) Principles and Practice of Management,
Sultan Chand & Sons, New Delhi.
4. Sherlekar S.A. &Sherlekar V.S 3rd Edition (2014) Principles of
Business Management, Himalaya Publishing House Pvt. Ltd,
Mumbai.
5. Tripathi, Sixth edition (2017) Principles of Management, Tata
McGraw Hill Education Private Limited, 7 thWest Patel Nagar, New
Delhi.

119
 6. Tripathi, P C, Reddy, P N, 5 edition (2012) Principles of
Management, Tata McGraw Hill Education private limited, 7 th west
Patel Nagar, New Delhi.
7. https://www.managementstudyguide.com/coordination.htm
8. https://www.economicsdiscussion.net/management/coordination/
principles-of-coordination/31861
9. https://www.iedunote.com/control-process-steps
ANSWERS TO CHECK YOUR PROGRESS
1) b 2) a 3) d 4) c 5) d

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 BLOCK 3

ORGANIZATIONAL BEHAVIOUR

Unit 9 : Organization Behavior

Unit 10 : Perception and Learning

Unit 11 : Motivation

Unit 12 : Attitude and Job satisfaction

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Unit 9

ORGANIZATION BEHAVIOUR
STRUCTURE
Overview
Learning Objectives

9.1 Organization Behaviour an overview

9.2 Organizational Participants

9.3 Foundations of Individual Behaviour

9.4 Implications of Individual Behaviour

9.5 Personality
9.6 Determinants of personality
9.7 Influence of Personality on Behaviour

9.8 Major Personality Traits Influencing Organizational Behaviour

Let Us Sum Up

Check Your Progress

Glossary
Suggested Readings

Answers to check your progress

OVERVIEW
The organizational Behavior can also be defined as the field of study that
investigates the impact the individuals, groups and the structure have on
the behavior in the organizations for the purpose of applying such
knowledge towards improving an organization's effectiveness. The
relationship between the individuals, organization and the working
environment is shown below.
LEARNING OBJECTIVES

After completing this unit, you should be able to,

• describe the foundations of individual behavior
• explain relationship between individual behavior and
organizational behavior
• discuss the implications of individual behavior.

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9.1 ORGANIZATION BEHAVIOUR AN OVERVIEW
Concept of Organizational Behavior
Organizational Behavior can be defined as the understanding, prediction
and management of human behavior in the organizations. The human
behavior in the organization is determined partly by the requirements of
the formal organization and partly by the personal system of the
individuals forming the organization.

9.2 ORGANIZATIONAL PARTICIPANTS

Organizational Behavior and Organizational Environment

The key elements in organizational behavior are people, structure,
technology, and the environment in which the organization operates.
When people join together in an organization to accomplish an objective,
some kind of structure is required. People also use technology to help get
the job done, so there is an interaction of people, structure, and
technology. In addition, these elements are influenced by the external
environment and they influence it.
(a) People: People make up the internal social system of the organization.
They consist of individual groups, large groups as well as small ones.
They may be unofficial, informal groups or official, formal ones. Groups
are dynamic. They form, change, and disband. The Human organizations
today are not the same as it was yesterday, or the day before. People are
living, thinking, feeling beings that created the organization to achieve
their objectives.
(b) Structure: Structure defines the official relationships of people in the
organizations. Different jobs are required to accomplish all of an
organization’s activities. The people who perform these jobs have to be
related in some structural way so that their work can be effective. These
relationships create complex problems of cooperation, negotiations, and
decision making.
(c) Technology: Technology provides the resources with which people
work and it affects the task that they perform. The great benefit of
technology is that it allows people to do more and better work, but it also
restricts people in various ways.
(d) Environment: All organizations operate within an external environment.
A single operation does not exist alone. It is part of a larger system that
contains many other elements. The environment in which an organization
operates influences the attitude of people, affects working conditions, and
provides competition for resources and power.

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Concepts Dealing with an Individual.
There are four concepts dealing with the nature of an individual in the
Organizational Behavior:
(a) Individual Differences: Every individual has a different gift of nature,
different quantity of intelligence and different way of behavior. When it
comes to human behavior there cannot be a prescriptive solution. This
concept tells a manager that every person should be treated as an entity
and should not be stereotyped just because he belongs to a group.
(b) Whole Person: When it comes to analyzing the behavioral problems
the manger should take into account all the roles an individual is playing
in the organization.
(c) Motivation: The manager by his own behavior can influence an
employee and can cause him to behave in a particular way.

(d) Human Dignity: This concept is more on an ethical philosophy. Every

person in an organization wants to be treated with respect and is engaged
in the same pursuit.
Models of Organizational Behavior
There are four recognizable models of the organizational behavior. These
are tabulated as below: -

• Autocratic
• Custodial
• Supportive
• Collegial

• Model Depends Upon

• Power

• Economic resources
• Leadership
• Partnership

• Managerial Orientation

• Authority
• Money

• Support

• Teamwork

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• Employee Orientation
• Obedience

• Security
• Job Performance

• Responsibility
• Employee Psychological Result
• Dependence on Boss

• Dependence on organization

• Participation
• Self-discipline

• Employee Needs Met

• Subsistence
• Maintenance
• Higher order

• Self-actualization
• Performance Result

• minimum
• Passive cooperation
• Awakened drives
• Moderate enthusiasm,
Autocratic model was in existence at the time of industrial revolution,
subsequently the thinking shifted to the custodial model which consisted
of giving some SOP’s, concessions and privileges to the employee to
keep them happy. In both the autocratic and the custodial models the
managers did not bother creating a conducive atmosphere for the
employees. The supportive model emerged as a sequel to the human
relations era. This model assumes that the employees have some skill
and will contribute to the organization. Thus, the manager is not the boss
of the team but a leader of the team of employees entrusted under him to
perform a particular job. Leader is responsible for creating an environment
to utilize the skills and wills of the employees to contribute to the
organizational effort. The collegial model is more applicable to the to
scientific and professional employees where the role of the manager is
changed to a partner in pursuit of the same objective as the employee

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9.3 FOUNDATIONS OF INDIVIDUAL BEHAVIOUR
The behavior of each individual is influenced by several factors. A study
of these factors is useful to understand the subject of Organization
behavior better. The factors that influence the behavior of individual are
classified as follows:
a. Environmental Factors
i) Economic Factors

ii) Cultural Environment

iii) Political Factors

b. Personal Factors

i) Age

ii) Sex
iii) Education
iv) Abilities

v) Marital Status
vi) Number of dependents

c. Organizational Systems & Resources

i) Physical facilities
ii) Organization structure and design

iii) Leadership

iv) Reward system

d. psychological factors
i) Personality

ii) Perception
iii) Attitudes

iv) Values
v) Learning
A brief description of the factors is given below:

a) Environmental Factors: These factors include variables such as

economic, social, and political and the like. These factors are mainly
external and will influence individual behavior considerably.

126
i) Economic Factors: The economic environment is an important
determinant of individual behavior. It is a synthesis of several factors such
as employment level, wage rates, economic outlook and technological
change.

Employment: Employment Opportunities will have a strong influence on

an individual behavior. Fewer job opportunities increase the emphasis on
job security and can change the basic motivation pattern of the individual.

The job, an individual holds, itself has significant influence on his or her
behaviour. The behavior of a professor in a university will be different
from an executive in industrial enterprise. Similarly, the behavior of a
worker in a factory will not be the same as the behavior of a cart puller on
the street.
Wages: Wages satisfy various individual needs. Money is a complex
variable and its effect on behavior varies tremendously. It is well known
that wages attract people to certain organizations and determine their
satisfaction on jobs.
Economic Outlook: The general economic outlook also influences
individual expectations, especially of those, employed in industries
severely affected by economic cycles. Individuals who experience
frequent layoffs are more likely to be motivated by factors that affect job
security, other individuals would consider job security to be relatively
unimportant and would be motivated by other factors.

Technological Change: Technological change is included as an

economic factor because of its potential impact on individual’s job
opportunities. Technological change has its strongest impact at lower
level jobs, although increased automation, robotics, computerization and
more sophisticated production technologies can affect individuals at all
levels.

ii) Cultural Environment: Culture varies from country to country

(between two regions within a country too) and these varieties produce
different behaviors across the countries. Work ethics, achievement need,
effort-reward expectations and values important cultural factors that have
behavioral implications.
Work Ethics: Work Ethics implies hard work and commitment to work.
Strong work ethics ensures motivated employees, and the opposite is
true, when work ethics is weak.
Achievement Need: Achievement need has great influence on employee
behavior. Individuals with a low need to achieve will be more difficult to

127
motivate using traditional motivation techniques. Similarly, individuals
with a high need to achieve would be relatively unhappy in an organization
that does not reward achieving power.
Effort and Reward: A perfect match between effort and reward will
produce better performance from an individual. When the individual
perceives that he or she has been treated unfairly, the performance
suffers.

Value: Value implies individual’s judgment of what is right, good or

desirable. Values influence one’s perception, attitudes and through this
his or her behavior.

iii) Political Factors: The political climate in which an individual lives can
affect individual behavior. The political ideology of a country affects
individual behavior, primarily through the relative freedom available to its
citizens. The relative freedom available can affect career choice, job
design, motivation methods and finally, individual performance.
b) Personal Factors: Every individual brings to the work place a variety
of personal characteristics and attributes like age, sex, education,
dependents, abilities and similar related factors.
i) Age: Age is an important variable, because of its impact on
performance, turnover, absenteeism, productivity and satisfaction.
ii) Performance: Performance depends on age. As age advances,
performance is likely to decline. Similarly, aging has an impact on
turnover. The older, one grows, less likely he or she is to quit the job.
With regard to productivity, older age results in reduced productivity. This
is because of the decline in individual’s skill as he or she grows older in
age. There is a positive association between age and satisfaction. Age
can also be a factor in adaptability, although it would be incorrect to
stereotype all older people as unadoptable.

iii) Sex: Sex has its impact on turnover and absenteeism. It has been
proved that the tendency to change jobs and to abstain from work is likely
to be high among female employees than among male workers.

iv) Education: Education has its effect upon individual behaviour, largely
through the level and type of education received. Increased levels of
education serve to increase an individual’s expectations about positive
outcomes. Disillusionment occurs when outcomes do not match
expectations.

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v) Ability: Ability of an individual is made up of two sets of skills viz.,
Intellectual skills and Physical skills. Individuals differ in the extent to
which, they have each of these abilities.
vi) Marital Status: Marital status has an influence on absenteeism,
turnover and satisfaction. Married employees have fewer absences,
undergo fewer turnovers, and are more satisfied with their jobs than the
unmarried ones.

vii) Number of Dependents: Number of dependents an employee has is

positively related to absence, especially among females. Similarly, there
is positive correlation between the number of dependents and
satisfaction.
viii) Creativity: Creativity is yet another personal factor that influences
individual behavior. It is from creativity that major inventions, scientific
break troughs and great works of music, literature and art emanate.
c) Organizational System and Remarks: Individual behavior is also
influenced by physical facilities, organizational structure and design,
leadership and reward systems.
i) Physical Facilities: Physical Facilities such as lighting, ventilation, air
conditioning, paintings on walls, space provided for each employee,
equipment and the like, will have their influence on employee behavior
and performance.
ii) Organization Structure and Design: The behavior and performance
of an individual is influenced by where that person fits into the overall
structure and the design of the organization.
iii) Leadership: The organization establishes a system of leadership and
supervision, to provide direction, assistance, advice and coaching to
individual members. The leader'sbehavior is, therefore, a potential source
of influence on individual.

iv) Reward Systems: The behavior and performance of an individual is

influenced by the reward system, his or her organization has established
to compensate its employees.

d) Psychological Factors: Psychological factors are an individual’s

mental characteristics and attributes that can affect behavior. There are
several psychological factors, but the more prominent among them are
personality, perception, attitudes, values and learning.
i) Personality: Personality influences behavior of an individual. Factors
such as Openness, Extroversion, Emotional stability,Conscientiousness,
Agreeableness etc., have impact on the behavior of individual.

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ii) Perception: Individual's behavior is influenced by the perception he or
she has in respect of a person or object. Perception of an individual may
differ based on the characteristics of the perceiver, perceived and
situation.

iii) Attitude: Attitude refers to feelings and beliefs of individuals directed

towards other people, objects or ideas. It affects individual behavior to a
great extent.

iv) Values: Values are powerful instruments influencing cognitive process

and behavior of individual. It is learned and acquired from the same
sources – experience with people and objects.

v) Learning: Learning is a fundamental variable in human behavior. A

worker’s skills, a manager’s attitude, a supervisor’s motivation and a
secretary’s mode of dress are all learned.

9.4 IMPLICATIONS OF INDIVIDUAL BEHAVIOUR

The study of Individual behavior forms the basis of organizational
behavior. It helps an individual understands himself and others better.
This will improve interpersonal relations considerably.
It helps managers understand the basis of motivation and what he should
do to motivate an individual. It also helps to maintain cordial industrial
relations.
9.5 PERSONALITY
In Psychology, personality is interpreted in different ways by different
theorists. Carl Rogers views personality in terms of self, “an organized,
permanent, subjectively perceived entity which is at the very heart of all
our experiences”.
Gordan Allport defines, personality as “what an individual really is, as an
internal ‘something’ that guides and directs all human activity”.
Freud describes the structure of personality as composed of three
elements – the id, ego and super ego.
Precisely, personality is defined as “the sum total of all physical and
mental characteristics of a person”.

9.6 DETERMINANTS OF PERSONALITY

After having understood the theories of personality it is pertinent to know
about the determinants of personality. The determinants to personality
can be grouped into five broad categories – heredity, environmental,
family, social and situational.

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i) Heredity: Heredity refers to those factors that were determined at
conception. Physical stature, facial attractiveness, sex, temperament,
muscle composition and reflexes, energy level and biological rhythms are
characteristics that are generally considered to be imported either
completely or substantially by one’s parents. The heredity approach
argues that the ultimate explanation of an individual’s personality of the
molecular structure of the genes, is located in the chromosomes. The role
of heredity on personality is still an unsettled area of understanding;
however, it cannot be totally ignored. The following classification of
characteristics is said to be inherited by all humans:

(1) Physical structure (how tall or short one is, whether one has a long or
short nose etc., (2) Reflexes, (3) Innate drives, (4) Intelligence, (5)
Temperament

ii) Environment: Personality development owes much to environment as

it does to heredity. Environment is a broad term and includes such factors
as culture. Culture establishes norms, attitudes and values that are
passed along from one generation to the next and creates consistencies
overtime.
Every culture has its own sub cultures, each with its own views about such
qualities as moral values, standards of cleanliness, style of dress, and
definitions of success.
iii) Contribution from the family: The family has considerable influence on
personality development, particularly in the early stages. The parents play
an important part in the identification process which is important to an
individual’s early development. The overall home environment created
by the parents, in addition to their direct influence is critical to personality
development. Siblings (brothers and sisters) also contribute to personality.
iv) Socialization Process: Besides the heredity, environmental, and family
influences of personality, there is a great realization that other relevant
persons, groups and organizations exercise their due role in personality
development. This is commonly called the socialization process.
Socialization starts with the initial contact between a mother and her new
infant. After infancy, other members of immediate family (father, brothers,
sisters and close relative or friends), followed by the social group (peers,
school friends and members of the working group) play influential roles.
v) Situational Considerations: It must also be recognized that it is the
immediate situation which may influence personality.

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From the preceding discussion of the development of personality, it is
clear that personality is a complex concept that reflects many influences
both within and outside the individual.
Personality and Organizational Behaviour

Personality is an important determinant of employee behavior. It is the

focal point determining motivation. Personality characteristics influence
selection of individuals to occupy various positions in an organization.

9.7 INFLUENCE OF PERSONALITY ON BEHAVIOUR

Influence of Personality on Organizational Behaviour

To understand organizational behavior, it is essential to understand
individual behavior. The nature and personality of individual human beings
is the root cause of behavior. The word personality is derived from the
Latin word persona. It denotes the masks that used to be worn by
theatrical players in ancient Greek dramas.
Hence, personality is the superficial social image that we adopt. Further,
we can also view personality as a reflection of the most dominant
characteristics in the behavior of an individual that are observable (namely,
aggressiveness or shyness). It is through personality that an individual
makes an overall impression on others in various social settings.

A quick comparison of behavior, character and personality can be made

by attributing Behaviour as the external appearance and not the
exposition of true feelings of the mind. The character is the index of the
mind and feelings, that is, Behaviour that is endorsed and directed by the
mind, while personality on the other hand, is self-directed behavior.
Personality components, therefore, are the mind (clarity and
understanding), the will (steadiness and equality), the heart (conservation,
warmth, expansiveness, and magnetism), vitality (energy), and the
physique (perseverance and endurance for work)

9.8MAJOR PERSONALITY TRAITSINFLUENCING

ORGANIZATIONAL BEHAVIOUR
(1) Authoritarianism, (2) Bureaucratic Personality, (3) Machiavellianism, (4)
Introversion and Extroversion, (5) Problem Solving Style, (6) Achievement
Orientation, (7) Locus of Control, (8) Self Esteem, (9) Self-Monitoring, (10)
Risk Taking, (11) ‘Type A’ and ‘Type B’ Personality, and (12) Myers-Briggs
Type Indicator (MBTI) have been identified as major personality traits
influencing organizational behavior . These have been listed below and
explained briefly.

1. Authoritarianism

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Authoritarianism as a concept was developed by the psychologist Adorno
during World War II to measure susceptibility to autocratic, fascistic or
antidemocratic appeals. After that the concept was extended to the human
personality. According to Adorno, “This concept refers to a belief that there
should be status and power differences among people in organizations.”
Authoritarians tend to place high moral value on their beliefs and are
strongly oriented towards conformity of rules and regulations. They
naturally prefer stable and structured work environments which are
governed by clean rules and procedures.
Further, they believe obedience and respect for authority and blind
acceptance of authority. These people are generally conservatives
concerned with toughness and power, are close minded and generally
less educated. But because of their belief in acceptance of authority they
make good followers, work better under directive supervision and are
more productive within authoritarian organizational structure.
2. Bureaucratic Personality
The personality of a bureaucratic person is based upon respect for
organizational rules and regulations. He is different from an authoritarian
person in respect that his acceptance of authority is not total and blind. A
person who is bureaucratic in nature values subordination, conformity to
rules, impersonal and formal relationships. These people become better
supervisors when the type of work is routine, repetitive and proceduralized
because these people are not innovative, they do not like taking risks and
feel more at ease in following established directions.
3. Machiavellianism
This personality trait of Machiavellianism also known as Mach is named
after Niccolo Machiavelli, who wrote in the 16th century on how to gain
and use power.

The characteristics of high MACH employers are as follows

(i) A Mach man is pragmatic, maintains emotional distance and believes
that ends can justify means.

(ii) A high Mach man manipulates more, wins more, are persuaded less
and persuade others more than the low machs.
(iii) High Mach people flourish when they interact face to face with others
rather than indirectly.
(iv) These people are successful when the situation has a minimum
number of rules and regulations.

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(v) High Mach man has high self-confidence and high self-esteem. They
are cool and calculating and have no hesitation using others or taking
advantage of others in order to serve their own goals.
(vi) They are not easily swayed by a sense of friendship, trust or loyalty.
They are especially successful in exploiting structured situations and
vulnerable people.
We cannot conclude that whether high mach make good employees or
not. The answer will depend upon the type of the job and whether moral
and ethical values are considered in evaluating the performance of a
person.

4. Introversion and Extroversion

These two terms are generally associated with the interpersonal
behaviour of an individual and his sociability. Extroverts are gregarious
and sociable individuals while introverts are shy, quiet and retiring. It has
been observed that introverts and extroverts’ people have different career
orientations and require different organizational environment to maximize
performance. Extroverts are more suitable for positions that require
considerable interaction with others that is why managerial positions are
dominated by extroverts.

Thus, we can say that to be an extrovert is a managerial trait to be a

successful manager. On the other hand, introvert people are more inclined
to excel at tastes that require thought and analytical skill. An extreme
introvert works best alone in a quiet office without external interruption or
influence.
5. Problem Solving Style
Individuals have their own style of solving their problems and making their
decisions and this style of their affects their personality in certain ways.
There are four problem solving styles based upon Don Hellriegll, John W.
Slocum and Richard W. Woodman “organizational behaviour”.
These styles are:
(i) Sensation Feeling Style

The people who have the sensation feeling style are dependable, friendly,
and social and they approach facts with human concerns. These people
are pragmatic, methodical and like jobs which involve human contract and
public relations. Some suitable areas of jobs for these people are teaching,
customer relations, social workers and marketing.
(ii) Sensation Thinking Style

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People with sensation thinking style are practical, logical, decisive and
sensitive to details. These people prefer bureaucratic type organizations.
They are not highly suitable for jobs requiring interpersonal relations. But
these people are more skilled in technical jobs e.g. production, accounting,
engineering and computers.
(iii) Intuition Feeling style
The persons with intuition feeling style are enthusiastic, people oriented,
charismatic and helpful. The professions which are suited to this style are
public relations, advertising, politics and personnel.
(iv) Intuition Thinking Style

These people are very creative, energetic, and ingenious and like jobs
which are challenging in terms of design and analysis such as system
design, law, research and development, top management and so on.

6. Achievement Orientation
Achievement orientation or a high need to achieve is a personality trait
which varies among different types of people and can be used to predict
certain behaviour. The people with very high achievement orientation
strive to do things in a better way. They want to feel that their success or
failure is due to their own actions. These people do not like to perform
easy tasks where there is no challenge or tasks with very high amount of
risk as the failure rate is more.
These people like to do the acts with moderate difficulties, so that they
can have a sense of achievement also and on the other hand the failure
rate is also not very high. Or in other words, achievers will like to do the
jobs where the outcome is directly attributed to their efforts and chances
of success are not same. The high achievers will do better in sports,
management and sales where there is moderate difficulty, rapid
performance feedback and direct relationship between effort and reward.

7. Locus of Control
Locus of control refers to an individual’s belief that events are either within
one’s control (Internal Locus of Control) or are determined by forces
beyond one’s control. Some people believe that they are the masters of
their own fate. Other people see themselves as pawns of fate, believing
that whatever happens to them in their lives is due to their luck or fate.
The first type is labeled as internals and the latter has been called
externals.

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Internal Locus of Control
(i) A person with a strong internal locus of control has more control over
his own behavior. He believes that he controls events concerning his own
life and his internal traits determine what happens in a given situation. He
believes that he is the master of his own density.
(ii) These people are more active in seeking more information to make
decisions. They are better at retaining the information and are less
satisfied with the amount of information they possess.

(iii) Internals are more active socially.

(iv) Internals prefer skill achievement outcomes.

(v) Internals are more likely to use personally persuasive rewards and
power bases and less likely to use coercion.
(vi)These people are more independent and less susceptible to influence
of others.

(vii) The internals prefer participative management.

(viii) Research has shown that internally oriented people hold jobs of
higher Status, advance more rapidly in their careers.
(ix) Internals take more responsibility for their health and have better
health habits. As a result, their incidents of sickness and of absenteeism
are lower.
External Locus of Control
(i) People who rate high in externality are less satisfied with their jobs,
have higher absenteeism rates, are more alienated from the work setting
and are less involved on jobs than are internals. They generally prefer
directive management.
(ii) Unlike the internals, these people prefer chance-oriented awards.
(iii) A person with a strong ‘external locus of control’ feels that outside
forces are affecting the events in his life and he is at the mercy of destiny,
chance or other people. He believes that everything will happen by the will
of God and nothing or nobody can stop it. External locus of control refers
to the individual belief of a person.

(iv) Unlike, the internals, the externals are more interested in job security
and not in advancement of careers.
(v) Whereas the internals prefer intrinsic rewards e.g. feeling of and he is
at the mercy of achievement, externals are more interested in extrinsic
awards, destiny, chance or other people. From the above mentioned traits

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of internals and controls it can be concluded that internals would be better
on sophisticated tasks, which include most managerial and professional
jobs or any other jobs which require complex information processing and
learning. In addition, they are suited to jobs requiring initiative and
independence of action. As against this, externals would do well on jobs
that are well structured and in routine jobs. The success depends heavily
on coupling with the directions given by others.

8. Self Esteem
“Self Esteem refers to the feeling of like or dislike for oneself.” “Self
Esteem is the degree of respect a person has for himself.” This trait varies
from person to person as people differ in the degree to which they like or
dislike each other. The research on self-esteem offers some interesting
insights into organization Behaviour.

A few of the research findings about self-esteem are:

(i) Self-esteem is directly related to the expectations for success. High
self-esteem people believe that they possess the ability they need to
succeed at work.
(ii) Individuals with high self-esteem will take more risks in job selection.
They are more likely to choose unconventional jobs than people with low
self-esteem.
(iii) People with low self-esteem are more susceptible to external influence
than are those with high self-esteems. Low esteems are dependent on the
receipt of positive evaluations from others. As a result they are more likely
to seek approval from others and more prone to conform to the beliefs
and behaviors of those they respect than are the high esteem.
(iv) In managerial positions, the low esteems tend to be concerned with
pleasing others and, therefore, less likely to take unpopular stands than
are high esteems.

(v) High esteems are more satisfied with their job than the low esteems.
(vi) High self-esteem people are very friendly, affectionate, find it easy to
form interpersonal attachments and find good in other people. Low self-
esteem people are usually critical of others, are generally depressed and
blame others for their own failures.
(vii) High esteem people are high performers while low esteem people
contribute to poor performance which in turn reinforces low self-esteem.

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9. Self-Monitoring
“Self-monitoring is a personality trait that measures an individual’s ability
to adjust his or her behavior to external situational factors”. Self-
monitoring is a personality trait which has recently received attention. The
research on self-monitoring is in infancy, so predictions must be guarded.
However, prime evidence suggests the following points:
(i) As self-monitoring refers to the individual’s ability to adjust his or her
Behaviour to external factors, individuals with high self-monitoring can
show considerable adaptability in adjusting their Behaviour to external,
situational factors.

(ii) High self-monitors can behave differently in different situations. They

are capable of presenting striking contradictions between their public,
personal and private selves. Low self-monitors cannot deviate their
Behaviour. They tend to display their true dispositions and attitudes in
every situation; hence, there is high behavioral consistency between who
they are and what they do.
(iii) The high self-monitors tend to pay closer attention to the Behaviour of
others and are more capable of conforming than are low self-monitors.
(iv) We can also hypothesize that high self-monitors will be more
successful in managerial positions where individuals are required to play
multiple and even contradictory roles. The high self-monitor is capable of
putting different faces for different audiences.

10. Risk Taking

The propensity of people to assume risks or avoid risks varies from person
to person depending upon the willingness of the people to take chances.
This human trait will affect the decision making capability of a manager.
This individual personality trait will determine how long will it take a person
to take a decision or how much information will be needed before he takes
a decision.
Some people are very conscious in nature, while the others are impulsive.
An impulsive person is a high risk taking manager; he will make rapid
decisions and use less information in making their choices than a very
conscious and low risk taking manager. But the research shows that the
decision accuracy is generally the same in both the groups.

Research has concluded that managers in organizations are risk aversive,

but still there are individual differences on this point. Some jobs
specifically demand high risk taking persons e.g. the job of a broker in a
brokerage firm, because in this job for effective performance rapid

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decisions are required. On the other hand, some jobs are such where risk
taking may prove a major obstacle e.g. the job of an accountant who
performs auditing activities. This job should be filled by, someone, with
low risk taking trait.

11. ‘Type A’ and ‘Type B’ Personality

People who are impatient, aggressive and highly competitive are termed
as ‘Type A’ personality. But those who are easy going, laid back and non-
competitive are termed as ‘Type B’ personality. Type ‘A’ people tend to be
very productive as they work very hard. Their negative side is that they
are very impatient, good team players, more irritable and have poor
judgment. Type ‘B’ people do better on complex tasks involving judgment
and accuracy rather than speed and hard work.
Despite Type ‘A’s hard work, the Type ‘B’ people are the ones who appear
to make it to the top. Great sales persons are usually Type A’s while senior
executives are generally Type B’s. The reason is that promotions in
corporate and professional organizations usually go to those “who are
wise rather than to those who are merely hasty, to those who are tactful,
rather than to those who are hostile and to those who are creative rather
than to those who are merely agile in competitive stride.”

12. Myers-Briggs Type Indicator (MBTI)

The personality theory proposed by Carl Jung identified the way people
preferred to perceive their environment. Almost Twenty years later, Briggs
and Myers developed the Myers – Briggs type indicator (MBTI) a
personality test that measured each of the traits in Carl Jung’s model.
MBTI is in-fact, one of the most widely used personality tests. It is used
by many organizations to select people for a particular position.
It measures how people focus their attention (extrovert or introvert),
collect information (sensing or intuition), process the same (thinking or
feeling) and finally direct themselves to the other world (judging or
perceiving) MBTI then combines the four classifications into 16
personality types.

The alphabet (E) denotes extrovert, (I) stands for introvert, (S) for sensing,
(N) for institution, (T) for thinking, (F) is feeling, (J) judging and (P)
perceiving. For example if we say marketing people tend to be ESTJ, this
means that they are extrovert, sensing, thinking and judging types. MBTI
as a test of personality type is so popular, that many organizations
encourage their employees to reveal their four-letter type so that others in
the organization can better understand their personality.

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From the above-mentioned personality traits, it becomes very clear that
understanding of personality is of immense help in the selection of right
lands of people for different jobs. Analysis of an individual’s personality
wills reveals his strong and weak points. A person may unfit for one job
but may be fit for another because job requirements may be different,
Understanding the personality will also help in designing the training
programmes for the personnel in the organization.

Personality helps the managers in understanding why do workers behave

as they do and what incentive schemes are to be designed to motivate
the workers. Further, personality has a great influence on work
performance, particularly, in a job with high human relations content,
where most of the working day is spent interacting with other people.
Personality is the major determinant of the person holding the key job.
Each man’s personality reveals itself in the way he works with his superior,
his subordinates and other people. As a result, when one person on a job
changes, everyone has to adjust to a whole series of changes in the way
the work is accomplished. All this will affect the individual performance as
well as the organizational performance.
Probably the best statement on personality was made many years ago by
Kluckhohn and Murray who said that to some extent, a person’s
personality is like all other people, like some other people’s and like no
other people.

LET US SUM UP
The behaviour of each individual is influenced by several factors. These
are classified as Environmental, Personal, Organizational and
Psychological factors. Individual behavior forms the basis of
organizational behaviour in this unit the four recognizable models of the
organizational behavior are discussed thus there is a clear understanding
on the individual and organizational behavior.
CHECK YOUR PROGRESS
Choose the Correct Answer

1. These factors include variables such as economic, social, and political

and the like. These factors are mainly external and will influence individual
behavior considerably.

a) Environmental factors b) micro factors

c) Macro economic factors d) employment factors

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 2. The ------------- is an important determinant of individual behavior. It is
a synthesis of several factors such as employment level, wage rates,
economic outlook and technological change.
a) Internal environment b) political factors

c) Economical factors d) employment factors

3 The ------------ is the rules that abide to legal proceedings and local law
a) External factors b) political factors

c) Economical factors d) legal factors

4. ---------------- provides the resources with which people work and it
affects the task that they perform.

a) Internet b) technology

c) Economical factors d) GDP

5. ------------ defines the official relationships of people in the organizations.
a) Structure b) technology

c) Budget d) employment factors

GLOSSARY

Individual Behaviour : Individual behaviour can

be defined as a mix of responses to
external and internal stimuli.

Perceptual Defense : The process by which stimuli that

are potentially threatening,
offensive, or unpleasant are either
not perceived or are distorted in
perception

Emotional Stability : A trait to handle adversity, and

remains productive and capable
throughout

SUGGESTED READINGS
1. DinkarPagare (2015) Principles of Management, Sultan Chand &
Sons, New Delhi.

141
 2. Harold Koontz, Cyril O'Donnell and Heinz Weihrich (2017)
Essentials of Management (5th Revised edition), McGraw-Hill Inc.,
US, (ISE Editions).
3. Prasad L.M. (2015) Principles and Practice of Management,
Sultan Chand & Sons, New Delhi.
4. Sherlekar S.A. &Sherlekar V.S 3rd Edition (2014) Principles of
Business Management, Himalaya Publishing House Pvt. Ltd,
Mumbai.
5. Tripathi, Sixth edition (2017) Principles of Management, Tata
McGraw Hill Education Private Limited, 7 thWest Patel Nagar, New
Delhi.
6. Tripathi, P C, Reddy, P N, 5 edition (2012) Principles of
Management, Tata McGraw Hill Education private limited, 7 th west
Patel Nagar, New Delhi.
7. https://epgp.inflibnet.ac.in/Home/ViewSubject?catid=ahLCajOqz6
/GWFCSpr/XYg==
8. http://www.simplinotes.com/determinants-of-personality/
9. https://www.youtube.com/watch?v=RoQi9Mvqip0
ANSWERS TO CHECK YOUR PROGRESS
1) a 2) c 3) b 4) b 5) a

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Unit 10

PERCEPTION AND LEARNING

Structure
Overview
Learning Objectives

10.1 Perception and Learning

10.1.1 Meaning and Definition

10.1.2 Perceptual Process

10.2 Factors Influencing Perception

10.3 Learning
10.3.1 Definition and Nature of Learning
10.4 Theories of Learning

10.5 Principles of Learning

10.6 Learning Curve

10.7 Learning and Organizational Behaviour

Let Us SumUp
Check Your Progress

Glossary
Suggested Readings
Answers to check your progress

OVERVIEW
Perception is a factor which influences the behavior of individuals. We are
constantly bombarded with various stimuli. It is surprising that we receive
some objects and reject others. It is equally surprising that an object
received is understood differently by different people. This is because of
perception, a strong component of human organism.

Learning is an important variable in human behavior. It is understood as

the modification of behavior through practice, training or experience.
Learning involves change which is permanent in nature and reflects in
behaviour. In this unit, we shall elaborate on the various aspects of
Perception and learning.

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LEARNING OBJECTIVES
After completing this unit, you should be able to,
• narrate the perceptual process and the factors influencing
perception
• explain how learning occurs
• describe the principles of learning
• establish the relationship between learning and OB.

10.1 PERCEPTION AND LEARNING

In psychology and the cognitive sciences, perception is the process of
taking in, picking, organizing, and understanding sensory information. It
includes collecting data from sense organs and interpreting it in the brain.
Learning is the process of acquiring new understanding, knowledge,
behaviours, skills, values, attitudes, and preferences. The ability to learn
is possessed by humans, animals, and some machines; there is also
evidence for some kind of learning in certain plants.
10.1.1 Meaning and Definition
In its simple sense, perception is understood as the art of seeing what is
there to be seen. But what is seen is influenced by the perceiver, the
object and the environment. A few definitions of perception are given
below:
Perception is the unique interpretation of situations by an individual.
i) Perception is the process of becoming aware of situations, of adding
meaningful associations to sensations.
ii) Perception can be defined as the process of receiving, selecting,
organizing, interpreting, checking and reacting to sensory stimuli or
data.
iii) Perception can be defined as a process by which individuals
organize and interpret their sensory impressions in order to give
meaning to their environments.
10.1.2 Perceptual Process
Perception is composed of six processes viz., receiving, selecting,
organizing, interpreting, checking and reacting to stimuli. These
processes are influenced by the perceiver and the situation. Figure (5.1)
illustrates the perceptual process:

i) Receiving Stimuli: Stimuli are received by us through the sensory

organs viz., vision, hearing, smell, touch and tasting. The stimuli may be

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external as well as internal. Examples of external stimuli are light waves,
sound waves, chemical energy and internal stimuli are passing of food
through digestive system and energy generated by muscles. Here, we
are more concerned about external stimuli.

ii) Selecting Stimuli: Though a number of stimuli clamour for our

attention we screen out most of them and deal with the important or
relevant ones. Two sets of factors govern the selection of stimuli: external
and internal.
The external factors influencing selection are nature, location, intensity,
size, contrast, repetition, motion and novelty and familiarity.

It is a fact that the nature of the object attracts attention. For instance,
pictures attract attention more readily than words.
Location: Location of the object influences selection. This fact is very well
used in advertising. The best location of a visual stimulus for attracting
attention is directly in front of the eyes in the centre of a page.
Intensity: Stimuli of higher intensity are perceived more than the objects
with low intensity. A loud noise and strong odor will be noticed more than
a soft sound and weak odour.
Size: Generally, objects of larger size attract more attention than the
smaller ones. For example, in advertising, full page spreads attracts more
attention than a few lines in the classified section.
Contrast: External stimuli which stand out against the background, or
which are not what people are expecting, will receive their attention.
Movement: A moving object always receives more attention than an object
that is standing still. Advertisers capitalize on this principle by creating
signs which incorporate moving parts.
Repetition: A repeated external stimulus is more attention drawing than a
single isolated one. That is why superiors often give directions to workers
over and over again for even simple tasks.
Novelty and Familiarity: Either a novel or a familiar external situation can
serve as an attention getter. Job rotation is an example of this principle.
Changing worker’s jobs from time to time will tend to increase the attention
they give to the task.
Internal Factors influencing selection: Internal factors influencing selection
of stimuli includes learning, psychological needs, age differences,
interests, ambivalence and paranoid perception.

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Learning: Learning has considerable influence on perception. It creates
expectancy in people. People tend to perceive what they want to perceive.
Psychological Needs: Needs play a significant role in perceptual
selectivity. Unreal things often look real because of deprived needs. A
thirsty person in a desert, for instance, gets the illusion of water.
Age Difference: Perception differs according to the age also. The
generation gap witnessed in recent years definitely contributes to different
perceptions.
Interest: Perception is unconsciously influenced by the interests of the
perceiver. For instance, an architect notices many details about a building
that he comes across only once. Someone else may pass the same
building every day for years without ever observing such details.
Ambivalence: Another factor in perceptual selection is ambivalence or
mixed feelings about a situation. For instance a young man may be
ambivalent about his finance’s virtues and short comings.
Paranoid Perception: When the person’s perception is so selective that
he can find little common ground for communication with others, he is
likely to be paranoid. It is because of this characteristic that his perceptual
field differs from that of most other persons.

iii) The Organizing Process: The phenomenon of forming bits of

information into meaningful wholes is called the perceptual organization.
There are three dimensions of the perceptual organization, viz., figurers
ground, perceptual grouping and perceptual constancy.
Figurers Ground: The figurer ground principle states that the relationship
of a target to its background influences perception.
Perceptual Grouping: The principle of perceptual grouping includes
similarity, proximity, closure and continuity.
The principle of similarity is exemplified when objects of similar shape,
size, or color tend to be grouped together. For example, in an organization
all employees who wear white-collars may be perceived as a common
group, when, in reality, each worker is a unique individual.

The principle of proximity underlines the tendency to perceive stimuli

which are near one another as belonging together. For example, several
employees in an organization may be identified as a single group because
of physical proximity.

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The principle of closure states that a person has a tendency to perceive a
whole when none exists. The person’s perceptual process will close the
gaps which are unfilled from sensory inputs.
The principle of continuity assumes that an individual tends to perceive
continuous lines or patterns.
Perceptual Constancy: It is our ability to perceive certain characteristics
of an object as remaining constant, despite variations in the stimuli that
provide us with conflicting information.
There are different aspects of constancy viz., shape constancy, size
constancy; color constancy etc.,

As per shape constancy an object appears to maintain its shape despite

marked change in the retinal image. For example, we see the top of a
glass bottle as ‘circular’ whether we view it from the side or from the top.

Size constancy refers to the fact that as an object is moved farther away
we tend to see it as more or less invariant in size.
Color constancy implies that familiar objects are perceived to be of the
same color in varied conditions.
iv) Process of Interpreting: Perception is said to have taken place only
after the data have been interpreted. The important factors that contribute
the interpretation of data are perceptual set, attribution, stereotyping, halo
effect, perceptual context, perceptual defence, implicit personality theory
and projection.

Perceptual Set: Perceptual set is the previously held beliefs about objects
that influence an individual’s perceptions of similar objects. For example,
the manager tends to interpret the behaviour of workers according to his
mental set.
Attribution: Attribution refers to the process by which the individual assigns
causes to the behaviour he conceives.

Stereotyping: Stereotyping is the tendency for a person’s perceptions of

another to be influenced by the social group to which the other belongs.
For example, the Americans are considered as materialistic, Japanese as
nationalistic, Indians as fatalistic, Germans as industrious.
Halo Effect: Halo effect refers to the tendency of perceiving people in
terms of good and bad, and ascribing all good qualities to one who is liked
and all bad qualities to another who is disliked.
Perceptual context: Perceptual context implies that the context in which
an object is placed influences perception. A verbal order, a memo, a new

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policy, a suggestion, a raised eye brow, or a pat on the back takes on
special meaning and value when placed in the context of a work
organization.
Perceptual defense: Perceptual defense implies that an individual is likely
to put a defense when confronted with conflicting, unacceptable or
threatening stimuli.
Implicit Personality Theory: Implicit Personality Theory implies that an
individual’s perceptions are influenced by his belief that certain human
traits are associated with one another. For example, the “honesty” trait is
associated with hardworking.

Projection: Projection implies that people tend to see in another person

trait that they themselves possess. For example, one who is dishonest
may be suspicious of others and may perceive dishonest intentions in
others where they do not exist.
v) Process of Checking: After data have been received and interpreted,
the perceiver tends to check whether his interpretations are right or wrong.
vi) Process of Reacting: The last phase in perception is the reaction.
The perceiver should indulge in some action in relation to his perception.
The action depends on whether the perception is favorable or unfavorable.
The action is positive when the perception is favorable. It is negative
when the perception is unfavorable.
10.2 FACTORS INFLUENCING PERCEPTION

Perception is influenced by the perceiver, the perceived and the situation.

Characteristics of the perceiver: A person’s needs, past experience,
habits, personality, values and attitudes may all influence the perception
process.
Characteristics of the perceived: The physical attributes, appearance,
and behavior of other persons in the situations also influence how that
situation is perceived. We tend to notice the physical attributes of a
person in terms of age, sex, height and weight.
Characteristics of the situation: The physical, social and organizational
settings of the situation or event in question can also influence perceptions.
Managing the Perception Process: Successful managers understand
the importance of perception as an influencing factor on behavior, and
they act accordingly. They are aware of perceptual distortions, and they
know that perceptual differences are likely to exist in any situation. As a
result, they try to make decisions and take action with a true

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understanding of the work situation as it is viewed by all persons
concerned.

A manager who is skilled in the perception process will –

i) Have a high level of self-awareness

ii) Seek information from various sources to confirm or disconfirm personal

impressions of a decision situation.
iii) Be empathetic – that is, be able to see a situation as it is perceived by
other people.
iv)Influence perceptions of other people when they are drawing incorrect
or incomplete impressions of events in the work setting.

v) Avoid common perceptual distortions that bias our views of people and
situation.
VI) Avoid inappropriate attributions.
10.3 LEARNING
Learning involves change, although the change may be for good or bad
from an organization's point of view.

10.3.1 Definition and Nature of Learning

◼ Learning can be defined as “relatively permanent change in behavior
potentiality that results from reinforced practice or experience”.

◼ Not all changes reflect learning. To constitute learning, change

should be relatively permanent. Temporary changes may be only
reflective and fail to represent any learning.
◼ Learning is reflected in behavior. A change in an individual’s thought
process or attitudes, not accompanied by behaviour, is not learning.
◼ The change in behavior should occur as a result of experience,
practice or training.
◼ The practice or experience must be reinforced in order for learning
to occur.

◼ Learning is not confined to one’s schooling. It occurs throughout

one’s life.
10.4 THEORIES OF LEARNING

The important theories of learning are: Classical conditioning, Operant

conditioning, Cognitive and Social learning.

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i) Classical Conditioning: Ivan Pavlov, the Russian Psychologist made
significant contribution to this theory. According to him the easiest way to
understand the process of learning is the association of one event with
another desired event resulting in a behavior. He termed this phenomenon
as “Classical Conditioning”.
To substantiate classical conditioning, Pavlov conducted an experiment
on a dog and tried to relate the dog’s salivation and the ringing of a bell.
A simple surgical procedure allowed him to measure accurately the
amount of saliva secreted by the dog. When Pavlov presented the dog
with a piece of meat, the dog exhibited a noticeable increase in salivation.
When he withheld the presentation of meat and merely rang a bell, the
dog had no salivation. Then Pavlov proceeded to link the meat and the
ringing of the bell. After repeatedly hearing the bell before getting the food,
the dog began to salivate as soon as the bell rang. After a while, the dog
would salivate merely at the sound of the bell, even if no food was offered.
In effect, the dog had learnt to respond (salivate) to the stimuli (bell).
When Pavlov’s repeated presentation of this bell followed by food led the
dog to salivate in response to the bell alone, this activation was designed
as conditioned reflex, which emphasized that arousal of the reflex was
dependent upon a stimulus other than the natural one.
In an organizational setting we can see classical conditioning operating.
For example, at one manufacturing plant, every time the top executives
from the head office would make a visit, the plant management would
clean up the administrative offices and wash the windows. This went on
for years. Eventually, employees would turn on their best behavior and
look prim and proper whenever the windows were cleaned even in those
occasions when the cleaning was not paired with the visit from the top
brass. People had learnt to associate the cleaning of the windows with
the visit from the head office.
ii) Operant Conditioning: Operant conditioning implies that behavior is
a function of its consequences. Behaviour is likely to be repeated if the
consequences are favourable. Behaviour is not likely to be repeated if
the consequences are unfavorable.
The term operant indicates that the organism operates on its environment
to generate consequences. The relationships between consequence and
response summarizes quite concisely a basic learning process that
occurs over time, in which a person changes, his behavior is based on his
past experience.
One can see an illustration of operant conditioning in organizations. For
example, if a worker in a factory works hard, the manager rewards the

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worker for his hard work. The worker repeats his hard work with renewed
enthusiasm.
iii) Cognitive Theory of Learning: Cognition refers to an individual’s
thoughts, knowledge, interpretations, understandings, or ideas about
himself and his environment. Cognitive theory of learning assumes that
the organism learns the meaning of various objects and events and
learned responses depending upon the meaning assigned to stimuli.
Cognitive theorists argue that the learner forms a cognitive structure in
memory, which preserves and organises information about the various
events that occur in a learning situation. When a test is made to determine
how much has been learned, the subject must encode the test stimulus
and scan it against his memory to determine an appropriate action. What
is done will depend upon the cognitive structure retrieved from memory.
Thus the subject’s response is a decision process that varies with the
nature of the test situation and the subject’s memory for prior events.
Many motivation theories centre on the concept of cognition. Expectation,
attributions and locus of control, and goal selling are all cognitive concepts
and represent the purposefulness of organizational behaviour.
iv) Social Learning Theory: The social learning theory, also called
observational learning, stresses upon the ability of an individual to learn
by observing models – parents, teachers, peers, motion pictures, TV
artists, bosses and others. Many patterns of behaviour are learned by
watching the behaviour of others and observing its consequences for
them.
Four processes have been found to determine the influence that a model
will have on an individual. They are:
Attentional Process: People only learn from a model when they recognize
and pay attention to its critical features.

Retention Process: A model’s influence will depend on how well the

individual remembers the model’s action, even after the model is no longer
readily available.

Production Process: It involves recall of the model’s behavior's and

performing own actions and matching them with those of the model.
Reinforcement Process: Individual will be motivated to exhibit the
modeled behavior if positive incentives or rewards are provided.
Behaviors that are reinforced will be given more attention and performed
more often.

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10.5 PRINCIPLES OF LEARNING
Learning principles help, particularly a training manager, gain maximum
efficiency in a learning situation. Some important principles of learning
considered here are motivation, knowledge of results, reinforcement,
schedule of learning, whole versus part learning, learning curves and
meaningfulness of material.
i) Motivation: The concept of motivation is basic because, without
motivation learning does not take place or, at least, is not discernible.
ii) Knowledge of Results: It is generally conceded that knowledge
regarding one’s own performance is a necessary condition for learning.
Feedback about the performance will enable the learner to know where
he stands and to initiate corrective action if any deviation from the
expected goal has taken place.

iii) Reinforcement: Reinforcement refers to the consequences of

behaviour. It may be understood as anything that both increases the
strength of response and tends to induce repetitions of the behavior that
preceded the reinforcement. There are four basic forms of reinforcement
in organizations: positive reinforcement, avoidance, extinction, and
punishment.

Positive reinforcement: Positive reinforcement strengthens and

increases behavior by the presentation of desirable consequences. The
reinforcement consists of a positive experience for the individual. For
example, if an employee does something well and is complimented for it
by the boss, the probability that the employee shall repeat the behaviour
will strengthen. The main purpose of providing positive reinforcement
after the behaviour is to maintain or increase the frequency of that
behaviour.
Avoidance: Avoidance, also known as negative reinforcement, is another
means of increasing the frequency of desirable behaviour. Here, the
person is given the opportunity to avoid an unpleasant consequence. For
example, a manager may habitually criticize individuals who dress
casually. To avoid criticism, the employees may dress to suit the
manager’s demands.
Extinction: Whereas positive reinforcement and avoidance increase the
frequency of desirable behaviour, extinction decreases the frequency of
undesirable behaviour, especially behaviour that was previously rewarded.
In other words, if rewards are withdrawn for behaviors that were previously
reinforced, the behaviors probably will become less frequent and
eventually die out.

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Punishment: Punishment also tends to decrease the frequency of
undesirable behaviour. In the work place, undesirable behaviour might
include being late, stealing and the like. Examples of punishment include
verbal or written reprimands, pay cuts, layoffs and termination.

iv) Schedules of learning: Schedules of learning also influence the

learning effectiveness. It is proved that distributed or spaced practice is
superior to continuous or massed practice.

v) Whole versus part learning: The effectiveness of learning is

dependent on the fact whether learning is taking place in whole or part.
In some cases, whole learning proves to be effective and in some other
cases part learning seems to be effective.

10.6 LEARNING CURVE

Learning curve is the diagrammatic presentation of the amount learned in
relation to time. A typical learning curve will show the y-axis the amount
learnt and on the x-axis the passage of time.

Figure.10.1 learning curve

Figure 10.1 represents a generalized learning curve, which shows the
extent to which the rate of learning increases or decreases with practice.
As shown in the figure, there is an initial spurt which means at the
beginning the rate of learning is high. Many experienced trainers exploit
this initial spurt by selecting the most important items to be communicated.
At some point in the learning process there is a flattening off in terms of
the improvement, a plateau. Frequently, the process of learning is marked
by discontinuities and involves escalating from one plateau to another.
Jumping from one plateau to another is called organization of learning.
When the training session draws nearer to an end, and the subject
realizes this, there is a change
Meaningfulness of Material: A definite relationship has been
established between learning and meaningfulness of the subject learnt.
More meaningful the material, the learning proceeds

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10.7 LEARNING AND ORGANIZATIONAL BEHAVIOUR
Knowledge of learning is, vital for understanding organizational behaviour
as there is clear relationship between behavior and learning. Worker’s
skill, manager’s attitude, supervisor’s motivation, secretary’s mode of
dressing is all learned.
Management can make use of the learning theory to reduce absenteeism.
Once a hardware company used the lottery with many attractive prizes to
reduce absenteeism. Only employees with perfect attendance and no
tardiness were eligible to contest. The programme was proved to be a
success.

Organizations may also reward employees for good attendance. Learning

is useful in developing effective training programmes also.
LET US SUM UP

This unit depicts that Perception is an important factor influencing

behavior and as a process it involves steps such as receiving, selecting,
organizing, interpreting, checking and reacting. Perception is influenced
by the factors such as, perceiver, perceived and situation. Learning is yet
another variable in human behavior. There are various theories of
learning, and by adopting, good learning principles maximum efficiency
can be achieved. Learning curves indicate the amount learned in relation
to time. Knowledge of learning is vital for understanding Organizational
behavior.

CHECK YOUR PROGRESS

Choose the Correct Answer:

1. Examples of --------------- are light waves, sound waves, chemical
energy

a) External stimuli b) internal stimuli

c) Frequency d) longitudinal wave

2. ---------- are passing of food through digestive system and energy

generated by muscles.
a) Impulse b) internal stimuli

c) Energy d) selecting stimuli

3.internal stimuli and external stimuli are types of --------------

a) External stimuli b) internal stimuli

c) Receiving stimuli d) both a and b

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4. The process of screening out the most of the stimuli and dealing with
the important is called

a) scrutiny b) internal stimuli

c) Motivation d) selecting stimuli

5. -------------- is the unique interpretation of situations by an individual.

a) Structure b) technology
c) Economical factors d) Perception

GLOSSARY

Perception : The way in which something is

regarded, understood, or
interpreted.

Stimuli : A thing or event that evokes a

specific functional reaction in an
organ or tissue.

Ambivalence : The state of having mixed feelings

or contradictory ideas about
something or someone.

SUGGESTED READINGS
1. DinkarPagare (2015) Principles of Management, Sultan Chand &
Sons, New Delhi.
2. Harold Koontz, Cyril O'Donnell and Heinz Weihrich (2017)
Essentials of Management (5th Revised edition), McGraw-Hill Inc.,
US, (ISE Editions).
3. Prasad L.M. (2015) Principles and Practice of Management,
Sultan Chand & Sons, New Delhi.
4. Sherlekar S.A. &Sherlekar V.S 3rd Edition (2014) Principles of
Business Management, Himalaya Publishing House Pvt. Ltd,
Mumbai.
5. Tripathi, Sixth edition (30 Private Limited, 7 thWest Patel Nagar,
New Delhi.
6. Tripathi, P C, Reddy, P N, 5 edition (2012) Principles of
Management, Tata McGraw Hill Education private limited, 7 th west
Patel Nagar, New Delhi.

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 7. https://epgp.inflibnet.ac.in/Home/ViewSubject?catid=ahLCajOqz6
/GWFCSpr/XYg==.
8. https://openstax.org/books/organizational-behavior/pages/4-2-
reinforcement-and-behavioral-
change#:~:text=From%20a%20managerial%20standpoint%2C%
20several,%3B%20and%20(4)%20punishment.

ANSWERS TO CHECK YOUR PROGRESS

1) a 2) b 3) d 4) d 5) d

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Unit 11

MOTIVATION
STRUCTURE
Overview
Learning Objectives

11.1 Definition and Meaning of Motivation

11.2 Theories of Motivation

11.3 Motivational Techniques

Let Us Sum Up

Check Your Progress

Glossary
Suggested Readings

Answers to check your progress

OVERVIEW

Motivation to work is a human state where competence to work and will

to work fuse together. In the absence of will, competence alone does not
result in performance. Similarly, in the absence of competence, will alone
does not produce results. Motivation provides for optimum use of human
resources in an organization through the involvement of employees and
determines the performance of the unit organization.

LEARNING OBJECTIVES
After completing this unit, you should be able to,
• explain the nature and importance of motivation

• describe the different theories of motivation and their applications

• list various monetary and non-monetary motivational methods
11.1 DEFINITION AND MEANING OF MOTIVATION

Motivation is a process that starts with a psychological or physiological

deficiency or need that activates Behaviour or a drive that is aimed at a
goal or incentive.

The source of motivation is in the needs resting in the personality of the

person. Needs are like a bundle of energy which create tensions that are

157
modified by the person’s culture or habits to arouse certain wants or
expectations. These wants are interpreted in terms of positive or negative
incentives and the person’s perception of the environment in order to
produce a certain response or action.

There are various ways of classifying needs. A simple but significant

classification is;
i) Basic Physiological Needs or Primary Needs

ii) Social and Psychological Needs or Secondary Needs.

Some of the Physiological needs are food, water, sex, sleep, air to breathe
and temperature within tolerable limits. These needs arise out of the basic
physiology of life, and are important for survival and preservation of the
species.
Secondary needs represent needs of the mind and spirit, rather than of
the body. Some of the secondary needs are rivalry, self-esteem, sense of
duty, self-assertion, sense of belonging, independence, giving and
receiving affection etc.,
People vary in their secondary needs much more than primary
physiological needs. The secondary needs are the ones which complicate
the motivational efforts of workers, supervisors and managers in
organizations.
If the varied needs are understood properly, motivation is much easier.
11.2 THEORIES OF MOTIVATION

There are several approaches to the study of motivation. A perusal of the

theories will help us understand the nature of motivation better. The
following are a few important theories of motivation:
i) Maslow’s Need Hierarchy theory

ii) Herzberg’s two-factor theory

iii) Alderfer’s Existence, Relatedness and Growth theory

iv) Achievement Motivation theory

v) Vroom’s Expectancy Model
vi) Adam’s Equity theory and

vii) Porter’s Performance and Satisfaction Model.

Maslow’s Need hierarchy theory: Maslow has presented a need priority
of five levels. These are Basic Physiological needs, Safety and Security,
Belonging and Social needs, Esteem and Status and Self actualisation.

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 Figure. 11.1 Maslow’s Need hierarchy theory

According to Maslow,
1. People want beings whose needs can influence their behaviour. Only
unsatisfied needs can influence Behaviour, satisfied needs do not act as
motivators.
2. Since needs are many, they are arranged in an order of importance
or hierarchy, from the basic to the complex.
3. Every person advances to the next level of hierarchy, or from the basic
to the complex, only when the lower level need is at least minimally
satisfied.
Further up the hierarchy the person is able to go, the more individuality,
humanness and psychological he will display.
Physiological needs: The most basic, powerful, and obvious of all human
needs is the need for physical survival. Foods, drink, oxygen, sleep, sex,
protection from extreme temperature are the examples of physiological
needs. The person who fails to satisfy this basic level of needs first won’t
be around long enough to attempt satisfaction of the other higher need
levels.
In the organizational context, physiological needs are represented by
employees’ concern for salary and basic working conditions. It is the duty

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of managers to ensure that these needs of the employees are met so that
they can be motivated to strive for gratification of higher order needs.
Safety needs: Once physiological needs are met, another set of motives,
called safety or security needs, become motivators.

The primary motivating force here is to ensure a reasonable degree of

continuity, order, structure and predictability in one’s environment. The
preference for secured income, the acquisition of insurance and owning
one’s own house may be regarded as motivated in part by safety seeking.
In the organizational context, factors such as job security, salary increases,
safe working conditions, unionization and lobbying for protective
legislation are a few examples of security needs. Pension schemes,
group insurance, provident fund, gratuity, grievance procedure etc.,
ensure safety of workers.

Belonging and love needs: These needs arise when physiological and
safety needs are satisfied. An individual motivated on this level longs for
affectionate relationship with others, namely, for a place in his or her family,
and reference groups.
In the organizational context, social needs represent the need for a
compatible work group, peer acceptance, professional friendship and
friendly supervision.
Self-esteem needs: Maslow classified these needs into two subsidiary
sets: Self-respect and esteem from others. Self-respect includes desire
for competence, confidence, personal strength, adequacy, achievement,
independence and freedom. Esteem from others includes prestige,
recognition, acceptance, attention, status, reputation and appreciation.
In the work place, self esteem needs correspond to job title, merit pay
increase, peer/supervisory recognition, challenging work, responsibility
and publicity in company publications.

Self-actualization needs: Finally, if all the four level needs are satisfied the
need for self actualization comes to the fore. Maslow characterized self
actualization as the desire to become everything that one is capable of
becoming. To self actualize is to become the total kind of person that one
wants to become to reach the peak of one’s potential. Though the impulse
to realize one’s potential is natural and necessary, only a few, usually the
gifted, ever do so. Maslow himself estimated that less than one percent
of the population fulfills the needs for self-actualizations.

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In an organization, self-actualization needs correlate to desire for
excelling oneself in one’s job, advancing, an important idea, successfully
managing a unit and the like.
Evaluation of Maslow’s Needs Hierarchy Theory: This theory offers
some useful ideas for helping managers think about motivating their
employees. It accounts for both interpersonal and intrapersonal variations
in human Behaviour. This model presents motivation as a constantly
changing force, expressing itself through the constant striving for
fulfillment of new and higher levels of needs. This theory deserves
appreciation for its simplicity, commonness, humanness and intuitiveness.

This theory is also criticized on the following counts:

It is said that Maslow’s theory is not a theory of work motivation. Maslow,
himself did not intend that his need hierarchy be directly applied to work
motivation. Second, the hierarchy of needs simply does not exist. At all
levels needs are present at a given time. An individual motivated by self-
actualizations needs, for example, cannot afford to forget his food. Third,
assuming hierarchy does exist among needs, it may not be the same in
all countries. There may be variations within countries and among
individuals also. Fourth, his assumption about psychological health is not
acceptable to many. Contrary to Maslow’s belief, many individuals may
stay content with lower level needs. Fifth, it has also been pointed out that
managers will not have the time to leisurely diagnose where every
employee is in Maslow’s hierarchy.
In spite of its serious limitations, the need hierarchy theory is important
because of its contribution in terms of making management reward
diverse needs of humans at work.
ii) Motivation – Hygiene theory: This theory of motivation was
propounded by the psychologist Frederick Herzberg. This theory is also
known as the Two-Factor theory or Dual factor theory.
Herzberg and his associates conducted a survey with accountants and
engineers and the respondents were essentially asked two questions:

1) When did you feel particularly good about your job; and
2) When did you feel exceptionally bad about your job.
Responses obtained from this critical incident method were interesting. It
was revealed that factors which made respondents feel good were totally
different from those which made them feel bad. Certain characteristics
tend to be constantly related to job satisfaction and others to job –
dissatisfaction.

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 Figure. 11.2 Motivation – Hygiene theory

Factors on the job that led to extreme dissatisfaction:

(Known as, Dissatisfiers, Hygiene factors, Maintenance factors or Job

context factors)
(i) Company Policy and Administration
(ii) Supervision
(iii) Work conditions
(iv) Salary

(v) Relationship with peers

(vi) Personal life

(vii) Relationship with subordinates

(viii) Status
(ix) Security

Factors on the job that led to extreme satisfaction:

(Known as, Motivators, Satisfiers, or Job content factors)

(i) Achievement

(ii) Recognition

(iii) Work itself

(iv) Responsibility

(iv) Advancement

(v) Growth

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According to Herzberg, satisfaction is affected by motivators and
dissatisfaction by hygiene factors. This is the key idea of Herzberg, and
it has important implications for managers.
To achieve motivation, managers should cope with both satisfiers and
dissatisfies. By improving hygiene factors, dissatisfaction is removed
from the minds of employees. A favorable frame of mind is now created
for motivation. Provide satisfiers, motivation will then take place.
Managers should be realistic not to expect motivation by only improving
the ‘hygienic’ environment.
This is the crux of the two-factor theory of motivation.

Evaluation of the two-factor theory: The theory is not really a theory of

motivation. It provides an explanation of job satisfaction. It also ignores
situational variables. There has been a tremendous emphasis on
motivators and the importance of hygiene factors has been ignored.
In spite of these drawbacks, one cannot ignore the fact that this theory
had impact on stimulating thought, research and experimentation on the
topic of motivation at work. This theory also offered specific action
recommendation for managers to improve motivational levels. According
to Herzberg, it is the content factors, and not money, that are primarily
related to work motivation.
iii) ERG Theory: The E, R and G of the ERG theory stand for existence,
relatedness and growth – the three sets of needs which are the focus of
this alternative theory of human needs in organizations.
Existence needs, perceived as necessary for basic human existence,
roughly correspond to the physiological and security needs of Maslow’s
hierarchy. Relatedness needs – the desire we have for maintaining
interpersonal relations are similar to Maslow’s belongingness and esteem
needs. Finally, an intrinsic desire for personal development – growth
needs, is analogous to Maslow’s needs for self-esteem and self-
actualization.
ERG theory, developed by Alderfer, argues that people do have needs
and those needs are arranged in a hierarchy and those needs are
important determinants of human behaviour. Alderfer suggests that more
than one need may be operating at the same time and there does not exist
a rigid hierarchy where a lower need must be substantially gratified before
one can move on.
A person can be working on growth even though existence or relatedness
needs are unsatisfied. He also postulates that when a higher level need

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is frustrated, the individual’s desire to increase a lower level need takes
place. Inability to satisfy a need for social interaction, for instance, might
increase the desire for money or for better working conditions. Thus, the
ERG theory contains a frustration – regression dimension. Frustration at
higher level can lead of regression to a lower level.
Evaluation of ERG Theory: The ERG theory represents a more valid
version of the need hierarchy. This theory emphasizes that variables such
as education, family background and cultural environment can alter the
importance or driving force that a group of needs holds for a particular
individual. However, this theory does not offer clear cut guidelines
regarding motivation.
iv) Achievement Motivation Theory: This theory has been advocated
by David. C. McClelland and his associates. McClell and believes that
there are three needs that motivate human behaviour viz., Power,
Affiliation and Achievement. He suggests that each person has a need
for all the three, but that people differ in the degree to which the various
needs motivate their behaviour.

Figure.11.3 Achievement Motivation Theory

A brief description of the three needs follows:

Need for Achievement (n Ach): Employees with a high need for

achievement derive satisfaction from achieving goals. Succeeding in a
task is important to the high achiever. High achievers are not motivated
by money per se; money is their indicator of achievement. They prefer
immediate feedback on their performance, and they generally undertake
tasks of moderate difficulty rather than those that are either very easy or
very difficult. They also prefer to work independently, so that successful
task performance (or failure) can be related to their own efforts rather than
to someone else’s. McClelland believes that the need for achievement
can be learned.

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Need for Power (n Pow): Employees exhibiting the needs for power derive
satisfaction from the ability to control others. Individuals with a high n Pow
derive satisfaction from being in positions of influence and control.
Organizations that foster the power motive tend to attract individuals with
a high need for power (Example: Military and Political organization).
Need for Affiliation (n Aff): Individuals exhibiting this need as a
dominant motive derive satisfaction from social and interpersonal
activities. There is a need to form strong inter-personalities and to ‘get
close’ to people psychologically.
Evaluation of the Theory: McClelland’s work seems to have
numerous practical applications. He highlights the importance of
matching the individual and the job. He suggests that managers can, to
some extent, raise the achievement need level of subordinates by
creating the proper work environment.
This theory is also criticized on a few counts. The critics question whether
motive can be taught to adults.
v) Vroom’s Expectancy Model: The expectancy model goes by several
other names such as Instrumentality theory, Path-goal theory and Valence
– Instrumentality – Expectancy (VIE) theory.

Expectancy theory, developed by Victor H. Vroom, postulates that

motivation depends on the strength of an expectation that the act will be
followed by a given outcome and on the preference of an individual for
that outcome.

Figure 11.4 Vroom’s Expectancy Model

There are three variables viz., Valence, Instrumentality, and Expectation,
in the model which need elaboration.
Valence: Valence refers to the degree of desirability of outcomes as seen
by the individual. In other words, valence refers to the strength of an
individual’s preference for a particular outcome. Valence may vary from -
1 to +1. Valence is negative if the individual prefers not attaining an
outcome compared with attaining it. Valence is O, if he is indifferent to the
outcome and valence is +1 if he has strong preference to the outcome. It

165
goes without saying that the valence of the individual must be positive if
motivation were to take place.
Instrumentality: Instrumentality refers to the belief that the first level
outcome will lead to the second level outcome. For example, the person
would be motivated towards superior performance because of the desire
to be promoted. The superior performance (first level outcome) is seen
as being instrumental in obtaining promotion (second level outcome). The
value of instrumentality varies from 0 to 1. If an employee sees that
promotions are based on performance, instrumentality will be rated high.
A low estimate of instrumentality will be made if the employee fails to see
such linkage between performance and reward.
Expectancy: If refers to the belief that an effort will lead to completion of a
task. Expectancies are stated as probabilities - the employee’s estimate
of the degree to which performance will be determined by the amount of
effort expanded. Since expectancy is the probability of connection
between effort and performance, its value may range from 0 to 1. If an
employee sees no chance that effort will lead to the desired performance,
the expectancy is 0. On the other hand, if he is confident that the task will
be completed, the expectancy has a value of 1. Normally, the
expectancies of employees will lie between these two extremes. Like
valence, expectancy must also be high for motivation to take place.
In summary, according to the expectancy theory,

Motivation = Expectancy x Instrumentality x Valence.

The above equation states that motivation to work results from
expectancy time’s instrumentality time’s valence. This multiplicative
relationship means that the motivational appeal of a given work path is
drastically reduced whenever one or more of expectancy, instrumentality
or valence approaches the value of zero. Conversely, for a given reward
to have a high and positive motivational impact as a work outcome, the
expectancy, instrumentality and valence associated with the reward must
all be high and positive.

Evaluation of the Expectancy Model: Expectancy theory helps

managers see beyond the Maslow and Herzberg models. It implies that
managers must make it possible for an employee to see that effort can
result in appropriate need satisfying rewards. It also guides managers in
designing work systems, management by objective and goal setting.
vi) Equity theory: Equity theory, developed by Adam, is based on the
assumption that individuals are motivated by their desire to be equitably
treated in their work relationship. The theory purposes that the motivation

166
to act develops after the person compares input/outcomes with the
identical ratio of comparison with others. Inequity is defined as the
perception that person’s job inputs/outcomes ratio is not equal to the
inputs/outcomes ratio of the other.

The basic equity proposal assumes that, upon feeling inequity, the person
is motivated to reduce it. Further, the greater the felt inequity, the greater
the motivation to reduce it. The equity theory may be summarized as
follows:

Individual rewards Compared Other’s rewards

----------------------- <—————> ---------------------

Individual Inputs with Other’s Inputs

Formula is an expanded explanation of the component of equity.

It is not that the person feeling inequity alone gets motivated to restore
equity. The person with a feeling of equity also gets motivated but to
maintain the current situation.
Evaluation of the theory: This theory recognizes the influence of social
comparison processes on motivation and adopts a realistic approach.
However this theory is criticized on various counts. There is ambiguity
regarding input, output, comparison, etc., Regardless of the criticism, the
equity theory continues to offer us some important insights into employee
motivation.
vii) Porter and Lawler’s Model: Porter and Lawler theory states that
motivation, performance and satisfaction are all separate variables and
relate in ways different from what was traditionally assumed.
Evaluation of the theory: The model has definitely made a significant
contribution to the better understanding of work motivation and the
relationship between performance and satisfaction, but to date, it has not
made much impact on the actual practice of human resource
management.

11.3 MOTIVATIONAL TECHNIQUES

Men work for various reasons, sometimes for a combination of reasons
and sometimes for different reasons at different times. It is important for
the supervisors and managers to know the needs and expectations of the
employees and to take timely action on them if they want to maintain
motivation and involvement in the work.

167
The following are some of the financial and non-financial rewards used to
motivate the employees:

i) Wage incentives
A variety of wage incentives are available to the management for offer to
their employees. The more common systems are: Straight time payment,
piece rates, bonus systems, profit sharing and numerous formula rates
based on production above a specified standard.

ii) Non-Wage Incentives

Competition and Achievement Orientation: Competition increases
speed of performance and individual competition is more effective than
competition between groups. Also competition among persons of nearly
equal skills produces better results than unequal skills. Competition as
incentives takes various forms in the Indian Industry. Contests are one
form of incentive of competition.
Praise and Punishment: The incentives of praise and punishment are
crucial to Indian business and industry as they directly relate to the
intricately connected issue of motivation of workers on one hand and that
of discipline on the other.
Knowledge of Results: Periodic knowledge of results psychologically
induces motivation and self-control in the person or a group of persons
engaged in performing a task. It also helps the supervisor to effectively
control and direct the performance by taking timely corrective actions.

Participation: Various studies have shown the effectiveness of

participation as an incentive to workers for increased and improved
performance. Participation incorporates the strongest social motive of
self-respect and social approval and the egoistic motive of self-expression.
Suggestion Systems: Suggestion system is an incentive which provides
the opportunity to satisfy self-expression needs. For the management it
may provide valuable suggestions from employees.
Fringe Benefits: The role of non-wage benefits like housing, subsidised
canteens, schools and hospitals are important factors in increasing labour
productivity.

LET US SUM UP
This unit proves the essentiality of motivation in an organization.
Motivation of the work force in the organization is of paramount
importance. The human needs form the basis of motivation. A number of
theories on motivation help us in understanding its various dimensions.

168
Both financial and non-financial rewards are used to motivate the
employees.

CHECK YOUR PROGRESS

Choose the Correct Answer:

1. --------------- developed by Adam

a) Equity theory b) need hierarchy theory
c) Game theory d) ERG theory

2. -------------- was developed by Maslow

a) Equity theory b) need hierarchy theory

c) Expectancy theory d) ERG theory

3. The ---------------theory was developed by Herzberg

a) Equity theory b) need hierarchy theory

c) Expectancy theory d) XY theory
4. The ---------------theory was developed by Alderfer

a) Equity theory b) need hierarchy theory

c) Expectancy theory d) ERG theory

5. The ---------------- was developed by Vroom

a) Equity theory b) need hierarchy theory
c) Expectancy theory d) ERG theory

GLOSSARY

Primary needs : The way in which something is

regarded, understood, or
interpreted.

Fringe benefits : A thing or event that evokes a

specific functional reaction in an
organ or tissue.

Secondary needs : The state of having mixed feelings

or contradictory ideas about
something or someone.

169
 Self-esteem : The process of encouraging or
establishing a belief or pattern of
behaviour.

Extrinsic rewards : The action of regarding something

as being caused by a person or
thing.

SUGGESTED READINGS

1. DinkarPagare (2015) Principles of Management, Sultan Chand &

Sons, New Delhi.
2. Harold Koontz, Cyril O'Donnell and Heinz Weihrich (2017)
Essentials of Management (5th Revised edition), McGraw-Hill Inc.,
US, (ISE Editions).
3. Prasad L.M. (2015) Principles and Practice of Management,
Sultan Chand & Sons, New Delhi.
4. Sherlekar S.A. & Sherlekar V.S 3rd Edition (2014) Principles of
Business Management, Himalaya Publishing House Pvt. Ltd,
Mumbai.
5. Tripathi, Sixth edition (2017) Principles of Management, Tata
McGraw Hill Education Private Limited, 7 thWest Patel Nagar, New
Delhi.
6. Tripathi, P C, Reddy, P N, 5 edition (2012) Principles of
Management, Tata McGraw Hill Education private limited, 7 th west
Patel Nagar, New Delhi.
7. https://epgp.inflibnet.ac.in/Home/ViewSubject?catid=ahLCajOqz6
/GWFCSpr/XYg==
8. https://www.yourarticlelibrary.com/employee-management/top-7-
non-financial-incentives-for-motivating-employees/34675
ANSWERS TO CHECK YOUR PROGRESS
1) a 2) b 3) d 4) d 5) c

170
Unit 12

ATTITUDES AND JOB SATISFACTION

STRUCTURE
Overview
Learning Objectives

12.1 Definition and Meaning

12.2 Formation of Attitudes

12.3 Types of Attitudes

12.4 Functions of Attitudes

12.5 Changing Attitudes

12.6 Job Satisfaction
12.6.1 Definition and Meaning

12.6.2 Consequences of Job Satisfaction

Let Us Sum Up

Check Your Progress

Glossary
Suggested Readings

Answers to check your progress

OVERVIEW
The terms job satisfaction and job attitudes are typically used
interchangeably. Both refer to effective orientation on the part of
individuals towards their work roles which they are presently occupying.
Positive attitudes towards the job are conceptually equivalent to job
satisfaction and negative attitudes towards the job indicate job
dissatisfaction. Attitude refers to predispositions to respond. Job
satisfaction, on the other hand, relates to performance factors.

LEARNING OBJECTIVES

After completing this unit, you should be able to,

• describe the term attitude

• explain the formation of attitudes

• discuss the types of attitude

171
 • elaborate the concept of job satisfaction.
12.1 DEFINITION AND MEANING
By attitudes we mean the beliefs, feelings and action tendencies of an
individual or group of individuals, towards objects, ideas and people.
Quite often persons and objects or ideas become associated in the minds
of individuals and as a result attitudes become multidimensional and
complex.

The following are the features of attitude:

i. It refers to feelings and beliefs of individuals or group of individuals.

ii. The feelings and beliefs are directed towards other people, objects or
ideas.

iii. Attitudes tend to result in behaviors or action.

iv. Attitudes can fall anywhere along a continuum from very favorable to
very unfavorable condition.

v. Attitudes endure.
vi. All people, irrespective of their status or intelligence, hold attitudes.

12.2 FORMATION OF ATTITUDES

The most important sources of acquiring attitudes are direct experience
with the object, association, family, neighborhood, economic and social
positions and mass communication.
i) Direct experience with the object: Attitudes can develop from a
personally rewarding or punishing experience with an object. Employees
form attitudes about present jobs on their previous experience. Attitudes
formed on experience are difficult to change.
ii) Classical conditioning and attitude: People develop associations
between various objects and the emotional reactions that accompany
them. This is due to classical conditioning. Both positive and negative
associations can develop through classical conditioning.

For example one may have a positive attitude towards a particular

perfume because a favorite model wears it. Similarly, many soldiers
stationed in the Persian Gulf during the war with Iraq formed a negative
attitude towards sand as they hated to sit on the sandy beach during the
hard fought war.
iii) Operant conditioning and attitude acquisition: Attitudes that are
reinforced, either verbally or non-verbally tend to be maintained.

172
Conversely, a person who states an attitude that elicits ridicule from others
may modify or abandon the attitude.
iv) Vicarious learning: In vicarious learning a person learns something
through the observance of others. It is through this process children pick
up prejudices of their parents. For example, even if they have never met
a blind person, children whose parents say that ‘blind people are
incompetent’ may adopt such attitudes themselves.

We also learn attitudes vicariously through television, films and other

media.
v) Family and Peer Groups: A person may learn attitudes through
imitation of parents. Similarly, attitudes are acquired from peer groups in
colleges and organizations.
vi) Neighborhoods: The neighborhood we live in also influences our
attitude. It has a certain structure in terms of culture, religious groupings
and ethnic differences. The neighbors tolerate, condone or deny certain
attitude and Behaviour and we may accept the move and conform or we
deny and rebel.
vii) Economic status and occupations: Our economic and occupational
positions also contribute to attitude formation. They determine, in part,
our attitudes towards union and management and our belief that certain
laws are ‘good’ or ‘bad’.
viii) Mass Communication: All varieties of mass communication –
television, radio, newspapers, and magazines – feed their audiences
large quantities of information. The audiences select the specific form of
mass communication that best reflects its attitudes on various subjects.
The item of interest includes sex and teenagers, crime, divorce, politics,
religion and the like.
12.3 TYPES OF ATTITUDES

Individuals possess hundreds of attitudes. But in organizations, there are

three work related attitudes. They are Job Satisfaction, Job involvement
and organizational commitment.

i) Job Satisfaction: It refers to one’s feeling towards one’s job. An

individual having satisfaction is said to possess a positive attitude towards
the job. Conversely, a dissatisfied person will have a negative attitude
towards his or her job.
ii) Job involvement: It refers to the degree with which an individual
identifies psychologically with his or her job and perceives his or her

173
perceived performance level as important to self-worth. High degree of
job involvement results in fewer absences and lower resignation rates.
iii) Organizational commitment: It is understood as one’s identification
with his or her organization and feels proud of being its employee. It
implies an employee’s identification with a particular organization and its
goals.
12.4 FUNCTIONS OF ATTITUDES

Attitudes serve four important functions viz., (i) Utilitarian (ii) Ego
defensive (iii) Value expressive and (iv) Knowledge.
i) Utilitarian: An attitude may develop because either the attitude or the
object of the attitude is instrumental in helping one to obtain rewards or
avoid punishments.
ii) Ego defensive function: People often form and maintain certain
attitudes to protect their own self-images. For example, workers may feel
threatened by the employment of female workers in their organization.
These threatened workers may develop prejudices against the new
workers. They may develop an attitude that such new comers are less
qualified and they might mistreat these workers. Such an ego defensive
attitude is formed and used to cope with a feeling of guilt or threat.

iii) Value expressive function: Our attitude reflects our value systems.
And our value expressive attitudes are closely related to our self-concept.
For one whose central value is freedom, the individual may express very
positive attitudes towards decentralization of authority in the organization,
flexible work schedules and relaxation of dress standards.
iv) Knowledge function: Attitude is often substituted for knowledge. In
the absence of knowledge, we use our attitude to organize and make
sense of the perceived object or person. For example, people who are
not familiar with nuclear energy, may develop an attitude that it is
dangerous and should not be used as an energy source.
Knowledge about attitude functions helps the managers to understand
and predict how a certain person is likely to behave. It helps the manager
change the attitude of another person. He can do this by changing the
conditions that sustain the attitude.
12.5 CHANGING ATTITUDES

Attitudes of employees can be changed. A few important ways of

changing attitudes have been examined here:

174
i) Providing new information: New information will help change attitudes.
Negative attitudes are mainly formed owing to lack of or insufficient
information. Hence by providing more information and new information
attitude of the people can be changed.

ii) Use of fear: Fear can change attitude. However the change depends
on the degree of fear. If low levels of fear arousal are used, people often
ignore them. If moderate levels of fear arousal are used, people often
become aware of the situation and will change their attitude. However, if
high degrees of fear arousal are used, people often reject the message,
because it is too threatening and thus not believable.

iii) Influence of friends or peers: Change of attitudes can come about

through persuasion of friends or peers. Credibility of the others, specially
peers, is important to effect change. Peers with high credibility shall
exercise significant influence on change.
iv) The co-opting approach: This means taking people who are
dissatisfied with a situation and getting them involved in improving things.
12.6 JOB SATISFACTION

12.6.1 Definition and Meaning

Job satisfaction is a set of favorable or unfavorable feelings with which
employees view their work.
It is also defined as a pleasurable or positive emotional state resulting
from the appraisal of one’s job or job experience.

There are three important dimensions to job satisfaction.

i) Job Satisfaction refers to one’s feeling towards one’s job. It can only be
inferred but not seen.
ii) It is often determined by how well outcomes meet or exceed expectation.

iii) Job Satisfaction and Job Attitudes are typically used interchangeably.
12.6.2 Consequences of Job Satisfaction

High satisfaction may lead to improved productivity, increased turnover,

improved attendance, reduced accidents, less job stress and lower
unionization.

i) Productivity: The relationship between satisfaction and productivity is

not definitely established. The consensus is that in the long-run job
satisfaction leads to increased productivity. However, there is more
evidence to suggest that job performance leads to job satisfaction and not
the other way round.

175
An employee who performs well in his job gets both intrinsic and extrinsic
rewards which will lead to his satisfaction A poor performer will feel worse
about his incompetence and will receive fewer rewards. He will be less
satisfied with his work experiences.

ii) Job Satisfaction and Employee Turnover: The connection between

job satisfaction and employee turnover is established beyond doubt. It
has been demonstrated that workers who have relatively low levels of job
satisfaction are the most likely to quit their jobs and that organizational
units with the lowest average satisfaction levels tend to have the highest
turnover rates.

iii) Satisfaction and Absences: Correlation of satisfaction to

absenteeism is also proved conclusively. Absenteeism is high when
satisfaction is low. It is also important to remember that while high job-
satisfaction will not necessarily result in low absenteeism, low satisfaction
is likely to bring about high absenteeism.
iv) Satisfaction and Safety: Poor safety practices are a negative
consequence of low satisfaction levels. When people are discouraged
about their jobs, company and supervisors, they are more liable to
experience accidents. An underlying reason for such accidents is that
discouragement may take one’s attention away from the task at hand.
v) Satisfaction and Job Stress: Chronic job dissatisfaction is a powerful
source of job stress. Prolonged stress can cause the employee serious
ailments such as heart diseases, ulcer, blurred vision, lower back pain,
dermatitis and muscle aches. An employee trapped in a dissatisfying job
may withdraw by such means as high absenteeism and tardiness; or the
employee may quit.
All things considered, practicing managers and organizational Behaviour
researchers would agree that job satisfaction is important to an
organization.
LET US SUM UP
This unit explained that Motivation of the work force in the organization is
of paramount importance. The human needs form the basis of motivation.
A number of theories on motivation help us in understanding its various
dimensions. Both financial and non-financial rewards are used to
motivate the employees. Job Satisfaction refers to one’s feeling towards
one’s job and its impact on productivity. Factors such as wages,
supervision, working conditions, etc., influence job satisfaction.

176
CHECK YOUR PROGRESS
Choose the Correct Answer
1. --------------- is a set of favorable or unfavorable feelings with which
employees view their work.

a) Job satisfaction b) contentment

c) Job promotion d) Job specification
2. ----------refers to the degree with which an individual identifies
psychologically with his or her job and perceives his or her perceived
performance level as important to self-worth.
a) Job involvement b) job rotation

c) Retrenchment d) Job specification

3. ---------------- refers to one’s feeling towards one’s job. An individual
having satisfaction is said to possess a positive attitude towards the job.
a) Job satisfaction b) lay off

c) job elimination d) Job specification

4. ------------ is understood as one’s identification with his or her
organization and feels proud of being its employee
a) Job enrichment b) job rotation
c) Organization commitment d) Job enlargement

5. -------------- refers to one’s feeling towards one’s job. It can only be

inferred but not seen.
a) Job satisfaction b) perception
c) career development d) Job specification

GLOSSARY

Attitude : Attitude is a way of feeling or

acting toward a person, thing or
situation.

Acquisition : An asset or object bought or

obtained.

Job Satisfaction : A feeling of fulfilment or

enjoyment that a person derives
from their job

177
SUGGESTED READINGS
1. DinkarPagare (2015) Principles of Management, Sultan Chand &
Sons, New Delhi.
2. Harold Koontz, Cyril O'Donnell and Heinz Weihrich (2017)
Essentials of Management (5th Revised edition), McGraw-Hill Inc.,
US, (ISE Editions).
3. Prasad L.M. (2015) Principles and Practice of Management,
Sultan Chand & Sons, New Delhi.
4. Sherlekar S.A. &Sherlekar V.S 3rd Edition (2014) Principles of
Business Management, Himalaya Publishing House Pvt. Ltd,
Mumbai.
5. Tripathi, Sixth edition (30 June 2017) Principles of Management,
Tata McGraw Hill Education Private Limited, 7 thWest Patel Nagar,
New Delhi.
6. Tripathi, P C, Reddy, P N, 5 edition (27 January 2012) Principles
of Management, Tata McGraw Hill Education private limited, 7 th
west Patel Nagar, New Delhi.
7. https://epgp.inflibnet.ac.in/Home/ViewSubject?catid=ahLCajOqz6
/GWFCSpr/XYg==
8. https://assignmentpoint.com/positive-and-negative-effects-on-
job-satisfaction/
ANSWERS TO CHECK YOUR PROGRESS

1) a 2) a 3) a 4) c 5) a

178
 BLOCK 4

GROUP BEHAVIOUR AND LEADERSHIP

Unit 13 : Group behavior

Unit 14 : Team development

Unit 15 : Leadership

179
Unit 13

GROUP BEHAVIOUR
STRUCTURE
Overview
Learning Objectives

13.1 Introduction

13.1.1 Meaning of Group Behaviour

13.1.2 Determinants of Group Behaviour

13.1.3 Classification of Groups

13.2 Stages of Group Development

13.3 Group Structure
13.4 Group Dynamics

13.5 Group Characteristics

13.6 Group Decision Making

Let Us Sum Up
Check Your Progress
Glossary

Suggested Readings
Answers to check your progress

OVERVIEW

A group can be defined as two or more interacting and interdependent

individuals who come together to achieve particular objectives. A group
behavior can be stated as a course of action a group takes as a family. A
successful organization should have successful implementation of
groups, this unit covers the aspects related to groups and decision making
in a group.

LEARNING OBJECTIVES
After completing this unit, you should be able to,
• define the group behaviour

• explain the classifications of group

180
 • discuss the decision making in groups
• elaborate the stages of group development.

13.1 INTRODUCTION
A formal definition of group is two or more individuals, interacting and
interdependent, who have come together to achieve particular objectives.
Group Behaviour is concerned with the formation and structure of groups
and the way they affect individuals' member, other groups and the
organization. A group is the arrangement of the individuals who have
something in common, i.e., either they possess a similar trait or falls into
the same situation. This association becomes a temporary identity of the
individuals who form it.

13.1.1 Meaning of Group Behaviour

Two or more people constitute group if

14 they have some common purposes or goal

15 there exists a relatively stable structure

13.1.2 Determinants of Group Behaviour

Group behavior in an organization is quite complex. Following are

the determinants of group behaviour
i) External Factors

ii) Group member Resources

iii) Group structure

iv) Group Process
v) Group Task

i) External Factors:
There are generally several groups in an organization. Each group is a
sub-system of the organization. It interacts with other sub-systems and
the organization system. The organization system influences the group
through corporate strategy, organization structure, rules and regulations,
organizational resources, staffing policies, appraisal and reward system,
organizational culture, physical work environment such as layout, lighting,
interior decoration, seating arrangement, temperature, etc.

ii)Group Member’s Resources:

Group performance depends, to considerable extent, on the number
resources, which comprise:

181
Abilities: the performance of a group may be influenced by the task
relevant intellectual abilities of each of its members.
Personality Characteristic: The personality traits of group members can
shape group attitudes and behavior. The attributes that have a positive
connotation tend to be positively related to group productivity, morale and
cohesiveness. These include traits such as sociability, self-reliance, and
independence. In contrast, negatively evaluated traits such as
authoritarianism, dominance, and manipulation tend to have adverse
effect on group performance in the long run.
iii) Group Structure: Work groups are not unorganized mobs. They have
a structure that shapes the behavior of members and makes it possible to
explain and predict a large proportion of individual behavior within the
group as well as the performance of the group itself.

iv) Group Process: This process refers to the communication patterns

used by members for information exchanges, group decision processes,
leader behavior, power dynamics and conflict interactions. Group
processes is significant as they create output greater than the inputs
v) Group Tasks: Group facilitates organizational task accomplishment.
Group performance depends on type of task. Task can be classified on
basis of time frame, task requirement, and objectives.
13.1.3 Classification of Groups
A person becomes a part of a group, knowingly or unknowingly; for a
purpose or as a choice; and for short-term or long-term. Groups can be
differentiated into the following nine major categories:
• Primary and Secondary Groups
• Formal and Informal Groups
• Membership and Reference Groups
• Small and Large Groups
• Organized and Unorganized Groups
• In and Out-going Groups
• Accidental and Purposive Groups
• Open and Closed Groups
• Temporary and Permanent Groups
• Nominal and Non-Performing Groups
a) Primary and Secondary Groups: In terms of face to face or indirect
interaction between the parties, groups can be bifurcated as follows:
Primary Group: The group where an individual directly interacts with
other members is termed as the primary group. It is responsible for
the initial learning and social behavior of an individual.

182
 Secondary Group: When a person in a group is indirectly associated
with or influenced by other members, he/she is said to be in a
secondary group.
b) Formal and Informal Groups: We can categorize the groups into two
major classes according to the purpose it serves. Whether it is for
fulfilling an organizational objective or for meeting the self-interest of
the members.

Formal Groups: When people collaborate to attain the organizational

goals or objectives, they are said to form a formal group.
Following are the three major types of formal groups existing in an
organization:
Command Group: As a result of hierarchical arrangement in an
organization, a command group is made of the superiors and their
subordinates representing the flow of command or orders from top
to bottom level.
Task Group: A group which includes individuals with different skills
and knowledge, to successfully carry out the assigned project, is
called as a task group.
Committees: For the special assignments or projects, a group is
formed by appointing the specialists or people with superior
knowledge; which is termed as a committee. After the project
responsibilities are executed successfully, the members can
disassociate from the committee.
c) Informal Groups: When the individuals associate with one another
to serve their common interest or for self-satisfaction, they are
known to form an informal group. Some of the most common
informal groups are:
Interest Groups: The individuals who join hands for a common
purpose (related to self-interest) create an interest group.
Friendship Groups: The group which is formed as a result of
personal choice by the individuals who are already familiar and feel
comfortable with one another is called a friendship group.
Cliques: In a workplace, few colleagues join hands to form a small
group (usually with two to six members) to share ideas and thoughts
on their mutual interest.
Sub-cliques: When a clique comprises of few organizational employees
along with some non-employees (who are associated with the other
members in either way), it termed as a sub-clique.

183
Sayles’ Classification of Groups: L.R. Sayles categorized the groups
into the following types depending upon the degree of pressure prevalent
in each:
Apathetic Groups: The group in which the leader does not pressurize the
members; moreover, leadership is hardly widespread; it is termed as an
apathetic group. Usually, it is formed by the lower-level workers who are
unskilled and work on low wages.

Erratic Groups: When the people belonging to a group gets enraged

quickly and similarly calms down, they are said to be in an erratic group.
Such a group comprises of semi-skilled workers who perform task
desiring communication between them.
Strategic Groups: Such a group includes skilled workers, who hold
various job positions to execute the independent technological task.
These members have the skills of systematically applying pressure on the
management and the other groups, by framing a suitable strategy.
Conservative Groups: The group which comprises of the stable and
highly skilled individuals or professional, who have extreme powers to
regulate the functioning of the organization, is called as a conservative
group.

d) Membership and Reference Groups: We can also distinguish

between the different groups by the need for official registration of the
members, into the following two categories:

Membership Group: Groups in which the members must get themselves

registered and acquire a membership card or certificate for becoming a
part of it, is termed as a membership group.
e) Reference Group: It may not be a real association of individuals;
an illusionary group to which an individual relates himself/herself due to
the same profession or other similar attributes is called a reference group.

Small and Large Groups

Based on the number of members involved in a group, we can classify it
as follows:

Small Group: Small groups consist of as little as three to ten members.

Such groups are usually well managed and organized.
Large Group: The groups made up of more than ten members are
considered to be large groups. These massive groups are challenging to
handle and unsystematic at times.
f) Organized and Unorganized Groups

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Given below is the categorization of the groups in terms of its structure
and bonding among the group members:
Organized Group: When the individuals belonging to a particular
discipline work together systematically as a team by supporting each
other, they are said to be in an organized group.
Unorganized Group: The disorganized group is not formed purposefully.
Instead, the individuals just did not happen to fall into a single group where
they have any attachment to one another nor have any belongingness.

g) In and Out-going Groups

We can also distinguish among groups according to the belongingness
and involvement of the individuals, as below:
In-Group: A group where an individual is socially active and adopts strong
values from the other members is termed as an in-group.

Out-going Group: The other groups, except the prevalent in-group,

where no inter-group exchange of values is facilitated is termed as out-
going groups.
h) Accidental and Purposive Groups
The purpose of the group formation provides a basis for its classification
into the following two categories:

Accidental Group: When a group is formed coincidently or unknowingly,

that too without any purpose, it is known as an accidental group.
Purposive Group: The group which is made for a definite reason or aim
of task fulfillment is termed as a purposive group.

i) Open and Closed Groups

Based on the scope for entry and exit of the members in a group, it can
be distinguished as follows:
Open Group: The group where the new individuals can freely enter and
old members can exit anytime is known as an open group.

Closed Group: The restricted group where no further entries are

entertained is called as a closed group.
j) Temporary and Permanent Groups

A group can be formed for a short period or a long duration. Let us now
discuss the two categories of groups based on these criteria:
Temporary Group: When the individuals come together for a particular
project or task accomplishment, they are known to be in a temporary

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group. Such a group disintegrates after the successful performance of the
task.
Permanent Group: Such groups represent a long-term association of the
group members. Here, people belonging to a particular organization are
known to be in a single group.
k) Nominal and Non-performing Groups
Based on the need for action, groups can also be bifurcated into the
following types:
Nominal Group: The group, in which the members are involved in
problem-solving, take up challenges and carry out operations, is termed
as a nominal group.
Non-performing Group: Whenever the individuals are put together in a
single group, just on a sheet of paper; however, they need not carry out
any task, they tend to be in a non-performing group.

13.2 STAGES OF GROUP DEVELOPMENT

This process of learning to work together effectively is known as team
development. Research has shown that teams go through definitive
stages during development. Bruce Tuckman, an educational psychologist,
identified a five-stage development process that most teams follow to
become high performing. He called the stages: forming, storming,
norming, performing, and adjourning. Team progress through the stages
is shown in the following diagram.

Forming stage
The forming stage involves a period of orientation and getting acquainted.
Uncertainty is high during this stage, and people are looking for leadership
and authority. A member who asserts authority or is knowledgeable may
be looked to take control. Team members are asking such questions as
“What does the team offer me?” “What is expected of me?” “Will I fit in?”
Most interactions are social as members get to know each other.
Storming stage
The storming stage is the most difficult and critical stage to pass through.
It is a period marked by conflict and competition as individual personalities
emerge. Team performance may actually decrease in this stage because
energy is put into unproductive activities. Members may disagree on team
goals, and subgroups and cliques may form around strong personalities
or areas of agreement. To get through this stage, members must work to
overcome obstacles, to accept individual differences, and to work through

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conflicting ideas on team tasks and goals. Teams can get bogged down
in this stage. Failure to address conflicts may result in long-term problems.

Norming stage
If teams get through the storming stage, conflict is resolved and some
degree of unity emerges. In the norming stage, consensus develops
around who the leader or leaders are, and individual member’s roles.
Interpersonal differences begin to be resolved, and a sense of cohesion
and unity emerges. Team performance increases during this stage as
members learn to cooperate and begin to focus on team goals. However,
the harmony is precarious, and if disagreements re-emerge the team can
slide back into storming.

Performing stage
In the performing stage, consensus and cooperation have been well-
established and the team is mature, organized, and well-functioning.
There is a clear and stable structure, and members are committed to the
team’s mission. Problems and conflicts still emerge, but they are dealt
with constructively. (We will discuss the role of conflict and conflict
resolution in the next section). The team is focused on problem solving
and meeting team goals.

Adjourning stage
In the adjourning stage, most of the team’s goals have been accomplished.
The emphasis is on wrapping up final tasks and documenting the effort
and results. As the work load is diminished, individual members may be
reassigned to other teams, and the team disbands. There may be regret
as the team ends, so a ceremonial acknowledgement of the work and
success of the team can be helpful. If the team is a standing committee
with ongoing responsibility, members may be replaced by new people and
the team can go back to a forming or storming stage and repeat the
development process.
13.3 GROUP STRUCTURE
The group structure shapes the Behaviour of members. Group
structure variables are as follows
Formal Leadership
The leader is responsible for the direction and goal accomplishment of
the group and can reward or punish individual members when they do not
comply with directions, orders or rules of the group. The leader has the
power to make the group members comply with directives because he has
the organization's support.

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Roles
Set of expected behavior patterns attributed to someone occupying a
given position in a social unit.
Role Identity

Certain attitudes and behavior consistent with a role. These attitudes and
behaviors create role identity.
Role perception

An individual's view of how he or she is supposed to act in a given situation.

Role Expectation:
How others believe a person should act in a given situation.

Role Conflict:
Situation in which an individual is confronted by divergent role
expectations.
Norms
Norms are acceptable standards of behavior within a group, which
are shared by the group's members.

13.4 GROUP DYNAMICS

Group dynamics studies the nature, formation and reasons why groups
are formed. It is the process by which people interact face to face with
each other. This process is named as “Group Dynamics”.
Elton Mayo and Kurt Lewin were the pioneers of group Dynamics theory.
Mayo through his Hawthorne experiments showed that workers tend to
establish informal groups that affect job satisfaction and effectiveness.
Group Dynamics theory suggests that Groups have properties of their
own that are different from the properties of individuals who make up the
group.
The social process by which people interact face-to-face in small groups
is called “Group Dynamics”.

The word “dynamics” comes from the Greek word meaning “force”; hence
Groups Dynamics refers to the study of forces operating within a group.
Elton Mayo and Kurt Lewin were the pioneers of group Dynamics theory.
Mayo through his Hawthorne Experiments showed that workers tend to
establish informal groups that affect job satisfaction and effectiveness.
Kurt Lewin showed that different kinds of leadership produced different
responses in groups.

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Group Dynamics theory suggests that Groups have properties of their
own that are different from the properties of the individuals who make up
the group. This is similar to the physical situation in which a molecule of
salt (sodium chloride) has different properties from the sodium and
chlorine elements that form a ‘group’ to make it.
The discussion about Group Dynamics will not be complete without
understanding the concepts Group Norms and Group Cohesiveness. A
brief description of these concepts is given below:
i) Group Norms: Group norms are a set of beliefs, feelings, and attitudes
commonly shared by group members. These are also referred to as rules
or standards of behaviour that apply to group members.
Norms provide a basis for understanding the behaviour of others and for
deciding one’s own behaviour. Norms regulate the behaviour of members.
When someone violates a norm, other members are likely to exercise
sanctions ranging from a casual remark to physical abuse. And some
norms define relationships among roles.
Group norms have certain characteristics. They are:
➢ Norms represent characteristics of groups, just as an individual’s
characteristics are revealed through his personality.

➢ They are related to behaviours considered important by most

group members. In fact, norms are the basis for behaviour of
members in groups.

➢ They are the basis of predicting and controlling behaviour of group

members.
➢ They are applied to all members, though not uniformly. Some
deviations by some members are tolerated but not to the extent of
jeopardising group goals.
Many work and non-work norms exist in small groups, but the one most
often referred to is the production norm, which is often different from
management expectations. The reasons for production norms are:
Fear of rate cutting if production gets too high.

Fear of reprisal against workers if production gets too low.

Fear of production changes if there is too great a deviation among
individuals.

ii) Group Cohesiveness: Another concept which helps understand group

behaviour is group cohesiveness.

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Group cohesiveness is the degree to which members are attached to and
motivated to remain part of the group.
Sources of Cohesiveness: Group cohesiveness can be affected by such
factors as interaction, threat, severity of initiation, co-operation, and
shared goals, similarity of attitudes and values and size.
Interaction: Group cohesiveness depends on possibilities of frequent
interaction. They become more cohesive when individual members spend
more time with each other.

Threat: Threat is a powerful unifier particularly when:

➢ It comes from outside the group

➢ Co-operation can help overcome the threat and

➢ There is little or no chance for escapes

Severity of Initiation: Difficulty in getting admission into a group also
affects cohesion. More the difficulty, greater the cohesiveness.
Co-operation: Sometimes the general atmosphere prevailing in the
group enhances cohesiveness. The overall atmosphere depends, among
others, leadership.
Shared goals: Groups that share common goals are likely to be more
cohesive than those that do not share such goals.

Attitudes and Values: Shared attitudes and values are the strongest
sources of cohesiveness.
Size: As group size increases, cohesiveness tends to decrease.
Consequence of Group Cohesiveness: Group cohesiveness has
positive consequences. First, there is increased morale in cohesive
groups. Each member of a cohesive group likes the other members,
there is increased bonhomie, reduced conflict and better communication
among members. Second, cohesiveness may contribute to increased
productivity as people in cohesive groups experience fewer work related
anxieties and tend to have lower absenteeism and turnover. Third,
members of cohesive groups communicate with each other more than
members of non-cohesive groups. Fourth, conformity and influence are
the other benefits of cohesive groups.

13.5 GROUP CHARACTERISTICS

It consists of two or more persons who interact with each other.

• Group members have reciprocal influence on each other

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 • Members in group develop mutual perceptions and emotions ties
with each other.
• Every group has formal leader (elected by members) and an
informal leader.

• Each individual in group performs a specified role which influence

and enhance future expectations of group members from each
others.

• Every group has standardized norms. Norms is standardized

Behaviour that the group accepts and expects from members.
• This maintains stability in its structure through cohesiveness.

• Members work for a common interest or goal.

13.6 GROUP DECISION MAKING

Group decision making is defined as decision made by members of the
group jointly. Group decision making involves commitment of all the
members of the group, this ensures better accuracy and quality of
decisions made. In this process each member is given a chance to put his
thoughts into ideas.
The decisions made by group are complete, accurate, and also increase
diversity of view.

Difference between groups and teams

Team and groups may look similar from the outer world but they possess
some uniqueness. They are as follows.

BASIS FOR GROUP TEAM

COMPARISON

Meaning A collection of individuals A group of persons

who work together in having collective identity
completing a task. joined together, to
accomplish a goal.

Leadership Only one leader More than one

Members Independent Interdependent

Process Discuss, Decide and Discuss, Decide and

Delegate. Do.

Work Products Individual Collective

Focus on Accomplishing individual Accomplishing team

goals. goals.

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 Accountability Individual Either individually or
mutually.

LET US SUM UP
The study of group Behaviour in the organizational context is of great
importance. There are several factors which determine group behavior.
The groups are classified into various categories and the role of formal
and informal groups is very significant. Group dynamics can very wellbe
understood with the help of the concepts – group norms and group
cohesiveness.
CHECK YOUR PROGRESS
Choose the Correct Answer

1. Elton Mayo and Kurt Lewin were the pioneers of ------------------

a) equity theory b) need hierarchy theory
c) expectancy theory d) group Dynamics theory
2. ------------- is the degree to which members are attached to and
motivated to remain part of the group
a) equity theory b) Group cohesiveness
c) expectancy theory d) selection
3. -------------are a set of beliefs, feelings, and attitudes commonly shared
by group members.

a) group norms b) cohesiveness

c) group role d) group dynamics
4. It is the process by which people interact face to face with each other.
This process is named as ----------------
a) Team spirit b) Group sink
c)Interview d) group dynamics

5. The ------------- is responsible for the direction and goal accomplishment

of the group.
a) Leader b) motivator
c) Linker d) facilitator
GLOSSARY

Group dynamics : Means the study of forces within a

group

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 Group cohesiveness : The extent to which members of the
group stick together and their
commitment to each other

Informal group : Groups that get created

spontaneously as soon as
individuals start interacting with
each other

Teams : A group of people forming one side

in a competitive game or sport or
firm.

SUGGESTED READINGS
1. DinkarPagare (2015) Principles of Management, Sultan Chand &
Sons, New Delhi.
2. Harold Koontz, Cyril O'Donnell and Heinz Weihrich (2017)
Essentials of Management (5th Revised edition), McGraw-Hill Inc.,
US, (ISE Editions).
3. Prasad L.M. (2015) Principles and Practice of Management,
Sultan Chand & Sons, New Delhi.
4. Sherlekar S.A. &Sherlekar V.S 3rd Edition (2014) Principles of
Business Management, Himalaya Publishing House Pvt. Ltd,
Mumbai.
5. Tripathi, Sixth edition (2017) Principles of Management, Tata
McGraw Hill Education Private Limited, 7 thWest Patel Nagar, New
Delhi.
6. Tripathi, P C, Reddy, P N, 5 edition (2012) Principles of
Management, Tata McGraw Hill Education private limited, 7 th west
Patel Nagar, New Delhi.
7. https://epgp.inflibnet.ac.in/Home/ViewSubject?catid=ahLCajOqz6
/GWFCSpr/XYg==
8. https://www.tutorialspoint.com/individual_and_group_behavior/gr
oup_structure.htm

ANSWERS TO CHECK YOUR PROGRESS

1) d 2) b 3) a 4) d 5) a

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Unit 14

TEAM DEVELOPMENT
STRUCTURE
Overview
Learning Objectives

14.1 Meaning of team

14.2 Features of team

14.3 Types of teams

14.4 Team Norms and Cohesiveness

14.5 Team Development over Time

14.6 Roles Within Teams
14.7 Action Check List

Let Us Sum Up
Check Your Progress

Glossary
Suggested Readings
Answers to check your progress

OVERVIEW
Teams have become a common feature of organizational life. Workplace
teams are used to carry out projects of various kinds and can make a
significant contribution to organizational success, but the development of
good working relationships is vital to team performance. Organizations
that take the time to invest in building effective teams will reap the benefits
of improved morale, better performance and the successful completion of
projects. This unit describes the essentiality of team building and its types
in detail.

LEARNING OBJECTIVES

After completing this unit, you should be able to,

• describe the features of team

• list out the types of teams

• discuss the roles of teams

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 • elaborate the norms of teams.
14.1 MEANING OF TEAM
The word Team can be defined as set of persons who willingly work
together for the benefit of the group. Team consists of small number of
people who are committed to common goal where they are mutually
accountable.
The word “team” can be quoted in different way in an organization like
quality circles, task forces, performance cadres, etc. Good leadership is a
key to team performance and team leaders have a vital role to play in
ensuring that team members work well together and are able to achieve
the goals which have been set. Their role is that of facilitator. They need
to understand the nature of the task in hand as well as the broader
organizational context. They need to assess the knowledge, skills and
experience of each team members and what motivates them. They need
to engage individuals and help them to find their place in the work of the
team.
Successful team building can:

Coordinate the efforts of individuals as they tackle complex tasks

• Make the most of expertise and knowledge which might otherwise
remain untapped
• Build on the complementary strengths of team members to
produce results which could not be achieved by employees
working individually
• Raise and sustain motivation and confidence as team members
feel supported and involved
• encourage members to work together to generate fresh ideas
solve problems, and find new ways forward › help to break down
communication barriers and avoid unhealthy competition, rivalry
and point scoring between departments
• Raise the level of individual and collective empowerment ›
enhance engagement with and ownership of the task in hand.

14.2 FEATURES OF TEAM

• Small number of people

• Team members possess complementary skills, these skills help to
plan and accomplish goals

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 • Team members feel mutually accountable for the result of their
action

• Members work with synergistic efforts

• Team a narrow term, designed for specific task.

14.3 TYPES OF TEAM

A team is a “group whose individual efforts result in performance that is
greater than the sum of individual inputs”. Following are the types of team

1. Problem – solving teams:

The members of the team are from same department who share ideas or
suggestions and methods to improve the effectiveness. Various
alternative solutions and recommendations are discussed towards the
problem.
2. Self-managing teams:
This team consist 10 to 15 people who take on responsibilities of their
former supervisor. Members in this team work independently, they plan,
set goals, schedule work, assign duties to members, monitor their work,
coordinate, design performance appraisal. The team members have
varied skills required to perform the task assigned.
3. Cross Functional Teams:

The members of this team are made up of employees from same

hierarchical level, but from different functional areas. This team is useful
for complex projects, where all departments are under one frame.
Members of each different department share information, create
innovative diverse ideas and also manage the project.
4. Virtual teams:
The above mentioned teams have face to face interaction amongst their
team, where as in this virtual team computer technology is used to bring
together physically dispersed members towards common goal.

5. Quality circle:
Group of labour and management members who are from single
department work similar or same task and meet periodically to discuss
manufacturing problems. This team is for improving quality of products,
productivity of firm, improves morale etc.

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14.4 TEAM NORMS AND COHESIVENESS
When you have been on a team, how did you know how to act? How did
you know what behaviors were acceptable or what level of performance
was required? Teams usually develop norms that guide the activities of
team members. Team norms set a standard for behavior, attitude, and
performance that all team members are expected to follow. Norms are like
rules but they are not written down. Instead, all the team members
implicitly understand them. Norms are effective because team members
want to support the team and preserve relationships in the team, and
when norms are violated, there is peer pressure or sanctions to enforce
compliance.
Norms result from the interaction of team members during the
development process. Initially, during the forming and storming stages,
norms focus on expectations for attendance and commitment. Later,
during the norming and performing stages, norms focus on relationships
and levels of performance. Performance norms are very important
because they define the level of work effort and standards that determine
the success of the team. As you might expect, leaders play an important
part in establishing productive norms by acting as role models and by
rewarding desired behaviors.
Norms are only effective in controlling behaviors when they are accepted
by team members. The level of cohesiveness on the team primarily
determines whether team members accept and conform to norms. Team
cohesiveness is the extent that members are attracted to the team and
are motivated to remain in the team. Members of highly cohesive teams
value their membership, are committed to team activities, and gain
satisfaction from team success. They try to conform to norms because
they want to maintain their relationships in the team and they want to meet
team expectations. Teams with strong performance norms and high
cohesiveness are high performing.
14.5 TEAM DEVELOPMENT OVER TIME

If you have been a part of a team—as most of us have—then you

intuitively have felt that there are different “stages” of team development.
Teams and team members often start from a position of friendliness and
excitement about a project or endeavor, but the mood can sour and the
team dynamics can go south very quickly once the real work begins. In
1965, educational psychologist Bruce Tuckman at Ohio State University
developed a four-stage model to explain the complexities that he had
witnessed in team development. The original model was called
Tuckman’s Stages of Group Development, and he added the fifth stage

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of “Adjourning” in 1977 to explain the disbanding of a team at the end of
a project. The four stages of the Tuckman model are:
➢ Forming
➢ Storming
➢ Norming
➢ Performing
➢ Adjourning

Forming
During the forming stage, team members not only get to know each other
but also familiarize themselves with their task and with other individuals
interested in the project, such as supervisors. At the end of the forming
stage, team members should know the following:
1. The project's overall mission
2. The main phases of the mission
3. The resources at their disposal
4. A rough project schedule
5. Each member's project responsibilities
6. A basic set of team rules
Keep in mind that no one person needs to be responsible for the team.
Project management duties can be shared, with different members taking
responsibilities for each stage of the project.
Storming

Storming is characterized by competition and conflict within the team as

members learn to bend and mold their feelings, ideas, attitudes, and
beliefs to suit the team organization. Although conflicts may or may not
surface as group issues, they do exist. Questions about who is
responsible for what, what the rules are, what the reward system is, and
what the evaluation criteria are arise. These questions reflect conflicts
over leadership, structure, power, and authority. Because of the
discomfort generated during this stage, some members may remain
completely silent, while others attempt to dominate. Members have an
increased desire for structural clarification and commitment.
In order to progress to the next stage, team members must move from a
testing‐and‐proving mentality to a problem‐solving mentality. Listening is
the most helpful action team members and the team leader can take to
resolve these issues.

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Norming
In Tuckman's norming stage, team relations are characterized by
cohesion. (Keep in mind that not all teams reach this stage.) Team
members actively acknowledge all members' contributions, build
community, maintain team focus and mission, and work to solve team
issues. Members are willing to change their preconceived ideas or
opinions on the basis of facts presented by other members, and they
actively ask questions of one another. Leadership is shared, and cliques
dissolve. As members begin to know and identify with one another, the
trust that individuals place in their colleagues fosters cohesion within the
team.
During this stage of development, team members begin to experience a
sense of group belonging and a feeling of relief as a result of resolving
interpersonal conflicts.
Stage 3 is characterized by the flow of data between team members: They
share feelings and ideas, solicit and give feedback to one another, and
explore actions related to the task. Creativity is high. If this stage of data
flow and cohesion is attained by the group members, their interactions are
characterized by openness and sharing of information on both a personal
and task level. They feel good about being part of an effective group.
The major drawback of the norming stage is that members may begin to
fear the inevitable future breakup of the group; they may resist change of
any sort.

Performing
Again, the performing stage is not reached by all teams. Those teams that
do reach this stage not only enjoy team members who work independently
but also support those who can come back together and work
interdependently to solve problems. A team is at its most productive
during this stage.
Team members are both highly task‐oriented and highly people‐oriented
during this stage. The team is unified: Team identity is complete, team
morale is high, and team loyalty is intense. The task function becomes
genuine problem solving, leading to optimal solutions and optimum team
development. There is support for experimentation in solving problems,
and an emphasis on achievement. The overall goal is productivity through
problem solving and work.

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Adjourning
Teams assembled for specific project or for a finite length of time go
through a fifth stage, called adjourning, when the team breaks up. A
planned conclusion usually includes recognition for participation and
achievement and an opportunity for members to say personal goodbyes.
Disbanding a team can create some apprehension, and not all team
members handle this well. The termination of the team is a regressive
movement from giving up control to the team to giving up inclusion in the
team. This last stage focuses on wrapping up activities rather than on task
performance.

Starting the Startup Team

Nothing is more exciting than a startup business. The enthusiasm is high,
and people are excited about the new venture and the prospects that
await. Depending on the situation, there may be funding that the startup
has received from investors, or the startup could be growing and powering
itself organically. Either way, the startup faces many different questions in
the beginning, which will have a tremendous impact on its growth potential
and performance down the road. One of the most critical questions that
faces a startup —or any business for that matter—is the question of who
should be on the team. Human capital is the greatest asset that any
company can have, and it is an especially critical decision in a startup
environment when you have limited resources and those resources will
be responsible for building the company from ground up.
“Nothing can bedevil a high-potential startup more than its people
problems. In research on startup performance, venture capitalists
attributed 65% of portfolio company failures to problems within the
startup’s management team. Another study asked investors to identify
problems that might occur at their portfolio companies; 61% of the
problems involved team issues. These problems typically result from
choices that founders make as they add team members…”
These statistics are based on people problems in startups, and it isn’t
quite clear what percent of larger company failures could be directly or
indirectly attributed to people and team issues. I would imagine that the
percentage is also significant. The impact of people problems and team
issues in a startup organization that is just getting its footing and trying to
make the right connections and decisions can be very significant. If you
know anyone who has a company in startup mode, you may have noticed
that some of the early team members who are selected to join the team
are trusted family members, friends, or former colleagues. Once a startup
company grows to a certain level, then it may acquire an experienced

200
CEO to take the helm. In any case, the startup is faced early on with
important questions on how to build the team in a way that will maximize
the chance of success.
In “Assembling the Startup Team,” the author refers to the three Rs:
relationships, roles, and rewards as being key elements that must be
managed effectively in order to avoid problems in the long term. A
relationship refers to the actual team members that are chosen, and there
are several caveats to keep in mind. Hiring relatives or close friends
because they are trusted may seem like the right idea in the beginning,
but the long-term hazards (per current research) outweigh the benefits.
Family and friends may think too similarly, and the team misses the benefit
of other perspectives and connections. Roles are important because you
have to think about the division of labor and skills, as well as who is in the
right roles for decision-making. The startup team needs to think through
the implications of assigning people to specific roles, as that may dictate
their decision power and status. Finally, defining the rewards can be
difficult for the startup team because it essentially means that they are
splitting the pie—i.e., both short-term and long-term compensation. For
startup founders, this can be a very difficult decision when they have to
weigh the balance of giving something away versus gaining human capital
that may ultimately help the business to succeed. Thinking through the
tradeoffs and keeping alignment between the “three Rs” is important
because it challenges the startup team to think of the long-term
consequences of some of their early decisions. It is easy to bring family
and friends into the startup equation due to trust factors, but a careful
analysis of the “three Rs” will help a startup leadership team make
decisions that will pay off in the long term.
14.6 ROLES WITHIN TEAMS
Following many years’ research on teams, Dr Meredith Belbin identified a
set of eight roles, which, if all present in a team, give it the best chance of
success. These roles are:

➢ Co-ordinator
➢ Shaper
➢ Plant
➢ Monitor-Evaluator
➢ Implementer
➢ Resource Investigator
➢ Team Worker
➢ Finisher

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Co-ordinator
The Co-ordinator clarifies group objectives, sets the agenda, establishes
priorities, selects problems, sums up and is decisive, but does not
dominate discussions.

Shaper
The Shaper gives shape to the team effort, looking for pattern in
discussions and practical considerations regarding the feasibility of the
project. Can steamroller the team, but gets results.

Plant
The Plant is the source of original ideas, suggestions and proposals that
are usually original and radical. The Monitor-Evaluator contributes a
measured and dispassionate analysis and, through objectivity, stops the
team committing itself to a misguided task.

Implementer
The Implementer turns decisions and strategies into defined and
manageable tasks, sorting out objectives and pursuing them logically.

Resource Investigator
The Resource Investigator goes outside the team to bring in ideas,
information and developments to it. They are the team’s salesperson,
diplomat, liaison officer and explorer.
Team Worker
The Team Worker operates against division and disruption in the team,
like cement, particularly in times of stress and pressure.

Finisher
The Finisher maintains a permanent sense of urgency with relentless
follow-through.
All of these roles have value and are missed when not in a team; there
are no stars or extras. An individual’s team role can be determined by the
completion of a Belbin questionnaire. It is not essential that teams
comprise eight people each fulfilling one of the roles above, but that
people who are aware and capable of carrying out these roles should be
present. In small teams, people can, and do, assume more than one role.
In addition, analyzing existing teams and their performance or behaviour,
using these team role concepts, can lead to improvements, e.g:

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➢ Underachievement demands a good coordinator or finisher
➢ Conflict requires a team worker or strong coordinator
➢ Mediocre performance needs a resource investigator, innovator
or shaper.

➢ Error prone teams need an evaluator

Different roles are important in different circumstances, e.g, new teams
need a strong shaper to get started, competitive situations demand an
innovator with good ideas, and in areas of high risk, a good evaluator may
be needed. Teams should, therefore, be analysed both in terms of what
team roles members can play, and also in relation to what team skills are
most needed. Despite having well defined roles within a team, the
interaction between the different personalities of individuals can be a
frequent source of friction. However, this can largely be avoided by
understanding and valuing people’s differences. The Myers Briggs Type
Indicator (MBTI) is a powerful aid to both team and personal development
by providing a well-researched framework for understanding these
differences.

14.7 ACTION CHECK LIST

1. Consider whether a team is the best option don't assume that a team
is necessarily the best way of achieving the objectives you have in mind.
Think carefully about the tasks to be completed and the skills required
before launching into the formation of a team. Consider whether there is
a need for a mix of skills and experience, the sharing of workloads, or for
brainstorming and problem solving. In such cases a team will often be the
best option. Otherwise, ask yourself whether the task can be more
effectively carried out by a single person with the relevant knowledge and
skills. It is important to weigh the advantages and disadvantages of team
working – there may be losses in coordination and motivation if teams are
not carefully developed and managed. Organizational culture should also
be considered - teamwork may be difficult, for example, in an organization
with a culture of rigid reporting structures or fixed work procedures.

2. Define objectives and the skills needed to reach them Think carefully
about the nature of the tasks or projects to be carried out by the team and
the mix of knowledge and skills needed. For teams handling routine tasks
on a long term basis, low levels of diversity in the team and clear
definitions of tasks and roles are required. In this context, the key aims
would be high levels of team cohesion and commitment and low levels of
conflict. For innovation and problem solving, on the other hand, high levels
of diversity and complementary skills will be required and the definition of

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goals and roles may be left to the team. This might involve losses in
coordination, much less cohesion, and fairly high potential for conflict, but
could be worthwhile if new ideas and solutions are required.
3. Consider the make-up of the team If you are forming a new team, you
need to consider the number of people involved, their cultural
backgrounds and the skill set they bring to the team. If you are setting up
an international or multi-cultural team you may wish to study Geert
Hofstede’s work on cultural differences. This will give you a better
understanding of issues such as differing attitudes to authority, individual
responsibility and uncertainty avoidance. In many organizations, however
the selection of team members will be outside the remit of the team leader.
In such cases the process of developing good working relationships and
practices within the team is even more vital to success. The work of R
Meredith Belbin provides some useful insights into the patterns of
behaviour exhibited by team members and the way they interact with each
other. You may wish to take these into account when putting a team
together or seeking to shape an existing team. Belbin identifies a number
of roles which team members can play and their respective strengths and
weaknesses. He suggests that teams need a balance of members with
differing roles if they are to work together effectively. Furthermore, an
understanding of personal differences and roles can help team members
to cooperate more successfully, complementing each other’s strengths.
Teams with a strong focus on innovation who need to develop new ideas
may benefit from members with who can think in different ways to analyse
problems and find solutions. Edward De Bono’s ‘six thinking hats’ model
of thinking styles may be helpful here.

4. Plan your team building strategy

The following aspects must be considered:
A Climate of Trust: nurturing team culture is a vital part of the team
leader’s role. Mistakes and failures should be seen as learning
experiences, not as occasions to apportion blame

Communication: clear and frequent communication is vital. The free flow

of information will help team members understand how their work
contributes to business objectives and promote better integration

Training: specialist training may be needed to handle the tasks required,

especially if the team leader has not been able to select team members
personally. Team leaders will need project management skills and the
ability to manage meetings, moderate discussions and handle conflict.

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Team members will also need good interpersonal skills, including
communication and negotiation.
Time: ensure that there is time to coordinate activities, to develop ideas
and to monitor progress and that there are opportunities for regular
meetings. Be aware that attitudes to time differ significantly across
cultures
Resources: make sure that the team has access to the resources and
materials they will need to complete their work
Objectives: these need to be clearly understood by all team members.
This is increasingly a matter of involving team members in setting
objectives rather than dictating prescribed objectives to them. Team
members with a clear understanding of their own objectives and their
place within the team and the wider organization are more likely to be able
to motivate themselves to achieve, and to exhibit higher levels of job
satisfaction, commitment, excitement and enthusiasm
Tasks and Roles: it is vital for team members to be absolutely clear about
what is expected of them and what tasks have to be carried out. Consider
how you will handle the situation if tasks and roles are not respected
Feedback: everybody needs to know how well they are doing and if and
where improvements can be made. Feedback should focus firstly on the
positive aspects and then on ways of addressing any problems or
difficulties. You may also consider bringing in someone with team building
experience to help with the initial phases, especially if the team's task is
major or complex. Alternatively, consider whether team building activities
such as outbound team building, games or process labs would be helpful
and appropriate.
5. Get the team together From the outset you should aim to start to
encourage the group to see themselves as a team, rather than a collection
of individuals. At the initial meeting, discuss and agree the overall
objectives the team is to achieve, rather than attempting to address tasks
in detail. Make sure that everyone understands their personal contribution
to the team's success, its place in the project schedule and its importance
to the project's success. Bear in mind that most teams pass through
several stages of development before starting to produce their best work.

For example, in the case of routine tasks, groups should proceed more
quickly to performing. Teams with innovative tasks will need more time for
forming and storming and may find it difficult to reach the performing
stage. Once a problem-solving strategy has been found by an ‘innovative’
team, it may be necessary to form a new team to implement the solution.

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Blanchard’s situational leadership model can help managers to lead
teams through these stages as it provides for individual team members to
be managed according to their differing needs for coaching, support or
direction.

6 Explore and establish operating ground rules It is vital to establish

ground rules from the outset, especially for cross-cultural or remote
teams. Agree processes for decision-making and reporting which will be
maintained throughout the life-span of the team. Establish when and how
often meetings will take place and how they will be managed. Encourage
a climate of open and honest communication, so that, as far as possible,
team members will be able to express opinions without fear of
recrimination and minority views will be heard and considered. For certain
projects you might want to consider using a version of the “Delphi
Method”. The team leader and all members may contribute to crucial
decision-making processes, anonymously via questionnaires, on an
iterative basis, until a consensus is reached. Anonymity can reduce
internal conflicts or personality issues among team members, and support
complex strategic decision-making.
7. Identify individuals’ strengths and motivations Carry out an audit of
individuals' strengths and place people in the right position based on their
skills and competences. Consider also how contributions and
responsibilities overlap and how synergy can be released. It is important
for team members to reach a common understanding of each other’s
strengths. This helps to integrate the skills of team members, strengthen
team cohesion and improve the efficiency and performance of the team
as a whole. Getting to know your team members better will help you to
understand which factors are most important to motivating each
individual, in the short-term and in the long-term, and to ensure that these
are not ignored in any rewards system that you design to reflect their
efforts.
8 See yourself as a team member your role as team leader is to be a
member of the team - not just the boss. Always maintain fairness in your
approach to members of the team. Make it clear to all that everyone in the
team has an important role to play and that your role happens to be that
of team leader. Act as a good role model and maintain effective
communication with all members, especially through listening. Be aware
of the formal and informal roles within the team and endeavor to keep
conflict between them to a minimum. In some cases, it may be beneficial
for roles to remain fluid, adding to the flexibility of working relationships,
but don’t allow team members to lose their focus on their individual

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strengths or objectives. An effective leader may decide to cede project
leadership (albeit temporarily) to another, when specific skills are
required.
9 Check progress towards objectives Check regularly to ensure that
everyone still has a clear focus on what they are working towards, both
individually and as a team. Identify milestones and hold team members
accountable for progress towards them. As the team develops, pride in
shared success and lessons learned from failure should also help to
develop a sense of shared purpose, strengthen commitment and
contribute to improved performance in the long run.

10. Time meetings with care unnecessary meetings are a bane, but if
there are too few, the project - and the team - can lose focus. Meet
regularly but with purpose, and with a clear agenda. Meetings provide
opportunities to:
➢ Check that everyone is comfortable with their roles and tasks
➢ Review progress towards goals
➢ Reflect on how the team is working together. If any problems are
identified, plan and implement appropriate action or corrective measures.
Make sure that decisions are clearly documented. Someone should take
responsibility for writing a summary of the meeting and ensuring that this
is circulated to the team and team leader for future reference.
11. Dissolve the team when the team has accomplished its tasks,
acknowledge this. Carry out a final review to confirm whether objectives
have been fully met. Evaluate the team's performance, so that individuals
can improve and learn from experience. If all the objectives have been
met the team can be disbanded.

Potential Pitfalls
Managers should avoid:

➢ Expecting a new team to perform effectively from the word go

dominating the work of the team, whether intentionally or
unconsciously
➢ Exercising excessive control which may stifle creativity
➢ Overlooking the influence of formal and informal team roles
➢ Allowing the team to lose focus on the tasks to be completed
➢ Letting a team become too exclusive, in case it loses touch with
the rest of the organization › allowing individuals to take credit for
the achievements of the team.

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LET US SUM UP
Team-working plays an important role for organization effectiveness,
which enhances quality, productivity and also cut costs. Normally teams
are built for specific task and the duration depends on the task, its just like
preparation to exercise for larger plan, this unit described and discussed
the various norms and types of team and how an individual should play in
a team.

CHECK YOUR PROGRESS

Choose the Correct Answer

1. The -------------stage is characterized by competition and conflict within
the team as members learn to bend and mold their feelings, ideas,
attitudes, and beliefs to suit the team organization.
a) Storming b) negotiating
c) Adjustment d) Performing
2. Members are willing to change their preconceived ideas or opinions on
the basis of facts presented by other members in this stage -------------
a) Structuring b) Norming
c) Adjudication d) performing
3. Team members are both highly task‐oriented and highly people‐
oriented during this stage.
a) Selecting stage b) entry stage
c) Adjourning d) Performing

4. Teams assembled for specific project or for a finite length of time go

through a stage, called ----------------------
a) initial stage b) monitoring stage
c) Adjourning d) Performing
5. At ---------------- stage team members not only get to know each other
but also familiarize themselves with their task and with other individuals
interested in the project, such as supervisors.
a) Forming b) Norming
c) settlement d) reinforcement

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GLOSSARY

Tasks : A piece of work to be done or

undertaken

Roles : The function assumed or part

played by a person or thing in a
particular situation.

Adjourning : An adjournment ends a meeting

Performing : The act of doing something.

Start-up : A start-up is a young company

founded by one or more
entrepreneurs to develop a unique
product or service and bring it to
market

SUGGESTED READINGS

1. DinkarPagare (2015) Principles of Management, Sultan Chand &

Sons, New Delhi.
2. Harold Koontz, Cyril O'Donnell and Heinz Weihrich (2017)
Essentials of Management (5th Revised edition), McGraw-Hill Inc.,
US, (ISE Editions).
3. Prasad L.M. (2015) Principles and Practice of Management,
Sultan Chand & Sons, New Delhi.
4. Sherlekar S.A. &Sherlekar V.S 3rd Edition (2014) Principles of
Business Management, Himalaya Publishing House Pvt. Ltd,
Mumbai.
5. Tripathi, Sixth edition (2017) Principles of Management, Tata
McGraw Hill Education Private Limited, 7thWest Patel Nagar, New
Delhi.
6. Tripathi, P C, Reddy, P N, 5 edition (2012) Principles of
Management, Tata McGraw Hill Education private limited, 7 th west
Patel Nagar, New Delhi.
7. https://legalpaathshala.com/types-of-teams/
8. https://asana.com/resources/team-roles
ANSWERS TO CHECK YOUR PROGRESS
1) a 2) b 3) d 4) c 5) a

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Unit 15

LEADERSHIP
STRUCTURE
Overview
Learning Objectives

15.1 Meaning and Nature of Leadership

15.2 Leadership and Management

15.3 Need for Leadership

15.4 Leadership Styles

15.5 Theories of Leadership

15.6 Qualities of a Good Leader
Let Us Sum Up

Check Your Progress

Glossary

Suggested Readings
Answers to check your progress

OVERVIEW

A successful organization has one major attribute that sets it apart from
an unsuccessful organization: dynamic and effective leadership. In a
business enterprise several tasks such as determining the objectives of
the enterprise, designing the methods to achieve them, directing and co-
coordinating the activities of various departments etc., can be successfully
performed only if there is an able leadership. This unit discusses the
various aspects of leadership.
LEARNING OBJECTIVES
After completing this unit, you should be able to,

• explain the term leadership

• explain the nature of leadership

• discuss the need for leadership

• elaborate the various leadership styles.

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15.1 MEANING AND NATURE OF LEADERSHIP
The following are some of the important definitions of leadership:
According to Peter Drucker, “Leadership is the lifting of man’s visions to
higher sights, the raising of a man’s performance to a higher standard, the
building of a man’s personality beyond its normal limitations”.
In the words of George Terry, “The will to do is triggered by leadership
and lukewarm desire for achievement is transformed into burning passion
for successful accomplishment by the skilful use of leadership “.
Alford and Beatty define leadership as the ability to secure desirable
actions from a group of followers voluntarily without the use of coercion.

According to Keith Davis leadership is the ability to persuade others to

seek defined objectives enthusiastically. It is the human factor which
binds a group together and motivates it towards goals.

The essence of leadership can be summarized as follows:

➢ Leadership is a group phenomenon. It involves interaction
between two or more people.
➢ It refers to the ability of one individual to influence others.
➢ The influence is exercised to change the behaviour of others.
➢ Behaviour is changed through non-coercive means.
➢ Change of behaviour is caused with an objective of achieving
shared goals.
➢ The person influencing others (leader) possesses a set of qualities
or characteristics which he uses to influence others .

15.2 LEADERSHIP AND MANAGEMENT

Management, manager ship and leadership are terms which are closely
related. Management is a process of planning, organising, coordinating
directing and controlling the activities of others.
Managership is the authority to carry out these functions.

Leadership, as mentioned above, is the process of influencing for the

purpose of achieving shared goals.
Managers, by virtue of being in a managerial position, have managership,
but they may not possess leadership or the ability to influence other
people.
The following are some of the differences between leaders and

managers;

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 1. Leaders have followers, but managers do not have.
2. Leaders have emotional appeal whereas managers are expected
to be rational decision makers and problem solvers.
3. Leaders give priority to follower’s needs, but managers give
importance to organizational goals.
15.3 NEED FOR LEADERSHIP
i) The incompleteness of formal organizational design: The formal
organization is generally incomplete and imperfect. Leadership helps
overcome the deficiency.
ii) Changing environment conditions: A leadership of high order would
be needed for the organization to cope with the technological, legal,
cultural and other changes.
iii) The internal dynamics of the organization: As the organization
grows new complexities of structure are created, new needs for co-
ordination arise, and new policies must be invented. Good leadership is
required to cope with these situations.
iv) The nature of human membership in organizations: Human
membership in an organization is segmental in nature. The organization
expects the person to adapt to its requirements. A leader is helpful for
such adaptation.
15.4 LEADERSHIP STYLES
Leadership style is the typical approach a particular person uses to lead
people. The familiar three way classification of leadership styles is as
follows;
i) Authoritarian style
ii) Participative style and

iii) Free-rein style

I) Authoritarian Style: In this type of leadership the leader alone
determines policy and makes plans. He tells others what to do and how
to do it. He demands strict obedience and relies on the power of his
position to reward and punish others. People have little freedom under
him. He shows greater concern for work than for his workers.

Merits
This type of leadership can increase efficiency and get quick results in
a crisis or emergency situation.

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 This style of leadership works well with the employees who have a low
tolerance for ambiguity, feel insecure with freedom and even minor
decision making requirements, and thrive under clear, detailed and
achievable directives.

Chain of command and division of work are clear and fully understood
by all in this type or leadership.
Demerits

One-way communication, without feedback, typically leads to

misunderstandings, communication breakdowns and costly errors.
This leadership style excludes the people from involvement and reduces
them to machine-like cogs without human dignity or importance.
ii) Participative style: In this type of leadership the entire group is
involved in and accepts responsibility for goal setting and achievement.
Subordinates have considerable freedom of action. The leader shows
greater concern for his people than for high production.
Merits
When people participate in and help formulate a decision, they support
it and work hard to make it work because it is their idea and now, part of
their life and their ego.

The leader consistently receives the benefit of the best information,

ideas, suggestions, talent and operating experience of his people.
This style of leadership permits and encourages people to develop,
grow and rise in the organization.

Demerits
This style needs a lot of time and human relations skill which are not
widely possessed.

This style very often results in watered down solutions.

This style may cause embarrassment and nervousness to certain
employees who are coming from authoritarian culture and family
background.
This style may alienate certain individuals whose opinions have been
rejected. These persons may join hands to oppose management.
This style, if not exercised properly, may degenerate into a complete
loss of leader’s control. Some leaders may use this style as a way of
avoiding responsibility.

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iii) Free-rein or Laissez Faire style: In this type of leadership, the leader
exercises absolutely no control. He only provides information, materials
and facilities to his men to enable them to accomplish group objectives.
This type of leadership can be a disaster if the leader does not know well
the competence and integrity of his people and their ability to handle this
kind of freedom.
15.5 THEORIES OF LEADERSHIP

The important theories of leadership are:

i. Trait theory
ii. Leader behaviour theory
iii. The managerial grid
iv. Contingency theory
v. The VDL theory
vi. Theory X and Theory Y.
i) Trait Theory: The trait theory of leadership focuses on the individual
characteristics of successful leaders. According to the theory, leaders
possess a set of traits which make them distinct from followers. One can
group these qualities under three broad heads: Physical qualities, Moral
qualities and mental qualities.

Physical qualities: A leader must possess a high degree of physical and

nervous energy. He must have a sense of robust joy in his mission and a
great vigour of body and mind to stand up to the stress and strain of his
high office and responsibility.
Moral qualities: First among moral qualities is the courage to own the
responsibility of one’s action, should the action prove wrong later on, next
comes the sense of fair play and justice. A leader must possess this
quality to be able to motivate his men into action.
Mental qualities: First among mental qualities is forgiveness and
compassion. Next comes knowledge. A leader’s knowledge of a subject
or technique must be greater than that of his followers. If it is not so, he
has no justification to lead them. He can, therefore, never afford to stop
learning.
A leader must possess decisiveness. Vacillation is fatal for a leader. But
rigidity of decision is equally bad.

A leader must possess empathy. It is the ability to look at things

objectively and understand them from another’s point of view. This quality
enables the leader to anticipate the sentiments and reactions of others,
and to prepare his own strategy accordingly.

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Last, but not the least is initiative. The success or failure of a leader very
much depends on his initiative in organising the means to achieve his
objective. Initiative simply means doing the right thing without being told.
Criticism of the theory: Traits theory is criticized on the following
grounds:
This theory has failed to identify any traits as being absolutely essential
for leadership. Numerous trait studies have been made but only 5% of the
traits are identified as common.
There is the problem of defining traits. The number of descriptive
adjectives which can be used for any trait is tremendously large.

There is the problem of measuring traits and difficulty in methodology

also.
This theory overlooks the situational nature of leadership qualities. The
fact is that with the same traits a person may become a successful leader
in one situation and may fail in another situation.
ii) Behavioral Theory: Beginning in the late 1940’s and continuing
through the early 1960’s researchers moved away from emphasis on traits
and towards the study of leader behaviors.
Ohio State University studies, University of Michigan studies and the
Managerial Grid are the important behavioral theories.
Ohio State University studies: These studies were carried out in the 1950s
at Ohio State University. These studies measured leader behaviour on
two dimensions: initiating structure and consideration. Initiating structure
refers to the leader’s endeavor to establish well-defined patterns of
organization, channels of communication, methods and procedures. It is
a task-oriented dimension. On the other hand, consideration refers to the
leader’s interpersonal relationships with his subordinates. It is a person
oriented dimension.

The findings of the Ohio State studies can be summarized as follows:

Consideration was positively related to low absenteeism and
grievance, but it was negatively or neutrally related to performance.

Initiating structure was positively related to employee performance but

was also associated with such negative consequences as absenteeism
and grievances.

When both consideration and structure were high, performance and

satisfaction tended to be high. But in some cases, high productivity was
accompanied by absenteeism and grievances.

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The University of Michigan Studies: The researchers at the University of
Michigan distinguished between two dimensions of leadership
Production – centered and Employee – centered.
Production – centered leaders set rigid work standards, organized tasks
down to the last detail, prescribed the work methods to be followed and
closely supervised subordinates’ performance.
Employee – centered leaders, on the other hand, encouraged employee
participation in goal setting and in other work related decisions, and
helped ensure high performance by inspiring respect and trust.
iii) The Managerial Grid: A graphic depiction of a two dimensional view
of leadership style has been developed by Blake and Mouton. They
proposed a managerial grid based on the terms, ‘concern for people’ and
‘concern for production’

These two dimensions (concern for production and concern for people)
are plotted on a 9 – point scale on two separate axes. Concern for
production is shown on the horizontal axis and concern for people is
shown on the vertical axis. There are thus 81 combinations of concerns
represented on the grid. But the emphasis is much on the styles in the
four corners and at the middle of the grid. These are explained as follows:

• The 9,1 leader (Task Management): The 9,1 leader is primarily

concerned with production and has little concern for people.
• The 1,9 leader (Country club management): The 1,9 leader is primarily
concerned with people.
• The 1,1 leader (Impoverished Management): The 1,1 leader has
minimum concern for people and production.
• The 5,5 leader (Middle of the road management): Here the leader
shows a balanced concern for production and people but achieves
little.
• The 9,9 leader (Team Management): It demonstrates high .
Concern for both production and people and is, therefore, the ideal
approach to leadership.

The model is useful to managers in as much as it helps them identify their

current styles and develop the most desirable style (9,9).
iv) Contingency theories of leadership: As the name itself implies,
Contingency theories of leadership are derived from the basic proposition
that the most effective behaviour for leaders to engage in is contingent
upon characteristics of the situation in which the leaders find themselves.

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Fiedler’s contingency theory, the Path-Goal theory and the situational
leadership theory are the most popular contingency theories of
leadership.
Fiedler’s Contingency theory: This theory postulates that the effectiveness
of leadership style depends on situational favorableness. According to
Fiedler, situational favorableness depends on three factors:
1. Leader-member relations
2. Task structure and
3. Position power.
One can classify group situations by means of these three dimensions.
For this purpose, all groups can be classified falling above or below the
median on each dimension. This will lead to an eight-fold classification
as shown in the figure

Good Poor

Structured Unstructured Structured Unstructured

High Low High Low High Low High Low
1 2 3 4 5 6 7 8
Favourable situations for Unfavorable situation for
leader leader

According to Fiedler, leader-member relations are good if the leader is

respected and accepted by his group. They are poor if his group distrusts
and rejects him. The task is highly structured if it is clearly outlined and
highly unstructured if it is vague. The leader’s position power is high if he
has the power to hire and fire, promote and transfer, increase or decrease
salaries. It is low if he has no such power.
As shown in Figure, the extreme left combination – good leader – member
relations, highly structured task, and high position power-represents a
very favorable situation for the leader, one in which it should be easy to
influence subordinates. The opposite extreme (relatively poor
relationships with subordinates, unstructured task, lowpower) is a leader’s
nightmare. Other situations fall in between these two extremes.

Path-Goal theory of leadership: This theory was developed by Robert

House. According to the theory the leader must clarify goals for the
subordinates and clear the path for realizing the goals. The theory is
called path goal because its major concern is how the leader influences
the subordinates’ perceptions of their work goals, personal goals and
paths to goal attainment. The theory suggests that a leader’s behaviour

217
is motivating or satisfying, to the degree that the behaviour increases
subordinate goal attainment and clarifies the paths to these goals. The
ultimate effect of leadership behaviour on motivation and satisfaction is
contingent upon the characteristics of environment and of the
subordinates.
The theory suggests that four different kinds of leader behavior and two
categories of contingency variables emerge. The four dimensions of
leader behavior are directive, supportive, achievement oriented and
participative and the contingency variables include subordinate attributes
and the work setting. Together, the behavior and contingencies influence
the motivation for task performance and satisfaction of employees.
Situational Leadership Theory: This theory was developed by Hersey
and Blanchard and it regards the level of maturity of the followers as the
most crucial variable among all situational determinants. Maturity is
determined as the capacity to set high but attainable goals (achievement
motivation) willingness and ability to take responsibility, and education
and experience of an individual or a group. These variables of maturity
should be considered only in relation to a specific task to be performed.
Since the level of maturity of the whole group may differ from the levels of
its individual members a leader may behave quite differently with the
members as individuals than when interacting with the group as a whole.
In this figure the maturity level of followers is depicted below the
leadership model as a continuum ranging from immaturity to maturity. To
determine what leaderships style is appropriate in a given situation, a
leader must first determine the maturity level of the individual or group in
relation to a specific task that the leader is attempting to accomplish
through their efforts. Once this maturity level is identified, the appropriate
leadership style can be determined by contracting a right (90°) angle from
the point on the continuum that represents the maturity level of the
follower(s) to a point where it intersects on the curvilinear function in the
style-of-leader portion of the model. The quadrant in which that
intersection takes place suggests the appropriate style to be used by the
leader in that situation with follower(s) of that maturity level.
v) The Vertical-Dyad linkage theory of leadership: The Vertical-Dyad
Linkage theory of leadership (VDL) is based on the premise that leaders
have different relationships with different subordinates. According to the
VDL theory, each superior-subordinate pair is considered to be a vertical
dyad. As presented in Figure the model stipulates that leaders establish
special relationships with a few trusted subordinates that are called the in-
group. This in-group generally receives special privileges and autonomy

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in exchange for assuming special duties and greater responsibilities.
Subordinates who are not members of the in-group receive less attention
from the superior and are referred to as the out group. The model shows
that the superior has one-on-one, dyadic, relationships with each
subordinate. Early in his/her association with each subordinate, the
superior initiates either an in-group or out-group relationship.
It is assumed that the decision is based on a combination of subordinate
competence and personal compatibility.
vi) McGregor’s Theory X and Theory Y: McGregor contended that
many managerial practices were based on Theory X and Theory Y
assumptions. Theory X has the following assumptions.
• Employees are inherently lazy and will avoid work unless forced to do
it.
• Employees have no ambition or desire for responsibility; instead they
prefer to be directed and controlled.
• Employees have no motivation to achieve organizational objectives.
• Employees are only motivated by physiological and safety needs.
• The assumptions under Theory Y are:
• Employees find work as natural as play if organizational conditions are
appropriate.
• Employees can be motivated by higher order needs such as ego,
autonomy and self-actualization.
• Employees seek responsibility since it allows them to satisfy higher
order needs.
It was McGregor’s belief that a manager’s style was an important
determinant of employee behaviour. If the manager assumed that his
employees were lazy and lacked a sense of responsibility, they would
respond in the same way. On the other hand, if the manager treated his
subordinates as though they were mature and responsible individuals,
they would react accordingly.
15.6 QUALITIES OF A GOOD LEADER

Till now, we have discussed the nature and theories of leadership. The
above discussion will help a practicing manager discharge his functions
more effectively in the following ways:

i) The manager must understand that leadership is a two-way influencing

process. Just as the leader influences his followers, the actions and
performance of subordinates will influence the behaviour of their leader.
The leader must realize this and accept the influence of followers on him.

219
ii) There is no denying the fact that effective leadership demands certain
unique qualities. One such quality is competence. The leader must be
competent enough to perform a task better than what his followers are
capable of. Competence gives robust confidence to the leader about
himself and about his team. It is the confidence which equips him to face
any adverse situation with courage. A leader needs to be an intellectual.
He needs to understand not only the intricacies of the immediate task
before him, but must also have knowledge about the political, economic,
social and cultural milieu operating beyond his company’s gate. The
leader should be a visionary to visualize and map out the future for his
organization 15 to 20 years ahead and even beyond. Communication skill
is yet another quality which a leader needs to be endowed with. What
makes a successful leader distinct from unsuccessful ones is the courage
to make quick decisions. Success in business lies in seizing an
opportunity before others do and exploiting it to one’s advantage. A
leader needs to be even tempered however trying the situation may be.
Selflessness pays rich dividends to the leader. He must have sincerity of
purpose. Above all the leader must be a man of character.
iii) The lesson from the behavioral theories is that the behaviors of
successful leaders can be learnt even if a leader is short on some of the
traits listed above. He can still be successful in his job provided he can
learn appropriate behaviors while delegating duties to their subordinates,
communicating, and motivating them.
iv) A leader can learn a valuable lesson from contingency theories; the
effectiveness of leadership depends on situations – the tasks to be
accomplished, the skills and expectations of subordinates, the
organizational environment, the past experiences of the leader and his
followers, and the like. An individual who is successful as a leader in one
situation may do poorly in another. Specifically, contingency theories
encourage managers to:
• Examine their situation – the people, task, and organization.
• Be flexible in the use of various skills within an overall style.
• Consider modifying elements of their jobs to obtain a better match
with their preferred style.

Thus, a successful leader does not have one best way of doing things.
He needs to follow different styles suiting different situations. Matching a
particular style to a specific situation is the essence of effective leadership.

McGregor’s Theory X and Theory Y can be an eye opener to any leader.

Most leaders assume that their followers fall under Theory X though they

220
are, in effect, under Theory Y. The leader needs to learn a new theory of
working with people – Theory Y.

LET US SUM UP
Leadership steers any organization to great success. There are various
styles of leadership such as Authoritarian, Participative and Free rein.
Various theories such as Trait Theory, Leader Behaviour Theory etc., are
helpful to understand the various dimensions of leadership.

CHECK YOUR PROGRESS

Choose the Correct Answer

1. The ------------- of leadership focuses on the individual characteristics of
successful leaders.
a) trait theory b) Maslow theory
c) contingency theory d) managerial grid
2. ------------- leader’s interpersonal relationships with his subordinates
a) XY theory b) behavior theory
c) equity theory d) managerial grid
3. Blake and Mouton proposed the -------- theory

a) Trait theory b) behavior theory

c) Vroom's theory d) managerial grid
4. Fiedler’ proposed the -------- theory
a) Expectancy theory b) Behavior theory
c) porter's theory d) Managerial grid
5. The entire group is involved in and accepts responsibility for goal setting
and achievement in -------------.
a) Authoritarian style b) Free-rein style
c) Participative style d) managerial grid style

GLOSSARY

Leader : The person who leads or

commands a group, organization,
or country

Grid : A network of lines that cross each

other to form a series of squares or
rectangles.

Trait : A distinguishing quality or

characteristic, typically one
belonging to a person.

221
 Free rein : Freedom of action or expression.

Authoritarian : Favoring or enforcing strict

obedience to authority at the
expense of personal freedom.

SUGGESTED READINGS
1. DinkarPagare (2015) Principles of Management, Sultan Chand &
Sons, New Delhi.
2. Harold Koontz, Cyril O'Donnell and Heinz Weihrich (2017)
Essentials of Management (5th Revised edition), McGraw-Hill Inc.,
US, (ISE Editions).
3. Prasad L.M. (2015) Principles and Practice of Management,
Sultan Chand & Sons, New Delhi.
4. Sherlekar S.A. &Sherlekar V.S 3rd Edition (2014) Principles of
Business Management, Himalaya Publishing House Pvt. Ltd,
Mumbai.
5. Tripathi, Sixth edition (2017) Principles of Management, Tata
McGraw Hill Education Private Limited, 7 thWest Patel Nagar, New
Delhi.
6. Tripathi, P C, Reddy, P N, 5 edition (2012) Principles of
Management, Tata McGraw Hill Education private limited, 7 th west
Patel Nagar, New Delhi.
7. https://www.managementstudyguide.com/leadership-
management.htm
8. https://epgp.inflibnet.ac.in/Home/ViewSubject?catid=ahLCajOqz6/
GWFCSpr/XYg==
ANSWERS TO CHECK YOUR PROGRESS
1) a 2) b 3) d 4) c 5) d

222
 BLOCK 5
ORGANIZATIONAL CHANGE & DEVELOPMENT

Unit 16 : Organizational Change

Unit 17 : Organizational development

Unit 18 : Organizational Culture and Climate

Unit 19 : Future Trends in Organization

Behavior

223
Unit 16

ORGANIZATIONAL CHANGE
STRUCTURE
Overview
Learning Objectives

16.1 Meaning of organizational change

16.2 Levels of change

16.3 Reasons for change

16.4 Resistance to change

16.5 Benefits of Resistance

16.6 Benefits of Resistance
16.7 implementation of change

16.8 Manger as change agent

16.9 Organizational Change Drivers

16.10 Types of organizational change

16.11 Organizational Change – Failure
Let Us Sum Up

Check Your Progress

Glossary
Suggested Readings

Answers to check your progress

OVERVIEW
Life itself is almost synonymous with the concept of change. All
organisms must adapt to the demands of their environments and their own
stages of growth. Similarly, an organization cannot and should not remain
constant overtime. Even if the management does not want to change,
external pressures force it to change. Not only is change inevitable, it is
pervasive too. The concept was observed throughout all aspects of the
study of organizational behaviour. Think about leadership, motivation,
organizational environment, and roles. It is impossible to think about
these and other concepts without enquiring about change.

224
LEARNING OBJECTIVES
After completing this unit, you should be able to,
• describe the nature of change, the levels of change and its
implication at each level
• explain the reasons why change occurs and why people resist
change
• describe the ways of introducing change successfully.

16.1 DEFINITION AND MEANING

Change is inevitable in the life of an organization. Change heralds new
opportunities and poses formidable challenges. Organizations that learn
and cope with change will thrive and flourish and others which fail to do
so will be wiped out. In this chapter we will discuss various aspects of
changes.

According to Stephen P. Robbins, change is concerned with making things

different. Things must be different because they change constantly.
Technological development changes the methods of producing goods and
services. Jobs become increasingly complex and technologically more
interdependent. Organizations today compete in world markets. All these
developments make change inevitable and pervasive in organizational life.
To quote another definition, “when an organizational system is disturbed
by some internal or external force, change frequently occurs”. Change,
as a process, is simply modification of the structure or process of a system.

Organizational Change looks both at the process in which a company or

any organization changes its operational methods, technologies,
organizational structure, whole structure, or strategies, as well as what
effects these changes have on it. Organizational change usually happens
in response to – or as a result of – external or internal pressures. It is all
about reviewing and modifying structures – specifically management
structures – and business processes. Small commercial enterprises need
to adapt to survive against larger competitors. They also need to learn to
thrive in that environment. Large rivals need to adapt rapidly when a
smaller, innovative competitor comes onto the scene. To avoid falling
behind, or to remain a step ahead of its rivals, a business must seek out
ways to operate more efficiently. It must also strive to operate more cost
effectively.

16.2 LEVELS OF CHANGE

Change can be at individual, group and organizational levels.

225
i) Individual level change: Change at the individual level will have its
repercussions on the group which, in turn, might influence the wider
organization. A manager who desires to implement a major change at the
individual level, must understand that the change will have repercussions
beyond the individual.
ii) Group level changes: As most activities in organizations are
organized on a group basis, the organizational changes have their major
effects at the group level. The groups would be departments, or informal
work groups. Changes at the group level can affect work flows, job design,
and social organization and communication patterns.

iii) Organizational level changes: Changes at this level involve major

programmes that affect both individuals and groups. Decisions regarding
these changes are generally made by senior management and are
seldom implemented by only a single manager. Examples of these
changes would be reorganization of the organizational structure and
responsibilities, revamping of employee remuneration system or major
shifts in an organization’s objective.

16.3 REASONS FOR CHANGE

Organizations change because of several reasons, some of which are
external to the company and others internal to it. The most common
external and internal causes are shown in the table below:
Causes for Change
External Causes External Causes
Internal Causes Internal Causes

Government policies Change in leadership

Changes in the economy Implementation of new

technology Competition

Raw material cost Decline in profitability

Pressure groups Union actions

Technology push Low morale and motivation

Scarcity of labour etc., Changes in employee profile

16.4 RESISTANCE TO CHANGE

226
The word change is not liked by many people. It produces emotional
reactions. To many people it is threatening, and makes them dissatisfied.
However, not all change is resisted.
Sources of resistance to change may be rational or emotional. Rational
resistance occurs when people do not have the proper knowledge or
information to evaluate change. Emotional resistance involves the
psychological problem of fear, anxiety, suspicion, insecurity and the like.
These feelings are evoked because of people’s perception of how the
change will affect them. An understanding of the difference between the
rational and emotional sources is necessary. The reasons for resistance
to change are categorized as logical, psychological and sociological.

i) Logical, rational factors:

a. Time required to adjust

b. Extra effort to relearn

c. Possibility of less desirable conditions, such as skill downgrading

d. Economic costs of change
e. Questionable technical feasibility of change

ii) Psychological, emotional causes:

a. Fear of the unknown

b. Low tolerance of change

c. Dislike of management or other agent of change
d. Lack of trust in others
e. Need for security, desire for status quo.

iii) Sociological factors, group interests:

a. Political conditions

b. Opposing group values

c. Parochial, narrow outlook
d. Vested interests

e. Desire to retain existing friendships

f. Group inertia
In addition to the causes stated above, there are other sources called
organizational sources which cause organizational resistance.

227
These include: over determination, narrow focus of change, threatened
expertise, threatened power, changes in resource allocation and
organizational culture.
Over determination: The structure of the organization provides
resistance to change because it was designed to maintain stability.
Narrow focus of change: Many efforts to create change in organizations
adopt to narrow a focus. Any effort to force change in the tasks of
individuals or groups must take into account the interdependencies
among organizational elements such as people, structure, tasks and
information system.

Threatened expertise: A change in the organization may threaten the

specialised expertise that individuals and groups have developed over the
years. A job redesign or a structural change may transfer the
responsibility for a specialized task from the current expert to someone
else, thus threatening the specialist’s expertise and developing his or her
resistance to change.
Threatened power: Any redistribution of decision-making authority may
threaten an individual’s power relationships with others. If an organization
is decentralizing its decision making, managers who wielded their
decision-making powers in return for special favors from others may resist
the change because they do not want to lose their power base.
Resource allocation: Groups that are satisfied with current resource
allocation methods may resist any change they believe will threaten their
future allocations.
Organizational culture: Culture helps an organization shape and
maintain own identity. Culture also guides employee behavior. Indeed,
many employees identify with their organization and take its gains and
losses personally. As a result, they may feel threatened by efforts to make
radical changes in the organization’s culture. Hence, the resistance to
change.
16.5 SYMPTOMS OF RESISTANCE

The following are some of the symptoms of resistance:

• Hostility or aggression shown towards boss, a fellow worker or
subordinates.

• Individual may develop apathy towards his work; loses interest in

his work; more spoilage of materials, excessive idling of time and
decline in performance.

228
 • Absenteeism and tardiness are forms of attempts by the individual
to escape his work environment.
• Development of anxiety and tension; The individual finds himself
uncomfortable, shaky and tensed up on his job.

• At the group level, slowdowns and strikes are the usual symptoms
of resistance.
16.6 BENEFITS OF RESISTANCE

Resistance can also bring some benefits. It may encourage the

management to re-examine its change proposals so that they are
appropriate. It can help identify specific problem areas where change is
likely to cause difficulties, so that the management can take corrective
action before serious problems develop. It also gives management
information about the intensity of employee emotions on an issue,
provides emotional release for pent up employee feelings, and may
encourage people to think and talk more about change so that they
understand it better.
16.7 IMPLEMENTATION OF CHANGE

Successful implementation of change involves three phases viz.,

(i) Unfreezing (ii) Changing (iii) Refreezing

i) Unfreezing: This involves casting aside existing attitudes and value

systems, managerial behaviors, or organizational structure so that new
ones can be learnt. Unfreezing creates the need for change.

ii) Changing: Actual change occurs at this stage. New value systems,
behaviors or structures replace the old ones. This is the action-oriented
stage. This can be a time of confusion, dis-orientation and despair mixed
with hope and discovery.
iii) Refreezing: Here the change becomes permanent. The newly
acquired values, beliefs and structures get refrozen. A new status quo is
established at this stage.
16.8 MANAGER AS CHANGE AGENT
Change agents are responsible for managing change activities. Change
agents can be managers, or non-managers, employees of the
organization or outside consultants.
Normally managers act as change agents and adopt various approaches
to introduce change successfully.

The methods suggested for the successful introduction of change are:

229
Use of group forces, use of leadership, shared awards, working with
unions and concern for employees.

Brief explanations of these factors are given below:

➢ The change agent must make use of the groups to bring about
change as they exercise considerable influence on the behavior of
members.
➢ The change agent himself must be willing and prepared to accept
new methods.
➢ The agent must ensure that the people affected by change derive
benefit out of the change.

➢ Benefits include increased pay, promotion, training, recognition and

the like.
➢ The change agent should take trade unions into confidence to
implement change successfully. Any changes introduced without
the union’s support may not stay for long.
➢ The change agent should see to it that the ultimate aim of any
change is for the benefit of employees.

16.9 ORGANIZATIONAL CHANGE DRIVERS

An organization’s change drivers include:

The economic climate

The term ‘economic climate’ means the state of the overall economy, i.e.,
economic conditions. If there is a recession, a company may have to lay
off workers; this requires restructuring. A merger or takeover also means
total reorganization and changes in corporate culture. Corporate culture
or organizational culture is a group of internal values and behaviors within
an organization.

Consumer demand & behavior

People’s lifestyles and how they shop, work, and spend their leisure times
are forever changing. Since the advent of the Internet, these changes
have been occurring at significantly faster rates.
New technologies

New hi-tech systems and devices have completely changed how

commercial enterprises do business and interact with other entities in the
marketplace. Business models such as virtual collaboration and
outsourcing are only possible today thanks to the Internet and ultra-high-
speed communications. Without technological change, our business

230
leaders would still be dictating correspondence to human beings, who
would then type them out and arrange for them to be distributed to the
relevant people – wasting an incredible amount of time and resources.
The competitive marketplace

If a new rival comes onto the scene with completely different commercial
behaviors, the other players may have to adapt, especially if that
competitor is successful in gaining market share.

Rules and regulations (government policy)

When companies are faced with new legislation or rules imposed by the
relevant regulatory authorities, they need to do two things: 1. Comply with
them. 2. Adapt so that they may continue to thrive.

16.10 TYPES OF ORGANIZATIONAL CHANGE

What type of organizational change a company requires or is going
through varies, depending on the person’s point of view.
A manager in technology may see it in terms of systems, tools, software,
hardware, etc. The CEO will invariably perceive change in terms of
structure and strategy. The operations manager, on the other hand, will
mainly see it in terms of processes, etc. In the majority of cases, the
change is so complex and intricate that nobody can define it fully from a
specific standpoint.
Below are some of the common types of organizational change. Bear in
mind that there is some or significant overlap between them:

Mission and Strategy

This is all about the company’s aims and goals and how it plans to
accomplish them. Hardly any change in an organization is not related to
its mission and strategy.
Mission and strategy affect every part of a business. Therefore, any
change in this area has a company-wide impact.

Policies and Legal Agreements

Changing policies and legal agreements may be highly unpopular with
customers and the workforce. Any change in this area, even a minor one,
may have a significant impact on a company.

Organizational Structure
The term refers to the hierarchy within an organization, which defines
each job and department, their function, and where they report to.

231
When two commercial enterprises merge, or one takes over another,
there are major structural changes. Sometimes the change may be minor,
such as when a new team is established.
Processes

This term refers to a collection of linked tasks which find their end in the
delivery of a product or service to a consumer.
Processes and tasks are commonly altered during organizational change.
In some organizations, changing or upgrading processes is ongoing or
occurs on a regular basis.
Personnel

Personnel mean staff or human resources, i.e., the employees. It includes

hiring, firing, training, roles, responsibilities, and other changes related to
the workforce.

Culture
Culture refers to the pervasive beliefs, values, and attitudes that
characterize a firm and guide its practices.

Any change in these areas can have a profound impact on every aspect
of the organization.
It can have an impact on, for example, productivity, compliance, and
innovation.
Products
This is all about changes to products, and everything related to
encouraging consumers to buy them. Marketing and sales are an
essential focus for most organizations.
Knowledge

Knowledge supports every product, process, initiative, project, and

program. Change here refers to the knowledge assets of the company.
Knowledge assets are the information or skills within an organization that
make it more competitive or valuable.
Technology
Today, virtually every commercial enterprise is a kind of tech company.

Sometimes, a company makes changes to its technology infrastructure,

automation, systems, hardware, software, etc.

232
Integration
• Integration includes synchronizing IT (information technology) and
business cultures and objectives, aligning technology with
company strategy and goals.

• In a company, integration is a reflection of how people are

absorbing IT as a function of the organization.
• Virtually every change requires integration. We must align
everything in a company so that they support, compliment, and
add value to each other.
• Integration is usually the most complex type of change. When
carried out successfully, the whole company is clearly much more
valuable than the sum of its parts.
16.11 ORGANIZATIONAL CHANGE – FAILURE

Perhaps this is why, in most cases, when people implement organizational

change, it usually fails.
The key conclusion of a study – ‘Where Change Management Fails‘ – by
Robert Half Management Resources, which included 300 senior
managers at US companies with at least 20 workers, was that
organizational change usually fails.

The study found that in the majority of cases, the failure occurs in the
executional phase. This is due mainly to broken or inadequate
communication.

Forty-six percent of respondents said that most change-management

efforts commonly failed at execution. However, only 10% claimed it
occurred during the strategy development stage.
When asked what was most important when leading their company
through a major organizational change, the respondents said:
Communicating clearly and often: 65%
Clearly outlining the goals: 16%
Delegating effectively: 9%
Executive Director of Robert Half Management Resources, Tim Hird,
explained:
“Whether major or incremental, many companies are initiating changes,
from transforming their business models to updating business systems
and looking for ways to enhance productivity. While change is never easy
for a company, it’s even harder for employees.”

233
LET US SUM UP
This unit makes it clear that Change is an inevitable phenomenon in
organizational life. Changes take place at individual, group and
organizational levels. There is external as well as internal causes for
change. Any change introduced is resisted for various reasons.
Resistance has its positive side too.
CHECK YOUR PROGRESS

Choose the Correct Answer

1. --------------- involves casting aside existing attitudes and value
systems, managerial behaviors.

a) unfreezing b) controlling

c)changing d) resistance
2. New value systems, behaviors or structures replace the old ones at---
------------- stage

a) Storming b) refreezing
c) Changing d) norming

3 The newly acquired values, beliefs and structures get permanent at ----
stage.
a) Planning b) refreezing

c) Controlling d) organizing
4. ------- involves the psychological problem of fear, anxiety, suspicion,
insecurity.
a) Acceptance b) negligence

c) Changing d) resistance
5 The reasons for resistance to change are categorized as ------------

a) Sociological b) logical
c) psychological d) all of the above
GLOSSARY

Organizational Change : Organizational change refers to the

actions in which a company or
business alters a major component
of its organization

234
 Change agent : The factor that causes change in an
organization is known as a change
agent

Resistance : The refusal to accept or comply with

something.

SUGGESTED READINGS
1. DinkarPagare (2015) Principles of Management, Sultan Chand &
Sons, New Delhi.
2. Harold Koontz, Cyril O'Donnell and Heinz Weihrich (2017)
Essentials of Management (5th Revised edition), McGraw-Hill Inc.,
US, (ISE Editions).
3. Prasad L.M. (2015) Principles and Practice of Management,
Sultan Chand & Sons, New Delhi.
4. Sherlekar S.A. &Sherlekar V.S 3rd Edition (2014) Principles of
Business Management, Himalaya Publishing House Pvt. Ltd,
Mumbai.
5. Tripathi, Sixth edition (2017) Principles of Management, Tata
McGraw Hill Education Private Limited, 7 thWest Patel Nagar, New
Delhi.
6. Tripathi, P C, Reddy, P N, 5 edition (2012) Principles of
Management, Tata McGraw Hill Education private limited, 7 th west
Patel Nagar, New Delhi.
7. https://epgp.inflibnet.ac.in/Home/ViewSubject?catid=ahLCajOqz6
/GWFCSpr/XYg==
8. https://whatfix.com/blog/lewins-change-model/
ANSWERS TO CHECK YOUR PROGRESS
1) a 2) c 3) b 4) d 5) d

235
Unit 17

ORGANIZATIONAL DEVELOPMENT
STRUCTURE
Overview
Learning Objectives

17.1 Meaning of Organizational Development

17.2 Characteristics of Organizational Development

17.3 Organizational Development Process

17.4 Organizational Development Techniques

17.5 Benefits of Organizational Development

17.6 Steps in Organizational Development
17.7 Modern Organization Development Techniques

Let Us Sum Up
Check Your Progress

Glossary
Suggested Readings
Answers to check your progress

OVERVIEW
Organizational Development is a long term, more encompassing change
approach meant to move the entire organization to higher levels of
functioning while improving greatly the performance and satisfaction of
organization members. The OD paradigm values human and
organizational growth, collaborative and participative processes and spirit
of enquiry. The OD techniques or interventions for bringing about change
are worth mentioning. This unit deals with the vital topics viz.,
Organizational Change and Organizational Development

LEARNING OBJECTIVES

After completing this unit, you should be able to,

• tell the meaning of OD
• explain the characteristics
• list out the process of OD
• discuss thevarious OD techniques.

236
17.1 MEANING OF ORGANIZATIONAL DEVELOPMENT
Organizational change which occurs over a long period of time and
requiring considerable planning and implementation is popularly called as
Organizational Development. It is the systematic application of
behavioural science knowledge at various levels (group, inter group, and
total organization) to bring about planned change. Its objectives include
a higher quality of work life, productivity, adaptability and effectiveness.

It seeks to use behavioral knowledge to change beliefs, attitudes, values,

strategies, structures and practices so that the organization can better
adapt to competitive actions, technological advances and the fast pace of
other changes in the environment.
Organizational Development has been understood as a system-wide
process of data collection, diagnosis, action planning, intervention and
evaluation aimed at (1) enhancing congruence among organizational
structure, process, strategy, people and culture; (2) developing new and
creative organizational solutions; (3) developing the organization’s self-
renewing capacity.
OD is an attempt to use the concepts and methodologies of applied
behavioral sciences (psychology, sociology, anthropology and social
psychology) to help organizations develop and maintain their health.
17.2 CHARACTERISTICS OF ORGANIZATIONAL DEVELOPMENT
The characteristics of OD are explained in the following paragraphs:

i) Humanistic values: OD programmes typically are based on humanistic

values, which are positive beliefs about the potential and desire for growth
among employees. The best climate for such growth is one that stresses
collaborations, open communications, interpersonal trust, shared power
and constructive confrontation.
ii) Use of change agents: OD programmes generally use one or
more change agents, whose role is to stimulate, facilitate and co-ordinate
change. The change agent usually acts as a catalyst, sparking change
within the system while remaining somewhat independent of it.

iii) Problem solving: OD emphasizes the process of problem solving. It

trains participants to identify and solve problems that are important to
them. The approach commonly used to improve problem-solving skills is
to have employees identify system problems, gather data about them,
take corrective action, assess progress and proceed to make adjustments.
This cyclical process of using research to guide action, which generates

237
new data as the basis for new actions, is known as “Action Research”, or
“Action Science”.
iv) Experiential learning: When participants learn by experiencing in the
training environment the kinds of human problems they face on the job;
the process is called “Experiential Learning”. Participants can discuss
and analyse their own immediate experiences and learn from them.
The general goal of OD is to build more effective organizations – which
will continue to learn, adapt and improve. OD accomplishes this goal by
recognising that problems may occur at the individual, interpersonal,
group, intergroup or total organization level. An overall OD strategy is then
developed with one or more “interventions”.
The ‘interventions’ are structured activities designed to help individuals or
groups improve their work effectiveness. These interventions are often
classified by their emphasis on individuals (such as career planning) or
groups (such as team building). Another way to view interventions is to
look at whether they focus on what people are doing or on how they are
doing it.
vi) Contingency orientation: OD is usually described as contingency
oriented. Most OD practitioners are flexible and pragmatic, selecting and
adapting actions to fit assessed needs. Usually there is a open discussion
of several useful alternatives rather than the imposition of a single best
way to proceed.

vii) Summary and application: The OD process applies behavioral

science knowledge and strategies to improve an organization. It is a long-
range, continuing effort that tries to build co-operative work relationships
through the use of a change agent. It seeks to integrate into an effective
unit the four elements that affect organizational behavior – people,
structure, technology and environment.

17.3 ORGANIZATIONAL DEVELOPMENT PROCESS

OD is a complex process. It may take a year or more to design and
implement and the process may continue indefinitely. OD tries to move
the organization from where it is now (requiring diagnosis) to where it
should be (by action interventions).
There are many different approaches to OD. A typical complete
programme includes most of the following step

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Steps in OD
i) Initial diagnosis: In this step, the consultant meets the top
management and determines nature of the firm’s problems. This is done
with a view to develop the OD approaches most likely to be successful
and to ensure the full support of top management. During this step the
consultant may seek inputs by means of interviews with various people in
the organization.

ii) Data collection: As the next step, the consultant conducts surveys to
determine organizational climate and behavioral problems.
iii) Data feedback: After collecting the data, the consultant reviews the
data and tries to find out the areas of disagreement and establishes
priorities for change.
iv) Action planning: In consultation with the work groups the consultant
develops specific recommendations for change. The consultation focuses
on actual problems in the organization. Specific plans are carved out,
including who is responsible and when the action should be completed.
v) Use of interventions: Once the action planning is finalized, the
consultant helps the participants select and use appropriate OD
interventions. Depending on the nature of the key problems, the
intervention may focus on individuals, teams; inter departmental relations,
or the total organization.
vi) Evaluation and Follow-up: The consultant helps the organization
evaluate the results of the OD efforts and develop additional programmes
in areas where additional results are needed.
17.4 ORGANIZATIONAL DEVELOPMENT TECHNIQUES
Several techniques have been included under the OD programme. The
most popular among them are:
• Management by Objectives

• Grid Training
• Survey feed back
• Team building

• Sensitivity training

• Quality of work life programmes

• Structural changes

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i) Management by Objectives: Management by Objectives (MBO) is a
technique designed to (1) increases the precision of the planning process
at the organizational level, and (2) reduce the gap between employee and
organizational goals.

The key elements of MBO are.

1) Effective planning and goal setting by top management.
2) Setting of individual goals related to the organization’s goals by
managers and subordinates.
3) Considerable autonomy in developing and selecting means for
achieving objectives.

4) Regular review of performance in relation to objectives.

The actual MBO programme may vary from organization to organization.
But the results of its application are uniform: higher morale and improved
attitude, improved level of performance and contributions and a better
understanding of overall organizational goals.
ii) Grid Training: Grid Training is based on the Managerial grid concept
developed by Blake and Mouton. (Also read chapter on leadership). They
believed that most organizational problems stem from poor
communication and inadequate planning and proposed a multi-step
process for improving organizations.
The first step is Grid Training consists of a grid seminar – a session in
which an organization’s managers analyses their own management styles
– using a specially designed questionnaire that allows managers to
determine how they stand with respect to two important dimensions of
effective management – concern for production and concern for people.
It may be any one of the following positions.
Impoverished Management (1, 1), Task Management (9,1), Country Club
Management (1,9) and Middle of the Road Management (5,5).

After a manager’s position along the grid is determined training begins to

reach the ideal 9,9 state. This training consists of organization - wide
team training aimed at helping people interact more effectively with each
other. Then, the training is expanded to reduce conflict between groups
that work with each other. Additional phases of training include efforts to
identify the extent to which the organization is meeting its strategic goals
and then comparing this performance to an ideal. Next, plans are
formulated to meet these goals, and these plans are implemented in the
organization. Finally, progress towards the goals is continuously assessed
and problem areas are identified.

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iii) Survey Feedback: It involves two basic activities: (1) Collecting data
about the organization through the use of questionnaires and (2)
Conducting feedback meetings and workshops in which the data are
presented to organizational members. The results are discussed,
problems are identified and corrective strategies are developed.
iv) Team Building: Team building is a process of diagnosing and
improving the effectiveness of a work group with particular attention to
work procedures and interpersonal relationships within it, especially the
role of the leader in relation to other groups members. Team building
activities aim at diagnosing barriers to effective team performance;
improving task accomplishments; improving relationships in the team
such as communication and task assignment.
v) Sensitivity Training: The purpose of sensitivity training sessions or
T – groups (T for training) is to change the behavior of the people through
unstructured group interaction. Members (10 to 15 individuals) are
brought together in a free and open environment, away from work places,
in which participants discuss amongst themselves freely, aided by a
facilitator. No formal agenda is provided. Instead, individual personalities
and group interactions, processes, and relationships become the focus of
discussion. The facilitator is no teacher. Rather his role is to create an
opportunity for members to express their ideas, beliefs and attitudes.
The objectives of the T-groups are to provide the participants with
increased awareness of their own behavior and how others perceive them,
greater sensitivity to the behavior of others, and increased understanding
of group processes.
vi Quality of Work Life programmes: These programmes have been
designed by OD practitioners to create work situations that enhance
employee’s motivation, satisfaction and commitment – factors that
contribute to high levels of organizational performance.
The QWL programmes attempts to humanize the work place. The two
popular approaches to humanize the work place are (i) work restructuring
and (ii) Quality circles.
Work restructuring is the process of changing the way jobs are done to
make them more interesting to workers.

Quality circles are small groups of employees who meet regularly on

voluntary basis to identify and solve problems related to the quality of the
work they perform and the conditions under which people work on their
jobs.

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vii) Structural Techniques: Change in the organization’s formal structure,
job design, human resource programmes in training and Career
development, modification of organization’s culture are some of the
structural approaches of the OD.

17.5 BENEFITS OF ORGANIZATIONAL DEVELOPMENT

Increasing productivity and efficiency comes with many benefits. One of
the best ways to encourage positive results in these metrics is by using a
well-thought-out organizational development structure. Organizational
development is used to equip an organization with the right tools so that
it can adapt and respond positively (profitably!) to changes in the market.
The benefits of organizational development include the following:

1. Continuous development
Entities that participate in organizational development continually develop
their business models. Organizational development creates a constant
pattern of improvement in which strategies are developed, evaluated,
implemented, and assessed for results and quality.
In essence, the process builds a favorable environment in which a
company can embrace change, both internally and externally. The change
is leveraged to encourage periodic renewal.

2. Increased horizontal and vertical communication

Of considerable merit to organizational development is effective
communication, interaction, and feedback in an organization. An efficient
communication system aligns employees with the company’s goals,
values, and objectives.
An open communication system enables employees to understand the
importance of change in an organization. Active organizational
development increases communication in an organization, with feedback
shared continuously to encourage improvement.

3. Employee growth
Organizational development places significant emphasis on effective
communication, which is used to encourage employees to effect
necessary changes. Many industry changes require employee
development programs. As a result, many organizations are working
toward improving the skills of their employees to equip them with more
market-relevant skills.

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4. Enhancement of products and services
Innovation is one of the main benefits of organizational development and
is a key contributing factor to the improvement of products and services.
One approach to change is employee development – a critical focal point
is a reward for motivation and success.
Successful engagement of employees leads to increased innovation and
productivity. Through competitive analysis, consumer expectations, and
market research, organizational development promotes change.

5. Increased profit margins

Organizational development influences the bottom line in many different
ways. As a result of increased productivity and innovation, profits and
efficiency increase. Costs come down because the organization can
better manage employee turnover and absenteeism. After the alignment
of an entity’s objectives, it can focus entirely on development and product
and service quality, leading to improvements in customer satisfaction.
17.6 STEPS IN ORGANIZATIONAL DEVELOPMENT
1. Problem identification—Diagnosis:
Organizational Development program starts with the identification of the
problem in the organization. Correct diagnosis of the problem will provide
its causes and determine the future action needed.
2. Planning Strategy for Change:
Organizational Development consultant attempts to transform diagnosis
of the problem into a proper action plan involving the overall goals for
change, determination of basic approach for attaining these goals and the
sequence of detailed scheme for implementing the approach.
3. Implementing the Change:
Organizational Development consultants play an important role in
implementing change.

4. Evaluation:
Organizational Development is a long-term process. So there is a great
need for careful monitoring to get process feedback whether the
Organizational Development programmed is going on well after its
implementation or not. This will help in making suitable modifications, if
necessary. For evaluation of Organizational Development programmed,
the use of critic sessions, appraisal of change efforts and comparison of
pre- and post-training behavioral patterns are quite effective.

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The following are the values in OD efforts:
1. Respect People
People are the raison d’etre of organization and they are responsible for
creating opportunities for growth. They must, therefore, be treated with
respect and dignified manners.
2. Confidence and Support
Organizations are made up of people and they are to be believed and
supported in order to have effective organization. The healthy
environment prevails when people are trusted and taken into confidence
and a necessary support is extended to them as and when needed.

3. Confrontation
Any conflict on any issue should not be suppressed. It should be dealt
with openness. Suppression leads to dampening of morale. Identifying the
problem and its causes, discussing it openly and finding out feasible
solution leads to boosting up morale of the employees and creating good
environment.
4. Employee Participation
The participation of employees who will be affected by the OD should be
sought in decision-making.

5. Expression
Human beings differ in experience, maturity, ideas, opinions, and outlook.
The organization is at the receiving end. It gains from the differences in
quality, ideas, opinions and experiences of its people. Human beings are
social animals; they have feelings, emotions, anger and sentiments etc.
They should be allowed to express their feelings and sentiments. This will
result in building up high morale and the people will be motivated towards
hard work ultimately resulting in increased efficiency.
6. Seeking Cooperation

Managers should learn to seek cooperation from each of the employees

working under him in his department. This will develop in creating the
atmosphere of cooperation leading to organizational effectiveness and
willingness to accept change in the event of organization development
process.

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17.7 MODERN ORGANIZATION DEVELOPMENT TECHNIQUES
Process Consultation
Concerned with the processes that take place within a group or between
groups and the consultant.
– The role of the outside consultant is seen as “helping the client to
perceive, understand and act upon process events which occur in the
client’s environment.
– The underlying assumption is that the process consultant can effectively
help diagnose and solve important problems facing modern organizations.
– Specific areas include: Communication, functional roles of group
members, group problem solving and decision making, group norms, and
growth, leadership and authority and intergroup processes.
Process
• Initiate contact
• Define the relationship
• Select a setting and a method
• Gather data and make a diagnosis (questionnaires, observation and
interviews)
• Intervene: agenda setting, feedback, coaching, and /or structural
interventions can be made
• Reduce involvement and terminate
Third Party Peace Making
• OD consultant works as a mediator
• The groups in conflict remain separated in the initial phase
Process
1. Gathering relevant data by interviewing the principals in the conflict
2. Selecting the place and structuring the context of the confrontation
meeting
3. Making a direct intervention in the process by
• Refereeing the interaction process
• Initiating the agenda
• Encouraging and participating in feedback
• Giving a diagnosis and prescription
• Assisting the principals to plan and prepare for further dialogue
after the confrontation.

Management By Objectives
(MBO) “A process whereby superiors and subordinate managers of an
enterprise jointly identify its common goals, define each individual’s major
areas of responsibility in terms of the results expected of him and use

245
these measures as guides for operating the units and assessing the
contribution of each of its members.”
Purpose
• To translate mission statements into operational terms.
• To give directions and set standards for the measurement of
performance
• To set both long term and short term objectives. It emphasizes on
converting the overall organizational goals into specific objectives
for organizational units and individual members.
• MBO operationalizes the concept of objectives by devising a
process by which objectives cascade down through the
organization.
• Because lower-unit managers jointly participate in setting their
own goals, MBO works from the “bottom-up” as well as “Top-down
approach.”
• The result is a hierarchy that links objectives at one level to those
at the next level.
And for individual employee, MBO provides specific personal
performance objectives.
• Four Ingredients
• Goal Specificity
• Participative Decision Making
• Explicit Time Period
• Performance Feedback
LET US SUM UP

OD techniques such as MBO, Grid Training, Survey feedback etc., are

used to bring about change in the organization. The unit discussed the
OD process involves various steps and OD has proved to be a successful
organization intervention.

CHECK YOUR PROGRESS

Choose the Correct Answer

1. ----- is designed to increase the precision of the planning process at the

organizational level
a) MBO b) off the job training

b) Coaching d) mentoring

2. ------------- is concept developed by Blake and Mouton

a) Maslow theory b) grid training
c) t- training d) survey

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3. ----------- method uses questionnaires
a) Monitoring b) grid training
c) Job transfer d) feedback
4. ---------- is also called as T-training

a) Role-play technique b) vestibule training

c) Sensitivity training d) coaching
5. ----------is a process of diagnosing and improving the effectiveness of a
work group with particular attention to work procedures and interpersonal
relationships within it.
a)Team building b) case study

c) Apprentice training d) technical training

GLOSSARY

Training : Teaching or developing in oneself

or others, any skills and knowledge
or fitness that relate to specific
useful competencies.

Survey : Examine and record the area and

features of (an area of land) so as
to construct a map, plan, or
description.

Teams : The arrangement of and relations

between the parts or elements of
something complex.

Structure : The arrangement of and relations

between the parts or elements of
something complex

Quality circles : Small group of employees of the

same work area, doing similar work

SUGGESTED READINGS
1. DinkarPagare (2015) Principles of Management, Sultan Chand &
Sons, New Delhi.
2. Harold Koontz, Cyril O'Donnell and Heinz Weihrich (2017)
Essentials of Management (5th Revised edition), McGraw-Hill Inc.,
US, (ISE Editions).

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 3. Prasad L.M. (2015) Principles and Practice of Management,
Sultan Chand & Sons, New Delhi.
4. Sherlekar S.A. &Sherlekar V.S 3rd Edition (2014) Principles of
Business Management, Himalaya Publishing House Pvt. Ltd,
Mumbai.
5. Tripathi, Sixth edition (2017) Principles of Management, Tata
McGraw Hill Education Private Limited, 7 thWest Patel Nagar, New
Delhi.
6. Tripathi, P C, Reddy, P N, 5 edition (2012) Principles of
Management, Tata McGraw Hill Education private limited, 7 th west
Patel Nagar, New Delhi.
7. https://www.yourarticlelibrary.com/hrm/organisation/top-9-
techniques-of-organisation-development/60275
8. https://www.businessmanagementideas.com/organization/develo
pment-process/the-organization-development-process/19236
ANSWERS TO CHECK YOUR PROGRESS
1) a 2) b 3) d 4) c 5) a

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Unit 18

ORGANIZATIONAL CULTURE AND

CLIMATE
Structure

Overview
Learning Objectives
18.1 Concept of Organizational

18.2 Concept of Organizational Culture

18.3 Concept of Organizational Climate

18.4 Elements of Organizational Climate

18.5 Organizational Behaviour Across Cultures
18.6 An International Perspective
18.7 Managing International Work Forces

Let Us Sum Up
Check Your Progress

Glossary
Suggested Readings
Answers to check your progress

OVERVIEW
Organizational cultures are important to a firm’s success for several
reasons. They give an organizational identity to employees – a defining
vision of what the organization represents. They are also an important
source of stability and continuity to the organization, which provides a
sense of security to its members.

The effectiveness of business organizations is important for society.

Actions of individuals and groups in organizations and organization
structures themselves must result in organizational efficiency. In this unit
we will discuss the various dimensions of conflict, organizational culture
and organizational effectiveness.

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LEARNING OBJECTIVES
After completing this unit, you should be able to,
• describe the nature of organizational culture and identify cultural
dimensions
• list out the ways of creating, transmitting and sustaining
organizational culture
• express the ways of changing organizational culture.

18.1 CONCEPT OF ORGANIZATION

There are hundreds of definitions of the concept of organization in the
management, psychological, and social and sociological literatures and
these definitions are being constantly updated and revised. Some of the
definitions of organization are as follows:
(a) “Organization is a social group in which the members are differentiated
as to their responsibilities for their task of achieving a common goal”
(Stogdill 1950).
(b) “Organization is a short hand expression for the integrated aggregation
of those persons who are primarily involved in the managing risk and
uncertainty- bearing, planning and innovation, co-ordination,
administration and control, and routine supervision of an enterprise”
( Harbinson 1959).
(c) An organization is a rational coordination of a number of people for the
achievement of some common explicit purpose or goal through a division
of labour and function through a hierarchy of authority and responsibility.
(d) Organizations are human groupings deliberately constructed and
reconstructed to meet specific goals
(e) Organizations are physical arrangement of people in various roles for
meeting organizational objective.
Common element that runs through these definitions include the fact that
organizations involve:
(a) Identifiable aggregation of human beings or Individuals banding
together to form a group.

(b) An organizational goal or the pursuit of a common goal or goals.

(c) Coordination of activities with a belief that the group can achieve what
an individual cannot.

(d) More or less clearly defined responsibilities for its members.

(e) Structure or system for coordination.

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A current concept which leads to better understanding of organizations is
to view them as ‘systems’ existing in the environment. The systems are
separate from the environment but their boundaries are permeable,
permitting the influence of the environment to act on the system and also
enable the outputs of the system to flow into the environment. Every
system is composed of a number of sub-systems which interact with and
influence each other and also with the larger system, which is their
environment. In the services for example, the army is a system with
commands as sub-systems. Each of the commands has its own sub-
systems such as corps and divisions, forming a hierarchy of systems.
Another way of looking at the sub-systems is to classify them by distinct
aspects of the functions in organizations for example, human, economic,
technical, and so on.

Organizations vary in their sensitiveness to the environment. This

depends on how open or closed they are to the external influences which
impinge on them from the environment However, organizations are
neither fully closed nor fully open and the degree of closure/openness
determines their characteristics, as described below:
(a) Closed System Organization [iv]. These are not affected by
environmental influences and are designed for the pursuit of clearly
specified goals. Organizational arrangements and decisions are geared
to goal achievement and are directed towards making the organization
more and more rational and mechanical in the pursuit of its goals. They
are characterized by rigid rules, procedures, hierarchical structures and
tasks. Such systems are very stable and usually efficient. But, as they are
closed from the environment, they have little adaptability and flexibility.
Bureaucratic systems are typical closed systems.
(b) Open System Organizations. These are systems that consider the
environment as a reality. The goals of such organizations emerge as
adaptive responses from the influences of the environment. They are not
rigid and do not have a strong hierarchical structure. The various parts or
sub-systems of the organization are interdependent; changes in one
causing important influences on the other. Such systems are highly
adaptive and flexible but are usually low in efficiency. Research and
development organizations are usually typical open establishments.

18.2 CONCEPT OF ORGANIZATIONAL CULTURE

Organizational culture is a pattern of beliefs and expectations shared by
the members of the organization. These beliefs and expectations produce
norms that powerfully shape the behavior of individuals and groups in the
organization. The organizational culture includes: -

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(a) Routine behavior when people interact.
(b) The norms that are shared by everyone in an organization.

(c) The dominant values held by the organization.

(d) The philosophy that guides the organization’s policies.

(e) Climate in an organization.

(f) Rules in an organization.
Organizational Culture has the potential to enhance the organizational
effectiveness, individual satisfaction and the sense of belonging to the
organization. However, if the organization culture gets out of step with the
changing expectation of the stakeholders, the organization’s effectiveness
can be hindered. A strong culture facilitates goal alignment. As all
employees have same basic values, therefore they agree on not only the
goals but also the methods of achieving them too. Thus the energies of
the employees are channeled in the same direction and the organization
performance is better. A strong culture leads to high levels of employee
motivation because a strong culture automatically attracts the people
towards the organization.
A strong culture also enables an organization to learn from its past. The
strong culture reinforces the consensus on the interpretation of issues and
events based on the past experiences, provides precedents from the
organization’s history which help in deciding course of action to meet the
new challenges.

Organizational culture exists on different levels that differ in terms of

visibility and the resistance to change The least visible or the deepest level
is the basic shared assumptions which represent the beliefs about the
organization that needs to be run.
The next level of culture is the cultural values which represent the
collective beliefs, assumptions and feelings about what things are good,
normal, rational, and valuable and so on. These values tend to persist
over time when the organizational membership changes. The next level is
that of the shared behaviors, including norms which are more visible and
somewhat easier to change than the values. The most superficial level of
organizational culture consists of the symbols. Culture symbols are the
words, gestures and pictures or other physical objects that carry particular
meaning to the culture.

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18.3 CONCEPT OF ORGANIZATIONAL CLIMATE
The concept of organizational climate is derived from the atmospheric
climate. Just as two places can be differentiated with reference to
elements of atmospheric climate like temperature, humidity, etc,
organizations also can be differentiated on the basis of organization
climate prevailing in them. There is evidence to show that there is a very
close relationship between organizational climate, job satisfaction,
performance of individuals and ultimately organizational effectiveness.
Organization Climate is a set of distinctive features that distinguish one
organization from another and influence the behavior of people. It may
also be defined as behaviour, shared beliefs, and values that members
have in organization. It often sets the tone for the organization and
establishes implied rules for the way people should behave.

18.4 ELEMENTS OF ORGANIZATION CLIMATE

In every organization, there exist certain elements which exert profound
influence on the existing climate. These are:-
(a) Organizational Context.: The foremost factor is command/
management philosophy. Reactions of the members of the organization
on the degree to which they accept this philosophy is crucial to a good
organizational climate.
The climate would be highly favorable, when existing command
styles/management techniques are such that members’ goals match
those of the organization.
(b) Structure.: Nature of relationships, de-alienation of the hierarchy,
centralized /decentralized decision making etc affect the climate of an
organization.
(c) Process.: Some of the vital processes in an organization are
communication, decision making and leadership. In all these processes
the interface between the superior and the subordinate are visible and
cannot be ignored.
(c) Physical Environment: The external factors like safety, comfort and
decor effect the organizational climate of an organization.
(d) System Value and Norms: Every organization has discernable and
fairly evident formal value system. The formal value system is
communicated to the members through rules, regulations and policies.
The informal organizations within also exert influence on values and
consequently on climate.

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18.5 ORGANIZATIONAL BEHAVIOUR ACROSS CULTURES
The people of the world are organised into communities and nations, each
in its own way, according to its resources and cultural heritage. There are
similarities among nations, but there are also significant differences on the
basis of economy, education and social development. The conditions of
work are also different because of different attitudes, values and
expectations from participants. The examination of social, legal and
ethical, political and economic conditions prevailing at the international
level help us understand the organizational behaviour across cultures.
i) Social Conditions: In many countries, there are major shortages of
managerial personnel, scientists and technicians. Needed skills must be
imported temporarily from other countries. The employees thus imported
normally struggle to fit into the new social condition. The work ethics of
one country also varies from the other and the outsider finds it difficult to
adjust himself to the new situation.
ii) Legal and Ethical conditions: Countries around the world vary
substantially in their legal systems, and especially in their relevant
employment laws and business practices. Such differences create a
severe dilemma for MNCs. Managers need to be aware of the possible
differences in both laws and ethical values that define acceptable and
unacceptable behaviours in foreign countries.
iii) Political conditions: Political conditions that have a significant effect
on OB include instability of the government, nationalistic drives and
subordination of employers and labour to an authoritarian state. Instability
spills over into organizations that wish to establish or expand operations
in the host country, making them cautious about further investments. This
organizational instability leaves workers insecure and causes them to be
passive and low in initiative.

A strong nationalistic drive may impel locals to desire to run their country
and their organizations by themselves, without interference by foreign
nationals. The foreign manager simply may not be welcome.

iv) Economic Conditions: A common economic condition in many less

developed countries is inflation. Inflation makes the economic life of
workers insecure. It encourages them to spend quickly before their
money loses its value. Workers do not even plan for their own retirement
security. They develop a dependence on the government, which is often
incapable of responding. Social unrest is compounded by tremendous
disparity in the distribution of wealth in these nations. All these factors
make it difficult to motivate employees.

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18.6 AN INTERNATIONAL PERSPECTIVE
In terms of OB, there are important contrasts across cultures regarding
employee attitudes, values and beliefs that influence how employees will
act on the job. Research on national cultures in sixty countries identified
five major dimensions that accounted for the sharpest differences among
employees. These individual difference factors include individualism /
collectivism, power distance, uncertainty avoidance, masculinity /
femininity and time orientation. We will discuss briefly about these factors
in the following paragraphs:
i) Individualism / Collectivism: Individualism lays strong emphasis
on the person’s own rights, freedom, career and personal rewards.
Collectivism heavily favours the group and values harmony among
members. Individual feelings are subordinated to the group’s overall goal.

Eg: US has individualistic culture and Japan has Collectivistic culture.

ii) Power Distance: Power Distance refers to the belief that there are
strong and legitimate decision-making rights separating managers and
employees. This custom is frequently observed in Asian and South
American countries. By contrast, employees in the U.S. and
Scandinavian countries (Norway, Sweden, Denmark, Iceland and
Finland) subscribe to beliefs of lower power distance and are less likely to
believe that their managers are automatically correct. Therefore, many
employees in these countries do not blindly defer to their manager’s
wishes.
iii) Uncertainty Avoidance: Employees in some cultures value clarity
and feel very comfortable receiving specific directions from their
supervisors. These employees have a high level of uncertainty avoidance
and prefer to avoid ambiguity at work. (Eg: Employees in countries such
as Greece, Portugal and Belgium).

Employees elsewhere react in an opposite manner, since ambiguity does

not threaten their need for stability and security. These employees may
even thrive on the uncertainty associated with their jobs. (Eg : Employees
in China, Ireland, and the U.S.)
iv) Masculinity / Femininity: Masculine societies define gender roles in
more traditional and stereotypical ways. They value assertive behaviour
and the acquisition of wealth (Eg : Japan)
Feminine societies have broader viewpoints on the great variety of roles
that both males and females can play in the work place and at home.

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They treasure relationships among people, caring for others and a greater
balance between family and work life. (Eg : Scandinavian Countries).
v) Time Orientation: Some cultures prefer values such as the necessity
of preparing for the future, the value of thrift and savings, and the merits
of persistence. The countries having such cultures are said to have long
term orientation (Eg : Hong Kong, China and Japan). Other cultures value
the past and favour the present, with a rich respect for tradition and the
need to fulfil historical social obligation. The countries having such
cultures are said to have short term orientation. (Eg : France, Russia and
West Africa).

18.7 MANAGING INTERNATIONAL WORK FORCES

Managing an international work force needs deep insight into the factors
such as multiculturalism, parochialism, ethnocentrism, cultural distance
and cultural shocks and these are to be handled by the managers of
MNCs to be successful in their operations.
i) Multiculturalism: Whenever an organization expands its operations,
its geographic boundaries / span two or more countries. It tends to
become multicultural and will face the challenges of blending various
cultures.

Managers and technical employees entering another nation to install an

advanced organizational system need to adjust their leadership styles,
communication patterns and other practices to fit the culture of their host
country.
Some cultures are termed as High Context Cultures (Eg : China, Korea
and Japan) which emphasise personal relations, place high value on trust,
and favour the need to attend to social needs before business matters.
Low context cultures (E.g. The U.S. and Germany) tend to rely on written
rules and legal documents, conduct business first and they value
expertise and performance. Lack of attention to these factors results in
costly failures for expatriates.
ii) Parochialism: The dominant feature of all international operations is
that they are conducted in a social system different from the one in which
the organization is based. Managers and other employees who come into
a host country in order to get a new operation established naturally tend
to exhibit a variety of behaviours that are often true of citizens in their
homeland. One such behaviour is Parochialism, which means that they
see the situation around them from their own perspective and may fail to

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recognise the key differences between their own and others’ culture.
Hence cultural adaptation is difficult for them.
iii) Ethnocentrism: Another behaviour is ethnocentrism, which means
that people are predisposed to believe that their homeland conditions are
the best. Though this is natural, it interferes with understanding human
behaviour in other cultures and obtaining productivity from local
employees.

iv) Cultural Distance: Cultural distance is the amount of difference

between any two social systems and may range from minimal to
substantial. Research has shown that some measures of cultural
distance from the US are greater for countries in the Mediterranean area
and Asia and smaller for Scandinavian and English-speaking countries.
v) Cultural Shock: Cultural shock is virtually universal. It occurs in
response to dramatic differences in language, forms of courtesy, customs,
housing conditions and cultural orientations in the use of space (relative
emphasis on privacy), time (focus on the past, present or future) and
activity (accent on life achievements versus life experiences). When
employees enter another nation, they may experience several reactions
such as stimulation, disillusionment, shock and adaptation. They are
stimulated and excited by the challenge of a new job, home and culture.
When they face problems, they get disillusionment and insecurity and
disorientation are caused by encountering all parts of a different culture
(cultural shock). If they can emotionally survive these phases, they will
reach the adaptation phase. At this point they accept the new culture,
regain a sense of self-esteem and respond constructively to their new
surrounding at work and home.

Now we will discuss how these barriers can be overcome:

i) Careful selection: Selection for the international assignment is to be
done carefully by taking into consideration, the potential expatriate’s
attitudes, adaptability, language skills etc. Learning the attitudes of the
employees’ spouse and family towards the assignment is also important.

ii) Compatible assignments: Adjustment to new surroundings is easier

if employees, especially on their first international assignment, are sent to
nations that are similar to their own. It is worthwhile to note that the
industrialised nations in the free world are grouped into six socio cultural
clusters as follows:
a) Anglo – American cluster which includes the US, the UK, Canada and
Australia.

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b) The Nordic group which includes Norway, Finland, Denmark and
Sweden.
c) The Latin European group has Portugal, Spain, Italy, France and
Belgium.

d) The Latin American cluster includes Peru, Mexico, Argentina, Chile and
Venezuela.
e) The Pacific Rim cluster includes Japan, China, Hong Kong, Taiwan and
Korea.
Interestingly some nations – such as Israel, India and Brazil – do not fit
cleanly into any of the clusters.

Using this information about clusters, a firm can attempt to assign

expatriate employees within their own cluster of nations, with the result
being easier adjustment and less cultural shock. For example, a
Canadian employees assigned to Australia is likely to adjust more quickly
than a Spanish employees would in the same assignment.
iii)Pre-departure Training: Many organizations try to hasten adjustment
to a host nation by imparting pre-departure training in language,
geography, customs, culture and political environment in which the
employee will be living.

iv) Orientation and support in the new country: Adjustment is further

encouraged after arrival in the new country if a special effort is made to
help the employees and family get settled. This task may include
assistance with housing, transportation and shopping. It is especially
helpful if a mentor can be assigned to ease the transition.
v) Preparation for Re-entry: Employees typically return to their home
country after working in another nation need to be smoothly blended into
the organization and effectively utilized there. This process is called
“Repatriation”. Companies need repatriation policies and programme to
help returning employees obtain suitable assignments and adjust to the
‘new’ environment.
LET US SUM UP

The unit covered concepts of organizational behaviour across culture

requires one to understand the social, legal and ethical, political and
economic conditions prevailing at the global level. Globalization has its
impact on the individual behaviour due to the factors such as
Individualism, Collectivism, Power distance etc., Managing international
workforce needs one to study the barriers such as multiculturalism,
parochialism, ethnocentrism, cultural shock etc., Organizational culture

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has various dimensions and it is created, sustained and transmitted in
different ways.

CHECK YOUR PROGRESS

Choose the Correct Answer

1. ------------------- lays strong emphasis on the person’s own rights,

freedom, career and personal rewards.
a) Individualism b) collectivism
c) Multiculturalism d) Parochialism
2. ------------ heavily favors the group and values harmony among
members.
a) Individualism b) collectivism
c) Multiculturalism d) Parochialism
3.In ----------------- people are predisposed to believe that their homeland
conditions are the best.
a) Individualism b) collectivism
c) Ethnocentrism d) Parochialism
4. People exhibit a variety of behaviors that are often true of citizens in
their homeland. One such behaviour is ----------------
a) Individualism b) collectivism
c) Ethnocentrism d) Parochialism
5.Employees typically return to their home country after working in
another nation need to be smoothly blended into the organization and
effectively utilized there, such process is called------------------
a) Repatriation b) host country
c) job transfer d) Parochialism
GLOSSARY
Work ethics : Work ethic is a set of values based
on the ideals of discipline and
hard work

Multiculturalism : Co-existence of diverse cultures

Individualism : The habit or principle of being

Independent and self-reliant.

Parochialism : Narrow-mindedness

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SUGGESTED READINGS
1. DinkarPagare (2015) Principles of Management, Sultan Chand &
Sons, New Delhi.
2. Harold Koontz, Cyril O'Donnell and Heinz Weihrich (2017)
Essentials of Management (5th Revised edition), McGraw-Hill Inc.,
US, (ISE Editions).
3. Prasad L.M. (2015) Principles and Practice of Management,
Sultan Chand & Sons, New Delhi.
4. Sherlekar S.A. &Sherlekar V.S 3rd Edition (2014) Principles of
Business Management, Himalaya Publishing House Pvt. Ltd,
Mumbai.
5. Tripathi, Sixth edition (2017) Principles of Management, Tata
McGraw Hill Education Private Limited, 7 thWest Patel Nagar, New
Delhi.
6. Tripathi, P C, Reddy, P N, 5 edition (2012) Principles of
Management, Tata McGraw Hill Education private limited, 7 th west
Patel Nagar, New Delhi.
7. https://epgp.inflibnet.ac.in/Home/ViewSubject?catid=ahLCajOqz6
/GWFCSpr/XYg==
8. https://www.usemultiplier.com/global-workforce
ANSWERS TO CHECK YOUR PROGRESS
1) a 2) b 3) c 4) d 5) a

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Unit 19

FUTURE TRENDS IN ORGANIZATION

BEHAVIOUR
STRUCTURE

Overview
Learning Objectives
19.1 Trends in Organizational Change

19.2 Future Trends in Organizational Behaviour

19.3 Emergence of E-Organization / Virtual Offices

19.4 Work Force Diversity

19.5 Coping with Temporariness
19.6 Improving Ethical Behaviour
19.7 Motivating Professionals and Diversified Workers

19.8 Trends Influencing the Way Businesses Organise

Let Us Sum Up

Check Your Progress

Glossary
Suggested Readings
Answers to check your progress

OVERVIEW
A global economy is now a reality. The scope of international trade has
changed dramatically in recent years, with the emergence of the
European Community, revolutionary changes in the former Soviet Union
and Eastern Europe, and strong markets developing in China, Japan,
Korea and many emerging nations. Today’s manager must acquire both
language and intercultural skills in dealing with people – customers,
suppliers, competitors, and colleagues – from other countries. The
Internet is also changing business and the way organizations operate.
The Internet, its complimentary technology, and the new e-world it is
creating are affecting organizational behaviour. Indeed, computers and
internet are reshaping OB topics from motivation, to leadership, to work

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design. As a result, many organizations add powerful new dimensions to
organizational behaviour.

LEARNING OBJECTIVES
After completing this unit, you should be able to,

• describe the emerging scenario of OB in the global context

• explain the future trends of OB
• explain the e-organisation/virtual office

• discuss the challenges to OB.

19.1 TRENDS IN ORGANIZATIONAL CHANGE

Organizations have entered a new era characterized by rapid, dramatic
and turbulent changes. The accelerated pace of change has transformed
how work is performed by employees in diverse organizations. Change
has truly become an inherent and integral part of organizational life.
Several emerging trends are impacting organizational life. Of these
emerging trends, five will be examined: globalization, diversity, flexibility,
flat, and networks. These five emerging trends create tensions for
organizational leaders and employees as they go through waves of
changes in their organizations. These tensions present opportunities as
well as threats, and if these tensions are not managed well, they will result
in dysfunctional and dire organizational outcomes at the end of any
change process.
Globalization
Organizations operate in a global economy that is characterized by
greater and more intense competition, and at the same time, greater
economic interdependence and collaboration. More products and
services are being consumed outside of their country of origin than ever
before as globalization brings about greater convergence in terms of
consumer tastes and preferences. Yet at the same time, in the midst of
greater convergence, there is the opposite force of divergence at work
where companies have to adapt corporate and business strategies,
marketing plans, and production efforts to local domestic markets.

To stay competitive, more organizations are embracing offshore

outsourcing. Many functions are being shifted to India, the Philippines,
Malaysia, and other countries for their low labor costs, high levels of
workforce education, and technological advantages. According to the
2002-2003 Society for Human Resource Management (SHRM)
Workplace Forecast, companies such as Ford, General Motors, and

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Nestle employ more people outside of their headquarters countries than
within those countries.
Almost any company, whether in manufacturing or services, can find
some part of its work that can be done off site. Forrester Research
projects that 3.3 million U.S. service- and knowledge-based jobs will be
shipped overseas by the year 2015, 70 percent of which will move to India.
Communication and information sharing are occurring across the globe in
multiple languages and multiple cultures. Global competition and global
cooperation coexist in the new world economy.
One major consequence of globalization is greater mobility in international
capital and labor markets. This creates a global marketplace where there
is more opportunity, because there are more potential customers.
However, there is also more competition, as local companies have to
compete with foreign companies for customers.
According to Dani Rodrik, professor of international political economy at
Harvard's Kennedy School of Government, the processes associated with
the global integration of markets for goods, services, and capital have
created two sources of tensions.
First, reduced barriers to trade and investment accentuate the
asymmetries between groups that can cross international borders, and
those that cannot. In the first category are owners of capital, highly skilled
workers, and many professionals. Unskilled and semiskilled workers and
most middle managers belong in the second category.
Second, globalization engenders conflicts within and between nations
over domestic norms and the social institutions that embody them. As the
technology for manufactured goods becomes standardized and diffused
internationally, nations with very different sets of values, norms,
institutions, and collective preferences begin to compete head on in
markets for similar goods. Trade becomes contentious when it unleashes
forces that undermine the norms implicit in local or domestic workplace
practices.

Professor Rodrik concluded that "the most serious challenge for the world
economy in the years ahead lies in making globalization compatible with
domestic social and political stability”. This implies ensuring that
international economic integration does not lead to domestic social
disintegration. Organizations that are confronted with this challenge will
have to manage the tension created by the global integration versus local
disintegration dilemma.

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The overall picture as a consequence of globalization is one of turbulence
and uncertainty, in which a variety of contradictory processes present a
wide range of both opportunities and threats that defy established ways
of doing business and working in organizations. Integration and exclusion
coexist uneasily side-by-side in organizations.
For example, many apparent dichotomies or paradoxes—competition
versus collaboration, market forces versus state intervention, global
actions versus local solutions—is losing their sharp edges as
contradictory forces appear to converge and reinforce each other in
organizations across the globe. Companies that compete fiercely in some
markets form strategic alliances in others; government guidance and
regulation are required to make markets work effectively; and "think
globally, act locally" has been adopted as business strategy (or as a
mantra) to deal with the challenges of doing business in the globalized
economy. As organizations transform themselves to stay competitive, they
will need to confront and resolve some, if not all, of these dichotomies or
paradoxes.
On another level, because of globalization, the fates of people living and
working in different parts of the world are becoming intertwined. Global
events may have significant local impact. September 11, 2001 has been
called the "day that changed the world". Heightened security concerns are
changing expectations for people in organizations, and the role of
organizations themselves. The threat of terrorism continues to be an
ongoing concern worldwide. It has created a renewed focus on workplace
security as employees experience a heightened sense of vulnerability in
the workplace. Employee monitoring and screening are occurring more
frequently. Concern over travel for business purposes is resulting in the
increased use of alternate forms of communication such as
teleconferencing and videoconferencing.

Diversity
Globalization is impacting how organizations compete with each other. In
combination with changing demographics, globalization is causing a rapid
increase in diversity in organizations. Never before have people been
required to work together with colleagues and customers from so many
different cultures and countries.
Diversity is moving a society away from "mass society" to "mosaic society".
Organizations reflect this "mosaic society" in their more diverse workforce
(in terms of not only race, ethnic or culture but also in terms of age, sexual
orientation, and other demographic variables). More than ever, people
have to interact and communicate with others who come from diverse

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backgrounds. This in turn has meant that employees need new relational
skills to succeed. An emerging stream of research in international
management has called these new relational skills "cultural intelligence".
Cultural intelligence is defined as the capability to adapt effectively across
different national, organizational and professional cultures. More
managers take up global work assignments in industries around the world.
They learn how to work with people who not only think and communicate
differently but also do things differently. Managers will need to develop
their cultural intelligence to manage greater diversity in organizations.
Diversity in organizations will continue to increase. As indicated by the
U.S Census Bureau National Population Projections, the Hispanic
population will increase by 11.2 percent between 2000 and 2025 to
become the largest minority group in the United States. All other minority
groups will increase by about 9 percent, while the number of Caucasians
will decrease by approximately 19 percent. The world population is
growing at a high rate in developing countries, while remaining stable or
decreasing in the developed world. The result will be income inequities
and economic opportunity leading to increased immigration and migration
within and between nations. More temporary workers will be used for
specific tasks, and there will be a greater demand for highly skilled
workers.
The aging American workforce population means more retirees and
potential gaps in availability of experienced workers. According to
American Association of Retired Persons (AARP), by 2015 nearly one in
five U.S. workers will be age 55 or older. Retirees often want to keep a
foot in the workplace. AARP's research shows that nearly 8 of 10 baby
boomers envision working part time after retirement; 5 percent anticipate
working full time at a new job or career; only 16 percent foresee not
working at all.
People of different ethnic and cultural backgrounds possess different
attitudes, values, and norms. Increasing cultural diversity in both public
and private sector organizations focuses attention on the distinctions
between ethnic and cultural groups in their attitudes and performance at
work. This greater focus can result in the tension between finding
similarities and accentuating differences in the face of greater diversity in
organizations.
There is an on-going debate between the heterogenists and
the homogenists concerning the impact of greater diversity in
organizations. The heterogenists contend that diverse or heterogeneous
groups in organizations have performance advantages over

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homogeneous groups while the homogenists take the opposing view that
homogeneous groups are more advantageous than heterogeneous or
diverse groups in organizations.
According to the heterogenists, organizations with greater diversity have
an advantage in attracting and retaining the best available human talent.
The exceptional capabilities of women and minorities offer a rich labor
pool for organizations to tap. When organizations attract, retain, and
promote maximum utilization of people from diverse cultural backgrounds,
they gain competitive advantage and sustain the highest quality of human
resources.

Organizations with greater diversity can understand and penetrate wider

and enhanced markets. Not only do these organizations embrace a
diverse workforce internally, they are better suited to serve a diverse
external clientele. Organizations with greater diversity also display higher
creativity and innovation. Especially in research-oriented and high
technology organizations, the array of talents provided by a gender- and
ethnic-diverse organization becomes invaluable. Heterogeneous or
diverse groups display better problem-solving ability as they are more
capable of avoiding the consequences of groupthink, compared to highly
cohesive and homogeneous groups that are more susceptible to
conformity.
On the other hand, greater organizational diversity has its drawbacks.
With the benefits of diversity come organizational costs. Too much
diversity can lead to dysfunctional outcomes. Diversity increases
ambiguity, complexity, and confusion. Organizations with greater diversity
may have difficulty reaching consensus and implementing solutions. In
many organizations, diversity can produce negative dynamics such as
ethnocentrism, stereotyping and cultural clashes.
The homogenists argue that homogeneous groups often outperform
culturally diverse groups, especially where there is a serious
communication problem. Cross-cultural training is necessary to enable
culturally diverse groups to live up to their potential and overcome
communication difficulties. The diversity movement, according to
the homogenists, has the potential to polarize different social groups and
harm productivity while breeding cynicism and resentment, heightening
intergroup frictions and tensions, and lowering productivity, just the
opposite of what managing diversity is intended to accomplish.

The challenge therefore is for management to manage the tension

produced by heterogeneity versus homogeneity. If properly managed,
organizations can reap the benefits of greater diversity. Aside from proper

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management, organizations need to learn to appreciate and value
diversity before the benefits of diversity can be fully realized. To achieve
this, diversity training programs may help people in organizations
understand and value diversity.

Flexibility
Globalization and diversity trends are forcing organizations to become
more flexible and adaptable. To be able to function globally and to
embrace diversity, leaders and employees in organizations have to
become more flexible and develop a wider repertoire of skills and
strategies in working with diverse groups of people in the workplace as
well as in the marketplace.
The response to increased diversity has, in many cases, been increased
organizational flexibility. Some organizations allow workers to have very
different work arrangements (e.g. flex-time) and payment schedules.
Some organizations (and workers) have found it convenient to treat some
workers as independent consultants rather than employees. In certain
occupations, advances in communication and information technologies
have enabled telecommuting working at home via computer. One
consequence of this is the blurring of boundaries between work and home,
and where and when work occurs. The benefits of greater flexibility may
be countered by the negative consequences of working 24/7 including
higher stress and burnout.

The response to increased competition, however, has resulted in a

tension generated by the demands to be flexible and yet maintain some
stability as changes are implemented in organizations. To stay competitive,
organizations are constantly changing and restructuring to increase
flexibility and decrease costs. Business process reengineering, business
process out-sourcing, job redesign, and other approaches to optimize
business processes have been implemented to increase operational and
process efficiency while reducing the costs of doing business.
Changes in business and operational processes need time to stabilize for
employees to learn the new processes, become familiar with them, and
be able to operate effectively and efficiently. Yet, competitive pressures
can cause organizations to go through a series of changes without giving
employees adequate time for learning and training, and for the benefits of
the change to be fully realized in the organization. This tension is well-
captured by Columbia Business School professor Eric Abrahamson in his
book, Change Without Pain (2004) in which he discussed how
organizations can go through change overload and how employees can
experience change fatigue and burnout. Professor Abrahamson proposes

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"creative recombination" as an alternative approach to the highly
destructive, destabilizing and painful changes caused by "creative
destruction".
Flat

In a greater competitive marketplace, speed or response time is critical.

How organizations response to customers and other stakeholders or be
the first to market may make a significant difference as time is at a
premium. Organizations that can develop new technologies faster or can
adapt to changes in the market faster are the ones that will survive the
competition. To maximize response time, organizations have been
flattening their hierarchies and structures, in addition to other initiatives
such as downsizing and networking. Flat organizations make decisions
more quickly because each person is closer to the ultimate decision-
makers. There are fewer levels of management, and workers are
empowered to make decisions. Decision-making becomes decentralized.
However, flat organizations create a new tension between
decentralization and centralization. Among the drivers of decentralization
are communications technologies that allow companies to push decision-
making away from the core. Proponents of decentralization emphasize
the idea that less hierarchical organizations mirror the efficiencies of the
networks that enable them: they are faster, more resilient, more
responsive, more flexible and more innovative. Also, they argue, people
who work within decentralized organizations feel empowered and
energized. They do not need to focus on the chain of command and they
do not feel constrained by it.
Organizations are caught between the opposing forces of centralization
and decentralization. They want to leverage the opportunities offered by
decentralization and create more nimble and forceful organizations, but
they cannot always do so because the forces of centralization come into
play. There are obvious benefits to centralization as control is
comparatively tighter and accountability is clearer compared to a flatter,
more decentralized organizational structure.
Take the example of IT operations. The key to a centralized organization's
success is its responsiveness. If the centralized operation can be
responsive to the needs of the business, then that approach can make
sense. Several companies, such as DaimlerChrysler and PepsiCo, have
migrated back to centralizing IT operations after attempts at
decentralization.

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The debate over the centralization versus decentralization of operations
in organizations is an enduring one. It is an age-old battle of
standardization versus autonomy, corporate efficiency versus local
effectiveness and pressure on costs and resources versus
accommodation of specific local needs.
Vacillation between centralization and decentralization is both non-
productive and unnecessary. Organizations, as they desire to become
flatter, will need to be clear about how they need to respond to the tension
between centralization and decentralization.
Networks

Organizations that flatten tend to encourage horizontal communication

among workers. Rather than working through the organizational hierarchy,
it is often faster for workers who need to coordinate with each other simply
to communicate directly. Such organizations are highly networked.
Another meaning of networked organizations refers to their relations to
other organizations. Organizations that have downsized to just their core
competencies must then outsource all the functions that used to be done
in house. To avoid losing time and effort managing contracts with suppliers,
organizations have learned to develop close ties to their suppliers so that
social mechanisms of coordination replace legal mechanisms, which are
slow and costly. In many industries, such as the garment industry in Italy,
strong relationships have developed between manufacturers and
suppliers (and other manufacturers), so that considerable work is done
without a contract and without even working out a firm price. For these
networked organizations to work, high trust and social capital between
organizations are key elements.
Networked organizations are particularly important in industries with
complex products where technologies and customer needs change
rapidly, such as in high technology industries. Close ties among a set of
companies enables them to work with each other in ways that are faster
than arms-length contracts would permit, and yet retains the flexibility of
being able to drop the relationship if needed (as opposed to performing
the function in-house). The trend towards networked organizations and
structures create a new tension between interdependence and
independence. The forces of aggregation and disaggregation throw up
new challenges for organizations, for example, the use of independent
contractors, joint ventures, strategic partnerships and alliances even with
competitors.

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One advantage of networks is that organizations have greater flexibility
and thus they can become more competitive in the global marketplace.
Another advantage is that organizations do not require that many
resources such as employee benefits, office space, and financing for new
business ventures.
On the other hand, networks have distinct disadvantages. Organizations
may find it more difficult to control quality of goods or services as they now
have to depend on their partners in the networks to deliver the quality that
is desired. Legal and contracting expertise as well as negotiation
expertise will also be important for networks. Alternative forms of control
may need to be developed to control quality. Alternative mechanisms for
coordination may also need to be developed to manage the growing
constellation and sometimes tenuous nature of other partner
organizations in the network.
All the five trends and the tensions they produce result in greater
organizational or system complexity for both leaders and employees in
organizations. The tensions produced by these trends cannot be solved.
They have to be managed. Effective approaches in organizational change
will involve not one strategy but many alternatives and will require leaders
and employees to develop greater resilience in confronting these tensions.
19.2 FUTURE TRENDS IN ORAGANISATION BEHAVIOR
The organizational environment in the future may be marked by shrinking
demand, scarce resources and more intense competition. When
organizations stagnate, decline or have their survival threatened, there is
evidence that stress and conflict increase. The motivational models, the
leadership styles and such other behavioural concepts may not be as
relevant as they are today. A lot of changes are inevitable and the OB
managers should also redefine their approaches and roles in the changed
scenario.

The following paragraphs highlight the trends in OB:

19.3 EMERGENCE OF E-ORGANIZATION / VIRTUAL OFFICES

The technological developments on communication offer both great

promise and some problems as well. Some companies, such as Compaq,
Hewlett-Packard and IBM have implemented virtual offices, in which
physical office space and individual desks are being replaced with an
amazing array of portable communication tools – electronic mail, cellular
phones, think pads, voice mail systems, laptop computers, fax machines,
modems and video conferencing systems.

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Employees armed with these tools can perform their work not just in their
homes, as telecommuters do, but almost anywhere in their cars, in
restaurants, in customers’ offices or in airports. Electronic communication
tools allow employers to greatly reduce the office space needed for each
employee, sometimes enabling them to replace dozens of desks with a
single ‘productivity centre’ that employees can use for holding meetings,
responding to mail, and accomplishing other short term tasks. One
significant risk is the loss of an opportunity for social interaction;
employees still need to gather informally, exchange ideas and
experiences face – to – face and develop a sense of teamwork. Managers
are to cope with this change and rearrange their strategies using modified
OB tools.

Figure. 19.1 virtual offices

19.4 WORK FORCE DIVERSITY

Organizations are no longer constrained by national borders. Due to these
managers and employee may find foreign assignments a necessary part
of their life. There the work force is likely to be very different in needs,
aspirations and attitudes from the ones they were used to back home.
They are made to work in different cultures. They find differences in
communication and the motivational patterns. The future managers face
the challenge of work force diversity. As a result, organizations are
becoming more heterogeneous in terms of gender, race and ethnicity.
The melting-pot approach which assumes people who were different
would somehow automatically want to assimilate does not find relevance
as the employees don’t set aside their cultural values and lifestyle
preferences. The challenge for organizations, therefore, is to make
themselves more accommodating to diverse groups of people by
addressing their different life styles, family needs and work styles.

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19.5 COPING WITH TEMPORARINESS
The world that most managers and employees face today is one of
permanent temporariness. They have to learn to live with flexibility,
spontaneity and unpredictability. With the mind boggling changes and
developments in science and technology the future managers are to be
on their toes, rethinking and re-organising their strategies and actions.
19.6 IMPROVING ETHICAL BEHAVIOUR

Members of organizations are increasingly finding themselves facing

ethical dilemmas, situations in which they are required to define right and
wrong conduct. Today’s manager needs to create an ethically healthy
climate for his or her employees, where they can do their work
productively and confront a minimal degree of ambiguity regarding what
constitutes right and wrong behaviours.

19.7 MOTIVATING PROFESSIONALS AND DIVERSIFIED WORKERS

In contrast to a generation ago, the typical employee today is likely to be
a highly trained professional with a college degree. These professionals
receive a great deal of intrinsic satisfaction from their work. Providing
challenging projects and autonomy, permitting them to structure their work
in ways that they find productive, reward them with educational
opportunities and giving due recognition may prove to be successful
motivators.
Motivating diversified workers requires flexibility. Work schedules design,
compensation plans, benefits and physical work settings reflect
employees’ varied needs. The motivational techniques may be designed
to suit these requirements.
19.8 TRENDS INFLUENCING THE WAY BUSINESSES ORGANISE
To improve organizational performance and achieve long-term objectives,
some organizations seek to reengineer their business processes or adopt
new technologies that open up a variety of organizational design options,
such as virtual corporations and virtual teams. Other trends that have
strong footholds in today’s organizations include outsourcing and
managing global businesses.
Reengineering Organizational Structure
Periodically, all businesses must reevaluate the way they do business.
This includes assessing the effectiveness of the organizational structure.
To meet the formidable challenges of the future, companies are
increasingly turning to reengineering—the complete redesign of business
structures and processes in order to improve operations. An even simpler

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definition of reengineering is “starting over.” In effect, top management
asks, “If we were a new company, how would we run this place?” The
purpose of reengineering is to identify and abandon the outdated rules
and fundamental assumptions that guide current business operations.
Every company has many formal and informal rules, based on
assumptions about technology, people, and organizational goals, that no
longer hold. Thus, the goal of reengineering is to redesign business
processes to achieve improvements in cost control, product quality,
customer service, and speed. The reengineering process should result in
a more efficient and effective organizational structure that is better suited
to the current (and future) competitive climate of the industry.

The Virtual Corporation

One of the biggest challenges for companies today is adapting to the
technological changes that are affecting all industries. Organizations are
struggling to find new organizational structures that will help them
transform information technology into a competitive advantage. One
alternative that is becoming increasingly prevalent is the virtual
corporation, which is a network of independent companies (suppliers,
customers, even competitors) linked by information technology to share
skills, costs, and access to one another’s markets. This network structure
allows companies to come together quickly to exploit rapidly changing
opportunities. The key attributes of a virtual corporation are:

• Technology. Information technology helps geographically distant

companies form alliances and work together.
• Opportunism. Alliances are less permanent, less formal, and more
opportunistic than in traditional partnerships.
• Excellence. Each partner brings its core competencies to the
alliance, so it is possible to create an organization with higher
quality in every functional area and increase competitive
advantage.
• Trust. The network structure makes companies more reliant on
each other and forces them to strengthen relationships with
partners.
• No borders. This structure expands the traditional boundaries of
an organization.
In the concept’s purest form, each company that links up with others to
create a virtual corporation is stripped to its essence. Ideally, the virtual
corporation has neither a central office nor an organization chart, no
hierarchy, and no vertical integration. It contributes to an alliance only its
core competencies, or key capabilities. It mixes and matches what it does

273
best with the core competencies of other companies and entrepreneurs.
For example, a manufacturer would only manufacture, while relying on a
product design firm to decide what to make and a marketing company to
sell the end result.

Although firms that are purely virtual organizations are still relatively
scarce, many companies are embracing several characteristics of the
virtual structure. One example is Cisco Systems. Cisco uses many
manufacturing plants to produce its products, but the company owns none
of them. In fact, Cisco now relies on contract manufacturers for all of its
manufacturing needs. Human hands probably touch fewer than 10
percent of all customer orders, with fewer than half of all orders processed
by a Cisco employee. To the average customer, the interdependency of
Cisco’s suppliers and inventory systems makes it look like one huge,
seamless company.

Virtual Teams
Technology is also enabling corporations to create virtual work teams.
Geography is no longer a limitation when employees are considered for a
work team. Virtual teams mean reduced travel time and costs, reduced
relocation expenses, and utilization of specialized talent regardless of an
employee’s location.
When managers need to staff a project, all they need to do is make a list
of required skills and a general list of employees who possess those skills.
When the pool of employees is known, the manager simply chooses the
best mix of people and creates the virtual team. Special challenges of
virtual teams include keeping team members focused, motivated, and
communicating positively despite their locations. If feasible, at least one
face-to-face meeting during the early stages of team formation will help
with these potential problems.

In today’s high-tech world, teams can exist any place where there is
access to the internet. With globalization and outsourcing being common
strategies in business operations today, companies of all shapes and
sizes utilize virtual teams to coordinate people and projects halfway
around the world. Unlike co-workers in traditional teams, virtual team
members rarely meet in person, working from different locations and
continents.

Outsourcing
Another organizational trend that continues to influence today’s managers
is outsourcing. For decades, companies have outsourced various
functions. For example, payroll functions such as recording hours,

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managing benefits and wage rates, and issuing paychecks have been
handled for years by third-party providers. Today, however, outsourcing
includes a much wider array of business functions: customer service,
production, engineering, information technology, sales and marketing,
and more.
Historically, companies have outsourced for two main reasons: cost
reduction and labor needs. Often, to satisfy both requirements, companies
outsource work to firms in foreign countries. In 2017, outsourcing remains
a key component of many businesses’ operations but is not strictly limited
to low-level jobs. Some of the insights highlighted in Deloitte’s recent
Global Outsourcing Survey bear this out. According to survey respondents
from 280 global organizations, outsourcing continues to be successful
because it is adapting to changing business environments. According to
the survey, outsourcing continues to grow across mature functions such
as HR and IT, but it has successfully moved to nontraditional business
functions such as facilities management, purchasing, and real estate. In
addition, some businesses view outsourcing as a way of infusing their
operations with innovation and using it to maintain a competitive
advantage—not just as a way to cut costs. As companies increasingly
view outsourcing as more than a cost-cutting strategy, they will be
expecting more of their vendors in terms of supplying innovation and other
benefits.

Structuring for Global Mergers

Recent mergers creating mega-firms raise some important questions
regarding corporate structure. How can managers hope to organize the
global pieces of these huge, complex new firms into a cohesive,
successful whole? Should decision-making be centralized or
decentralized? Should the firm be organized around geographic markets
or product lines? And how can managers consolidate distinctly different
corporate cultures? These issues and many more must be resolved if
mergers of global companies are to succeed.

Beyond designing a new organizational structure, one of the most difficult

challenges when merging two large companies is uniting the cultures and
creating a single business. The merger between Pfizer and Pharmacia,
makers of Dramamine and Rogaine, is no exception. Failure to effectively
merge cultures can have serious effects on organizational efficiency.
As part of its strategic plan for the giant merger, Pfizer put together 14
groups that would make recommendations concerning finances, human
resources, operation support, capital improvements, warehousing,
logistics, quality control, and information technology. An outside

275
consultant was hired to facilitate the process. One of the first tasks for the
groups was to deal with the conqueror (Pfizer) versus conquered
(Pharmacia) attitudes. Company executives wanted to make sure all
employees knew that their ideas were valuable and that senior
management was listening.
As more and more global mergers take place, sometimes between the
most unlikely suitors, companies must ensure that the integration plan
includes strategies for dealing with cultural differences, establishing a
logical leadership structure, implementing a strong two-way
communications channel at all levels of the organization, and redefining
the “new” organization’s vision, mission, values, and culture.

LET US SUM UP
The arrival of e-organization and virtual offices, existence of work force
diversity, increasing temporariness, changing view of workers regarding
ethical behaviour, motivation, leadership and host of other developments
make the job of the future managers more challenging and interesting.
CHECK YOUR PROGRESS

Choose the Correct Answer:

1. Combining two large companies is uniting the cultures and creating a
single business is called------------------
a) Virtual Firms b) Ethical behaviour
c) Strategic plan d) global merger

2. Recruiting external sources to run internal works of a firm is called---

-----------
a) Structuring b) strategic plan
c) Outsourcing d) acquisition
3. ------------- reduced travel time and costs, reduced relocation expenses,
and utilization of specialized talent regardless of an employee’s location.

a) Virtual teams b) promotion

c) Recruitment d) job enlargement
4. Confronting a minimal degree of ambiguity regarding what constitutes
right and wrong Behaviour is known as -------------
a) Moral obligations b) ethical behavior
c) Team spirit d) global merger

5. ---------------- is moving a society away from "mass society" to "mosaic

society".

276
 a) Online media b) virtual platforms
c) Diversity d) global merger

GLOSSARY

E-organization : Organisation run on virtual mode

Virtual office : A virtual office is a company that

operates as one unit and has a
physical mailing address, but
does
not exist in one specific location.

Work force diversity : Workforce diversity means

similarities and differences
among employees in terms of age,
cultural background, physical
abilities and disabilities.

Cultural shock : Culture shock is a sense of

anxiety, depression, or confusion
that results from being cut off from
your familiar culture.

Merger : A combination of two things,

especially companies, into one.

SUGGESTED READINGS
1. DinkarPagare (2015) Principles of Management, Sultan Chand &
Sons, New Delhi.
2. Harold Koontz, Cyril O'Donnell and Heinz Weihrich (2017)
Essentials of Management (5th Revised edition), McGraw-Hill Inc.,
US, (ISE Editions).
3. Prasad L.M. (2015) Principles and Practice of Management,
Sultan Chand & Sons, New Delhi.
4. Sherlekar S.A. &Sherlekar V.S 3rd Edition (2014) Principles of
Business Management, Himalaya Publishing House Pvt. Ltd,
Mumbai.
5. Tripathi, Sixth edition (2017) Principles of Management, Tata
McGraw Hill Education Private Limited, 7 thWest Patel Nagar, New
Delhi.

277
 6. Tripathi, P C, Reddy, P N, 5 edition (2012) Principles of
Management, Tata McGraw Hill Education private limited, 7 th west
Patel Nagar, New Delhi.
7. https://www.managementnote.com/emerging-trends-in-ob/
ANSWERS TO CHECK YOUR PROGRESS
1) d 2) c 3) a 4) b 5) c

278
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280
 SYLLABUS
Course Title : Economic Analysis for Management Decisions

Course Code : MSPS 12

Course Credit : 6

COURSE OBJECTIVE

Course Objective :

CO 1. Explain managerial economics and its execution while making a business

decision and apply the concepts of microeconomics such as utility and
demand analysis

CO 2. Discuss the supply and cost analysis and develop thorough knowledge of the

production theories and cost while dealing with factors of production.

CO 3. State key characteristics and consequences of different forms of markets
and apply different pricing strategies for products under different market
structures.
CO 4. Assess cost volume profit analysis, illustrate techniques to measure profit
and demonstrate profit maximization.
CO 5. Explain different concepts of national income and its measurements, factors
affecting national income and state monetary and fiscal policy.

BLOCK 1 Overview of Managerial Economics & Demand Analysis

Managerial Economics – Meaning, Nature and Scope – Managerial Economics and
Business decision making – Role and responsibility of Managerial Economist –
Fundamental Concepts of Managerial Economics – limitations - Utility analysis -
Demand Analysis – Meaning, Determinants and Types of Demand – Elasticity of
demand – Demand forecasting -methods.

BLOCK 2 Supply & Cost Analysis

Supply: Meaning and determinants, Law and Elasticity of Supply, Equilibrium of
demand and supply; Production: factors- Types of production functions –
Isoquants- law of variable proportions, Economies and diseconomies of scale. Cost
analysis: – types – cost-output relationships.
BLOCK 3 Market Structure
Market Structure – Various forms – Equilibrium of a firm – Perfect competition –
Monopolistic competition – Oligopolistic competition – Pricing of products under
different market structures – Methods of pricing – Factors affecting pricing decision
– Differential pricing – Government Intervention and pricing.

BLOCK 4 Profit & Cost Volume Analysis

The concept of profit: Profit planning, control and measurement of profits. Profit
maximization – Cost Volume Profit analysis.

BLOCK 5 National Income

National Income – concepts and components-computation /measurement of national
income –difficulties in measurement-factors affecting national income – inequalities
of income –Monetary and Fiscal Policy.

References:
1. Ahuja, H.L., (2017) Managerial Economics, latest Edition, S. Chand & Company
Ltd., New Delhi
2. Chaturvedi, (2012), Business Economics (Theory & Application), latest Edition,
IBH, New Delhi
3. Joel Dean, (2008), Managerial Economics, latest Edition, PHI Learning Private
Ltd., New Delhi
4. Justin Paul, Leena, Sebastian, (2012) Managerial Economics, latest Edition,
Cengage, USA
5. Maheshwari, (2014), Managerial Economics, latest Edition, Sultan & Chand,
New Delhi.
6. Mithani, D.M., (2009), Managerial Economics, latest Edition, Himalaya
Publishing House, New Delhi.
7. Moti Paul S. Gupta, (2007), Managerial Economics, latest Edition, Tata McGraw
Hill Pub., New Delhi.
8. Narayanan Nadar, E. and S. Vijayan, (2013), Managerial Economics, latest
Edition, PHI Learning Private Ltd., New Delhi.
9. Petersen & Lewis, (2003), Managerial Economics, 4th edition, Prentice Hall of
India (P) Ltd., New Delhi.
10. Sumitrapal, (2011), Managerial Economics Cases & Concepts, latest Edition,
Macmillan, Chennai.
11. https://epgp.inflibnet.ac.in/Home/ViewSubject?catid=ahLCajOqz6/GWFCSpr/XY
g==

12. https://archive.nptel.ac.in/courses/110/101/110101149/

13. https://corporatefinanceinstitute.com/resources/economics/market-structure/

14. https://www.wallstreetmojo.com/cost-volume-profit-analysis/
15. https://www.economicsdiscussion.net/national-income/4-main-concepts-of-
national-income/17241

Course Outcome :
CLO 1. Comprehend the nature of managerial economics and its relevance in
decision-making. Interpret the use of price elasticity of demand in pricing
decision. Predict the revenue and profit effects of a price change with
techniques of demand forecasting.
CLO 2. Analyse supply and cost, thereby assessing the functional relationship
between production and factors of production. List out the various costs
associated with the production.
CLO 3. Integrate the concept of price and output decisions of firms under a various
market structure.
CLO 4. Recognize profit planning and interpret cost - volume profit analysis and
construct profit maximistaion.
CLO 5. Critically analyse various concepts of national income and the factors that
affect national income.
 CONTENT
BLOCK 1 OVERVIEW OF MANAGERIAL ECONOMICS &
DEMAND ANALYSIS

UNIT 1 CONCEPTS AND TECHNIQUES 2

1.1 Meaning of Managerial Economics 3

1.2 Definitions of Managerial Economics 3

1.3 Nature of Managerial Economics 4

1.4 Scope of Managerial Economics 5

1.5 Managerial Economics and Business Decision 6

Making

1.6 Role of Managerial Economist 7

1.7 Fundamental Concepts of Managerial Economics 8

UNIT 2 UTILITY ANALYSIS 15

2.1 Meaning and definition of Utility Analysis 15

2.2 Assumptions of Utility Analysis 16

2.3 Features of Utility Analysis 17

2.4 Concept of Utility Analysis 17

UNIT 3 DEMAND ANALYSIS 21

3.1 Meaning of Demand 22

3.2 Definitions of Demand 22

3.3 Determinants of Demand 22

3.4 Types of Demand 23

3.5 Law of Demand 23

3.6 Elasticity of Demand 24

UNIT 4 DEMAND FORECASTING AND METHODS 34

4.1 Objectives of demand forecasting 35

4.2 Methods of demand forecasting 35

4.3 Features of a good forecasting method 43

BLOCK 2 SUPPLY & COST ANALYSIS

UNIT 5 SUPPLY ANALYSIS 47

5.1 Meaning of Supply 48

5.2 Determinants of Supply 48

5.3 Supply Analysis 49

5.4 Law of Supply 50

5.5 Exceptions of the Law of Supply 52

5.6 Change in Supply 52

5.7 Shift in Supply Curve 53

5.8 Equilibrium Between Demand and Supply 53

5.9 Determinants of the Law of Supply 55

5.10 Elasticity of Supply 56

5.11 Determinants of Elasticity of Supply 57

UNIT 6 PRODUCTION ANALYSIS 60

6.1 Definition of Production Function 61

6.2 Factors of Production 61

6.3 Types of Production 64

6.4 Law of Production Function 68

6.5 Law of Variable Proportions 70

 6.6 Law of Return to Scale 73

6.7 Least Cost Combination 77

UNIT 7 COST ANALYSIS 81

7.1 Types of Cost 82

7.2 Cost-output Relationship 84

7.3 Economies and Diseconomies of Scale 88

7.4 Cost Functions 91

BLOCK 3 MARKET STRUCTURE

UNIT 8 MARKET STRUCTURE 96

8.1 Meaning of Market 97

8.2 Definitions of Market 97

8.3 Market Structure 97

8.4 Forms of Market Structure 97

8.5 Equilibrium of a Firm 98

8.6 Pricing Under Different Market Structure 98

UNIT 9 ORGANISATION STRUCTURE 107

9.1 Perfect Competition 108

9.2 Meaning of Perfectly Competitive Market 109

9.3 Definition of Perfectly Competitive Market 109

9.4 Assumptions behind a Perfectly Competitive Market 109

9.5 Characteristics of Perfectly Competitive Market 110

9.6 Price and Output Determination 110

9.7 Perfect v/s pure competition 111

 9.8 Short run equilibrium of the firm and industry 112

9.9 Long run equilibrium of the firm and industry 113

9.10 Derivation of the supply curve of the firm 114

9.11 Derivation of the supply curve of the industry 116

9.12 Price and output determination under perfect 118

competition

9.13 Demand under Perfect Competition 119

9.14 Supply under Perfect Competition 119

9.15 Equilibrium under Perfect Competition 120

9.16 Price and output determination in long run 120

9.17 Long run supply curve of a competitive industry 123

UNIT 10 MONOPOLISTIC COMPETITION 126

10.1 Meaning of Monopolistic Competition 127

10.2 Features of Monopolistic Competition 127

10.3 Foundation of monopolistic competition model 128

10.4 Price and Output Determination in short Run 130

10.5 Price and Output Determination in long Run 130

10.6 Analysis of selling cost and firm’s equilibrium 132

10.7 Critical appraisal of Chamberlin’s theory of 133

Monopolistic

UNIT 11 OLIGOPOLY MARKET 138

11.1 Oligopoly 139

11.2 Oligopoly Market 139

11.3 Characteristics of Oligopoly 139

 11.4 Causes of Oligopoly 140

11.5 Effects of Oligopoly 141

11.6 Price determination under oligopoly 142

11.7 Price Determination Models of Oligopoly 142

11.8 Game theory approach to oligopoly 145

BLOCK 4 PROFIT & COST VOLUME ANALYSIS

UNIT 12 PRICING 149

12.1 Methods of Pricing 150

12.2 Factors affecting Pricing Decision 155

12.3 Differential Pricing 157

12.4 Government Intervention and Pricing 158

UNIT 13 PROFIT 162

13.1 Concept of Profit 163

13.2 Profit Planning 163

13.3 Profit Control 164

13.4 Measurement of Profit 164

13.5 Profit Maximization 171

UNIT 14 COST VOLUME PROFIT ANALYSIS 175

14.1 Introduction 176

14.2 Meaning of Break-Even Analysis 176

14.3 Break Even Point 176

14.4 Determination of BEP 177

14.5 Assumptions of BEP 179

 14.6 Managerial Uses Break Even Analysis 180

14.7 Limitations Of Break-Even Analysis 183

BLOCK 5 NATIONAL INCOME

UNIT 15 NATIONAL INCOME 187

15.1 Meaning of National Income 188

15.2 Definition of National Income 188

15.3 National Income Concepts 188

15.4 Measurement of National Income 189

15.5 Importance of National Income Estimate 189

15.6 Difficulties Encountered in the Estimation of National 190

Income

UNIT 16 FISCAL POLICY 194

16.1 Fiscal policy 195

16.2 Objectives of fiscal policy of India 195

16.3 Fiscal policy and economic growth 196

16.4 Fiscal policy and full employment 197

16.5 Fiscal policy and social justices 197

16.6 Fiscal policy and Economic stabilization 199

16.7 Role of fiscal policy in developing countries 199

UNIT 17 MONETERY POLICY 202

17.1 Meaning of the Monetary Policy 202

17.2 Neutrality of Money 203

17.3 Price Stability and Control of Business Cycles 204

17.4 Full Employment 205

17.5 Monetary Policy and Economic Growth 205

Plagiarism Report 210

 BLOCK 1

OVERVIEW OF MANAGERIAL ECONOMICS &

DEMAND ANALYSIS

Unit 1: Concepts and Techniques

Unit 2: Utility Analysis

Unit 3: Demand Analysis

Unit 4: Demand Forecasting and Methods

1
Unit 1

CONCEPTS AND TECHNIQUES

STRUCTURE

Overview

Learning Objectives

1.1 Meaning of Managerial Economics

1.2 Definitions of Managerial Economics

1.3 Nature of Managerial Economics

1.4 Scope of Managerial Economics

1.5 Managerial Economics and Business Decision Making

1.6 Role of Managerial Economist

1.7 Fundamental Concepts of Managerial Economics

Let Us Sum Up

Check Your Progress

Glossary

Suggested Readings

Answers to Check Your Progress

OVERVIEW
Modern business and management are complex. Hence a systematic
knowledge and techniques of Managerial Economics is an absolute
requirement these days. Managerial Economics provides the analytical
framework and understanding of economic behaviour, logical thinking and
useful techniques for decision making and highlights the role of
managerial economist in decision making. Further, Managerial
Economics deals with the demand for and supply of commodities, pricing
methods, profit planning etc. In this unit, we will discuss the concept,
scope and fundamental concepts.

LEARNING OBJECTIVES

After completing this unit, you should be able to,

• explain the meaning and nature of managerial economics.
• discuss the scope of managerial economics
• define the fundamental concepts of managerial economics
• list out the role of managerial economist.

2
1.1 MEANING OF MANAGERIAL ECONOMICS
Managerial Economics is a specialized discipline of management studies
which deals with the application of economic concepts, theories and tools
of analysis for decision making process in business. In other words,
Managerial Economics is an applied economics in business management.
In brief, Managerial Economics is the integration of economic principles
with business management practices. It is the branch of Economics which
serves as a bridge between abstract theory and managerial practice.
Since Economics is a science concerned with the problem of allocation of
scarce resources, Managerial Economics is the application of Economics
to the problem of choice of scarce resources by the firms. Hence,
Managerial Economics deals with the application of economic theory that
can be helpful in solving the problems of management. In management
studies, the terms ‘Managerial Economics’, ‘Business Economics’,
‘Economics of Firm’, ‘Economics of Business Enterprise’, ‘Economics for
Managers’, ‘Economics of Business Management’, ‘Economics of
Business Decisions’, ‘Economics for Decision Making’ and ‘Economic
Analysis in Management Decision’ are used as synonyms.

1.2 DEFINITIONS OF MANAGERIAL ECONOMICS

Following are some of the important definitions of Managerial Economics:

1. “Managerial Economics is the integration of economic theory with the
business practice for the purpose of facilitating decision making and
forward planning by the Management"– Milton, H., Spencer and
Louis Siegelman.
2. “Managerial Economics consists of the use of economic modes of
thought to analyse business situations” – Malcom P. Mc. Nair and
Richard S. Meriam.
3. “Managerial Economics is concerned with business efficiency” –
Christopher I. Savage and John R. Small.
4. “Managerial Economics is Economics applied in decision making. It
is a special branch of Economics bridging the gap between abstract
theory and managerial practice” – Haynes.
5. “Managerial Economics is a study of the behaviour of the firms in
theory and practice” – James Bates and J.R. Parkinson.
6. “Managerial Economics is the application of economic theory and
methodology to business administration practice” – Eugene F.
Brigham and James L. Pappas.

3
 7. “Managerial Economics is a fundamental academic subject which
seeks to understand and to analyse the problems of business
decision making” – D.C. Haynes
8. “Managerial Economics can be defined as the use of economic logic
and principles to aid management decision making” – J.R. Davies
and S. Hughes.
9. “Managerial Economics is concerned with the application of
economic concepts and economic analysis to the problems of
formulating rational management decision” – Edwin Mansfield.

1.3 NATURE OF MANAGERIAL ECONOMICS

i) Managerial Economics is the use of economic analysis in the
process of making managerial decisions. It is not a part of economic
theory but a separate branch by itself.
ii) Managerial Economics is pragmatic. It is concerned with analytical
tools that are useful in decision making. It is an applied science.
iii) Managerial Economics combines and synthesises, ideas as well as
methods from the various functional fields of business management
like Accountancy, Production Management, Marketing etc. Thus, it
employs a multi-disciplinary approach.
iv) The main aim of Managerial Economics is to increase business
efficiency.
v) Managerial Economics is a part of Normative Economics. It is
prescriptive rather than descriptive in character.
vi) Managerial Economics is micro economic in character but it uses
some of the macro-economic concepts in forecasting.
vii) Managerial Economics serves as a tool in the study of Business
Administration because its theories, methods and techniques of
analysis are used in the functional areas of Business Administration
such as production, marketing, accounting etc.
viii) Managerial Economics serves as an integrating course combining
the various functional areas and showing not only how they interact
with one another but also how the firm interacts with the environment
in which it operates.
ix) Managerial Economics is both conceptual and metrical. It takes the
help of conceptual framework to understand and analyse the
decision problems and takes the help of quantitative techniques to
measure the impact of different factors and policies.

4
1.4 SCOPE OF MANAGERIAL ECONOMICS
The scope of a subject means area or the extent of coverage of a
particular subject. In that aspect, Managerial Economics includes the
following:

a) Demand Analysis

b) Production and Cost Analysis

c) Pricing

d) Profit Management

e) Capital Budgeting
a) Demand Analysis: Understanding the basic concepts of demand is
essential for demand forecasting. Demand analysis deals with
demand determinants, demand distinctions (i.e., different types of
demand) and demand forecasting. Demand analysis also highlights
the factors which influence the demand for a product. This helps to
manipulate demand. Demand forecasting has become an
increasingly important function of a modern Managerial Economist.
b) Production and Cost Analysis: Production and Cost Analysis is
concerned with the supply side of the market. Production analysis
studies the production function, factors of production, least cost
combination, returns to scale etc. Cost analysis deals with various
types of costs and their role in decision making, determinants of
costs, cost-output relationship in both the short-run and long-run and
cost control. The production and cost analysis are essential for
effective project planning.
c) Pricing: Pricing of the product or products produced by firms is a
very important aspect of Managerial Economics since firm’s revenue
mainly depends on its pricing policy. The chief function of the firm is
pricing. Pricing depends upon the cost of production. Price affects
profit which in turn affects the business. Pricing explains how prices
are determined under different market conditions such as, Perfect
Competition, Monopoly, Duopoly, Oligopoly and Monopolistic
Competition. The manager is required to have a thorough
knowledge of profit. The manager of the business has to determine
suitable pricing policies. The success or failure of a firm mainly
depends on accurate price decisions. A correct pricing policy makes
firm successful, while an incorrect pricing policy leads to its
elimination.

5
 d) Profit Management: Since the aim of the firm is generally to
maximise profit. Profit management is also an important area of
study in Managerial Economics. Profit management deals with the
nature, functions and measurement of profit, profit policies, profit
planning like Break-Even Analysis and control. Profit making is the
major goal of firms. There are several constraints on account of
competition from other products, changing input prices etc. Hence,
there is always certain amount of risk involved. Managerial
Economics deals with techniques that minimizing risks and
maximizing profit. The success or failure of a firm is measured only
in terms of profit.
e) Capital Budgeting: Capital is a scarce and expensive factor of
production. Lack of capital may result in the small size of the
operations. Availability of capital from various sources may help to
undertake large scale. Hence capital management is one of the
most important functions of the managers. This capital management
is done by means of capital budgeting. Capital budgeting is
concerned with the long-term allocation of resources. It deals with
the analysis of capital expenditure, demand for and supply of capital,
cost of capital etc.

1.5 MANAGERIAL ECONOMICS AND BUSINESS DECISION MAKING

Decision making means the process of selecting a particular suitable
course of action from among the various alternative courses of action.
Every Business Manager has to work on uncertainties and the future
cannot be precisely predicted accurately, Hence, decision making is an
integral part of modern management. The most important function of the
Business Manager is decision making.

Business decisions are classified into the following:

a) Financial Decisions: Financial decisions relates to costing,
budgeting, accounting, capital structure, dividend etc.
b) Production Decisions: These decisions relate to product,
technology, product mix, location of the plant, maintenance etc.
c) Personnel Decisions: Such decisions relate to selection,
recruitment, training, placement, promotion, transfer, retrenchment,
etc.
d) Marketing Decisions: Marketing decisions relates to sales volume,
sales force, sales promotion, market research, packaging,
advertisement etc.

6
 e) Miscellaneous Decisions: These decisions relate to all residual
items like purchasing, processing, public relations etc.

1.6 ROLE OF MANAGERIAL ECONOMIST

The Managerial Economist has a significant role to play in assisting the
management of the firm in decision making and forward planning by using
specialised skills and techniques. The ‘Managerial Economist’ is also
called ‘Business Economist’, ‘Company Economist’ or ‘Economic
Adviser’. The following are the important functions of the Managerial
Economist:
i) The job of the Managerial Economist lies in designing the course of
operations to maintain and improve the systems of the firm like
productivity and market share. He assists the entrepreneur in making
a rational choice among alternative ways of producing goods.
ii) The Managerial Economist is an economic adviser to a firm. By virtue
of his expertise, he helps the businessmen in arriving at correct
decisions. It is the Managerial Economist of a firm who has to advise
them on all matters of trade.
iii) Forecasting is a fundamental activity of a Managerial Economist. He
is an effective model builder. He deals with the business problems in
a sharp manner.
iv) The Managerial Economist should be well aware of the current and
changing trends in the national as well as international economy.
Knowledge of balance of payments position, exchange rates, import
and export policies of the Government are also essential for the
Managerial Economist.
v) The Managerial Economist has also been keeping an eye on the fast-
changing technological developments. He has to suggest ways and
means of economizing and thereby to minimize the cost of
production.
vi) The Managerial Economist has to help the management in business
planning by providing guidance for the correct and economical
organization and running of the enterprise.
vii) The most important role of the Managerial Economist relates to
demand forecasting. He prepares a short term forecast of general
business activity and relates general economic forecasts to specific
market trends.

7
viii) The success of a firm depends upon a proper pricing strategy. The
Managerial Economist has to be very alert to take correct pricing
decision.

1.7 FUNDAMENTAL CONCEPTS OF MANAGERIAL ECONOMICS

The basic concepts that are used in Managerial Economics are the
following:

a) The Incremental Concept

b) The Concept of Time Perspective

c) The Discounting Principle

d) The Concept of Opportunity Cost

e) The Equi-Marginal Principle

a) The Incremental Concept: The Incremental Concept is the most
important concept in Economics and is certainly the most frequently
used in Managerial Economics. The Incremental Concept involves
the impact of decision alternatives on total cost and total revenue
due to changes in output.

There are two fundamental concepts in this analysis. They are:

I. Incremental Cost
II. Incremental Revenue
Incremental Cost is the change in the total cost due to a decision.
Similarly, the Incremental Revenue is the change in the total revenue
due to a decision.
Marginal Revenue and Incremental Revenue
Marginal Revenue (MR) is the additional revenue made to total revenue
by selling one more unit of the commodity. The formula to calculate the
Marginal Revenue is:

MR = [Change in Revenue]/[Change in Output]

= R1 – R0 / Q2 – Q1

where,

MR = Marginal Revenue

R0 = New Total Revenue

R1 = Old Total Revenue

Q1 = New Quantity
Q0 = Old Quantity

8
Incremental Revenue (IR) is the difference between the old revenue (R 0)
and new revenue (R1) resulting from a new decision taken by the firm. In
other words, Incremental Revenue is the change in total revenue as a
result of new decision taken by the firm. When incremental revenue
exceeds the incremental cost resulting from a particular decision, it is
regarded as ‘profit’. The formula to calculate Incremental Revenue is:

IR = R1 – R0

Illustration
The difference between Incremental Revenue and the Marginal Revenue
can be illustrated as follows:
Suppose the price of a commodity falls from Rs. 15 to Rs. 10 per unit and
hence the sales go up from 1000 units to 2500 units. Calculate
Incremental Revenue and Marginal Revenue.

IR = R1 – R0

= (Rs.10 x 2500) – (Rs.15 x 1000)

= Rs.25,000 – Rs.15,000
= Rs.10, 000.

MR = R1 – R0 / Q2 – Q1

= 25000 – 15000 / 15-10

= 10000 / 5 = Rs.2000

Marginal Cost and Incremental Cost

Marginal Cost is the additional cost made to the total cost by producing
one more unit of output. The formula to calculate Marginal Cost is:

MC = [Change in Cost]/[Change in Output]

= C1 – C0 / Q1 – Q0

Where,

MC = Marginal Cost

C1 = New Total Cost

C0 = Old Total Cost

Q1 = New Quantity

Q0 = Old Quantity
Incremental Cost is the change in total cost as a result of new decision.
In other words, Incremental Cost is the difference between old cost and

9
new cost resulting from a new decision taken by the firm. The formula to
calculate Incremental Cost is: IC = C 1 – C0

Where,

IC = Incremental Cost

C1 = New Total Cost

C0 = Old Total Cost

b) The Concept of Time Perspective: Marshall was the first
Economist who introduced the ‘time element’ in the value analysis.
According to him, time plays an important role in determining the price of
a commodity. Marshall distinguished the time element into four. They
are
i) Market Period or Very Short Period: The Market Period is a very
short period in which the commodities are perishable and the supply
of such commodities being fixed, i.e., perfectly inelastic. For example,
if the demand for commodities like vegetables, flowers, meat, fish,
eggs, fruits, milk increases, its supply cannot be increased on the
same day. Since the supply of such commodities is fixed, its price is
determined by the demand on that day. The price prevailing in the
market period is called the ‘Market Price’.
ii) Short Period: The Short Period is a period in which the supply can
be changed in accordance with the demand. This is possible by
changing the variable factors only. This means, in the short period, it
is not possible to change the fixed factors. In this time period, the
commodity is non-perishable and also reproducible by using variable
factors like raw materials, wage earnest etc.,
iii) Long Period: The Long Period is a period in which supply can be
fully adjusted to demand. This is done by changing the fixed factors
like machines, equipment’s, plants, scale of productions, organization
and management. In the long period, new firms can enter the industry
and old firms can leave the industry.
iv) Very Long Period or Secular Period: Secular Period is a period in
which changes in demand fully adjust themselves to supply.
c) The Discounting Principle
The Discounting Principle is very useful in Managerial Economics in
making investment decisions. A sum of money available at present is
considered more valuable at than the same amount at some other
period. Hence, present gain is valued more than a future gain.
Therefore, it is necessary to know the techniques for measuring the
value today (i.e., the present value of money) to be received in future.

10
 The equation for the future value (FV) of any amount ‘S’ for ‘n’ periods
at an interest rate of ‘r’ is

FV = S(1 + r)n
Where,

FV = Future Value

S = Present Value

r = Rate of Interest

N = Number of Years

The equation for the computation of present value (PV) of an

amount due in future is:

PV = FV (1/ (1+r) n)

The process of reducing future values of their present values is

often referred to as “Discounting”. In this context, the interest rate
used in present value problem is sometimes referred to as
“Discounting Rate”.

d) The Concept of Opportunity Cost

The Opportunity Cost is the cost of using something in a particular
venture is the benefit foregone by not using it in its best alternative
use. In Managerial Economics, opportunity costs are the costs of
displaced alternatives. They represent only sacrificed alternatives.
They involve the measurement of sacrifices made in taking a particular
decision. Hence, opportunity cost is not recorded in any financial
account.
For example, a farmer who is producing paddy can also produce
wheat with the same inputs. Therefore, the opportunity cost of a
quintal of paddy is the amount of output of wheat given up.
The concept of opportunity cost has a wide application in Managerial
Economics. It is applied in determining factor prices and product
prices, consumption and public expenditure.

e) The Equi-Marginal Principle

The Equi – Marginal Principle states that an input should be allocated
in such a way that the value added by the last unit is the same in all
uses.
Let us explain this principle with a simple illustration. A firm is involved
in four activities, namely A, B, C and D. All these activities require the

11
 services of labour. According to this principle, the optimum output will
be obtained when the value of Marginal Product of Labour is equal in
all activities. That is, output is maximum when,

VMPLA = VMPLB = VMPLC = VMPLD

Where,

VMP = Value of Marginal Product

L = Labour and

A, B, C and D are various activities.

LET US SUM UP
This unit expresses the meaning, nature and scope of Managerial
Economics. Managerial Economics is the application of economic
principles in business decision. Managerial Economics is pragmatic. It is
a part of Normative Economics. The scope of Managerial Economics
includes Demand Analysis, Production and Cost Analyses, Pricing, Profit
Management and Capital Budgeting. Decision making means the
process of selecting a particular suitable course of action from among the
various alternative courses of action. The role of Managerial Economist
has also been discussed in this unit. In this unit you have also been
exposed to an overview of fundamental concepts like incrementalism,
time perspective, discounting, opportunity cost and equi-marginalism.

CHECK YOUR PROGRESS

Choose the Correct Answer:

1. The process of selecting a particular suitable course of action from

among the various alternative courses of action means ___________

a) Capital budgeting b) Profit management

c) Demand analysis d) Decision making

2. The difference between the old revenue and new revenue resulting

from a new decision taken by the firm is___________

a) Total revenue b) Average revenue

c) Incremental revenue d) Marginal revenue

3. Additional cost made to the total cost by producing one more unit of

output is___________

a) Total Cost b) Average Cost

c) Incremental Cost d) Marginal Cost

12
4. Market period is also called ___________

a) Very Short Period b) Short Period

c) Very Long Period d) Long Period

5. Very long period is also known as___________

a) Secular Period b) Short Period

c) Nuclear Period d) Long Period

GLOSSARY

Pricing : Pricing of the product or products produced

by firms is a very important aspect of
Managerial Economics since firm’s
revenue mainly depends on its pricing
policy.

Profit management : Profit management deals with the nature,

functions and measurement of profit, profit
policies, profit planning like Break-Even
Analysis and control.

Capital budgeting : Capital is a scarce and expensive factor of

production. Lack of capital may result in
small size of operations. Availability of
capital from various sources may help to
undertake large scale.

Decision making : Decision making means the process of

selecting a particular suitable course of
action from among the various alternative
courses of action.

Equi-marginal : The Equi – Marginal Principle states that

principle an input should be allocated in such a way
that the value added by the last unit is the
same in all uses.

SUGGESTED READINGS
1. Dewett, K K&Navalur,M H (2006), Modern Economic Theory, S.
Chand Publishing, New Delhi.
2. Mehta, P.L. (1997) “Managerial Economics",5th Edition Sultan
Chand & Sons Publications.

13
 3. Mehta, P L,(2016), Managerial Economics Analysis , Problems And
Cases, Sultan Chand & Sons, New Delhi .
4. Mote,V, Samuel Paul , Gupta,G.(2017),Managerial Economics :
Concepts & Cases, Tata McGraw-Hill Publishing Company
Limited, New Delhi.
5. Sankaran,S. Dr.3rd Editions (2012), Business Economics,
Margham Publications, Chennai.
6. Varshney, R.L., Maheshwari,K.L. 19th Edition (2014), Managerial
Economics, Sultan Chand & Sons, New Delhi.
7. https://www.analyticssteps.com/blogs/scope-managerial-
economics
8. https://www.economicsdiscussion.net/managerial-
economics/concepts-of-managerial-economics-with-
diagram/19260
9. https://www.google.com/search?q=NATURE+and+scope+OF+MA
NAGERIAL+ECONOMICS&sxsrf=ALiCzsZGBF5Q7fqlchMLg7jv3
_8JYeCxLA:1668740593581&source=lnms&tbm=vid&sa=X&ved=
2ahUKEwiAv7WS37b7AhVgZWwGHVSgACAQ_AUoBHoECAEQ
Bg&biw=1280&bih=577&dpr=1.5#fpstate=ive&vld=cid:3303332e,
vid:A9daYVRKewM

ANSWERS TO CHECK YOUR PROGRESS

1) d 2) c 3) d 4) b 5) a

14
Unit 2

UTILITY ANALYSIS
STRUCTURE

Overview

Learning Objectives

2.1 Meaning and definition of Utility Analysis

2.2 Assumptions of Utility Analysis

2.3 Features of Utility Analysis

2.5 Concept of Utility Analysis

Let Us Sum Up

Check Your Progress

Glossary

Suggested Readings

Answers to Check Your Progress

OVERVIEW
The Cardinal Approach or Utility Analysis to the theory of consumer
behavior is based upon the concept of utility. This unit is to explain Utility
Analysis its Meaning, Definition, Assumptions, Features, and Concept. It
assumes that utility is capable of measurement. It can add, subtract,
multiply, and so on. Cardinal utility analysis is the oldest theory of demand
which provides an explanation of consumer’s demand for a product and
derives the law of demand which establishes an inverse relationship
between price and quantity demanded of a product.

Learning Objectives

After completing this lesson, you should be able to

• define Utility Analysis

• discuss the features of utility analysis

• describe the concept of utility analysis.

2.1 MEANING AND DEFINITION OF UTILITY ANALYSIS

Cardinal utility approach to the theory of demand has been subjected to
severe criticisms and as a result, some alternative theories, namely,
Indifference Curve Analysis, Samuelson’s Revealed Preference Theory,

15
and Hicks’ Logical Weak Ordering Theory have been propounded.
According to this approach, the utility can be measured in cardinal
numbers, like 1,2,3,4, etc. Fisher has used the term “Util” as a measure
of utility. Thus, in terms of cardinal approach, it can be said that one gets
from a cup of tea 5 utils, from a cup of coffee 10 utils, and a Rasgulla 15
utils worth of utility.

Meaning and definition of Utility Analysis

The term utility in Economics is used to denote that quality, in a goods or
service by which our wants are satisfied. In, other words utility is defined
as the want satisfying power of a commodity.
According to Mrs. Robinson, “Utility is the quality of commodities that
makes individuals want to buy them.”
According to Hibdon,“Utility is the quality of a good to satisfy a want.”

2.2 ASSUMPTIONS OF UTILITY ANALYSIS

Cardinal utility analysis of demand is based upon certain important
assumptions. Before explaining how cardinal utility analysis explains
consumer’s equilibrium regarding the demand for a good, it is essential to
describe the basic assumptions on which the whole utility analysis rests.
As we shall see later, cardinal utility analysis has been criticized because
of its unrealistic assumptions.

Figure 2.1 Utility Analysis

The utility analysis is based on a set of following assumptions:

• The utility analysis is based on the cardinal concept which assumes
that utility is measurable and additive like weights and lengths of
goods.
• Cardinal or Utility is measurable in terms of money.

• The marginal utility of money is assumed to be constant

16
 • The consumer is an rational who measures, calculates, chooses
and compares the utilities of different units of the various
commodities and aims at the maximization of utility.
• He has full knowledge of the availability of commodities and their
technical qualities.
• He possesses perfect knowledge of the choice of commodities
open to him and his choices are certain.
• They know the exact prices of various commodities and thei r
utilities are not influenced by variations in their prices.
• There are no substitutes.

2.3 FEATURES OF UTILITY ANALYSIS

The utility analysis has the following main features

1. Subjective: The utility is subjective because it deals with the mental
satisfaction of a man. A commodity may have different utility for
different persons. Cigarette has utility for a smoker but for a person
who does not smoke, the cigarette has no utility. Utility, therefore, is
subjective.
2. Relative: The utility of a good never remains the same. It varies with
time and place. The fan has utility in the summer but not during the
winter season.
3. Usefulness: A commodity having utility need not be useful. Cigarette
and liquor are harmful to health, but if they satisfy the want of an addict
then they have utility for him.
4. Morality: The utility is independent of morality. Use of liquor or opium
may not be proper from the moral point of views. But as these
intoxicants satisfy wants of the drunkards and opium eaters, they have
utility for them.

2.4 CONCEPT OF UTILITY ANALYSIS

There are three concepts of utility analysis;

1. Initial: The utility derived from the first unit of a commodity calls initial
utility. Utility derived from the first piece of bread calls initial utility. Thus,
the initial utility is the utility obtained from the consumption of the first
unit of a commodity. It is always positive.
2. Total: Total utility is the sum of utility derived from different units of a
commodity consumed by a household.

17
According to Left witch,“Total utility refers to the entire amount of
satisfaction obtained from consuming various quantities of a commodity.”
Supposing a consumer gets four units of apple. If the consumer gets 10
utils from the consumption of first apple, 8 utils from the second, 6 utils
from third, and 4 utils from the fourth apple, then the total utility will be
10+8+6+4 = 28.

Accordingly, the total utility can calculate as:

TU = MU1+ MU2+ MU3+ ……… + MUn

or

TU = EMU`

Here TU = Total utility and MU 1, MU2, MU3, + MUn

The Marginal Utility derived from the first, second, third……….and nth
unit.
3. Marginal: The Marginal Utility is the utility derived from the additional
unit of a commodity consumed. The change that takes place in the total
utility by the consumption of an additional unit of a commodity calls
marginal utility.

According to Chapman,
“Marginal utility is the addition made to total utility by consuming
one more unit of commodity.”
Supposing a consumer gets 10 utils from the consumption ofone mango
and 18 utils from two mangoes then, the marginal utility of second mango
will be 18-10=8 utils.
The marginal utility can be measured with the help of the following
formula MUnth = TUn – TUn-1

Here;

MUnth= Marginal utility of nth unit.

TUn= Total utility of “n” units, and.

TUn-1 = Total utility of n-1 units.

Types of Marginal utility

The types of marginal utility can be; positive marginal utility, zero
marginal utility, or negative marginal utility.
1. Positive: If by consuming additional units of a commodity, total
utility goes on increasing, marginal utility will be positive.

18
 2. Zero: If the consumption of an additional unit of a commodity
causes no change in total utility, the marginal utility will be zero.
3. Negative: If the consumption of an additional unit of a commodity
causes falls in total utility, the marginal utility will be negative.

LET US SUM UP
The Cardinal Approach or Utility Analysis to the theory of consumer
behavior is based upon the concept of utility. We have explained Utility
Analysis Meaning, Definition, Assumptions, Features, and Concept in this
lesson.

CHECK YOUR PROGRESS

Choose the Correct Answer:

1._____________ is the quality of commodities that makes individuals
want to buy them
a) Utility b) Stock

c) Money d) Strategic
2. The marginal utility of money is assumed to be ____________

a) Semi Variable b) Constant

c) Average d) Variable

3. Consuming additional units of a commodity, total utility goes on

____________Marginal utility will be positive

a) Increasing b) Decreasing
b) Partly increase and Partly Decrease d) Stable

4. Consumption of an additional unit of a commodity causes no change

in total utility, the marginal utility will be ____________

a) No Change b) Zero

c) Positive d) Negative

5. If the consumption of an additional unit of a commodity cause falls in

total utility, the marginal utility will be negative___________

a) No Change b) Zero

c) Positive d) Negative

19
GLOSSARY

Utility : Utility is the quality of commodities that

makes individuals want to buy them

Subjective : The utility is subjective because it deals

with the mental satisfaction of a man. A
commodity may have different utility for
different persons. Cigarette has utility for
a smoker but for a person who does not
smoke, the cigarette has no utility. Utility,
therefore, is subjective.

Positive : If by consuming additional units of a

commodity, total utility goes on
increasing, marginal utility will be
positive

SUGGESTED READINGS
1. Dewett, K K&Navalur,M H (2006), Modern Economic Theory, S.
Chand Publishing, New Delhi.
2. Mehta, P.L. (1997) “Managerial Economics",5th Edition Sultan
Chand & Sons Publications.
3. Mehta, P L,(2016), Managerial Economics Analysis , Problems And
Cases, Sultan Chand & Sons, New Delhi .
4. Mote,V, Samuel Paul , Gupta,G.(2017),Managerial Economics :
Concepts & Cases, Tata McGraw-Hill Publishing Company Limited,
New Delhi.
5. Sankaran,S. Dr.3rd Editions (2012), Business Economics, Margham
Publications, Chennai.
6. Varshney, R.L., Maheshwari,K.L. 19th Edition (2014), Managerial
Economics, Sultan Chand & Sons, New Delhi.
7. https://www.yourarticlelibrary.com/economics/elasticity-as-
demand/the-neo-classical-utility-analysis-assumptions-total-utility-
vs-marginal-utility/10634
8. https://www.economicsdiscussion.net/articles/utility-features-
creation-and-concepts-on-utility/2024

ANSWERS TO CHECK YOUR PROGRESS

1) a 2) b 3) a 4) b 5) d

20
Unit 3

DEMAND ANALYSIS
STRUCTURE

Overview

Learning Objectives

3.1 Meaning of Demand

3.2 Definitions of Demand

3.3 Determinants of Demand

3.4 Types of Demand

3.5 Law of Demand

3.6 Elasticity of Demand

Let Us Sum Up

Check Your Progress

Glossary

Suggested Readings

Answers to Check Your Progress

OVERVIEW
Now you are familiar with the meaning and nature of Managerial
Economics. You have also acquired an idea about the scope and
fundamental concepts of Managerial Economics. This unit is going to the
most important aspects of Managerial Economics, namely Demand
Analysis Elasticity of Demand explain you and Demand Forecasting.
Demand depends upon price. Demand forecasting has an important
influence on production planning. It is essential for a firm to produce the
required quantities at the right time.

LEARNING OBJECTIVES

After completing this unit, you should be able to,

• define demand and elasticity of demand

• mention the factors influencing elasticity of demand

• Analyse the methods of demand forecasting.

21
3.1 MEANING OF DEMAND
In common parlance, demand means the desire for a commodity. But in
Economics demand means the desire backed up by willingness and ability
to buy a commodity at some price in a given period of time. Hence,
demand is always at a price for a definite quantity in a specified time.
Demand depends upon price.

3.2 DEFINITIONS OF DEMAND

To Stonier and Hague, “Demand in Economics means demand backed
up by enough money to pay for the goods demanded.”
To Benham, “the demand for anything at a given price is the amount of it
which will be bought per unit of time at that price.”

3.3 DETERMINANTS OF DEMAND

The demand for goods may change not only due to change in price but
also due to change in certain conditions or factors. These factors are
known as “Determinants of Demand”.
a) Changes in Climate: Change in climate will cause a change in
demand. For example, the demand for cool drinks is high during
summer.
b) Changes in Tastes, Preferences and Fashions: Changes in tastes,
preferences and fashions will also cause a change in demand. For
example, sarees are out of fashion among Indian ladies and chudithars
have come into fashion. Hence, the demand for chudithars has
increased.
c) Changes in Size and Composition of Population: If population
increases, the demand for commodities automatically increases
without any change in price.

Note: Real income itself depends on price level.

d) Expectations: If the consumers expert that there will be a rise in price
in future, the demand for the commodity will increase at present
irrespective of the current price and vice versa.
e) Changes in the price of Substitutes: The demand for a commodity
may change due to a change in price of its substitutes. For example,
the demand for cigarette increases at the same price, because due to
rise in the price of beedi.
f) Changes in the Distribution of Income: When there is equal
distribution of income and wealth, the demand for commodities will

22
 increase more than when there is inequality in the distribution of
income and wealth.
g) Advertisement: The demand for goods increases due to
advertisement, publicity, attractive label and packing.

3.4 TYPES OF DEMAND

1. Durable and non-Durable

2. Perishable and non-perishable

3. Autonomous demand and Indeemed demand

4. Individual demand and firm demand

3.5 LAW OF DEMAND

The Law of Demand was originally introduced by Cournot. But the final
credit goes to Alfred Marshall who improved this concept.

Definition
Marshall defines the Law of Demand as, “Other things remain the same,
the amount demanded increases with a fall in price and diminishes with a
rise in price”.

Explanation
This Law states that there is an inverse relationship between the price and
the quantity demanded of a commodity.

Demand Schedule
A tabular statement which shows the relationship between the price and
the quantity demanded for a commodity is ‘Demand Schedule’.

Table 3.1 Demand Schedule

Price Quantity Demanded

1 50

2 40

3 30

4 20

5 10

In Table 3.1, when price is Re.1, the quantity demanded of the commodity
is 50 units. If price is increased from Re.1 to Rs.2, the demand decreased
from 50 units to 40 units. Similarly, if price is Rs.5, the quantity demanded

23
of commodity is 10 units. If price is decreased from Rs.5 to Rs.4, the
demand increased from 10 units to 20 units.

Demand Curve
The graphical representation of the demand schedule is said to be the
“Demand Curve”.
6
5
4
Price

3
2
1
0
10 20 30 40 50
Quantity

Quantity Demand

Figure.3.1 Law of Demand

In Figure 3.1, DD is the demand curve, which slopes downward from left
to right. It indicates that when price falls, the demand expands and when
price rises, the demand contracts.

Assumptions
The Law of Demand is based on the following assumptions:
1. The income, taste, habit and preference of the consumer remains
constant.

2. The prices of related goods remain constant.

3. No substitute for the commodity.

4. There should be continuous demand for the commodity.

3.6 ELASTICITY OF DEMAND

The Law of Demand explains the direction of change in demand due to
change in price. That is, a fall in the price of a commodity leads to an
increase in its quantity and vice versa. But, it does not explain the rate of
change in demand due to a small change in price. The Elasticity of
Demand explains the exact rate change in demand due to change in price.

24
3.6.1 Definition
In the words of Marshall, “The Elasticity (or Responsiveness) of demand
in a market is great or small accordingly as the amount demanded
increased much or little for a given fall in price and diminishes much or
little for a given rise in price”.

3.6.2 Types of Elasticity of Demand

Elasticity of Demand can be broadly divided to three. They are:

i. Price Elasticity of Demand

ii. Cross Elasticity of Demand

iii. Income Elasticity of Demand

a) Price Elasticity of Demand

Alfred Marshall stated: "The elasticity (or responsiveness) of demand in a
market is great or small as the amount demanded increases much or little
for a given fall in price and diminishes much or little for a given rise in
price”. It is the rate at which quantity purchased changes as the price
changes.
Price elasticity of demand is a measure of responsiveness of demand for
a product to a change in its price. It is a ratio of proportionate change in
quantity demanded to a given proportionate change in price. The simple
formula for this is as follows:
Percentage change in quantity demanded
PE = Percentage change in price
(𝑄 −𝑄 )/ 𝑄
PE = (𝑃2 −𝑃1)/ 𝑃 1
2 1 1

Where

PE = price elasticity of demand

Q1 = quantity demanded before changes

Q2 = quantity demanded after changes

P1 = price before change

P2 = price after change

b) Cross Elasticity of Demand

The quantity demanded of a particular commodity varies according to the
price of other commodities. Cross elasticity measures the responsiveness
of the quantity demanded of a commodity due to changes in the price of
another commodity. For example, the demand for tea increases when the
price of coffee goes up. Here the cross elasticity of demand for tea is high.

25
If two goods are substitutes then they will have a positive cross elasticity
of demand. In other words, if two goods are complementary to each other
than negative income elasticity may arise.
The responsiveness of the quantity of one commodity demanded to a
change in the price of another good is calculated with the following
formula.
% change in demand for commodity A
Ec= % change in price of commodity B
If two commodities are unrelated goods, the increase in the price one of
the good does not result in any change in the demand for the other goods.
For example, the price fall in Tata salt does not make any change in the
demand for Tata Nano.

c) Income Elasticity of Demand

Income elasticity of demand measures the responsiveness of quantity
demanded to a change in income. It is measured by dividing the
percentage change in quantity demanded by the percentage change in
income. If the demand for a commodity increases by 20% when income
increases by 10% then the income elasticity of that commodity is said to
be positive and relatively high. If the demand for food were unchanged
when income increases, the income elasticity would be zero. A fall in
demand for a commodity when income rises results in a negative income
elasticity of demand.

3.6.3 Types of Price Elasticity of Demand

The following classification of price elasticity is also applicable to the
income elasticity and the cross elasticity.
i) Perfectly Elastic Demand or Infinitely Elastic Demand: Though
there is no change in the price level, there will be some changes n the
demand is called are perfectly elasticity demand. For example
Price demand
50 100
50 120
EP= ∞

Figure. 3.2 Perfectly Elastic Demand

26
ii) Perfectly Inelastic Demand or Zero Elastic Demand: It refers to that
situation where there is no change in the quantity demanded of the
commodity due to a substantial change in price.

EP= 0

Figure.3.3 Perfectly Inelastic Demand

iii) Relatively Elastic Demand or More Elastic Demand: It refers to that
situation where a proportionate change in the quantity demanded is
greater that the proportionate change in price. EP > 1

Figure.3.4 Relatively Elastic Demand

iv) Relative Inelastic Demand or More Inelastic Demand: It refers to
that situation where a proportionate change in quantity demand is less
than the proportionate change in price. EP < 1

Figure. 3.5 Relatively Inelastic Demand

27
v) Unit Elastic Demand: It refers to that situation where the
proportionate change in the quantity demanded of a commodity is
equal to the proportionate change in price.
EP = 1

Figure. 3.6 Unitary Elastic Demand

3.6.4 Methods of Measuring Price Elasticity of Demand

Generally, four methods are used to measure the price elasticity of
demand. They are:
a) Total Outlay Method (Total Expenditure Method): This method was
introduced by Alfred Marshall. In this method, we consider the change in
total outlay or expenditure of a consumer due to change in price of the
commodity. To calculate the elasticity, rate the following formula is used
TR =P ×Q

Were

P = Price

Q = Quantity demand
a) If change in price does not cause any change in the total
expenditure, then the elasticity of demand is equal to unity.
b) If change in price will lead to the increase in total expenditure, then
the elasticity of demand is greater than unity.
c) If change in price will lead to decrease in total expenditure, then
the elasticity of demand is less than unity.

Figure. 3.7 Total Outlay Method

28
In Figure 3.7, Panel (A) represents an upward sloping total revenue
curve (T1R) indicating that when price rises from P 1to P2total outlay
(or total revenue) rises from R1to R2. It shows how the demand is
relatively inelastic (e < 1).
Panel (B) represents a vertical straight-line total revenue curve
(T2R). Here, total revenue remains unchanged (OR), whether price
changes from P1to P2or vice versa. It means that the demand is
unitary elastic (e = 1).
Panel (C) represents a downward sloping total revenue curve (T 3R).
So, with the rise in price from P1to P2, total revenue decreases from
R1to R2. It means that the demand is relatively elastic (e > 1).
b) Arc Method: To calculate a price elasticity over some portion of
the demand curve rather than at a point, the concept of arc elasticity
of demand is used (See Figure 3.8).
In Figure 3.8, point elasticity is measured at a point (say ‘a’) on the
demand curve. Arc elasticity is measured on a range of demand
curve, say between ‘a and b.’ The formula for arc elasticity
measurement is:

Figure 3.8 Point vs Arc Elasticity

∆𝑄 𝑃 +𝑃
earc =∆𝑃 × 𝑄1 + 𝑄2
1 2

Where,

P1= original price,

P2= new price,

Q1= original quantity demand,

Q2= new demand,

∆ P = P2– P1; ∆ Q = Q2– Q1

29
c) Point Method: Marshall also suggested another method called the
point elasticity method or geometrical method for measuring price
elasticity at a point on the demand curve.
The simplest way of explaining the point method is to consider a linear
(straight-line) demand curve. Let the straight-line demand curve be
extended to meet the two axes, as in Figure 3.9. When a point is plotted
on the demand curve like point Pin Figure 3.9, it divides the curve into two
segments. The point elasticity is, thus, measured by the ratio of the lower
segment of the curve below the given point to the upper segment of the
curve above the point.

For brevity, we may again put that:

Lower segment of the curve below the given point
Po int Elasticity = Upper segment of the demand curve above the point

or, to remember through symbols, we may put as:

𝐿
e=U

where, e stands for point elasticity, L stand for lower segment, and U for
the upper segment.

Figure. 3.9 Point Method

In Figure 3.9, AB is the straight-line demand curve and P is a given
point. Thus, PB is the lower segment and PA the upper segment.
𝐿 𝑃𝐵
e = U = PA

d) Percentage Method: According to this method, the elasticity of

demand can be measured by comparing the ratio of percentage change
in the quantity demanded to the percentage change in the price of the
commodity. Therefore,
%𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞
EP = × 100
%𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝

By Percentage Method, five kinds of price elasticity of demand can be

measured as follows:

30
 i. EP =1, when =1, e.g.:= 1

ii. EP >1, when>1, e.g.:= 2

iii. EP <1, when<1, e.g.:= 0.5

iv. EP = ∝, when = ∝1, eg:= ∝

v. EP = 0, when= 0, e.g.: = 0

3.6.5 Factors Influencing Elasticity of Demand

i) The demand for necessities is less elastic or inelastic, while the
demand for luxury and comfortable goods is elastic.
ii) The demand for a commodity on which a consumer spends only a
small portion of his income is less elastic.
iii) The demand for a commodity is more elastic, when the commodity
has several uses.
iv) The demand for a commodity is more elastic, if the commodity has
good substitutes.
v) The demand for a commodity to which the consumer is accustomed
is inelastic.
vi) When the demand for a commodity is post ponable, its demand is
more elastic.
vii) The demand for commodities will be less elastic in the short period
and will be more elastic in the long period.
viii) The demand for complementary goods like pen and ink, petrol and
car is less elastic or inelastic.

3.6.6 Uses of Elasticity of Demand

a) Monopolist has to consider the elasticity of demand for his product
when he fixes the price for his product. If his products have inelastic
demand, he may fix a higher price for it and if his products have
elastic demand, he may fix a lower price for it.
b) The concept of elasticity of demand is also helpful to the finance
minister before levying tax for a commodity. If increasing tax on a
commodity has inelastic demand for that commodity, there will be
imposition of higher tax rates on Alcohol, Cigarette consumption.
c) The concept of elasticity of demand is also useful in the
determination of the rewards for various factors of production. For
example, if the demand for labour in a particular industry is relatively
inelastic, the trade unions can bargain for higher wages.

31
 d) The terms of trade between two countries can be calculated by
taking into account the mutual elasticities of demand for each other’s
product.
e) The concept of elasticity of demand also helps the Government in
fixing appropriate foreign exchange rate.

LET US SUM UP
In this unit we have shown the meaning and determinants of demand.
Demand means desire backed by willingness and ability to pay. Further
we have highlighted the meaning, methods and factors influencing
Elasticity of Demand.
CHECK YOUR PROGRESS
Choose the Correct Answer:
1. The change in demand for a commodity, due to change in the price of
its substitute is called___________

a) Price demand b) Income demand

c) Cross demand d) Law of demand

2. The desire backed up by a willingness to buy a commodity at some
price is said to be __________

a) Demand b) Supply

c) Cross demand d) Income demand

3. The rate of change in demand due to change in price is said to be
___________
a) Cross Elasticity b) Price Elasticity

c) Cross demand d) Law of Elasticity

4. The ratio of percentage change in quantity demanded of a commodity
to a given percentage change in the price of the substitute is called
______________

a) Cross Elasticity b) Price Elasticity

c) Cross demand d) Law of Elasticity

5. The demand for a commodity to which the consumer is accustomed
is __________

a) Elastic b) Less elastic

c) Inelastic d) Law of Elasticity

32
GLOSSARY

Demand : Demand in Economics means demand

backed up by enough money to pay for
the goods demanded

Elasticity of Demand : The Elasticity (or Responsiveness) of

demand in a market is great or small
according as the amount demanded
increased much or little for a given fall in
price and diminishes much or little for a
given rise in price

SUGGESTED READINGS
1. Dewett, K K&Navalur,M H (2006), Modern Economic Theory, S.
Chand Publishing, New Delhi.
2. Mehta, P.L. (1997) “Managerial Economics",5th Edition Sultan
Chand & Sons Publications.
3. Mehta, P L,(2016), Managerial Economics Analysis , Problems And
Cases, Sultan Chand & Sons, New Delhi .
4. Mote,V, Samuel Paul , Gupta,G.(2017),Managerial Economics :
Concepts & Cases, Tata McGraw-Hill Publishing Company Limited,
New Delhi.
5. Sankaran,S. Dr.3rd Editions (2012), Business Economics, Margham
Publications, Chennai.
6. Varshney, R.L., Maheshwari,K.L. 19th Edition (2014), Managerial
Economics, Sultan Chand & Sons, New Delhi.
7. https://www.economicsdiscussion.net/elasticity-of-
demand/measuring-price-elasticity-of-demand-4-methods/21878
8. https://www.youtube.com/watch?v=Olh4je1JLWA

ANSWERS TO CHECK YOUR PROGRESS

1) c 2) a 3) b 4) c 5) c

33
Unit 4

DEMAND FORECASTING AND METHODS

STRUCTURE

Overview

Learning objectives

4.1 Objectives of demand forecasting

4.2 Methods of demand forecasting

4.3 Features of a good forecasting method

Let Us Sum Up

Check your Progress

Glossary

Suggested Readings

Answers to Check Your Progress

OVERVIEW
Forecasting is a prediction or estimation about a future event which is
most likely to happen under given conditions. Thus, demand forecasting
refers to an estimate of future demand for the product. Demand
forecasting has an important influence on production planning. It is
essential for a firm to produce the required quantities at the right time.
Demand forecasts relate to production, inventory control etc. Since
management operates under conditions of uncertainty, one of the most
important functions of the managerial economist is that of demand
forecasting.

LEARNING OBJECTIVES

After completing this unit, you should be able to,

• describe the objectives of demand forecasting

• analyse the methods of demand forecasting

• discuss the features of demand forecasting method.

34
4.1 OBJECTIVES OF DEMAND FORECASTING

The following are the important objectives of demand forecasting:

(i) To eliminate the gap between demand for and supply of goods,
demand forecasting helps the producers to take up production
planning.
(ii) Demand forecasting induces the producers to maintain sufficient
inventory stock, so that when supply falls and demand increases,
the stock may be released to the market to fill up the gap.
(iii) Demand forecasting helps the businessmen to formulate appropriate
price policies, so that the prices do not fluctuate over a period of time.
(iv) Demand forecasting helps the businessmen to determine sales
targets.
(v) Demand forecasting is very helpful to the businessmen to prepare
the budget.
(vi) Demand forecasting enables the companies to decide about the
production capacity.
4.2 METHODS OF DEMAND FORECASTING
The demand forecasting can be done for established (existing) products
as well as and for new products. Let us see the methods of demand
forecasting for established products.
Methods of Demand Forecasting for Established Products
The methods of demand forecasting for established products can be
classified into two. They are

1.Survey Methods

Survey Methods are further classified into the following:

i) Consumers’ Survey Method: In this method, consumers are contacted
personally and asked to give their opinions about their consumption in the
near future. This method is the most ideal method. Though this method
is very simple, it is the most expensive method. Because, the consumers
are numerous in number and scattered. Further, the consumers may be
hesitant to reveal their purchase plans because of commercial secrecy.

Consumers’ survey method may be undertaken in three ways. They are:

a) Complete Enumeration Method: Under this method, a complete
survey of all the consumers of the product is made. The interviewer asks
every consumer the quantity he would like to buy in the near future. Once

35
this information is collected, the demand forecasts are obtained by simply
adding the probable demands of all the consumers. As first-hand
information is collected, this method is free from bias. However, this
method is impracticable, because the consumers are numerous in
number and scattered. Hence, this method is most expensive
b) Sample Survey Method: Under this method, a sample of few
consumers is interviewed. The total demand of all the consumers in the
sample is finally blown up to generate the total demand of all the
consumers in the forecast period. This method is easy, less costly, time
saving and also highly useful. But, if the sample selected is not
representative, then wrong results will be obtained.
c) End Use Method: Under this method, data regarding the demand for
the product in the near future from different sectors such as industries,
consumers, export and import are collected.
d) Experts’ Opinion Method: Under this method, the experts like
wholesalers and retailers of the product are requested to tell their opinions
about the demand in the near future. Since the wholesalers and retailers
have been dealing in the products for a long period, they are in a position
to predict the likely demand for the product in the near future on the basis
of experience.

Advantages
• This method is very simple.

• The calculation is also very easy.

• This method is less costly.

• This method is time saving.

Disadvantages
• This method is purely subjective.

• Different experts may give different kinds of forecasts.

• The experts may be biased.

e) Opinion Survey Method

This method is also known as Sales – Force – Composite Method or
Collective Opinion Method. Under this method, the company asks its
salesmen to submit the estimates of the future demand for the product in
their respective regions.

36
Advantages
• This method is very simple.

• This method is less costly.

• This method is time saving.

• Since this method requires less statistical skill, there is no need for
special technical skill.

Disadvantages
• This method is purely subjective.

• The salesmen may not be aware of the changes that affect the
demand for the product in near future.

f) Delphi Method
Under this method, a panel is selected to give suggestions to solve the
problems in hand. Both internal and external experts can be the members
of the panel. Panel members are kept apart from each other and express
their views in an anonymous manner. There is also a coordinator who acts
as an intermediary among the panelists. The coordinator prepares the
questionnaire and sends it to the panelists. At the end of each round, the
coordinator prepares a Let us sum up report. On the basis of the Let us
sum up report, the panel members have to give suggestions. This method
has been used in the area of technological forecasting. It has proved
more popular in forecasting non-economic rather than economic
variables.

2. Statistical Methods
The Statistical Methods are:
• The Trend Projection Method

This method is based on analysis of past sales patterns. A firm will

have accumulated considerable data regarding sales for a number of
years. Such data is arranged chronologically with regular intervals of
time. This type of data is called ‘Time Series’.
The trend in time series can be estimated by using any one of the
following methods:

a) The Least Square Method

The common technique used in constructing the line of best fits is
by the method of least squares. The trend is assumed to be linear.
The equation for the straight-line trend is y = a + bx, where ‘a’ is the

37
 intercept and ‘b’ is the slope, i.e., the impact of the independent
variable. The ‘y’ intercept and the slope of the line are found by
making the appropriate substitutions in the following normal
equations:
∑y = na + b∑x ……… (1)

∑xy = a∑x + b∑x2 ……… (2)

According to the principle of Least Squares, if Sx is equal to zero, then

a = and b =

Examples
1. Calculate the trend value from the following data using the method
of least square and estimate the production for 2007.

Years 1999 2000 2001 2002 2003 2004

Production 9 12 18 27 36 45
(in tons)

Solution

Years x Y x2 xy
1999 -3 9 9 -27

2000 -2 12 4 -24
2001 -1 18 1 -18
2002 1 27 1 27
2003 2 36 4 72
2004 3 45 9 135
Sx = 0 Sy = 147 2
Sx = 28 Sxy=165

a = 24.5

b = 5.89

Therefore =a + bx

= 24.5 + 5.89x

Y 1999 = 24.5 + 5.89 (-3) = 24.5 – 17.67 = 6.83 tons

Y 2000 = 24.5 + 5.89 (-2) = 24.5 – 11.78 = 12.72 tons

Y 2001 = 24.5 + 5.89 (-1) = 24.5 – 5.89 = 18.61 tons

Y 2002 = 24.5 + 5.89 (1) = 24.5 + 5.89 = 30.39 tons

Y 2003 = 24.5 + 5.89 (2) = 24.5 + 11.78 = 36.28 tons

38
 Y 2004 = 24.5 + 5.89 (3) = 24.5 + 17.67 = 42.17 tons

Y 2005 = 24.5 + 5.89 (6) = 24.5 + 35.34 = 59.84 tons

2. With the help of the following data, project the trend values for the
next five years.

Years 2000 2001 2002 2003 2004

Sales (Rs. In 50 60 72 87 107

crores)

Solution

Years X Y x2 xy

2000 -2 50 4 -100

2001 -1 60 1 -60

2002 0 72 0 0

2003 1 87 1 87

2004 2 107 4 214

Sx = 0 Sy = 376 Sx2 = 10 Sxy =

141

a = 75.2
b = 14.1
Therefore, y = a + bx = 75.2 + 14.1x
Y 2005 = 75.2 + 14.1 (3) = 75.2 + 42.3 = Rs. 117.5 crores
Y 2006 = 75.2 + 14.1 (4) = 75.2 + 56.4 = Rs. 131.6 crores
Y 2007 = 75.2 + 14.1 (5) = 75.2 + 70.5 = Rs. 145.7 crores
Y 2008= 75.2 + 14.1 (6) = 75.2 + 84.6 = Rs. 159.8 crores
Y 2009 = 75.2 + 14.1 (7) = 75.2 + 98.7 = Rs. 173.9 crores

b) The Free Hand Curve Method

This method of demand forecasting is very simple. In this method,
we must plot the original data on the graph. Draw a smooth curve
carefully which will show the direction of the trend. The time is shown
on the X axis and the values are represented in Y axis.

39
c) The Moving Average Method
In the Moving Average Method, the average value for a number of years
or months or weeks is taken into account and placing it at the centre of
the period of moving average. It is calculated from overlapping groups
of successive time series data. Moving average can be calculated for 3,
4,5,6,7,8 or 9 years period.

d) The Method of Semi Averages

In this method, the original data is divided into two equal parts and
averages are calculated for both the parts. These averages are called
‘Semi Averages’.
• The Regression Method: Regression Analysis is the most popular
method of demand forecasting. In regression, the demand function
is an expression of the relationship between sales and other
determinants. The regression method makes use of both economic
theory and statistical estimation techniques to generate sales
forecasts from past data. The first step in regression analysis is to
specify the variables that are supposed to affect the demand for the
product in question. The variables are generally chosen from the
determinants of demand, namely, price of the product, price of its
substitute's income, taste and preferences of the consumers.
These variables are treated as independent variables. Once
independent variables are specified, the second step is collection of
time series data on the independent variables. After the necessary
data are collected, the next step is to specify the form of equation
which can appropriately describe the nature and extent of
relationship between the dependent and independent variables.
The final step is to estimate the parameters in the equation with the
help of statistical techniques.
• The Barometric Method: Barometric Method is an improvement
over the trend projection method. In the trend projection method,
the future demand is an extension of the past demand while in the
Barometric Method; the present demand is used to predict the future
demand. This is done by the use of certain economic and statistical
indicators from the selected time series to predict variables. There
are three kinds of indicators of time series, namely,
a) Leading Series

b) Coincident Series

c) Lagging Series

40
The leading series provide data on the variables which move up
or down behind some other series. For example, the bank rate is
leading the interest rate. The rates at which the commercial banks
lend to private sectors are coincident series and the rates at which
the private money lenders lend to individuals are the lagging
series.
The following indicators are used in estimating the future demand
for certain products:
a) Construction Contracts – Demand for building materials like
cement.
b) Increased Prices of - Demand for agricultural inputs
Agricultural Commodities like fertilizers.
c) Automobile Registration – Demand for Petrol.
In the Barometric Method, firstly it is necessary to find out the
existence of any relationship between the demand for the product
and the indicators. Then establish the relationship with the help of
the method of least squares and then form the regression equation.
Assuming the relationship to be linear, the equation will be of the
form y = a + bx. Once the regression equation is derived, the value
of ‘y’ i.e., the demand for the product can be estimated for any value
of ‘x’.
The advantage of Barometric Method is that it is simple. The
limitations of this method are:

1. It is not always possible to find a leading indicator

2. The link between sales and its leading variables may vary
over time

3. It is useful only for short-term forecasting.

• The Simultaneous Equation Method
In this method, all variables are considered simultaneously, for
every variable influences other variables. It is a system of ‘n’
equations with ‘n’ unknowns. The advantage of this method is that
an estimate of future demand for the product can be made with pre-
determined variables.
This method is a highly complicated. Further, this method is time
consuming and costly method and it requires historical data on the
variables affecting sales.

41
Although this method is theoretically better than any other statistical
methods, its severe limitations are responsible for its unpopularity.

Demand Forecasting for New Products

The methods of demand forecasting for new products are quite different
from those for established products. For the new products, an intensive
study of the economic and competitive characteristics of the product
provides the key to intelligent forecasting of demand. Joel Dean provides
six possible approaches of forecasting the demand for new products.
They are as follows:
i) Evolutionary Approach: Forecast the demand for the new product is
an outgrowth and evolution of an established product. For example,
start with the assumption that color television picks up where black
and white television left off. The evolutionary approach is useful only
when the new product is very close to the existing product. The 100
CC two wheelers are an improvement of Rajdoot and Bullet.
ii) Substitute Approach: According to this approach, the new product
is to be considered as a substitute for the established product. Then
forecast the demand for the new product (i.e., substitute) on the basis
of the established product. For example, the new laser typesetting
substitutes photographic composition for the established type-setting
equipment. Likewise, any toilet soap or tooth paste is a close
substitute for the existing soap or tooth pastes.
iii) Growth Curve Approach: Estimate the rate of growth and the
ultimate level of demand for the new product on the basis of the
pattern of growth of established products. For example, analysis of
growth curves of all established household appliances and try to
establish an empirical law of market development is applicable to a
new household appliance. Likewise, a company which is producing a
new washing soap should estimate the growth trends of all the
washing soaps of different brands.
iv) Opinion – Polling Approach: Under this approach, the demand for
the new product will be estimated by making direct enquiries of the
ultimate consumers in the sample area. Then extend the sample to
derive the total demand for the product by the population as a whole.
Sending a representative for a new industrial product to a sample
company is an example.
v) Sales Experience Approach: According to this approach, the
demand for the new product will be estimated by offering the new

42
 product for sale in a sample market and then estimate the total
demand.
vi) Vicarious Approach: By this approach, the reactions of the
consumers are indirectly studied. The specialized dealers who are
able to judge the needs, tastes and preferences of the consumers are
contacted. Since the dealers having link with consumers, they will be
able to know how the customers will receive the new product. The
opinions of dealers are very much solicited regarding the demand for
the new products. This approach is easy but difficult to quantify.
Another limitation of this approach is that the bias of the dealers
cannot be ruled out completely.

4.3 FEATURES OF A GOOD FORECASTING METHOD

We have studied about various methods of demand forecasting. Some of
these methods are costlier and some of them are cheaper. Further, some
methods are flexible and some require skill. Therefore, there is a problem
of choosing the best method of demand forecasting. Hence, in order to
choose the best method, the following criteria have to be considered:
i) Accuracy: The method of forecasting should be very accurate. Then
only the management will have confidence in the techniques adopted.
It is very important to verify the accuracy of the past forecasts against
present and present forecasts against the future forecast.
ii) Plausibility: Plausibility means belief. The management should have
good knowledge of the method chosen and also, they should have
belief in the method used for that purpose. The plausibility increases
the accuracy of the result.
iii) Durability: Whenever a forecast is chosen, it should hold good for a
certain period of time. The durability of a forecast depends upon the
reasonableness and simplicity of the functions fitted.
iv) Simplicity: Whenever a forecast is chosen, it should be of simple in
nature. Mathematical and econometric procedures are not desirable
by the management.
v) Availability: Adequate availability of data is very important for the
forecasting method. Then only the method should yield quick and
accurate result.
vi) Economy: The cost of forecasting should be less. If the forecast is of
very little importance, there is no need to spend a large amount of
money for the demand forecasting.

43
LET US SUM UP
The demand forecasting refers to an estimate of future demand for the
product. The demand forecasting methods are broadly divided into two
namely, Survey Methods and Statistical Methods.

CHECK YOUR PROGRESS

Choose the Correct Answer

1. ___________ shows the relationship between price and quantity
demanded of a commodity at a particular time period in the market.

a) Law of demand b) Investment alternatives

c) Evaluation of alternatives d) All of the above.

2. ___________refers to the process of predicting the future demand for
the firm's product.

a) Law of demand b) Demand Forecasting

c) Evaluation of alternatives d) All of the above

3. ___________ refers to the rate of variation of demand with respect to
the rate of variation of prices of related or substitutable goods.

a) Law of demand b) Demand Forecasting

c) Cross Elasticity of demand d) All of the above

4.Related goods are of kinds ___________

a) One b) Two

c) Four d) Three
5. ___________forecasting is predicting a commodity/product/service
price by evaluating the characteristics

a) Law of demand b) Demand Forecasting

c) Cross Elasticity of demand d) Price

GLOSSARY

Demand : Forecasting is a prediction or estimation

Forecasting about a future event which is most likely to
happen under given conditions. Thus,
demand forecasting refers to an estimate
of future demand for the product. Demand
forecasting has an important influence on
production planning. It is essential for a

44
 firm to produce the required quantities at
the right time.

Accuracy : The method of forecasting should be very

accurate. Then only the management will
have confidence in the techniques
adopted. It is very important to verify the
accuracy of the past forecasts against
present and present forecasts against the
future forecast.

Plausibility : Plausibility means belief. The

management should have good
knowledge of the method chosen and also
they should have belief in the method used
for that purpose.

SUGGESTED READINGS
1. Dewett, K K&Navalur,M H (2006), Modern Economic Theory, S.
Chand Publishing, New Delhi.
2. Mehta, P.L. (1997) “Managerial Economics",5th Edition Sultan
Chand & Sons Publications.
3. Mehta, P L,(2016), Managerial Economics Analysis , Problems And
Cases, Sultan Chand & Sons, New Delhi .
4. Mote,V, Samuel Paul , Gupta,G.(2017),Managerial Economics :
Concepts & Cases, Tata McGraw-Hill Publishing Company
Limited, New Delhi.
5. Sankaran,S. Dr, 3rd Editions (2012), Business Economics,
Margham Publications, Chennai.
6. Varshney, R.L.,Maheshwari,K.L. 19th Edition (2014), Managerial
Economics, Sultan Chand & Sons, New Delhi.
7. https://managementknowledgeforall.blogspot.com/2014/03/metho
ds-of-demand-forecasting.html
8. https://www.economicsdiscussion.net/demand-
forecasting/demand-forecasting-concept-significance-objectives-
and-factors/3557

ANSWERS TO CHECK YOUR PROGRESS

1) a 2) b 3) c 4) b 5) d

45
 BLOCK 2

SUPPLY & COST ANALYSIS

Unit 5 : Supply Analysis

Unit 6: Production Analysis

Unit 7: Cost Analysis

46
Unit 5

SUPPLY ANALYSIS
STRUCTURE

Overview

Learning Objectives

5.1 Meaning of Supply

5.2 Determinants of Supply

5.3 Supply Analysis

5.4 Law of Supply

5.5 Exceptions of the Law of Supply

5.6 Change in Supply

5.7 Shift in Supply Curve

5.8 Equilibrium Between Demand and Supply

5.9 Determinants of the Law of Supply

5.10 Elasticity of Supply

5.11 Determinants of Elasticity of Supply

Let Us Sum Up
Check Your Progress

Glossary

Suggested Readings

Answers to Check Your Progress

OVERVIEW
Supply may be the amount of goods offered for sale per unit of time. This
unit will explain the concept of supply analysis with the help of the law of
supply, supply schedule and the supply curve. Supply has a direct relation
with price. The tendency of the producer is to sell more as the price
increases .Therefore, market supply will also increase. The second part
of this unit explains about the change in the supply curve and the shift in
the supply curve. After studying this, we can learn about the major factors
determining supply. The final part of this unit will explain the Elasticity of
supply as well as Advertisement elasticity of supply.

47
LEARNING OBJECTIVES

After completing this unit, you should be able to,

• explain the concept of supply

• express the law of supply, supply schedule and supply curve

• identify the factors influencing the law of supply

• describe the elasticity of supply

• indicate how the equilibrium between the Law of Demand and

supply.

5.1 MEANING OF SUPPLY

The word ‘Supply’ implies the quantities of a commodity offered for sale
by the producer at a particular price during a given period of time. Hence,
the supply of a commodity is the amount of that commodity which the
sellers or producers are able and willing to offer for sale at a particular
price during a given period of time.

5.2 DETERMINANTS OF SUPPLY

The supply of a commodity not only depends on the price of the
commodity, but also on several factors. These factors are called
‘Determinants’ or ‘Conditions’ of supply. They are:
a) Price of the Commodity: If the price of the commodity is high, there
will be more profit. The higher the profit, the greater will be the supply.
b) Cost of Production: The cost of production of a commodity depends
on the cost of various factors of production. If the prices of various
factors of production rise, the production cost will also rise and in turn
price for the same level of output. Similarly, a fall in the price of the
factors of production would reduce the cost of production and in turn,
the price too . In both the cases, the supply will be affected.
c) Technology: The supply of a commodity also depends upon the
methods of production. Most of the inventions and innovations have
greatly contributed to increase the supply of commodities at lower
cost.
d) Weather Conditions: The natural calamities like floods, epidemics
cause fluctuations in the supply of goods, especially agricultural
goods. The war and earthquakes may destroy productive assets of a
commodity and curtail future supplies.
e) Tax and Subsidy: A tax on a commodity or a factor of production
raises the cost of production of the commodity and hence the price of

48
 the commodity is increased. Consequently, production is reduced.
On the other hand, subsidy provides an incentive to production and
hence supply has increased.

5.3 SUPPLY ANALYSIS

Supply analysis is a study of sales offered by any producer in the market
at a particular price in a given time period. Normally this supply analysis
focuses only on the producer’s intention. It is the tendency of the producer
to maximize profit with minimum expenses. As a law of demand, supply
can also be studied individually or collectively.
Individual supply analysis is the supply of commodity in some quantity like
kilogram, litre, meter etc., by a single producer or firm in a given price at
a particular time. The following supply schedule explains this.
Table 5.1 Individual Supply Schedule

Price of Shampoo in Rs. Supply of Shampoo

29 100

32 130

34 140

From the above schedule, it could be inferred that as price increases from
Rs. 29 per 100 gm to Rs. 32 the producer is willing to increase supply
from 100 units to 130 units. Further, when the price goes up to Rs. 34 the
producer is willing to increase his sales to 140 units. It shows that
because of higher price, the producer is willing to increase his sales.
In the case of market supply analysis, it includes the number of firms
willing to sell some specific quantity of the product in a given price at a
particular time. In short it is the total supply of a product in a market at a
given price in a particular time period.
The table 5.2 shows how when the price of shampoo is Rs. 4. Vaiduriya
is willing to sell 10 units, Abinaya is willing to sell 5 units and Yoga Priya
is willing to sell 8 units. The total sales in the market is 23 units in the
price level of Rs. 4. The same way total market sales increases to 34
units because of an increase in price to Rs.8. Further increase in price
from Rs. 8 to Rs. 10 leads to increase in the market sales to 45 units.

49
 Table 5.2 Market Supply Schedule of Shampoo

Price Vaiduriya Abinaya Yoga Priya Market Supply

4 10 5 8 23

8 12 10 12 34

10 17 13 15 45

12 20 15 18 53

The term supply implies producer’s willingness or desire to offer the

commodity at a particular price in a given period of time. Supply is a
function of the price of the product and the demand for the product.
Supply = f (demand, advertisement, competitive advantage etc.)

5.4 LAW OF SUPPLY

According to Alfred Marshall law of supply is defined as, “Other things
remaining the same a small increase in price leads to an increase in the
supply and a fall in price leads to a decrease in sales”.
According to this law there is a direct relationship between the sales and
the price of the product at a particular point of time. The law of supply can
be explained with the help of supply schedule and supply curve.

5.4.1 Supply Schedule

Supply Schedule is a two column, ‘n’ row explanation. The first column
represents price level, and the second column represents the quantity of
sales. This can be illustrated as follows.

Table 5.3 Supply Schedule

Price of wheat Supply of wheat

in kg

10 70

15 80

20 140

From the above table it can be found that when the price of wheat is Rs.10
and the producer is willing to sell only 70kg of wheat. The producer is

50
willing to increase the supply to 140kg because of increased price level to
Rs. 20.

5.4.2 Supply Curve

In the Supply Curve ‘X’ axis represents the quantity of sales and the ‘Y’
axis represents the price of the product. Using the table we can get the
following supply curve.

Figure. 5.1 Supply Curve

The above Figure shows that there is a positive relationship between the
price and sales. Increase in price level leads to an increase in sales to
100 kilograms of wheat.

5.4.3 Assumptions of Law of Supply

Following are the various assumptions of the Law of Supply. In the
definition it was mentioned as ‘other thing remaining the same’.
i) There should not be any change in the cost of production: If there
is any change in the cost of production, that would affect the sales
irrespective of market price variation. For example, increase in the
cost of production leads to the reduced quantity of sales though there
is no change in price.
ii) There is no change in technology: If the producer uses any new
technology, then that will increase the sales irrespective of price
variation. Over the long run, usage of modern technology leads to
increase in the output level of the company. Therefore, changes in
the technology leads to increased sales, rather than the changes in
the price level of the commodity
iii) There is no Government intervention: If the Government regulates
the business activity then, that tends to affect the sales in the market.
iv) There is no change in the competitor’s action: There should not
be any change in the competitors’ action. If any one of the competitors
is going to change, even the product design, advertisement etc., that

51
 leads to create some reaction among other sellers also. Because of
this reaction, their cost of production will increase, that will in turn
affect the sales of all other competitors.

5.5 EXCEPTIONS OF THE LAW OF SUPPLY

There are some exceptions of the law of supply. They are as follows.
a) Future expectations: When prices are expected to fall much, sellers
will try to sell more at present in order to clear the stock and avoid
loss. The same way if he expects the price to increase in the near
future then he will try to store the product and sell it in the future with
the intention of gaining more profit.
b) Changes in Technology: If any company is going to use modern
technology that creates changes in the taste and preferences, that in
turn affects the existing firms. Therefore, the existing firm will try to
dispose off their product.
c) Changes in the Taste and Preference: If there is a vast change in
the taste, habits and fashion of the consumers, they will try to use
only modern products.
d) Changes in natural elements: Changes in the weather, national
and international disturbances will also influence the supply of the
commodities. In all the above-mentioned reasons the supply curve
slopes downward like as follows:
e) Backward sloping Supply Curve: One more reason for the
exceptional supply curve is when the wages rise to a level where the
workers get maximum satisfaction level (Saturation point). Then they
will work less than before in order to have more leisure time. The
supply curve in such a situation is “backward sloping”.

5.6 CHANGE IN SUPPLY

The concept of change in supply occurs because of changes in the price
level. Here we operate on the assumption, “no other factor will influence
the sales, only price is allowed to operate the sales”.
Change in the supply curve occurs because of changes in the price.
Changes in supply curve includes the ‘expansion’ of sales. Expansion
occurs because of increase in price level. It leads to increase in sales.
Another aspect is called as ‘contraction’ of sales. This means, that
decrease in price leads to decrease in sales.

52
5.7 SHIFT IN SUPPLY CURVE
Shift in supply occurs because of influence of many other factors other
than the price level. At a particular time period any one of the external
factors will influence the sales. Because of this change there will be shift
in the supply curve either towards right or to the left side. This can be
explained with the help of the supply curve analysis.

Figure. 5.2 Shifts in Supply

In Figure 5.3, an increase in supply in indicated by the shift of the supply
curve from S1 to S2. Because of an increase in supply, there is a shift at
the given price OP, from A 1 on supply curve S1 to A2 on supply curve S2.
At this point, large quantities (i.e. Q2 instead of Q1) are offered at the given
price OP.
On the contrary, there is a shift in the supply curve from S1 to S3 when
there is a decrease in supply. The amount supplied at OP is decreased
from OQ1 to OQ3 due to a shift from A 1 on supply curve S 1 to A3 on supply
curve S3.
However, a decrease in supply also occurs when producers sell the same
quantity at a higher price (which is shown in Figure) as OQ1 is supplied at
a higher price OP2.
5.8 EQUILIBRIUM BETWEEN DEMAND AND SUPPLY
Equilibrium between the demand and supply is the balance between the
demand and sales of a product in a given price level at a particular point
of time. At the equilibrium point both producer and the consumer will
maximize their satisfaction level. Here the producers’ aim is to maximize
profit and the consumers’ objective is to maximize satisfaction. The
following schedule explains this equilibrium point.

53
 Table 5.4 Equilibrium

Price Demand Supply

10 30 10

15 20 20

20 10 30

The above table indicates that at Rs.10 the product leads the consumer
to buy 30 units and the supplier is willing to sell only 10 units. Here we
have an excess demand of 20 units. Further increase in price to RS. 20
leads to reduction in the consumption level to 10 units, but the producer
is willing to offer 30 units for sales. Here we have an excess supply of 20
units.
Because of this excess demand or sales that leads to automatic
adjustment between the producers and the consumers, which make them
to consume or sell 20 units at Rs 15. This can be explained with the help
of following curve.

price
25
20
Axis Title

e
15
10
5
0
0 10 20 30 40
Axis Title

Figure 5.3 Equilibrium between Demand and Supply

where point ‘e’ indicates the equilibrium between the demand and supply.
If the price is Rs.20 the consumer is willing to consume 10 units but seller
is willing to sell 30 units, reselling in 20 units of excess supply. The
producer can’t keep it up for a long time. Therefore, he is willing to accept
a lower price. Likewise, the consumer is also willing to accept some higher
price than Rs10, since having decided to purchase the product; the
consumer cannot afford to postpone his consumption. This type of
automatic adjustment between the producer and the consumer leads to
equilibrium point ‘e’ where the price level is Rs15 and the quantity is 20
units. Hence, both the producer and the consumer are happy with the
price and quantity.

54
5.9 DETERMINANTS OF THE LAW OF SUPPLY

Following are the major determinants of supply

a) Cost of production: Total expenses incurred for the production of
any commodity is called as cost of production. This cost of production
includes,

a. Expenses incurred for the purchase of Raw Materials

b. Labour Charges

c. Rent for the capital

d. Other administrative expenses.

If all these expenses increase, that leads to an increase in the cost of
production.
b) Change in the technology: Changes in technology are also very
important determinants of the supply. Modern usage of technology
leads to increased sales.
c) Competition: Market competition is also a very important determinant
of supply.
d) Type of market: Type of market is also another important determinant
of supply. Type of market includes local market, national, international
markets. According to the type of market the sellers will attempt to
sell more or less.
e) Government Regulation: The degree of Government regulation is
also a very important determinant of supply. Heavy imposition of tax,
price regulation etc., are the major instruments of the Government
regulations. Based on these there could be either an increase or
decrease in sales.
f) Type of consumers: We are having three types of consumers:
Hardcore consumer, soft-core consumer and switchers. Higher the
elasticity of demand lower will be the sales, the reason being that the
type of consumer here switchers. Switchers are those who are not
satisfied with any one brand but prefer to taste different brand.
Inelasticity leads to more profits, the reason being the consumer here
is the loyal hardcore consumer.
g) Price expectation: If the seller expects any future increase in price
level, then he will try to hoard the product and try to sell it in future.
Therefore, price expectation is an important factor that will influence
the sales in the market.

55
h) Natural Factors: Supply is governed by the natural factors like rain,
drought, etc. This is more so in agro-industries. Normally monsoon
failure may lead to poor power generation; this in turn affects the
production in other sectors also.

5.10 ELASTICITY OF SUPPLY

Elasticity of supply explains the responsiveness of sales with respect to
price. Supply may be called as elastic if the responsiveness of sales is
greater than the rate of change in price (E>1) or the supply may be
inelastic, if the rate of variation of sales is lesser than the rate of variation
of price.
In short, elasticity of supply measures the adjustability of supply to price.
This is expressed as the ratio between the proportionate changes in the
quantity supplied and proportionate changes in the price. The formula for
this is as follows.
Proportionate Change in the quantity supplied
Es = Proportionate Change in the price

This can be calculated with the help of following supply schedule.

Table 5.5 Elasticity of Supply

Price Sales

100 200

80 100
50
ES = 20 = 2.5 > 1

In the above given table, the elasticity of supply is relatively elastic.

Like demand elasticity, supply elasticity also has five classifications as
follows:
a) Relative elasticity of supply: When the rate of variation of sales
is greater than the rate of variation of price, then it is called as
relatively elastic supply. It is denoted as E > 1.
b) Relative inelasticity of supply: When the rate of variation of
sales is lesser than the rate of variation of price then, it is called
as relatively inelastic supply. It is denoted as E < 1.
c) Perfectly elasticity of supply: Though, there is no change in the
price level there will be variation in the sales. It is called as the
perfectly elastic sales. It is denoted as E = œ

56
 d) Perfectly inelastic supply: Though, there is heavy change in the
price level there will be no variation in the sales. It is called as
perfectly inelastic sales. It is denoted as E = 0
e) Unit elasticity of supply: The rate of variation of sales is exactly
equal to the rate of variation of price. It is called as the unit
elasticity of supply. It is denoted as E = 1.

Advertisement Elasticity of Supply

Advertisement elasticity can be calculated either for sales or for
demand. It depends either on available sales data or the demand data.
Here we are going to calculate advertisement elasticity of sales with
respect to advertisement expenses.

Table 5.6 Advertisement Elasticity

Advertisement Sales of Toilet Soaps

Expenses

50,000 1,00,000

1,00,000 1,50,000

The following formula is used to calculate the advertisement elasticity of

sales.
Proportionate Change in Sales
Ea = Proportionate Change in advertisement expenses
50
= = .5 < 1
100

Advertisement elasticity of sales is relatively inelastic.

5.11 DETERMINANTS OF ELASTICITY OF SUPPLY

The following are the various determinants of elasticity of supply.

a) Availability of suitable formula: For calculating the supply
elasticity, selection of suitable formula is important. We can use Arc
Method or Percentage Method or Graphical Method. Based on the
available production or sales data we should select the suitable
method.
b) Gestation Period: Gestation period means the period of investment
and the period of production and sales. Higher the gestation period
lower will be the elasticity of supply (inelastic sales). Lower the
gestation period the sales will be highly elastic (E > 1).

57
 c) Possibilities of changing the technique of production: If the firm
is able to change its techniques of production immediately then the
elasticity will be elastic sales. If it is having very low possibilities then
the rate of variation of sales is relatively inelastic sales.
d) Availability of competitors in the market: If the product is having
more competition in the market, then the elasticity rate will be very
low (relatively inelastic sales).

LET US SUM UP
After reading this unit you would have gained sufficient knowledge about
the concepts of supply analysis, individual and market sales analysis. The
law of supply states that as the price increases sales would also increase.
This can be explained with the help of supply schedule and the supply
curve. The fast part also explained about the reason for exceptional
supply curve, supply shift and change in the supply curve. The second
part explained the equilibrium between demand and supply. And the final
part of this unit explained the elasticity of supply and the advertisement
elasticity of supply with the major determinants of supply curve.
CHECK YOUR PROGRESS

Choose the Correct Answer:

1. ___________ is a study of sales offered by any producer in the market
at a particular price in a given time period

a) resource allocation b) deductive methods

c) case studies method d) supply analysis

2. ___________ explains the responsiveness of sales with respect to
price

a) resource allocation b) deductive methods

c) elasticity of supply d) supply analysis

3. ___________ Determinants of the law of Supply

a) cost of Production b) deductive methods

c) elasticity of supply d) supply analysis

4. ___________ between the demand and supply is the balance between
the demand and sales of a product in a given price level at a particular
point of time.

a) equilibrium b) deductive methods

c) elasticity of supply d) supply analysis

58
5. Higher the ___________ lower will be the sales, the reason being that
the type of consumer here switchers.

a) equilibrium b) elasticity of supply

c) elasticity of demand d) supply analysis

GLOSSARY

Law of Supply : According to Alfred Marshall law of supply

is defined as, “Other things remaining the
same a small increase in price leads to an
increase in the supply and a fall in price
leads to a decrease in sales”.

Advertisement : Advertisement elasticity can be calculated

Elasticity either for sales or for demand. It depends
either on available sales data or the
demand data.

Cost of Production : the actual cost or money incurred for the

production process the actual cost or
money incurred for the production process

SUGGESTED READINGS
1. Dewett, K K&Navalur,M H (2006), Modern Economic Theory, S.
Chand Publishing, New Delhi.
2. Mehta, P.L. (1997) “Managerial Economics",5th Edition Sultan
Chand & Sons Publications.
3. Mehta, P L,(2016), Managerial Economics Analysis , Problems And
Cases, Sultan Chand & Sons, New Delhi .
4. Mote,V, Samuel Paul , Gupta,G.(2017),Managerial Economics :
Concepts & Cases, Tata McGraw-Hill Publishing Company Limited,
New Delhi.
5. Sankaran,S. Dr.3rd Editions (2012), Business Economics, Margham
Publications, Chennai.
6. Varshney, R.L., Maheshwari,K.L. 19th Edition (2014), Managerial
Economics, Sultan Chand & Sons, New Delhi.
7. https://www.youtube.com/watch?v=H8VLO6as7pc
8. https://www.economicsonline.co.uk/competitive_markets/shifts_in_s
upply.html/

ANSWERS TO CHECK YOUR PROGRESS

1) d 2) c 3) d 4) a 5) c

59
Unit 6

PRODUCTION ANALYSIS
STRUCTURE

Overview

Learning Objectives

6.1 Definition of Production Function

6.2 Factors of Production

6.3 Law of Production Function

6.4 Law of Variable Proportions

6.5 Law of Return to Scale

6.6 Least Cost Combination

Let Us Sum Up

Check your Progress

Glossary

Suggested Readings

Answers to Check Your Progress

OVERVIEW
This unit will explain two major parts of the production process. The first
part explains about the factors of production. We have four factors of
production such as land, labour, capital and organisation. The second part
of this unit explains about the production function and the law of
production functions. Law of production function includes law of Return to
Scale and the law of variable proportion. After reading these laws you can
have a better knowledge about the various stages of production process,
by using different input combinations. Based on these analyses you can
find out the least cost combination, where you can minimize your cost and
maximize the revenue.

LEARNING OBJECTIVES

After completing this unit, you should be able to,

• identify the various factors of production

• describe the concepts related to the production

• explain the least cost combination

60
 • describe the law of variable proportion

• define the Law of Production

• discuss about the economies of scale.

6.1 DEFINITION OF PRODUCTION FUNCTION

Production is a simple relationship between the physical inputs and
physical outputs of a firm at any particular time period where physical
inputs are (in management it is called as 6Ms) Men and Women, Money,
Materials, Method, Market and Machine. Physical output includes goods
and services. In short production is the transformation of resources into
commodities and services over time.

Definition
According to Jane Bates and J.R. Parkinson “Production is the organized
activity of transforming resources into finished products in the form of
goods and services and the objective of production is to satisfy the
demand of such transformed resources”.

In algebraic terms, the production function may be written as

Q = f (land, labour, capital and Technology) here ‘Q’ represents
quantity of output per unit of time.

6.2 FACTORS OF PRODUCTION

Productive resources required to produce a given product are called
factors of production. These productive resources may be raw material or
services of the various categories of workers or of capitalists supplying
capital or of an entrepreneur assembling the factors and organizing the
work of production. They are now generally called as “inputs”.
Fraser defined the factor of production as, “a group or class of original
productive resources”. The factors of production have been traditionally
classified as Land, Labour, Capital and Organisation. Now we shall briefly
deal with them one by one. These factors are complementary in the sense
that their co-operation or combination is essential in the production
process.
6.2.1 Land: Land stands for all natural resources which yield an income
or which have exchange value. It represents those natural resources,
which are useful and scarce, actually or potentially. The term ‘Land’ has
been given a special meaning in Economics. It does not mean soil as in
the ordinary speech, but it is used in a much wider sense. Let us discuss
the peculiarities of land.

61
Peculiarities of Land
• Land is nature’s gift to man

• Land is fixed in quantity

• Land is permanent

• Land lacks mobility

• Land provides infinite variations of the degree of fertility and

situation, so that no two pieces of land are exactly alike.
6.2.2 Labour: In Economics labour is defined as “any work, whether
manual or mental which is undertaken for a monetary consideration”. The
work done for the sake of pleasure or love does not fall under labor in the
economics sense.

Peculiarities of Labour

The following are the major peculiarities of labour:

• The labour has to sell his labour in person.

• Labour is perishable.

• Labour has very weak bargaining power.

• Supply of labour cannot be quickly adjusted with the demand of

labour.
As age increases, the physical productivity level of the labour will come
down.

Factors determining the efficiency of labour

The following are some of the main factors, which affect labour efficiency.
• Climatic Factors: A cool bracing climate is conducive to hard work,
whereas the tropical climate is enervating.
• Education: Labour efficiency also depends on the education and
knowledge level of the workers.
• Working Hours: Long working hours leads to reduced productivity
of the labour. Normal working hours with breaks proves to be more
productive (Ref. Hawthorne Study)
• Personal Qualities: A worker’s efficiency also depends upon his
personal qualities like physique, resourcefulness and initiatives etc.,
• Factory Environment: Surrounding within the organisation will
affect the working efficiency of an employee. Cramped and ill

62
 ventilated factories, situated in crowded and unsanitary surroundings
are not conducive to efficiency.

Division of Labour
Division of labour is an important characteristic feature of modern
production. Division of labour is associated with the efficiency of
production. “The division of labour is not a quaint practice of eighteenth-
century pin factories; it is the fundamental principles of economic
organisation”. In short division of labour implies instead of making an
article by the same employee, the articles can be split into a number of
processes and sub-processes and each process or sub process is carried
out by a separate group of people.

Advantages
Division of labour facilitates the following advantages:
• Increases the productivity: Since the same employee is going to do
the same job or process, he can produce more output.
• Higher productivity or efficiency of the labour leads to saving time.

• Innovation: Because of this excess time the employee can do

innovative things for an economy.
• By doing the same job repeatedly the employee can become an
expert in that process.
6.2.3 Capital: Capital refers to that part of a man’s wealth, which is used
in producing further wealth, which yields excess income. It is a
“Produced means of production”. Therefore, capital is not a primary or
original factor of production. The term “capital’ is generally used for
capital goods, for example plant and machinery tools and accessories,
stocks of raw materials, goods in process, and fuel. The raw materials
are used up in a single act of consumption. Moreover, money spent on
them is fully recovered when goods made with them are sold in the
market. But, plant and machinery are permanent investment.

Importance
Capital plays a vital role in the modern productive system. Production
without capital is hard for us even to imagine. Nature cannot furnish goods
and materials to man unless he has the tools and machines for mining,
farming, foresting, fishing etc.
Because of its strategic role in raising productivity, capital occupies a
central position in the process of economic development. In fact, capital
formation is the core of economic development

63
Another important economic role of capital formation is the creation of
employment opportunities in the country. Capital formation creates
employment at two stages. First, when the capital is produced; some
workers have to be employed to make capital goods like machinery,
factories etc. Secondly more men have to be employed when capital has
to be used for producing further goods.

6.2.4 Enterprise
The fourth factor of production is enterprise, which is supplied by the
entrepreneur. The entrepreneur’s functions may be summarized as,
i) Initializing a business enterprise by mobilizing and harnessing the
necessary productive resources.
ii) Taking the final responsibility of the business enterprise risk – taking
and uncertainty – bearing.

iii) The entrepreneur’s role as an innovator.

In the words of professor Harvey Leibenstein, the entrepreneur’s role is to
“search and discover economic opportunity, evaluate economic
opportunities, marshal the financial resources necessary for the
enterprise, make time-binding arrangements, take ultimate
responsibilities for management, be the ultimate uncertainty or risk -
bearer, provide and be responsible for the motivational system within the
firm, search and discover new economic information, translate new
information into new markets, techniques and good, and provide
leadership for the work group”.

6.3 TYPES OF PRODUCTION

There are different types of production functions that can be classified
according to the degree of substitution of one input by the other.

Cobb Douglas Production Function

64
The Cobb Douglas production function, given by the American
economists, Charles W. Cobb and Paul. H Douglas, studies the relation
between the input and the output.
The Cobb Douglas production function is that type of production function
wherein an input can be substituted by others to a limited extent.
For example, capital and labour can be used as a substitute of each other,
however to a limited extent only. Cobb Douglas production function can
be expressed as follows:

Q = AKa Lb

Where,

A = positive constant

a and b = positive fractions

b = 1–a

Another way of expressing Cobb- Douglas production function is:

Q = 𝐴𝐾𝑎 𝐿1−𝑎
Let us take up an example to understand the calculations involved in the
cobb-Douglas function.

Assume A = 40, a = 0.3 and b= 0.7 , K = 3 and L = 5

Therefore,

Q = 40 (3)0.3 (5)0.7

log Q = log 40 + 0.3 log 3 + 0.7 log 5

log Q = 1.6020 + (0.3 X 0.4771) + (0.7 X 0.6989)

log Q = 1.6020 + 0.1431 + 0.4892

log Q = 2.2343
Now, we will take the antilog of the above to get the value of Q.
antilog log Q = antilog 2.2343

Q = 171.5141

Cobb Douglas Production Function Properties

The main attributes of the Cobb Douglas production function are
discussed as follows:
• It enables the conversion of the algebraic form into log linear form,
represented as follows:

log Q = log A + a log K + b log L

65
 This production function has been estimated with the help of linear
regression analysis.
• It acts as a homogeneous production function, whose degree can
be calculated by the value obtained after adding values of a and
b. If the resultant value of a+b is 1, it implies that the degree of
homogeneity is 1 and indicates the constant returns to scale.
• It makes use of parameters a and b, which signifies the elasticity
coefficients of output for inputs, labour and capital, respectively.
Output elasticity coefficient is the change in output that occurs due
to adjustment in capital while keeping labour at constant.
• It depicts the non-existence of production at zero cost.

6.3.1 Leontief Production Function

Leontief production function, evolved by W. WassilyLeontif, uses the fixed
proportion of inputs having no substitutability between them.
It implies that if the input-output ratio is independent of the scale of
production, there is existence of Leontief production function. It assumes
strict complementarily of factors of production. Leontief production
function is also called as fixed proportion production function.

This production function can be expressed as follows:

q= min (z1/a, z2/b)

where, q = quantity of output produced

z1 = utilized quantity of input 1

z2 = utilized quantity of input 2

a and b = constants
Minimum implies that the total output depends upon the smaller of the two
ratios.
The coefficients a and b are the fixed input requirements for producing a
single unit of output. It means that if we want to produce q units of output,
we need aq units of capital (z1) and bq units of labour (z2).
Or we can mathematically state that, z 1 = aq represents the capital
requirements and z2 = aq represents the labour requirements.
Therefore, z1 / z1 = a/b. that is, there is a particular fixed proportion of
capital and labour required to produce output. That is if we increase one
of the factors without increasing the other factor proportionally, then there
will be no increase in output.

66
For example, suppose the Leontief production functions for goods X is

X = min [ 3 Lx , 7 Kx]
This implies that for producing a single unit of X, a minimum of 1/3 unit of
labour and 1/7 unit of capital would be required.

X = min [ Lx / (1/3) , Kx / (1/7)]

In this case, the values 1/3 and 1/7 depict labour activities and therefore,
are activity coefficients as they depict labour activities.
Now, say 1/3 of a day’s work is required to produce 1 unit of X, and the
activity required of capital 1/7 of a day’s work to produce 1 unit of X.

With Lx = 5 and Kx = 3, X = min [ 15, 21] = 15 units of X.

Therefore, with 15 units of X ; Lx = 5 and Kx = 2, you get X = min [15, 14]
= 14 units of X.
The logical capital-labor ratio in the X industry to choose will be Kx / Lx =
3/5 = 0.6

6.3.2 CES Production Function

CES stands for constant elasticity substitution. CES production function
displays a constant change produced in the output due to change in input
of production.

It is expressed as:
Q = A [𝛼K–β + (1–𝛼) L–β]–1/β

CES has the homogeneity degree of 1 that implies that output would be
increased with the increase in inputs. For example, labour and capital has
increased by constant factor m.
Q’ = A [𝛼 (mK)–β + (1–𝛼) (mL)–β]–1/β

Q’ = A [m–β {𝛼K–β + (1–𝛼) L– β}]–1/β

Q’ = (m–β) –1/β .A [𝛼K–β + (1-𝛼) L–β]-1/β

Because, Q = A [𝛼K–β + (1-𝛼) L–β]-1/β

Therefore, Q’ = mQ
This implies that CES production function is homogeneous with degree
one.
For example, let us assume that the CES production function’s
parameters are as follows:

A = 1.0

67
a = 0.3

b = 0.7

β = 0.18

s = 1/(1+β) = 1/(1+0.18) = 0.847

L = 50

K = 30

The CES production function will be formed as follows:

Q = A [𝛼K–β + (1–𝛼) L–β]–1/β

Q = 1.0 * .3 X (L0.18) + .7 X (K0.18)

Q = 1.0 * .3 X 500.18 + .7 X 300.18

Q = 1.0 * .3 X 1 + .7 X 1

Q = 1.0 * 1

Q = 1.0 / 11/.18

Q=1

1. Properties of CES Production Function

The properties of CES function are as follows:

• The value of elasticity of substitution depends upon the value of a.

• The marginal products are positive and slope downwards.

2. Merits of CES Production Function

The merits of CES production are as follows:

• Covers a number of parameters, such as efficiency and
substitutability
• Easy to estimate

• Free from unrealistic assumptions, such as fixed technology, etc.

3. Demerits of CES function

The demerits of CES production system are as follows:

• Fails to fit for manufacturing industries

• Cannot be maximization in case of n factors of production

• Fails to give correct economic implications

68
6.4 LAW OF PRODUCTION FUNCTION
Law of production function considers two types of Input-Output
relationships:
a) The input-output relationship when certain inputs are kept fixed and
other inputs are made variable. It is called as Law of variable
proportion;
b) When all the inputs are made variable. It is called as Law of returns to
scale.

6.4.1 Iso Quant

To understand the production function with two variable inputs, iso-quant
curve is used. These curves show the various combinations of two
variable inputs resulting in the same level of output. The shape of an Iso-
quant reflects the ease with which a producer can substitute among inputs
while maintaining the same level of output. From the graph we can
understand that the iso-quant curve indicates various combinations of
capital and labour usage to produce 100 units of motor pumps. The points
a, b or any point in the curve indicates the same quantum of production.
If the production increases to 200 or 300 units definitely the input usage
will also increase therefore the new iso-quant curve for 200 units (Q1) is
shifted upwards. Various iso-quant curves presented in a graph is called
as iso- quant map.

Figure.6.1 Iso-Quant
The above graph explains clearly that the iso quant curve for 100units of
motor consists of ‘n’ number of input combinations to produce the same
quantity. For example, at ‘a’ to produce 100 units of motors the firm uses
OC amount of capital and OL amount of labour, more capital and less
labour force. At ’b’ OC1 amount of capital and OL1 labour force is used to
produce the same that means more labour and less capital.

69
6.4.2 Iso – Cost
Different combination of inputs that can be purchased at a given
expenditure level.
Optimal input combination: The points of tangency between the iso
quant and the iso cost curves depict optimal input combination at different
activity levels.

Figure.6.2 Combination of iso-quant and iso-cost

Expansion path: Optimal input combinations as the scale of production
expand. From the graph it is clear that the optimum combination is
selected based on the tangency point of the iso cost (budget line) and the
iso- quant i.e., a, b respectively. The point ‘a’ indicates that to produce
100 units of motor the best combination of capital and labour are OC and
OM which is within the budget. Over a period of time a firm will face
various optimum levels, if we connect all the points , that we derive at the
expansion path of a firm.

6.5 LAW OF VARIABLE PROPORTIONS

The level of output of a firm depends on the combination of different
factors, viz., land, labour, capital, and organization. In order to bring about
a change in the level of production, the quantities of the various factors
engaged in production will have to be changed. An increase in production
would be possible only when either the quantity of all the factors is
increased simultaneously, or when the quantity of some of the factors is
increased while that of the others remains constant. Since all the factors
are not easily available in the required quantities, it becomes necessary
to keep the scarce factor constant and increase the quantity of other
factors. Such factors whose quantities are given and fixed are called
Fixed Factors, while those whose supply can be easily changed are called
Variable Factors. Therefore, to bring about an increase in the output, the
producer would use more of the variable factor with the given quantity of

70
the fixed factors. In the theory of production, the law that examines the
relationship between one variable factor and output, keeping the
quantities of other factors fixed, is called the Law of variable proportions.
Under this law we study the effects on output of variations in factor
proportions and this has come to be known as the law of variable
proportions. Different economists have variously defined this law.
“As the proportion of the factor in a combination of factors is increased,
after a point, first the marginal and then the average product of that factor
will diminish”.

Assumptions of the Law of Variable Proportions

The law is based upon the following assumptions:

• The state of technology in production remains constant and
unchanged. If there is any improvement in technology, the average
and marginal output will not decrease but increase.
• Only one factor of input is made variable and other factors are kept
constant. This law does not apply in case all factors are
proportionately varied. Behaviour of output as a result of the
variations in all inputs is studied under “Returns to Scale”.
• It is possible to vary the proportions in which the various inputs are
combined. This law does not apply to those cases where the factors
must be used in rigidly fixed proportions to yield a product.
• All units of the variable factor are homogeneous.

• Finally, it is also assumed that the entire operation is for short-run,

as in the long run all inputs can be variable.

Three Stages of the Law

The behaviour of the output when the varying quantity of one factor is
combined with a fixed quantity of the other can be divided into three
distinct stages. The three stages could be better understood by the Table
6.2. With data of the schedule, the law is illustrated by means of a Figure
6.2 by taking the variable factor in the X axis and the output in the Y axis.

71
 Figure. 6.3 Stages of Law
Stage I: In this stage, the total product increases at an increasing rate.
The Total Product Curve (TP) increases sharply up to the point F. i.e.,
fourth combination where the marginal product (MP) is at the maximum.

Fixed Variable Total Average Marginal

Factor(Machine) Factor(Labour) Prod. Prod. Prod. (in
(in (in units)
units) units)

(1) (2) (3) (4) (5)

1+ 1 10 10.0 10

1+ 2 22 11.0 12

1+ 3 36 12.0 14

1+ 4 52 13.0 16

1+ 5 66 13.2 14

1+ 6 76 12.6 10

1+ 7 80 11.4 4

1+ 8 82 10.2 2

1+ 9 82 9.1 0

Afterwards i.e., beyond F, the total product curve increases at a

diminishing rate, as the marginal product falls, but is positive. The point
F where the total product stops increasing at an increasing rate and starts

72
increasing at a diminishing rate is called the point of inflexion. At this
point, the marginal product is at the maximum. So stage I refers to the
increasing stage where the total product, the marginal product and
average product are increasing. It is the Increasing Returns Stage.
Stage II: In the Second Stage, the total product continues to increase,
but at a diminishing rate until it reaches the point S where it completely
stops to increase any further. At this place the Second Stage ends. In
this stage, the marginal product and average products are declining but
are positive. At the end of the second Stage, at point S, the total product
is at the maximum and the marginal product is zero. It cuts the X axis.
This second Stage is the Stage of Diminishing Returns.
Stage III: In this Stage, the total Product declines and therefore the TP
curve slopes downwards. The marginal product becomes negative
cutting the x axis. This Stage is called the Negative Returns Stage.
Thus, the total product, Marginal product and average product pass
through three phase’s viz., increasing, diminishing and negative returns
stage. The law of variable proportions is nothing but the combination of
the Law of Increasing and Diminishing Returns.
Now, the question is in which Stage will the producer seek to produce the
commodities. Being rational, a producer will not come to the third Stage
where the marginal product becomes negative. The producer will not
choose to produce to get negative returns. The producer will also not
choose to produce in Stage I, as he will not be making the best use of the
fixed factor and he will not be utilizing fully the opportunities of increasing
production by increasing quantity of the variable factor whose average
product continues to rise throughout the Stage I. So, the rational producer
will not stop in Stage I, but expand further. Stage I and III are stages of
economic absurdity representing non-economic region in production
function. Hence the producer will produce in Stage II, where the total
product leads to the maximum at which particular point of the Second
Stage the producer will decide to produce depending upon the prices of
factors. Stage II represents the range of rational production.

6.6 LAW OF RETURN TO SCALE

The law of return to scale explains how the proportionate increase or
decrease of all the factors of production to have some impact on the
output. Normally this law of return to scale can be operated only in the
long-run phenomenon, as during this period any alteration of any or all the
factors of production is possible. But in the shot-run only variable factors
can get altered, so this law is not meant for the short run.

73
Whenever the firm expands its activities through the input alterations, one
can get three types of possibilities

a. the return in unit may increase more than proportionally.

b. It may be at equal proportion or

c. the return may be less than proportionate to the inputs. All these
three possibilities are called as various stages of return to scale. The
return in units is normally measured with the help of marginal
products (MP).

Stages of Return to Scale

Following are the different stages of return to scale:

Assumptions
• Technique of production is unchanged

• All units of factors are homogeneous

• Returns are measured in physical terms

i) Law of Increasing Return to Scale

The law of increasing returns describes increasing returns to scale.
There are increasing returns to scale when a given percentage
increase in input will lead to a greater relative percentage increase in
the resultant output.
∆Q ∆F
Algebraically, Q , F
∆Q
Where =Proportionate change in output and
Q
∆F
= Proportionate change in inputs (factors).
F

The production function coefficient (PFC) in the long run is, thus,
measured by the ratio of the proportionate change in output to a given
proportionate change in input. In symbolic terms:
(∆Q/Q) ∆Q 𝐹
PFC = or Q × ∆𝐹
(∆F/F)

If PFC > 1, it means increasing returns to scale.

74
 Figure. 6.3 Returns to Scale
Diagrammatically, the law of increasing returns may be represented
as in Figure. 6.3. In Figure. 6.3(A), the curve IR is an upward sloping
curve denoting increasing returns to scale. The increasing returns to
scale are attributed to the 75ealization of internal economies of scale
such as labour economies, managerial economies, technical
economies, etc., with the expansion of the size of the firm.
Marshall explains increasing returns in terms of ‘increased efficiency’ of
labour and capital in the improved organisation with the expanding scale
of output and employment of factor input. It is referred to as ‘the economy
of organisation’ in the earlier stages of expansion.
In short, increasing returns may be attributed to improvements in large
scale operation, division of labour, use of sophisticated machinery, better
technology, etc. Thus, increasing returns to scale are due to indivisibilities
and economies of scale and technological advancement.

Law of constant return to Scale

The process of increasing returns to scale, however, cannot go on forever.
It may be followed by constant returns to scale. As the firm continues to
expand its scale of operations, it gradually exhausts the economies
responsible for the increasing returns. Then, the constant returns may
occur. There are constant returns to scale when a given percentage
increase in inputs leads to the same percentage increase in output.
∆Q ∆F
Algebraically, = . It implies that the doubling of factor inputs doubles
Q F
the output.Thus, PFC = 1 under constant returns to scale.
Diagrammatically, the law of constant returns may be represented as in
Figure 6.3(B).
In Figure 6.3(B), the curve CR is a horizontal straight-line depicting
constant returns to scale. The operation of the law of constant returns to
scale implies that the effect of internal economies emerging in certain
factors is neutralized by internal economies that may result in some other

75
factors, so that the output increases in the same proportion as input. It
must be noted that constant returns to scale are relevant only for the time
periods in which adjustment of all factors is possible.
According to Marshall, the law of constant returns tends to operate when
the actions of the laws of increasing returns and decreasing returns are
balanced out; or in other words, economies and diseconomies of scale
are exactly in balance over a range of output.
Constant returns to scale are quite often assumed in economic theoretical
models for simplification. Such an assumption is based on the following
conditions:

1. All factors are homogeneous.

2. All factors are perfectly substitutable.

3. All factors are infinitely divisible.

4. The supply of all factors is perfectly elastic at the given prices.

ii) Law of diminishing returns to scale

As the firm expands, it may encounter growing diseconomies of the
factors employed .As such when powerful diseconomies are met by feeble
economies of certain factors, decreasing returns to scale set in. There are
decreasing returns to scale when the percentage increase in output is less
than the percentage increase in input.
∆Q ∆F
Algebraically, Q < F . Thus, PFC < 1 under decreasing returns to scale.

Diagrammatically, the law of decreasing returns may be presented as in

Figure 6.3©.
In Figure 6.3 ©, the curve DR is a downward sloping curve denoting
decreasing returns to scale.
Decreasing returns to scale are usually attributed to increased problems
of organization and complexities of large-scale management which may
be physically very difficult to handle.
Economists generally consider the following causes for the decreasing
returns to scale:
1. Though all physical factor inputs are increased proportionately,
organisation and management as a factor cannot be increased in
equal proportion.
2. Business risk increases more than proportionately when the scale
of production is enhanced. An entrepreneurial efficiency has its
own physical limitations.

76
 3. When scale of production increases beyond a limit, growing
diseconomies of large-scale production set in.
4. The increasing difficulties of managing a big enterprise. The
problem of supervision and coordination becomes complex and
intractable in a large-scale of production. A very large enterprise
may become unwieldy to manage.
5. Imperfect substitutability of factors of production causes
diseconomies resulting in a declining marginal output.

6.7 LEAST COST COMBINATION

The problem here is to find out a combination of inputs, which should cost
the least, i.e., minimization of cost. The tangency of iso-cost and iso-quant
would indicate the least cost combination of X1and X2, i.e., slope of iso-
quant = slope of iso-cost. Least cost combination is given, algebraically,
by equating
∆𝑋1 P𝑋
MRSx2x1 = =− Q𝑋2 , i.e., - Px1(∆X1) = Px2(∆X2)
Q𝑋2 1

Figure. 6.4 Least Cost Combination

If - Px1 (ΔX1) > Px2 (ΔX2 ), then, the cost of producing the given output
amount could be reduced by increasing X2 and decreasing X1 because
the cost of an added unit of X2 is less than the cost of the units of X1, it
replaces. On the other hand, if between two points of the isoquant, Px 1
(ΔX1) < - Px2 (ΔX2), then the cost of producing the specified quantity of
output can be reduced by using less X2 and adding X1. The marginal
physical product equations can be used to determine the returns per
rupee spent at the least cost point. Rewriting the l east cost combination
as:

77
Limitation

i) Factors may not be always perfectly divisible as labour and capital

ii) It will be very difficult to calculate the marginal product of each
factor.
iii) The producer has to decide not only the best proportion of factors,
but also the best scale of production.

LET US SUM UP
A firm is a business unit that undertakes the activity of transforming inputs
into outputs of goods and services. In the production process, a firm
combines various inputs in different quantities and proportions to produce
different levels of outputs. The producer is intention in to produce those
outputs with least cost combination of various inputs. This concept again
leads to minimized cost and expanded business operations. Analysis of
production helps the students to know about various stages of law of
returns to scale. It explains how proportionate change in the combination
of two inputs leads to different stages in the law.

CHECK YOUR PROGRESS

Choose the Correct Answer:

1.Marginal product of labour is the addition to the total product resulting
from a unit increase in the employment of ___________

a) Labour b) Engineer

c) Expert d) None of them

2.The scale of production of a firm is determined by the amount of
__________

a) Factors units b) Fixed units

c) Both of them d) None of the above

3.An ISO-quant derived from quantity and the Greek word __________

a) IGO b) SD

78
 c) ISO d) None of the above
4.The technological-physical relationship between inputs and outputs is
referred to as the __________

a) Demand Function b) Production function

c) Supply Function d) None of them

5.The average product refers to the total product per unit of a given
_____________factor.

a) Variable b) Fixed

c) Sloping Curve d) None of them

GLOSSARY

Production function : Production function expresses in

physical terms the relationship between
factor input and the resulting output.
Average product of labour is the ratio of
total product to the units of labour input.

The law of variable : The law of variable proportion is based

proportions upon the fact that all factors of
production cannot be substituted for one
another.

ISO-quant : An ISO-quant derived from quantity and

the Greek word ISO, meaning equal is
a contour line drawn through the set of
points at which the same quantity of
output is produced while changing the
quantities of two or more inputs.

SUGGESTED READINGS
1. Dewett, K K&Navalur,M H (2006), Modern Economic Theory, S.
Chand Publishing, New Delhi.
2. Mehta, P.L. (1997) “Managerial Economics",5th Edition Sultan
Chand & Sons Publications.
3. Mehta, P L,(2016), Managerial Economics Analysis , Problems And
Cases, Sultan Chand & Sons, New Delhi .
4. Mote,V, Samuel Paul , Gupta,G.(2017),Managerial Economics :
Concepts & Cases, Tata McGraw-Hill Publishing Company Limited,
New Delhi.

79
 5. Sankaran,S. Dr.3rd Editions (2012), Business Economics, Margham
Publications, Chennai.
6. Varshney, R.L., Maheshwari,K.L. 19th Edition (2014), Managerial
Economics, Sultan Chand & Sons, New Delhi.
7. https://corporatefinanceinstitute.com/resources/economics/factors-
of-production/
8. https://www.youtube.com/watch?v=7phzEfJmUKc
9. https://www.economicsdiscussion.net/notes/study-notes-on-
isoquants-with-diagram/16342

ANSWERS TO CHECK YOUR PROGRESS

1) a 2) a 3) c 4) b 5) a

80
Unit 7

COST ANALYSIS
STRUCTURE

Overview

Learning Objectives

7.1 Types of Cost

7.2 Cost-output Relationship

7.3 Economies and Diseconomies of Scale

7.4 Cost Functions

Let Us Sum Up

Check your Progress

Glossary

Suggested Readings

Answers to Check Your Progress

OVERVIEW
The cost analysis is essential for effective project planning. It is
concerned with the supply side of the market. Cost is the basis for pricing.
Price affects profit, which in turn affects the business. Hence, this unit will
discuss the various Cost Concepts and Cost-output relationship both in
the short-run and long-run. The advantages of large-scale production are
also helpful to the small entrepreneurs to work hard and to improve their
business.

LEARNING OBJECTIVES

After completing this unit, you should be able to,

• define various cost concepts

• describe the cost-output relationship

• analyse the forms of internal and external economies

• discuss the different cost functions.

81
7.1 TYPES OF COST

(i) Money Cost and Real Cost

The total money expenses incurred by a firm or a producer in the
production of goods is said to be the ‘Money Cost’.

Example: Rent, wage, interest, EB bill, fuel etc.

Real Cost is not explained in terms of money. It is explained in terms
of efforts, troubles, sacrifices etc.

(ii) Explicit Cost and Implicit Cost

The direct money payments by a firm towards rent, wage, interest,
taxes etc., is known as the ‘Explicit Cost’.
The money payments made to the factors contributed by the
entrepreneur is called ‘Implicit Cost’. The implicit Cost is also called
‘Imputed Cost’.

(iii) Opportunity Cost

Wants are unlimited and means to satisfy them are limited. This
scarce means also capable of alternative uses. Thus, the problem
of choice is involved. Hence, when we select the resource in one
use, the second alternative use of the resources is to be sacrificed.
Thus, the sacrifice or loss of opportunity of alternative use of a given
resource is called ‘Opportunity Cost’ or ‘Alternative Cost’.
(iv) Short-run Cost and Long-run Cost
Short-run is a period in which at least one factor input remains
constant. Therefore, short-run cost is the cost which varies with
output when the plant and equipment remains constant.
Long-run is a period in which all the factor inputs including the plant
and equipment are varied. Therefore, long-run cost is the cost which
varies with output when all the factor inputs including plant and
equipment vary.

(v) Out of Pocket Cost and Book Cost

Out of Pocket Costs are those costs that involve immediate cash
payments to outsiders.

Example: Salaries to employees.

Book Costs are those costs which do not involve immediate cash
payments. Such costs are included in the books of account.

Example: Salary to the owner. Credit Purchase

82
(vi) Past Cost and Future Cost
Past Costs are the actual costs incurred in the past and they are
furnished in the statement of income or financial accounts.
Future Costs are those costs which are likely to be incurred by a firm
in future periods.

(vii) Acquisition Cost

Acquisition Costs are those costs incurred to acquire a commodity.
These costs are generally recorded in the account books.

Example: hiring land, labour, capital, management etc..

(viii) Historical Cost and Replacement Cost

Historical Cost of an asset is the actual cost of the asset at the time
of purchase of the asset.
Replacement Cost of an asset is the cost which will likely to be
incurred in case the said asset is to be purchased now.

(ix) Separable (Traceable) Cost and Common (Non-Traceable) Cost

Separable Costs are those costs which can be attributed (or traced)
to a particular product or a department or a process.

Example: The cost of raw materials.

Common Costs are those costs which cannot be traced to any
particular product or a department or a process.
Example: Electricity charges.
(x) Escapable (Avoidable) Cost and Inescapable (Unavoidable)
Cost
Escapable Costs are those costs which can be reduced by affecting
contraction in the activities of the business enterprise.

Example: Painting the factory building.

Inescapable Costs are those costs which cannot be avoided by
reducing the output.

Example: Depreciation Costs.

(xi) Sunk Cost and Incremental Cost

Sunk Cost is one which cannot be affected or altered by a change
in the level of output or nature of business activity or business
decision. This cost will remain the same, whatever be the level of

83
 activity of the firm. Incremental Cost is one, if it results from a
decision.

(xii) Controllable Cost and Uncontrollable Cost

Controllable Costs are those costs which can be identified and
controlled by the business executives.

Example: Labour cost, raw materials etc.

Uncontrollable Costs are those costs which cannot be controlled by
business executives.

Example: Property tax.

7.2 COST-OUTPUT RELATIONSHIP

The Cost – Output relationship has two aspects:

i) Cost-Output relationship in the Short-Run and

ii) Cost-Output relationship in the Long-Run.

Cost-Output relationship in the Short-Run

The short-run is a period in which at least one factor input remains
constant. Hence, in the short-run, any increase in output can be achieved
by using the existing equipment. Since fixed equipment of the firm cannot
be altered in the short-run, more output can be achieved only at higher
marginal cost. The short-run cost – output relationship refers to a
particular scale of operation or to a fixed plant. The cost – output
relationship in the short-run may be studied in the following terms:

Total Cost
The Total Cost is the aggregate of expenditure incurred by a firm in
producing a given level of output. Total Cost is the sum of Total Fixed
Cost and Total Variable Cost.

TC =TFC + TVC

Total Fixed Cost

The Total Fixed Cost is a cost which does not vary with output in the short-
run. But it may vary in the long-run. It includes rent, depreciation, interest
etc.

84
 Figure.7.1 Total Costs

Total Variable Cost

The Total Variable Cost is a cost which do vary with output. In other
words, the total variable cost is a cost which rise when output expands
and fall when output contracts. It includes wages, raw materials,
power, fuel etc.

Average Fixed Cost

The Average Fixed Cost is obtained by dividing the Total Fixed Cost
by Total Output. Therefore,
TFC
AFC= N

Figure 7.2. Average Fixed Cost

Average Variable Cost

The Average Variable Cost is obtained by dividing the Total Variable
Cost by Total Output. Therefore,
TVC
AVC= N

85
 Figure 7.3 Average Variable Cost

Average Cost (or) Average Total Cost

The Average Cost or the Average Total Cost or Cost per Unit is
obtained by dividing the Total Cost by Total Output.
TC
ATC or AC =
N

= AFC + AVC
Therefore, Average Cost is the sum of Average Fixed Cost and
Average Variable Cost.

Figure 7.4 Average Cost or Average Total Cost

Marginal Cost
The Marginal Cost is the additional cost made to the total cost by
producing one more unit of the output. Mathematically, Marginal Cost
is the first order derivative of the total cost function. Hence, Marginal
Cost gives the slope of the total cost curve.
MC =TCn – TCn-1

Where MC = Marginal cost

TCn = Total cost of current output

TC n-1= Total cost of precious output

86
The following Figure is used to explain MC

Figure 7.5 Marginal Cost

Cost – Output relationship in the short-run is summarized below:

1. TFC remains constant at all levels of output.

2. TVC initially increases at a diminishing rate, but after a point,
it increases at an increasing rate.
3. TC varies in the same proportion as TVC.

4. AFC declines continuously as output increased.

5. AVC first declines, reaches a minimum and then rises as
output is increase.

6. AC ‘u’‘U’ shaped curve.

7. MC also first declines and then increases as output
increased.

i) Cost-Output relationship in the Long-Run.

In order to study the cost – output relationship in the long-run, it is
imperative to know the concept of long-run cost. The long-run cost is
a cost which varies with output when all the factor inputs including
plant and equipment vary. The long-run cost-output relationship is
shown graphically by the Long-Run Cost Curve (LAC) – a curve
showing how costs would change when the scale of production is
changed. To draw a long-run cost curve, we have to start with a
number of Short-Run Average Cost Curves (SACs), each curve
representing the size of the plant.

Figure. 7.6 Long-Run Average Cost Curve (LAC)

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 In Figure 7.6, SAC1 indicates the initial SAC. In this case output is
OQ1 units at the lowest average cost P 1Q1. If output is increased from
OQ1 to OQ2, the average cost is increased from P 1Q1 to P2Q2. If
output is further increased from OQ2 to OQ3, the average cost is
increased from P2Q2 to P3Q3. If we join the three points P 1, P2 and P3,
we can get the LAC curve.

7.3 ECONOMIES AND DISECONOMIES OF SCALE

7.3.1 Economies of Scale

Under large scale production, the producer obtains a number of
advantages. These advantages are called ‘Economies of Scale’. These
economies of scale may be classified into two. They are:

i) Internal Economies and

ii) External Economies.

i) Internal Economies
Internal Economies are those economies which accrue to a single firm
when its size expands. They emerge within the firm itself as its scale
of production increases. Thus, internal economies are the functions of
the size of the firm.

Forms of Internal Economies

• Labour Economies: Large scale production leads to division of
labour. This division of labour increases the production, and in
turn, the cost of production is low.
• Technical Economies
• As a firm expands its size, it can use modern machines and
techniques. Such modern machines are more efficient and
hence their output is large.
• The large scale producer can establish his own research which
reduces the cost of production.
• The large-scale producer can make use of waste materials for
manufacturing by-products.
• Marketing Economies
• The large scale producer can purchase raw materials on a
large scale at low cost than a small scale producer.
• The large-scale producer can use effective advertisements
which increases the demand for his product.

88
 • The large-scale producer can employ the transport
companies. Hence, he can secure low rates from them.
• Managerial Economies

When output increases, the cost per unit of management will

fall. Thus, with the increasing scale of output, greater
managerial economies are enjoyed by an expanding firm. A
good manager can organise a large output with the same
efficiency. Further, his remuneration normally remains the
same whether the output is large or small. A large scale firm
can employ an efficient manager by paying good salary and
hence its overall administration will be more efficient as well as
economical.
• Financial Economies

Since large scale producer enjoys a good reputation in the

market and greater influence in the money market, he can
easily secure credit facilities at cheaper rates of interest than
to the small scale producers.
• Risk Bearing Economies

The large scale firm is able to reduce risks by compensating

the loss of one market by the profit from another market.

ii) External Economies.

External Economies are those economies which accrue to all the firms
in an industry when their size expands. Hence, external economies
are enjoyed by all the firms in an industry. External economies accrue
to all the firms in an industry, irrespective of their size and scale of
production.

Forms of External Economies

The types of external economies are grouped under the following
headings:
• Economies of Localization

When large number of firms producing the same commodity are

located in a particular place, all the firms enjoy mutual advantages
like skilled labour, transport facilities, credit facilities, repairs and
maintenance of machines.

89
 • Economies of Information

In a large industry, research work is done jointly. Hence, producers

are saved from independent research which is more costly. Each
firm enjoys the benefits of research. Market information is also
readily available to all the firms.
• Economies of By-Products

Under large industry, waste materials can be converted by-

products.

7.3.2 Diseconomies of Scale

When there is an expansion of the firm beyond an optimum limit, certain
disadvantages of large scale production (diseconomies) emerge. They
are:
• Difficulties of Management
As a firm expands, problems of management increase. The manager
finds it difficult to control the organisation. The problem of supervision
becomes complex which leads to mismanagement.
• Difficulties of Coordination

As the size of the firms increases, the task of coordination becomes

more difficult. Hence, the manager has to face many problems of
decision making which increases the cost of production.
• Labour Diseconomies

In a large firm, the contact between the management and workers

becomes less. Hence, there are more chances for labour disputes and
unrest.
• Increased Risk

As the scale of production increases, investment also increases and

hence the risks of business also increase. For example, if the
anticipated demand for the product is incorrect, there will be heavy loss
to the firm.
• Evils of Factory System

Since large numbers of firms producing the same commodity are

located in a particular area, there may be evils of factory system like
overcrowded, poor housing, pollution, long hours of work etc.

90
7.4 COST FUNCTIONS
Cost Function explains the relationship between the costs (expenditure)
incurred in production and the output of a commodity.

C = f (x)
There are three types of cost functions namely, linear, quadratic and
cubic.

Linear Cost Function

A linear short-run cost function is stated as:

TC = a + bQ

Where,
a and b are constant parameters, a is intercept, b is slope coefficient.
Here, ‘a’ represents total fixed cost and ‘bQ’ represents total variable cost.
Thus:
TFC a
AFC = =Q
Q
TTC
AFC = =b
Q
TC a+bQ a
ATC =Q = = Q+ b
Q
dTC
MC = dQ = b

When plotted graphically linear cost function depicts TC, AC and MC

curves as illustrated in Figure 7.7.

Figure. 7.7 Linear Cost Function

Quadratic Cost Function

Quadratic Cost Function is represented by the equation.

C=a + bQ + cQ2

In this case:
a
AC= + b + cQ
Q

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 MC= b + 2cQ
The graphical representation of the Quadratic Function is
inFigure7.8.

Figure. 7.8 Quadratic Cost Function

Cubic Cost Function

Cubic Cost Function is represented by the equation,

TC=a + bQ – cQ2 + dQ3

a
AC=Q + b – cQ + dQ2

MC=b – 2cQ + 3dQ2

The shape of the curve of the Cubic Cost Function will be as in Figure 7.9.

Figure. 7.9 Cubic Cost Function

LET US SUM UP
In this unit we have emphasized the different types of costs, cost functions
and the cost-output relationship in the short run and long run. We have
also analysed the economies and diseconomies of scale. The
advantages obtained by the large-scale producer are called ‘Economies
of Scale’. In this unit, we have discussed the cost functions. Cost
Function explains the relationship between the costs incurred in
production and the output of a commodity. Linear, Quadratic and Cubic
Cost functions are also analysed.

92
CHECK YOUR PROGRESS

Choose the Correct Answer:

1. Total cost divided by total output is ___________

a) Marginal cost b) Average cost

c) Average variable cost d) Average fixed cost

2. The additional cost made to total cost by producing one more unit of
output is___________

a) Marginal cost b) Average cost

c) Money cost d) Real cost

3. TFC + TVC =___________

a) Marginal cost b) Total cost

c) Money cost d) Real cost

4. Cost per unit is also called ___________

a) Marginal cost b) Average cost

c) Money cost d) Real cost

5. The relationship between the cost incurred in production and the output
of a commodity is known as___________

a) Marginal cost b) Average cost

c) Money cost d) Cost function

GLOSSARY

Total cost : The Total Cost is the aggregate of expenditure

incurred by a firm in producing a given level of
output.

Average cost : The Average Cost or the Average Total Cost

or Cost per Unit is obtained by dividing the
Total Cost by Total Output.

Marginal cost : The Marginal Cost is the additional cost

made to the total cost by producing one more
unit of the output. Mathematically, Marginal
Cost is the first order derivative of the total
cost function.

93
Economies of scale : Under large scale production, the producer
obtains a number of advantages. These
advantages are called ‘Economies of Scale’.

Diseconomies of : When there is an expansion of the firm

scale beyond an optimum limit, certain
disadvantages of large scale production
(diseconomies) emerge.

SUGGESTED READINGS
1. Dewett, K K&Navalur,M H (2006), Modern Economic Theory, S.
Chand Publishing, New Delhi.
2. Mehta, P.L. (1997) “Managerial Economics",5th Edition Sultan
Chand & Sons Publications.
3. Mehta, P L,(2016), Managerial Economics Analysis , Problems And
Cases, Sultan Chand & Sons, New Delhi .
4. Mote,V, Samuel Paul , Gupta,G.(2017),Managerial Economics :
Concepts & Cases, Tata McGraw-Hill Publishing Company Limited,
New Delhi.
5. Sankaran,S. Dr.3rd Editions (2012), Business Economics, Margham
Publications, Chennai.
6. Varshney, R.L., Maheshwari,K.L. 19th Edition (2014), Managerial
Economics, Sultan Chand & Sons, New Delhi.
7. https://study.com/academy/lesson/economies-diseconomies-of-
scale.html
8. https://theintactone.com/2019/10/01/me-u3-topic-2-cost-output-
relationship-in-short-run-long-run-cost-curves/
9. https://www.economicsdiscussion.net/production/cost-of-
production/8-main-types-of-costs-involved-in-cost-of-production-
and-revenue-with-diagram/13829

ANSWERS TO CHECK YOUR PROGRESS

1) b 2) a 3) b 4) b 5) d

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 BLOCK 3

MARKET STRUCTURE

Unit 8 : Market Structure

Unit 9 : Perfect Competition Market

Unit 10 : Monopolistic Competition

Unit 11 : Oligopoly Market

Unit 12 : Pricing

95
Unit 8

MARKET STRUCTURE
STRUCTURE

Overview

Learning Objectives

8.1 Meaning of Market

8.2 Definitions of Market

8.3 Market Structure

8.4 Forms of Market Structure

8.5 Equilibrium of a Firm

8.6 Pricing under Different Market Structure

Let Us Sum Up

Check your Progress

Glossary

Suggested Readings

Answers to Check Your Progress

OVERVIEW
The price-output decisions by a firm are influenced by the structure and the different
forms of the market. The structure of the market is determined by the nature and
pattern of competition which prevails. There are many market structures. Different
market structures affect the behaviour of the buyers and sellers. If there are large
number of buyers and sellers are selling homogeneous products, perfect competition
will prevail. If there is existence of many firms and also there is product differentiation,
then monopolistic competition will prevail and if there are few sellers in the ma rket,
oligopoly will be obtained.

LEARNING OBJECTIVES

After completing this unit, you should be able to,

• define the concept of market

• classify the various market structures

• determine pricing of products under different market structures.

96
8.1 MEANING OF MARKET
In ordinary language, market refers to a place where goods and services are bought
and sold. But, in Economics, it has no reference to a place, but to a commodity which
is being bought and sold. That is a market refers to a group of buyers and sellers
dealing with a particular commodity for a price at a particular time.

8.2 DEFINITIONS OF MARKET

Different Economists have defined market in different ways:

Cournot defines market as “… not any particular market place in which things are
bought and sold, but the whole of any region in which buyers and sellers are in such
free intercourse with each other that the prices of the same goods tend to equal easily
and quickly.”
To Ely, “Market means the general field within which the force determining the price
of particular product operate”.
According to Benham, “Market is any area over which buyers and sellers are in close
touch with one another either directly or through dealers, that the price obtainable in
one part of the market affects the prices paid in other parts”.
Stonier and Hague defines market as “any organisation whereby buyers and sellers
of a good are kept in close touch with each other …”

8.3 MARKET STRUCTURE

The price – output decisions which are taken by a firm are very much influenced by
the forms and structure of the market for goods and services. The structure of the
market, commodity market as well as factor market is determined by the nature and
pattern of competition which prevails. There are many different market structures,
which affect the behaviour of buyers and sellers. Further, different prices and trade
volumes are influenced by different market structures.

8.4 FORMS OF MARKET STRUCTURE

The Economists have standard forms of market structure that are based on the
nature of competitive conditions. They are:
i. Perfect Competition
A perfectly competitive market is one which satisfies the following features:
• A large number of buyers and sellers in the market.

• The sellers are selling homogeneous or identical products.

• The firms are free to enter or leave the industry.

• There exists perfect knowledge on the part of the buyers and sellers
regarding the market conditions.

97
 • There is perfect mobility of factors.

• There are no transport costs.

• There is only one price for the commodity.

ii) Monopoly
Monopoly is a market situation in which there is only one seller of the commodity
which has no substitutes.

iii) Discriminating Monopoly

It means charging of different prices from different consumers for the same
commodity at the same time.

iv) Bilateral Monopoly

It is a market situation in which single seller faces a single buyer.

v) Monopsony
It is a market situation in which there are many sellers but there is a single buyer
of a commodity.

vi) Duopoly
It refers to a market situation in which there are only two sellers selling
homogenous products.

vii) Oligopoly
It refers to a market situation in which there are few sellers selling either
homogeneous products or products which are having close substitutes but no
perfect substitutes.
vii) Monopolistic Competition
It refers to a market situation in which there are many producers produce products
which are close substitutes.

8.5 EQUILIBRIUM OF A FIRM

In the short-run, a firm is said to be in equilibrium at the point of intersection of the
marginal cost and marginal revenue curves. The first condition for the equilibrium of
a firm is that marginal revenue should be equal to marginal cost. The second
condition for equilibrium requires that marginal cost curve should cut the marginal
revenue curve from below. In the long-run, firms are in equilibrium when they have
adjusted their plant so as to produce at the minimum point of their long-run AC Curve.

8.6 PRICING UNDER DIFFERENT MARKET STRUCTURE

In this section, let us study the pricing of products under Perfect Competition,
Monopolistic Competition and Oligopoly.

98
8.6.1 Pricing Under Perfect Competition
In a market, the exchange value of a product expressed i n terms of money is called
price. In a market economy, the equilibrium price is determined by the market forces.
Under perfect competition, there is a single ruling market price the equilibrium price,
determined by the interaction of forces of total demand (of all the buyers) and total
supply(of all the sellers) in the market.
Thus, both the market or equilibrium price and the volume of production in a market
under perfect competition are determined by the intersection of total demand and total
supply. To elucidate the prices of intersection, let us consider hypothetical data on
market demand for and market supply of wheat, as in Table 8.1.

Table 8.1 Market Demand and Supply Schedules for Wheat

Price of Total Total Supply Pressure on

Wheat (in Demand (in (in Kg) Price
Rs. Per kg) Kg)

20 1000 10000 Downward

19 3000 8000 Downward

18 4000 6000 Downward

17 5000 5000 Neutral

16 7000 4000 Upward

15 10000 2000 Upward

Comparing the market demand and supply position at alternative possible prices, we
find that when the price is Rs. 20, supply of wheat is 10,000 kg., but demand for wheat
is only 1,000 kg. Hence,9,000 kg. of wheat supply remains unsold. This would bring
a downward pressure on price, as the seller would compete and the force will push
down the price. When the price falls to Rs. 19, demand rises to 3,000 kg., while the
supply will contract to 8,000 kg. Still the supply is in excess of demand. Thus, the
surplus of the supply causes a further downward pressure on price. Eventually, the
price will tend to fall. This process continues till the price settles at Rs. 17 per kg. at
which the same amount (5,000 kg.)is demanded as well as supplied. This is termed
as equilibrium price. Equilibrium price is the market clearing price. In this price, market
demand tends to be equal to the market supply.
If, however, we begin from a low price (Rs. 15 per kg.), we find that the
demand(10,000 kg.) exceeds the supply (2,000 kg.). Thus, there is a shortage at Rs.
15 per kg. This causes an upward pressure on the price, so the price will tend to move
up. When the price rises, the demand contracts and the supply expands. This process

99
continues till the equilibrium price is reached, at which the demand becomes equal to
the supply. At equilibrium price, there is neutral pressure of demand and supply forces
as both are equal in quantity. In general, a pictorial depiction of price is determined at
the intersection point of the demand curve and the supply curve.
In Figure 8.1, PM is the equilibrium price, at which OM is the quantity demanded as
well as supplied. At point P, the demand curve intersects the supply curve. To
understand the process of equilibrium, suppose the price is not at the equilibrium
point. Now, if the price is higher than the equilibrium price, as OP1, then at this price
the supply is P1b, while the demand is P1a. Thus, there is a surplus amounting to ab.
That is to say, more is offered for sale than what the people are willing to buy at the
prevailing price. Hence, to clear the stock of unsold output, the competing sellers will
be induced to reduce the price. Eventually, a downward movement and adjustment,
as shown by the downward pointed arrows, will begin, which would lead to: (i) the
contraction of supply, as the firms will be prompted to reduce their resources in the
industry, and (ii) the expansion of demand, as the marginal buyers* and other potential
buyers will be attracted to buy in the market and old buyers also may be induced to
buy more at the falling price. Similarly, if the price is below the equilibrium level, the
demand tends to exceed the supply.

Figure. 8.1 Market Price Determination

At OP2price, for instance, the demand is P 2d, while the supply is P 2c. Thus, there is a
shortfall of supply amounting to cd. That is to say, buyers want to purchase more than
what is available in the market at the prevailing price. This induces the competing
buyers to bid up the price. So, an upward push and adjustment will develop as shown
by the arrows pointed upwards. Thus, the demand contracts as marginal buyers will
be driven away from the market and some buyers will buy less than before. On the
other hand, the supply expands as the existing firms will increase their output to which
new firms will also add their output. Evidently, when the price is set at an equilibrium
point at which the demand curve intersects the supply curve, shortages and surpluses
disappear, hence there is perfect adjustment between demand and supply under the
given conditions. So long as demand and supply positions are unchanged, the ruling
equilibrium price will prolong over a period of time.

100
8.6.2 Pricing Under Monopolistic Competition
A firm under monopolistic competition is a price-maker. Thus, unlike perfect
competition, there is a pricing problem. The firm has to determine a suitable price for
its product which yields a maximum total profit. Assuming a given variety of product
and constant selling outlays, when price is considered as the only variable factor, the
short-run analysis of price adjustment by an individual firm under monopolistic
competition, more or less, entails the same features like that of price-output
determination under pure monopoly. In the long-run, however, a major difference is
noticeable in the equilibrium process and position due to a change in demand
conditions and other factors associated with the process of group equilibrium.

The Short-run Equilibrium

To explain the process of individual equilibrium, we assume that all other producers
are in equilibrium with respect to their prices, varieties of products, and sales outlays.
We further assume that the firm which we have taken in our consideration has also a
given variety of product and constant sales expenditure. Hence, there is only the
problem of price and output determination.
In the short-run, the firm can adopt an independent price policy, with least
consideration for the varieties produced and prices charged by other producers. The
firm being rational in determining the price for a given product will seek to maximise
total profits.
Since the quality of product is assumed to be given, we have a definite demand
schedule for it. Again as the product is differentiated, the demand curve is downward
sloping. The demand curve or the sales curve of the firm in a monopolistically
competitive market is, however, much more elastic than that of a firm in a pure
monopoly. This is so because there is a large number of a competitor selling similar
products as close substitutes, whereas in the case of pure monopoly, there is absence
of competition. The precise shape and degree of elasticity contained in the demand
curve of a firm under monopolistic competition, however, depends on two factors:

(i) the number of firms in the group, and

(ii) the extent of product differentiation.

If, however, the group has a large number of firms and if the product differentiation is
relatively weak, the demand curve of each firm will be highly elastic. If, however, the
group is relatively small and the product differentiation is prominently significant, then
the demand curve of each firm will tend to be less elastic.
Knowing the demand curve, which is the sales curve of the firm for a given product,
we can easily derive its marginal revenue curve. The demand curve itself is the
average revenue curve, which is downward sloping curve for a firm in a

101
monopolistically competitive market. The marginal revenue curve also slopes
downward and lies below the average revenue curve.
In order to maximise its total profits or minimise its losses in the short-run, the firm
produces that level of output at which marginal cost is equal to marginal revenue (i.e.,
MC= MR). Thus, equilibrium output is determined at the point of intersection of the
MC curve and the MR curve as shown in Figure 18.2.

Figure.8.2 Short-run Equilibrium of a Monopolistically Competitive Firm

In Figure, 8.2, we have assumed the case of a representative firm with hypothetical
cost and revenue data in a monopolistically competitive market. For the sake of
simplicity, it is thus assumed that: (i) demand conditions, and (ii) cost conditions are
identical for all the firms in the group. These assumptions, in fact, are the bold
assumptions made by Chamberlin in his theory of monopolistic competition and its
characteristic, i.e., diversity of group under product differentiation. No doubt, these
assumptions very much simplify our model, but they are not altogether unrealistic. In
the case of retail shops such as provision stores or chemist shops, etc; standardized
products will tend to have more or less identical demand and cost conditions, as their
product differentiation is confined to only locational differences.

Equilibrium point E is determined where, SMC = SMR. OP price.

OQ output. PABC is profit.

In Figure 8.2, we see that the firm attains equilibrium when OQ output is produced at
which SMR = SMC. In relation to the given demand curve (SAR curve), the firm will
set OP price to sell OQ output. The firm as such earns supernormal profits to the tune
of PABC. Such profits in the short-run are possible when there are not enough rivals
who sell closely competitive substitutes to compete these profits away.

The Long-run Equilibrium

When firms in the short-run earn supernormal profits in a monopolistically competitive
market, some new firms will be attracted to enter the business, as the group pertaining
to the industry is open. On account of rivals’ entry, the demand curve faced by the
typical firm will shift to the origin and it will also tend to be more elastic, as its share in
the total market is reduced due to competition from an increasing number of close
substitutes. Gradually, in the long-run, when the firm’s demand curve (AR curve)

102
becomes tangent to its average curve, the firm earns only normal profits. The situation
is depicted in Figure 8.3.
As shown in Figure 8.3 in the long-run, the firm produces OQ level of output, at which
LMC = LMR, (EQ). At this equilibrium output, the LMR curve is tangent to the LAC
curve at point P. Thus, PQ, is the price which is equal to the average cost. Apparently,
OQPA is the total revenue as well as total cost, so the firm earns only normal profit in
the long run. Existing competitors in the market in the long-run will be producing
similar products, and their economic profits will be competed away. Thus, in the
absence of long-run profits, there is an incentive to the entry of new firms.
Furthermore, it can also be noticed that when a typical firm attains equilibrium and
determines the price (= AC), by producing OQ level of output as shown in Figure 8.3,
it is just breaking even. Since the LAR curve is tangent to the LAC curve at point P,
which is attainable only by producing OQ level of output, any output less than that
implies that AR < AC, indicating a loss. So also, any output more than OQ means P
< AC and a loss.

Figure. 8.3: Long-run Equilibrium of a Monopolistically Competitive Firm

At E, LMC = LMR. Further, PQ Price = LAR. Only normal profit.

It should be noted that monopolistic competition implies severe competition between
a large number of firms producing close substitute products. Hence, this market
situation is more similar to perfect competition than monopoly. In a monopolistic
group, owing to the unrestricted entry of new firms, abnormal profits are usually
competed away in the long-run, and firms will always seek to realize pure economic
profits once again by advertising and innovation in products or processes.
Consequently, firms will resort to non-price competition, i.e., competition in product
variation as well as by increasing their advertising expenditure (selling costs).

8.6.3 Pricing Under Oligopoly

Pricing under Oligopoly has been explained by Prof. Paul M. Sweezy by using “Kinked
Demand Curve”. That means, the demand curve will have a ‘kink’ or ‘bend’. The
Kinked Demand Model represents a condition in which he has no incentive either to
increase or decrease the price. But keeps the price rigid. This is because, if a firm
increases the prices while other firms maintain the same price, it will lose its

103
customers and if it decreases the prices, the other firms have to reduce the price and
hence profit of all firms will be reduced. Hence, the firms stick on the present price.
An important point involved in kinked demand curve is that it accounts for the kinked
average revenue curve to the oligopoly firm. The kinked average revenue curve, in
turn, implies a discontinuous marginal revenue curve MA-BR (as shown in Figure.
8.4). Thus, the kinky marginal revenue curve explains the phenomenon of price rigidity
in the theory of oligopoly prices.

Figure.8.4 Discontinuous Marginal Figure.8.5 Oligopoly Price Rigidity

Revenue Curve
Because of discontinuous marginal revenue curve (MR), there is no change in
equilibrium output, even though marginal cost changes hence, there is price rigidity.
OP does not change.
It is observed that quite often in oligopolistic markets, once a general price level is
reached whether by collusion or by price leadership or through some formal
agreement, it tends to remain unchanged over a period of time. This price rigidity is
on account of conditions of price interdependence explained by the kinky demand
curve. Discontinuity of the oligopoly firm’s marginal revenue curve at the point of
equilibrium price, the price output combination at the kink tends to remain unchanged
even though marginal cost may change, as shown in Figure 8.5.
In the Figure 8.5, it can be seen that the firm’s marginal cost curve can fluctuate
betweenMC1and MC2within the range of the gap in the MR curve, without disturbing
the equilibrium price and output position of the firm. Hence, the price remains at the
same level OP, and output OQ, despite change in the marginal costs.

LET US SUM UP
In this unit, we have defined the concept market. Market refers to a group of buyers
and sellers dealing in a particular commodity. We have also explained the meaning
of various forms of market structure namely, Perfect Competition, Monopoly, Duopoly,
Oligopoly, Monopolistic Competition etc. Further we have analysed the price-output
determination under Perfect Competition, Monopolistic Competition and Oligopoly.

104
CHECK YOUR PROGRESS

Choose the Correct Answer:

1. A market situation in which there is only one seller is called___________

a) Monopoly b) Monopsony

c) Duopoly d) Oligopoly

2. A market situation in which there are few sellers is known as___________

a) Monopoly b) Monopsony

c) Duopoly d) Oligopoly

3.__________refers to a market situation in which there are only two

sellers.

a) Monopoly b) Monopsony

c) Duopoly d) Oligopoly

4. It is a market situation in which there are many sellers but there is a

single buyer of a commodity. ___________

a) Monopoly b) Monopsony

c) Duopoly d) Oligopoly

5.It refers to a market situation in which there are only two sellers selling

homogenous products___________
a) Monopoly b) Monopsony

c) Duopoly d) Oligopoly

GLOSSARY

Market : Market refers to a place where goods and services

are bought and sold. But, in Economics, it has no
reference to a place, but to a commodity which is
being bought and sold. That is, market refers to a
group of buyers and sellers dealing with a
particular commodity for a price at a particular time.

Monopoly : Monopoly is a market situation in which there is

only one seller of the commodity which has no
substitutes.

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 Duopoly : It refers to a market situation in which there are
only two sellers selling homogenous products

Oligopoly : It refers to a market situation in which there are few

sellers selling either homogeneous products or
products which are having close substitutes but no
perfect substitutes.

Perfect Competition : A perfectly competitive market is a hypothetical

market where competition is at its greatest possible
level. Neo-classical economists argued that perfect
competition would produce the best possible
outcomes for consumers, and society.

Monopolistic : Monopolistic competition is a type of imperfect

Competition competition such that many producers sell products
that are differentiated from one another (e.g. by
branding or quality) and hence are not perfect
substitutes.

SUGGESTED READINGS
1. Dewett, K K&Navalur,M H (2006), Modern Economic Theory, S. Chand
Publishing, New Delhi.
2. Mehta, P.L. (1997) “Managerial Economics",5th Edition Sultan Chand &
Sons Publications.
3. Mehta, P L,(2016), Managerial Economics Analysis , Problems And Cases,
Sultan Chand & Sons, New Delhi .
4. Mote,V, Samuel Paul , Gupta,G.(2017),Managerial Economics : Concepts
& Cases, Tata McGraw-Hill Publishing Company Limited, New Delhi.
5. Sankaran,S. Dr.3rd Editions (2012), Business Economics, Margham
Publications, Chennai.
6. Varshney, R.L., Maheshwari,K.L. 19th Edition (2014), Managerial
Economics, Sultan Chand & Sons, New Delhi.
7. https://www.youtube.com/watch?v=frHyR9FiKt4
8. https://www.economicshelp.org/microessays/markets/
9. https://www.tutorialspoint.com/managerial_economics/market_structure_p
ricing_decisions.htm

ANSWERS TO CHECK YOUR PROGRESS

1) a 2) c 3) c 4) b 5) c

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Unit 9

PERFECT COMPETITION MARKET

STRUCTURE

Overview

Learning Objectives

9.1 Perfect Competition

9.2 Meaning of Perfectly Competitive Market

9.3 Definition of Perfectly Competitive Market

9.4 Assumptions behind a Perfectly Competitive Market

9.5 Characteristics of Perfectly Competitive Market

9.6 Price and Output Determination

9.7 Perfect v/s pure competition

9.8 Short run equilibrium of the firm and industry

9.9 Long run equilibrium of the firm and industry

9.10 Derivation of the supply curve of the firm

9.11 Derivation of the supply curve of the industry

9.12 Price and output determination under perfect competition

9.13 Demand under Perfect Competition

9.14 Supply under Perfect Competition

9.15 Equilibrium under Perfect Competition

9.16 Price and output determination in long run

9.17 Long run supply curve of a competitive industry

Let Us Sum Up

Check your Progress

Glossary

Suggested Readings

Answers to Check Your Progress

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OVERVIEW
A perfectly competitive market is a hypothetical market where competition is at its
greatest possible level. Neo-classical economists argued that perfect competition
would produce the best possible outcomes for consumers, and society.

LEARNING OBJECTIVES

After reading this unit, you should be able to,

• explain perfect competition market and its features

• distinguish between perfect v/s pure competition

• describe an equilibrium of the firm

• explain the derivation of the supply curve of the firm

• draw the derivation of the supply curve of the industry

• discuss the price and output determination under perfect competition

• tell the long run supply curve of a competitive industry.

9.1 PERFECT COMPETITION

Perfect competition describes markets such that no participants are large enough to
have the market power to set the price of a homogeneous product. As the conditions
for perfect competition are strict, there are few if any perfectly competitive markets.
Still, buyers and sellers in some auction-type market say for commodities or some
financial assets may approximate the concept. Perfect competition serves as bench
mark against which to measure real-life and imperfectly competitive markets.
In neoclassical economics there have been two strands of looking at what perfect
competition is. The first emphasis is on the inability of any one agent to affect prices.
Usually it is justified by the fact that any one firm or consumer is so small relative to
the whole market that their presence or absence leaves the equilibrium price very
nearly unaffected. This assumption of negligible impact of each agent on the
equilibrium price has been formalized by Aumann (1964) by postulating a continuum
of infinite malagents. The difference between Aumann’s approach and that found in
undergraduate textbooks is that in the first, agents have the power to choose their
own prices but do not individually affect the market price, while in the second it is
simply assumed that agents treat prices as parameters. Both approaches lead to the
same result.
Perfect competition is a theoretical market structure that features no barriers to entry,
an unlimited number of producers and consumers, and a perfectly elastic demand
curve.
The degree to which a market or industry can be described as competitive depends
in part on how many suppliers are seeking the demand of consumers and the ease

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with which new businesses can enter and exit a particular market in the long run. The
spectrum of competition ranges from highly competitive markets where there are
many sellers, each of whom has little or no control over the market price- to a situation
of pure monopoly where a market or an industry is dominated bygone single supplier
who enjoys considerable discretion in setting prices, unless subject to some form of
direct regulation by the government.
In many sectors of the economy markets are best described by the term oligopoly -
where a few producers dominate the majority of the market and the industry is highly
concentrated. In duopoly two firms dominate the market although there may be many
smaller players in the industry.

9.2 MEANING OF PERFECTLY COMPETITIVE MARKET

A perfectly competitive market is a hypothetical market where competition is at its
greatest possible level. Neo-classical economists argued that perfect competition
would produce the best possible outcomes for consumers, and society.
9.3 DEFINITION OF PERFECTLY COMPETITIVE MARKET
According to Prof. Marshall, “The more nearly perfect a market is, the stronger is
the tendency for the same price, to be paid for the same thing at the same time in all
parts of the market”.
According to Prof. Benham, “A market is said to be perfect when all the potential
sellers and buyers are promptly aware of the price at which transactions take place
and all of the offers made by other sellers and buyers and when any buyer can
purchase from any seller and vice-versa”.

9.4 ASSUMPTIONS BEHIND A PERFECTLY COMPETITIVE MARKET

1. Many suppliers each with an insignificant share of the market – this means that
each firm is too small and relative to the overall market to affect price via a change
in its own supply and each individual firm is assumed to be a price taker.
2. An identical output produced by each firm: In other words, the market supplies
homogeneous or standardized products that are perfect substitutes for each
other. Consumers perceive the products to be identical
3. Consumers have perfect information about the prices all sellers in the market
charge – so if some firms decide to charge a price higher than the ruling market
price, there will be a large substitution effect away from this firm
4. All firms (industry participants and new entrants) are assumed to have equal
access to resources (technology, other factor inputs) and improvements in
production technologies achieved bygone firm can spill-over to all the other
suppliers in the market

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5. There are assumed to be no barriers to entry and exit of firms in long run. This
means that the market is open to competition from new suppliers –this affects
the long run profits made by each firm in the industry. The long run equilibrium
for a perfectly competitive market occurs when the marginal firm makes normal
profit only in the long term
6. No externalities in production and consumption so that there is no divergence
between private and social costs and benefits

9.5 CHARACTERISTICS OF PERFECTLY COMPETITIVE MARKET

Perfectly competitive markets exhibit the following characteristics:

i) Infinite buyers and sellers: Infinite consumers with the willingness and ability
to buy the product at a certain price, and infinite producers with the willingness
and ability to supply the product at a certain price.
ii) Zero entry and exit barriers: It is relatively easy for a business to enter or exit
in a perfectly competitive market.
iii) Perfect factor mobility: In the long run factors of production are perfectly
mobile allowing free long term adjustments to changing market conditions.
iv) Perfect information: Prices and quality of products are assumed to be known
to all consumers and producers.
v) Zero transaction costs: Buyers and sellers incur no costs in making an
exchange (perfect mobility).
vi) Profit maximization: Firms aim to sell where marginal costs meet marginal
revenue, where they generate the most profit.
vii) Homogeneous products: The characteristics of any given market good or
service do not vary across suppliers.
viii) Non-increasing returns to scale: on-increasing returns to scale ensure that
there are sufficient firms in the industry.

9.6 PRICE AND OUTPUT DETERMINATION

Before Marshall there was controversy among economists on whether the force of
demand (i.e. marginal utility) or the force of supply (i.e. cost of production) is more
important is determining price. Marshall gave equal importance to both the demand
and supply in determination of price. According to him, “As both blades of a scissors
are important for cutting a cloth, so is both demand and supply essential for
determination of price.”
As we know that quantity demanded and quantity supplied varies with the price, the
equilibrium price is determined at the point where quantity demanded and quantity
supplied are equal. If the equality between quantity demanded and quantity supplied

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doesn’t hold for some price, buyer’s and seller’s desires are inconsistent. In case of
either quantity demanded by the buyers is more than that offered by the sellers or the
quantity supplied by the sellers is greater than the quantity demanded by the buyers
the price will change so as to bring about equality between quantity demanded and
quantity supplied. The process of price determination can be explained with the help
of following table below:

Table9.1 Process of Price Determination

Price per Quantity Quantity Pressure on

Unit Demanded Supplied Price

5 9 18 Falling

4 10 16 Falling

3 12 12 Neutral

2 15 07 Rising

1 20 00 Rising

It is seen in the table that when price is Rs 3 per unit, quantity demanded and quantity
supplied are equal at 12 units. When price is Rs 5 per unit, quantity demanded is 9
units and the amount offered at this price is 18 unit is greater than demand and there
will be the tendency for the price to fall, because at the price Rs.5 some of the seller
will be unable to sell all the quantity they want to sale therefore they will reduce the
price in order to attract the customers. Similarly at price Rs 4quantity demanded 10
units is less than the quantity supplied 16 units’ causes to fall in price. Similarly at
price Rs 1 quantity demanded 20 are greater than quantity supplied zero causes to
increase in price. In the other words, at this price the buyers who are willing to buy
will find that quantity offered is not sufficient to satisfy their wants. Hence those
consumers who have not been able to satisfy their wants will induce to increase the
price or are willing to pay more for getting commodity.

9.7 PERFECT V/S PURE COMPETITION

Pure Competition Perfect Competition

Pure competition is said to exist in In perfect competition, all the three

a market where (a) there is a large features of pure competition exist.
number of buyers and sellers (b) Besides these, perfect competition
products are homogeneous and has more features. These are (d)
perfect knowledge of the buyers

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 (c) there is freedom of entry and and sellers regarding the market
exit of buyers and sellers. conditions (e) perfect mobility of
factors of production (f) absence
of transport cost and (g) uniform
price.

The essential feature of pure Perfect competition is not only

competition is the absence of any pure but also free from other
monopoly element. imperfection. It is a broader
concept than pure competition.

Under pure competition, there is Under perfect competition, there is

limited number of buyers and large number of buyers and
sellers. sellers.

9.8 SHORT RUN EQUILIBRIUM OF THE FIRM AND INDUSTRY

Under perfect competition a firm takes price as given. In other words imperfect
competition at a single firm and consumer cannot influence the price by varying their
supply and demand respectively. Hence price remains constant in perfect
competition. So, the problem is to determine the output level to maximize profit.
We know that in short run total fixed cost incurred even if the output is nil or fixed cost
remains same whatever be the level of output.. If the price falls below the minimum
average variable cost then the firm will shut down in order to minimize losses. So the
minimum variable cost sets a limit to the price in short run.
As we know that firm will be in equilibrium when it is earning maximum profit.
According to marginal cost and marginal revenue approach a firm will make maximum
profit when MR and MC are equal and MC cuts MR from below. The short run
equilibrium of the firm requires short run equality between demand and supply. This
can be explained clearly with the help of following diagram:

Figure.9.1 Short Run Equilibrium of the Firm

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It is seen in the Figure that the market price OP has been determined by the
intersection point of the demand curve (D) and supply curve(S).

9.9 LONG RUN EQUILIBRIUM OF THE FIRM AND INDUSTRY

In the long-run, all the inputs available to the firms are variable, so that the concept of
fixed cost is absent and the total cost (TC) equals the total variable cost (TVC).
Therefore, we need only to deal with the long-run average cost (LAC= LTC/q). We
assume the LAC to be U-shaped exhibiting the fact that at the low levels of output,
the cost is falling and beyond a point, it rises. We have stated above that a perfectly
competitive market is characterized by free entry and exit of the firms. As in the short-
run, the firms are making profits; there will be entry of new firms in the market. As a
result, the industry supply would go up and price would fall. This would continue until
the profits are driven down to zero. Such a process is described in the following
diagram.

Figure. 9.2 Long run Profit of Competitive Firm

In Figure at price P1, the firm is producing an output q1 whereby it is making profit
shown by the shaded area. At price, P1, the industry output is Q1. As the existing
firms are making profit, there will be entry into the market. As a result, the total supply
in the market would go up and the price in market would fall. If at the new price the
firms are still making some profit, then there will be further entry and market supply
would go up.
Consequently, the price would go down further level. This process would continue
until the price falls to such a level that all profits are eliminated. From the diagram, the
shaded area ceases to exist. This price is P 2, where P= MC= AC and therefore profit
is zero. The zero profit scenarios faced by the firms means that the economic profit is
zero implying that the firms earn no more than they would elsewhere. In other words,
the firms are breaking even at priceP 2. At P2, as the firms are earning zero profit, there
is no incentive for other firms to enter the industry. Hence, price P 2 would represent
an equilibrium price level withQ 2 as the equilibrium output. With that the long-run

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equilibrium is characterized by a situation where the economic profits for the firms are
zero.

9.10 DERIVATION OF THE SUPPLY CURVE OF THE FIRM

‘short-run’ is meant as a period of time in which the size of the plant and machinery
are fixed, and the increased demand for the commodity is met only by an intensive
use of the given plant, i.e., by increasing the amount of the variable factors.
Under perfect competition, a firm produces an output at which marginal cost equals
the Price. If the price is higher than the marginal cost, it will pay the firm to expand its
output, so, as to equal its price. If, on the other hand, the price is less than the marginal
cost, it is incurring a loss, and it will reduce its output till the marginal cost and the
price are made equal. Hence, the marginal cost curve of the firm is the supply curve
of the perfectly competitive firm in the short-run.
But, even in the short-run, a firm will not supply at a price below its minimum average
variable cost. That is, in the short-run, a firm must try to cover its’ Variable cost at
least. Hence, the short-run supply curve of a firm coincides with that portion of the
short-run marginal cost curve which lies above the minimum point of the short-run
average variable cost (SAVC) curve. The following diagram [Figure. 10.3(a)) will make
it clear:

Figure. 9.3 deriving short-run Supply curve

In this diagram, Figure. 9.3(a) relates to a firm and 9.3(b) gives the supply curve of
the industry. First look at the Figure. 9.3(a), which relates to a single firm. Along the
axis OX are represented the output supplied and along OY the prices SMC curve is
the short-run marginal cost curve, and, as mentioned above, it is the short-run supply
curve of the firm. But only that portion of SMC curve which lies above the short-run
average variable cost (SAVC), which means the thick portion above the dotted portion
has be taken into consideration.
Thus, at the price OP 0, OM0 output will be supplied, at OP1 price, OM1, quantity will
be supplied at OP 2 price, and OM2 will be supplied, and so on. Nothing will be
supplied below the price OP”, because prices below OP 0 correspond to the dotted

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portion of the SMC which is below the minimum point of the SAVC (short-run average
variable cost) curve.
Now from the supply curve of a firm, let us derive the supply curve of the “entire”
industry of which all the firms are a constituent par) The supply curve SRS of the
industry “‘is derived by the lateral summation (i.e., adding up sideways) of that part of
all the firms’ marginal cost curves which lies above the minimum point on their
average friable cost curves. This industry is supposed to consist of 100identical firms
like the firm represented by the Figure. 9.3(a).
It can be seen that at OP„ price, 100 OM1 are supplied, at OP, price 100OM, are
supplied, at OP, price 100 OM, are supplied, and so on. We see that the short-run
supply curve SRC of the industry rises upwards, because the short-run marginal curve
SMC rises upwards.

Long-run Supply Curve

The long-run is supposed to be a period sufficiently long to allow changes to be made
both in the size of the plant and in the number of firms in the industry. Whereas in the
short period, an increase in demand is met by over-using the existing plant, in the
long-run, it will be met not only by the expansion of the plants of the existing firms but
also by the entry into the industry of new firms.
Moreover, we have seen that, in the short-run, a firm produces that output at which
its marginal cost is equal to the price. But, in the long-run, the price must be equal to
both the-marginal cost and the average cost. The reason is that an industry will be in
equilibrium when all firms in the industry are making normal profits, and they will be
making normal profits only if the price, i.e., average revenue (AR) is equal to average
cost AC.
The shape of supply curve, in the long run, will depend on whether the industry is
subject to the law of constant return (i.e., constant costs), or to diminishing returns
(i.e., increasing costs) or to increasing returns (i.e., diminishing costs). We show these
curves below.

Supply Curve of Constant Cost Industry

The supply curve of the constant cost industry is shown in the following diagram
(Figure. 9.4).

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 Figure. 9.4 Long-run Supply Curve of a Constant Cost Industry
In the Figure. 9.4(a) which relates to a firm, LMC is the long-run marginal cost curve,
and LAC is the long-run average cost curve. They intersect at R which means that at
the point R, the marginal cost is equal to the average cost. Here they are also equal
to price OP. The output at this point is OM. Thus, at the output, MC = AC = Price.
Now look at the Figure. 9.4(b). Corresponding to OP price, the long-run supply curve
is LSC, which is a horizontal straight line parallel to the X-axis. This means that
whatever the output along the X-axis, price is the same OP where the marginal cost
and average cost are equal. The cost remains the same, because it is a constant cost
industry.
It is an industry in which, even if the output is increased (or decreased), the economies
and diseconomies cancel out so that the cost of production does not change. Also,
when new firms enter the industry to meet the increased demand, they do not raise
or lower the cost per unit.
Thus, the industry is able to supply any amount of the commodity at the price OP
which is equal to the minimum long-run average cost which ensures normal profit to
all the firms engaged in the industry. That is, every firm will be in the long run
equilibrium where Price = MC = AC. All firms have identical cost conditions.
Hence, in the case of a constant cost industry, the long-run supply curve LSC is a
horizontal straight line (i.e., perfectly elastic) at the price OP, which is equal to the
minimum average cost. This means that whatever the output supplied, the price would
remain the same.

9.11 DERIVATION OF THE SUPPLY CURVE OF THE INDUSTRY

In the case of an increasing cost industry, the cost of production increases as the
existing firms expands or the new firms enter into the industry to meet an increase in
demand. The external diseconomies outweigh the external economies. The increased
demand for the productive resources required to produce larger output to meet
increased demand for the product raises their prices resulting in higher cost of
production.

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The rise in costs will shift both the average and marginal cost curves upward and the
minimum average cost will rise. This means that the additional supplies of the product
will be forthcoming at higher prices, whether the additional supplies come from the
expansion of the existing firms or from the new firms which may have entered the
industry. All this is shown in the following diagram

Figure. 9.5 Long-run Supply curve of Increasing cost Industry

The Figure. 9.5(a) shows the position of individual firms. The position of the dotted
LMC and LAC curves shows that they have been shifted upwards where each firm
achieves a long-run equilibrium so that the price OP, =MC = AC. But, in the Figure.
9.5 (b) which relates to the industry, we find that at the price OP is larger amount ON1
is supplied than at the price OP (i.e., ON).
This means that the long-run supply curve LSC slopes upwards to the right as the
output supplied increases. That is, more will be supplied at higher prices. This is
probably typical of the actual competitive world, because higher prices have to be
paid for the scarce productive resources to attract them from other uses so that
production in this particular industry may be increased. Thus, we see that in the case
of an increasing cost industry, the long-run supply curve slopes upward to the right.

Supply Curve of a Decreasing Cost Industry

In a decreasing cost industry, costs decrease as output is increased either byte
expansion of the existing firms or by the entry of new firms. In this case, the economies
of scale out-weight the diseconomies, if any. This happens when young industry
grows in a new territory where the supply of productive resources is plentiful. The net
external economies will push the cost curves down so that the additional supplies of
the output are forthcoming at lower prices. The following diagram (Figure. 9.6) makes
the whole thing clear:

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 Figure. 9.6 long run supply curve of a Decreasing Cost Industry
The Figure. 9.6(a) shows how the new, i.e., dotted LMC and LAC curves have been
shifted downwards from their original position, when the LMC and LAC curves
intersect at E where every firm was the equilibrium and was producing OM. The new
curves intersect at E1 which means that, at this point, the firms in the industry have
achieved the- long-run equilibrium, each producing OM, output, so-that the price OP
=MC =AC. But looking at the Figure. 9.6(b), we find that, at OP1price, ON is supplied
which is more than ON supplied at the original price OP.
The LSC slopes downwards to the right which means that the additional supplies of
the output are forthcoming at lower prices, since both the marginal cost and average
cost have fallen owing to cheaper supplies of the productive resources.

9.12 PRICE AND OUTPUT DETERMINATION UNDER PERFECT COMPETITION

Perfect competition refers to a market situation where there are a large number of
buyers and sellers dealing inhomogeneous products.
Moreover, under perfect competition, there are no legal, social, or technological
barriers on the entry or exit of organizations.
In perfect competition, sellers and buyers are fully aware about the current market
price of a product. Therefore, none of them sell or buy at a higher rate’s result, the
same price prevails in the market under perfect competition.
Under perfect competition, the buyers and sellers cannot influence the market price
by increasing or decreasing their purchases or output, respectively. The market price
of products imperfect competition is determined by the industry. This implies that in
perfect competition, the market price of products is determined by taking into account
two market forces, namely market demand and market supply.
In the words of Marshall, “Both the elements of demand and supply are required for
the determination of price of a commodity in the same manner as both the blades of
scissors are required to cut a cloth. "As discussed in the previous units, market

118
demand is defined as a sum of the quantity demanded by each individual organization
in the industry.
On the other hand, market supply refers to the sum of the quantity supplied by
individual organizations in the industry. In perfect competition, the price of a product
is determined at a point at which the demand and supply curve intersect each other.
This point is known as equilibrium point as well as the price is known as equilibrium
price. In addition, at this point, the quantity demanded and supplied is called
equilibrium quantity.

9.13 DEMAND UNDER PERFECT COMPETITION

Demand refers to the quantity of a product that consumers are willing to purchase at
a particular price, while other factors remain constant. A consumer demands more
quantity at lower price and less quantity at higher price. Therefore, the demand varies
at different prices.

Figure.9.7Demand Curve under Perfect Competition

As shown in Figureure9.7, when price is OP, the quantity demanded is OQ. On the
other hand, when price increases to OP 1, the quantity demanded reduces toOQ1.
Therefore, under perfect competition, the demand curves (DD’) slopes downward.

9.14 SUPPLYUNDER PERFECT COMPETITION

Supply refers to quantity of a product that producers are willing to supply ata particular
price. Generally, the supply of a product increases at high price and decreases at low
price.

Figure. 9.8 Supply curve under perfect competition

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In Figure 9.8, the quantity supplied is OQ at price OP. When price increases to OP1,
the quantity supplied increases to OQ1. This is because the producers are able to
earn large profits by supplying products at higher price. Therefore, under perfect
competition, the supply curves (SS’) slopes upward.

9.15 EQUILIBRIUMUNDER PERFECT COMPETITION

As discussed earlier, in perfect competition, the price of a product is determined at a
point at which the demand and supply curve intersect each other. This point is known
as equilibrium point. At this point, the quantity demanded and supplied is called
equilibrium quantity.

Figure. 9.9 Price ant Output Determination under perfect competition

In Figure 9.9, it can be seen that at priceOP 1, supply is more than the demand.
Therefore, prices will fall down to OP. Similarly, at priceOP 2, demand is more than the
supply. Similarly, in such a case, the prices will rise to OP. Thus, E is the equilibrium
at which equilibrium price is OP and equilibrium quantity is OQ.
9.16 PRICE AND OUTPUT DETERMINATION IN LONG RUN
The long run is a period of time which is sufficiently long to allow the firms to make
changes in all factors of production. In the long run, all factors are variable and none
fixed. They may expand their old plants or replace the old lower-capacity plants by
the new higher-capacity plants or add new plants.
Besides, in the long run, new firms can enter the industry to compete the existing
firms. On the contrary, in the long run, the firms can contract their output level by
reducing their capital equipment; they may allow a part of the existing capital
equipment tower out without replacement or sell out a part of the capital equipment.
Moreover, the firms can leave the industry in the long run. The long-run equilibrium
then refers to the situation when free and full adjustment in the capital equipment as
well as in the number of firms has been allowed to take place. It is therefore long-run
average and marginal cost curve which are relevant for deciding about equilibrium
output in the long run. Moreover, in the long run, it is the average total cost which is
of determining importance, since all costs are variable and none fixed.

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As explained above, a firm is in equilibrium under perfect competition when marginal
cost is equal to price. But for the firm to be in long-run equilibrium, besides marginal
cost being equal to price, the price must also be equal to average cost.
For, if the price is greater or less than the average cost, there will be tendency for the
firms to enter or leave the industry. If the price is greater than the average cost, the
firms will earn more than normal profits. These supernormal profits will attract outer
firms into the industry.
With the entry of new firms in the industry, the price of the product will go down as a
result of the increase in supply of output and also the cost will go up as a result of
more intensive competition for factors of production. The firms will continue entering
the industry until the price is equal to average cost so that all firms are earning only
normal profits.
On the contrary, if the price is lower than the average cost, the firms would make
losses. These losses will induce some of the firms to quit the industry. As a result, the
output of the industry will fall which will raise the price.
On the other hand, with some firms going out of the industry, cost may go down as a
result of fall in the demand for certain specialized factors of production. The firms will
continue leaving the industry until the price is equal to average costs that the firms
remaining in the field are making only normal profits. It, therefore, follows that for a
perfectly competitive firm to be in long-run equilibrium, the following two conditions
must be fulfilled.

1. Price - Marginal Cost

2. Price =Average Cost
If price is equal to both marginal cost and average cost, then we have a double
condition of long-run perfectly competitive equilibrium:

Price =Marginal Cost –Average Cost

But from the relationship between marginal cost and average cost we know that
marginal cost is equal to average cost only at the minimum point of the average cost
curve.

Therefore, the condition for long-run equilibrium of the firm can be written as:

Price =Marginal Cost =Minimum Average Cost.

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 Figure. 9.10 Long-run Equilibrium of the firm
Figure. 9.10 represents long-run equilibrium of firm under perfect competition. The
firm cannot be in the long-run equilibrium at a price greater than OP in Figure. 9.10.
This is be-cause if price is greater than OP, then the price line (demand curve)would
lie somewhere above the minimum point of the average cost curves that marginal cost
and price will be equal where the firm is earning abnormal profits.
Since there will be tendency for new firms to enter and compete away these abnormal
profits, the firm cannot be in long-run equilibrium at any price higher than OP.
Likewise, the firm cannot be in long-run equilibrium at a price lower than O Pin Figure.
9.10 under perfect competition.
If price is lower than OP, the average and marginal revenue curve will lie below the
average cost curve so that the marginal cost and price will be equal at the point where
the firm is making losses. Therefore, there will be tendency for some of the firms in
the industry to go out with the result that price will rise and the firms left in the industry
make normal profits.
We therefore conclude that the firm can be in long-run equilibrium under perfect
competition only when price is at such a level that the horizontal demand curve (that
is, AR curve) is tangent to the average cost curve so that price equals average cost
and firm make sonly normal profits.
It should be noted that a horizontal demand curve can be tangent to a U-shaped
average cost curve only at the latter’s minimum point. Since at the minimum point of
the average cost curve the marginal cost and average cost are equal, price in long-
run equilibrium is equal to both marginal cost and average cost. In other words, double
condition of long-run equilibrium is fulfilled at the minimum point of the average cost
curve.
It is clear from above that long-run equilibrium of the firm under perfect competition is
established at the minimum point of the long-run average cost curve. Working at the
minimum point of the long-run average cost curve signifies that the firm is of optimum
size, that is, it is producing output at the lowest possible cost. The fact that the firm,
working under conditions of perfect com-petition tends to be of optimum size in the
long run is beneficial from the social point of view into ways. Firstly, working at

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optimum size implies that the resources of the society are being utilized in the most
efficient way. Secondly, it signifies that the consumers are getting the goods at the
lowest possible price.

9.17 LONG RUN SUPPLY CURVE OFA COMPETITIVE INDUSTRY

The supply curve in the long run will be totally elastic as a result of the flexibility
derived from the factors of production and the free entry and exit of firms imagine the
firm-entry process portrayed before a few more times. In the long run, market demand
will only affect the number of firms but not to the quantity produced by each of these
firms. Therefore, we can assume that the equilibrium in the long run is the point where
profits are maximised (although each firm achieves zero economic profit), there are
neither firm’s entries nor exits and there is market clearance.

LET US SUM UP
Perfect competition refers to the market structure where competition among the
sellers and the buyers prevails in its most perfect form. Ina perfectly competitive
market, a single market price prevails for a commodity, which is determined by the
forces of total demand and total supply in the market. Under perfect competition, every
participant (whether a seller or a buyer) is a price-taker. Everyone has to accept the
prevailing market price as individually no one is in a position to influence it.
A distinction is often made between pure competition and perfect competition. But this
distinction is more a matter of degree than of kind. For a market to be purely
competitive, three fundamental conditions must prevail. These are: (i) a large number
of buyers and sellers; (ii) homogeneity of product. (iii) Free entry or exit of firms. For
the market to be perfectly competitive, four additional conditions must be fulfilled, viz.,
(a) perfect knowledge of market, (b) perfect mobility of factors of production, (c)
absolute government non-intervention, and (d) no transport cost difference.
Perfect competition is an ‘ideal concept’ of market rather than an actual market reality.
To some extent, the perfect competition model fits into the market for farm products
like rice, cotton, wheat, etc., when all the units of each commodity are identical.
Moreover, all conditions of perfect competition may not are satisfied.
In realty, competition is never perfect. So there is imperfect competition when perfect
form of competition among the sellers and buyers does not exist. This happens as the
number of firms maybe small or products maybe differentiated by different sellers in
actual practice. Similarly, there is no pure monopoly in reality.
Imperfect competition covers all other forms of market structures ranging from highly
competitive to less competitive in nature. Traditionally, oligopoly and monopolistic
competition are categorized as the most realistic forms of market structures under
imperfect competition.

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An industry is in equilibrium in the short run when there is no tendency for its total
output to expand or contract, i.e., the output of the industry is steady.
The short-period market price and its determining factors, viz., short demand and
short-period supply, are in equilibrium. When the quantity demanded is equal to total
quantity supplied, at the equilibrium short run market price, the market is cleared so
there is no reason for the market price to change in the short run.

CHECK YOUR PROGRESS

Choose the Correct Answer

1. Which market is a simple and convenient form of market structure to understand
and analyze?

a) Perfect market b) Imperfect market

c) Both of them d) None of them

2. According to Marshall, which are the time periods of varying duration?

a) Market period b) Short period

c) Long period d) All of them

3.___________ competition refers to the market structure where competition among
the sellers and the buyers prevails in its most perfect form.

a) Perfect b) Imperfect

c) Both d) none of them

4. Under perfect competition, there is a ___________ruling market price.

a) Single b) Short period

c) Long period d) none of them

5. The market period is a very _________period.

a) Market period b) Short period

c) Long period d) none of them

GLOSSARY
Perfect competition : Perfect competition refers to the market
structure where competition among the sellers
and the buyers prevail in its most perfect form.
In a perfectly competitive market, a single
market price prevails for a commodity, which is
determined by the forces of total demand and
total supply in the market.

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 Pure Competition : Pure competition is a market situation where
there are a large number of independent Sellers
offering identical products. It means it is a term
for an industry where competition is stagnant
and relatively on-competitive.
Imperfect competition : Imperfect competition covers all other forms of
market structures ranging from highly
competitive to less competitive in nature..

SUGGESTED READINGS
1. Dewett, K K&Navalur,M H (2006), Modern Economic Theory, S. Chand
Publishing, New Delhi.
2. Mehta, P.L. (1997) “Managerial Economics",5th Edition Sultan Chand &
Sons Publications.
3. Mehta, P L,(2016), Managerial Economics Analysis , Problems And Cases,
Sultan Chand & Sons, New Delhi .
4. Mote,V, Samuel Paul , Gupta,G.(2017),Managerial Economics : Concepts
& Cases, Tata McGraw-Hill Publishing Company Limited, New Delhi.
5. Sankaran,S. Dr.3rd Editions (2012), Business Economics, Margham
Publications, Chennai.
6. Varshney, R.L., Maheshwari,K.L. 19th Edition (2014), Managerial
Economics, Sultan Chand & Sons, New Delhi.
7. https://www.economicsdiscussion.net/perfect-competition/perfect-
competition-with-7-assumptions/5230
8. https://www.economicsdiscussion.net/articles/market-forms-pure-
competition-perfect-competition-and-imperfect-competition/1685
9. https://www.youtube.com/watch?v=Aqn7BPMvhCY

ANSWERS TO CHECK YOUR PROGRESS

1) a 2) d 3) a 4) a 5) b

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Unit 10

MONOPOLISTIC COMPETITION
STRUCTURE

Overview

Learning Objectives

10.1 Meaning of Monopolistic Competition

10.2 Features of Monopolistic Competition

10.3 Foundation of Monopolistic competition model

10.4 Price and Output Determination in short Run

10.5 Price and Output Determination in long Run

10.6 Analysis of selling cost and firm’s equilibrium

10.7 Critical appraisal of Chamberlin’s theory of Monopolistic Competition

Let Us Sum Up

Check your Progress

Glossary

Suggested Readings

Answers to Check Your Progress

Suggested Readings

OVERVIEW
Monopolistic competition is a type of imperfect competition where that many
producers sell products that are differentiated from one another as goods but not
perfect substitutes. In the monopolistic competition, a firm takes the prices charged
by its rivals as given and ignores the impact of its own prices on the prices of other
firms.
The long-run characteristics of a monopolistically competitive market are almost the
same as a perfectly competitive market. Two differences between the two are that
monopolistic competition produces heterogeneous products and that monopolistic
competition involves a great deal of non-price competition ,which is based on subtle
product differentiation. A firm making profits in the short run will nonetheless only
break even in the long run because demand will decrease and average total cost will
increase. This means in the long run; a monopolistically competitive firm will make
zero economic profit.

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LEARNING OBJECTIVES

After reading this unit, you should be able to,

• describe the monopolistic competition market and its features

• explain the foundation of monopolistic competition model

• discuss the price and output determination under monopolistic competition

• analyse the selling cost and firm’s equilibrium

• appraise the Chamberlin’s theory of Monopolistic Competition.

10.1 MEANING OF MONOPOLISTICCOMPETITION

Monopolistic competition is a market structure quite similar to perfect competition in
that vigorous price competition among a large number of firms and individuals is
present.
Monopolistic competition is the market situation mid-way between the extremes of
perfect competition and monopoly, and displaying features of the both. In such
situation’s firms are free to enter a highly competitive market where several
competitors offer products that are close substitutes and, therefore, prices are at the
level of average costs. Some consumers have a preference for one product over
another that is strong enough to make them keep buying it even when its price
increases, thus giving its producer a small amount of market power. Monopolistic
situation is a common situation in all free markets.

10.2 FEATURES OF MONOPOLISTIC COMPETITION

Following are the features of a monopolistic competitive market:

i) Large number of firms

Monopolistic competition is characterized by large number of firms producing
close substitutes but not identical product. Each firm must control a small yet
significant portion of the market share such that by substantially extending or
restricting its own sales, it is not able to affect the sales of any other individual
seller. This condition is the same as in perfect market.

ii) There is product differentiation

No seller has full control over the market supply. Each seller produces very close
substitute products. The product is neither identical nor markedly different. Since
every seller produces slightly differentiated product, each seller has minor control
over the price. Unlike perfect market conditions, the firm is a price –maker to
some extent. That is, a firm can change the price slightly, though not much. The
control over price will depend on the degree of product differentiation.

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iii) Absence of Inter-dependence
Existence of a large number of firms insures the condition too large and too small.
Thus, the individual firm’s supply is small constituent of total supply. Therefore,
individual firm has limited control over price level. Similarly, each firm can decide
,its price or output policies independently through price discrimination, any action
by one firm may not invite reaction from rival firms.

iv) Selling cost

Competitive advertisement is an essential feature of monopolistic competition.
Selling cost becomes an integral part of the marketing of firms when product is
differentiated. It is necessary to tell the buyers about the superiority of the product
and induce the customer to buy the products. However, the presence of many
close substitutes limits the price-setting ability of individual firms, and drives
profits down to a normal rate of return in the long-run. As in the case of perfect
competition, above-normal profits are only possible in the short-run before rivals
are able to take effective countermeasures. Examples of monopolistically
competitive market structures include abroad range of industries producing
clothing, consumer financial services, professional services, restaurants, and so
on.
v) Free entry and exit
Under monopolistic competition, new firm firms can exit. There are no restrictions
on entry or exit of the small size of firms. Existence of super normal profit attracts
entry loss, business firms to quit the market.
10.3 FOUNDATION OF MONOPOLISTIC COMPETITIONMODEL
A monopolistically competitive market has features that represent a cross between a
perfectly competitive market and a monopolistic market (hence the name). The
following are some of the main assumptions of the model:
Many, firms produce in monopolistically competitive industry. This assumption is
similar to that found in amodelof0020perfect competition.
Each firm produces a product that is differentiated (i.e., different in character)from all
other products produced by the other firms in the industry. Thus one firm might
produce a red toothpaste with a spearmint taste, and another might produce white
toothpaste with wintergreen taste. This assumption is similar to a monopoly market
that produces a unique (or highly differentiated) product.
The differentiated products are imperfectly substitutable in consumption. This means
that if the price of one good were to rise, some switch their purchases to another
product within the industry. From the perspective of a firm in the industry, it would face
a downward-sloping demand curve for its product, but the position of the demand
curve would depend on the characteristics and prices of the other substitutable

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products produced by other firms. This assumptions intermediate between the
perfectly competitive assumption in which goods are perfectly substitutable and the
assumption in a monopoly market in which no substitution is possible.
Consumer demand for differentiated products is sometimes described using two
distinct approaches: the love-of-variety approach and the ideal variety approach. The
love-of-variety approach assumes that each consumer has a demand for multiple
varieties of a product over time. A good example of this would be restaurant meals.
Most consumers who eat out frequently will also switch between restaurants, one day
eating at a Chinese restaurant, another day at a Mexican restaurant, and so on. If all
consumers share the same love of variety, then the aggregate market will sustain
demand for many varieties of goods simultaneously. If a utility function is specified
that incorporates a love of variety, then the wellbeing of any consumer is greater the
larger the number of varieties of goods available. Thus the consumers would prefer
to have twenty varieties to choose from rather than ten.
The ideal variety approach assumes that each product consists of a collection of
different characteristics. For example, each automobile has a different color, Interior
and exterior design, engine features, and so on. Each consumer is assumed to have
different preferences over these characteristics. Since the final product consists of a
composite of these characteristics, the consumer chooses a product closest to his or
her ideal variety subject to the price of the good. In the aggregate, as long as
consumers have different ideal varieties, the market will sustain multiple firms selling
similar products. Therefore, depending on the type of consumer demand for the
market, one can describe the monopolistic competition model as having consumers
with heterogeneous demand (ideal variety) or homogeneous demand(love of variety).
There is free entry and exit of firms in response to profits in the industry. Thus firms
making positive economic profits act as a signal to others to open up similar firms
producing similar products. If firms are losing money (making negative economic
profits), then, one by one, firms will drop out of the industry. Entry or exit affects the
aggregate supply of the product in the market and forces economic profit to zero for
each firm in the industry in the long run. (Note that the long run is defined as the period
of time necessary to drive the economic profit to zero.) This assumption is identical to
the free entry and exit assumption in a perfectly competitive market.
There are economies of scale in production (internal to the firm). This is incorporated
as a downward-sloping average cost curve. If average costs fall when firm output
increases, It means that the per-unit cost falls with an increase in the scale of
production. Since monopoly markets can arise when there are large fixed costs in
production and since fixed costs result in declining average costs, the assumption of
economies of scale is similar to a monopoly market.
These main assumptions of the monopolistically competitive market show that the
market is intermediate between a purely competitive market and a purely monopolistic

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market. The analysis of trade proceeds using a standard depiction of equilibrium in a
monopoly market. However, the results are reinterpreted in light of these
assumptions. Also, it is worth mentioning that this model is a partial equilibrium model
since there is only one industry described and there is no interaction across markets
based on an aggregate resource constraint.

10.4 PRICE AND OUTPUT DETERMINATION IN SHORT RUN

In monopolistic competition, every firm has a certain degree of monopoly power i.e.
every firm can take initiative to set a price. Here, the products are similar but not
identical, therefore there can ever be a unique price but the prices will be in a group
reflecting the consumers’ tastes and preferences for differentiated products. In this
case the price of the product of the firm is determined by its cost function, demand,
its objective and certain government regulations, if there are any. As the price of a
particular product of a firm reduces, it attracts customers from its rival groups (as
defined by Chamberlin). Say for example, if ‘Samsung ‘TV reduces its price by a
substantial amount or offers discount, then the customers from the rival group who
have loyalty for, say ‘BPL’, tend to move to buy ‘Samsung ‘TV sets. As discussed
earlier, the demand curve is highly elastic but not perfectly elastic and slopes
downwards. The market has many firms selling similar products, therefore the firm’s
output is quite small as compared to the total quantity sold in the market and so its
price and output decisions go unnoticed. Therefore, every firm acts independently and
for a given demand curve, marginal revenue curve and cost curves, the firm
maximizes profit or minimizes loss when marginal revenue is equal to marginal cost.
Producing an output of selling at price P maximizes the profits of the firm.

In the short run, a firm may or may not earn profits. The equilibrium point for the firm
is at price P and quantity Q and is denoted by point A. Here, the economic profit is
given as area PAQR. The difference between this and the monopoly cases that here
the barriers to entry are low or weak and therefore new firms will be attracted to enter.
Fresh entry will continue to enter as long as there are profits. As soon as the super
normal profit is competed away by new firms, equilibrium will be attained in the market
and no new firms will be attracted in the market. This is the situation corresponding to
the long run and is discussed in the next section.

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10.5 PRICE AND OUTPUT DETERMINATION IN LONG RUN
The difference between monopolistic competition and perfect competition is that in
monopolistic competition the point of tangency is downward sloping and does not
occur at minimum of the average cost curve and this is because the demand curve is
downward sloping.
Under monopolistic competition in the long run we see that LRAC is the long run
average cost curve and LRMC the long run average marginal curve. Let us take a
hypothetical example of a firm in a typical monopolistic situation where it is making
substantial amount of economic profits.
Here it is assumed that the other firms in the market are also making profits. This
situation would then attract new firms in the market. The new firms may not sell the
same products but will sell similar products. As a result, there will be an increase in
the number of close substitutes available in the market and hence the demand curve
would shift downwards since each existing firm would lose market share. The entry of
new firms would continue as long as there are economic profits. The demand curve
will continue to shift downwards till it becomes tangent to LRAC at a given price P1
and output at Q1 as shown in the Figure 10.1.At this point of equilibrium, an increase
or decrease in price would lead to losses. In this case the entry of new firms would
stop, as there will not be any economic profits.

Figure.10.1 Demand Curve

Due to free entry, many firms can enter the market and there may be a condition
where the demand falls below LRAC and ultimately suffers losses resulting in the exit
of the firms. Therefore under the monopolistic competition free entry and exit must
lead to a situation where demand becomes tangent to LRAC, the price becomes equal
to average cost and no economic profit is earned. It can thus be said that in the long
run the profits peter out completely. One of the interesting features of the
monopolistically competitive market is the variety available due to product
differentiation. Although firms in the long run do not produce at the minimum point of
their average cost curve, and thus there is excess capacity available with each firm,

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economists have rationalized this by attributing the higher price to the variety
available. Further, consumers are willing to pay the higher price for the increased
variety available in the market.

10.6 ANALYSIS OF SELLING COST AND FIRM’S EQUILIBRIUM

Selling costs play the key role in monopolistic competition and oligopoly. Under these
market forms, the firms have to compete to promote their sale by spending on
advertisements and publicity.
Moreover, producer has not to decide about price and output and he also keeps in
view how to maximize the profit.
Thus, cost on advertisement publicity and salesmanship ads to the demand of the
product. We do not find perfect competition or monopoly in the real world but
monopolistic competition or oligopoly. In short, selling costs is a broader concept than
the advertisement expenditures. Advertisement expenditures are part of selling costs.
In selling costs we include the salaries of sales persons, allowances to retailers to
display the products etc. besides the advertisements. Advertisement expenditure
includes costs incurred for advertising in newspapers and magazines, televisions,
radio, cinema slides etc. It was Chamberlin who introduced the analysis of selling
costs and distinguished it from the production costs. The production costs include all
those expenses which are spent on the manufacturing of the commodity, its
transportation cost of handling, storing and delivering of the commodity to actual
customers because these add utilities to a commodity.
On the other hand, all selling costs include all expenditures in order to raise demand
for a commodity. In short, selling costs are those which are made to create the
demand for the product. Transport costs should not be included in selling costs; rather
these should be included in the production costs. Transport costs actually do not
increase the demand; it only helps in meeting the demand of the consumers.
In the same fashion, high rents are not the part of selling costs. High rents are paid
so as to meet the already existing demand of the people. According to Edward H.
Chamberlin, “Those costs which are made to adopt the product to the demand are
costs of production; those made to adopt the demand to product are costs of selling.”

Definitions
“Selling costs are costs incurred in order to alter the position or shape of the demand
curve for the product.” E.H. Chamberlin
“Selling costs may be defined as costs necessary to persuade a buyer to buy one
product rather than another or to pay from one seller rather than another.” Meyers

Assumptions

Basically, the concept of selling cost is based on the following two assumptions:

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 1. Buyers do not have any perfect knowledge about the different types of product.

2. Buyers demand and tastes can be changed.

10.7 CRITICAL APPRAISAL OF CHAMBERLIN’S THEORY OF MONOPOLISTIC
COMPETITION
Edward Hastings Chamberlin (b. 1899) in 1933 published The Theory of Monopolistic
Competition as a reorientation of the theory of value, designed to base it on a
synthesis of monopolistic and competitive theories. He argues that the old idea of
monopoly and competition as alternative is wrong; and that most situations are
composites in which elements of both monopoly and competition are combined. But
he asserts that the correct procedure is to start from the theory of monopoly. This, he
thinks, has the merit of eliminating none of the competitive elements, since these
operate through the demand for the monopolist’s product; while on the contrary the
alternative assumption of competition rules out the monopoly elements.
Thus, in taking monopoly as a starting point, Chamberlin’s approach is similar to that
of Cournot. But, while with Cournot the transition to perfect competition takes place
only on a scale of numbers of competitors, with Chamberlin it takes place also on a
scale of substitution of products. Any producer whose product is significantly different
from the products of others has some monopoly of it, subject to the competition of
substitutes. He considers each producer in an industry as having some monopoly in
his own product. If he be the sole seller of a unique product, he has a pure monopoly.
If there be two sellers of similar products, the situation is one of “duopoly”. If there be
several, an “oligopoly” exists. The condition may range through various degrees of
oligopoly to pure competition, under which there are so many sellers of a highly
standardized product that anyone could sell all his product without affecting the
demand. Pure competition is found only under the dual condition of (a) a large
number, and (b) a perfectly standardized product. The usual condition Chamberlin
considers being in the intermediate area, in which some element of “monopoly “exists,
and which he calls “monopolistic competition.”
Economic inertia and friction are “imperfections “which he does not consider as part
of “monopolistic competition.”
Thus Chamberlin’s thought centers on the product. Each producer, under
“monopolistic competition,” faces competition from “substitute” products which are not
identical and which are sold by other concerns with various price policies, and sales
expenses. These merely limit his “monopoly” of his own product.
The individual demand curve (or sales) for one seller’s product is then regarded as
affected by the market policies of other individual sellers whose products are partial
substitutes. Total sales of the partly competing group of substitute products are
treated as limiting the sales of the product of any one seller. Under “pure “competition
(many sellers and a completely standardized product) a horizontal demand curve

133
(average revenue) would exist for each individual competitor’s product. This would
mean identical prices. Chamberlin argues that “pure” competition would force all
individual competitors to treat differential advantages, or rents, as costs, the same as
other costs.
Chamberlin emphasizes the effect of judgments by one seller concerning his rivals’
policies, possible retaliation, etc. He also argues that selling costs such as advertising
are not part of the cost of production, but are incurred to increase the sales of the
given product; and thus they affect the demand curve. Through-out, his basic idea is
that, no matter how slight, any differentiation of a seller’s product gives him to that
extent a monopoly. And all these conditions, commonly found in competitive markets,
are either “impurities” in the nature of monopoly elements, or are associated with such
elements. They make “pure” competition impossible.
To Chamberlin, actual “competition”1 includes the effort of competitors to increase
their monopoly powers.

Figure.10.2.Demand Curve

DD’= demand curve (avg. rev.)

PP’= avg. cost of production, including a “minimum profit” (charge required to attract
capital and enterprise) and all “rents”

FF’= avg. total cost, including fixed uniform selling costs

AR= price

EHRR’= profit (above “minimum”)

OA= quantity sold

pp’=marginal cost of production

Did’=marginal revenue

Q= intersection of pp’ and did’

And the essence of “monopoly,” and therefore of “monopolistic competition, "is seen
as lying-in differences

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 (1) Differences in price policy,

(2) Differences in nature of product, and

(3) Differences in such sales effort as advertising outlays.

It is a contribution of Chamberlin’s to have developed the second and third of these
variables as arising out of the mixture of monopoly and competition. Chamberlin starts
with a single firm and develops the idea of monopoly price and competitive prices as
determined by the intersection of revenue or sales curves with expense curves. Either
the marginal revenue curve, or the average revenue curve (from which it is derived),
maybe used to determine the monopoly output and price, the former by intersecting
the rising marginal cost curve, the latter by the familiar Marshalling method of fitting
the maximum profit area between it and the average cost curve, which includes rents
or differentials and thus equals the average price.
The analysis with respect to all three variables then is extended beyond the firm to
groups of sellers, which may be taken as corresponding to conventional “industries,”
depending on how broadly a “class of product” is conceived in a particular case. The
group is analyzed, first under the assumption of symmetry (all its members assumed
to have uniform cost and demand curves). Then some consideration is given to what
might hap-pen if a “diversity of conditions” existed. If selling costs are not great, and
if they reduce the slope of the sellers’ demand curves, increasing them may result in
a lower price. Variations in product may lead to either smaller or larger outputs. Group
equilibrium (with “alert” competitors) must result in the optimum with respect to all the
variables, and no profits above a necessary minimum for every producer.
The conclusion is drawn that under monopolistic competition the equilibrium price is
higher, and the volume of output probably (not necessarily) lower, than under pure
competition. The net profits of enterprise, however, may or may not be higher than
under pure competition because of the expense which is required to maintain the
monopoly elements and which is often increased by multiplication of substitute
products surrounding the monopolist. Chamberlin argues that monopolistic
competition need not bring higher profits to the marginal firm in a given industry.
Instead, it may allow the existence of a larger number of firms making normal profits.

LET US SUM UP
Monopolistic competition is a market structure quite similar to perfect competition in
that vigorous price competition among a large number of firms and individuals is
present.
Monopolistic competition is characterized by large number of firms producing close
substitutes but not identical product. Each firm must control a small yet significant
portion of the market share such that by substantially extending or restricting its own

135
sales, it is not able to affect the sales of any other individual seller. This condition is
the same as in perfect market.
Under monopolistic competition in the long run we see that LRAC is the long run
average cost curve and LRMC the long run average marginal curve. Let us take a
hypothetical example of a firm in a typical monopolistic situation where it is making
substantial amount of economic profits.

CHECK YOUR PROGRESS

Choose the Correct Answer

1. What is Monopolistic Competition?

a) It is characterized by large number of firms producing close
Substitutes but not identical product.
b) It is a market structure where only a few large rivals are responsible for
the bulk, if not all, industry output.

c) Both (a) and (b)

d) None of the above

2. What is a marketing process that showcases the differences between Products?

a) Product differentiation
b) It is characterized by large number of firms producing close
substitutes but not identical product
c) It is a market structure where only a few large rivals are
responsible for the bulk, if not all, industry output.
d) None of the above

3.__________competition is a market structure quite similar to perfect

Competition in that vigorous price competition among a large number

Of firms and individuals is present.

a) Monopolistic b) Oligopoly

c) Duopoly d) None of the above

4. Under monopolistic competition, there are no restrictions on entry or

Exit of the ___________of firms.

a) Large size b) Small size

c)Medium size d) none of the above

5.__________looks to make a product more attractive by contrasting its

Unique qualities with other competing products.

136
 a) Resource allocation b) Deductive methods

c) Differentiation d) Pricing

GLOSSARY

Monopolistic : Monopolistic competition is a market structure

competition quite similar to perfect competition in that
vigorous price competition among a large number
of firms and individuals is present.

Product Differentiation : Product differentiation is a marketing process that

showcases the differences between products.
Differentiation looks to make a product more
attractive by contrasting its unique qualities with
other competing products.

Selling costs : Products under monopolistic competition are

spending huge amounts on advertising and
publicity. Much of this expenditure is wasteful from
the social point of view. The producer can reduce
the price of the product instead of spending on
publicity.

SUGGESTED READINGS
1. Dewett, K K&Navalur,M H (2006), Modern Economic Theory, S. Chand
Publishing, New Delhi.
2. Mehta, P.L. (1997) “Managerial Economics",5th Edition Sultan Chand & Sons
Publications.
3. Mehta, P L,(2016), Managerial Economics Analysis , Problems And Cases,
Sultan Chand & Sons, New Delhi .
4. Mote,V, Samuel Paul , Gupta,G.(2017),Managerial Economics : Concepts &
Cases, Tata McGraw-Hill Publishing Company Limited, New Delhi.
5. Sankaran,S. Dr.3rd Editions (2012), Business Economics, Margham
Publications, Chennai.
6. Varshney, R.L., Maheshwari,K.L. 19th Edition (2014), Managerial Economics,
Sultan Chand & Sons, New Delhi.
7. https://www.yourarticlelibrary.com/economics/7-most-important-features-of-
monopolistic-competition/9154
8. https://www.economicsdiscussion.net/monopolistic-competition/chamberlins-
model-of-monopolistic-competition/5369

ANSWERS TO CHECK YOUR PROGRESS

1) a 2) a 3) a 4) b 5) c

137
Unit 11

OLIGOPOLY MARKET
STRUCTURE

Overview

Learning Objectives

11.1 Oligopoly

11.2 Oligopoly Market

11.3 Characteristics of Oligopoly

11.4 Causes of Oligopoly

11.5 Effects of Oligopoly

11.6 Price determination under oligopoly

11.7 Price Determination Models of Oligopoly

11.8 Game theory approach to oligopoly

Let Us Sum Up

Check your Progress

Glossary

Suggested Readings
Answers to Check Your Progress

OVERVIEW
An oligopoly is a market structure in which a few firms dominate. When a market is
shared between a few firms, it is said to be highly concentrated. Although only a few
firms dominate, it is possible that many small firms may also operate in the market.

LEARNING OBJECTIVES

After reading this unit you will be able to,

• list out the characteristics of Oligopoly market

• explain the Duopoly model

• elaborate the Oligopoly models

• apply game theory approach to oligopoly.

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11.1 OLIGOPOLY
According to Mrs. John Robinson, “Oligopoly is a market situation that is in between
monopoly and perfect competition in which the number of sellers is more than one but
is not so large that the market price is not influenced by any one of them”.
According to Prof.George J. Stigler, “Oligopoly is a market situation in which a firm
determines its marketing policies on the basis of expected behavior of close
competitors”.
According to Prof.Stoneur and Hague, “Oligopoly is different from monopoly on one
hand in which there is a single seller, on the other hand, it differs from perfect
competition and monopolistic competition also in which there is a large number of
sellers. In other words, while describing the concept of oligopoly, we include the
concept of a small group of firms”.
11.2 OLIGOPOLYMARKET
Oligopoly is a market structure where only a few large rivals are responsible for the
bulk, if not all, industry output. As in the case of monopoly, high to very high barriers
to entry are typical. Under oligopoly, the price/output decisions of firms are interrelated
in the sense that direct reactions from leading rivals can be expected. As a result, the
decision-making of individual firms is based, in part, on the likely response of
competitors.
The term oligopoly is derived from two Greek words, Oleg’s and ‘Pollen’. Oleg’s
means a few and Pollen means to sell thus. Oligopoly is said to prevail when there
are few firms or sellers in the market producing and selling a product. Oligopoly is
often referred to as “competition among the few”. In brief oligopoly is a kind of
imperfect market where there are a few firm in the market, producing either and
homogeneous product or producing product which are close but not perfect
substitutes of each other.
There is no such border line between a few and many. Usually oligopoly is understood
to prevail when the numbers of sellers of a product are two to ten. Oligopoly is of two
types-oligopoly without product differentiation or pure.

11.3 CHARACTERISTICS OFOLIGOPOLY

1. Interdependence: The firms under oligopoly are interdependent in making
decision. They are interdependent because the number of competition is few
and any change in price & product etc. by a firm will have a direct influence on
the fortune of its rivals, which in turn retaliate by changing their price and output.
Thus under oligopoly a firm not only considers the market demand for its
product but also the reactions of other firms in the industry. No firm can fail to
take into account the reaction of other firms to its price and output policies.

139
 There is, therefore, a good deal of interdependences of the firm under
oligopoly.
2. Importance of advertising and selling costs: The firms under oligopolistic
market employ aggressive and defensive weapons to gain a greater share in
the market and to maximise sale. In view of this firms have to incur a great deal
on advertisement and other measures of sale promotion. Thus advertising and
selling cost play a great role in the oligopolistic market structure. Under perfect
competition and monopoly expenditure on advertisement and other measures
is unnecessary. But such expenditure is the life-blood of an oligopolistic firm.
3. Group behavior: Another important feature of oligopoly is the analysis of group
behavior. In case of perfect competition, monopoly and monopolistic
competition, the business firms are assumed to behave in such away also
maximize their profits. The profit-maximizing behavior on his part may not be
valid. The firms under oligopoly are interdependent as they are in a group.
4. Indeterminateness of demand curve: This characteristic is the direct result
of the interdependence characteristic of an oligopolistic firm. Mutual
interdependence creates uncertainty for all the firms. No firm can predict the
consequence of its price-output policy. Under oligopoly a firm cannot assume
that its rivals will keep their price unchanged if he makes charge in its own
price. The demand curve as is well known, relates to the various quantities of
the product that could be sold it different levels of prices when the quantity to
be sold is itself unknown and uncertain the demand curve can’t be definite and
determinate.
5. Elements of monopoly: There exist some elements of monopoly under
oligopolistic situation. Under oligopoly with product differentiation each firm
controls a large part of the market by producing differentiated product. In such
a case it acts in its sphere as a monopolist in lining price and output.
6. Price rigidity: Under oligopoly there is the existence price rigidity. Prices lend
to be rigid and sticky. If any firm makes a price-cut it is immediately retaliated
by the rival firms by the same practice of price-cut. There occurs a price-war in
the oligopolistic condition. Hence under oligopoly no firm resorts to price-cut
without making price-output decision with other rival firms. The net result will
be price -finite or price-rigidity in the oligopolistic condition.

11.4 CAUSES OFOLIGOPOLY

1. Economies of Scale: The firms in the industry, with heavy investment, using
improved technology and reaping economies of scale in production, sales,
promotion, etc., will compete and stay in the market.

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2. Barrier to Entry: In many industries, the new firms cannot enter the industry
as the big firms have ownership of patents or control of essential raw material
used in the production of an output. The heavy expenditure on advertising by
the oligopolistic industries may also be a financial barrier for the new firms to
enter the industry.
3. Merger: If the few firms in the industry smell the danger of entry of new firms,
they then immediately merge and formulate a joint policy in the pricing and
production of the products. The joint action of the few big firms discourages the
entry of new firms into the industry.
4. Mutual Interdependence: As the number of firms is small in an oligopolistic
industry, therefore, they keep a strict watch of the price charged by rival firms
in the industry. The firm generally avoids price ware and tries to create
conditions of mutual interdependence.

11.5 EFFECTS OFOLIGOPOLY

1. Small output and high prices: As compared with perfect competition,
oligopolistic sets the prices at higher level and output at low level. Restriction
on the entry: Like monopoly, there is a restriction on the entry of new firms in
an oligopolistic industry.
2. Prices exceed Average Cost: Under oligopoly, the firms fixed the prices at
the level higher than the AC. The consumers have to pay more than it is
necessary to retain the resources in the industry. In other words, the economy’s
productive capacity is not utilized in conformity with the consumers’
preferences.
3. Lower efficiency: Some economists argued that there is a low level of
production efficiency in oligopoly. There is no tendency for the oligopolists to
build optimum scales of plant and operate them at the optimum rates of output.
However, the Schumpeterian hypothesis states that there is high tendency of
innovation and technological advancement in oligopolistic industries. As a
result, the product cost decreases with production capacity enhancement. It will
offset the loss of consumer surplus from too high prices.
4. Selling Costs: In order to snatch markets from their rivals, the oligopolistic
firms may engage in aggressive and extensive sales promotion effort by means
of advertisement and by changing the design and improving the quality of their
products.
5. Wider range of products: As compared with pure monopoly or pure
competition, differentiated oligopoly places at the consumers’ disposal a wider
variety of commodities.

141
 6. Welfare Effect: Under oligopoly, vide sums of money are poured into sales
promotion to create quality and design differentiations. Hence, from the point
of view of economic welfare, oligopoly fares fairly badly. The oligopolist push
on-price competition beyond socially desirable limits.

11.6 PRICE DETERMINATION UNDER OLIGOPOLY

The price and output behavior of the firms operating in oligopolistic orduopolistic
market condition can be studied under two main heads:

1. Price and Output Determination under Duopoly

a. If an industry is composed of two giant firms each selling identical or
homogenous products and having half of the total market, the price and output
policy of each is likely to affect the other appreciably, therefore there is every
likelihood of collusion between the two firms. The firms may agree on a price,
or divide the total market, or assign quota, or merge themselves into one unit
and form a monopoly or try to differentiate their products or accept the price
fixed by the leader firm, etc.
b. In case of perfect substitutes the two firms may be engaged in price
competition. The firm having lower costs, better goodwill and clientele will drive
the rival firm out of the market and then establish monopoly.
c. If the products of the duopolists are differentiated, each firm will have a close
watch on the actions of its rival firms. The firm good quality product with lesser
cost will earn abnormal profits. Each firm will fix the price of the commodity and
expand output in accordance with the demand of the commodity in the market.

2. Price and Output Determination under Oligopoly

a. If an industry is composed of few firms each selling identical or homogenous
products and having powerful influence on the total market, the price and
output policy of each is likely to affect the other appreciably, therefore they will
try to promote collusion.
b. In case there is product differentiation, an oligopolistic can raise or lower his
price without any fear of losing customers or of immediate reactions from his
rivals. However, keen rivalry among them may create condition of
monopolistic competition.

11.7 PRICE DETERMINATION MODELS OF OLIGOPOLY

1. Kinky Demand Curve

The kinky demand curve model tries to explain that in non-collusive oligopolistic
industries there are not frequent changes in the market prices of the products. The
demand curve is drawn on the assumption that the kink in the curve is always at the
ruling price. The reason is that a firm in the market supplies a significant share of the

142
product and has a powerful influence in the prevailing price of the commodity. Under
oligopoly, a firm has two choices:
a) The first choice is that the firm increases the price of the product. Each firm in
the industry is fully aware of the fact that if it increases the price of the product,
it will lose most of its customers to its rival. In such a case, the upper part of
demand curve is more elastic than the part of the curve lying below the kink.
b) The second option for the firm is to decrease the price. In case the firm lowers
the price, its total sales will increase, but it cannot pushup its sales very much
because the rival firms also follow suit with a price cut. If the rival firms make
larger price cut than the one which initiated it, the firm which first started the
price cut will suffer a lot and may finish up with decreased sales. The
oligopolists, therefore avoid cutting price, and try to sell their products at the
prevailing market price. These firms, however, compete with one another on the
basis of quality, product design, after sales services, advertising, discounts,
gifts, warrantees, special offers, etc.

Figure.11.1 Marginal Revenue Curve

In the above diagram, we shall notice that there is a discontinuity in the marginal
revenue curve just below the point corresponding to the kink. During this
discontinuity the marginal cost curve is drawn. This is because of the fact that
the firm is in equilibrium at output ON where the MC curve is intersecting the
MR curve from below. The kinky demand curve is further explained in the
following diagram:

143
 Figure.11.2 Kinky Demand Curve
In the above diagram, the demand curve is made up of two segments DB and
BD’. The demand curve is kinked at point B. When the price is Rs. 10 per unit,
a firm sells 120 units of output. If a firm decides to charge Rs. 12 per unit, it
loses a large part of the market and its sales come down to 40 units with a loss
of80 units. In case, the producer lowers the price to Rs. 4 per unit, its competitors
in the industry will match the price cut. Its sales with a big price cut of Rs. 6
increase the sale byonly40 units. The firm does not gain as its total revenue
decreases with the price cut.

2. Price Leadership Model

Underprice leadership, one firm assumes the role of a price leader and fixes the
price of the product for the entire industry. The other firms in the industry simply
follow the price leader and accept the price fixed by him and adjust their output to
this price. The price leader is generally a very large or dominant firm or firm with
the lowest cost of production. It often happens that price leadership is established
as a result of price warning which one firm emerges as the winner.
In oligopolistic market situation, it is very rare that prices are set independently
and there is usually some understanding among the oligopolists operating in the
industry. This agreement maybe either tacit or explicit.

Types of Price Leadership

There are several types of price leadership. The following are the principal types:
a) Price leadership of a dominant firm, i.e., the firm which produces the bulk
of the product of the industry. It sets the price and rest of the firms simply
accepts this price.
b) Barometric price leadership, i.e., the price leadership of an old,
experienced and the largest firm assumes the role of a leader, but undertakes
also to protect the interest of all firms instead of promoting its own interests
as in the case of price leadership of a dominant firm.
c) Exploitative or Aggressive price leadership, i.e., one big firm built its
supremacy in the market by following aggressive price leadership. It compels
other firms to follow it and accept the price fixed by it. In case the other firms
show any independence, this firm threatens them and coerces them to follow
its leadership.

Price Determination under Price Leadership

There are various models concerning price-output determination underprice
leadership on the basis of certain assumptions regarding the behavior of the price

144
 leader and his followers. In the following case, there are few assumptions for
determining price-output level underprice leadership
a) There are only two firms A and B and firm A has a lower cost of production
than the firm B.
b) The product is homogenous or identical so that the customers are indifferent
as between the firms.
c) Both A and B have equal share in the market, i.e., they are facing the same
demand curve which will be the half of the total demand curve.

In the above diagram, MCa is the marginal cost curve of firm A and MCb is the
marginal cost curve of firm B. Since we have assumed that the firm A has a lower cost
of production than the firm B, therefore, the MCa is drawn below MCb.
Now let us take the firm A first, firm A will be maximizing its profit by selling OM level
of output at price MP, because at output OM the firm A will be in equilibrium as its
marginal cost is equal to marginal revenue at point E. Whereas the firm will be in
equilibrium at point F, selling ON level of output at price NK, which is higher than the
price MP. Two firms have to charge the same price in order to survive in the industry.
Therefore, the firm B has to accept and follow the price set by firm A. This shows that
firm A is the price leader and firm B is the follower.
Since the demand curve faced by both firms is the same, therefore, the firm B will
produce OM level of output instead of ON. Since the marginal cost of firm B is greater
than the marginal cost of firm A, therefore, the profit earned by firm B will be lesser
than the profit earned by firm A.

11.8 GAME THEORY APPROACH TO OLIGOPOLY

Game theory is concerned with predicting the outcome of games of strategy in which
the participants (for example two or more businesses competing in a market) have
incomplete information about the others’ intentions
Game theory analysis has direct relevance to the study of the conduct andbehavior
of firms in oligopolistic markets for example the decisions that firms must take over
pricing and levels of production, and also how much money to invest in research and
development spending.

145
Costly research projects represent a risk for any business but if one firm invests in
R&D, can arrival firm decide not to follow? They might lose the competitive edge in
the market and suffer a long term decline in market share and profitability.
The dominant strategy for both firms is probably to go ahead with R&D spending. If
they do not and the other firm does, then their profits fall and they lose market share.
However, there are only a limited number of patents available to be won and if all of
the leading firms in a market spend heavily on R&D, this may ultimately yield a lower
total rate of return than if only one firm opts to proceed.

The Prisoner’s Dilemma

The classic example of game theory is the Prisoner’s Dilemma, a situation where two
prisoners are being questioned over their guilt or innocence of a crime.
They have a simple choice, either to confess to the crime (thereby implicating their
accomplice) and accept the consequences, or to deny all involvement and hope that
their partner does likewise.

Nash Equilibrium
Nash Equilibrium is an important idea in game theory .This describes any situation
where all of the participants in a game are pursuing their best possible strategy given
the strategies of all of the other participants.
In a Nash Equilibrium, the outcome of a game that occurs is when player takes
the best possible action given the action of player B, and player B takes the best
possible action given the action of player A.

LET US SUM UP
An oligopoly is a market structure in which a few firms dominate. When a market is
shared between a few firms, it is said to be highly concentrated. Although only a few
firms dominate, it is possible that many small firms may also operate in the market.
Oligopoly is a market structure where only a few large rivals are responsible for the
bulk, if not all, industry output. As in the case of monopoly, high to very high barriers
to entry are typical. Under oligopoly, the price/output decisions of firms are interrelated
in the sense that direct reactions from leading rivals can be expected. As a result, the
decision-making of individual firms is based, in part, on the likely response of
competitors.
The kinky demand curve model tries to explain that in non-collusive oligopolistic
industries there are not frequent changes in the market prices of the products. The
demand curve is drawn on the assumption that the kink in the curve is always at the
ruling price. The reason is that a firm in the market supplies a significant share of the
product and has a powerful influence in the prevailing price of the commodity.

146
Under price leadership, one firm assumes the role of a price leader and fixes the price
of the product for the entire industry. The other firms in the industry simply follow the
price leader and accept the price fixed by him and adjust their output to this price. The
price leader is generally a very large or dominant firm or afirm with the lowest cost of
production. It often happens that price leadership is established as a result of price
warring which one firm emerges as the winner.

CHECK YOUR PROGRESS

Choose the Correct Answer

1. What is a market structure where only a few large rivals are responsible for the
bulk, if not all, industry output?

a) Oligopoly b) Duopoly

c) Pure competition d) All the above

2. The term oligopoly is derived from two Greek words ___________

a) Oleg’s b) ‘Pollen’

c) Both a and b d) None of the above

3. Bertrand, a French Mathematician developed his own model of duopoly in the
year___________

a) 1883 b) 1884

c) 1885 d) 1886

4. Edge worth developed his model of duopoly in the year___________

a) 1897 b) 1884

c) 1885 d) 1886
5. ___________ is a market structure where only a few large rivals are responsible
for the bulk, if not all, industry output.

a) Oligopoly b) Duopoly

c) Pure competition d) All the above

GLOSSARY

Oligopoly : An oligopoly is a market structure in which a few

firms dominate. When a market is shared between
a few firms, it is said to be highly concentrated.
Although only a few firms dominate, it is possible

147
 that many small firms may also operate in the
market.

Kinky demand curve : The kinky demand curve model tries to explain that
in non-collusive oligopolistic industries there are not
frequent changes in the market prices of the
products. The demand curve is drawn on the
assumption that the kink in the curve is always at
the ruling price.

Price leadership : Under price leadership, one firm assumes the role
of a price leader and fixes the price of the product
for the entire industry. The other firms in the industry
simply follow the price leader and accept the price
fixed by him and adjust their output to this price.

Oligopolistic market : In oligopolistic market situation, it is very rare that

prices are set independently and there is usually
some understanding among the oligopolists
operating in the industry. This agreement maybe
either tacit or explicit.

SUGGESTED READINGS
1. Dewett, K K&Navalur,M H (2006), Modern Economic Theory, S. Chand
Publishing, New Delhi.
2. Mehta, P.L. (1997) “Managerial Economics",5th Edition Sultan Chand &
Sons Publications.
3. Mehta, P L,(2016), Managerial Economics Analysis , Problems And Cases,
Sultan Chand & Sons, New Delhi .
4. Mote,V, Samuel Paul , Gupta,G.(2017),Managerial Economics : Concepts
& Cases, Tata McGraw-Hill Publishing Company Limited, New Delhi.
5. Sankaran,S. Dr.3rd Editions (2012), Business Economics, Margham
Publications, Chennai.
6. Varshney, R.L., Maheshwari,K.L. 19th Edition (2014), Managerial
Economics, Sultan Chand & Sons, New Delhi.
7. https://www.youtube.com/watch?v=P0hAiUwU7Ss
8. https://www.youtube.com/watch?v=wYc51ezZDX0
9. https://www.economicsdiscussion.net/oligopoly/price-leadership-under-
oligopoly-with-diagram/3778

ANSWERS TO CHECK YOUR PROGRESS

1) a 2) c 3) a 4) a 5) a

148
Unit 12

PRICING
STRUCTURE

Overview

Learning Objectives

12.1 Methods of Pricing

12.2 Factors affecting Pricing Decision

12.3 Differential Pricing

12.4 Government Intervention and Pricing

Let Us Sum Up

Check your Progress

Glossary

Suggested Readings

Answers to Check Your Progress

OVERVIEW
In the preceding unit, you have been exposed to the meaning and the structure of
the market. In this unit, we shall analyse the methods of pricing. Pricing of the product
by firms is very important aspect of Managerial Economics, since firm’s revenue
mainly depends on its pricing policy. The chief function of the firm is pricing. Pricing
depends on cost of production. Price affects profit which in turn the business. Pricing
explains how prices are determined under different market structures. The manager
is required to have a thorough knowledge of profit. He has to determine suitable price
policies. The success or failure of a firm mainly depends on accurate price decisions.
A correct pricing policy makes the firm to the successful, while an incorrect pricing
policy leads to its failure.

LEARNING OBJECTIVES

After completing this unit, you should be able to,

• analyse the various methods of pricing

• explain the factors affecting pricing

• discuss the differential pricing.

149
12.1 METHODS OF PRICING

a) Full Cost Pricing

Full Cost Pricing is the most common method used for pricing. This method is also
known as ‘Cost Plus Pricing’. Full cost pricing is a practice of adding a certain
percentage of total cost of production to average cost. That is, the selling price of
the product is equal to the cost of production plus anticipated profit. According to
Joel Dean, there are three methods of computing the cost. They are:

(i) the actual costs

(ii) the expected costs and

(iii) the standard cost.

Actual Cost is the cost incurred in the production of an article. It is the historical
cost for the latest available period which includes recent wages, material prices
etc.
Expected Cost is a forecast of actual cost for the pricing period on the basis of
expected prices, output etc.
Standard Cost refers to a normal cost determination at some normal rate of
output with normal efficiency.

Illustration
Suppose the cost of production of a product is Rs.10. If the management decides
to have a mark of 10 per cent as profit, then Re.1 is the addition to the cost.
Hence, the price per unit of the product is Rs.11.
Advantages

1. Full cost pricing is a very simple method.

2. Full cost prices are regarded as fair from the point of view of the
consumers.
3. It enables the firm to make up price lists even before the actual production
begins.

4. It eliminates frequent price fluctuations.

5. It is particularly suitable for industries where there is price leadership.

6. It reduces the costs of decision making.

7. When businessmen are uncertain about the demand conditions for their
product, this method is a safe and secure method.

150
 Limitations

1. This method ignores completely the market demand.

2. It fails to reflect competitive forces.

3. It is useless for the industries whose products are perishable.

4. This method uses only average cost instead of marginal cost. So this
method is not relevant.

5. This method neglects the future cost.

6. Inefficiency during initial stages of producers is not considered and finally
the ultimate consumers suffer.

b) Marginal Cost Pricing

Both under Cost Plus Pricing and Rate of Return Pricing, the prices of products
are determined on the basis of total costs (Variable + Fixed Costs). But under
Marginal Cost Pricing, fixed costs are ignored and price is determined on the basis
of marginal costs or variable costs. Marginal cost pricing implies the practice of
fixing price just to cover the marginal cost incurred in the production of a
commodity. That is, according to marginal cost pricing, the price of the products
should be equal to marginal cost. Marginal cost is the additional cost made to
total cost by increasing one more unit of output.

Advantages

1. This method enables the firms to face competition.

2. It accurately reflects future costs than current costs.

3. It enables a producer to develop an aggressive pricing policy.

4. It is more useful for pricing over the life cycle of a product.
5. It is extremely useful in setting the price of a product produced according
to special orders or for exports.

6. This method is highly useful for public utility undertakings.

Limitations
1. When the executives are not fully aware of this method, they could not
explain the use of this method to the management.
2. During the period of recession, a firm using this method may reduce its
price which will lead to cut-throat competition.
3. This policy neglects the importance of long period. That is, this policy
holds good only when the problem is of a short period only.

151
c) Rate of Return Pricing
This method of pricing is only a refinement of the Full Cost Pricing. Under this
method, the price is determined on the basis of rate of return on investment.
According to this method, the producer considers a pre-determined target rate of
return on capital invested. The rate of return is to be translated into a per cent
mark-up on cost as profit margin. The profit margin is determined on the basis of
normal rate of production. The total cost of a year’s normal production is
estimated and regarded as standard cost. The mark-up percentage of profit
margin is obtained by multiplying capital turn over by the goal rate of return.

Illustration
Suppose the capital turn over I is 0.6 and the goal rate of return I is 12 per cent
on invested capital. Then,
Mark-up Profit Margin = CxR

= 0.6 x 12

= 7.2 per cent.

d) Going Rate Pricing

The Going Rate Pricing is opposite to Full Cost Pricing. Going rate pricing implies
that though the firm has the power to fix up its own price for the product, it will not
do so, but instead it tries to adjust its own price policy with the general pricing
structure prevailing in the industry. This means the firm which practices going rate
pricing policy does not have a price policy of its own; instead, it imitates the price
fixed by others in the industry.

This pricing policy is adopted under the following conditions:

(i) When costs are difficult to measure.
(ii) The adoption of going rate pricing will avoid price war among rival firms,
particularly in oligopolistic market.

(iii) This method avoids unnecessary troubles in calculating actual costs.

The Going rate pricing is usually happening in oligopoly.

Advantages

The following are the important advantages of going rate pricing:

1. This method helps in avoiding cut-throat competition among the firms.

2. This method is a rational pricing method, when costs are difficult to measure.
3. This method is less trouble-some and less costly. Because, exact calculation
of costs and demand is not necessary.

152
 4. This method is suitable to avoid price hazards in oligopoly market.

e) Customary Pricing
When a price prevails for a long period of time, the same price becomes to be a
fixed price for a given commodity. For this situation, there is no deliberate action
on the part of the sellers / producers. Consumers are accustomed to that price
and hence consider it as a rigid price. Such prices are said to be ‘Customary
Price’. In other words, customary pricing refers to charging a price which has
prevailed for a long time. In case, if the firm increases the price, the demand
changes immediately. Thus, there is high degree of elasticity for the product.
Suppose if the firm decreases the price from the customary prices, there will not
be much difference in demand. When demand is slack, producers aim to reduce
the supply rather than reduce the price of the product.

f) Administered Price
The term Administered Price was introduced by J.M. Keynes for the prices
charged by a monopolist. A monopolist being a price maker administers the price
of his product. According to the Indian Economists like L.K. Jha and Malcolm
Adiseshiah, administered price for a commodity is the one which is decided and
arbitrarily fixed by the Government. It is not allowed to be determined by the
market forces of demand and supply. The administered prices are fixed by the
Government to prevent price fluctuations, black marketing, shortages in supply
etc. The Government may adopt administered prices for the commodities like
steel, cement, fertilizers etc. The objective of administered prices is to prevent
sudden rise in their prices and to ensure reasonable prices to the users. If the
prices of these commodities are allowed to rise or fall, the production of final
commodities is affected. The administered prices are fixed on the basis of the
cost of production plus a certain amount of profit.

Characteristics of Administered Prices

The following are the important characteristics of administered prices:

1. They are fixed by the Government.

2. They are statutory, i.e., they are legally enforced by the Government.

3. They are regulatory in nature.

4. They are meant as corrective measures.

5. They are outcome of the price policy of the Government.

g) Skimming Price
For the products that represents a drastic departure from accepted ways of
performing a service, a policy of relatively high prices have coupled with heavy
promotional expenditure in the early stages of the market development and lower

153
 prices at later stages has proved successful for many products. Therefore,
skimming price is the price where the initial price is high. Whenever a firm
introduces a new product, it spends a huge sum of money on advertisements.
The firm may put the product in attractive packages. Therefore, to cover all these
costs, the firm fixes a highest possible price. When it has no rivals, a high price
is fixed for the product. When the new firms enter into the market, then the price
is reduced.

Conditions for the Success of Skimming Prices

The following are the important reasons for the success of the skimming price.
1. The demand is likely to be more inelastic in the early stages than in the later
stages.

2. The cross elasticity is usually very low.

3. The initial advertisement elasticity is very high.

h) Penetration Price
Penetration Price is the reverse of the skimming price policy in which price is
lowered right from the beginning to penetrate the market as quickly as possible.
This policy is intended to maximize the profit in the long-run. Therefore, the firms
adopting the penetration price policy set a low price of the product in the initial
stage. It is due to the fact that the consumers may buy the product at a low price.
As the product catches the market, price is gradually raised up. The objective of
the penetration pricing policy is to keep the rivals away from entering into the
market with substitute products. The low price of the products prevents
competition.

Conditions for the Success of Penetration Price

The success of the penetration price policy requires the existence of the following
conditions in the market:

1. The short run demand for the product has elasticity greater than unity.

2. The economies of large scale production are available to the firm.

3. The market for the product is large.

4. The product should have a high cross elasticity in relation to rival products.

5. The product can be easily purchased by the mass of consumers.

i) Peak Load Pricing

Peak Load Pricing implies the practice of raising the price above the average
variable cost during high demand periods and reducing it towards average
variable cost during low demand periods. For example, the demand for electricity

154
 is high during the day time and low during night time. It is high in a cold country
and low in a hot country. Similarly, the demand for telephone is more during day
time and low during night time. Since these services are not storable, the capacity
to be installed should depend upon that maximum demand, i.e., peak load
demand. Hence, in the case of electricity and telephone, the prices are high for
the peak load period and low for low demand period.

Advantages
1. It depresses peak demand and thereby reduces the total resources needed to
satisfy consumers’ demand.
2. It stimulates peak consumption during slack periods and allows more efficient
155maximization of existing facilities.

12.2 FACTORS AFFECTING PRICING DECISION

The factors affecting pricing decision can be divided into two groups. They are: a)
Internal Factors b) External Factors

a) Internal Factors
Internal factors are generally within the control of the organization. They are
sometimes referred to as “Built-in-Factors” that affect the pricing decision. These
factors include the following:

a) Cost
The most important factor which affects pricing decision is the cost of
production. In the past, the price fixing was a simple affair; just add up all the
costs incurred and divided the final Figure (i.e., total cost) by the number of
units produced. Adding necessary profits with the cost of production would
give the price at which the products are to be sold.
The main defect with this approach is that it disregards the external factors like
demand, competition. Whatever be the cost of production, there is a price at
which the consumer is willing to buy. Furthermore, finding the cost of
production is not so simple today on account of indirect costs.

b) Objectives
Many firms have various objectives and pricing contributes its share in
achieving such objectives. These objectives may be 155maximization sales
revenue, 155maximization market share, maintaining an image, maintaining
stable price etc.

155
b) External Factors
External factors are generally beyond the control of an organization. These
factors include demand, competition, distribution channels, suppliers of raw
materials, economic conditions etc.

a) Demand
The market demand for a product also affects pricing decision. If the demand for
a product is inelastic, high prices may be fixed. On the other hand, if the demand
is elastic, lower prices must be fixed than that of the competitors.

b) Competition
Competition is a crucial factor that influences pricing decision. No producer is free
to fix the price for his product without considering competition, unless he is a
monopolist. A firm can fix the price equal to or lower than that of the competitors,
provided the quality and size of the product are not lower than that of the
competitors.

c) Distribution Channels
The distribution channels also sometimes affect the price. The consumer knows
only the retail price. But there are middlemen working in the channel of distribution
between the manufacturer and the consumer. Each one of them has to be paid
for the services rendered. This compensation must be included in the ultimate
price.

d) Supply of Raw Materials

The suppliers of raw materials also affect the pricing decision. For example, if the
price of cotton goes up, the price of cloths goes up. Hence, scarcity or abundance
of the raw materials also determines the price.

e) Economic Conditions
The inflationary or deflationary tendency affects pricing. During recession period,
the prices are reduced to a sizeable extent to maintain the level of turnover. On
the other hand, the prices are increased in boom period to cover the increasing
cost of production and distribution.
Hence, legal restraints, Government interference such as control of prices, levying
of taxes, etc., are other factors which also affect the pricing decision.

156
12.3 DIFFERENTIAL PRICING
It means charging of different prices from different consumers for the same commodity
at the same time.

12.3.1 Degrees of Differential Pricing

i. First Degree Discrimination

The seller charges different prices for each commodity bought by the same
buyer.

ii. Second Degree Discrimination

The seller charges different prices for blocks of units instead of each item.

iii. Third Degree Discrimination

The seller divides the buyers into different groups keeping in view their income,
location and kinds of uses of the commodity and charge different prices from each
group.

12.3.2 Bases for Price Differentials

The main bases for price differentials are:

• The trade status of the buyer

• The amount of his purchase

• The location of the purchases

• The promptness of payment

• The time of purchase

• The personal situation

12.3.3 Conditions for Differential Pricing

The following are the conditions for differential pricing:

• The seller categorizes the buyers according to their income, location, taste
etc.
• The seller must be able to divide the total market into various sub-markets.

• The seller must prevent the resale of goods from lower to the high priced
market.

12.3.4 Goals of Differential Prices

The producer will have the following goals in adopting differential prices:

157
 • Implementation of marketing strategy to reach a particular sector of the market
through price differentials.
• Differential pricing is adopted to achieve profitable market segmentation, if legal
and competitive considerations permit it.
• Differential prices help to attract new customers.

• Differential prices are major device for selective adjustment to competitive

situations.
• Allowing seasonal discounts reduce the overall production costs by encouraging
off season purchases.

12.4 GOVERNMENT INTERVENTION AND PRICING

Often Governments intervene with the normal process of price determination by fixing
prices either above equilibrium level or below it.The Government should take the
following steps to make this intervention effective or difficulties in price fixing:
i. Examples of attempts to fix prices above an equilibrium level are minimum wage
legislation and price support policies. When Government step is to fix a
minimum price much above the equilibrium price, consumers curtail their
consumption.
On the other hand, farmers are encouraged to increase their production under
the incentive of high prices. As a result, there is disequilibrium between the
demand and supply. There are two ways to maintain prices at a higher level.
a) The Government can buy large quantities to make up the difference
between quantity supplied and quantity demanded.

b) The Government can ask the farmers to cut their output.

ii. Efforts to set maximum prices below the equilibrium level are shown by price
control.
The Government would have to adopt both or either of the following measures:
a) Introduction of Rationing.

b) Payment of subsidy to the producers

LET US SUM UP
In this unit, we have seen the methods of pricing and factors affecting pricing decision.
Further in this unit, we have analyzed the differential pricing and Government
intervention and pricing. Differential pricing means charging of different prices from
different consumers for the same commodity at the same time.

158
CHECK YOUR PROGRESS

Choose the Correct Answer

1. The practice of adding a certain percentage of total cost to average

Cost is ___________

a) Marginal cost pricing b) Full cost pricing

c) Rate of return pricing d) Administered price

2. The practice of fixing price just to cover the marginal cost is ___________

a) Marginal cost pricing b) Full cost pricing

c) Rate of return pricing d) Average cost pricing

3. The charging of different prices from different consumers for the same

Commodity at the same time is called ___________

a) Marginal cost pricing b) Full cost pricing

c) Rate of return pricing d) Differential Pricing

4. The seller charges different prices for blocks of units instead of each

Item is ___________

a) First Degree Discrimination b) Full cost pricing

c) Second Degree Discrimination d) Differential Pricing

5. The seller charges different prices for each commodity bought by the
Same buyer___________

a) First Degree Discrimination b) Full cost pricing

c) Second Degree Discrimination d) Differential Pricing

GLOSSARY

Full cost pricing : Full Cost Pricing is the most common method used
for pricing. This method is also known as ‘Cost plus
pricing’. Full cost pricing is a practice of adding a
certain percentage of total cost of production to
average cost.

Penetration price : Penetration Price is the reverse of the skimming

price policy in which price is lowered right from the
beginning to penetrate the market as quickly as
possible. This policy is intended to maximize the
profit in the long-run. Therefore, the firms adopting

159
 the penetration price policy set a low price of the
product in the initial stage.

Marginal cost pricing : Both under Cost Plus Pricing and Rate of Return
Pricing, the prices of products are determined on
the basis of total costs (Variable + Fixed Costs).
But under Marginal Cost Pricing, fixed costs are
ignored and price is determined on the basis of
marginal costs or variable costs.

Skimming price : For the products that represent a drastic departure

from accepted ways of performing a service, a
policy of relatively high prices coupled with heavy
promotional expenditure in the early stages of
market development and lower prices at later
stages has proved successful for many products.

SUGGESTED READINGS
1. Dewett, K K&Navalur,M H (2006), Modern Economic Theory, S. Chand
Publishing, New Delhi.
2. Mehta, P.L. (1997) “Managerial Economics",5th Edition Sultan Chand & Sons
Publications.
3. Mehta, P L,(2016), Managerial Economics Analysis , Problems And Cases,
Sultan Chand & Sons, New Delhi .
4. Mote,V, Samuel Paul , Gupta,G.(2017),Managerial Economics : Concepts &
Cases, Tata McGraw-Hill Publishing Company Limited, New Delhi.
5. Sankaran,S. Dr.3rd Editions (2012), Business Economics, Margham
Publications, Chennai.
6. Varshney, R.L., Maheshwari,K.L. 19th Edition (2014), Managerial Economics,
Sultan Chand & Sons, New Delhi.
7. https://www.toppr.com/guides/fundamentals-of-economics-and-
management/forms-of-market/pricing-strategies/
8. https://www.youtube.com/watch?v=DMtezEw7VrQ

ANSWERS TO CHECK YOUR PROGRESS

1) b 2) a 3) d 4) c 5) a

160
 BLOCK 4

PROFIT & COST VOLUME ANALYSIS

Unit 13: Profit

Unit 14: Cost Volume Profit Analysis

161
Unit 13

PROFIT
STRUCTURE

Overview

Learning Objectives

13.1 Concept of Profit

13.2 Profit Planning

13.3 Profit Control

13.4 Measurement of Profit

13.5 Profit Maximization

Let Us Sum Up

Check your Progress

Glossary

Suggested Readings

Answers to Check Your Progress

OVERVIEW
Success or failure of any firm depends on profit. A business firm is always profit
motivated. Profit seeking is the motive force of any business. Market economy is,
thus, profit oriented. Reasonable profit is the reward of the entrepreneur for his
entrepreneurial ability. As such, a rational profit policy is important for a modern
business. Hence profit planning is indispensable for a successful firm. Therefore,
profit maximization is the basic objective of each firm. In this unit, let us discuss the
meaning of profit, profit planning, profit control, measurement of profit and profit
maximization.

LEARNING OBJECTIVES

After completing this unit, you should be able to,

• define the concept of profit

• explain the concept of profit planning and profit maximization

• analyse the measurement of profit.

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13.1 CONCEPT OF PROFIT
Profit is the remuneration paid to the entrepreneur for his service (or for the use of his
ability). In other words, profit is the amount left with the entrepreneur after he has
made payments for all the other factors (land, labour and capital) used by him in the
production.

13.2 PROFIT PLANNING

Profit is indispensable for the health and well-being of the business. Hence, in the
operation of the firm, profit planning is considered as a vital operation. Towards that,
a firm considers the expected demand for its product and measures needed to reduce
the cost for increasing profit margin. Hence, appropriate profit planning is necessary
for a firm to realize a high level of profit.

Methods of Profit Planning

To maximise the profit, a firm can use any of the following or more than one method
in its managerial operations:

a) Profit Budget Method

The profit budget method is an annual profit plan prepared by a business firm in order
to estimate the anticipated profit. It is based on the income statement of the firm
relating to the previous year. The firm has to forecast its estimated demand for its
product, price of the product, cost of production of the product for the forthcoming
year. Finally, the expected profit for the forthcoming year is calculated. The profit
budget deals with the activities like production and marketing of the product, getting
and administrating the number of labour required, purchase and storage of raw
materials, securing the required finance etc.
One more aspect of budget is control aspect. Effective control of activities is essential.
Hence, a systematic check on operations is needed to have implementation of budget.

b) Break Even Analysis

The Break Even Analysis studies the relationship between cost of production, volume
of output, sales, revenue and profit. The impact of level of output on costs, revenues
and profits can be studied through this analysis.

c) Rate of Return on Investment Method

To measure the profitability, the rate of return on invested capital can be used. The
rate of return on investment is defined as the quotient (ratio) of the after tax earnings
plus interest charges on bonds to total long term committed funds of the firm.

Therefore,

163
Rate of Return on Investment =
Current Value of Investment − Cost of Investment
Cost of Investment
Normally, the marginal rate of return is used for taking marginal decisions. When the
marginal rate of return is found to be equal to the marginal cost of capital, a firm can
introduce a new product. This method is used as a standard method of measuring
the performance of the business firm.

13.3 PROFIT CONTROL

The use of the profit incentive and profit accounting in the measurement and control
of executive performance in large business enterprises is another managerial aspect
of profits. Perhaps the major internal threat to vitality in the big corporation is
bureaucratic deviation.
Keith Powlison has pointed out three common deviationist tendencies that appear
when the profit motive is attenuated:
1. More energy is spent in expanding sales volume and product lines than in
raising profitability, the valid company objective.
2. Subordinates spend too much time and money doing jobs to perfection
regardless of cost and usefulness. This is particularly common among staff
men who don’t understand or appreciate the insignificance of that last digit in
their estimates and projections.
3. Lower management’s insecurity feelings become barricaded by expensive
overstocking and playing-safe tactics, since there is no reward for imaginative
ventures that can possibly offset the perils of making a mistake.
Companies that have become concerned about this problem have sought methods of
measuring and rewarding executive performance that will guard against this
hardening of the profit seeking arteries. Such plans have two characteristics in
common.
1. The first is realignment of the managerial organization to shift the basic
breakdown of operating responsibility from a functional basis.
2. The second common trait is reorientation of accounting reports to conform to
the areas of executive responsibility. Each executive is given a profit goal for
his operation and his performance is appraised on the basis of periodic profit
and loss statements, as well as subordinate budgetary controls.
This kind of managerial decentralization and control-by-profits has important
advantages for the big company.

164
13.4 MEASUREMENT OF PROFIT
The measurement of the amount of profit earned by a firm during a given period is not
simple. Even in the accounting sense, measurement of profits is not an easy task.
There is a wide variety of generally accepted accounting principles which provide for
different methods of treatment for certain items of revenue or expenditure. They are:

a) Depreciation

b) Valuation of Stock

c) Treatment of Deferred Expenses and

d) Capital Gains and Losses.

a) Depreciation
During the process of production, equipments and machines are used and hence
they are gradually worn out. Some machines may also become obsolete. Hence,
a certain part of the income must be used for the replacement of worn out and
obsolete machines. This amount is called “Depreciation” by the accountants. In
order to measure the true income of a business, this depreciation is made against
the annual income of the business.
Methods of Measuring Depreciation
There are a number of methods of measuring depreciation. The following three
methods are commonly accepted:

i) The Straight Line Method

ii) The Declining Balance Method

iii) The Sum of the Year’s Digits Method

i) The Straight Line Method
This method is simple and is most commonly used method of depreciation.
Under this method, an asset is supposed to wear out evenly during its normal
life. Hence, depreciation is provided on a uniform basis regardless of the fact
that the asset depreciates more rapidly at some stages of its life. The amount
of annual depreciation is obtained by dividing the initial cost of the assets by
the estimated life in years, assuming that there is no scrap value (residual
value of the asset). If the asset has an estimated scrap value, the scrap
value has to be deducted from the initial cost before dividing it by the estimated
life in years. This method is known as the ‘Straight Line Method’ because of
the successive values of depreciation is plotted against the life time of the
asset, as the fall in a straight line. The formula to calculate depreciation under
the straight-line method is:
D = (F-S)/n

165
 where,
D= Annual Depreciation
F= Original value of the Asset
S= Scrap value of the Asset
n= Life of the Asset in years.
Illustration
Suppose an asset has an original value of Rs. 9,000 with a scrap value of
Rs.900 and the life of the asset is 9 years. The depreciation charge on this
asset will be:

D = Rs. 990
Under the “Working Hours Method”, the life of the asset is expressed
in terms of working hours, rather than in years. Under this method,
depreciation is calculated by dividing the initial cost less scrap value by the
number of working hours.
Illustration
Suppose an asset has a working life of 12000 hours whose original cost is
Rs.40,000 and its scrap value is Rs.4000. The depreciation per working hour
will be:

= Rs.3 per working hour

ii) The Declining Balance Method

Under this method, depreciation is provided on a uniform rate on the written
down value of the asset at the beginning of the year. If the cost of the asset
is Rs.10,000 and the rate of depreciation is 20 per cent, the depreciation for
the first year would be Rs.2,000 (20 per cent of Rs.10,000 i.e., 20/100 x
10,000). The written down value of the asset at the beginning of the second
year would be Rs.8,000 (10,000 – 2000). Then the depreciation for the second
year would be Rs.1,600 (20 per cent of Rs.8,000, i.e., 20/100 x 8000) and the
value of the asset at the beginning of the third year would be Rs.6,400
(Rs.8,000 – Rs.1,600). Then the depreciation for the third year would be
Rs.1,280 (20 per cent of Rs.6,400, i.e., 20/100 x 6400).
Thus, the depreciation amount will show a declining trend of Rs.2,000 for the
first year, Rs.1,600 for the second year and Rs.1,280 for the third year. Under
this method, the written down value however small, will never be zero. Hence,
the asset is assumed to have some scrap value.

The formula for determining the fixed rate of depreciation is as follows:

d = 100

where,

166
 d = Percentage of Depreciation

s = Scrap Value

c = Initial cost of the Asset

n = Estimated Life of the Asset in Years.

The method of computing the fixed rate of depreciation as described above is
rather complicated. A similar and more widely used method is to use a uniform
percentage which is double the reciprocal of the estimated life.

Uniform Rate or d = 2 (…….)

The basic idea behind the use of this method is to provide for a more or less
uniform total cost of operation of the asset over different years of its life. On
the other hand, under this method, depreciation is higher in earlier part of the
life of the asset, but it declines progressively in the later years. The
combined effect is that the total charge in the profit and loss account for the
asset concerned is more or less equated over different years.

iii) The Sum of the Year’s Digits Method

The basic idea of this method is similar to that of the Declining Balance
Method, i.e., to provide for a uniform total cost of operation of the asset. The
amount of depreciation in the beginning of the life of the asset is higher and it
progressively declines with the passage of time. The variable rate of
depreciation is calculated as follows:
(i) Each digit of the years of the usual life of the asset is added up and
the resulting Figure is the denominator of the fraction to find out the
depreciation rate.
(ii) The numerator of the fraction for each year is the expected life of the
asset in that particular year and this declines by one, each year.
Thus, the depreciation rate is composed of a varying numerator and
an unvarying denominator. And this rate is applied each year to the
assets original cost.

Illustration
The sum of the year’s digit method can be explained by a simple illustration.
Suppose the original cost of an asset is Rs.10,000, its scrap value is Rs.1,000
and its expected life is 5 years. In the beginning, the asset has an expected
life of 5 years, one year later it has an expected life of 4 years and so on.
Thus the expected life periods of the asset are 5, 4, 3, 2 and 1 years. The
sum of these expected life periods is 15 (5+4+3+2+1) years which will be the
common denominator of the annual rates. The numerators are 5/15, 4/15,
3/15, 2/15 and 1/15 respectively. The original value of the asset is Rs.10,000

167
 and the scrap value is Rs.1,000 and hence the depreciation charge should be
made for Rs.9,000 (Rs.10,000 – 1,000).
The calculation of annual depreciation, accumulated depreciation and book
value of the asset by the sum of the year’s digits method is shown in Table
11.1.

Age of Rate of Annual Accumulated Book

the Depreciation Depreciation Depreciation Value
Assets of the
in the Asset
Asset

1 5/15 or 33 3,000 3,000 7,000

1/3%

2 4/15 or 26 2,400 5,400 4,600

3/8%

3 3/15 or 20% 1,800 7,200 2,800

4 2/15 or 13 1,200 8,400 1,600

1/3%

5 1/15 or 6 2/3% 600 9,000 1,000

Depreciation and Profit

From this, we can understand that the amount of profit of a firm depends on the
method of depreciation adopted. With the same machine, equipment, building,
etc., different firms can show different amounts of depreciation and consequently,
different amounts of profit.
b) Valuation of Stock
In business, the valuation of stock will influence the profit. The method adopted
to calculate the valuation of stock will have the impact on the profit. There are
three common methods of valuation of stocks. They are:

i) First in First Out Method (FIFO)

ii) Last in First Out Method (LIFO)

iii) Weighted Average Method.

i) First In First Out Method (FIFO)

This method assumes that the raw materials purchased first will always be
the used first. Hence, when the earlier purchases have been consumed, the
later purchases will be used, i.e., first in stock should go out first and the

168
 stock acquired very recently will be used later. As a result, the inventory is
supposed to consist of goods purchased most recently.

ii) Last In First Out Method (LIFO)

This method assumes that the raw materials purchased very recently will be
used in production. Under this method, the prices of the most recently
purchased stocks become the costs of raw materials in current production.
As a result, the inventory (the closing stock) earlier is supposed to consist of
goods purchased earlier. Cost of goods sold under LIFO approximates their
replacement cost.

iii) Weighted Average Method.

This method assumes that it is not possible to identify the cost of goods
purchased at different times at different prices. Since the cost of one unit of
good in the stock cannot be distinguished from the cost of another, the goods
in the stock are priced at an average of the cost of each purchase, weighted
by the quantity purchased at that cost. As a result, inventory also gets
valued at the average cost.

Illustration
The above three methods of valuation of stock can be explained with a
simple illustration.
Suppose a firm purchases 500 kg of raw materials at different times at
different prices as per the details given below:

Purchased on February 7th :100 kg @ Rs.2.25= Rs.225

Purchased on June 19th:150 kg @ Rs.2.50= Rs.375

Purchased on June 21st:250 kg @ Rs.2.75= Rs.687.50
Suppose, on September 11, the stores department issued a quantity of 200
kg of the raw materials to the production department. Then the calculation
of value of stock on hand under the three methods are:
Under FIFO method, the raw material issued to the production department
(200 kg) will be valued at Rs.475 (100 kg @ Rs.2.25 = Rs.225 plus
100 kg @ Rs.2.50 = Rs.250) and the stock will be valued at Rs.812.50 (50
kg @ Rs.2.50 = Rs.125 plus 250 kg @ Rs.2.75 = Rs. 687.50). According to
this method, the first acquired should go out first.
Under LIFO method, the raw materials issued to the production department
will be valued at Rs.550 (200 kg @ Rs.2.75) and the stock will be valued at
Rs.737.50 (50 kg @ Rs.2.75 = Rs.137.50 plus 150 kg @ Rs.2.50 = Rs.375

169
 plus 100 kg @ Rs.2.25 = Rs.225). Under this method, recently procured
materials should be issued first.
Under Weighted Average Method, the raw materials issued will be valued at
Rs.515.

X Quantity of Raw materials Issued

x 200=Rs.515 and the stock will be valued at Rs.772.50

x Remaining Stock

x (500 – 200)

x 300 = Rs.772.50
Thus, it will be seen that the value of the stock is different under different
methods.
c) Treatment of Deferred Expenses and
The firm will have intangible fixed assets. This intangible fixed asset can be
classified into two categories, namely,
(i) those having a limited life, i.e., Patents and Copy right, Licenses and
Permits etc., and
(ii) those having no such limited life, e.g., Trade Marks, Goodwill,
Preliminary Expenses etc.
Businessmen prefer to write off the intangible assets during their life time, because
they are having a limited life. Sometimes, the businessmen prefer to write off
these intangible assets even before their useful life expires. For example, this
type is provided by copyrights. The copyrights have a legal life equal to author’s
life plus 50 years thereafter. But publications rarely have an active market for
such a long period. It is therefore, considered advisable to write off the cost of
copyright against the income from the first edition.
The treatment of intangible fixed asset with no limited life is more complicated
because of the following reasons:
(i) There is a difference of opinion, whether the assets should be written off at
all or not.
(ii) If they have to be written off, what should be the period for their
amortization? This amortization may be done either gradually or by an
immediate write off.
For example, this type is provided by “Goodwill”. The goodwill should be written
off immediately upon or after acquisition, because goodwill is a fancy asset which
has no place in the balance sheet. This is the conservative view which is not

170
 wholly commendable because sometimes goodwill is based on certain important
factors giving decisive advantage to the firm. In that case, a more rational view
would be to write off the goodwill over an appropriate period of time. And there is
always room for difference of opinion on what is an appropriate time.
Regarding preliminary expenses of the firm, it is regarded as a permanent asset.
Because, they are expected to benefit the company so long as it continues in
operation. But, the conservative view is that they are a sheer loss and therefore,
they must be written off as soon as possible. Accountants have regarded the
preliminary expenses as deferred charge on profits to be written off during the
early of the company’s life, say 5 to 7 years.

d) Capital Gains and Losses.

The conservative companies may decide not to include capital gains in the current
profit. At the same time, they would like to write off capital losses from the current
profits of the year in which the loss occurs. On the other hand, a company may
decide to include the capital gains in the profits of the year in which capital gains
may occur. So far as capital losses are concerned, it may decide to write off, out
of retained earnings. Thus, the amount of profit would also be affected by the
treatment of capital gains and losses. It would be lower in the case of conservative
companies than in the case of non-conservative companies.

13.5 PROFIT MAXIMISATION

Profit maximization is the basic objective of each firm. Because, the success of a firm
is based on the volume of profit earned by it. Most firms want to limit short-run profits
in order to maximize long-run profit. All activities of the firms are to limit the size of
the profit in the short-run by the following ways:
1. Firms often aim at becoming leader in their respective industries even if it means
higher costs and lower profit. In such firms, profit 171 maximization is
subordinated to industry leadership.
2. When a firm aims at 171maximization profits, it attracts competitors to enter the
field and share the market. To avoid such competitors, a firm may follow a policy
of profit restriction rather than a policy of profit 171maximization.
3. High profits are often regarded as an index of monopoly power. They may
create an impression that the firm is exploiting the consumers. Hence,
Government may investigate into its profits. Therefore, the firms may decide to
aim less than the maximum profits.
4. A policy of profit restraint rather than profit 171maximizations may be followed
in order to maintain goodwill of the customers.
5. Much management give greater importance to financial soundness of a firm and
hence prefer liquidity to profit maximization. This is because; profit maximization

171
 often enters into the new areas of production involving a huge investment in
fixed assets and consequent reduction in liquidity.
6. Profit maximization may involve an element of risk. Business executives may
avoid such risks because in case of failure, they may loss their job, status and
image.
7. If the firm maximizes its profit, trade unions will demand high wages, which
increases the costs and also creates management problems. Thus, to avoid
such problems and to maintain good labour relations, profit control is imperative.

LET US SUM UP
In this unit, we have defined the concept of profit. Profit is the reward paid to the
entrepreneur for his service. Profit planning is indispensable for a successful firm.
We have also discussed the meaning and methods of profit planning, namely, Profit
budget method, Break Even Analysis and Rate of return on investment. In this unit,
we have analyzed the measurement of profit and profit maximization, because profit
maximization is the sole objective of each firm.

CHECK YOUR PROGRESS

Choose the Correct Answer

1. The relationship between cost of production, volume of output, sales,

revenue and profit is called ___________

a) Profit planning b) Profit control

c) Profit budget d) Break Even Analysis

2.______________ is the remuneration paid to the entrepreneur for his

service.

a) Profit b) Profit control

c) Profit budget d) Break Even Analysis

3._______________is an annual profit plan prepared by a business firm

in order to estimate the anticipated profit.

a) Profit planning b) Profit control

c) Profit budget d) Break Even Analysis

4.To measure the ____________, the rate of return on invested capital can be used.

a) Break Even Analysis b) Profit control

c) Profitability d) Break Even Analysis

5. The method adopted to calculate the valuation of stock will have the

172
impact on the ___________

a) Profit b) Profit control

c) Profit budget d) Break Even Analysis

GLOSSARY

Profit : Profit is the remuneration paid to the entrepreneur

for his service (or for the use of his ability)

Profit planning : Profit is indispensable for the health and well-

being of the business. Hence, in the operation of
the firm, profit planning is considered as a vital
operation.

Profit control : The use of the profit incentive and profit

accounting in the measurement and control of
executive performance in large business
enterprises is another managerial aspect of profits.
Perhaps the major internal threat to vitality in the
big corporation is bureaucratic deviation.

Depreciation : During the process of production, equipment's and

machines are used and hence they are gradually
worn out. Some machines may also become
obsolete. Hence, a certain part of the

Valuation of stock : In business, the valuation of stock will influence

the profit. The method adopted to calculate the
valuation of stock will have the impact on the
profit.

SUGGESTED READINGS
1. Dewett, K K&Navalur,M H (2006), Modern Economic Theory, S. Chand
Publishing, New Delhi.
2. Mehta, P.L. (1997) “Managerial Economics",5th Edition Sultan Chand & Sons
Publications.
3. Mehta, P L,(2016), Managerial Economics Analysis , Problems And Cases,
Sultan Chand & Sons, New Delhi .
4. Mote,V, Samuel Paul , Gupta,G.(2017),Managerial Economics : Concepts &
Cases, Tata McGraw-Hill Publishing Company Limited, New Delhi.
5. Sankaran,S. Dr.3rd Editions (2012), Business Economics, Margham
Publications, Chennai.

173
 6. Varshney, R.L., Maheshwari,K.L. 19th Edition (2014), Managerial Economics,
Sultan Chand & Sons, New Delhi.
7. https://corporatefinanceinstitute.com/resources/accounting/types-
depreciation-methods/
8. https://www.economicsdiscussion.net/profit/profit-maximization-model-of-a-
firm-with-diagram/6129

ANSWERS TO CHECK YOUR PROGRESS

1) d 2) a 3) c 4) c 5) a

174
Unit 14

COST VOLUME PROFIT ANALYSIS

STRUCTURE

Overview

Learning Objectives

14.1 Introduction

14.2 Meaning of Break-Even Analysis

14.3 Break Even Point

14.4 Determination of BEP

14.5 Assumptions

14.6 Managerial Uses of Break-Even Analysis

14.7 Limitations of Break-Even Analysis

Let Us Sum Up

Check your Progress

Glossary

Suggested Readings

Answers to Check Your Progress

OVERVIEW
In the preceding unit, we have seen the profit planning and profit control. Profit
maximization is the basic objective of each firm, for which Cost Volume Profit Analysis
is essential. Hence, in this unit let us discuss this analysis in an elaborate manner.
This analysis has considerable significance for economic research, business decision
making, company management and public policy. This analysis is also useful to
understand the financial relationship among cost, revenue and the rate of output.
Capital budgeting is also necessary for a successful firm.

LEARNING OBJECTIVES

After completing this unit, you should be able to,

• define Break-Even Point and Capital Budgeting

• examine the Break-Even Analysis

• explain the managerial uses of BEA

• analyse the evaluation techniques for the appraisal of projects.

175
14.1 INTRODUCTION
Mathematical techniques are now considered as an effective aid towards solving
management problems. Business executives and others are supposed to have a
good knowledge of mathematical techniques. In this topic, we deal in an elementary
way with the important mathematical technique, Break Even Analysis, which is used
for managerial decision making.

14.2 MEANING OF BREAK EVEN ANALYSIS

The Break-Even Analysis studies the relationship between the volume and cost of
production on the one hand and the revenue and profits obtained from the sales on
the other hand.

14.3 BREAK-EVEN POINT (BEP)

The Break-Even Point (BEP) is the point at which the total revenue is equal to the
total cost and consequently the net profit is equal to zero. That level or point is said
to be ‘No-Profit, No-Loss’ point

BREAK-EVEN CHART
A Break-Even Chart is the graphic form of the relationship between production and
sales or profits. Figure 12.1 illustrates the break-even chart.

Figure. 14.1 Break-Even Chart

In Figure 14.1, X axis represents output and Y axis represents total cost / total
revenue. Both the Total Cost (TC) and the Total Revenue (TR) curves are shown as
linear.TR curve is linear because of the assumption of constant variable costs. TR
curve is drawn as a straight line from the origin because every unit of output
contributes constant amount to total revenue.TC curve is also a straight line starting
from Y axis because total cost includes fixed and variable costs. In the chart, ‘B’ is
the break-even point at which TR equals TC at OQ level of output. So the net profit is
zero at this level of output OQ. That is OQ is the level of output where the firm makes
neither profit nor loss. Below the break-even point, total cost is more than total
revenue and the firm would suffer a loss. Above the break-even point, total revenue

176
exceeds total cost and the firm would make profit. Since profit or loss occurs between
cost and revenue lines, the space between them is known as the “Profit Zone” (to the
right of the BEP) and the “Loss Zone” (to the left of the BEP).
The Break-Even Chart can also be represented in an alternative form (Figure: 14.2)
where the contribution to fixed cost (contribution margin) and profits is clearly
depicted.

Figure. 14.2 The Break-even Chart (Alternative Form)

14.4 DETERMINATION OR CALCULATION OF BEP

The BEP is determined either in physical units or in money terms (i.e., in terms of
sales value of total output).
(i) BEP in terms of physical units

This method is useful for a firm that produces a single product.

In this method, we use AR and AC concepts instead of TR and TC. Then, the BEP
is to be found out at a level of output where AR is equal to AC. AR is nothing but
price. So AR or price must cover the AVC in full and part of FC. The difference
between the selling price and variable cost per unit (AVC) is the “Contribution
Margin”. BEP can be found out at a point of output, where the total “Contribution
Margin” is equal to TFC. The following formula can be used to find BEP:
TFC
BEP =
P −AVC

where,

BEP = the break-even point

TFC = the total fixed cost

P = the selling price

AVC = the average variable cost

177
 Obviously, P–AVC measures the contribution margin per unit.

Examples
1. An establishment is producing only one product. It sells at Rs.7.50 per unit. The
Fixed Cost is Rs.40,000 and Variable Cost is Rs.3.50 per unit. How
many units must be produced to Break-Even and how many units of the product
must be produced to get a profit of Rs.10,000? What would be the profit if
12,000 units are produced?

Solution

Break-Even Point (in units) = 10,000 Units.

BEP (units) to earn a profit of

Rs.10,000 = 12,500 units.

Profit at sales of 12,000 units = TR – TVC – TFC

=PQ – (AVC) Q – TFC

= 7.5 x 12,000 –(3.5x12000)

- 40,000

=90,000 – 42,000 – 40,000

= 90,000 – 82,000

= Rs.8,000.
2. Suppose the Fixed Cost of a factory is Rs.6,012 and the Variable Cost isRs.3 per
unit and the selling price is Rs.9 per unit. Find out the Break- Even Point.
Solution
BEP = 1002 units.
Answer
The Break-Even Point is reached, when the factory sells 1002 units.

TR = PQ = Rs.9 x 1002 = 9018

TC = TFC + TVC = 6012 + (1002 X 3)

= 6012 + 3006 = Rs.9,018

Hence, [Net Profit is 0 TR – TC = 9018 – 9018 = 0].

(ii) BEP in terms of sales value

This method is used when a firm is engaged in multi-products. Under this method,
TR and TC concepts are used. The BEP is determined in terms of money or sales
value. The difference between the total sales value (TR) and Total Variable Cost

178
 (TVC) is called ‘Contribution Ratio’. Then the formula to calculate BEP is as
follows:
Total Fixed Cost
BEP = ContributionRatio

The formula to find out the ‘Contribution Ratio’ is as follows:

TR−TVC
Contribution Ratio (CR) = TR

Examples
1. A firm incurs a Fixed Cost of Rs.40,00 and Variable Cost of Rs.10000.The
total sales receipts is Rs.15000. Determine the BEP.
Solution
TR−TVC
CR = TR
15000−1000 1
= =3
15000
=
TFC 4000 4000 x 3
BEP = = 1 = 1 =12000
CR ⁄3

Answer
The Break-Even Point is reached when the firm’s sales value is Rs.12,000.
2. The Fixed Cost of a factory is Rs.6,000 per year. The Variable Cost is
Rs.12,000. The sales value is Rs.18,000. Find out the Break-Even Point.
Solution
TR−TVC
CR = TR
18000−12000
= 18000
1
=3

BEP =6,000 x 3

= Rs.18, 000.

Answer

The Break-Even Point is reached when the firm’s sales value is Rs.18,000.

14.5 ASSUMPTIONS OF BREAK-EVEN ANALYSIS

The Break-Even Analysis is based on the following assumptions.

1. The total cost can be classified into fixed cost and variable cost. It
ignores semi-variable cost.
2. The volume of sales and volume of production are equal. So, there is
no closing stock.

179
 3. The selling price remains constant.

4. The variable costs vary proportionately with volume.

5. It assumes constant technology and no improvement in labour
efficiency.

6. The factor prices remain unaltered.

7. Both the total cost and total revenue are assumed to be linear.

14.6 MANAGERIAL USES OF BREAK-EVEN ANALYSIS

The following are the important managerial uses of the Break-Even Analysis:

i) Safety Margin
The Break-Even Analysis is useful to calculate ‘Safety Margin’. Safety Margin
refers to the extent to which the firm can afford a decline in sales before it starts
incurring loss. Safety Margin can be calculated by using the following formula:
Sales−BEP
Safety Margin= × 100
Sales

Example
The sales volume of a firm is 45000 units and the BEP is 27000 units. Find the
Safety Margin.

Solution
45000−27000
Safety Margin = x 100
45000
18000
= x 100
45000

= 0.4 x 100= 40

ii) Target Profit

The Break-Even Analysis is also useful to determine the volume of sales needed
to secure a target profit. The formula to calculate the target sales volume is:
TFC−Target Profit
Target Sales Volume = Contribution Margin

Example
If Total Fixed Cost of a firm is Rs.36,000, selling price is Rs.6 per unit and
Variable Cost per unit is Rs.3, find out the volume of sales to achieve a profit
target of Rs.9,000.

Solution
TFC−Target Profit
Target Sales Volume = Contribution Margin

180
 Contribution Margin= Price – AVC

=6–3=3

Therefore,
36000−9000
Target Sales Volume = 3

= 9000

iii) Change in Price

Whenever the firm reduces the price, there will be a reduction in the Contribution
Margin. This means that, to remain at the same level of profit, the firm has to
increase its output. The following formula can be used to calculate the increase
in volume of output in order to maintain the same level of profits.
TFC−Target Profit
New Sales Volume = Contribution Margin

Example
If Total Fixed Cost of a firm is Rs.9,000, profit target is Rs.27,000, selling price is
Rs.12 per unit and Variable Cost is Rs.3 per unit. Suppose the firm decides to
reduce the price from Rs.12 to Rs.9, find the new sales volume to maintain the
same level of profit.

Solution
TFC−Target Profit
Target Sales Volume = Contribution Margin

Contribution Margin= Price – AVC

= 12 – 3 = 9

Therefore,
9000 −27000
Target Sales Volume =
9

=- 2000
If the firm decides to reduce the price from Rs.12 to Rs.9

Contribution Margin= Price – AVC

=9–3=6

Therefore,
9000 −27000
New Sales Volume =
6
−18000
= 6

= - 3000.

181
iv) Change in Costs
The impact of an increase in Variable Cost is to push up the total cost. As a
result, Contribution Margin declines. This decline in the Contribution Margin will
shift the Break-Even Point downwards. Likewise, a fall in the Variable Cost
increases the Contribution Margin and the Break-Even Point moves upwards.
When Variable Cost changes, the business executive has to decide about the
new price or the new sales volume to maintain the previous level of profit.

The formulae to calculate the new sales volume and the new sales price are:

1. The New Sales Volume=

2. New Sales Price = Present Selling Price + New Variable
Cost – Present Variable Cost
Example
The Contribution Margin is Rs.9,000, the present selling price is Rs.9 and the
present Variable Cost is Rs.3. If the Variable Cost per unit rises from Rs.3 to
Rs.6, find the new sales volume and new selling price.

Solution
New Sales Volume =
= 3,000 units
New Selling Price =Present Selling Price + New
Variable Cost – Variable Cost
= 9 + 6 – 3= Rs.12.

v) Make or Buy Decision

The Break-Even Analysis also helps to decide whether components which are
part of their finished products should be manufactured by themselves or bought
from outside firms.

Example
A manufacturer of bicycle buys a certain part of a bicycle at Rs.90 each. If
he decides to manufacture it himself, his Fixed Cost would be Rs.36,000 and the
Variable Cost per unit is Rs.60. Find out the Break-Even Point.

Solution
TFC
BEP =𝑃−𝐴𝑉𝐶
36000
= 90−60
36000
= 30

= 1,200 units

182
 The manufacturer can produce the parts himself, if he needs more than 1,200
units. If his requirement is less than 1,200 units, it is better to buy from outside
firms.

vi) Advertising Decisions

The Break-Even Analysis helps the management to examine the effects of
different levels of advertising expenditure and different modes of advertisement

14.7 LIMITATIONS OF BREAK-EVEN ANALYSIS

Even though the BEA has many managerial uses, it has several limitations. They are:
1. It assumes that profit is a function of output only. But the firm may increase
profit without increasing its output, by adopting a new technique which cuts
costs.
2. In BEA, everything is assumed to be constant. But costs and revenues may
change over a period of time.
3. The BEA is based on accounting data. It neglects imputed costs, takes the
arbitrary depreciation estimates and considers the inappropriate allocation
of overhead costs.
4. The BEA assumes cost and revenue functions are linear. In fact, the linearity
of cost and revenue functions are real only for a limited range of output.
5. The Break-Even Chart cannot be drawn for the firm’s producing and selling
multiple products.
6. The BEA assumes that the volume of production and volume of sales are equal.
But they may not be equal always.
7. It is very difficult to handle selling cost such as, advertisement and sales
promotion in a Break-Even Chart.

LET US SUM UP
In this unit, we have introduced the concept of Break Even Point. Break Even point is
the point at which the total revenue equals total cost and consequently the net profit
is equal to zero. That point is said to be “No-Profit, No-Loss” point. The Break Even
Analysis studies the relationship between the volume and cost of production on the
one hand and the revenue and profits obtained from the sales on the other hand.
Capital Budgeting is the planning of expenditure for assets, which will yield a series
of returns over future time periods.

183
CHECK YOUR PROGRESS

Choose the correct answer

1.The Break-Even Analysis is useful to calculate___________

a) Safety Margin b) Target Profit

c) Change in Price d) Change in Costs

2. Break Even Point is also called ___________

a) Safety Margin b) Target Profit

c) Change in Price d) Cost Volume and Profit analysis

3.The total cost can be classified into fixed cost and___________

a) Safety Margin b) Target Profit

c) Variable Cost d) Change in Costs

4. Break-Even Analysis helps the management to examine the effects of

different levels of___________

a) Safety Margin b) Target Profit

c) Variable Cost d) advertising expenditure

5. Whenever the firm reduces the price, there will be a reduction in the

___________Margin

a) Safety Margin b) Target Profit

c) Contribution d) advertising expenditure

GLOSSARY
Break Even point : The Break-Even Point (BEP) is the point at
which the total revenue is equal to the total cost
and consequently the net profit is equal to zero.
That level or point is said to be ‘No-Profit, No-
Loss’ point
Safety margin : The Break-Even Analysis is useful to calculate
‘Safety Margin’. Safety Margin refers to the
extent to which the firm can afford a decline in
sales before it starts incurring loss.
Advertising Decisions : The Break-Even Analysis helps the
management to examine the effects of different
levels of advertising expenditure and different
modes of advertisement.

184
SUGGESTED READINGS
1. Dewett, K K&Navalur,M H (2006), Modern Economic Theory, S. Chand
Publishing, New Delhi.
2. Mehta, P.L. (1997) “Managerial Economics",5th Edition Sultan Chand &
Sons Publications.
3. Mehta, P L,(2016), Managerial Economics Analysis , Problems And Cases,
Sultan Chand & Sons, New Delhi .
4. Mote,V, Samuel Paul , Gupta,G.(2017),Managerial Economics : Concepts
& Cases, Tata McGraw-Hill Publishing Company Limited, New Delhi.
5. Sankaran,S. Dr.3rd Editions (2012), Business Economics, Margham
Publications, Chennai.
6. Varshney, R.L., Maheshwari,K.L. 19th Edition (2014), Managerial
Economics, Sultan Chand & Sons, New Delhi.
7. https://www.investopedia.com/terms/b/breakevenpoint.asp
8. https://www.yourarticlelibrary.com/accounting/break-even-point/break-
even-point-meaning-assumptions-uses-and-limitations/65309

ANSWERS TO CHECK YOUR PROGRESS

1) a 2) d 3) c 4) d 5) c

185
 BLOCK 5
NATIONAL INCOME

Unit 15: National Income

Unit 16: Fiscal Policy

Unit 17: Monetary Policy

186
Unit 15

NATIONAL INCOME
STRUCTURE
Overview
Learning Objectives

15.1 Meaning of National Income

15.2 Definition of National Income

15.3 National Income Concepts

15.4 Measurement of National Income

15.5 Importance of National Income Estimate

15.6 Difficulties Encountered in the Estimation of National Income

Let Us Sum Up

Check your Progress

Glossary

Suggested Readings

Answers to Check Your Progress

OVERVIEW
National Income is an important indicator of economic development of any country.
Hence, it is imperative to know the meaning, concepts, measurement and difficulties
encountered in the estimation. Business cycles and unemployment affects national
income, and in turn, retard economic development of developing countries. Hence, if
any developing country wants to attain economic development, first it has to take
necessary measures to increase national income. In order to increase national
income, the developing country should know the causes for the economic factors like
business cycles and unemployment and take necessary steps to solve these
problems.

LEARNING OBJECTIVES

After completing this unit, you should be able to,

• describe the concepts of National Income, unemployment and business cycles

• classify different National Income concepts.

187
15.1 MEANING OF NATIONAL INCOME
National Income means aggregate income of a country during a given period, usually
one year

15.2 DEFINITION OF NATIONAL INCOME

According to the National Income Committee of India, “A national income estimate
measures the volume of commodities and services turned out during a given period
counted without duplication”.

15.3 NATIONAL INCOME CONCEPTS

i) Gross National Product (GNP)

It is the total value of all final goods and services produced in the country in one
year.

ii) Net National Product (NNP)

When we subtract depreciation charges for renewals and repairs from GNP, we
obtain Net National Product.

NNP at market prices = GNP at market prices – Depreciation

iii) Net National Income at Factor Cost

It is the sum total of all income payments made to the factors of production. The
sum total of goods and services are produced by the co-operation of factors of
production. Hence, the money value of the goods and services is to be
distributed among the factors of production. Therefore, national income may also
be regarded as the total of income received by the factors of production used in
production. So, Net National Income at Factor Cost shows the income actually
received by the factors of production. Hence,

NNI at Factor Cost = NNI at Market Price + Subsidies

- Indirect Taxes – Government Earned Profits

iv) Personal Income

It is the total of income received by all persons from all sources. It consists of
wages and salaries, interest, rent and dividends received by individuals including
the corporate bodies. It also includes the mixed incomes of self-employed
persons like farmers and shop keepers and all transfers received from public
authorities such as pension. Therefore,
Personal Income = National Income – Undistributed Profits of
Companies - Corporate income tax- Social
Security Contribution + Transfer Payments

188
v) Disposable Income
It is obtained by deducting personal direct taxes from the personal income. The
personal taxes are in the form of income tax, wealth tax, expenditure tax
and professional tax. Hence, disposable income denotes the actual income
which can be used by the individuals. Therefore,

Disposable Income = Personal Income – Personal Taxes

vi) Per capita Income

It is obtained by dividing the national income by total population. Therefore,

National Income
Per capita Income = Total Population

15.4 MEASUREMENT OF NATIONAL INCOME

i) The Product Method

According to this method, national income is calculated by adding together
the net value of all goods and services produced in a country during one year.

ii) The Income Method

According to this method, national income is estimated by adding together all
incomes accruing to the factors of production in the form of rent, wage, profit and
interest.

iii) The Expenditure Method

According to this method, national income is estimated by adding together the
consumption expenditure, gross private domestic investment, state purchase of
goods and services and net foreign investment.

iv) Social Accounting Method

All economic transactions of a country are classified into Productive Enterprises,
Financial Intermediaries and Final Consumers. Each sector will maintain
accounts of their receipts and payments. By totaling these accounts, the national
income is estimated.

15.5 IMPORTANCE OF NATIONAL INCOME ESTIMATE

• National income estimates are the most important tools for economic planning.
A country cannot frame a plan without having a prior knowledge of the trends in
national income.
• National income Figure enables us to have an idea of the inflationary and
deflationary gaps.

189
 • Modern Governments try to prepare their budgets within the framework of
national income data.
• National income estimates show how national expenditure is divided between
consumption expenditure and investment expenditure.
• With the help of national income estimates of various countries, we can compare
the standards of living of people of these countries.
• National income Figure enables us to know the relative roles of public and
private sectors in the economy.
• National income estimates reveal the contributions made by various sectors of
the economy such as agriculture, industry, trade etc.
• National income estimates help us to find out the distribution of national
income among different categories of income such as rent, wage, profit and
interest.
• By comparing national income estimates over a period of time, we can know
whether the economy is growing or stagnant or declining.
15.6 DIFFICULTIES ENCOUNTERED IN THE ESTIMATION OF NATIONAL
INCOME
• The definition of ‘Nation’ itself is a problem in the estimation of national
income. For example, national income does not refer to income produced
within the country alone. But, income earned from other countries is also
included.
• Commodities and services having money value are included in the national
income, but there are goods and services performed for love and kindness
are having economic value but have no money value. Whether these services
should be included in national income and how to measure their money value.
• Another difficulty is regarding the method to be used in the estimation of national
income.
• Yet another difficulty is the non-availability of statistical data.

• A very important difficulty is inadequacy of efficient and trained personnel’s.

• People of developing countries like India are illiterate and they do not keep
proper accounts. Even, if they keep any accounts, they are highly unreliable.
• One more difficulty is that of transfer payments. A person receives income, a
part of it may have been received as interest payment on Government loans.
This part is in the nature of transfer payments and may be taken either as the
income of the individual or of the Government.

190
 • Another important difficulty is “Double Counting”. Double counting implies
the possibility of a commodity like raw material being included in national
income more than twice. For example, a former sells wheat to mill-owner, the
mill-owner further sells the wheat flour to a wholesaler who further sells it to a
retailer and who in turn sells it to the consumers. If we calculate it at every
stage, its money value will increase.
• Income earned through illegal activities like gambling, smuggling, illicit
extraction of liquor is not included in the national income.

LET US SUM UP
National income is an uncertain term which issued interchangeably with national
dividend, national output and national expenditure. On this basis, national income has
been defined in a number of ways. National income means the total value of goods
and services produced annually in a country.
National income is the total net value of all goods and services produced within a
nation over a specified period of time, representing the sum of wages ,profits, rents,
interest, and pension payments to residents of the nation. It is the total amount of
income earned by the citizens of a nation.
The National Income Unit of the Central Statistical Organization (CSO)estimates a
major part of the national incomes by the product method, e.g., in sectors like
agriculture, animal husbandry, forestry, fishing, mining and factory establishments.

CHECK YOUR PROGRESS

Choose the Correct Answer

1. The amount obtained by deducting personal taxes from the personal income is
called___________

a) Disposable income b) Personal income

c) Per capita income d) National income

2.__________ means aggregate income of a country during a given period, usually
one year.

a) Disposable income b) Personal income

c) Per capita income d) National income

3.The total value of all final goods and services produced in a country in one year is
called _________

a) Disposable income b) Personal income

c) GNP d) National income

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4._________ method, national income is calculated by adding together the net value
of all goods and services produced in a country during one year.

a) Product b) Supply

c) Income d) None of the above

5.___________ method, national income is estimated by adding together all incomes
accruing to the factors of production in the form of rent, wage, profit and interest.

a) Product b) Supply

c) Income d) None of the above

GLOSSARY
National income : National income is an uncertain term
which is used interchangeably with
national dividend, national output and
national expenditure. On this basis,
national income has been defined in a
number of ways. National income means
the total value of goods and services
produced annually in a country.
Gross Domestic Product : Gross Domestic Product (GDP) is the
total market value of all final goods and
services currently produced within the
domestic territory of a country in a year.
Gross National Product : Gross National Product is the total
market value of all final goods and
services produced in a year.GNP
includes net factor income from abroad
whereas GDP does not.

SUGGESTED READINGS
1. Dewett, K K&Navalur,M H (2006), Modern Economic Theory, S. Chand
Publishing, New Delhi.
2. Mehta, P.L. (1997) “Managerial Economics",5th Edition Sultan Chand &
Sons Publications.
3. Mehta, P L,(2016), Managerial Economics Analysis , Problems And Cases,
Sultan Chand & Sons, New Delhi .
4. Mote,V, Samuel Paul , Gupta,G.(2017),Managerial Economics : Concepts
& Cases, Tata McGraw-Hill Publishing Company Limited, New Delhi.
5. Sankaran,S. Dr.3rd Editions (2012), Business Economics, Margham
Publications, Chennai.

192
 6. Varshney, R.L., Maheshwari,K.L. 19th Edition (2014), Managerial
Economics, Sultan Chand & Sons, New Delhi.
7. https://www.economicsdiscussion.net/national-income/4-main-concepts-
of-national-income/17241
8. https://www.economicsdiscussion.net/national-income/measure/how-to-
measure-national-income-top-3-methods/12678

ANSWERS TO CHECK YOUR PROGRESS

1) a 2) d 3)c 4)a 5)c

193
Unit 16

FISCAL POLICY
STRUCTURE

Overview

Learning Objectives

16.1 Fiscal policy

16.2 Objectives of fiscal policy of India

16.3 Fiscal policy and economic growth

16.4 Fiscal policy and full employment

16.5 Fiscal policy and Social justices

16.6 Fiscal policy and Economic stabilization

16.7 Role of fiscal policy in developing countries.

Let Us Sum Up

Check your Progress

Glossary

Suggested Readings

Answers to Check Your Progress

OVERVIEW
Fiscal policy is a part of general economic policy of the government, which is primarily
concerned with budget receipts and the expenditure of the government. Fiscal policy
explains the tax and expenditure policy of the government. It encompasses two
separate but related decisions, public expenditures and the level and structure of
taxes. The amount of public outlay, the incidence and effects of taxation and the
relation between expenditure and revenue exert a significant impact upon free
enterprise economy.

LEARNING OBJECTIVES

After completing this unit, you should be able to

• define fiscal policy

• list out the objectives of fiscal policy

• discuss fiscal policy and economic growth.

194
16.1 INTRODUCTION
Fiscal policy is defined as the conscious attempt of the government to achieve certain
macro-economic goals of policy by altering the volume and pattern of its revenue and
expenditures and the balance between them. The major economic goals of fiscal
policy are to maintain a high average level of employment and business activity, to
minimize fluctuations in employment activity, prevent inflation and to produce and
promote economic growth.
The fiscal policy is used to control inflation through making deliberate changes in
government revenue and expenditure to influence the level of output and prices. It is
a budgetary policy. Fiscal policy is the use of government taxes and spending to alter
macroeconomic outcomes of the country. During the great depression of the 1930s
people were out of work, they were unable to buy goods and services therefore
government had to increase, to regulate macroeconomic values and money supply.
The use of government spending and taxes to adjust aggregate demand is the
essence of fiscal policy. The simplest solution to the demand shortfall would be to
increase government spending. The government increases it’s spending through
construction of tanks, schools, highways. This increased spending is a fiscal stimulus.
Economic stability is a macro goal of the fiscal policy of a country whether developed
or developing. By economic stabilization it means; controlling recession or depression
and price stability.

16.2 OBJECTIVES OF FISCAL POLICY OF INDIA

1. To maintain economic stability in the country

2. To bring Price stability

3. To achieve full employment

4. To provide social justice

5. To promote export and introduce import substitution

6. To mobilize more public revenue

7. To reallocate available resources

8. To achieve balanced regional growth.

Instruments:
The major instruments to be used to control inflation and to achieve the above said
objectives are

(i) Taxation

(ii) Public borrowings

(iii) Deficit financing.

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Fiscal policy deals with the government expenditure and its composition. Government
expenditures are classified into two categories as capital expenditure and
consumption expenditure. The spending on construction of road, dams and others are
called as capital expenditure. Government expenditure on consumption of goods and
services are called as consumption expenditure. The interest paid by the government
against the borrowings or national debt is called as interest payment. Governments’
transfer of money from one sector to other is called Transfer of payments.

16.3 FISCAL POLICY AND ECONOMIC GROWTH

Developed economies aim at attaining full employment through long term fiscal policy.
Keynesian analysis of fiscal policy is considered as short-term view whereas post
Keynesian economists like Hanson, Harrod and Domer have tried to extend
Keynesian analysis to a more comprehensive long-term theory of income and
employment. Therefore, the main objective of long-term fiscal policy in developed
country is conceived to be the maintenance of a steady growth of full employment
income without inflation or deflation in order to avoid secular stagnation or secular
inflation.
According to Harrod and Domer, investment plays a vital role in the process of
economic growth. In the process of secular growth, along run dis-equilibrium may
occur in a mature economy. The reason behind this dis-equilibrium may be the income
does not grow at a rate just sufficient to ensure full capacity use of a growing capital
stock. Thus, the objective of growth and full employment in the long run is associated
with problem of enlarging capacity through investments in capital goods sector.
Therefore, in the long run, employment is the function of the rate of growth, investment
and income.
But the role of fiscal policy in a developing country is different because this type of
countries is caught in the grip of vicious circle of poverty, and quite obviously the aim
and objective of long-term fiscal policy in the countries should be breaking the vicious
circle of poverty. Rapid economic growth is the long-term objective of fiscal policy in
poor countries and thereby to break the circle.
Fiscal policy aims at fulfilling following objectives while used as a means of
encouraging economic growth:
• Providing revenue to public enterprises.

• Imposition of additional taxes

• Realizing and channelizing the potential resources into productive projects.

• Direct physical control.

• Increase in the rate of taxation.

• Public dept.

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 • Deficit financing.

• To promote investment into socially desirable channels.

• Inducing and stimulating private investment.

To change the direction and pattern of investment and production so that general
economic welfare is improved and to level the gap of the distribution of wealth and
income. (reframe the highlighted sentence)

16.4 FISCAL POLICY AND FULL EMPLOYMENT

According to Keynes, public finance is a compensatory finance which should aim at
full employment and to maintain it. To attain this let us see some of the suggestions
made by Keynes-
a) Deficit budget: Budgetary policy should be designed to Figure deflation and
unemployment. A deficit budget will bring about expansionary effects in a
stagnant economy.
b) Tax Policy for Stimulation: The tax policy should be designed in such way that
it stimulates consumption and investment both. To affect this, indirect taxes
should be brought to minimum so that purchasing power of the people should
increase and effective demand increases. Direct taxes should also follow the
same policy so as to step up investment
c) Compensatory Public Spending: Compensatory public expenditure and public
sector investment play a vital role in attaining full employment in the present-day
public policy. Public expenditure and public works like road construction,
buildings, parks, school, colleges, hospitals, canals etc. This will stimulate
effective demand and volume of employment.
d) Public debt management: Efficient and effective public debt management can
be used for achieving full employment. This can happen when public expenditure
is partly financed through public borrowings. Government should follow cheap
money policy so that burden of public debt will not be much. Government should
borrow from the people with whom money remains idle.
Democratic governments aim at providing maximum social welfare which can be
attained through providing social justice which lie in equitable distribution of income
and wealth. Fiscal policy can serve as an effective means of achieving this much
desired objective through expenditure, tax and debt policy. Therefore, budget policy
should aim at re-distribution of wealth by taxing more to the rich and by providing free
medical, education, housing and other social up liftment measures.

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16.5 FISCAL POLICY AND SOCIAL JUSTICES

Anti-Depressionary Fiscal Policy

Keynes advocated the effectiveness of fiscal policy to overcome depression.
According to Keynes, depression is the consequence of deficiency in effective
demand and that can be overcome by a deficit budget policy.

A deficit budget policy during depression follows the following strategies -

1) Reduction in direct taxes.

2) Increases in public expenditure and

3) Repayment of public debt

These strategies will tend to increase the flow of total expenditure and thereby the
size of effective demand which as per Keynes, pull out a country from the state of
depression.
Expenditure could be increased through two different prescriptions-pump
priming and compensatory spending.
Pump priming refers to that initial public expenditure which helps to initiate and revive
economic activity in a depressed economy. The idea is aimed at increasing private
investment through public expenditure.
Compensatory spending on the other hand, refers to government expenditure which
is undertaken with the idea of compensating the decline in private investment.
Depression brings down the private investment because of the low marginal efficiency
of capital, whose automatic revival is not possible. Thus, the government having no
other alternative than to resort to public investment fills the gap in private investment.

Deficit Financing
Keynes’ another suggestion to raise the effective demand is deficit financing which
means the government spends more than its revenue and thereby relying on
unbalanced budget. It rises public spending because the public have extra purchasing
power in their hand and consequently effective demand rises.

Fiscal Policy during Inflation

The economy which has initiated economic growth makes huge investment to
construct social overhead capital, infrastructure of the economy and development of
heavy industries which all have a long gestation period, and returns are not
immediate, shortage of consumption goods are felt. This leads to rise in prices. This
demand pull inflation causes wages to go up and resultantly cost push inflation is
generated. This vicious circle of inflation has to be checked through appropriate fiscal
measures. Therefore, in order to arrest the inflation, fiscal policy should aim at curbing

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the flow of expenditure, particularly consumption expenditure and reduce the demand.
Hence a surplus budget policy will help which may have the following prescriptions.
i) Increases in direct taxes to squeeze the purchasing power of the people and
reduce their consumption expenditure.

ii) Reduction in public expenditure and

iii) Attempt to increase public debt by issuing bonds etc., to seize people’s
purchasing power.

16.6 FISCAL POLICY AND ECONOMIC STABILIZATION

Economic stability is a macro- goal of the fiscal policy of a country whether developed
or developing. By economic stabilization it means -Controlling recession or
depression and Price stability as well as Checking inflation or deflation.

16.7 ROLE OF FISCAL POLICY IN DEVELOPING COUNTRIES.

The role of fiscal policy in the developing countries has to be different from that of in
developed countries for the obvious reason that the task of fiscal policy in developing
country is or ought to be rapid economic growth.

Objective of Fiscal Policy in Developing Countries

i. Capital Formation: Fiscal policy in the developing countries aims at the
formation of high rate of capital. Private capital is generally shy in these countries
and so the government has to fill up this lacuna.
ii. Allocation of Resources: Another objective of fiscal policy in a poor country is
to divert existing resources from unproductive sectors to productive socially more
desirable projects.
iii. Social Justice: Equitable distribution of wealth and income in the society is
another important objective of the fiscal policy. Though, equitable distribution of
wealth and income and economic growth-are two paradoxical issues. Hence
difficulty arises. Equitable distribution reduces aggregate savings as the
propensity to consume of the poor people is high and the propensity to save of
the rich people reduces. Socialism brings social justice but not growth. Hence,
government has to choose between capitalistic system suitable for high growth
or socialism.

LET US SUM UP
Fiscal policy is an important and integral part of modern public finance. It is related to
government spending, taxation, borrowing and management public debt. Therefore,
fiscal policy comprises, budget instruments and government transactions designed to
further general economic development and allied objectives.

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It operates through both taxation and expenditure programs of the government.
Obviously, fiscal policy relates itself with aggregative effects of public expenditure and
taxation on income, output and employment.

CHECK YOUR PROGRESS

Choose the Correct Answer

1. Equitable distribution of wealth and income in the society is another

important objective of ___________

a) Fiscal policy b) Deficit budget

b) Deficit financing d) All of them

2. ___________ which means the government spends more than its

revenue and thereby relying on unbalanced budget

a) Deficit budget b) Deficit financing

b) Fiscal policy d) All of them

3. A___________ will bring about expansionary effects in a stagnant economy

a) Deficit budget b) Production Budget

b) Purchase budget d) All of them

4. ___________ is defined as the conscious attempt of the government to achieve
certain macro-economic goals of policy by altering the volume and pattern of its
revenue and expenditures and the balance between them

a) Deficit budget b) Production Budget

c) Fiscal Policy d) All of them

5. Fiscal policy in the developing countries aims at the formation of high rate of capital
___________

a) Rate of Interest b) Rate of Capital

c) Profit d) Income

GLOSSARY
Fiscal Policy : Fiscal policy is defined as the conscious attempt
of the government to achieve certain macro-
economic goals of policy by altering the volume
and pattern of its revenue and expenditures and
the balance between them.
Deficit budget : Budgetary policy should be designed to
Figurants deflation and unemployment. A deficit

200
 budget will bring about expansionary effects in
a stagnant economy.
Deficit Financing : Keynes’ another suggestion to raise the
effective demand is deficit financing which
means the government spends more than its
revenue and thereby relying on unbalanced
budget. It rises public spending because the
public have extra purchasing power in their
hand and consequently effective demand rises.
Capital Formation : Fiscal policy in the developing countries aims at
the formation of high rate of capital. Private
capital is generally shy in these countries and so
the government has to fill up this lacuna.

SUGGESTED READINGS
1. Dewett, K K&Navalur,M H (2006), Modern Economic Theory, S. Chand
Publishing, New Delhi.
2. Mehta, P.L. (1997) “Managerial Economics",5th Edition Sultan Chand &
Sons Publications.
3. Mehta, P L,(2016), Managerial Economics Analysis , Problems And Cases,
Sultan Chand & Sons, New Delhi .
4. Mote,V, Samuel Paul , Gupta,G.(2017),Managerial Economics : Concepts
& Cases, Tata McGraw-Hill Publishing Company Limited, New Delhi.
5. Sankaran,S. Dr.3rd Editions (2012), Business Economics, Margham
Publications, Chennai.
6. Varshney, R.L., Maheshwari,K.L. 19th Edition (2014), Managerial
Economics, Sultan Chand & Sons, New Delhi.
7. https://www.economicsdiscussion.net/fiscal-policy/top-8-objectives-of-
fiscal-policy/4694
8. https://www.yourarticlelibrary.com/policies/role-of-fiscal-policy-in-
developing-countries/26320

ANSWERS TO CHECK YOUR PROGRESS

1) a 2) b 3) a 4) a 5) b

201
Unit 17

MONETERY POLICY
STRUCTURE

Overview

Learning Objectives

17.1 Meaning of the Monetary Policy

17.2 Neutrality of Money

17.3 Price Stability and Control of Business Cycles

17.4 Full Employment

17.5 Monetary Policy and Economic Growth

Let US Sum Up

Check your Progress

Glossary

Suggested Readings

Answers to Check Your Progress

OVERVIEW
Monetary policy plays a vital role in shaping the economy of a country because money
and credit influence tremendously the course, nature and volume of economic
activities. A keenly and appropriately weaved monetary policy can significantly aid
economic growth by adjusting the money supply according to the needs of economic
growth by directing the flow of funds into desired channels. Apart from that, monetary
policy can make available the institutional credit to the much desired and required
economic pursuit more appropriately, in the present-day management of the
economy, monetary policy plays an extremely important role of stabilizing the
economy.

LEARNING OBJECTIVES

After completing this unit, you should be able to,

• discuss monetary policy

• explain the neutrality of money.

17.1 MEANING OF THE MONETARY POLICY

Monetary policy is an important tool in the hands of the monetary authority (more often
central bank of the country) to regulate the flow of money in the economy according

202
to needs at a particular point of time. Through this tool, the monetary authority
achieves many macroeconomic goals. The need for monetary policy is felt because
money can’t manage itself. Monetary management itself therefore, the main issue of
monetary policy.
According to Prof.Wrightsman, the deliberate effort by the central bank to control the
money supply and credit condition for the purpose of achieving certain broad
economic objectives. (Something needs to be added, sentence incomplete).
In the Indian context, monetary policy comprises those decisions of the government
and the Reserve Bank of India which directly influence the volume and composition
of money supply, the size and distribution of credit, the level and structure of interest
rates, and the direct and indirect effects of these monetary variables upon related
factors such as savings and investment and determination of output, income and
price.
Monetary policy is only a means to an end and not an end in itself. Monetary policy
has to be structured and operated within the institutional framework of the money
market of the country. Credit control measures and decisions are the constituent
elements of a monetary policy.
In a developing economy there are two factors of monetary policy-Positive and
Negative. In its positive aspect, it sets out the promotional role of central banking in
improving the savings ratio and expanding credit for facilitating capital formation. In
its negative approach, it implies a regulatory phase of restricting credit expansion, and
its allocation according to the absorbing capacity of the economy.

17.2 NEUTRALITY OF MONEY

According to some economists like Wicks Steed, Hayek and Robertson the best
monetary system is one in which money is neutral. Money should be a passive factor.
It should not be allowed to interfere with economic forces like productive efficiency,
real cost of production and consumer preferences. Therefore, according to them
money should facilitate exchange alone. The quantity of money should be controlled
in such a way that the total output, the total transactions and prices of goods and
services being exactly what they would be in an efficient barter economy.

It implies that the monetary authority must keep the quantity of money perfectly stable.
The neutral money concept has been criticized severely by many economists as
follows:
• It is based on the out-dated concept of quantity theory of money - The critics have
discarded the concept of neutrality of money as an outdated concept which can’t
be practiced in the modern day management of the economy.
• Neutrality can’t guarantee price stability - In modern economy in which
technological and scientific developments play a vital role in increasing

203
 production and under such conditions quantity of money is kept fixed, it would
only lead to deflationary conditions.
• Neutral money policy not suitable during depression- During depression when
prices are falling neutral money policy will not hold good. There is the need to
have active money policy during depression.
• Contradictory and impractical - The concept of neutral monetary policy and the
very purpose for which it is suggested are not only contradictory but also
impractical. This is based on concept of laissez - faire philosophy and existence
of perfect competition, have been rejected long back in modern dynamic
economy.
Therefore, as a conclusion it can be said that a neutral money policy can’t check the
occurrence of business cycle in an economy and that money has come to stay as an
active element in a modern economy.

17.3 PRICE STABILITY AND CONTROL OF BUSINESS CYCLES

In Normal cases, capitalism has inborn characteristics of fluctuations in prices and
cyclical variations among other disadvantages of monetary system under capitalism.
Therefore, according to Cassel and Keynes and others, a more important aim of
monetary policy is to achieve and maintain price stabilization and normal business
activity through regulating the credit appropriately.

Arguments in favour of Price Stabilization

• Smooth production and distribution: Price instability create difficult problem
of production and distribution, affecting differently different sections of the
community. Precisely, there are innumerable evil aspects of inflation or
deflation.
• Eliminates the Evils of Inflation and Deflation: Both inflation and deflation
bring reduction in social welfare and hardships to individuals. Inflation reduces
purchasing power and thereby reduces economic welfare, deflation brings fall
in production, employment and income and thereby hardships. Therefore,
stability of price can prevent these evils.
• It eliminates socio-economic disturbances: Changes in price level cause
disturbances in economic relationships within a country and among countries as
well. This may bring dire economic and social consequences to all concerned.
Therefore, price stabilization is prescribed to eliminate these disturbances.
• It Leads to Economic Stabilization: By eliminating cyclical fluctuations price
stability leads to economic stabilization. Apart from the above, price stabilization
leads to equity in distribution and economic welfare also.

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Arguments against price stabilization
• Price stability is opposed generally following grounds

• It is a Vague Policy- The concept of price stabilization is vague and thereby it is

difficult to determine the price level to be selected for stabilization.
• Obstructs Economic Growth - Price stabilization as the potentials of hindering
economic development, as it will remove much of the price incentives to the
business community and as such productive activity will suffer from stagnation.
• It is not suited for a dynamic economy.

• It ignores the importance of relative prices and changes in working of the market
economy.
• It also has the potentials to adversely affect economic relations.

• It is impractical.

• In fact, a mild inflation of the magnitude of 2 to 3 percent is suggested for the

smooth growth and economic development of an economic.

17.4 FULL EMPLOYMENT

Most economists considered attainment of full employment as for most and ideal
objective of monetary policy after the publication of “General Theory” of Keynes. Thus,
the use of monetary policy for promoting full employment is of recent origin. Many
modern economists are of the view that, economic stabilization can be combined with
the objective of having a full level of employment. By encouraging saving and
investment, monetary policy can play an effective role in realizing its objective of full
employment. Many modern economists feel that the proper aim of a monetary policy
is neither price stability nor neutrality of money, but optimum utilization of resource full
employment level.

17.5 MONETARY POLICY AND ECONOMIC GROWTH

Economic growth is undoubtedly the primary goal of any country. Therefore, monetary
policy is taken into help for achieving this goal. Though, till recently many economists
considered monetary policy as a short-term policy primarily aimed at full employment
and mitigating cyclical fluctuations and not concerned with economic growth.
However, recreantly it has been realized by the economists and the managers of the
economy that mere achieving full employment is not enough but the economy should
aim at achieving continuous and faster economic growth for providing a high standard
of living to the people. Some economists like Howard Ellis, are strongly opposed of
the idea of the role monetary policy is economic growth because they fear inflation.
Still there are economists like Whittlesey, who strongly support the role of monetary
policy in economic growth and argue that since economic growth is the primary aim
of the general economic policy which is a part of the general economic policy, there

205
is no reason why monetary policy should not be directed to achieve this objective.
Monetary policy can contribute to the achievement of economic growth in two ways-

1) Management of aggregate demand

It is expected from the monetary authority to keep the aggregate demand for
money in balance with the aggregate supply of goods and services. For this, a
flexible monetary policy is required. A tight or dear restrictive money policy will
have to be applied when there is excess demand on the economy threatening to
raise prices and create conditions of unsustainable boom. Contrary to that are
expansionary or cheap credit policy has to be followed when there deficiency a of
aggregate demand and supply is in excess casing a fall in prices, production,
employment and income.
It is argued that a tight money policy impedes while an easy money policy
promotes economic growth. But both are extremist views whereas the truth lies in
the mid-way. A tight money policy is not conductive to growth when it is applied at
a wrong time. In a situation when demand is deficient and resources are
unemployed, an easy money policy is most suitable. But if it is carried beyond the
limit, it will generate inflationary pressure and to control it. A tight money policy
would be need. Therefore, a flexible monetary policy has been advocated to
achieve economic growth with price stability. Precisely, monetary policy can assist
in promoting economic growth by maintaining reasonable price stability and
optimum use of economic resources in an economy.

2) Encouragement to saving and investment

Monetary authority can help economic development by creating favorable
environment for saving and investment which is the backbone of the economic
growth. For this monetary policy should aim at price stabilization. Price stability
encourages saving and investment. Saving being the main source of capital
formation, when saving increases under favorable circumstances,
capital formation can also be accelerated which in turn accelerate economic
growth.

Exchange Rate Stability and Equilibrium in the Balance of Payments

A smooth operation of international trade depends upon exchange rate stability
and this in turn brings confidence internationally. Instability in exchange rate might
lead to undesirable effects such as weakening of the currency in the world market,
speculation and even flight of capital.
The objectives of exchange stability of a monetary policy could easily achieve
equilibrium in the balance of payments of a country under the gold standard.
Traditionally, countries that have faced disequilibrium in their balance of payment,
have used monetary policy for correcting it.

206
 Following are the ways through which a restrictive monetary policy tends to reduce
country’s balance of payments deficit: -
• It forces domestic demand downwards and thereby reduces the demand for
imports and of domestic goods.
• Fall of domestic demand ease down the pressure of inflation which makes
imported article less attractive. At the same time exports become more
attractive.
• Under dear money policy, higher interest rates make it less attractive for
foreign countries to borrow from the deficit country and induce them to invest
there.

LET US SUM UP
Monetary policy refers to all such decisions and measures of the monetary authorities,
state and central bank, influencing money supply and credit situation in the monetary
system as a whole with a view to full fill certain macro-economic goals.
Monetary policy basically deals with two aspects of credit- 1) The cost of credit and
2) The availability of credit. Monetary policy involves three major steps- 1) Choice of
objectives 2) Implementation of the policy and 3) Relationship between action and
steps. Major objectives of monetary policy include–Neutrality of money, exchange
rate stability, price stability, full employment and economic growth.

CHECK YOUR PROGRESS

Choose the Correct Answer:

1. ___________ should be a passive factor

a) Money b) Cost
c) Investment d) Pricing
2. Price stability encourages saving and___________
a) Money b) Cost

c) Investment d) Pricing
3. Both inflation and ___________bring reduction in social welfare and hardships to
individuals.

a) Deflation b) Cost

c) Investment d) Pricing

4. Economic growth is undoubtedly the___________ goal of any country

a) Primary b) Secondary

c) Investment d) Pricing

207
5. Changes in___________level cause disturbances in economic

relationships within a country and among countries as well.

a) Price b) Secondary

c) Investment d) Cost

GLOSSARY

Monetary policy : Monetary policy is an important tool in the hands of

the monetary authority (more often central bank of
the country) to regulate the flow of money in the
economy according to needs at a particular point of
time. Through this tool, the monetary authority
achieves many macroeconomic goals.

Neutrality of Money : According to some economists like Wicks Steed,

Hayek and Robertson the best monetary system is
one in which money is neutral. Money should be a
passive factor.

Economic growth : Economic growth is undoubtedly the primary goal of

any country. Therefore, monetary policy is taken into
help for achieving this goal. Though, till recently many
economists considered monetary policy as a short-
term policy primarily aimed at full employment and
mitigating cyclical fluctuations and not concerned
with economic growth.

SUGGESTED READINGS
1. Dewett, K K&Navalur,M H (2006), Modern Economic Theory, S. Chand
Publishing, New Delhi.
2. Mehta, P.L. (1997) “Managerial Economics",5th Edition Sultan Chand &
Sons Publications.
3. Mehta, P L,(2016), Managerial Economics Analysis , Problems And
Cases, Sultan Chand & Sons, New Delhi .
4. Mote,V, Samuel Paul , Gupta,G.(2017),Managerial Economics : Concepts
& Cases, Tata McGraw-Hill Publishing Company Limited, New Delhi.
5. Sankaran,S. Dr.3rd Editions (2012), Business Economics, Margham
Publications, Chennai.
6. Varshney, R.L., Maheshwari,K.L.19th Edition (2014), Managerial
Economics, Sultan Chand & Sons, New Delhi.
7. https://corporatefinanceinstitute.com/resources/economics/neutrality-of-
money/

208
 8. https://www.thebalancemoney.com/what-is-monetary-policy-objectives-
types-and-tools-3305867

ANSWERS TO CHECK YOUR PROGRESS

1) a 2) c 3) a 4) a 5) a

209
210
211
 SYLLABUS

Course Title :Accounting for Managers

Course Code : MSPS 13

Course Credit : 6

Course Objective :

CO 1.Discuss accounting concepts and conventions, differentiate book keeping

and accounting, identify users of accounting information. Explain double
entry system of accounting and construct accounting cycle. Prepare final
accounts to know the financial position of the business.
CO 2.Explain the financial statement analysis and techniques to analyse the
financial statements of the company. Discuss various ratios to show the
liquidity and profitability position of the business. Demonstrate the
preparation of cash and fund flow statement.
CO 3.Define cost accounting, classify various kinds of cost and list out elements of
cost. Prepare cost sheet to estimate the cost of materials and overheads and
identify issues while framing the price. Combine overheads with cost centre.
CO 4.Explain marginal costing along with break even and cost volume analysis.
Applying marginal costing techniques for making decisions. Examine the role
of budgets in organisations, their limitations and the issues to consider when
developing and using budgets for planning and control.
CO 5.Explain standard costing and its procedure for setting standards. Classifying
the different forms of variances. Illustrate the significance of computerized
accounting system and pre-packaged accounting software.

BLOCK I: Introduction to Accounting

Introduction to Accounting: Book-Keeping and Accounting – Financial Accounting -
External and Internal users of Accounting Information, Concepts and Conventions –
Double Entry System - Accounting cycle - Financial Accounting – Preparation of
Journal, Ledger and Trial Balance – Preparation of Final Accounts –Income
Statement and Balance Sheet With Adjustment Entries - Capital and Revenue
Expenditure and Receipts.

BLOCK II: Financial Statement Analysis

Financial Statement Analysis: Horizontal Analysis and Vertical Analysis of Company

Financial Statements – Ratio analysis - Liquidity, leverage, solvency and profitability
ratios - Preparation and analysis of cash flow statement and funds flow statement.
BLOCK III: Cost Accounting

Cost Accounting: Classification of Cost - Elements of Costs - Preparation of Cost

Sheet - Materials Costs: Materials purchasing, receiving, storing and issuing
including pricing of issues- EOQ – Overheads - Identifying the overheads with cost
centre -Allocation, Apportionment and Absorption.

BLOCK IV: Marginal Costing

Marginal Costing: Concept – Advantages and Disadvantages – Break even analysis
– Cost volume profit analysis (CVP) – Application of Marginal Costing Techniques,
Fixing Selling Price, Make or Buy, Accepting a Foreign Order, Deciding Sales Mix -
Budget and Budgetary control – Objectives - Type of budgets – Preparation of
Cash, flexible and master budgets

BLOCK V: Standard Costing

Standard Costing: Meaning and uses - procedure of setting standards - Variance

Analysis- Classification of Variances- Material Cost, Labour Cost, Overhead Cost
And Sales Variance– responsibility accounting and report writing - Excess present
value method -Significance of Computerized Accounting System - Prepackaged
Accounting software

References:
1. Brigham & Ehrhardt, (2015), Financial Management Text and cases, latest
Edition, Cengage Learning, India
2. Chandra &Iyer, (2012), Financial Management, latest Edition, IBH, India
3. James C Van Horne, Sanjay Dhamija,(2012), “Financial Management and
Policy” latest Edition, Pearson Education, India
4. Khan. M.Y., P K Jain (2014), “Financial Management-Text and Problems”,
7th Edition, McGraw Hill Education, India
5. Pandey IM, (2013),Financial Management, 10th Edition, Vikas, India
6. Prasanna Chandra, (2012), “Financial Management Theory and Practice”,
8th Edition. TMH , India

7. Preeti Singh, (2012), Financial Management, Latest Edition, Ane books PVT
Ltd., Chennai.
8. Rajiv Srivastava, Anil Mishra , (2012), Financial Management” latest Edition,
Oxford University Press, New Delhi
9. Shashi K.Gupta, R.K.Sharma , (2012), “Financial Management” latest
Edition, Kalyani Publishers, Chennai
 10. TulsianP.C.,C.A. Bharat Tulsian , (2019), “Financial Management” latest
Edition, S.Chand Publications, New Delhi.
11. https://nptel.ac.in/courses/110101003
12. https://testbook.com/learn/financial-statement-analysis/amp
13. https://www.wallstreetmojo.com/cost-accounting/
14. https://www.tutorialspoint.com/accounting_basics/cost_accounting_marginal
_costing.htm
15. https://www.wallstreetmojo.com/standard-cost/

Course Outcome :

CLO 1. Comprehend the basic concepts of accounting, examine the difference

between single and double entry system and demonstrate accounting life
cycle, examine the nature and role of financial statements.
CLO 2. Evaluate the financial statement by show the financial position of the
business and illustrate ratio analysis to measure liquidity. Profitability state
of a business and demonstrate the preparation of cash and income flow
statement.
CLO 3. Summarise cost accounting and illustrate cost sheet to infer cost of
material and overheads and examine the interpret the collaboration of
overheads with cost centre.
CLO 4. Analyse marginal costing and state the techniques of applying marginal
costing for making desired decisions. Examine budgets and its different
types.
CLO 5. Evaluate the standard cost and demonstrate the classification of variance,
recognize the significance of packaged accounting software.
 CONTENT

BLOCK 1 INTRODUCTION TO ACCOUNTING

UNIT 1 AN INTRODUCTION TO ACCOUNTING 2

1.1 Definition and Scope of Accounting 3

1.2 Objectives of Accounting 4

1.3 Emerging role of accounting 5

1.4 Financial Accounting vs Other Accountings 8

1.5 Book keeping vs Accounting 11

1.6 Parties Interested in Accounting Information 12

1.7 Accounting System 14

1.8 Advantages and Limitations of Accounting 14

1.9 Systems of Book-Keeping 16

1.10 Types of Accounts 17

1.11 Accounting Rules 18

UNIT 2 ACCOUNTING CONCEPTS AND STANDARDS 22

2.1 Need for Accounting Concepts 23

2.2 Accounting Framework 23

2.3 Accounting Concepts 24

2.4 Accounting Standards 28

2.5 Accounting Standards in India 30

UNIT 3 DOUBLE ENTRY SYSTEM 35

3.1 Single Entry System 36

3.2 Salient Features 37

3.3 Disadvantages and Advantages of Single-Entry System 37

 3.4 Calculation of Profit or Loss 38

3.5 What is the double-entry system? 41

3.6 Accounting Equation 42

3.7 Characteristics of the Double Entry System 43

3.8 Advantages of Double Entry System 44

3.9 Limitations of Double Entry System 46

3.10 Single Entry System Vs Double Entry System 47

UNIT 4 ACCOUNTING PROCESS 50

4.1 Meaning of Accounting Cycle 51

4.2 Steps in Accounting Cycle 51

4.3 Introduction to Journal 53

4.4 Rules for journalizing 53

4.5 Points to be noted before journalizing 54

4.6 Between Trade Discount and cash Discount 56

4.7 Advantages of Journal 57

4.8 Limitations of journal 57

4.9 Meaning of Ledger 57

4.10 Ruling of ledger account 58

4.11 Ledger posting of Journal 58

4.12 Distinction between journal and ledger 59

UNIT 5 TRIAL BALANCE 71

5.1 Meaning and Definition of Trial balance 72

5.2 Objectives of preparing Trial balance 73

 5.3 Features of Trial balance 73

5.4 Limitations of Trial balance 74

5.5 Methods of preparing trial balance 74

5.6 Accounting Errors 75

5.7 Steps for Location of Errors 75

5.8 Rectification of Errors and Suspense Account 76

5.9 Effect of Rectifying Entries on Profits 80

UNIT 6 FINAL ACCOUNTS 83

6.1 Final Accounts and Trial Balance 84

6.2 Trading, Profit and Loss Account, And Balance Sheet 85

6.3 Manufacturing Account 92

6.4 Treatment of Adjustments in Final Accounts 94

6.5 Preparation of Final Accounts 103

BLOCK 2 FINANCIAL STATEMENT ANALYSIS

UNIT 7 FINANCIAL STATEMENT ANALYSIS 112

7.1 Meaning and Types of Financial Statements 113

7.2 Nature of Financial Statements 116

7.3 Limitations of Financial Statements 118

7.4 Analysis and Interpretation of Financial Statements 119

7.5 Limitations of Financial Analysis 121

UNIT 8 TOOLS OF FINANCIAL ANALYSIS 125

8.1 Techniques of financial analysis 126

UNIT 9 FUNDS FLOW STATEMENT 139

9.1 Meaning of Funds 140

9.2 Meaning of Flow of Funds 140

9.3 Steps in the preparation of Funds Flow Statement 143

9.4 Treatment of Certain Important Items 142

9.5 Some Important Illustrations 152

9.6 Uses and Limitations of Funds Flow Statement 162

UNIT 10 CASH FLOW STATEMENT 168

10.1 Meaning of Cash Flow Statement 169

10.2 Classification of Cash Flows 171

10.3 Reporting of Cash Flows from Operating Activities 173

10.4 Usefulness of Cash Flow Statement 174

10.5 Some Illustrations 176

UNIT 11 RATIO ANALYSIS 194

11.1 Meaning of Financial Ratios 195

11.2 Steps in Ratio Analysis 195

11.3 Classification of Ratios 196

11.4 Summary Sheet of Important Financial Ratios 199

11.5 Computation of Different Accounting Ratios 203

11.6 DU Pont Chart 211

11.7 Uses and Limitations of Ratio Analysis 212

11.8 Inter-firm and Intra-firm comparison 214

BLOCK 3 COST ACCOUNTING

UNIT 12 COST ANALYSES 219

12.1 Introduction 220

12.2 Costing and Cost accounting 221

12.3 Financial Accounting vs Cost Accounting vs Management 221

12.4 General Principles of Cost Accounting 224

12.5 Objectives and Importance of Cost Accounting 225

12.6 Objections against Cost accounting 228

12.7 Cost Centre 229

12.8 Cost Classification—Basis 231

12.9 Cost Sheet 233

UNIT 13 METHODS OF COSTING 239

13.1 Methods of Costing 240

13.2 Techniques of Costing 242

13.3 Practical Difficulties in Installing Costing System 243

UNIT 14 MATERIAL COSTING 247

14.1 Introduction 248

14.2 Material Costing 249

14.3 Economic Order Quantity 254

14.4 Overheads 256

14.5 Allocation and Apportionment of Overhead to Cost 257

Centres

14.6 Overhead Absorption 261

BLOCK 4 MARGINAL COSTING

UNIT 15 MARGINAL COSTING AND BREAK-EVEN ANALYSIS 269

15.1 Concept of Marginal Costing 270

15.2 Steps Involved in Marginal Cost 272

15.3 Absorption Costing 274

15.4 Tools or Techniques of Marginal Costing 278

15.5 Advantages of Marginal Costing 290

15.6 Limitations of Marginal Costing 291

UNIT 16 APPLICATION OF MARGINAL COSTING AND 295

DIFFERENTIAL COSTING

16.1 Product Pricing 297

16.2 Make or Buy Decisions 298

16.3 Expansion Decision 298

16.4 Selection of Suitable Sales Mix 299

16.5 Effect of Changes in Sales Price 301

16.6 Acceptance of Special Order 302

16.7 Alternative Methods of Production 302

16.8 Key Factor 305

16.9 Merger of Plant Capacity 306

UNIT 17 BUDGETS AND BUDGETARY CONTROL 312

17.1 What is a Budget? 313

17.2 Difference between Budget and Forecast 314

17.3 Budgetary Control 315

17.4 Classification of Budgets 319

 17.5 Control Ratios 329

17.6 Zero Based Budgeting 330

BLOCK 5 STANDARD COSTING

UNIT 18 RESPONSIBILITY ACCOUNTING 337

18.1 Meaning and Features 338

18.2 Responsibility Accounting as an Information System 339

18.3 Levels of Responsibility and Flow of Information 341

18.4 Responsibility Centres 341

18.5 Matching Accounting System with Organisation 344

UNIT 19 STANDARD COSTING 352

19.1 Meaning of Standard Cost and Costing 353

19.2 Advantages and Limitations of Standard Costing 355

19.3 Variance Analysis 357

UNIT 20 COMPUTERIZED ACCOUNTING SYSTEMS 385

20.1 Introduction to computerized accounting system 386

20.2 Comparison between manual and computerized 388

accounting

20.3 Advantages and Limitations of computerized accounting 389

20.4 Meaning and types of accounting packages 392

20.5 Factors to consider for an Accounting Software 394

20.6 Introduction of tally ERP 9 395

20.7 Features of tally ERP 9 396

Plagiarism 400
 BLOCK 1

INTRODUCTION TO ACCOUNTING

Unit 1 : An Introduction to Accounting

Unit 2 : Accounting Concepts and Standards

Unit 3 : Double Entry System

Unit 4 : Accounting Process

Unit 5 : Trial Balance

Unit 6: Final Accounts

1
Unit 1

AN INTRODUCTION TO ACCOUNTING
STRUCTURE

Overview

Learning Objectives

1.1 Definition and Scope of Accounting

1.2 Objectives of Accounting

1.3 Emerging role of accounting

1.4 Financial Accounting vs Other Accountings

1.4.1 Distinction between Financial Accounting and

Cost Accounting

1.4.2 Distinction between Financial Accounting

and Management Accounting

1.5 Book keeping vs. Accounting

1.6 Parties Interested in Accounting Information

1.7 Accounting System

1.8 Advantages and Limitations of Accounting

1.9 Systems of Book-Keeping

1.10 Types of Accounts

1.11 Accounting Rules

Let Us Sum Up

Check Your Progress

Glossary

Suggested Readings

Answers to Check Your Progress

OVERVIEW
You know in business a lot of transactions are taking place every day in
the business organizations. It is highly impossible to the human mind to
remember all those transactions. Therefore, there must be a proper
system of accounting to record all the transactions of the business.
Accounting serves the purpose of recording, classifying and summarising

2
the business transactions in a meaningful manner. Further, accounting
system helps the business to fix the accountability, and to have a control
over expenditures. Accounting can be described as the ‘language of
businesses. You know that the basic function of any language is to serve
as a means of communication. Accounting serves as a means of
communication in the business. It communicates the operating results
and financial condition of the business to various parties who have interest
in the operation of the business. As a management student you should
be familiar with various accounting concepts and conventions so that you
can understand the accounting terms in their proper sense. In this unit
the objectives and scope of accounting, the emerging role of accounting,
distinction between book – keeping and accounting etc. are discussed.

LEARNING OBJECTIVES

After reading this unit, you should be able to:

• define and explain the scope of accounting
• discuss the emerging role of accounting
• distinguish between book-keeping and accounting
• discuss the parties interested in accounting information
• explain the advantages and limitations of accounting
• describe the system of book-keeping
• explain the types of account.

1.1 DEFINITION AND SCOPE OF ACCOUNTING

The term accounting has been defined in different ways by different
authorities. American Accounting Association defines accounting as “The
process of identifying, measuring and communicating economic
information to permit informed judgments and decisions by users of the
information”. This definition stresses three important aspects of
accounting, namely, identifying, measuring and communicating economic
information. According to American Institute of Certified Public
Accountants, “Accounting is the art of recording, classifying and
summarizing in a significant manner and in terms of money, transactions
and events which are, in part at least, of a financial character and
interpreting the results there of.” This is a popular and widely accepted
definition of accounting.
The analysis of the above definition highlights the scope of accounting.
These are given bellow:
1. The accountant identifies the transactions which are having financial
character (at least partly). Then the financial transactions are recorded in
the book of original entry (Journal) in accordance with the accounting

3
principles. Thus, the basic process of accounting begins with identifying
and recording the financial transactions in the “Journal’. The Journal can
be further classified into various subsidiary books like Purchases Book,
Purchases Returns Book, Sales Book, Sales Returns Book, Bills
Receivable Book, Bills Payable Book, Cash Book and Journal Proper.
2. The financial transactions recorded in the Journal wouldn’t give
meaningful information. Therefore, they must be properly classified. For
classification of recorded transaction, the Ledger is used in accounting.
Ledger can be described as a book which contains various accounts.
Ledger is also called as the ‘Principal Book’ of account. In the ‘Ledger’
for each transaction a separate account is opened and all transactions
which are relating to particular item are brought into one place. Therefore,
ledger provides the complete picture of dealings pertaining to particular
person or item. For example, purchases made at different times are
brought under ‘Purchases Account’.
3. The financial transaction which are recorded and classified must be
summarized in a meaningful form in order to know the overall effect of all
transaction. Trial Balance, Profit and Loss Account (Income Statement)
and Balance Sheet are used for summarizing the financial transactions.
When the trial balance helps to check the arithmetical accuracy of the
business, the Income Statement and Balance Sheet helps the owners and
or other interested parties in the operations of the business to know the
net results and financial position of the business.
4. The summarized results must be analysed and interpreted with the
help of some statistical and other tools like ratio analysis, averages,
common size statements, comparative statements, fund and cash flow
statements etc.

1.2 OBJECTIVES OF ACCOUNTING

The following are the important objectives of accounting.

i) To keep a systematic and permanent record of all financial
transactions: Accounting helps the business to keep systematic records
of all financial transactions of the business. The accounting records
become evidence for the transaction and base for future reference.
ii) To ascertain the financial results of the business: The accounting
records help in preparing the Profit and Loss Account at the end of the
accounting period. The profit and loss account is a statement which
shows the summary of all the revenues or incomes and the expenses
incurred for earning that revenues. The Profit and Loss Account helps the
businessman to ascertain the net profit earned or the loss incurred.

4
iii) To ascertain the financial position of the business: Every
businessman wants to know the financial position of the business at the
end of the accounting period. The Balance Sheet prepared from the
accounting records helps the businessman to know the financial position
of the business. The Balance Sheet is a statement which shows the value
of assets, liabilities and owners’ equity at a particular point of time.
iv) To communicate accounting information to interested parties: In
addition to the owners there are many numbers of parties interested in
accounting information of the business. Creditors, banks and financial
institutions, tax authorities, present and prospective investors are
important ones. They need accounting information in order to study the
profitability of the business and to judge the financial soundness of the
business. The accounting information communicated through the annual
reports helps them to make various important decisions.

1.3 EMERGING ROLE OF ACCOUNTING

The role of accounting is fast changing. It is very different now than it was
in the past. In this section, you can learn the history of accounting and
the changing role of accounting in the modern days.
i) Stewardship Accounting: Accounting is an ancient art. It is as old
as money itself. In India, Chanakya in his Arthashastra, indicated the
existence of accounting and auditing system. In the olden days, rich
people employed ‘Stewards’ to manage their properties. The stewards
under the stewardship accounting system keep records the transactions
of their owners, the property and the tools owned, the liability owed to
others and the liability owed by others to the owners. The modern system
of accounting as we have, now owes its origin to Pacioli who lived in Italy
in the 15th century. The Italian model which emphasized ‘double entry
book-keeping’ was adopted by other European countries during the 19 th
century.
ii) Financial Accounting: The development of financial accounting
owes to the emergence of large-scale business and the advent of joint
stock companies. Joint stock company is a form of business organization
functions under a Law. In India, Joint stock companies are functioning
under Companies Act. Joint Stock companies issue shares to the public.
When a person invests in the shares of a company, he becomes
shareholder, (members) of the company. Shareholders are having more
interest to know the functioning of the company. Therefore, it is the duty
of the companies to communicate operating results of the business to the
shareholders. The Companies Act also insist the companies to disclose
all important information to the shareholders of the company. The

5
financial accounting through its financial statement, namely, Profit and
Loss Account and Balance Sheet communicates the profit or loss and
financial position of the business to the shareholder and other parties
having interest in the operation of the business. Financial accounting also
helps the prospective investors to make right investment decisions.
iii) Cost Accounting: The industrial revolution in England gave a lot of
challenge to the business community for the development of accounting
as a tool of industrial management. Financial accounting provides
information about the past. If fails to give information about the future.
Management concern is in the future only, that is, on planning and
controlling. Costing techniques were developed to evaluate operating
efficiency of the business, to formulate policies, to facilitate planning,
controlling and decision making. Preparation of various budgets (like
production budget, purchase budget, sales budget, flexible budget, cash
budget etc,) comparing actual performance with the budgeted
performance, assisting the management to exercise control where the
actual performance is not up to the budgeted or standard performance are
some of the important functions of cost accounting.
iv) Management Accounting: The advent of factory system during the
industrial revolution has significantly changed the production and
management process. You know that before industrial revolution, the
businesses were functioning at smaller size. Therefore, the
owners/entrepreneurs with the help of book keeping system prevailed
during that period find out the overall profit of the business easily. But
after industrial revolution, they needed an accounting system which helps
them in planning, controlling and decision making. This caused the
emergence of techniques of management accounting.
Management accounting is mainly concerned with providing appropriate
accounting information to the management in order to assist in formulating
policies, planning, controlling and decision making. Management
accounting by employing various techniques such as standard costing,
marginal costing, uniform costing, inter-firm comparison, ratio analysis,
etc. provides accounting information to the management in such a way
for planning, controlling and decision making.
v) Social Accounting: Social accounting or social responsibility
accounting is a new phase in the development of accounting. It owes its
origin due to increasing awareness in our society in recent times. As the
society provides the required inputs to the business, the business, in
return has to do something for the welfare of the society. A business has
to seriously consider social implications of its decisions. Further, the

6
business enterprise has to inform the general public about the social
welfare measures taken by it. Now days the role of business in society is
increasingly coming under serious scrutiny. Social scientist, social
workers give a lot of pressures to the government to have a close eye on
the functioning of business enterprises to safeguard the society,
environment and ecology. Businesses also give priority to the social
activities and inform properly the general public about the social measures
taken by them.
vi) Human Resource Accounting: Human Resource Accounting
involves accounting for investment in human resource and replacement
costs as well as accounting for the economic values of human resource
to an organization. American Accounting Association defines Human
Resource Accounting as “a process of identifying and measuring data
about human resources and communicating this information to interested
parties”. Human resource plays a vital role in the success of any
organization. In recent times, organization has realized this. In 1964
Roger H. Hermanson made first attempt to include human capital in the
balance sheet. Later it came to be known as Human Resource
Accounting. Human resource accounting emphasizes the importance
human resource in company’s earning capacity and total asset. In the
present knowledge era, knowledgeable, well-trained employees are the
real assets of the organization. Human resource accounting provides
information to all the interested parties regarding the earning potential of
human resource. And also, it assists the management in taking
appropriate decisions regarding investment on human resources. In
short, human resource accounting provides comparative information
regarding costs and benefits associated with investment in human
resources that helps the management and other interested parties for
taking suitable decisions.
vii) Inflation Accounting or Accounting for Price Level Changes:
Accountants prepare the financial statement, namely, Profit and Loss
Account and Balance Sheet at historical or original costs. Because of
that, the financial statement presents much distorted figures to the users
of accounts. Inflation accounting was developed to overcome the
limitation of conventional accounting system. Inflation accounting shows
the adjustment in the value of assets (current and fixed) and of profit in
the light of price level changes. Therefore, the users of the accounting
can know the true financial position of the business.

7
1.4 FINANCIAL ACCOUNTING VS OTHER ACCOUNTINGS
You might have learnt that financial accounting was originally developed
to record the financial transactions in order to ascertain the financial
results of the business. Financial accounting as any other branch of
knowledge has some limitations. The limitations of accounting have
caused the emergence of cost and management accounting systems.
Cost accounting is concerned with measuring the economic resources
exchanged or consumed in the production of goods or rendering of
services. It also provides information to the management for estimation of
cost of goods and services to be produced and sold in the future.
Management accounting system was developed with the intention to
provide the needed information to the management for planning,
controlling and decision making. Thus, management accounting helps the
management to perform its functions efficiently and effectively. In this
section, you can learn the important distinction between financial
accounting and cost accounting and financial accounting and
management accounting. Now let us discuss the basic differences
between financial accounting and cost accounting.
1.4.1 Distinction Between Financial Accounting and Cost
Accounting
The following are the important differences between financial accounting
and cost accounting.
i) Objective: The main objective of financial accounting is to prepare Profit
and Loss Account and Balance Sheet to report the financial results and
financial position of the business to the owners, management, outsiders
etc. Cost accounting aims to provide cost-related information to the
management for proper planning, control and decision making.
ii) Legal Compulsion: According to Companies and Income Tax Acts
maintaining financial records has become compulsory for every business
organization. Cost accounts are maintained to provide information largely
in the areas of costs to fulfill the internal requirements of the management.
But, at present Companies Act has made it compulsory to maintain cost
records in some manufacturing industries.
iii) Classification of Transactions: In financial accounting, all monetary
transactions are recorded, classified and analysed in a subjective manner,
that is, according to the nature of expenses. Cost accounting records and
analyses costs in an objective manner, that is, according to the purpose
for which costs are incurred.

8
iv) Efficiency: Financial accounting measures the overall efficiency of the
business. It does not focus on the relative efficiencies of workers, plant
and machineries. Cost accounting measures the efficiency of each
department. It highlights which department is efficient and which is not.
So, cost accounting facilitates the management to take corrective
measures.
v) Valuation of Stock: In financial accounting stock is valued at cost price
or market price whichever is less. In cost accounting stock is valued at
cost only.
vi) Accounting Record: In financial accounting transactions are
recorded for a definite period generally one year. Cost reports are
generally prepared on continuous basis (like daily, weekly, monthly,
quarterly or annually) as per the requirements of managements.
vii) Emphasis: Financial accounting lays emphasis on recording aspect
of internal transactions of the business. It does not focus on control of
cost. On the other hand, cost accounting takes internal transactions and
lays emphasis on the ascertainment of cost. It attempts to control the cost
with the help of standard costing and budgetary control techniques.
viii) Nature of Expenses: Financial accounting takes all expenses viz.,
manufacturing, office, selling and distribution etc. Cost accounts take into
account the expenditures which are related to the production of goods
and/ or services.
ix) Disclosure: Financial accounting deals with the accounts of whole
business. It records all the transactions of the business and discloses the
net profit or loss of the business for an accounting period. Cost accounting
records costs which are associated with manufacture of goods and / or
services and discloses the profit or loss of each product, job or service.
x) Nature: Financial accounting mainly deals with actual facts and
figures. Cost accounting partly deals with facts and figures and partly with
estimates. Further, in financial accounting only monetary transactions are
recorded whereas in cost accounting monetary as well as non-monetary
(like units) transactions are recorded.
1.4.2 Distinction Between Financial Accounting and Management
Accounting
There is no doubt that financial accounting provides valuable information
to the outsiders like prospective investors, creditors etc. But it fails to
provide all the needed information to the management. You know that
today’s organizations are more complex in nature and facing severe

9
international competitions. To compete effectively and to thrive they need
more and accurate information for planning, controlling and decision
making. Management accounting takes more information from financial
accounting, modifies them according to the requirement of management
and presents them to the management whenever it requires. As
management accounting draws major portion of information from financial
accounting, they are interrelated. Even though they are interrelated, there
are some differences between these two and these differences are
explained below.
i) Objective: The main objective of financial accounting is to report the
operating results and financial position of the business to the outside
parties who have interest in business. Management accounting aims to
provide the needed information to the management. Thus, financial
accounting is concerned with external reporting and management
accounting is concerned with internal reporting.
ii) Nature of Data: Financial accounting uses data which are historical,
quantitative, monetary and objective in nature. Whereas management
accounting uses data which are descriptive, statistical, subjective and
concerned with future.
iii) Main Emphasis: Financial accounting measures the overall
performance of an organization. But management accounting focuses
only on important activities. It mainly deals with evaluating the
performance of different units, departments or divisions. Management
accounting provides information for planning, controlling and decision
making. Financial accounting attempts to explain what has happened in
the organization for an accounting period.
iv) Flexibility: The accounting concepts and standards followed in
financial accounting are well standardized and rigid in nature. On the other
side, the standards followed in management accounting are flexible and
they can be tailored according to the requirements of management.
v) Legal Compulsion: Financial accounting has become compulsory for
almost all organization. It is governed by Companies Act, Income Tax Act
etc. Management accounting is adopted on voluntary basis in order to
enhance the efficiency of management.
vi) Reporting Period: In financial accounting the reporting period is
usually one year. That is, at the end of the year financial accounting
reports the operating results and financial positions to outside parties.
Management accounting provides information or report to the
management whenever it seeks.

10
vii) Availability: Financial accounting information are publicly available.
But the information provided by management accounting are confidential.
viii) Precision: In financial accounting, transactions are recorded at their
actual amounts. Here the emphasize is more accuracy. In the case of
management accounting there is less emphasis on precision. More often
management accounting provides information with approximate figures.
ix) Accounting Principles: Financial accounting follows the generally
accepted accounting principles (GAAP) and standards for recording and
reporting accounting transactions. In management accounting no such set
of principles are followed. The form and method of presentation of
information may differ from business to business.
x) Unit of Account: In financial accounting money is the unit of account.
It records only monetary transactions. Whereas management accounting
takes both monetary as well as non-monetary information.
xi) Audit: Financial statements (Income Statement and Balance Sheet)
prepared under financial accounting are subject to auditing by practicing
Chartered Accountants. In management accounting, there is no need of
such audit. Because the reports, forecasts and other information are
prepared for internal use only.
xii) Methodology: Financial accounting and management accounting
are differed from each other in the methodology also. Under financial
accounting system, records are maintained in the form of revenue, income
and expenditure, personal accounts and real accounts etc. In
management accounting, costs and revenues are mostly reported by
responsibility centres (or profit centres).

1.5 BOOK - KEEPING VS ACCOUNTING

A layman thinks book-keeping and accounting as synonymous terms, but
they are basically different from each other. In this section, you can learn
the basic differences between book-keeping and accounting. Book-
keeping is mainly concerned with the maintenance of the books of account
and includes the processes of identifying the transactions and events to
be recorded, measuring them in terms of money, recording them in the
books of original entry and posting them into the ledger. A major portion
of the book-keeper’s work is of a clerical nature. On the other hand,
accounting is mainly concerned with summarizing the recorded data,
analysing and interpreting the data and reporting them to the internal as
well as external end users of accounting.

11
The scope of book-keeping is a narrow one; whereas, the scope of
accounting is wider and includes all the accounting activities. Further
book-keeper does not require specialized skill and knowledge. Whereas
the accountant (an accountant is a professional who is responsible for the
work of accounting) requires specialized knowledge of accounting, skills,
imagination and experience. However, in broader sense, book -keeping
is considered as a part of accounting.

1.6 PARTIES INTERESTED IN ACCOUNTING INFORMATION

You must have observed that there are various groups of people
interested in the operating results of the business. The interested parties
can be grouped into two, namely internal users of accounting and external
users of accounting. Accounting as an information system provides
information which fulfils the needs of its users. Now let us discuss the
internal users and how accounting information is useful to them.

Internal Users of Accounting Information

i) Owners: The internal users consist of owners, management and
employees. The sole trader (in the case of proprietary concern), partners
(in the case of partnership concern), shareholders (in the case of company
or corporation) are owners of the business. They contribute their hard-
earned money in the business in the form of capital and assume the risk
of business. Naturally, they are very much interested in the results of
operations and financial positions of the business, in order to decide the
profitability of the business, the soundness of their investment and future
prospects of the business. Historically, financial accounting was
developed to provide the information to those who have invested their
funds in the business organizations.
ii) Managers: Unlike the sole trading and partnership concerns
companies are managed by professional managers. Accounting
information is very much useful to them in their management activities.
Particularly, accounting information helps them in setting up targets for
future periods (planning), evaluating the performance of the various units
of the business and also the enterprises as whole by comparing the actual
performance with planned or budgeted ones (controlling) and taking
remedial action for overcoming the deviations if any (decision making). In
a nutshell, accounting helps the managers in planning, controlling and
decision making.
iii) Employees: The necessity of maintaining harmonious industrial
relation between employees and management has been well recognized
by today’s organization. Employees are allowed to participate in the

12
activities of management. Sharing of information improves the
relationship and cooperation between employees and management.
Matters like settlement of wages, bonus and profit sharing can be decided
amicably with the help of accounting information.

External Users of Accounting Information

The external users of accounting information are given below:

i) Creditors: Creditors may be classified as short-term creditors and
long-term creditors. Short-term creditors are those who supply materials,
goods or services on credit. They are normally called as trade creditors.
Long-term creditors are those who lend money to the business for a long
period. Commercial banks, financial institutions, debenture holders,
public deposit holders include in this category. Creditors are mainly
interested in the liquidity of a firm in order to judge the credit worthiness
and ability of the business unit to repay their claims. Accounting
information helps the creditors to determine the limit and terms under
which credit can be given.
ii) Potential Investors: Those who are interested in investing their
surplus funds in shares/debentures and the persons who want to become
partner in a partnership firm can be called as potential investors. Potential
investors are interested in the firm’s earning capacity, the present and
future earnings per share, the stability of such earnings etc., to know how
safe the proposed investment will be. In short, accounting information
helps the potential investors to make right investment decisions.
iii) Tax Authorities: Accounting information helps the tax authorities to
determine sale tax, income tax etc. to be levied from the business
enterprise.
iv) Government: Regulatory agencies of government (like Registrar of
companies, Ministry of commerce etc.) that are charged with the
responsibility of regulating the general business activities need the
accounting information. Accounting information helps the government in
evolving policies for managing the economy. The government can also
check to what extent the business enterprises comply with requirements
of the law relating to financial aspects. Now-a-days there is a lot of
pressure on the business enterprises to disclose all the material
information to public scrutiny.
v) Consumers and others: Consumers’ organization, media, research
scholars, financial analyst, NGOs and welfare organizations etc. are also
interested in the operations of the businesses. They need accounting

13
information in order to appraise the efficiency of the business and to
evaluate the social role of the enterprises.

1.7 ACCOUNTING SYSTEM

There are basically three systems of accounting. These are discussed
below:
i) Cash System of Accounting: Under this system of accounting
transactions are recorded only when cash is received or paid. The
transactions which are based on accrual basis are not entered under this
system. Government system of accounting is mainly based on the cash
system. Non- trading concerns such as club, schools, colleges,
professionals like doctors, lawyers etc. follow this system of accounting.
ii) Mercantile System of Accounting: Under this system of accounting,
both cash and credit transactions are entered, that is, entries are made
on the basis of accounts having become due for receipt or payment. As
the system records all the transactions relating to a particular period, the
complete picture of the financial transactions can be visualized. That is,
this system reveals the real profit or loss of the business for a particular
period and the true financial position of the business on a particular date.
iii) Mixed System of Accounting: This system combines both cash
system and mercantile system. That is, some records are maintained
under cash system and some records are maintained under mercantile
system. However, due to its inconsistency, at present the system is not
widely practiced in the business.

1.8 ADVANTAGES AND LIMITATIONS OF ACCOUNTING

The following are the important advantages of accounting:
i) Systematic and permanent records: The books of account serve as
historical records. At any time, we get information from these records.
ii) Facilitates control over assets: Management of assets is an
important function of management. Accounting records facilitate the
control over assets.
iii) Facilitates the preparation of financial statements: Accounting
records help the businessman to prepare the financial statement viz.,
Profit and Loss Account and Balance Sheet. They can know the net
results of the operations of the business and the financial position of the
business with the help of financial statements.

14
iv) Helps in planning, controlling and decision making: Accounting
information helps the management in planning, controlling and decision
making.
v) Meets the information requirements: In our previous discussion we
have seen that many parties are interested in the accounting information.
Accounting provides the needed information to all the parties.
vi) Assessing the progress of the business: With the help of
accounting information one can evaluate the present performance of the
business with of its past. Similarly, one can compare the performance of
one business with that of another one having similar nature.
vii)Statutory requirements: Accounting helps the business people to
fulfil the legal requirements like income tax return, return for sales tax,
provident fund requirements etc.
viii) Reliable evidence: Accounting records are accepted by the court of
law as reliable evidence for the settlement of disputes.
ix) Merger and acquisition of the business: Accounting records helps
in the process of merger and acquisition of the business. The correct
value of business can be determined with accounting information.
Therefore, the terms of merger and acquisition can be decided. In the
present globalized world, a lot of merger and acquisitions are taking place.
Accounting information helps to determine the value of the business.
x) Helps to have a control over cost: Accounting records help to keep
control over expenses in order to minimise the same.

LIMITATIONS OF ACCOUNTING

The following are the important limitations of accounting:

i) Records transactions having financial nature only: Accounting
records the transactions which are having financial nature only. The
transactions which cannot be measured in monetary terms cannot be
recorded. Hence accounting records do not reveal a complete picture.
For instance, the efficiency of management and the commitment of
employees to the job are not recorded in the accounting records even
though they seriously affect the performance of the business.
ii) Historical in nature: Accountants adopt the historical cost for
recording the transaction in the books of account. The effect of price level
changes is not taken into account. This drastically affects the values of
assets and liabilities. In other words, accounts with historical costs do not
reflect current values of assets and liabilities.

15
iii) Personal Judgements: Accounting information may not be realistic
as financial statements are greatly influenced by different accounting
concepts and conventions and personal judgments of accountant. The
accountant may adopt any method for depreciation, valuation of stock,
treatment of deferred revenue expenditure etc. The personal judgment of
the accountant may affect the value of the financial statements. Further,
in many cases, estimates and forecasts of the future are used in
accounting. Due to uncertainly, accounting results may not be accurate
and reliable. These are the important limitations of accounting. However,
the professional bodies of accounting seriously consider all these
limitations. Recent developments in the accounting field like human
resource accounting, social accounting, inflation accounting or accounting
for price level changes, international accounting standards etc. aim at
improving the reliability and value of the accounting.

1.9 SYSTEMS OF BOOK - KEEPING

Book-keeping as explained in the earlier section is the art of recording
business transactions in a systematic manner. There are two systems of
book-keeping.
These are: (i) Double Entry system and (ii) Single Entry system. In this
section, you can learn the meaning of double entry and single-entry
system of book-keeping.
i) Double Entry System of Book- Keeping: The double entry system
recognizes that every transaction has a two- fold effect. For example,
when we purchase a machine for office use for cash, the machine comes
in and the cash goes out. Under the double entry system both the effects
are recorded. As the machine comes to the business it is debited and as
the cash goes out from the business it is credited. It is to be noted that for
every debit there will be an equivalent credit. Double entry system of
accounting provides a lot of benefits to the business. One can verify the
arithmetical accuracy of the accounts by preparing the trial balance.
Similarly, the financial results and the financial position of the business
can be ascertained from the accounting records prepared under double
entry system.
ii) Single Entry System: This is an incomplete system of double entry
system. Kohler defines single entry system as “a system of book keeping
in which as a rule only records of cash and personal accounts are
maintained, it is always incomplete double entry, varying with
circumstances.” The accounts maintained under this system are
incomplete and unsystematic. Therefore, the accounts maintained under
this system are considered unreliable. Further, one cannot find out the

16
correct profit or loss and the financial position of the business from the
single-entry system of accounting.

1.10 TYPES OF ACCOUNTS

There are three types of accounts maintained for recording all business
transactions. They are: (i) Personal Accounts, (ii) Real Accounts and (iii)
Nominal accounts. These accounts are explained below briefly:
i) Personal Accounts: Accounts relating to persons with whom the
business has dealings can be described as personal accounts. Personal
accounts take in the following forms:
a) Natural Persons: In accounting a separate account is maintained
for each individual. The individual may be a customer or suppliers, debtors
or creditors. Examples are: Kannan’s Account, Raju’s Account, Loan from
Aravind Account etc.
b) Artificial Persons or Legal Bodies: The accounts in the names
of firms, companies or institutions such as Mafatlal & Sons’ Account,
Aishwarya Finance Limited Account, Consumers’ Cooperative Society
Accounts are examples of artificial persons’ accounts.
c) Representative Personal Accounts: The accounts which
represent expenses outstanding, or prepaid expenses, incomes received
in advance are examples of representative personal accounts. Accounts
which are related to the owners of the business, that is, Capital Account
and Drawings Account are also treated as personal accounts.
ii) Real Accounts: Accounts which are relating to the tangible or
intangible assets of the concern are called real accounts. You know every
business need asset to carry out its business activities. The business has
to maintain a separate account for each asset. Cash Account, Plant and
Machinery Account, Furniture Account, Buildings Account are some
examples of tangible real accounts. The assets which cannot be touched
but can be measured in terms of money are intangible assets. Patents’
accounts, Goodwill Account are examples of intangible real accounts. As
these accounts show things of value owned by the business, they are
called real accounts.
iii) Nominal Accounts: Accounts which are relating to expenses,
losses, incomes and gains are known as Nominal Accounts. Rent
Account, Wage and Salaries Account, Advertisement Account, and
Discount Received Account are some examples of nominal accounts.
Real and Nominal Accounts taken together can be described Impersonal
Accounts.

17
1.11 ACCOUNTING RULES
You have already learnt that as per double entry system of accounting
every transaction has two aspects. One is benefit receiving aspect or
income aspect and another one is giving aspect or outgoing aspect. The
general rule is debiting the account which involves a receiving aspect and
credit the account which involves a giving aspect. Before recording a
transaction, we have to identify the accounts which are affected by the
transaction. Then we have to decide which one should be debited and
which one should be credited. The rules for making entries under double
entry system are given below:

i) Personal Accounts: Debit the receiver and credit the giver.

ii) Real Accounts: Debit what comes in and credit what goes out.

iii) Nominal Accounts : Debit all expenses and losses and credit all
incomes and gains.

You can understand better the rules of debit and credit with the help of
the following examples.

Example 1: Paid cash to Gopal& Co. Rs. 10,000

In this case the two accounts affected are Gopal& Co. Account and Cash
Account. Gopal& Co. Account is a personal account. Cash Account is a
real account. Gopal& Co. has received the benefit of Rs. 10,000 from the
business. Therefore, as per the first part of the rule of Personal Account
(Debit the receiver) we have to debit Gopal& Co. Account by Rs. 10,000.
You know cash is real item. As the cash goes out of the business as per
the rule of real account (Credit what goes out) we have to credit the Cash
Account byRs. 10,000.
Example 2: Furniture worth Rs. 20,000 for business use on credit
from Arun Furniture Mart
In this case the accounts affected are Furniture Account and Arun
Furniture Mart Account. Furniture Account is a real account and Arun
Furniture Mart Account is a personal account. As per the first part of the
rule of real account ‘Debit what comes in’ Furniture Account has to be
debited as the furniture comes to the business. Arun Furniture Mart is the
giver of benefit. As per the second part of the rule of personal account
‘Credit the giver’ Arun Furniture Mart Account will have to be credited.

18
Example 3: Rent paid Rs. 5,000
In this case the two accounts affected are Rent Account and Cash
Account. As rent paid is an expense to the business, it is a nominal
account. As the cash is an asset to the business, it is a real account. As
per the rule of first part of the nominal account ‘Debit the expenses and
losses’ the Rent Account will have to be debited. And as per the second
part of the rule of real account ‘Credit what goes out’ Cash Account will
have to be credited.

LET US SUMUP
Accounting is the language of business. Accounting can be described as
the process of identifying, classifying and summarizing the transactions,
and analysing, interpreting and communicating the results thereof.
Accounting serves the purpose of recording, classifying and summarizing
the business transactions in a meaningful manner. The main objectives of
the accounting are: (i) to keep a systematic and permanent record of all
financial transactions, (ii) to ascertain the financial results (profit or loss)
of the business, (iii) to ascertain the financial position of the business and
(iv) to communicate the operating results and financial position of the
business to various parties interested in accounting information. The
interested parties can be grouped into internal users of accounting and
external users of accounting. Owners of the business, managers and
employees of the organization are major internal users of accounting.
Creditors, potential investors, tax authorities, Government and consumers
are important external users of accounting.
Book-keeping and accounting are basically different from each other.
Book-keeping is mainly concerned with the maintenance of the books of
account and includes the processes of identifying the transactions and
events to be recorded, measuring them in terms of money, recording them
in the books of original entry and posting them into the ledger. On the
other hand, accounting is mainly concerned with summarizing the
recorded data, analysing and interpreting the data and reporting them to
the internal as well as external end users of accounting. The scope of
book-keeping is a narrow one; whereas, the scope of accounting is wider
and includes all the accounting activities. Book-keeper does not require
specialized skill and knowledge. Whereas the accountant requires
specialized knowledge of accounting, skills, imagination and experience.
There are basically three systems of accounting. These are: (i) cash
system of accounting, (ii) mercantile system of accounting and (iii) mixed
system of accounting. Under cash system of accounting transactions are
recorded only when cash is received or paid. The transactions which are

19
based on accrual basis are not entered under this system. Under the
mercantile system of accounting entries are made on the basis of
accounts having become due for receipt or payment. As the system
records all the transactions relating to a particular period, the complete
picture of the financial transactions can be visualized. Mixed system of
accounting combines both cash system and mercantile system. That is,
some records are maintained under cash system and some records are
maintained under mercantile system.

CHECK YOUR PROGRESS

Choose the Correct Answers:

1) Accounting provides information on ____________
a) Cost and income for managers
b) Company's tax liability for a particular year
c) Financial conditions of an institutions
d) All of the above
2) AAA stands for? ____________
a) American accounting agency
b) American accounting association
c) Asian accounting association
d) Australian accounting association
3) Which one of the following statements completely and correctly
describes accounting?
a) Recording, classifying and summarizing economic activities in
systematic way
b) Recording, classifying and summarizing all activities in useful
manner
c) Accounting is the systematic process of recording social
activities only
d) Recording, classifying and summarizing economic activities in
informal manner
4) Which of the following statement is true about purpose of accounting?
___________
a) The purpose of accounting provides information to manager
b) Accounting purpose gives quantitative information to
economic Decision makers
c) Provision of base for decision making is purpose of accounting
d) All of above statement are true regarding purpose of
accounting

20
 5) Accounting is the language of ?

a) Proprietor b) School

c) Business d) Management

GLOSSARY

Asset : Anything having an economic value to the

Intangible Assets : Those fixed assets which cannot be seen and

touched

Account : A summarized statement of transactions

relating to a particular person, thing,
expenses and losses and incomes and
gains.

Debit : It represents the receiving aspect of a

transaction

Credit : It represents the giving aspect of a

transaction.

Personal : Accounts relating to persons/ institutions.

Accounts

SUGGESTED READINGS
1. Gupta, R.L. and Radhaswamy, M., (2006), Financial Accounting,
Sultan and Chand Sons, New Delhi.
2. M C Shukla, S C Gupta & T S Grewal, (2017), Advance
Accounting, 19th Edition, S.Chand Publishing, New Delhi
3. Maheswari, S.N and Maheshwary, S.K. (2006), Fundamental of
Accounting, Vikas Publications.
4. Shashi K. Gupta, R.K.Sharma , (2012), “Financial Management”
latest Edition, Kalyani Publishers, Chennai
5. Tulsian P. C., (2017), Financial Accounting, Pearson Education,
New Delhi.
6. https://www.cliffsnotes.com/study-guides/accounting/accounting-
principles-i/principles-of-accounting/introduction-to-accounting
7. https://www.investopedia.com/articles/professionals/091715/care
er-advice-accounting-vs-bookkeeping.asp
8. https://www.mastersindia.co/blog/objectives-and-functions-of-
accounting/

ANSWER TO CHECK YOUR PROGRESS

1) d 2) b 3) a 4) d 5) c

21
Unit 2

ACCOUNTING CONCEPTS AND

STANDARDS
STRUCTURE

Overview

Learning Objectives

2.1 Need for Accounting Concepts

2.2 Accounting Framework

2.3 Accounting Concepts

2.4 Accounting Standards

2.5 Accounting Standards in India

Let Us Sum Up

Check Your Progress

Glossary

Suggested Readings

Answers to Check Your Progress

OVERVIEW
In unit 1 you have learnt that accounting is the language of business. To
make the language intelligible and to convey the same meaning to all the
people as far as possible, accountants, all over the world have agreed
upon to follow a number of uniform and scientifically laid down rules and
conventions. These rules and conventions are referred to as Generally
Accepted Accounting Principles (GAAP). GAAP serves as an explanation
of current practices followed by a business enterprise at a particular point
of time. In this unit, the need for accounting concepts, the accounting
concepts to be observed at the recording and reporting stage of
accounting information and the Generally Accepted Accounting Principles
(GAAP) are discussed.

LEARNING OBJECTIVES

After reading this unit, you should be able to:

• appreciate the need for accounting concepts / principles
• explain the accounting concepts to be observed at the recording
and reporting stage

22
 • appreciate the Generally Accepted Accounting Principles (GAAP)

2.1 NEED FOR ACCOUTING CONCEPTS

You just imagine what will happen if the drivers do not follow traffic rules
while driving the vehicle. Certainly, there will be chaos on the road. When
everybody follows the traffic rules, everything goes smoothly. The same
thing applies to the accounting also. If each accountant follows his own
principles, the reliability and credibility of the accounting information will
be a question mark and there will be a lot of confusion in understanding
the accounting information. There wouldn’t be any scope for comparison
of accounting information of one firm with another and within the firm itself
over different periods. On the other hand, if accountants follow uniform
and universally standardized rules and conventions, the users of
accounting can understand the message of accounting easily.
Further, Inefficient and/or loss-making concerns many manipulate the
accounting statements as high profit-making concerns and can mislead
the investors and others. Accounting has evolved over a period of several
centuries. During this period certain rules and conventions have been
developed and accepted by the accounting profession. The rules and
conventions of accounting serve as guidelines for identifying, measuring,
and recording, summarizing and reporting the accounting transactions to
the interested parties. If you are familiar with the rules and conventions
of accounting, you can understand the financial statements (i.e., Profit and
Loss Account and Balance Sheet), the outcome of the process of
accounting in a better way. This unit is an attempt in this direction.

2.2 ACCOUNTING FRAMEWORK

For the growth of any profession a theoretical framework is required. The
same thing is applied to the accounting profession also. Hendriksen
(1977) defines accounting theory as logical reasoning in the form of a set
of broad principles that (i) provide a general frame of reference by which
accounting practices can be evaluated, and (ii) guide the development of
new practices and procedures. Generally Accepted Accounting Principles
(GAAP) is described as the theory base of accounting. GAAP includes
the conventions, rules and procedures needed to define and explain
accepted accounting practices at a point of time.
The word principle refers to a general law or rules adopted or professed
as a guide to action. Any activity that you perform is facilitated if you have
a set of principles to guide you. Accounting principles serve as guide for
the selection of conventions and procedures where different alternatives
exit. However, accounting principles cannot be equated with laws of

23
natural sciences. As accounting principles are man-made, they will
change according to changing needs and circumstances of business
enterprises. In fact, accounting principles are constantly evolving and are
influenced by changes in the legal, social and economic environment.
Accounting principles should provide a coherent set of logical principles
that form a general frame of reference for the evaluation and development
of generally accepted accounting practices. Further, the accounting
principles must fulfill the three criteria of relevance, objectivity and
feasibility. A principle is relevant to the extent that it results in giving
meaningful or valuable information to those who are interested in the
accounting information of the business. A principle is objective to the
extent that the information is based on facts that can be proved and not
influenced by personal judgments / bias of those who provided the
information. A principle is feasible to the extent that it can be implemented
without making the situation complex and the cost of affordable by
business units.

2.3 ACCOUNTING CONCEPTS

To explain the generally accepted accounting principles, different writers
adopt different terminologies such as concepts, postulates, basic
assumptions, underlying principles, fundamentals, conventions,
doctrines, rules etc. The wide diversity in terminology to express the basic
accounting framework often confuses the learners. Hence we can adopt
the term Accounting Concepts to explain the rules and conventions of
accounting. Basic accounting concepts are the pillars of accounting
language. The following are some of the important accounting concepts
that are popularly adopted and practiced in accounting.
1.Business Entity Concept: In accounting business is treated as
separate from the owner. All transactions of the business are recorded in
the books of the firm from the view point of the business rather than that
of owner. The personal affairs of the owner(s) should not appear in the
books of accounts of the business. If the personal expenditures of the
owner(s) are met from business funds, they must be properly recorded in
the books of accounts. Similarly, if the owner(s) have taken goods/cash
from the business for personal use, they must be treated as drawings and
should be shown in the books of accounts in the Drawings Account.
Another implication of this business entity concept is that the owner should
be treated as creditor to the extent of his/her capital. The business entity
concept is applicable to all forms of business enterprises. This distinction
can be maintained easily in the case of limited company because the
company has a legal entity of its own. But in the case of sole trading

24
concern and partnership firm the application of this concept is difficult.
The law does not make any distinction between the business and
owner(s). However, for accounting purpose the business is treated as
separate from the owner(s). Because of the application of business entity
concept one can assure that accounting records show only the activities
of the business. Therefore, the reliability of records can be ensured.
2.Money Measurement Concept: In business, a variety of transactions
are taking place. For instance, the company may purchase raw materials
in kilograms or tons etc. Similarly, the company may sell its products in
units, kilograms or tons etc. All these transactions must be recorded in a
common denomination in order to facilitate the users of accounting
information in a better way. Money serves as a common denominator in
India.
An important implication of this concept is that only those transactions
which can be expressed in monetary terms are recorded in the books of
account. The transactions which cannot be expressed in monetary terms
are not recorded. For instance, better work environment, smooth relations
between employer and employees, efficient management, committed
work force even though they are contributing significantly for the success
of the organization are not recorded in the books of accounts. The simple
reason is they cannot be measured or quantified in terms of money. So,
the users of accounting information cannot get the complete picture of
business events from accounting records. Another important limitation of
money measurement concept is that it ignores the fluctuation in the
purchasing power of money. You are perhaps known that the purchasing
power of money is inversely related with fluctuations in the level of prices.
In other words, when the prices are increasing the purchasing power of
the money will be decreasing and vice versa. In accounting, it is assumed
that rupee has stable or constant value. Money is expressed in terms of
its value at the time an event is recorded in accounting. Despite these
limitations, money as a common denominator helps the accountants to
record the diverse transaction of the business.
3.Going Concern or Continuity Concept: In accounting, it is assumed
that the business will continue to operate form a long time in the future
unless there is strong evidence to the contrary. According to International
Accounting Standard-1 (IAS-1) the enterprise is normally viewed as a
going concern, that is, as continuing in operation for the foreseeable
future. It is assumed that the enterprise has neither the intention nor the
necessity of liquidation.

25
This concept is of considerable importance for recording and valuation of
assets and liabilities. Assets are recorded at original cost on the
assumption that the business will continue for a long period and giving the
asset at its realizable value will be meaningless. Similarly, depreciation
is provided by considering the expected life of the asset. Giving due effect
for outstanding expenses / liability and prepaid expenses are made on the
going concept only. However, if the company is expected to be liquidated
or cease to operate within a short period say a year or two, then going
concern principle must be ignored. And the resources could be reported
at their market values i.e., liquidation values.
4. Cost Concept: The properties (land and buildings, machineries,
furniture and fittings etc) that a business owns can be described as assets.
Under cost concept assets are recorded in the books of account at the
price at which they are acquired. The expenditure incurred to acquire the
assets is termed as cost and this cost is the basis for all subsequent
accounting for the assets. For example, when an asset is acquired for Rs.
5 lakhs it will be recorded in the books of account at Rs. 5 lakhs. Suppose
the market value of the asset increases to Rs. 8 lakhs (or decreases to
Rs. 3 lakhs) the asset will continue to be shown at Rs. 5 lakhs only and
not its market value. This does not mean that all assets will be shown at
their original cost for all the time to come. The cost of an asset that has a
long but limited life is systematically reduced year by year by charging
depreciation. The value of the asset after deducting depreciation is called
book -value. The book value of the asset has no relevance to its market
value. We should be clear that the purpose of providing depreciation is to
allocate the cost of the asset over its useful life time and not to adjust its
cost so as to bring it to the close of the market value.
As there is wide gap between the book value and market value of the
assets, the financial statements fail to reflect the true picture of the
business. However, accountants these days try to overcome this
limitation with the help of inflation accounting. The cost concept is also
preferred because of frequent changes in the market values of assets.
And there will be too much of subjectivity in ascertaining the market values
of assets.
5. Dual aspect concept: This is very basic concept of accounting. This
concept recognizes the two-fold effect of a transaction. In accounting we
say that ‘every receiver is also a giver and every giver is also a receiver’.
For instance, if you purchase an asset say a machine for Rs.1, 00,000
you receive machine on the one hand and give Rs.1, 00,000 on the other.
Thus, this transaction has a two-fold effect, namely, (i) increase in one

26
asset and (ii) decrease in another asset. Similarly, if you sell goods for
cash say Rs.50, 000, you will receive cash and give the goods. The effect
of this transaction is that the stock will be reduced by Rs.50, 000 and your
cash balance will be increased by Rs.50, 000. Thus, every business
transaction has two aspects. (i) The receiving aspect, and (ii) the giving
aspect. When both aspects of a transaction are recorded, it facilitates the
business to maintain complete records for all transactions of business.
As per the dual aspect concept, at any given point of time, the total assets
will be equal to the total liabilities. This can be expressed in the form of
following equation

Liabilities (Equities) = Assets

or
Capital + Outside Liabilities=Assets.
The term ‘assets’ denotes the resources owned by a business while the
term ‘equities’ denotes the claims of various parties against the assets of
the business. Equities can be classified as: (i) owners’ equity, and (ii)
outsiders’ equity. Owners’ equity can be described as the claim of the
owners against the assets of the business. Outsiders’ equity is the claim
of outside parties such as debenture holders, creditors of the business
etc. As all assets of the business are claimed either by the owners or by
the outsiders, the total assets of a business will be always equal to its
liabilities.
6. Accounting Period Concept or Periodicity Concept: The success
or failure of an organization can be known only after the business has
ceased its operations, its assets have been sold off and liabilities paid off.
But the parties who are interested in the operating results of the business
cannot wait till the end. They want to know the operating results at
periodic intervals. To fulfil their desires and to fulfil the legal requirements,
accountants measure the results at shorter period. The shorter intervals
of time adopted by accountants are called accounting periods. Normally
business adopts twelve-month period as accounting period. The twelve-
month period concept is applied mostly for external reporting purpose
only. For internal purpose, that is, for providing accounting information to
the management for decision making, the business usually adopts a
shorter span of interval say one month or three months. Periodicity
concepts helps the users of accounting to know how business is going on,
to compute and disburse periodic rewards (profits) to the owners of the
business at periodic intervals and to pay off the liabilities for tax to the
government.

27
2.4 ACCOUNTING STANDARDS

You have learnt somewhere else in Unit-1 that there are various parties
interested in the accounting information of the companies. Shareholders
and investors use the financial statements to take decisions about their
investments. Creditors use the financial statements to decide the credit
limit and to fix other terms and conditions of credit. The financial
statements should communicate the correct picture about the
performance of the companies. There is a great possibility for the
companies to over state the income and assets and understate the
liabilities (window-dressing). Similarly, a company in spite of incurring a
loss can declare dividend by manipulating the loss into profit. Under these
circumstances the investors cannot take right decision. Eventually, the
companies cannot build up and gain the public confidence on the
securities market. Therefore, it is evident that the companies and their
accountants should not be allowed too much discretion to present
financial information in the way they like. To put it in other words, the
companies and their accountants should adopt carefully considered
accounting standards for preparing and reporting financial statements.
To achieve uniformity in the financial statements and to guide the
investors to make right investment decisions, Companies Act in India has
prescribed the minimum level of information which companies should
disclose in financial statements. The Institute of Chartered Accountants
has also taken various measures to develop several accounting
standards. At international level, International Accounting Standards
Committee (IASC) was established on 29th June 1973 when 16 accounting
bodies from nine nations (called founder members) have signed the
agreement and constitution for its formation. The aim of the committee is
“to formulate and publish, in public interest standards to be observed in
the presentation of audited financial statements and to promote their
worldwide acceptance and observance”. The formulation of such
standards harmonizes varying accounting policies and practices and
helps the users of accounting information to understand and exchange of
economic information in the right sense.
The accounting standards laid down by International Accounting
Standards Committee are given below:

IAS- 1 Presentation of financial statements

IAS- 2 Inventories

IAS- 3 Consolidated financial statements- withdrawn

IAS- 4 Depreciation accounting –withdrawn

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IAS- 5 Information to be disclosed in financial statements- withdrawn
IAS- 6 Accounting responses to changing prices (superseded by IAS
15)

IAS -7 Cash Flow Statement

IAS -8 Net profit/ loss for the period. Fundamental errors and changes
in accounting policies
IAS -9 Accounting for Research and Development activities
withdrawn

IAS-10 Events after the Balance Sheet Date

IAS -11 Construction contracts

IAS -12 Income Taxes

IAS- 13 Presentation of current assets and current liabilities –
withdrawn

IAS- 14 Segment Reporting

IAS -15 Information reflecting effects of changing prices

IAS -16 Property, Plant and Equipment

IAS -17 Leases

IAS -18 Revenue

IAS- 19 Employee benefits

IAS- 20 Accounting for Government grants and disclosure of
Government assistance
IAS- 21 The effects of changes in Foreign Exchange Rates

IAS- 22 Business combinations

IAS- 23 Borrowing cost

IAS -24 Related Party Disclosures

IAS- 25 Accounting for investments –withdrawn

IAS- 26 Accounting and reporting by retirement benefits plans

IAS-27 Consolidated financial statements and accounting for
investments in Subsidiaries

IAS -28 Accounting for investments in associates

IAS- 29 Financial reporting in Hyper- Inflationary Economies

29
IAS-30 Disclosures in the financial statement of banks and similar
financial institutions

IAS -31 Financial reporting of interests in Joint- ventures

IAS-32 Financial instruments: Disclosure and presentation

IAS- 33 Earning per share

IAS-34 Interim financial reporting

IAS-35 Discontinuing operations

IAS -36 Impairment of assets

IAS -37 Provisions, contingent liabilities and contingent assets

IAS- 38 Intangible assets

IAS -39 Financial instruments: Recognition and Measurement

IAS-40 Investment properties

IAS -41 Agriculture

2.5 ACCOUNTING STANDARDS IN INDIA

In India, the Institute of Chartered Accountants of India (ICAI) has formed
the Accounting Standards Board (ASB) in April 1977 which includes
representative from Industry and Government. So far, twenty eight
standards have been issued by ASB. These standards are recommended
for use by companies listed on recognized Stock Exchanges and other
large commercial, industrial and business enterprises both in the public
and private sectors. These twenty eight standards are listed below.
Framework for the Preparation and Presentation of Financial
Statements

(AS 1) Disclosure of Accounting Policies

(AS 2) Valuation of Inventories

(AS3) Cash Flow Statements

(AS 4) Contingencies and Events Occurring after the Balance Sheet
Date
(AS 5) Net Profit or Loss for the period, Prior Period and Extraordinary
items and changes in Accounting Policies

Announcement-Limited Revision to Accounting Standards (AS) 5

(AS6) Depreciation Accounting

(AS7) Accounting for Construction Contracts

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 Revised Accounting Standard (AS) 7, Construction Contracts,
28-5-2002

(AS 8) Accounting for Research and Development

(AS9) Revenue Recognition

(AS 10) Accounting for Fixed Assets

Announcement-Status of certain provisions of AS 10, Accounting for
Fixed Assets, pursuant to the issuance of AS 19, Leases and AS 16,
Borrowing Costs
(AS 11) Accounting for the Effects and Changes in Foreign Exchange
Rates
(AS 11) (Revised 2003) The Effects of Changes in Foreign Exchange
Rate 21-02-2003

(AS 12) Accounting for Government Grants

(AS 13) Accounting for Investments

(AS14) Accounting for Amalgamations

(AS 15) Accounting for Retirement Benefits in the Financial Statement
of Employers

(AS16) On Borrowing Costs

(AS 17) Segment Reporting

Disclosure of corresponding previous year figures in the first year of
application of Accounting Standards (AS) 17, Segment Reporting
Accounting Standard 18, Related Party Disclosures Applicability of
Accounting Standards (AS 18) Related Party Disclosures

(AS 19) Leases

(AS 20) Earnings Per Share

(AS 21) Consolidated Financial Statements

(AS 22) Accounting for Taxes on Income

Clarification of Accounting Standards (AS) 22, Accounting for
Taxes on Income
(AS 23) Accounting for Investments in Associates in Consolidated
Financial Statements
(AS 24) Discontinuing Operations Announcement-Accounting
Standards (AS) 24, Discontinuing Operations
(AS 25) Interim Financial Reporting

31
(AS 26) Intangible Assets

(AS 27) Financial Reporting of Interests in Joint Ventures

(AS 28) Impairment of Assets 30-05-2002

LET US SUMUP
Accounting is the language of business. To convey the same meaning to
all the people as far as possible accountants all over the world have
agreed upon to follow a number of uniforms and scientifically laid down
rules and conventions. These rules and conventions are generally termed
as “Generally Accepted Accounting Principles”. These concepts enjoy a
wide measure of support of the accounting profession. GAAP helps the
users of accounting information significantly. Lack of well-defined rules
and conventions makes it difficult to compare the financial statements of
different companies. Furthermore, the multiplicity of accounting practices
makes it possible for management to conceal the real facts by selecting
the alternative presentation of financial results which allow information to
be manipulated. The financial analysis made on the basis of these
financial statements will also have limited uses.
Business entity concept, money measurement concept, going concern
concept, cost concept, dual aspect concept, accounting period concept,
objectivity concept, realization or revenue recognition concept, matching
concept, conservatism concept, consistency concept, concept of full
disclosure, materiality concept are the important accounting concepts
followed at present. In this unit all these concepts have been explained.
Further accounting standards followed in India and the International
Accounting Standards (ISA) have been discussed in this unit.

CHECK YOUR PROGRESS

Choose the Correct Answers:

1) According to accrual concept of accounting, financial or business
transaction is recorded _____
a) when cash is received or paid
b) when transaction occurs
c) when profit is computed
d) when balance sheet is prepared
2) A company is a going concern if ____
a) its balance sheet shows a strong financial position
b) its income statement for the current year shows huge profit
c) there is no evidence that it will or will have to cease operations
within foreseeable future.

32
 d) it is a public limited company
3) Which accounting concept or principle states that the transactions of
a business must be recorded separately from those of its owners or
other businesses?
a) materiality concept of accounting
b) time period concept of accounting
c) matching principle of accounting
d) business entity concept of accounting
4) The business or economic entity concept is applicable to ____
a) sole proprietorship form of business
b) partnership form of business
c) corporate form of business
d) all of the above
5) Which of the following states that a transaction is not recorded in the
books of accounts unless it is measurable in terms of money?

a) Matching principal b) Revenue recognition principle

c) Monetary unit assumption d) Time period assumption

GLOSSARY
Accounting Framework : refers to generally accepted
accounting principles (GAAP) on
the basis of which accounting data
is processed, analysed and
reported.
Accounting theory : is a set of inter –related principles
and propositions which provide a
general framework for accounting
practice and deal with new
developments in the area.
Business : refers to any activity which is
carried out with profit motive.
Business entity concept : implies that in accounting business
is a separate entity from the owners
of the business.
Conservatism : means playing safe, that is,
anticipating no profit but provide for
all possible losses.
Accounting period : refers to the period for which the
accounts are usually kept.

33
SUGGESTED READINGS
1. Gupta, R.L. and Radhaswamy, M., (2006), Financial Accounting,
Sultan and Chand Sons, New Delhi.
2. Maheswari, S.N and Maheshwary, S.K. (2006), Fundamental of
Accounting, Vikas Publications.
3. Shashi K. Gupta, R.K.Sharma , (2012), “Financial Management”
latest Edition, Kalyani Publishers, Chennai
4. M C Shukla, S C Gupta & T S Grewal, (2017), Advance
Accounting, 19th Edition, S.Chand Publishing, New Delhi
5. Tulsian P. C. , (2017), Financial Accounting , Pearson Education,
New Delhi.
6. https://www.vedantu.com/commerce/accounting-concepts
7. https://www.mca.gov.in/content/mca/global/en/acts-
rules/ebooks/accounting-standards.html
8. https://www.accountingtools.com/articles/basic-accounting-
concepts.html

ANSWER TO CHECK YOUR PROGRESS

1) b 2) c 3) d 4) d 5) c

34
Unit 3

DOUBLE ENTRY SYSTEM

STRUCTURE

Overview

Learning Objectives

3.1 Single Entry System

3.2 Salient Features

3.3 Disadvantages and Advantages of Single- Entry System

3.4 Calculation of Profit or Loss

3.4.1 Increase in Net worth Method

3.4.2 Conversion Method

3.5 What is the double-entry system?

3.6 Accounting Equation

3.7 Characteristics of the Double Entry System

3.8 Advantages of Double Entry System

3.9 Limitations of Double Entry System

3.10 Single Entry System vs Double Entry System

Subsidiary Books

Let Us Sum Up

Check Your Progress

Glossary

Suggested Readings

Answers to Check Your Progress

OVERVIEW
Usually, accounting is understood as the language of business. However,
a business may have a lot of aspects which may not be of financial nature.
As such, a better way to understand accounting could be to call it the
language of financial decisions. The better the understanding of the
language, the better is the management of financial aspects of living. The
knowledge of accounting is an added advantage in performing different
roles. However, we shall limit our scope of discussion to a business

35
organisation and the various financial aspects of such an organisation.
The modern system of accounting is based on the principles of double
entry system owes it origin to lucopacioli who first published the principles
of double entry system in 1494 at Venice in Italy. Thus, the art of
accounting has been practised for centuries but it is only in the late thirties
that the study of the subject 'accounting' has been taken up seriously.

LEARNING OBJECTIVES

After reading this unit, you should be able to:

• Compute profit or loss under single entry system.
• The meaning double-entry system
• Accounting Equation
• Characteristics of the Double Entry System
• Advantages of Double Entry System
• Limitations of Double Entry System
• Differentiate Single Entry System and Double Entry System

3.1 SINGLE ENTRY SYSTEM

Single Entry System is an incomplete ‘double entry system’. In case of
double entry system of book- keeping both the aspects of every
transaction are recorded. In this system, the first entry is made to the debit
of an account, and the second entry to the credit of second account.
However, in case of single entry system, the business houses for their
convenience and more practical approach ignore the strict rules of double
entry system. The users of this system maintain only the essential
records. In other words, it is a system which may not keep some books of
subsidiary records and some ledger accounts which otherwise are kept in
case of double entry system. In fact, single entry system may consist of
double entry in respect of certain transactions such as cash paid to
creditors, cash received from debtors, etc, and single entry in regard to
certain events and transactions such as cash sales and purchases and
expenses incurred on purchase of fixed assets. Further, the users of this
system may pass no entry in respect of certain transactions, for instance,
depreciation, bad debts, etc.
According to a Dictionary of Accountancy by Kohler, “A system of book -
keeping in which as a rule only records of cash and of personal accounts
are maintained, it is always incomplete double entry varying with the
circumstances.” Thus, under the so-called single entry system both the
aspects of business transactions and events are not recorded and,
therefore, this may be defined, “as any system which is not exactly the

36
Double Entry System”. Under the single entry system usually a cash book
and personal accounts are maintained.

3.2 SALIENT FEATURES

From the foregoing discussion, the following salient features have
emerged about the single-entry system:
a) Under this system usually a cash book and personal accounts are
maintained.

b) Usually real and nominal accounts are not kept in this system.
c) The cash book maintained, under this system usually mixes up both the
personal and the business transactions.
d) In this system, it is seen quite oftenly that in order to collect the
necessary information one has to depend on original vouchers. For
example, the amount of credit purchases may have to be found out on the
basis of original invoices received from the suppliers in case the figures
are not readily available.
e) This system can be applied only in case of sole trader or partnership
concerns. Limited companies, because of legal provisions, cannot keep
books on single entry system.
f) It is adopted as per individual requirements and convenience by the
business houses. Therefore, the system may differ from firm to firm, which
brings lack of uniformity in accounting books.
3.3 DISADVANTAGES AND ADVANTAGES OF SINGLE-ENTRY
SYSTEM
Disadvantages of single-entry system
a) It is an incomplete system of accounting since this system does not
record both the aspects of business transactions and events. Because of
this limitation, one cannot prepare trial balance and, thus, the arithmetical
accuracy cannot be easily checked in the absence of a trial balance. This
increases the chances of misappropriations and frauds as compared to
the Double Entry System of book-keeping.
b) This system lacks uniformity since the businessmen apply it as per their
individual requirements and conveniences.
c) It becomes difficult to valuate assets in case a businessman wanted to
sell his business.
d) In the absence of complete information for sales, purchases and other
expenses, the trading and profit and loss account cannot be prepared.

37
Hence, rate of gross profit on sales and the true profit or loss position
cannot be known.
e) As there are no real accounts, the balance sheet cannot be drawn up
to give a correct picture of the financial position of the business on a
particular date.
f) This system hampers comparison, planning, and sound decision-
making because the system does not provide accurate figures about the
performance of the business and its financial position.
Advantages
a) This system is more economical than double entry system and hence,
suitable for small business firms.
b) This system is also suitable to those firms which have more cash
transaction and a large number of personal accounts.
c) This system does not require specialised knowledge of accounting
since only selected books of accounts are kept under it.

3.4 CALCULATION OF PROFIT OR LOSS

In case of a business maintaining accounts according to single entry
system, profit (or loss) made during the year are calculated by any of the
following two methods:

i) Increase in net worth method.

ii) Conversion method.

3.4.1 Increase in Net Worth Method

Under this method, profit can be calculated by comparing the net worth in
the beginning of the year and at the end of the year. Any decrease in net
worth is taken as loss, but any increase in net worth is taken as profit.
However, this is true only in the absence of any other information. Thus,
under a pure single entry system profit cannot be calculated by preparing
trading and profit and loss account. For this purpose, we need to calculate
and compare capital (net worth) in the beginning and at the end of the
year. For example, if net worth of the business on 1.4.2019 is Rs.
50,00,000 and it is Rs. 52,00,000 on 31st March, 2020, it can be said that
the business has made profit of Rs. 2,00,000 during the period.
In order to determine the capital in the beginning of the period and at the
end, we prepare ‘statement of affairs’. A statement of affairs is a statement
of all assets and liabilities. The excess of assets over liabilities is taken as
net worth.

38
For calculating profit by net worth method the following adjustments are
required:
(i) Adjustment for drawings: The drawings made by proprietor from the
business for his personal use are added to the capital at the end because
drawings made during the year will reduce the capital at the end but not
the profit for the year. In other words, accurate amount of profit (or loss)
can be known only by making adjustments, in the capital at the end, for
the drawings made.
(ii) Adjustment for capital introduced: The proprietor may introduce
fresh capital in the business during the course of the financial year. This
fresh capital is deducted from the capital at the end because the fresh
capital will increase the capital of the proprietor at the end of the financial
year, but not the profit. Thus, the increase in the capital at the end due to
introduction of capital during the year should not be misunderstood for
increase in capital because of profits made during the year.

Steps for Preparing Statement of Affairs

The procedure for preparing the Statement of Affairs can be understood
with the following steps:
a) Firstly, we are to prepare statement of affairs at the beginning for
ascertaining net worth in the beginning.
b) Secondly, we shall prepare statement of affairs at the end for
calculating net worth at the end.
c) Thirdly, make adjustments for drawings, and capital introduced during
the year.
d) In the end, deduct net worth in the beginning from the net worth at the
end. The excess of capital at the end over capital in the beginning will
denote the profit.

3.4.2 Conversion Method

We have seen under the net worth method in the preceding explanation
that the method does not give details of the gross profit and net profit.
Also, it does not provide a clear picture of the operational results of a
business. Resultantly, it becomes just impossible to make a objective
analysis of the financial statements. But the effective steps needed to
strengthen the financial position of the business cannot be devised
without making a meaningful analysis of financial position. Hence, it is
quite essential to ascertain the missing information from the books of
accounts, and other sources. The missing information can be ascertained
by preparing Total Debtors Account, Receipts and Payments Account,

39
Total Creditors Account, Memorandum Trading Account, etc. After
ascertaining the required information, it will be possible to prepare a trial
balance. Now, one can prepare final accounts in the usual manner since
full information as under double entry system is available. Hence, under
conversion method net profit is ascertained by conversion of single entry
system into double entry system.
Under conversion method, firstly statement of affairs in the beginning is
prepared to ascertain capital in the beginning. For preparing this
statement, the students should ascertain the information’s on debtors in
the beginning or creditors or cash in khand or cash at bank or any other
items, if these are missing. This is done by preparing a cash book, total
debtors account, total creditors account, bills receivable account, bills
payable account, etc. These various accounts will help in revealing a
missing figure of cash, bank, credit sales, cash sales, creditors or debtors
balance either in the beginning or at the end or any other information. After
preparing these accounts the students should calculate total sales by
adding credit sales and cash sales; total purchases by adding cash
purchases and credit purchases. Information relating to nominal accounts
can be ascertained from the cash book. Real accounts and amounts
outstanding will be available by way of information. Now, it will be possible
to prepare a trial balance. However, in practice trial balance is skipped
and only such information is collected which is required for preparing the
Trading and Profit and Loss Account, and Balance Sheet of the business.
In order to prepare trading and profit and loss account and balance sheet,
the students need the following information:

1. Opening stock and closing stock

2. Purchases

3. Direct expenses

4. Sales

5. Indirect expenses and other incomes

6. All assets and all liabilities

7. Capital in the beginning

8. Profit made during the year

Opening Stock and Closing Stock: The amount of Opening and Closing
Stock can be ascertained by preparing a Memorandum Trading Account.
Purchases: Purchases are calculated by adding cash purchases and
credit purchases. Cash book reveals the amount of cash purchases. The

40
amount of credit purchases can be ascertained by preparing (i) total
creditors account, and (ii) bills payable account.
Bill payable account: Sometimes, bill payable account and total
creditors account are prepared to ascertain purchases. This is required
when a part of payment to creditors is made by accepting bills. This
information will be depicted by bills payable account and this is taken to
creditors account. The balancing figure of total creditors account is
assumed as credit purchases.
Direct Expenses: Information relating to nominal accounts can be
ascertained from the cash book. These expenses may require adjustment
in the light of outstanding and prepaid expenses.
Sales: Sales for the purpose of trading account are ascertained by adding
cash sales and credit sales. Credit sales should be found out by preparing
a Total Debtors Account while cash sales should be found out from the
Cash Book.
Indirect expenses: Indirect expenses (expenses shown in Profit and
Loss a/c) can be traced to cash book. However, sometimes these
expenses need adjustment in the light of outstanding and prepaid
expenses.
Ascertaining Capital in the Beginning: The amount of capital in the
beginning of the year can be found out by preparing the Balance Sheet of
the business.
3.5 WHAT IS THE DOUBLE-ENTRY SYSTEM?
Double Entry System is the scientific method of keeping financial records,
developed by Luca Pacioli, in 1494. This system is based on the principle
of duality, i.e., every transaction has a dual aspect. Each transaction
affects two accounts at the same time, in which one account is debited
while the other is credited.
The double-entry system of accounting or bookkeeping means that for
every business transaction, amounts must be recorded in a minimum of
two accounts. The double-entry system also requires that for all
transactions, the amounts entered as debits must be equal to the amounts
entered as credits.

Example of a Double-Entry System

To illustrate double entry, let's assume that a company borrows ₹10,000
from its bank. The company's Cash account must be increased by
₹10,000 and a liability account must be increased by ₹10,000. To increase
an asset, a debit entry is required. To increase a liability, a credit entry is

41
required. Hence, the account Cash will be debited for ₹10,000 and the
liability Loans Payable will be credited for ₹10,000.

Double Entry Keeps the Accounting Equation in Balance

Double entry also means that the accounting equation (assets = liabilities
+ owner's equity) will always be in balance. In our example, the accounting
equation remained in balance because both assets and liabilities were
each increased by ₹. 10,000.
It’s a fundamental concept encompassing accounting and book -keeping
in present times. Every financial transaction has an equal and opposite
effect in at least two different accounts.

Equation can be: ASSETS = LIABILITIES + EQUITY

Recording System
Double entry system records the transactions by understanding them as
a DEBIT ITEM or CREDIT ITEM. A debit entry in one account gives the
opposite effect in another account by credit entry. This means that the
sum of all Debit accounts must be equal to the sum of Credit accounts.
This method of accounting and book-keeping results in the accurate
depiction of financial statements. Thus, it also lowers the rate of errors by
detecting them on a timely basis.

3.6 ACCOUNTING EQUATION

Dual concept states that 'for every debit, there is a credit'. Every
transaction should have two-sided effect to the extent of same amount.
This concept has resulted in accounting equation which states that at any
point of time assets of any entity must be equal (in monetary terms) to the
total of owner's equity and outsider's liabilities. In other words, accounting
equation is a statement of equality between the assets and the sources
which finance the assets and is expressed as :

Assets = Sources of Finance

Assets may be tangible e.g. land, building, plant, machinery, equipment,
furniture, investments, cash, bank, stock, debtors etc. or intangible e.g.
patent rights, trade marks, goodwill etc.,
Sources include internal i.e. capital provided by the owner and external
i.e. liabilities. Liabilities are the obligations of the business to others/
outsiders. The above equation gets expanded.

Assets = Liabilities + Capital

All transactions of a business can be referred to this equation :

42
Assets = Liabilities + Owner's equity
To further explain the transaction of revenues, expenses, losses and
gains, the equation can be expanded thus:

Assets + Expenses = Liabilities + Revenue + Owner's equity

or Assets = Liabilities + (Revenue – Expenses) + Owner's equity

or Assets = Liabilities + Owner's equity + Owner's equity

(income) which ultimately becomes

Assets = Liabilities + Owner's equity

Types of Accounts
The accounting and book-keeping process measures, records and
communicates day to day financial activities. A transaction is an event
taking place between two economic entities, such as customers or
vendors and businesses. Accounting and book-keeping record this event.
Under a systematic accounting process, the activities are recorded into
various accounts to keep the data bifurcated and classified under account
heads. There are majorly seven types of accounts wherein all the
business accounting entries and transactions are classified. These are:
• Assets
• Liabilities
• Equity
• Gains
• Losses
• Expenses
• Revenues

The accounting and book-keeping is a continuous process of tracking

changes in each account as the company continues to do its operations.

Debit and Credit

Debits and Credits are essentials to enter data in a double entry system
of accounting and book-keeping. While posting an accounting entry, an
entry on the left side of the account ledger is a debit entry and right side
entry is a credit entry.

3.7 FUNDAMENTAL PRINCIPLES OF DOUBLE ENTRY SYSTEM

Characteristics of the double-entry system are stated below;

a) Two parties: Every transaction involves two parties – debit and
credit. According to the main principles of this system, every debit of

43
 some amount creates corresponding credit, or every credit creates
the corresponding debit for the same amount.
b) Giver and receiver: Every transaction must have one giver and one
receiver.
c) Exchange of equal amount: The amount of money of a transaction
the party gives is equal to the amount the party receives.
d) Separate entity: Under this system, business is treated as a
separate entity from the owner. Here the business is considered as
a separate entity.
e) Dual aspects: Every transaction is divided into two aspects. The left
side of the transaction debit and the right side is credit.
f) Results: Under double entry system totality of debit is equal to the
totality of credit. In its ascertainment of the result is easy.
g) Complete accounting system: Double entry system is a scientific
and complete accounting system.

3.8 ADVANTAGES OF DOUBLE ENTRY SYSTEM

The double-entry system is the most scientific method of keeping
accounts. In the modem age, this system is accepted as the best one.

The advantages of the double-entry system are stated in brief;

i) Complete accounts of transactions: The double-entry system can
keep complete accounts of transactions as it is based on dual
aspects of each transaction, i.e., debit and credit, are recorded
simultaneously.
ii) Verification of arithmetical accuracy: Arithmetical accuracy of
accounting can be verified through the preparation of trial balance if
the accounts are maintained under the double-entry system.Under
this system, every debit for a certain amount of money will have
corresponding credit for an equal amount.
iii) Determining profit or loss: Under the double-entry system, profit
or loss of the company for a particular accounting period can be
known by preparing an income statement.
Since all accounts relating to income and expenditure are
maintained properly in the ledger under the double-entry system, it
becomes convenient to draw income statement at the end of a
particular accounting period.
iv) Determining the financial position: Under the double-entry
system, the total assets and liabilities of a business concern are
recorded properly.

44
v) Knowing assets and liabilities: The total amount of assets and
liabilities can be ascertained if the account is kept under a double-
entry system, and it becomes easier to settle liability and assets.
vi) Fixation of the price of commodities: It becomes easier to fix-up
the price of commodities as the accounts are maintained
systematically under the double-entry system.
vii) Submission of income and VAT statements: The double-entry
system being the reliable system of keeping accounts the
submission of reliable income and VAT statement under it is possible
based on which income tax and VAT are fixed and paid.
viii) Comparative analysis: Under this system of accounting, the
future course of action can be formulated by comparing income -
expenditure, asset, and liability of the current year with that of the
previous year.
ix) Increase in profit: Under this system of accounting, the picture of
all incomes or profits is reflected. It can be identified which item is
more profitable for a business comparing the items relating to a profit
of the current year with that of the previous year. In this way,
attempts can be made to make more profit.
x) Expenditure control: Through comparative analysis, expenditure
may be controlled by curtailing expensive expenditure.
xi) Detection and prevention of forgery: Under this system of
accounts, errors, or forgery of accounts can easily be detected. As a
result, the moral qualities of an accountant and other employees are
upheld.
xii) Supply of information: This system helps run the business
properly, supplying necessary information and statistics to the
management.
xiii) Future reference: Under this system, as every transaction is
permanently recorded properly and completely, any necessary
information can be detected easily in the future.
xiv) Easy application: It is easier to record the transactions properly
in the books of accounts following the scientific method of the
double-entry system.
xv) Generally accepted method: The double-entry system is a
scientific method, is a generally accepted system. The accounts
under the double-entry system become reliable and acceptable to all
concerned, like income tax authority, creditors, etc.
xvi) Efficiency evaluation of business concern: Capacity for
earning a profit and repaying liabilities can be evaluated with the help
of various ratios relating to accounts from financial statements. For

45
 example, creditors or loan givers evaluate the loan repaying capacity
of a business concern with the help of the current ratio. If the ratio is
2:1, then it is assumed that the loan repaying capacity of the
business concern is sound enough.
xvii) Timely step for correcting accounting errors: Accounting
errors can properly be detected, and taking necessary measures for
correction is possible under a double-entry system of accounting;
i.e., before going to the next stage, the errors of accounting can be
corrected.
xviii) Utility: The utility and application of this system in the accounts of
all business concerns, whether big, medium or small, are accepted
by all.
3.9 DISADVANTAGES OR LIMITATIONS OF DOUBLE ENTRY
SYSTEM
The double entry system is a generally accepted scientific method.
Despite its many important advantages, some limitations of it exist which
are stated below:
a) Increased size of books of accounts: Under the double-entry
system, every transaction is recorded on two sides of two accounts
and in two steps (Journal & ledger) of books of accounts.
b) Complexity in the accounting process: Complexity arises in
following rules, principles, techniques, and methods, etc. for keeping
accounts under the double-entry system.
c) Expensive, time and labor-consuming: Since the accounting
process under the double-entry system is extensive, a good number
of books are to be kept, and a large number of employees are
employed for accounting work.
d) As a result, it requires enough labor, time, and money. Therefore, it
becomes impossible to follow this system by small business
concerns.
e) Persons of specialized knowledge required: The accountant
should possess both theoretical and practical knowledge of
accounting for the proper keeping of accounts under the double-
entry system.
An inexperienced person in accounting fails and faces problems in
maintaining accounts under this double-entry system.
f) Possibility of mistake: As the accounting process under the
double-entry system is complex and complicated, the possibility of
errors and mistakes cannot be avoided completely.

46
 g) The limited scope of application: In a small business organization,
daily shopping, a cultural ceremony, the application of a single entry
system of accounting is more popular and advantageous than the
double-entry system.
h) A problem in maintaining the secrecy: A lot of people are engaged
in maintaining accounts under the double-entry system since the
accounting process is very wide and extensive.
As a result, a problem arises in maintaining the secrecy of the accounts
or business.Though there arise some problems in maintaining accounts
under double entry systems, its advantages and acceptability are so wide
and comprehensive that at present age in almost all field accounts is kept
under this system.
3.10 DIFFERENCE BETWEEN SINGLE AND DOUBLE ENTRY
SYSTEM
The bookkeeping system in which only one aspect of a transaction is
recorded, i.e. either debit or credit, is known as Single Entry System.
Double Entry System, is a system of keeping records, whereby both the
aspects of a transaction are captured.

Basis of
Differences Single Entry System Double Entry System

Double Entry System, is

It is the system of
a system of keeping
bookkeeping, in which only
records, whereby both
Meaning one aspect of a transaction
the aspects of a
is recorded, i.e. either debit
transaction are
or credit
captured.

Duality It is not based on duality It is based on duality

Generally, Sole proprietors Large corporations use

User and Partnership firms use this method of book-
this method of book-keeping keeping

Costs
Cheap Costly
Involved

Personal, Real and

Accounts Simple personal accounts
Nominal accounts are
maintained are maintained
maintained

47
 Detection of
Difficult to detect errors Easy to detect errors
Errors

LET US SUMUP
A system of book-keeping in which as a rule only records of cash and of
personal accounts are maintained, it is always incomplete double entry
varying with the circumstances. Double Entry System of accounting deals
with either two or more accounts for every business transaction. For
instance, a person enters a transaction of borrowing money from the bank.
So, this will increase the assets for cash balance account and
simultaneously the liability for loan payable account will also increase. It’s
a fundamental concept encompassing accounting and book-keeping in
present times. Every financial transaction has an equal and opposite
effect in at least two different accounts.

CHECK YOUR PROGRESS

Choose the Correct Answers:

1) Double Entry System is a ________.
a) Reporting system
b) Financial Statement preparation system
c) Recording system
d) Debit and Credit determining system
2) Which one is correct?
a) Opening capital = opening total assets - closing total assets
b) Closing capital = opening total liabilities + closing total liabilities
c) Opening capital = opening total assets - opening total liabilities
d) Closing capital = opening total assets + closing total assets
3) Which one is used a rough working for financial statement?

a) Trial balance b) Adjusting entries

c) Closing entries d) Works sheet

4) If opening capital is Rs.70,000 and closing capital is Rs.90,000, what
is the amount of profit or loss?

a) Profit Rs.20,000 b) Loss Rs.20,000

c) Loss Rs.70,000 d) Profit Rs.90,000

5) Which one is the principle of Double Entry System?________.
a) Purchase increases Debit, income decreases Credit
b) Expense increases Debit, Income decreases Credit
c) Receiver is Debit and Giver is Credit
d) Receiver is Credit and Giver is Debit

48
GLOSSARY

Personal Account : Accounts which are related to any person

or institution.

Double Entry : System of accounting in which every

System transaction and event affects two accounts.

Statement of Affairs : A statement of the financial position of an

enterprise under single entry system.

Cash Book : A subsidiary book in which only cash

transactions are recorded.

SUGGESTED READINGS
1. Gupta, R.L. and Radhaswamy, M., (2006), Financial Accounting,
Sultan and Chand Sons, New Delhi.
2. Maheswari, S.N and Maheshwary, S.K. (2006), Fundamental of
Accounting, Vikas Publications.
3. Shashi K. Gupta, R.K.Sharma , (2012), “Financial Management”
latest Edition, Kalyani Publishers, Chennai
4. M C Shukla, S C Gupta & T S Grewal, (2017), Advance
Accounting, 19th Edition, S.Chand Publishing, New Delhi
5. Tulsian P. C. , (2017), Financial Accounting , Pearson Education,
New Delhi.
6. https://www.accountingtools.com/articles/what-is-a-single-entry-
system.html
7. https://www.toppr.com/guides/principles-and-practice-of-
accounting/basic-accounting-procedures/double-entry-system/
ANSWER TO CHECK YOUR PROGRESS
1) d 2) c 3) d 4) a 5) c

49
Unit 4

ACCOUNTING PROCESS
STRUCTURE

Overview

Learning Objectives

4.1 Meaning of Accounting Cycle

4.2 Steps in Accounting Cycle

4.3 Introduction to Journal

4.4 Rules for journalizing

4.5 Points to be noted before journalizing

4.6 Between Trade Discount and cash Discount

4.7 Advantages of Journal

4.8 Limitations of journal

4.9 Meaning of Ledger

4.10 Ruling of ledger account

4.11 Ledger posting of Journal

4.12 Distinction between journal and ledger

Let Us Sum Up

Check Your Progress

Glossary

Suggested Readings

Answers to Check Your Progress

OVERVIEW
You have learnt that accounting is based on certain accounting concepts
and standards. Accounting process involves four stages, namely (i)
recording the transactions (ii) classifying the transactions, (iii)
summarizing the transactions and (iv)interpreting the results. Generally
small firms or sole traders use the single journal system and the bigger
firms use subsidiary books system for recording of business transactions.
This unit focuses on the procedures to be followed for journalizing the
transactions. The procedures to be followed for posting journal entries in
the Ledger Accounts and the procedures for preparing a Trial Balance in

50
order to check the arithmetical accuracy of the books of account are also
explained in this unit.

LEARNING OBJECTIVES

After reading this unit, you should be able to:

⚫ define journal and explain the procedures for journalizing the
transactions
⚫ post journal entries in the concerned ledger accounts
⚫ describe what an open entry is and how it is posted into ledger
⚫ Prepare a trial balance to check the arithmetical accuracy of
recording in the books of account.
⚫ Differentiate journal and ledger
⚫ Do ledger posting
4.1 MEANING OF ACCOUNTING CYCLE
The accounting cycle refers to the entire process where all financial
statements and transactions of a business are processed and recorded.
This is from the moment transactions take place to when they're
represented and added into financial statements to the closure of the
company accounts. Accountants and bookkeepers are highly involved in
ensuring the entire accounting cycle is tracked efficiently from the
beginning up to the end. With each fiscal year things actually become
easier as the cycle begins again as far as the business remains in
operation all along.
4.2 STEPS IN ACCOUNTING CYCLE

Figure 4.1 Accounting Cycle

51
In every accounting cycle all debits and credits, T-accounts, journal
entries and entire accounts and entries adjustments throughout the full
cycle are all incorporated forming the bedrock of all accounting cycle
steps. These steps are usually eight and include:
i) Recording of Transactions: The procedure is commenced by financial
transactions. It's actually financial transactions that are tracked throughout
the accounting cycle and can include expenses, sales revenue, assets
acquisition, purchases and debt payoffs, among others.
ii) Journal entries: As the transactions are taking place, they need to be
recorded in journal entries chronologically. Accounts are debited and
credited and it's important that each debit and credit equals and balances.
iii) General Ledger posting: Once the journal entries are prepared and
ready, they will then be added into a general ledger will all transactions in
a summarized form and all accounts clearly evident.
iv) Trial balance: After the accounting time frame has come to an end,
such as monthly, quarterly or annually a trial balance is expected showing
a total balance of all accounts.
v) Adjustment Entries: This is an important process that seeks to correct
errors and adjust properly where the total balances in terms of debits and
credits appearing on a trial balance have refused to equal.
vi) Adjustment Trial Balance: It’s also important for adjustment of entries
to be added accounting for deferrals and accruals once the accounting
period comes to an end.
vii) Closing Entries: Once everything is done expenses and revenue
accounts need to be closed to pave way for another accounting cycle.
Income statements in expense and revenue accounts indicate how a
company is performing for a certain period of time and thus closed once
that cycle is up. However, since balance sheets indicate the financial
position of a business over a specific period of time, its accounts cannot
be closed yet considering the accounting cycle might just be for a month
or quarter.
viii) Financial Statements: The last step in the accounting cycle is
preparing financial statements that tell you where your business’s money
is, and how it got there. Once you’ve created an adjusted trial balance,
assembling financial statements is a fairly straightforward task. First, an
income statement can be prepared using information from the revenue
and expense account sections of the trial balance. A balance sheet can
then be prepared, made up of assets, liabilities, and owner’s equity.

52
4.3 INTRODUCTION TO JOURNAL
Journal is derived from the French word ‘Jour’ which means a day. A
journal is a detailed account that records all the financial transactions of a
business, to be used for the future reconciling of accounts and the transfer
of information to other official accounting records, such as the general
ledger. Journal means daily recorded. It is a book of original record where
every transaction is recorded in the first instance and then is posted to the
ledger.

Journal entry

The form in which it is recorded is called Journal entry.

Journal entries that are recorded in a company's general journal will
consist of the following:
• the appropriate date
• the account(s) and amount(s) that will be debited
• the account(s) and amount(s) that will be credited
• a short description/memo/reference

Journalizing
Recording or entering a transaction in the journal is known as journalizing.
Journalizing transactions is the process of keeping a record of all your
business transactions, tracking them in chronological order, and generally
includes the date, the account you're debiting or crediting and a brief
description of the transaction that occurred. The specimen ruling of journal
is given below:

JOURNAL

Date Particulars L.F Amount Amount

(Dr) (Cr)
Rs. Rs.
Name of the a/c to be debited.
Name of the a/c to be credited.
(Narration or explanation)

4.4 RULES FOR JOURNALIZING

4.4.1 Based on Accounting Equation

1. Increase in assets are debits, decrease in assets are credits.
2. Increase in liabilities are credit, decrease in liabilities are debit.
3. Increase in capital are credit, decrease in capital are debit.

53
 4. Increase in profits are credit, decrease in profits are debit.
5. Increase in expenses are debit, decrease in expenses are credit.

4.4.2 Based on Traditional Approach

1. Debit the receiver, credit the giver.
2. Debit what comes in, credit what goes out.
3. Debit all expenses & losses, credit all incomes and gains.

4.5 POINTS TO BE NOTED BEFORE JOURNALIZING

1. Capital account: If the proprietor has introduced cash or goods or
property in business, it is known as capital. It should be debited to cash
or stock of goods or property account and credited to the proprietor’s
capital account. It must be clearly understood that the entity of the
proprietor is totally different from the business.
2. Drawing’s account: If the proprietor has withdrawn cash or goods from
the business for his personal Or domestic use, it is called drawings. It
should be debited to drawings account and credited to cash or purchases
account.
3. Cash / Credit transactions: When goods are purchased or sold for
cash, it is known as cash transaction. If goods are purchased or sold on
credit, then it will be credit transaction. If nothing is mentioned whether it
is a credit or cash transaction, then it should be treated as a credit
transaction
4. Casts and Carry forwards: When journal entries extend to several
pages of the journal, the total are cast (done) at the end of each page. AT
the end of each page the words “Total C/F (carried forward) are written in
the particulars column against the debit and credit totals .At the end of the
specified period or on the last page, the grand total is cast.
5. Goods given away as charity: If some goods from the business are
given away as charity to a particular person or Institution, it should be
debited to charity account and credited to purchases Account.
6. Compound journal entry: If there are two or more transactions of a
similar nature occurring on the same day and either debit or credit amount
is common, such transactions can be conveniently
Recorded in the form of one journal entry instead of making a separate
entry for each transaction. Such entry is known as compound journal
entry.
7. Opening Entry: The balances of the previous year are brought forward
in the beginning of the year by means of an entry in a going concern. Such

54
entry is made on the basis of accounting equation that is by debiting all
assets and crediting liabilities and capital account.
8. Cash Discount: This discount is allowed by a credit to a debit when
the latter pays the amount of goods purchased by him either immediately
or within a specified period. It is an incentive given to a debtor for making
an early payment. Being a nominal account discount allowed is debited
and discount received credited.
9. Trade discount: It is a deduction on the gross value are list price of
goods allowed by the manufacturer to the wholesaler or a wholesaler to a
retailer in order to enable them to sell the goods further at list price to the
consumer and yet earn a profit.
10. Purchase of shares: When shares or securities are purchased, the
entry is made at market value and not at face value. Brokerage paid on
the purchase of such investment is also added in the amount of
investment.
11. Sale of shares: If sale or securities are sold, the entry should be
passed at market value less brokerage, if any, paid on such shares.
12. Expenses incidental to the purchase of fixed assets: If some
expenses are incurred on the purchase of a fixed asset, these should be
added to the cost of the asset to the buyer. Such expenses should be
debited to the asset account and not to any expense account. Thus
installation charges paid on the purchase of machinery are debited to
machinery account.
13. Insurance of life policy: Premium paid on the proprietor’s life
insurance policy is debited to drawings account and not to insurance
premium account. It is a personal expense and not relating to the
operation of the business.
14. Carriage paid on buyer’s account: When goods are sold and
carriage /freight etc is paid on buyer’s behalf, it should be debited to
buyer’s personal account and not to carriage/freight account.
15. Goods distributed as free samples: If goods are distributed as free
samples to promote the sale of the business. It should be debited to
advertisement a/c and credited to purchases a/c.
16. Bad debts: When an amount is irrecoverable from a customer
because of his insolvency or otherwise, it is a loss for the business. It
should be debited to bad debts account and credited to customer’s
account.

55
17. Interest due to loans: When a loan is taken from a person and
interest is yet to be paid, it should be debited to interest account and
credited to loan account.
18. Loss of stock by fire: If some stock is lost by fire, it should be debited
to loss of stock by fire and credited to purchases account. If any part of
such loss is recoverable from insurance company, it should be debited to
insurance claim account and credited to loss of stock by fire account
19. Commission: It is the remuneration, which is given by an enterprise
to an employee, or an agent who is performing some services relating to
purchase, sale, and collections and other types of business transactions.
Commission is a nominal account, when paid will be debited as an
expense and credited and received.
4.6 DIFFERENCE BETWEEN TRADE DISCOUNT AND CASH
DISCOUNT

Basis of
Trade Discount Cash Discount
Distinction

1.When It is allowed on a certain It is allowed when

allowed payment is made before a
Quantity being purchased
certain date.
or As a trade provide.

2. Purpose It is given to promote It is allowed to encourage

sales early cash payment.

3.Vary with It may vary with the It may vary with the period
quantity of goods within which the payment
purchased. is to be made.

4.Entry in It is not recorded in the A separate account in the

books books of accounts. ledger is maintained for
such discount.

5. Deduction It is deducted from the It is not deducted from the

invoice. invoice.

6.When It is offered at the time of It is offered at the time of

offered sale or purchase. getting quick payment.

7.Form It is usually given in It may be given in % or in

percentage. It is given on absolute figure.
the list price or catalogue
price or retail price.

56
4.7 ADVANTAGES OF JOURNAL
1. Chronological record of all transactions.
2. Permanent record.
3. Information of debit and credit and an explanation to it.
4. Reduces the error (since both transaction are written side by side).
5. Eliminates the need for a reliance on memory of the accounts
keeper.
6. Journal provides information relating to the following aspects:
a. Credit sale and purchases, b. Allowances received and
supplied, c. Losses by fire, earthquakes, theft, etc, d. Depreciation,
e. Transactions with bank, f.Income earned, expenses incurred, g.
Closing entries, h.Transfer entries (Drawings account will be
transferred to capital account at the end of the trading period) and
I. Renewal of bills, dishonour, etc.

4.8 LIMITATIONS OF JOURNAL

1. Too long.
2. Journal is unable to ascertain daily cash balance. (That is why
cash transactions are directly recorded in a separate cashbook so
that daily cash balances may be available).
3. Difficult to post each and every transaction from the journal to the
ledger.

4.9 MEANING OF LEDGER

A ledger a/c may be defined a summary statement of all the transactions
relating a person, asset, expenses or income, which have taken, place
during a given period of time and shows their net effect. Ledger is a
register having a number of pages, which are numbered consecutively.
One account is usually assigned one page in the ledger.
A ledger is the principal book or computer file for recording and totaling
economic transactions measured in terms of a monetary unit of account-
by-account type, with debits and credits in separate columns and a
beginning monetary balance and ending monetary balance for each
account. The general ledger is a master accounting document providing
a complete record of all the financial transactions of your business. It helps
you look at the bigger picture. Accounts include assets (fixed and current),
liabilities, revenues, expenses, gains, and losses.

57
4.10 RULING OF LEDGER ACCOUNT

The ruling of each account in the ledger is as following:

NAME OF THE ACCOUNT

Date Particulars J. Amount Particulars J Amount

F. Rs. Date F. Rs.

To Name of By Name
credit Debit
Account. account.

4.11 LEDGER POSTING OF JOURNAL

Every transaction is first recorded in the form of a journal entry. From the
journal it is transferred to the concerned accounts in the ledger. This
process of transferring the transactions from the journal to the ledger is
known as posting.
While posting from the journal, the Dr. Account is debited and Cr. Account
is credited and the entry in each account indicates the account in which
the corresponding entry appears.

Balancing of Accounts:
Various accounts in the ledger are balanced with a view to propriety the
final accounts. The procedure of balancing accounts is as follows.

1.Take the total of the two sides of the account concerned.

2.Ascertain the difference between the totals of 2 sides.

3.Enter the difference in the amount column of the side showing less total
writing against the difference in the particulars column “ To Balance C/d”
on the credit side of the account.

4.The balance is brought forward at the beginning of the next period.

An account is said to have a debit balance → if the total of debit
side is more then credit side.
An account is said to have a credit balance → if the total of its credit
side is more than the total of its debit side.

58
4.12 DISTINCTION BETWEEN JOURNAL AND LEDGER

S. No Journal Ledger

1 Journal is a subsidiary book of Ledger is the permanent and

account. It is the storehouse final book of accounts. It is
for recording transactions. termed as the means of
classified transactions.

2 Transactions are recorded in Transactions are posted in

the journal in chronological the ledger in classified form
order of dates just after their from the journal.
occurrences.

4 In journal explanation of In ledger explanations of

entries of the transaction are entries of transactions are not
shown. needed.

5 Journal helps in preparing The object of the ledger is to

ledger accounts correctly. know the income and
expenditures of different
heads.

6 Transactions are recorded in Ledger is prepared according

the journal in chronological to the nature of accounts.
order of dates.

7 The total results of The results of the particular

transactions cannot be known head of accounts can be
from the journal. known from the ledger.

8 Preparation of trial balance is The trial balance is prepared

not possible from the journal. from the ledger.

9 It is not possible to prepare an The income statement is

income statement at the end prepared with the ledger
of a period from journal to no balances at the end of a
profit or loss. period to know the net profit
or loss.

59
 10 The balance sheet cannot be The balance sheet is
prepared directly from the prepared with the help of
journal. ledger balances.

11 Transactions are recorded in Journal is the source of

the journal in the light of the preparation of ledger.
voucher.

12 There is no debit side or credit Each account in ledger has

side in money columns in it for two sides.
writing debit.

13 Recording of the transaction Recording of transactions in

in the journal is called the ledger is called posting.
journalizing.

14 There is no scope of Balances are drawn in ledger

balancing in the journal. accounts.

15 Journals are generally Ledgers are generally

classified into eight groups classified into two groups.
according to practice.

16 Journal does not start with Some ledger accounts start

opening balance. It is with opening balance, which
prepared from current is the closing balance of the
transactions that occurred. previous year.

ILLUSTRATION 1
1) Journalise the following transactions

2018 PARTICULARS

Feb. 3 X commenced business with a capital of ₹. 15,000

5 Purchased good ₹. 6,000

7 Purchased goods on credit from S & Co. ₹. 3,000

10 Purchased furniture ₹. 2,400

11 Sold goods ₹. 3,900

15 Sold goods on credit to D ₹. 2,250

20 Paid salaries ₹. 960

60
 25 Received commission ₹. 75

26 Returned goods to S & Co. ₹. 600.

27 Returned goods by D ₹. 450

Received from D ₹. 1,500

Paid to S & Co. ₹. 1,800

28
X withdrew from business ₹. 900

Charged depreciation on ₹. 240

Borrowed from K ₹. 1,500

Solution

Date Particular L.F Amount Amount

2018
Feb. Cash A/C Dr. 15,000
3
To Capital A/C 15,000

(Being capital brought in account)

5 Purchases A/C Dr. 6,000

To Cash A/C 6,000

(Being goods purchased for cash)

7 Purchases A/CDr. 3,000

S & Co. A/C 3,000

(Being goods purchased form S &

Co on credit)

10 Furniture A/C Dr. 2,400

Cash A/C 2,400

(Being furniture purchased for cash)

11 Cash A/C Dr. 3,900

Sales A/C 3,900

(Being goods sold for cash)

61
15 D Bros. A/C Dr. 2,250

Sales A/C 2,250

(Being goods sold on credit to D)

20 Salaries A/C Dr. 960

Cash A/C 960

(Being salaries paid)

25 Cash A/C Dr. 75

Commission A/C 75

(Being commission received)

26 S & Co. A/C Dr. 600

Purchases A/C Return 600

(Being goods returned to S & co.)

27 Sales Returns A/C Dr. 450

D Bros. A/C 450

(Being goods returned by D Bros.)

28 Cash A/CDr. 1,500

D Bros. A/C 1,500

(Being amount received from D

Bros.)

" S & Co. A/CDr. 1,800

Cash A/C 1,800

(Being amount paid to S & Co.)

" Drawings A/CDr. 900

Cash A/C 900

(Being amount paid to S & Co.)

" Depreciation A/C Dr. 240

Furniture A/C 240

62
 (Being depreciation charged on
furniture)

" Cash A/CDr. 1,500

K A/C 1,500

(Being amount borrowed from K)

ILLUSTRATION 2
Journalise the following transactions, post them in the Ledger and balance
the accounts as on 31st March, 2020.

1. Ram started business with a capital of Rs. 10,000.

2. He purchased goods from Mohan on credit Rs. 2,000.

3. He paid cash to Mohan Rs. 1,000.

4. He sold goods to Suresh Rs. 2,000.

5. He received cash from Suresh Rs. 3,000.

6. He further purchased goods from Mohan Rs. 2,000.

7. He paid cash to Mohan Rs. 1,000.

8. He further sold goods to Suresh Rs. 2,000.

9. He received cash from Suresh Rs1000.

Solution
JOURNAL
Date Particulars L.F. Debit Credit
Rs. Rs.

Cash A/CDr 10,000

To Capital A/C 10,000
(Being commencement of
business)
Purchase A/CDr 2,000
To Mohan A/C 2,000
(Being purchase of goods on
credit)
Mohan A/CDr 1,000
To Cash A/C 1,000
(Being payment of cash to Mohan)
Suresh A/CDr 2,000
To Sales A/C 2,000
(Being goods sold to Suresh)
Cash A/CDr 3,000
To Suresh A/C 3,000
(Being cash received from Suresh)
Purchase A/CDr 2,000
To Mohan a/c
(Being purchase of goods from 2,000

63
 Mohan)
Mohan A/CDr 1,000
To Cash A/C 1,000
(Being payment of cash to Mohan)
Suresh A/CDr 2,000
To Sales A/C 2,000
(Being goods sold to Suresh)
Cash A/C 1,000
Dr 1,000
To Suresh A/C
(Being cash received from Suresh)

LEDGER

CASH ACCOUNT

Dr Cr
Date Particular Amount Date Particular Amount
Rs. Rs.

To Capital 10,000 By Mohan 1,000

To Suresh 3,000 By Mohan 1,000

To Suresh 1,00 By Balance c/d 12,000

14,000 Mar. 31 14,000

April 1 To Balance b/d 12,000

CAPITAL ACCOUNT

Dr Cr
Date Particular Amount Date Particular Amount
Rs. Rs.
Mar. 31 To Balance c/d 10,000 By Cash A/c 10,000

Apr. 1 By Balance b/d

10,000 10,000

10,000

PURCHASE ACCOUNT

Dr Cr
Date Particular Amount Date Particular Amount
Rs. Rs.

To Mohan 2,000 4,000

To Mohan 2,000 March. By Balance c/d
31
To Balance b/d

April 1.
4,000 4,000

4,000

64
 MOHAN ACCOUNT

Dr Cr
Date Particular Amount Date Particular Amount
Rs. Rs.
To Cash 1,000 By Purchases 2,000

To Cash 1,000 By Purchases 2,000

To Balance c/d 2,000

4,000 4,000

Apr. 1 By Balance b/d 2,000

SURESH ACCOUNT

Dr Cr

Date Particular Amount Date Particular Amount

Rs. Rs.

To Sales 2,000 By Cash 3,000

To Sales 2,000 By Cash 1,000

4,000 4,000

SALES ACCOUNT

Dr Cr

Date Particular Amount Date Particular Amount

Rs. Rs.

Mar. To Balance c/d 4,000 By Suresh 2,000

31 By Suresh
2,000

4,000 By Balance b/d 4,000

April. 1 4,000

EXERCISES
1) Journalise the following transactions in the books of Shankar & Co.
2019 Rs.
June 1 Started business with a capital of 60,000
June 2 Paid into bank 30,000

65
June 4 Purchased goods from Kamal on credit 10,000
June 6 Paid to Shiram 4,920
June 6 Discount allowed by him 80
June 8 Cash Sales 20,000
June 12 Sold to Hameed 5,000
June 15 Purchased goods from Bharat on credit 7,500
June 18 Paid Salaries 4,000
June 20 Received from Prem 2,480
June 20 Allowed him discount 20
June 25 Withdrew from bank for office use 5,000
June 28 Withdraw for personal use 1,000
June 30 Paid Hanif by cheque 3,000
2) Journalise the following transactions, post the same in relevant ledger
account and balance the same.
2021
June 1 Karthik commenced business with Rs.20,000.
June 2 Paid into bank Rs.5,000.
June 3 Purchased Plant worth Rs.10,000 from Modi& Co.
June 4 Purchased goods worth Rs. 5,000 form Anwar.
June 6 Goods worth Rs.4,000 sold to Anbu
June 8 Sold goods worth Rs.2,000 for cash.
June 10 Goods returned by Anbu Rs.50.
June 15 Paid rent Rs.250.
June 18 Withdrawn from bank for office use Rs. 2,500.
June 20 Paid Salaries Rs.1,800.
June 25 Withdrawn for personal use Rs.250.
June 26 Goods returned to Anwar Rs.100.
June 27 Paid for office furniture Rs.1,500 by cheque.
June 28 Received Rs.3,900 cash from Anbu and discount allowed
Rs.50.
June 29 Paid Anwar on account Rs.4,800 and discount allowed by
him Rs.100.

LET US SUMUP

Accounting can be understood as the language of financial decisions. It is an

ongoing process of performance measurement and reporting the results to
decision makers. The discipline of accounting can be traced back to very
early times of human civilization. With the advancement of industry,

66
modern day accounting has become formalized and structured. A person
who maintains accounts is known as the account. The information
generated by accounting is used by various interested groups like,
individuals, managers, investors, creditors, government, regulatory
agencies, taxation authorities, employee, trade unions, consumers and
general public. Depending upon purpose and method, accounting can be
broadly three types; financial accounting, cost accounting and
management accounting. Financial accounting is primarily concerned with
the preparation of financial statements. It is used on certain well-defined
concepts and conventions and helps in framing broad financial policies.
However, it suffers from certain limitations.

CHECK YOUR PROGRESS

Choose the Correct Answer:

1) The accounting cycle starts with the _________

a) preparation of ledger accounts
b) preparation of trial balance
c) analysis of business transaction
d) preparation of adjusting entries
2) After proper analysis, the business transaction is recorded in journal in
a ___________

a) chronological order b) reverse chronological order

c) random order d) none of the above

3) In accounting/bookkeeping, the term posting refers to___________

a) transfer of information from ledger to trial balance
b) transfer of entries from journal to ledger
c) preparation of financial statements from trial balance
d) none of the above
4) The collection or group of accounts in an organization is known as
___________

a) general journal b) general ledger

c) trial balance d) balance sheet

5) The right-hand side of a T-account is termed as___________

a) debit side b) credit side

c) income side d) expense side

67
GLOSSARY

Accounting : Accounting equations is an accounting

equation formula expressing equivalence of the two
expressions of assets and liabilities.

Journal : Journal is a tabular record in which

business transactions are recorded in a
chronological order.

Journal entry : The record of the transaction in the journal

is called a journal entry.

Ledger : Ledger is the principal book of accounts

where similar transactions relating to a
particular person or thing are recorded.

Review Questions
1. Pass necessary Journal entries in the books of Narender for the
month of March, 2006:
i) An old machinery appearing in books exchanged for a new machinery
of Rs. 5,000.
ii) Issued a cheque for Rs. 1,000 in favour of landlord for a rent for the
month of March.
iii) Paid electricity bill of Rs. 450 by cheque.

iv) The goods destroyed by theft Rs. 3,000.

v) Paid wages for the installation of machinery Rs. 5,000.

vi) Accrued interest Rs. 1100.

vii) Goods worth Rs. 4,000 given away by way of charity.

viii) Goods taken by Proprietor worth Rs. 10,000 for personal use.
2. From the following transactions of Mr. Kamal Mahajan write up journal
entries and post them into ledger.

2006
Jan.1 Assets-Cash in hand Rs. 2,000, Cash at bank Rs. 5,000, Stock of
goods Rs. 4,000, Machinery Rs. 9000, Furniture Rs. 2,000, Sham owes
Rs. 500, Ram owes Rs. 3,500. Liabilities - Loan Rs. 4,000; sum owing to
Y Rs. 3,000.

Jan.2 Sold goods to Pawan Rs. 3,000.

68
Jan. 5 Received Rs. 2,950 from Pawan in full settlement of his accounts.
Jan. 6 Payment made to Y Rs. 1,975 by cheque, he allowed discount of
Rs. 25.

Jan. 8 Old furniture sold for Rs. 200.

Jan. 10 Ram pays Rs. 3,400 by cheque and discount allowed to him Rs.
100, cheque deposited in bank.

Jan. 13 Paid for repairs to machinery Rs. 250

Jan. 15 Bank intimates the cheque of Ram has been returned
dishonoured.

Jan. 18 Paid municipal taxes Rs. 200.

Jan. 22 Bought goods from Sita& Co. Rs. 1,000.

Jan. 25 Goods worth Rs. 600 given away as charity.

Jan. 31 Returned goods to Sita& Co. Rs. 1,000.

Jan. 31 An amount which was written off as bad debts in 1998 recovered
Rs. 1,000.
3. Pass necessary journal entries and post them in the appropriate
Ledger.

Accounts of Kamal for the month of January 2006 :

1 Started business with Rs. 2,00,000 in the bank and Rs. 40,000 cash.
1 Bought shop fitting Rs. 40,000 and a van Rs. 60,000, both paid by
cheque.
2 Paid rent by cheque Rs. 5,000.

3 Bought goods for resale on credit from Zakir& Co. Rs. 50,000.

5 Cash sales Rs. 5,000.

8 Paid wages of assistant in cash Rs. 1,000.

10 Paid insurance by cheque Rs. 500

12 Cash sales Rs. 8,000

15 Goods returned to Zakir& Co. Rs. 6,000.

17 Paid Zakir& Co. Rs. 30,000 by cheque.

24 Bought stationery and paid in cash Rs. 500.

25 Cash sales Rs. 15,000.

27 Paid Rao& Co. Rs. 14,000 by cheque.

69
31 Paid Rs. 20,000 into the bank.

SUGGESTED READINGS
1. Gupta, R.L. and Radhaswamy, M., (2006), Financial Accounting,
Sultan and Chand Sons, New Delhi.
2. Maheswari, S.N and Maheshwary, S.K. (2006), Fundamental of
Accounting, Vikas Publications.
3. Shashi K. Gupta, R.K.Sharma , (2012), “Financial Management”
latest Edition, Kalyani Publishers, Chennai
4. M C Shukla, S C Gupta & T S Grewal, (2017), Advance
Accounting, 19th Edition, S.Chand Publishing, New Delhi
5. Tulsian P. C. , (2017), Financial Accounting , Pearson Education,
New Delhi.
6. https://www.investopedia.com/terms/a/accounting-cycle.asp
7. https://accountlearning.blogspot.com/2010/06/rules-of-
journalizing-or-rules-of-debit.html
8. https://www.investopedia.com/terms/g/generalledger.asp

ANSWER TO CHECK YOUR PROGRESS

1) c 2) a 3) b 4) b 5) b

70
Unit 5

TRIAL BALANCE
STRUCTURE

Overview

Learning Objectives

5.1 Meaning and Definition of Trial balance

5.1.1 Meaning

5.1.2 Definition

5.2 Objectives of preparing Trial balance

5.3 Features of Trial balance

5.4 Limitations of Trial balance

5.5 Methods of preparing trial balance

5.5.1 Total method

5.5.2 Balance method

5.6 Accounting Errors

5.7 Steps for Location of Errors

5.7.1 Transposition Error

5.7.2 Transplacement Error

5.8 Rectification of Errors and Suspense Account

5.8.1 Rectification of Errors

5.8.2 Classification of Rectification of Errors

5.8.3 Suspense Account

5.9 Effect of Rectifying Entries on Profits

Let Us Sum Up

Check Your Progress

Glossary

Suggested Readings

Answers to Check Your Progress

71
OVERVIEW
The purpose of a trial balance is to ensure that all entries made into an
organization's general ledger are properly balanced. A trial balance lists
the ending balance in each general ledger account. The total dollar
amount of the debits and credits in each accounting entry are supposed
to match. The main purpose of a trial balance is to ensure that the list of
credit and debit entries in a general ledger are mathematically correct.

LEARNING OBJECTIVES

After reading this unit, you should be able to:

• understand the concept of trial balance
• objectives and features of trial balance
• explain the methods of preparation of trial balance
• define accounting errors and steps for location of accounting
errors

5.1 MEANING AND DEFINITION OF TRIAL BALANCE

5.1.1 Meaning
According to the dual aspect concept, the total of debit balance must be
equal to the credit balance. It is a must that the correctness of posting to
the ledger accounts and their balances be verified. This is done by
preparing a trail balance.
Trial balance is a statement prepared with the balances or total of debits
and credits of all the accounts in the ledger to test the arithmetical
accuracy of the ledger accounts. As the name indicates it is prepared to
check the ledger balances. If the total of the debit and credit amount
columns of the trail balance are equal, it is assumed that the posting to
the ledger in terms of debit and credit amounts is accurate. The
agreement of a trail balance ensures arithmetical accuracy only, A
concern can prepare trail balance at any time, but its preparation as on
the closing date of an accounting year is compulsory.

5.1.2 Definition
According to M.S. Gosav “Trial balance is a statement containing the
balances of all ledger accounts, as at any given date, arranged in the form
of debit and credit columns placed side by side and prepared with the
object of checking the arithmetical accuracy of ledger postings”.

72
Trial Balance:
A trial balance may be defined as a statement of debit and credit totals or
balances extracted from the various accounts in the ledger with a view to
test the arithmetical accuracy of the books.

5.2 OBJECTIVES OF TRIAL BALANCE

1.To have balances of all the accounts of the ledger in order to avoid the
necessity of going through the pages of the ledger to find it out.
2.To have a proof that the double entry of each transaction has been
recorded because of its agreement.
3.To have arithmetic accuracy of the books of accounts because of the
agreement of the trial balance.
4.Important conclusions can be derived by comparing the balances of two
or more than two years with the help of trail balances of those years.
5.It is a check on the accuracy of posting. If the trail balance agrees, it
proves:

(a) That both the aspects of each transaction are recorded and

(b)That the books are arithmetically accurate.

6.It facilitates the preparation of profit and loss account and the balance
sheet.

5.3 FEATURES OF TRAIL BALANCES

The following are the important features of a trail balances:

(i) A trail balance is prepared as on a specified date.

(ii) It contains a list of all ledger account including cash account.

(iii) It may be prepared with the balances or totals of Ledger accounts.

(iv) Total of the debit and credit amount columns of the trail balance must
tally.
(v) It the debit and credit amounts are equal, we assume that ledger
accounts are arithmetically accurate.
(vi) Difference in the debit and credit columns points out that some
mistakes have been committed.
(vii) Tallying of trail balance is not a conclusive profit of accuracy of
accounts.

73
5.4 LIMITATIONS OF TRAIL BALANCE
Trial balance can be prepared only in those concerns where double entry
system of accounting is adopted. This system is very costly and cannot
be adopted by the small concerns.
1.Though trial balance gives arithmetic accuracy of the books of accounts
but there are certain errors balances is not a conclusive proof of the
accuracy of the books of accounts.
2.If trial balance is not prepared correctly then the final accounts prepared
will not reflect the true and fair view of the state of affairs of the business
whatever conclusions and decisions are made by the various groups of
persons sill not be correct and s\will mislead such persons.

5.5 METHODS OF PREPARING TRIAL BALANCE

A trial balance can be prepared by the following two methods:

5.5.1 Total Method: In this method, the debit and credit totals of each
account are shown in the two Amount columns (one for the debit total and
the other for the credit total) against it.
5.5.2 Balance Method: In this method, the difference of each account is
extracted. If debit side of an account is bigger in amount than the credit
side, the difference is out in the debit column of the trial balance and if the
credit side is bigger, the difference is written in the credit column of the
trial balance.

Trial balance can be prepared on a sheet having four columns.

A specimen is given as follows:

TRIAL BALANCE OF …… As on………

Dr. Cr.
Balance Balance
Name of the
Serial No. (or total) (or total)
account
Rs. Rs.

Of the 2 methods of preparation the second is usually used in practice

because it facilitates the preparation of the final accounts.

74
5.6 ACCOUNTING ERRORS

A) Trial Balance disclosed by the Errors

i) Wrong totalling of subsidiary books

ii) Posting of an amount on the wrong side

iii) Omission to post an amount into ledger

iv) Double posting or omission of posting

v) Posting wrong amount

vi) Error in balancing

B) Trail Balance not disclosed by the Errors

i) Error of principle

ii) Error of omission

iii) Errors of Commission

iv) Recording wrong amount in the books of original entry

v) Compensating errors

5.7 STEPS FOR LOCATION OF ERRORS

The following steps should be taken to locate the errors and the step
may be taken one after another until the errors that cause the difference
are located:
(1) Re-total the debit and credit columns of the Trial Balance. Find out the
amount of difference by the two columns, divided by 2 and see similar
amount appears in the Trial Balance. If similar figure exists, see whether
it is in the correct column. It is also possible that such a balance might
have been recorded on the wrong side, causing a difference of double the
amount.
(2) See that Cash balance and Bank balance are properly listed in the
Trial Balance.
(3) If still the difference exists, divide the difference by 9. If the difference
is evenly divisible by 9, the error is likely to occur from the transposition
or trans-placement of figures. Disarrangement of figures is transposition
and trans-placement means the digits of the numbers are moved to the
left or right.

5.7.1 Transposition Error

If the error is due to transposition, the number will divide evenly by 9. For
example, in your year-end review of the trial balance, you discover that

75
there is a difference of Rs. 900 between your debits and credits. Since
this number is evenly divisible by 9 (there is no remainder), it is a
transposition error.
Example, If 6418 is recorded as 4618, the difference is 1800. Complete
division of 1800 by 9 (1800/9 = 200, there is no reminder) is possible.

5.7.2 Transplacement Error

(1) If the error is due to transplacement, the digits of the numbers are
moved to the left or right.
(2) Example, If 67,180 is recorded as 6718, the difference is 60,462.
Complete division of 60,462 by 9 (60,462/9 = 6,718, there is no reminder)
is possible.
(3) If such a difference exists, search the figures, where such errors might
have been made.
(4) Confirm that the opening balances have been correctly brought
forward in the current year, from the previous year.
(5) Recheck the amounts listed in the Trial balance and confirm that all
the ledger balances have been copied down.

(6) Check the totals in the lists of Sundry Debtors and Sundry Creditors.

(7) Re-compute the Account balances.

(8) Check the casting and carry forward of all subsidiary books.

(9) Verify the postings of individual items from the subsidiary books.
(10) After making complete checking of journal, ledger and subsidiary
books, if the errors cannot be located, then transfer the difference to a
Suspense Account and when the mistake is found out the Suspense
Account is closed.

5.8 RECTIFICATION OF ERRORS AND SUSPENSE ACCOUNT

5.8.1 Rectification of Errors

When the trial balance tallies it provides us only with the proof of the
arithmetical accuracy of the ledger accounts. However, there may still be
some errors present. Some errors affect the trial balance while some do
not. When the trial balance does not tally, it is a clear indication of the
presence of errors. We need to identify and locate these errors. Thus,
after locating them Rectification of Errors is also necessary.

76
5.8.2 Classification of Rectification of Errors
On the basis of rectification of errors, we can classify the errors into the
following two broad categories:
A. Errors not affecting the Trial Balance
B. Errors affecting the Trial Balance
The errors need to be categorized in these categories because we can
usually rectify the errors not affecting the trial balance by passing a
rectification journal entry. While the errors affecting the trial balance affect
only one account and for these, we cannot pass a journal entry. However,
we can pass a journal entry only by opening a Suspense A/c.

A. Rectification of Errors not affecting the Trial Balance

These errors affect two or more accounts simultaneously. Thus, these are
two-sided errors. We can rectify these by passing a journal entry giving
the correct debit and credit to the accounts. In order to rectify an error, we
need to cancel the effect of wrong debit or credit by reversing it and restore
the effect of correct debit or credit.
When there is short debit or excess credit in an account we need to debit
the concerned account. Whereas, when there is short credit or excess
debit in an account we need to credit the concerned account. Complete
omission to record an entry in the journal or the subsidiary books, incorrect
recording of transactions in the books, complete omission of posting and
errors of principle are the examples of these errors.

B. Rectification of Errors affecting the Trial Balance

These errors affect only one account. Thus, these are one-sided errors.
We can rectify these errors by giving an explanatory note in the account
or by passing a journal entry with the help of Suspense A/c. When we
detect an error before posting to the ledger, we can correct it by simply
crossing the wrong amount, writing the correct amount above it and
initializing it. Similarly, we can also correct an error in the ledger account.
Errors of casting, errors of carrying forward the balances, errors of
balancing the accounts, errors of posting the wrong amount in the correct
account, error of posting in the correct account on the wrong side, omitting
to show an account in the trial balance, posting in wrong side with wrong
amount are the examples of errors affecting the Trial Balance.

5.8.3 Suspense Account

When the trial balance does not tally due to the one-sided errors in the
books, an accountant puts the difference between the debit and credit

77
side of the trial balance on the shorter side as the Suspense A/c. As and
when we locate and rectify the errors, the balance in the Suspense A/c
reduces and consequently becomes zero. Thus, we cannot categorize the
Suspense A/c. It is a temporary account and can have debit or credit
balance depending upon the situation.
While using the Suspense A/c to rectify the one-sided errors, the
accountant needs to follow the following steps:
1) Identification of the account with the error.
2) Ascertainment of the excess debit or credit or short debit or credit
in the above account.
3) In case of short debit or excess credit in an account, we need to
debit the concerned account. Whereas, in case of short credit or
excess debit in an account we need to credit the concerned
account.
4) Pass the necessary journal entry by debiting or crediting the
Suspense A/c

Rectification of Errors in the Next Accounting Year

When we cannot locate and rectify the errors before the final accounts,
we need to carry forward the balance of the Suspense A/c to the next
financial year. When we rectify the errors of the previous accounting year,
we need to route them through the Profit and Loss Adjustment A/c for the
items of expenses, losses, incomes and gains. This avoids their impact
on the current income statement.
Solved Example for You
Question: Trial Balance of M/s Shinde Enterprises did not agree. It puts
the difference to the Suspense A/c. Rectify the following errors and
prepare the Suspense A/c to ascertain the original difference in the trial
balance.

2020 June
3 Amount paid for the installation of the machinery ₹10000 was
posted to the Repairs and maintenance A/c.

7 Total of Purchases book ₹50000 was not posted to the ledger.

12 Goods returned to John ₹3000 were recorded in Sales Book.

21 Salary paid to Ram ₹6000 was debited to his personal account.

28 Depreciation written-off on furniture ₹500 was not posted to the
furniture account.
Solution:

78
Date Particulars L.F. Amount Amount
(Dr.) (Cr.)

2020
June Machinery A/c Dr. 10000
3

To Repairs and Maintenance 10000

A/c

(Being rectification of the wrong

journal entry in the Repairs and
maintenance A/c)

7 Purchases A/c Dr. 50000

To Suspense A/c 50000

(Being rectification of the

omission to post the total of
purchases book in the ledger)

12 Sales A/c Dr. 3000

To Purchases Return A/c 3000

(Being rectification of wrong

recording of the purchases
return in the sales book)

21 Salary A/c Dr. 6000

To Ram’s A/c 6000

(Being rectification of wrong

debit to the personal account of
an employee)

28 Suspense A/c Dr. 500

To Furniture A/c 500

(Being rectification of omission

of posting in the furniture
account)

79
 Suspense A/c

Dr Cr

Date Particular Amount Date Particular Amount

Rs. Rs.

2020 Difference as per Trial 49500 2020 By Purchases A/c 50,000

balance June 7
June

28 To Furniture A/c 500

50,000 50,000

5.9 EFFECT OF RECTIFYING ENTRIES ON PROFITS

This is a stage where the preparation of Trial Balance and Final Accounts
is completed. That, if the errors in the accounts are not readily traceable,
then the difference in the Trial Balance is placed in the Suspense Account
and the Final Accounts – Trading and Profit and Loss Account and
Balance Sheet, are prepared. Since the Suspense Account is entered in
the Trial Balance it has to be incorporated in the Final Accounts.
If the Suspense Account is placed in the Balance Sheet, Suspense
Account should be reopened in the next financial year and as and when
errors committed in the previous year are located, rectification entry
should be made. Thus finally, Suspense Account should completely be
closed when all such errors committed in previous year are located and
rectified. An error in a nominal account and some real accounts affects
the trading result.
After the preparation of Final accounts, nominal account must not be
rectified through the concerned nominal accounts. Moreover, the profits
disclosed in the previous year differ from the true profits. Therefore, such
errors are rectified through Profit and Loss Adjustment Account.

LET US SUMUP
As air, food and water are indispensable to life, Trial Balance is
indispensable to accounting. It serves as a lubricant for the smooth
movement and completion of the accounting cycle. Moreover, it forms a
useful connecting link between ledger accounts and final accounts. The
agreement of a Trial Balance is not a conclusive proof as to the absolute
accuracy of the books. It only gives an indication of the arithmetical
accuracy. Even if both the sides of trial Balance agree to each other yet
there may be some errors in the books of accounts.

80
CHECK YOUR PROGRESS

Choose the Correct Answer:

1) Trial balance is used to check the accuracy of _________

a) Balance sheet balances

b) Ledger accounts balances

c) Cash flow statement balances

d) Income statement balances

2) In the books of account if a transaction is completely deleted, will it
affect the trial balance?

a) No
b) Yes

c) A transaction cannot be omitted

d) None of the above

3) What is used in preparing trial balance?

a) Specialized Journals b) Balance Sheet

c) Ledger Accounts d) General Journal

4) What is the trial balance used?

a) It is a financial statement

b) It records balances of a balance sheet

c) It doesn’t contribute to the accounting cycle

d) It records balances of accounts
5) When debit balance is equal to credit balance then the trial balance
means __________

a) Account balances are correct

b) Mathematically Capital Liabilities=Assets

c) No mistake in recording transactions

d) No mistake in posting entries to ledger accounts.

GLOSSARY

Trial Balance : A Trial Balance is a statement of debit and

credit balances extracted from all the
ledgers with a view to ascertain arithmetical

81
 accuracy of posting of all transactions into
the respective ledgers.

Clerical Errors : Those errors which are committed by the

clerical staff during the course of recording
business transactions in the books of
accounts is known as clerical errors.

Compensating : Compensating errors are those errors

Errors which cancel or compensate themselves.

SUGGESTED READINGS
1. Gupta, R.L. and Radhaswamy, M., (2006), Financial Accounting,
Sultan and Chand Sons, New Delhi.
2. Maheswari, S.N and Maheshwary, S.K. (2006), Fundamental of
Accounting, Vikas Publications.
3. Shashi K. Gupta, R.K.Sharma , (2012), “Financial Management”
latest Edition, Kalyani Publishers, Chennai
4. M C Shukla, S C Gupta & T S Grewal, (2017), Advance
Accounting, 19th Edition, S.Chand Publishing, New Delhi
5. Tulsian P. C. , (2017), Financial Accounting , Pearson Education,
New Delhi.
6. https://corporatefinanceinstitute.com/resources/accounting/trial-
balance/
7. https://www.freshbooks.com/hub/accounting/types-of-errors-
accounting

ANSWER TO CHECK YOUR PROGRESS

1) b 2) a 3) c 4) d 5) b

82
Unit 6

FINAL ACCOUNTS
STRUCTURE

Overview

Learning Objectives

6.1 Final Accounts and Trial Balance

6.2 Trading, Profit and Loss Account and Balance Sheet

6.2.1 Trading Account

6.2.2 Profit and Loss Account

6.2.3 Balance Sheet

6.3 Manufacturing Account

6.4 Treatment of Adjustments in Final Accounts

6.5 Preparation of Final Accounts

Let Us Sum Up

Check Your Progress

Glossary

Suggested Readings
Answers to Check Your Progress

OVERVIEW
You know that the main objectives of preparing and maintaining accounts
are to know the operating results of the business for a particular
accounting period and to ascertain financial position of the business on a
particular date. To achieve these objectives every businessman prepares
the final accounts at the end of accounting year. The preparation of final
accounts is the final step in the accounting process. That is why they are
called final accounts. Final accounts communicate the profitability and
financial position of the business to the various parties (like management,
owners, creditors, banking and financial institutions, employees etc.) who
have interest in the performance of the business. Final accounts include
the preparation of:(i) Trading and Profit and Loss Account and (ii) Balance
Sheet. Trial Balance is mainly used in the preparation of final accounts.
Final accounts are prepared every year to make continuous evaluation of
performance of the business. While preparing final accounts, accounting

83
principles must be strictly followed. All adjustment items should be
brought into the books of account by passing suitable adjustment entries.
Then only the final accounts will reveal the true and fair view of the
performance of the business. This unit explains the procedures for the
preparation of Trading, Profit and Loss Account and Balance Sheet. The
role of Trial Balance in preparation of these accounts and treatment of
various adjustment items are also explained in this unit.

LEARNING OBJECTIVES

After reading this unit, you should be able to:

• explain the purpose of preparing final accounts
• prepare a trial balance
• describe the procedures involved in the preparation of final
accounts
• explain why adjustment entries are needed at the time of
preparing the final accounts
• pass necessary adjustment entries
• prepare final accounts with adjustments.
6.1 FINAL ACCOUNTS AND TRIAL BALANCE
Final accounts include the preparation of (i) Trading and Profit and Loss
Account and (ii) Balance Sheet. They are prepared to know the final
results of the business. You know there are various parties interested in
the accounting information of a business. Final accounts convey the
message to the parties interested in the accounting information about the
profitability and financial position of the business.
Final accounts are prepared with the help of a Trial Balance. Trial balance
is a statement of debit and credit totals or balances extracted from the
various accounts in the ledger. Normally, you will be asked to prepare
final accounts with a properly prepared Trial Balance. Suppose, if you are
asked to prepare final accounts from the list of closing balances extracted
from various ledger accounts, at that time first you have to prepare Trial
Balance. Therefore, you must know how to prepare Trial Balances from a
given list of balances. The following guidelines may help you to prepare
the Trial Balance correctly.
(i)All accounts of expenses (including purchases) and losses will be debit
balances.
(ii) All accounts of income (including sales) and gains will be credit
balances.

(iii) All accounts of assets will be debit balances.

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(iv) All accounts of liabilities will be credit balances.

(v) Capital Account will be normally be a credit balance.

(vi)Drawing Account will be a debit balance.

There are certain items that may be expenses as well as incomes in
accounting. Rent, discount, commission and interest are some examples
of these items. Normally, when these items are given, they will be
indicated by mentioning (Dr.) or (Cr.) Against each item, or the word
'received' or 'paid' is written after each item. That will help you how to
treat these items correctly.

6.2 TRADING, PROFIT AND LOSS ACCOUNT AND BALANCE SHEET

You know well the Profit and Loss Account is prepared to ascertain the
operating results of the business. The Profit and Loss Account is divided
into two sections, namely, Trading Account and Profit and Loss Account.
Trading Account is prepared to know the gross profit or gross loss of the
business. And Profit and Loss Account is prepared to know the net profit
or net loss of the business.

6.2.1 Trading Account

As discussed above the gross profit or gross loss of the business can be
ascertained by preparing Trading account. Gross profit is the excess of
net sales revenue over cost of goods sold. Net sales means gross sales
minus returns from customers. Cost of goods sold involves an adjustment
for stocks on hand (unsold stocks). Calculation of gross profit and cost of
goods sold can be presented in the form of an equation as follows.

Gross Profit = Net Sales - Cost Of Goods Sold

Cost of goods sold = Opening stock + Net Purchases + Direct
expenses - Closing stock
You know opening stock is the unsold stock of previous year. Closing
stock is the unsold stock of the current year. Direct expenses refers to
those expenses which are incurred on the goods purchased business.
Freight, customs duty or octroi paid on purchases are some examples of
direct expenses.
Look at Illustration 1 and study how cost of goods sold and gross profit
are calculated.

Illustration 1
The following figures have been extracted from the books of a firm.
Compute the cost of goods sold.

85
 Rs.
Stock as on 1.1.2017 2,50,000
Purchases for 2017 22,50,000
Purchases Returns 60,000
Carriage Inwards 20,000
Octroi 75,000
Freight 10,000
Stock as on 31.12.2017 22,000
Solution

Rs.

Opening Stock 2,50,000

Add: Net Purchases

(Purchases 22,50,000 -Purchases Returns 60,000) 21,90,000

Carriage inwards 20,000

Octroi 75,000

Freight 10,000

25,45,000

Less: Closing Stock 2,20,000

Cost of Goods Sold 23,25,000

Form of Trading Account

While preparing Trading Account opening stock, purchases, direct
expenses are put on the debit side and the sales and closing stock are
put on the credit side. Goods purchased for resale are to be shown in the
Trading Account. The purchase of assets which are meant for permanent
use in business such as furniture, plant and machinery are not included in
the purchases. In the case of sales we should not take sale of old
furniture, car, machinery etc. Wages, freight, carriage and cartage are
treated as direct expenses. Therefore, they should be shown in the
Trading Account.

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 Figure 6.1
Trading Account for The Period …………..

Particulars Amount Particulars Amount

RS. P. RS. P. RS. P. RS. P.

To Opening Stock xxx xx By Sales xxx xx

To Purchases xxx xx LESS:

Sales Return xxx xx xxx xx

LESS: By Closing Stock xxx xx

Purchases Return xxx xx xxx xx

To Direct Expenses xxx xx

To Gross Profit
(transferred to profit
and loss account) xxx xx

xxx xx xxx xx

After entering items on debit and credit sides of the trading account, to
we have total both sides. If credit side is more than the debit side, the
difference should be treated as gross profit. Suppose if the debit side total
is more than credit side, then the difference should be treated as gross
loss. You know the gross profit or gross loss is not the final profit or loss.
We have to adjust many number of indirect expenses with the gross profit
or loss to find out the net profit or loss of the business. Therefore, the
gross profit or loss ascertained from the trading account is transferred to
profit and loss account.

6.2.2 Profit and Loss Account

As mentioned above the Profit and Loss Account is prepared to know the
net profit or loss of the business. Net profit is the excess of gross profit
and other incomes over the indirect expenses and losses. Indirect
expenses include all administrative, selling and distribution expenses.
Salaries, rent and taxes, postage and stationery, insurance, interest paid,
etc. are examples of indirect expenses. Losses refer to items like loss by
fire, loss by theft etc. Incomes such as rent received, commission
received, dividend received should be entered in the credit side of Profit
and Loss Account. If the total of credit side is more than the total of the
debit side, the difference is treated as net profit. Suppose, if the debit side

87
total is more than the credit side, then the difference is to be treated as
net loss. Look at figure 6.2, which shows various expenses, losses,
incomes etc. which usually appear in the Profit and Loss Account.

Figure 6.2

Profit and Loss Account for the period ended . . .

Dr Cr

Particulars Amount Particulars Amount

Rs. Rs.
P. P.

To Gross Loss, if any By Gross Profit

(transferred from trading (transferred from Trading
xxx xx xxx xx
account) account)

To Salaries xxx xx By Interest Received xxx xx

To Rent, Rates, Taxes xxx xx By Discount Received xxx xx

To Postage and xxx xx By interest Received xxx xx

Telegrams

To Telephone Charges xxx xx By Rent Received xxx xx

To Printing and Stationery xxx xx By Commission xxx xx

Received

To Legal expenses xxx xx By Dividend Received xxx xx

To insurance xxx xx By other Income and xxx xx

Gains

To Office Lighting xxx xx

To Bad Debts xxx xx

To Advertising xxx xx

To Travelling Expenses xxx xx

To Carriage Outwards xxx xx

To Trade Expenses xxx xx

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To Discount Allowed xxx xx

To Interest Paid xxx xx

To Repair and Renewals xxx xx

To Loss by Fire xxx xx

To Loss by Theft xxx xx

To Other Expenses and xxx xx

Losses, if any

To Net Profit (Transferred xxx xx

to Capital A/C)

The specimen Performa of Profit and Loss Account given above may
spells out what are the items to be taken in the debit side of Profit and
Loss Account and what are the items to be taken in the credit side of Profit
and Loss Account. Look at the Illustration 4.3 which will help you how to
prepare Profit and Loss Account.

Illustration 2
From the following balances extracted from the books of a firm for the year
2015, prepare Profit and Loss Account.
Particulars Amount Particulars Amount
Rs. P. Rs. P.
Gross Profit 72,000 00 Travelling Expenses 1,200 00
Carriage Outward 2500 00 Sundry Trade Expenses 1,500 00
Salaries 12,500 00 Discount allowed by 900 00
creditors
Rent 2,700 00
Fire Insurance 1,800 00
Premium
Bad Debts 4,200 00
Commission Received 1,700 00
Discount(Dr) 1,500 00
Apprentice 3,500 00
Premium(Cr)
Printing & Stationery 1,250 00
Rent and Taxes 950 00

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Solution

Profit And Loss Account of M/S . . .

for the year ended 31st December, 2015
Dr. Cr.

Particulars Amount Particulars Amount

Rs. P. Rs. P.

To Carriage Outward 2,500 00 By Gross Profit b/d 72,000 00

To Salaries 12,500 00 By Apprentice Premium 3,500 00

To Rent 2,700 00 By Discount by 900 00

Creditors

To Fire Insurance 1,800 00 By Commission 1,700 00

Premium

To Bad debts 4,200 00

To Discount 1,500 00

To Printing & 1,250 00

Stationery

To Rent & Taxes 950 00

To Travelling 1,200 00
Expenses

To sundry Trade 1,500 00

Expenses

To Net Profit 48,000 00

transferred to Capital
A/C

78,100 00 78,100 00

You have to note the Trading Account and Profit and Loss Accounts are
prepared separately just for your understanding. In practice the Trading

90
and Profit and Loss Account are combined and one account, namely,
‘Trading and Profit and Loss Account is prepared.

6.2.3 Balance Sheet

A Balance Sheet is a statement which sets out the assets and liabilities of
a business on a particular date. You should know that the Balance Sheet
is prepared at a particular point of time not for a period. In the process of
preparing final accounts, preparation of Balance sheet is a final step. The
main purpose of preparing balance sheet is to ascertain the financial
position of a business on a particular date. Excess of assets over liabilities
can be described as capital of the business. The total of assets should
always be equal to the total of liabilities. Balance sheet is not an account
but it is only a statement of assets and liabilities. Balance sheet is also
called as “Position Statement” or “Statement showing the sources and
application of capital”. It is mainly prepared from real and personal
accounts.

Balance Sheet of __________ as on ___________

Liabilities Amount Assets Amount
Rs. P. Rs. P.
Current Liabilities Current Assets
Bills Payable xxx xx Cash in hand xxx xx
Sundry Creditors xxx xx Cash at Bank xxx xx
Bank Overdraft xxx xx Sundry Debtors xxx xx
Long-Term Liabilities Investment(short xxx xx
term)
Loan from Bank and xxx xx Bills Receivable xxx xx
Financial Institution
Debentures xxx xx Stock in Trade xxx xx
Fixed Liabilities Prepaid xxx xx
Expenses
Fixed Assets
Machinery xxx xx
Land and xxx xx
Building
Furniture and xxx xx
Fixtures
Motor Car xxx xx
Long term xxx xx
Investment
Fictitious Asset

91
 Advertisement xxx xx

Misc. Expenses xxx xx

Profit & Loss A/C xxx xx

Intangible Assets

Goodwill xxx xx

Patents xxx xx
Copyright xxx xx
Total xxx xx Total xxx xx

6.3 MANUFACTURING ACCOUNT

A trading concern can straight away prepare Trading Account to compute
gross profit or loss of the business. But a manufacturing concern has to
prepare Manufacturing Account before preparing Trading Account.
Manufacturing Account helps to ascertain the cost of goods produced.
The cost of goods produced is then transferred to Trading Account. The
cost of goods sold and gross profit are calculated from the Trading
Account. Look at Figure 4.4 for the specimen of Manufacturing Account.

Manufacturing Account for the year ended...

Particulars Amount Particulars Amount
Rs. P. Rs. P.
To Raw Material consumed xxx xx By Cost of Goods xxx xx
(opening stock of raw Manufactures
material + Purchases during transferred to
the year(-)Closing stock of Trading A/C
Raw material)
To Direct Expenses(as xxx xx
carriage on purchases)
Factory Expenses
To Factory Lighting xxx xx
To Rent xxx xx
To Wages xxx xx
To Depreciation on plant & xxx xx
machinery
To Factory Supervisors xxx xx
salary
To stores consumed etc. xxx xx

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To work-In-Progress xxx xx
Beginning
Less Closing Work In xxx xx
Progress
Scale of Scrap xxx xx
xxx xx xxx xx

Illustration 3
From the following particulars relating to the year 2020, Prepare
manufacturing account.
Particulars Amount
Rs.
Purchases of Raw material 1,20,000
Stock on 1.1.2020
Raw Materials 20,000
Work-in-Progress 6,000
Finished goods 25,000
Factory Wages 15,000
Factory Rent 5,000
Fuel & Power 2,000
Carriage Inwards 2,000
Repairs of plant 2,000
Depreciation on Plant 5,000
Scale of Scarp 1,500
Stock on 31.12.2020
Raw Material 30,000
Work-in-Progress 7,500
Finished Goods 30,000
Solution
Manufacturing Account for The Year Ended Dec. 31, 2020
Dr. Cr.

Particulars Amount Particulars Amount

Rs Rs

To work in Progress at the 6,000 By Scale of Scarp 1,500

beginning

To Raw Material By Work-in-Progress at 7,500

consumed the end

93
Opening Stock 20,000 By Cost of Goods 1,38,000
produced(transferred to
Add: Raw
Trading A/C)
Material
Purchases 1,20,000
1,40,000
Less: Closing
stock 30,0000 1,10,000

To Factory Wages 15,000

To Factory Rent 5000

To Fuel & Power 2,000

To Carriage Inwards 2,000

To Repairs of Plant 2,000

To Depreciation on Plant 5,000

1,47,000 1,47,000

You can observe that the stock of finished goods has not appeared in the
manufacturing account. Stock of finished goods must be shown in the
Trading Account. Now, suppose the sales for the year 2004 were Rs.
1,75,000 the Trading Account will appear as given below :

Trading Account of ............ for theyear ending December 31, 2020

Dr. Cr.

Particulars Amount Particulars Amount

Rs. Rs.

To opening stock of 25,000 By sales 1,75,000

finished goods

To cost of goods By Closing stock of 30,000

produced( finished goods
1,38,000
transferred from mfg
.A/C)

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To Gross Profit
(transferred to P/L 42,000
A/C)

2,05,000 2,05,000

6.4 TREATMENT OF ADJUSTMENTS IN FINAL ACCOUNTS

The very purpose of preparing final accounts is to know the correct profit
or loss of the business and the financial status of the business. Therefore,
the items which are related to the previous year or the coming year must
be duly adjusted. In this section, you can study about all items which
require adjustments and learn how they are treated while preparing the
final accounts. Some of the important items which need adjustment at the
time of preparing the final accounts are given below :
1. Closing Stock: Closing Stock refers to the goods which remain unsold
in the business at the end of the year. It is given mostly as an additional
information. The adjustment entry is :

Closing Stock A/c Dr

To Trading A/c
If closing stock is given as an additional information, it will appear on the
credit side of Trading Account and assets side of the Balance Sheet.
Suppose, if the closing stock is given in the trial balance itself, then this
item should be treated differently. We need not show it in the Trading
Account. It can be shown straight away on the asset side of the Balance
Sheet.
2. Outstanding Expenses: Outstanding expenses are those expenses
which have been due during the current accounting year but have not
been paid till the end of the year. Generally, salaries, wages and rent for
the last month of the academic year are paid in the first month of the next
year. These expenses are due for payment in the current year but actually
paid in the next accounting year. While preparing the final accounts all
such expenses must be brought into books, otherwise the financial
statement wouldn’t reveal the true profit or loss of the business.

The adjustment entry is :

Concerned Expenses A/c Dr

To Expenses Outstanding

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The outstanding expenses are added to the concerned expenses in the
Trading and Profit and Loss Account and also shown on the liabilities side
of the Balance Sheet.
3.Prepaid Expenses : Prepaid expenses are those expenses which have
been paid in advance and the benefit is available not only in the current
accounting year but also during the next year. To find out the true profit
(or loss) of the business the unexpired portion must be adjusted.
Unexpired insurance, interest paid in advance, rent paid in advance are
some examples of prepaid expenses. Prepaid expenses are also called
as ‘Unexpired expenses. The adjustment entry is :

Prepaid Expenses A/c Dr

To Concerned Expenses A/c

Prepaid expenses are subtracted from the concerned expenses in the
Trading and Profit and Loss Account, and shown on the asset side of the
Balance Sheet.
4.Accrued Income: Accrued income refers to those incomes which have
been earned during the current accounting year but have not been
received till the end of the accounting year. Accrued incomes are also
called as “incomes earned but not yet received”. The adjustment entry is

Accrued Income A/c Dr

To Concerned Income A/c

Accrued income are added to the concerned income in the Profit and Loss
Account and also shown on the asset side of the Balance Sheet.
5. Income Received in Advance: Income received in advance are those
incomes which belong to the next accounting year but have been received
during the current year. They are also called as unearned incomes. The
unearned portion of the income must be adjusted while preparing the final
accounts.

The adjustment entry is :

Concerned Income A/c Dr

To Income Received in Advance A/c

The unearned incomes are deducted from the concerned income in the
Profit and Loss Account and shown on the liabilities side of the Balance
Sheet.

96
6. Depreciation: Depreciation is a permanent decrease in the value of
fixed assets due to their usage or passage of time. The strinkage in the
book value of the fixed asset is an expense or loss to the business,
therefore, the amount of depreciation should be charged to Profit and Loss
Account. While calculating depreciation we have to take only the book
value of the fixed asset not its market value. The adjustment entry is :

Depreciation A/c Dr

To Concerned Asset A/c

Depreciation is shown as a separate item on the debit side of the Profit
and Loss Account and deducted from the concerned asset in the Balance
Sheet. If depreciation is given in the Trial Balance itself, then it is to be
shown in the Profit and Loss Account only.
7. Interest on Capital: Sometimes, the proprietor of the business may
like to know whether the business is really earning profit or not after
charging interest on capital. In such situation interest is provided on
capital. Interest on capital is an expense to the business. The following is
the adjustment entry:

Interest on Capital A/c Dr

To Capital A/c
Interest on Capital is shown on the debit side of Profit and Loss Account
and added to the capital on the liabilities side of the Balance Sheet. If
interest on capital is given in the Trial Balance itself, in such a situation it
has to be shown on the debit side of Profit and Loss Account only.
8. Interest on Drawing: When the proprietor withdraws money from the
business for personal use, it is called as drawings. Drawings reduce the
capital of the business. If interest is allowed to the proprietor on his
capital, it is but natural that interest should be charged on the amounts
drawn by him. Interest on drawings is a gain to the business. The
adjustment entry is :

Capital A/c or Drawings A/c Dr

To Interest on Drawings A/c

Interest on drawings is shown on the credit side of Profit and Loss Account
and deducted from the capital on the liabilities side of be Balance Sheet.

97
9. Bad Debts: The amount of debt which cannot be recovered from the
debtors is called bad debts. It is a loss to the business. Therefore, it
should be charged to the Profit and Loss Account. The journal entry for
bad debts in the books of account is:

Bad Debts A/c Dr

To Concerned Debtors A/c

If bad debts are given outside the Trial Balance as an adjustment item, it
means that such bad debts have not yet been written off. At the time of
preparing the final accounts, the following adjustment entry should be
passed.

Bad Debts A/c Dr

To Sundry Debtors A/c

First the additional amount of bad debts is shown as an additional to bad
debts already written off on the debit side of Profit and Loss Account.
Second, it is shown on the asset side of the Balance Sheet by way of
deduction from sundry debtors.
10. Provision for Bad And Doubtful Debts: You have learnt that bad
debt is a loss to the business. According to the conservatism concept,
provisions are made in the business to meet the loss of bad debts.
Provision for bad and doubtful debts is calculated on the total amount due
from sundry debtors after writing of all known bad debts. The percentage
of provision is usually determined on the basis of past experience of the
business. The following adjustment entry is passed while creating such
provision.
Profit and Loss A/c Dr

To Provision for Bad Debts A/c

When old provision already exists (i.e. the provision for bad debts brought
forward from the previous year) the new provision required at the current
year should be adjusted against it. You can understand it better with the
help of an example. Suppose old provision on January 1, 2004 was Rs.
2,000. The bad debts written off during 2004 amounted to Rs. 900 and
the new provision required on 31st December 2004 was Rs. 3000 . In such
a situation, the Profit and Loss Account will be debited with Rs. 1,900 as
calculated below :

98
 Profit and Loss Account

Rs. (Debit Side)

Bad debts 900

Add : New Provision 3,000

3,900

Less : Old Provision 2,000 1 ,900

You have to note that the new provision should be calculated on sundry
debtors after adjusting the amount of further bad debts. You can adopt
the following way for calculation.

Profit and Loss Account (Debit Side)

Rs. Rs.

Bad debts (as given in Trial Balance) xxx

Add : Bad debts (as per adjustments) xxx

Add : New Provision required xxx

xxx

Less : Existing Provision (as given in

Trial Balance) xxx xxx

The Amount to be debited to Profit & Loss A/c. You have to also
remember that in the Balance Sheet only further bad debts (as given in
adjustments) and the new provision for bad debts should be subtracted
from the sundry debtors.
11. Provision for Discount On Debtors : You know in business cash
discount is allowed to the debtors as an incentive for prompt payment. As
in the case of anticipated loss on account of doubtful debts, a provision is
made to provide discount in the next year, such a provision is called as
the provision for Discount on Debtors. The provision for discount on
debtors is calculated at a certain percentage on net sundry debtors. Net
sundry debtors refer to debtors which are calculated after deducting
further bad debts and provision for doubtful debts.

The adjustment entry for provision for discount on debtors is :

Profit and Loss A/c Dr

To Provision for Discount on Debtors A/c

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The Provision for discount on debtors is shown on the debit side of Profit
and Loss Account and in the asset side of Balance Sheet, it is shown as
a deduction from sundry Debtors.
12. Provision for Discount on Creditors: Creditors may offer some
discount to the firm in order to motivate it to make prompt payment. It is
calculated at a certain percentage on the creditors. While making
provision for discount on creditors, the following adjustment entry is
passed:

Provision for Discount on Creditors A/c Dr

To Profit and Loss A/c

The provision for discount on creditors is shown on the credit side of Profit
and Loss Account and in the liabilities side of the Balance Sheet as a
deduction from Sundry Creditors.
13. Loss of Stock by Accident, Fire Etc: In the course of business some
loss of stock may arise due to various reasons. Depending on the cause
of loss, the loss is classified as normal and abnormal. The loss which arise
due to the inherent characteristics of stock (like evaporation, drying up of
goods etc.) is called as normal loss. The loss which arise due to accident,
fire or theft can be termed as abnormal loss. The abnormal loss should be
properly accounted in the accounting records. The following adjustment
entry is passed to record such loss :

Loss by Fire A/c Dr

To Trading A/c
The accounting treatment will vary according to the level of insurance of
stock. The different accounting treatments are given below :
i) When the Stock is Fully Insured : In this case the entire loss can
be claimed from the insurance company. The following journal entry
passed :

Insurance Company A/c Dr

To Loss by Fire A/c

ii) When the Stock is Partially Insured: In case the stock is partially
insured the amount of insurance can be claimed from the insurance
company and uninsured stock will be a loss to the business. The following
journal entry is passed :

Insurance Company A/c Dr

Profit and Loss A/c

100
iii) When The Stock is Not Insured: In this situation the entire loss is
borne by the firm. The journal entry is :

Profit and Loss A/c Dr

To Trading A/c
Trading Account is credited with the total loss. In the case of uninsured
stock, the profit and loss account is debited. In case of fully insured loss,
insurance claim will be shown as an asset in the asset side of the balance
sheet. Suppose the stock is partially insured, the amount of insurance
claim is shown as an asset in the Balance sheet and the balance is loss
to the business therefore, debited to the Profit and Loss Account.
14. Manager’s Commission: To motivate and improve the performance
of manager the business may give certain percentage of commission to
them on profits. This motivates the manager to work hard to enhance the
profit of the business in order to get more commission. So the profitability
position of the business gets improved. Suppose the Net Profit of a
concern after meeting all expenditures but before charging commission to
manager is Rs. 90,000. The business offers manager 10% of commission
of profit before charging such commission. In this case the manager’s
commission will work out as Rs. 9,000. The following journal entry will be
passed :

Profit and Loss A/cDr

To Commission Payable
But sometimes, the commission to the manager is to be calculated on
profit after charging such commission. In such a case the commission will
be calculated by the following formula :

In the above example, the commission payable will be Rs.

The commission to the manager is an outstanding expense. Therefore, it
will be shown on the debit side Profit and Loss Account and on the
liabilities side of the Balance Sheet as commission payable.
15. Drawing of Goods by the Proprietor: When the proprietor takes
away some goods from the business for personal use, that must be
properly recorded in the books of account. This helps to ascertain the real
profits of the business. The following journal entry is passed to record
drawings:

Drawings A/c Dr

To Purchase A/c

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In is shown on the debit side of Trading Account by ducting it from
purchases and on the liabilities side of the Balance Sheet by deducting it
from capital.
16. Goods Distributed as Free Samples: Today’s organisations are
facing intense competition from all comers of the world. To market their
products organisations, adopt different strategies. Distribution of goods
are free samples is one of the way of promotion of sales. The following
journal entry is passed to record the goods distributed as free samples:

Advertisement A/c Dr

To Trading or Purchases A/c

Goods distributed as free sample is shown the credit side of the Trading
Account or deducted from the purchases on the debit side of Trading
Account and on the debit side of the Profit and Loss Account as
advertisement expenses.

6.5 PREPARATION OF FINAL ACCOUNTS

In the previous section you have learnt various items which require
adjustment at the time of preparing final accounts. You have also learnt
the accounting treatment of these adjustment items. In this section, you
can learn how final accounts are prepared with various types of
adjustments.

Illustration 4
The following are the Ledger balances extracted from the books of
Ramani as on 31-12-2019
Particulars Amount Particulars Amount
Rs. P. Rs. P.
Debit Balances: Credit Balances
Drawings 3,000 00 Sales 24,000 00
Goodwill 6,000 00 Provisions for Bad 900 00
& Doubtful Debts
Land &Building 12,000 00 Provision for 342 00
discount on
debtors
Plant & Machinery 8,000 00 Loan at 6% 4000 00
Loose tools 600 00 Capital 40,000 00
Bills Receivable 1,600 00 Sundry creditors 8,000 00
Stock,1st 8,000 00 Purchases 500 00
Jan.2019 Returns
Purchases 10,200 00 Discount Received 300 00

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Wages 4,000 00 Commission 400 00
received
Carriage inwards 200 00 Bills payable 2,278 00
Carriage Outward 80 00
Coal, Gas & Coke 1,160 00
Sales Return 400 00
Furniture & 240 00
Fixtures
General Expenses 1,050 00
Provision for 320 00
discount on
creditors
Interest on loan 120 00
salaries
Rent ,Rates &
Taxes
Discount Allowed
Cash at bank
Cash in Hand
Sundry Debtors
Repairs
Printing&
Stationery
Bad debts
Advertisement
(special) 6,000
(Normal) 700 6,700 00
Total 80,720 00 Total 80,720 00

Adjustments
(i) Closing Stock on 31-12-2019 amounted to Rs. 15,654
(ii) Depreciate Plant & Machinery at 5% Loose tools at 15% and
Furniture & Fixtures at 20%
(iii) Provide for Bad & Doubtful Debts at 5% and for discount on Debtors
and Creditors at 2%
(iv) Outstanding : Wages Rs.200 and Rent, Rates, & Taxes Rs.100.
(v) Write off one - third of advertisement (Special)
(vi) Interest on loan has been paid for six months only.
(vii) A Bill for Rs.1,000 included in Bills Receivable has been
dishonoured.

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(viii) The Manager is untilled to a Commission of 5% on net profit after
charging such commission.
Prepare final accounts for the year ended 31-12-2019.
Solution
Particulars Amount Particulars Amount
Rs. P. Rs. P.
Debit Balances: Credit Balances
Drawings 3,000 00 Sales 24,000 00
Goodwill 6,000 00 Provisions for Bad 900 00
& Doubtful Debts
Land &Builiding 12,000 00 Provision for 342 00
discount on
debtors
Plant & Machinery 8,000 00 Loan at 6% 4000 00
Loose tools 600 00 Capital 40,000 00
Bills Receivable 1,600 00 Sundry creditors 8,000 00
Stock,1st 8,000 00 Purchases 500 00
Jan.2019 Returns
Purchases 10,200 00 Discount Received 300 00
Wages 4,000 00 Commission 400 00
received
Carriage inwards 200 00 Bills payable 2,278 00
Carriage Outward 80 00
Coal, Gas & Coke 1,160 00
Sales Return 400 00
Furniture & 240 00
Fixtures
General Expenses 1,050 00
Provision for 320 00
discount on
creditors
Interest on loan 120 00
salaries
Rent ,Rates &
Taxes
Discount Allowed
Cash at bank
Cash in Hand
Sundry Debtors
Repairs

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Printing &
Stationery
Bad debts
Advertisement
(special) 6,000
(Normal) 700 6,700 00
Total 80,720 00 Total 80,720 00

Balance Sheet of Ramani as on 31-12-2019

Liabilities Rs. P. Assets Rs. P.
Sundry Creditors Cash in hand 80 00
8,000
Less:
provisions for
discount 160 7,840 00
6% Loan 4,000 Cash at Bank 5,000 00
Add: Interest
Outstanding 120 4,120 00
Bills Payable 2,278 00 Bills Receivable 1,600
Less: Dishonoured
1,000 600 00

Outstanding Expenses: Sundry Debtors 9000

wages 200 Add: B/R
Rent, rates taxes Dishonoured
100 1000
Managers Less: Provision
Commission 448 748 00 for bad debts
500
_____

9,500
Less: Provision
for discount
190 9,310 00
______
Capital Stock 15,654 00
Opening 40,000
Add: Net profit
8,960
48,960
Less:
Drawings 3,000 45,960
Loose Tools 600
Less:
Depreciation 90 510 00
Furniture & fixtures
240
Less:
Depreciation 48 192 00

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 Plant & Machinery
8,000
Less:
Depreciation 400 7,600 00
Land & Buildings 12,000 00
Advertisement
special 6000
Less:
written off 2,000 4,000 00
Goodwill 6,000 00
60,946 00 60,946 00

LET US SUMUP
Final Accounts are prepared to ascertain the final results of the business.
They are prepared at the end of a regular periodic interval. Final accounts
can be described as the summary of all the accounting information
recorded in the subsidiary books and the ledger. Final accounts include
the preparation of:(i) Trading and Profit and Loss Account and (ii) Balance
sheet. Trading Account, a part of the Profit and Loss Account, reveals the
gross profit and or gross loss of business profit & loss Accounts shows
the net profit or loss of the business during a particular period. Balance
sheet highlights the financial condition (or position) of the business on a
particular date.
A manufacturing concern may also prepare the Manufacturing Account
for computing the cost of goods produced, which is later transferred to
Trading Account. Preparation of Manufacturing Account is not
compulsory. Nowadays many manufacturing concerns prepare the
Trading account directly by including all factory expenses in the trading
account itself.
Final accounts convey very useful information to the owners,
management, creditors, banks etc. This enables them to take important
decisions on the liquidity position and financial soundners of the concern.

CHECK YOUR PROGRESS

Choose the Correct Answers:

1) Gross profit is _______.

a) Cost of goods sold + Opening stock

b) Excess of sales over cost of goods sold

c) Sales fewer Purchases

d) Net profit fewer expenses of the period

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2) Net profit is computed in the _______.

a) Profit and loss account b) Balance sheet

c) Trial balance d) Trading account

3) In order to find out the value of the closing stock during the end of the
financial year we, ________.

a) do this by stocktaking

b) deduct the cost of goods sold from sales

c) deduct opening stock from the cost of goods sold

d) look in the stock account

4) Which of this best explains fixed assets?

a) Are bought to be used in the business

b) Are expensive items bought for the business

c) Are items which will not wear out quickly

d) Are of long life and are not purchased specifically for resale
5) The charges of placing commodities into a saleable condition should
be charged to ________.

a) Trading account b) P & L a/c

c) Balance Sheet d) None of the above

GLOSSARY

Adjustment item Item given outside the Trial Balance and

: requires adjustment at the time of
preparing Final Accounts.

Adjustment entry : Journal entries passed to affect the

required adjustments.

Outstanding expenses : Expenses which have been incurred

during the accounting year but not yet
paid.

Prepaid expenses : Expenses which have been paid in

advance but the benefit of which is yet to
be received.

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 Accrued income or : Incomes which have been earned but not
outstanding income received during the accounting period.

REVIEW QUESTIONS
1.Following are the balance, extracted from the books for Narendra
Sharma on 31-12-20. Prepare Trading and Profit and loss a/c and balance
sheet after considering the adjustments given below:
Particulars Rs. P. Particulars Rs. P.
Capital 35,000 Drawings 6,000
Furniture 2,600 Bank overdraft 4,200
Stock (1-1-20) 20,000 Sundry creditors 13,800
Debtors 15,000 Business Premises 24,000
Purchases 1,12,000 Rent from tenants 1,000
Salaries 12,000 Taxes & Insurance 2,000
Commission (Dr) 1,600 General Expenses 4,000
Carriage 2,000 Discount (cr) 2,000
Discount (Dr) 2,000 Bad debts 800
Sales 1,50,000 Sales returns 2,000
Adjustments
a) Stock on hand on 31-12-20 Rs.20,000
b) Write off depreciation: Business premises - Rs.1,000, Furniture -
Rs.600.
c) Make a reserve of 5% on debtors for doubtful debts.
d) Allow interest on capital at 5%
e) Carry forward Rs.200 for unexpired insurance
(Ans : Gross Profit Rs.34,000, Net Profit Rs.10700, Balance Sheet
Rs.59450]
5. From the following Trial Balance of Mr. X, prepare Final Accounts
for the year ended as 31-12-17.
Particulars Rs. P. Particulars Rs. P.
Land and Buildings 50,000 Returns 2,500
Purchases 1,10,000 Discounts 1,200
Stock 40,000 Sales 2,05,000
Returns 1,500 Capital 1,15,000
Wages 10,000 Loan 15,000
Salaries 9,000 Commission 1,500
Office Expenses 2,400 Creditors 25,000
Carriage 3,200 Bills Payable 2,350

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 Discounts 750
Bad Debts 1,200
Insurance 1,500
Machinery 50,000
Furniture 10,000
Debtors 40,000
Cash 26,000
Office Equipment 12,000
3,67,550 3,67,550
Adjustments
a) Closing stock - Rs.60,000
b) Outstanding wages - Rs.2,000 and Rent Rs.3,000
c) Depreciate Land & Building at 5%, Machinery at 10%. Office
equipment and furniture by 10%.
d) Provide reserve at on debtors
e) Insurance prepaid Rs.200.
f) Calculate interest on capital at 5%.
[Answer : Gross Profit Rs.1,00,800
Net Profit Rs.69,400
Balance Sheet Rs.2,37,500

SUGGESTED READINGS
1. Gupta, R.L. and Radhaswamy, M., (2006), Financial Accounting,
Sultan and Chand Sons, New Delhi.
2. Maheswari, S.N and Maheshwary, S.K. (2006), Fundamental of
Accounting, Vikas Publications.
3. Shashi K. Gupta, R.K.Sharma , (2012), “Financial Management”
latest Edition, Kalyani Publishers, Chennai
4. M C Shukla, S C Gupta & T S Grewal, (2017), Advance
Accounting, 19th Edition, S.Chand Publishing, New Delhi
5. Tulsian P. C. , (2017), Financial Accounting , Pearson Education,
New Delhi.
6. https://www.investopedia.com/terms/t/tradingaccount.asp
7. https://www.investopedia.com/terms/p/plstatement.asp
8. https://corporatefinanceinstitute.com/resources/accounting/balan
ce-sheet/

ANSWER TO CHECK YOUR PROGRESS

1) b 2) a 3) a 4) d 5) a

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 BLOCK 2

FINANCIAL STATEMENT ANALYSIS

Unit 7 : Financial Statement Analysis

Unit 8 : Tools of Financial Analysis

Unit 9 : Funds Flow Statement

Unit 10 : Cash Flow Statement

Unit 11 : Ratio Analysis

110
Unit 7

FINANCIAL STATEMENT ANALYSIS

STRUCTURE

Overview

Learning Objectives

7.1 Meaning and Types of Financial Statements

7.2 Nature of Financial Statements

7.3 Limitations of Financial Statements

7.4 Analysis and Interpretation of Financial Statements

7.4.1 Meaning of Analysis and Interpretation

7.4.2 Types of Financial Analysis

7.5 Limitations of Financial Analysis

Let Us Sum Up

Check Your Progress

Glossary

Suggested Readings

Answers to Check Your Progress

OVERVIEW
The main purpose of accounting is to provide useful information to various
interested parties like investors, lenders, managers, suppliers, customers
etc., to help them make better decisions. Many organisations provide
information in the form of Financial Statements. Financial statements
attempt to provide information about the financial health and performance
of a business unit. Financial statements are only a means and not an end
by themselves. One cannot derive meaningful conclusion from the
information contained in the financial statements. The financial
statements must be properly analysed and interpreted. Financial analysis
includes: (i) breaking financial statement into simpler ones (ii) re grouping
(iii) rearranging the figures given in financial statements and (iv) finding
out ratios and percentages. Analysis of financial statements helps to fully
diagnose the profitability and financial position of the firm concerned. With
the help of analysis of financial statements, the potential investors can

111
evaluate the past performance and can predict the future prospects of a
firm. Creditors may get information about the short-term liquidity position
of a concern. Debenture holders and financial institutions who give long
term loans to the organisations can study the cash flow ability of the
business. And, the management can evaluate their own performance and
can take better decisions. So, the analysis of financial statement enables
the end users of accounting to take better decisions.
This unit explains the meaning and nature of financial statements,
significance of analysis of financial statements, various techniques that
are used for the financial analysis and the limitations of financial analysis.

LEARNING OBJECTIVES

After reading this unit, you should be able to,

• explain what financial statements are
• describe the information presented in financial statements
• discuss the nature of financial statements
• describe the limitations of financial statements and financial
analysis
• explain the different techniques of financial analysis
• analyse the role of techniques of financial analysis.

7.1 MEANING AND TYPES OF FINANCIAL STATEMENTS

You have learnt that the main aim of maintaining various accounting
records is to determine profitability of the enterprise from operations of the
business and also to ascertain its financial position. Financial statements
are the outcome of summarising process of accounting information.
Financial statements convey information about the financial aspects of a
business firm to different users of accounting information. According to
John N. Myer, (the author of “Financial Statement Analysis”) The financial
statements provide a summary of the accounts of a business enterprise,
the balance sheet reflecting the assets, liabilities and capital as on a
certain date and the income statement showing the results of operations
during a certain period”.
Thus, the term financial statements generally refers to two basic
statements, namely, (i) Income Statement, and (ii) the Balance Sheet. A
business may also prepare (iii) a Statement of Retained Earnings, and
(iv) a Statement of Changes in Financial Position in addition to the above
two statements. The following chart show these statements.

112
Apart from the above statements, several schedules are also prepared in
which special / specific details are given such as schedule of investments,
fixed assets, Debtors, Schedule of reserves and funds etc.
The meaning and significance of each of these statements are explained
below:
Income Statement (or Profit and Loss Account): It is a summary of all
the revenues or incomes and all the expenses incurred for earning those
revenues. The difference between the revenues and expenses is called
net profit or loss of the business for the period.
A business firm earns net profit when its total revenues earned exceed its
total expenses. On the other hand, a business incurs loss when its total
expenses exceed total revenues. Revenues are the amounts which the
business receives from the customers for providing goods and services to
them. Expenses are costs incurred in connection with the earnings of
revenue. Net profit increases owners’ equity. On the contrary, net losses
decreases owners’ equity.
Income statement explains what has happened to a business concern as
a result of operations between two balance sheet dates. It is of great use
to end- users of accounting statements because it enables them to
ascertain whether the business operations have been profitable or not
during a particular period. It also enables them to make various crucial
financial decisions.
Balance Sheet: Balance sheet is one of the most important financial
statements. The balance sheet represents all the assets owned by a
company at a particular point of time and the claims (or equities) of the
owners and outsiders against those assets at that time. It is in a way a
snap shot of the financial condition of the business enterprise at that time.
There are two conventions of preparing the Balance sheet - the American
and the English. According to the American convention, assets are shown
on the left-hand side and the liabilities and the owners’ equity on the right
hand side. The English convention is just the opposite i.e., assets are
shown on the right hand side of the Balance sheet and liabilities and
owners’ equity on the left hand side. In India, generally the English
convention is followed. Assets and liabilities in a Balance Sheet may be
arranged either according to liquidity order or permanency order. Assets
can be classified into current assets and fixed assets. The following
paragraphs give a brief details about current assets and fixed assets.

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Current Assets: Current assets are assets which are acquired with the
intention of converting them into cash during the normal business
operations of the company.

The broad categories of current assets are:

• Cash including fixed deposits with banks
• Accounts receivable i.e., trade debtors and bills receivable
• Inventory i.e., stocks of raw materials, work-in-progress, finished
goods etc.
• Advances recoverable
• Prepaid expenses
• Short-term investments

Non - Current Assets (Fixed Assets): All assets other than current
assets can be called non - current assets. Goodwill, land, building,
machinery, furniture, long - term investments, patent rights, trade marks,
debit balance of profit and loss account, discount on issue of shares and
debentures, preliminary expenses come under this category. The special
feature of non - current asset is that the benefits of these assets are
available not only in the accounting period in which the cost is incurred
but over several accounting periods.
Non - current assets can be further classified as tangible and intangible
assets. The assets which are having physical dimension are called
tangible assets. Examples are land, buildings, machinery, furniture etc.
Intangible assets mean the assets or things of value without physical
dimension. They cannot be seen and touched. Goodwill, patents,
franchises, formation expenses and copy rights are some examples of
intangible assets.
Current liabilities: Liabilities of a business concern can be classified as
long - term liabilities and short - term liabilities. Long term liabilities are
those payable in a period of more than one year from the date of balance
sheet.
Short - term liabilities are current liabilities. Current liabilities include those
liabilities which are payable from cash or current assets with in a year from
the date of the balance sheet. The broad categories of current liabilities
are:
• Accounts payable, e.g., bills payable and trade creditors
• Outstanding expenses
• Bank over drafts
• Short - term loans, i.e., loans from banks or financial institutions
which are payable with in one year from the date of Balance sheet

114
 • Advance payments received by the business for the services to be
rendered, or goods to be supplied in future.
Non - Current Liabilities: All liabilities other than current liabilities come
within the category of non - current liabilities. Share capital, long term
loans, debentures, share premium, credit balance in the profit and loss
account, general reserve, dividend equilisation fund, debentures sinking
fund, capital redemption reserve come under the category of non - current
liabilities.
Statement of Retained Earnings: Statement of Retained Earnings are
also called as profit and loss appropriation account or Income Disposal
Account. It shows the accumulated excess earnings over losses and
dividends. The previous year’s balance is first brought forward to this
account. Then current year’s net profit is added to this balance.
Appropriations like interim dividend paid, proposed dividend on
preference and equity share capital, amounts transferred to debenture
redemption fund, capital redemption fund, general reserve etc. are shown
on the debit side. Thus, the statement of retained earnings creates a link
between the balance sheet and the Income Statement.
Statement of Changes in Financial Position: You have already learnt
that the income statement show the operating results of the business for
a particular accounting period and Balance sheet shows the financial
conditions of the business on a particular date. However, as a manager
of a concern you must have a good amount of knowledge on the
movement of working capital or cash in and out of the business. Funds
flow Statements show the movements of working capital between two
balance sheet dates. Cash flow statement shows the movements of cash
between two balance sheet dates. Change in overall financial position can
be studied with the help of simply as statement of changes in financial
position.

7.2 NATURE OF FINANCIAL STATEMENTS

Financial statements are prepared for the purpose of presenting a
periodical review or report on progress by the management and deal with
the status of investment in the business and the results achieved during
the period under the review. According to John N. Myer (The author of
book ‘Financial statement Analysis’), “The financial statements are
composed of data which are the result of a combination of (i) recorded
facts concerning the business transactions, (ii) conventions adopted to
facilitate the accounting technique, (iii) postulates, or assumptions made
to, and (iv) personal judgements used in the application of the
conventions and postulates”.

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The analysis of the above definition reveals that the financial statements
are having the following features.
i) Recorded Facts: The term ‘recorded facts’ refers to the data which are
taken out from the accounting records. You know in accounting, records
are maintained on the basis of actual cost data (or historical cost). The
figures of various accounts such as cash in hand and at bank, sundry
debtors, bills receivable, fixed assets are taken as per the figures originally
recorded in the accounting books. The assets are shown at cost price.
ii) Accounting Conventions: You have learnt in Unit 2 that certain
accounting conventions are followed while recording accounting
transactions. The convention of valuing inventory at cost or market price
whichever is lower is followed. Similarly, the conventions of conservatism,
materiality and full disclosure are also followed. The use of accounting
conventions makes financial statements reliable and comparable.
iii) Postulates: Like conventions accountants make use of certain
assumptions while recording accounting transactions. For instance,
accountants record the transactions on the assumption that the business
will continue for a long period (i.e. going concern concept or postulate)
The other alternative to this postulate is that the concern is to be
liquidated. Adopting this alternative will create a lot of practical problems,
if the management shows no intention to liquidate the concern. So the
fixed assets are shown after deducting depreciation on the basis of going
concern postulate.
iv) Personal Judgements: Accountants have tried to bring some
uniformity in accounting principles, assumptions and conventions. But the
use of accounting conventions mainly depends on the personal
judgements of the accountants. For instance, inventory is to be valued at
cost or market price whichever is lower. But the accountants generally
follow the cost concept for its valuation. Similarly, in case of depreciation,
a lot of methods can be adopted to provide depreciation on fixed assets.
The method of depreciation chosen is at the discretion of the accounts.
Thus, personal judgements of the accountants play a critical role in
preparing financial statements.
Financial statements are very much useful to various categories of people.
Owners, management, financial institutions, creditors, prospective
investors, Government and society are some of the important users of
accounting information.

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7.3 LIMITATIONS OF FINANCIAL STATEMENTS
Financial statements provide vital information to different end - users of
accounting information. The end - users of accounting information before
taking final decisions on the basis of financial statements, they have to
bear in mind the limitations of financial statements. The important
limitations of financial statements are given below:
i) Only interim reports: The financial statements are just an interim
report. They do not give the final picture of the concern. The actual and
final position of the business can be ascertained only at the time of
liquidation of the business. The operating results and financial position
revealed in the financial statements may change immediately.
ii) Ignores the facts which cannot be expressed in terms of money:
Financial statement reveal only those facts which can be expressed in
terms of money. The facts which are having long values to the
organisation or the facts which adversely affect the business are not
revealed in financial statements.
For example, financial statements will depict only the amount spent for
training and development of employees. But these will not reveal how
trained and efficient employees are valuable assets to the organisation.
Frequent strike in the organisation seriously affects the performance of a
business concern. These matters are considerable importance for the
business but these are completely igroaned in financial statements just
for the reason of difficulties in measuring in terms of money.
iii) Do not reveal exact position: As accounting adopts various
assumptions and conventions, the financial statements prepared from
accounting records do not reveal the correct position of the business. The
profit and loss account shows only a relative figure. Similarly, the value of
fixed assets shown in the balance sheet (fixed assets are shown at cost
less depreciation as per going concern concept) represents neither the
value for which the assets can be sold nor the amount which will be
required to replace these assets. In addition, there are certain items in the
balance sheet like preliminary expenses, goodwill, discount on issue of
shares etc., which will realise nothing at the time of liquidation even
though they are shown in the asset side of the balance sheet.
iv) Historical costs: The financial statements are generally prepared on
the basis of historical cost or original costs. The balance sheet which
shows assets at cost less accumulated depreciation losses the
significance of being an index of current economic realities. In other
words, we can say balance sheet does not portray the effect of price level

117
changes over a period of time. Similarly, the income statement may not
show the real operating efficiency of the business. The increase in profits
may be due to various abnormal causes, not necessarily due to
improvement in the operating efficiency of the business. Therefore, the
conclusion drawn from such statements may not show the true picture of
the concern.
v) No Precision: In the process of accounting many decisions are based
on personal judgements of the accountant. Treatment of an expense as a
capital expense or revenue expense, provisions for bad and doubtful
debts and contingent liabilities, treatment of deferred revenue
expenditure, selection of method of depreciation, etc., are all depend on
the personal judgement of the accountant. If the accountant is competent
but does not utilise his competencies, then financial statements prepared
on these personal judgements may not give a fair view of the concern.

7.4 ANALYSIS AND INTERPRETATION OF FINANCIAL STATEMENTS

Financial statements attempt to reveal the profitability and financial
soundness of a firm. But unless the financial statements are
systematically analysed and interpreted one cannot fully diagnose the
profitability and financial soundness of a firm. Financial statements
analysis is a part of the larger information processing system which forms
the very basis of decision making. The figures presented in the financial
statements are rearranged and relationship between related figures is
studied for interpretation and analysis of financial statements. In the words
of Myers, “Financial statement analysis is largely a study of relationship
among the various financial factors in a business as disclosed by a single
set of statements and a study of the trends of these factors as shown in a
series of statement.”

7.4.1 Meaning of Analysis and Interpretation

The term ‘Analysis’ means methodical classification of the data given in
the financial statements. For example, in order to study the short - term
solvency position of a firm all items relating to current assets are put in
one place while all items relating to current liabilities are put at another
place and the relationship between these two are studied. The term
‘Interpretation’ refers to explaining the meaning and significance of the
data so simplified. ‘Analyses and ‘interpretation’ are complementary to
each other. There is no use of analysis without proper interpretation.
Similarly, one cannot give right interpretation without analysis of
information. As analysis involves interpretation most of the authors use
the term ‘Analysis’ only to cover the meanings of both analysis and

118
interpretation. In this unit, the term financial statement analysis is used
throughout the chapter to cover both analysis and interpretation.

7.4.2 Types of Financial Analysis

Financial analysis can be classified into two different categories
depending upon (i) the materials used, and (ii) the modus of operandi of
analysis

A. On The Basis of Material Used

On the basis of material used financial analysis can be grouped into two
types, namely, external analysis and internal analysis.
i) External Analysis: The analysis which is done by those who are
outsiders for the business can be called as external analysis. Investors,
credit agencies, government agencies and other creditors who have no
access to the internal records of the company come under the category
of outsiders. External analysis serves only a limited purpose.
ii) Internal Analysis: This analysis is carried out by persons who have
access to the books of account and other information related to the
business. Compared to external analysis, this analysis gives more
benefits.

B. On The Basis of Modus Operandi

On the basis of modus operandi, financial analysis can also be of two

types: (i) Horizontal analysis and (ii) Vertical analysis.

A brief note about this analysis are given below:

i) Horizontal Analysis: Under this analysis, financial statements for a
number of years are reviewed and analysed. The current year’s figures
are compared with the standard or base year and changes are shown
regarding each item form the base year usually in the form of percentage.
This analysis gives considerable insights into levels and areas of strength
and weakness. It is also called as ‘Dynamic Analysis’.
ii) Vertical Analysis: Under this analysis a study is made of the
quantitative relationship of the various items in the financial statements on
a particular date. It is very much useful in comparing the performance of
several companies in the same group, or divisions or departments in the
same company. However, this analysis is not very conducive to a proper
analysis of the firm’s financial position and its interpretation as it does not
enable to study data in perspective. It is also called as ‘Static Analysis.’

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7.5 LIMITATIONS OF FINANCIAL ANALYSIS
There is no doubt that financial analysis is a powerful mechanism which
helps to study the strengths and weaknesses in the operations and
financial position of a concern. But it suffers from certain limitations.
Earlier in this unit, we have seen that financial statements are suffering
from certain limitations. All the limitations of financial statements affects
the reliability and validity of the results of financial analysis. Some of the
important limitations of financial analysis are given below.
i) Financial analysis is only a means, not an end: The financial analysis
should be considered only as a starting point and the conclusion should
be drawn keeping in view the overall picture prevailing economic and
political situation.
ii) financial analysis ignores the current costs: Earlier we have seen
that financial statements are prepared on the concept of historical cost.
As financial statements are not reflecting the value of current costs, the
financial analysis made on these statements may not portray the effects
of price level changes over the period.
iii) Financial statements are essentially interim reports: We cannot
ascertain the exact profitability and financial position of the business on
the basis of information given in financial statements. The exact position
can be known only when a business is closed down. As the financial
statements are just interim reports, the analysis made on these
statements also may not show the exact position.
iv) Ignores the facts, which cannot be expressed in terms of money:
Financial statements take into account only those transactions and events
which can be measured in terms of money. Because of that the matters
which are able consider importance for the business (e.g. high level
competencies of the people, highly efficient management, etc.) is ignored.
Because of those limitations the financial analysis is also affected.
v) Influence of personal judgement: You have learnt that many matters
are left to the personal judgement of the accountant. The influence of the
personal judgement of the accountants adversely affects the financial
statement analysis.
Irrespective of these limitations, financial analysis provides valuable
information to various people that help them to make better decisions.

LET US SUMUP
Financial statements provide information about the financial health and
performance of a business unit in a condensed and highly informative

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format. Financial statements consist of : (i) Income Statement and (ii)
Balance Sheet. But these days big organisations provide (iii) Statement
of Retained Earnings and (iv) a statement of changes in Financial
Position in addition to the above mentioned two statements, Income
statement shows whether a business earned a profit or incurred a loss.
Balance sheet shows the list of assets, liabilities and owners’ equity.
Statement of Retained Earnings shows the accumulated excess earnings
over losses and dividends. The Statement of changes in financial position
reveals how the amount of cash changed between the beginning and
ending balance sheets. The changes in other assets and liabilities can
also be studied with the help of statement of changes in financial position.
Financial statements are recorded facts based on various accounting
concepts and conventions. Personal judgements of accountants also
influence significantly in the accounting process.
There are a number of techniques used to analyse and interpret the
financial statements. The important ones are : (i) Comparative financial
statements, (ii) Common - size financial statements, (iii) Trend
percentages, (iv) funds flow and cash flow analysis and (v) Ratio
analysis.
Financial analysis suffers from certain limitations. They are: (i) Financial
analysis is only a means, not an end, (ii) financial analysis ignores the
current costs, (iii) financial statements are essentially interim reports, (iv)
financial statements ignores the facts, which cannot be expressed in
terms of money and (v) Influence of personal judgements of accountants.
Irrespective of these limitations financial analysis provides vital
information to the end - users of accounting. We have so far discussed
about the financial statements and a few techniques used in the analysis
and interpretation of financial statements.

CHECK YOUR PROGRESS

Choose the Correct Answer:

1) The term current assets do not include __________

a) Trade debtors b) Bills Receivable

c) Long - term Deferred charges d) cash in hand

2) The term fixed assets include __________

a) Stock - in – trade b) Machinery

c) Payments in Advance d) stock

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 3) Fixed assets are shown at cost less accumulated depreciation on
the basis of ___________

a) Going concern concept b) Business Entity concept

c) Realisation concept d) Consistency concept

4)The financial statements are generally prepared on the basis of
_________

a) Fixed Costs b) Variable Costs

c) Actual Costs d) Historical Costs

5) Which of the following is a recorded fact _________

a) Market value of investment b) Debtors

c) Replacement cost of machinery d) Business Entity Concept

GLOSSARY

Financial Statement : refers to two basis statements, namely,

the income statement and Balance Sheet.

Income Statement : is the final summary of all revenues,

expenses and losses during an
accounting period. Reveals the net profit
or net loss for that period.

Current Assets : include cash and other assets which are

expected to be realized during the normal
business operations.

Current Liabilities : refer to the claims against the assets of a

concern to be met out of cash or other
current assets within a year or within the
operating cycle, which ever is longer.

Intangible Assets : are assets which are useful to the

business for long - period and having no
physical characteristics.

SUGGESTED READINGS
1. Gupta, R.L. and Radhaswamy, M., (2006), Financial Accounting,
Sultan and Chand Sons, New Delhi.
2. Maheswari, S.N and Maheshwary, S.K. (2006), Fundamental of
Accounting, Vikas Publications.

122
 3. Shashi K. Gupta, R.K.Sharma , (2012), “Financial Management”
latest Edition, Kalyani Publishers, Chennai
4. M C Shukla, S C Gupta & T S Grewal, (2017), Advance
Accounting, 19th Edition, S.Chand Publishing, New Delhi
5. Tulsian P. C. , (2017), Financial Accounting , Pearson Education,
New Delhi.
6. https://www.accountingtools.com/articles/financial-statements
7. https://www.investopedia.com/terms/f/financial-analysis.asp

ANSWER TO CHECK YOUR PROGRESS

1) c 2) b 3) a 4) d 5) b

123
Unit 8

TOOLS OF FINANCIAL ANALYSIS

STRUCTURE

Overview

Learning Objectives

8.1 Techniques of financial analysis

8.1.1 Comparative financial statements

8.1.2 Common - size financial statements

8.1.3 Trend Percentages

8.1.4 Funds flow analysis

8.1.5 Cash flow analysis

8.1.6 Ratio Analysis

Let us Sum Up

Glossary

Check Your Progress

Suggested Readings

Answer to Check Your Progress

OVERVIEW
Financial statements are prepared to have complete information
regarding assets, liabilities, equity, reserves, expenses and profit and loss
of an enterprise. To analyse& interpret the financial statements,
commonly used tools are comparative statements, common size
statements etc. The information pertaining to the financial statements is
of great importance through which interpretation and analysis is made.
Internal constituents use it as a monitoring tool for managing the finances.
Internal constituents use it as a monitoring tool for managing the finances.

LEARNING OBJECTIVES

After reading this unit, you should be able to:

• explain the various tools of financial analysis
• explain how each tool works
• differentiate the various tools of financial analysis

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8.1 TECHNIQUES OF FINANCIAL ANALYSIS
The main aim of any analytical method or technique is to simplify or
reduce the data under review to more understandable terms. By applying
the techniques of analysis, we can study whether the financial position
and operating results of a company are satisfactory or unsatisfactory. A
financial analyst can adopt any one of the following techniques.

i) Comparative financial statements

ii) Common - size financial statements

iii) Trend Percentages

iv) Funds flow analysis

v) Cash flow analysis

vi) Ratio Analysis

Brief details about each of these techniques are given below:

8.1.1 Comparative Financial Statements

As their name suggests, comparative financial statements are those
statements which have been designed in a way so as to provide time
perspective to the consideration of various elements of financial position
embodied in such statements. The figures for two or more periods are
placed side by side. This facilitates easy and meaningful comparison.
Both the income statement and Balance Sheet can be prepared in the
form of comparative financial statements.
a) Comparative Income Statement: A comparative income statement
shows the absolute figures for two or more periods, the absolute change
from one period to another and of desired the change in terms of
percentages. Since the figures for two or more periods are shown side by
side, the reader can easily ascertain whether sales revenues have
increased or decreased, whether cost of sales has reduced or not.
b) Comparative Balance Sheet: Comparative balance sheet shows not
only the balance of accounts as on different dates, but also highlights the
increase or decrease in those items between these dates.
While in the single balance sheet the emphasis is on status, in the
comparative balance sheet it is on change. As comparative balance sheet
reveals the increase or decrease in various assets and liabilities as well
as in proprietors equity or capital, it is very much useful in studying the
trends in an enterprise.

125
You can understand better the preparation of comparative financial
statement with the help of following illustration.

Illustration 1
From the following profit and loss account and the Balance sheet of
Swadeshi Polytex Ltd. for the year ended 31st December, 2017 and 2018;
you are required to prepare a comparative income statement and a
comparative Balance Sheet.

Profit and Loss Account

(In Lakhs of Rs. )

Particulars 2017 2018 Particulars 2017 2018
Rs. Rs. Rs. Rs.
To Cost of goods 600 750 By Net Sales 800 1,000
sold
To Operating
expenses: 20 20
Administration
Selling 30 40
To Net Profit 150 190
800 1,000 800 1,000

Balance Sheet as on 31st December

Liabilities 2017 2018 Asset 2017 2018
Rs. Rs. Rs. Rs.
Bills Payable 50 75 Cash 100 140
Sundry creditors 150 200 Debtors 200 300
Tax Payable 100 150 Stock 200 300
6% Debentures 100 150 Land 100 100
6% Preference Building 300 270
capital 300 300
Equity capital 400 400 Plant 300 270
Reserves 200 245 Furniture 100 140
1,300 1,520 1,300 1,520

Solution

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 Swadeshi Polytex Ltd.
Comparative income statement for the year ended 31st December
2017and 2018
(Figures in lakhs of rupees)
Absolute Percentage
increase or increase or
2017 2018 decrease in decrease in
2017 2018
Net Sales 800 1,000 + 200 +25
Less: Cost of goods Sold 600 750 +150 +25
Gross Profit 200 250 +50 +25
Operating Expenses
Administrative Expenses 20 20 --------- ---------
Less: Selling Expenses 30 40 +10 +33.33
Total Operating Expenses 50 60 10 +20
Operating Profit 150 190 +40 +26.67
Swadeshi Poly Tex. Ltd.
Comparative Balance Sheet as on 31st December 2017, 2018
(Figures in lakhs of rupees)

Absolute Percentage
increase or increase (+)
decrease or decrease
during (-) during
2017 2018 2018 2018

Current Assets
Cash 100 140 40 +40%
Debtors 200 300 100 +50%
Stock 200 300 100 +50%

Total Current Assets 500 740 240 +50%

Fixed Assets
Land 100 100 --- ---
Building 300 270 -30 -10%
Plant 300 270 -30 -10%
Furniture
100 140 +40 +40%

Total Fixed Assets 800 780 -20 -2.5%

Total Assets 1300 1520 220 +17%

Liabilities of Capital

Current Liabilities

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 Bills Payable 50 75 +25 +50%
Sundry Creditors 150 200 +50 +33.33%
Tax Payable 100 150 +50 +50%

300 425 +125 +41.66%

Long- Term Liabilities

6% Debentures 100 150 +50 +50%

400 575 +125 43.75%

Capital & Reserves

6% Preference Capital 300 300 --- ---
Equity Capital --- ---
400 400
Reserves 45 22.5%
200 245

Total Shareholder’s funds 900 945 45 5%

Total Liabilities and Capital 1300 1520 220 17%

Interpretation
Comparative financial statements can be prepared for more than two
periods. However, it will difficult to study the trend with more than two
periods’ data. In this case, the trend analysis will be a suitable technique.
We can discuss later the trend analysis.
8.1.2 Common - Size Financial Statements
Common - size financial statements are often called ‘component
percentage’. In this the figures reported in the financial statements are
converted into percentages to some common base. Generally in the
Income Statement, the sales figure is assumed to be 100 and all figures
are expressed as a percentage of this total. In the Balance Sheet the total
assets or total liabilities are assumed to be 100 and all the items in the
balance sheet are expressed as a percentage of this total. Each
percentage shows the relation of the individual item to its respective total
(base). You can understand this with the help of an illustration.

Illustration 2
On the basis of data given in Illustration 1, prepare a common - size
income statement and common - size balance sheet of Swadeshi Polytex
Ltd., for the years ended 31st December 2017 and 2018.

Solution

128
 Swadeshi Polytex Ltd.
Common - size income statement for the year ended 31st December
2017 and 2018
(Figures in percentage)
2017 2018
Net Sales 100 100
Cost of goods sold 75 75
Gross Profit 25 25
Operating expenses:
Administration expenses 2.50 2
Add: Selling expenses 3.75 4
Total operating expenses 6.25 6
Operating Profit 18.75 19

The above statement reveals that though in absolute terms the cost of
goods sold has gone up (from Rs.600 lakhs to Rs.750 Lakhs)
The percentage of its cost to sales remains constant at 75%. That is why
the Gross Profit continues to be at 25% of the sales. Similarly, in absolute
terms the administration expenses remain the same (i.e. at Rs.20 lakhs
each) but as a percentage to sales it has come down by 0.5%. Selling
expenses have increased by 0.25%. (i.e. from 3.75% to 4%). All these
lead to net increase in net profit by 0.25% (i.e. from 18.75% to 19%).

Common size Balance Sheet

So far we have discussed about common size Income Statement. Now
we can work the common size Balance Sheet.

SwadeshiPolytex Ltd.

Common size Balance Sheet as on 31st December 2017 and 2018

(Figures in percentage)

2017 2018
% %

Assets 100 100

Current Assets
Cash 7.70 9.21
Debtors 15.38 19.74

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 Stock 15.38 19.74

Total Current Assets 38.46 48.69

Fixed Assets
Building 23.07 17.76
Plant 23.07 17.76
Furniture 7.70 9.21
Land 7.70 6.58

Total Fixed Assets 61.54 51.31

Total Assets 100 100

Current Liabilities
Bills payable 3.84 4.93
Sundry creditors 11.54 13.16
Taxes payable 7.69 9.86

Total Current Liabilities 23.07 27.95

Long - term Liabilities 7.69 9.86

Capital & Reserves

6% Preference share Capital 23.10 19.72
Equity share capital 30.76 26.32
Reserves 15.38 16.15

Total Shareholders Funds 69.24 62.19

Total Liabilities and Capital 100 100

Interpretation
The above statement shows that the percentage of current assets to total
assets was 38.46 in 2017. It has gone up to 48.69 in 2018. Similarly the
percentage of current liabilities to total liabilities has also gone up from
23.07 in 2017 to 27.95 in 2018.
The comparison of increase to current assets to current liabilities reveals
that the current assets have increased by a higher percentage as to
compare current liabilities. You know when there is an increase in current
assets, the working capital position of the firm will also increase. The
proportion of total shareholders’ fund to total liabilities has come down
from 69.24% to 62.19%. However, the proportion of debenture - holders
has gone up from 7.69% to 9.86%.

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8.1.3 Trend Percentages
We have seen in the earlier paragraphs that it becomes very difficult to
study the trend with more than two periods’ data by applying comparative
Financial Statements. In this case, trend percentages are more useful.
The technique of computing the trend percentages are discussed here.
The calculation of trend percentages involves the calculation of
percentage relationship that each item bears to the same item in the base
year. Any year may be taken as base year. Generally the first year is taken
as base year. The figures of the base year are taken as 100 and on that
basis the percentage for each of the items of each of the years are
calculated. We have to note that trend percentages should be calculated
only for items having logical relationship with one another. You can
understand well the calculation of trend percentage with the help of an
illustration.

Illustration 3
Calculate the trend percentages from the following figures of Raju Ltd.,
taking 2015 as the base and interpret them:
Year Sales Stock (Rs. in lakhs)
Profit before Tax
2015 1.881 709 321
2016 2,340 781 435
2017 2,655 816 458
2018 3,021 944 527
2019 3,768 1,154 672

Solution
Trend Percentages
(Base year 2000 = 100)

Year Sales Stock Profit before Tax

Amount Trend Amount Trend Amount Trend

(Rs. Percentage (Rs. Percentage (Rs. Percentage
Lakhs) Lakhs) Lakhs)

2015 1,881 100 709 100 321 100

2016 2,340 124 781 110 435 136

131
 2017 2,655 141 816 115 458 143

2018 3,021 161 944 133 527 164

2019 3,768 200 1,154 162 372 116

Interpretation
i) The sales have continuously increased in all the years. The percentage
of sales in 2019 is 200 (doubled) as compared to 100 in 2015. It can be
observed that the increase is sales in quite satisfactory
ii)The figures of stock have also increased from 2015 to 2019. However,
the percentage of increase is more in 2018 and 2019 as compared to
earlier years.
iii) Profit before tax of the concern has also increased significantly. In five
years period the profit has more than doubled. This should be welcomed.
The overall analysis shows that the company has more potential for
growth. In the five years period, the sales and profit have become
doubled. Compared to sales, the growth rate of profit is more significant.
It highlights that the company has proper control over the cost of goods
sold. Hence, it can be stated that the overall performance of the company
is good.
8.1.4 Funds Flow Analysis: Funds flow analysis is another important
technique in the analytical kit of financial analyst, managers and financial
institutions. It shows the sources and application of funds. Here the term
fund refers to working capital. Hence, funds flow statement can be
described as a statement which tells about the sources from which the
working capital was obtained and the purpose for which it was utilised.
You can learn in detail about the funds flow statement in Unit 10.
8.1.5 Cash Flow Analysis: A cash flow statement shows the inflow and
outflow of cash between two balance sheet dates. The term cash here
refers to cash and bank balances. Cash flow statement list out the items
which bring changes in the cash position of the business between two
balance sheet dates. Now a day’s cash flow analysis is considered an
important technique of financial analysis. By releasing the significance of
cash flow statement, Securities and Exchange Board of India (SEBI) in
June 1995 amended clause 32 of the Listing Agreement requiring every
listed company to give along with its balance sheet and profit and loss
account, a cash flow statement. The technique and the new procedure

132
involved in the preparation of cash flow statement has been discussed in
detail in Unit 10.
8.1.6 Ratio Analysis: Ratio analysis is one of the most frequently used
yardstick for financial statement analysis. The financial analysts study the
numerical or quantitative relationship between two variables (or items) by
applying this tool. Thus, ratio analysis helps to assess the performance
and status of the business unit. You can learn in detail the ratio analysis
in the next unit (i.e., Unit 12)

Exercises
1.Convert the following statement of profit and loss into the comparative
statement of profit and loss of BCR Co. Ltd.:
Particulars 2015-16 2016-17.
Rs. Rs.
(i) Revenue from operations 60,00,000 75,00,000
(ii) Other incomes 1,50,000 1,20,000
(iii) Expenses 44,00,000 50,60,000
(iv) Income tax 35% 40%
2. The following are the income statements of Swastik Ltd., Bombay for
the years 2018 and 2019. Prepare a comparative income statement and
comment on the profitability of the company.

2018 2019 2018 2019

(Rs.) (Rs.) (Rs.) (Rs.)
To Opening By Sales Less:
85,000 2,00,000 10,00,000 12,00,000
stock Returns
To Purchases By closing
5,00,000 5,50,000 2,00,000 2,25,000
Less: Returns Stock
By Income
To wages 60,000 80,000 from 12,000 15,000
investments
By Dividend
To Salaries 42,000 64,000 5,000 7,500
received
To Rent, rates
35,000 40,000
and taxes

To Depreciation 40,000 60,000

To Selling
12,000 12,000
expenses
To Discount
5,000 7,000
allowed
To Loss on sales
---- 8,000
of plant
To Interest paid 12,000 14,000
Net profit 4,26,000 4,12,500
Total 12,17,000 14,47,500 Total 12,17,000 14,47,500

3. Prepare common size Balance Sheet of XRI Ltd. from the following
information:

133
 March 31, March 31,
Particulars
2018 2019
I. Equity and Liabilities
1. Shareholders’ Fund
a) Share capital 15,00,000 12,00,000
b) Reserves and surplus 5,00,000 5,00,000
2. Non-current liabilities
Long-term borrowings 6,00,000 5,00,000
3. Current liabilities
Trade Payable 15,50,000 10,50,000
Total 41,50,000 32,50,000
II. Assets
1. Non-current assets
a) Fixed assets
- Tangible asset
Plant & machinery 14,00,000 8,00,000
- Intangible assets
Goodwill 16,00,000 12,00,000
b) Non-current investments 10,00,000 10,00,000
2. Current assets
Inventories 1,50,000 2,50,000
Total 41,50,000 32,50,000
4.Convert the following Balance sheets into common-size balance sheet
and interpret the results:
2015 2016 2015 2016
Liabilities Assets
(Rs.) (Rs.) (Rs.) (Rs.)
Equity share Current assets:
1,000 1,200 450 390
capital Debtors
Capital reserves 90 185 Cash 200 15
General reserves 500 450 Stock 320 250
Sinking fund 90 100 Investments 300 250
Fixed assets:
Debentures 450 650 Buildings Less
800 1,400
depreciation
Sundry creditors 200 150 Land 198 345
Furniture and
Others 15 20 77 105
fixture
Total 2,345 2,755 Total 2,345 2,755

LET US SUM UP
Financial statements are the means of conveying to management, owners
and interested outsiders a concise picture of profitability and financial
position of the business. The preparation of the final accounts is not the

134
first step in the accounting process but they are the end products of the
accounting process which give a concise accounting information of the
accounting period after the accounting period is over. In order to know the
profit or loss earned by a firm. Trading and Profit and Loss Account is
prepared. Balance Sheet will portray the financial condition of the firm on
a particular date.

CHECK YOUR PROGRESS

Choose the Correct Answer :

1) Analysis of any financial Statement comprises of ________

a) Balance sheet b) P&L Account

c) Trading account d) All of the above

2) Which of the following are techniques, tools or methods of analysis and
interpretation of financial statements? __________
a) Ratio Analysis b) Average Analysis

c) Trend Analysis d) All of the above

3) Interpretation of accounts is the

a) Art and science of translating the figures

b) To know financial strengths and weaknesses of a business

c) To know the causes for the prevailing performance of business

d) All of the above

4) Which of the following statement(s) is/are TRUE?

a) When all the figures in a balance sheet are stated as percentage
of the total, it is termed as horizontal analysis.
b) When financial statements of several years are analyzed, it is
termed as vertical analysis.

c) Vertical Analysis is also termed as dynamic analysis.

d) None of the above

5) Reliability of financial analysis depends upon the reliability of financial
data.

a) Both 1 and 2 b) Both 1 and 3

c) Both 2 and 3 d) None of the above

135
GLOSSARY

Financial statement : Financial statements

refer to formal and
original statements
which are prepared to
disclose financial
health in the terms of
profits, position, and
prospects as on a
certain data.

Analysis of financial : It refers to the art of

applying various tools
Statement
to know the behaviour
of the accounting
information.

Interpretation of : This refers to

evaluating the
statement
performance of the
business.

Comparative financial : These enable

comparison of financial
Statements
information for two or
more years placed side
by side.

Trend : Trend analysis can be

defined as the index
analysis
numbers of the
movements of the
various financial items
on the financial
statement for a number
of periods.

SUGGESTED READINGS
1. Gupta, R.L. and Radhaswamy, M., (2006), Financial Accounting,
Sultan and Chand Sons, New Delhi.
2. Maheswari, S.N and Maheshwary, S.K. (2006), Fundamental of
Accounting, Vikas Publications.
3. Shashi K. Gupta, R.K.Sharma , (2012), “Financial Management”
latest Edition, Kalyani Publishers, Chennai

136
 4. M C Shukla, S C Gupta & T S Grewal, (2017), Advance
Accounting, 19th Edition, S.Chand Publishing, New Delhi
5. Tulsian P. C. , (2017), Financial Accounting , Pearson Education,
New Delhi.
6. https://www.youtube.com/watch?v=TwHCnYPVnJM
7. https://www.youtube.com/watch?v=GoKIZqSFMIE

ANSWER TO CHECK YOUR PROGRESS

1) d 2) d 3) d 4) b 5) d

137
Unit 9

FUNDS FLOW STATEMENT

STRUCTURE

Overview

Learning Objectives

9.1 Meaning of Funds

9.2 Meaning of Flow of Funds

9.3 Steps in the preparation of Funds Flow Statement

9.3.1 Preparation of Schedule of Changes in Working Capital

9.3.2 Calculation of Funds from Operations

9.3.3 Preparation of Funds Flow Statement

9.4 Treatment of Certain Important Items

9.5 Some Important Illustrations

9.6 Uses and Limitations of Funds Flow Statement

Let Us Sum Up

Check Your Progress

Glossary
Suggested Readings

Answers to Check Your Progress

OVERVIEW
Financial statements, namely, Income Statement and Balance Sheet
have a limited role to perform. They just reveal the net effect of various
transactions on operational and financial position of the company. Income
statement measures cash flows restricted to transactions that are
concerned with rendering of goods and / or services to customers.
Balance Sheet shows the details of assets and liabilities on a particular
date. It does not highlight the transactions which have been behind the
changes in the funds position of an organisation. For example, if fixed
assets worth Rs. 5, 00,000 are purchased during the current year by
raising share capital of Rs. 5, 00,000 the Balance Sheet will simply show
a higher capital figure and higher fixed assets figure. Unless we compare
the current year’s Balance Sheet with the previous year, we cannot infer
that fixed asset worth Rs. 5, 00,000 were acquired by raising share capital

138
of Rs. 5, 00,000. Funds flow analysis / statement is a tool used by
financial analyst and others to study the movement of funds between two
balance sheet dates. In this unit we shall discuss the concept of funds,
the preparation of the schedule of changes in working capital and the
preparation of funds flow statement.

LEARNING OBJECTIVES

After reading this unit, you should be able to:

• define the term funds
• explain the concept of working capital
• discuss the procedures or steps involved in the preparation of
funds flow statement
• prepare schedule of changes in working capital, calculate funds
from operations and prepare funds flow statement
• explain the uses and limitations of funds flow statement\

9.1 MEANING OF FUNDS

The term funds have been defined in a number of ways depending on the
user’s purpose. In a narrow sense, it means cash resource of the
business. In a broader sense, it means all financial resources of the
business. Here, funds refer to money values in whatever form it may exit.
In a popular sense, the term funds mean working capital i.e. the excess
of current assets over current liabilities. In fact, there are two concepts of
working capital, namely, gross concept of working capital and net concept
of working capital. Gross working capital refers to the entire investment
in current assets. Net working capital means the excess of current assets
over current liabilities or total current assets fewer current liabilities. We
use it here in the sense of net working capital.

9.2 MEANING OF FLOW OF FUNDS

The term flow means change or movement. Therefore, the flow of funds
means “Changes in Funds” or changes in Working Capital or movement
in the working capital. In business several transactions are taking place
every day. Some of these transactions may increase the funds and some
of these transactions may decrease the funds. And some transactions
may not result in the change in the funds position. In case if a transaction
results in increase of funds it will be called a ‘source of funds’ and if a
transaction results in decrease of funds, it will be called an ‘application of
funds’. In case if a transaction does not make any change in the funds
position, then it is called a ‘non-fund transaction’.

139
a) Current Assets and Current Liabilities

The term current assets include assets which are acquired with the
intention of converting them into cash within a year or within the normal
operating cycle of the business. Current assets include: cash in hand,
cash at bank. stock-in-trade or inventories, prepaid expenses, debtors,
bills receivable, short-term investments etc. ‘Current liabilities’ mean
those liabilities which are expected to be paid in the near future, that is,
within a period of one year or within the normal operating cycle of the
business. Current liabilities include: sundry creditors, bills payable,
accrued or outstanding expenses, bank overdraft, short-term loans,
dividends payable, provision against current assets (like provision for
doubtful debts, provision for discount on debtors etc.) tax payable, etc. An
amount which is due within a year does not make it a current liability
unless it is payable out of existing current assets or by creation of new
current liabilities.
b) Non-Current Assets and Non-Current Liabilities
Non-current assets: All assets other than the current assets can be
termed as non-current assets. Non-current assets include: Land and
buildings, plant and machinery, furniture, loose tools, goodwill, patents,
copyrights, long-term investment in shares of other companies,
Government bonds etc.
Non-current liabilities: are those liabilities which are not included under
current liabilities. They include: share capital, debentures, long -term
loans, share premium, credit balance in the profit and loss account,
revenue and capital reserves (such as general reserve, dividend
equalization fund, capital redemption reserve) etc.

c) Identification of Transactions Which Cause Flow of Funds

In order to prepare funds flow statement, it is essential to identify which
transactions result in flow of funds (or change in working capital) and
which transactions do not result in flow of funds (or change in working
capital). The following guidelines may be adopted for identification
purpose.
a) Transactions among current accounts do not affect flow of funds:
Transactions involving two current assets do not affect funds.
Transactions involving two current liabilities do not affect funds.
Transactions involving current assets and current liabilities do not affect
funds.

140
You can understand better the above points with the help of following
examples. A company realizes Rs.25,000 from its debtors. This
transaction will reduce the debtors by Rs.25,000 but at the same time the
cash balance of the company will increase by Rs.25,000. Therefore, the
total of current assets will continue at the old figure. This means, a
transaction involving two current assets does not affect funds or change
working capital position of the company. Similarly, a transaction involving
a current asset and a current liability does not affect funds. Suppose, if a
company pays Rs.20,000 to its creditors out of its cash balance, the total
of current assets will be reduced by Rs.20,000 and the total of current
liabilities will be reduced by Rs.20,000. Therefore, there will not be a ny
change in working capital.

b) Transactions among non-current accounts do not affect funds

Transactions involving two non-current (or fixed) assets do not affect
funds.

Transactions involving two long term liabilities do not affect funds.

Transactions involving non-current assets and long term liabilities do not
affect funds.
Suppose, if a company purchases furniture for Rs.15,000 by raising long
term loans of Rs.15,000, this transaction will not have any impact on
working capital position. The reason is furniture (a non-current asset) and
long-term loan (a non-current liability) is not the constituents of the
working capital. Similarly, if the company redeems its preference shares
by issuing debentures, this transaction will not result in any change in
working capital position of the company as both the two accounts involved
in the transaction are not the constituents of the working capital.
c) Transactions between current accounts and non-current accounts
affect funds
Funds move when there is a cross transaction between a non-current to
current account and vice-versa. The details are given below:
• Transactions involving a current asset and a fixed asset affect
funds;
• Transactions involving a current liability and a fixed asset affect
funds;
• Transactions involving a current asset and a fixed liability affect
funds;
• Transactions involving a current liability and a fixed liability affect
funds.

141
Look at the following example and see how the transaction between a
current account and a non-current account affects working capital position
of the company. A company raises Rs.75,000 in cash by issue of shares.
Due to this transaction the cash position of the company will raise by
Rs.75,000. As there is no change in the current liabilities position the
working capital of the company will increase by Rs.75,000. Similarly,
transactions of sale of fixed assets, repayment of long-term liabilities by
cash of by creating current liabilities will affect the working capital position
of the company. You have learnt that the cross transactions affect the
funds or working capital position of a company. Now we can discuss the
procedures or steps involved in the preparation of funds flow statement.

9.3 STEPS IN THE PREPARATION OF FUNDS FLOW STATEMENT

Funds flow statement is a statement showing sources and applications of
funds for a period of time. As you know, the term ‘funds’ is interpreted to
mean net working capital. As net working capital is the excess of current
assets over current liabilities, funds represent the position of current
assets which is financed from the long-term / non-current source. Fund
flow analysis / statement helps to know where the increased working
capital is applied if it has increased, and from where funds have been
released if it has decreased. Funds flow statement is also called the
statement of sources and applications of funds or movement of funds
statement.

SOURCES OF FUNDS APPLICATION OF FUNDS

(Inflow) (Outflow)
Funds from Operations xxx Funds lost in Operations xxx
Issue of Share Capital xxx Trading Loss xxx
Issue of Debentures xxx Redemption of Redeemable
Long term Borrowings xxx Preference Shares xxx
Sale of Fixed Assets xxx Redemption of Debentures xxx
Non-Trading Incomes xxx Repayment of Other Long
Decrease in Working Term Loans xxx
Capital xxx Purchase of Fixed Assets xxx
Non-Trading Expenditures xxx
Increase in Working Capital xxx
Total xxx Total xxx

As already stated somewhere else in this unit, there are three steps in
preparation of funds flow statement.

142
i) Preparation of schedule of changes in working capital to ascertain
increase or decrease in working capital.
ii) Calculation of funds from operations.
iii) Preparation of funds flow statement.
Now we can discuss all these steps

9.3.1 Preparation of Schedule of Changes in Working Capital

The schedule of changes in working capital is prepared to know the
changes in working capital between two balance sheet dates. This
statement is prepared with the current items of balance sheet i.e., current
assets and current liabilities.

A typical form of schedule of changes in working capital is as follows:

The changes in the current assets or current liabilities in the current year’s
balance sheet as compared to that of the previous year’s balance sheet
either results in increase or decrease in working capital. The following
rules can be followed in order to ascertain whether there is an increase in
working capital or decrease in working capital.

i) Increase in a current asset, results in increase (+) in ‘working capital’.

ii) Decrease in a current asset, results in decrease (-) in ‘working capital’.

iii) Increase in a current liability, results in decrease (-) ‘working capital’.

iv) Decrease in a current liability, results in increase (+) in ‘working capital.

You can understand better these rules when you go through the following
illustration.
Statement of Changes in Working Capital

Particulars Previous Current Effect on Working

Capital
Year Year
Increase Decrease

Current Assets

Stock

Debtors

Cash in Hand

Cash at Bank

Bill Receivable

Prepaid Expenses

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Accured Incomes

Short-term Temporary -
Investment

Total Current Assets

Current Liabilities

Sundry Creditors

Bills Payable

Bank Overdraft

Outstanding expenses

Dividends Payable

Proposed Divided*

Provision for Taxation*

Total Current Liabilities

Net Increase / Decrease in Working Capital

* Treated as Current Liability
Illustration 9.1
The balance sheets of Arvind Mills Ltd. at the end of 2017 and 2018 are
given below. You are required to prepare schedule of changes in working
capital.

2018 2019 2018 2019

Liabilities Assets
Rs Rs Rs RS

1,00,00 1,50,00 1,00,00 1,00,00

Shapre Capital Land
0 0 0 0
1,04,00 1,00,00
Share Premium --------- 5,000 Plant at cost
0 0
General Reserve 50,000 60,000 Furniture at cost 7,000 9,000
Investment at
P & L A/C 10,000 17,000 60,000 80,000
cost
8% Debebtures 70,000 50,000 Debtors 30,000 70,000
Provision for Depreciation on
50,000 56,000 Stock 60,000 65,000
plants

Provision for dep. on Furniture 5,000 6,000 Cash 30,000 45,000

Provision for taxation 20,000 30,000
Creditors 86,000 95,000
3,91,00 4,69,00 3,91,00 4,69,00
0 0 0 0

Solution

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 Schedule / Statement of Changes in Working Capital
Particulars 2018 - 2019 Changes in Working Capital

2018 2019
Increase Decrease
Rs Rs
Current Assets
Debtors 30,000 70,000 40,000
Stock 60,000 65,000 5,000
Cash 30,000 45,000 15,000
Total (A) 1,20,000 1,80,000
Current Liabilities:
Creditors 86,000 95000 9,000
Total (B) 86,000 95000
Working Capital 34,000 85,000
Net Increase in Working
Capital 51000 51000
85000 85000 60000 60000

Note: Provision for taxation is treated as a non-current liability and

investments are taken as non-current asset.

9.3.2 Calculation of Funds from Operations

The sources of funds of a company can be classified as internal sources
and external sources. External sources of funds refer to sources of funds
generated outside the business. Internal sources of funds refer to funds
generated internally by the organisation. Profits generated by business
are important internal sources of funds. While calculating profits all
revenues are matched against expenses irrespective of whether these
items affect the funds position or not. Therefore, the items which do not
affect the funds position of a company should be adjusted with the net
profit of the company for ascertaining the real funds from operations. For
example, depreciation charged during the current period should be added
back to the net profit to calculate funds from operations. The reason is
charging depreciation did not involve the use of funds. You know
depreciation is just a method of showing the expired cost of the asset
concerned. Similarly, certain expenses / losses incurred in the past (such
as written off intangible asset / deferred revenue expenditure) may be
written off fully or partly during the current period. These types of items
do not involve in out flow of funds. Therefore, they should be added back
to the net profit to derive real funds from operations.

145
The procedures generally used to calculate funds from operations are
given below:

Closing Balance of P & L A/c or Retained Earnings (as

xxx
given in the Balance Sheet)
Add: Non-fund and non-operating items which have
been already debited to P & L A/c:
i) Depreciation on Fixed Assets xxx
ii) Goodwill, Patents, Trademarks, Preliminary expenses,
xxx
Discount on Issue of Shares etc.
iii) Transfer to general reserve, contribution to debenture, xxx
redemption fund, contingency reserve etc.
iv) Loss on sale of fixed assets xxx
v) Interim dividend xxx
vi) Proposed dividend if it is an appropriation of profits and
xxx
not taken as a current liability
vii) Provision for taxation if it is not taken as a current liability xxx
viii) Any other non-fund / non-operating Items which have
xxx
been debited to P & L A/c
Total (A) xxx
Less: Non-fund or Non-operating Items which have
already been credited to P & L A/c:
i) Profit on sale of fixed assets since the full sale proceeds
xxx
are taken as a separate source of funds
ii) Appreciation in the value of fixed assets if it has been
xxx
credited to P & L A/c
iii) Dividends received or accrued dividend, refund of
Income tax, rent received or accrued rent. [They are non- xxx
operating incomes]
iv) Any other non-operating item which has been credited to
xxx
P & L A/c
v) Opening Balance of P & L A/c or Retained Earnings (as
xxx
given in the Balance Sheet)
Total (B) xxx
(A) – (B) = Funds from Operations xxx

Look at the following illustration. You can understand better calculation

of funds from operation with the help of it.

146
Illustration 9.2
From the following P & L A/c, calculate the funds from operations.
Rs. Rs.
To Expenses:

Operation 1,00,000 By Gross Profit 2,00,000

Depreciation 40,000 By Profit on sale 20,000
of Plant
To Loss on sale of 10,000
building
To Advertisement 5,000
suspense A/c
To Discount (allowed to 500
customer)
To Discount on issue of 500
shares written off
To Goodwill 12,000
To Net Profit 52,000
2,20,000 2,20,000

Solution

Calculation of Funds from Operations

Rs. Rs.
Net profit (as given) 52500
Add: Non-fund or non-operating items which
have been debited to P&L A/c:
Depreciation 40,000
Loss on sale of building 10,000
Advertisement written off 5,000
Discount on issue of shares written off 500
Goodwill written off 12,000 67,500
1,19,500
Less: Non-fund or non-operating items which
have been credited to P&L A/c:
Profit on sale of plant 20,000
Funds from Operations 99,500

9.3.3 Preparation of Funds Flow Statement

You have already been exposed to preparation of schedule of changes in
working capital, calculation of funds from operations. In this section, you

147
can learn how to prepare funds flow statement. Funds flow statement is
a statement which shows the sources and applications of funds. The
sources of funds can be classified as internal sources and external
sources. You have learnt funds from operation are the only internal
sources of funds. External sources of funds include funds from long term
loans such as issue of debentures, borrowings from financial institutions,
sale of fixed assets and funds from increase in share capital etc.
Application of funds refers to use of funds. Funds can be used for
purchase of fixed assets, repayment of long-term liabilities, redemption of
preference share capital, payment of dividends and tax etc. Funds flow
statement can be prepared in the following form.

Funds flow statement

Rs.
Sources of funds Issue of shares xxx
Issue of debentures xxx
Long-term borrowings xxx
Sale of fixed assets xxx
Operating profit xxx
Total Sources xxx
Applications of Funds
Purchase of fixed assets xxx
Redemption of redeemable preference shares xxx
Redemption of debentures xxx
Repayment of other long term loans xxx
Payment of dividends, tax, etc. xxx
Operating loss xxx
Total uses xxx
Net increase / decrease in working capital xxx
The funds flow statement can also be prepared in ‘T’ shape as shown
below:
Funds flow statement

SOURCES OF FUNDS APPLICATION OF FUNDS

(Inflow) (Outflow)
Funds from Operations xxx Funds lost in Operations xxx
Issue of Share Capital xxx Trading Loss xxx
Issue of Debentures xxx Redemption of Redeemable
Long term Borrowings xxx Preference Shares xxx

148
 Sale of Fixed Assets xxx Redemption of Debentures xxx
Non-Trading Incomes xxx Repayment of Other Long
Decrease in Working Term Loans xxx
Capital xxx Purchase of Fixed Assets xxx
Non-Trading Expenditures xxx
Increase in Working Capital xxx
Total xxx Total xxx

*Only one figure will be there.

9.4 TREATMENT OF CERTAIN IMPORTANT ITEMS

It is necessary to have clear ideas about treatment of certain items. The
reason is they can be treated as non-current items or current items. For
instance, provision for taxation and proposed dividends can be treated as
non-current items or current items. In this section, we can discuss how
certain items can be treated and what the implications of such treatment
are.
a) Provision for Taxation: Provision for tax can be treated as current
liability or non-current liability. When it is treated as a current liability, this
item will be shown in the schedule of changes in working capital. Because
this transaction involves P & L Appropriation account (a fixed liability) and
Provision for Tax account (a current liability).
When provision for tax is taken as an appropriation of profit, it should be
treated as a non-current liability. As this transaction involves two fixed
liabilities, namely, P & L Appropriation account and Provision for tax
account, this will not result in change in working capital position. Provision
made during the year will be ascertained by preparing provision for tax
account and added back with the net profit in order to find out the funds
from operations. When tax is paid, it will be taken as appropriation of funds
and shown as an application of funds in the funds flow statement.
Because it involves provision for tax which is a non-current liability and
cash which is a current asset. When provision for taxation is given in the
balance sheet as a current liability, it must be taken as such. If suppose
nothing is specified it can be treated as a non-current item.
b) Proposed Dividends: Whatever points discussed about provision for
tax is also applicable to proposed dividends. Proposed dividend can be
treated either as a current liability or a non-current liability. However,
when proposed dividends are formally declared and approved in the
Annual General Body meeting of shareholders, certainly it becomes a
current liability and must be treated as such.

149
Once the dividends are proposed and declared, they are to be paid within
42 days (now reduced to 30 days by the “Companies (Amendment) Act,
2000). In case proposed dividend is taken as a current liability, it will
appear as one of the items in the schedule of changes in working capital.
As the accounts involved are current and non-current items (Profit and
Loss Appropriation Account – a fixed liability and Proposed Dividend – a
current liability, proposed dividend will change the working capital
position. When dividends are paid later on, it will not be shown as an
application of funds as the accounts involved are current items only (that
is, cash – a current asset and proposed dividends – current liability).
Proposed dividends can also be treated as appropriation of profits. In
such a case, it will not find a place in the schedule of changes in working
capital. The proposed dividend for the current year must be ascertained
by preparing proposed dividend account and to be added back to current
year’s profit to calculate funds from operation if it has already been
charged to profits. On payment of dividend, it will be shown as an
application of funds as the two accounts involved are cash (a current
asset) and proposed dividend (a non-current liability).
c) Investments: The treatment of investments in the funds flow analysis
mainly depends on their nature. If a company purchases shares in some
other company with the intention of acquiring control, the company may
treat such investment as ‘trade’ investment. At the time, such investment
will be treated as a non-current item (a fixed asset). Any increase or
decrease in the investments will be shown directly in the funds flow
statement. However, if investments are made in marketable or short-term
securities for short period, they should be treated as current assets. Any
increase or decrease in such item will be shown in the schedule of
changes in working capital.
d) Depreciation: Depreciation means the gradual decrease in the value
of an asset due to wear and tear, due to use and passage of time. Profit
and Loss Account is debited and fixed asset account is credited while
providing depreciation. Since, the accounts involved, namely Profit and
Loss Account and Fixed Asset Account are non-current accounts,
depreciation does not affect the working capital. Depreciation is a non-
fund item. Therefore, depreciation charged during the year should be
added back to net profit in order to calculated funds form operation.
Is depreciation a source of fund? There are differences of opinion on this.
Some people view depreciation is neither a source nor an application.
And some people view, depreciation in a limited sense can be taken as a
source of fund. In fact, under certain circumstances, depreciation helps a

150
business concern to save tax and funds. Under these circumstances
depreciation can be taken as an indirect source of funds.
e) Amortisation of expenses and writing off of Intangible Assets:
Sometimes, a company decides to write off its intangible assets (like
goodwill, patents, copy rights, etc.) and deferred revenue expenses (like
preliminary expenses, discount on issue of shares, etc.) by charging some
amount to profit and loss account. The amounts written off are non-fund
items. As these amounts are already charged to Profit and Loss Account,
they must be added back to Net Profit to calculate funds from operation.

9.5 SOME IMPORTANT ILLUSTRATIONS

You have learnt the procedures or steps involved in the preparation of
funds flow statement. You have also learnt treatment of certain items. In
this section, we can work some important problems. That will make you
to understand better. The steps involved in the preparation of funds flow
statement. In few of problems information, will be given hidden, they
should be ‘dug out’ as ‘balancing figures’ by preparing relevant accounts.
Now you can learn it with the help of the following illustrations.
Illustration 9.3
From the following balance sheets of X Ltd. on 31st December, 2019 and
2020, you are required to prepare,

a) A schedule of changes in working capital;

b) A funds flow statement.

Rs. Rs. Rs. Rs.

Liabilities Assets
2019 2020 2019 2020
Shapre Capital 1,00,000 1,00,000 Goodwill 12,000 12,000
General Reserve 14,000 18,000 Building 40,000 36,000
Profit & Loss A/c 16,000 13,000 Plant 37,000 36,000
Sundry Creditors 8,000 5,400 Investments 10,000 11,000
Bills payable 1,200 800 Stock 30,000 23,400
Provision for Bills
Taxation 16,000 18,000 Receivable 2,000 3,200
Provision for Doubt
for debts 400 600 Debtors 18,000 19,000
Cash at
Bank 6,600 15,200
1,55,600 1,55,800 1,55,600 1,55,800
The following additional information has also been given:
i) Depreciation charged on plant was Rs.4,000 and on building Rs.4,000.

151
ii) Provision for taxation of Rs.19,000 was made during the year 2020.
iii) Interim dividend of Rs.8,000 was paid during the year 2020.
Solution
Schedule of changes in working capital

2019 2020 Increase Decrease

Rs. Rs. Rs. Rs.

Current Assets
Cash at Bank 6,600 15,200 8,600
Debtors 18,000 19,000 1,000
Bills receivable 2,000 3,200 1,200
Stock 30,000 23,400 6600
Total (A) 56,600 60,800
Current Liabilities
Provision for Doubtful
Debts 400 600 200
Bills payable 1,200 800 400
Sundry Creditor 8,000 5,400 2600
Total (B) 9,600 6,800
Working Capital (A) - (B) 47000 54000
Increase in Working Capital 7,000 7000
Total 54000 54000 13800 13800
Net increase in working capital Rs.7,000.
Funds flow statement

Rs.

Sources:

Funds from operations (See Note 1) 36,000

Total sources 36,000

Applications:

Purchase of plant (See Note 2) 3,000

Tax paid (See Note 3) 17,000

Investments purchased (See Note 4) 1,000

Interim dividend paid 8,000

Total applications 29,000

152
 Net increase in working capital 7,000

Working Notes
1. Calculation of funds from operations
Calculation of funds from operations

Particulars Rs. Rs.

P & L Account balance on 31st Dec. 2020 13000

Add: Items which do not decrease funds from

operations

Transfer to general reserve 4,000

Provision for tax 19,000
Depreciation:
Plant 4,000
Building 4,000
Interim dividend paid 8,000 39000
52000
Less:

P & L Account balance on 31st Dec. 2019 16000

Funds from operations of the year 36000
2. Purchase of plant can be find out by preparing the plant account.
Plant Account

Rs. Rs.
To Balance b/d 37,00 By Depreciation 4,000
0
To Bank 3,000 By Balance c/d
36,000
(Purchase of Plant
balancing figure)
40,000 40,000

3. Tax paid during the year can be ascertained by preparing a provision

for tax account.
Provision for tax account

Rs. Rs.
To Bank 17,00 By Balance b/d 16,000
0
(balancing figure)

153
 By P & L A/c 19,000
To Balance c/d 18,00
0
35,000 35,000

4. Investments have been taken as a non-current asset presuming that

they are long-term investments.

Illustration 9.4
Balance sheets of M/S Black and White as on 01.01.2018 and 31.12.2018
were as follows:

Balance sheet

01.01.201 31.12.201 01.01.201

Liabilities Assets 31.12.2018
8 8 8
Creditors 40,000 44,000 Cash 10,000 7,000
Mr White’s
Loan 25,000 Debtors 30,000 50,000
Loan from P.N.
Bank 40,000 50,000 Stock 35,000 25,000
Capital 1,25,000 1,53,000 Machinery 80,000 55,000
Land 40,000 50,000
Building 35,000 60,000
2,30,000 2,47,000 2,30,000 2,47,000

During the year machine costing Rs.10,000 (accumulated depreciation

Rs.3,000) was sold for Rs.5,000. The provision for depreciation against
machinery as on 01.01.2018 was Rs.25,000 and on 31.12.2018 Rs.
40,000. Net profit for the year 1988 amounted to Rs.45,000. You are
required to prepare funds flow statement (working capital).
Solution
Schedule of changes in working capital

2017 2018 Increase Decrease

Particulars
Rs. Rs. Rs. Rs.
Current Assets:
Cash 10,000 7,000 xxx 3000
Debtors 30,000 50,000 20000 xxx
Stock 35,000 25,000 xxx 10000
Total (A) 75,000 82,000
Current Liabilities
Creditors 40,000 44,000 xxx 4000

154
 Total (B) 40,000 44,000
Working capital (A)-(B) 35,000 38,000
Increase in Working
Capital 3,000 xxx xxx 3000
38,000 38,000 20000 20000

Funds flow statement for the year ending 31.12.2018

Rs.

Sources:

Loan from P.N.Bank 10,000

Sale of plant 5,000

Funds from operations 65,000

(See Working Note 2)

Total sources 80,000

Applications:

White’s loan repaid 25,000

Partner’s drawings (Note 3) 17,000

Purchase of land 10,000

Purchase of building 25,000

Total applications 77,000

Net increase in working capital 3,000

Note 1
Machinery A/c
Rs. Rs.
To Balance b/d 1,05,000 By cash (Sales) 5,000

By Prov. for depreciation 3,000

By Adj. P & L A/c 2,000

(Loss on sale)
By Balance c/d 95,000

1,05,000 1,05,000

155
 Provision for Depreciation on Machinery A/c
Rs. Rs.
To Machinery A/c 3,000 By Balance b/d 25,000

To Balance c/d 40,000 By Adj. P & A/c 18,000

43,000 43,000

Capital A/c
Rs. Rs.
To Drawings 17,000 By Balance b/d 1,25,000

To Balance c/d 1,53,000 By Net Profit 45,000

1,70,000 1,70,000

Adjusted P & L A/c

Rs. Rs.
To Machinery 2,000 By Balance b/d xxx
(Loss on sale)
To Prov. for depreciation 18,000 By Funds from 65,000
Operations
To Balance c/d 45,000
65,000 65,000

Illustration 9.5
The following are the summarized balance sheets of Gourav Ltd., on 31 st
December 2016 and December 2017:

Rs. Rs. Rs. Rs.

Liabilities Assets
2016 2017 2016 2017
Share capital 12,00,000 16,00,000 Plant & 8,00,000 12,90,000
Machinery
(at cost)
Debentures 4,00,000 6,00,000 Land & 6,00,000 8,00,000
Building (at
cost)
P & L A/c 2,50,000 5,00,000 Stock 6,00,000 7,00,000
Creditors 2,30,000 1,80,000 Bank 40,000 80,000
Provision for 12,000 6,000 Preliminary 14,000 12,000
Bad and Expenses
Doubtful Debts
Depreciation: 40,000 48,000 Debtors 1,38,000 1,22,000
Land & Building
Plant & 60,000 70,000
Machinery

21,92,000 30,04,000 21,92,000 30,04,000

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Additional Information
i) During the year, a part of the machinery, costing Rs.1,40,000
(accumulated depreciation thereon Rs.4,000), was sold for Rs.12,000.

ii) Dividend of Rs.1,00,000 was paid during the year.

Ascertain: Change in working capital for 2017.

Funds flow statement for 2017.

Solution
Schedule of changes in working capital

2017 2018 Increase Decrease

Particulars
Rs. Rs. Rs. Rs.

Current Assets:
Stock 6,00,000 7,00,000 1,00,000 xxx
Bank 40,000 80,000 40,000 xxx
Debtors 1,38,000 1,22,000 xxx 16,000
Total (A) 7,78,000 9,02,000
Current Liabilities
Creditors 2,30,000 1,80,000 50,000 xxx
Provision for Doubtful Debts 12,000 6,000 6,000 xxx

Total (B) 2,42,000 1,86,000

Working capital (A)-(B) 5,36,000 7,16,000
Increase in Working Capital 1,18,000 xxx xxx 3000
7,16,000 7,96,000 1,96,000 1,96000

Funds Flow Statement

Rs.

Sources:

Issues of Shares 4,00,000

Issues of Debentures 2,00,000

Sale of Machinery (Working Note 1) 12,000

Funds from Operations 4,98,000

Total sources (A) 11,10,000

Applications:

Purchase of Plant and Machinery(Working Note 1) 6,30,000

Purchase of Land and Buildings 2,00,000

157
 Payment of Dividend 1,00,000

Total sources (B) 9,30,000

Increase in working capital 1,80,000

Working Note 1
Plant and Machinery A/c
Rs. Rs.
To Balance b/d 8,00,000 By Bank 12,000

To Bank (Purchase of 6,30,000 By P & L A/c(Loss on 124000

Plant) Sale)
By Provision for 4000
Depreciation (on Plant
Sold)
By Balance c/d 1290000
14,30,000 14,30,000

Illustration 9.6
The Balance sheet of A, B & C Co. Ltd. as at the end of 2016 and 2017
are given below.

Liabilities 2016 2017 Assets 2016 2017

Rs. Rs. Rs. Rs.

Share capital 1,00,000 1,50,000 Freehold land 10,000 7,000

Share
premium xxx 5,000 Plant at cost 1,04,000 1,00,000

General Furniture at
reserve 50,000 60,000 cost 7,000 9,000

Profit & Loss Investment at

A/c 10,000 17,000 cost 60,000 80,000

6% Debenture 70,000 50,000 Debtors 30,000 70,000

Provision for
Depreciation
on Plant 60,000 65,000 Stock 60,000 65,000

Furniture 5,000 6,000 Cash 30,000 45,000

Provision for
Taxation 20,000 30,000

Sundry
creditors 86,000 95,000

3,91,000 4,69,000 3,91,000 4,69,000

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A plant purchased for Rs.4, 000 (depreciation Rs.2, 000) was sold forcash
for Rs.800 on September 30, 2017. On June 30, 2017, an item of furniture
was purchased for Rs.2, 000. These were the only transactions
concerning fixed assets during 2017. A dividend of 22½% on original
shares was paid.
You are required to prepare a funds flow statement and verify the results
by preparing a schedule of changes in working capital.
Solution
Funds Flow Statement
Rs.
Sources of funds
Shares capital (including premium) 55,000
Sale of plant 800
Funds from operations (Note 2) 79,700
Total sources 1,35,500

Applications of funds
Redemption of debentures 20,000
Purchase of furniture 2,000
Dividend paid 22,500
Investments purchased 20,000
Tax paid (Note 1) 20,000
Total uses 84,500
Increase in working capital 51,000

The increase in working capital can be verified by preparing a schedule of

changes in working capital.

Schedule of changes in working capital

Particulars 2016 2017 Increas Decreas

e e
Rs Rs

Current Assets
Debtors 30,000 70,000 40000 xxx
Stock 60,000 65,000 5000 xxx
Cash 30,000 45,000 15000 xxx
1,20,00 1,80,00
Total (A) 0 0
Current liabilities

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 Sundry Creditors 86,000 95,000 xxx 9000
Total (B) 86,000 95,000
Working Capital (A)-(B) 34,000 85,000
Increase in Working
Capital 51,000 51000
85,000 85,000 60000 60000

Working notes

Note 1
Provision for taxation has been taken as a non-current liability. Moreover,
in the absence of any specific instructions in the question, it is safe to
presume that tax must have been paid equivalent to last year’s provision
for taxation.

Note 2
Funds from operations have been calculated as follows:

Adjusted Profit & Loss A/c

Rs. Rs.
To Dividend paid 22,500 By Balance b/d 10,000

To Provision for 30,000 By funds from 79700

Taxation operations
To Transfer to general 10,000
reserve(Balancing
figure)
To Depreciation:
Plant 8,000
Furniture 1,000
To Loss on sale of 1,200
plant
To Balance c/d 17,000
89,700 89,700

Note 3
Loss on sale of plant and provision for depreciation on plant and furniture
made during the year has been found out by preparing different accounts:

Plant A/c
Rs. Rs.
To Balance b/d 1,04,000 By Bank 800

To Bank (Purchase of 6,30,000 By P & L A/c 1,200

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 Plant)
By Provision for 2000
Depreciation(on Plant
Sold)
By Balance c/d 1,00,000
1,04,000 1,04,000

Furniture A/c
Rs. Rs.
To Balance b/d 7,000 By Balance c/d 9000

To Bank (Bal. fig) 2,000

9000 9000

Provision for Depreciation of Furniture A/c

Rs. Rs.
To Balance c/d 6,000 By Balance b/d 5,000

By P & L(Depreciation 1,000

for the year balancing
fig)
6,000 6,000

Provision for Depreciation of Plant A/c

Rs. Rs.
To Plant A/c(Dep. on 2,000 By Balance b/d 50,000
plant sold)
To Balance c/d(Bal. fig.) 56,000 By P & L 8,000
Dep. Charged during
the year
58,000 58,000

9.6 USES AND LIMITATIONS OF FUNDS FLOW STATEMENT

Financial statements do not throw light on the changes in the financial
position that took place between two balance sheet dates. They also do
not reveal the sources and application of funds. Funds flow statement
shows from where we got funds and where we have used.
1) It helps to determine the financial consequences of business
operations: In business there is a possibility for imbalance between
liquidity and profitability position. The business may face the problem of
liquidity in spite of profits. Similarly, the business may be in a comfortable
liquid position in spite of losses. Funds flow statement provides the
causes for imbalance between liquidity and profitability and also shows
where have the profits gone. Thus, funds flow statement enables the

161
management to direct the funds in the more profitable channels, which
serves the overall interest of the organisation.
2) It helps in the formation of a realistic dividend policy of the
organisation: Funds flow statement answers questions such as

a) What has happened to the net profit of the firm?

b) Why more dividends could not be declared in spite of profits?

c) How was it possible for the concern to distribute more dividends than
the present earnings? etc.
The answers to the above questions enable management to formulate a
realistic dividend policy.
3) It helps to forecast funds position: The preparation of projected
funds flow statement helps the firm to know adequacy or inadequacy of
funds in advance. With that one can plan temporary investment of idle
funds, intermediate and long term financing of the etc. the firm planning
repayment of long-term debt etc. the situation of running out of funds can
be avoided by arranging additional working capital when required. In
short, optimum utilization of funds for the overall growth of organisation is
possible with the information of projected funds flow statement.
4) It helps to know the overall credit worthiness of firm: Funds flow
statement helps to analyse the credit worthiness of a firm. Financial
institutions and banks which are coming forward to offer financial
assistance ask the funds flow statement for different periods to judge the
creditworthiness of the firm. Therefore, the firms which are planning to
raise funds from the external sources have to necessarily prepare funds
flow statement.

Limitations of Funds Flow Statement

In spite of many uses, funds flow statement suffers from the following
limitations:
1. Funds flow statement is not a substitute of an income statement or a
balance sheet. Only it provides some additional information as regards
changes in working capital.

2. Funds flow statement cannot reveal continuous changes.

3. Funds flow statement is simply a re-arrangement of data given in the
financial statements. Therefore, it lacks originality.
4. Like financial statements, funds flow statement is also essentially
historic in nature. Hence, the preparation of funds flow statement with
much accuracy is difficult.

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5. Changes in cash are more important and relevant for decision making
than the working capital.

Distinction between Funds Flow Statement and Income Statement

Funds flow statement reveals the sources from which the funds are
obtained and the areas in which they are used. It is not a substitute of an
income statement, namely, profit and loss account and a Balance Sheet.
Income statement reports the operating results of the business. It does
not highlight the changes in the fund’s positions between two balance
sheet dates. The important differences between funds flow statement and
income statement are given below:
1. Funds flow statement highlights the changes in the financial position
of a business and indicates sources from which the funds were
obtained and the areas in which the funds were deployed for a
particular period. Income statement does not reveal the inflows and
outflows of funds but reveals of expenses and incomes to arrive the
operating results viz.1 profit or loss of the business.
2. Income statement helps in the preparation of funds flow statement. It
is complementary to income statement. Whereas, income statement
is not prepared from the funds flow statement.
3. Both capital and revenue items are considered at the time of
preparing funds flow statement. Only revenue items are considered
in the preparation of income statement.
4. There is no prescribed format for preparing funds flow statement. But
income statement is prepared in a prescribed format.
Distinction between Funds Flow Statement and Balance Sheet
The important distinctions between funds flow statement and balance
sheet are given below:
1. Funds flow statement is dynamic in nature whereas balance sheet is
static in nature.
2. Funds flow statement shows the sources and application of funds for
a particular period of time. Balance sheet depicts the assets and
liabilities at a particular point of time.
3. Funds flow statement is an important tool in the hands of
management for financial analysis and helps significantly in decision
making. Balance sheet is not of much help to management for
decision making.

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4. Schedule of changes in working capital is prepared before preparing
funds flow statement. Profit and loss account is prepared before
preparing balance sheet. Schedule of changes in working capital is
not prepared here.

LET US SUM UP
Funds flow statement shows the changes in the financial position between
two balance sheet dates. The term ‘funds’ has different meanings. In the
context of funds flow statement ‘funds’ means net working capital. Flow
of funds means changes in funds position or change in working capital.
Working capital refers to that part of capital which is required for meeting
the needs of current operations. There are two concepts of working
capital, namely, ‘gross working capital’ and ‘net working capital’. Gross
working capital refers to total investment in current assets. Net working
capital means excess of current assets over current liabilities.
Transactions involving a fixed asset/liability on the one hand and a current
asset/liability on the other result in change in working capital.
Transactions within the same category will not result in change in working
capital.
There are three steps involved in the preparation of funds flow statement.
They are: (i) Preparation of schedule of changes in working capital (ii)
calculation of funds from operation, and (iii) preparation of funds flow
statement. While preparing schedule of changes in working capital, we
have to take only current items, viz., current assets and current liabilities.
While calculating funds from operations we have to take first net
profit/loss. Then we have to adjust the items which do not involve outflow
of funds and the items which are already debited to profit and Loss
Account. Non-fund or non-operating items which have already been
credited to profit and Loss Account must be also adjusted. Funds flow
statement shows the sources from which are acquired additional funds
and the use to which these are sources are utilized. Funds from
operations, issue of share capital, debentures, long terms loans from
banks and financial institutions, sale proceeds of fixed assets are
important sources of funds. Repayment of long term loans and
debentures, repayment of preference share capital, payment of dividends,
acquisition of fixed assets are the important application of funds. Funds
flow statement helps the management accountant, financial analyst and
creditors in many ways.

164
CHECK YOUR PROGRESS

Choose the correct Answer:

1) In the context of funds flow analysis, the word “funds” is used to define
___________

a) net working capital

b) total current assets-total current liabilities

c) both a and b

d) none of the above.

2) Which of the following are non-current assets?

a) land, building and plant b) leasehold property

c) computer software d) all of the above

3) Bond, debentures and term loans falls under _________

a) current assets b) non-current assets

c) non-current liabilities d) current liabilities

4) Funds flow statements are prepared so as to _________

a) To identify the changes in working capital

b) To identify reasons behind change in working capital

c) to know the item-wise outflow of funds during given
period

d) all of the above

5) Funds flow statement holds significance for __________

a) Shareholders b) Financiers

c) Government d) all of the above

GLOSSARY

Flow of Funds : Change in net working capital

Working Capital : Current assets minus current liabilities

Funds from Operations : Difference between inflow of funds
and outflow of funds during a
particular period.
Sources of funds : The sources from which are obtain
working capital.

165
SUGGESTED READINGS
1. Gupta, R.L. and Radhaswamy, M., (2006), Financial Accounting,
Sultan and Chand Sons, New Delhi.
2. Maheswari, S.N and Maheshwary, S.K. (2006), Fundamental of
Accounting, Vikas Publications.
3. Shashi K. Gupta, R.K.Sharma , (2012), “Financial Management”
latest Edition, Kalyani Publishers, Chennai
4. M C Shukla, S C Gupta & T S Grewal, (2017), Advance
Accounting, 19th Edition, S.Chand Publishing, New Delhi
5. Tulsian P. C. , (2017), Financial Accounting , Pearson Education,
New Delhi.
6. https://www.youtube.com/watch?v=fPAwVSLEtx0
7. https://www.youtube.com/watch?v=zNKw4Gm-VoU

ANSWER TO CHECK YOUR PROGRESS

1) c 2) d 3) c 4) d 5) d

166
Unit 10

CASH FLOW STATEMENT

STRUCTURE

Overview

Learning Objectives

10.1 Meaning of Cash Flow Statement

10.2 Classification of Cash Flows

10.2.1 Cash Flows from Operating Activities

10.2.2 Cash Flow from Investing Activities

10.2.3 Cash Flow from Financing Activities

10.3 Reporting of Cash Flows from Operating Activities

10.4 Usefulness of Cash Flow Statement

10.5 Some Illustrations

Let Us Sum Up

Check Your Progress

Glossary

Suggested Readings
Answers to Check Your Progress

OVERVIEW
Financial statements (Profit and Loss Account and Balance Sheet)
provide vital information to the management, investors, owners, creditors,
etc., But, they fail to provide all information required by them. For
instance, the creditors may be interested to know the short-term ability of
the concern to pay its creditors. Neither the Profit and Loss Account nor
the Balance Sheet (component of financial statements) provides
information on these aspects. Hence, today many businesses present a
statement called Funds Flow Statement showing changes in financial
position along with the final accounts. You learnt in the previous unit that
funds flow statement suffers from certain limitations. For instance, stock
and prepaid expenses are the components of working capital as per funds
flow statement. The cash flow statement provides information in addition
to those provided by financial statements. In June 1995 the Securities and
Exchange Board of India (SEBI) amended clause 32 of the listing

167
agreement requiring every listed company to give along with its final
accounts, a cash flow statement presented in the prescribed format
showing separately the cash flows from operating activities, investing
activities and financing activities, In this unit, you can learn the meaning
of cash flow statement, the new format of AS- 3 (the received format of
Cash flow Statement), the methods of cash flow statement, the
importance of cash flow statement, distinction between cash flow and
funds flow statement and the preparation of cash flow statement

LEARNING OBJECTIVES

After reading this unit, you should be able to,

• explain the meaning of a cash flow statement
• discuss the new format of AS-3
• explain classification of cash flows
• describe the methods of cash flow statement - direct and Indirect
• explain the format of cash flow statement
• appreciate the usefulness of cash flow statements

10.1 MEANING OF CASH FLOW STATEMENT

A statement of cash flows reports the inflows (receipts) and outflows
(payments) of cash and its equivalents of an organization during a
particular period. It provides important information that compliments profit
and loss account and balance sheet. A statement of cash flow reports
cash receipts and payments classified according to the entities’ major
activities-operating, investing and financing during the period.
This statement reports a net cash inflow or net cash outflow for each
activity and for the overall business. It also reports from where cash has
come and how it has been spent. It explains the causes for the changes
in the cash balance. In substance, the cash flow statement for a business
entity is analogous in that it summarizes a myriad of specific cash
transactions into a few categories.
The statement of cash flows reports the cash receipts, cash payments,
and net statement of cash flows reports the cash receipts, cash payments,
and net changes in cash resulting from operating, investing and financing
activities of an enterprise during a period in a format that reconciles the
beginning and ending cash balances.
The Institute of Chartered Accountants of India has issued 28 Accounting
Standards up to 30th June 2002. According to the revised Accounting
Standard - 3, it is mandatory to prepare Cash Flow Statements in the new
format with effect from 1.4.2001. Enterprises whose Equity or Debts or

168
Debts securities are listed on a stock exchange in India and enterprises
that are in the process of issuing equity or debt securities that will be listed
on a recognized stock exchange in India as evidenced by the Board of
Directors in this regard. This is also applicable for other commercial,
Industrial and reporting enterprises, whose turnover for the accounting
period exceeds Rs. 50 Crores.
According to the revised Accounting Standard-3, an organization should
prepare a cash flow statement and should present it for each period. In
this context, the terms, cash, cash equivalents and cash flows mean the
following:
Cash comprises cash on hand and demand deposits with banks. Demand
deposits mean those deposits, which are repayable by bank on demand
by the depositor.
Cash equivalent are short term, highly liquid investments that are readily
convertible into known amounts of cash and which are subject to an
insignificant risk of changes in value. Cash equivalents are short term,
highly liquid investments that are readily convertible into known amounts
of cash and which are subject to an insignificant risk of changes in value.
Cash equivalents are held for the purpose of meeting short term cash
commitments rather than for investments or other purposes. Examples of
cash equivalents are treasury bills, commercial paper etc. Investments in
shares are excluded from cash equivalents unless they are in substance
cash equivalents. For example, preference shares of a company acquired
shortly before their specified redemption date (provided there is only an
insignificant risk of failure of the company to repay the amount of maturity).
Cash flows are inflows and outflows of cash and cash equivalents. It
means the movement of cash into the organization and movement of cash
out of the organization. The difference between the cash inflows and
outflows is known as net cash flow, which can be either net cash inflow or
net cash outflow.
Cash flows exclude movements between items that constitute cash or
cash equivalents because these components are part of the cash
management of an enterprise rather than part of its operating, investing
and financing activities. Cash management includes the investment of
excess cash in cash equivalents.

10.2 MEANING OF FLOW OF FUNDS

The term flow means change or movement. Therefore, the flow of funds
means “Changes in Funds” or changes in Working Capital or movement

169
in the working capital. In business several transactions are taking place
every day. Some of these transactions may increase the funds and some
of these transactions may decrease the funds. And some transactions
may not result in the change in the funds position. In case if a transaction
results in increase of funds it will be called a ‘source of funds’ and if a
transaction results in decrease of funds, it will be called an ‘application of
funds. In case if a transaction does not make any change in the funds
position, then it is called a ‘non-fund transaction’.
To understand which transactions, increase the funds position or which
transactions decrease the funds position or which transactions do not
cause change in funds position you should know the meaning of current
assets, current liabilities, non-current assets and non-current liabilities.

A) Current Assets and Current Liabilities

The term current assets includes assets which are acquired with the
intention of converting them into cash within a year or within the normal
operating cycle of the business. Current assets include: cash in hand,
cash at bank. stock-in-trade or inventories, prepaid expenses, debtors,
bills receivable, short-term investments etc. ‘Current liabilities’ mean
those liabilities which are expected to be paid in the near future, that is,
within a period of one year or within the normal operating cycle of the
business. Current liabilities include: sundry creditors, bills payable,
accrued or outstanding expenses, bank overdraft, short-term loans,
dividends payable, provision against current assets (like provision for
doubtful debts, provision for discount on debtors etc.) tax payable, etc. An
amount which is due within a year does not make it a current liability
unless it is payable out of existing current assets or by creation of new
current liabilities.

B) Non-Current Assets and Non-Current Liabilities

Non-current assets: All assets other than the current assets can be
termed as non-current assets. Non-current assets include: Land and
buildings, plant and machinery, furniture, loose tools, goodwill, patents,
copyrights, long-term investment in shares of other companies,
Government bonds etc.
Non-current liabilities: are those liabilities which are not included under
current liabilities. They include: share capital, debentures, long-term
loans, share premium, credit balance in the profit and loss account,
revenue and capital reserves (such as general reserve, dividend
equalization fund, capital redemption reserve) etc.

170
C) Identification Of Transactions Which Cause Flow of Funds
In order to prepare funds flow statement, it is essential to identify which
transactions result in flow of funds (or change in working capital) and
which transactions do not result in flow of funds (or change in working
capital). The following guidelines may be adopted for identification
purpose.

a) Transactions among current accounts do not affect flow of funds

Transactions involving two current assets do not affect funds.

Transactions involving two current liabilities do not affect funds.

Transactions involving current assets and current liabilities do not affect
funds.
You can understand better the above points with the help of following
examples. A company realizes Rs.25,000 from its debtors. This
transaction will reduce the debtors by Rs.25,000 but at the same time the
cash balance of the company will increase by Rs.25,000. Therefore, the
total of current assets will continue at the old figure. This means, a
transaction involving two current assets does not affect funds or change
working capital position of the company. Similarly, a transaction involving
a current asset and a current liability does not affect funds. Suppose, if a
company pays Rs.20,000 to its creditors out of its cash balance, the total
of current assets will be reduced by Rs.20,000 and the total of current
liabilities will be reduced by Rs.20,000. Therefore, there will not be any
change in working capital.

b) Transactions among non-current accounts do not affect funds

Transactions involving two non-current (or fixed) assets do not affect
funds.

Transactions involving two long term liabilities do not affect funds.

Transactions involving non-current assets and long term liabilities do not
affect funds.
Suppose, if a company purchases furniture for Rs.15,000 by raising long
term loans of Rs.15,000, this transaction will not have any impact on
working capital position. The reason is furniture (a non-current asset) and
long-term loan (a non-current liability) are not the constituents of the
working capital. Similarly, if the company redeems its preference shares
by issuing debentures, this transaction will not result in any change in
working capital position of the company as both the two accounts involved
in the transaction are not the constituents of the working capital.

171
c) Transactions between current accounts and non-current accounts
affect funds
Funds move when there is a cross transaction between a non-current to
current account and vice-versa. The details are given below:
• Transactions involving a current asset and a fixed asset affect
funds;
• Transactions involving a current liability and a fixed asset affect
funds;
• Transactions involving a current asset and a fixed liability affect
funds;
• Transactions involving a current liability and a fixed liability affect
funds.
Look at the following example and see how the transaction between a
current account and a non-current account affects working capital position
of the company. A company raises Rs.75,000 in cash by issue of shares.
Due to this transaction the cash position of the company will raise by
Rs.75,000. As there is no change in the current liabilities position the
working capital of the company will increase by Rs.75,000. Similarly,
transactions of sale of fixed assets, repayment of long-term liabilities by
cash of by creating current liabilities will affect the working capital position
of the company. You have learnt that the cross transactions affect the
funds or working capital position of a company. Now we can discuss the
procedures or steps involved in the preparation of funds flow statement.

10.3 REPORTING OF CASH FLOWS FROM OPERATING ACTIVITIES

There are two methods of converting net profit into net cash flows from
operating activities:

(i). Direct method, and

(ii). Indirect method

Format of Cash Flow Statement

Accounting Standard-3 (Revised) has not provided any specific format for
preparation of cash flow statements, but a general idea can be had from
the illustration appearing thereof. There seems to be flexibility in the
preparation of cash flow statements. However, a widely accepted format
under direct method and indirect method is given below.
CASH FLOW STATEMENT (INDIRECT METHOD)
A. Cash flows from operating activities
Net profit before tax and extraordinary items
Adjustments for:

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Depreciation
Foreign Exchange
Investments
Gain or loss on sale of fixed assets
Interest/dividend
Operating profit before working capital changes
Adjustments for:
Trade & other receivables
Inventories
Trade payable
Cash generation from operations
Interest paid
Direct taxes
Cash before extraordinary items
Deferred revenue
Net cash from operating activities.
B. Cash flows from investing activities
Purchase of fixed assets
Sale of fixed assets
Sale of investments
Purchase of investments
Interest received
Dividend received
Loans to subsidiaries
Net cash from investing activities
C. Cash flows form financing activities
Proceeds from issue of share capital
Proceeds from long term borrowings
Repayment to finance/lease liabilities
Dividend paid
Net cash from financing activities
Net increase (Decrease) in cash and cash equivalents (A+B+C)
Cash and cash equivalents at the beginning of the period
Cash and cash equivalents at the end of the period

Alternatively, the Cash Flows from Operating Activities

(Indirect Method) may be summarized as below:

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NET PROFIT BEFORE TAX AND EXTRA-ORDINARY ITEMS XXX

Adjustments for non-cash and non-operating items

(+) Depreciation

(+) Amortization of intangible assets, preliminary expenses,

debenture discount etc.

(+) or (-) Other non-cash and non-operating items included in

net profit.

Adjustments for gains and losses on sale of fixed

assets and investments

(-) Gains on sale of fixed assets and investments

(+) Loss on sale of fixed assets and investments

Adjustments for changes in in current assets

and current liabilities

(-) Increases in current assets

(+) Decreases in current assets

(+) Increases in current liabilities

(-) Decreases in current liabilities

(-) Income-tax paid

(-) Extra ordinary items

NET CASH FLOWS FROM OPERATING ACTIVITIES XXX

10.4 USEFULNESS OF CASH FLOW STATEMENT

The purpose of cash flow statement is to provide information about the
cash flows associated with the periods of operations and also about the
entity’s investing and financing activities during the period. This
information is important to shareholders, part of whose investment return
(dividends) is dependent on cash flows and to lenders, whose interest
payment and principal repayment require in the use of cash. The welfare
of other constituents of a company including its employees, its suppliers,
and the local bodies that may levy taxes on it, depends to varying degrees
on the company’s activity to generate adequate cash flows to fulfil its
financial obligations. The usefulness of cash flow statement can be
summarized as follows:

174
i) Predicts future cash flows: The cash flow statement makes it possible
to predict the amounts, timing and uncertainty of future cash flows on the
basis of what has happened in the past. This approach is better than
accrual basis date presented by profit and loss account and balance
sheet.
ii) Determines the ability to pay dividends and other commitments:
A cash flow statement indicates the sources and uses of cash under
suitable headings such as operating, investing and financing activities.
Shareholders are interested in receiving dividends on their investments in
the shares. Creditors want to receive their interest and principal amount
on time. The statement of cash flows helps investors and creditors to
predict whether the business can make these payments.
iii) Shows the relationship of net income to changes in the business
cash: Usually cash and net income move together. High levels of income
tend to lead to increase in cash and vice-versa. However, a company’s
cash balance can decrease when its net income is high, and cash can
increase when income is low. The users want to know the difference
between the net profit and net cash provided by operations. The net
profit shows the progress of the business during the year while cash flow
relates more to the liquidity of the business. The users can assess the
reliability of net profit with the help of cash flow statement.
iv) Efficiency in cash management: Cash flow analysis helps in
evaluating financial policies and cash position. The management can
estimate how much funds are needed, from which source they will be
derived, how much can be generated internally and how much should be
arranged from outside.
v) Discloses the movement of cash:A comparison of cash flow
statement for the previous year with the budget for that year would
indicate to what extent the resources of the enterprise were raised and
applied.
vi) Discloses success or failure of cash planning: A success or failure
of cash planning can be known by comparing the projected cash flow
statement with the actual flow statement and necessary remedial
measures can be taken. Moreover, it provides a better measure for
interperiod and inter-firm comparison.
vii) Evaluates management decisions: The statement of cash flows
reports the companies’ investing and financing activities and thus gives
the investors and creditors about cash flow information for evaluating
managers’ decisions.

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10.5 SOME ILLUSTRATIONS
Illustration 1
Balance Sheet of A and B on 1.1.19 and 31.12.19 were as follows:

Liabilities 01.01.19 31.12.19 Assets 01.01.19 31.12.19

Rs. Rs. Rs. Rs.
Creditors 40,000 44,000 Cash 10,000 7,000
Mrs. A’s
Loan 25,000 xxx Debtors 30,000 50,000
Loan from
Bank 40,000 50,000 Stock 35,000 25,000
Capital 1,25,000 1,53,000 Machinery 80,000 55,000
Land 40,000 50,000
Building 35,000 60,000
2,30,000 2,47,000 230,000 2,47,000

During the year, a machine costing Rs.10,000 (accumulated depreciation

Rs. 3,000) was sold for Rs. 5,000. The provision for depreciation against
machinery as on 1.1.04 was Rs. 25,000 and on 31.12.04 Rs. 40,000. Net
Profit for the year 2004 amounted to Rs. 45,000. You are required to
prepare Cash Flow Statement.

Solution

Cash Flow Statement (Traditional Method)

Cash Inflow Rs. Cash Outflow Rs.

Cash 10,000 Purchase of Land 10,000
Sale (Machinery) 5,000 Purchase of Building 25,000
Bank Loan 10,000 Mrs. A ‘s Loan 25,000
Cash From Operation 59,000 Drawings 17,000
Cash 7,000
84,000 84,000
Cash from Operations

Particulars Rs. Rs.

Funds From Operations 65000
(+) Increase in Current Assets Decrease in
Current Liabilities
Decrease in Stock 10000
Increase in Creditors 40000 14000
79000

176
(-) Decrease in Current Assets & Increase in
Current Liabilities
Increase in Debtors 20000
Cash From Operations 59000
Profit and Loss Adjustment Account
Rs. Rs.
To Loss on sale of 2,000
Machinery
To Depreciation 18,000 By Funds from 65,000
Operations
To Net Profit 45,000
65,000 65,000

Machinery Account at Cost

Rs. Rs.
To Balance b/d By Cash 5,000
(80,000+25,000) 1,05,000 By P&L a/c 2,000
By Depreciation 3,000
By Balance c/d
55,000+40,000 95,000
1,05,000 1,05,000

Land Account
Rs. Rs.
To Balance b/d 40,000
To Cash 10,000 By Balance c/d 50,000
50,000 50,000

Building Account
Rs. Rs.
To Balance b/d 35,000
To Cash 25,000 By Balance c/d 60,000
60,000 60,000

Mr. A ‘s Loan Account

Rs. Rs.
To Cash 25,000 By Balance b/d 25,000
To Balance c/d xxx
25,000 25,000

Bank Loan Account

Rs. Rs.
By Balance b/d 40,000

177
To Balance c/d 50,000 By Cash 10,000
50,000 50,000

Capital Account
Rs. Rs.
To Drawings 17,000 By Balance b/d 1,25,000
To Balance c/d 1,53,000 By Net Profit 45,000
1,70,000 1,70,000

Depreciation Provision Account

Rs. Rs.
To Machinery 3,000 By Balance b/d 25,000
To Balance c/d 40,000 By P&L a/c 18,000
43,000 43,000

Calculation of Loss on Sale of Machine

Rs.

Cost Price 10,000

(-) Depreciation 3,000

Written Down Value 7,000

Selling Price 5,000

Loss 2,000

Cash Flow Statement (Revised Method)

Particulars Rs Rs

Cash flows from Operating Activities:

Net profit made during the year 45,000

Adjustments for depreciation 18,000

Loss on sale of machinery 2,000

Operating profit before working capital changes 65,000

Decrease in stock 10,000

Increase in creditors 4,000

Increase in debtors (20000)

Net Cash flows from Operating Activities 59000

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 Cash flows from Investing Activities:

Sale of Machinery 5000

Purchase of Land (10000)

Purchase of Building (25000)

Net Cash flows from Investing Activities (30000)

Cash flows from Financing Activities:

Loan from bank 10000

Mrs. A ‘s Loan repaid (25000)

Drawings (17000)

Net Cash flow from Financing Activities (32000)

Net increase (decrease) in cash and cash

equivalent (3000)

Cash and cash equivalents at the beginning of

the period (10000)

Cash and cash equivalents at the end of the

period (7000)

Working Notes

a. Cash comprises cash in hand and demand deposits.

b. Cash equivalents are short term highly liquid investments that are
readily convertible into known amounts of cash and which are subject
to an insignificant risk of changes in value.

Illustration 2
A company finds on 1.1.16 that it is short of funds with which to implement
its programme of expansion. On 1.1.16, it had a credit balance of Rs.
1,80,000. From the following information, prepare a statement for Board
of Directors, to show how the overdraft of Rs. 68,750 as at 31.12.16 has
arisen:
Figures as per Balance Sheet as at 31st December of each year are as
follows:

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 2015 2016
Particulars
Rs Rs

Fixed Assets 7,50,000 11,20,000

Stock and stores 1,90,000 3,30,000

Debtors 3,80,000 3,35,000

Bank Balance (Cr.) 1,80,000 (OD) 68,750

Trade creditors 2,70,000 3,50,000

Share capital (in shares of Rs. 10 each) 2,50,000 3,00,000

Bills receivable 87,500 95,000

The profit for the year ended 31.12.2016, before charging depreciation
and tax amounted to Rs. 2,40,000. The 5,000 shares were issued on
1.1.16, at a premium of Rs.5 per shares Rs.137,500 were paid in March
2016, by way of Income tax. Dividend was paid as follows:

2015 (Final) on the Capital on 31.12.2003 at 10% less tax at 25%

2016 (Interim) 5% free of tax.

Solution
Cash Flow Statement
(Traditional Method)

Particulars Rs. Particulars Rs.

Bank balance 1,80,000 Tax paid 1,37,500
Issue of shares 50,000 Fixed dividend 18,750
Share premium 25,000 Interim dividend 15,000
Cash from Purchase of fixed
operations 2,17,500 assets 3,70,000
Over draft 68,750
5,41,250 5,41,250
Cash from Operations

Particulars Rs. Rs.

Funds From Operations 240000
(+) Increase in Current Assets & Decrease in
Current Liabilities
Decrease in Debtors 450000

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 Increase in Creditors 800000 125000
365000
(-) Decrease in Current Assets Increase in
Current Liabilities
Increase in Stock 140000
Increase in Bills Receivable 7500 147500
Cash From Operations 217500
Fixed Assets Account

Rs. Rs.
To Balance b/d 7,50,000
To Cash 3,70,000 By Balance b/d 11,20,000
11,20,000 11,20,000
Share Capital Account

Rs. Rs.
To Balance c/d 3,00,000 By Balance b/d 2,50,000
By Cash 50,000
3,00,000 3,00,000
Working Notes

1. Final Dividend:

250000 x 10 % = Rs. 25,000

(-) Tax 6,250

18,750

2. Interim Dividend:

3,00,000 x 5 % = Rs. 15,000

Illustration 3
From the following information as contained in the income statement and
the balance sheet of Strong Ltd., you are required to prepare a cash flow
statement using (i) direct method; and (ii) indirect method;

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 Income Statement and Reconciliation of Earnings for the year

ended 31.03.2015

Rs Rs

Net Sales 40,32,000

Less: Cost of sales 31,68,000
Depreciation 96,000
Salaries and wages 3,84,000
Operating expenses 1,28,000
Provision for taxation 1,40,800 39,16,800
Net operating profit 1,15,200
Non-recurring income:
Profit on sale of equipment 19,200
Profit for the year 1,34,400
Retained earnings (balance in P&L a/c brought
forward) 2,42,880
Dividend declared and paid during the year 1,15,200
Profit and loss account balance as on 31st
March, 2015 2,62,080
Comparative Balance Sheet

As on As on
31.03.2014 31.03.2015
Rs. Rs.
Fixed Assets:
Land 76,800 1,53,600
Building and equipments 5,76,000 9,21,600
Current Assets:
Cash 96,000 1,15,200
Debtors 2,68,800 2,97,600
Stock 4,22,400 1,53,600
Advances 12,480 14,400
Total 14,52,480 16,56,000
Capital 5,76,000 7,10,400
Surplus in P&L a/c 2,42,880 2,62,080
Sundry creditors 3,84,000 3,74,400
Outstanding expenses 38,400 76,800
Income-tax payable 19,200 21,120

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 Accumulated depreciation on
building & equip. 1,92,000 2,11,200
Total 14,52,480 16,56,000
Cost of equipment sold was Rs. 1,15,200

i) Direct Method
Strong Ltd.
Cash Flow Statement for the year ended 31.03.2015

Particulars Rs Rs

A) Cash receipts from customers

Cash paid to suppliers and employees 40,03,200
Cash generated from operations -33,84,320
Income-tax paid 6,18,880
Net cash from Operating Activities -1,38,880 480000
B) Cash Flows from Investing Activities
Purchase of land -76,800
Purchase of building and equipment -4,60,800
Sale of equipment 57,600
Net cash used in Investing Activities -480000
(C) Cash Flows from Financing Activities
Issue of share capital 1,34,400
Dividend paid -1,15,200
Net cash from financing Activities 19200
Net increase in Cash and Cash
Equivalent(A+B+C) 19200
Cash and cash equivalents at the beginning 96000
Cash and cash equivalents at the end 115200
Working Notes

Particulars Rs Rs

(i) Cash receipts from customers:

Sales 40,32,000
Add: Debtors at the beginning 2,68,800
43,00,800
Less: Debtors at the end 2,97,600
40,03,200

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(ii) Cash paid to suppliers and employee
Cost of goods sold 31,68,000
Add: Operating expenses 1,28,000
Salaries and Wages 3,84,000
36,80,000
Add: Creditors at the beginning 3,84,000
Outstanding expenses at the beginning 38,400
Stock at the end 1,53,600
Advances at the end 14,400 5,90,400
42,70,400
Less: Creditors at the end 3,74,400
Outstanding expenses at the end 76,800
Stock at the beginning 4,22,400
Advances at the beginning 12,480 8,86,080

33,84,320

(iii) Income-tax paid:

Income tax payable at the beginning 19,200
Add: Provisions for taxation 1,40,800
1,60,000
Less: Tax payable at the end 21,120
Tax paid during the year 1,38,880
(iv) Accumulated depreciation written off on
equipment sold
Accumulated depreciation at the beginning 1,92,000
Add: Depreciation for the year 96,000
2,88,000
Less: Accumulated depreciation at the end 2,11,200
76,800
(v) Sale price of equipment:
Cost price 1,15,200
Less: Accumulated depreciation 76,800
38,400
Add: Profit on sale 19,200
Sale price 57,600

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 (vi) Purchase of building and equipment’s
Balance at the beginning 5,76,000
Less: Cost of equipments sold 1,15,200
4,60,800
Balance at the end 9,21,600
Purchases of buildings & equipment 4,60,800
(ii) Indirect Method
Strong Ltd.
Cash Flow Statement for the year ended 31.03.2015

Particulars Rs Rs

(A)Cash flows from Operating Activities:

Net profit before taxation and extra ordinary items 2,56,000
Adjustment for Depreciation 96,000
Operating profit before working capital changes 3,52,000
Increase in debtors -28,800
Decrease in stock 2,68,800
Increase in advances -1,920
Decrease in creditors -9,600
Increase in outstanding expenses 38,400
Cash generated from operations 6,18,880
Income tax paid 1,38,880
Net Cash from Operating Activities 480000
(B) Cash Flows from investing Activities
Purchase of land 76,800
Purchase of building and equipment 4,60,800
Sale of equipment 57,600

Net cash used in investing Activities 19200

Net increase in Cash and Cash Equivalents
(A+B+C) 19,200
Cash and Cash Equivalents at the beginning 96,000
Cash and Cash Equivalents at the end 1,15,200

LET US SUMUP
Namely, Balance Sheet and Income Statement, are financial statements,
that provides information about the financial soundness and the operating
results of the business on a particular accounting period. But neither of
these financial statements can provide information about the real cash

185
position of the business and the cash flows relating to operating, financing
and investing activities. Cash Flow statement explains the changes that
take place in cash position between two accounting periods. According
to the revised Accounting Standard - 3, an organisation should prepare a
cash flow statement and should present it along with its final accounts.
Cash flows of a business can be classified into three: (i) Cash flows from
operating activities, (ii) Cash flows from investing activities, and (iii) Cash
flows from financial activities. As per the revised accounting statement a
business should provide information about the cash flows relating to
operating, financing and investing activities. There are two methods of
converting net profit into cash flows from operating activities, namely,
direct method and indirect method.
Cash flow statement is an important tool in the hands of management.
With the help of this statement an organisation can do cash planning,
therefore, effective utilisation of cash in highly possible. In addition, the
cash flow statement provides the following benefits:

i) It helps to predict the future cash flows:

ii) It helps to determine the ability to pay dividends and other
commitments

iii) It shows the relationship of net income to changes in the business,

iv) It helps in evaluating financial policies and cash position

v) It discloses success or failure of cash planning and

vi) It helps to evaluate management decisions.

Even though there are many similarities between cash flow and fund flow
statement, in some respects, the cash flow statement differs from fund
flow statement. For instance, the term ‘fund’ in the fund flow statement
has a wider meaning. Where as in the cash flow statement ‘fund’ refers to
only cash and cash equivalent items. Increase in current assets or
decrease in current liabilities increases the working capital whereas the
decrease in current assets or increase in current liabilities increases the
cash flows. We have made a detailed discussion on cash flow statement.
We have also explained steps involved in the preparation of cash flow
statement and have highlighted its usefulness.

186
CHECK YOUR PROGRESS

Choose the Correct Answer:

1) As per Accounting Standard-3, Cash Flow is classified into _________

a) Operating activities and investing activities
b) Investing activities and financing activities
c) Operating activities and financing activities
d) Operating activities, financing activities and investing activities

2) Cash Flow Statement is also known as_________

a) Statement of Changes in Financial Position on Cash basis
b) Statement accounting for variation in cash
c) Both a and b
d) None of the above

3) Cash Flow Statement is based upon _________

a) Cash basis of accounting b) Accrual basis of accounting

c) Credit basis of accounting d) None of the above

4) Which of the following statement is true?
a) Cash flow reveals only the inflow of cash
b) Cash flow reveals only the outflow of cash
c) Cash flow is a substitute for income statement
d) Cash flow statement is not a replacement of funds flow statement.

5) Which of the following statements are false?

a) Cash Flow Statement is helpful in the formation of policies.
b) Cash Flow Statement is useful for external analysis
c) Cash Flow Statement is helpful in estimating future cash flow
d) None of the above
GLOSSARY

Flow of Funds : It refers to change in funds

Cash : Cash refers to cash on hand and

Cash flow Statement : It is a statement which shows the change

in cash position from one period to
another.

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REVIEW QUESTIONS
1.The following are the Balance Sheets of a co. as on 31.12.17 and
31.12.18:

2018 2019 2018 2019

Liabilities Assets
Rs Rs Rs RS
Eq. Sh. 7,00,000 800000 Fixed 5,00,000 6,00,000
Capital Assets
General 450000 600000 (+) 1,00,000 80,000
Reserve Additions
P&L a/c 1,73,000 233000 6,00,000 6,80,000
Current (-)
Liabilities Depreciatio 2,00,000 3,20,000
: n
Creditors 7,00,000 900000 4,00,000 3,60,000
Bank 11,50,00 140000 Investments 1,20,000 xxxx
Overdraft 0 0
Crs for 80,000 92000 Current
expenses Assets
Provn. for 1,97,000 370000 Debtors 13,00,000 21,85,000
tax
Proposed 1,50,000 150000 Stock at 17,80,000 2000000
Dividend cost
36,00,00 454500 36,00,000 4545000
0 0

The profit for the year 2018 as per P&L a/c after providing for depreciation
amounted to Rs. 7,00,000 Which was further adjusted as follows:

Rs. P.
Profit and loss balance b/f 1,73,000 00
Profit after depreciation 7,00,000 00
(+) profit on sale on investments 20,000 00
8,93,000 00
(-) Provision for tax 3,60,000 00
Transfer to Reserve 1,50,000 00
Proposed dividend 1,50,000 00
6,60,000 00
Balance c/f 2,33,000 00

You Are Informed That

a. The sale and purchase in the year 2018 amounted to Rs. 80 lakhs and
Rs. 65 lakhs respectively.

188
b. In arriving at the profit from the sales referred to already, the cost of
sale and administration and selling expenses were deducted.

You are required to prepare a Cash Flow Statement.

(Ans: Cash Flow from Operating Activities: (2,60,000); cash flow from
Investment Activities: Rs. 60,000; Cash Flow from financing Activities: Rs.
(50,000)).
2. From the following Balance Sheet of Winners limited, for years ended
31.3.2013 and 2014. Prepare a Cash Flow Statement:

2013 2014 2013 2014

Liabilities Assets
Rs Rs Rs RS
Equity Shares 9,00,000 1200000 Loans to 50,000 xxx
of Rs.100 Subsidiary
each Co
Securities xxx 90000 Plant less 7,80,000 9,00,000
Premium Depreciation
P&L 3,00,000 300000 Share in 60,000 60,000
appropriation Subsidiary
a/c Co.
Profit for the 50000 600000 Land 6,00,000 7,50,000
year
9% 4,00,000 300000 Stock 3,70,000 4,50,000
Debentures
Creditors 4,05,000 230000 Debtors 3,00,000 4,00,000
Pron. for tax 1,50,000 300000 Bank 90000 560000
Proposed 45,000 100000
Diidend
22,50,000 3120000 22,50,000 3120000

The following additional information are available:

a. The Plant’s Depreciation is Rs.4,20,000 and Rs.4,50,000 for 2003 and 2014
respectively.

b. A Plant costing Rs.1,50,000 was sold during the year for Rs.60,000.
Accumulated depreciation on this plant was Rs. 1,00,000 and profit / loss, if
any, arising out of this sale was transferred to profit and loss account.

c. During the year, the company paid income-tax amounting Rs.1,80,000.

(Ans: Cash Flow From Operating Activities: 5,65,000; cash flow from
Investment Activities: Rs. (3,40,000); Cash Flow from Financing
Activities: Rs. 2,45,000).
3.Swastik Oils Ltd. has furnished the following information for the year
ended31.3.2018:

Liabilities

189
 Net Profit 37,500 00
Dividend (including interim dividend paid) 12,000 00
Provision for income tax 7,500 00
Income tax during the year 6,372 00
Loss on sale of assets (net) 60 00
Book value of assets sold 277 50
Depreciation charged to P&L a/c 30,000 00
Profit on sale of investments 150 00
Value of investments sold 41,647 50
Interest income on investments 3,759 00
Interest expenses 15,000 00
Interest paid during the year 15,780 00
Increase in working capital (excluding cash and
bank balance) 84,122 50
Purchase of fixed assets 24,840 00
Investments in Joint venture 5,775 00
Expenditure on construction work in progress 69,840 00
Proceeds from long term borrowings 38,970 00
Proceeds from short term borrowings 30,862 50
Opening cash and bank balances 11,032 50
Closing cash and bank balances 2,569 50

You are required to prepare the Cash Flow Statement in accordance with
AS-3 for the year-ended 31.3.2018. (Make assumptions wherever
necessary).
(Ans: Cash Flow from Operating Activities: (4,333.50); CF from
Investment Activities: Rs. (51,321.00) Crores; CF from Financing
Activities: Rs. 42,052.50).
4. From the following information as contained in income statement and
balance sheets of Ril Ltd., you are required to prepare a cash flow
statement using (i) direct method; and (ii) indirect method:

Income Statement for the year ended 31st March, 2020

Rs Rs
Net sales (In Crores)
Less: Cost of sales 15,984
Depreciation 2,534
Salaries and wages 375
Operating expenses 891
Provision for tax 57 19841

190
 Net operating profit 460
Add: Other Income 645
Profit on sale of asset 42 687
Profit for the year 1147
Add: Balance of profit and loss account brought forward 11183
12330
Less: Dividend declared 420
Tax on dividend 46 466
11864
Add: Share premium account 772
Profit and loss account as on 31st March, 2020 12636

Comparative Balance Sheet as on 31st March

2020 2019 2020 2019

Liabilities Rs (In Rs (In Assets Rs (In Rs (In
crores) crores) crores) crores)

Equity Fixed
1,053
capital 933 assets:
Preferenc
293 Land 1,029 901
e Capital 253
Reserves
and 12,636 23,634 21,187
Surplus 11183 Buildings
Gross
Loans 24,663 22,088
11520 11650 block
(-) Accum.
Creditors 2,959
3345 dep. 9,214 6,692
Provision
266 Net block 15,449 15,396
for tax 544
Other Investment
643 6,067
liabilities 248 s 4,295
Current
Assets
Cash 1082 4,898
Debtors 842 457
Stock 1823 1409
Advances 4,059 1676
Other
Current
assets 48 25
29,370 28156 29,370 28156

Cost of equipment sold was Rs. 40 Crores.

191
(Ans: Cash Flow From Operating Activities: 165 Crores; CF from
Investment Activities: Rs. (4,317) Crores; CF from Financing Activities:
Rs. 336 Crores).

SUGGESTED READINGS
1. Gupta, R.L. and Radhaswamy, M., (2006), Financial Accounting,
Sultan and Chand Sons, New Delhi.
2. Maheswari, S.N and Maheshwary, S.K. (2006), Fundamental of
Accounting, Vikas Publications.
3. Shashi K. Gupta, R.K.Sharma , (2012), “Financial Management”
latest Edition, Kalyani Publishers, Chennai
4. M C Shukla, S C Gupta & T S Grewal, (2017), Advance
Accounting, 19th Edition, S.Chand Publishing, New Delhi
5. Tulsian P. C. , (2017), Financial Accounting , Pearson Education,
New Delhi.
6. https://www.youtube.com/watch?v=jbSEUe1gZj8
7. https://www.edupristine.com/blog/cash-flow-statement-in-detail

ANSWER TO CHECK YOUR PROGRESS

1) d 2) c 3) a 4) d 5) d

192
Unit 11

RATIO ANALYSIS
STRUCTURE

Overview

Learning Objectives

11.1 Meaning of Financial Ratios

11.2 Steps in Ratio Analysis

11.3 Classification of Ratios

11.4 Summary Sheet of Important Financial Ratios

11.5 Computation of Different Accounting Ratios

11.6 DU Pont Chart

11.7 Uses and Limitations of Ratio Analysis

11.8 Inter-firm and Intra-firm comparison

Let Us Sum Up

Check Your Progress

Glossary

Suggested Readings
Answers to Check Your Progress

OVERVIEW
Financial statements, namely, Profit and Loss Account and Balance Sheet
are prepared for the purpose of presenting a periodical review of report
on the progress of the company by the management. Financial statements
contain a lot of information which, if properly analysed and interpreted can
provide valuable insights into a firm’s operating efficiency and financial
position. A financial analyst can adopt different techniques or tools for
analysis of financial statements. Trend percentages, funds flow and cash
flow analysis and ratio analysis are the important tools of analysis of
financial statements. In this unit, ratio analysis is discussed in detail. The
figures contained in the financial statements are absolute. Absolute
figures do not convey much meaning. They must be properly analysed
and interpreted in order to make meaningful conclusion and decision. In
this unit, different ratios are worked out and compared with standards or
norms in order to highlight the deviations made from those standards or

193
norms. The uses and limitations of ratio analysis are also discussed in this
unit.

LEARNING OBJECTIVES

After reading this unit, you should be able to,

• define financial ratios
• explain steps involved in ratio analysis
• list broad classification of ratios
• explain various accounting ratios and their purposes
• analyse and interpret different accounting ratios
• explain Du Pont Chart
• discuss the uses and limitations of ratio analysis.

11.1 MEANING OF FINANCIAL RATIOS

Ratio analysis is one of the most widely used yardsticks by the financial
analyst to evaluate the efficiency and performance of business units.
Financial analyst by calculating and interpreting different ratios diagnose
the financial health of an enterprise. Ratio analysis helps the
management, creditors (both short term and long term), investors (both
current and prospective), financial analyst Government etc., to analyse
the past performance of business enterprises.
A ’Ratio’ is a mathematical relationship between two items expressed in
a quantitative form. In other words, ratio can be defined as “relationship
expressed in quantitative terms, between figures which have cause and
effect relationships or which are connected with each other in some
manner or the other”. Accounting ratio when applied and interpreted
properly will reveal financial strengths and weakness of a firm.

11.2 STEPS IN RATIO ANALYSIS

A Ratio can be calculated by dividing one of the variables of the
relationship with other variables and such ratio value is compared with the
standard or norms in order to find out the deviations and to make
meaningful interpretation. Ratios can be expressed in different forms such
as proportion, rate or times and percentage. The following are steps
involved in ratio analysis:
i) Selection of Relevant Information: Ratios can be calculated
between figures which are having connection with each other in some
manner. ratios calculated from the figures which are not at all connected
with each other wouldn’t serve any purpose. Therefore, the very first step
in ratio analysis is selecting the relevant information.

194
ii) Comparison of Calculated Ratios: Mere Computation of ratios
wouldn’t give any meaningful information. They must be compared with
the standard ratios (ideal ratios) or norms of the industry and with the past
ratios of the same organizations.
iii) Interpreting and Reporting: The third step involves interpreting the
results, drawing of inferences and writing report. The ratios calculated
must be compared with the standard ratios in order to find out the
deviations. On the basis of analysis and interpretation of ratios, reports
are prepared for decision making.

11.3 CLASSIFICATION OF RATIOS

Financial ratios can be classified in different ways. The basis of
classification and the brief details about each ratio are given below:
1) Traditional classification: According to this, ratios can be classified
as (i) balance sheet ratios or financial ratios, (ii) revenue statement ratios
(iii) inter-statement ratios or combined ratios. Liquidity ratio, current ratio,
fixed asset ratio, debt equity ratio, capital gearing ratio are examples of
balance sheet ratios. Gross profit ratio, net profit ratio, operating ratio,
expense ratio are examples of Profit and loss account ratios. Return on
investment, return on networth, stock turnover, fixed assets turnover,
earning per share ratio are some examples for combined ratios.
2) Classification: According to Tests Satisfied or Functional
Classification
Robert N. Anthony views ratios are grouped in accordance with certain
tests which they are intended to sub serve from the view point of various
parties having financial interest in an enterprise. According to this
classification, ratios can be classified as liquidity ratios, profitability ratios,
and market test ratios.
3) Fundamental Classification: According to the purpose or function of
ratios, ratios can be classified into liquidity ratios, leverage ratios, activity
ratios and profitability ratios. The meaning of each ratio is given below
A) Liquidity Ratios: You know that liquidity is the very basis of survival
of any business unit. The credibility of business units mainly depends on
their liquidity. Liquidity ratios are ratio which are used to judge a business
unit’s ability to meet its short term obligations. The most common ratio
indicating the level of liquidity are current ratio, quick ratio and super quick
ratio.

195
Current Ratios show the firm’s ability to meet its current liabilities. If the
ratio is on the higher side, it means the firm has sufficient funds to meet
its current liabilities. A current ratio of 2:1 is considered as an idle one.
Quick Ratio: Quick Ratio is also known as liquid ratio, or acid test ratio.
It expresses relationship between quick (or liquid) assets and quick
liabilities. For calculating quick ratio we have to divide the quick assets
by the current liabilities (or quick liabilities). It can be expressed as follows
Quick Assets or Liquid Assets = Current Assets – Stock and Prepaid
Expenses

Liquid Liabilities = Current Liabilities – Bank Overdraft

As current assets consist of more stock, work –in – progress, prepaid
expenses etc., which are not easily convertible into cash, it cannot be
taken as a conclusive proof of real liquidity of a firm. Therefore, quick ratio
is applied to test the liquidity of a firm. As inventories cannot be converted
into cash immediately and without much loss of value it is excluded from
the list of liquid / quick assets. Similarly, prepaid expenses are also
excluded from the list of quick assets since they are not expected to be
converted into cash. In the liabilities side bank overdraft is not included in
the list of quick / liquid liabilities. Because bank overdraft is generally
considered as permanent way of financing.
Quick ratio is a good indicator of short term solvency of business unit. A
high quick ratio indicates that the business concern is liquid and has the
ability to meet its current or liquid liabilities in time. On the other side, a
low quick ratio indicates that the firm’s liquidity position is not in good
condition. As a convention, a quick ratio of 1:1 is considered to be
satisfactory.
Super Quick Ratio or Absolute Liquid Ratio: In the super quick ratio
even, receivables are excluded from the list of quick or liquid assets. That
is, only cash and bank balance and marketable securities are taken as
current assets. The ratio is calculated as follows:
Absolute liquid assets include Cash and Marketable securities. The
standard norm for this ratio is 50% or 5:1. Even though super quick ratio
is more vigorous in measuring the liquidity position of the firm, it is not
widely used in practice.
B) Leverage Ratios: Leverage Ratios are ratios which are used to study
the extent to which a firm has been financed by debt. Now a day’s almost
all business units adopt debt along with equity for financing their capital
requirement. Use of debt gives more benefits when the return exceeds
the cost of debt. It increases returns on equity.

196
Leverage can be further classified as, financial leverage and operating
leverage. When financial leverage indicates the presence of fixed return
securities in the capital structure of the firm, operating leverage indicates
the use of fixed costs in operations. Operating leverage is concerned to
the firm’s production processes. The greater the use of leverage the
higher is the risk. Suppose, if the break-even point is reached, the
operating leverage gives more benefits. Similarly in financial leverage if
the returns exceed the cost of debt, the organization can get more profits.
Debt – equity ratio, interest coverage ratio, capital gearing ratio are some
examples of leverage ratios.
C) Activity Ratios: Activity ratios are calculated to measure the
effectiveness with which a firm uses its resources. As these ratios indicate
the speed with which assets are being turned over into sales, they are
also called turnover ratios. Inventory turnover ratio, debtors turnover ratio,
fixed assets turnover ratio, total assets turnover ratios are examples of
activity ratio.
D) Profitability Ratios: Profitability ratios are calculated to measure the
net results of business operations or overall performance and
effectiveness of the firm. In other words, Profitability ratios are used to
study the efficiency of operations of business units. Generally, profitability
ratios are calculated in relation to (i) sales and (ii) investments. The
profitability ratios in relation to sales are: (a) Profit Margin; and (b)
expenses ratio or operating ratio. The profitability ratios in relation to
investment are: (a) return on assets; (b) return on capital employed; and
(c) return on equity capital. Owners, bankers, financial institutions and
other creditors are interested to know the profitability of a firm. By knowing
the profitability they can predict and / or calculate the return on their
investments. Gross profit ratio, operating ratio, net profit ratio, expenses
ratio are examples of profitability ratios in relation to sales. Return on
Investment (ROI), Return on capital employed, return on equity capital,
return on total resources, earning per share, price earning ratio are
examples of profitability ratios in relation to investments.
4. Classification According to Importance: On the basis of importance
ratios can be classified as (i) primary ratios and (ii) secondary ratios.
Primary Ratios: Primary ratios refer to the ratios which are used to
calculate Return on Investment (ROI) i.e., the size of profit in relation to
capital employed. As profit is the basis for survival and growth of any
organization everybody having some connection with the organization is
interested to know the profit. Primary ratios serve this purpose.

197
Secondary Ratios : The ratios other than primary ratios are called
secondary ratios. Secondary ratios can be further classified into
supporting ratios, general explanatory ratios and specific explanatory
ratios. You have learnt various classification of accounting ratios. You can
learn these ratios with some illustrations. Now let us focus our attention
on computation and purpose of ratios.

11.4 SUMMARY SHEET OF IMPORTANT FINANCIAL RATIOS

Sl. Ratio Formula Purpose Interpretatio

No n
.

I Profitability Ratio
Gross Profit Ratio

i (Gross Margin Gross Profit Reveals the High ratio

× 100
or Trading Net Sales efficiency of indicates
Maring Ratio) Production / healthy
Trading operations
and growth of
Operations
the company

ii Operating or Operating Costs Measures the High ratio

Expenses Ratio Net Sales efficiency of indicates low
× 100 management level of
to have efficiency of
(or)
control over operation.
Cost of Goods operating Attempts
Sold + expenses should be
Operating Expenses according to made to keep
the levels of the actual
Net Sales sales costs within
× 100
achieved.. the budget.

iii Net Profit Ratio Net Profit Reveals the A high ratio is
× 100
Net Sales net margin on desirable for
sales and long-term
Net sales = Total
reflects survival of
sales + sales
management business and
returns
ability to to give
operate compensation
business. to owners

iv Cost of Goods Cost of Goods Sold Indicates the A high ratio

sold Rations Net Sales margin of means high
× 100 safety. break even
point. So a
low ratio is
desirable

v Net Profitto Net Profit after Measures the High ratio

TotalAssets profitability of indicates the
(Return on investments. efficient use of
Assets) the total

198
 Cost of Goods Sold assets. So it is
Total Sales preferred.
× 100

vi Return on Profits available Measures the High ratio

Shareholder’s for equity profitability indicates the
Funds from the efficient use of
Shareholders
shareholders the share
(Return on AverageEquity point of view. holder’s funds
Shareholders’s × 100 and hence it is
equity)
Shareholder’s preferred.
Funds

vii Earning per Profits available Indicates the Highratio

Equity Share forequityshare − holders company’s helps the
No. of equityshares ability to pay company to
× 100 dividend to its magnify the
equity value of
shareholders. shares in the
market as it
attracts new
investments
from different
quarters.

viii Return on Capital Net Profit after Measures the High ratio
Employed Taxes operational indicates
CapitalEmployed and higher rate of
× 100 managerial return on
efficiency of capital
the business.
employed.
The higher
Because of
the ratio, the
more efficient this,
use of business can
easily
Capital
employed. raise funds.

ix MarketPriceofa share Indicates the Helps the

Earningpershare number of prospective
Price Earning × 100
times the investor
Ratio
earning per indeciding
share is whether to buy
covered by its or not to buy
market price. the shares of
a company at
a particular
market price.
The existing
investors prefer
high ratio as it
fetches them
high value for
their holdings.

199
 x Dividend Yield Dividendper share Indicates the Helpstheprospe
Ratio Marketpriceforshare rate of return ctiveinvestorink
× 100
to equity nowingtheeffect
share holders ivereturnhe is
in the form of going to get
dividend on
based on theproposed
themarket investment.A
value of the highratiomaybe
equityshare. referredinthesh
ort term by the
existinginvest
ors.

Sl. Ratio Formula Purpose Interpretation

No.

II Leverage/
Capital

xi Structure Profit before Indicates the Higher the ratio, better is

Ratios Fixed margin of the position of long-term
interest and tax
Interest coverage of creditors and low risk of
Coverage Fixed interest fixed interest being liquidated.
Ratio Charges charges

xii Debt Equity Total Iong term debit Indicates the A high ratio indicates that
Ratio TotalIongtermsfunds relative the claims of credit or are
proportion of greater than owners. It
debts and emphasizes to maintain
equity in optimum capital structure
financing the in the long term. A very
assets of a high ratio in unfavorable
firm from the firm's point of
view.

xiii Proprietary Shareholders’Funds Indicates the Higher ratio shows the

Ratio TotalTangibleAssets extent of strength of the company.
shareholder's It may be preferred by
funds in the creditors. A low ratio
total assets indicates greater risk
employed from the point of view of
creditors.
in the
business.

xiv Fixed FixedAssets Measures the A higher ratio implies that

Assets Long − termFunds proportion of fixed assets are
Ratio long-term purchased with short
funds term funds which is not a
invested in prudent policy.
fixed assets.

xv Capital Fixed Interest Indicates the High gearing means

Gearing proportion ‘trading on the nequity’ and
Ratio BearingFunds between low gearing means’
trading on thick equity’
EquityShareCapital owner's .High gearing indicates
funds and

200
 non-owners under capitalization and
funds. low gearing indicates
over-capitalisation .Both
are not good to business

xvi Activity costofgoodssold Measures the A high investor ratio

Ratios AverageIndustry liquidity of the indicates efficient
inventory and investor management.
Inventory efficiency of So, itis preferred.
Turn Over inventory However, Avery high ratio
Ratio management may indicate under
(Stock in terms of investment in inventory.
Velocity capital
Ratio) investment.

xvii Fixed Assets Sales Measures the Higher the ratio, greater is
Turnover Next FixedAssets efficiency and efficient utilisation of fixed
profit earning assets. Lower ratio means
capacity of the under utilisation of fixed
firm. assets.

xviii Accounts Fixed Interest Measures the As high ratio indicates

Receivables liquidity of better credit management
Turnover Net Sales on Credit debtors and and prompt payment by
(Debtors AverageReceivable effectiveness debtors, it is preferred.
Turnover) of credit
(or)
Ratio policy.
Total Sales
𝐶𝑙𝑜𝑠𝑖𝑛𝑔 𝐷𝑒𝑏𝑡𝑜𝑟𝑠

xix Accounts NetCreditPurchases Indicates the A higher ratio means

Payable AverageAccounts number of creditors are not paid in
(Creditors times the time. A lower ratio means
Turnover) Payable payable rotate business is not taking the
in a year. full advantage of credit
Ratio period allowed by the
creditors.

Sl. Ratio Formula Purpose Interpretation

No.

III Liquidity or
Working Capital
Ratios

xviii Current Ratio Fixed Interest Measures the A higher ratio

short-term indicates the larger
CurrentAssets
liquidity or amount of rupees
CurrentLiabilities solvency of a available per
concern. rupeeof current
liability.

xix Quick(AcidTest)Ratio QuickAssets Are fined A higher ratio

QuickLiabilities measure of the reveals a
short term debt company’s
paying ability. soundposition
tomeet
itsshortterm
liabilities.

201
11.5 COMPUTATION OF DIFFERENT ACCOUNTING RATIOS
In the previous section you have been exposed to various accounting
ratios and their purposes. In this section, you can learn with the help of
some illustrations how to calculate ratios and how to analyse and interpret
them.

Illustration7.1
ThefollowingarethesummarizedProfitandLossAccountofRajLtdforthey
earending31 st March,2005andtheBalanceSheetasonthatdate:
Profit and Loss Account
Rs. P Rs. P
To Opening Stock 9,950 00 By Sales 85,000 00
To Purchase 54,525 00 By Closing Stock 14,900 00
To Incidental Expenses 1,425 00
To Gross ProfitC/d 34,000 00
99,900 00 99,900 00

Rs. P Rs. P
To Operating Expenses ByGrossProfitb/d 34,000 00
Selling and ByNon-Operating
Distribution3,000 Income: Interest 200
Profit on sale
of shares 600 900 00
Administration15,000
Finance 1,500 19,500 00

To Non-Operating
Expenses:
Loss on sale of assets 400 00
To Net Profit 15,000 00
34,900 00 34,900 00

Liabilities Rs. P Assets Rs. P

IssuedCapital
(2000EquitySharesofRs.1
0each) 20,000 00 Land Buildings 15,000 00
Reserve 9,000 00 Plant Machinery 8,000 00
Current Liabilities 13,000 00 Stock-in-Trade 14,900 00
Profitless/c 6,000 00 Sundry Debtors 7,100 00
Cash Bank Balance 3,000 00
48,000 00 48,000 00
You are required to Calculate:
a) Current Ratio
b) Operating Ratio
c) Stock turnover Ratio
d) Return on total resources
e) Turn over of fixed assets
Solution
CurrentAssets
a) Current Ratio =
CurrentLiabilities

202
 =Rs.14,900+7,100+3,000
Rs.13,000
25 ,000
Rs. 13 ,000 = 1.923
Costofgoodssold+ OperatingExpenses
b) Operating Ration = × 100
NetSales
Cost of goods sold = Opening Stock + Purchases + Direct expenses -
Closing Stock
Rs.9,950+54,525+1,425—14,900=Rs.51,000
Rs.51,000+19,500
Operating Ratio = × 100 = 82.94%
Rs.85,000
Costofgoodssold
(c)Stock turnover Ratio = Averageinventoryatcost
OpeningStock +ClosingStock
Average Inventory =
2
Rs. 9,950 + 14,900
= = 𝑅𝑠. 12,24
2
Rs.51,900
= = 4.10 times
12,425

(d) Return on total resources

NetProfit 𝑅𝑠. 15,000
× 100 = × 100 = 31.25
TotalAssets 𝑅𝑠. 48,000
e) Turnover of fixed assets
𝑁𝑒𝑡 𝑆𝑎𝑙𝑒𝑠 85,000
= = 𝑅𝑠. = 3.7
𝐹𝑖𝑥𝑒𝑑 𝐴𝑠𝑠𝑒𝑡𝑠 23,000
Intheabsenceofinformationaboutnetsalescostofgoodssoldcanbetaken
.Thenturnoveroffixedassetsratiowillbe:
𝐶𝑜𝑠𝑡 𝑜𝑓 𝑔𝑜𝑜𝑑𝑠 𝑠𝑜𝑙𝑑 51,000
= 𝑅𝑠. = 2.22
𝐹𝑖𝑥𝑒𝑑 𝐴𝑠𝑠𝑒𝑡𝑠 23,000
Illustration7.2
Comment on the financial position of the company from the following
balance sheet.
BalanceSheetofLaxmiMillsLtdason31st Dec,2004

Liabilities Rs. P Assets Rs. P

Equity share capital 20,000 00 Goodwill 12,000 00
Capital Reserves 4,000 00 Fixed Assets 28,000 00
8%LoanonMortgage 16,000 00 Stocks 6,000 00
Trade Creditors 8,000 00 Debtors 6,000 00
Bank Overdraft 2,000 00 Investments 2,000 00
Taxation:
Current 2,000 00
Future 2,000 00

Profit & Loss A/c:

Profit for 2004 after taxation
and interest on fixed deposits
12,000
Less : Transfer to

203
 Reserve 4,000
Dividend 2,000 6,000 00
60,000 00 60,000 00

SalesamountedtoRs.1,20,000. Calculate ratio for (a)testing liquidity,

(b)testing solvency
Liquidity Ratios
Current Assets
1. Current Ratio =
Current Liabilities
Liabilities Rs. P Assets Rs. P
Stock 6,000 00 Trade Creditors 8,000 00
Debtors 6,000 00 Bank Overdraft 2,000 00
Investment 2,000 00 Current Taxation 2,000 00
Cash in Hand 6,000 00
20,000 00 12,000 00
Current Ratio =20,000
12,000
=1.67

Comment: A current ratio of 2:1 Is Considered an ideal one. The ratio is

1.67 which is near to 2. So, it is satisfactory.
2. Quick or Liquidity Ratio
Liquid Assets
Current Liabilities
Liquid Assets = Current Assets – Stock and Prepaid expenses
20,000 – 6,000 = 14,000
14,000
Liquidity Ratio = = 1.167
12,000

Comment: The ideal liquidity ratio is 1. The ratio is more than 1. Hence it
can be stated that the liquidity position of the company is strong and
satisfactory.
Ratios for Testing Solvency
1. Debt – equity ratio = Shareholder’s funds  Total long – term funds
18,000
= 0.5
36,000

Shareholder’s funds Rs. P. Long termfunds Rs. P.

Equity share capital 20,000 00 Share holder's 18,000 00
funds Mortgage
Capital Reserve 4,000 00 16,000 00
Loan
P&L Account Balance 6,000 00 2,000 00
Future Taxation
Less: Goodwill 30,000 00 36,000 00
12,000 00
18,000 00 18,000 00

Comment: The ratio measures the proportion between shareholder's

funds and long term funds. The ideal ratio is 0.5. The debt equity ratio of
the firm is also 0.5. Hence, it can be observed that debt-equity ratio is
satisfactory.

204
 Fixed Assets 28,000
2. Fixed Assets Ratio = = = 0.77
Long Term Funds 36,000

Comment: The ideal fixed assets ratio is 0.67. As the ratio is 0.77 (less
than one), it can be assumed that a part of the working capital has been
financed through long term funds. Hence it can stated that the ratio is
satisfactory.
Net Profit before interest and tax
3. Interest Cover Ratio = Interest

Net Profit before Interest and Tax =

Profit after tax and interest on fixed deposits Rs. 12,000 00

Add Tax Rs. 2,000 00

14,000 00

Interest = 8% loan on Mortgage Rs. 16,000 = Rs. 1,280

14,000
Interest Coverage Ratio = = 10.94 times
1280

Comment : The standard for this ratio for an industrial organization is

that interest charges should be covered six to seven times. As the ratio
is 10.94times, it is very satisfactory.
The overall analysis of short-term solvency and long term solvency ratios
showsthatthecompanyhasagoodpositionfrombothliquidityandsolvency
pointofview.

Illustration 7.3
From the following information, you are required to prepare a Balance
Sheet.
a) Current Ratio : 1.75

b) Liquid Ratio : 1.25

c) Stock Turnover Ratio :9

(cost of sales / closing stock)

d) Gross Profit Ratio : 25%

e) Debt collection period : 1.5 months

f) Reserves & Surplus to Capital = 0.2

g) Fixed assets turnover (on cost of sales) = 1.2

h) Capital gearing ratio (Long term debt to share capital ) : 0.6

i) Fixed assets to net worth : 1.25

j) Sales for the year :Rs. 12,00,000

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Solution

Balance Sheet as on .........

Liabilities Rs. P. Assets Rs. P.

Capital 5,00,000 6,00,000 00 Fixed Assets 7,50,000 00

Reserves and 1,00,000 3,00,000 00 Current Assets 3,50,000 00
Surplus Net Worth Stock
2,00,000 00 1,00,000 00
Long term Debt Debtors Other
1,50,000 00
Current Liability Current Assets
(Balance)1,00,00
0

11,00,000 00 11,00,000 00

Working notes

1) Calculation of Closing Stock

Sales for the year = Rs. 12,00,000

Gross Profit Ratio = 25%

25
Gross Profit = 12,00,000 x 100

= Rs.3,00,000

Cost of goods sold = Sales – Gross Profit

= 12,00,000 - 3,00,000
= Rs. 9,00,000
Cost of goods sold
Stock turnover ratio = Closing Stock
9,00,000
=
Closing Stock
9,00,000
Closing Stock = = Rs. 1,00,000
9

2) Calculation of Debtors

Debtors Collection Period = 1.5 months

Months in the year
Debtors Collection Period = Debtors turnover ratio
12
Debtors turnover ratio = = 8 times
1.5
Credit Sales
Debtors turnover ratio = Average Receivable

206
 12,00,000
8= Average Receivable
12,00,000
Average Receivables = 8

= 1,50,000

Note : In the absence of information about cash sales, all sales can be
taken as credit sales. Similarly, in the absence of information about
opening and closing bills receivable, average receivables are taken as
closing debtors.

3) Calculation of current assets and current liabilities

Current Assets
Current Ratio =
Current Liabilities

Current ratio given in the problem is = 1.75

It means current assets = 1.75, and current liabilities = 1

Liquid Assets
Liquid Ratio = Current Liabilities

Liquid ratio given in the problem is 1.25.It means liquid assets = 1.25
and current liabilities=1

Stock = Current Assets – Liquid Assets = 1.75 – 1.25 = .5

We have already ascertained the value of stock. Stock = Rs. 1,00,000
Now we can find out the values of current assets and current liabilities.
1.75
Current Assets = 1,00,000 × .5

= 3,50,000
1
Current Liabilities 1,00,000 × .5

= Rs. 2,00,000

Other Current Assets = Total Current Assets – (Stock + Debtors)

= 3,50,000 - (1,00,000 + 1,50,000)

= Rs. 1,00,000

4) Calculation of fixed assets

Cost of Sales
Fixed Assets turnover =
Fixed Assets

Fixed assets given in the problem is = 1.2

900000
Fixed Assets turnover = 1.2 =
Fixed Assets

207
 9,00,000
Fixed Assets =
1.2

= Rs. 7,50,000

5) Calculation of Capital and Reserves

Fixed assets to net worth = 1.25

750000 75,000
1.25 = Networth =
Networth 1.25
Net worth = Rs. 6,00,000

Net Worth = Capital + Reserves & Surplus

Reserves and Surplus to capital given in the sum = 0.2

It means reserves & surplus = 0.2 and capital = 1.

Net worth = Capital + Reserves &Surolus

= 1 +.02 = 1.2

1.2 = Rs. 6,00,00

6,00,000
Capital = × 1 = 𝑅𝑠. 5,00,000
1.2
6,00,000
Reserves & Surplus = × .2
1.2

= Rs. 1,00,000

6) Calculation of long - term debt

Long Term Debt
Capital gearing Ratio =
Share Capital

Capital gearing Ratio given in the problem = 0.6

Long−term debt
0.6 =
5,00,000

Long term debt = 5,00,000 x 0.6

= Rs. 3,00,000

Illustration 7.4
From the following make out a statement of proprietor's funds with as
much details as possible.

Current Ratio : 2.5

Liquidity Ratio 1.5

Proprietary Ratio : 0.75

(Fixed Assets / Proprietary Funds)

208
Working Capital = Rs. 60,000

Bank Overdraft = Rs. 10,000

Reserves and Surplus = Rs. 40,000

There is no long term or fictitious assets.

Solution

1) Calculation of current assets and current liabilties

Current Assets (CA)
Current ratio = Current Liabilities (CL)

Current Ratio = 2.5 (given)

It means current assets = 2.5 and current liabilities = 1

Working Capital = Current Assets - Current Liabilities

Rs. 60,000 = 2.5 – 1

Rs. 60,000 = 1.5
60,000
1=
1.5
Current Liabilities (1) = Rs. 40,000

Current assets = Rs. 40,000 x 2.5

= Rs. 1,00,000

2) Calculation of Proprietary funds

Proprietary ratio = 0.75 (given)

Fixed Assets
Proprietary ratio = = 0.75
Proprietary Funds

Fixed assets = 0.75 (Proprietary funds)

We can solve this by using the following relationship :

Proprietary funds + 40,000 = 1,00,000+ 0.75 Proprietary funds

0.25 Proprietary funds = 60,000

60,000
Proprietary funds =
0.25

= Rs. 2,40,000

Fixed assets = 2,40,000 x.75

= Rs. 1,80,000

3) Calculation of Share Capital

Share Capital = Proprietary funds - Reserves & Surplus

209
= Rs. 2,40,000 - Rs. 40,000

= Rs. 2,00,000

Calculation of Stock
Liquid Assets
Liquidity Ratio =
Current Liabilities

Liquid Assets = 1.5

We have already ascertained current liabilities

le., Rs. 40,000

Liquid Assets = 1.5 x 40,000

= Rs. 60,000

Stock = Current assets – Liquid assets

= Rs. 1,00,000 – Rs. 60,000

= Rs. 40,000
Statement of Proprietary funds
Rs.P Rs.P
Proprietary funds
Share Capital 2,00,000 00
Reserves & Surplus 40,000 00
2,00,000 00
Fixed Assets 1,80,000 00
Current Assets :
Stock 40,000 00
Other Current Liabilities 60,000 00
2,40,000 00
Less: Current Liabilities 40,000 00
2,40,00000

11.6 DU PONT CHART

Return on Investment (ROI) represents the relative net profit earned on
the capital employed. It shows the operational efficiency of the company.
Return on Investment mainly depends on two ratios, namely, net profit
ratio and capital turnover ratio. A change in any of these ratios will change
the earning capacity of firm. Net profit ratio and capital turnover ratio are
affected by many factors.
Any change in these factors also cause change in these ratios. The
various factors affecting the ROI can be shown with the help of a chart.

210
The chart is popularly known as Du Pont Control Chart as it was first used
by DU Pont Company of US.

The chart shows that return on capital employed is influenced by much

number of factors. A change in one factor affects the return on capital
employed. For instance, if the operating costs increase without any
corresponding increase in the sales revenues, the net profit would
decrease and consequently the ROI will get reduced. Similarly, if the fixed
assets are increased, the total capital employed would increase. Now the
sales revenues of the organization must increase. Suppose, if there is no
increase in the sales due to the increase in the capital employed, then
ROI would decrease.

11.7 USES AND LIMITATIONS OF RATIO ANALYSIS

The uses and limitations of Ratio Analysis are as follows,

11.7.1 Uses of Ratio Analysis

Ratio analysis has been applied widely today to analyse and interpret the
financial statements. With the help of ratio analysis, we can study the
financial health or condition of an organization.
a) Simplifies Financial Statements: Ratio analysis by studying the
numerical or quantitative relationship between two variables or items
simplifies comprehension of financial statements. With the help of ratio
analysis, we can analyse and interpret the financial position of the
business.
b) Helps in Decision Making: Ratio analysis helps many people in taking
decisions. The financial analyst, managers, present and prospective

211
investors, supplier of goods on credit banks, financial institutions, crucial
etc., all use ratio analysis as a tool for evaluating the performance of a
firm and take decisions.
c) Helps in Basic Functions of Management: Ratio analysis helps in
financial forecasting and planning. According to Batty J., “ratios can assist
management in its basic functions of forecasting, planning, control and
communication. The ratios prepared from the pro-forma financial
statements can be taken as standard and the actual ratios calculated can
be compared with standard ratios. Thus, variations scan be ascertained
and corrective measures can be taken at the right time.
d) Helps in Inter-firm and Intra-firm Comparison: Ratio analysis
provides the required data for inter-firm and intra-firm comparison. Ratio
analysis point out strengths and weakness of firms. Therefore, we can
decide which firm is successful and strong and which one is unsuccessful.
Similarly, the performance or efficiency of different divisions within a firm
can be evaluated with the help of ratio analysis.

11.7.2 Limitations of Ratio Analysis

Though ratio analysis provides invaluable aid to management in the
discharge of its basic functions, it suffers from certain limitations. They are
given below:
a) Limited use of a Single Ratio: A single ratio does not convey much
information. It conveys meaningful information when it is studied along
with many other ratios. Sometimes, calculation of more number of ratios
may create more confusion.
b) Non-availability of Standards for all Ratios: Ratios will give
meaningful information only when they are compared with standards or
norms. But for all ratios we don’t have standards or norms. This makes
interpretation of ratios difficult.
c) Inherent Limitations of Financial Statements: You know that
financial statements suffer from a number of limitations. For example, non-
financial changes like changes in the management, improvement in the
efficiency of workforce etc. are not revealed by financial statements. Ratio
analysis takes only quantitative data for analysis. Qualitative nature of
events is ignored by it.
d) Different Accounting Policies: The accounting policies adopted may
differ from company to company. The comparison of one company with
another on the basis of ratio analysis without taking into account the
changes in the accounting policies will be misleading and meaningless.

212
Further, the accounting policies within the company may differ from period
to period. The changes in the accounting policies must be observed and
necessary adjustments should be made before applying ratio analysis.
e) Problem of Window Dressing: Window dressing means manipulation
of accounts in a way so as to conceal vital facts and present the financial
statements in a way to show a better financial position than what it actually
is. Due to window dressing of financial statements the ratios calculated
from them may not show real position.
f) Problem of Price Level Changes: A change in the price level can
affect the validity of comparison of ratios computed for different time
periods. For instance, an old firm which has purchased assets very long
back may charge less depreciation, where as a new company which
purchased assets recently may charge more amount of depreciation. The
effect of price level changes may mislead the results of financial analysis.
g) Ratios No Substitute: Ratio analysis is just an aid to management in
taking right decisions. If ratios are calculated mechanically without
application of knowledge, they will become useless.
h) Difficulties of Comparison: Industries and business may differ in
their nature. Even, within the same nature of activities, industries/business
may differ in their size, accounting policies, historical background etc., It
makes comparison of ratios difficult.

11.8 INTER-FIRM AND INTRA-FIRM COMPARISON

Ratio analysis facilitates inter-firm and intra-firm comparison. The term
Intra-firm comparison can be described comparison of two or more
departments or divisions belonging to the same firm with the objective of
making meaningful analysis for the purpose of increasing the efficiency
and effectiveness of the departments or divisions involved.

Advantages and Limitations of Inter-firm or Intra-firm Comparison

The following are the advantages of inter-firm or intra-firm comparison:

Inter-firm comparison helps to evaluate relative financial position or
operating results or both of different firm. Inter-firm comparison provides
information about the efficiency and profitability of various departments or
divisions. This helps the companies concerned to identify specific areas
in the business which may require more managerial attention.
There are certain limitations in the inter-firm and intra-firm comparison.
For intra-firm comparison we need some information from member-firms
or departments (within the company). If the member-firms or departments
are not cooperating there will be problems in comparison. For inter-firm

213
comparison it will be difficult to get the required information from member
– firms. Further, due to differences of accounting methods, policies and
procedures among companies, it is difficult to have meaningful
comparison.

Requisites for Inter-firm and Intra-firm comparison

The following are the important requisites for a meaningful inter-firm and
intra-firm comparison.
i)Similarity of firms or Departments: There must be more similarities
between the firms or departments which are going to be compared on the
age, character of production and the market which the firms or divisions
are catering etc., For example, there should not be a comparison between
a firm which operate at local level and the firm which operate at the global
level even through the product or service which they deal is same.
ii) Use of accounting ratios: Accounting ratios should be used for inter-
firm comparison. Absolute figures would not help in inter-firm comparison.
Accounting ratios analyse the financial strength and weakness of the firm
by properly establishing relationship between the items of the balance
sheet and the profit and loss account. Therefore, accounting ratios can be
used for inter-firm and intra-firm comparison. Return on Investment(ROI),
debt-equity ratio, liquidity ratio and turnover ratios are the important ratios
normally used for comparison.
iii) Similarity in Accounting Policies: There should be uniformity in
accounting policies regarding valuation of inventories, provision of
depreciation etc. among the firms or divisions selected for comparison.
iv) Adjustment for Inflation: The effects of inflation must be adjusted
before making any comparison. Ratios calculated without adjusting the
effects of inflation may mislead. The inter-firm or intra-firm comparison
should be made keeping in view all these points.

LET US SUM UP
A ratio is a mathematical relationship between two items expressed in a
quantitative form. Ratio analysis when applied and interpreted properly
will reveal financial strengths and weakness of a firm. Financial ratios can
be classified in different ways. According to the purpose or function, ratios
can be classified into liquidity ratios, leverage ratios, activity or turnover
ratios and profitability ratios. Liquidity ratios are calculated to judge the
ability of a concern to meet its short term obligations. Leverage ratios are
calculated to evaluate the ability of a concern to pay its long-term debts.
Activity ratios are computed to measure the effectiveness with which a

214
firm is using its resources. Profitability ratios are calculated to measure
management’s overall effectiveness as shown by the return generated on
sales and investment.
Return on Investment (ROI) represents the relative net profit earned on
the capital employed. It shows the operational efficiency of the company.
Return on Investment mainly depends on two ratios, namely, net profit
ratio and capital turnover ratio. A change in any of these ratios will change
the earning capacity of the firm. The use of ROI was pioneered by DU
pont company. That is why it is sometimes called as the DU pont system
of Financial Control.
Ratio analysis helps various parties in many ways. The management,
shareholders, prospective investors, banks and financial institutions,
debenture holders etc., can take important decisions on the basis of
information provided by ratio analysis. Ratio analysis simplifies financial
statements, helps in inter-firm comparison, and also helps in financial
forecasting and planning. Inherent limitations of financial accounting like
problems of window dressing, price level changes, chances of different
accounting policies, non-availability of standards for all ratios affect the
reliability and utility of ratio analysis.

CHECK YOUR PROGRESS

Choose the Correct Answer:

1) The relationship between two financial variables can be expressed in
_______

a) Pure ratio b) Percentage

c) Rate or time d) Either of the above

2) Liquid assets comprise all current assets minus ________

a) Stock and prepaid expenses
b) debtors and bills receivable
c) stock and debtors
d) stock and bills receivable
3) The statistical yardstick that provides a measure of the relationship
between two accounting figures is ________

a) Current ratio b) Accounting ratio

c) Capital turnover ratio d) Asset turnover ratio

4) Current ratio is a ________

a) short term solvency ratio b) Profitability ratio

215
 c) Turnover ratio d) inventory ratio
5) Ratio of fixed interest-bearing securities to equity share capital is
___________

a) Proprietary ratio b) Capital gearing ratio

c) fixed assets ratio d) None of the above

GLOSSARY

Ratio : Refers to the numerical or quantitative

relationship between two figures which are
mutually interdependent and influence
each other.

Liquidity : atios measures the short term solvency of

a concern.

Profitability Ratios : Measure the efficiency with which the

operations of the business are carried on.

Interpretation : means explaining the meaning and

commenting the data so simplified

Ratio Norm or : means explaining the meaning and

Standard commenting the data so simplified.
SUGGESTED READINGS

1. Gupta, R.L. and Radhaswamy, M., (2006), Financial Accounting,

Sultan and Chand Sons, New Delhi.
2. Maheswari, S.N and Maheshwary, S.K. (2006), Fundamental of
Accounting, Vikas Publications.
3. Shashi K. Gupta, R.K.Sharma , (2012), “Financial Management”
latest Edition, Kalyani Publishers, Chennai
4. M C Shukla, S C Gupta & T S Grewal, (2017), Advance
Accounting, 19th Edition, S.Chand Publishing, New Delhi
5. Tulsian P. C. , (2017), Financial Accounting , Pearson Education,
New Delhi.
6. https://www.carboncollective.co/sustainable-investing/ratio-
analysis#:~:text=There%20are%20four%20main%20types,its%2
0resources%20to%20generate%20sales.
7. https://www.youtube.com/watch?v=bhbDDSohJ84

ANSWER TO CHECK YOUR PROGRESS

1) d 2) c 3) b 4) a 5) b

216
 BLOCK 3
COST ACCOUNTING

Unit 12 : Cost Analysis

Unit 13 : Methods of Costing

Unit 14 : Material Costing

217
Unit 12

COST ANALYSIS
STRUCTURE

Overview

Learning Objectives

12.1 Introduction

12.2 Costing and Cost accounting

12.3 Financial Accounting vs Cost Accounting vs Management

Accounting

12.3.1 Difference between Financial and Cost Accounting

12.3.2 Difference between Management and Cost Accounting

12.4 General Principles of Cost Accounting

12.5 Objectives and Importance of Cost Accounting

12.6 Objections against Cost accounting

12.7 Cost Centre

12.7.1 Meaning of Cost Centre

12.7.2 Profit Centre

12.7.3 Difference between Profit and Cost Centre

12.8 Cost Classification—Basis

12.9 Cost Sheet

12.10 Importance of Cost Sheet

Let Us Sum Up

Glossary

Check Your Progress

Suggested Readings

Answer to Check Your Progress

OVERVIEW
When cost accounts and financial accounts are maintained in two different
sets of books, there will be prepared two profit and loss accounts one for
costing books and the other for financial books. The profit or loss shown

218
by costing books may not agree with that shown by financial books. Such
a system is termed as 'non-integral system' whereas under the integral
system of accounting, there are no separate cost and financial accounts.
However, where two sets of accounting systems, namely, financial
accounting and cost accounting are being maintained, the profit shown by
the two sets of accounts may not agree with each other. Although both
deal with the same basic transactions like purchases, consumption of
materials, wages and other expenses, the difference of purpose leads to
a difference in approach in a collection, analysis and presentation of data
to meet the objective of the individual system. Financial accounts are
concerned with the ascertainment of profit or loss for the whole operation
of the organisation for a relatively long period, usually a year, without
being too much concerned with cost computation, whereas cost accounts
are concerned with the ascertainment of profit or loss made by
manufacturing divisions or products for cost comparison and preparation
and use of a variety of cost statements. The difference in purpose and
approach in cost accounting generally results in a different profit figure
from what is disclosed by the financial accounts and thus arises the need
for the reconciliation of profit figures given by the cost accounts and
financial accounts.

LEARNING OBJECTIVES

After reading this lesson, you should be able to:

• identify the reasons for difference in profit/loss between cost and
financial accounts.
• understand the principles of cost accounting
• differentiate financial, cost and management accounting
• explain the procedure for reconciliation of cost and financial
accounts.
• describe the meaning of cost sheet

12.1 INTRODUCTION
Cost Accounting is a branch of accounting and has been developed due
to limitations of financial accounting. Financial accounting is primarily
concerned with record keeping directed towards the preparation of Profit
and Loss Account and Balance Sheet. The financial accounting reports
help the management to control in a general way the various functions of
the business but it fails to give detailed reports on the efficiency of various
divisions.

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12.2 COSTING AND COST ACCOUNTING
1. Costing: The costing terminology of C.I.M.A., London defines costing
as the “the techniques and processes of ascertaining costs”. These
techniques consist of principles and rules which govern the procedure of
ascertaining cost of products or services. The techniques to be followed
for the analysis of expenses and the processes by which such an analysis
should be related to different products or services differ from industry to
industry. These techniques are also dynamic and they change with time.
The main object of traditional cost accounts is the analysis of financial
records, so as to subdivide expenditure and to allocate it carefully to
selected cost centres, and hence to build up a total cost for the
departments, processes or jobs or contracts of the undertaking. The
extent to which the analysis of expenditure should be carried will depend
upon the nature of business and degree of accuracy desired. The other
important objective of costing are cost control and cost reduction.
2. Cost accounting: Cost Accounting may be regarded as “a specialized
branch of accounting which involves classification, accumulation,
assignment and control of costs.” The costing terminology of C.I.M.A,
London defines cost accounting as “the process of accounting for costs
from the point at which expenditure is incurred or committed to the
establishment of its ultimate relationship with cost centres and cost units.
In its widest usage, it embraces the preparation of statistical data, the
application of cost control methods and the ascertainment of profitability
of activities carried out or planned”.
Wheldon defines cost accounting as “classifying, recording and
appropriate allocation of expenditure for determination of costs of
products or services and for the presentation of suitably arranged data
purposes of control and guidance of management”. It is thus a formal
mechanism by means of which costs of products or services are
ascertained and controlled.
12.3 FINANCIAL ACCOUNTING VS COST ACCOUNTING VS
MANAGEMENT ACCOUNTING

12.3.1 Difference between Cost and Financial Accounting

Cost Accounting refers to that branch of accounting which deals with costs
incurred in the production of units of an organization. On the other hand,
financial accounting refers to the accounting concerned with recording
financial data of an organization, in order to exhibit exact position of the
business. Conversely, financial accounting ascertains the financial
results, for the accounting period and the position of the assets and

220
liabilities on the last day of the period. There is no comparison between
these two because they are equally important for the users. This article
presents you the difference between cost accounting and financial
accounting in tabular form.

Basis for Cost Accounting Financial Accounting

Comparison

Meaning Cost Accounting is an Financial Accounting is an

accounting system, through accounting system that
which an organization captures the records of
keeps the track of various financial information about
costs incurred in the the business to show the
business in production correct financial position of
activities. the company at a particular
date.

Information Records the information Records the information

type related to material, labour which are in monetary
and overhead, which are terms.
used in the production
process.

Type of Cost Both historical and pre- Only historical cost.

determined cost

Users Information provided by the Users of information

cost accounting is used provided by the financial
only by the internal accounting are internal and
management of the external parties like
organization like creditors, shareholders,
employees, directors, customers etc.
managers, supervisors etc.

Valuation of At cost Cost or Net Realizable

Stock Value, whichever is less.

Mandatory No, except for Yes for all firms.

manufacturing firms it is
mandatory.

Time of Details provided by cost Financial statements are

Reporting accounting are frequently reported at the end of the
prepared and reported to accounting period, which is
the management. normally 1 year.

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 Profit Generally, the profit is Income, expenditure and
Analysis analyzed for a particular profit are analyzed
product, job, batch or together for a particular
process. period of the whole entity.

Purpose Reducing and controlling Keeping complete record

costs. of the financial
transactions.

Forecasting Forecasting is possible Forecasting is not at all

through budgeting possible.
techniques.

12.3.2 Difference between Management and Cost Accounting

The two-accounting system plays a significant role, as the users are the
internal management of the organization. While cost accounting has a
quantitative approach, i.e., it records data which is related to money,
management accounting gives emphasis on both quantitative and
qualitative data. Now, let’s understand the difference between cost
accounting and management accounting, with the help of given article.

Basis of Cost Accounting Management

Comparison Accounting

Meaning The recording, The accounting in which

classifying and the both financial and
summarising of cost non-financial
data of an organisation information are provided
is known as cost to managers is known
accounting. as Management
Accounting.

Information Type It uses Quantitative It uses Quantitative and

information’s Qualitative information’s

Objective Ascertainment of cost of Providing information to

production. managers to set goals
and forecast strategies.

Specific There are specific There are no specific

Procedure procedures procedures to be
followed

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 Scope Concerned with Impart and effect aspect
ascertainment, of costs
allocation, distribution
and accounting aspects
of cost

Recording Records past and It gives more stress on

present data the analysis of future
projections.

Planning It helps in short range It helps in both short

planning range and long-range
planning

Interdependence Can be installed without Cannot be installed

management without cost accounting.
accounting.

12.4 GENERAL PRINCIPLES OF COST ACCOUNTING

The following may be considered as the General Principles of Cost
Accounting:
1. A cost should be related to its causes: Cost should be related as
closely as possible to their causes so that cost will be shared only among
the cost units that pass thorough the department of which the expenses
are related.
2. A cost should be charged only after it has been incurred: While
determining the cost of individual units those costs which have actually
been incurred should be considered. For example, a cost unit should not
be charged to the selling costs, while it is still in the factory. Selling costs
can be charged with the products which are sold.
3. The convention of prudence should be ignored: Usually
accountants believe in historical costs and while determining cost, they
always attach importance to historical cost. In Cost Accounting this
convention must be ignored, otherwise, the management appraisal of the
profitability of the projects may be vitiated. According to W.M. Harper, “a
cost statement should, as far as possible, give facts with no known bias.
If a contingency needs to be taken into consideration it should be shown
separately and distinctly”.
4. Abnormal costs should be excluded from cost accounts: Costs
which are of abnormal nature (eg. Accident, negligence etc.) should be

223
ignored while computing the cost, otherwise, it will distort costs figures
and mislead management as to working results of their undertaking under
normal conditions.
5. Past costs not to be charged to future period: Costs which could not
be recovered or charged in full during the concerned period should not be
taken to a future period, for recovery. If past costs are included in the
future period, they are likely to influence the future period and future
results are likely to be distorted.
6. Principles of double entry should be applied wherever necessary:
Costing requires a greater use of cost sheets and cost statements for the
purpose of cost ascertainment and cost control, but cost ledger and cost
control accounts should be kept on double entry principle as far as
possible

12.5 OBJECTIVES AND IMPORTANCE OF COST ACCOUNTING

12.5.1 Objectives of Cost Accounting
Cost accounting aims at systematic recording of expenses and analysis
of the same so as to ascertain the cost of each product manufactured or
service rendered by an organization. Information regarding cost of each
product or service would enable the management to know where to
economize on costs, how to fix prices, how to maximize profits and so on.
Thus, the main objectives of cost accounting are the following.
1. To analyse and classify all expenditure with reference to the cost of
products and operations.
2. To arrive at the cost of production of every unit, job, operation, process,
department or service and to develop cost standard.
3. To indicate to the management any inefficiencies and the extent of
various forms of waste, whether of materials, time, expenses or in the use
of machinery, equipment and tools. Analysis of the causes of
unsatisfactory results may indicate remedial measures.
4. To provide data for periodical profit and loss accounts and balance
sheets at such intervals, e.g. weekly, monthly or quarterly as may be
desired by the management during the financial year, not only for the
whole business but also by departments or individual products. Also, to
explain in detail the exact reasons for profit or loss revealed in total in the
profit and loss accounts.
5. To reveal sources of economies in production having regard to
methods, types of equipment, design, output and layout. Daily, Weekly,

224
Monthly or Quarterly information may be necessary to ensure prompt
constructive action.
6. To provide actual figures of costs for comparison with estimates and to
serve as a guide for future estimates or quotations and to assist the
management in their price fixing policy.
7. To show, where Standard Costs are prepared, what the cost of
production ought to be and with which the actual costs which are
eventually recorded may be compared.
8. To present comparative cost data for different periods and various
volume of output and to provide guidance in the development of business.
This is also helpful in budgetary control.
9. To record the relative production results of each unit of plant and
machinery in use as a basis for examining its efficiency. A comparison
with the performance of other types of machines may suggest the
necessity for replacement.
10. To provide a perpetual inventory of stores and other materials so that
interim Profit and Loss Account and Balance Sheet can be prepared
without stock taking and checks on stores and adjustments are made at
frequent intervals. Also to provide the basis for production planning and
for avoiding unnecessary wastages or losses of materials and stores.

12.5.2 Importance of cost accounting

Cost accounting increases the overall productivity of an organization and
serves as an important tool, in bringing prosperity to the nation, thus, the
importance of cost accounting can be discussed under the following
headings:

a) Costing as an aid to Management

Cost accounting provides invaluable aid to management. It provides
detailed costing information to the management to enable them to
maintain effective control over stores and inventory, to increase efficiency
of the organization and to check wastage and losses. The various
advantages derived by the management from a good system of costing
are as follows:
1. Cost accounting helps in periods of trade depression and trade
competition. In periods of trade depression, the organization cannot afford
to have wastages which pass unchecked. The management must know
areas where economies may be sought, waste eliminated and efficiency
increased. The organization must wage a war not only for its survival but
also continued growth. The management should know the actual cost of

225
their products before embarking on any scheme of price reduction.
Adequate system of costing facilitates this.
2. Cost accounting aids price fixation. Although the law of supply and
demand determines the price of the product, cost to the producer does
play an important role. The producer can take necessary guidance from
his costing records in case he is in a position to fix or change the price
charged.
3. Cost accounting helps in making estimates. Adequate costing records
provide a reliable basis for making estimates and quoting tenders.
4. Cost accounting helps in channelizing production on right lines. Proper
costing information makes it possible for the management to distinguish
between profitable and non-profitable activities; profits can be maximized
by concentrating on profitable operations and eliminating non-profitable
ones.
5. Cost accounting eliminates wastages. As cost accounting is concerned
with detailed breakup of costs, it is possible to check various forms of
wastages or losses.
6. Cost accounting makes comparisons possible. Proper maintenance of
costing records provides various costing data for comparisons which in
turn helps the management in formulating future lines of action.
7. Cost accounting provides data for periodical Profit and Loss Account.
Adequate costing records provide the management with such data as may
be necessary for preparation of Profit and Loss Account and Balance
Sheet at such intervals as may be desired by the management.
8. Cost accounting helps in determining and enhancing efficiency. Losses
due to wastage of materials, idle time of workers, poor supervision etc will
be disclosed if the various operations involved in the production are
studied carefully. Efficiency can be measured, cost controlled and various
steps can be taken to increase the efficiency.
9. Cost accounting helps in inventory control. Cost accounting furnishes
control which management requires, in respect of stock of materials, work
in progress and finished goods.

b) Costing as an aid to Creditors

Investors, banks and other money lending institutions have a stake in the
success of the business concern are therefore benefitted immensely by
the installation of an efficient system of costing. They can base their
judgment about the profitability and future prospects of the enterprise on
the costing records.

226
c) Costing as an aid to Employees
Employees have a vital interest in their employer’s enterprise in which
they are employed. They are benefited by a number of ways by the
installation of an efficient system of costing. They are benefited, through
continuous employment and higher remuneration by way of incentives,
bonus plans, etc.

d) Costing as an aid to National Economy

An efficient system of costing brings prosperity to the business enterprise
which in turn brings prosperity to the business enterprise which in turn
results in stepping up of the government revenue. The overall economic
development o f a country takes place as a consequence of increase in
efficiency of production. Control of costs, elimination of wastages and
inefficiencies led to the progress of the industry and, in consequence of
the nation as a whole.
12.6 OBJECTIONS AGAINST COST ACCOUNTING
A number of objections are generally raised against the introduction of
costing on various grounds. Following are some of the important
objections usually raised:
1. Want of Necessity: It has been argued that costing is of recent origin
and that industries prospered in the past and are still prospering without
the aid of costing and, therefore, expenditure incurred in installing a
costing system would be an unnecessary expenditure. This argument
overlooks the fact that modern industries are running under highly
competitive conditions and that every manufacturer should know the
actual cost of production to decide how far he can reduce the selling price.
Many industrial failure.’ in the past may be attributed to the lack of
knowledge on the part of manufacturer of actual cost of production and,
therefore, selling products below cost.
2. Inapplicability: It is argued that modern methods of costing are
inapplicable to many types of industries. It is true that costing cannot be
applied with advantage to trading concerns and concerns of small size.
But in many cases some methods of costing can always be devised to suit
the requirements of the business. It should be clearly understood that
there is no stereotyped system of costing which can be applied to all types
of industries. The system of costing should be so devised as to suit the
business but not the business to suit the system.
3. Failure in Many Cases: It is argued that the adoption of costing system
failed to produce the desired results in many cases and, therefore, the

227
system is defective. The failure of a system may be due to several causes
such as apathy or indifference of management, lack of adequate facilities,
non-co-operation or opposition from the employees. So it is hasty to find
fault with the system, if it fails to produce the desired results.
4. Mere Matter of Forms and Rulings: It is argued that after some time,
a costing system degenerates into a matter of forms and rulings. This is
not the fault of the system. It is the fault of the way in which the system is
maintained. Forms and rulings are essential for a costing system but they
must be revised and brought up-to-date in the light of altered conditions.
If this is not done, the system is bound to degenerate into a mere matter
of forms and rulings.
5. Expensive: It is said that the cost involved in installing and working a
cost system is out of all proportions to the benefits derived therefrom. It
may be stated in this connection that a costing system must be a profitable
investment and should produce benefits commensurate with the
expenditure incurred on the system. If care is taken to devise a costing
system to suit the requirements of the industry and avoid unnecessary
elaboration, expenditure incurred in installing and operating the system
will be a profitable investment and will bring adequate return.

12.7 COST CENTRE

12.7.1 Meaning of Cost Centre

According to Chartered Institute of Management Accountants, London,
cost centre means “a location, person or item of equipment (or group of
these) for which costs may be ascertained and used for the purpose of
cost control”. Cost centre is the smallest organizational sub- unit for which
separate cost collection is attempted. Thus cost centre refers to one of the
convenient unit into which the whole factory organization has been
appropriately divided for costing purposes.
Each such unit consists of a department or a sub-department or item of
equipment or, machinery or a person or a group of persons.
For example, although an assembly department may be supervised by
one foreman, it may contain several assembly lines. Some times each
assembly line is regarded as a separate cost centre with its own assistant
foreman.
The selection of suitable cost centres or cost units for which costs are to
be ascertained in an undertaking depends upon a number of factors which
are listed as follows.

1. Organization of the factory

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2. Conditions of incidence of cost
3. Requirements of the costing system ie. Suitability of the units or centres
for cost purposes.

4. Availability of information
5. Management policy regarding making a particular choice from several
alternatives

12.7.2 Profit Centre

A profit centre is that segment of activity of a business which is
responsible for both revenue and expenses and discloses the profit of a
particular segment of activity. Profit centres are created to delegate
responsibility to individuals and measure their performance.
A profit centre is a branch or division of a company that directly adds or is
expected to add to the entire organization's bottom line. It is treated as a
separate, standalone business, responsible for generating its revenues
and earnings. Its profits and losses are calculated separately from other
areas of the business. Peter Drucker coined the term "profit centre" in
1945.
The managers or executives in charge of profit centres have decision-
making authority related to product pricing and operating expenses.
They also face considerable pressure as they must ensure that their
division's sales from products or services outweigh the costs—that their
profit centre produces profits year after year, either by increasing
revenue, decreasing expenses, or both.

12.7.3 Difference between Profit and Cost Centre

The various points of difference between Profit centre and cost centre are
as follows. Cost centre is the smallest unit of activity or area of
responsibility for which costs are collected whereas a profit centre is that
segment of activity of a business which is responsible for both revenue
and expenses.

Basis for Cost Centre Profit Centre

Comparison

Meaning Cost centre is a Profit centre is a department

department of a of an entity, which
company to which direct recognizes profit.
and indirect costs are
charged.

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 Objective Its objective is to Control Its objective is to ascertain
and Reduce cost the exact profit and
maximizing it.

Evaluation of It is evaluated by It is evaluated by deducting

Performance deducting Actual Cost Actual Cost from Budgeted
from Standard Cost Cost

Area of Its area of Operation is Its area of Operation is

Operation Narrow Wide

Autonomy It is not autonomous It is autonomous

Target A cost centre does not Profit centre has a profit

have target cost but target and enjoys authority
efforts are made to to adopt such policies as
minimize costs are necessary to achieve its
targets

12.8 COST CLASSIFICATION

Cost analysis and cost classification involve grouping of costs into various
logical groups on some suitable basis. Cost analysis and classification are
essential for the purpose of cost control and managerial decision making.
There are various methods of classification of costs. The method selected
is based on the purpose for which it is needed. The important bases of
classification are:
1. By nature or element

2. By function

3. By Degree of Traceability

4. By Changes in activity

5. By association with the product

6. By controllability

7. By normality

8. By Relationship with accounting

9. By Time
1. By Nature or Elements: According to this classification the costs are
classified into three categories i.e., Materials, Labour and Expenses.
Materials can further be sub-classified as raw materials components,

230
spare parts, consumable stores, packing materials etc. This helps in
finding the total cost of production and the percentage of materials (labour
or other expenses) constituted in the total cost. It also helps in valuation
of work-in-progress.
2. By Functions: This classification is on the basis of costs incurred in
various functions of an organization ie. Production, administration, selling
and distribution. According to this classification, costs are divided into
Manufacturing and Production Costs and Commercial costs.
Manufacturing and Production Costs are costs involved in manufacture,
construction and fabrication of products. Commercial Costs are (a)
administration costs (b) selling and distribution costs.
3. By Degree of Traceability to the Product: According to this, costs are
divided indirect costs and indirect costs. Direct Costs are those costs
which are incurred for a particular product and can be identified with a
particular cost centre or cost unit. Eg:- Materials, Labour. Indirect Costs
are those costs which are incurred for the benefit of a number of cost
centre or cost units and cannot be conveniently identified with a particular
cost centre or cost unit. Eg:- Rent of Building, electricity charges, salary
of staff etc.
4. By Changes in Activity or Volume: According to this costs are
classified according to their behavior in relation to changes in the level of
activity or volume of production. They are fixed, variable and semi -
variable. Fixed Costs are those costs which remain fixed in total amount
with increase or decrease in the volume of the output or productive activity
for a given period of time. Fixed Costs per unit decreases as production
increases and vice versa. Eg:- rent, insurance of factory building, factory
manager’s salary etc. Variable Costs are those costs which vary in direct
proportion to the volume of output. These costs fluctuate in total but
remain constant per unit as production activity changes. Eg:- direct
material costs, direct labour costs, power, repairs etc. Semi -variable
Costs are those which are partly fixed and partly variable. For example;
Depreciation, for two shifts working the total depreciation may be only
50% more than that for single shift working. They may change with
comparatively smal changes in output but not in the same proportion.
5. Association with the Product: Cost can be classified as product costs
and period costs. Product costs are those which are traceable to the
product and included in inventory cost, thus product cost is full factory
cost. Period costs are incurred on the basis of time such as rent, salaries
etc. thus it includes all selling and administration costs. These costs are
incurred for a period and are treated as expenses.

231
6. By Controllability: The CIMA defines controllable cost as “a cost which
can be influenced by the action of a specified member of an undertaking”
and a non-controllable cost as “a cost which cannot be influenced by the
action of a specified member of an undertaking”.
7. By Normality: There are normal costs and abnormal costs. Normal
costs are the costs which are normally incurred at a given level of output
under normal conditions. Abnormal costs are costs incurred under
abnormal conditions which are not normally incurred in the normal course
of production:- damaged goods due to machine break down, extra
expenses due to disruption of electricity, inefficiency of workers etc.
8. By Relationship with Accounting Period: There are capital and
revenue expenses depending on the length of the period for which it is
incurred. The cost which is incurred in purchasing an asset either to earn
income or increasing the earning capacity of the business is called capital
cost, for example, the cost of a machine in a factory. Such cost is incurred
at one point of time but the benefits accruing from it are spread over a
number of accounting years. The cost which is incurred for maintaining an
asset or running a business is revenue expenditure. Eg:- cost of materials,
salary and wages paid, depreciation, repairs and maintenance, selling
and distribution.

9. By Time: Costs can be classified as

1) Historical cost and

2) Predetermined Costs
The costs which are ascertained and recorded after it has been incurred
is called historical costs. They are based on recorded facts hence they
can be verified and are always supported by evidences. Predetermined
costs are also known as estimated costs as they are computed in advance
of production taking into consideration the previous periods’ costs and the
factors affecting such costs. Predetermined costs when calculated
scientifically become standard costs. Standard costs are used to prepare
budgets and then the actual cost incurred is later-on compared with such
predetermined cost and the variance is studied for future correction.

12.9 COST SHEET

Cost sheet is a statement, which shows various components of total cost
of a product. It classifies and analyses the components of cost of a
product. Previous period data is given in the cost sheet for comparative
study. It is a statement which shows per unit cost in addition to Total Cost.
Selling price is ascertained with the help of cost sheet. The detail of total

232
cost presented in the form of a statement is termed as Cost sheet. Cost
sheet is prepared on the basis of:
1. Historical Cost: Historical Cost Historical Cost sheet is prepared on
the basis of actual cost incurred. A statement of cost prepared after
incurring the actual cost is called Historical Cost Sheet.
2. Estimated Cost: Estimated Cost Estimated cost sheet is prepared on
the basis of estimated cost. The statement prepared before the
commencement of production is called estimated cost sheet. Such cost
sheet is useful in quoting the tender price of a job or a contract.

12.9.1Importance of Cost Sheet

1. Cost Ascertainment: main objective of the cost sheet is to ascertain
the cost of a product. Cost sheet helps in ascertainment of cost for the
purpose of determining cost after they are incurred. It also helps to
ascertain the actual cost or estimated cost of a Job.
2. Fixation of Selling Price: To fix the selling price of a product or
service, it is essential to prepare the cost sheet. It helps in fixing selling
price of a product or service by providing detailed information of the cost.
3. Help in cost Control: For controlling the cost of a product it is
necessary for every manufacturing unit to prepare a cost sheet. Estimated
cost sheet helps in the control of material cost, labour cost and overheads
cost at every point of production.
4. Facilitates Managerial Decisions: It helps in taking important
decisions by the management such as: whether to produce or buy a
component, what prices of goods are to be quoted in the tender, whether
to retain or replace an existing machine etc.
A statement of cost giving total cost, cost per unit along with different cost
components of is termed as a cost sheet. The computation of different
cost components and preparation is a cost sheet can be understood with
the following illustration:
Illustration 1
Calculate the Prime cost, Factory cost, Total cost of production and Cost
of sales from the following particulars:

Rs. Rs.
Raw Materials consumed 20,000
Wages paid to labourers 5,000
Directly chargeable expenses 1000

233
 Oil & Waste 100
Wages of Foremen 1,000
Storekeepers' Wages 500
Electric Power 200
Lighting : Factory 500
Office 200 700
Rent :
Factory 2,000
Office 1000 3000
Repairs & Renewals :
Factory Plant 500
Machinery 1000
Office Premises 200 1700
Depreciation :
Office Premises 500
Plant & Machinery 200 700
Consumable Stores 1,000
Manager's Salary 2,000
Directors' Fees 500
Office Printing & Stationery 200
Telephone Charges 50
Postage & Telegrams 100
Salesmen's Commission & Salary 500
Travelling Expenses 200
Advertising 500
Warehouse Charges 200
Carriage Outward 150
Solution

Particulars Rs. Rs.

Direct material : Raw material consumed 20000
Direct labour : Wages paid to labourers 5000
Direct expenses : Directly chargeable expenses 1000
PRIME COST 26000
Add : Factory Overheads :
Indirect material : Consumable stores 1000
Oil and waste 100 1100

234
 Indirect labour : Wages of foreman 1000
Storekeepers' wages 500 1500
Indirect expenses : Electric power 200
Factory lighting 500
Factory rent 2000
Repairs & Renewals
Plant 500
Machinery 1000
Depreciation :
Plant & machinery 200 4400 7000
FACTORY OR WORKS COST 33000
Add : Office and administrative overheads : 200
Indirect material : Office printing and Stationary
Indirect labour : Manager's salary 2000
Directors' fees 500 2500
Indirect expenses : Office lighting 200
Office rent 1000
Repairs and renewals
office premises 200
Dep. on office premises 500
Telephone charges 50
Postage & telegrams 100 2050 4750
TOTAL COST OF PRODUCTION 37750
Add: Selling & Distribution overheads :
Indirect labour : Salesmen's commission and salary 500
Indirect expenses : Travelling expenses 200
Advertising 500
Warehouse charges 200
Carriage outward 150 1050 1550
COST OF SALES 39300

Illustration 2:

Calculate prime cost from the following particulars for a production unit:

Rs.
Cost of material purchased 30,000
Opening stock of material 6,000
Closing stock of material 4,000
Wages paid 3,000

235
 Rent of hire of a special machine for
production 5,000
Solution

Amount
Particulars (Rs.)
Direct Material:
Material Consumed
Opening stock of material 6,000
Add : Material Purchased 30,000
Material available for consumption 36,000
Less: Closing stock of Material 4,000
Materials Consumed 32,000
Direct Labour : Wages 3,000
Direct Expenses: Rent of hire a special machine 5,000
PRIME COST 40,000

LET US SUM UP
In case of non-Integral system, separate books of accounts are
maintained for costing and financial transaction. Normally under this
system profit shown by the two sets of the books will be different.
However, it is possible per chance, that the overall profit shown by the two
sets of the books is the same. Nonetheless in such a case also the items
and/or amounts incorporated will be different. Hence, the results shown
by two sets of books are always required to be reconciled to identify the
causes of difference and to establish the accuracy of both sets of books.
A reconciliation statement is prepared simply to identify such causes. In
case such reconciliation brings out certain errors or discrepancies, they
have to be separately rectified. However, it is necessary that the
classification of income and expenses both for financial and cost accounts
is on the same basis so that it is possible to compile them on the same
lines in both cases.
CHECK YOUR PROGRESS
Choose the Correct Answer:
1) ________ provides information for income determination.
a) financial accounting b) cost accounting
c) management accounting d) none of these

236
2)________ helps in ascertaining costs beforehand.
a) financial accounting b) cost accounting
c) management accounting d) none of these
3) Cost accounting disclose ________
a) The Financial position
b) profit/loss of a product, job or service
c) effect and impact of cost on business
d) none of these
4)________is a post mortem of past costs.
a) financial accounting b) cost accounting
c) both a & b d) none of these
5)________ aids in price fixation.
a) financial accounting b) cost accounting
c) management accounting d) none of these
GLOSSARY

Cost accounting : An area of accounting that involves

measuring, recording, and reporting
product costs.

Cost accounting : Manufacturing cost accounts that are

system fully integrated into the general ledger of
a company.

Cost behaviour : The study of how specific costs respond

analysis to changes in the level of business
activity.

Fixed costs : Costs that remain the same in total

regardless of changes in the activity
level.

Variable costs Costs : That vary in total directly and

proportionately with changes in the
activity level.

SUGGESTED READINGS
1. Gupta, R.L. and Radhaswamy, M., (2006), Financial Accounting,
Sultan and Chand Sons, New Delhi.
2. Maheswari, S.N and Maheshwary, S.K. (2006), Fundamental of
Accounting, Vikas Publications.

237
 3. Shashi K. Gupta, R.K.Sharma , (2012), “Financial Management”
latest Edition, Kalyani Publishers, Chennai
4. M C Shukla, S C Gupta & T S Grewal, (2017), Advance
Accounting, 19th Edition, S.Chand Publishing, New Delhi
5. Tulsian P. C. , (2017), Financial Accounting , Pearson Education,
New Delhi.
6. https://www.investopedia.com/terms/c/cost-accounting.asp
7. https://keydifferences.com/difference-between-cost-centre-and-
cost-unit.html
ANSWER TO CHECK YOUR PROGRESS
1) a 2) b 3) b 4) a 5) b

238
Unit 13

METHODS OF COSTING
STRUCTURE

Overview

Learning Objectives

13.1 Methods of Costing

13.1.1 Job Costing

13.1.2 Batch Costing

13.1.3 Contract Costing

13.1.4 Process Costing

3.2 Techniques of Costing

13.3 Practical Difficulties in Installing Costing System

Let Us Sum Up

Check your Progress

Glossary

Suggested Readings
Answers To Check Your Progress

OVERVIEW
Manufacturing costing methods are accounting techniques that are used
to help understand the value of inputs and outputs in a production
process. By tracking and categorizing this information according to a
rigorous accounting system, corporate management can determine with
a high degree of accuracy the cost per unit of production and other key
performance indicators. Management needs this information in order to
make informed decisions about production levels, pricing, competitive
strategy, future investment, and a host of other concerns. Such
information is primarily necessary for internal use, or managerial
accounting. The main costing methods available are process costing, job
costing and direct costing. Each of these methods apply to different
production and decision environments. The main product costing methods
are: job costing and Process costing.

239
LEARNING OBJECTIVES

After reading this lesson, you should be able to:

• explain the objectives, advantages and limitations of job costing
• discuss the procedure adopted for costing purposes in a firm using
job costing
• explain the features, advantages and limitations of process costing
• describe the costing procedure of process costing
• discuss the accounting for joint products and by products

13.1 INTRODUCTION
The basic principles of ascertaining costs are the same in every system
of cost accounting. However, the methods of analysing and presenting the
cost may vary from industry to industry. The method to be used in
collecting and presenting costs will depend upon the nature of production.
Basically, there are two methods of costing, namely. Job costing and
Process costing.

13.1.1 Methods of Costing

1.Job Costing: Job costing is used where production is not repetitive and
is done against orders. The work is usually carried out within the factory.
Each job is treated as a distinct unit, and related costs are recorded
separately. This type of costing is suitable to printers, machine tool
manufacturers, job foundries, furniture manufactures etc. The following
methods are commonly associated with job costing :
2.Batch Costing: Where the cost of a group of product is ascertained, it
is called 'batch costing'. In this case a batch of similar products is treated
as a job. Costs are collected according to batch order number and the
total cost is divided by the numbers in a batch to find the unit cost of each
product. Batch costing is generally followed in general engineering
factories which produce components in convenient batches, biscuit
factories, bakeries and pharmaceutical industries.
3.Contract Costing: A contract is a big job and, hence, takes a longer
time to complete. For each individual contract, account is kept to record
related expenses in a separate manner. It is usually followed by concerns
involved in construction work e.g. building roads, bridge and buildings etc.
4.Process Costing: Where an article has to undergo distinct processes
before completion, it is often desirable to find out the cost of that article at
each process. A separate account for each process is opened and all
expenses are charged thereon. The cost of the product at each stage is,
thus, accounted for.

240
The output of one process becomes the input to the next process. Hence,
the process cost per unit in different processes is added to find out the
total cost per unit at the end. Process costing is often found in such
industries as chemicals, oil, textiles, plastics, paints, rubber, food
processors, flour, glass, cement, mining and meat packing. The following
methods are used in process costing:
i) Output/Unit Costing: This method is followed by concerns producing
a single article or a few articles which are identical and capable of being
expressed in simple, quantitative units. This is used in industries like
mines, quarries, oil drilling, cement works, breweries, brick works etc. for
example, a tonne of coal in collieries, one thousand bricks in brick works
etc. The object here is to find out the cost per unit of output and the cost
of each item of such cost. A cost sheet is prepared for a definite period.
The cost per unit is calculated by dividing the total expenditure incurred
during a given period by the number of units produced during the same
period.
ii) Operational Costing: This method is applicable where services are
rendered rather than goods produced. The procedure is same as in the
case of unit costing. The total expenses of the operation are divided by
the units and cost per unit of service is arrived at. This is followed in
transport undertakings, municipalities, hospitals, hotels etc.
iii) Multiple Costing: Some products are so complex that no single
system of costing is applicable. Where a concern manufactures a number
of components to be assembled into a complete article, no one method
would be suitable, as each component differs from the other in respect of
materials and the manufacturing process. In such cases, it is necessary
to find out the cost of each component and also the final product by
combining the various methods discussed above. This type of costing is
followed to cost such products as radios, aeroplanes, cycles, watches,
machine tools, refrigerators, electric motors etc.
iv) Operating Costing: In this method each operation at each stage of
production or process is separately identified and costed. The procedure
is somewhat similar to the one followed in process costing. Process
costing involves the costing of large areas of activity whereas operation
costing is confined to every minute operation of each process. This
method is followed in industries with a continuous flow of work, producing
articles of a standard nature, and which pass through several distinct
operations in a sequence to completion. Since this method provides for a
minute analysis of cost, it ensures greater accuracy and better control of
costs. The costs of each operation per unit and cost per unit up to each

241
stage of operation can be calculated quite easily. This method is in force
in industries where toys, leather and engineering goods are
manufactured.
v) Departmental Costing: When costs are ascertained department by
department, such a method is called 'departmental costing'. Where the
factory is divided into a number of departments, this method is followed.
The total cost of each department is ascertained and divided by the total
units produced in that department in order to obtain the cost per unit. This
method is followed by departmental stores, publishing houses etc.

13.2 TECHNIQUES OF COSTING

In addition to the different costing methods, various techniques are also
used to find the costs. These techniques may be grouped under the
following heads:
1.Historical Absorption Costing: It is the ascertainment of costs after
they have been incurred. It is defined as the practice of charging all costs,
both variable and fixed, to operations, process or products. It is also
known as traditional costing. Since costs are ascertained after they have
been incurred, it does not help in exercising control over costs. However,
It is useful in submitting tenders, preparing job estimates etc.
2. Marginal Costing: It refers to the ascertainment of costs by
differentiating between fixed costs and variable costs. In this technique
fixed costs are not treated as product costs. They are recovered from the
contribution (the difference between sales and variable cost of sales). The
marginal or variable cost of sales includes direct material, direct wages,
direct expenses and variable overhead. This technique helps
management in taking important policy decisions such as product pricing
in times of competition, whether to make or not, selection of product mix
etc.
3. Differential Costing: Differential cost is the difference in total cost
between alternatives evaluated to assist decision making. This technique
draws the curtain between variable costs and fixed costs. It takes into
consideration fixed costs also (unlike marginal costing) for decision
making under certain circumstances. This technique considers all the
revenue and cost differences amongst the alternative courses of action to
assist management in arriving at an appropriate decision.
4. Standard Costing: It refers to the ascertainment and use of standard
costs and the measurement and analysis of variances. Standard cost is a
predetermined cost which is computed in advance of production on the
basis of a specification of all factors affecting costs. The standards are

242
fixed for each element of cost. To find out variances, the standard costs
are compared with actual costs. The variances are investigated later on
and wherever necessary, rectification steps are initiated promptly. The
technique helps in measuring the efficiency of operations from time to
time.

13.3 PRACTICAL DIFFICULTIES IN INSTALLING COSTING SYSTEM

Apart from technical costing problems, a cost accountant is confronted
with certain practical difficulties in installing a costing system.

These are:
1. Lack of Support of Management: In order to make the costing system
a success, it must have the whole-hearted support of every member of
the management. Many a time, the costing system is introduced at the
behest of the Managing Director or the Financial Director without the
support of functional managers. They view the system as an interference
in their work and do not make use of the system. Before the system is
installed, the cost accountant should ensure that the management is fully
committed to the costing system. A sense of cost consciousness should
be created in their minds by explaining them that the system is for their
benefit. A cost manual should be prepared and distributed to them giving
the details and functions of the system.
2. Resistance from the Accounting Staff: The existing accounting staff
may not welcome the new system. This may be because they look with
suspicion at a system which is not known to them. The co-operation of the
employees should be sought by convincing them that the system is
needed to supplement the financial accounting system and that it is for
the betterment of all.
3. Non-cooperation of Working and Supervisory Staff: Correct activity
data which is supplied by supervisory staff and workers is necessary for
a costing system. They may not co-operate and resist the additional paper
work arising as a result of the introduction of the system. Such resistance
generally arises out of ignorance. Proper education should be given to the
staff regarding benefits of the system and the important roles they have
to play to make it successful.
4. Shortage of Trained Staff: In the initial stages, there may be shortage
of trained costing staff. The staff should be properly trained so that costing
department can run efficiently.

243
LET US SUM UP
In cost accounting, the cost books are basically maintained under the two
systems namely (a) Non-Integral or Non-Integrated Cost Accounting and
(b) Integrated Cost Accounting. The system is called non-integral when
cost and financial transactions are kept separately. On the contrary, when
cost and financial transactions are integrated, the accounting system is
known as integrated. Under the system of non-integral accounting
separate ledgers are maintained for cost and financial transaction. The
financial accountants look after financial transactions and the cost
accountants are responsible for cost accounting transactions. The cost
accounting department maintains the stores ledger, work -in-progress
ledger, finished goods/stock ledger and cost ledger. Cost Ledger is main
ledger and records impersonal accounts i.e., accounts relating to income
and expenditure.

CHECK YOUR PROGRESS

Choose the Correct Answer:

1) _________ is a statement showing cost of production of a particular
product.
a) Tender b) Quotation
c) Cost sheet d) Work sheet
2) Consumables are treated as _________ overheads in cost sheet.

a) Factory b) Office
c) Selling and Distribution d) Pay roll
3) In cost sheet the expenses on discount allowed are considered under
________ overheads.
a) Factory b) Office
c) Selling and Distribution d) Pay roll
4) _______ cost is predetermined cost for each element of cost.

a) Marginal b) Historical

c) Standard d) Total

5) Non-cost items are those which are _______ from the cost.

a) Excluded b) Included

c) Partly included d) All the above

GLOSSARY

Job Cost Sheet : A form used to record the costs

chargeable to a specific job and

244
 to determine the total and unit
costs of the completed job.

Job Order Cost System : A cost accounting system in

which costs are assigned to each
job or batch.

Process Cost System : A system of accounting used

when a large quantity of similar
products are manufactured.

Absorption Costing : A costing approach in which all

manufacturing costs are charged
to the product.

SUGGESTED READINGS
1. Gupta, R.L. and Radhaswamy, M., (2006), Financial Accounting,
Sultan and Chand Sons, New Delhi.
2. Maheswari, S.N and Maheshwary, S.K. (2006), Fundamental of
Accounting, Vikas Publications.
3. Shashi K. Gupta, R.K.Sharma , (2012), “Financial Management”
latest Edition, Kalyani Publishers, Chennai
4. M C Shukla, S C Gupta & T S Grewal, (2017), Advance
Accounting, 19th Edition, S.Chand Publishing, New Delhi
5. Tulsian P. C. , (2017), Financial Accounting , Pearson Education,
New Delhi.
6. https://www.toppr.com/guides/fundamentals-of-
accounting/fundamentals-of-cost-accounting/methods-of-costing/
7. https://www.google.com/search?q=overheads+in+cost+accountin
g&source=lnms&tbm=vid&sa=X&ved=2ahUKEwjsvobfwLf7AhV7
yHMBHSSiCLYQ_AUoAnoECAIQBA&biw=1366&bih=625&dpr=1
#fpstate=ive&vld=cid:addb1ccd,vid:VRdHXLPGfPM

ANSWER TO CHECK YOUR PROGRESS

1) c 2) a 3) c 4) c 5) a

245
Unit 14

MATERIAL COSTING
STRUCTURE

Overview

Learning Objectives

14.1 Introduction

14.2 Material Cost

14.2.1 What is Material Cost?

14.2.2 Accounting Procedures for Ordering and Issuing
Inventory

14.2.3 Ordering, Purchasing and Receiving Inventory

14.2.4 Issuing Inventory

14.2.5 Accounting for Material Inventory Accounting

14.2.6 Physical Inventory and Book Inventory

14.2.7 Stocktaking

14.2.8 Inventory Losses and Wastes

14.3 Economic Order Quantity

14.3.1 Carrying Cost

14.3.2 Ordering Cost

14.4 Overheads

14.4.1 What are Overheads?

14.4.2 Types of Overheads

14.5 Allocation and Apportionment of Overhead to Cost Centres

14.5.1 Types of Departments

14.5.2 Allocation of Overhead Expenses

14.5.3 Apportionment of Overhead Expenses

14.5.4 Bases of Apportionment

14.4.5 Principles of Apportionment of Overhead Costs

14.6 Overhead Absorption

14.6.1 Methods of Overhead Absorption

246
Let Us Sum Up

Check your Progress

Glossary

Suggested Readings

Answers to Check Your Progress

OVERVIEW
Manufacturing costing methods are accounting techniques that are used
to help understand the value of inputs and outputs in a production
process. By tracking and categorizing this information according to a
rigorous accounting system, corporate management can determine with
a high degree of accuracy the cost per unit of production and other key
performance indicators. Management needs this information in order to
make informed decisions about production levels, pricing, competitive
strategy, future investment, and a host of other concerns. Such
information is primarily necessary for internal use, or managerial
accounting. The main costing methods available are process costing, job
costing and direct costing. Each of these methods apply to different
production and decision environments. The main product costing methods
are: job costing and Process costing.

LEARNING OBJECTIVES

After reading this unit, you should be able to:

• explain the objectives, advantages and limitations of job costing
• discuss the procedure adopted for costing purposes in a firm
using job costing
• explain the features, advantages and limitations of process
costing
• describe the costing procedure of process costing
• discuss the accounting for joint products and by products

14.1 INTRODUCTION
The basic principles of ascertaining costs are the same in every system
of cost accounting. However, the methods of analysing and presenting the
cost may vary from industry to industry. The method to be used in
collecting and presenting costs will depend upon the nature of production.
Basically, there are two methods of costing, namely. Job costing and
Process costing.

247
14.2 MATERIAL COST

14.2.1 What is Material Cost?

Material cost is the cost of materials used to manufacture a product or
provide a service. Excluded from the material cost is all indirect materials,
such as cleaning supplies used in the production process. Follow these
steps to determine the amount of material cost to assign to a unit of
production (such as a completed finished goods item):
• Ascertain the standard quantity of the material used to
manufacture one unit.
• Add the standard amount of scrap associated with manufacturing
one unit.
• Determine the standard amount of scrap associated with setting
up the production run, and apportion it to the individual unit.
• If any scrap is then sold, apportion the revenue back to the
individual unit.
For many materials, the cost of scrap and the revenue from the resale of
scrap are so small that it is not worthwhile to apportion it to the material
cost.

14.2.2 Accounting Procedures for Ordering and Issuing Inventory

Accounting and control procedures for ordering and issuing inventory
include the following functions:
(i) Ordering
(ii) Purchasing
(iii) Receiving
(iv) Issuing
(v) Storing
(vi) Stocktaking

14.2.3 Ordering, Purchasing and Receiving Inventory

The procedures for ordering, purchasing and receiving materials are as
follow
When a department requires new materials, a purchase requisition is
completed (including authorisation by the relevant manager) and sent to
the purchasing department.
1. On receipt of a properly authorised requisition, the purchasing
department will select a supplier and create an order on a purchase
order form.

248
2. The purchase order form is sent to the supplier and copies are also
sent to the accounts department and the goods receiving department.
3. On receipt of the goods, the goods receiving department will check
the goods against the relevant purchase order, and check the delivery
note which accompanies the goods. Full details of the goods are then
entered onto a goods received note (GRN).
4. A copy of the GRN is attached to the relevant purchase order and they
are both sent to the purchasing department where they are matched
to the relevant supplier's purchase invoice. Once approved, the
purchase invoice can be paid.

14.2.4 Issuing Inventory

The accounting procedures for issuing inventory are as follows.

• Materials requisition notes are issued to production departments.
Their purpose is to authorise the storekeeper to release the goods
which have been requisitioned and to update the stores records.
• Materials returned notes are used to record any unused materials
which are returned to stores. They are also used to update the stores
records.
• Materials transfer notes document the transfer of materials from one
production department to another. They are also used to update the
stores records.
Some specimen documents that are used in the ordering, receiving and
issuing of inventory.

249
250
14.2.5 Accounting for Material Inventory Accounting

Debit Entries
• It reflects an increase in inventory
• It reflects return to stores

Credit Entries
• It reflects issue to production
• It reflects return to suppliers

14.2.6 Physical Inventory and Book Inventory

Perpetual Inventory
Perpetual inventory is the recording as they occur of receipts, issues and
the resulting balances of individual items of inventory in either quantity or
quantity and value.
• Inventory records are updated using stores ledger cards and bin
cards.
• Bin cards also show a record of receipts, issues and balances of
the quantity of an item of inventory handled by stores.
• As with the store’s ledger card, bin cards will show materials
received (from purchases and returns) and issued (from
requisitions).

A typical stores ledger card is shown below.

14.2.7 Stocktaking
The process of stocktaking involves checking the physical quantity of
inventory held on a certain date and then checking this balance against
the balances on the stores ledger (record) cards or bin cards. Stocktaking
can be carried out on a periodic basis or a continuous basis.

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 • Periodic stocktaking involves checking the balance of every item
of inventory on the same date, usually at the end of an accounting
period.
• Continuous stocktaking involves counting and valuing selected
items of inventory on a rotating basis. Specialist teams count and
check certain items of inventory on each day. Each item is
checked at least once a year with valuable items being checked
more frequently.
• Any differences (or discrepancies) which arise between 'book'
inventory and physical inventory must be investigated.
• In theory any differences, as recorded in the stores ledger or the
bin card, must have arisen through faulty recording.
• Once the discrepancy has been identified, the stores ledger card
is adjusted in order that it reflects the true physical inventory count.
• Any items which are identified as being slow-
moving or obsolete should be brought to the attention of
management as soon as possible.
• Management will then decide whether these items should be
disposed of and written off to the income statement.
• Slow-moving items are those inventory items which take a long
time to be used up.
• Obsolete items are those items of inventory which have become
out of date and are no longer required.
14.2.8 Inventory Losses and Wastes
• Inventory losses may be quantified by comparing the physical
quantity of an item held with the balance quantity recorded on the
bin card and/or stores ledger card.
• There are two categories of loss: those which occur because of
theft, pilferage, damage or similar means and those which occur
because of the breaking of bulk receipts into smaller quantities.
• It is the second of these which are more commonly referred to as
waste.
• Inventory losses must be written off against profits as soon as they
occur. If the value to be written off is significant then an
investigation should be made of the cause.

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 • When waste occurs as a result of breaking up bulk receipts, it is
reasonable to expect that the extent of such wastage could be
estimated in advance based upon past records. Either of two
accounting treatments could then be used:
• Issues continue to be made and priced without any
adjustment and the difference at the end of the period is
written off.
• Alternatively, the issue price is increased to compensate
for the expected waste.

14.3 ECONOMIC ORDER QUANTITY

The quantity of material to be ordered at one time is known as economic
ordering quantity. This quantity is fixed in such a manner as to minimize
the cost of ordering and carrying the stock.

The total costs of a material usually consist of:

Total Acquisition Cost + Total Ordering Cost + Total Carrying Cost

Since the acquisition cost per unit of material is same whatever is the
quantity purchased, it is usually excluded when deciding the quantity of a
material to be ordered at one time. The only costs to be taken care of are
the ordering costs and carrying costs which vary with the quantity ordered.

14.3.1 Carrying Cost

It is the cost of holding the materials in the store and includes:

1. Cost of storage space which could have been utilized for some other
purpose.
2. Cost of bins and racks
3. Cost of maintaining the materials to avoid deterioration.
4. Amount of interest payable on the amount of money locked up in the
materials.
5. Cost of spoilage in stores and handling.
6. Transportation cost in relation to stock.
7. Cost of obsolescence of materials due to change in the process or
product.
8. Insurance cost
9. Clerical cost etc.

In India all these costs amount to 20 to 25 % of the cost of materials per

year. Hence it becomes necessary to reduce such carrying cost for
efficient operations.

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14.3.2 Ordering Cost

It is the cost of placing orders for the purchase of materials and includes:
1. Cost of staff posted in the purchasing department, inspection section
and stores accounts department.

2. Cost of stationary postage and telephone charges.

Thus, this type of costs includes cost of floating tenders, cost of
comparative evaluation of quotations, cost of paper work, and postage
involved in placing the order, cost of inspection and cost of accounting
and making payments. In other words, the cost varies with the number of
orders.
When the quantity of materials ordered is less, the cost of carrying will
decrease but ordering cost will increase and vice versa.
√2𝐶𝑂
𝐸𝑂𝑄 =
𝐼
Q = Quantity to be ordered

C = Consumption of the material concerned in units during a year.

O = Cost of placing one order including the cost of receiving the goods i.e.
the cost of getting an item into the firms inventory
I = Interest payment including variable cost of storing per unit per year i.e
holding costs of inventory.

Illustration 1
Find out the economic ordering quantity (EOQ) from the following
particulars.

Annual usage: 6000 units

Cost of material per unit: Rs. 20

Cost of Placing and receiving one order: Rs.60

Annual carrying cost of one unit: 10% of inventory value.

Solution
√2𝐶𝑂
𝐸𝑂𝑄 =
𝐼
Where C = Annual usage of material i.e 6,000 units

O = Cost of placing one order ie Rs.60

I = Annual carrying cost of one unit i.e Rs.2 (20X10/100)

EOQ = √2x6000x60/2

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 = √360000

=600 units

14.4 OVERHEADS

14.4.1 What are Overheads?

Overheads are business costs that are related to the day-to-day running
of the business. Unlike operating expenses, overheads cannot be traced
to a specific cost unit or business activity. Instead, they support the overall
revenue-generating activities of the business.

14.4.2 Types of Overheads

There are three main types of overhead that businesses incur. The
overhead expenses vary depending on the nature of the business and the
industry it operates in.
1. Fixed Overheads: Fixed overheads are costs that remain constant
every month and do not change with changes in business activity levels.
Examples of fixed overheads include salaries, rent, property taxes,
depreciation of assets, and government licenses.
2. Variable Overheads: Variable overheads are expenses that vary with
business activity levels, and they can increase or decrease with different
levels of business activity. During high levels of business activity, the
expenses will increase, but with reduced business activities, the
overheads will substantially decline or even be eliminated.
Examples of variable overheads include shipping costs, office supplies,
advertising and marketing costs, consultancy service charges, legal
expenses, as well as maintenance and repair of equipment.
3. Semi-Variable Overheads: Semi-variable overheads possess some
of the characteristics of both fixed and variable costs. A business may
incur such costs at any time, even though the exact cost will fluctuate
depending on the business activity level. A semi-variable overhead may
come with a base rate that the company must pay at any activity level,
plus a variable cost that is determined by the level of usage.
Examples of semi-variable overheads include sales commissions, vehicle
usage, and some utilities such as power and water costs that have a fixed
charge plus an additional cost based on the usage.

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14.5 ALLOCATION AND APPORTIONMENT OF OVERHEAD TO

COST CENTRES
Let us make in-depth study of types of departments, allocation and
apportionment of overhead to cost centres, its bases, principles and
advantages of departmentalisation.
When all the items are collected properly under suitable account
headings, the next step is allocation and apportionment of such expenses
to cost centres. This is also known as departmentalisation of overhead.
Departmentalisation of production overheads is the process of identifying
production overhead expenses with different production/service
departments or cost centres. It is done by means of allocation and
apportionment of overheads among various departments.
Thus, it involves:
(i) Allocation and apportionment of overheads among production and
service departments and
(ii) Reapportionment of service departments overheads among production
departments.
A factory is administratively divided into sub-divisions known as
departments for running it smoothly and efficiently. This sub-division is
done in such a manner that each department represents a division of
activity of the concern such as repairs department, power department,
tools department, stores department, cash department, cost department
etc.

14.5.1 Types of Departments

In a manufacturing concern, there are three types of departments:

(а) Manufacturing or Producing Departments: A department where
actual process of manufacturing is carried on is called manufacturing or
producing department. It covers direct manufacture and is engaged in
converting raw materials into finished goods by performing some manual
and/or machine operations on any part of the product.
The number of such departments and their number will depend upon the
nature of industry, type of work performed and the size of the factory. For
example, in Steel Rolling Mill, Hot Mill, Cold Mill, Pickling Shop, Annealing
Shop, Hardening, Polishing and Grinding are the producing departments.
(b) Service Departments: Service department is an auxiliary and is not
directly engaged in production though its existence is very essential for
smooth and efficient running of production departments. Such

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departments are not directly engaged in the conversion of raw materials
into finished goods. Such departments (as electricity or repairs and
maintenance) render a particular type of service for the benefit of other
departments.
The number of departments in a factory and the names to be assigned to
them depends upon size of the factory, nature of industry and the nature
of service rendered. The service departments, common to most concerns
are stores, cost office, personnel department, planning and progress
department, tool room, hospital and dispensary, machine maintenance
and electrical maintenance section etc.
(c) Partly Producing Departments: A department may normally be a
service department but sometimes does some productive work, so it
becomes partly producing department. For example, a carpentry shop
which is mainly responsible for the repairs and upkeep of sundry fixtures
and fittings may occasionally be required to manufacture packing boxes
for direct charge to outturn, will be a partly producing department.

14.5.2 Allocation of Overhead Expenses

Allocation is the process of identification of overheads with cost centres.
An expense which is directly identifiable with a specific cost centre is
allocated to that centre. So it is the allotment of whole item of cost to a
cost centre or cost unit or refers to the charging of expenses which can
be identified wholly with a particular department. For example, the whole
of overtime wages paid to the workers relating to a particular department
should be charged to that department.
Similarly, the cost of repairs and maintenance of a particular machine
should be charged to that particular department wherein the machine is
located. Power, if separate meters are provided at each cost centre and
fuel oil for boilers are other examples of allocation. So, the term allocation
means the allotment of the whole item without division to a particular
department or cost centre.

14.5.3 Apportionment of Overhead Expenses

Cost apportionment is the allotment of proportions of items to cost centres
or cost units on an equitable basis. The term refers to the allotment of
expenses which cannot identify wholly with a particular department. Such
expenses require division and apportionment over two or more cost
centres or units.
So, cost apportionment will arise in case of expenses common to more
than one cost centre or unit. It is defined as the allotment to two or more

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cost centres of proportions of the common items of cost on the estimated
basis of benefit received. Common items of overheads are rent and rates,
depreciation, repairs and maintenance, lighting, works manager’s salary
etc.

14.5.4 Bases of Apportionment

Suitable bases have to be found out for apportioning the items of
overhead cost to production and service departments and then for
reapportionment of service departments costs to other service and
production departments. The basis adopted should be such by which the
expenses being apportioned must be measurable by the basics adopted
and there must be proper correlation between the expenses and the basis.
Therefore, the common expenses have to be apportioned or distributed
over the departments on some equitable basis. The process of distribution
is usually known as ‘Primary Distribution’.
Following are the main bases of overhead apportionment utilised in
manufacturing concerns:
(i) Direct Allocation: Overheads are directly allocated to various
departments on the basis of expenses for each department respectively.
Examples are: overtime premium of workers engaged in a particular
department, power (when separate meters are available), jobbing repairs
etc.
(ii) Direct Labour/Machine Hours: Under this basis, the overhead
expenses are distributed to various departments in the ratio of total
number of labour or machine hours worked in each department. Majority
of general overhead items are apportioned on this basis.
(iii) Value of Materials Passing through Cost Centres: This basis is
adopted for expenses associated with material such as material handling
expenses.
(iv) Direct Wages: According to this basis, expenses are distributed
amongst the departments in the ratio of direct wages bills of the various
departments. This method is used only for those items of expenses which
are booked with the amounts of wages, e.g., workers’ insurance, their
contribution to provident fund, workers’ compensation etc.
(v) Number of Workers: The total number of workers working in each
department is taken as a basis for apportioning overhead expenses
amongst departments. Where the expenditure depends more on the
number of employees than on wages bill or number of labour hours, this
method is used. This method is used for the apportionment of certain

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expenses as welfare and recreation expenses, medical expenses, time
keeping, supervision etc.
(vi) Floor Area of Departments: This basis is adopted for the
apportionment of certain expenses like lighting and heating, rent, rates,
taxes, maintenance on building, air conditioning, fire precaution services
etc.
(vii) Capital Values: In this method, the capital values of certain assets
like machinery and building are used as basis for the apportionment of
certain expenses.
Examples are Rates, taxes, depreciation, maintenance, insurance
charges of the building etc.

(viii) Light Points: This is used for apportioning lighting expenses.

(ix) Kilowatt Hours: This basis is used for the apportionment of power
expenses.
(x) Technical Estimates: This basis of apportionment is used for the
apportionment of those expenses for which it is difficult, to find out any
other basis of apportionment. An assessment of the equitable proportion
is carried out by technical experts. This is used for distributing lighting,
electric power, works manager’s salary, internal transport, steam, water
charges etc. when these are used for processes.

14.4.5 Principles of Apportionment of Overhead Costs

The determination of a suitable basis is of primary importance and the
following principles are useful guides to a cost accountant:
(i) Service or Use or Benefit Derived: If the service rendered by a
particular item of expense to different departments can be measured,
overhead can be conveniently apportioned on this basis. Thus, the cost
of maintenance may be apportioned to different departments on the basis
of machine hours or capital value of the machines, rent charges to be
distributed according to the floor space occupied by each department.
(ii) Ability to Pay Method: Under this method, overhead should be
distributed in proportion to the sales ability, income or profitability of the
departments, territories, basis of products etc. Thus, jobs or products
making higher profits take a higher share of the overhead expenses. This
method is inequitable and is not generally advisable to relieve inefficient
units at the cost of efficient units.
(iii) Efficiency Method: Under this method, the apportionment of
expenses is made on the basis of production targets. If the target is

259
exceeded, the unit cost reduces indicating a more than average efficiency.
If the target is not achieved, the unit cost goes up, disclosing thereby the
inefficiency of the department.
(iv) Survey Method: In certain cases, it may not be possible to measure
exactly the extent of benefit wick the various departments receive as this
may vary from period to period, a survey is made of the various factors
involved and the share of overhead costs to be borne by each cost centre
is determined.
Thus, the salaries of foreman serving two departments can be
apportioned after a proper survey which may reveal that 30% of such
salary should be apportioned to one department and 70% to the other
department. The cost of lighting, when not metered, may similarly be
apportioned on a survey of the number and wattage of light points and the
hours of use in each cost centre.

14.6 OVERHEAD ABSORPTION

CIMA defines Absorption of Overheads as “the process of absorb,
overhead costs allocated or apportioned over a particular cost
centre or production department by the units produced”.
Absorption of overheads refers to charging of overheads to individual
products or jobs. It is a process of distribution of overheads allotted to a
particular department or cost centre over the units produced. The
absorption of overhead is done by applying overhead absorption rates.
The overheads allocated or apportioned over different cost centres or cost
units are again absorbed into unit cost on some equitable basis.
Overheads absorption is a process of charging of overheads to cost units
by means of rates separately calculated for each cost centre. In most
cases the rates are predetermined. The overhead to be absorbed by a
particular cost unit will be calculated by dividing the producing cost centre
overhead for a period by the cost units produced by that centre in the
period.
When a cost centre produces dissimilar units e.g., jobs to customer order,
the volume of production must be expressed in a common measurement
e.g., direct labour hours, machine hours etc. When a cost unit passes
through several centres, the overhead absorbed should be separately for
each centre.

The overhead absorption rate is calculated as follows:

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14.6.1 Methods of Overhead Absorption
The important methods used in absorption of overhead are discussed
below:

i. Production Unit Method

ii. Percentage of Direct Material Cost Method

iii. Percentage of Direct Labour Cost Method

iv. Percentage of Prime Cost Method

v. Direct Labour Hour Rate Method

vi. Machine Hour Rate Method

i. Production Unit Method: Under this method, overhead absorption rate
is calculated by dividing the overhead cost by number of units produced
or expected to be produced as shown below:

For example, the budgeted overhead is Rs. 2,00,000 p.a. and the
budgeted production is 50,000 units p.a.

Advantages:
• Where the manufacturing methods are simple and the company
makes only one product, this method can be used.

• It is simple to understand and easy to apply.

• This method is suitable if production consists of products that are
more or less identical and which take approximately the same time
to produce.
ii. Percentage of Direct Material Cost Method: Under this method
overhead is absorbed based on the actual or predetermined absorption
rate calculated by expressing the overhead cost as percentage of direct
materials for the same period.

The absorption rate is calculated as follows:

For example, budgeted overhead is Rs. 1,00,000 and the budgeted

direct material cost is Rs. 4,00,000, then overhead absorption rate is:

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Advantages:
• This method is useful if materials are a major part of the cost of
units made in the cost centre.

• This method is simple to understand and easy to apply.

Disadvantages:
• The cost of materials is often subject to considerable fluctuations
which will not be accompanied by similar fluctuations in overhead.
• Most of the overheads are attributable to time spent on the job or
cost unit and this factor is completely ignored in this method.
For example, cheap raw material may take longer time for process than
expensive quality material. The unit with cheap raw material should
absorb higher overhead cost than the unit processed with high quality raw
material.
iii. Percentage of Direct Labour Cost Method: Under this method,
overhead absorption rate is calculated by expressing the overhead
expense to be absorbed as a percentage of cost of direct labour for the
same period, as shown below:

For example, the budgeted overhead is Rs. 1,00,000 and the budgeted
direct labour cost is Rs. 5,00,000.
The absorption rate is calculated as shown below:

Advantages:
• This method is used where labour cost is an important part of total
unit cost.
• This method is fair in situation where more than one product is
made, and each product requires different amounts of various
grades of labour, which are paid at different rates.

• It is simple to understand and easy to apply.

• This method is better than percentage of direct material cost, since
labour rates fluctuate less frequently than the rate of materials.

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Disadvantages:
• It ignores time taken for completion of the job or unit, as job
performed by a skilled worker takes lesser time than an unskilled
worker.
• It ignores the work performed by machine where the labour is a
mere attendant.
• If a job undertaken by a skilled worker may have a higher labour
cost than one undertaken by an unskilled worker, but if the two
jobs take equal amounts of time to complete, it might be unfair to
charge different amounts of overhead to them.
iv. Percentage of Prime Cost Method: This method is a combination of
both direct material cost and direct labour cost method. The overhead
absorption is calculated as follows:

For example, the budgeted overhead is Rs. 2,00,000 and the budgeted
prime cost is Rs. 8,00,000.

Disadvantages:

• This method suffers from the disadvantages of both the methods.

• It gives equal weightage to both material and labour.
• Where the cost of material is predominating item of prime cost,
insufficient allowance is given for the time factor.
v. Direct Labour Hour Rate Method:Under this method, overhead
absorption rate is calculated by dividing the overhead with the number of
direct labour hours.

For example, the budgeted overhead of production centre is Rs. 2,00,000

and the budgeted direct labour hours for the period is 40,000.

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Advantages:
• This method takes into account the time spent by the labour in
production of each unit where the production units are not uniform
or identical.
• It is more appropriate in a labour intensive cost centre where
proper records are maintained for time booking.

• It is adopted where labour is the limiting factor.

Disadvantages:

• It is not suitable in mechanized and capital intensive production.

• Maintenance of labour time records is difficult.

• No distinction of hours spent by skilled worker and unskilled
worker.
vi. Machine Hour Rate Method:CIMA defines Machine Hour Rate as
an “actual or predetermined rate of cost apportionment or overhead
absorption, which is calculated by dividing the cost to be
apportioned or absorbed by a number of hours for which a machine
or machines are operated or expected to be operated.”
In a manufacturing environment where automatic and semi-automatic
capital intensive machinery used, machine hour rate is applied in
absorption of overheads. This is the most scientific method of absorption
of factory overheads, the budgeted overhead cost to be absorbed is
divided by the budgeted hours for which the machine or machines will
work.
The machine hour rate is calculated as follows:

For example, the budgeted production overhead is Rs. 3,00,000 and

estimated machine hours is 15,000.

Then machine hour rate is:

Advantages:
• It is used in mechanized production environment where machine
time is vital and limiting factor.

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 • Machine hour rate will be able to account for varying lengths of
time taken by products or jobs as they are worked on by the
various machines in the department.
• It is more realistic because machine hour rate is applied only when
the machine is used in production of the job or cost unit.
• Machine hour rate can be computed for the entire plant (called
composite machine hour rate) or machine hour rate for individual
machines (simple machine hour rate).

Disadvantages:

• In labour intensive industries machine hour rate is not suitable.

• It is difficult to maintain detailed record of machine usage.

• Ascertainment of machine hour rate requires skill and detailed
working knowledge.
LET US SUM UP
In cost accounting, the cost books are basically maintained under the two
systems namely (a) Non-Integral or Non-Integrated Cost Accounting and
(b) Integrated Cost Accounting. The system is called non-integral when
cost and financial transactions are kept separately. On the contrary, when
cost and financial transactions are integrated, the accounting system is
known as integrated. The cost accounting department maintains the
stores ledger, work-in-progress ledger, finished goods/stock ledger and
cost ledger. Cost Ledger is main ledger and records impersonal accounts
i.e. accounts relating to income and expenditure.
CHECK YOUR PROGRESS
Choose the Correct Answer:
1) Which of the following is the correct valuation base for finished goods
stock for balance sheet valuation purpose?
a) Prime cost per unit b) Production margin per unit
c) Total cost per unit d) overheads
2) Total costs of a material consist of_______________
a) Total acquisition cost + total ordering cost + total carrying cost
b) Total over heads + total ordering cost + total carrying cost
c) Total administration cost + total overhead cost + total carrying
cost
d) Total overhead+ total administration cost

265
3) indirect expenses are also known as___________
a) overheads b) marginal
c) Selling and Distribution d) administration expenses
4) _______ cost is predetermined cost for each element of cost.
a) Marginal b) Historical
c) Standard d) overheads
5) Direct expenses are also called as __________
a) sundry expenses b) chargeable expenses
c) overhead d) marginal
GLOSSARY
Overhead Absorption : The amount of indirect costs
assigned to cost objects
Economic Order : The optimal inventory size that
quantity should be ordered with the
supplier to minimise the total
annual inventory cost of
business.
Overhead Expenses : The expenses which are not
directly attributed to creating a
product or service.
Prime Cost : The firm expenses that are
directly related to material and
labour used in production.

SUGGESTED READINGS
1. Gupta, R.L. and Radhaswamy, M., (2006), Financial Accounting,
Sultan and Chand Sons, New Delhi.
2. Maheswari, S.N and Maheshwary, S.K. (2006), Fundamental of
Accounting, Vikas Publications.
3. Shashi K. Gupta, R.K.Sharma , (2012), “Financial Management”
latest Edition, Kalyani Publishers, Chennai
4. M C Shukla, S C Gupta & T S Grewal, (2017), Advance Accounting,
19th Edition, S.Chand Publishing, New Delhi
5. Tulsian P. C. , (2017), Financial Accounting , Pearson Education,
New Delhi.
6. https://learn.financestrategists.com/explanation/cost-
accounting/material-costing/material-cost/
7. https://www.youtube.com/watch?v=AYpjPWmlyHM

ANSWER TO CHECK YOUR PROGRESS

1) a 2) a 3) a 4) a 5) b

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 BLOCK 4

MARGINAL COSTING

Unit 15: Marginal Costing and Break-Even Analysis

Unit 16: Application of Marginal Costing and
Differential Costing
Unit 17: Budget and Budgetary Control

267
Unit 15

MARGINAL COSTING AND

BREAK-EVEN ANALYSIS
STRUCTURE

Overview

Learning Objectives

15.1 Concept of Marginal Costing

15.2 Steps Involved in Marginal Cost

15.3 Absorption Costing

15.4 Tools or Techniques of Marginal Costing

15.5 Advantages of Marginal Costing

15.6 Limitations of Marginal Costing

Let Us Sum Up

Check your Progress

Glossary

Suggested Readings

Answers to Check Your Progress

OVERVIEW
In the initial stages cost accounting was defined as the technique and
process of ascertaining cost of a given thing. Today the scope of cost
accounting has enlarged. Today’s organizations, due to cut-throat
competition, seriously try to control cost. Cost accounting helps the
organization to ascertain, control and reduce the cost.
The term cost cannot be exactly defined. Its interpretation mainly
depends on the nature of the business or industry and the context in which
it is used. In general, cost can be defined as the amount of expenditure
(actual or notional) incurred on, or attributable to a thing. Institute of cost
and Management Accountant (ICMA) Terminology defines cost as
resources sacrificed or foregone to achieve a specific objective. For the
purpose of identification, accounting and control cost can be broken down
into three basic elements, namely, material, labour and other expenses.
These elements of costs are further classified into different elements, such
as direct and indirect material, direct labour and indirect labour and direct

268
expenses and indirect expenses. Direct materials, direct labour and direct
expenses can be described as direct cost. Direct cost is those which are
incurred and can be conveniently allocated to specific cost centres or cost
units. Indirect cost (the composite of indirect material cost, indirect labour
and indirect expenses) cannot be directly, conveniently and wholly
allocated to cost centres or cost units. Cost can also be classified as fixed,
variable and semi-variable cost. Fixed cost is the cost which remain the
same irrespective of quantum of output and upto the capacity that has
been built up. The cost which varies in direct proportion to output is called
variable cost. The cost which vary but not in direct proportion is called
semi-variable cost. This unit explains you an important technique of cost
accounting, that is, marginal costing. Marginal costing is also called direct
or variable costing. The principle of the marginal costing, the differences
between marginal and absorption costing, the procedures for calculation
of Break-even point, profit/ volume ratio and margin of safety are
explained in this unit.

LEARNING OBJECTIVES

After reading this unit, you should be able to,

• define the meaning of Marginal Costing
• explain how marginal costing differs from absorption costing
• discuss the relationship between selling price, variable costs and
the contribution
• calculate the contribution, profit volume ratio and use them to
calculate the break- even point
• describe margin of safely and angle of incidence
• apply marginal costing techniques to the solve problems involving
profit targets and key factors
• discuss the uses and the limitations of marginal costing

15.1 CONCEPT OF MARGINAL TECHNIQUES COSTING

Marginal costing popularly known as variable costing, is an approach to
product costing and income determination. In this costing, only variable
manufacturing costs are used to value inventories and to determine the
cost of goods sold. Each unit of output is charged with variable production
costs. Fixed production costs are not considered as actual costs of
production, but rather as those costs which provide the capacity for a
period which allows production to take place. They are therefore, treated
as costs of the period and charged to the period. They are not carried
forward in closing stock, which is valued on a variable production basis.
For decision making, it is more helpful to the management. The other

269
names for marginal costing are direct costing, differential costing,
incremental costing and comparative costing.

Marginal Cost

The Institute of Cost and Management Accountants, London, has defined

‘marginal cost’ as “the amount at any given volume of output by which
aggregate costs are changed if the volume of output is increased or
decreased by one unit”. In this context, a unit may be a single unit, a
batch of articles, an order, a stage of production capacity, a process or a
department. Suppose the cost of production of 1,000 units is Rs. 6,000
and that of 1,001 units is Rs. 6,004, the marginal cost is Rs. 4. Marginal
cost is the variable cost comprising the cost of direct materials consumed,
direct wages paid and the variable overhead incurred for producing the
additional unit.
The ICMA, England has defined marginal cost as “the cost for producing
one additional unit of product”. It has also been defined as, “the amount
of change in the aggregate cost due to changes in the existing level of
production by one unit”.
An analysis of these definitions reveals that the marginal cost is the cost
of producing an additional unit. That means, marginal cost refers to the
extra cost for the production of an additional unit.

Marginal Costing

The institute of Cost and Works Accountants of India (ICWAI) defines

marginal costing as, “A method that considers only the variable cost as
cost of production, leaving out period costs to be absorbed from the
marginal contribution”. Batty defines marginal costing as, “a technique of
cost accounting which pays special attention to the behaviour of costs with
charges in the volume of output”. When compared to the definition by the
ICWAI, the definition by the Chartered Institute of Management
Accountants (CIMA), England appears to be more comprehensive.
Because, the CIMA, England defines marginal cost and effect of changes
in volume or type of output on the company’s profit, by segregating total
costs into variable and fixed costs.
Marginal costing has been defined by the Institute of Cost and
Management Accountants as “the ascertainment, by differentiating
between fixed costs and variable costs, of marginal costs and of the effect
on profit of changes in volume or type of output”. Thus, marginal costing
is not a system of ascertaining cost, such as process costing, job costing,
operating costing etc., but a special technique which is concerned with the
changes in costs resulting from changes in the volume or range of output.

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Features of Marginal Costing

Marginal costing technique has the following main features:

i) Marginal costing is not a method of costing likes process costing, job
costing, operating costing etc., but a technique dealing with the effects of
changes in the cost, volume, price, sales mix on the profits.
ii) Under marginal costing technique, cost of production comprises of
variable costs only. As such the valuation of the finished good and work-
in-progress is made on the basis of variable costs.
iii) Fixed costs do not form part of cost of production for the purposes of
marginal costing. They are treated separately and may be charged wholly
to the Profit and Loss Account for the accounting period.
iv) The profitability of a product or department is ascertained in terms of
‘Contribution’ or ‘Contribution Margin’. Contribution represents the
difference between sales value and marginal cost of sales. The aggregate
of contribution for all products is called ‘fund’.
v) For marginal costing techniques prices of the various products are fixed
by the manufacturing concerns on the basis of marginal cost and marginal
contribution.

15.2 STEPS INVOLVED IN MARGINAL COSTING

The technique of marginal costing involves the following steps :

a) Differentiation between fixed costs and variable costs:

b) Ascertainment of marginal costs; and
c) Ascertaining the effect on profit due to changes in volume or type of
output i.e., the determination of cost-volume-profit relationship.

The steps involved in marginal costing are explained below:

a) Difference Between Fixed Costs and Variable Costs: Marginal
costing technique involves the segregation of all costs into fixed costs and
variable costs. Costs may be divided into fixed costs, variable costs and
semi-fixed or semi-variable costs. Fixed cost may be defined as a cost
which tends to remain unaffected in aggregate by changes in the volume
of output. Fixed costs are generally referred to as period costs as they
are incurred on the basis of time and do not vary directly with volume or
rate of output such as rent, rates, insurance premium etc. Variable cost
may be defined as a cost which tends to change in aggregate in direct
proportion to changes in output. Variable costs mainly depend on output
and are sometimes referred to as direct costs. Examples of variables
costs are direct material cost, direct wages, direct expenses etc. Semi-

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variable cost or semi-fixed cost is a cost which is partly fixed and partly
variable. It tends to change in aggregate with changes in volume of output
but not directly in proportion to such changes. Examples of semi-variable
costs are repairs and maintenance, cost of supervision etc.
b) Ascertainment of Marginal Cost: Under the marginal costing
technique only variable costs are applied to products. The cost of
production is the marginal cost of production and the cost of sales is the
marginal cost of sales. Marginal cost refers to the aggregate of prime cost
and all variable overheads. Prime cost is the aggregate of direct material
cost, direct wages and direct or chargeable expenses. ‘All variable
overheads’ means variable overheads plus the variable portion of semi -
variable overheads. Semi-variable overheads require segregation into
fixed and variable elements. The variable portion is added to fixed
overheads thus forming part of marginal cost whereas the fixed portion is
added to fixed overheads and the total fixed overheads are treated as
separate costs. These separate costs are related to time and hence
known as ‘period costs’.
The main problem to a cost accountant is to segregate the semi-variable
overhead into fixed and variable elements. Segregation or separation of
semi-variable overhead into fixed and variable elements can be done by
adopting various methods such as Comparison method, High and Low
points method, Equation method, Averages method, Graphical method or
Least Square method.
c) Cost-Volume-Profit Relationship: Herman C Heiser, in his book, ‘
Budgeting – Principles and Practice’ writes that “the most significant single
factor in profit planning of the average business is the relationship
between the volume of business, cost and profit”. As the term itself
suggests the cost-volume-profit analysis is the analysis of three variables,
viz cost, volume and profit. It explores the relationship existing amongst
costs, revenue, activity levels and the resulting profit.
The cost volume profit (C.V.P) analysis is an extension of marginal
costing. It makes use of the principles of marginal costing. It is an
important tool of short term planning and is more relevant where the
proposed changes in the level of activity are relatively small. The C.V.P.
analysis is highly applicable in taking short term decisions. In addition the
analysis of the cost-volume-profit relationship provides answers to
questions such as :

i) What should be the minimum level of sales to avoid losses?

ii) What should be the sales level to earn desired profits?

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iii) What will be the effect of changes in costs, prices and volume on
profits?

iv) What will be the effect of changes in sales-mix on profits?

v) What will be the revised break-even point in case there is a change in
costs, prices, volume or sales-mix?

vi) Which product is most profitable and which one is the least profitable?

vii) Should the sale of a product be discontinued? And so on.

15.3 ABSORPTION COSTING

According to Charles T. Horngreen, absorption costing is the type of
product costing which assigns fixed manufacturing overheads to the units
produced as a product cost. According to C.I.M.A, London, “absorption
costing is a technique whereby fixed costs as well as variable costs are
allotted to cost units”. Under absorption costing, all costs, whether fixed
or variable, are charged to the cost units. For this reason, absorption
costing is also known as full costing or total costing. Absorption costing
is, thus, also a method of cost ascertainment. All the cost are charged to
the products, cost units or cost centres on the basis of their nature.
Accordingly, fixed costs and variable costs, both, are included in the cost.
Absorption costing is the basis of all financial accounting statements. In
this technique, the cost per unit varies to a large extent with the volume of
production because fixed costs are also included therein. Profit is defined
here as the difference between sales and cost of sales. You have learnt
what is marginal costing and what is absorption costing. Now you can
learn the major differences between marginal costing and absorption
costing.

Difference between Marginal Costing and Absorption Costing

The main points of difference between marginal costing and absorption

costing are as follows:
1.Segregation of costs into fixed and variable costs: Marginal costing
considers variable costs as cost of production and, therefore, requires
segregation of costs into fixed and variable costs. On the other hand,
under absorption costing, all costs are allocated to products. Hence, there
is no need of segregation of costs into fixed and variable costs.
2. Cost element in product cost: Under absorption costing, fixed
overheads are added to the cost of production whereas under marginal
costing, fixed costs are not included in the cost of production.

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3.Inventory values: Under marginal costing, the value of inventories is
comparatively lower as inventories are valued in terms of variable costs
only. Under absorption costing, the value of inventories is comparatively
higher because inventories are valued at total cost, i.e. variable as well as
fixed costs.
4. Profit: The term profit, under the absorption costing, is the difference
between sales and cost of goods sold. Under marginal costing, the term
profit, in a broader perspective, is known as contribution margin which is
excess of sales over variable cost of goods sold.
5. Effect of increase or decrease in inventories: If inventories increase
during the period, absorption costing will reveal more profit than marginal
costing. When inventories decrease, absorption costing will report lesser
profits than marginal costing.
6. Suitability: Absorption costing does not reveal the cost, volume, profit
relationship. Therefore, it is not suitable for decision-making whereas
marginal costing study the relationship cost, volume and profit. Hence, it
is very much suitable for making decisions.
7.Problem of Under or over absorption: As fixed costs are included in
the products under absorption costing, there is a possibility for over or
under-absorption. Whereas in the case of marginal costing fixed costs
are included in the product. So the problem of under and absorption of
fixed costs does not arise.
You can understand better the determination of profit or income under
both absorption and marginal costing techniques with the help of an
illustration. Look at illustration 1, which shows the determination of profit
under both the method.

Illustration 1

Statement of profitability

(Absorption Costing Technique)

Products
A B C Total
Rs. Rs. Rs. Rs.
(a) Sales 20,000 30,000 50,000 1,00,000
Direct Material 5,000 15,000 10,000 30,000
Direct Wages 6,000 4,500 5,000 15,500
Variable Factory Overhead 2,600 4,500 13,000 20,100
Variable Selling Overhead 1,400 3,000 10,000 14,400

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 Fixed Overhead 1,600 2,400 6,000 10,000
(b) Total Cost
Net Profit 16,600 29,400 44,000 90,000
(a) – (b) 3,400 600 6,000 10,000

Statement of Profitability

(Marginal Costing Technique)

Products
A B C Total
Rs. Rs. Rs. Rs.
(a) Sales 20,000 30,000 50,000 1,00,000
Direct Material 5,000 15,000 10,000 30,000
Direct Wages 6,000 4,500 5,000 15,500
Variable Factory Overhead 2,600 4,500 13,000 20,100
Variable Selling Overhead 1,400 3,000 10,000 14,400
(b) Marginal Cost 15,000 27,000 38,000 80,000
Contribution (a) – (b) 5,000 3000 12,000 20,000
Less : Fixed Overhead 10,000
Net Profit 10,000

From the Statement of Profitability prepared under marginal costing

technique, you can observe that:

Sales – Marginal Cost = Contribution

or, Fixed Cost + Profit = Contribution.

Similarly in case of loss:

Fixed Cost- Loss = Contribution

Combining these two equations, we can get the fundamental marginal
cost equation as follows:

Sales – Variable Cost = Fixed Cost ± Profit / Loss.

Or symbolically S-V = F ± P

Where ‘S’ denotes : Sales

‘V’ denotes : Variable Cost or Marginal Cost

‘F’ denotes : Fixed Cost

‘P’ denotes : Profit

‘P’ denotes : Loss.

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This marginal cost equation is widely used in marginal costing problems
since it plays an important role in profit projection. If in any given case,
any three of the four factors or items (S,V,F and P) are known, the fourth
can easily be found out with the help of the marginal cost equation.

Illustration 2

Following are the data relating to X Co. Ltd., for January, 2004:

Sales : Rs. 1,00,000

Fixed Cost : Rs. 25,000

Profit : Rs. 15,000

Ascertain variable cost.

Solution
Marginal Cost equation is :

Sales – Variable Cost = Fixed Cost+ Profit

Fixed Cost + Profit = Contribution

In this problem you have information about fixed cost and profit. You can
calculate contribution by adding fixed cost with profit. Thus contribution:

Rs. 25,000 (F) + Rs. 15,000 (P) = Rs. 40,000 (C)

Sales – Variable Cost = Contribution

or

Sales – Contribution = Variable Cost

or

Rs. 1,00,000 (S) – Rs. 40,000 (C) = Rs. 60,000 (V)

Hence : Variable Cost = Rs. 60,000

15.4 TOOLS OR TECHNIQUES OF MARGINAL COSTING

You have learnt that marginal costing requires the ascertainment of the
effects of changes in volume or type of output on profits or the cost-
volume-profit analysis. The assessment of cost-volume-profit analysis
requires the study of the following tools:

(a) Contribution

(b) P/V Ratio

(c) Break-even Point

(d) Margin of Safety

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(e) Angle of Incidence

(f) Break-even Charts and Profit Graph or Profit-Volume Graph

The last two tools are applied for the graphical presentation of cost -
volume-profit relationship.
a) Contribution Margin Concept: Contribution margin is a concept that
is developed for internal reporting to Management. The same basic cost
and revenue data that are reported externally are used in preparing
contribution reports. The cost data are merely grouped as given in the
Exhibit to compute contribution margin:

Exhibit-1
Grouping of Costs for Contribution Margin
I. Variable Cost
A. Manufacturing costs (Product cost)
(i) Direct Material
(ii) Direct Labour
(iii) Variable Factory Overhead
B. Other cost (Non product costs)
(i)Selling
(ii) Administration (only variable portion)
II. Fixed Costs
A. Manufacturing Costs (Product costs)
1) Fixed Factory overhead
B. Other cost (Non Product costs)
1) Selling
2) Administration (only fixed portion)

Contribution margin is defined as revenue less variable costs. Fixed costs

are then subtracted from the contribution margin to equal the net income.
Contribution margin is also known as gross margin. Contribution margin
concept emphasizes variable and fixed costs. It represents the amount
available after sales revenue has covered all variable costs. Variable
costs here include both product as well as less product costs. The
contribution margin is the amount available to cover fixed costs, both
product and non product costs and provides net income. If variable cost
of a certain product is Rs. 20,000, fixed cost Rs. 15,000 and selling price
Rs. 40,000, then contribution will be Rs. 20,000. You know contribution =
Selling price - Variable cost

Here selling price= Rs. 40,000 and variable cost = Rs. 20,000. Therefore,

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contribution = Rs. 40,000 – Rs. 20,000 = Rs. 20,000. Contribution can
be also found out by adding fixed cost with profit of the business
(ie.,FC+P).

Advantages Of Contribution

The knowledge of contribution margin is a valuable aid to management in

the decision- making process. A few advantages resulting from the
knowledge of contribution margin may be summarized as follows :
(i) It helps in the determination of the profitability of various products,
processes, departments etc.
(ii) Contribution helps the management in taking a decision on the
proposal to introduce a new product in the market.

(iii) It assists in the fixation of the selling price of the product.

(iv) It helps the management in making ‘buy or make decision’.

(v) It assists in determining the break-even point.
(vi) It guides the management in the selection of the profitable sales-mix
or the profitable method of production.
(vii) It also helps in determining whether it is worthwhile to continue a
product among different products.

b) Profit/ Volume Ratio or Contribution/ Sales Ratio

Profit volume ratio expresses the relationship of contribution to sales. It
is popularly known as P/V Ratio. The P/V ratio denotes the amount of
contribution per rupee (or hundredth) of sales revenue. P/V ratio may be
expressed as:

Sales−Variable Cost Contribution Fixed Cost+Profit

P/V Ratio = (or)= (or)=
Sales Sales Sales

Normally the P/V Ratio is expressed in percentage.

If expressed as a percentage:
Contribution
P/V Ratio = X 100
Sales

Assuming the sales price to be Rs. 50,000 and variable cost Rs. 40,000
50,000−40,000 10,000
P/V Ratio = x 100= =20%
50,000 50,000

P/V Ratio can also calculate as follows:

Change in Contributions
P/V Ratio =
Change in Sales

And since fixed cost is constant or common in two periods.

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 Change in Profits
P/V Ratio = Change in Sales

A high P/V ratio denotes high profitability while a low P/V ratio is an
indicator of low profitability. The basic property of P/V ratio is that it
remains constant at various levels of sales activity since the variable costs
change directly in proportion to changes in the volume of output. A
change in the fixed costs does not affect the P/V ratio. The management
always tries to increase the P/V ratio since by doing so the contribution
margin towards meeting fixed costs and profits is increased. The P/V ratio
can be increased by:

(i) increasing the selling price per unit; or

(ii) reducing the marginal cost per unit by new and improved methods of
production; or
(iii) selling more profitable products where relative contribution is larger,
thereby improving the overall P/V ratio.

Uses Of P/V Ratio

Profit Volume ratio is one of the most important ratios to be taken care of
in any business. P/V ratio helps the management in making various
decisions. The important ones are given below:
(i) Ascertaining the relative profitability of different sections of the
business such as sales area, product lines, methods of production
etc.
(ii) Determining the break-even point i.e., the point of no profit and no
loss.
(iii) Determining the amount of profit at a given volume of sales.
(iv) Calculating the volume of sales required to earn a desired amount of
profit.
(v) Calculating the volume of sales required to maintain the present
amount of profit under the conditions of change in selling price.

c) Break-Even Analysis
A breakeven analysis is performed to identity the level of operation at
which the entity has covered all cost but has not yet earned any profit.
The breakeven point identifies the volume of activity at which total
revenues equal total costs. This is often important part to management
because it represents a minimum acceptable level of operations. Of
course, the desirability of the profit on the investment increases as profit

279
increase, but profitable operation can only result when the level of activity
exceeds the breakeven point.

Break-Even Analysis in Units

The breakeven point is defined as the level of operations at which total
revenues equal total costs. The analysis can be for an entire firm, a
division, or a separate department. Breakeven analysis utilize the
contribution margin approach to computing net income, which splits costs
into a fixed and variable.

Equation for Break-Even Point in Unit

The breakeven point in unit can be computed by dividing total fixed costs
(F) by the contribution margin provided by each unit.
𝑇𝑜𝑡𝑎𝑙 𝐹𝑖𝑥𝑒𝑑 𝐶𝑜𝑠𝑡𝑠 𝐹𝐶
B.E.P = (or)
𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑃𝑒𝑟 𝑈𝑛𝑖𝑡 𝑆−𝑉𝐶
𝐹𝑖𝑥𝑒𝑑 𝑂𝑣𝑒𝑟ℎ𝑒𝑎𝑑𝑠
or, B.E.P =
𝑃𝑟𝑖𝑐𝑒 𝑃𝑒𝑟 𝑈𝑛𝑖𝑡−𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝐶𝑜𝑠𝑡 𝑃𝑒𝑟 𝑈𝑛𝑖𝑡
𝐹𝑖𝑥𝑒𝑑 𝐶𝑜𝑠𝑡𝑠
or, B.E.P =
𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑃𝑒𝑟 𝑈𝑛𝑖𝑡
The contribution margin per unit is sales price per unit (S) less variable
cost per unit (VC). You can understand well the concept of break even
point with the help of an illustration. Look at Illustration 3, which gives you
an idea to calculate break-even point in units.

Illustration 3
From the following information in relation to a manufacturing concern,
calculate the break-even point in units.
Output : 3,000 units

Variable Cost per unit : Rs. 30

Selling Price per unit : Rs. 40

Total Fixed Cost : Rs. 15,000.

Solution

Contribution per unit = Selling Price per unit – Variable Cost per unit

= Rs. 40- Rs. 30

= Rs. 10
𝑇𝑜𝑡𝑎𝑙 𝐹𝑖𝑥𝑒𝑑 𝐶𝑜𝑠𝑡𝑠
Break – even Point (in unit) =
𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑃𝑒𝑟 𝑈𝑛𝑖𝑡
15,000
=
10

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At the sales level of 1,500 units, total contribution available will be Rs.
15,000 (1,500 Units x Rs. 10) which is equal to total fixed costs. As sucat
the sales level of 1,500 units, there shall neither be profit nor loss.

Break –Even Point in Rupees

The break-even for a single product firm can also be determined in terms
of rupee value of sales volume. For calculating the break-even point for
sales, the following formulae are applied.
𝑇𝑜𝑡𝑎𝑙 𝐹𝑖𝑥𝑒𝑑 𝐶𝑜𝑠𝑡𝑠
i) Break – even Point (for Sales) = 𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑃𝑒𝑟 𝑈𝑛𝑖𝑡
𝑥 𝑆𝑒𝑙𝑙𝑖𝑛𝑔 𝑃𝑟𝑖𝑐𝑒 𝑃𝑒𝑟 𝑈𝑛𝑖𝑡
𝑇𝑜𝑡𝑎𝑙 𝐹𝑖𝑥𝑒𝑑 𝐶𝑜𝑠𝑡𝑠
ii) Break – even Point (for Sales) = 𝑇𝑜𝑡𝑎𝑙 𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑥 𝑇𝑜𝑡𝑎𝑙 𝑆𝑎𝑙𝑒𝑠
𝑇𝑜𝑡𝑎𝑙 𝐹𝑖𝑥𝑒𝑑 𝐶𝑜𝑠𝑡𝑠
iii) Break – even Point (for Sales) =
𝑃/𝑉 𝑅𝑎𝑡𝑖𝑜

From the Illustration 3 we can calculate the break-even point in sales

volume.
𝑇𝑜𝑡𝑎𝑙 𝐹𝑖𝑥𝑒𝑑 𝐶𝑜𝑠𝑡𝑠
i) Break – even Point (for Sales) =𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑃𝑒𝑟 𝑈𝑛𝑖𝑡 𝑥 𝑆𝑒𝑙𝑙𝑖𝑛𝑔 𝑃𝑟𝑖𝑐𝑒 𝑃𝑒𝑟 𝑈𝑛𝑖𝑡
15,000
= 𝑥40= Rs. 60,000.
10
𝑇𝑜𝑡𝑎𝑙 𝐹𝑖𝑥𝑒𝑑 𝐶𝑜𝑠𝑡𝑠
ii) Break – even Point (for Sales) = 𝑇𝑜𝑡𝑎𝑙 𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑥 𝑇𝑜𝑡𝑎𝑙 𝑆𝑎𝑙𝑒𝑠
15,000
= 30,000 𝑥 1,20,000= Rs.60,000.

Output = 3000 units.

Total sales = 3,000 units X RS. 40 = Rs. 1,20,000

Total contribution = 3,000 units X Rs. 10 = Rs. 30,000

𝑇𝑜𝑡𝑎𝑙 𝐹𝑖𝑥𝑒𝑑 𝐶𝑜𝑠𝑡𝑠
iii) Break – even Point (for Sales) = 𝑃/𝑉 𝑅𝑎𝑡𝑖𝑜
15,000 100
= = 15,000 x =Rs. 60,000.
25% 25

Note
Contribution 30,000
P/V Ratio = x 100 = x 100 = 25%
Sales 1,20,000

Break –Even Point As A Percentage Of Capacity

A number of business concerns are interested in ascertaining the break -
down point as a percentage of estimated sales of capacity. It can be done
by dividing the capacity sales by the break-even sales. For example, in
illustration (2), if the firm has an estimated capacity of 5,000 units of the
product, the firm breaks even at 30% of the capacity.
15,000 units 60,000
[ x 100 or x 100]
5,000 units 2,00,000

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Direct calculation of the break-even point as a percentage of estimated
capacity can be done if the total amount of contribution at estimated
capacity is known, by applying the following formulae:

Break-even Point (as a percentage of capacity)

𝐹𝑖𝑥𝑒𝑑 𝐶𝑜𝑠𝑡𝑠
= 𝑇𝑜𝑡𝑎𝑙 𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛(𝑎𝑡 𝑒𝑠𝑡𝑖𝑚𝑎𝑡𝑒𝑑 𝑐𝑎𝑝𝑎𝑐𝑖𝑡𝑦) 𝑥 100

Continuing Illustration (2), where

Total Fixed cost is Rs. 15,000

Total Contribution is Rs. 50,000

(at estimated capacity of 5,000 units)

Break-even Point (as a percentage of capacity)

𝑇𝑜𝑡𝑎𝑙 𝐹𝑖𝑥𝑒𝑑 𝐶𝑜𝑠𝑡𝑠 15,000
= 𝑇𝑜𝑡𝑎𝑙 𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑥 100 = 𝑥 100
50,000

= 30%

ASSUMPTIONS OF BREAK-EVEN ANALYSIS

The break-even analysis is based on the following assumptions:

i) All costs can be segregated into fixed and variable components.

ii) Total fixed costs remain constant at all levels of production.

iii) Total variable costs fluctuate directly in proportion to changes in
volume of output but the variable cost per unit remains constant.
iv) Selling price per unit remains constant and does not change with
changes in volume or due to other factors.
v) The firm concerned is a single-product concern or if it is a multi-
product concern, there is no change in the sales-mix.
(vi) The number of units produced and sold is the same so that there
is no opening or closing stock.

d) Margin of Safety (MOS)

Every manufacturer is interested in knowing the extent by which he is
above the break-even point, which is technically known as ‘margin of
safety’. Margin of safety may be defined as the excess of actual or
budgeted sales over the break-even sales. The margin of safety can be
ascertained as follows :
i) Margin of Safety = Actual Sales (or Budgeted Sales) – Sales at Break-
even Point
Or

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 Profit
ii) Margin of Safety =
P/V Ratio

The margin of safety, if expressed as a percentage of sales, will be :

Actual Sales−Break−Even Sales
Margin of Safety Ratio = x 100
Actual Sales

Illustration 4
From the following data, calculate the P/V ratio, B.E.P., and Margin of
Safety.

Sales Rs. 80,000

Variable Costs 40,000

Fixed Costs 24,000 64,000

Profit 16,000

Solution
𝑆𝑎𝑙𝑒𝑠−𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝐶𝑜𝑠𝑡𝑠
(a)P/V Ratio = x 100
𝑆𝑎𝑙𝑒𝑠
80,000 −40,000 40,000
= x 100 = = 50%
80,000 80,000

= Rs.80,000
𝑇𝑜𝑡𝑎𝑙 𝐹𝑖𝑥𝑒𝑑 𝐶𝑜𝑠𝑡𝑠
(b)Break - even point (for sales) =
𝑃/𝑉 𝑅𝑎𝑡𝑖𝑜
24,000 100
= = 24,000 x 50
50%

=Rs.48,000

(c) Margin of Safety = Actual Sales – Sales at Break-even Point

= Rs. 80,000-Rs. 48,000

= Rs. 32,000

Alternatively
Profit 16,000 100
Margin of Safety = = = 16,000 x 50 = Rs.32,000
P/V Ratio 50%

If it is desired to calculate Margin of Safety Ratio:

Actual Sales−Break−Even Sales
Margin of Safety Ratio = x 100
Actual Sales
80,000 −48,000
= x 100 = 40%
80,000

The margin of safety shows the extent to which sales may fall before the
firm suffers a loss. Larger the margin of safety, more safer is the firm. In
times of depression when the demand for the firm’s product is falling, a

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high margin of safety is particularly significant. In case of a firm having a
low P/V ratio, the margin of safety is low. In case both the P/V ratio and
margin of safety are low, management should explore the possibilities of
increasing the selling price per unit without affecting sales volume
adversely or by reducing the variable cost per unit by employing new
improved methods of production.

e) Angle of Incidence
In the break-even chart, angle of incidence is the angle formed by the
sales line and total cost line at the break-even point. A large angle of
incidence shows a high rate of profit being made while a small angle of
incidence indicates a low rate of profit.

Additional Uses of The Formulae of Break-Even Point

In addition to the calculation of the point at which a business firm breaks
even, the above formulae can also be used for the following purposes:

i)Calculation of Sales required to earn desired profits:

(a) Sales Required to earn desired profits

Total Fixed Cost+Desired Profits
(In terms of Number of Units) = Contribution per Unit

(b)Sales Required to earn desired profits

Total Fixed Cost+Desired Profits
(In terms of Number of Units) = P/V Ratio

ii)Calculation of profit at different levels of sales volume.

iii)Ascertainment of missing figures.

You can understand better these points with the help of the following
illustrations:

Illustration 5
Raj corp.Ltd. has prepared the following budget estimates for the year
2019 –2020.

Sales(Units) 15,000

Fixed Expenses Rs.34,000

Sales Rs.1,50,000

Variable costs Rs. 6 per unit

You are required to:

a) Find the P/V ratio, break-even point and margin of safety

b) Calculate the revised P/V ratio, break-even point and margin of

284
 safety in each of the following cases:

i) Decrease of 10% in selling price:

ii) Increase of 10% in variable costs:

iii) Increase of sales volume by 2,000units:

iv) Increase of Rs. 6000 in fixed costs.

Solution

a) At exiting Level
Contribution
P/V Ratio = x 100
Sales

Sales Value = Rs.1,50,000

Sales Units = 15,000

1.50,000
Selling Price Per Unit = 15,000 = Rs.10

Contribution = Rs.10 – Rs.6 = Rs.4

4
P/V Ratio = x 100 = 40%
10
𝐹𝑖𝑥𝑒𝑑 𝐸𝑥𝑝𝑒𝑛𝑐𝑒𝑠
B.E.P. (in Units) = 𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑃𝑒𝑟 𝑈𝑛𝑖𝑡
34,000
= =8,500 Units
4

B.E.P. (in Rs.) = B.E.P in Units x Selling Price Per Unit

= 8,500 x Rs.10 = Rs.85,000

Margin of Safety = Present Sales – B.E.P. Sales

= Rs.1,50,000 - Rs.85,000 = Rs. 65,000

b) (i) Decrease of 10% in selling price

Selling prideperone Rs.10
Less :10%Reduction 1
9

Contribution = Rs. 9 – Rs. 6 = Rs.3

3 1
P.Vratio =9 x 100 = 33 3 %
3 4,000
B.E.P(inunit) = = 11,333 units
3

Margin of Safety = (15,000 x 9) – (11,333 x 9) = Rs. 33,303

b) (ii) Increase of 10% in Variable Costs

Variable cost per unit = Rs. 6.00

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 Add : 10% increase = Rs. 0.60
Rs. 6.60

Contribution = Rs. 10 – Rs. 6.60 = Rs.3.40

3 .40
P.Vratio = x 100 = 34 %
10
3 4,000
B.E.P(inunit) = = 10,000 units
3.40

B.E.P. (in Rs.) = 10,000 x Rs.10 = Rs.1,00,000

Margin of Safety = 1,50,000 – 1,00,000 = Rs. 50,000

b) (iii) Increase of Sales Volume by 2,000 Units

Sales 15,000Units

Add: Increase 2,000Units

Revised Sales 17,000 Units

4
P.Vratio = 10 x 100 = 40 %
3 4,000
B.E.P(inunit) = = 8,500 units
4

B.E.P. (in Rs.) = 8,500 x Rs.10 = Rs. 85,000

Margin of Safety = (17,000 x 10) – Rs. 85,000= Rs. 85,000

b) (iv) Increase of Rs. 6,000 in Fixed Costs

4
P.Vratio = 10 x 100 = 40 %

Fixed costs = Rs.34,000

Add: increase = Rs.6,000

= Rs.40,000
40,000
B.E.P(inunit) = = 10,000 units
4

B.E.P. (in Rs.) = 10,000 x Rs.10 = Rs. 1,00,000

Margin of Safety = Rs.1,50,000 – Rs.1,00,000 = Rs. 50,000

Illustration 6

From the following information calculate the amount of variable cost.

Break-even sales volume : Rs. 30,000

Profit : Rs. 1,500

Fixed Cost : Rs. 6,000

Solution

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 (i) Contribution = Total Fixed Cost + Profit

= Rs. 6,000 + Rs. 1,500

= Rs. 7,500

(ii) Actual sales

𝐹𝑖𝑥𝑒𝑑 𝐶𝑜𝑠𝑡
Sales at B.E.P. =𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑥 𝑆𝑎𝑙𝑒𝑠
6,000
Rs.30,000 = 7,500 𝑥 𝑆𝑎𝑙𝑒𝑠
6,000
Sales = 𝑥 30,000= Rs.37,500
7,500
(iii) Variable Cost = Sales- Contribution

= Rs. 37,500- Rs. 7,500= Rs. 30,000

f) Break Even Chart and Profit – Volume Graph

The technique of break – even analysis can be made easy with the help
of graph or mathematical formula. Graphical representation of break-even
point (or cost Volume- profit) is known as the break – even chart. It shows
the profitability or otherwise of an undertaking at various levels of activity,
and indicates the point at which neither profit nor loss is made. Break-
even point is known as “no profit, no loss point” .So the chart is also known
as break – even chart. At this point, the total costs are recovered and profit
begins.

Significance of Break-Even Chart at Various of Activity

i) It will show the variable costs, fixed costs and total costs.

ii) Sales unit or value can be known.

iii) Profit or loss can be known

iv) Margin of safety can be known

v) Angle of incidence or the intersection of sales line with costs line also
be known.

Assumptions Of Break – Even Chart

i) Fixed costs remain the same and do not change with level of activity.
ii) Costs are divided into fixed and variable costs, Variable costs change
according to the volume of production.
iii) Variable cost vary with the volume of output but price of variable costs
such as wage rate, price of materials, supplies, will be unchanged,

iv) Selling price of remains the same at different levels of activity.

v) There is no change in the product mix

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vi) There is no change in the level of efficiency

vii) Policies of management do not change.

viii) No change in the manufacturing process is due to non static operating
efficiency.
ix) As the number of units produced and sold are the same, there is no
closing or opening stock.

Limitations Of Break-Even Chart

The break-even chart is constructed under some unrealistic assumptions

i) Exact and accurate classification of cost in to fixed and variable is not
possible. Fixed costs vary beyond a certain level of output. Variable
cost per unit is constant and it varies in proportion to the volume.

ii) Constant selling price is not true.

iii) Detailed information cannot be known from the chart. To know all the
information about fixed cost, variable cost and selling price , a number
of charts must be drawn.
iv) No importance is given to opening and closing stocks.
v) Various product mix on profits cannot be studied as the study is
concerned with only one sales mix or product mix.
vi) Cost, volume and profit relationship can be known; capital amount,
market aspects, effect of government policy etc., which are important
for decision – making cannot be ascertained from break even chart
vii)If the business conditions change during a period, the break even chart
becomes out of date as it assumes no change in business condition.

15.5 ADVANTAGES OF MARGINAL COSTING

Marginal costing technique is a very important tool in the hands of
management as it helps and guides the management in solving a number
of problems. The main uses of marginal costing may be given as follows
i) Simple valuation of stock: Under marginal costing technique, the
valuation of stocks of work-in-progress and finished goods is made on the
basis of marginal cost (or variable cost) which is more simple and helps
in ascertaining the profits accurately.
ii) Effective cost control: Marginal costing involves the segregation of
all costs into fixed and variable elements. Fixed costs are not treated as
product costs but as period costs. The management, by concentrating

288
more on controlling variable costs, can exercise effective cost control and
ensure maximum profitability.
iii) No possibility of over-or under-absorption of overhead: Under
marginal costing, there is no question of under-absorption or over-
absorption of fixed overhead since fixed overhead are not treated as
product costs. It also simplifies the process of reconciliation of cost
accounts and financial accounts.
iv) Ascertainment of break-even point: Marginal costing technique
helps in determining the level of production or sales at which a business
firm breaks-even as a result of which it may plan its production at a
level above the break-even Point so as to earn profits.
v) Ascertainment of the comparative profitability of various
products: Marginal costing technique, by showing the comparative
profitability of various products manufactured by a manufacturing concern
(by measuring the amount of Contribution and P/V Ratio), helps it in
planning its future production and sales.
vi) Assistance in taking managerial decisions: Marginal costing
technique helps the management in taking a number of important
business decisions such as :
a) Fixation of selling price: Under normal conditions, selling price is
fixed at a level which not only covers the total cost but also leaves some
margin for profit. But under the conditions of trade depression, sale of
production from surplus capacity etc., goods may be sold at a price below
the total cost but not below the marginal cost. Thus, marginal cost is the
guiding factor in the fixation of selling price of the products under abnormal
market conditions.
b) Buy or make decision: Marginal costing helps the management in
taking a decision as to whether a component or spare part should be
manufactured in the factory or bought from outside supplier through the
comparison of marginal cost and the market price.
c) Determination of profitable sales – mix: In case of a multi-product
concern selling various products in some pre-determined ratio, marginal
costing technique helps in determining the most profitable sales-mix
through the comparison of the total contribution available under the
various alternative of sales-mix.
d) Determination of profitable method of production: In case of the
availability of alternative methods of production for a particular product,
marginal costing helps in determining the profitable method of production

289
by making a comparison of the contribution available under various
methods of production.
e) Problem of limiting factor: Limiting factor or key factor refers to any
factor which is likely to limit production or sale of a product e.g., shortage
of material, labour, machine costing technique provides a guidance as to
which line of production is least profitable and should be discontinued.
vii) Use with standard costing: Marginal costing is simple to operate
and can be combined with standard costing system for exercising cost
control.
viii) Determination of Tender Price or Quotation Price: Marginal
costing helps in determining tender price or quotation price on scientific
basis.
15.6 LIMITATIONS OF MARGINAL COSTING
As marginal costing is based on number of assumptions, it suffers from
certain limitations. The important limitations are summarised below:
i) Marginal costing involves the segregation of all costs into fixed and
variable elements but this segregation is very difficult in actual practice.
ii) The calculation of variable costs and overhead is made on the basis of
estimates and not on actuals. As such there is a possibility of under-
recovery or over-recovery.
iii) Marginal costing assumes that total fixed costs are constant at all levels
of activity but this assumption is not always correct.
iv)Under marginal costing technique, stocks of finished goods and work -
in-progress are valued on the basis of variable costs only and the fixed
costs are ignored as a result of which these are under-stated.
v)Under marginal costing technique, no consideration is given to the ‘time
factor’ involved in production.
vi) Marginal costing techniques cannot be applied to industries in which
the value of work-in–progress is high in relation to turnover.

LET US SUM UP
Marginal costing and absorption costing are the two important techniques
used for ascertaining the cost of product, job or a process. In marginal
costing fixed costs are not allocated to cost units or cost centres at the
time of ascertaining cost of product. Absorption costing is a technique in
which both fixed and variable costs are charged for ascertaining the cost
of production. Marginal costing, as an improved technique over the
technique of absorption costing, helps the management of an organization

290
in taking various crucial decisions such as product pricing, retain or
replace, make or buy decisions etc.
There are a lot of differences between marginal costing and absorption
costing. The important ones are: (i) In marginal costing there is a
necessity to separate fixed cost and variable cost. In absorption costing
there is no such need. (ii) Fixed costs are not included in the cost of
production in the marginal costing, where as in absorption costing both
fixed and variable costs are charged. (iii) Marginal costing reveals the
cost, volume, profit relationship, whereas absorption costing does not
reveal the cost volume, profit relationship.
Profit / Volume ratio is a ratio of contribution in relation to sales or profit in
relation to sales volume. P/V ratio can also be calculated by expressing
change in profit in relation to change in sales. P/V ratio is generally
expressed in percentage. Break-even analysis helps the organization to
find out the point at which the total sales will be equal to total costs.
Marginal costing helps and guides the management in solving a number
of problems. However, marginal costing suffers from certain limitations.
CHECK YOUR PROGRESS
Choose the Correct Answer:
1) Marginal costs is taken as equal to ________
a) Prime Cost plus all variable overheads
b) Prime Cost minus all variable overheads
c) Variable overheads
d) None of the above

2) If total cost of 100 units is Rs 5000 and those of 101 units is Rs 5030
then increase of Rs 30 in total cost is __________
a) Marginal cost b) Prime cost
c) All variable overheads d) None of the above
3) Marginal cost is computed as _________
a) Prime cost + All Variable overheads
b) Direct material + Direct labor + Direct Expenses + All variable
overheads
c) Total costs – All fixed overheads
d) All of the above
4) Marginal costing is also known as __________

291
 a) Direct costing b) Variable costing
c) Both a and b d) None of the above
5) Which of the following are characteristics of B.E.P?
a) There is no loss and no profit to the firm.
b) Total revenue is equal to total cost.
c) Contribution is equal to fixed cost.
d) All of the above.
GLOSSARY
Fixed cost : The cost which remains fixed irrespective of
the quantum of output over a certain
capacity of the organization.
Variable cost : The cost which tends to vary in direct
proportion to changes in the volume of
output or turnover.
Marginal cost : A technique in which only variable costs are
considered for calculating the cost of
product. Fixed costs are charged against the
revenue of the period.
Absorption costing : A technique where both fixed and variable
costs are considered for calculation of fixed
and variable costs.
Contribution : The difference between selling price and
variable cost.
Break-Even point : It is a point at which its total sales volume is
equal to its total costs.

SUGGESTED READINGS
1. Gupta, R.L. and Radhaswamy, M., (2006), Financial Accounting,
Sultan and Chand Sons, New Delhi.
2. Maheswari, S.N and Maheshwary, S.K. (2006), Fundamental of
Accounting, Vikas Publications.
3. Shashi K. Gupta, R.K.Sharma , (2012), “Financial Management”
latest Edition, Kalyani Publishers, Chennai
4. M C Shukla, S C Gupta & T S Grewal, (2017), Advance
Accounting, 19th Edition, S.Chand Publishing, New Delhi
5. Tulsian P. C. , (2017), Financial Accounting , Pearson Education,
New Delhi.
6. https://www.youtube.com/watch?v=wVeHtQ3k2X0
7. https://www.youtube.com/watch?v=wOEkc3O_Q_Y

292
ANSWER TO CHECK YOUR PROGRESS

1) a 2) a 3) a 4) c 5) d

Unit 16

APPLICATION OF MARGINAL COSTING

& DIFFERENTIAL COSTING
STRUCTURE

Overview

Learning Objectives

16.1 Product Pricing

16.2 Make or Buy Decisions

16.3 Expansion Decision

16.4 Selection of Suitable Sales Mix

293
16.5 Effect of Changes in Sales Price

16.6 Acceptance of Special Order

16.7 Alternative Methods of Production

16.8 Key Factor

16.9 Merger of Plant Capacity

Let Us Sum Up

Check your Progress

Glossary

Suggested Readings

Answers to Check Your Progress

OVERVIEW
The industrial undertakings aim at maximising their values to their owners.
The managerial personnel at the helm of affairs of the undertakings have
to direct all their efforts towards the accomplishment of this objective. The
decisions which the management has to take should ensure both the
minimization of cost and the maximization of profit. This decision-making
process is therefore reckoned as the most significant one as the very
survival of the business entity depends upon these managerial decisions.
Decision making process has been defined as “the process of selecting
the best alternative out of a number of possible alternatives available”.
The use of the phrase ‘best alternative’ implies that the alternative must
ensure the best result to the company. An alternative may be considered
to the best one, which ensures least cost and / or maximum profit.
Marginal costing technique is a valuable aid to management in taking
many managerial decisions. It is a useful tool for making policy decisions,
profit planning and cost control. The information supplied by the “total
cost method” is usually not sufficient to solve managerial problem. Hence,
marginal costing facilitates “management by exception” by focusing
attention of the management towards more important areas than to waste
time on problems which do not require urgent attention of top level
management.

LEARNING OBJECTIVES

After reading this unit, you should be able to:

• explain how marginal costing technique helps the management to
take a number of vital decisions

294
 • discuss the application of marginal costing in cost control, product
pricing, profit planning, make or buy decision, accept or reject the
offer, shut -down or closure of business

Application of Marginal Costing Technique

When performing the manufacturing and selling functions, management
is constantly faced with the process of choosing between alternative
course of action. Typical questions to be answered include :
▪ What to make?
▪ How to make it ?
▪ Where to sell the product ? and,
▪ What price should be charged ?etc.
▪ In the short run, management is typically faced with the following
non recurring types of decisions :
▪ Product Diversification
▪ Make or Buy decision
▪ Pricing Decision
▪ Temporary Shut-Down or Closure
▪ Alternative method of production
▪ Problem of key or limiting factor
▪ Effect of changes in Sales Price
▪ Selection of a suitable or profitable sales mix
▪ Merger of plants.

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16.1 PRODUCT PRICING
The following details were extracted from the budget for the
forthcoming year:

Rs. Rs.
Sales (4,000 units) - 3,60,000
Direct Materials 1,20,000
Direct Labour 80,000
Variable Overheads 40,000
Fixed Overheads 1,00,000 3,40,000
Net profit 20,000

In order to improve the amount of net profit budgeted it is proposed to

reduce the selling price from Rs. 9 to Rs. 8 per unit. It is anticipated that
if this reduction is made, the volume of sale would increase by 30,000
units. Assume that if the selling price were reduced as suggested,
calculate the net profit that will be achieved.

Solution
Statement of Profitability

40,000 70,000
( Rs. 9) (Rs.8) Units
Units
Sales 3,60,000 5,60,000
Less Marginal
Cost
Materials 1,20,000 2,10,000
Labour 80,000 1,40,000
Variable Overhead 40,000 2,40,000 70,000 4,20,000
Contribution 1,20,000 1,40,000
Fixed Cost 1,00,000 1,00,000
Profit 20,000 40,000

Thus a price reduction by Re.1 would increase the contribution by Rs.

20,000 and net profit also by the same amount. The reduction is desirable
provided the market is capable of absorbing the additional output and
there in no increase in fixed costs.

296
16.2 MAKE OR BUY DECISIONS
A radio manufacturing company finds that while it costs Rs. 8.00 to make
each component No: 011, the same is available in the market at Rs. 6.50
each, with an assurance of continued supply. The breakdown of cost is :
Per unit
Materials Rs. 3.00
Labour Rs. 2.00
Other Variable Expenses Rs. 1.00
Depreciation and other fixed costs Rs. 2.00
Total cost Rs. 8.00

Should you make or buy? Give also your views in case the supplier
reduces the price from Rs. 6.50 to Rs. 5.50.

Solution
Variable cost of manufacturing component No: 011 is Rs. 6 (8-2). It is
advisable to make the component itself if the marginal cost of making the
component is lower than the purchase price because every component
produced will give some contribution to the company. But in case the
marginal cost is higher than the purchase price, it is better to buy the
component from outside than to make it.
In the above problem, if the purchase Price is Rs. 6.50, it is not advisable
to buy the component from outside, rather make the component because
every component manufacture will give a contribution of 50 paise. But if
the purchase price is Rs. 5.50, it is better to buy than to make.

16.3 EXPANSION DECISION

A company is considering expansion. Fixed costs account to Rs. 4,20,000
and are expected to increase by Rs. 1,25,000 when plant expansion is
completed. The present plant capacity is 80,000 units a year. The
capacity will increase by 50% with the expansion. Variable costs are
currently Rs. 6.80 per unit and are expected to go down by Rs. 0.40 per
unit with expansion. The current selling price is Rs. 16 per unit and is
expected to remain same under both alternatives. What are the
breakeven points under each alternative? Which alternative is better and
why?

Solution

Before Expansion
Units produced and Sold 80,000
Sales (80,000 X Rs.16) 12,80,000

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 Variable cost (80,000 X 6.80) 5,44,000
Contribution 7,36,000
Fixed cost 4,20,000
Profit 3,16,000
Contribution 16−6.80
P/V Ratio = x 100 = x 100
Sales 16
9.80
= x 100= 57.5%
16

Fixed Cost 4,20,000

B.E.P = = = Rs.7,30,435
P/V.Ratio 57.5 %

After Expansion
Capacity will increase by 50%., FC by 1,25,000 and VC by Re. 0.40 per
unit.

Units produced and sold 1,20,000

Sales 1,20,000 X Rs. 16 19,20,000

VC 1,20,000 X Rs. 6.40 7,68,000

Contribution 11,52,000
FC (4,20,000 + 1,25,000) 5,45,000

Profit 6,07,000

Contribution 11,52,000
P/V Ratio = x 100 = x 100= 60%
Sales 19,20,000

As the expanded position yields better profitability, considering expansion

is necessary and profitable to the company.

16.4 SELECTION OF A SUITABLE / SALES MIX

Illustration
Present the following information to show clearly to management.

(a) The marginal product cost and the contribution per unit.
(b) The total contribution and profits resulting from each of the followin g
mixtures.

ProductPrice Unit (Rs.)

Direct Material A 10

Direct Material B 9

Direct Wages A 3

Direct Wages B 2

298
 Fixed Expenses ...... Rs. 800

Product Priceper Unit Rs.

Sale Price A 20

Sale Price B 15

Sales Mixtures :

(a) 100 units of product A and 200 of B.

(b) 150 units of product A and 150 of B.

(c) 200 units of product A 100 of B.

Solution

Marginal Cost Statement

Product A Product B
Rs. Rs.
Selling Price (per unit) 20 15
Less : Marginal / Variable Cost:
Direct Material
Direct wages
Variable Expenses (100% wages)
16 13
Contribution (per unit) 4 2
Sales Mixtures
(a) 100 units of product A and 200 to B
Contribution:
A = 100 x 4 400
B = 200 x 2 400

Total Contribution 800

Less : Fixed Expenses 800
Profit Nil

(b) 150 units of Product A and 15 of B

Contribution :
A = 150 x 4 600
B = 150 x 2 300
Total Contribution 900
Less : Fixed Expenses 800
Profit 100

299
 (c) 200 units of Product A and 100 of B

Contribution :
A = 200 x 4 800
B = 100 x 2 200
Total Contribution 1000
Less : Fixed Expenses 800
Profit 200

As sales mixture (c) i.e., 200 units of A and 100 units of B gives the
maximum profit, it is more profitable.

16.5 EFFECT OF CHANGES IN SALES PRICE

Calculate the effect of sales mix from the following data by comparing the
P/V ratio and breakeven point :

P Q R S

Sales 40,000 50,000 20,000 10,000

Variable Costs 24,000 34,000 16,000 4,000

New Sales Mix 30,000 44,000 40,000 6,000

Fixed Cost Rs. 29,400.

Solution
Existing Sales Mix

P Q R S Total
Rs. Rs. Rs. Rs. Rs.
Sales 40,000 50,000 20,000 10,000 1,20,000
Less : Variable Cost 24,000 34,000 16,000 4,000 78,000
Contribution 16,000 16,000 4,000 6,000 42,000
P/V Ratio =
Contribution 40% 32% 20% 60% 35%
x 100
Sales

BEP =
29,400 84,000
Rs. 35%

300
 New Sales Mix

P Q R S Total
Rs. Rs. Rs. Rs. Rs.
Sales 30,000 44,000 40,000 6,000 1,20,000
Less : Variable Cost 18,000 29,920 32,000 2,400 82,320
Contribution 12,000 14,080 8,000 3,600 37,680
P/V Ratio =
Contribution 40% 32% 20% 60% 31.4%
x 100
Sales

BEP =
29,400 93,630
Rs.
31.4%

From the above it is clear that new sales mix is not favourable as it
reduces the P/V Ratio and pushes up the break even point.
16.6 ACCEPTANCE OF SPECIAL ORDER
Due to industrial depression, a plant is running at present at 50% of its
capacity. The following details are available.
Cost of production per unit

Direct materials Rs.2

Direct Labour Rs.1

Variable overhead Rs.3

Fixed Overhead Rs.2

TC Per Unit Rs.8

Production per month 20,000 units

Total cost of production Rs. 1,60,000

Sales Price Rs. 1,40,000

Loss 20,000
An exporter offers to buy 5,000 units per month at the rate of Rs. 6.50
per unit and the company hesitates to accept the offer for fear of
increasing its already opening losses.

Advise whether the company should accept or decline this offer.

Solution

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 Existing Offer Total

(20,000 units) (5,000 units)

Rs. Rs. Rs.

Sales 1,40,000 10,000 50,000

Variable Cost :

Materials 40,000 10,000 50,000

Labour 20,000 5,000 25,000

Variable Overhead 60,000 15,000 75,000

Total variable cost 1,20,000 30,000 1,50,000

Contribution (S-V) 20,000 2,500 22,500

Less Fixed Cost 40,000 --- 40,000

Profit -20,000 2,500 -17,500

Since the loss has been reduced from Rs.20,000 to 17,500 the Co: shall
accept this after.

16.7 ALTERNATIVE METHODS OF PRODUCTION

Illustration
A company is engaged in three distinct lines of production. Their
production cost per unit and selling prices are as under :

‘A’ ‘B’ ‘C’

Production (Units) 3,000 2,000 5,000

Rs. Rs. Rs.

Material Cost 18 26 30

Wages 7 9 10

Variable overheads 2 3 3

Fixed overheads 5 8 9

32 46 52

Selling price 40 60 61

Profit 8 14 9
The management wants to discontinue one line and gives you the
assurance that production in two other lines shall be raised by 50%

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They intend to discontinue the line which produces Article A as it is less
profitable.
(a) Do you agree to the scheme in principle? If so, do you think that
the line which produces article A Should be discontinued ?
(b) Offer your comments and show the necessary statements to
support your decision.

Solution
The decision should be taken on the relative profitability of various
alternatives as ascertained below :
Total fixed overheads : Rs.
A 3,000 x 5 = 15,000
B 2,000 x 8 = 16,000
C 5,000 x 9 = 45,000
Total Fixed Expenses 76,000

Contribution per unit of different products: (S-V)

A = 40 – 27 = Rs. 13 per unit

B = 60 – 38 = Rs. 22 per unit

C = 61 – 43 = Rs. 18 per unit

Profit from different production arrangements may be found as
under :
a) If ‘A’ is given up sale of ‘B’ and ‘C’ will increase by 50%. The sales
of B would be i.e., B-3000 units, C-7,500 units.
Contribution ‘B’ = 3,000 x 22 = Rs. 66,000
Contribution ‘C’ = 7,500 x 18 = Rs. 1,35,000
Total Rs. 2,01,000
Less: Fixed overheads Rs. 76,000
Profit Rs. 1,25,000

b) If B is discontinued production A and C will be more by 50% i.e., A-

4,500 units, C-7,500 units.
Contribution A = 4,500 x 13 = Rs. 58,500
Contribution C = 7,500 x 18 = Rs. 1,35,000
1,93,000
Less : Fixed Cost 76,000
Profit 1,17,500

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c) If ‘C’ is given up production of ‘A’ and ‘B’ will be i.e., A-4,500 units,
B-3,000 units.
Contribution A = 4,500 x 13 = 58,500
Contribution B = 3,000 x 22 = 66,000
Total 1,24,500
Less : Fixed Cost 76,000
Profit 48,500

Under these three alternatives the profit is maximum (Rs. 1,25,000)

when ‘A’ is discontinued. Therefore we may agree with the
management’s decision to discontinue article ‘A’.

16.8 KEY FACTOR

Illustration

The following particulars are extracted from the records of a company :

Per unit

Product A Product B

Sales Rs.100 Rs.120

Consumption of material 2 kgs. 3 kgs.

Material cost Rs.10 Rs.15

Direct wages cost Rs.15 Rs.10

Direct expenses Rs. 5 Rs.6

Machine hours used 3 2

Overhead expenses

Fixed Rs.5 Rs.10

Variable Rs.15 Rs.20

Direct wages per hour is Rs.5. Comment on profitability of each product
(both use the same raw material) when :

(i) Total sales potential in units is limited;

(ii) Total sales potential in value is limited ;

(iii) Raw material is in short supply ;

(iv) Production capacity (in terms of machine hours) is the factor.

Assuming raw material as the key factor, availability of which is 10,000
kgs. And maximum sales potential of each product being 3,500 units,
find the product mix which will yield the maximum profit.

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Solution

Per Unit
Product A Product B
Rs. Rs.
Sales 100 120
Material 10 15
Direct wages 15 10
Direct Expenses 5 6
Variable overhead 15 20
Marginal cost 45 51
Contribution (Sales Marginal Cost)
Contribution per Re. of Sale:
Contribution 55 69
⌊ ⌋ = Rs. 0.55 = Rs. 0.58
Sales 100 120

Material required per unit 2 kgs 3 kgs

Contribution per kg. of material 55 69
= Rs. 27.50 = Rs. 23
2 3
Machine hours used 3 2
Contribution per machine hour 55 69
= Rs. 18.33 = Rs.34.50
3 2

(i) When the limiting factor is sales potential in units, product B is more
profitable than product A because contribution per unit of product B is
more than that of product A.
(ii) When the limiting factor is sales potential in value, product B is more
profitable than product A because contribution per Re. of sale is 58
paise in case of product B whereas contribution per Re. of sale in case
of product A is 55 paise.
(iii) When material is limiting factor, product A is more profitable because
contribution per kg. of sale in case of product A is 55 paise.
(iv) When machine hours are limiting factor, product B is more profitable
than product A because contribution per machine hour is more in case
of product B.

16.9 MERGER OF PLANT CAPACITY

Illustration
There are two similar plants under the same management. The
management desires to combine these two plants. The following
particulars are available:

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 Plant I Plant II

Capacity operation 100 % 60%

Sales Rs. 300 lacs Rs. 120 lacs

Variable costs Rs. 220 lacs Rs. 90 lacs

Fixed costs Rs. 40 lacs Rs. 20 lacs

You are required to calculate :

(a) the capacity of the combined plant to be operated for the purpose of
break-even; and

(b) profitability on working at 75% the combined capacity.

Solution
(a) Calculation of the capacity of the combined plant to be operated for
the purpose of Breaking-Even

Factory I Factory II Total i.e.,

Merged Plant

Capacity 100% 60% 160%

Sales (In Lakhs Rs.) 300 120 500

200 ⌊𝑖. 𝑒. 60 𝑥100⌋
Variable cost (In lakhs Rs.) 220 90 370
150 ⌊𝑖. 𝑒. 60 𝑥100⌋

Contribution 80 50 130
(i.e. SalesVariable cost)
Contribution
P/ V Ratio of the Combined Plant = x 100
Sales
130 Lakhs
= 500 Lakhs x 100 = 26%
Total Fixed Expenses of the two Plants
B.E.P for the Combined Plant = P/V Ratio
Rs.40 Lakhs+Rs.20 Lakhs
= 26
100
100 3,000
= Rs. 60 Lakhs x = Rs. Lakhs
26 13

If sales value is Rs. 500 lakhs, combined plant operates at 100%

If sale value is Rs 3000 lakhs, combined plant operates at

100 3,000
x i.e., 46.15 %
500 13

Thus, at B.E.P. combined plant operates at 46.15% capacity.

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b) Calculation of Profit on Working at 75% of the Combined Capacity
Sales at 100% combined capacity Rs. 500 lakhs
75
Sales at 75% combined capacity i.e., 500 x Rs. 375 lakhs
100

P/V Ratio of combined plat 26%

(as calculated in (a) above )
Contribution @ 26% on Rs. 375 lakhs Rs. 97.5 lakhs
Less : Fixed Expenses :
Plant I Rs. 40 lakhs
Plant II Rs. 20 lakhs Rs. 60.0 lakhs
Profit at 75% of the combined capacity Rs. 37.5 lakhs

LET US SUMUP
Decision making is one of the important functions of management. In the
present competitive world, a business has to take right and quick
decisions in order to thrive. Now-a-days managements apply different
techniques to take right decisions. Marginal costing technique is a
valuable aid to management in taking crucial management decisions. It is
highly useful for making policy decisions, profit planning and cos t control.
It is also useful in taking decisions about product pricing, accepting or
rejecting an offer, shut-down or closure of business, introduction of a
product line, temporary shut-down or closure of business, selection of
suitable mix, make or buy decisions etc.

CHECK YOUR PROGRESS

Choose the Correct Answer:

1) Minimum price is calculated as ________

a) Variable cost + Fixed costs b) Marginal cost + Contribution

c) Marginal cost-Contribution d) None of the above

2) The few items of fixed costs which can be saved or eliminated by
suspending the trading activities are ________

a) Escapable fixed costs b) Special fixed costs

c) Suspension fixed costs d) None of the above

3) During trade recession, the goods are sold at ________

a) Depression price b) Normal price

c) Minimum price d) None of the above

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4) __________ refers to changes in total costs that occur due to changes
in volume of production or sales, product system, product mix or from the
adoption of an alternative course of action.

a) Differential costs b) Marginal costs

c) Absorption costs d) None of the above

5) As per J.M. Clark, when a decision has to be made involving
___________ , the difference in cost between two policies may be
considered to be the cost really incurred on account of these n-units of
business.

a) An increase of n-units of output

b) A decrease of n-units of output

c) An increase or decrease of n-units of output

d) None of the above

GLOSSARY

Marginal Cost : The cost incurred in producing an

additional unit of product is known as
marginal cost.

Marginal costing : It is a technique of ascertaining cost of

production of goods or services
manufactured.

Semi-variable cost : It is defined as a cost containing both fixed

and variable elements.

Break-even point : The point, which breaks the total cost and
the selling price evenly to show the level
of output or sales at which there shall be
neither profit nor loss, is regarded as
break-even point.

Differential cost : Differential cost means difference in cost

between alternatives.

REVIEW QUESTIONS
1) A company seeking to improve its competitive positions has launched
a cost reduction programme in its existing plants, apart from trying to
increase output.
The present profit-before tax comes to 15% of turnover and 30% of
capital employed other relevant working ratios are :

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 Gross Margin 35%
Margin of Safety 43%
Capital Turnover Ratio 2
The operating figures for the last year were as follows :
Total sales value Rs. 12,00,000
Variable Costs Rs. 7,80,000
Fixed Costs Rs. 2,40,000
Capital Employed Rs. 6,00,000
It has been proposed to reduce the sale price by 10% and increase the
output by 20%. No change in fixed costs is expected. The estimated cost
reduction amounted to Rs. 42,000.
You are required to workout the relevant figures and ratios based on the
proposal and present those along with the existing ones in a meaningful
manner and offer your comments.
2) An analysis of costs of a company led to the following information :
Variable Shut-down
Costs Costs
(% of Sales)
Direct Materials 33.6 ---
Direct labour 28.4 ---
Factory Overhead 11.6 1,66,700
Distribution expenses 3.3 63,400
General and Administration Expenses 1.1 99,900
Budgeted sales for the next year are Rs. 20,00,000
You are required to determine :
1) the break-even sales volume
2) the profit at the budgeted sales volume
3) the profit if actual sales (a) drop by 12% (b) increase by 10%
4) sales to generate a profit of Rs. 2,30,000.
3. A company has a capacity of producing 1,00,000 units of a certain
product in a month. The schedule of Prices of sales in given below :
Volume of output (%) Selling Price (Rs.)
60 0.90
70 0.80
80 0.75
90 0.67
100 0.61

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The variable cost of manufacture between these levels is 15 paise per unit
and fixed costs Rs. 40,000.
Calculate
1) At which volume of production with the profit be maximum.
2) If there is a bulk offer at Rs. 0.40 per unit for the balance capacity over
maximum profit volume for export and the price without affecting
internal market. Will you advice accepting this offer?

SUGGESTED READINGS
1. Gupta, R.L. and Radhaswamy, M., (2006), Financial Accounting,
Sultan and Chand Sons, New Delhi.
2. Maheswari, S.N and Maheshwary, S.K. (2006), Fundamental of
Accounting, Vikas Publications.
3. Shashi K. Gupta, R.K.Sharma , (2012), “Financial Management”
latest Edition, Kalyani Publishers, Chennai
4. M C Shukla, S C Gupta & T S Grewal, (2017), Advance
Accounting, 19th Edition, S.Chand Publishing, New Delhi
5. Tulsian P. C. , (2017), Financial Accounting , Pearson Education,
New Delhi.
6. https://www.youtube.com/watch?v=wVeHtQ3k2X0
7. https://www.accountingnotes.net/cost-accounting/differential-
cost/differential-cost-meaning-features-and-applications/7736

ANSWER TO CHECK YOUR PROGRESS

1) a 2) a 3) a 4) a 5) c

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Unit 17

BUDGET AND BUDGETARY CONTROL

STRUCTURE

Overview

Learning Objectives

17.1 What is a Budget?

17.2 Difference between Budget and Forecast

17.3 Budgetary Control

17.3.1 Steps involved in Budgetary Control

17.3.2 Objectives of Budgetary Control

17.3.3 Installing a Budgetary Control System

17.4 Classification of Budgets

17.5 Control Ratios

17.6 Zero Based Budgeting

Let Us Sum Up

Check your Progress

Glossary
Suggested Readings

Answers to Check Your Progress

OVERVIEW
In the present competitive world the success of any organisation mainly
depends on its ability to control cost and maximise profit. A systematic
planning and controlling is required to control the cost and maximise profit.
Budgeting is an important technique of planning and controlling.
Budgetary control system as an essential tool of management, helps to
control costs and maximise profits. Through the budgetary control system,
the actual performance can be compared with the budgeted performance.
Therefore, the discrepancy between plan performance and actual
performance can be found out and suitable remedial actions can be taken.
In a nutshell, the performance of every level of organisation can be
evaluated with the help of an effective budgetary control system.
Budgets may be divided into two basic classes: Capital Budgets and
Operating Budgets. Capital Budgets are directed towards proposed

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capital expenditure for new projects. As the amounts involved are huge a
special financing is required here. The Operational budgets are directed
towards achieving short term Operational goals of the organisation. In this
unit, meaning of (Operational) budget, budgetary control, the importance
of budgets and the techniques of preparing various budgets are
discussed.

LEARNING OBJECTIVES

After reading this unit, you should be able to:

• define budget and budgetary control

• explain the difference between budget and forecast

• describe the significance of preparing budgets

• explain the techniques of preparing various types of budgets

• enumerate the various control ratios

• explain some new ideas and development in the area of budgeting

17.1 WHAT IS A BUDGET?

A budget is a detailed plan of operations expressed in quantitative, usually
in monetary terms, covering a specific period of time, usually one year.
Fregmen defines budget as a “Comprehensive and coordinated plan,
expressed in Financial terms, for the operations and resources of an
enterprise for some period in the future”. ICMA, London defines a budget
as “A financial and / or quantitative statement prepared and approved prior
to a defined period of time, of the policy to be pursued during that period
for the purpose of attaining a given objective.” An analysis of the above
definitions reveals the following features of a budget:
(a) It is a plan expressed in quantitative form, physical or monetary units
or both.

(b) It is prepared prior to the period during which it will operate.

(c) It is approved by the management before its implementation.

(d) It is prepared to a definite future period.

(e) The policy to be followed to achieve a given objective must be clearly
spelled out before the budget is prepared.
Budget is an effective tool for planning and control. As today’s
organisations are more complex and facing international competition from
all corners of the world, budgeting becomes an essential requirement for
effective functioning. Budget helps the management to co-ordinate its

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various activities (such as purchase, production, sales, etc.) This
facilitates the organisation to achieve its objectives smoothly. The process
of preparing budget is called budgeting. The important benefits of
preparing budget are given below :
(a) It communicates the visions of the top management to the
subordinates. This helps the subordinates to function efficiently and
effectively.
(b) It helps to clearly define and fix responsibilities. As budgets are
prepared for all the departments / divisions there is a great possibility to
assign responsibilities to each individual. Therefore, the possibility of
back-passing can be minimised or avoided.

(c) It is very much helpful in developing a team work.

(d) It motivates managers to achieve the goals set for the units.
(e) It helps to control the performance of various departments / or persons
operating at different levels.

(f) It helps in the effective utilisation of all resources of the organisation.

17.2 DIFFERENCE BETWEEN BUDGET AND FORECAST

You have learnt the meaning of budget. The term budget should not be
confused with the terms estimate and forecast. Therefore, in this section,
you can learn the basic differences between budget and forecast. The
following are the important differences between budget and forecast.
First, budget is a pre-determined plan of action. It is concerned with
planned events. It shows the policy and programme to be followed in a
future period under planned conditions. Forecast is concerned with
probable events. It is just an estimate of what is likely to happen under
anticipated conditions during a particular period of time.
Second, budget is usually planned separately for each accounting period.
Forecast can be done for long periods or years.
Third, as budget serves as a guide to current operations and as a partial
basis for the subsequent evaluation of performance, it can be considered
as a tool of control. As forecast is just a statement of future events, it does
not connote any sense of control.
Fourth budget starts when forecasting ends. Forecast is the basis for
budgeting. In other words, forecast is converted into budget.
Last, budget is prepared in respect of spheres which are related to
business or industry. Hence, it has limited scope. Forecast is made in

313
several other spheres which may not be connected with the budgeting
process. Thus, the scope of forecast is wider in scope.

17.3 BUDGETARY CONTROL

There is no use of planning without proper control system. To make the
plan a successful one an effective control system is required. There is a
close link between budget and control. Budgetary control is a system of
planning and accounting of control through the use of budget. The
Chartered Institute of Management Accountants, London defines
budgetary control as “The establishment of budgets relating to the
responsibilities of executives to the requirements of a policy, and the
continuous comparison of actual with budgeted results either to secure by
individual action the objectives of that policy or to provide a firm basis for
its revision.”

The following are the important features of Budgetary Control

(i) Establishment of budgets for each function, department or division of
the organisation.
(ii) Fixation of responsibilities to the executives with the intention of
achieving the objectives of the organisation.
(iii) Budget is a policy statement of the organisation. It gives clear direction
to the employees to follow the prescribed policy of the organisation.
(iv) Budgetary control facilitates continuous comparison of actual with
budgeted results with the aim to ascertain deviations and to take remedial
action.
(v) Comparison of actual performance with the budgeted one’s assists
revision of policy.

17.3.1 Steps Involved in Budgetary Control

The following steps are involved in the process of budgetary control.

(i) Setting up plans and budgets for each functional areas like sales,
production, etc.
(ii) Measuring and recording actual performance of each functional area
with the intention to compare with planned one.
(iii) Comparing actual performance with the planned performance and
assessing the deviations or variations.
(iv) Finding out the causes of deviations and identifying the people
responsible.

(v) Evaluation of performance of people are done there.

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(vi) Taking corrective measures and ensuring that such deviations do not
arise in future. Actions are taken against the people who are responsible
for deviations in order to avoid deviations in future and improve the
performance of the people.

17.3.2 Objectives of Budgetary Control

The general objectives of budgetary control may be listed under three
heads :
a) Planning: An organisation has to plan its activities well in advance in
order to achieve its objectives. A Budget is a plan of the policy to be
pursued during a particular period of time to achieve a given objective.
Budgetary control system insists the management at all levels to plan in
time all the activities to be carried out in future periods. After formulation
of budget, it communicates the policy and plan of the top management to
the operatives. So budget gives a clear direction to the people and serves
as a guide of action.
b) Co-ordination: Budgetary control facilitates co-ordination of activities
of various departments or divisions. Co-ordination brings co-operation
among various peoples and departments. With the co-operation of the
people the work culture of work excellence, team spirits etc. can be
cultivated, so that the organisation can achieve its objective easily.
c) Control: There is no use of planning without control. Control makes the
people to follow the policy of the management strictly and to do job
according to the plan. Budgetary control makes control possible by
comparing actual performance and budgeted performance. Through
comparison deviations or variations can be easily identified and a report
can be submitted to the top management for corrective action.

17.3.3 Installing A Budgetary Control System

You might have understood the meaning and significance of budgetary
control in an organisation. Now, you learn how a budgetary control system
can be installed in the organisation. A careful analysis of the following
should be made to have an effective system of budgetary control system

(a) What is likely to happen?

(b) What can be made to happen?

(c) What are the objectives to be achieved?

(d) What are the constraints all the time and to what extent effects could
be minimised?

315
After analysing and getting answers to the above questions, the following
steps can be taken for installing an effective system of budgetary control
in an organisation.
Determination of the objectives: Determination of the objectives is the
first step towards installing budgetary control system in an organisation.
Normally earning higher profits will be the objective of budgetary control
system.
Organisation for Budgeting: The setting up of a definite plan of
organisation is the second step towards installing budgetary control
system. The responsibility of each executive in the organisation must be
clearly defined.
Budget Manual: The budget manual is a written document which shows
the responsibility and functions of each executive in the organisation. It
guides the executives in the organisations. It guides the executives in
preparing various budgets. Further, every one in the organisation knows
what is his role, what is to be done and how it is to be done in the system
of budgetary control. The problem of duplication or overlapping of
responsibilities can be avoided.
Budget Controller: Although the Chief Executive is ultimately
responsible for the budget programme, it is better if the large part of the
supervisory responsibility is delegated to an official designated as Budget
controller or Budget Director. Budget controller (or Budget Director) co-
ordinates and plays a greater role in drawing up all budgets. He has to
directly report to the president or chief Executive of the organisation. The
knowledge of the technical side of the business is essential for the Budget
control (or Budget Director)
Budget Committee: The Budget controller is normally assisted in his
work by the Budget committee. The Budget committee may consists of
chief executive as the chairman of the committee and heads of various
departments, viz., Production, Sales, Material, Finance, Personal,
Purchase, etc. It is the duty of the Budget committee to submit, discuss
and finally approve the budget figures. Each head of the department will
have his own sub-committee with executives working under him as its
members.
Budget Period: The budget period is the period of time for which the
budget is prepared and employed. The period of the budget mainly
depends on the nature of the business and the control techniques. For
example, a seasonal industry will budget for each season, while an

316
industry requiring long periods such as ship building or generation of
electricity will budget for four, five or even large number of years.

Budget Procedure
After the establishment of budget organisation and fixation of the budget
period, the actual work of budget control can be taken in the following
form:
Determination of Key Factor: A factor which influences all other budgets
can be described as key factor or principal or limiting factor. It is essential
to consider the key factor before preparing the budgets. The levels of
influence of this factor must be assessed first in order to ensure that the
budget targets are met. It is better to prepare first the budget relating this
key factor, and then prepare the budget for all other functional areas. An
illustrative list of key factors in different industries is given below:

Industry Key Factor

Motor Car Sales demanded

Aluminium Power

Petroleum Refinery Supply of oxide oil

Elector optics Skilled technicians

Hydel Power generation Monsoon

The key factors should be correctly identified. There is no use of preparing
budgets without identifying the correct key factor. The key factor need not
necessarily remain the same. In the long run, the management may
overcome the key factors by taking appropriate measures like introducing
new methods, changing material mix, working overtime, introducing
incentive system etc.
Making Forecasts: Already you have learnt the difference between
forecast and budget. Forecast is an estimate of the future financial
conditions or operating results. Budget is an operating and financial plan
of a business concern. It is a sort of commitment to certain objectives or
targets which the management attempts to obtain on the basis of the
forecasts prepared. Forecast becomes the basis for preparation of
budget. A forecast may be prepared in financial or physical terms for
sales, production cost and financial requirements of the business.
Preparing Budgets: After finalising the forecast the preparation of budget
starts. Sales budget is prepared first, then production budget is prepared
on the basis of sales budget and according to the production capacity
available. Financial budget, that is, cash or working capital budget will be

317
prepared on the basis of sales forecast and production budget. All these
budgets are combined and coordinated into one master budget. These
budgets may be revised from time to time by taking into account the latest
developments that are taking place or likely to take place.
Choice between Fixed and Flexible Budgets: A budget may be fixed or
flexible. A fixed budget is based on a fixed volume of activity. This budget
remains fixed over a given period and does not change with the change
in the volume of production or level of activity attained. Fixed budget is of
limited practical application, because the actual capacity utilisation may
vary from month to month or quarter to quarter. The flexible budget is
more useful for changing levels of activity as it recognises the difference
in behaviour between fixed and variable costs. The flexible budget
changes according to the changes in the level of output or activity. Fixed
costs remain unchanged over a certain range of output. They change only
when there is a change in capacity level. The variable costs change in
direct proportion to output. The concept of fixed and variable costs will be
explained in detail in the next section of this unit.

17.4 CLASSIFICATION OF BUDGETS

Budget can be classified into different categories on the basis of time,
function or flexibility. The following chart shows the budgets prepared
under each category.

Figure 17.1 Classification of Budget

Some of the budgets covered in the above classification are discussed
below.
i) Long - term Budget: The budgets prepared for a long period generally
for a period of 5 to 10 years is called long - term budget. This budget is
prepared to show long term plan of the business.
ii) Short - term Budget: These budgets are designed generally for a
period of one or two years (not exceeding 5 years). They are mostly

318
prepared in physical as well as monetary terms. The consumers goods
industries prepare short - term budgets.
iii) Current Budget: The budgets which cover a very short period, say, a
month or a quarter can be termed as current budgets.
iv) Rolling Budget: Some business organisations follow the practice of
preparing a rolling or progressive budget. In such organisations there will
always be a budget for a year in advance. After the end of each month /
quarter a new budget will be prepared covering a full year ahead. The
figures for the month / quarter which has rolled down are dropped and the
figures for the next month / quarter are added. For example, if a budget
has been prepared for the year 2005, after the expiry of first quarter
ending 31st March 2005, a new budget for the full year ending 31st March
2006 will be prepared by dropping the figures for the quarter which has
rolled (i.e. quarter ending 31st March 2005) and adding the figures for the
new quarter ending 31st March 2006. This process will continue whenever
a quarter ends and a new quarter starts.
v) Sales Budget: A Sales budget is the starting point on which all other
budgets are built up. It is estimate of sales to be achieved in a budget
period. The sales manager, being the head of the sales department is
responsible for preparation and execution of sales budget. He has to
consider the following factors at the time of preparing the sales budget.
• Past sales figures and trend
• Salesmen’s estimates
• Plant capacity
• General trade prospects
• Orders in hand
• Proposed expansion and discontinuance of products
• Seasonal fluctuations
• Potential market
• Availability of material and supply
• Financial capacity of the business
• Nature and degree of competition within the industry

The sales manager after considering all these factors prepare the budget
in terms of quantities and money, distinguishing between products,
periods and areas of sales.

Illustration 17.1
A company produces and sells three items : (a) Snow Cream, (b) Talcum
Powder and (c) Cold Cream. The company has divided its market into two

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zones: Zone A and Zone B. The actual figures for the previous year sales
were as under:
Zone A Zone B
Units Unit Price Units Unit Price
Rs. Rs.
(a)Snow Cream 4,00,000 12.00 2,50,000 12.00
(b)Talcum Powder 2,50,000 15.00 3,50,000 15.00
(c)Cold Cream 3,00,000 16.00 3,00,000 16.00

For the current year i.e. 2015, it is estimated that sales of snow cream will
go up by 10% in Zone B and of cold cream by 2,500 units in Zone A. The
company plans to introduce a publicity film for talcum powder in the TV
network. The budgeted figures for talcum powder are to be increased by
20% in both the Zones.
The price of the two creams are to be maintained for talcum powder, a
bonus cut of Re. 1 will be announced.
You are required to prepare quantitative-cum-financial budget for sales in
the current year i.e. 2015.

Solution

Sales Budget (2015)

Products Snow Cream Talcum Powder Cold Cream Total

Sales Rs. 12 Rs. 14 (Rs. 15-1) Rs. 16

price

Units Amount Units Amount Units Amount Amount

Rs. Rs. Rs. Rs.

Zone A 4,00,000 48,00,000 3,00,000 42,00,000 3,25,000 52,00,000 1,42,00,000

Zone B 2,75,000 33,00,000 4,20,000 58,80,000 3,00,000 48,00,000 1,39,80,000

Total 6,75,000 81,00,000 7,20,000 1,00,80,000 6,25,000 1,00,00,000 2,81,80,000

vi) Production Budget: The production budget is prepared by the

production manager. It shows the quantities of the products to be made,
the departments which will produce them and the time within which the
production will take place. The production budget is prepared on the
basis of sales budget. This budget can be expressed in physical or
financial terms or both in relation to production. Production budget
serves as a basis for production of material cost budget, labour cost
budget, cash budget, etc. The following factors are considered while
preparing the production budget :

i) The time lag between the production in the factory and sales

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ii) The stock of goods to be maintained.

iii) Sales requirements.

iv) Production stability.

v) Plant capacity.

vi) Availability of materials and labour.

vii) Time taken in the production process etc.,

Illustration 17.2
Prepare a production Budget for three months ending March 31, 2018,
for a factory producing for products, on the basis of the following
information.
Estimated Estimated Desired
Type of Stock on Sales during Closing
Product
Jan. 1, Jan. March Stock on
2018 (units) March
(units) 2004
(units)

A 3.000 10,000 3,000

B 2,000 15,000 5,000

C 4,000 13,000 3,000

D 3,000 12,000 2,000

Solution
Production Budget for Three Months to March, 31, 2018

Product Particulars Units

Estimated Sales 10000

Product A : Add : Desired Closing Stock 3,000

13,000

Less : Estimated Opening Stock 3000 10,000

Product B : Estimated Sales 15,000

Add : Desired Closing Stock 5,000

20,000

Less : Estimated Opening Stock 2,000 18,000

Product C : Estimated Sales 13,000

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 Add : Desired Closing Stock 3,000

16,000

Less : Estimated Opening Stock 4,000 12,000

Product D : Estimated Sales 12,000

Add : Desired Closing Stock 2,000

14,000

Less : Estimated Opening Stock 3,000 11,000

Total units to be produced 51,000

vii) Cost of Production Budget: After determining the volume of

output, it is necessary to ascertain the cost of producing this output.
There are three elements of costs, namely, material, labour and
overhead. Cost of Production includes all these three elements of costs.
Therefore, separate budgets for each of these elements have to be
prepared.
viii) Materials Budget: Materials may be classified as direct and indirect.
Material budget deals with the requirement of direct materials. Indirect
materials may be dealt under the works overhead budget. It helps in
determining the quantities and value of materials that are needed to be
purchased. The following factors are generally considered in preparing
materials budget.

i) The quantity of raw materials required for the budgeted output.

ii) The percentage of raw materials to total cost of products.

iii) Inventory policy of the company.

iv) Time lag between placing of the order and the receipt of materials.

v) The seasonal nature in the availability of raw materials.

vi) The price trend in the market, etc.

ix) Direct Labour Budget: This can be classified into two categories,
namely, direct labour requirement budget and labour recruitment budget.
The former tells about the total direct labour requirement in terms of
quantity and / or value, while the later states the additional labour force
needed and to be recruited.
x) Factory Overhead Budget: This includes the cost of the indirect
material, indirect labour and indirect expenses. Manufacturing over heads
may be classified into (i) fixed overheads (ii) variable overheads and (iii)

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semi-variable over heads. This budget provides an estimate of these
overheads to be incurred during the budget period.
xi) Master Budget: It is a comprehensive plan which is prepared from
and summarises the functional budgets. The master budget influences
both operating and financial decisions.
xii) Capital Expenditure Budget: This budget is prepared to determine
the amount of capital that may be required for procurement of capital
assets during the budget period.
xiii) Cash Budget: A cash budget is a summary of anticipated cash
receipts and cash payments over a particular period of time. This helps to
estimate cash short falls or surpluses. So corrective actions can be taken
well in advance. While cash budgets may be made for almost any interval
of time, it is desirable to break this budget into monthly or quarterly
budgets.
A cash budget helps the management in :

• Determining the future cash needs of the firm.

• Planning for financing of these needs.

• Exercising control over its cash and liquidity.

A cash budget can be prepared by any of the following methods :

• Receipts and Payments method.

• Adjusted Profit and Loss Account method, and

• The Balance Sheet method

Receipts and Payments method is generally adopted to prepare cash
budget.

Illustration 17.3
A, B, C co. Wishes to arrange overdraft facilities with its Bankers during
the period April to June. When it will be manufacturing mostly for stock.
Prepare a Cash Budget for the above period from the following date
including the extent of bank facilities the company will require at the end
of each month :

a)

Months Sales Purchases Wages

Rs. Rs. Rs.

February 1,80,000 1,24,800 12,000

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 March 1,92,000 1,44,000 14,000

April 1,08,000 2,43,000 11,000

May 1,74,000 2,46,000 10,000

June 1,26,000 2,68,000 15,000

(b) 50 percent of credit sales are realised in the month following the sales
and the remaining 50 percent in the second month following. Creditors
are paid in the months following the month of purchase.

(c) Cash at bank on 1st April (estimated), Rs. 25,000

Solution

Cash Budget for Three Months from April to June

April May June

Rs. Rs. Rs.
(a) Receipts
Opening Balance 56,000 (-) 47,000
25,000
Sales 90,000 96,000 54,000
Amount received from sales 96,000 54,000 54,000
Total Receipts 2,11,000 2,06,000 94,000
(b) Payments
Purchases 1,44,000 2,43,000 2,46,000
Wages 11,000 10,000 15,000
Total Payments 1,55,000 2,53,000 2,61,000
Closing Balance(a - b) 56,000 (-) 47,000 1,67,000

Illustration 17.4
Prepare a cash budget for the months of May, June and July 2020 on the
basis of the following information.
1) Income and Expenditure Forecast :
Months Credit CreditWages Manufacturing Office Selling
Sales Purchasesexpenses expenses expenses
Rs Rs. Rs. Rs. Rs. Rs.
March 60,000 36,000 9,000 4,000 2,000 4,000
April 62,000 38,000 8,000 3,000 1,500 5,000
May 65,000 33,000 10,000 4,500 2,500 4,500
June 58,000 35,000 8,500 3,500 2,000 3,500
July 56,000 39,000 9,500 4,000 1,0004,500
August 60,000 34,000 8,000 3,000 1,5004,500

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2) Cash balance on 1st May 2005, Rs. 8,000
3) Plant costing Rs. 16,000 is due for delivery in July, payable 10% on delivery
and the balance after 3 months.
4) Advance Tax of Rs. 8,000 each is payable in March and June.
5) Period of credit allowed (i) by suppliers - two months, and (ii)
to customers - one month.
6) Lag in payment of manufacturing expenses - 1/2 month.
7) Lag in payment of office and selling expenses - one month.
Solution
Cash Budget for the months of May, June and July 2020

Particulars May June July

Rs. Rs. Rs.
Opening Balance 8,000 13,750 13,250
Estimated CashReceipts

Cash from Debtors 62,000 65,000 58,000

Total 70,000 78,750 71,250
Estimated Cash Payments
Cash Payment to creditors
36,000 38,000 33,000
Wages
10,000 8,500 9,500
Manufacturing expenses
3,750 4,000 3,750
Office expenses
1,500 2,500 2,000
Selling expenses
5,000 4,500 3,500
Plant – Payment on delivery
- - 1,600
Advance tax
- 8,000 -
Total
56,250 65,500 53,350
Closing Balance
13,750 13,250 17,900

Fixed and Flexible Budgets

You are already familiar with fixed and flexible budgets. A fixed budget is
designed to remain unchanged irrespective of changes in the level of
activity. It is prepared on the basis of a standard or fixed level of activity.
Flexible budget is designed to change in accordance with the level of
activity attained. Compared to fixed budget, flexible budget gives a lot of
advantages. You can understand better the uses of flexible budget with
the following illustration.

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Illustration 17.5
The Expenses for budgeted production of 10,000 units in a factory are
given below.
Rs.
Materials70
Labour25
Variable Overheads20
Fixed Overheads (Rs. 1,00,000) 10
Variable Expenses (Direct) 5
Selling Expenses (10% fixed) 13
Distribution Expenses (20% fixed) 7
Administration Expenses (Rs. 50,000) 5
Total cost of per unit 155

Prepare a budget for Production of (a) 8,000 units (b) 6,000 units (c)
indicate cost per unit at both level. Assume total administration expenses
are fixed for all levels of production.
Solution

Flexible Budget

Cost of Expenses 10,000 Units 8,000 Units 6,000 Units

Per AmountR Per AmountR Per AmountRs.
Unit s. Unit s. Unit
Production Expenses

Material 70.00 7,00,000 70.00 5,60,000 70.00 4,20,000

Labour 25.00 2,50,000 25.00 2,00,000 25.00 1,50,000
Overhead 20.00 2,00,000 20.00 20.00 1,20,000
1,60,000
Direct Variable 5.00 50,000 5.00 40,000 5.00 30,000
Fixed Over heads

Rs. 1,00,000 10.00 1,00,000 12.50 1,00,000 16.67 1,00,000

50
Selling Expenses
Fixed 1.30 13,000 1.625 13,000 2.617 13,000
Variable 11.70 1,17,000 11.70 93,600 11.70 70,200
Distribution
Expenses
Fixed 1.40 14,000 1.75 14,000 2.334 14,000
Variable 5.60 56,000 5.60 44,800 5.60 33,600
Administrative 5.00 50,000 6.25 50,000 8.333 50,000
Expenses

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 Total 155.0 15,50,000 42.00 12,75,400 166.8 10,00,800
0 0

Illustration 17.6
The following information at 50% capacity is given. Prepare a flexible
budget and forecast the profit or Loss at 60% , 70% , 90% capacity.
Fixed Expenses 50% Capacity
Salaries 50,000
Rent 40,000
Depreciation 60,000
Administrative Expenses 70,000
Variable Expenses
Material 2,00,000
Labour 2,50,000
Others 40,000
Semi Variable Expenses
Repairs 1,00,000
Indirect Labour 1,50,000
Others 90,000

It is estimated that fixed expenses will remain constant at all capacities.

Semi-variable expenses will not vary between 45% and 60% , will rise by
10% between 60% and 75% capacity, a further increase of 5% when
capacity crosses 75%.

Estimated Sales at Various Levels of Capacity

Rs.

60% 11,00,000

70% 13,00,000

90% 15,00,000

Solution

Flexible Budget

Particulars 50% 60% 70% 90%

Fixed Exp.

Salaries 50,000 50,000 50,000 50,000

Rent 40,000 40,000 40,000 40,000

Depreciation 60,000 60,000 60,000 60,000

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 Administrative Exp. 70,000 70,000 70,000 70,000

Variable Exp.

Materials 2,00,000 2,40,000 2,80,000 3,60,000

Labour 2,50,000 3,00,000 3,50,000 4,50,000

Others 40,000 48,000 56,000 72,000

Semi-Variable Exp.

Repairs 1,00,000 1,00,000 1,10,000 1,15,000

Indirect Labour 1,50,000 1,50,000 1,65,000 1,72,500

Others 90,000 90,000 99,000 1,03,500

Total Cost 10,50,000 11,48,00012,80,000 14,93,000

Profit or Loss ------- - 48,000 + 20,000 + 7,000

Estimated Sales ------- 11,00,00013,00,000 15,00,000

17.5 CONTROL RATIOS

Preparation of budget is a part of planning process. After preparation of
all budgets the management may try to find out whether the deviations of
actual from budgeted results are favourable or otherwise. This is possible
with the help of the following ratios.

These ratios are expressed in terms of percentages. If the ratio is 100%

or more, the indication is taken as favourable. On the contrary, if the ratio
is less than 100, the indication is taken as unfavourable. A brief detail
about these ratios are given below :
i) Activity Ratio : It measures the level of activity attained over a
period of time. The formula is :
Standard Hours for Actual Production
Activity Ratio = x 100
Budgeted Hours

ii) Capacity Ratio : This ratio indicates whether and to what extent
budgeted hours of activity are actually utilised. The formula is
Actual Hours Worked
Capacity Ratio = x 100
Budgeted Hours

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iii) Efficiency Ratio : It measures the level of efficiency attained by the
productive process. The formula is
Standard Hours for Actual Production
Efficiency Ratio = x 100
Actual Hours Worked

17.6 ZERO BASED BUDGETING

The concept of zero base budgeting (Z B B) was primarily developed by
Peter A. Pyhrr in his article published in the Harvard Business Review in
1970. The technique gained more publicity when Mr. Jimmy Carter, in
1979, issued a mandate asking for use of Z B B technique throughout the
federal government agencies. Thus, Z B B replaced the conventional
budgeting technique at the federal government level. Zero base budgeting
(Z B B) has been defined by CIMA as “a method of budgeting whereby all
activities are re-evaluated each time a budget is set. Discrete levels of
each activity are valued and a combination chosen to match funds
available.
Peter A. Pyhrr, who was termed as ‘Father of Zero base budgeting’
defines Z B B as an operating planning and budgeting process which
requires each manager to justify his entire budget requests in detail from
scratch (hence zero-basis). Each manager states why he should spend
any money at all. This approach requires that all activities be identified as
decision packages which would be evaluated by systematic analysis
ranked in order of importance.
The traditional budgets are having a lot of drawbacks. Some of them are
as follows :
i) The problem of using historical data or previous years expenditures
as the basis for current years budget. So, the inefficiencies of a
prior year are carried forward in determining subsequent year’s
levels of performance.
ii) No priorities are established throughout the organisation.
iii) Decision-making is irrational in the absence of rigorous analysis of
all proposed costs and benefits.
iv) No attempts to evaluate alternative means of accomplishing the
same objective.
The technique of Z B B attempts provide a solution for overcoming the
drawbacks of traditional budgeting by enabling top management to focus
on key areas, alternatives and priorities of action throughout the
organisation.

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Zero base budgeting examines a programme, function or responsibility
from ‘scratch’. It suggests that an organisation should not only make
decision about the proposed new programmes but it should also, from
time to time, review the appropriateness of the existing programmes. The
manager proposing the activity has to prove that the activity is essential
and the amounts demanded are reasonable taking into account the
volume of activity. Nothing is allowed simply because it was being allowed
in the past.

Process of Zero-Base Budgeting

The following steps are involved in Zero base budgeting :

i) Determination of the objectives of budgeting.

ii) Determination of the extent to which the Z B B is to be introduced.

iii) Development of decision units.

iv) Development of decision packages.

v) Review and ranking of packages.

vi) Preparation of budgets.

Advantages of ZeroBase Budgeting

(i) It provides the organisation with systematic way to evaluate
different operations and programmes undertaken.

(ii) It ensures the more efficient allocation of resources.

(iii) It ensures that each and every programme undertaken by
managers isreally essential for the organisation, and is being
performed in the best possible way.

(iv) It motivates the managers by involving their participation.

(v) It creates the sense of cost consciousness in the minds of
managers,therefore it helps them in identifying the priorities in the
overall interests of the organisation.
(vi) The documentation of decision packages provides the
management with a deep, co-ordination knowledge of all the firm’s
operations.

Disadvantages of Zero Base Budgeting

i) It involves a lot of additional paper work.

ii) It may invite stiff resistance from managers as they have to
practically justify all their work.

330
iii) The cost of preparing the various decision packages may be very
high in large firms involving vast number of decision packages.
iv) It may not offer any significant control advantage in the areas where
objectives are difficult to quantify such as research and
development and general administration.

LET US SUMUP
A budget is a detailed plan of operations expressed, usually in monetary
terms covering a specific periods of time, usually one year. It includes
projections regarding the levels of activity, expenses and revenues.
Budget is an effective tool of planning and control. It is different from
forecast. Forecast is an estimate of the future financial conditions or
operating results. Budget is an operating plan of an organisation.
Budget Director or controller is mainly responsible for preparing the
budget. He is assisted in his work by a Budget Committe. The budget
committee consists of heads of various departments. Each head of the
department is made responsible for preparing and execution of the budget
in his department.
Budgets can be classified on the basis of time, function and flexibility.
According to time, budget can be classified as long-term, short-term,
current and rolling budget. On the basis of function budget can be
classified as sales, production, cost of production, purchases, personnel,
research, capital expenditure, cash and master budget. On the basis of
flexibility, budget can be classified into fixed and flexible.
In a budgetary control system, control ratios may be computed and
applied in order to compare the actual performance with the budgeted
performance. These ratios are : activity ratio, capacity ratio and efficiency
ratio. If the ratio is 100% or more, the indication is taken as favourable.
Suppose, if the ratio is less than 100, the indication is taken as
unfavourable.
The traditional budgets are having a lot of limitations. Zero base
budgeting, a new technique of budgeting, is a correct alternative to
replace the traditional budget method. Zero base budgeting technique
suggests that an organisation should not only make decisions about the
proposed new programmes, but should also from time to time review the
appropriateness of the existing programmes. Z B B provides a lot of
advantages of the organisation.

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CHECK YOUR PROGRESS

Choose the Correct Answer:

1) The process of budgeting helps in the control of ________

a) Cost of production b) Liquidity

c) Capital Expenditure d) All of the above

2) Plant utilization budget and Manufacturing overhead budgets are types
of ________

a) Production budget b) Sales budget

c) Cost budget d) None of the above

3) R&D budget and Capital expenditure budget are examples of _______

a) Short-term budget b) Current budget

c) Long-term budget d) None of the above

4) Capacity ratio * Efficiency ratio = __________

a) Liquidity Ratio b) Activity Ratio

c) Turnover Ratio d) Profitability Ratio

5) The scare factors is also known as ____________

a) Key factor b) Abnormal factor

c) Linking factor d) None of the above

GLOSSARY

Budget : It is the monetary expression of business

plans and policies in future period of time.

Budget Centre : It is that part of the organisation for which

the budget is prepared.

Budget Manual : It is a document spells out the duties & the

responsibilities of various executives
concerned with budget

Key Factor : A factor which influences all other budgets

is principal or key factor.

Performance : A budget based on function, activities, and

budgeting projects and may be described as a system.

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REVIEW QUESTIONS
1. Draw up a flexible budget for overhead expenses on the basis of
following and determine the overhead rate at 70%, 80% and 90%
plant capacity.

At 70% At 80% At 90%

Capacity Capacity Capacity

Variable Overheads

Indirect Labour - 12,000 00

Stores including spares - 4,000 00

Semi Variable Overheads

Power - 20,000 00

(60% fixed 40% variable)

Repairs & Maintenance - 2,000 00

(60% fixed 40% variable)

Fixed Overheads

Depreciation - 11,000 00

Insurance - 3,000 00

Salaries - 10,000 00

Estimated direct Labour Hrs. 1,24,000 Hrs.

2. Trader Ltd. manufactures two products ‘R’ & ‘S’ and sells them in two
market East, West. Normal sales estimates prepared by marketing
department for the year 1999 based on the report are as follows:

Product ‘R’ : East 12000 units, west 20,000 units

Product ‘S’ : East 8000 units, west 6000 units

Selling price : R - Rs.100 per unit, S - Rs.200 per unit

A special incentive system is proposed in east Zone which is expected to
push up the estimated sales of ‘R’ and ‘S’ by 20%. The advertising
department in west zone is estimated to get an additional sales of 2000
units and 1500 units of products ‘R’ and ‘S’ in west zone. You are required
to prepare sales budget for the year 2005 incorporating the above details.
3. X Y Z Company wishes to arrange O.D. facilities with its bankers during
the period April - June, When it will be manufacturing mostly for stock.

(i) Prepare Cash budget for the above period.

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 Month Sales Purchases Wages

Feb 1,80,000 1,24,800 12,000

March 1,92,000 1,44,000 14,000

April 1,08,000 2,43,000 11,000

May 1,74,000 2,46,000 10,000

June 1,26,000 2,68,000 15,000

(ii) 50% of credit sales is realised in the month following the sale, the
other 50% in the second month following. The creditors are paid in the
month following the month of purchase.

(iii) wages are paid at the end of respective month.

(iv) Cash at Bank - Ist April - Rs.25000/-

4. For the production of 10,000 automatic goods the following are
budgeted expenses.

Per unit Rs.

Direct Material 60
Direct Labour 30

Variable over heads 25

Fixed overheads (Rs.1,50,000) 1

Variable expenses (Direct) 5

Selling expenses (10% fixed) 5

Administration Expenses (Rs.50,000 fixed) 5

Distribution expenses (20% fixed) 5

Total cost 150

Prepare a budget for the production of 6000 electrical goods.

SUGGESTED READINGS
1. Gupta, R.L. and Radhaswamy, M., (2006), Financial Accounting,
Sultan and Chand Sons, New Delhi.
2. Shashi K. Gupta, R.K.Sharma , (2012), “Financial Management”
latest Edition, Kalyani Publishers, Chennai
3. M C Shukla, S C Gupta & T S Grewal, (2017), Advance
Accounting, 19th Edition, S.Chand Publishing, New Delhi
4. Tulsian P. C. , (2017), Financial Accounting , Pearson Education,
New Delhi.

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 5. https://www.fao.org/3/w4343e/w4343e05.htm
6. https://www.henryharvin.com/blog/budgets-and-budgetary-
controls/

ANSWER TO CHECK YOUR PROGRESS

1) d 2) c 3) c 4) a 5) a

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 BLOCK 5

STANDARD COSTING

Unit 18 : Responsibility Accounting

Unit 19 : Standard Costing

Unit 20 : Computerized Accounting Systems

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Unit 18

RESPONSIBILITY ACCOUNTING
STRUCTURE

Overview

Learning Objectives

18.1 Meaning and Features

18.2 Responsibility Accounting as an Information System

18.3 Levels of Responsibility and Flow of Information

18.4 Responsibility Centres

18.5 Matching Accounting System with Organisation

Let Us Sum Up

Check your Progress

Glossary

Suggested Readings

Answers To Check Your Progress

OVERVIEW
Responsibility accounting provides a frame work where the accounting
control system and organisational design are made inter-dependent.
Indeed, Responsibility accounting is a system of accounting that identifies
responsibility centres as units of divisibility in an organisation, the
performance of which is measured in terms of organisational goals
through accounting criteria. The system creates “accountability centres,”
the performance of which are well designed and identified. It is an
accounting control system that reflects the performance of a decentralised
organisation. The creation of responsibility centres in the entire
organisation delineates not only the areas of responsibility, accountability
and authority but also plans/actions, operational, strategic planning for
each centre along with particulars of cost/income assigned to each centre
under the control of some execustive. It is also called activity accounting
and profitability accounting as well as management by objectives through
the accounting control system. Responsibility accounting refers to the
various concepts and tools used by managerial accountants to measure
the performance of people and department in order to foster goal
congruence.

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LEARNING OBJECTIVES

After reading this unit, you should be able to;

• discuss the role of responsibility accounting in achieving the goals
of the organisation
• explain the concepts of cost centre, a revenue centre, a profit
centre and an investment centre
• explain why organisations use responsibility centres,
• Use return on investment and residual income as financial control
tools

18.1 MEANING AND FEATURES

Responsibility accounting is a specialized form of accounting used to
evaluate the financial performance of the segments of a business. In
essence, responsibility accounting requires each manager to participate
in the development of financial plans for his or her segment and provides
timely performance reports that compare actual results with those
planned. When responsibility accounting is combined with the budgeting
process, the combination provides managers with an effective mean of
planning and controlling a firm's performance.
Responsibility accounting focuses on the reporting and not on the
recording of cost and revenue data. It is a reporting function that provides
each level of management with the information it needs to control costs.
Responsibility accounting works well for all kinds of decentralized
operations regardless of whether the segments are based on functions,
products, customer, or geographical territories. The responsibility
accounting system is a subject of the firm's general accounting system. It
is used to accumulate performance information by segment and to report
the results to the responsible managers. As such, a responsibility
accounting system must be tailored to meet the specific needs and
operating conditions of a given firm so that performance reporting for all
financial items are considered within the organization.
All persons involved with the design, implementation, and operation of a
responsibility accounting system mostly understand both the assignment
of authority and responsibility in the organisation as well as the network
of accountability. This understanding is necessary to ensure that the right
kind of responsibility centres are utilized and that the performance
evaluation and reporting are meaningful.

Thus, Responsibility Accounting is the process of:

i) Designating the responsibility centres within an organization.

338
 ii) Delegating authority to the managers of the responsibility centres.
iii) Preparing budgets, accumulating results, and preparing
performance reports for the responsibility centres.

iv) Holding the managers responsible, or accountable for their actions.

Features of Responsibility Accounting

The following are the most essential features of responsibility accounting.

i) Best choice of responsibility centres.

ii) Correct matching of accounting system and organization.

iii) Emphasis on controllability.

iv) Use of participative Management.

v) Relevant performance reporting.

vi) Application of management by exception.

18.2 RESPONSIBILITIES ACCOUNTING AS AN INFORMATION
SYSTEM
The system of responsibility accounting is designed like a framework in
which functions of information gathering and internal reporting match the
organizational structure of a unit. An information system (basically
financial) is designed to measure the performance of the segment of an
organisation for which a given manager is responsible in responsibility
accounting. The effectiveness of the executives is judged on the basis of
costs / revenues which are directly under their control. It is an information
system identifying accountability and providing a base for meaning the
performance of an accountability centre. The responsibility accounting
information system reflects the plans / performance of each segment /
activity of the decentralized unit i.e., responsibility centre. All items of
expenditure are the responsibility of some individual and should be traced
to that individual at the point of orgin. Hence, the expenses incurred by
the head of the department in generating sales and providing services to
other segments of business should be clearly reported so that the head of
department is held accountable for a specific area of responsibility without
at passing the blame for poor performance to others. From the information
point of view, responsibility accounting identifies each person in an
organization, who has any control over cost or revenue as a separate
responsibility centre where stewardship must be defined, measured and
reported upward in the organization.

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18.3 LEVELS OF RESPONSIBILITY AND FLOW OF INFORMATION
The organisation structure and needs will decide the levels of
responsibility for each individual business Unit which will vary in each
case. At each level of responsibility, there may be several responsibility
Centres.
The line of responsibility starts with the operating superintendent,
department heads and the works manager to the chairman. These are
levels of responsibility. The flow of information is upward from the lowest
to the highest level in each responsibility centre.
Fourth Level of Responsibility Centre (Operating Superintendent):
Variable Statements showing budgeted / actual variable costs in terms of
labour, material and overheads will be reported to the third level, ie the
department head.
Third Level of Responsibility Centre (Department Head): The
responsibility centres will be, say, standing operation, wiring operation
and assembly operation. The summarised Variables for each operation
will be prepared and communicated to the second level of responsibility
ie., Works Manager.
Second Level of Responsibility Centre (Works Manager): The
responsibility centres at this level may be, say, cutting department,
machining department, finishing department and Packaging department -
again variable reporting of each responsibility centre is Prepared and
communicated upward ie., to the Chairman.
First Level of Responsibility Centre - The Chairman: The responsibility
centres will be sales manager, works manager, finance manager,
personal manager and R and D. Again, variance statements of each
responsibility centre will be prepared and total variance will be ascertained
with favourable and unfavourable dimensions.

18.4 RESPONSIBILITY CENTRES

A responsibility centre is a business segment, such as a department that
can be established as a cost centre, a profit centre, or an investment
centre with the proper control focus as follows:

Type of Responsibility Centre Control Focus

Cost Centre Cost Performance

Profit Centre Profit Performance

Investment Centre Return on Investment

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Many large firms have all three types of responsibility centres. The choice
between the three types depends on the answer to the question, "What
aspect of the financial performance is to be Controlled?" If the only
concern is the costs incurred in a Particular department, for example, that
segment will be defined as a cost centre. A segment's size is not the
determining factor in the choice of responsibility centre. Instead, the
choice is made on the basis of what constitutes the financial performance
to be evaluated in a given centre.
Cost Centres: Cost centres are the most frequently used type of
responsibility centre because so many business segments do not have
revenue responsibilities. A cost centre can be small or large depending
on the activities involved. For example, a retailing firm's accounting
department could be established as a separate small cost centre or as
part of a large cost centre consisting of the Company's entire
administrative function. A large cost centre such as a manufacturing plant
may be further divided into many cost centres such as the fabricating
department, assembly department and testing department.
Performance evaluation with a cost centre emphasizes efficiency
measures to assure that operating results of a given period are achieved
with the minimum possible costs. This efficiency is evaluated with
performance reports that show the actual costs of operating the centre
compared with the budgeted costs that represent an acceptable efficiency
level. A manufacturing operation will use standard costs for the efficiency
measures reported for its costs centres.
Profit Centres: A profit centre exists when revenues as well as costs can
be traced to the business segment. A sales department of a retail store
can be organised as a profit centre since earnings from the segment's
activities can be measured. A profit measure such a segment Income or
Contribution margin is used to evaluate the earnings performance of a
Profit Centre.
Profit centre managers are often responsible for both the production and
sale of the products involved. Efficiency and effectiveness measures
should be considered when evaluating a profit centre since its manager is
responsible for revenue and cost performance.
Some profit centres are classified as artificial centres because they mainly
sell their products in this the firm's organization. The selling price involved
with sales to other segments of the same organisation is called a transfer
Price. This price may not accurately reflect what the same products would
sell for on the open market. The use of an artificial profit centre provides
a profit Incentive to the manager responsible for its performance even

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though the results usually are not the same as they would be with outside
sales. The Delco Electronics Division of General Motors Corporation is an
example of a business segment selling a significant part of its output to
other segments within the same organisation since Delco Provides radios
for GM automobiles. The choice of a reasonable transfer price has a major
impact on the reliability of performance evaluation for an artificial Profit
Centre.
In a Profit centre approach, the Profit may be targeted and the manager
has:

1.Full authority to control costs.

2.Full authority to earn revenue

3.Full operational authority to effect costs / revenues.

4.Internal Competition: transfer Pricing Problem.

5.External Competition.
Investment Centres: The Most Complete form of responsibility centre is
an investment centre. Here, the manager in charge is held responsible for
the return of the resources used by the segment. In this case, the manager
of an investment centre is accountable for the revenues, costs and
operating assets with the goal of achieving a satisfactory return on
Investment. A department store operated by a chain store organization is
an example of an investment centre as long as the store manager can
control all the financial factors contributing to return in Investment
measurement.
An Investment centre manager has extensive authority for such actions
as Purchasing long-term assets, establishing Credit terms, determining
appropriate Inventory Levels, and Setting Selling Prices. The manager is
responsible for earning acceptable profits and for selecting the operating
assets required for the profit results. Efficiency and effectiveness
measures an Investment Centre with Primary attention directed towards
the actual return on Investment achieved compared with the budgeted
return on investment wanted. Like any Investment, high returns indicate
good performance by an investment centre. The most beneficial feature
of an investment centre is that it usually represents the ultimate in
autonomy. As a result, it offers the centre manager the opportunity and
incentive to achieve satisfactory return on investment results as through
the person is in charge of his or her own company.

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18.5 MATCHING ACCOUNTING SYSTEM WITH ORGANISATION
Once the choice between the different responsibility centres has been
made for a particular firm's organizational structure, the accounting
system, as an integral part of the total management information system,
must be designed to accumulate financial data for each responsibility
centre. This is accomplished through added digits in the coding system
used for the chart of accounts that identify a financial item not only by its
nature (e.g. direct labour) but also by the responsibility centre in which the
item is incurred (e.g. a specific production department). For example,
account number 410-12 could be used to record direct labour in a
Production cost centre. The 410 indicates that direct labour is involved
and the 12 indicates the cost centre in which the cost is involved. The type
of responsibility centre determines how many accounts must be given the
added designation to identify the source of responsibility involved.
The added designations would be used most extensively in an investment
centre since its revenues, costs, and operating assets must be identified
and accounted for separately from other centres' financial activities. The
segmentation of the accounting system provide the firm with the capability
to accumulate reliable financial data with which individual centres
performance as well as the performance of the business as a whole can
be measured.

Participative Management
The Managers accountable for the performance of the responsibililty
centres should actively participate in the development of the planned
financial performance, which is expressed in the form of a budget. When
managers prepare their own estimates, the goals become self-imposed
instead of being established by higher management. The approach
should motivate managers to do everything possible to achieve the
planned performance and is an important part of management by
objective. With management by objective, each manager responsible for
a business segment participates with the managers to whom he or she is
accountable in defining segment goals that are compatible with the overall
organizational goals. The segment goals then become the responsibility
of the segment manager who is accountable for their accomplishment.
The financial goals are formulated in the master budget, and the
responsibility accounting system reports how well the segment is
achieving its financial goals.

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Measuring Divisional Performance

Three important criteria for measuring divisional performance are :

i) The measure chosen should indicate clearly the contribution made by
each division to the overall profitability of the company.
ii) The measure should be independent from the performance achieved
by other divisions of the company. This will be possible only if all the
costs can be completely allocated to each division and overlapping’s
are not there. Divisional managers can then be completely held
accountable for the costs and profits of their divisions.
iii) The measure should provide a common basis for comparing and
evaluating the performance of divisions operating in different
geographic and product markets.

The measurement of divisional performance rests on :

i) The contribution margin, approach/net profit/operational profit
approach.

ii) Return on Investment (ROI) approach.

iii) Residual Income Approach.

i) The Contribution Margin Approach

Profit can take the form of net profit (before / after tax) for assessing the
profitability of a division in absolute figures. The disadvantage is that net
profit may be more or less due to non-operating income or expense of a
sizeable amount like profit on sale of capital assets or loss in it. The other
basis can be figure of net operating profit. This is profit from the main
business for which a company was incorporated. Thus, the higher the
figure of absolute net profit / operating profit, the better is the performance.
Another approach can be relative contribution produced in a division, as
below:

Sales of a Division XXX

Less : Variable Cost (Cost of good sold & Other Valuable Costs) XXX

Contribution / Variable Profit XXX

The contribution approach statement can be further the presented with
concept of cost controllability and cost allocation presenting thereby net
profit earned by each division, which can be the basis for measuring the
performance of the division.

The statement can be as below :

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 Sales XXX

Less : Variable Cost XXX

Variable Profit XXX

Less : Controllable divisional overhead XXX

Controllable Profit XXX

Less : Fixed non-controllable :

Divisional Overhead XXX

Contribution Margin XXX

Less : Allocation of fixed expenses XXX

Net Profit before tax XXX

Less : Tax XXX

Net Profit XXX

ii) Return On Investment (ROI) Approach

Return on Investment (ROI) = Net Profit / Cost of the investment * 100

The ratio of net income to sales measures the profit margin whereas the
ratio of sales to assets measures the assets turnover. The ROI can be
increased by increasing the profit margin and the asset turnover ratio or
by some combination of both.
The Return on Investment as a measure of overall performance is
conceptually easy to understand. It can be used for making comparisons
between the performances of various divisions. It also encourages
divisional managers to retain assets that give satisfactory return on
investment and to discard assets that are not up to the mark. Also the
expanded version of ROI shows that an increase in sales, by itself, will not
increase ROI because sales cancel out. But a decrease in
investment/assets with other factors remaining the same, will increase
ROI.
Suppose that return on sales is 15% and investment turnover is 2 times.
This gives a ROI of 30% (15 x 2). If the manager now changes the product
mix to items with so that return to sales is 10% and Investment turnover
lower margins and faster turnover, is times. ROI will now fall to 25% (10
x ). Hence the expanded version of the ROI gives clues regarding the
strategies used by companies. Two companies may be having the same
ROI, but by using two different strategies. One company may operate on

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a high investment turnover while the other may be working towards a high
return on sales.

COMPANY

A B

Return on Sales 12% 8%

Investment Turnover 2% 3%

ROI 24% 24%

iii) Residual Income (RI) Approach

Residual Income is the income of a division produced in excess of the
minimum required rate of return. Management usually establishes the
minimum rate of return which is greater than the cost of capital. For
different divisions, companies usually set different minimum rates of
return which is in accordance with the risks associated with their business.
Business which are risky will need to earn higher returns than business
which are more stable. RI can be calculated as follows.

RI = Divisional Income - ( Divisional Investment x Target ROI )

Assume that the divisions income is Rs. 2,00,000 divisional investment is

Rs. 5,00,000 and that the cost of capital is 20%. RI can now be calculated
as follows.

RI = 2,00,000 - ( 20% x Rs. 5,00,000 )

= 2,00,000 - 1,00,000

= Rs. 1,00,000
Thus, RI calculates the minimum required rupee return. If the firm earns
less than the RI, the investors will want their capital to be invested
elsewhere. The basic reason for using RI as a measure of divisional
performance is that it measures the profits that, the division to the firm
over and above the minimum profit required from the amount invested.
RI also offers significant advantage over the ROI measure. RI is more
flexible since a different percentage or rate can be applied to investments
of different risks. For example, division in different lines of business may
have different cost of capital; assets in the same division may be exposed
to different risk classes. RI allows the managers to incorporate differences
in risk adjusted capital costs while the ROI measure accounts for no such
changes.

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 Required ROI is Required ROI is
10% 20%
Division Division Division Division
A B C D
Rs. Rs. Rs. Rs.
Investment 1,00,000 8,00,000 1,00,000 8,00,000
Divisional income 25,000 1,20,000 25,000 1,20,000
Required/minimum
return ( Investment x 10,000 80,000 20,000 1,60,000
minimum return)
Residual Income 15,000 40,000 5,000 40,000

RI has an advantage over ROI as a measure of divisional performance. It

could show that a division with a higher ROI is less valuable to the firm as
a whole than with the lower ROI.
Suppose that division A produces Rs. 25,000 income on an investments
of Rs. 1,00,000. This gives a ROI of 25% . Division B earns Rs. 1,20,000
on an investment of Rs. 8,00,000. This gives a ROI of 15%
As shown in the example, consider two alternatives :

(1) required ROI is 10% and

(2) required ROI is 20%

The residual income for each division are as shown in the example above.
If the minimum required ROI is 10%, division B makes a greater
contribution to the firm than does division A despite division B's lower ROI.
However, if the minimum required ROI is 20%, division A is more valuable
to the firm as division B makes a loss of Rs. 40,000. Hence, if the decision
criteria for evaluating divisional performance is RI, the division with the
highest RI will be rated highest.
Management by Exception: Significant variances between the planned
and actual performance of each responsibility centre are emphasized in
the performance reports so their causes can be determined and corrective
action taken whenever necessary (or adoptive action of the goals are
considered unrealistic given current information). This application of
management by exception is intended to identify a situation that is likely
to be out of control without the need to evaluate all results.
Transfer Prices: The measurement of Profit in a profit centre type of
responsibility accounting is also complicated by the problem of transfer
prices. A transfer price is a price used to measure the value of

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goods/services furnished by a profit centre to other responsibility centres
within a company. That is, when internal exchange of goods and services
take place between the different divisions of a firm, they here to expressed
in monetary terms. The monetary amount of these later-divisional
exchanges/transfers is called the transfer price. That is, a transfer price is
that notional value at which goods and services are transferred between
divisions in a decentralised organisation. The implication of the transfer
price is that for the selling division (the division whose goods or services
are being transferred) it will be a source of revenue whereas for the buying
division (that division which is receiving the goods or services) it is an
element of cost. The goods that are produced by the buying division and
sold as the outside world are known as final products. While determining
transfer prices a number of criteria should be carefully considered:
i) Transfer prices should held in the accurate measurement of
divisional performance (Profitability) measurement.
ii) Transfer prices should motivate the divisional managers into
maximising the profitability of their divisions and making decisions that are
in the best interest of the organisation as a whole.
iii) Transfer price should ensure that divisional autonomy and authority
is preserved.
iv) Transfer prices should allow goal congruence to take place, which in
effect means that the objectives of divisional managers are compatible
with the objectives of overall company.
Chiefly there are two methods of transfer pricing-cost based and market
based. Based on these, there are many types of transfer pricing - cost
price, marginal cost price, standard cost price, cost plus fixed margin,
market price, negotiated price, opportunity cost price etc. Each type of
transfer pricing have advantages and disadvantages too.

LET US SUMUP
Responsibility accounting systems are designed to foster goal
congruence among the managers in decentralised organisations. Each
subunit in an organizational is designated as a cost centre, revenue
centre, profit centre or investment centre. The managerial accountant
prepares a performance report for each responsibility centre. The reports
show the performance of the responsibility centre and its manager for a
specified time period. To use irresponsibility accounting effectively, the
emphasis must be an information rather than blame. The latent should be
to provide manager, with information to help them better manager their
sub-units. Responsibility accounting system can bring about desired

348
behaviour, such as reducing the number of rush orders in a manufacturing
company. Segmented Income statement often are incurred in a
irresponsibility accounting system to slaw the performance of the
organisation and its various segments. Return as investment is widely
used tool in financial control and when used properly, can provide insight
into the profitability of invested assets.

CHECK YOUR PROGRESS

Choose the Correct Answer:

1) Which of the following statements are true about responsibility
accounting?
a) Responsibility accounting results in inter-departmental conflicts
b) In responsibility centre more focus is paid on products,
processes or jobs
c) No focus is paid on controlling costs
d) None of the above
2) ________ is Responsible only for costs incurred by the centre and has
no direct influence over revenue generation.

a) Investment centre b) Cost Centre

c) Profit Centre d) Equity Centre

3) In profit centre revenue represents a monetary measure of output
emanating from a profit centre in a given period irrespective whether
___________

a) The revenue is realized or not b) The output is sold or not

c) Both a and b d) None of the above

4) Contribution margin centre is also known as___________

a) Expense centre b) Profit centre

c) Investment centre d) All of the above

5) ______ is the income of a division produced in excess of the minimum
required rate of return.

a) Residual Income b) Divisional Income

c) Earned Income d) Interest Income

GLOSSARY
Responsibility Centre : Business segment for example
departments

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Cost Centre : Responsible only for costs incurred by
the centre and have no direct
influence over revenue generation.
Profit Centre : Segment of an organisation called
division is to generate earnings and so
the manager of a profit centre has full
control over both costs/ revenues.
Investment Centre : Decision to invest in plant, equipment
and other capital resources
SUGGESTED READINGS
1. Gupta, R.L. and Radhaswamy, M., (2006), Financial Accounting,
Sultan and Chand Sons, New Delhi.
2. Maheswari, S.N and Maheshwary, S.K. (2006), Fundamental of
Accounting, Vikas Publications.
3. Shashi K. Gupta, R.K.Sharma , (2012), “Financial Management”
latest Edition, Kalyani Publishers, Chennai
4. M C Shukla, S C Gupta & T S Grewal, (2017), Advance
Accounting, 19th Edition, S.Chand Publishing, New Delhi
5. Tulsian P. C. , (2017), Financial Accounting , Pearson Education,
New Delhi.
6. https://www.wallstreetmojo.com/responsibility-accounting/
7. https://www.yourarticlelibrary.com/accounting/responsibility-
accounting/responsibility-accounting-meaning-features-and-
steps-for-achieving-goals/67700

ANSWER TO CHECK YOUR PROGRESS

1) a 2) b 3) c 4) b 5) a

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Unit 19

STANDARD COSTING
STRUCTURE

Overview

Learning Objectives

19.1 Meaning of Standard Cost and Costing

19.2 Advantages and Limitations of Standard Costing

19.3 Variance Analysis

19.3.1 Different types of Standards

19.3.2 Possible causes of Standard Cost Variance

19.3.3 Material Cost Variance

19.3.4 Labour Cost Variance

19.3.5 Overhead Variance

19.3.6 Sales Variance

Let Us Sum Up

Check your Progress

Glossary

Suggested Readings

Answers To Check Your Progress

OVERVIEW
Today’s manufacturing environment is rapidly changing, due to the
influences of worldwide competition. JIT, FMS, and an emphasis on
product quality and customer service. As a result, many manufactures
are adapting this standard costing system to reflect these aspects of the
new manufacturing environment. Moreover, non-financial measures of
operational performances are widely used to augment the control
information provided by standard costing. These measures, typically
focus on raw material, scrap, inventory, machinery, product quality,
production and delivery, productivity and innovation and learning.

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LEARNING OBJECTIVES

After completing this unit, you should able to:

• explain what a standard is and some of the considerations
involved in its construction
• distinguish between standard cost and estimated cost

• explain why a variance is either adverse or favourable

• compute labour, material and overhead variances

• discuss the causes of labour and material variances

19.1 MEANING OF STANDARD COST AND COSTING

The technique of standard costing is applied in order to overcome the
various limitations of historical costing. Standard costing technique
involves the preparation and use of standard costs, their comparison with
actual costs and the analysis of the deviations to their causes so as to
provide for corrective action. According to W.B. Lawrence – a standard
cost system is a method of cost accounting in which standard costs are
used in recording certain transactions and the actual costs are compared
with the standard costs is to learn the amount and reason for any
variations from the standard”
According to the institute of Cost and Management Accountants –
“Standard costing is the preparation and use of standard costs, their
comparison with actual costs and the analysis of variances to show their
causes and points of incidence.”
The definition of standard costing as given by W.W. Bigg is more clear
and comprehensive. He is of the opinion that – “ Standard Costing
discloses the cost of deviation from standard and classifies these as to
their cause, so that management is immediately informed of the sphere of
operations in which remedial action is necessary. The main features of
standard cost drawn on the basis of the above definitions, may be given
as follows:
i) Standard costing is primarily a technique of cost accounting
concernedwith cost control.
ii) It determines standards for each element of total costs (i.e., material,
labour and overhead) for each product or service.

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iii) These standards are determined well in advance and are treated as
‘Standard Costs’
iv) It also determines and records the actual costs when these are
incurred.
v) It makes a comparison of actual costs with standard costs to find out
the variances or deviations of actuals from standards. These
variances reveal the level of efficiency or otherwise of the business
operations.
vi) A systematic analysis of the variances is made to ascertain the reasons
responsible for them.
vii) Variances are reported to the management for the purpose of taking
remedial actions.
Standard costs are those costs which are determined in advance for a
normal level of efficiency of operation and which are used periodically as
a basis for comparison with actual costs. These may be termed as
‘common-sense costs’ reflecting best judgment of management as to
what costs ought to be if the business operations are conducted with high
degree of efficiency. According to Brown & Howard “The Standard Cost
is a pre – determined cost which determines what each product or service
should cost under given circumstances. The Institute of Cost and
Management Accountants has defined Standard Cost as a “pre –
determined cost which is calculated from Management’s standards of
efficient operation and the relevant necessary expenditure. It may be used
as a basis for price fixation and for cost control through variance analysis.”

Applicability Of Standard Costing

The technique of standard costing can be applicable under certain

conditions which can be given as follows:
i) There should be output or production of sufficient volume of some
standard product.
ii) The methods, operations and processes of production should be
capable of standardisation.

iii) The costs should be capable of being controlled.

Distinction Between Standard Cost and Estimated Cost

Both, standard cost and estimated cost are pre-determined costs and are
considered to carry the same meaning. But it is not so. The objectives of
both cost are different.

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The main points of difference between standard cost and estimated cost
are as follows:
1. Estimated cost is a reasonable assessment of what a cost ‘will be’,
whereas standard cost is a specification of what a cost ‘should be’.
2. Estimated cost is ascertained on the basis of expected actuals.
Standard cost is said to be a planned cost ascertained on scientific
basis.
3. Estimated cost is an expression of likely cost in future and cannot be
used to measure efficiency or otherwise. Standard cost is used as a
barometer of effiency. Standard cost is compared with actual cost with
a view to ascertain operational efficiency.
4. The use of estimated cost is made in a business concern where
historical costing is in operation whereas standard cost is used in a
concern making the use of standard costing system.
5. Estimated cost does not serve any control purpose but standard cost
serves as a tool of exercising control over costs.

19.2 ADVANTAGES AND LIMITATIONS OF STANDARD COSTING

Standard costing is said to a tool of control in the hands of management
which helps the management in a number of ways in controlling and
reducing costs through the elimination of wastages and inefficiencies of
all types. The main advantage of standard costing may be given as
follows:
1.Valuable Aid to Management: The technique of standard costing
enables the management to perform the functions of planning, organising,
co-ordinating , motivating and controlling effectively. Determination of
standard costs involves a careful analysis of different activities of the
business concern. Thus, it helps the management to plan effectively.
Further, it helps in determining the responsibility of the various executives
of a business concern through the preparation of organisation chart.
2.Formulation of Production and Price Policies: Standard costing
system facilitates the ascertainment of estimated costs promptly and thus
helps the management in formulating production policies. The estimation
of total cost in advance helps in fixing the selling price in advance.
3.Facilitates Delegation of Authority: Standards Costing system
enables the top management to delegate authority through the
establishment of cost and profit centres and to control the departmental
executives by their actions through costing reports.

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4.Assists in Detecting and Preventing Inefficiency: The measurement
and analysis of variances assist the management in detecting
inefficiencies which in their own turn enable the management to
investigate into their originating causes and take corrective action.
5.Promotes Cost Consciousness: Standard costing system stimulates
cost consciousness of all executives as the variance analysis indicates
the responsibility of various executives for favourable or unfavourable
performances.
6.Encourages Management by Exception: Under standard costing
system, the principle of ‘management by exception’ can be applied. The
management need not spend time and efforts in respect of activities which
proceed according to plans and can concentrate on other important
matters.
7.Quick Reporting: Standard costing makes possible the quick
communication of operating data. The preparation of cost reports does
not obstruct the routine activities of the business. The quick and
immediate reporting helps the management in taking suitable and timely
measures.
8.Economy :Standard costing system is economical too. Standard
costing system does not require the maintenance of detailed cost records.
Standard cost Cards are prepared for each product or job and on that
basis, materials cost, labour cost and other expenses are arranged. Thus,
it saves both, time and money.
9.Assistance in Budget Planning: Standards set up in respect of
materials, labour and overheads under the standard costing technique,
are of great help in preparing the various budgets. A proper knowledge of
variations between actual and standard increases the capacity to
anticipate about the changing conditions in the future. Thus, a more
accurate and effective budget can be prepared for the future.

Limitations Of Standard Costing

The technique of standard costing suffers from the following limitations:

1. Introduction of standard costing system is very expensive.
Establishment of standard costs not only requires high degree of skill but
is also very costly. As such, small business concerns find it difficult to
adopt standard costing system due to their financial limitations.
2. Under standard costing system, executives are held responsible for
unfavourable variances caused due to the factors within their control. As

355
such it is necessary to make a distinciton between controllable and
uncontrollable factors, which is a tedious task.
3. The standards to be fixed under standard costing system should be
realistic, accurate and close to the actuals. If the standards are not
properly fixed, these are not going to help the management.
4. Any change in the original factors or circumstances under which
standards were fixed, requires the revision of standards. if it is not done,
the standards become rigid and incapable of being used effectively. But
the revision of the standards is also a very tedious and difficult task.
5. Standard costing is not suitable for all types of business concerns. If
a business deals with non – standard products and jobs, the system of
standard costing shall be found to be unsuitable.
6. Implementation of standard costing system requires a lot of interest
on the part of the management and co – operation from employees. High
standard may have adverse psychological effects on workers. It may
discourage the workers.

19.3 VARIANCE ANALYSIS

The calculation and the analysis of variance is one of the most important
features of standard costing. Variance analysis is a process of analysing
variance by sub – dividing the total cost variance in such a way that the
management can assign the responsibility for off production performance.
Variance are calculated and analysed in respect of the three major
elements of cost (viz ., direct material, direct labour and overhead)and
sales.
Thus, the main Cost Variances are:

1) Direct Material Cost Variance

2) Direct Labour Cost Variance., and

3) Overhead Variance

19.3.1 Different Types of Standards

The two principal considerations affecting the classification of standards
are (i) attainability of standards, that is, the case with which it is possible
to achieve the standards, and (ii) frequency with which the standards are
revised. On the basis of these two factors, it is possible to classify
standards as ideal, normal, basic, current or expected actual standards.

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Ideal, perfect, Maximum Efficiency or Theoretic Standards: Ideal
standards (costs) are the standards which can be attained under the most
favourable conditions possible . The level of performance under ideal
standards would be achieved through the best possible combination of
factors– the most favourable prices for materials and labour, highest
output with best equipment and layout , and maximum efficiency in the
utilisation of the production resource –in other words, maximum output at
minimum cost.
Normal Standards : Normal standards are the average which (it is
anticipated) can be attained during a future period of time , preferably long
enough to cover one business cycle. Standards are set on a normal
capacity basis which represent a volume that averages out the company’s
peak and slack periods. Constant unit costs are employed throughout the
cycle, regardless of changes in current costs or selling prices. These
standards are not revised until the cycle has run its full course. This
generally results in an incorrect valuation of inventories and consequent
errors in the profit disclosed as the inventories are understated in periods
of high prices, and overstated when prices are low. Since these standards
do not reflect the goals to be attained, they are not often used.
Basic Standards: The chartered Institute of Management Accountants
(UK) defines a basic standard as the standard which is established for use
unaltered for an indefinite period which may be a long period of time. Basic
standards are seldom revised or updated to reflect current operating costs
and price level changes.
Currently Attainable or Expected Actual Standards: Current standards
are standards which are established for use over a short period of time,
and are related to current conditions. They respect current costs to be
expected from efficient operations. These standards not anticipate ideal
performance; they are difficult, but possible to achieve. Currently
attainable standards are formulated after marking allowance for the cost
of normal spoilage, cost of idle time due to machine breakdowns, and the
cost of other events which are unavoidable in normal efficient operations.
Managerial uses of variances: Determination of variances is only the
first step in the process of standard cost variance analysis. Mere
computation of material, labour and overhead variances is useless for cost
control and performance evaluation. The final objective of variance
analysis is to determine the person(s) responsible for each variance and
to pinpoint the causes for incurrence of these variances. Properly used,
standard cost variance are useful tools in achieving effective cost control.
That is, before management can take effective action for improving

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control over costs it needs to know not only the amount of variances , but
also where the variance originated, who was responsible for them and
what caused them to arise. Analysis of standard cost variances is,
therefore, necessary for fixing responsibilities and finding causes.
Analysis of Variances by Responsibilities: Variances must be
identified with the manager responsible for the costs incurred. Specific
titles of individuals who are responsible for each type of variance differ
among business enterprises. Generally speaking, the following personal
are held accountable for variance noted against them:

Responsibility for Cost Variance

VARIANCE PERSONNEL RESPONSIBLE

i) Materials price variance Purchasing agent purchasing

manager

i) Materials Quantity Plant superintendent, departmental

Variance machine operators, quality control
department and material handlers.

iii) Labour rate standard Personal (employment) department

manager, departmental supervisors
and plant supervisors.

iv) Labour efficiency Plant superintendent

variance

v) Overhead spending Variable portion is the responsibility

variance of the individual foremen or
supervisor; they are expected to keep
actual expenses within the budget,
Fixed portion is the responsibility of
top management.

vi) Overhead efficiency Same personnel who are responsible

variance for labour efficiency variance.

vii) Overhead volume Top management and production

variance schedulers.

19.3.2 Possible Causes of Standard Cost Variance

Material Price Variances

• Recent changes in purchase price of materials.
• Failure to purchase anticipated quantities when standards were
established resulting in higher prices owing to non-availability of
quantity purchase discounts.

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 • Not taking cash discounts anticipated at the time of setting
standards resulting in higher prices.
• Substituting raw material differing from original materials
specifications.
• Freight cost changes and changes in purchasing and store
keeping cost if these are debited to the material cost.

Materials Quantity Variance

• Poor material handling.
• Inferior workmanship by machine operator
• Faulty equipment.
• Cheaper, defective raw material causing excessive scrap.
• Inferior quality control inspection.
• Pilferage
• Wastage due to inefficient production method.
• Labour Rate Variance
• Recent labour rate changes within industry.
• Employing a man of a grade different from the one laid down in the
standard.
• Labour strike leading to utilization of unskilled help.
• Labour layoff causing skilled labour to be retained at higher rates,
so as to prevent resignations and job switching.
• Employee sickness and vacation time.
• Paying a higher overtime allowance than provided for in standard.

Labour Efficiency
• Machine breakdown, use of defective machinery and equipment
• Inferior raw materials.
• Poor supervision.
• Lack of timely material handling
• Poor employee performance
• Inefficient production scheduling — delays in routing work,
materials, tools and instructions.
• Inferior engineering specifications.
• New inexperienced employees.
• Insufficient training of workers.
• Poor working conditions—inadequate or excessive heating,
lighting, ventilation, etc.

Overhead Volume Variance

• Factors causing either late time or overtime of plant and facilities
• Failure to utilize normal capacity.

359
 • Lack of sales order.
• Too much idle capacity
• Inefficient of efficient utilization of existing capacity
• Machine breakdown.
• Defective materials.
• Labour troubles.
• Power failures.

19.3.3 Material Cost Variance

Clarification of Material Variances

1) Material Cost Variance

The material cost variance is also called material total variance, is the
difference between standard direct material cost of actual production and
the actual cost of direct material

Material Cost Variance

= (Standard units X Standard Price) - (Actual units X Actual Price)

or
= Standard cost of Material – Actual cost of Material used

2) Material Price Variance

The material price variance is the difference between standard price and
the actual purchase price for each unit of material multiplied by the actual
quantity of material purchased.
It is preferable to base the price variance on the actual quantity of material
purchased and not on the actual quantity used in order that price variance
can be reported for control purpose as soon as possible ie. when the
materials are purchased.
Material Price Variance = Actual Quantity (Standard Priceper unit of
material - Actual Price per unit of material)

3) Material Usage Variance

The Material usage variance is the difference between the actual quantity
of material used and the standard quantity of material that should be used
for actual production, multiplied by the standard price per unit of material.

Material Usage Variance

𝐴𝑐𝑡𝑢𝑎𝑙 𝑆𝑡𝑎𝑛𝑑𝑎𝑟𝑑
𝑆𝑡𝑎𝑛𝑑𝑎𝑟𝑑 𝑝𝑟𝑖𝑐𝑒
=[ ] [𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦 − 𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦]
𝑃𝑒𝑟 𝑢𝑛𝑖𝑡 𝑜𝑓 𝑚𝑎𝑡𝑒𝑟𝑖𝑎𝑙

Material Usage Variance is further segregated into the following :

360
a) Material Mix Variance: If a process uses several different materials
which could be combined in a standard proportion, a mix variance can be
calculated which shows the effect on cost of variances from the standard
proportion.
There are two recongnised ways of calculating this mix variance. Some
authorities regard the variance as a sub-set of the usage variance but
others treat it as part of the price variance.
If the mix variance is treated as a sub-set of the usage variance, then the
material mix variance is the difference between the total quantity in
standard proportion, priced at the standard price and the actual quantity
of material used priced at the standard price.
Material Mix Variance =Standard Price (Revised Standard Quantity –
Actual Quantity)

Revised Standard Quantity

Total Quantity of Actual Mix
= Total Quantity of Standard Mix x Standars Quantity

b) Material Yield Variance: Apart from operator or machine performance,

output quantities produced are often different to those planned, e.g., this
arises in chemical plants where plant should produce a given output a
period for a given input but the actual output differs for a variety of
reasons.
Material yield variance is the difference between the standard yield of the
actual material input and the actual yield, both valued at the standard
material cost of the product.
Material Yield Variance = Standard Cost per unit (Standard output for
actual mix – Actual output)
Illustration 1
Chennai Chemical Industries provide the following information from their
records:-
For making 10kgs. of Chemical, the standard material requirement is

Material Quantity Rate per Kg. Rs.

A 8 6.00
B 4 4.00

During April, 2020 1000 kgs. of Chemical were produced. The actual
consumption of materials is as under :-

361
 Material Quantity Rate per Kg. Rs.

A 750 7.00
B 500 5.00

Calculate

a) Material Cost Variance

b) Material Price Variance

c) Material Usage Variance

Basic Calculations
Standard and actual cost of 1,000 kgs. of Actual output of Chemical during
April, 2020.

Material Quantity Rate Amount

Kgs. Rs. Rs.

Standard Cost A 800 6 4,800

B 400 4 1,600

6,400

A 750 7 5,250
Actual Cost B 500 5 2,500

7,750

Calculation of Material variance

a) Material Cost Variance
= Std. Cost – Actual Cost
= 6,400- 7,750
= Rs. 1,350 (A)
b) Material Price Variance
= Actual Quantity (Std. Price- Actual Price)
= (750 (6-7)) + (500 (4-5))
= Rs. 750 (A) + Rs. 500 (A)
= Rs. 1,250 (A)
c) Material Usage Variance
= Std. Price (Std. Qty. - Actual Qty.)
= (6 (800-750)) + (4(400-500))

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 = Rs. 300 (F) + Rs. 400 (A)
= RS. 100 (A)
Summary of Material Variance
MCV= MPV + MUV
1350(A) = (1250(A) + 100 (A))
Illustration 2
The standard cost of one of the products of the company shows the
following standards:

Materials Quantity Standard Price per kg Total Rs.

A 40 kg 75 3,000

B 10 kg 50 500

C 50 kg 20 1,000

Material Cost per unit (Total) 4,500

The standard input mix is 100 kg. and the standard output of the finished
product is 90 kg. The actual results for period are:
Material used
A 240kg @ Rs. 80/kg.
B 40kg @ Rs. 52/kg.
C 220kg @ Rs. 21/kg.
Actual output of the finished product – 420 kg.
You are required to calculate the material variances.
Basic data
Calculation of Standard and Actual quantity of Material consumed

Standard Actual
Material
Qty. Rate Amount Qty Rate Amount
Kg. Rs. Rs. Kg. Rs. Rs.

A 200 75 15,000 240 80 19,200

B 50 50 2,500 40 52 2,080

C 250 20 5,000 220 21 4,620

Total 500 22,500 500 25,900

Standard output = 450 kgs

Actual output = 420 kgs.

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Calculation of Direct Material Variances

1. Direct material cost variance

Std. Cost of actual output- Actual cost

= (420 X 50) – 25,900

21,000- 25,900

= Rs. 4,900 (A)

2. Direct material price variance

Actual Qty. (Std. Rate- Actual rate)

A = 240 (75-80) = Rs. 1200 (A)

B = 40 (50-52) = Rs. 80 (A)

C - 220 (20-21) = Rs. 220 (A)

= Rs. 1500 (A)

3. Direct material usage variance

Std. Rate (Std. Qty. for actual output- Actual qty.)

A = 75 [200X 42/45- 240] = Rs. 4000 (A)

B = 50 [50 X 42/45- 40] = Rs. 333 (F)

C = 20 [250 X 42/45 – 220] = Rs. 267 (F)

= Rs. 3400 (A)

4. Direct material mix variance

Std. Rate (Revised Std. Qty. – Actual Qty.)

A = 75 (200 – 240) = Rs. 3000 (A)

B = 50 (50- 40) = Rs. 500 (F)

C = 20 (250- 220) = Rs. 600 (F)

= Rs. 1900 (A)

5. Direct material yield variance

Std. Cost per unit (Std. Output for actual mix- Actual output)

= 50 (450- 420) = Rs. 1500 (A)

MCV = MPV + MMV + MYV

4900 (A) = 1500 (A) + 1900(A) + 1500 (A)

364
19.3.4 Labour Cost Variance

Classification of Labour Variances

1) Labour Cost Variance: The labour cost variance is also called the
labour total variance, is the difference between the standard direct
labour cost and the actual direct labour cost incurred for the production
achieved.
𝑆𝑡𝑎𝑛𝑑𝑎𝑟𝑑 𝐿𝑎𝑏𝑜𝑢𝑟 𝑥 𝑆𝑡𝑎𝑟𝑛𝑑𝑎𝑟𝑑
𝐴𝑐𝑡𝑢𝑎𝑙 𝐷𝑖𝑟𝑒𝑐𝑡 𝑥 𝐴𝑐𝑡𝑢𝑎𝑙 𝑅𝑎𝑡𝑒
=[ ] -[ 𝐿𝑎𝑏𝑜𝑢𝑟 𝐻𝑜𝑢𝑟𝑠 𝑃𝑒𝑟 𝐻𝑜𝑢𝑟 ]
𝐻𝑜𝑢𝑟𝑠 𝑃𝑟𝑜𝑑𝑢𝑐𝑒𝑑 𝑅𝑎𝑡𝑒

or

= Standard cost for actual output- Actual cost

2) Labour Rate Variance: The labour rate variance is the difference
between the actual direct labour rate per hour and the standard direct
labour rate per hour, multiplied by the actual hours paid, i.e. the rate per
hour paid to the direct labour force more or less than standard use of
higher/ lower grade of skilled workers than planned or wage inflation
causes this variance.

Labour Rate variance = Actual time (Standard rate – Actual rate)

3) Labour Efficiency Variance: The labour efficiency variance is the
difference between the actual hours taken to produce the actual output
and the standard hours that this output should have taken, multiplied by
the standard rate per hour.
The possible cause for this variance is due to use of higher/ lower grade
of skilled workers than planned or the quality of material used, errors in
allocation time to jobs.
Labour efficiency variance= Standard Rate (Standard time for actual
output – Actual time)

The labour efficiency variance can be segregated into the following :

a) Labour Mix Variance: The labour mix variance arises due to change
in composition of labour force

Labour Mix variance

= Standard Rate (Revised Standard Time- Acutal Time)

Revised Standard Time

Total Actual Time
= Total Standard Time x Standard Time

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b) Labour Yield Variance: The Labour Yield variance arise due to the
difference in the standard output specified and the actual output obtained.
𝑆𝑡𝑎𝑛𝑑𝑎𝑟𝑑 𝑜𝑢𝑡 𝑝𝑢𝑡 𝐴𝑐𝑡𝑢𝑎𝑙
= Standard Cost per unit ( )-( )
𝑓𝑜𝑟 𝑎𝑐𝑡𝑢𝑎𝑙 𝑡𝑖𝑚𝑒 𝑜𝑢𝑡 𝑝𝑢𝑡

c) Idle Time Variance : The idle time variance represents the different
between hours paid and hours worked, i.e. idle hours multiplied by the
standard wage rate per hour. This variance may arise due to illness,
machine break – down, hold – ups on the production line because of lack
of material.

Idle time variance = Idle hours X Standard rate

d) Net Efficiency Variance: This variance is calculated after deducting
idle hours form actual hours. The efficiency variance less idle time
variance is called net efficiency variance.

Net Efficiency Variance

𝑆𝑡𝑎𝑛𝑑𝑎𝑟𝑑 𝑡𝑖𝑚𝑒 𝐴𝑐𝑡𝑢𝑎𝑙 𝑡𝑖𝑚𝑒 )
= Standard rate ( )- (
𝑓𝑜𝑟 𝑎𝑐𝑡𝑢𝑎𝑙 𝑜𝑢𝑡 𝑝𝑢𝑡 𝑊𝑜𝑟𝑘𝑒𝑑
= Standard rate (Standard Time – Actual Time – Idle Hours)
illustration 3

The Standard labour component and the actual labour component

engaged in a week for a job

Skilled Semi-skilled Unskilled

workers workers workers

A) Standard number of workers in the 32 12 6

gang

B) Standard wage rate per hour(Rs.) 30 20 10

C) Actual number of workers employed 28 18 4

in the gang during the weeK

D) Actual wage rate per hour(Rs.) 40 30 20

During the 40 – hours working week the gang produced, 1,800 standard
labour hours of work. Calculate.

i) Labour efficiency variance

ii) Labour mix variance

iii) Rate of wages variance

iv) Total labour cost variance

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Solution

Category of Standard Actual

workers
Hrs. Rate Amount Hrs Rate Amount

Skilled 1,280 30 38,400 1120 40 44,800

Semi – skilled 480 20 9,600 720 30 21,600

Unskilled 240 10 2,400 160 20 3,200

2,000 50,400 2,000 69,600

Labour cost variance output = Actual cost – Standard cost for actual
= Rs. 69,600 – Rs. 45,360
= Rs. 24,240 (Adverse)
Labour rate variance = Actual time x (Actual rate – Standard rate)
Skilled = Rs. 1,120 x (40-30)= Rs.11,200 (A)
Semi – Skilled = Rs. 720 x (30-20)
= Rs. 7,200(A)
Un Skilled = Rs. 160 x (20-10)
= Rs. 1,600(A)
Total = Rs. 11,200(A) + Rs. 7,200(A) +Rs.1,600(A)
= 20,000(Adverse)
Labour efficiency variance = Standard Rate (Actual time–Standard
time for actual output)
Skilled = 30 x (1,120-1,152)
= Rs.960 (F)
Semi – Skilled = 20 x (720-432)
= Rs. 5,760(A)
Un Skilled = 10 x (160-216)
= Rs. 560(F)
Total = Rs. 960(F) + Rs. 5,760(A) + Rs. 560(F)
= Rs. 4,240(A)
Labour mix variance = Standard Rate (Actual time – Revised
standard time)
Skilled = 30 x (1,120-1,280)
= Rs.4,800 (F)

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 Semi – Skilled = 20 x (720-480)
= Rs. 4,800(A)
Un Skilled = 10 x (160-240)
= Rs. 800(F)
Total Rs. 4,800(F) + Rs. 4,800(A) + Rs. 800(F)
= Rs.800(Favourable)
Labour yield variance = Standard cost per hour of work x
(Actual output –
Standard output for actual mix)
= 25.2 x (1,800 – 2,000)
= Rs. 5,040(Adverse)
Working Notes
50,400
1. Standard cost for actual output = Rs.
2,000
x 1,800

2. Standard time for actual output:

1,800
Skilled =
2,000
x 1,280 = 1,152 hrs

Actual Mix
Semi - skilled = x 𝑆𝑡𝑎𝑛𝑑𝑎𝑟𝑑 𝑇𝑖𝑚𝑒
Standard Mix
1,800
Unskilled = x 240 = 216 hrs
2,000
Actual Mix
3.Revised standard time = x 𝑆𝑡𝑎𝑛𝑑𝑎𝑟𝑑 𝑇𝑖𝑚𝑒
Standard Mix

Since, Standard Mix and Actual Mix are the same, the standard Time will
also be the Revised Standard Time.
Total Standard Cost
Standard Cost per hour of standard work = Total Standard Hours of Work
50,400
= = Rs. 25.2
2,000

19.3.5 Overhead Variance

The analysis of factory overhead variances is more complex than variance
analysis for direct materials and direct labour. There is no standardization
of the terms or methods used for calculating overhead variance. For this
reason it is necessary to be familiar with the different approaches which
can be applied in overhead variances. Generally, the computation of the
following overhead variances suggested:

368
1)Total Overhead Cost Variance: This overall overhead variance is the
difference between the actual overhead cost incurred and the standard
cost of overhead for the output achieved. This can be computed by
applying the following formula:
(Actual overhead incurred) – (Standard hours for the actual output x

Standard overhead rate per hour)

Or

(Actual overhead incurred ) – (Actual output x Standard overhead rate

per unit)
2)Variable Overhead Variance: It is the difference between actual
variable overhead cost and standard variable overhead allowed for the
actual output acheived. The formula for computing this variance is a
follows:

(Actual overhead cost ) – (Actual output x Variable overhead rate per

unit)

Or

(Actual overhead cost ) –(Std. hours for actual output X Std. Variable

overhead rate per hour)

3) Fixed Overhead Variance : This variance indicates the
difference betweeen the actual fixed overhead cost and standard fixed
overhead cost allowed for the actual output. This variance is found by
using the following formula:

369
Fixed Overhead Variance=(Actual Overhead Cost – Fixed Overhead

absorbed)

or

(Actual Overhead Cost) – (Actual Output x Fixed Overhead rate per unit)

or
(Actual Overhead Cost) - (Std. hours for actual output x Std. fixed
overhead rate per hour)
4) Variable Overhead Expenditure Variance : This Variance indicates
the difference between actual variable overhead and budgeted variable
overhead based on actual hours worked. This variance is found by using
the following.

(Actual variable overhead – Budgeted variable overhead)

5) Variable Overhead Efficiency Variance :This Variance is like labour
efficiency variance and aries when actual hours worked differ from
standard hours required for good units produced. The actual quantity
produced and standard quantity fixed might be different because of higher
or lower efficiency of workers employed in the manufacturing of goods.
This variance is found by using the following formula:

(Actual hours – Standard hours for actual output )

x Standard variable overheadrate per hour

6) Fixed Overhead Expenditure (Spending or Budget)Variance :

This Variance indicates the difference between actual fixed overhead and
budget fixed overhead . The formula for computing this variance is as
follows :

(Actual fixed overhead – Budgeted fixed overhead)

7) Fixed Overhead Volume Variance: Volume variance relates to only
fixed overhead. This variance aries due to the difference between the
standard fixed overhead cost allowed (absorbed) for the actual output
and the budgeted fixed overhead on standard hours allowed for actual
output achieved during the period. The variance shows the over-or-under
absorption of fixed overheads during a particular period. If the actual
output is less than the standard output; the volume variance is
unfavourable. The formula for computing this variance is as follows:

(Budgeted overhead applied to actual output – Budgeted fixed overhead

based on standard hours allowed for actual output)

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 or

(Actual Production – Budgeted production )x Std. fixed overhead rate

per unit

Volume variance is further sub – dividend into three variance

8) Fixed Overhead Calendar Variance: It is that portion of volume
variance which is due to the difference between the number of actual
working days in the period to which the budget is applicable and budgeted
number of days in the budget period.
If actual working days is more than the budgeted working days, the
variance is favourable as work has been done on days more than
budgeted and vice – versa. The formula is as follows:

(No. of actual working days – No. of Budgeted working days) x Std.

fixed overhead rate per day

Calendar variance can be computed based on hours or output. Then the
formula are:
Hours Basis

Calendar Variance = (Revised Budget Capacity hours - Budget Hours) x

Std. Fixed Overhead rate per hour

If revised budgeted capacity hours are more than the budgeted hours, the
variance will be favourable. In the reverse situation, the variance will be
unfavourable.

Output Basis
Calendar Variance = (Revised budgeted quantity in terms of actual
number of days worked – Budgeted quantity) x Standard fixed overhead
rate per unit.
If revised budgeter quantity is more than the budgeted quantity; the
variance is favourable ; if revised budgeted quantity is less, the variance
will be unfavourable.
9) Fixed Overhead Efficiency Variance: It is that portion of volume
variance which arises when actual hours of production used for actual
output differ from the standard hours specified for that output. If actual
hours worked are less than the standard hours, the variance is favourable
and when actual hours are more than the standard hours, the variance is
unfavourable. The formula is :

371
Fixed Overhead Efficiency Variance =(Actual hours- Standard hours for
actual Production) x Fixed
overhead rate per hour

OR

Fixed Overhead Efficiency Variance =(Actual Production- Standard

production as per actual time
available) x Fixed overhead rate
per unit.
10) Fixed Overhead Capacity Variance: It is that part of fixed overhead
volume variance which is due to the difference between the actual
capacity (in hours) worked during a given period Capacity Variance =
(Actual Capacity Hours- Budgeted Capacity) x Standard fixed overhead
rate per hour
This variance represents idle time also. If actual capacity hours are more
than the budgeted capacity hours, the variance is favourable and if actual
capacity hours are less than the budgeted capacity hours the variance will
be unfavourable.
In case actual number of days and budgeted number of days are also
given, then budged capacity hours will be calculated in terms of actual
number of days and it will be known as revised budgeted capacity hours,
i.e., budgeted hours in actual days worked. In this situation, the formula
for calculating capacity variance will be as follows:

Capacity Variance=(Actual Capacity hours- Revised Budgeted

Capacity hours)Standard fixed overhead rate per
hour.

Two – way, Three – way and Four - way Variance Analysis

The above overhead variance are also classified as Two – way, Three –
way and Four way variance. The different variances under these
categories are listed below. The formula for computing these variances
are similar to as explained in the preceeding section.
A)Two – way Variance Analysis : The two – way analysis computes two
variance ; budget variance (some times called flexible budget or controlled
variance )and volume variance, which means;

i) Budget Variance =Variance spending variance + Fixed spending

(budget)Variance + Variable efficiencyvariance

ii) Volume variance=Fixed volume variance

372
B)Three – way Variance Analysis: The three – way analysis computes
three variance: spending, efficiency and volume variance . Therefore,

i)Spending variance = Variable spending variance + Fixed

spending (budget) variance

ii) Efficiency variance = Variable efficiency Variance

iii) Volume variance =Fixed volume variance

C)Four – way Variance Analysis : The four – way analysis includes

i) Variable Spending Variance

ii) Fixed spending (budget ) variance

iii) Variable efficiency variance

iv) Fixed volume variance

Illustration 4

From the following data, calculate overhead variance:

Budgeted Actual

Output 15,000 units 16,000 units

No. of working days 25 27

Fixed overheads Rs. 3,00,000 Rs. 3,05,000

Variable overheads Rs. 4,50,000 Rs. 4,70,000

Solution

1. Total Overhead Cost Variance

Actual overhead cost – (Actual units x Std. Rate)

(Rs. 3,05,000 + 4,70,000 – 16,000 x Rs.50)

Rs. 7,75,000 – Rs. 8,00,000 = Rs. 25,000 unfavourable

2. Variable Overheads Variance

Actual overhead cost – (Actual units x St. Rate)

(Rs. 4,70,000 – 16,000 x Rs.30)

Rs. 4,70,000 – Rs. 4,80,000 = Rs. 10,000 unfavourable

3. Fixed Overhead Variance

Actual overhead cost – (Actual units x Std. Rate of fixed overhead)

(Rs. 3,05,000 – 16,000 x 20)

Rs. 3,05,000 – 3,20,000 = Rs. 15,000 unfavourable

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4. Volume Variance

Actual units x Std. Rate – Budgeted fixed overheads

(Rs. 16,000 x Rs. 20) - Rs. 3,00,000 = Rs. 20,000 favourable

5. Expenditure Variance

Actual fixed overheads – Budgeted fixed overheads

Rs. 3,05,000 – Rs. 3,00,000 = Rs. 5,000 favourable

6. Capacity variance

St. Rate x (Revised budget units – Budgeted units)

Revised budgeted units – Budgeted units + Increase in capacity

= Capacity variance

= Rs. 20 (15, 750 units – 15,000 units)

= Rs. 20 x 750 = Rs. 15,000 favourable

7. Calendar Variance
Increase or decrease in production due to more or less working days x St.
Rate per unit within 25 days, Standard production with increased capacity
= 15,750 units within 2 days (27 – 25),

Production will be increased by =

Calendar variance = 1260 units x Rs. 20

= Rs. 25,200 favourable

8. Efficiency Variance
Std. Rate x (Actual Production – St. Production)

Standard production ;

Budgeted production = 15,000 units

Production increased due to increase in capacity = 750 units

Production increased due to

2 more working days =

Efficiency Variance = Rs 20 (16, 000 units – 17, 010 units)

Rs. 20 (-1,010 units) = Rs. 20,200 unfavourable

19.3.6 Sales Variance

All of the variance discussed previously have been concerned with costs;
the effects on profits due to adverse or favourable variance affecting direct

374
materials, direct labour or overheads. Some companies calculate cost
variance only; but to obtain the full advantages of standard costing, many
companies also calculate sales variances. Sales variance affect a
business in terms of charges in revenue; changes which have been
caused either by a variation in sales quantities or in sales prices.
There are two distinctly separate systems of calculating sales variances,
which show the effect of a charge in sales as regards;

I. Sales margin variance (on the basis of profit) and ,

II. Sales value Variance (on the basis of turnover)

Sales Variances based on Profit : The Sales variance based on profit
are also called sales margin variances which indicates the deviation
between actual profit and standard or budgeted profit.
1. Total Sales Margin Variance : This variance taken into account
the difference between actual profit and standard or budgeted profit.

Total Sales Margin Variance

= Actual Profit - Budgeted Profit

𝐴𝑐𝑡𝑢𝑎𝑙 𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑥 𝐴𝑐𝑡𝑢𝑎𝑙 𝑃𝑟𝑜𝑓𝑖𝑡
𝐵𝑢𝑑𝑔𝑒𝑡𝑒𝑑 𝑄𝑢𝑎𝑛𝑑𝑖𝑡𝑦 𝑥 𝐵𝑢𝑑𝑔𝑒𝑡𝑒𝑑 𝑃𝑟𝑜𝑓𝑖𝑡
=[ ] -[ 𝑜𝑓 𝑆𝑎𝑙𝑒𝑠 𝑃𝑒𝑟 𝑈𝑛𝑖𝑡 ]
𝑜𝑓 𝑆𝑎𝑙𝑒𝑠 𝑃𝑒𝑟 𝑈𝑛𝑖𝑡

Classification of Sales Margin Variances

2. Sales Price Variance : The Price variance is the difference
between standard price of the quantity of sales effected and the actual
price of those sales.

Sales Price Variance

375
3. Sales Volume Variance : It represents the difference between the
actual units sold and the budgeted quantity multiplied either the standard
profit per unit or the standard contribution per unit. In a absorption
costing standard profit per unit is issued , but in marginal costing,
standard contribution per unit must be used.

Sales Volume Variance

Sales Volume Variance can be further segregated in to:

3. a) Sales Mix Variance

The sales mix Variance arise when the company manufactures and sells
more than one type of product. This variance will be due to variation of
actual mix and budgeted mix of sales.
Sales Mix Variance

3. b) Sales Quantity Variance

The Sales quantity is the difference between the budgeted profit on
budgeted sales and expected profit on actual sales.

Sales Quantity Variance

376
 or

Illustration 5
Chennai Ltd is manufacturing and selling three standard products. The
company has a standard cost system and analyse the variance budget
and the actuals periodically.

The summarised working results for 2018 – 19 were as follows:

Product Budget Actual

Selling Price Cost per No. of Selling Cost per No. of

per Unit
unit units to Price per unit units to
be sold Unit be sold

A Rs.50 Rs.32 10,000 Rs.48 Rs.30 12,000

B 40 24 14,000 42 25 12,000

C 30 18 16,000 31 20 15,000

a) Calculate the variance in profit during the period

b) Analyse the variance in profit into :

i) Sales price variance; ii) Sales Volume variance;

iii) Cost Variance; iv) Sales margin quantity variance;

v) Sales margin mix variance.

Working Notes

1. a) Actual margin per unit

Actual sales price per unit - Std. Cost per unit

A = Rs. 48 - Rs. 32 = Rs. 16

B = Rs. 42 - Rs. 24 = Rs. 18

C = Rs. 31 - Rs. 18 = Rs. 13

b) Budgeted margin per unit

377
 Budgeted sales price unit – Std. Cost per unit

A = Rs. 50 – Rs. 32 = Rs. 18

B = Rs. 40 – Rs. 24 = Rs. 16

C = Rs. 30 – Rs. 18 = Rs. 12

2. a) Actual Profit

Actual Qty. Of units sold Actual margin per unit

Rs.

A = 12,000 x 16 = 1,92,000

B = 12,000 x 18 = 2,16,000

C = 15,000 x 13 = 1,95,000

Total 6,03,000

b) Budgeted Profit

Budgeted Qty. Of units sold Budgeted Margin per unit

Rs.

A = 10,000 x 18 = 1,80,000

B = 14,000 x 16 = 2,24,000

C = 16,000 x 12 = 1,92,000

Total 5,96,000
3. a) Budgeted margin per unit on actual mix
18 x 12,000+16 x 12,000+12 x 15,000
=
39,000
2,16,000+1,92,000+1,80,000
=
39,000

= Rs. 15.077 per unit

b) Budgeted margin per unit on budgeted mix

18 x 10,000+16 x 14,000+12 x 16,000
=
40,000
1,80,000+2,24,000+1,92,000
=
40,000

= Rs. 14.90 per unit

Calculation of Sales Variances

1. Total Sales Margin Variance

Actual profit- Budgeted Profit

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 = Rs. 6,03,000 – Rs. 5,96,000

= Rs. 7,000 (F)

2. Sales Margin Price Variance

Actual Qty. (Actual margin per unit – Budgeted margin per unit)

A = 12,000 (16-18) = 24,000 (A)

B = 12,000 (18-16) = 24,000 (F)

C = 15,000 (13-12) = 15,000(F)

= Rs.15,000 (F)

3. Sales Margin Volume Variance

Budgeted margin per unit (Actual Qty. – Budgeted Qty.)

A = 18(12,000 - 10,000) = 36,000 (F)

B = 16 (12,000- 14,000) = 32,000(A)

C = 12 (15,000- 16,000) = 12,000 (A)

= Rs. 8,000 (A)

The sales margin volume variance can be further segregated into the
following

4. Sales Margin Mix Variance =

Total Actual Quantity (Budgeted margin per unit on actual mix –

Budgeted margin per unit on budgeted mix)

5. Sales Margin Quantity (sub-volume) Variance =

Budgeted margin per unit on budgeted mix (Total actual Qty- Total
budgeted Qty.)

= 14.90 (39,000 – 40,000) = Rs. 14,900 (A)

Summary of Sales Margin Variance

Rs.

Price Variance 15,000 (F)

Volume Variance

i) Mix Variance 6,900 (F)

ii) Qty. Sub-volume variance 14,900 (A) 8,000 (A)

Total Sales Margin Variance 7,000 (F)

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Sales Variance based on Turnover

The sales variance based on turnover are classified as follows

Formula

1. Sales Value Variance

= (Actual Quantity X Actual Selling Price) - (Standard Quantity
Standard Selling Price)
2. Sales Price Variance

= Actual Quantity (Actual Selling Price- Standard Selling Price)

3. i) Sales Volume Variance

= Standard Value of Actual Mix – Standard Value of revised Standard
Mix)

3. ii) Sales Quantity Variance

or

= Revised Standard Sales Value- Budgeted Sales Value

LET US SUMUP
A standard costing system serves two purposes: Cost control and product
costing. The managerial accountant works with others in the organization
to set standard costs for direct material, direct labour and manufacturing
overhead through either historical cost analysis or task analysis. The
accountant then uses the standard costs as a bench mark against which
to compare actual cost incurred. Managers use management by
exception to determine the causes of significant cost variances. This
control purpose of the standard costing system is accomplished by

380
composing a direct material price variance, a direct material quantity
variance; direct labour variance and a direct labour efficiency variance.
Managers determine the significance of cost variances, through judgment
and rules of thumb. The absolute and relative size of variance, recurrence
of variances, variance trends, and contributing of variances are all
considered in deciding whether variances warrant investigation. The
managerial accountant achieves the product- costing purpose of the
standard–costing system by entering the standard cost of production into
work-in- progress inventory as a product cost. Standard costing systems
offer an organization many benefits. However, these benefits, will be
obtained only if the standard costing system is used property.

CHECK YOUR PROGRESS

Choose the Correct Answer:

1) Which of the following standards cannot be used for cost control?

a) Basic standard b) Normal standard

c) Both a and b d) None of the above

2) When standard costs are used, the amount of detailed record keeping
will normally _________

a) Reduce b) Increase

c) Stay the same d) None of the above

3) If labour time is based on the maximum efficiency, the unit cost will be
___________

a) Higher b) Lower
c) Equal d) None of the above

4) Which of the following statements are true about standard labour time?
a) Standard labour time indicates the time in hours needed for a
specified process
b) It is standardized on the basis of past experience with no
adjustments made for time and motion study
c) In fixing standard time due allowance should not be given to
fatigue and tool setting
d) The production manager does not provide any input in setting
the labour time standards

5) The labour engaged in the making of a product is known as _______

a) Direct labour b) Indirect labour

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 c) Temporary labour d) None of the above

GLOSSARY
Standard Cost : Predetermined cost or forecast
estimate of cost.
Standard Costing : System of cost accounting which is
designed to find out how much should
be the cost of a product under the
existing conditions.
Historical Costing : Ascertainment and recording of actual
cost after these have been incurred.
Material Cost Variance : Difference between standard material
cost and actual material cost.
Material Mix Variance : Is that part of material variance which
arises due to changes in standard and
actual composition of mix.

REVIEW QUESTIONS
1. The standard material cost to produce a tonne of chemical is:

300 kg of material A @ Rs. 10 per kg

400 kg of material B @ Rs.5 per kg

500 kg of material C @ Rs. 6 per kg

During a period 100 tonnes of mixture were produced from the usage
of :
35 tonnes of material A at a cost of Rs. 9,000 per tonne.

42 tonnes of material B at a cost of Rs. 6,000 per tonne

53 tonnes of material C at a cost of Rs. 7,000 per tonne

Calculate Price, Usage and Mix Variance.

2. The standard cost of certain chemical mixture is :

35% material A @ Rs. 25 per kg

65% material B @ Rs. 36 per kg

A standard loss of 5% is expected in production.

During a period there is used :

125 kgs of Material A at Rs. 27 per kg; and 275 kgs of

Material B at Rs. 34 per kg. The actual output were 365 kgs.

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 Calculate material cost variances.

3. Calculate Labour cost variance from the following figures

Standard Actual

Number of workers explained 600 550

Average wages per worker per month 250 264

Number of working days in a month 25 24

Output in units 30,000 28,000

4. The cost figures relating to a company are as follows :

Actual overhead Rs. 1,800

Budgeted overhead Rs. 2,000

Budged Period : 4,000 Labour hours

Standard hours per unit : 10 Labour hours

Budgeted number of days : 20

Standard overhead per hour : Re. 0.50

Actual number of days : 22

Actual hours : 4300

Actual production : 425 units

Calculate expense variance, calendar variance, capacity variance,
efficiency variance and volume variance.

SUGGESTED READINGS
1. Gupta, R.L. and Radhaswamy, M., (2006), Financial Accounting,
Sultan and Chand Sons, New Delhi.
2. Maheswari, S.N and Maheshwary, S.K. (2006), Fundamental of
Accounting, Vikas Publications.
3. Shashi K. Gupta, R.K.Sharma , (2012), “Financial Management”
latest Edition, Kalyani Publishers, Chennai
4. M C Shukla, S C Gupta & T S Grewal, (2017), Advance
Accounting, 19th Edition, S.Chand Publishing, New Delhi
5. Tulsian P. C. , (2017), Financial Accounting , Pearson Education,
New Delhi.
6. https://www.accountingtools.com/articles/standard-costing
7. https://www.youtube.com/watch?v=i9NXE_9BgF8

ANSWER TO CHECK YOUR PROGRESS

1) c 2) a 3) c 4) a 5) a

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Unit 20

COMPUTERIZED ACCOUNTING
SYSTEM
STRUCTURE

Overview

Learning Objectives

20.1 Introduction to computerized accounting system

20.2 Comparison between manual and computerized accounting

20.3 Advantages and Limitations of computerized accounting

20.4 Meaning and types of accounting packages

20.4.1 Ready to use

20.4.2 Customised

20.4.3 Tailored

20.4.4 Comparison among Ready-to-Use, Customised

and Tailored

20.5 Factors to consider for an Accounting Software

20.6 Introduction of tally ERP 9

20.7 Features of tally ERP 9

Let Us Sum Up

Check your Progress

Glossary

Suggested Readings

Answers To Check Your Progress

OVERVIEW
Computer is an important part of an accounting system. Computerized
accounting systems are important to business in various ways.
Computers helps businesses by making their staff efficient, productive
and also save their valuable time. It helps to maintain business and all
financial information for the business is well-organized. Computerised
accounting system is a software that helps businesses to manage the big
financial transactions, data, reports, and statements with high efficiency,

384
speed, and better accuracy. Better quality work, lower operating costs,
better efficiency, greater accuracy, minimum errors are some of the
advantages of Computerized Accounting. Let us learn more about
Computerized accounting environment. Manual accounting system
requires large storage to keep accounting records, and vouchers. The
requirement of books and stationery and books of accounts along with
vouchers and documents is dependent on the volume of transactions.

LEARNING OBJECTIVES

After reading this unit, you should be able to

• Understand the concept of computerised accounting system
• Differentiate manual and computerised accounting system
• Analyse the advantages and limitations of computerised
accounting system
• Know the various accounting packages
• Its types and comparison among them
• Understand what tally ERP 9 is
• Know the features and advantages of tally ERP 9

20.1 INTRODUCTION
A computerised accounting system is an accounting information system
that processes the financial transactions and events as per Generally
Accepted Accounting Principles (GAAP) to produce reports as per user
requirements. Every accounting system, manual or computerised, has
two aspects. First, it has to work under a set of well-defined concepts
called accounting principles. Another, that there is a user -defined
framework for maintenance of records and generation of reports.
In a computerised accounting system, the framework of storage and
processing of data is called operating environment that consists of
hardware as well as software in which the accounting system, works. The
type of the accounting system used determines the operating
environment. Both hardware and software are interdependent. The type
of software determines the structure of the hardware. Further, the
selection of hardware is dependent upon various factors such as the
number of users, level of secrecy and the nature of various activities of
functional departments in an organisation.
Take the case of a club, for example, where the number of transactions
and their variety is relatively small, a Personal Computer with
standardised software may be sufficient. However, for a large business
organisation with a number of geographically scattered factories and
offices, more powerful computer systems supported by sophisticated

385
networks are required to handle the voluminous data and the complex
reporting requirements. In order to handle such requirements, multi-user
operating systems such as UNIX, Linux, etc. are used.
Modern computerised accounting systems are based on the concept of
database. A database is implemented using a database management
system, which is define by a set of computer programmes (or software)
that manage and organise data effectively and provide access to the
stored data by the application programmes. The accounting database is
well-organised with active interface that uses accounting application
programs and reporting system.

Every computerised accounting system has two basic requirements;

▪ Accounting Framework: It consists a set of principles, coding
and grouping structure of accounting.
▪ Operating Procedure: It is a well-defined operating procedure
blended suitably with the operating environment of the
organisation.
The use of computers in any database-oriented application has four basic
requirements as mentioned below;
i) Front-end Interface: It is an interactive link or a dialog between the
user and database-oriented software through which the user
communicates to the back-end database. For example, a transaction
relating to purchase of goods may be dealt with the accounting system
through a purchase voucher, which appears on the computer’s monitor of
data entry operator and when entered into the system is stored in the
database. The same data may be queried through reporting system say
purchase analysis software programme.
ii)Back-end Database: It is the data storage system that is hidden from
the user and responds to the requirement of the user to the extent the
user is authorised to access.
iii) Data Processing: It is a sequence of actions that are taken to
transform the data into decision useful information.
iv)Reporting System: It is an integrated set of objects that constitute the
report.
The computerised accounting is also one of the database-oriented
applications wherein the transaction data is stored in well-organised
database. The user operates on such database using the required and
desired interface and also takes the desired reports by suitable
transformations of stored data into information. Therefore, the

386
fundamentals of computerised accounting embrace all the basic
requirements of any database-oriented application in computers.
Accordingly, the computerised accounting system has the above four
additional requirements.
20.2 COMPARISON BETWEEN MANUAL AND COMPUTERIZED
ACCOUNTING

BASIS FOR COMPUTERIZED

MANUAL ACCOUNTING
COMPARISON ACCOUNTING

Meaning Manual Accounting is a Computerized Accounting

system of accounting that is an accounting system
uses physical registers that uses an accounting
and account books, for software, for recording
keeping financial records. financial transactions
electronically.

Recording Recording is possible Data content is recorded

through book of original in customized database.
entry.

Calculation All the calculation is Only data input is

performed manually. required, the calculations
are performed by
computer system.

Speed It is slow It is comparatively faster.

Adjusting It is made for rectification It cannot be made for

entries of errors. rectification of errors.

Backup Taking backup is not Entries of transactions

possible can be saved and backed
up

Trial Balance It is prepared only when Instant trial balance is

necessary. provided on daily basis.

Financial It is prepared at the end It is provided at the click

Statement of the period, or quarter. of button.

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20.3 ADVANTAGES AND LIMITATIONS OF COMPUTERISED
ACCOUNTING SYSTEM

20.3.1 Advantages of Computerised Accounting System

Computerised accounting offers several advantages vis-a-vis manual
accounting, these are summarised as follows,
1. Speed: Accounting data is processed faster by using a computerised
accounting system than it is achieved through manual efforts. This is
because computers require far less time than human beings in performing
a task.
2. Accuracy: The possibility of error is eliminated in a computerised
accounting system because the primary accounting data is entered once
for all the subsequent usage and processes in preparing the accounting
reports. Normally, accounting errors in a manual accounting system occur
because of repeated posting of same set of original data by several times
while preparing different types of accounting reports.
3. Reliability: The computer system is well-adapted to performing
repetitive operations. They are immune to tiredness, boredom or fatigue.
As a result, computers are highly reliable compared to human beings.
Since computerised accounting system relies heavily on computers, they
are relatively more reliable than manual accounting systems.
4. Up-to-Date Information: The accounting records, in a computerised
accounting system are updated automatically as and when accounting
data is entered and stored. Therefore, latest information pertaining to
accounts get reflected when accounting reports are produced and printed.
For example, when accounting data pertaining to a transaction regarding
cash purchase of goods is entered and stored, the cash account,
purchase account and also the financial statements (trading and profit and
loss account) reflect the impact immediately.
5. Real Time User Interface: Most of the automated accounting systems
are inter-linked through a network of computers. This facilitates the
availability of information to various users at the same time on a real time
basis (that is spontaneously).
6. Automated Document Production: Most of the computerised
accounting systems have standardised, user defined format of accounting
reports that are generated automatically. The accounting reports such as
Cash book, Trial balance, Statement of accounts are obtained just by click
of a mouse in a computerised accounting environment.

388
7. Scalability: In a computerised accounting system, the requirement of
additional manpower is confined to data entry operators for storing
additional vouchers. The additional cost of processing additional
transactions is almost negligible. As a result, the computerised accounting
systems are highly scalable.
8. Legibility: The data displayed on computer monitor is legible. This is
because the characters (alphabets, numerals, etc.) are type written using
standard fonts. This helps in avoiding errors caused by untidy written
figures in a manual accounting system.
9. Efficiency: The computer-based accounting systems ensure better
use of resources and time. This brings about efficiency in generating
decisions, useful information’s and reports.
10. Quality Reports: The inbuilt checks and untouchable features of data
handling facilitate hygienic and true accounting reports that are highly
objective and can be relied upon.
11. MIS Reports: The computerised accounting system facilitates the real
time production of management information reports, which will help
management to monitor and control the business effectively. Debtors’
analysis would indicate the possibilities of defaults (or bad debts) and also
concentration of debt and its impact on the balance sheet. For example,
if the company has a policy of restricting the credit sales by a fixed amount
to a given party, the information is available on the computer system
immediately when every voucher is entered through the data entry form.
However, it takes time when it comes to a manual accounting system.
Besides, the results may not be accurate.
12. Storage and Retrieval: The computerised accounting system allows
the users to store data in a manner that does not require a large amount
of physical space. This is because the accounting data is stored in hard -
disks, CD-ROMs, floppies that occupy a fraction of physical space
compared to books of accounts in the form of ledger, journal and other
accounting registers. Besides, the system permits fast and accurate
retrieval of data and information.
13. Motivation and Employees Interest: The computer system requires
a specialised training of staff, which makes them feel more valued. This
motivates them to develop interest in the job. However, it may also cause
resistance when we switch over from a manual system to a computer
system.

389
20.3.2 Limitations of Computerised Accounting System
The main limitations emerge out of the environment in which the
computerised accounting system is made to operate. These limitations
are as given below,
1. Cost of Training: The sophisticated computerised accounting
packages generally require specialised staff personnel. As a result, a
huge training costs are incurred to understand the use of hardware and
software on a continuous basis because newer types of hardware and
software are acquired to ensure efficient and effective use of
computerised accounting systems.
2. Staff Opposition: Whenever the accounting system is computerised,
there is a significant degree of resistance from the existing accounting
staff, partly because of the fear that they shall be made redundant and
largely because of the perception that they shall be less important to the
organisation.
3. Disruption: The accounting processes suffer a significant loss of work
time when an organisation switches over to the computerised accounting
system. This is due to changes in the working environment that requires
accounting staff to adapt to new systems and procedures.
4. System Failure: The danger of the system crashing due to hardware
failures and the subsequent loss of work is a serious limitation of
computerised accounting system. However, providing for back-up
arrangements can obviate this limitation. Software damage and failure
may occur due to attacks by viruses. This is of particular relevance to
accounting systems that extensively use Internet facility for their online
operations. No full proof solutions are available as of now to tackle the
menace of attacks on software by viruses.
5. Inability to Check Unanticipated Errors: Since the computers lack
capability to judge, they cannot detect unanticipated errors as human
beings commit. This is because the software to detect and check errors is
a set of programmes for known and anticipated errors.
6. Breaches of Security: Computer related crimes are difficult to detect
as any alteration of data may go unnoticed. The alteration of records in a
manual accounting system is easily detected by first sight. Fraud and
embezzlement are usually committed on a computerised accounting
system by alteration of data or programmes. Hacking of passwords or
user rights may change the accounting records. This is achieved by
tapping telecommunications lines, wire-tapping or decoding of

390
programmes. Also, the people responsible for tampering of data cannot
be located which in a manual system is relatively easier to detect.
7. Ill-effects on Health: The extensive use of computers systems may
lead to development of various health problems: bad backs, eyestrain,
muscular pains, etc. This affects adversely the working efficiency of
accounting staff on one hand and increased medical expenditure on such
staff on the other.

20.4 MEANING AND TYPES OF ACCOUNTING PACKAGES

Every Computerised Accounting System is implemented to perform the
accounting activity (recording and storing of accounting data) and
generate reports as per the requirements of the user. From this
perspective.
The accounting packages are classified into the following categories:

(a) Ready to use

(b) Customised

(c) Tailored
Each of these categories offers distinctive features. However, the choice
of the accounting software would depend upon the suitability to the
organisation especially in terms of accounting needs.
20.4.1 Ready-to-Use: Ready-to-Use accounting software is suited to
organisations running small/ conventional business where the frequency
or volume of accounting transactions is very low. This is because the cost
of installation is generally low and number of users is limited. Ready-to-
use software is relatively easier to learn and people (accountant)
adaptability is very high. This also implies that level of secrecy is relatively
low and the software is prone to data frauds. The training needs are
simple and sometimes the vendor (supplier of software) offers the training
on the software free. However, this software offer little scope of linking to
other information systems.
20.4.2 Customised: Accounting software may be customised to meet the
special requirement of the user. Standardised accounting software
available in the market may not suit or fulfil the user requirements. For
example, standardised accounting software may contain the sales
voucher and inventory status as separate options. However, when the
user requires that inventory status to be updated immediately upon entry
of sales voucher and report be printed, the software needs to be
customised. Customised software is suited for large and medium
businesses and can be linked to the other information systems. The cost

391
of installation and maintenance is relatively high because the high cost is
to be paid to the vendor for customisation. The customisation includes
modification and addition to the software contents, provision for the
specified number of users and their authentication, etc. Secrecy of data
and software can be better maintained in customised software. Since the
need to train the software users is important, the training costs are
therefore high.
20.4.3 Tailored: The accounting software is generally tailored in large
business organisations with multi users and geographically scattered
locations. This software requires specialised training to the users. The
tailored software is designed to meet the specific requirements of the
users and form an important part of the organisational MIS. The secrecy
and authenticity checks are robust in such softwares and they offer high
flexibility in terms of number of users.

20.4.4 Comparison among Ready-to-Use, Customised and Tailored

S.No Basis Ready-to-Use Customised Tailored

1 Nature of Small and Large and Large and

business conventional medium typical
Business business business

2 Cost of Low Relatively High

installation and high
Maintenance

3 Expected Level Low Relatively Relatively

of secrecy high high

4 Number of Limited As per Unlimited

users and their specifications
interface

5 Linkage to Restricted Yes Yes

other
information
system

6 Adaptability High Relatively Specific

high

392
 7 Training Low Medium High
requirements

20.5 GENERIC FACTORS TO CONSIDER BEFORE SOURCING AN

ACCOUNTING SOFTWARE
The following factors are usually taken in considerations before sourcing
an accounting software.
1. Flexibility: An important consideration before sourcing an accounting
software is flexibility, viz. data entry and the availability and design of
various reports expected from it. Also, it should offer some flexibility
between the users of the software, the switch over between the
accountants (users), operating systems and the hardware. The user
should be able to run the software on variety of platforms and machines,
e.g. Windows 98/2000, Linux, etc.
2. Cost of Installation and Maintenance: The choice of the software
obviously requires consideration of organisation ability to afford the
hardware and software. A simple guideline to take such a decision is the
cost benefit analysis of the available options and the financing
opportunities available to the firm. Some times, certain software which
appears cheap to buy, involve heavy maintenance and alteration costs,
e.g. cost of addition of modules, training of staff, updating of versions, data
failure/restoring costs. Conversely, the accounting software which appear
initially expensive to buyers, may require least maintenance and free
upgrading and negligible alteration costs.
3. Size of Organisation: The size of organisation and the volume of
business transactions do affect the software choices. Small organisations,
e.g. in non-profit organisations, where the number of accounting
transactions is not so large, may opt for a simple, single user operated
software. While, a large organisation may require sophisticated software
to meet the multi-user requirements, geographically scattered and
connected through complex networks.
4. Ease of Adaptation and Training needs: Some accounting software
is user friendly requiring a simple training to the users. However, some
other complex software packages linked to other information systems
require intensive training on a continuous basis. The software must be
capable of attracting users and, if its requires simple training, should be
able to motivate its potential users.
5. Utilities/ MIS Reports: The MIS reports and the degree to which they
are used in the organisation also determine the acquisition of software.

393
For example, software that requires simply producing the final accounts
or cash flow/ratio analysis may be readyto-use software. However, the
software, which is expected to produce cost records needs to be
customised as per user requirements.
6. Expected Level of Secrecy (Software and Data): Another
consideration before buying accounting software is the security features,
which prevent unauthorised personnel from accessing and/or
manipulating data in the accounting system. In tailored software for large
businesses, the user rights may be restricted to purchase vouchers for the
purchase department, sales vouchers to the billing accountants and petty
cash module access with the cashier. The operating system also matters.
Unix environment allows multi-users compared to Windows. In Unix, the
user cannot make the computer system functional unless the user clicks
with a password, which is not a restriction in Windows.
7. Exporting/Importing Data Facility: The transfer of database to other
systems or software is sometimes expected from the accounting software.
Organisations may need to transfer information directly from the ledger
into spread sheet software such as Lotus or Excel for more flexible
reporting. The software should allow the hygienic, untouched data
transfer.
Accounting software may be required to be linked to MIS software in the
organisation. In some ready to use accounting software’s, the exporting,
importing facility is available but is limited to MS Office modules only, e.g.
MS Word, MS Excel, etc. However, tailored software’s are designed in
manner that they can interact and share information with the various sub
components of the organisational MIS.

20.6 INTRODUCTION OF TALLY ERP 9

Tally is powerful accounting software, which is driven by a technology
called concurrent multi-lingual accelerated technology engine. It is easy
to use software and is designed to simply complex day to day activities
associated in an enterprise. Tally provides comprehensive solution
around accounting principles, inventory and data integrity. Tally also has
feature encompassing global business. Tally software comes with easy to
use interface thus making it operationally simple.
Tally accounting software provides a solution around inventory
management, stock management, invoicing, purchase order
management, discounting, stock valuation methodology, etc.
Tally accounting software also comes with drill down options, which can
track every detail of transaction. It helps in maintaining simple

394
classification of accounts, general ledger, accounts receivable and
payable, bank reconciliation, etc.
The technology employed by tally makes data reliable and secure. Tally
software supports all the major types of file transfer protocols. This helps
in connecting files across multiple office locations. Tally accounting
software is capable of undertaking financial analysis and financial
management. It provides information around receivables turnover, cash
flow statement, activity consolidation and even branch accounting.
Tally accounting software is east to set up and simple to use. A single
connection can support multiple users. It can be easily used in conjunction
with the Internet making possible to publish global financial reports. Tally
accounting software can seamlessly connect with various Microsoft
applications.

20.7 FEATURES OF TALLY ERP 9

1. Voucher Entry: Tally software has the unique voucher entry system
that enables diverse transactions at ease. The feature is also flexible to
use. As per the accounting terminology, the voucher is a document with
the details of various business transactions. Likewise, the software has
also been loaded with several accounting vouchers each used for
particular purpose.
2. Interest Calculation: The software uses different interest calculation
methods that are customized for every transaction. Once the calculation
is done, the user can get a detailed report of the interest obtained. The
report helps in knowing the balance amounts that are ought to receive.
3. Integration of Ledgers: Tally software inculcates multiple ledgers
including General ledger, Sales ledger, and Purchase Ledger into a single
ledger. The ledgers have been differentiated into groups to get ease in the
account management. Unified ledgers concept helps in entering data and
creating records simultaneously.
4. Individual Bill Tracking: The software enables the user to track the
bills of trading and non-trading accounts. The user can track the new bills,
receipts, payments and adjustments made against the bills without any
hassles.
5. Replacing Accounting Codes: The software replaces the accounting
codes with regular names for accounts. It eases up the maintenance of
complex ledger systems. Due to the replacement of accounting codes,
everyone can operate this system without the knowledge of accounting
codes.

395
6. Control, Audit and Budgeting: Tally’s superior audit capabilities
enable the user to have unlimited periods and budgets. With the help of
this feature, the user can track changes and make corrections at ease.
Using security levels, the user can gain the robust access control.
7. Billing Information: Tally software enables the user to handle the top
to bottom billing information that is receivable and payable as well. It helps
the organizations in allocating payments regarding invoices and the
overdue ones. The software also helps in segregating good customers
and bad customers using the billing information.
8. Multiple Currency Support: Many companies involving in
International Trade conduct transactions has increased usage of multiple
currencies. Due to exchange rate fluctuations, companies find it difficult
to record transactions. Tally software renders a great help in easy
transaction management involving foreign currencies.

LET US SUMUP
Computerised Accounting System: A computerised accounting system is
an accounting information system that processes the financial
transactions and events to produce reports as per user requirements. It is
based on the concept of database and has two basic requirements: (a)
Accounting framework and (b) Operating Procedure. Advantages of
Computerised Accounting System are Speed, Accuracy, Reliability, Up-
to-date, Scalability, Legibility, Efficiency, Quality Report, MIS Reports,
Real time user interface, Storage and Retrieval, Motivation and
Employees interest and automated document production. The Limitations
of Computerised Accounting System are Cost of training, Staff
Opposition, Disruption, System failure, Breache of security, Ill-effects on
health and Inability to check unanticipated errors. Categories of
Accounting Packages are Ready-to-Use, Customised and Tailored

CHECK YOUR PROGRESS

Choose the Correct Answer:

1) Which of the following is not a disadvantage of introducing
computerized accounting system?

a) Possible demotivation through redundance

b) High expenditure on set up

c) Saving made on labour cost

d) Required staff training

396
2) Tally package is developed by __________

a) Peutronics b) Tally solutions

c) Coral software d) Vedika software

3) Budget represents __________

a) Estimation b) Forecasting

c) Assumption d) All of these

4) The process of ascertaining the balance of a particular account on a
given date is __________

a) Posting b) Journalizing

c) Balancing d) Accounting.
5) __________ is the expense which is unpaid at the end of the
accounting period.
a) Outstanding expenses b) Prepaid expenses

c) Proposed expenses d) Working capital.

GLOSSARY

Computerised Accounting : An accounting information system

that processes the financial
System
transactions and events as per user
requirements

Manual Accounting System : a bookkeeping system where

records are maintained by hand,
without using a computer system

Generally Accepted : Generally accepted accounting

Accounting Principles principles, are a set of rules that
encompass the details, complexities,
and legalities of business and
corporate accounting

Accounting Software : a software that does various

accounting and bookkeeping tasks

Accounting Packages : a piece of software that a business

uses to organize its financial records

397
SUGGESTED READINGS
1. Gupta, R.L. and Radhaswamy, M., (2006), Financial Accounting,
Sultan and Chand Sons, New Delhi.
2. Maheswari, S.N and Maheshwari, S.K. (2017), Fundamental of
Accounting, Vikas Publications.
3. Shashi K. Gupta, R.K.Sharma , (2017), Financial Management,
13th Revised Edition, Kalyani Publishers, Chennai
4. M C Shukla, S C Gupta & T S Grewal, (2017), Advance
Accounting, 19th Edition, S.Chand Publishing, New Delhi
5. Tulsian P. C. , (2017), Financial Accounting , Pearson Education,
New Delhi.
6. https://www.geeksforgeeks.org/computerized-accounting-
system-meaning-features-advantages-and-disadvantages/
7. https://www.youtube.com/watch?v=mn8BcMI_lHc

ANSWER TO CHECK YOUR PROGRESS

1) c 2) b 3) d 4) c 5) a

398
399
 SYLLABUS
Course Title :Quantitative Methods for Managers

Course Code : MSPS 14

Course Credit : 6

Course Objective :

CO 1.Demonstrate graphical representation of linear and non-linear functions.

Discuss decision making under minimax and maximax criteria
CO 2.Define probability and its rules. Illustrate various probability distribution
CO 3.Recognize the technique to present the data and the measures of central
tendency and dispersion. Explain the concept of correlation and regression
CO 4.Discuss concepts of index number and the significance of time series for
business forecasting.
CO 5.Interpret the procedure for testing hypothesis by applying parametric and
non-parametric test
BLOCK I: Liner & Non-Liner Functions

Linear & Non-Linear functions – graphical representation of functions, Constants,

Variables –notion of Mathematical models- Simple problem applied to business and
industry - Decision making under risks and uncertainty:Minimax and Maximax
Criterions – Their Implications Decision Tree

BLOCK II: Probability

Probability – Definition – Addition and Multiplication rules (only) – Simple business

application problems – Probability distribution – Binomial, Poission and normal
distribution – Simple problem applied to Business.

BLOCK III: Presentation of Statistical Data

Presentation of Statistical Data – Tables and Graphs – Frequency Distribution –

Histogram – Cumulative Frequency Curves - Data Analysis – UniVariant ungrouped
and grouped Data – Measures of Central Tendencies – Measures of Dispersion –
Bivariate Analysis – Correlation and regression.

BLOCK IV: Index Numbers

Index numbers – Simple and weighted index numbers Concept of Weights –

Business Index numbers – CPI, WPI, Niffy, Production Index,
Time series, variation in time series, trend - Cyclical and random – Use of Time
series for business forecasting.

BLOCK V: Testing of Hypothesis

Procedure for Testing of Hypothesis - One Sample t-test for the Population Mean -
Two Sample t-test for independent Samples - Paired Sample t-test - F-test for two
population Variances (Variance ratio test) - ANOVA one and two way.

References:

1. Sundarsan.V & Jeyaseelan , (2015),An Introduction of Business

Mathematics, Reprint, Sultan Chand & Sons Pvt. Ltd., New Delhi.
2. Peer Mohamed &Shazuli Ibrahim,(2008),Business Mathematics,Pass
Publication, Madurai.
3. P.A.Navaneethan, (2008), Business Mathematics & Statistics, jai Publishers,
Trichy.
4. D.C.Sancheti, V.K.Kapoor,( 2014), Business Mathematics, 11 th edition,
Reprint, Sultan Chand and Sons, New Delhi.
5. JK. Sharma, (2009), Business Mathematics Theory And Applications, 13 th
Edition, ANE Books, New Delhi.
6. https://thebusinessprofessor.com/en_US/management-leadership-
organizational-behavior/quantitative-approach-to-management
7. https://study.com/academy/lesson/nonlinear-function-definition-
examples.html
8. https://www.dynamictutorialsandservices.org/2020/10/index-number-
business-statistics-notes.html
9. https://nptel.ac.in/courses/103106120

Course Outcome :

CLO 1. Recite linear and non-linear functions in a graphical presentation and

solve problems related to business
CLO 2. Examine probability by using its rules and the types of probability
distribution
CLO 3. Infer the data presented and the measures of central tendency and
dispersion. Calculate and interpret statistical values by applying
correlation & regression
CLO 4. Review concepts of index numbers and the use of time series for
forecasting
CLO 5. Assess the hypothesis by applying appropriate parametric or non-
parametric techniques
 CONTENT

BLOCK 1 LINEAR AND NON LINEAR FUNCTIONS 1

UNIT 1 RELATIONS AND FUNCTIONS 2

1.1 Introduction 2

1.2 Difference between Relation and Function with Examples 5

1.3 Finding Function Values 5

1.4 Types of Functions 9

UNIT 2 LINEAR FUNCTIONS 15

2.1.1 2.1 Simple Linear Function Introduction 16

2.1.2 2.2Solutions of Systems of Linear Equations 23

2.3Some Useful Functions In Management Studies and Economics 29

2.1.3

UNIT 3 NON-LINEAR FUNCTIONS 45

3.1 Introduction 46

3.2 Difference between Linear and Non-linear functions 46

3.3 Nonlinear Function: Quadratic Equation 47

3.4 Nonlinear Function: Exponential Function and Examples 57

3.5 Nonlinear Function: Logarithmic Function and Examples 59

UNIT 4 DECISION MAKING UNDER RISKS AND UNCERTAINTY

4.1 Introduction 71

4.2 Decision theory under risk 71

4.3 Decision theory under uncertainty 81

4.4 Decision Tree analysis with Solved Example 85

BLOCK 2 DISTRIBUTIONS

UNIT 5 PROBABILITY 93

5.1 Introduction 93

5.2 Concept of Uncertainty 94

5.3 Concept of probability 94

5.4 Basic Terminology 95

5.5 Classification of Probability 97

5.6 Basic probability Rules 105

UNIT 6 PROBABILITY DISTRIBUTION: BINOMIAL DISTRIBUTION 120

6.1 Introduction 121

6.2Bernoulli Distribution 122

6.3 Binomial Distribution 122

UNIT 7 POISSION DISTRIBUTION 132

7.1 Introduction to Poisson distribution 132

7.2 Meaning, Role and Moments 133

7.3 Problems and Solutions 135

UNIT 8 NORMAL DISTRIBUTION 143

8.1Introduction 144

8.2 Normal Distribution 144

158
BLOCK 3 DATA ANALYSIS

UNIT 9 PRESENTATION OF DATA 159

9.1 Introduction 160

9.2Secondary Data 164

9.3 Classification and Tabulation of data 166

9.4Types of Classification 167

9.5Formation of continuous distribution 170

9.6Graphical and diagrammatic representation 172

9.7Graphs of frequency distribution 182

UNIT 10 DATA ANALYSIS: CENTRAL TENDENCY 190

10.1Introduction 190

10.2Ungrouped data 191

10.3 Grouped data 192

10.4 Measures of Central Tendency 194

10.5 Types of Averages 195

UNIT 11 DATA ANALYSIS: MEASURES OF DISPERSION 230

11.1 Introduction 231

11.2 Measures of Dispersion 231

11.3Lorenz Curve 251

UNIT 12 BIVARIATE ANALYSIS: CORRELATION 256

12.1Bivariate (or) Two-way frequency distribution 257

12.2Correlation 257

12.3Types of correlation 258

12.4Analytical Statistics 259

12.5Methods of studying correlation 260

12.6Algebraic Methods 262

12.7Probable Error 276

BLOCK 4 INDEX NUMBERS 279

UNIT 13BIVARIATE ANALYSIS: REGRESSION 280

13.1Introduction 281

13.2Regression Analysis 281

13.3Types of Regression Analysis 282

13.4Methods of representing Regression lines 284

UNIT 14 INDEX NUMBERS 299

14.1Introduction 300

14.2Definitions 301

14.3Uses Of Index Numbers 301

14.4Classification Of Index Numbers 301

14.5Construction Of An Index Number 302

14.6Methods Of Calculation 305

14.7Weighted Methods 313

14.8Quantity Index 325

14.9Index Number Tests 328

UNIT 15 INDEX IN BUSINESS AND FINANCIAL MARKET 338

15.1 Introduction 339

15.2Business Index Numbers 339

15.3 Nifty Index
349

15.4Production Index 355

UNIT 16 TIME SERIES 361

16.1 Introduction 362

16.2 Essential Requirements of a Time Series 363

16.3 Definitions and uses of Time series 363

16.4 Models of Decomposition 364

16.5 Components of Time Series 365

16.6 Secular Trend 366

16.7 Seasonal variations 367

16.8 Cyclical variations 368

16.9 Irregular variations 369

16.10 Measurement of Trend 371

16.11 Measurement of Seasonal Variations 384

BLOCK 5 HYPOTHESES 409

UNIT 17 INTRODUCTION TO HYPOTHESES, SOURCES AND TYPES 410

17.1 Introduction 411

17.2 Meaning& Definition of Hypothesis 412

17.3 Types of Hypotheses 413

17.4 Sources and Basic concepts 415

17.5Testing Hypothesis and its Classification 418

17.6 Procedures for Testing Hypothesis with illustration 418

17.7 Limitations of Hypothesis testing 421

UNIT 18 TESTING OF HYPOTHESES: APPLYING T-STATISTIC 424

18.1 Introduction 425

18.2 t-test meaning, assumptions and Properties 425

18.3 One Sample test for population mean with solved examples 426

18.4 Two Sample t-test for Independent Samples with solved examples 439

18.5 Paired Sample t-test with solved examples 444

UNIT 19 TESTING OF HYPOTHEISES: APPLYING F-STATISTIC FOR
TWO POPULATION VARIANCES AND ANALYSIS OF VARIANCE
451
(ANOVA)

19.1 Introduction 452

19.2 F-test meaning, assumptions and Properties 452

19.3 Applying F-test for two population variance 452

19.4 ANOVA: Meaning and applying one way 456

19.5 ANOVA-Two way 464

19.6 Nexus between F test and ANOVA 471

Plagiarism Report 476

 BLOCK 1

LINEAR AND NON-LINEAR FUNCTIONS

Unit 1: Relations and Functions

Unit 2: Linear Functions
Unit 3: Non-Linear Functions
Unit 4: Decision Making Under Risks and
Uncertainty

1
Unit 1

RELATIONS AND FUNCTIONS

STRUCTURE

Overview
Learning Objectives
1.1 Introduction
1.1.1 Terminologies related to function.
1.1.2 History, Meaning and Definition of Function
1.2 Difference between Relation and Function with Examples

1.3 Finding Function Values

1.4 Types of Functions
Let Us Sum Up

Check Your Progress

Glossary
Suggested Readings

Answers to check your progress

OVERVIEW

The aim of this unit is to define function, to introduce the mathematical

concept of relation and function. Further, this unit made an attempt to
highlight the domain of a relation, the types of functions with some relevant
examples.
LEARNING OBJECTIVES
After completing this unit, you should be able to:
 explain the range of a relation and comprehend different ways to
write a relation
 understand the different concepts of functions and understand the
function notation
 explicate the types of functions.
1.1 INTRODUCTION
For the use of mathematical models in decision-making the first requirement
is to identify relevant factors (also called variables) involved in the problem

2
and then defining their interrelationships. Such relationships are expressed
in the form of an equation or set of equations/inequalities. These equations
or inequalities with or without an objective function help the decision-maker
in better understanding of the problem and arriving at an optimal decision.
For example, total inventory cost is expressed in terms of total purchase
cost, ordering cost, holding cost and shortage cost. The differential calculus
method is used to calculate economic order quantity to achieve minimum
total inventory cost. The aim of this chapter is to explain some fundamental
concepts about functions, their classification and application in the context
of business management and economic problem
1.1.1 Meaning of Terminologies related to function with Examples
A relation is just a set of ordered pairs. There is absolutely nothing special
at all about the numbers that are in a relation. In other words, any bunch of
numbers is a relation so long as these numbers come in pairs. In maths
Relation is just a set of ordered pairs.
Relation can be written in several ways;
 Ordered pairs
 Table
 Graph/mapping
Domain and Range of a Relation
The Domain is the set of the entire first numbers of the ordered pairs. In
other words, the domain is all of the x-values. The range is the set of the
second numbers in each pair, or the y-values.
Example: if relation is {(0, 1), (55, 22), (3, -50)}, then
Domain is {0, 55, 3}
Range is {1, 22, -50}
NOTE: 1. when writing the domain and range, do not repeat the values 2.
The first element in the braces stands for domain and the second element in
the braces denotes the range.
Example: 1.1
What is the domain and range of the following relation?
{(-1, 2), (2, 51), (1, 3), (8, 22), (9, 51)}
Answer
Domain: -1, 2, 1, 8, 9 the first numbers in every pair
Range: 2, 51, 3, 22, 51 the second numbers in the above braces
Example: 1.2
What is the domain and range of the following relation?
{(-5, 6), (21, -51), (11, 93), (81, 202), (19, 51)}

3
Answer
Domain: -5, 21, 11, 81, 19
Range: 6, -51, 93, 202, 51
1.1.2 Historical Background of Function
The concept of function has evolved over a long period of time starting from
R. Descartes (1596-1650), who used the word ‘function’ in his manuscript
“Geometrie” in 1637 to mean some positive integral power xn of a variable x
while studying geometrical curves like hyperbola, parabola and ellipse.
James Gregory (1636-1675) in his work “Vera Circuli et Hyperbolae
Quadratura” (1667) considered function as a quantity obtained from other
quantities by successive use of algebraic operations or by any other
operations.
Later G.W.Leibnitz (1646-1716) in his manuscript “Method
ustangentiuminversa, seudefunctionibus” written in 1673 used the word
‘function’ to mean a quantity varying from point to point on a curve such as
the coordinates of a point on the curve, the slope of the curve, the tangent
and the normal to the curve at a point. However, in his manuscript “Historia”
(1714), Leibnitz used the word ‘function’ to mean quantities that depend on
a variable. He was the first to use the phrase ‘function of x’. John Bernoulli
(1667-1748) used the notation f(x) for the first time in 1718 to indicate a
function of x. But the general adoption of symbols like f, F, f, y ... to
represent functions was made by Leonhard Euler (1707-1783) in 1734 in
the first part of his manuscript “Analysis Infinitorium”. Later on, Joseph Louis
Lagrange (1736-1813) published his manuscripts “Theorie des functions
analytiques” in1793, where he discussed about analytic function and used
the notion f (x), F(x),f(x) etc. for different function of x. Subsequently,
Lejeunne Dirichlet (1805-1859) gave the definition of function which was
being used till the settheoretic definition of function presently used, was
given after set theory was developed by Georg Cantor (1845-1918). The set
theoretic definition of function known to us presently is simply an abstraction
of the definition given by Dirichletin a rigorous manner.
Meaning of Functions
A function is a relationship between two sets of numbers.
We may think of this as a mapping; a function maps a number in one set to
a number in another set. Notice that a function maps values to one and only
one values. Two values in one set could map to one value, but one value
must never map to two values: that would be a relation, not a function.

4
Definition
A function is a correspondence between a first set, called the domain, and a
second set, called the range, such that each member of the domain
corresponds to exactly one member of the range.
1.2 DIFFERENCE BETWEEN THE RELATION AND FUNCTION
A relation refers to a set of inputs and outputs that are related to each other in
some way. In other words, when each input in relation gets precisely one
output, we refer to the relation as function. Moreover, in order to determine
whether a relation is a function or not, you need to make sure that no input gets
more than one output.
1.3 FINDING FUNCTION VALUES
Examples to understand the relation and which a function is and
which are not a function is:
Example 1.3: Determine whether or not each correspondence is a function.
a) Cumulative number of iphones sold (b) Squaring

Domain Range Range

Domain
0 3 9
2006
1,389,000 4 16
2007

2008 11,627,000 5
20,371,000 -5 25
2009
(Source: Apple Inc.)
c) Baseball teams d) Baseball teams

Domain Range Range

Domain
Diamondbacks Diamondbacks
Arizona Arizona

Cubs Cubs Chicago

Chicago
White Sox White Sox

Baltimore Orioles Orioles Baltimore

Solution
a) The correspondence is a function because each member of the domain
corresponds (is matched) to only one member of the range.

5
b) The correspondence is a function because each member of the domain
corresponds to only one member of the range, even though two
members of the domain correspond to 25.
c) The correspondence is not a function because one member of the
domain,
d) Chicago corresponds to two members of the range, the Cubs and the
White Sox.
e) The correspondence is a function because each member of the domain
corresponds to only one member of the range, even though two
members of the domain correspond to Chicago.
Example 1.4: Check the following relation is a function.{(−1,0) (1,−7) (2,−7)
(3,6) (4,5)}
Solution
From these ordered pairs we have the following sets of first part/Domain
(i.e. the first number from each ordered pair) and second part/range (i.e. the
second number from each ordered pair).
1st part /Domain: {−1, 1, 2,3,4}
2nd part/Range: {0,−7, 6,5}

Remember that note given in the meaning of terminologies, for the set of
second part/range notice that the “-7” occurred in two ordered pairs but we
only listed it once.

To see why this relation is a function simply pick any value from the set of
first parts. Now, go back up to the relation and find every ordered pair in
which this number is the first part Domain and list all the second parts
/range from those ordered pairs. The list of second part range will consist of
exactly one value.
For example, let’s choose 2 from the set of first part/Domain. From the
relation we see that there is exactly one ordered pair with 2 as a first
part,(2,−7)(1,−7). Therefore, the list of second part/range (i.e. the list of
values from the set of second components) associated with 2 is exactly one
number, -7.
Note that we don’t care that - 3 is the second part/range of a second
ordered pair in the relation. That is perfectly acceptable. We just don’t want
there to be any more than one ordered pair with 2 as a first part/domain

6
We looked at a single value from the set of first parts for our quick example
here but the result will be the same for all the other choices. Regardless of
the choice of first part there will be exactly one second part associated with
it. Therefore, this relation is a function.
Example 1.5: Examine the following relation is a function or not
{(5,2)(−4,3)(0,4)(5,−1)}

Solution:
Here is the list of first and second part of the ordered pairs: 1st part: {5,
−4,0}

2nd Part: {2, 3,4, −1}

From the set of first part let’s choose 5. Now, if we go up to the relation we
see that there are two ordered pairs with 6 as a first component: (5,2)(5,-1) .
The list of second part associated with5 is then: 2, -1.The list of second
components associated with 5 has two values and so this relation is not a
function.
The fact that we found even a single value in the set of first components
with more than one second component associated with it is enough to say
that this relation is not a function. As a final comment about this example
let’s note that if we removed the first and/or the fourth ordered pair from the
relation we would have a function.

Differences Relations Functions

A relation is a relationship
A function is a relation in
between sets of values. Or, it is
Definition which there is only one
a subset of the Cartesian
output for each input.
product

A function is denoted by
Denotation A relation is denoted by “R”
“F” or “f”.

R = {(1, x), (9, y), (1, z)} ** It is

Example not a function, as “1” is input for F = {(2, x), (9, y), (5, x)}
both x and z.

Every function is a
Note: Every relation is not a function.
relation.

7
Therefore, we can define a function as a special relation which maps each
element of set A with one and only one element of set B. Both the sets A and B
must be non-empty. A function defines a particular output for a particular input.
Hence, f: A → B is a function such at for a ∈ A there is a unique element b ∈ B
such that (a, b) ∈ f

Summary of Difference between Relations and Functions

Most functions considered in mathematics are described by an equation like

y = 2x + 3
To graph the function given by y = 2x + 3, we find ordered pairs by
performing calculations for selected x values.
For x = 4, y = 2x + 3 = 2.4 + 3 = 11; The graph includes (4, 11).
For x = - 5, y = 2x + 3 = 2. (- 5) + 3 = - 7; The graph includes (- 5, - 7).
For x = 0, y = 2x + 3 = 2.0 + 3 = 3; and so on. The graph includes (0.3).
Example1. 6: Given F(x) = x2 then find f(1), f(-1), f(7) ,f(1/2) and f(4).
Solution
If we write (define) a function as: f(x) = x2 then we say: 'f of x equals to ‘x
squared' and we have,
F (-1) = 1
f (1) = 1
f(7) = 49
f(1/2) = 1/4
f (4) = 16 and so on.
Example1. 7 The squaring function f is given by f(x) = x2. Find f (- 3), f
(1), f (k), f ( k ) , f(1+t), and f (x + h).

Solution
We have f (-3) = (-3)2 = 9;

f (1) = 12 = 1;
f (k) = k2;
f ( k )  ( k )2  k ;

f (1+t)

f (1+t) = (1+t)2 = 1+2t+t2;

f (x + h) = (x + h)2 = x2 + 2xh + h2

8
Range, image, co-domain
If d is a set, we can say,
f (D) = {f(x)x D}, which forms a new set, called the range of F.D is called
the domain of f, and represents all values that f takes. In general, the range
of f is usually a subset of a larger set. This set is known as the co-domain of
a function.
Notations
f: D  R when we have a function f, with domain D and range R, we write: If
we say that, for instance, x is mapped to x2, we also can add
Notice that we can have a function that maps a point (x, y) to a real number,
or some other function of two variables. We have a set of ordered pairs as
the domain. The domain of an equation/function is the set of all x’s that we
can plug into the equation and get back a real number for y. The range of
an equation/function is the set of all y’s that we can ever get out of the
equation.
1.4 TYPES OF FUNCTIONS
Functions are classified by the type of mathematical equation which
represents their relationship. Some functions are algebraic. Other functions
like f(x) = sin x, deal with angles and are known as trigonometric. Still other
functions have logarithmic and exponential relationships and are classified
as such. Algebraic functions are the most common type of function.

These are functions that can be defined using addition ,subtraction

,multiplication ,division, powers, and roots. For example f(x) = x + 4 is an
algebraic function. Algebraic functions are called polynomial functions if the
equation involves powers of x and constants. The most famous of these is
the quadratic function (quadratic equation), f(x) = ax2 + bx + c where a, b,
and c are constant numbers. A type of function that is especially important
in geometry is the trigonometric function. Common trigonometric functions
are sine, cosine, tangent, secant, cosecant, and cotangent. One interesting
characteristic of trigonometric functions is that they are periodic. This means
there are an infinite number of values of x which correspond to the same
value of the function. Algebraic functions are used extensively by chemists
and physicists. Trigonometric functions are particularly important in
architecture, astronomy, and navigation.Financial institution suse
exponential and logarithmic functions. Hence, There are various functions
such as One – one function (Injective function), Many – one function, Onto –
function (Subjective Function), Into – function, Polynomial function, Linear

9
Function ,Non Linear Function, Identical Function, Quadratic Function
Rational Function, Algebraic Functions, Composite Function, Constant
Function and Identity Function.
One – one function (Injective function)
One to one function or Injective function: A function f: P → Q is said to
be one to one if for each element of P there is a distinct element of Q.
Otherwise, If each element in the domain of a function has a distinct image
in the co-domain, the function is said to be One – one function.

Figure 1.1
For examples f: R R given by f(x) = 2x + 1 is one – one.

Many – one function

Many to one function: A function which maps two or more elements of P
to the same element of set Q. On the other hand, if there are at least two
elements in the domain whose images are same, the function is known as
many to one.

Figure 1.2
For example, f: R given by f(x) = x2 + 1 is many one.

Onto – function (Subjective Function)

Onto Function or Surjective function: A function for which every element
of set Q there is pre-image in set P Otherwise, A function is called an onto

10
function if each element in the co-domain has at least one pre – image in
the domain.
Into – function

If there exists at least one element in the co-domain which is not an image
of any element in the domain then the function will be Into function.
(Q) Let A = {x : 1 < x < 1} = B be a mapping f : A B, find the nature of the
given function (P) F(x) = |x|

f(x) = |1| Figure 1.3

Solution: for x = 1 & -1Hence it is many one the Range of f(x) from [-1, 1] is
[0,1] which is not equal to co-domain. Hence it is into function.
Identity Function

P= set of real numbers. The function f: P → P defined by b = f (a)=a for

each a \epsilonϵ P is called the identity function. Domain of f = P, Range
of f = P. Graph type: A straight line passing through the origin.
Constant Function
The function f: P → P defined by b = f (x) = D, a \epsilonϵ P, where D is a
constant \epsilonϵ P, is a constant function. Domain of f = P, Range of f =
{D}, Graph type: A straight line which is parallel to the x-axis. In simple
words, the polynomial of 0th degree where f(x) = f(0) = a_{0}a0=c.
Regardless of the input, the output always results in constant value. The
graph for this is a horizontal line.

Figure 1.4

11
Composite Function
Let A, B, C’ be three non-empty sets Let f: A B &g : G C be two functions
then g of : A C. This function is called composition of f and g given g of (x) =
g(f(x))
For example f(x) = x2 & g(x) = 2x the nf(g(x)) = f(2x) = (2x)2 = 4x2 and
g(f(x)) = g(x2) = 2x2

Polynomial function
The degree of Polynomial function is the highest power in the expression. If
the degree is zero, it’s called a constant function. If the degree is one, it’s
called a linear function. Example: b = a+1.Graph type: Always a straight
line. The highest power in the expression is known as the degree of the
polynomial function. The different types of polynomial functions based on
the degree are: The polynomial function is called a Constant function if the
degree is zero. The polynomial function is called a Linear if the degree is
one. The polynomial function is Quadratic if the degree is two. The
polynomial function is Cubic if the degree is three.
Linear Function
All functions in the form of ax + b where a, b\in Rb∈R & a ≠ 0 are called
as linear functions. The graph will be a straight line. In other words, a linear
polynomial function is a first-degree polynomial where the input needs to be
multiplied by m and added to c. It can be expressed by f(x) = mx + c. For
example, f(x) = 2x + 1 at x = 1
f(1) = 2.1 + 1 = 3 Therefore f(1) = 3

Figure 1.5

Another example of linear function is y = x + 3

12
 Figure 1.6
LET US SUM UP

A relation is just a set of ordered pairs. There is absolutely nothing special

at all about the numbers that are in a relation. In other words, any bunch of
number is a relation so long as these numbers come in pairs. The Domain
is the set of all the first numbers of the ordered pairs, and the Range is the
set of the second numbers in each pair, or the y-values. A function is a
relationship between two sets of numbers. Difference of Relation and
Function: When each input value of a function generates one and only
output, it is called a function. Here, the input values are known as domain
and output values are known as the range.
CHECK YOUR PROGRESS
Choose the Correct Answer:
1. What is the domain of the following relation?
{(-1,2), (2,51), (1,3), (8,22), (9,51)}
a) {-1,2,1,8,9} b) {2,51, 3, 22, 51}

c) {-1, 2, 51, 1, 3} d) {1, 3, 8, 22, 9}

2. What is the range of the following relation?
{(-5,6), (21,-51), (11, 93), (81,202), (19,51)}

a) {-5, 21, 11, 81, 19} b) {6,-51, 93, 202,51}

c) {-1, 2, 51, 1, 3} d) {1, 3, 8, 22, 9}
3. Which relations below are functions?
a) Relation#1 {(3,4), (4,5), (6,7), (3,-9)}
b) Relation#2 {(3,4), (4,5), (6,7), (5,4)}
c) Relation#3 {(0,4), (4,-5), (0,0), (8,9)}
d) Relation#4 {(8,11), (34,5), (6,17), (6,19)}
4. For the following relation to be a function, X cannot be what values?
{(12,14), (13,5), (-2,7), (X,13)}

13
 a) 12, 13, -2b. 14, b) 5, 7, 13
c) 12, 13, -2, 14, 5, 7, 13 d) 12, 13, -2, 14, 5, 7
5. For the following relation to be a function, X cannot be what values?

{(12,13), (-11,22), (33,101), (X, 22)}

a) 12, -11, 33 b) 13, 22, 101
c) 12, -11, 33, 13, 22, 101, 22 d) 12, 33
GLOSSARY
:
Relation A set of ordered pairs is termed as Relation.
:
Domain The domain is all the values that go into a
Function.
:
Range The range is all the values that come out from
a function.
:
Function A function relates an input to an output.

SUGGESTED READINGS

1. Arora, P.N. & S. Arora, (2007) ,Statistics for Management, latest

Edition, S. Chand & Company Ltd., New Delhi.
2. D.C.Sancheti, V.K.Kapoor,( 2014), Business Mathematics, 11th
edition, Reprint, Sultan Chand and Sons, New Delhi.

3. Gupta, B.N., (2015), Business Statistics, First Revised Edition,

SBPD, New Delhi.
4. JK. Sharma, (2009), Business Mathematics Theory And
Applications, 13th Edition, ANE Books, New Delhi.
5. S. P. Gupta, (2012), Statistical Methods, 42nd Revised Edition Sultan
Chand & Sons Pvt. Ltd., New Delhi.
6. https://study.com/academy/lesson/the-difference-between-relations-
functions.html
7. https://economics.uwo.ca/math/resources/linear-functions/2-types-
of-functions/content/
ANSWERS TO CHECK YOUR PROGRESS

1) a 2) c 3) b 4) b 5) b

14
Unit 2

LINEAR FUNCTIONS
STRUCTURE

Overview
Learning Objectives
2.1 Simple Linear Function Introduction
2.1.1 Meaning of Linear function,
2.1.2 Meaning of Intercepts
2.1.3 Slope of a line

2.2 Solutions of Systems of Linear Equations

2.2.1 Linear equations in two variables by graphing.
2.2.2 Solving of linear equations by Substitution

2.2.3 Solving of linear equations by Elimination

2.2.4 Solving of Linear Equation be Left to
Right Elimination

2.2.5 Solving of three linear Equations

2.3 Some Useful Functions in Business and Economics.
Let Us Sum Up

Check Your Progress

Glossary
Suggested Readings

Answers to Check Your Progress

OVERVIEW
This unit two devoted to learn the linear function and it’s solving for applying
in day to day management decision in all aspects. The single function, its
intercepts and slope implication in application aspects presented by aiming
the self-learners. In addition, with this unit attempt to find the solution for
system of equation and its role in management.

15
LEARNING OBJECTIVES
After Completing this unit, you should be able to,
 find the intercept and slope of the graphs linear functions and
applications
 write the equation of a line given information about its graph and
applications
 solve systems of linear equations in two variables by graphing by
substitution and by elimination
 solve systems of three linear equation in three variables
2.1 SIMPLE LINEAR FUNCTION INTRODUCTION
A wide variety of problems from business may be solved by equations.
Managers use equations and their graphs to study costs, sales, national
consumption, or supply and demand.
Numerous applications of mathematics are given throughout the chapter. In
particular, this chapter introduces two important applications that will be
expanded and used throughout the text as increased mathematical skills
permit: supply and demand as functions of price in market analysis and total
cost, total revenue, and profit as functions of the quantity produced and sold
industrial aspects.
2.1.1 Meaning of Linear Function
A linear function is a function of the form y = f (x) = mx +c, where m and c
are constants. A linear function is a function whose graph produces a line.
Linear functions can always be written in the form f(x) =c + mx or f(x) = mx +
c; they’re equivalent, where c is the initial or starting value of the function
(when input, x = 0), and m is the constant rate of change of the function.
Many people like to write linear functions in the form f(x) = c + mx because it
corresponds to the way we tend to speak: “The output starts at c and
increases at a rate of m.”
2.1.2 Meaning of Intercepts

Because the graph of a linear function is a line, only two points are
necessary to determine its graph. It is frequently possible to use intercepts
to graph a linear function. The points(s) where a graph intersects the x-axis
are called the x-intercepts points, are the x-coordinates of these points are
the x-intercepts. Similarly, the points where a graph intersects the y-axis
are the y-intercepts points, and the y-coordinates of these points are the y-

16
intercepts. Because any point on the x-axis has y-coordinate 0 and any
point on the y-axis has x-coordinate 0, we find intercepts as follows.
Intercepts
a) To find the y-intercepts(s) of the graph of an equation, set x = 0 in
the equation and solve for note: A function of x has at most one y-
intercept.
b) To find the x-intercept(s), set y = 0 and solve for x.
Example 2.1 Find the intercepts and graph the following.(a) 3x + y
=9(b) x = 4y.

Solution
a) To find the y-intercept, we set x = 0 and solve for y. 3(0) + y = 9 gives y
= 9, so the y-intercept is 9. To find the x-intercept, we set y = 0 and
solve for x. 3x + 0 = 9 gives x = 3, so the x-intercept is 3. Using the
intercepts gives the graph, shown in Figure 2.1.
b) Letting x = 0 gives y = 0, and letting y = 0 gives x = 0, so the only
intercept of the graph of x = 4y is at the point (0,0). A second point is
needed to graph the line. Hence, if we let y = 1 in x = 4y, we get x = 4
and have a second point (4, 1) on the graph. It is wise to plot a third
point as a check. The graph is shown in Figure 2.2

Figure 2.1 Figure 2.2

Note, that the equation graphed in Figure 2.1 can be rewritten asy = 9 –
3xorf(x) = 9 – 3x .We see in Figure 2.1 that the x-intercept (3,0) is the point
where the function value is zero.
The x-coordinate of such a point is called a zero of the function. Thus we
see that the x-intercepts of a function are the same as its zeros.

17
Example 2.2 A business property is purchased for Rs. 122,880 and
depreciated over a period of 10 years. Its value y is related to the
number of months of service x by the equation 4096x + 4y = 491,520.
Find the x-intercept and the y-intercept and use them to sketch the
graph of the equation. (Application of Intercepts with graph).

Solution

X-intercept: y = 0 gives 4096x = 491,520

x = 120
Thus 120 is the x- intercept.

y – intercept t : x = 0 gives 4y = 491,520

y = 122,880
Thus 122,880 is the y-intercept. The graph is shown in Figure 2.3. Note that
the units on the x- and y-axes are different and that the y- intercept
corresponds to the value of the property 0 months after purchase. That is,
the y-intercept gives the purchased price. The x-intercept corresponds to
the number of months that have passed before the value is 0; that is the
property is fully depreciated after 120 months, or 10 years. Note that only
positive values for x and y make sense in the application, so only the
Quadrant I portion of the graph is shown.

Figure 2.3

Despite the ease of using intercepts to graph linear equations, this method
is not always the best. For example, vertical lines, horizontal lines, or lines
that pass through the origin may have a single intercept, and if a line has
both intercepts very close to the origin, using the intercepts may lead to an
inaccurate graph.

18
2.1.3 Slope of a Line
If a no vertical line passes through the points P1 ( x1 , y1 ) and P2 ( x2 , y2 ), its
slope, denoted by m, is found by using either
y2  y1
m
x2  x1

Figure 2.4
or, equivalently,
y1  y2
m
x1  x2
The Slope of vertical line is undefined.
Note that for a given line, the same regardless of which two points are used
in the calculation; this is because corresponding sides of similar triangles
are in proportion:
We may also write the slope by using the notation
y
m (y  y2  y1 and x  x2  x1 )
x
Where, y is read “delta y” and means “change in y”, and x means
“change in x”.
Example 2.3 If f(x) is a linear function, f (3) = –2, and f (8) = 1, find the
rate of change.(Application of Slope with graphical representation).

Solution

f(3) = –2 tells us that the input 3 corresponds with the output –2, and
f(8) = 1 tells us that the input 8 corresponds with the output 1.
To find the rate of change, we divide the change in output by the change in
input:
m= = m,If desired we could also write this as m = 0.6

19
Note that it is not important which pair of values comes first in the
subtractions so long as the first output value used corresponds with the first
input value used.
Example 2.4 The number of banks in the United States for selected
years from 1980 to 2005 is given by y = -416.454 xs + 18,890.75 where x
is the number of years after 1980. (a)Find the slope and the y-intercept,
(b) What does the y-intercept tell us about the banks?, (c)Intercept the
slope as a rate of change, (d)Why is the number of banks decreasing?

Solution

a) The slope is m = -416.454 and the y-intercept is b = 18,890.75.

b) Because x is the number of years after 1980, x = 0 represents 1980
and the y-intercept tells us that there were approximately
18,891banks in 1980.
c) The slope is -416.454, which tells us that the number of banks was
decreasing at a rate of approximately 416.5 banks per year during
this period.
d) The decrease in number is largely due to consolidation of banks,
with larger banks acquiring smaller banks.
Example2.5 Find the slope and y-intercept of the line whose equation
is x + 2y = 8 and Use this information to graph the equation
Solution

(a)To put the equation in slope-intercept form, we must solve it for y.

1 1
2y = -x + 8ory = x + 4Thus the slope is  and the y-intercept is 4.
2 2
1 1
(b) First we plot y-intercept point (0, 4). Because the slope is   ,
2 2
moving 2 units to the right and down 1 unit from (4,2) gives the point (2,3)
on the line. A third point (for a check) is plotted at (4, 2). The graph is shown
in Figure 2.5

20
 Figure 2.5
It is also possible to graph a straight line if we know its slope and point on
the line; we simply plot the point that is given and then use the slope to plot
other points.
The following summarizes the forms of equations of lines.
General form: ax =+ by + c = 0
Point-slope form: y- y1 = m(x- x 1 )

Slope-intercept form: y = mx +b, Vertical line: x = a, Horizontal line: y = b

Example 2.6 Write an equation for the linear function graphed below.

Figure 2.6
Solution

Looking at the graph, we might notice that it passes through the points (0, 7)
and (4, 4). From the first value, we know the initial value of the function is
b = 7, so in this case we will only need to calculate the rate of change:
m= = m,

This allows us to write the Equation(x) =7− x

Example 2.7 Working as an insurance salesperson, Naga earns a base

salary and a commission on each new policy, so Naga’s weekly
income, I, depends on the number of new policies, n, he sells during

21
the week. Last week he sold 3 new policies, and earned $760 for the
week. The week before, he sold 5 new policies, and earned $920. Find
an equation for I(n), and interpret the meaning of the components of
the equation.
Solution
The given information gives us two input-output pairs: (3,760) and (5,920).
We start by finding the rate of change.
m= = = 80

Keeping track of units can help us interpret this quantity. Income increased
by $160 when the number of policies increased by 2, so the rate of change
is $80 per policy; Naga earns a commission of $80 for each policy sold
during the week.
We can then solve for the initial value: I (n) =b+80n,

Therefore b= I (n)-80n
Then, when n=3,b=760−80 (3)=520.
This value is the starting value for the function. This is Naga’s income
when n = 0, which means no new policies are sold. We can interpret this as
Naga’s base salary for the week, which does not depend upon the number
of policies sold.

Writing the final Equation: I(n) = 520 + 80n. Our final interpretation is:
Naga’s base salary is $520 per week and he earns an additional $80
commission for each policy sold each week.

Exercises
1. .Find the intercept and graph the following functions.
a. a. 3x + 4y = 12 b. 6x - 5y = 90
b. c. 5x – 8y = 60 d. 2x - y + 17 = 0
c. e. 3x + 2y = 0f. 4x + 5y = 8
2. Construct the line and find the slope of the line passing through the
given pair of points.
(22, 11) and (15, -17)
(-6, -12) and (-18, -24)

.(3, -1) and (-1, 1), iv (-5,6) and (1,-3)v. (3,2) and (-1,2)

22
 3. What is the rate of change of the function whose graph is a line
passing through (3, 2) and (-1, 2)?
4. What is the rate of change of the function whose graph is a line
passing through (11, - 5) and (-9, -4)?
5. The balance in your University payment account, C, is a function of
the number of quarters, q, you attend. Interpret the function C(a) =
20000 – 4000q in words. How many quarters of University can
you pay for until this account is empty?
2.2 SOLUTIONS OF SYSTEMS OF LINEAR EQUATIONS

(a) Solution by Substitution

Graphical solution methods may yield only approximate solutions to some

systems. Exact solutions can be found using algebraic methods, which are
based on the fact that equivalent systems result when any of the following
operations are performed.
Equivalent systems result when
1. One expression is replaced by an equivalent expression.
2. Two equations are interchanged.
3. A multiple of one equation is added to another equation.
4. An equation is multiplied by a nonzero constant.
The substitution method is based on operation (1).
Substitution Method for Solving Systems

Example
Procedure

To solve a system of two equations 2x + 3y = 4

Solve the system 
in two variables by substitution:  x - 2y = 3

1. Solve one of the equations for

Step 1. Solving x- 2y = 3 for x gives
one of the variables in terms of
x = 2y + 3.
the other

2. Substitute this expression into

Step 2. Replacing x by 2y + 3 in 2x +
the other equation to give one
3y = 4 gives 2(2y + 3) + 3y = 4.
equation in one unknown.

Step3. 4y + 6 + 3y = 4
3. Solve this linear equation for the
2
unknown. 7y = -2  y = 
7

23
4. Substitute this solution into the
equation in Step 1 or into one of Step 4.  2 17
x  2    3 x 
the original equations to solve for  7 7
the other variable.

 17   2 
5. Check the solution by
Step 5. 2   3    4
 7   7
substituting for x and y in both
17  2
original equations.  2   3
7  7

4x + 5y =18 --------- (1)

Example 2.8: Solve the system 
3x - 9y = -18-------- (2)
Solution
9 y 12
1. x= = 3y–4Solve for x in equation (2)
3
2. 4(3y- 4) +5y=18Substitute for x in equation (1)
3. 12y-16 +5y=18Solve for y.
17y=34
y= 2

4. x =3 (2)- 4Use y=2 to find x, x= 2

5. 4 (2)+5 (2)=18and 3 (2)-9 (2)=12 Check.

Thus the solution is x = 2, y = 2 This means that when the two equations
are graphed Simultaneously, their point of intersection is (2, 2 ) See Figure
1.35

Figure 2.7

24
(b) Solution by Elimination we can also eliminate one of the variables in a
system by the elimination method, which uses addition or subtraction of
equations.

Elimination Method for solving systems

Procedure Example

To solve a system of two equations Solve the system2x - 5y =4 (1)

in two variable by the elimination
X + 2y = 3 (d2)
method:

1. If necessary, multiply one or both Multiply equation (2) b by - 2.

equations by a nonzero number
2x - 5y=4
that will make the coefficients
one of the variables identical., -2x - 4y = -6
except perhaps for signs

Adding gives 0x- 9y= 2

2. Add or subtract the equations to
eliminate one of the variables.

3. Solve for the variable in the 2

resulting equation. y= 9

2
4. Substitute the solution into one 2x- 5   4
of the original equations and 9
10 36 10
solve for the other variable. 2x  4   
9 9 9
46 23
2x  so x 
9 9
 23   2 
5. Check the solutions in both 2   5   4 
original equations.  9  9
23  2 
 2   3 
9 9

Example 2.9 A person has $200,000 invested, part at 9% and part at

8%. If the total yearly income from the two investments is $ 17,200,
how much is invested at 9% and how much at 8%? (Application of
system of equation in investment decision)

25
Solution
If x represents the amount invested at 9% and y represents the amount
invested at 8%, then x+y is the total investment,

x + y = 200,000 (1)
and0.09x + 0.08yis the total income earned.
0.09x+0.08y=17,200 (2)

We solve these equations as follows:

8 x  8 y   1, 600, 000 .............(3)
9 x  8 y  1, 720, 000 ................(4)
Multiply equation (1) by 8.
x 120, 000
Multiply equation (2) by 100.
Add (3) and (4).
We find y using x = 120,000 in equation (1).120,000 + y = 200,000 gives y=
80,000, Thus $120,000 is invested at 9% and, $80,000 is invested at 8%.
As a check, we note that equation
(10 is satisfied and 0.09 (120,000) + 0.08(80,000) = 10,800 + 6400 = 17,200
Example2.10 Solve the systems:
4x + 3y = 4 4x + 3y = 4
(a)  (b) 
8x + 6y = 18 8x + 6y = 8
Solution
4x + 3y = 4  8x  6 y   8
(a)  Multiply by -2 to get:
8x + 6y = 18 8 x  6 y 18
Leave as is, which gives: 0 x  0 y  10
Add the equations to get: 0 10
The system is solved when 0 = 10. This is impossible, so there are no
solutions of the system. The equations are inconsistent. Their graphs are
parallel lines; see Figure 1.34 (a) earlier in this section.
(b) {4x + 3y = 4Multiply by -2 to get: 8 x 6 y  8
8x  6 y  8
{8x + 6y = 8Leave as is, which gives:
0x  0 y  0
Add the equations to get:
0 0

26
This is an identity, so the two equations share infinitely many solutions. The
equations are dependent.
Example 2.11 A nurse has two solutions that contain different
concentrations of a certain medication. One is a 12.5% concentration
and the other is a 5% concentration. How many cubic centimeters of
each should she mix to obtain 20 cubic centimeters of an 8%
concentration? (Application of System of equation in hospital
management)

Solution

Let x equal the number of cubic centimeters of the 12.5% solution, and let y
equal the number of cubic centimeters of the 5% solution. The total amount
of substance is
x + y =20 and the total amount of medication is 0.125x + 0.05y = (0.08)(20)
= 1.6, Solving this pair of equations simultaneously gives
50x  50 y  1000
 125x  50 y   1600
 75x   600

x=8,8 + y = 20, so y = 12
Thus 8 cubic centimeters of a 12.5% concentration and 12 cubic
centimeters of a 5% concentration yield 20 cubic centimeters of an 8%
concentration.
Checking, we see that 8 + 12 = 20 and0.125 (8) + 0.05 (12) = 1 + 0.6 = 1.6.

Check point Exercise

3x - 4y = - 24
1. Solve by substitution: 
 x + y = -1

2.
2x - 3y = 5
Solve by elimination: 
3. 3x + 5y = - 25
Left to Right Elimination Method
4.
Left-to-Right Elimination Method

Procedure Example

27
To solve a system of three equations 2x + 4y + 5z = 4

in three variables by the left-to-right Solve: x - 2y - 3z = 5
elimination method: x + 3y + 4z = 1


1. If necessary, interchange two 1. Interchange the first two

equations or use multiplication to equations:
make the coefficient of the first
x- 2y - 3z = 5 (1)
variable in equation (1) a factor of
the other first variable coefficients. 2x+ 4y + 5z = 4 (2)
x + 3y + 4z = 1 (3)

2. Add multiples of the first equation 2. Add (-2) x equation (1) to equation
to each of the following equations so (2) and add (-1) x equation (1) to
that the coefficients of the first equation (3):
variable in the second and third
x - 2y - 3z = 5 (1)
equations become zero.
0x + 8y + 11z = -6 (2)
0x + 5y + 7z = -4 (3)

3. Add a multiple of the second  5

3. Add     equation (2) to
equation to the third equation so that  8
the coefficient of the second variable equation (3):
in the third equation becomes zero.
x- 2y - 3z = 5 (1)
8y + 11 z = -6 (2)
1 2
0y +  (3)
8z 8

4. Solve the third equation and back 4. z = -2from equation(3)

substitute from the bottom to find the 1
remaining variables. y= (6  11z )  2 from equation(2)
8
x = 5 + 2y +3z = 3
Sox =3, y =2, z= -2from equation (1)

28
Example 2.12 Left-to-Right Elimination Method

x + 2y + 3z = 6 (1)

Solve: 2x + 3y + 2z = 6 (2)
{-x + y + z = 4
 (3)

Solution
Using equation (1) to eliminate x from the other equations gives the
equivalent system:

Re movingx

-y -4z = -6 Equation A obtained from Substractionequation2*(1)  (2)
3y +4z =10 Equation B from addingEquation(1)and (3)


(-2) x equation (A) added to equation (B)to eliminate y from equations (3)
gives

-y -4z = -6 equation A and equation B 3y+ 4z=10 added

 2y=4 which gives the value of y=2

Sustitute the value of y=2 in A or B to get the value of z

 Here, substituted in A as (-2)-4z=-6
 -4z=-6+2

 -4z=-4

 z=-4/-4 =1
In a system of equations such as this, the first variable appearing in each
equation is called the lead variable. Solving for each lead variable gives

x = 6 – 2(2)- 3
x = 6 - 4 - 3 = -1
Hence the solution is x = -1, y=2, z=1.
2.3 Some Useful Functions in Management Studies and Economics
Linear Functions: Many economic laws can be represented by the linear
function. We will take up a few examples to illustrate the procedure of
constructing such functions and finding their solutions (roots).
1. Demand Function : In general, the demand function is expressed as :
Qd=a – bp

29
Where, Qd is the quantity demanded (or purchased if offered) and p, is the
price, a andb are constants.
2. Supply Function: In general, the supply function is expressed as :

Qs=c – dp
Where, Qs is the quantity offered for sale, and p is the price c and d are
constants.

3. Total Cost Function : In general, the total cost function explicitly can be
expressed as:
C = C (x)

Where, x is the quantity produced and C is the total cost incurred. However,
if total cost of producing x number of units of a particular commodity is
analyzed in terms of fixed cost F, which is independent of x (with certain
limits) and variable cost V(x), which varies with x, then we can write
C (x) = F + V (x)
The average cost of production or cost per unit is obtained by dividing total
cost by the quantity produced. That is AC (x) = C (x)/x.
4. Total Revenue Function : If Q (x) is the demand for the output of a firm
costing Rs. p per unit, then total revenue (R) collected is given by
R =p⋅ Q (x)

5. Consumption Function : In general, the consumption function is

expressed as :

C=a+cY
Where, C is the total consumption and Y is the national income, a andc are
constants.

6. Investment Function : The simple investment function is expressed as :

I = a + b r ;a> 0 and b< 0 where I represents investment and r the
interest rate.

7. Production Function: In general, the production of an item depends upon

two input variables, namely, capital (K) and labour (L). Thus, symbolically it
is expressed as :

P = f (L, K)
In economics, the popular Cobb-Douglass production function is defined as:

30
 P = aLαKβ ; α + β = 1.
Example 2.13 Assume that for a closed economy E = C + I + G, where E
is total expenditure, C is expenditure on consumption of goods, I is
expenditure on investment on goods and G is Government spending.
For equilibrium, we must have E = Y, where Y is the total income
received. For a certain economy, it is given that C = 15 + 0.90 Y, I = 20
+ 0.05 Y, and G = 25. Find the equilibrium values of Y, C and I. How will
these change if there is no Government spending?
Solution: Given that E = C + I + Grand E = Y. Thus, we have

(a) Y = C + I + G = (15 + 0.90 Y ) + (20 + 0.05 Y ) + 25 = 60 + 0.95 Y

Y= 60 +0.95Y
or Y (1 – 0.95) = 60 or Y = 60/0.05 = 1200
For this value of Y, we have
C = 15 + 0.90 Y = 15 + 0.90 × 1200 = 1095
and I = 20+0.05Y=20+0.05×1200=80
(b)If there is no government spending, i.e., G = 0, then closed economy
equation becomes

Y=C+I=(15+0.90Y)+(20+0.05Y)=35+0.95Y
Y = 35+0.95Y
or Y (1 – 0.95) = 35, i.e.,

Y = 35/0.05 = 700
For this value of Y, we have
C =15+0.90Y=15+0.90×700=645

and I =20+0.05Y=20+0.05×700=55
Example 2.14 The ABC company is producing an item at unit cost of
Rs. 4.If the supply function is q = 160 + 8 p, where q represents the
quantity produced and p represents the market price, then find the
total cost function in terms of p. Total Revenue and Total Profit.

Solution: Total cost = (Cost/unit) (Number of units produced) = 4 ·q

Total sales revenue = (Price/unit) (Number of units supplied) = p · q

31
Total profit (P) = Revenue – Cost = p⋅q – 4 ⋅q

= (p – 4)q
= (p – 4) (160 + 8 p)

= 8p2 + 12 p – 640
Given that P = Rs. 500. Then we have
500 = 8p2 + 12 p – 640 or 8p2 + 128 p – 1140 = 0

 128  128 2
 4  8   1140  128  29.92
p  = 6.37 or -2.3
28 16

The company must charge Rs. 6.37 per unit for its item. The negative price
p = – 22.37 is meaningless.
Example 2.15 A firm produces an item whose production cost function
is C = 80 + 4x, where x is the number of items produced. If entire stock
is sold at the rate of Rs. 8 then determine the revenue function. Also
obtain the ‘break-even’ point.
Solution: The revenue function is given by R = 8x. Also given that,
C=80+4x.Therefore,Profit
P = R – C = 8x – (80 + 4x) = 4x – 80
The break-even point occurs when R – C = 0 or R = C, i.e., 8x = 80 + 4xorx
= 20 (units).
Example 2.16 A company producing Battery for torch lights introduces
production bonus for its employees which increases the cost of
production. The daily cost of production C (x) for x number of battery
is Rs. (3.5x + 12,000).
(a) If each is sold for Rs. 6, determine the number of batteries that
should be produced to ensure no loss.
(b) If the selling price is increased by 50 paise, what would be the
break-even point?

Solution: Let R (x) be the revenue due to the sales of x number of

batteries.
(a) Given that, cost of each Battery is Rs. 6. Then R (x) = 6x. For no
loss, we must have
R (x) = C(x)

32
That is 6x=3.5x + 12000
6x-3.5x = 12000
2.5x =12000
x= =4,800 batteries

(b)Increased selling price is, Rs. (6 + 0.50) = Rs. 6.5. Thus, R (x) = 6.5.
Now for break-even point, we must have R(x) = C(x)
6.5x= 3.5x+ 12000

6.5x-3.5x =12000
3x =12000
x =4000 batteries
Example 2.17 XYZ company wish to set up an another production
plant in North Zone of Tamil Nadu for manufacturing Medical Wearable
Devices for Deaf persons. The total cost for initial set-up (fixed cost) is
Rs. 9 lakh. The additional cost (i.e., variable cost) for producing each
Wearable Device is Rs. 300. Each device is sold at Rs. 750. During the
first month, 1500 devices are produced and sold:
(a) Determine the cost function C(x) for the total cost of producing x
wearable devices.
(b)Determine the revenue function R(x) for the total revenue from the
sale of x devices.
(c) Determine the profit function P(x) for the profit from the sale of x
wearable devices.

Solution:
(a) We know that the cost function includes fixed cost and variable cost.
From the given data, fixed cost = Rs. 9, 00,000 and variable cost = Rs. 300
per Wearable Device.
Let C(x) denote the cost function to manufacture x , then
C(x) = Fixed cost + Variable cost to produce x wearable devices

= 9, 00,000 + 300x
(b) R(x) =(b).R(x)= p⋅Q (x)
=750.x
(c) P(x) = R(x)-C(x)

33
 = 750x- (90000 +300x)
= 750x-300x-900000= 450x-900000devices
Application of Functions in Cost, Revenue, and Profit

The Profit a firm makes on its product is the difference between the
amount it receives from sales (its revenue) and its cost. If x units are
produced and sold, we can write Px   Rx   C x 

where,
Px  = profit from sale of x units

Rx  = total revenue from sale of x units

C x  = total cost of production and sale of x units

In general, Revenue is found by using the equation

Revenue = (price per unit) (number of units)
The cost is composed of two parts: fixed costs and variable costs, fixed
costs FC  , such as depreciation, rent, utilities, and so on, remain constant
regardless of the number of units produced. Variable costs VC  are those
directly related to the number of units produced. Thus the cost is found by
using the equation
Cost = Variable costs +Fixed costs
Example 2.18
Suppose that a firm manufactures MP3 players and sells them for %50
each. The costs incurred in the production and sale of the MP3 players
are $200, 00 plus $10 for each player produced and sold. Write the
profit function for the production and sale of x players.

Solution
The total revenue for x MP3 players is 50 x , so the total revenue function is
Rx   50 x .

The fixed costs are $200,000, So the total cost for x players is 10 x  200,000 .
Hence, C x   10 x  200,000 . The profit function is given by Px   Rx   C x  .
Thus,
Px   50 x  10 x  200,000

Px   40 x  200,000

34
Figure shows the graphs of Rx , C x  , and Px  .The symbols generally used
in economics for total cost, total revenue, and profit are TC, TR , and  ,
respectively. In order to avoid confusion, especially with the use of  as a
variable, we do not use these symbols.

Figure 2.8
Figure By observing the intercepts on the graphs, we note the following.
Revenue : 0 units produce 0 Revenue; R0  0
Cost : 0units costs equal fixed costs = $200,000; C 0  FC  200,000

Profit : 0 units yield a loss equal to fixed costs = $200,000;

P0   FC  200,000 .

5000 units result in a profit of $0 (no loss or gain); P5000  0 Marginal

In Example 1, both the total revenue function and the total cost function are
linear, so their difference, the profit function, is also linear. The slope of the
profit function represents the rate of change in profit with respect to the
number of units produced and sold. This is called the marginal profit MC  
for this product is $10 (the slope of the cost function), and the marginal
 
revenue MR is $50 (the slope of the revenue function).

Example 2.19 Suppose that the cost (in dollars) for a product is
C  21.75x  4890 . What is the marginal cost for this product, and what does it
mean? ( to find Marginal Cost)

Solution
The equation has the form C  mx  b , so the slope is 21.75. Thus the
 
marginal cost is MC =21.75 dollars per unit. Because the marginal cost is

35
the slope of the cost line, production of each additional unit will cost $21.775
more, at any level of production.
Note that when total cost functions are linear, the marginal cost is the same
as the variable cost. This is not the case if the functions are not linear.
Checkpoint
1. Suppose that when a company produces its product, fixed costs are
$12,500 and variable costs are $75 per item.
(a) Write the total cost function if x represents the number of units.
(b) Are fixed costs equal to C 0 ?
2. Suppose the company in Problem 1 sells its product for $175 per
item.
(a) Write the total revenue function.
(b)Find R100 and give its meaning.
3. (a) Give the formula for profit in terms of revenue and cost.
(b) Find the profit function for the company in problems 1 and 2
Examples 2.20 for Profit Manipulation
Suppose the profit function for a product is linear and the marginal
profit is $5. If the profit is $200, when 125 units are sold. Write the
equation of the profit function.

Solution
The marginal profit gives us the slope of the line representing the profit
function. Using this slope m  5 and the point (125,200) in the point-slope
formula P  P1  mx  x1  gives slope P  200  5x  125

P  5x  425

Break-Even Analysis
We can solve the equations for total revenue and total cost simultaneously
to find the point where cost and revenue are equal. This point is called the
break -even point. On the graph of these functions, we use x to represent
the quantity produced and y to represent the dollar value of revenue and
cost. The point where the total revenue line crosses the total cost line is the
break-even point.
Solution
The total revenue for x units of the product is 10x , so the equation for total
revenue is R  Rx   10 x . The fixed costs are $1200, so the total cost for x

36
units is 2.50x  1200 . Thus the equation for total cost is C  C x   2.50 x  1200 .
We find the break-even point by solving the two equations simultaneously
( R  C ) at the break-even point). By substitution,

10x  2.50x  1200

7.5x  1200

x  160

Thus the manufacturer will break even if 160 units are produced per month.
The manufacturer will make a profit if more than 160 units are produced.
Figure shows that for x  160, Rx   C x  (resulting in a loss) and that for
x  160, Rx   C x  (resulting in a profit).

Figure 2.9
Using the fact that the profit function is found by subtracting the total cost
function from the total revenue function, we can form the profit function for
the previous example. The profit function is given by
Px   10 x  2.50 x  1200 or Px   7.50 x  1200

We can find the point where the profit is zero (the break-even point) by
setting Px   0 and solving for x .

0  7.50x 1200

1200  7.50x

x  160

Note that this is the same break-even point that we found by solving the
total revenue and total cost equations simultaneously (see Figure)

37
 Figure 2.10
Supply, Demand and Market Equilibrium
Economists and managers also use points of intersection to determine
market equilibrium. Market equilibrium occurs when the quantity of a
commodity demanded is equal to the quantity supplied.
Demand by consumers for a commodity is related to the price of the
commodity. The law of demand states that the quantity will decrease as
price increases. Figure shows the graph of a typical linear demand function.
Note that although quantity demanded is a function of price, economists
have traditionally graphed the demand function with price on the vertical
axis. Throughout this text, we will follow this tradition. Linear equations
relating price p and quantity demanded q can be solved for either p or q and
we will have occasion to use the equations in both forms.
Just as a consumer’s willingness to buy is related to price, a manufacturer’s
willingness to supply goods is also related to price. The law of supply
states that the quantity supplied for sale will increase as the price of a
product increases. Figure 1.45 shows the graph of a typical linear supply
function. As with demand, price is placed on the vertical axis. Note that
negative prices and quantities have no meaning, so supply and demand
curves are restricted to the first quadrant.
If the supply and demand curves for a commodity are graphed on the same
coordinate system, with the same units, market equilibrium occurs at the
point where the curves intersect. The price at that point is the equilibrium
price, and the quantity at that point is the equilibrium quantity.

38
 Figure 2.11 Figure 2.12
For the supply and demand functions shown in Figure 1.46, we see that the
curves intersect at the point (30, 11). This means that when the price is $11,
consumers are willing to purchase the same number of units (30) that
producers are willing to supply.

Figure 2.13
In general, the equilibrium price and the equilibrium quantity must both be
positive for the market equilibrium to have meaning.
We can find the market equilibrium by graphing the supply and demand
functions can the same coordinate system and observing their point of
intersection. As we have seen, finding the point(s) common to the graphs of
two (or more) functions is called solving a system of equations or solving
simultaneously.

Example 2.21 Market equilibrium

Find the market equilibrium point for the following supply and demand
functions.
Demand: p = -3 q +36
Supply: p =4 q +1
Solution
At market equilibrium, the demand price equal the supply price, thus,

39
 -3 q +36 = 4 q +1
35 =7 q
q =5
p =21
The equilibrium point is (5,21),Checking, we see that
21 = -3(5)+36 and 21 = 4(5)+1

We can use Goal Seek with Excel to find the market equilibrium for given
supply and demand functions. To find the equilibrium quantity and price for
the supply and demand functions in Example 5, we set up the table with
entries for quantity, demand and supply. We enter the functions as in the
following table and add a fourth entry representing demand – supply.

A B C D

1 Q P: Demand P: Supply Demand -Supply

2 L = -3*A2+36 =4*A2+1 =B2-C2

We find the equilibrium quantity and price by using Goal Seek with D2 set to
0, with changing cell A2. The resulting solution gives the equilibrium
quantity as 5 and the equilibrium price as 21.

A B C D

1 Q P: Demand P: Supply Demand -Supply

2 5 21 21 0

Example 2.22 Market Equilibrium

A group of wholesalers will buy 50 dryers per month if the price is $200 and
30 per month if the price is $300. The manufacturer is willing to supply 20 if
the price is $210 and 30 if the price is $230. Assuming that the resulting
supply and demand functions are linear, find the equilibrium point for the
market.

40
Solution
Representing price by p and quantity by q , we have
Demand function:
300  200
m  5
30  50
p  200  5q  50
p  5q  450

Supply function:
230  210
m 2
30  20
p  230  2q  30
p  2q  170

Because the prices are equal at market equilibrium, we have

 5q  450  2q  170
280  7q
q4
p  250

The equilibrium point is (40, 250), See Figure 1.47 fot the graphs of these
functions.

Supply and Demand with Taxation

Supply a supplier is taxed $ K per unit sold, and the tax is passed on to the
consumer by adding $ K to the selling price of the product. If the original
supply function p  f q  gives the supply price per unit, then passing the
tax on gives a new supply function, p  f q   K . Because the value of the
product is not changed by the tax, the demand function is unchanged.
Figure 1.48 shows the effect that this has on market equilibrium.

41
 Figure 2.14
Note the new market equilibrium point is the point of intersection of the
original demand function and the new (after-tax) supply function.
Example 2.23 Taxation
The supply and demand functions for dryers were given as follows.
Supply: p  2q  170

Demand: p  5q  450

The equilibrium point was q  40 , p  $250 . If the wholesaler is taxed $14

per unit sold, what is the new equilibrium point?
Solution
The $14 tax per unit is passed on by the wholesaler, so the new supply
function is
p  2q  170  14

And the demand function is unchanged. Thus we solve the system

 p  2q  184

 p  5q  450
2q  184  5q 450
7q  266
q  38
p  238  184  260
The new equilibrium points q  38 , p  $260

Checking, we see that

260=2(38) +184 and 260 = -5(38) +450

42
LET US SUM UP
The following summarizes the forms of linear function
General form: ax =+ by + c = 0
Point-slope form: y- y1 = m(x- x 1 )

Slope-intercept form: y = mx +b,

Vertical line: x = a, Horizontal line: y = b

The linear equation is the equality of two linear functions. There is a step by
step explanation presented to solve the linear equation which is the equality
of two linear functions by substitution method by elimination method with
examples.
CHECK YOUR PROGRESS

1. What is the rate of change of the function whose graph is a line passing
through (3,2) and (-1, 2)?
2. What is the rate of change of the function whose graph is a line passing
through (11, - 5) and (-9, -4)?
3. The balance in your University payment account, C, is a function of the
number of quarters, q, you attend. Interpret the function C(a) = 20000 –
4000q in words. How many quarters of University can you pay for until
this account is empty?
3x - 4y = - 24
4. Solve by substitution: 
 x + y = -1
2x - 3y = 5
5. Solve by elimination: 
3x + 5y = - 25
GLOSSARY

Linear Function : A linear function is defined as a function that

has either one or two variables without
exponents. It is a function that graphs to the
straight line.
:
Linear equation Linear equations are equations of degree 1,
written for two different variables with a
constant. he standard form of a linear
equation in two variables is of the form ax +
by = c. Here, x and y are variables, and a, b

43
 and c are constants.
:
Elimination Method The elimination method is where you actually
eliminate one of the variables by adding the
two equations. In this way, you eliminate one
variable so you can solve for the other
variable. In a two-equation system, since you
have two variables, eliminating one makes
the process of solving for the other quite
easy.

Substitution Method : A way to solve a linear system algebraically

is to use the substitution method. The
substitution method functions by substituting
the one y-value with the other

SUGGESTED READINGS
1. Arora, P.N. & S. Arora, (2007) ,Statistics for Management, latest
Edition, S. Chand & Company Ltd., New Delhi.
2. D.C.Sancheti, V.K.Kapoor,( 2014), Business Mathematics, 11th
edition, Reprint, Sultan Chand and Sons, New Delhi.

3. Gupta, B.N., (2015), Business Statistics, First Revised Edition,

SBPD, New Delhi.
4. JK. Sharma, (2009), Business Mathematics Theory And
Applications, 13th Edition, ANE Books, New Delhi.
5. S. P. Gupta, (2012), Statistical Methods, 42nd Revised Edition Sultan
Chand & Sons Pvt. Ltd., New Delhi.
6. https://en.wikipedia.org/wiki/Linear_function
7. https://www.investopedia.com/terms/b/breakevenanalysis.asp
ANSWERS TO CHECK YOUR PROGRESS

1. Rate of change is slope and the value is 0

2. -
3. 20000 – 4000q=0; q= Answer is q=5
4. Substitution Method: x= y=
5. Elimination Method :x=- y=

44
 Unit 3

NON-LINEAR FUNCTIONS
STRUCTURE

Overview
Learning Objectives
3.1 Introduction

3.2 Difference between Linear and Non-linear functions

3.3 Nonlinear Function: Quadratic Equation
3.3.1 Meaning, Features of Parabola

3.3.2 Significance of Quadratic Function

3.3.3 Examples in Root Method and Factoring Method
3.4 Nonlinear Function: Exponential Function and Examples

3.5 Nonlinear Function: Logarithmic Function and Examples

Let Us Sum Up
Check Your Progress

Glossary
Suggested Readings
Answers to check your progress

OVERVIEW
The unit attempt to describe the non-linear function such as Quadratic,
Exponential and Logarithmic with its meanings and importance in Business
studies. This chapter aids to the learners in utilizing the functions in
management decisions in different perspectives.
LEARNING OBJECTIVES

After learning this unit, you should be able to

 aid the students in graphing quadratic, exponential functions, and
logarithmic functions.
 enable the students to convert equations for logarithmic functions
from logarithmic to exponential form, and vice versa.

45
  make the learners to apply the nonlinear functions in Business
decision making
3.1 INTRODUCTION

By definition, nonlinear functions are functions which are not linear. Non-
linear means the graph is not a straight line. The graph of a non-linear
function is a curved line. A curved line is a line whose direction constantly
changes. Three non-linear functions commonly used in business decision
making and in economics are: a) the quadratic function b) the exponential
function and c) the logarithmic function.
3.2 DIFFERENCE BETWEEN LINEAR AND NONLINEAR EQUATIONS

Linear Equations Non-Linear Equations

It forms a straight line or represents It does not form a straight line but
the equation for the straight line forms a curve.

It has only one degree. Or we can also A nonlinear equation has the
define it as an equation having the degree as 2 or more than 2, but
maximum degree 1. not less than 2.

All these equations form a straight line

It forms a curve and if we increase
in XY plane. These lines can be
the value of the degree, the
extended to any direction but in a
curvature of the graph increases.
straight form.

The general representation of linear The general representation of

equation is; nonlinear equations is;ax2 + by2 =
y = mx +c, Where x and y are the c Where x and y are the variables
variables, m is the slope of the line and and a, b and c are the constant
c is a constant value. values

An example of Nonlinear Function

An example of Linear Function Graph
Graph’

46
Examples: Examples:
Y=2X+3 x2 + 2xy + y2 = 4
3y + 2x + 1 = 0 Y=

99x + 12 = 23 y Y

3.3 QUADRATIC FUNCTIONS

Quadratic functions are one type of nonlinear function. Quadratic equations
are commonly used in situations where two things are multiplied together
and they both depend on the same variable. For example, when working
with area, if both dimensions are written in terms of the same variable, you
use a quadratic equation. Because the quantity of a product sold often
depends on the price, you sometimes use a quadratic equation to represent
revenue as a product of the price and the quantity sold. Quadratic functions
help forecast business profit and loss, plot the course of moving objects,
and assist in determining minimum and maximum values.
There are many real-world situations that deal with quadratics
and parabolas. Throwing a ball, shooting cannon, diving from a platform and
hitting a golf ball are all examples of situations that can be modeled by
quadratic functions. In many of these situations you will want to know the
highest or lowest point of the parabola, which is known as the vertex.
3.3.1 Definition
A Quadratic function f is given by f (x) = ax2+bx+c, where a  0 with
highest power is two. For example, f(x)= x2 and g(x)= x2-1. The graph of a
quadratic function f(x) =ax2+bx +c is called a parabola.
A parabola is the set of points that are equidistant from a fixed point on the
interior of the curve, called the '''focus''', and a line on the exterior, called the
'''direct rix'''. The direct rix is vertical or horizontal, depending on the
orientation of the parabola.

47
The vertex of a parabola is the highest or lowest point on the graph of a
parabola. The vertex is the maximum point of a parabola that opens
downward and the minimum point of a parabola that opens upward.

Features of Parabola
a) It is always a cup-shaped curve,
b) It opens upward if a>0, or opens downward if a<0.
b
c) It had a turning point, or vertex, whose first coordinate is, x= 
2a
d) The vertical line x = -b/(2a) (not part of the graph) is the line of
symmetry.
3.3.2 Significance of Quadratic Function in day to day life
a) Manipulation of Profit
Quadratic equations are often used to calculate business profit. Even when
dealing with small products, you will need to solve a quadratic equation to
determine how many of them will make a profit.
b) Calculating Room Areas
In construction, when it is taking place, constructors use quadratic
equations to determine the area. People also calculate the areas of other
things such as a piece of land and boxes.
c) Quadratics in sports

There are many uses of quadratic equations in sports daily. It has become
very useful in the game play and analysis as well. For example when a
football analyst needs to determine the form of a team or athlete then they
always make calculations.
d) Management and clerical work

There are thousands of management and clerical work that involve the use
of quadratic equations daily. For example production, managers and
engineering managers supervise people that are dealing with equations.
That means they need to have solid knowledge on the same. Human
resource managers have to determine the workforce cable of completing
some given tasks. In addition, they have to figure out how to pay or design
pension plans. All those activities actively depend on the quadratic
equations. Insurance agents also deal with them because they have to
design complex insurance models and plans that involve a lot of
computation.

48
e) Agriculture
Quadratic equations are also applied in agriculture extensively. One of the
biggest applications of quadratic equations in Agriculture is in the
arrangement of boundaries. For example, calculating the areas of
cultivating land that will produce high yields involves. Some area
calculations lead to the formation of an equation.

Function value for Quadratic: ROOTS (ZEROS) OF A FUNCTION

The value (or values) of x at which the given function f (x) becomes equal to
zero are called zeros of the function f (x).

The zeros of the function are also called the roots of the given function f
(x).For the linear function y = ax + b the roots are given by ax + b = 0, i.e., x
= – b/a
Thus, if x = – b/a, then substituting in the given equation, ax + b = 0, the left
hand side of its becomes equal to its right hand side.
For the quadratic function
y = ax2+bx+c , a ≠0
the quadratic equation ax2 + bx + c = 0 ; a≠ 0 has to be solved to find the
roots of the function y. The general value of x which satisfy the given
quadratic equation is given by
√

This shows that, in general, there are two values of x (also called roots ) for
which ax2 + bx + c becomes zero. These two values are
√ √
X1= orx2 =

where, Sum of Roots= -b/a and Product of the roots = c/a

Then the generalequationisx2 – (Sum of roots) x + (Product of roots) = 0.
This is the formula to find an equation whose roots are given. Alternatively,
an equation whose roots are α and β is given by (x – α) (x – β) = 0
Note: The number of roots of the given function is always equal to the
highest power of the independent variable.

49
Special Cases
The expression b2 – 4 ac in the value of x is known as discriminant which
determines the nature of the roots of the quadratic equation as discussed
below:
(i) If b2 – 4 ac> 0, then the two roots are real and distinct.
(ii) If b2 – 4 ac = 0. then the two roots are equal and are equal to – b/2a.
(iii) If b2 – 4 ac< 0, then the two roots are imaginary (not-real) because
of the square root of negative number.
The roots of a polynomial: y = (x – a) (x – b) (x – c) ... are a, b, c
Remark: From this discussion, it is clear that we need to find out the actual
roots to determine their nature.
The value of (b2 – 4 ac) is sufficient to determine the nature of the roots.
3.3.3 Solved Examples of with Graphical Presentation and its
application
Example 3.1 Graph: f(x) = x2 -2x – 3.

Solution
Note that for f(x) = 1x2 -2x -3, we have a=1, b= -2, and c= -3. Since a>0, the
graph opens upward. Let’s next find the vertex, or turning point. The x-
coordinate of the vertex is
b
x
2a
2
 1
2(1)

Substituting 1 for x, we find the second coordinate of the vertex, f(1):

f(1) = 12 -2(1) -3
= 1-2-3
= -4.

The vertex is (1, -4). The vertical line x= 1 is the line of symmetry of the
graph. We choose some x-values on each side of the vertex, compute y-
values, plot the points, and graph the parabola.

50
 Figure 3.1
Example 3.2 Graph: f(x) = -2x2 + 10x -7.

Solution
We first note that a = -2, and since a< 0, the graph will open down-ward.
Let’s next find the vertex, or turning point. The x-coordinate of the vertex is
b
x
2a
10 5
 
2 2 2
5
Substituting for x in the equation, we find the second coordinate of the
2
vertex:
2
5 5 5
y  f    2   10   7
2 3 2
 25  11
 2   25  7  .
 4 2

 5 11  5
The vertex is  ,  , and the line of symmetry is x  . We choose some
2 2  2
x-values on each side of the vertex, compute y-values, plot the points, and
graph the parabola:

51
 Figure 3.2
First coordinates of points at which a quadratic function intersects the x-axis
(x-intercepts), if they exist, can be found by solving the quadratic equation
ax2+bx+c=0. If real-number solutions exist, they can be found using the
quadratic formula.
The Quadratic Formula -Root Method
The solutions of any quadratic equation ax2 + bx+ c = 0, a  0, are given by

 b  b 2  4ac
x
2a
When solving a quadratic equation, ax2 + bx+ c = 0, a  0, first try to factor.
When factoring is not possible or seems difficult, use the quadratic formula.
It will always give the solutions. If for the given quadratic equation b 2 -4ac <
0, there are no real-number solutions and thus no x-intercepts.
Example 3.3 Solve: 3x2 -4x = 2.

Solution
We first find the standard form ax2 + bx + c = 0, and then determine a, b,
and c:

3x2 -4x -2 =0,

a = 3, b = -4, c = -2.
We then use the quadratic formula:

 b  b 2  4ac
x
2a

52
  (4)  (4) 2  4(3) (2)
 Substituting
23
4  16  24 4  40
  Simplifying
6 6
4  4  10 4  2 10
 
6 6



2 2  10 
23
2  10
 .
3
   
The solutions are 2  10 / 3 and 2  10 / 3, or approximately 1.721 and -
0.387.
Solving by Factoring Method
For every quadratic equation, there can be one or more than one solution.
These are called the roots of the quadratic equation.
For a quadratic equation ax2+bx+c = 0,
The sum of its roots = –b/a and the product of its roots = c/a.
A quadratic equation may be expressed as a product of two binomials.

For example, consider the following equation

x2-(a+b) x+ab = 0
x2-ax-bx+ab = 0
x(x-a)-b(x-a) = 0
(x-a)(x-b) = 0
x-a = 0 or x-b = 0

x = a or x=b
Here, a and b are called the roots of the given quadratic equation.
Example 3.4 Calculate the roots of an equation x2+5 x+6 = 0.

Solution
We have to take two numbers adding which we get 5 and multiplying which
we get 6. They are 2 and 3.

53
Let us express the middle term as an addition of 2x and 3x.
→ x2+2x+3x+6 = 0
→ x(x+2)+3(x+2) = 0

→ (x+2)(x+3) = 0
→ x+2 = 0orx+3 = 0
→ x = -2orx = -3This method is called factoring.
Example 3.5 Solve for x: x2-3x-10 = 0

Solution
Let us express - 3x as a sum of -5x and +2x.
→ x2-5x+2x-10 = 0
→ x(x-5)+2(x-5) = 0
→ (x-5)(x+2) = 0
→ x-5 = 0orx+2 = 0
→ x = 5orx = -2
Example 3.6 Solve for x: x2 - 18x+45 = 0

Solution
The numbers which add up to -18 and give +45 when multiplied are -15 and
-3.

Rewriting the equation,

→ x2-15x-3x+45 = 0
→ x(x-15)-3(x-15) = 0

→ (x-15) (x-3) = 0
→ x-15 = 0orx-3 = 0
→ x = 15orx = 3
Example 3.7 Solve for x: 11x2+18x+7 = 0

Solution
In this case, the sum of the numbers we choose should equal to 18 and the
product of the numbers should equal 11*7 = 77.
This can be done by expressing 18x as the sum of 11x and 7x.

54
 → 11x2+11x+7x+7 = 0
→ 11x(x+1) +7(x+1) = 0
→ (x+1)(11x+7) = 0

→ x+1 = 0or11x+7 = 0
→ x = -1orx = -7/11.
Example 3.8 A motorboat whose speed is 18 km/h in still water
takes 1 hour more to go 24 km upstream than to return downstream to
the same spot. Find the speed of the stream.

Solution
Let the speed of the stream be represented by x. Therefore, the speed of the
motorboat upstream is (18 – x) km/h and the speed of the motorboat
downstream is (18 + x) km/h.

Time taken by the boat to go upstream = =

Similarly, the time taken by the boat to go downstream =

From the condition given here, we have:

24(18 + x) – 24(18 – x) =(18 – x) (18 + x)

Simplification of the above equation gives: x2 + 48x -324 = 0.
x2 +6x-54x -324= 0
x(x-6)-54(x-6)=0
(x-6)(x-54)=0
Hence, using the quadratic formula, we have x = 6 and x = -54. Speed can’t be
negative, so we have x = 6 km/h.
Example3.9 Assume you are working for Builder’s and you are needed
to manipulate the length and width for a given area of a particular
building. Specifically, there is a meeting hall whose length is five times
the width. The area of the floor is 45m2. Find the length and width of
the hall.
Solution

55
Let us suppose that ‘w’ is the width of the hall. The length of hall is given as
5w.
Area of the hall= length and width.

That is Area of the hall = w (5w)

We can write:5w2 = 45 ,
w2 = w2 – 9 = 0(w+3)(w-3) = 0,

w = -3 or w = 3.
Therefore, the width is 3 m and length is 5(3) = 15 m.

So, you have to take 3 meter length wise and 15 meter width wise for
the area of the floor as 45m2.
Example 3.10 The profit (in 1000USD) of a company is given by P(x) =
5000 + 1000 x - 5 x2 where x is the amount (in1000USD) the company
spends on advertising. a) Find the amount, x, that the company has to
spend to maximize its profit. b) Find the maximum profit Pmax.

Solution
a) Function P that gives the profit is a quadratic function with the
leading coefficient a = - 5. This function (profit) has a maximum
value at x = h = - b / (2a)x = h = -1000 / (2(-5)) = 100
The maximum profit Pmax, when x = 100 thousands is spent on
advertising, is given by the maximum value of function P
k = c - b 2 / (4 a)
b) The maximum profit Pmax, when x = 100 thousands is spent on
advertising, is also given by P(h = 100) = P(100) = 5000 + 1000
(100) - 5 (100) 2 = 55000.
When the company spends 100 thousand dollars on advertising, the profit is
maximum and equals 55000 dollars. Shown below is the graph of P(x), note
the maximum point, which is the vertex, at (100, 55000).

56
 Figure 3.3
Example 3.11 Find the formula for the revenue function if the price-
demand function of a product is p = 54 − 3x, where x is the number of
items sold and the price is in dollars. How many items should be sold
in order to maximize the revenue? What is the maximum revenue?

Solution
R(x) = p ∗ x = (54 − 3x) ∗ x = 54x − 3x 2 = −3x 2 + 54x Since a = −3 indicates
the revenue function opens downward, there will be a maximum and it will
be at the vertex. The number of items needed to maximize the revenue
function isx= =
∗

The maximum revenue is R(9) = −3(9)2 + 54 ∗ 9 = $243 dollars

3.4 NON- LINEAR FUNCTIONS: EXPONENTIAL

Introduction
In the following pages we study exponential and logarithmic functions,
which provide models for many applications. We will examine their
descriptions, their properties, their graphs, and the special inverse
relationship between these two functions. We will see how exponential and
logarithmic functions are applied to business managers in their decision
making.
a) Meaning of Exponential Functions.

If a is a real number with a > 0 and a  1, then the function

f(x) = axis an exponential function with base a.
Suppose a culture of bacteria has the characteristic that each minute, every
microorganism splits into two new organisms. We can describe the number
of bacteria in the culture as a function of time. That is, if we begin the
culture with one microorganism, we know that after 1 minute we will have
two organisms, after 2 minutes, four, and so on. Table 5.1 gives a few of the

57
values that describe this growth. If x represents the number of minutes that
have passed and y represents the number of organisms, the points (x, y) lie
on the graph of the function with equation y = 2x

A table of some values satisfying y = 2x and the graph of this function are
given in Figure This function is said to model the growth of the number of
organisms in the previous discussion, even though some points on the
graph do not correspond to a time and a number of organisms. For
example, time x could not be negative, and the number of organisms y
could not be fractional.

Figure 3.4
Example 3.12 Graph of an Exponential Function graph y  10x.

Solution
values and the graph are given in Figure 5.2.
A Table of values and the graph are given in Figure 5.2.

Value of an Investment (Application Preview)

Figuree 3.5
7. EXAMPLE 3 Futur
Example 3.13 If Rs.10,000 is invested at 6 %, compounded monthly,
then the future value of the investment S after x years is given byS
=10,000(1.005)12x , Find the future value of the investment after (a) 5
years and (b) 30 years.

58
Solution
These future values can be found with a calculator.
(a) S = 10,000(1.005)12(5)
= 10,000(1.005)60
=Rs.13,488.50 (nearest cent)
(b) S = 10,000(1.005)12(30)

=10,000(1.005)360
=Rs.60,225.75 (nearest cent)
Note that the amount after 30 years is significantly more than the amount
after 5 years, a result consistent with exponential growth models.
3.5 NONLINEAR FUNCTION: LOGARITHMIC FUNCTION AND
EXAMPLES

LOGARITHMIC FUNCTION
Logarithms were developed in the 17th century by John Napier, or by using
a slide rule, which is based on logarithms. The use of logarithms as a
computing technique has all but disappeared today, but the study of
logarithmic functions is still very important because of the many
applications of these functions.

For example, let us again consider the culture of bacteria. If we know that
the culture is begun with one microorganism and that each minute every
microorganism present splits into two new ones, then we can find the
number of minutes it takes until there are 1024 organisms by solving1024 =
2y , The solution of this equation may be written in the form
y = log21024 which is read “y equals the logarithm of 1024 to the base 2.”
a) Meaning of Logarithmic Function
For a>0 and a  1, the logarithmic function y= loga x (logarithmic form),
has domain x> 0, base a, and is defined by ay =x (exponential form). From
the definition, we know that y= loga x means that log381 = 4 because 34 =81.
In this case the logarithm, 4, is the exponent to which we have to raise the
base 3 to obtain 81. In general, if y= loga x, then y is the exponent to which
the base a must be raised to obtain x.
a is called the base in both loga x = y and ay =x, and y is the logarithm in
loga x=y and the exponent in ay= x. Thus a logarithm is an exponent.

59
 Table 3.1

Logarithmic Form Exponential Form

log10 100 = 2 102 =100

log10 0.1 = -1 10-1 = 0.1

log2 x = y 2y = x

loga 1 = 0(a>0) a0 = 1

loga a = 1 (a>0) a1 = a

Example 3.14 Write 64 = 43 in logarithmic form. (b) Write log4 

1  -3
=
 64 
in Exponential form and (c) If 4 = log2x. Find x.

Solution

(a) In 64 = 43, the base is 4 and the exponent (or logarithm) is 3. Thus
64 = 43 is equivalent to 3 log464.
 1 
(b) In log4   = -3, the base is 4 and the logarithm (or exponent) is -3.
 64 
 1  1
Thus log4   = -3 is equivalent to 4 =
-3
.
 64  64
(c) If 4 = log x, then 24 = x and x= 16.

Example 3.15 Evaluating Logarithms :(a) log2 8(b) log3 9and(c) log5
 1 
 
 25 
Solution
(a) If y = log2 8, then 8 = 2y, Because 23 = 8, log2 8 = 3.
(b) If y = log3 9, then 9 = 3y. Because 32 = 9, log3 9 = 2.

If y = log5 
1  1
= 5y. Because 5-2=
1
, log5 
1  = -2.
(c)  , then 
 25  25 25  25 

60
Example 3.16 Graphing a Logarithmic Function: y = log2x.
Solution
We may graph y = log2x by graphing x = 2y. The table of values (found by
substituting values of y and calculating x) and the graph are shown in Figure
5.13.

Figure 3.6
From the definition of logarithms, we see that every logarithm has a base.
Most applications of logarithms involve logarithms to the base 10 (called
common logarithms) or logarithms to the base e (called natural
logarithms). In fact, logarithms to the base 10 and to the base e are the
only ones that have function keys on calculators. Thus it is important to be
familiar with their names and designations.
Difference in Common and Natural Logarithms
Common logarithms: log xmeanslog10x.
Natural logarithms: In x means logex.
Values of common and natural logarithmic c functions are usually found with
a calculator. For example, a calculator gives log 2 = 0.301 and in 2 = 0.693.

Example 3.17 If $P is invested for t years at interest rate r,compounded

continuously, then the future value of the investment is given by S =
Pert . The doubling time for this investment can be found by solving for
t in S=P \ert when S= 2 P. That is, we must solve 2P = Pert, or
(equivalently) 2 = ert.
(a) Express 2 = ertin logarithmic form and then solve for t to find the
doubling-time formula.
(b) If an investment earns 10% compounded continuously, in how
many years will it double?(A solved problem for Doubling Time for
an Investment )

61
Solution
(a) In logarithmic for, 2 = ert is equivalent to loge 2 = rt. Solving for t
gives the doubling-time formula
loge 2 In 2
t 
r r
(b) If the interest rate is r = 10 %, compounded continuously, the time
required for the investment to double is
In 2
t  6.93 Years
0.10
Note that we could write the doubling time for this problem as
In 2 0.693 69.3
t  
0.10 0.10 10
In general we can approximate the doubling time for an investment at r%,
70
compounded continuously, with . (In economics, this is called the Rule of
r
70.)
Example 3.18 Suppose that after a company introduces a new product,
the number of months m before its market share is s percent can be
 40 
modelled by m  20 In   When will its product have a 35% share
 40  s 
of the market?( An example for application in Market Share)
Solution
A 35% market share means s = 35. Hence
 40 
m  20 In  
 40  s 
 40   40 
 20 In    20 In   = 20 In 8  41.6
 40  35   5 
Thus the market share will be 35% after about 41.6 months.

Example 3.19 The population of a certain city was 30,000 in 1990 and
40,500 in 2000. If the formula P = P0eht applies to the growth of the
city’s population, what should the population be in the year 2020?(An
application in Demography issues)
Solution
We can first use the data from 1990 (t=0) and 2000 (t=10) to find the value
of h in the formula. Letting Po = 30,000 and P = 40,500, we get
40,500 = 30,000eh (10)

62
 1.35 = e10h Isolate the exponent
Taking the natural logarithms of both sides and using logarithmic. Property I
give
In 1.35 = Ine10h = 10h
0.3001 = 10h
H = 0.0300(approximately)
Thus the formula for this population is P = Poe003t. To predict the population
for the year 20202, we set the most recent data point (for 2000) as t= 0, Po
= 40,500, and find P for t = 20. This gives
P = 40,500e0.03 (20)
= 40,500e0.6
= 40,500(1.8221)
= 73,795(approximately)

Example 3.20 Suppose the demand function for q thousand units of a

certain commodity is given by p = 30(3-q/2)At what price per unit will the
demand equal 4000 units? How many units, to the nearest thousand
units, will be demanded if the price is $17.32?

Solution
(a) If 4000 units are demanded, then q = 4 and
p =30(3-4/2)
= 30(0.1111)
= 3.33 dollars(approximately)
(b) If p = 17.32, then 17.32 = 30(3-q/2)
0.5773 = 3-q/2 Isolate the exponential.
In 0.5773 = In 3-q/2
q
In 0.5773 =  In 3
2
 2 In 0.5773
q
In 3
1.000  q
The number of units demanded would be approximately 1000 units.

Example 3.21 Suppose the demand function for a commodity is given

by p = 100e-x/10, where p is the price per unit when x units is sold.
a) What is the total revenue for the commodity?

63
 b) What would be the total revenue if 30 units were demanded and
supplied?

Solution

(a) The total revenue can be computed by multiplying the quantity sold
and the price per unit. The demand function gives the price per unit
when x units are sold, so the total revenue for x units is R(x) = x 

p = x(100e-x/10). Thus the total revenue function is R(x) = 100xe-x/10.

(b) If 30 units are sold, the total revenue is
R (30) = 100(30)e-30/10  100(30)(0.0498)

= 149.40 (dollars)
Gompertz Curves
Gompertz Curves and Logistic Functions
One family of curves that has been used to describe human growth and
development, the growth of organism in a limited environment, and the
growth of many types of organizations is the family of Gompertz curves.
These curves are graphs of equations of the form
N  Ca Rt

Where, t represents the time, R(0< R< 1) is a constant that depends on the
population, a represents the proportion of initial growth, C is the maximum
possible number of individuals, and N is the number of individuals at a given
time t.
For example, the equation N = 100(0.03)0.2t could be used to predict the size
of a deer herd introduced on a small island. Here the maximum number of
deer C would be 100, the proportion of the initial growth a is 0.03, and R is
0.2. For this example, t represents time, measured in decades. The graph of
this equation is given in Figure 3.7

Figure 3.7

64
Example 3.22 A hospital administrator predicts that the growth in the
number of hospital employees will follow the Gompertz equation N =
2000(0.6)0.5twhere t represents the number of years after the opening of
a new facility.
(a) What is the number of employees when the facility opens?
(b) How many employees are predicted after 1 year of operation?
(c) Graph the curve. And What is the maximum value of N that the
curve will approach?
Solution
0
(a) The facility opens when t = 0, so N = 2000(0.6) 0.5 = 2000(0.6)1 =
1200
(b) In 1 year, t = 1, so N = 2000(0.6)0.5 = 2000 0.6 1549
(c) The graph is shown in Figure 5.22.
(d) From the graph we can see that as larger values of t are substituted
in the function, the values of N approach, but never, 2000. We say
that the line N = 2000 (dashed) is an asymptote for this curve and
that 2000 is the maximum possible value.

Figure 3.8
t
Example3.23: The Gompertz equation N = 100(0.03)0.2 Predicts the size
of a deer herd on a small island decades from now. During what year
will the deer population reach or exceed 70?
Solution
We solve the equation with N = 70.
t
70 = 100(0.03)0.2
t
0.7 = 0.030.2 Isolate the exponential.
t
In 0.7 = In 0.030.2 = 0.2tIn 0.03

65
 In 0.7
 0.2 t Again, isolate the exponential.
In 0.03
 In 0.7 
In    t In 0.2
 In 0.03 
In (0.10172)  t (6.094)
 2.2855
t
 1.6094
t  1.42 decades
The population will exceed 70 in just over 14 years, or during the 15th year.
Example 3.24 According to Newsweek, DVD players entered U.S.
households faster than any other piece of home electronics equipment
in history. The sales revenues from 2009 to 2014 can be modeled by
the logistic function
9.46
y Where x is the number of years past 2009 and y is in
1  53.08e 1.28 x
billions of dollars. a) Graph this function. And b) Use the function to estimate
the sales revenue for 2014.
Solution
(a) The graph of this function is shown in Figure 5.25 on the following
page. Note that the graph is an S-shaped curve with a relatively slow
initial rise, then a steep climb, followed by a leveling off. It is
reasonable that sales would eventually level off, even if everyone in
the United States bought a DVD player. Very seldom will exponential
growth continue indefinitely, so logistic functions often better
represent many types of sales and organizational growth.
(b) For the 2014 estimate, use x = 6 in the function.

9.46 9.46
y 1.28( 6 )

1  53.08e 1  53.08e 7.68

9.46
  9.234
1  0.0245216276
Thus the model estimates that in 2004, the sales revenue from DVD players
was about $9.234 billion.

66
 Figure 3.9
LET US SUM UP

This unit given the detailed note on nonlinear functions such as Quadratic
function, Logarithmic function, and Exponential function with solved
examples. The graphical presentation were given might be useful to the
self-learners for understanding the purpose of the sum which will help them
to use in reality when necessary arise.
KEY TERMS AND FORMULAS

Key Terms Formulas

 b  b 2  4ac
Quadratic Function x
2a

f(x) = ax(a>1)
f(x) = C(ax)(C>0, a>1)
Exponential functions
f(x) = C(a-x)(C>0, a>1)
Growth Functions
f(x) = C(bx)(C> 0, 0< b<1)

e 2.71828

Logarithmic function Y =logax, defined by x= ay

Common logarithm logx = log10x

Natural logarithm In x = logex

Logarithmic Properties logaax=x; alogax=x;

I-V loga(MN)=logaM+logaN;

67
 loga(M/N)=logaM-logaN;
loga(MN)=N(logaM)

log a x
logbx=
log a b
Change-of-base
formulas In x
logbx =
In b

CHECK YOUR PROGRESS

1. Evaluate: log3 1
2. Evaluate: log4 4
3. Evaluate: log7 73
4. Solve the equation - 2 = 12
5. Solve the following logarithmic equations
6. log x + log(x - 1) = log(4x)
GLOSSARY

Logarithmic Function :The logarithmic function is an

inverse function to exponentiation.
The logarithmic function is defined
as For x > 0 , a > 0, and a≠1, y=
loga x if and only if x = ay Then the
function is given by f(x) = loga x

Natural Logarithmic Function :The logarithmic function to the base

e is called the natural logarithmic
function and it is denoted by loge.
f(x) = loge x

Exponential Function :An exponential function is a

Mathematical function in form f (x) =
ax, where “x” is a variable and “a” is
a constant which is called the base
of the function and it should be
greater than 0. The most commonly
used exponential function base is
the transcendental number e, which
is approximately equal to 2.71828.

68
Non Linear Function : Nonlinear functions are functions
that are not linear functions. the
graph of a nonlinear function is not a
line Non-linear means the graph is
not a straight line. The graph of a
non-linear function is a curved line.
A curved line is a line whose
direction constantly changes.

SUGGESTED READINGS

1. Arora, P.N. & S. Arora, (2007) ,Statistics for Management, latest

Edition, S. Chand & Company Ltd., New Delhi.
2. D.C.Sancheti, V.K.Kapoor,( 2014), Business Mathematics, 11th
edition, Reprint, Sultan Chand and Sons, New Delhi.
3. Gupta, B.N., (2015), Business Statistics, First Revised Edition,
SBPD, New Delhi.
4. JK. Sharma, (2009), Business Mathematics Theory And
Applications, 13th Edition, ANE Books, New Delhi.
5. S. P. Gupta, (2012), Statistical Methods, 42nd Revised Edition Sultan
Chand & Sons Pvt. Ltd., New Delhi.
6. https://www.geeksforgeeks.org/difference-between-linear-and-non-
linear-equations/
7. https://mathstat.slu.edu/~may/ExcelCalculus/sec-2-3-
NonlinearFunctions.html
ANSWERS TO CHECK YOUR PROGRESS

1. 0
2. 1
3. 3
4. S = 2:402
5. S=5

69
Unit 4

DECISION MAKING UNDER RISKS

AND UNCERTAINTY
STRUCTURE
Overview
Learning Objective
4.1 Introduction
4.2 Decision theory under risk
4.2.1 Expected Monetary Value Criterion
4.2.2 Expected Opportunity Loss Criterion

4.3 Decision theory under uncertainty

4.3.1 Maximin Criterion with Solved Example
4.3.2 Minimax Criterion with Solved Example

4.3.3 Maximax Criterion with Solved Example

4.4 Decision Tree analysis with Solved Example
Let Us Sum Up
Check Your Progress
Glossary
Suggested Readings
Answers to check your progress
OVERVIEW

The students are able to find an answer for to take a best strategy under
risk and uncertainty situation in routine day today real issues in
management issues.
LEARNING OBJECTIVE

After learning this unit, you, should be able to,

 learn, understand and make the students to capable of good
decision maker in risk and uncertain situation.

70
  facilitate the use of Mathematical techniques in managerial decisions
4.1 INTRODUCTION

Decision making is studied from a number of different theoretical

approaches. Normative theories focus on how to make the best decisions
by deriving algebraic representations of preference from idealized
behavioral axioms. Descriptive theories adopt this algebraic representation,
but incorporate known limitations of human behavior. Goodwin P., and
Wright, G. 1998. Decision Analysis for Management Judgment. New York:
Wiley. Decision theory is the distinction among three different states of
nature or decision environments: certainty, risk and uncertainty. The
distinction is drawn on the basis of the degree of knowledge or information
possessed by the decision-maker. Certainty can be characterized as a state
in which the decision-maker possesses complete and perfect knowledge
regarding the impact of all of the available alternatives. Risk can be
characterized as a state in which the decision-maker has only imperfect
knowledge and incomplete information but is still able to assign probability
estimates to the possible outcomes of a decision. These estimates may be
subjective judgments, or they may be derived mathematically from a
probability distribution. Uncertainty is a state in which the decision-maker
does not have even the information to make subjective probability
assessments. It was Frank Knight who first drew a distinction between risk
and uncertainty. Risk is objective but uncertainty is subjective; risk can be
measured or quantified but uncertainty cannot be. Modern decision theory is
based on this distinction.
4.2 DECISION THEORY UNDER RISK (STOCHASTIC BUSINESS
SITUATION)

Business decision can be determined by the probabilistic Decision Model

(or Stochastic Model) under the existing competitive or risky business
situation in which the decision-maker often knows the probability of
occurrence of each state of Nature (event) and corresponding Act and also
the pay-off of each state of Nature (event and corresponding Act. In this
case, if the decision pay-off matrix of each state of Nature and
corresponding Act without/with the probability of each state of Nature is
given, then the business decision, i.e., the choice of best (optimum) Act
(strategy) is determined by using any one of the two decision criteria which
are given below:

71
 (a) Expected Monetary Value Criterion (EMV- Criterion).
(b) Expected Opportunity Loss Criterion (EOL- Criterion).
4.2.1 Expected Monetary Value Criterion

Expected monetary value Criterion (EMV-Criterion): Given decision pay-

off matrix of many states of Nature (events) and corresponding Acts (or
strategies) without or with probability of each state of Nature (event), the
EMV of each Act is computed by the formulae given below:
(i) Without given probability of each state of Nature (Pj, Not given) case
n
EMV1   a1 J , i  1,2    , m.
j 1

where, EMV1= Expected Monetary Value of ith..Act (or Strategy).

aij= Pay Off of ith.. Act (or Strategy) corresponding to jth..State of Nature
(Event).
 = Summation.
i = Number of Act (or Strategy).or, i = 1,2, ---, m.
j= Number of states of Nature (Events).or, j = 1,2, ---- n.
This EMVl is computed from the given decision pay-off matrix as follows:
Decision Pay-Off (Monetary Value)

The computation table of EMV1s by using the given formula of computing

EMV1 may be as follows:

72
Computation Table of Total EMV (Monetary Value)

(ii) With given probability of each state of Nature (Pj, Given) Case ---
n
EMV1   ai J PJ , i  1,2,.......... , m.
J 1

Where,
EMVl = Expected Monetary Value of ith..Act (or Strategy).
aij = Pay - off of ith.. Act (or Strategy) corresponding to jth...state of Nature
(Event).
PJ = Probability of occurrence of Nature (Event), PJ,  O ,  PJ  1
 = Summation
i = Number of Act (or Strategy).or, i = 1,2, ...................., m.
j= Number of states of nature (Events).or, j = 1,2, ----, n.
This EMVl is computed from the given decision pay-off matrix as follows:
Decision Pay-Off (Monetary Value)

The computation table of EMVls by using the given formula of computing

EMVl may be as follows:

73
Computation Table of Total EMV (Monetary Value)

In both of these cases, the available computation table is used for

determining the best (optimum) Act (or Strategy), According to EMV-
Criterion, the best (optimum) Act (or Strategy) is one which yield maximum
(largest) Total EMV out of determined Total EMVls in this computation
Table.
This EMV- Criterion's application can be explained with the help of an
illustration as follows:
Example 4.1 The decision pay-offs in lakhs of Rupees for each Act and
Event is given below:
Decision Pay-Off (in lakhs of Rs.)

Events C
A B
Acts
-20 200 400
X
-50 -100 600
Y
200 -50 300
Z

Probability of 0.3 0.4 0.3

Events (P)

Determine the best (optimum) Act by EMV- Criterion in the two cases
being (a) without given probability of each event, and (b) with given
probability of each event.
Solution
By EMV Criterion:

74
(a) Without given probability of each event case:
Computation Table of Table EMV (in lakhs of Rs.)
Events Remark
A B C Total EMV
Acts
-
X -20 200 400 20+200+400=EMVx=
580
- Optimum
Y -50 100 600 50+100+600=EMVY= Act = Y
650
200-
Z 200 -50 300
50+300=EMVz=450

EMVx = (-20) + 200 + 400 = 580

EMVY = (-50) + 100 + 600 = 650
EMVz = 200 + (-50) + 300 = 450
In this case, the maximum Total EMV is obtained by Act__Y. Therefore, the
best (optimum) Act is Y which yields Total EMVmax = 650 (in lakhs of Rs.)
Answer.
(b) With given probability of each event case:
Computation Table of Total EMV (in lakhs of Rs.)

Events Total
A B C Remark
Acts EMV

200  400 
X (-20)0.3 194
0.4 0.3

(-50)  100  600  Optimum Act

Y 205
0.3 0.4 0.3 =Y

(-50)  300 
Z 200  0.3 130
0.4 0.3

Probability
of Events 0.3 0.4 0.3
(P)

Using the formula of EMV-Criterion:

75
 n
EMVl =  aij .. PJ where, EMVl = Expected Monetary Value of ith.. Act.
Jl

aij = Pay- Off of ith.. Act corresponding to jth..Event.

PJ = Probability of occurrence of jth.. Event
I= Number of Act.or, i= 1,2, ----, m,
J= Number of Event.or. J=1,2, ----, n. and  = Summation.
Therefore, we get:
EMVx = (-20) x 0.3 + 200 x 0.4 + 400 x 0.3 =194
EMVY = (-50) x 0.3 + 100 x 0.4 + 600 x 0.3 = 205
EMVz = 200 x 0.3 + (-50) x 0.4 + 300 x 0.3 = 130
In this case, the maximum Total EMV is obtained by Act-Y.
Therefore, the best (optimum) Act is Y which yields Total EMVmax = 205 (in
lakhs of Rs.)
4.2.2 Expected Opportunity Loss Criterion
Expected Opportunity Loss criterion (EOL- Criterion): Given decision
pay-off matrix of many states of Nature (Events), and corresponding Acts
(or Strategies) without or with probability of each state of Nature (Event), the
EOL of each Act is computed by the formulae given below
(i) Without given probability of each state of Nature (Pj, Not given)
Case
n
EOLl =  lij, i =1,2, ----, m.
Jl

EOLl = Expected Opportunity loss of ith..Act (or Strategy).

lij= Opportunity Loss of ith.. Act (or Strategy corresponding to jth. state of
Nature (Event).
or, lij = Maximum Pay-Off of jth. State of Nature (Event) Pay-Off of ith. Act (or
Strategy) corresponding to jth. State of Nature (Event)
or, lij = MJ __aij, aiJ  MJ  amJ
 = Summation.
I= Number of Act (or Strategy).or, i= 1,2, ---, m.
J = Number of states of Nature (Events).or, j=1,2, ---,n.
This EOLl is computed from the given decision pay-off matrix as follows:

76
Decision Pay-Off (Monetary Value)

Let the maximum pay-offs out given pay-offs of all Acts of the corresponding
states of Nature (Events) be given as follows:

The computation Table of EOL1s by using the given formula of computing

EOL1 may be as follows:
Computation Table of Total EOL (Monetary Value)

77
(ii) With given probability of each state of Nature (Pj, Given) Case__
n
EOLl =  lij. Pj, i= 1,2, ----, m.
j 1

where,
EOLl = Expected Opportunity Loss of ith..Act (or Strategy).
lij =Opportunity Loss of ith.. Act (or Strategy) corresponding to jth.. state of
Nature (Event).
or, lij = Maximum pay-off of jth..state of Nature (Event)_ pay-off of ith..Act (or
Strategy).
or, lij = MJ-aij , aij  Mj  amj
Pj = Probability of occurrence of jth..state of Nature (Event), PJ  O,
 Pj 1.
 = Summation.
I= Number of Act (or Strategy).or, i = 1,2, ----, m.
j = Number of state of Nature (Event). or, j = 1,2, ----, n.
The EOLl is computed from the given decision pay-off matrix as follows:
Decision Pay-Off (Monetary Values)

Let the maximum pay-offs out of given pay-offs of all Acts of the
corresponding states of Nature (Events) be given as follows:

78
The computation table of EOLls by using the given formula of computing
EOLl may be as follows:
Computation Table of Total EOL (Monetary Value)

In both of these cases, the available computation table is used for

determining the best (optimum) Act (or Strategy). According to EOL-
Criterion, the best (optimum) Act (or Strategy) is one which yield minimum
(smallest) Total EOL out of determined Total EOLls in this computation
table.
Example 4.2 The decision pay-offs in lakhs of Rupees for each Act and
Event are given below:
Decision Pay-Off (in lakhs of Rs.)
Events C
A B
Acts
50 120 200
1
20 50 240
2
-10 200 400
3
-20 300 350
4
Probability of 0.2 0.5 0.3
Event (P)

79
Determine the best (optimum) Act by EOL-Criterion in the two cases
being
(a) Without given probability of each event, and (b) With given
probability of each event.
Solution: Applying EOL-Criterion:
(a)Without given probability of each event Case:
n
Using Formula: EOLl =  lij, i= 1,2, ----, m. where lij = MJ-aij
J 1

Computation Table of Total EOL (in lakhs of Rs.)

Events Remark
A B C Total EOL
Acts
300- 400-
1 50-50=0 0+180+200=380
120=180 200=200
50- 300- 400-
2 30+100+0=130
20=30 200=100 400=0
50-(-10) 300- 400-
3 60+100+0=160
= 60 200=100 400=0
50-(- 300- 400- Optimum
4 70+0+50=120 Act = 4
20)=70 300=0 350=50

This computation table of Total EOL shows that the best (optimum)
Act is 4 which results Total EOLmin. = 120 (in lakhs of Rs.) Answer
(b)With given probability of each event Case:
n
Using Formula: EOLl =  lij. Pj, i = 1,2, ----,m. Where the lij =Mj-aij
j 1

Computation Table of Total EOL (in lakhs of Rs.)

Events Remark
A B C Total EOL
Acts
(50-50)  (300-120) (400-200)
1 0+90+60=150
0.2 = 0 0.5 =90  0.3 = 60
(300-50)
(50-20)  (400-240) 6+125+48 =
2  0.5
0.2 = 6  0.3 = 48 179
=125
[50-(-10)] (300-200) (400-400)
3 12+50+0 = 62
 0.2 = 12  0.5 = 50  0.3 =0
[50-(-20)] (300-300) (400-350) Optimum
4 14+0+15=29 Act = 4
 0.2 = 14  0.5 = 0  0.3 = 15
Probability 0.2 0.5 0.3
Event (P)

80
This computation table of Total EOL shows that the best (optimum) Act is 4
which results Total EOLmin.= 29 (in lakhs of Rs.).Answer.
4.3 DECISION THEORY UNDER UNCERTAINTY
Business Decision Theory under uncertainty - According to this theory
the business decision criteria being: (a) Maximin Criterion. (b) Minimax
Criterion. (c) Maximax Criterion. (d) Laplac Criterion. (e) Hurwicz Alpha
Criterion and (f) Regret Criterion, Under existing uncertain business
situation in which the decision - maker knows the decision pay-off of each
state of Nature (event) and corresponding Act but businessman does not
know probabilities of the states of Nature (Events). The choice of using any
one decision criterion out of these decision criteria by the decision-maker
depends upon his personal judgment, experience, and the company's
policy. A brief account of these business decision criteria is given below:
4.3.1 Maxi-min Criterion
This criterion is a conservative approach to arrive at business decision.
According to this criterion minimum pay-off for each of the given events is
determined in the given decision pay-off matrix. Then the maximum of
determined minimum pay-offs is determined in it. The corresponding act to
the determined maximin pay-off is the determined best (optimum) act out of
given acts in decision pay-off matrix. In this case the pay-off should be cost
or any other economic variable of which minimum value is to be maxi-mised
by the best act. It can be illustrated as follows:-
Example 4.3.1 Determine the best act by Maxi-min Criterion from the
following decision pay-off (cost) Table: Pay-Off Table

States of Nature X4
X1 X2 X3
Acts
-2 -3 5 3
a1
-1 0 8 4
a2
-3 -4 6 7
a3

Solution
Using Maximin Criterion

81
 Computation Table of Maxi-min
States of
Nature X1 X2 X3 X4 Min. Maximum Remark
Acts

a1 -2 -3 5 3 -3
Best act
a2 -1 0 8 4 -1 -1 = a2

a3 -3 -4 6 7 -4

This computation table of maxi-min shows that act a2 results maxi-min = -1.
Therefore, the best act is a2. And that is the answer.
4.3.2 Minimax Criterion
This criterion is an optimistic approach to arrive at business decision.
According to this criterion maximum pay-off for each act of the given events
is determined in the given decision pay-off matrix. Then the minimum of
determined maximum pay-offs is determined in it. The corresponding act to
the determined minimax pay-off is the determined in it. The Corresponding
act to the determined minimax pay-off is the determined best (optimum) act
out of given acts in the decision pay-off matrix. In this case, the pay-off
should be profit or any other economic variable of which minimum value is
to be maximised by the best act. It can be illustrated as follows:-
Example 4.3.2 Determine the best act by Minimax Criterion from the
following pay-off (profit) table:
Pay-Off Table
States of
Nature X1 X2 X3 X4
Acts
5 -2 7 10
a1
-1 3 6 -2
a2
4 0 -5 3
a3

Solution

82
Using Minimax Criterion
Computation Table of Minimax
States of
Nature X1 X2 X3 X4 Max. Minimax Remark
Acts

a1 5 -2 7 10 10

a2 -1 3 6 -2 6
Best Act =
a3 4 0 -5 3 4 4 a3

This computation table of minimax shows that act a3 results minimax =4.
Therefore, the best act is a3.Answer.
4.3.3 Maximax Criterion

This criterion is most optimistic approach to arrive at business decision.

According to this criterion maximum pay-off matrix, then the maximum of
determined in the given decision pay-off matrix. Then the maximum of
determined maximum pay-offs is determined in it. The corresponding act to
the determined maximax pay-off is the determined best (optimum) act out of
given acts in the decision pay-off matrix. In this case, the pay-off should be
profit or any other economic variable of which maximum value is to be
maximised by the best act. It can be illustrated as follows:
Example 4.3.3 Determine the best act by Maximax Criterion from the
following pay-off (profit) table:
Pay-Off Table
States of
Nature X1 X2 X3 X4
Acts
5 3 7 9
a1
8 12 15 -1
a2
0 8 20 4
a3
-5 3 -2 1
a4

Solution
Using Maximax Criterion

83
 Computation Table of Maximax
States of
Nature X1 X2 X3 X4 Max. Maximax Remark
Acts

a1 5 3 7 9 9

a2 8 12 15 -1 15
Best act
a3 0 8 20 4 20 20 = a3

a4 -5 3 -2 1 3

This computation table of maximax shows that act a3 results maximax = 20.
Therefore, the best act is a3.Answer
Example 4.3.4 Determine the best act Maximax Criterion from the
following pay-off (profit) table:
Pay - Off Table
Events X5
X1 X2 X3 X4
Acts
4 0 -5 3 6
a1
-2 6 9 1 6
a2
7 3 2 4 3
a3
8 5 -3 5 2
a4

Probability of Events (P) 0.2 0.2 0.2 0.2 0.2

Solution
Using Maximax Criterion
Computation Table of Maximax
Events Total Remark
X1 X2 X3 X4 X5
Acts EMV
(-5)
4 0.2 00.2 30.2 60.2
a1 0.2 1.2
= 0.8 =0 =0.6 =1.2
=-1.0
(-2) 
60.2 9  0.2 1  0.2 6  0.2 Best
a2 0.2 = - 4.0 act = a2
= 1.2 = 1.8 = 0.2 = 1.2
0.4

a3 7 0.2 3 20.2 = 4 0.2 3 0.2 3.8

84
 = 1.4 0.2 0.4 = 0.8 = 0.6
= 0.6
5
8 0.2 3 0.2 5 0.2 20.2
a4 0.2 3.4
= 1.6 = 0.6 = 1.0 = 0.4
= 1.0

Probability
of Events 0.2 0.2 0.2 0.2 0.2
(P)

Where the total EMV is calculated by adding

0.8+0+(-1.0)+0.6+1.2 =1.6
-0.4+1.2 +1.8+0.2+1.2 =4.0 similarly adding all values for total EMV and
take the highest or the maximum value as the best.
This computation table of Total EMV shows that act a2 is best act because it
gives maximised total expected monetary value. i.e.,
Total EMVmax = 4.0.Answer.
4.4 DECISION TREE ANALYSIS WITH SOLVED EXAMPLE

The business decision analysis has assumed a place of vital significance in

the modern business era. Under varying degrees of business situations,
several business decision theories are taken into account but still there are
requirements for the analysis of business decisions of the assumed
business decision problems on logical, scientific, and rational reasoning.
From this viewpoint, several special types of business decision analysis can
be taken into account specifically the decision tree analysis explained in
following pages.
Decision Tree Analysis

According to eminent statisticians the decision tree analysis is more useful

and informative than the matrix analysis of decision-making in business.
With the help of it, extremely complex decision problems can be analysed. It
represents a decision tree diagram which shows each choice situation
together with each pay-off and each probability. Decision tree is a network
which shows the logical relationship between the different parts of a
complex decision and the alternative courses of action in any phase of a
decision situation. Thus, this network of depicting the decision-making
situation graphically in the form of decision tree represents the combinations
of all the possible actions and potential events. The decision tree consists of
nodes and branches with each branch representing an alternative course of

85
action and decision. This depicting the various courses of action and the
expected outcome in the form of a decision tree helps the decision-maker to
estimate the monetary gains that could be expected by choosing any
particular alternative course of action.
The decision tree analysis in a particular business situation involves, in
general, certain steps as follows:

(i) Formulate the decision problem in a particular business situation in

the statement form.
(ii) Identify the decision points and the alternative courses of action at
each point systematically.
(iii) At each decision point, determine the prior probability associated
with the different possible outcomes and the related pay-off values.
(iv) Commencing from the final stage of decision points, compute the
expected pay-off values (EMVs) under different courses of action.
(v) Select the course of action which yields the best (maximum)
expected pay-offs (EMVs) for each of the decisions.
(vi) Proceed backwards to the next stage of decision points and again
compute the expected pay-off values under different courses of
action by considering only the selected strategies under step (v)
(vii) Repeat steps (iv), (v) and (vi) till the first decision point is reached.
(viii) Lastly, determine the alternative courses of action (strategies) to be
adopted from start to end under different outcomes for the given
business situation as a whole.
Example 4.4.1 The XYZ Associates deals with instant soft drink. They
have two courses of action for selling their product in the market
being (a) regional distribution through distributors, and direct selling.
The probabilities of high penetration and low penetration or regional
distribution channel are 0.7 and 0.3 respectively. The prior
probabilities of high penetration and low penetration of direct selling
channel are 0.6 and 0.4 regional distribution channel are Rs. 50 lakhs
and Rs. 10 lakhs respectively. The pay-offs of high penetration and
low penetrations of direct selling channel are Rs. 30 lakhs and Rs. 5
lakhs respectively. Draw the decision tree and determine the best-
selling channel/ strategy.

86
Solution
Computation Table for Decision Tree

Total
Expected
Pay-Off
Course of Prior Monetary
Chance event (Rs. in
action probability Value (Total
lakhs)
EMV) (Rs. in
lakhs)

High
0.7 50
Penetration 0.7 
Regional
50+0.310 =
Distribution
Low 65
0.3 10
Penetration

High
0.6 30
Penetration
0.6 
Direct Selling
30+0.45 =20
Low
0.4 5
Penetration

Decision Tree Diagram

Figure 4.1
=Decision Point. , O= Node. The decision tree diagram shows that the
best selling channel. The strategy of the XYZ association is regional

87
distribution channel which yields maximum total monetary value (Total
EMV) of Rs. 65 lakhs.
Example 4.8 A marketing manager has to determine in which of two
regions a new product should be introduced. The level of sales can be
characterized as either high, average or low. He estimates that the
probabilities associated with each of these outcomes are 0.25, 0.50
and 0.25, respectively. The payoff matrix has been constructed as
follows:

Using EMV as a criterion, in which of the two regions should the

product be introduced?
Solution
EMV(A1) = 0.25 (40,000) + 0.50 (30,000)+ 0.25 (20,000)
= Rs. 30,000
EMV (A2) = 0.25 (70,000) + 0.50 (20,000) + 0.25 (0)
= Rs. 27,500, Select A1Answer
LET US SUM UP
This unit attempted to give the decision making in risk and uncertainty
situation. The risk case depicted the expected monetary value criterion and
expected loss criterion with examples. The decision under uncertainty
explained for Maximini, Minimax and Maximax with solved examples.
Further the decision tree analysis also presented which is an implication of
expected monetary value criterion.
CHECK YOUR PROGRESS

1. Suppose that you have the following payoff matrix:

Select the optimal action by applying maximin, maximax

88
 2. Determine the best act by Minimax Criterion from the following pay-
off (profit) table:
Pay-Off Table

3. The decision pay-offs in lakhs of Rupees for each Act and Event is given
below:

Events C
A B
Acts
200
X -30 300

- 500
Y -50
100
400
Z 200 60

Probability
0.2
of Events 0.4 0.4
(P)

Decision Pay-Off (in lakhs of Rs.)

Determine the best (optimum) Act by EMV- Criterion in the two cases being
(a) without given probability of each event, and (b) with given probability of
each event.
GLOSSARY

Decision Making : Decision making theory is a theory of how rational

Theory individuals should behave under risk and
uncertainty.

89
 :
Maxi-min Criterion According to this criterion minimum pay-off for
each of the given events is determined in the given
decision pay-off matrix. Then the maximum of
determined minimum pay-offs is determined in it.
The corresponding act to the determined maxi-min
pay-off is the determined best (optimum) act out of
given acts in decision pay.
:
Minimax Criterion This criterion is an optimistic approach to arrive at
business decision. According to this criterion
maximum pay-off for each act of the given events
is determined in the given decision pay-off matrix.
Then the minimum of determined maximum pay-
offs is determined in it. The corresponding act to
the determined minimax pay-off is the determined
in it. The Corresponding act to the determined
minimax pay-off is the determined best (optimum)
act out of given acts in the decision pay-off matrix.
:
Decision Tree Decision tree is a network which shows the logical
relationship between the different parts of a
complex decision and the alternative courses of
action in any phase of a decision situation.

SUGGESTED READINGS
1. Arora, P.N. & S. Arora, (2007) ,Statistics for Management, latest
Edition, S. Chand & Company Ltd., New Delhi.
2. D.C.Sancheti, V.K.Kapoor,( 2014), Business Mathematics, 11th
edition, Reprint, Sultan Chand and Sons, New Delhi.
3. Gupta, B.N., (2015), Business Statistics, First Revised Edition,
SBPD, New Delhi.
4. JK. Sharma, (2009), Business Mathematics Theory And
Applications, 13th Edition, ANE Books, New Delhi.

5. S. P. Gupta, (2012), Statistical Methods, 42nd Revised Edition Sultan

Chand & Sons Pvt. Ltd., New Delhi.
6. https://www.pmlearningsolutions.com/blog/sensitivity-analysis-
versus-expected-monetary-value-emv-pmp-concept-

90
 26#:~:text=Expected%20monetary%20value%20(EMV)%20analysis
%20is%20a%20statistical%20concept%20that,the%20different%20
options%20or%20scenarios.
7. https://www.mindtools.com/az0q9po/decision-tree-analysis
ANSWERS TO CHECK YOUR PROGRESS

1. Best act is a4 for Maximax =400 and Best act for Maximini is a3 =80

2. Best Act is a2 and Minimax is =4

3. (a) without given probability of each event EMVz = Rs 660lakshs
and (b) with given probability of each event. EMVx=Rs148 lakhs

91
 BLOCK 2
DISTRIBUTIONS

Unit 5 : Probability

Unit 6: Probability Distribution: Binomial

Distribution
Unit 7: Poisson Distribution

Unit 8: Normal Distribution

92
Unit 5

PROBABILITY
STRUCTURE

Overview
Learning objectives
5.1 Introduction

5.2 Concept of Uncertainty

5.3 Concept of probability
5.4 Basic Terminology

5.6 Basic probability Rules

5.6.1 Addition Rule
5.6.2 Multiplication theorem

5.6.3 Conditional probability

5.6.4 Baye’s theorem
Let Us Sum Up

Check Your Progress

Glossary
Suggested Readings

Answers to Check Your Progress

OVERVIEW
In this unit we shall discuss the basic concept of probability. We shall deal
with the concept of axioms of probability. We shall explain classical and
empirical approach of probability. We shall learn about the various
applications of probability, probability rules and laws.
LEARNING OBJECTIVES

After reading this unit, you should be able to,

 discuss basic laws of probability
 explain the axioms of probability
 illustrate the applications of probabilities

93
  explain the rules of probabilities
 describe empirical and classical approach.
5.1 INTRODUCTION

So far, we were concerned with the problems in which distances, times and
the variables were almost always given precise numerical values. In many
situations, however, there are quantities, which are subject to random
variation like monthly level of sales in a super market shop. Since it is not
easy to construct a deterministic model, we can choose to adopt a
stochastic model. In this unit, we will discuss concept of probability.
5.2 CONCEPT OF UNCERTAINTY
A person x tosses a coin and Y also tosses a similar coin simultaneously
and observe the result. It is uncertain to say:
i. Whether both heads come up (or)
ii. Both tails come up (or)
iii. One head and one tail come up.
The situation of uncertainty can also be observed by considering two sets A
and B in three different situations as shown in the diagram

B
A B A
A B

Figure 5.1

In situations i, and ii, , , if is certain that X  A => X  B ; X  A => X  B. In

situation iii, if X  A we cannot say X  B or X  B which is the situation of
uncertainty.
5.3 CONCEPT OF PROBABILITY

In our daily life, we often come across the words.

i. It is impossible he may refuse to do my work.

ii. Probably, it will remain tomorrow.

In sentence i, the probability of doing work is unity. Probability of refusing
the work is zero. In sentence ii, the probability of raining lies between zero
and unity.

94
5.4 BASIC TERMINOLOGY
a) Sample space
A sample space can be defined as the set of all possible outcomes of an
experiment and is devoted by‘s’.
For example, A coin is tossed, the sample space is S’= {H, T}
Two coins are tossed, S’ = {HH, TH, HT, TT}

A fair die is thrown, S’ = {1,2,3,4,5,6}

Example 5.1 From a box containing 4 balls of different colours red, yellow,
blue and green. Two balls are drawn; i, simultaneously ii, one after the other
with replacement. Write down the sample space.
Solution
The number of ways drawing two balls from
4 3
4 balls = 4 C 2   6 ways.
2
i) Set of all possible outcomes of two balls of different colours.
Sample space S’= {BR, YR, GR, BY, BG, YG}

ii) One after the other with replacement.

S’= {GG, GY, GB, GR, YR, YB, YY, YG, BB, BR, BY, BG, RR, RB,
RY, RG}

a) An Experiment
Any operation that results in two or more outcome is called an experiment.
(i) Tossing a fair coin
(ii) Rolling an unbiased die
(iii) Drawing a card from a pack of cards
(iv) Experiments in business: number of defective items being produced
by a machine.
(v) In advertising division, number of items sold may be observed.
b) Possible out comes

The result of a random experiment is called an outcome.

95
c) Collectively Exhaustive cases
The total number of possible outcomes of a random experiment is called
collectively exhaustive cases.

d) Equally likely cases

The outcomes are said to be equally likely or equally probable if none of
them is expected to occur in preference to other.
Eg: Tossing a coin, all outcomes of head (or) tail are equally likely if the
coin is not biased.
e) An Event

Every subset of a sample space S’ of an experiment is called event,

denoted by E. In particular the sample space S’ itself is called the certain
Event. The impossible event will be denoted by  of sample space S’.
f) Simple Event
Any event that contains any one member of a sample space is called simple
event.
Eg: Tossing a single die, the event of getting ‘5’ is single event.
g) Compound Event
When an event is decomposable in to a number of simple events then it is
called compound event.
Eg: An event of getting an even number.
h) Favorable Events

The number of outcomes of a random experiment which result in the

happening of particular event is termed as the favourable event.
Eg: Tossing two coins, favourable chances for the event, exactly one
head’’. Which are 2 i.e. {HT, TH}.
In drawing a card from 52 cards, favourable cases of getting “ spade” is 13.
i) Mutually exclusive Events

Events are said to be mutually exclusive when the happening of one

excludes the happening of the other. i.e., Any two events cannot occur
simultaneously.
Eg: Tossing a coin, head and tail are mutually exclusive events.

96
j) Dependent and Independent events
Two events are said to be independent when occurrence of one has no
effect on the probability of other.
Eg: In tossing of a coin, head occurring in the first trial does not affect the
head in the second trial. The events, which are not independent is called
dependent events.
5.5 CLASSIFICATION OF PROBABILITY

Probability

Objective Subjective

Classical Empirical
approach approach

Modern approach

Figure 5.2
I. Mathematical (or) Classical (or) a Prior Probability

It is based on certain prior laws of nature. It employs deductive logic to

derive probability measures from certain undisputed laws of nature. Being
based on abstract mathematical logic it is also called as ‘abstract’ (or)
‘mathematical’. The probability theory owes its birth to the games of chance
– roulette and cards.
“If a random experiment result in N exhaustive mutually exclusive and
equally likely out comes out of which M are favourable to the happening of
an event A, then the probability of occurrence of A, usually denoted by p (A)
is given by.
m
P( A ) 
n
The probability of non-happening of event A expressed as p (A’) is given by,
P (A1) = 1- p (A)

97
 No. of cases not favorable

P(A1) = Exhaustive number of cases

Remarks
i) omn
m
o l
n
o  p (A)  l => probability of any event always lies between
o and l.
nm
ii) P (A’) =
n
m
= 1
n
= I - P (A)
=> P (A) + P(A’) = 1 Where A and A’ are two mutually
exclusive events.

iii) If p(A) = 0, then A is called an ‘impossible event’.

iv) If p(A) = 1, Then A is called ‘an event which is certain’.
The probability ‘p’ of the happening of an event in also known
as the probability of success and the probability ‘q’ of the non-
happening of the event as the probability
II. Empirical or statistical approach

If a trial is repeated a number of times under essentially homogeneous and

identical conditions, then the limiting value of the ratio of the number of
times the event happens to the number of trials, as the number of trials
become indefinitely large, is called the probability of happening of the event.
Symbolically, if in n trials an event E happens m times, then the probability
‘p’ of the happening of E is given by
m
P = P(E) = lim
n n
The only objection to the above definition is that it is difficult to prove the
existence of limit of the relative frequency. It is based on experiments and
observations and therefore is called empirical.

98
Remarks

 The experimental conditions may not remain essentially

homogeneous and identical in a large number of experiments.
 Since in the relative frequency approach the probability is obtained
objectively by repetitive empirical observations.
 An experiment is unique and non-repeating only in the case of
subjective probability.
 The experiments are random.

III. Subjective probability

In the subjective or personal interpretation of a probability, a probability is
interpreted as a measure of degree of belief, or as the qualified judgment of
a particular individual. It measures the confidence that an individual has in
the truth of a particular proposition, it is bound to vary with person and is
therefore, called a subjective measure of probability.
It is calculated guess of an experienced businessman and is based only on
his belief and experience. It has a considerable role to play particularly
when there is neither any prior laws of nature to guide nor the experiments
can be repeatedly performed to establish the chance of occurrence.
IV. Modern approach to probability
It combines both the objective and subjective concepts of probability. The
entire event like mutually exclusive dependent and independent events,
exhaustive events, equally likely, etc where explained by through the theory
and operations on sets. It is based on certain axioms, which express the
rules for operating with such number it means that the probability of events
must only satisfy these axioms. The advantage of axiomatic theory is that it
narrates all situations irrespective of whether the possible outcomes of a
random experiment are equally likely or not. It may be noted that the
classical theory can be obtained from the axiomatic theory as a special
case.

Axioms of Probability
Let S’ be the sample space. Let E be the event and P be a real valued
function defined on E. Then P is called probability measure and P(A) is
called probability of the event A if it satisfies the following axioms.

99
 i. o P (A) 1 for every event A
ii. P (S) = 1
iii. For every finite or infinite sequence of disjoint events A1, A2 -----

P (A1, A2, A3, ------ ) = P (A1) + P (A2) + -------

Remarks
1. Pi  o for all I = 1,2, ------- n

2. The sum of pi is unity is p1+ p2 + ------ + p n = 1.

3. The above definition applies for countable infinite (or) uncountable
sample spaces.
4. If an event A consists of M sample points, then the probability of A is
n( A)
P( A) 
n( S )

Example 5.5.1 Find the probability of getting head in a throw of a coin.

Solution
Sample space = {H, T} n (S) = 2
A = the number of favourable chances = 1
n (A) = 1

n( A) 1
P( A)  
n( S ) 2
Example 5.5.2 In a single throw with dice, find the probability of getting
a sum (i) five, (ii) six.

Solution
The sample space.
 (1,1) (1, 2) ...... (1, 6) 
 ( 2,1) ( 2, 2) ...... ( 2,6) 
 
S =  
     
 (6,1) (6, 2) ...... (6, 6) 

n(S) = 36
(i). Let A be the event, getting a sum is five A = {(1,4), (2,3),
(3,2) (4,1)}

100
 n (A) = 4.
n( A ) 4 1
P( A )   
n(S) 36 9

(ii) B be the event of getting the sum is ‘six’

B = {(1,5), (2,4), (4,6), (3,3) ,(5,1)}
n(B) = 5
n( B ) 5
P( A)  
n( S ) 36

Example 5.5.3 What is the probability of getting a king drawn a pack

of 52 cards?

Solution

Total number of cards = 52

Let A be event of getting ‘king’
The number of favourable cases = 4
n( A) 4 1
P( A)   
n( S ) 52 13

Example 5.5.4 What is the probability of not getting a space in a single

draw of cards?

Solution
The total number of cards = 52
The favourable cases to get space = 13
13
P (space) =
52
13 39 3
1  
52 52 4
Example 5.6 Three unbiased coins are tossed. What is the probability
of obtaining (i) all heads, (ii) two heads, (iii) one head, (iv) at least one
head, (v) at least two heads, and (vi) all tails?

Solution
There are 8 possible cases for throwing three coins.

101
 S = {HHH, THH, THT, TTH, TTT, HTT, HHT, HTH}
n (S) = 8
i) The number of favorable cases of getting all heads = 1

i.e., A = {HHH} n(A) = 1

1
P (A) = P (all heads) =
8
ii) The number of favorable cases to getting to heads.
B = {HHT, HTH, THH}
n(B) = 3
n( B ) 3
P( B)  
n( S ) 8

iii) The number of favorable cases to get one head.

C = {HTT, THT, TTH}
n(C) = 3
n(C ) 3
P(C )  
n( S ) 8

iv) The number of favorable cases to get at least one head.

D = {HTT, THT, TTH, HHT, HTH, THH, HHH}
n (D) = 7
n(D) 7
P(D)  
n(S) 8

v) The number of favorable cases to get at least two heads.

E = {HHT, HTH, THH, HHH}
n(E) = 4
n(E) 4
P(E)  
n(S) 8

vi) The number of favorable cases to get all fails.

F = {TTT}
n(F) = 1

102
 n(F) 1
P(F)  
n(S) 8

Example 5.5.5 A card is drawn from a pack of cards, Find the

probability that it is (i) a black card (ii) a red card (iii) a club (iv) an ace
(v)a red ace (vi) ace of spades (vii) not a spade (viii) king or a queen.
Solution
The total no. of cards = 52
n(S) = 52
i) The number of favourable cases to get a black card.
n(A) = 26
n( A) 26 1
P ( A)   
n( S ) 52 2

ii) The number of favourable cases to get a red card

n(B) = 26
n( B) 26 1
P( B)   
n( S ) 52 2

iii) The number of favourable cases to get a club

n(C) = 13
n(C ) 13 1
P(C )   
n( S ) 52 4

iv) The number of favourable cases to get an ace

n(D) = 4
n( D ) 4 1
P( D)   
n( S ) 52 13

v) The number of favourable cases to get a red ace.

n (E) = 2 (ace of diamonds & ace of hearts)
n( E ) 2 1
P( E )   
n( S ) 52 26

vi) The number of cases favourable to get ace of spades.

n(F) = 1 (only one card)

103
 n( F ) 1
P( F )  
n( S ) 52

vii) The number of favourable cases to get “not a spade”.

The no. of spade cards = 13
The no. of not spade cards = 39
n(G) = 39
n(G ) 39 3
P(G )   
n( S ) 52 4

viii) The number of favourable cases to get “a king”.

n(G) = 4
n(G ) 4 1
P(G )   
n( S ) 52 13

ix) The number of favourable cases to get a queen

n(H) = 4
n( H ) 4 1
P( H )   
n( S ) 52 13

x) The number of favourable cases to get a (king or queen)

4 4 8 2
P (G or H )    
52 52 52 13
Example 5.5.6 Tickets are numbered from 1 to 100.
They are well shuffled and a ticket is drawn at random. What is the
probability that the drawn ticket has?

i. An even number?
ii. A number 5 (or) multiple of 5?
iii. A number which is greater than 75?
iv. A number, which is a square?
Solution
i) Let A denote the event that the drawn ticket has even number.

The number of favourable cases to the event A is 50. i.e., n(A) = 50

104
 n( A) 50 1
P( A)   
n( S ) 100 2

ii) Let B denote the event that the drawn ticket has a number 5 or multiple of
5
The numbers of cases favourable to event B are enumerated below
5,1015,20 ……………95,100
n (B) =20
n( B ) 20 1
P( B)   
n( S ) 100 5

iii) Let C denote the number which is greater than 75 (i.e.) 76, 77, 78
n(C) 25 1
n(C) =25 P(C)   
n(S) 100 4

iv) Let D be the event that drawn from a ticket has a number which is a
square.
D= {1, 4, 9, 16, 25, 36, 49, 64, 81,100}
n(D) =10
n(D) 10 1
P(D)   
n(S) 100 10
5.6 BASIC PROBABILITY RULES

Probability Rule

Addition Rule Multiplication Rule

(For simultaneous (For consecutive
trials) trials) Baye’s Rule

Events are Events are Events

mutually partially over are Events are
exclusive lapping independent dependent

Figure 5.3

105
5.6.1 Addition Rule
Let A and B be any two events then
P (AUB) = P(A) + P(B) - P(AnB)

When the events are mutually exclusive

P(AUB) = P(A) +P(B)
Example 5.9 The probability that a Company executive will travel by
train is 2/3 and that he will travel by Plane is 1/5. What is the
probability of his traveling by train or plane?

Solution
P (travel by train) = 2/3
P (travel by plane) = 1/5
P (train and plane) = 0
P (Train or plane) = P (Train) + P (Plane)
= 2/3 +1/5
=0.866
Example 5.10 One card is drawn from a standard pack of 52. What is
the probability that it is either a king (or) a queen?
Solution

There are 4 kings and 4 queens in a pack of 52 cards

P (King card taken) = 4/52
P (Queen card taken) = 4/52

P (King or queen) = P (king) + P (queen)

4 4 8 2
=   
52 52 52 13
Example 5.6.1The managing committee of Vaishali welfare association
formed a sub-committee of 5 people to look into electricity problem
profiles of the 5 persons are,
1. Male Age 40 Female Age 27

2. Male Age 43 Male Age 65

3. Female Age 38

106
 Chairperson has to be selected from this what is the probability that
he would be either female or over 30 years?
Solution

P (Female or over 30) = P (Female) + P (over 30) - P (Female and

Over 30)
2 4 1 5
=    1
5 5 5 5
Example 5.6.2 A card is drawn at random from a well-shuffled pack of
cards. What is the probability that it is a heart or a queen?

Solution

Let A be the event of drawing heart card P (A) =13/52

B be event of drawing queen card = 4/52
A  B be event of drawing a card which is heart or queen

P (A  B) = 1/52
P (A  B) = P(A) + P(B) – P(A  B)
13 4 1 16 4
=    
52 52 52 52 13
5.6.2 Multiplication Theorem

If A and B are two independent events than P (A and B) = P (A). P (B)

P (A  B) = P(A) . P (B)
In case of 3 sets A, B and C, then
P (A  B  C) = P(A) . P(B) . P(C)
When the events are dependent then
P (A  B) = P(A) . P (B/A)

Or
P (A  B) = P(B) P(A/B)
Example 5.6.3 A coin is tossed 4 times. What is the probability that all
the four are heads?
Solution: Let A, B, C, D be the event that 1st, 2nd, 3rd and 4th times
P(A) = P(B) = P(C) = P(D) =1/2

107
 P (ABCD) = P(A) P(B/A P(C/AB) P (D/ABC)
1 1 1 1 1
=    
2 2 2 2 16
Example 5.6.4 A lot contains 10 items of which 3 are defective. Three
items are chosen from the lot at random one after another without
replacement. Find the probability that all the three are defective

Solution
Let A, B, C denote event of drawing (defective item in 1st, 2nd and 3rd
drawing
P(ABC) = P(A) . P (B/A) . P(C / AB)
3 2 1 1
=   
10 9 8 120
Example 5.6.5 A candidate is selected for interview for three posts. For
the first post there are three conditions. For the second there are 4
and for the third there are 2 what are chances of his getting at least
one post?
Solution

Let A, B and C denotes the events that candidate gets the 1st, 2nd and 3rd
post then A, B and C represent example. A Mentor event of the candidates
does not get 1st, 2nd and 3rd.
1 2
P ( A)   P ( A ) 1  P ( A) 
3 3
1 3
P( B)   P ( B ) 1  P ( B ) 
4 4
1 1
P(C )   P(C ) 1  P(C ) 
4 2
P (Candidate will get at least one)

= P (A U BUC)
= 1 – P (candidate will not get any post)
= 1 - P (ABC)

= 1 - P (A). P(B). P(C)

108
 2 3 1 3
= 1   
3 4 2 4
Theorem

If A and B are independent then A and B are also independent.

Proof

If A and B are independent

P (A  B) = P (A). P (B)
To prove that A and B are independent
P (A  B)
= 1- P (A  B)
= 1 – [ P(A) + P(B) – P(A  B)]
= 1- P(A) –P (B) + P (A) – P(B)
= 1 – P(A) + P(B) (1- P(A)
= [1 – P(A) ] [ 1- P(B) ]
P (AUB) = P(A) P (B)
 A and B are also independent

Theorem
If A and B are independent events then A and B are also independent
events.

Proof
If A and B are independent events then
P (A  B) = P(A) P(B)

To prove that A and B are also independent

P (A  B ) = 
P A B 
= 1- [P(A) + P(B) – P(A  B)]
= 1- P(A) - P(B) + P(A) . P(B)

= 1- P(A) – P(B) (1- P(A))

= [1-P(A)] [1-P(B)]
P (A  B ) = P( A ) . P( B )

109
  A and B are also independent.
Example 5.6.6 Let A and B be two events such that
3 5
P(A) = and P(B) =
4 8
Show that a) P (A  B) ≥ 3/4 b) 3/8 ≤ P(A  B) ≤ 5/8
Solution

Given P(A) = 3/4 P(B) = 5/8

We have A ≤ A  B
P(A) < P (A  B)
3 3
< P (AUB) = P(AUB) ≥
4 4
ii) AB≤B
5
P (A  B) ≤ P(B) =
8
Also P(A  B) = P(A) + P(B) – P(A  B) ≤ 1
3 5
+ -1 ≤ P(A  B)
4 8
6  58
≤ P (A  B)
8
3
≤ P (A  B)
8
3 5
≤ P (A  B) ≤ . Hence proved
8 8
5.6.3 Conditional Probability

Let A and B be any two events. The conditional probability of A, B has

already happened. It is denoted by A/B
P( A  B )
P(A/B) =
P(B )

(or)
P( A  B )
P(B/A) =
P( A )

110
 P( A  B)
P( A /B) =
P( A )

If A and B are independent then P (AB) = P(A) P.(B) the conditional

probability becomes
P( A )  P(B)
P(A/B) =
P(B)

P (A/B) = P (A)
P( A )  P(B)
P (B/A) =
P( A )

P (B/A) = P(B)

Example 5.6.7 The personal department of a company has records

which show the following analysis of its 200 engineers.

Bachelor’s Master’s
Age Total
degree Degree

Under 30 90 10 100
30 to 40 20 30 50
Over 40 40 10 50

Total 150 50 200

If one engineer is selected at random from the company find.

a) The probability that has only a bachelor’s degree.
b) The probability he has a master’s degree given that he is over 40.

c) The probability he is under 30 given that he has only a bachelor’s

degree.
Solution

Let us define the events A, B, C & D as follows

A: an engineer has bachelor’s degree
B: an engineer has Master degree

C: an engineer is under 30 years of age

D: an engineer is over 40 years of age

111
a) The number of favourable cases for engineer has got bachelor’s
degree
n (A) =150
n( A ) 3
P( A )    0.75
n(S) 4

a) The number of favourable cases for an engineer has got an age

over 40
P(B  D) 10 / 200 1
P(B/D) =  
P(D) 50 / 200 5
P(C  A ) 90 / 200 3
b) P (C/A) =  
P( A ) 150 / 200 5

Example 5.6.8 In a certain town male and female each forms 50 per
cent of the population. It is known that 20% of the males and 5% of the
females are unemployed. A research student studying the employment
situation selects an employed person at random. What is the
Probability that the person so selected is
i) Male ii) Female
Solution

Employed Unemployed Total

Male 0.40 0.10 0.50

Female 0.475 0.025 0.50

Total 0.875 0.125 1.00

i) M= a male is chosen
ii) F – a female is chosen

iii) U – a shown is employment

P(M  U) 0.10
a) P (M/U) = 
P(U) 0.125
P(F  U) 0.025
P (F/U) =   0.2
P(U) 0.125

112
Example 5.19 An auditor selects accounts for inspection of random
from the file of accounts receivable. Accounts that are less than six
months old are termed few accounts. The accounts are classified as
follows:
Current Delinquent

New Account 120 15

Old Account 780 85

Let N denote the event of the selection of a new account, and c, an account
is current evaluate the following.
i) P (N/C) ii) P (NC) iii) P (N C ) iv) P ( N d)

v) P (C/N) vi) P (C/N) vii) P (CUM) viii) P (N/CUC)

Solution
P(N  C) 120 / 1000
i) P (N/C) =   0.13
P(C) 900 / 1000

ii) P (NC) = 120/1000 =0.120

iii) P (NC) = P(N) + P(C) - P(NC)
135 100 15
=    0.220
1000 1000 1000
780
iv) P( N C) =  0.780
1000
P( C  N) 15 / 1000
v) P ( C /N) =   0.111
P(N) 135 / 10

P(C  N ) 780 / 0.00

vi) P (C N ) =   0.903
P( N ) 865 / 1000
85
vii) P ( C ∩ N) =  0.085
1000
P(M  (C  C ) 135
viii) P (N/CU C )=   0.135
P(C  C ) 1000

113
5.6.4 Bayes’ Theorem
If E1, E2 …. En are mutually disjoint events with P (E) ≠ 0 (E = 1,2,..n) then
n
for any arbitrary event, A which is a sub, set of E
i 1
i

Such that P (A) > 0, we have

P ( Ei ) . P ( A / Ei )
P(Ei(A) = n
i= 1,2 …n
 P ( Ei ) P ( A / Ei )
i 1

Remarks

1. The probabilities P(E1), P(E2) … P (En) are termed as the a prior

probabilities because they exist before we gain any information from the
experiment itself.
2. The probabilities P(E/A) i-1,2,… n are called. Posterior probabilities
because they are determined after the result of the experiment are
known.
3. The probabilities P (A/Ei) i = 1,2.. n are called likelihood because they
indicate how likely the event A under consideration is to occur, given
each and every a priori probability
Example 5.6.9 In 1989 there were three candidates for the position of
principal Mr. Chatterji, Mr. Ajay sharma and Dr. Singh whose chances
of getting the appointment are in the proportion 4:2:3. The probability
that Mr. Chatterji if selected would introduce co–education in the
College is 0.3. The probabilities of Mr. Ajay sharma and Dr. Singh
doing the same are respectively 0.5 and 0.8 what is the probability that
there was co-education in the college in 1990?

Solution
Let the events and probabilities be detailed follows
A : Introduction of Co-education

E1 : Mr. Chatterji is selected as principal

E2 : Mr. Ajay sharma is selected as principal
E3 : Dr. Singh is selected as principal

Then P(E1) = 4/9 P (E2) = 2/9 & P(E3) = 3/9

114
 P(A / E1) = 3/10 P (A/E2) = 5/10 P(A / E3) = 8/10
P(A) = P(E1) P(A/E1) + P(E2) P(A)/E2)+ P(E3) +P(A/E3)
= 4/9  3/10 +2/9  5/10 + 3/9  8/10
12 10  24 46 23
P(A) =  
90 90 45
Example 5.6.10 A manufacturing firm produces steel pipes in three
plants with daily production volumes of 500, 1000 and 2000 units
respectively. According to past experiences it is known that the
fractions of defective outputs produced by the three plants are
respectively 0.005 .008 and .010 If a pipe is selected from a day's total
production and found to be defective, find out

i) From which plant the pipe comes

ii) What is the probability that it came from the first plant
Solution
Let the probabilities of the possible events be
P (A1) = Prob. that a pipe is manufactured in plane I
500 1
= 
500 1000  2000 7
P (A2) = Prob. A pipe is manufactured in plane II
1000 1
= 
500 1000  2000 7
P (A3) = Prob. that a pipe is manufacturing in plane III
2000 4
= 
500 1000  2000 7
P(B) = Prob. That a defective pipe is drawn
P (B/A1) = 0.005

P (B/A2) = 0.008
P (C/A3) = 0.010
P (A1 ∩ B) = P (B/A1) P (A1) = 0.005 x 1/7
P (A2 ∩ B) = P (B/A2) P (A2) = 0.008 x 2/7

115
 P (A3 ∩ B) = P (B/A3) P (A3) = 0.010 x 4/7
Using Baye’s Rule we have
P(A1  B)
P (A1/B) =
P(A1  B)  P(A 2  B)  P(A 3  B)
0.005 / 7
=
0.005 2 4
 (0.008)   (0.010) 
7 7 7
5
P (A1 /B) =
61
0.016 / 7 16
P (A2/B) = 
0.06 / 7 61
0.040 / 7 40
P (A3/B) = 
0.06 / 7 61
Example 5.6.9 The contents of Urns I, II and are as follows:
1 White, 2 black and 3 red balls
2 White, 1 black and 1red balls and
4 White, 5 black and 3 red balls

One urn is chosen at random and two balls are drawn. They happen to be
white and red what is the probability that they come from Urns I, II or III?
Solution
Let E1, E2 and E3 denote the event, that the Urn I, II and III is chosen and let
A be even that the two balls taken from the selected urn are white and red
then
P (E1) = P(E2) = P (E3) = 1/3
1 3 1
P (A/E1) = 
6 C2 5

2 1 1
P (A/E2) = 
4 C2 3

4 3 2
P (A/E3) = 
12 C2 11

116
 P( E 2 )  P( A / E 2 )
P ( E2(A1) = 3
 P( E i ) P( A / E i )
i 1

1 1

3 3 55
= 
1 1 1 1 1 2 118
    
3 5 3 3 3 11
1 2

3 11 30
P (E3/A) = 
4 1 1 1 1 1 118
    
3 5 3 3 3 11
30 55
P (E1/A) = 1 
118 118
85 33
= 1 
118 118
LET US SUM UP
This unit dealt with the basic concept of probability and with axioms of
probability. We have discussed about the properties of probability,
conditional probability, rules of probability like addition, multiplication etc.
We have analyzed the basic rules. We have also discussed the various
applications of probability concepts in various branches like medicine,
Engineering, Mechanical, Electrical, etc.
CHECK YOUR PROGRESS

1. Two six faced unbiased dice are thrown is 7 or their product of 3. Find
the probability that the sum of numbers shown or their product
2. If P(A) =2/3 P (AB) =4/5 and P AB = 14/15 find P(B)

3. The chance of an accident in a factory in a year is 10 in 50 in Bombay.

10 in 60 in Poona, 10 in 120 in Nagpur. Find the chances that an
accident may occur in i) at least one of these cities ii) All of these cities
4. Three machines A, B, C produce respectively 50% 30% and 20% of the
total number of items of a factory. The percentages of defective output
of these machines are respectively 3% 4% and 5% if an item is
selected at random. What is the probability that the item is defective?

117
5. A lot contains 10 items of which 3 are defective three items are chosen
from the lot at. Random one after another without replacement find the
probability that all the three are defective
GLOSSARY

Probability : Probability is the ratio of the number of

outcomes in an exhaustive set of equally likely
outcomes that produce a given event to the
total number of possible outcomes.
:
Dependent Event If the incidence of one event does affect the
probability of the other event, then the events
are dependent.
:
Mutually Mutually exclusive events are things that can't
Exclusive events happen at the same time. For example, you
can't run backwards and forwards at the same
time
:
Exhaustive When a sample space is distributed down into
events some mutually exclusive events such that
their union forms the sample space itself, then
such events are called exhaustive events.
:
Equally likely Equally likely events are events that have the
events same theoretical probability (or likelihood) of
occurring. For example, each numeral on a
die is equally likely to occur when the die is
tossed.
:
Conditional Conditional probability is defined as the
Probability likelihood of an event or outcome occurring,
based on the occurrence of a previous event
or outcome.

118
SUGGESTED READINGS
1. Arora, P.N. & S. Arora, (2007) ,Statistics for Management, latest
Edition, S. Chand & Company Ltd., New Delhi.
2. D.C.Sancheti, V.K.Kapoor,( 2014), Business Mathematics, 11th
edition, Reprint, Sultan Chand and Sons, New Delhi.
3. Gupta, B.N., (2015), Business Statistics, First Revised Edition,
SBPD, New Delhi.
4. JK. Sharma, (2009), Business Mathematics Theory And
Applications, 13th Edition, ANE Books, New Delhi.

5. S. P. Gupta, (2012), Statistical Methods, 42nd Revised Edition Sultan

Chand & Sons Pvt. Ltd., New Delhi.
6. https://www.cuemath.com/data/probability-rules/
7. https://web.ma.utexas.edu/users/mks/statmistakes/probability.html
ANSWERS TO CHECK YOUR PROGRESS
1.

2.

3.

4. 0.037
5.

119
Unit 6

PROBABILITY DISTRIBUTION: BINOMIAL

DISTRIBUTION
STRUCTURE
Overview
Learning objectives
6.1 Introduction

6.2 Bernoulli Distribution

6.3 Binomial Distribution
6.3.1 Definition

6.3.2 Physical Conditions

Let Us Sum Up
Check Your Progress

Glossary
Suggested Readings
Answers to Check Your Progress
OVERVIEW
In this unit we shall discuss on probability distribution, types of distribution
whether it is discrete (or) continuous one. Theoretical distributions provide
the decision maker with a sound basis for taking rational and dependable
decisions. Theoretical distributions are of many types. We will, however
discuss the distribution of binomial in this unit.
LEARNING OBJECTIVES

After reading this unit, you should be able to,

 explain probability distribution

 classify them into discrete or continuous distribution

 explain binomial co – efficient and binomial distributions
 discuss various applications of theoretical distribution

120
6.1 INTRODUCTION
Any rule, which assigns probabilities to each of the possible values of a
random variable, is called a probability distribution. There are two types in
theoretical distribution.
1. Discrete distribution
2. The Theoretical continuous distribution

We shall now discuss another important type of distribution known as

theoretical (or) expected frequency distribution. Often we can
mathematically deduce the expected frequency distribution of certain
“Popularities" on the basis of theoretical considerations. Such distributions
are known as theoretical Distribution or probability distributions. For these
distributions a random experiment is theoretically assumed to serve as a
model and the probabilities are given by a function of the random variable
called probability function. The Importance of theoretical distribution cannot
be over emphasized. They provide us data on the basis of which the results
of actual observations or experiments can be assessed. In fact where
theoretical distribution is available there is no need for having observed
distributions. Theoretical distributions provide the decision maker with a
sound basis for taking rational and dependable decisions. Theoretical
distributions are of many types. We will, however, discuss here only three
such distributions, which are more popular than others and are widely used.

i. Binomial distribution
ii. Poisson distribution
iii. Normal distribution

The first two, Binomial and the Poisson distribution are discrete distribution
and normal distribution is a continuous distribution.
6.2 BERNOULLI DISTRIBUTION

When the random variable must assume one of two values 0 or 1, such
variable is called Bernoulli’s random variable. The corresponding
experiments which has only two possible outcomes said to be a Bernoulli
trial. Usually the outcome which is mapped by the random variable into the
value '1' is named as a 'success ' the other (o) is called "failure". The
probability distribution is given by P (1) = P; P (0) = 1-P where P is the only
Parameter of the distribution.Usually referred to as the 'Probability of
success'. This distribution may appear so trivial requiring no special

121
attention. Although the direct application of this distribution are very limited,
but a number of more important distribution can be obtained by considering
a sequence of independent Bernoulli trials. A random variable x which taken
two values 0 and 1 with probabilities q and p.
i.e., P(x=1)=p ; p(x=0) = q
Moment of Bernoulli distribution

rth moment about origin

'r = E (xr) = 0r, q + 1r * P = P r = 1,2...
'1 = E ( x ) = p

'2 = E(x^2 ) = p
M.G. F. of Bernoulli variate is given by
M x(t) = e 0.t P(x = 0) + e 1. t P (x = 1)
Mx(t) = q + Pet
M x(t) = q + Pet

6.3 BINOMIAL DISTRIBUTION

Let a random experiment be formed repeatedly and let the occurrence of an

event in a trial be called a success and its non-occurrence is failure.
Consider a set of n independent Bernoulli trials in which the probability 'P' of
success in any trial is constant for each trial. Then q = 1-p, is the probability
of failure in any trial.
6.3.1 Definition

A random variable x is said to follow binomial distribution if it assumes only

non-negative values and its probability mass function is given by
 n  x n x
  p q ; x  0,1, 2 ...n, q  1  p
P (X = x) = P(x) =  x 
0
 Otherwise

The independent constants n and p in the distribution are known as the

parameters of the distribution .'n' is also some times, known as the degree
of the binomial distribution. It is a discrete distribution. Any variable which
follows binomial distribution is known as binomial variate.
It is denoted by x ~ B (n, p)

122
Where X - Random variable
n - no. of trial
p - Probability of success.

Let that n trials constitute as experiments. Then if this experiment is

repeated N times, the frequency function of the binomial distribution is given
by
n
x n x
f(x) = N p(x) = N   p q , x  0,1, 2...n
x
6.3.2 Physical Conditions

 Each trial results in two mutually disjoint outcomes, termed as

success and failure.
 The number of trials 'n' is finite
 The trials are independent of each other.
 Probability of success 'p' is constant for each trial.

Note:

Mean of the Binomial Distribution = np

Variance(2) = npq
Standard deviation() = npq

where q = 1–p

Example 6.1 Ten coins are known simultaneously find the probability
of getting at least seven Heads.

Solution

p = Probability of getting head = ½

q = Probability of getting tail = 1/2
Probability of getting heads in a random throw of 10 coins is
10 x 10
 10   1   1 
x
10  1 
p(x) =            x = 0,1, 2…
 x  2 2 x 2 

123
Probability of getting at least seven heads
P (x 7) = P (7) + P (8) + P (9) + P (10)
= (0.5) 10 [ (10/7) +(10/8)+(10/9)+(10/10) ]

= 120 + 45 + 10 + 1 / 1024
= 176/1024 = 0.172
Example 6.2 A and B play a game in which their chances of winning
are in the ratio 3:2. Find A's Chance of winning at least three games
out of the five games played.

Solution
Let p be probability that 'A' wins the game.
Then we are given
p= 3/5 , q = 1-3/5 = 2/5
By binomial distribution, the probability that as of 5 games played. A
wins r games is given by
3 r
 5  3   2 
r

P (x = r) = P (r) =       r = 0,1,2,3,...5
 r  5   5 
The required probability that 'A' wins at least three games.
5
 5  3r 2 5r
P (X  3) =    5
r 3  r 5
33  5  2 5 
=   2    . 3  2  1.3 2 1
55  3  4 
27  ( 40  30  9)
=  0.68
3125
Example 6.3
a) Comment the following. For a binomial distribution mean= 7,
variance = 11.
b) For binomial distribution, the mean is 6 and the standard deviation
is 2. Write down all the terms.

Solution

124
Given mean = np = 7
Variance = npq = 11
7*q = 11

q = 11/7
q = 1.6
Since q cannot be more than 1, the given data are in consistent.

b) Here , np = 6
Standard division npq =2
npq = 2

6q = 2
q = 2/6 p = 1-q
q = 1/3 p = 2/3
p = 2 np = 6
p(x) = ncxpxqn-x
x n x
2 2 1
n  6 p ( x  x)  nc x    
3 3 8
63
n   9
2
The terms nc0,nc1,nc2,.... (1/3) 9
9c0,9c1,9c2,..... 9 (2/4) 4 (1/3) 8
Example 6.4 If the sum of the mean and variance of Binomial
distribution for 5 trials is 18. Find the distribution

Solution

Mean = np variance = npq

np + npq = 1.8 5p(2-p) = 1.8
np(1+q) = 1.8 10p - 5p = 1.8

5p(1-q) = 1.8
=> 5p2 - 10p+1.8 =0
Solving we get,

125
 p = 1 + 0.8
p = 1+0.8 or p = 1 - 0.8
p = 1.8 = 0.2
Example 6.5 In a Hurdle race, a player has to cross the hurdles. The
probability that he will clear each hurdle is 5/6. What is the probability
that he will knock down more than 2 hurdles?

Solution
P (knock down more than 2 hurdles)
= P (0) + P (1)
0 100 1 101
1 5 1  5
= 10c 0      10c 1    
6 6 6  6
10 1 9
5 1  5
= 11    10    
6 6  6
9
 5   5 10 
=    
 6 6 6 
9
 5   15 
=    
6  6 
Example 6.6 Three percent of a given lot of manufactured parts are
defective. What is the probability that in a sample of four items none
will be defective?
Solution

Here p = p (Defective item)

3
=  0.03
100
q = 1-p
q = 1 - 0.03 = 0.97
Probability of getting x defectives in a sample of size 4 is given by
P (x) = 4 Cx (0.03)x (0.97)4-x

The probability that none of the four items will be defectives is

P (0) = 4c0(0.03)0 (0.97)4-0

126
 = 1-1. (0.097)4
= (0.97)4
Example 6.7 Five coins are to bet 3200 times, find the frequencies of
the distribution of heads & tails and tabulate the results. Calculate the
mean number of successes and standard deviation.

Solution

p (head with the coins) = 0.5

q = 1-p
q = 0.5
n= no. of independent trials = 5
p (x) = 5cx (0.5)x ×(1/2 )5-x
= 5c x (0.5) 5
Frequency of heads
F(x) = N.P (x)
= 3200 × 5 c (0.5)5
x

No. of heads (x) f(x) = 3200 × 5 c (0.5)5

x

0 f(0) = 3200 * 5c0( 0.5) 5 = 100

1 f(1) = 3200 * 5c1( 0.5) 5 = 500
2 f(2) = 3200 * 5c2( 0.5) 5 = 1000

3 f(3) = 3200 * 5c3( 0.5) 5 = 1000

4 f(4) = 3200 * 5c4( 0.5) 5 = 500
5 f(5) = 3200 * 5c5( 0.5) 5 = 100

Total 3200

Mean no. of success = np= 5 × 0.5

= 5 × 0.5
= 2.5

S.D= npq  5 0.5  0.5 =1.118

127
Example 6.8 Calculate P (r) for r = 1,2,3,4 and 5 taking n=5 and p =1/6
with the help of the recurrence formula of the S.D.

Solution

n r p
p (r+1) =       p(r )
 r  1  q
Given n = 5, p = 1/6 q=1-1/6 = 5/6

1
 
5 r 6
p(r+1) =     p( r )
 r  1   5 
6
5r  1
=       p(r ),
 r 1   5 
Put r = 0,1,2,3,4 we get;

50 1
P (1) =       p(0)
 0 1   5 
5
5 3125
= q n
=     04018
6 7776
 5  1  1 
P (2) =       p(1)
 1  1  5
 4   1  3125 1250
=      0.1007
 2   5  7776 7776
5 2 1
P (3) =       p(2)
 2 1   5 
 3   1  1250 250
=      0.0321
 3   5  7776 7776
qp
γ1 = 1 
npq

128
Co-efficiant of kurtosis is given by
4 npq (1  6pq )
β2 = 
 22 n 2 p 2q 2
1  6pq
= 3
npq
1  6pq
γ2 = β2 - 3 =
npq
Remarks
1. For binomial distribution variance symmetrical mean
2. Binomial distribution is symmetrical it p=q = 1./2. It is positively
skewed if p< 1/2 and negatively skewed if p > 1/2
3. It is Unimodal if np is whole number.
LET US SUM UP

The binomial distribution is a common type of probability distribution for

discrete random variables which obeys certain conditions. There are only
two possible outcomes (usually called successes or failures).There are a
fixed number of trials (n).Each trial must be independent of the other trials.
The probability of success (π) is fixed at each trial. Binomial probabilities
can be found using a formula or from tables. The mean and variance of a
binomial distribution can be found using formulae.
CHECK YOUR PROGRESS
Choose the Correct Answer:

1. Which of the following is the most common example of a situation for

which the main parameter of interest is a population proportion?
a) A binomial experiment
b) A normal experiment
c) A randomized experiment
d) An observational study
2. Which statement is not true about confidence intervals?
a) A confidence interval is an interval of values computed from
sample data that is likely to include the true population value.

129
 b) An approximate formula for a 95% confidence interval is sample
estimate ± margin of error.
c) A confidence interval between 20% and 40% means that the
population proportion lies between 20% and 40%.
d) A 99% confidence interval procedure has a higher probability of
producing intervals that will include the population parameter than a
95% confidence interval procedure.
3. A poll is done to estimate the proportion of adult Americans who like their
jobs. The poll is based on a random sample of 400 individuals. What is the
“conservative” margin of error of this poll?
a) 0.10 b) 0.05
b) c) 0.04 d) 0.025
4. The expected value of a random variable is the
a) value that has the highest probability of occurring.
b) mean value over an infinite number of observations of the
variable.
c) largest value that will ever occur.
d) most common value over an infinite number of observations
of the variable.
5. Which one of these variables is a binomial random variable?
a) time it takes a randomly selected student to complete a
multiple choice exam
b) number of textbooks a randomly selected student bought this
term
c) number of women taller than 68 inches in a random sample
of 5 women
d) number of CDs a randomly selected person owns
GLOSSARY

Bernoulli Random Variable : When the random variable must

assume one of two values 0 or 1,
such variable is called Bernoulli’s
random variable

Bernoulli trial : Experiments which has only two

130
 possible outcomes said to be a
Bernoulli trial

Binomial Distribution : A random variable x is said to

follow binomial distribution if it
assumes only non-negative values.

SUGGESTED READINGS

1. Arora, P.N. & S. Arora, (2007) ,Statistics for Management, latest

Edition, S. Chand & Company Ltd., New Delhi.
2. D.C.Sancheti, V.K.Kapoor,( 2014), Business Mathematics, 11th
edition, Reprint, Sultan Chand and Sons, New Delhi.
3. Gupta, B.N., (2015), Business Statistics, First Revised Edition,
SBPD, New Delhi.
4. JK. Sharma, (2009), Business Mathematics Theory And
Applications, 13th Edition, ANE Books, New Delhi.
5. S. P. Gupta, (2012), Statistical Methods, 42nd Revised Edition Sultan
Chand & Sons Pvt. Ltd., New Delhi.
6. https://www.mygreatlearning.com/blog/bernoulli-distribution-
explained/
7. https://epgp.inflibnet.ac.in/Home/ViewSubject?catid=ahLCajOqz6/G
WFCSpr/XYg==
ANSWERS TO CHECK YOUR PROGRESS

1) a 2) c 3) b 4) b 5) c

131
Unit 7

POISSION DISTRIBUTION
STRUCTURE

Overview
Learning objectives
7.1 Introduction to Poisson distribution

7.2 Meaning, Role and Moments

7.2.1 Definition
7.2.2 Examples

7.2.3 Role of Poisson distribution

7.2.4 Moments of Poisson distribution
7.3 Problems and Solutions

Let Us Sum Up
Check Your Progress
Glossaries

Suggested Readings
Answers to check your progress
OVERVIEW

The Poisson distribution, like the binomial, is a counted number of times

something happens. The difference is that there is no specified number n of
possible tries. Here is one way that it can arise. If an event happens
independently and randomly over time, and the mean rate of occurrence is
constant over time, then the number of occurrences in a fixed amount of
time will follow the Poisson distribution. The following pages will give the
Poisson distribution and it's important in routine day to day life and business
decisions.
LEARNING OBJECTIVES

After Completing this unit, you should be able to,

132
  recognize the Poisson probability distribution and apply it
appropriately
7.1 INTRODUCTION POISSON DISTRIBUTION

Poisson distribution was developed by Simeon Poisson (1781-1840), a

French mathematician. This distribution was discovered in the early part of
the nineteenth century. It measures the probability of a random event within
a given interval of time or space and it is a discrete distribution. It can be
safely put that the Poisson distribution arises from a binomial distribution or
the exponential density. It is important to look into the assumptions made
while applying this distribution: (a) The probability of the occurrence of the
event is constant for any two intervals of time or space. (b).The occurrence
of the event in a particular interval does not depend on the occurrence of
the event in any other interval. The Poisson distribution can be applied to
several real life instances. The following are a few important ones: (i) the
number of deaths resulted due to kicking of the horse in Prussian army. (ii)
Number of times a machine breaks down in a month (iii) Spread of any
endangered animal in a particular region (iv) Typing errors on a page (v)
Number of defective electrical connections per mile in the power system of
a city
7.2 MEANING, ROLE AND MOMENTS OF POISSON DISTRIBUTION
Position Distribution is due to S.D. Poisson. It is a limiting case of binomial
distribution. When the number of trials n is very large and P (Proportion of
successes) is very small so that n p (the average number of success) is a
finite constant (λ)

i.e., n  P 0
np=

Thus P = /n : q = 1
n
7.2.1 Definition

A random variable x is said to follow a poisson distribution if it assumes only

non-negative values and its probability mass function is given by

133
  e   . x
 ; x  0,1, 2, ...
 x!
P(x, ) = P( X  x )   0 ; Here  is
0 Otherwise


known as the parameter of the distribution. x~P () to denote that x is a
poisson variant with parameter()
The distribution function is

x
r
F(x) = p(Xx) =  P( r )  e    r!
, r  0,1, 2, ...
r 0 r 0

7.2.2 Examples
1. Number of deaths due to disease
2. Number of suicides reported in a particular city
3. Number of faulty blades in a packet of 100
4. Number of air accidents in some unit of time.
5. Number of primary mistakes at each base
6. The emission of radioactive particles.
7.2.3 Role of Poisson Distribution

Poisson distribution is used in practice in a wide variety of problems where

they are frequent, occuring events with respect to time, area, volume or
similar units.

1. It is used in quality control statistics to count the number of defects

of an items.
2. In biology to count the number of bacteria.

3. In Physics to count the number of Particles emitted from a

radioactive substances .
4. In insurance problem to count the number of causulities

5. In quereing problems, number of incoming telephone calls or

incoming customers.
6. Number of traffic arrivals such as trucks at terminals, aeroplane at
airports ships at docks.

134
 7. In determining the number of deaths in a district in a given period.
8. The number of typographical errors purpose in typed materials.
7.2.4 Moments of Poisson Distribution

11  

12  2  

13  3  32  

14  4  63  72  

7.3 PROBLEMS AND SOLUTIONS
Example 7.9: A box contains 20 ticket, each bearing one of the
numbers from 1 to 200 20 tickets are drawn successively with
replacement from the box.Find the probability that at most 4 tickets
bear number divisible by 20.
Solution
10 1
Here n = 20 P = (divisible by 20 ) = 
200 20
1
Mean = np = 20  1
20
 1
=


e   . r
P(r) =
r!
e 1 .1o
P(0) =  e 1
1

Since P(r+1) = p (r ) (recurrence relation)
 1

1
P(1) = p (0)  1. p(0)  1.e 1  e 1
0 1
1 1
P(2) = p (1)  e 1
11 2!

135
 1 1 1
P(3) = p (2)  . . p(1)
2 1 3 2!
1
= p (1)
3!
Required problem
= P(0)+P(1)+P(2)+...
= e-1(2+0.5!+1/3!+)

= e-1+e-1+0.5!*e-1+1/3!*e-1
Example 7.10 A book contains 100 misprints distributes randomly
throughout its 100 pages. What is the probability that a page
observed at random contains at least two misprints.
Solution
Given: x repeated the number of misprints in a page. Then x has a
poisson distribution, we have

em m x
P(X=x) = P(x) =
x!
The probability that a page contains at least two misprints is
P(X  2) = P(x = 2 ) + P (x = 3) + P(x = 4) +...
= 1- [P(0)+P(1)]

 1. e 1  1.e 1 
= 1   
 
 0 !  1! 

 1 1  1 1 
= 1     
 e e   2.718 2.718 
= 1 - 0.736 = 0.264
Example 7.11 Fit the distribution mistakes committed by a typist is
given below. Assuming a poisson model, find out the expected
frequencies.

Mistakes per page 0 1 2 3 4 5

No. of Pages 142 156 69 27 5 1

136
Solution

Mean =
 fx 
400
 1
N 400
Taking the mean of the given distribution as the mean of the poisson
distribution ,we want to fit we get m = 1

Expected solution

0 400 × 0.3679 = 147.16

1 400× e-1 ×1 = 147.16

400  e 1 2
1 = 73.58
2 2!
400  e 1 3
1 = 24.52
3 3!
400  e 1 4
1 = 6.13
4 4!
400  e 1 5
1 = 1.2
5 5!

Since frequencies are always integers, therefore by converting them to

nearest integers.

Observed ferquency 142 156 69 27 5 1

Expected frequency 147 147 74 25 6 1

Example 7.12 If x is a poisson variate such that

P(x = 2) = 9p(x = 4) + 90p(x=6).

Find (i) mean (ii)coefficient of Skewness.
Solution

If x is a poisson variate with parameter

e  x
P(x=x) =
x!

137
Given P(x=2) = 9p(x=4) + 90p(x=6)

e  2 e  4 e  6
9  90
2! 4! 6!
e  2 e  4 e  6
9  90
2 24 720
e  2 e  2  92 90 4 
   
 3 6  5  3 
2 24 
1
= (32  4 )
4
4  32  4

4  32  4  0

3 9  16
2 
2
 3  25
2 
2
 3 5
2 
2
Solving a quadratic equation
2 =1 => λ =1
Since 1 > 0 we get λ =1 here mean => λ =1 variance (λ) = 1
1
Also 1 = coefficient of skewness =

Example 7.13 If X and Y are independent poisson variates such that

P(X=1) = P(X=2) find the variance of X-2Y and

P(Y=2) = P(Y=3)
Solution

e  x
P(X=X) = = X=0,1,2 …>0
X!
e   y
P(Y=Y) = = Y = 0,1,2 …u > 0
Y!

138
 Given P (X=1) = P (X=2)
2
 =  λ=2
2!
p(Y = 2) = p(Y = 3)

e   2 e   2
=
2! 3!

 2 3 1 
  
2 6 2 6

=3
Var (X) = λ =2 Var (y) = =3
Var (X-2Y) =12 Var(X) + (-2)2 VarY)
= 1.2 + 4 x 3 = 2+12 =14
Example 7.14 If a random variable X follows a Poisson distribution
such that

p(x = 1) = p (x = 2) Find p (x = 0)
Solution
e   . x
P(x=x) = x = 0,1,2…, λ > 0
x!
Given P(X=1) = P(X=2)
e   . 1 e   . 2

1! 2!

2

2
2=
e   . 0 e 2 . 1
P(X=0) =  = e-2
0! 1
Example 7.15 Using Poisson distribution to the binominal distribution
solves the following problem. If the probability that an individual
suffers a bad reaction from a particular injection is 0.01 determine the
probability that out of 2,000 individuals

139
i) Exactly three ii) more than two iii) individuals will suffer a bad
reaction (Given e2 = 7.4)

Solution

The random variable x, number of individuals out of 2000 who suffer from
bad reaction follows binomial distribution with n = 2000 and p = 0.01.
Since p is small, n is large np=2000 x 0.01 np =2 is finite.

The binomial distribution is approximated by Poisson distribution within

using Poisson distribution
i) Probability of exactly 3 individuals suffer from bad reaction is

em m x
p(X = x) =
x!
ii) Probability of exactly 3 individual’s buffer from bad reaction is
e 2 2 3 e 2  8
p (3) = 
3! 6
4
= 0.1353  = 0.180
3
iii) The probability that more than 2 individuals suffer is
P (X>2) = p(3) + p(4) + p(5)+….
= 1- [p(0) + p(1) + p(2)]

 e 2 . 20 e 2 . 21 e 2 . 2 2 
= 1    
 0! 1! 2! 

1 2 2
= 1  2  2  2 
e e e 
 1 2 2 
= 1   
 7.4 7.4 7.4 
= 1  (0.1351  0.2702  0.2702) = 0.3245

LET US SUM UP

In statistics Poisson distribution is a statistical distribution that shows how

many times an event is likely to occur within a specified period of time. It is
used for independent events which occur at a constant rate within a given

140
interval of time. The Poisson distribution is a discrete function meaning that
the event can only be measured as occurring or not as occurring, meaning
the variable can only be measured in whole numbers. Fractional
occurrences of the event are not a part of the model.
CHECK YOUR PROGRESS
Choose the Correct Answer:

1. Which of the following distribution is referred to as law of improbable

events?
a) Uniform b) Binomial

c) Poisson d) Hyper geometric

2. In case of Poisson distribution, mean is equal to _____________
a) Standard deviation b) Variance
c) Covariance d) None of the above
3. The _____________ is a discrete distribution that measures the
probability
of a given number of events happening in a specified time period.
a) Poisson distribution b) Normal distribution
c) Binomial distribution c) None

4. In a Poisson distribution, if ‘n’ is the number of trials and ‘p’ is the

probability of success, then the mean value is given by?
a) m = np b) m = (np)2
c) m = np (1-p) d) m = p
5. In a Poisson Distribution, the mean and variance are _____________
a) equal b) not equal

c) mean greater than variance d) mean lesser than variance

GLOSSARIES

Poission Distribution : A random variable x is said to

follow a poisson distribution if it
assumes only non-negative values

141
Random Variable : A Random Variable is a set of
possible values from a random
experiment.

Sample Space : The set of possible values is called

the Sample Space.

SUGGESTED READINGS

1. Arora, P.N. & S. Arora, (2007) ,Statistics for Management, latest

Edition, S. Chand & Company Ltd., New Delhi.
2. D.C.Sancheti, V.K.Kapoor,( 2014), Business Mathematics, 11th
edition, Reprint, Sultan Chand and Sons, New Delhi.
3. Gupta, B.N., (2015), Business Statistics, First Revised Edition,
SBPD, New Delhi.
4. JK. Sharma, (2009), Business Mathematics Theory And
Applications, 13th Edition, ANE Books, New Delhi.
5. S. P. Gupta, (2012), Statistical Methods, 42nd Revised Edition Sultan
Chand & Sons Pvt. Ltd., New Delhi.
6. https://epgp.inflibnet.ac.in/Home/ViewSubject?catid=ahLCajOqz6/G
WFCSpr/XYg==
7. https://corporatefinanceinstitute.com/resources/data-
science/poisson-distribution/
ANSWERS TO CHECK YOUR PROGRESS

1) c 2) b 3) a 4) a 5) a

142
Unit 8

NORMAL DISTRIBUTION
STRUCTURE

Overview
Learning objectives
8.1 Introduction

8.2 Normal distribution

8.2.1 Graph of Normal Distribution
8.2.2 Properties of Normal curve

8.2.3 Area Properties of Normal curve

8.2.4 Constant of normal distribution
8.2.5 Standard normal probability curve

8.2.6 Fitting the normal curve

Let Us Sum Up
Check Your Progress

Glossary
Suggested Readings
Answers to check your progress

OVERVIEW
This unit attempted to reveals about the Normal Distribution, its properties,
fitting the normal curve and its role in business world. The probabilities of
the normal distribution have to be determined numerically. Tables of such
probabilities, which refer to a simplified normal distribution called the
standard normal distribution, which has mean 0 and variance 1, will be used
to determine probabilities of the general normal distribution. Finally you will
learn how to deal with combinations of random variables which is an
important statistical tool applicable to many business situations.

143
LEARNING OBJECTIVES
After completing this unit, you should be able to:
 identify and compute a simple probability.

 identify eight characteristics of the normal distribution.

 define the standard normal distribution and compute the standard
normal transformation.

 locate proportions of area under any normal curve above the mean,
below the mean, and between two scores.
8.1 INTRODUCTION

The normal distribution is the most widely used model for the distribution of
a random variable. There is a very good reason for this. Practical
experiments involve measurements and measurements involve errors.
However you go about measuring a quantity, inaccuracies of all sorts can
make they felt. For example, if you are measuring a length using a device
as crude as a ruler, you may find errors arising due to: (i) the calibration of
the ruler itself;(ii) parallax errors due to the relative positions of the object
being measured, the ruler and your eye; (iii) rounding errors; (iv)
guesstimation’ errors if a measurement is between two marked lengths on
the ruler.(v) mistakes.
8.2 NORMAL DISTRIBUTION
It is one of the continuous probability distributions. The most important
distribution used in the entire field of statistics is the normal distribution. Its
graph called normal curve, is bell shaped curve that extends indefinitely in
both directions, coming closer and closer to the horizontal axis without ever
reaching it. The normal distribution is often referred to as the Gaussian
distribution in honour of Karl Friedrich Gauls (1777-1855). The
mathematical equation of normal curve was developed by De-moiure in
1733. It was later rediscovered and applied in sciences, both natural and
social by the French mathematician laplace (1949-1827). The term normal
is somewhat unfortunate since it suggests that there is something abnormal
about other types of distribution.
The normal distribution
( x )
1
p ( x)  e 22
, -  x 
 2

144
Where
x – Values of the continuous random variable
 – mean of the normal random variable.

e – Mathematical constant approximated by 2.7183.

 – Mathematical constant approximated by 3.1416.
8.2.1 Graph of Normal Distribution

1. Normal distribution is a limiting case of binomial distribution when

(i) n  (ii) neither p nor q is very small
2. Normal distribution is limiting case of poisson distribution when its
mean is large
3. The mean of a normally distributed population lies at the centre of its
normal curve.
4. The probability that a normally distributed random variable with
mean  and variance 2 lies between two specified values a andis
p(a < x < b) = Area under the curve p(x) between the specified
values  = a and x = b.
8.2.2 Properties of Normal Curve

1. This is symmetrical about the mean () and is bell shaped.

2. The mean, Median and mode of the normal distribution are equal,
say x  z  M e .

3. Its skewness is zero and Kurtosis is 3. It is called a meso kurtic

curve.

4. The quartiles Q1 and Q3 are equidistant from the median and are
indicated as below
Q1 =  - 0.6745; Q3 =  + 0.6745 
Q3 Q1
Quartile Deviation =  0.6745 .
2
4
5. Mean deviation about mean is .
5
6. The curve has two points of inflexion at
x =  -  and x =  + 

145
 7. It is asymptotic to the base line on its either side
8. Since there is only one maximum point the normal curve is Unimodel
it has only one mode

9. The sum of independent normal varieties also a normal variate. This

is known as the additive or Re-productive property of the normal
Distribution.

10. As X increases numerically, the value of P(x) decrease rapidly, the

Maximum probability occurring at x= µ and is given by.
8.2.3 Area Properties of Normal Curve

Area under the Normal curve distributed as follows.

a) Mean ± 1  covers 68.27% area
b) Mean ± 2  covers 95.45% area
c) Mean ± 2  covers 95.45% area
d) Mean ± 3  covers 99.73% area
e) Mean ± 1.96  covers 95. % Area, 47.5% on each side
f) Mean ± 2.5758  covers 99% area, 49.5% on each side
g) Mean ± 0.6745 covers 50% area, 25% on each side

Remarks
1. Normal distribution with a mean  and variance 2 may be denoted
N(, 2)

2. (a < x < b) =Area under the curve P(x) between the specified values
X = a and x=b
3. Since p (x) is probability distribution, the total area under the curve
P(x) is equal to 1
4. Normal distribution is a limiting case of distribution when its mean m
is large

5. Normal distribution when,

i) n, the number of trials is very large
ii) Neither P nor q is very small.

146
8.2.4 Constant of Normal Distribution
Mean = X or µ (Standard form x =0)
Standard Deviation =  (Standard form ∂=1)

Variance or µ2 = 2
Third central moment µ3 =0
Moment central moment µ4 = 34 = 3 µ22
Fourth central moment µ4 = 3∂4 = 3µ2
3
Moment coefficient of skewness, 1  0
3
4
Moment coefficient of kurtosis 2   3,
2
It is mesokurtic curve
8.2.5 Standard Normal Probability Curve
A normal curve with mean 0 and standard deviation 1 is known as standard
Normal curve
1
e z
2
P( Z)  -  Z 
 2

It is also called standard probability curve

X u
Standard normal variate = Z


Figure 8.1
Example 8.16

Assume mean height of soldiers to be 68.22 inches with a variance of 10.8

inches. How many soldiers in a regiment of 1000 would you expect to be
six feet tall?

147
Solution
Assume that the distribution of height is normal
X u
Standard deviation = Z


Figure 8.2
Here X=72 inches (6 feet)
X = 68.22 2 = 10.8

 = 10.8

 = 3.286
X  68.22  72
Z  
 3.286
Z = 1.15

Area to the right of the ordinate at 1.15 from the normal table is (0.5000 -
0.3749) =0.1251. Hence, the probability of getting soldiers above six feet is
0.1251 and out of 1000 soldiers over six feet fall =0.1251 x 1000=125
Example 8.17 In a distribution exactly normal 7% of the items are
under 35% and 79% are under 63. What is the mean and standard
deviation of the distribution?

Solution
The standard normal variate corresponding to 0.43 (43%) is 1.48
35  x
Thus   1.48 (1)

The stand normal variate corresponding to 0.39 is 1.23
63  x
 1.23 (2)


148
From (1) and (2)
-1.48  + x = +35
-1.23  + x = -63

(-) -2.71  = -28

Figure 8.3
 28
 =
 2.71
 = 10.33

-1.48 x10.33 + X=35

X =35 +15.28
X =50.28  X=50.30
Example 8.18 A customer account of a certain departmental store has
an average balance Of Rs.120 and a standard deviation of Rs.40.
Assuming that the account Balances are normally distributed
i) What proportions are of the accounts is over 150?
ii) What proportion of the accounts is between Rs.150 and Rs.100?
iii) What proportion of the accounts is between Rs.60 and Rs.90?

Solution
Let the random variable X denotes the balance of the customer accounts.
Then we are given that X is normally distributed with mean u=120 and

S.D =40 ()

X
Z =

X  120
=
40

149
(i) Probability that the customer accounts is over Rs.150 is given by P
(X > 150) When X=150
150  120 30
Z=  0.75
40 40
P (x> 150) = P(Z >0.75)
Area to the right of Z=0.75
= 0.5000-0.2734
P(X>150) = 0.2266
Hence 22.66% of the accounts have a balance in excess of Rs.150
ii) Probability that the accounts lie between Rs.100 and Rs.150
i.e. P(100 < X150)
100  120
When X=100 Z= = -0.5
40
150  120
When X=150 Z= = Z-0.75
40
P(100 < x <150) =P (-0.5 < x 7.5)
Area between Z= -0.5 and Z=0.75
= Area between Z= 0.5 and Z=0 + Area between Z=0
and Z=0.75
= P (0 ≤ Z ≤ 0.5) + P (0 ≤ Z≤0.75)
= 0.1915 + 0.2734
= 0.4649

Figure 8.4
Hence 46.49% of the accounts have an average balance between Rs.100
And Rs.150

150
iii) Here we want to find P (60 ≤ X ≤90)
60  120
When X=60 Z = = -1.5
40
90  120
X=90 Z = = -0.75
40

Figure 8.5

P (60≤ X≤ 90) = P (-1.5 < Z < 0.75)

P (0.75 ≤ Z ≤ 1.25) by symmetry
= Area between 0.75 and Z=1.25

= Area between Z=0 and Z=1.25

= Area between Z=0 and 0.75
= 0.4332 -0.2734

= 0.1598
Hence 15.98 % of the accounts lie between Rs.60 and Rs.90
Example 8.19

In an intelligence test administered to 1000 students the average score was

42 and standard deviation 24 find a) the number of students exceeding a
score of 50 b) the number of student lying between 30 and 54 c) the value
of score exceeded by the top 100 students.
Solution
a) Given X =42
X=50  = 24
XX 50  42
Z= = = 0.333
 24
Area to the right of ordinate at 0.333 is 0.5 – 0.1304 = 0.3696
The expected number of children exceeding a score of 50

151
 = 0.36896 x 1000 = 369.6 or 370
b) Standard normal variate for score 30 when
XX 30  42
X=30 Z = = = -0.5
 24
54  42
When X= 54, Z= = 0.5
24
Area from Z = 0 to Z-0.5 =0.1915
Area from Z = -0.5 to Z=0 = 0.1915

Area from Z = -0.5 to Z=0.5 =0.1915+ 0.1915

= 0.3830
Thus the no. of children having score between 30 and 54
= 0.383 x 1000 = 383
c) Probability of getting top 100 students
100
=  0.1
1000
Standard normal variate having 0.1 are to the right =2.81
Standard normal variate for score X
XX
Z=


X  42
1.281 =
24
1.281 x 24 = X-42
X = 42 + 1.281 x 24

= 42 + 30.74
= 72.74
X = 73
8.2.6 Fitting the Normal Curve

There are two main objects of fitting a normal curve to sample data
1) To provide a visual device for judging whether or not the normal
curve is a good fit to the sample data

152
 2) To use the smoothed normal curve, instead of the irregular curve
representing the sample data, to estimate the characteristics of the
population.

Methods of Fitting
The following two methods are used to fit a normal curve to an observed set
of data

1. Method of ordinates
2. Method of areas
Ordinate Method

We know that the ordinate on the mean value has the maximum height. Let
the size of this be known first. We know that the probability function a
normal curve is
1 2
  x  
1 e 2  
  
P (x) =
 2
Since √2 =2.5006 and e =2.71828
2
1  X  
1   
 
P(x) = ( 2.71828) 2 
2.5006
In order to find out absolute height of the ordinate we have to put n in place
of Ni in the numerator of the function which now becomes
2
1  X  
Ni   
 
Y= ( 2.71828) 2 
2.5006
Ni
Y = 0.399

This is because at the point of Mean, X- µ =0
2
1  X
i.e. -1/2     0
2  

The other ordinate heights can be found with the help of table of Z values
which is indicated by the standard normal variation.
X
Z=


153
ii) Area Method
The ordinate height of a given value the horizontal axis gives the frequency
Density whereas the area between two ordinates gives the relative
frequency In the range of values. Although there is no basic difference in
the two, whereas the maximum height of the ordinate is one the mean, the
extent of area covered will depend on the range of values.

Relative frequency = Relative frequency density  class interval

(Ordinate height)
The ordinate height and the area are therefore intimately connected. The
Separate tables are available for both with reference to the Z – value and
therefore it should be grasped fully before detailed calculation of area or
ordinate heights are taken up
Example 8.20 Construct a normal distribution with N=1000, i= 2 =16
 = 4 This can be one with the help of ordinate heights for given
variate values of say 4,8,12,16,20,24 and 28 as well as the area in
between these ordinates. The method of calculating ordinate heights
and areas is shown below:
Solution

Table values of
relative Ordinate Table values of Area in
x  ordinate heights for relative area Absolute
b/w
X heights for Ni Ni area
  500 z for  500 z given z
1000 z
x    values


4 -3 0.0044 2.2 0.4987 - 4772 0.0215 21.5

04772 –
8 -2 0.0540 27.0 0.1359 135.9
0.3413

12 -1 0.2420 121.0 0.3413 0.3413 341.3

16 0 0.3989 199.4 0.000 0.0000 0

20 1 0.2420 121.0 0.3413 0.3413 341.3

24 2 0.0540 27.0 0.4772-0.3413 0.1359 135.9

28 3 0.0044 2.2 0.4987-0.4772 0.0215 21.5

154
Example 8.21 A sample of 100 dry batter cells tested to find the length
of life produced the following results

X= 12 hrs = 3 hrs.

Assuming the data to be normally, distributed what percentage of battery

cells Are expected to have life.
a) More than 15 hrs

b) Less than 6 hrs and

c) Between 10 to 14 hrs
d) Given Z: 2.5 2 1 0.67
Area: 0. 4938 0.4772 0.3413 0.02487
Solution
Let the random variable x denote the length of life of day battery cells
i) P (X=15) = P (Z=1)
It is under the standard normal curve to curve of 2 = +1
=0.5000 – 0.3413 = 0.1587 or 15.87%
ii) P (X <6) = P (Z<-2)
6  12
Where Z = = -2
3
Area under the standard normal curve to the left to 2= -2

= Area to the right of Z=2

= 0.5000 - 0.4772
= 0.228 = 2.28%

iii) P (10< X<14) =P(-0.67 < Z < 0.67)

Area under the standard normal curve between Z= - 0.67 to Z=0.67
= 2 (Area between Z=0 and Z=0.67)

= 2  0.2484
= 0.4974 =49.74%

155
LET US SUM UP
In this unit, we have discussed the concepts of continuous distribution. We
have discussed the problems related to the normal distribution, its
properties and area under normal curve.
CHECK YOUR PROGRESS

1. In a normal distribution 31 % of the items are under 45 and 8% are

over 64. Find the mean and standard deviation of the distribution.
2. A random variable X follows Poisson law such that P (X) = (C) =
P (X=K+1). find its mean and variance.

3. If 5% of the electric bulbs manufactured by a company are defective.

We Poisson distribution to find the probability that in a sample of 100
Bulbs. i) none is defective ii) 5 bulbs will be defective
4. 8 coins are tossed at a time, 256 times. Find the expected
frequencies of success (getting ahead) and tabulated the result
obtained. Find the mean and S.D of the fitted distribution.
GLOSSARY

Normal Distribution : The normal distribution is

( x )
1
p ( x)  e 22
, -
 2
  x   Where x – values of the
continuous random variable,  – mean of the
normal random variable. e – Mathematical
constant approximated by 2.7183.  –
Mathematical constant approximated by
3.1416.
:
Gaussian Distribution Gaussian distribution (also known as normal
distribution) is a bell-shaped curve, and it is
assumed that during any measurement
values will follow a normal distribution with
an equal number of measurements above
and below the mean value.
:
Continuous A continuous distribution is one in which data
can take on any value within a specified

156
Distribution range (which may be infinite).
:
Standard Normal A standard normal variate is a normal variate
Variate with mean µ=0 and standard deviation σ =1

SUGGESTED READINGS
1. Arora, P.N. & S. Arora, (2007) ,Statistics for Management, latest
Edition, S. Chand & Company Ltd., New Delhi.
2. D.C.Sancheti, V.K.Kapoor,( 2014), Business Mathematics, 11th
edition, Reprint, Sultan Chand and Sons, New Delhi.
3. Gupta, B.N., (2015), Business Statistics, First Revised Edition,
SBPD, New Delhi.
4. JK. Sharma, (2009), Business Mathematics Theory And
Applications, 13th Edition, ANE Books, New Delhi.
5. S. P. Gupta, (2012), Statistical Methods, 42nd Revised Edition Sultan
Chand & Sons Pvt. Ltd., New Delhi.
6. https://epgp.inflibnet.ac.in/Home/ViewSubject?catid=ahLCajOqz6/G
WFCSpr/XYg==
7. https://www.investopedia.com/terms/n/normaldistribution.asp
ANSWERS TO CHECK YOUR PROGRESS

1. a. μ =50 b. σ = 10
2. Mean=variance = K+1
3. i) =0.007 ii) =0.1821
4. Mean =4 , S.D = 1.414 expected Frequencies are 1,8,28,
56,7056,28,8,and 1

157
 BLOCK 3

DATA ANALYSIS

Unit 9 : Presentation of Data

Unit 10 : Data Analysis: Central Tendency
Unit 11 : Data Analysis: Measures of
Dispersion
Unit 12 : Bivariate Analysis: Correlation

158
Unit 9

PRESENTATION OF DATA
STRUCTURE

Overview
Learning Objectives
9.1 Introduction

9.1.1 Primary data

9.1.2 Reasons for use of Primary data
9.1.3 Methods of collecting primary data

9.2 Secondary Data

9.2.1 Advantages of Secondary data
9.2.2 Choice between secondary data and primary data

9.2.3 Sources of secondary data

9.3 Classification and Tabulation of data
9.3.1 Introduction

9.3.2 Objectives of classification

9.4 Types of Classification
9.4.1 Geographical classification

9.4.2 Chronological classification

9.4.3 Qualitative classification
9.4.4 Quantitative classification

9.5 Formation of continuous distribution

9.5.1 Class limits
9.5.2 Class Intervals

9.5.3 Class frequency

9.6 Graphical and diagrammatic representation
9.6.1 Diagrams

159
 9.6.2 Types of Diagrams
9.7 Graphs of frequency distribution
9.7.1 Histogram

9.7.2 Frequency polygon

9.7.3 Frequency curve
9.7.4 Cumulative frequency curves or ogives

Let Us Sum Up
Check Your Progress
Glossary

Suggested Readings
Answers to check your
OVERVIEW

This unit deals with collection of data i.e. primary and secondary data. It
deals with the presentation of data by various methods. We will learn how to
tabulate the given data, classification of data and diagrammatic
representation of data. Graphs of frequency distribution like Histogram,
frequency polygon, frequency curve and ogive will be discussed at the end
of this unit.
LEARNING OBJECTIVES
After reading this unit you, should be able to,

 explain stand the classification of data

 illustrate how to draw one dimensional, two dimensional diagram

 explain the construction of pie diagram bar diagram and draw

frequency curve, frequency polygon, ogive curve etc

 discuss diagrammatic representation of given data..

9.1 INTRODUCTION

Data may be obtained either from the primary source or the secondary
source. A Primary source is one that itself collect the data. A secondary
source is one that makes available data which were collected by some other
agency. A primary source usually has more detailed information, particularly

160
on the procedures followed in collecting and compiling the data. It may be
noted that a given source may be partly primary and partly secondary.
9.1.1 Primary Data

Primary data are obtained by a study specifically designed to fulfill the data
needs of the problem at hand. For example data obtained in a population
census by the office of the registrar general and census Commissioner.
Ministry of home affairs, are primary data.
9.1.2 Reasons for use of Primary Data

i) The secondary source may contain mistakes due to errors in

transcription made when figures were copied from primary source.
ii) Primary data includes definition of terms and units used.
iii) It includes a copy of the schedule and description of the procedure
used.
iv) It shows the data greater in detail.
9.1.3 Methods of Collecting Primary Data

Primary data may be obtained by applying any of the following methods.

i) Direct personal interviews
ii) Indirect oral interviews

iii) Information from correspondents

iv) Mail questionnaire method
v) Schedules sent through enumerators

i) Direct personal interview: In this method, there is a face to face

contact with the persons from whom the information is to be obtained. The
interviewer asks them questions pertaining to the survey and collects the
desired Information. Thus, if a person wants of data about the working
conditions of the workers of some textiles company, we would obtain the
desired information.

Merits

 Response is more encouraging

 People are much eager to supply information

 Collected information is likely to be accurate

161
  It will be useful to clear the doubts

 The language communication can be adjusted

 The questions in this method are very simple.

Demerits

 It may be costly where the number of persons to be interviewed is

large.

 The interviewer has to be thoroughly trained and supervised.

 Untrained or poorly trained people may spoil the entire work.

 More time is required for collecting information.

 Chances of personal prejudice and bias are greater.

ii) Indirect oral interviews: In this method of collecting data the
investigator contacts third parties called witness, capable of supplying the
necessary information. This method is adopted when the information to be
obtained is of a complex nature and informants are not inclined to respond
directly. For example, the committee appointed by the Government adopts
this method to get people’s views and all possible details of facts relating to
the enquiry. It is very popular in practice. If the people do not know the full
facts of the problem under investigation it will not be possible to arrive at
correct conclusions.
 Utmost care must be exercised in the selection of these persons.
 For the success of this method it is necessary that the evidence of
one person alone is not relied upon.
 It is suitable in such cases where indirect sources of information are
required to be tapped either because direct sources do not exist or
cannot be relied upon or would be reluctant to part with the
information.

iii) Information from correspondents: Under this method the investigator

appoints local agents or correspondents in different places to collect
information. These correspondents collect and transmit the information to
the central office where the data are processed.

 Newspaper agents adopt this method.

 Correspondents supply information to the head office.

 It is also adopted by various departments of Government.

162
  It may not always ensure the accurate result, because of the
personal prejudice and bias of the correspondents.

 This method is generally adopted in those case where the

information is to be obtained at regular intervals from a wide area.

 It is particularly suitable in case of crop estimates.

 The special advantage of this method is that it is cheap and

appropriate for extensive investigation.

iv) Mail questionnaire method: Under this method, a list of questions

pertaining to the survey is prepared and sent to the various informants by
post.

 The questionnaire contains questions and space for answers

 It can be classified on the basis of

 The degree to which questionnaire is formalized.
 The disguise or lack of disguise of the questionnaire.
 The communication method is used.

 In case of sequence questions is followed it is referred as structured

study

 The questionnaire should be clear to the respondents

 There are four types of disguised and structured studies
 Non-disguised structured
 Non- disguised non-structured
 Disguised structured

 Disguised non-structured
Merits

 Collecting the data should be very even the field investigation is vast
and wide

 It is cheap and expeditious provided the information

 It is generally superior to either personal interviews or telephone

method or telephone

163
Limitation

 In case of literate people, this method should be adopted

 It involves some uncertainty about the response

 Co-operation on the part of informants may be difficult to presume

 The information supplied by the informants may not be correct

 It may be difficult to verify the accuracy

v) Schedules sent through enumerators: In this method, schedules are

sent through the enumerators or interviewers. The enumerators contact the
informants, get replies to the questions contained in a schedule and fill them
their own handwriting in the questionnaire form. In this method the
questionnaire form is sent to the informants by post.
Merits

 It can be adopted in those case where informants are illiterate

 There is very little non- response as the enumerators go personally to
obtain the information

 Information received is more reliable

Limitations

 Success of this method is due to large number of training imparted

to the enumerators

 Without interviewing most of the information collected is of doubtful

value

 The way in which the enumerators conduct the interview would

affect the data collected
9.2 SECONDARY DATA

The data which are not originally collected but rather obtained from
published or unpublished sources are known as secondary data. It
constituted the chief material on the basis of which statistical work is carried
out in many investigations. The difference between the primary and
secondary data is the only of degree. Data which are primary in the hands
of one becomes secondary in the hands of another.

164
9.2.1 Advantages of Secondary Data
It is highly convenient to use information which someone has compiled.

 If the secondary data are available they are much quicker to obtain than
primary data

 Secondary data may be available on some subjects where it would be

impossible to collect primary data.

 However, two major problems are in countered in using secondary data

 The first is the difficulty of finding data which exactly it needs. The
second problem is finding data which are sufficiently accurate
9.2.2 Choice between Secondary Data and Primary Data

 Nature and scope of the enquiry

 Availability of time

 Degree of accuracy desired and the collecting agency i.e. whether

an individual, an institution or a Government body

 Availability of financial resources

9.2.3 Sources of Secondary Data

In most of the studies the investigator finds it impracticable to collect. First

hand information on all related issues and as such he make use of the data
collected by others. There is a vast amount of published information from
which statistical studies may be made and fresh statistics are constantly in a
state of production. The sources of secondary data can broadly be
classified under two heads.
a) Published sources
b) Unpublished sources
a) Published sources: The various sources of published data are (1)
reports and official publications of
i) International bodies such as the World Bank, International Labor
Organization, Statistical office of the United Nations.
ii) Central and State Governments such as Abstract of the Indian
Union, Economic Survey of 2000-2001, Government of India,
Ministry of Finance.

165
 iii) Reports of the Committees and commissions such as Report of the
committee on corporate Governance, Semi-official publications of
various local bodies such as Municipal corporations and District
Boards.
Publications of autonomous and private institutes such as:

 Trade and professional bodies, such as the Federation of Indian

Chambers of Commerce and Industry, the Institute of Chartered
Accountants, the Institute of Foreign Trade. The prestigious journals
of these institutes are respectively “Economic Trends” the Chartered
Accountant, Foreign Trade Review.

 Financialand economic Journals such as Indian Economic Review,

Reserve Bank of India Bulletin, Indian Finance.

 Annual reports of Joint stock companies and corporations

 Publicationsbrought out by various autonomous Research Institute
and Scholars such as Institute of economic growth.
b) Unpublished sources: All statistical material is not always published.
There are various sources of unpublished data such as records maintained
by various Government and private offices, studies made by research
institutions, scholars etc. Such sources can be used where necessary.
9.3 CLASSIFICATION AND TABULATION OF DATA
9.3.1 Introduction

After collection and editing of data, the first step towards further processing
the same is classification. It is the grouping of related facts into classes. It is
a function very similar to that of sorting letters in post office. The process
with the help of which this information in a summary form is obtained is
called the classification of data.
9.3.2 Objectives of Classification

The principle objectives of classifying data are:

 To arrange millions of figures in a few classes having common

features.
 To pin point the most significant features of the data at a
glance.
 To give prominence to the important information gathered while
dropping out unnecessary elements.

166
  To enable a statistical treatment of the material collected.
9.4 TYPES OF CLASSIFICATION

a) Geographical i.e. area wise.

b) Chronological i.e. on the base time

c) Qualitative i.e. according to some attributes.
d) Quantitative i.e. in terms of magnitudes.
9.4.1 Geographical Classification

In this type of classification data are classified on the basis of geographical

or vocational differences between the various items, like states, cities,
regions zones, etc. These are usually listed by size to emphasize the
important areas as in ranking the States by population. Normally, in
reference table the first approach is followed and in summary tables the
second approach is followed.
9.4.2 Chronological Classification
When data are observed over a period of time the type of classification is
known as chronological classification. For example, we may present the
figures of population for production, sales etc. as follows.
Population of India from 1941 to 1991 in corers

Year Population Year Population

1941 31.87 1971 54.82

1951 36.11 1981 68.33

1961 43.92 1991 84.63

Time series are usually listed in chronological order, norms starting with the
earliest period. When the major emphasis falls on the most recent events, a
reverse time order may be used.
9.4.3 Qualitative Classification
In qualitative class fixation, data are classified on the basis of some attribute
or quality such as sex, colour of hair, literacy, religion etc. The point to note
in this type is that the attribute under study cannot be measured. One can
only find out it is present or absent in the units of population under study.

167
For example if the attribute under study is population, one can find out how
many persons are living in urban area and how much in rural area. These
types of classification are simple classification.

Population

URBAN RURAL

Figure 9.1
In a similar manner, we may classify population on the basis of sex, i.e into
males and females or literacy i.e into literate and illiterate and so on. The
type of classification where only two classes are formed is also called two-
fold or dichotomous classification. We further divide the data into several
classes, this type of classification is known as manifold classification.

Population

MALE FEMALES
S

LITERATES ILLITERATES LITERATES ILLITERATES

EMP UNEMP EMP UNEMP EMP UNEMP EMP UNEMP

Figure 9.2
9.4.4 Quantitative Classification

It refers to the classification of data according to some characteristics that

can be measured such as height, weight, income, sales, profits, production
etc.,
For example, the students of a college may be classified according to
weight as follows

Weight 90-100 100-110 110-120 120-130 130-140

No. of students 50 200 260 360 90

168
Such distribution is known as empirical frequency distribution or simple
frequency distribution. A frequency distribution refers to data classified on
the basis of some variable that can be measured such as prices, wages,
age, number of units produced or consumed. The term variable refers to
the characteristic that varies in amount or magnitude in a frequency
distribution. A variable may be either continuous or discrete. A continuous
variable, also called continuous random variable on the other hand, a
discrete variable is that which can vary only be finite jumps and cannot
manifest every conceivable fractional value.

DISCRETE CONTINUOUS

No. of Children No. of Families Weight No. of persons

0 10 100-110 10

1 40 110-120 15

2 80 120-130 40

3 100 130-140 45

4 250

Example 9.1 In survey of 35 families in a village, the number of children per

family was recorded and the following data obtained.
0 1 2 3 4 5 6 7 2 4 0 2 5
8 4 5 12 6 3 2 7 6 5 3 3 7

8 9 7 9 4 5 4 3 3
Represent the data in the form of discrete frequency distribution
Solution

No. of Children Tally bars Frequency

0 II 2

1 I 1

2 IIII 4

169
 3 IIII I 6

4 IIII 5

5 IIII 5

6 III 3

7 IIII 4

8 II 2

9 II 2

10 - 0

11 - 0

12 I 1

Total 35

9.5 FORMATION OF CONTINUOUS DISTRIBUTION

9.5.1 Class Limits

These are the lowest and highest values that can be included in the class.
For example, take the class 30-40. The lowest value is 30 and highest
value is 40. The lower limit of the class is the value below which there can
be no item in the class. The upper limit of a class in the value above which
no item. In the class, if we take the class 90-109, there can be no value in
that class which is less than 90 or more than 109.
9.5.2 Class Intervals

The difference between the upper and lower limit of a class is known as
class interval. An important decision while constructing a frequency
distribution is about the width of the class interval. An important decision
while constructing a frequency distribution is about the width of the class
interval, i.e whether should be 10,20,50,100,500 etc., the decision would
depend upon a number of factors such as the range in the data i.e
difference between highest and lowest data.

170
Simple formula to calculate the class interval i
L S
i.e. i 
K
L – Largest item, S – Smallest Item, K – The number of classes
For example, L= 5500 S=500, K=10
5500  500 5000
Therefore i =   500
10 10
The starting class would be 500-1000, the next class 1000-1500 and so on.
9.5.3 Class Frequency
The number of observations corresponding to a particular class is known as
frequency of that class or the class frequency class mid value can be
calculated by
Mid point of a class = Upper Limit + Lower Limit
2

There are two methods of calculating mid value

i) Exclusive method
ii) Inclusive method

In exclusive method, when class intervals are so fixed that the upper limit of
one is the lower limit of the next class. In inclusive method, the upper limit
of one class is included in that class itself.
Example 9.2 Prepare a frequency distribution for the following observations

15 45 40 42 50 60 62 68 70 42
75 75 80 81 25 26 31 32 78 45

31 45 42 43 55 56 78 80 81 62
60 62 58 69 70 45 50 56 72 58
75 62 62 65 60 70 35 37 40 55
Solution

Since the lowest value is 15 and largest value is 81 we take the interval
is 10.

171
 Variable Tally bars Frequency

15-25 I 1

25-35 IIII 5

35-45 IIII III 8

45-55 IIII I 6

55-65 IIII IIII IIII 14

65-75 IIII II 7

75-85 IIII 4

TOTAL 45

Format of a table

Title Head Note

Stub Heading Caption Heading – Column heading

Stub entries Body

Foot Notes Table number

9.6 GRAPHICAL AND DIAGRAMMATIC REPRESENTATION

9.6.1 Diagrams

Diagrams give a bird’s – eye view of the entire data and, therefore, the
information presented is easily understood. It is a fact that as the number
and magnitude of figures increases they become more confusing and their
analysis tends to be more strenuous. Pictorial presentation helps in proper
understanding from it. They have great memorizing effect. It is a very
popular in Exhibitions, conferences, board Meetings and public functions. It
is one in making quick and accurate comparison of data.

172
9.6.2 Types of Diagrams
i) One - dimensional bar diagrams
ii) Two - dimensional bar diagrams

iii) Three - dimensional bar diagram

iv) Pictographs
v) Cartograms

i) One - dimensional bar diagrams: These are the most common type of
diagrams used in practice. A bar is thick line whose width is known merely
attention. They are called one-dimensional because it is only the length of
the bar that matters and not the width. When the number of terms is large,
lines may be drawn instead of bars to economize space.
Merits
 They are simplest and easiest
 Easy to understand
 The gap between one bar to another should be uniform
 Compare with large number of items, it is too easy to understand.
Types of Bar Diagrams
Bar diagrams are of the following types:

 Simple bar diagrams

 Sub-divided bar diagrams
 Multiple bar diagrams

 Percentile bar diagrams

 Deviation bars
Simple Bar Diagrams: It is used to represent only one variable. These are
very popular in practice. This can be either vertical or horizontal. In
practice vertical bars are more popular in practice. However, an important
limitation in such diagrams is that they can present only one classification or
one category of data.

173
 100
90
80
70
60
50
40
30
20
10
0
INDIA U.K. CHINA SWEDEN

Figure 9.3
Sub-Divided Bar Diagrams: In a sub-divided bar diagram each representing
the magnitude of a given phenomenon is further sub divided in its various
components. Each component occupies a part of the bar proportional to its
share in the total. It should not be used where the number of components is
more than 10 to 12. To distinguish between the different components, it is
better to use different shades or colours. The sub-divided bar diagrams can
be constructed both as horizontal and vertical bars.

90
80
70
60
50
40
30
20
10
0
1 2 3 4

INLAND MARINE

Figure 9.4
Multiple Bars: In a multiple bar two or more sets of interrelated data are
represented. The technique of drawing such a diagram is the same as that
of simple Bar diagram. The only difference is that since more than one the
phenomenon is represented, different shades, colours, dots or crosses are
used to distinguish between the bars. In case of two ore more related
variables, we use multiple bar diagram.

174
 100
90
80
70
60
50
40
30
20
10
0
1 2 3
Sales Net profit Gross profit

Figure 9.5

Percentage Bars: These are particularly useful in statistical work which

requires the portrayal of relative changes in data. When such diagrams are
prepared, the length of bars is kept equal to 100 and segments are cut in
these bars to represent the components of an aggregate.

120

100

80

60

40

20

Wages Others Polution Profit

Figure 9.6

Deviation Bar: These are popularly used for representing net quantities –
excess or deficit, i.e net profit, net loss, net exports or imports etc. Such
bars can have positive and negative values. Positive values are shown
above the base line and negative values below it.

175
 50
40
30
20
10
0
1995-96 1996-97 1997-98
-10
-20
-30

sales metprofits

Figure 9.7
ii)Two-dimensional bar diagrams: In two dimensional diagrams the length
as well as width of the bars is considered. Thus the area of the bars
represents the given data. These are also known as surface diagrams or
area Diagrams.
a) Rectangular diagrams

b) Squares
c) Circles
d) Pie Diagram

Rectangular diagrams: This form is quite popular, since the area of a

rectangle is equal to the product of its length and width, while constructing
such a diagram both length and width are considered.

When two sets of figures are to be represented by rectangles, either of the

two methods may be adopted.

176
 120
100
80
60 Miscellance
40
20 Light
0 Rent
Family A Family B
Miscellance 5 8 Clothing
Light 5 2
Food
Rent 20 10
Clothing 30 30
Food 40 50

Figure 9.8
Squares: The rectangular method is difficult one, we use where the values
of items vary widely. The method of drawing a square diagram is very
simple. One has to take the square – root of the values of various items
that are to be shown in the diagrams and then select a suitable scale to
draw the square Plans
IV
III I
II I
I

Figure 9.9
Circles: Another way of preparing a two dimensional diagram is the form of
circles. In such diagrams both the total and component parts or sector can
be shown. The area of a circle is proportional to the square of its radius. As
in the construction of squares, the square roots of various figures are
worked out while constructing the circle. However, in the latter case the
radius of the circles can be obtained by dividing the value of pie and taking
square – root. Circles can be used in all those cases in which squares are
used.
Example 9.3: Represent the data with help of circles

Five
I II III IV V VI VII VIII
Year

177
 Plans 19
4672 8577 16566 35595 68380 180000 325000
Outlay 60

Solution

Square-root
Outlay Dividing by
n-(22/7)

I 1960 624 24.98

II 4672 1486.54 38.57

III 8577 2729.53 52.24

IV 16566 5271.80 72.63

V 35595 11325.68 106.61

VI 69380 22075.54 148.57

VII 180000 57272.72 239.31

VIII 325000 103409.04 321.57

178
 VIII Plan

VII Plan

VI Plan

V Plan

IV Plan

III Plan

II Plan

I Plan

Figure 9.10
We use the formula to find out the radius
Area of a Circle = r2
Area
r2 =

Area
r =

Pie Diagram: These are very popularly used in practice to show percentage
breakdowns for example, with the help of a pie diagram we can show how
the expenditure of the Government is distributed over different heads like
agriculture, Irrigation, Industry, Transport, Defence etc. By using pie

179
diagram, we show the distribution of expenditures to various departments.
The pie chart is so called because the entire graph looks like a pie and the
components resemble slices cut from pie. These are making on a
percentage basis and not an absolute basis, since a series of pie diagrams
showing absolute figures would require that larger totals be represented by
larger circles. When pie diagrams are constructed on a percentage basis,
percentages can be presented by circles equal in size.
Procedure to Draw Pie Diagrams

 To prepare the data so that the various components values can be

transposed into corresponding degrees on the circle. Suppose we
divide the circle into 4 components representing the values.
i) 60% ii) 25% iii) 10% iv) 5%
The values are
360
i) 60 x 3.6 = 216 Note: = 3.6
100

ii) 25 x 3.6 = 90
iii) 10 x 3.6 = 36
iv) 5 x 3.6 = 18
 To draw a circle of appropriate size with a compass

 To measure the points on the circle representing the size of each

sector with the help of protractor. The ordinary protractor is based
upon a scale in which the total circle is 360 degrees.
Example 9.4 Draw a pie diagram for the following data of sixth five year
plan public sector outlays
Agriculture and Rural Development 12.9%

Irrigation etc 12.5%

Energy 27.2%
Industry and Minerals 15.4%

Transport, communication 15.9%

Social services and others 16.1%

180
Solution
The angle at the centre is given by
Percentage outlay
x 360 = Percentage outlay x 3.6
100
Computation for pie diagram

Sector Percentage Angle outlay

Agriculture and Rural

12.9 12.9 x 3.6 =46
development

Irrigation etc., 12.5 12.5 x 3.6=45

Energy 27.2 27.2 x 3.6 =98

Industry and Minerals 15.4 15.4 x 3.6 =56

Transport, Communication 15.9 15.9 x 3.6 = 57

Social services and others 16.1 16.1 x 3.6 = 58

Total 100 360

15.4

27.8

15.9

12.5

16.1
Energy 12.9 Irrigation
Agriculture & Rural Development Social services & others
Transport Industry & Minerals

Figure 9.11
iii) Three – dimensional bar diagrams: It is also known as volume
diagrams. It consists of cubes, cylinders, spheres etc., in such diagrams
three things length, width and height have to be taken into account. Such
diagrams are used where the Range of difference between the smallest and
the largest value is very value.

181
iv) Pictographs: These are very popularly used in presenting statistical
data. They are not abstract presentations such as lines or bars but really
depict the kind of data we are dealing with. Pictures are attractive and
easy to comprehend and as such this method is particularly useful in
presenting statistics to the layman. While constructing pictographs we keep
the points in mind.

 The pictorial symbol should be self – explanatory changes in numbers

are shown by more.
 Pictographs should be simple to understand and convey essential facts.

Pictographs

Figure 9.12
v) Cartograms: These are used to give quantitative information on a
geographical basis. They are used to represent spatial distributions. The
quantities on the map can be shown in many ways. Such as through shades
or colours, by dots, by placing pictograms in each geographical unit and by
placing the appropriate numerical figure in each geographical unit.
9.7 GRAPHS OF FREQUENCY DISTRIBUTION

Frequency distribution can be presented graphically in any of the following

ways.

a) Histogram
b) Frequency Polygon
c) Frequency curve

d) Cumulative Frequency curves (or) ogives

182
9.7.1 Histogram
A histogram is a set of vertical bars whose areas are proportional to the
frequencies represented. While constructing histogram the variable is
always taken on the x –axis and the frequencies depending on it on the Y-
axis. Each class is then represented by a distance on the scale that is
proportional to its class-interval. The distance for each rectangle on the X-
axis shall remain the same. If they are different they vary. The Y-axis
represents the frequencies of each class which constituted the height of its
rectangle. The area of the histogram represents the total frequency as
distributed throughout the classes. It should clearly distinguished from a bar
diagram. It is most widely used for graphical presentation of a frequency
distribution.
In case of unequal internal we cannot construct histogram. The technique of
constructing histogram is given below i) for distributions have equal class
intervals and ii) for distributions having unequal class – intervals. When the
class intervals are equal, take frequency on Y axis, the variables on x axis
and construct adjacent rectangles. When class internals are unequal, a
correction for unequal class intervals must be made. For making adjustment
we take that class which has lowest class interval and adjust the
frequencies of other classes. If one class interval is twice as wide as the
one having lowest class interval we divide the height of its rectangle by two,
if it is three times more we divide the height of its rectangle by three, etc.
The heights will be proportional to the ratio of the frequencies of the width of
the class.
Example 9.5 Represent the following data by a histogram.

Marks 0 – 10 10 – 20 20 – 30 30 – 40 40 – 50

No. of Students 4 10 6 5 7

Solution

Since the class intervals are equals no adjustment is required. Plot marks in
X axis and number of students marked into Y axis.

183
 12
10

No. of Students
8
6
4
2
0

Marks

0-10 10-20 20-30 30-40 40-50

Figure 9.13
9.7.2 Frequency Polygon

It means that ‘many angled’ diagram. A frequency polygon is a graph of

frequency distribution. It has more than four sides. It is particularly effective
in comparing two or more frequency distributions. There are some ways to
construct frequency polygon.

i) Draw the histogram to the given data.

ii) Mark the midpoint of each class interval.
iii) Join the each mid-point by straight line. We have to draw the
frequency polygon.
Example 9.6 Draw frequency polygon to the following data.

Interval: 0 – 10 10 – 20 20 – 30 30 – 40
Marks: 5 3 2 5

0
0

0-10 10-20 20-30 30-40

Figure 9.14

184
9.7.3 Frequency Curve
A smoothed frequency curve can be drawn through the various points of the
polygon. The curve is drawn freehand in such a manner that the area
included under the curve is approximately the same as that of the polygon.
For drawing a smoothed frequency curve it is necessary to first draw the
polygon and then smooth it out. First to draw a histogram then a polygon
and lastly to smooth it to obtain the smoothed frequency curve. The Area
under the curve should represent the total number of frequencies in the
entire distribution.
Example 9.7 Represent the following frequency distribution by means of a
histogram and frequency polygon and frequency curve.

300- 400- 500- 600- 700- 800- 900- 1000-

Salary
400 500 600 700 800 900 1000 1200

No. of
20 30 60 75 115 100 60 40
employees

140
120
100
80
60
40
20
0
1

300-400 400-500 500-600 600-700

700-800 800-900 900-1000 1000-1200

Figure 9.15
9.7.4 Cumulative Frequency Curves or Ogives

When the frequencies are added, they are called cumulative frequencies.
These frequencies are then listed in a table called cumulative frequency
table. The curve obtained by plotting cumulative frequencies is called a
cumulative frequency curve (or) ogive curve.
There are two types in this ogive curve

a) “The less than” ogive

b) The “greater than” ogive

185
In “Less than” ogive method, we start with the upper limits of the classes
and go on adding the frequencies. When these frequencies are plotted we
get a rising curve.

In “More than” ogive method, we start with the lower limits of the classes
and go on subtracting the frequencies of each class. When frequencies are
plotted we get a declining curve.
Example 9.8 Construct more than ogive and less than ogive curve to the
following frequency distribution.

Marks 10-20 20-30 30-40 40-50 50-60 60-70

No. of
4 6 10 20 18 2
Students

Solution

Cumulative
Cumulative
Class Class Frequency
Frequencies Frequency Class IDT
Interval interval greater
‘less than’
than

10 – 20 4 20 4 70 60

20 – 30 6 30 10 60 56

30 – 40 10 40 20 50 50

40 – 50 20 50 40 40 40

50 – 60 18 60 58 30 20

60 – 70 2 70 60 20 2

Ogive by the "more than" method

186
 70
60
50
40
30
20
10
0
0 2 4 6 8

Figure 9.16

Ogive by less than method

70

60

50

40

30

20

10

0
0 20 40 60 80

Figure 9.17
LET US SUM UP
In this unit, data collection and classification of data has been discussed.
We have learnt construction of pie diagram, bar diagram, frequency polygon
and ogive curve. The method of collecting primary data and secondary data
is also explained here.
CHECK YOUR PROGRESS

Choose the Correct Answer:

1.__________ are the lowest and highest values that can be included in the
class.
a) Class Limits b) Class interval
c) Class frequency d) Both a and b

187
2. In __________, when class intervals are so fixed that the upper limit of
one is the lower limit of the next class
a) inclusive method b) diagram method

c) extensive methods d) exclusive method

3. A __________ is a set of vertical bars whose areas are proportional to
the frequencies represented.

a) Frequency Polygon b) histogram

c) Frequency curve d) Cumulative
Frequency curves
4. A __________ is a graph of frequency distribution.
a) histogram b) Frequency Polygon
c) Frequency curve d) Cumulative
Frequency curves
5. A __________is a type of graph that represents the data in the
circular graph.
a) bar chart b) histogram
c) pivot chart d) pie chart
GLOSSARY

Primary Data Primary data is data that is collected by a

researcher from first-hand sources, using
:
methods like surveys, interviews, or
experiments.

Secondary Data Secondary data is the data that has already

been collected through primary sources and
: made readily available for researchers to use
for their own research. It is a type of data that
has already been collected in the past.

Frequency Curve A frequency-curve is a smooth curve for

which the total area is taken to be unity. It is
:
a limiting form of a histogram
or frequency polygon.

188
Frequency Polygon A frequency polygon is a graph constructed
by using lines to join the midpoints of each
:
interval, or bin. The heights of the points
represent the frequencies.

Histogram A histogram is a chart that groups numeric

data into bins, displaying the bins as
: segmented columns. They're used to depict
the distribution of a dataset: how often values
fall into ranges.

Pie diagram A pie chart is a type of graph that represents

:
the data in the circular graph.

Bar diagram Bar graph (bar chart) is a graph that

represents the categorical data using
:
rectangular bars. The bar graph shows the
comparison between discrete categories.

SUGGESTED READINGS
1. Arora, P.N. & S. Arora, (2007) ,Statistics for Management, latest
Edition, S. Chand & Comany Ltd., New Delhi.
2. D.C.Sancheti, V.K.Kapoor,( 2014), Business Mathematics, 11th
edition, Reprint, Sultan Chand and Sons, New Delhi.
3. Gupta, B.N., (2015), Business Statistics, First Revised Edition,
SBPD, New Delhi.
4. JK. Sharma, (2009), Business Mathematics Theory And
Applications, 13th Edition, ANE Books, New Delhi.

5. S. P. Gupta, (2012), Statistical Methods, 42nd Revised Edition Sultan

Chand & Sons Pvt. Ltd., New Delhi.
6. https://www.brainkart.com/article/Methods-of-collecting-primary-
data_35047/
7. https://www.toppr.com/guides/maths/data-handling/data-and-its-
frequency-distribution/
ANSWERS TO CHECK YOUR PROGRESS

1) a 2) d 3) b 4) b 5) d

189
Unit 10

DATA ANALYSIS: CENTRAL

TENDENCY
STRUCTURE
Overview
Learning Objectives
10.1 Introduction
10.2 Ungrouped data
10.2.1 Direct Method
10.2.2 Shortcut Method

10.3 Grouped data

10.3.1 Direct Method
10.3.2 Shortcut Method

10.4 Measures of Central Tendency

10.4.1 Introduction
10.4.2 Uses of average
10.4.3 Essentials of good average
10.5 Types of Averages
10.5.1 Mathematical Averages
10.5.2 Geometric Mean
10.5.3 Harmonic Mean
10.5.4 Median

10.5.5 Mode
Let Us Sum Up
Check Your Progress

Glossary
Suggested Readings

190
Answers to check your progress
OVERVIEW

In this unit we deal with the data analysis and its classification like
univariate, bivariate, data analysis. We discuss about grouped and
ungrouped data in various types of measures. We discuss the measures of
central tendency like mean, median, mode, geometric mean, Harmonic
Mean.
LEARNING OBJECTIVES

After reading this unit, you should be able to,

 explain central tendency or measures of location

 demonstrate the ungrouped data procedure.
 illustrate the process to find mode in grouping method.
 illustrate the various cases to find the measures.
10.1 INTRODUCTION
Data Analysis

Univariant Data Bivarient Data

Analysis Analysis

The data has been divided into two

a) Ungrouped data
b) Grouped data
10.2 UNGROUPED DATA

There are variable to be considered in the given distribution is called

ungrouped data Average,
a) Direct Method
b) Shortcut Method
10.2.1 Direct Method

In this method the values of the items given are summed up. Let X 1,
X2 …… Xn be various items in the series. The arithmetic mean X is
calculated by formula

191
 x1  x 2  . . .  x n x
x 
n n
The symbol  denotes the sum of n items.
10.2.2 Short –Cut Method

Under this method as assumed or an arbitrary average (indicated as

A) is used as the basis calculated of deviations from individual values. The
formula is

d
x  A
n
Where A- the assumed mean (or) Arbitrary selected value.
The value  d would be equal to zero if assumed average is equal to the
actual average.
The Principle on which the above method is based is that the algebraic
sum of deviations from an actual average is equal to zero. Therefore, the
deviations from any other figure will depend on how the assumed average is
related to the actual average.
The need for this method arises in a distribution where values are too
large and or in functions. Though this method calculated work is reduced a
great deal.
10.3 GROUPED DATA

In computation of arithmetic average for grouped data, the mid- point

of each class is used to represent the value of each item included in the
class. The mean computed from a frequently distribution thus may differ
from the mean computed from the original data, since not every one of the
actual values of the class would be the same value as the mid-point.
However, the difference is usually insignificant. Moreover the work of
computing the mean from a frequency distribution is much simple than that
from Ungrouped data comprising of a large number of items. In addition,
the original data may not be given If the frequently distribution table is
obtained from a published source.

192
10.3.1 Direct Method
The mean for grouped data is obtained from the following formula
 fx  fx
x  or
f N
Where x = The midpoint of the individual class
f = the frequency of individual class

N = the sum of the frequencies or f

10.3.2 Short Cut Method

The shortcut method of computing the arithmetic average for

grouped data is preferred in most cases, especially when the number of
classes in the given distribution is large. The method is easy to apply Same
size. The principle used in the illustration of the short-cut method of
computing the mean for ungrouped data can also be applied to the short-cut
method for grouped data.
Procedure of Short-Cut Method of Computing Mean

 Select assumed mean.

 Find deviation of each class mid-point from the assumed mean in
original units such as rupees, inches.
d = X – A.
 Deviation d multiplied byfd.
 Add these products to obtain the total deviation of all items included
in the distribution fd.
 Divide fd by f (or) N to obtain correction factor
 fd
x 
N .

 Add the correction factor to the assumed mean

 fd
x  A
N .

193
10.4 MEASURES OF CENTRAL TENDENCY
10.4.1 Introduction & Definition

One of the most important objectives of statistical Analysis is to get one

single value that describes the characteristic of the entire mass of unwieldy
data such value is called the central value or an average is very commonly
expected value of the variable.

An average is a single value selected from grouped values to represent

them in some way. Sometime it is described as a number which is typical of
the whole group.

It is an attempt to find one single figures. It is a representative figure which

is gist if not the substances of statistics.
10.4.2 Uses of an Average

a) It helps in comparison between two or more sets of data.

b) It helps to obtain a picture of a complete Universe by Means of
sample data.
c) An index number is also an average of change in a group with
reference to a given base.
d) Statistics is a science of average.
10.4.3 Essential of a Good Average
a) It should be rigidly detained.
b) It should be easy to understand.

c) It should be based on all items.

d) It should be capable of mathematical treatment because some
formulae is based on mathematical logic.

e) It should be capable of further statistical processing.

f) The average of different series should be capable of being
combined.

g) Therefore, no Average is good or bad much would depend on

the character of data and purpose for which an average is going to be
used.

194
 10.5 TYPES OF AVERAGES
I Mathematical Average

a) Arithmetic average or mean ( x )

b) Geometric Mean (G.M.)
c) Harmonic Mean (H.M.)
II Positional Averages

a) Median
b) Mode
III Business Averages

a) Moving Average (M.A)

b) Progressive Average (P.A)
c) Quadratic Average (Q.A)
10.5.1 Mathematical Averages
I Arithmetic Mean
a) The Arithmetic Average or Mean (x) is obtained by dividing the sum of
the value of all observations in a series (∑x) by the number of items (N)
constituting the series
i) Direct Method:
x1  x 2  x 3 ...  x n x
x =  (Individual case or ungrouped
n n
data)
ii) Shortcut method:

Under this method an assumed or an arbitrary average (indicated as

A) is used as the basis of calculation of deviation from individual values
d
x = A
n
where
A - assumed average

d – Deviation of each value from the assumed mean X-A

(ie) d=X -A

195
Example 10.1 Calculate X from the following data
2, 5, 7, 9, 15
Solution

Values Deviation from assumed

X mean d= X-12

2 -10

5 -7

7 -5

9 -3

15 +3

28 +16

x = 66 d = - 6

n=6
x 66
Direct Method: AM x =   6
n 6
d (6)
Short cut method: A.M ( x ) = A = 12 
n 6
= 11
Correcting the Incorrect Values

It sometimes happens that due to an oversight or mistake in copying certain

wrong items are taken while calculating mean. The problem is how to find
out correct mean. The process is very simple. From incorrect Ex deduct
wrong items and add correct items and then divide the correct x by the
number of observations. The result, we will obtain the correct mean.

196
Example 10.2 The Mean marks of 100 students were found to be 40.
Later on it was discovered that the score of 53 was misread as 83.
Find the correct mean corresponding to the correct score.

Solution
Given n = 100 x = 40
x
x 
n
x
40 
100
 x  40  100
 x  4000

But this is not correct ∑x

Therefore, correct ∑x = incorrect – wrong item + correct item
= 4000 – 83 + 53

= 3970
correct  x 3970
Therefore correct x =  = 39.7
n 100
Example 10.3 Mean of 100 observations in found to be 40. If at the
time of computation two items are wrongly taken as 30 and 27 instead
of 3 and 72. Find correct mean
Solution

Given n = 100
X = 40
x
X =
n
Therefore  x = X  n

∑x = 4000 But it is correct ∑x

Correct ∑x = Incorrect (∑x) - Wrong items + Correct items

= 4000 – (30+27) + (3+72)

= 4000 – 57+75

197
 = 4000 + 18
Correct ∑x = 4018
Correct  x 4018
Therefore correct X = ∑x =   40.18
n 100
Grouped Data
It has been divided into two types

(i) Discrete type

(ii) Continuous type
In both two types the frequency of the data is to be considered.
(i) Discrete Series
 fx
X = (direct Method)
N
 fd
X = (short cut Method)
N
Where N = ∑f,
Steps
(i) Multiply the frequency of each item with the variable and obtain the total
∑fx.
(ii) Divide the total obtained by step (i) by the total frequency
Example 10.4 Calculate Mean of the following data

Marks 20 30 40 50 60 70

No. of Students 8 12 20 10 6 4

Solution

Marks No. of Students

X f fx

20 8 160

30 12 360

40 20 800

198
 50 10 500

60 6 360

70 4 280

N = ∑f = 60 ∑fx =2460

 fx  dx 2460
X = X = =
N f 60
 A.M. ( X )= 41
Example 10.5 Calculate Mean by short-cut method to the following

Salaries (in Rs.000) 45 50 55 60 65 70 75 80

No. of persons 3 5 8 7 9 7 4 7

Solution

N =∑ f = 50
Assumed value A= 60

X d=X–A f Fd

45 -15 3 -45

50 -10 5 -50

55 -5 8 -40

60 0 7 0

65 5 9 45

70 10 7 70

75 15 4 60

80 20 7 140

N = 50 ∑fd = 180

∑ f =50, ∑ fd = 180

199
  fd
X = A
f
180
= 60 
50
= 60 + 3.6
AM ( X )= 63.6
Grouped Data – Continuous Series
In this type the midpoint of the interval is to be considered as X. The
frequency is given as usual. In this type we use

(i) Direct method

(ii) Shortcut method
(iii) Step deviation method
Mean of the given data
 fd  fd
X = A or X = A  xc
f f
X A
Where d = X-A, Where d 
C
Example 10.6

Calculate Average of the given data

Marks 0-10 10-20 20-30 30-40 40-50

No. of Students 5 10 25 30 20

by step deviation method

Solution

Mid XA
Marks d =X-A d f Fd
Value C

0-10 5 -20 -2 5 -10

10-20 15 -10 -1 10 -10

20-30 25 0 0 25 0

200
 30-40 35 10 1 30 30

40-50 45 20 2 20 40

50-60 55 30 3 10 30

∑f=100 ∑fd =80

 fd
X = A C
f
80
= 25   10
100
= 25 + 8 = X = 33
Example 10.7
Calculate average of the following by short cut method

Height (inches) 60-62 63-65 66-68 69-71 72-74

Frequency 15 54 126 81 24

Solution

A = 25

Mid Value
Height d = X-A f Fd
X

60-62 61 -6 14 -70

63-65 64 -3 54 -162

66-68 67 0 126 0

69-71 70 3 81 243

71-74 73 6 24 144

∑f =300 ∑fd =135

 fd
X = A
f

201
 135
= 67 
300
13.50
X = 67 
3
= 67 + 4.5
A.M. X  = 71.5

Example 10.8
Calculate Arithmetic mean of the following

Marks 0-10 10-20 30-60 60-100

No. of pupils 5 12 25 8

Solution

The class intervals are unequal but still to simplify calculations we can take
5 as common factor
A = 45, C = 5.

Mid Value XA

Height d f fd
X C

0-10 5 -8 5 -40

10-30 20 -5 12 -60

30-60 45 0 25 0

60-100 80 7 8 56

∑f = 50 ∑fd = 44

 fd
(X) = A C
f
 44
= 45  5
50
44
= 45 
10

202
 = 45 - 4.4
A.M. ( X ) = 40.6

Combined Arithmetic Mean

If the arithmetic averages and the number of items in two or more related
groups are known, the Combined or the composite mean of the entire group
can be obtained by adding the aggregates of mean and the numbers of
items in each and dividing the same by the total number of items in the
entire group. Thus if there are two series with n1 and n2 items having X1
and X 2 as their arithmetic averages.

X 1n1  X 2 n2
Combined Mean X 12 =
n1  n2

Example 10.9
Calculate arithmetic Mean of the

X : 1 2 3 4 -6 7-9 10 -12 13 -20 21 – 28

F : 10 5 3 9 6 2 1 10

Solution

The above distributions can be split into three sections with values 1
-3, 4 - 6,7 - 9, 10 – 12 and 13-20 to 29-36

Group – I Group II Group III

M F2 Mid
x1 F1 F1 X1 X2 F2 X3 F3 F3 X3
V X2 Value

1 10 10 4-6 5 9 45 13-20 16.5 1 16.5

2 5 10 7-9 8 6 48 21-28 24.5 10 245.0

3 3 9 10-12 11 2 22 29-36 32.5 15 487.5

18 29 17 115 26 749

 f 1 x1 29
X1 = 
N1 18

203
  f 2 x2 115
X2 = 
N2 17
 f 3 x3 749
X3 = 
N3 26

N1 X 1  N 2 X 2  N 3 X 3
Combined Mean X 123 =
N1 N 2 N 3
29 115 749
=
18 17  26
893
=
61
X 123 = 14.64

Example 10.10 The mean height of 25 male workers a factory is 61cm

and the mean height of 35 female workers in the same factory is 58 cm
Find the combined mean height of 60 workers in the factory.
Solution

I II

Male Female

No. of Workers 25(n1) 35(n2)

61( X1 ) 58( X 2 )
Average height

Given n1= 25 n2 = 35 n1 + n2 = 60
X1 = 61 X 2 = 58
n1 x1  n 2 x 2  n 3 x 3
X12 =
n1n 2 n 3

The combined mean height of 60 workers in the factory is 59.25

204
Example 10.11 The mean wage of 100 workers in a factory, running
two shifts of 60 and 40 workers is Rs.38 the mean wage of 60 labour
working in the morning Shift is Rs.40/- Find the mean wage of 40
workers working in the evening shift.
Solution

Given

I II

Morning Shift Evening Shift

No. of Workers 60(n1) 40(n2)

Average wage 40 ( x1 ) ? (x 2 )

x 1 = 40 x2 = ? x12 = 38

n1 x 1  n 2 x 2
x12 =
n1  n 2
60  40  40 x 2
38 =
60  40
2400 40 x 2
38 =
100
3800 = 2400 + 40 x 2 40 x 2 = 3800 - 2400

40 x 2 = 3800 – 2400

1400
x2 =  35
40
Therefore Mean Wage of 40 workers in evening shiftRs. 35.
Merits and Limitations of mean (x )

Merits
1. It is easy to understand and calculate
2. It is possible to calculate if some data are lacking

3. It is widely used method because of its mathematical property

4. If the no. of observations are large, it is more accurate and reliable

205
5. It is affected by the value of every item in the series
6. The mean is typical in the sense that it is the centre of gravity, Balancing
the values or either side of it

7. It is calculated value not based on positive in the series.

Limitations
1. It cannot be obtained by inspection nor located through a frequency
graph.
2. It cannot be used in the study of Qualitative phenomena not capable
of numerical measurement.

3. It can ignore any single item only at the risk of losing its accuracy
4. It is not always a good measure of central tendency
5. If the extreme classes be open. It cannot be calculated
6. Arithmetic average is affected very much by extreme values
7. In case of V – shaped distribution the mean is not likely to serve a
useful purpose.
Weighted Arithmetic Average

It may be defined as the average whose component items are being

multiplied by certain values known as weights It x1,x2………..xn be the
values of the variable x with respective weights of w1,w2 ………wn assigned
to them.
w1 x1  w2 x2 ......  wn xn
Xw=
w1  w2  ........ Wn
 wx
=
w
Example 10.12 Calculate weighted averages from the following data

Designation Monthly Salary Strength of the cadre

Class I Officers 1500 10

Class II Officers 800 20

Subordinate staff 500 70

206
 Clerical Staff 250 100

Labour staff 100 150

Solution

Designation Salary Strength X WX

Class I Officers 1500 10 15000

Class II Officers 800 20 16000

Subordinate staff 500 70 35000

Clerical Staff 250 100 25000

Labour staff 100 150 15000

w = 350 WX = 106000

 WX
Xw =
W
106000
Xw =  Rs. 302.57
359
Example 10.13 Calculate weighted averages to the following

Bombay Calcutta Madras

Course of
Study
% of No. of % of No. of % of No. of
University
Pass students Pass students Pass students

M.A 71 3 82 2 81 2

M.COM 83 4 76 3 76 3.5

B.A 73 5 73 6 74 4.5

B.COM 74 2 76 7 58 2

B.Sc., 65 3 65 3 70 7

M.Sc., 66 3 60 7 73 2

207
Solution

% of Pass No. of students

d=X-A wd
X W

M.A 71 3 82 2

M.COM 83 4 76 3

B.A 73 5 73 6

B.COM 74 2 76 7

B.Sc., 65 3 65 3

M.Sc., 66 3 60 7

A=73 EW=20 EWd = -9

 dw
Xw = A
Ew
(9)
= 73   73  0.45
20
Xw = 72.55

10.5.2 Geometric Mean

b) It contains N observations is the Nth root of the product of values. If

there are two items, the square root of the product of the two values is the
Geometric Mean. If three values the cube root is the Geometric Mean.

Ungrouped data

Geometric Mean (G.M) = Production of n values

1
log(G.M) = log (x1+x2…… xn)
n
 log x
log(G.M) =
n
  log x 
G.M. = Antilog  
 n 

208
Procedure
(i) Convert the given variable x into log x q
(ii) Divide  log x by n
(iii) Take Antilog the result obtained from ii)
Example 10.14 Find Geometric Mean of the following data: 180,250,
490, 120, 1400, 7000, 1050, 150, 360, 100.

Solution

x log x

180 2.2553

250 2.3979

490 2.6902

120 2.0792

1500 3.1461

7000 3.8451

1050 3.0212

150 2.1761

360 2.5563

100 2.0000

 log x  26.1674

Geometric Mean
  log x 
G.M. = Anti log  
 n 
 26.1674 
= Anti log  
 10 
= Anti log (2.61674)

209
 G.M. = 413.75
Grouped Data
When the data is presented as a frequency distribution and if f 1,
f2………..fn represent the frequencies of values x1, x2……xn.

G.M. = N ( x1 , x 2 ..... x n ) ( x 2 . x 2 ) .... ( x n ... x n )

= N ( x1f1 , x 2f 2 ..... x nf n )

f1 log x1  f 2 log x 2  ......... f n log x n

=
f1  f 2  .... f n

  f log x 
G.M. = Antilog  
 f 
Procedure
i) Calculate mid value of each class internal name it as x

ii) Convert X into log X

iii) Multiply each log x with its corresponding f
i) Find total f log x
  f log x 
ii) Compute  
 f 
iii) Take antilog we get the value
Example 10.15: Compute Geometric Mean to the following data:

Internal 0-100 100-200 200-300 300-400

Frequency 2 6 5 7

Solution

Internal Midvalue (X) logx f f logx

0-100 50 1.6989 2 3.3978

100-200 150 2.1761 6 13.0566

200-300 250 2.3979 5 11.9895

210
 300-400 350 2.5441 7 17.8084

f = 20 f =flogx

  f log x 
G.M. = Antilog  
 f 
 46.2523
= Antilog  
 20 
= Antilog ( 2.3126)

G.M. = 205.39.
10.5.3 Harmonic Mean (HM)
Harmonic Mean of a set of observation is defined as the reciprocal
of the arithmetic average of the reciprocal of the given values.
Ungrouped data
The Arithmetic mean of the Reciprocal if N Values x1, x2 …xn is
1 1 1
  .... 
x1 x2 xn
n
 1
   
H.M. = Reciprocal 
 x
 n 
 
 
In case of Grouped data
 1
 f  
H.M. = Reciprocal 
 x
 f 
 
 
In case of weighted data
 1
  w  
H.M. = Reciprocal 
 x
 w 
 
 

211
Example 10.16
Calculate Harmonic Mean of the following data 180, 250, 490, 120, 1400,
7000,1050,150
Solution

1
X
x

180 0.00555

250 0.00400

490 0.00204

120 0.00833

1400 0.00071

7000 0.00014

1050 0.00095

150 0.00666

1
    0.02838
x

  1 
  
= Reciprocal 
 x    Re ciprocal  0.02838
H.M.  
 n   8 
 
 
= Reciprocal (0.0035475)

1
=  281.88
0.0035475
Example 10.17 Calculate Harmonic Mean to the following data

Class Internal 0-10 10-20 20-30 30-40

No. of Pupils 3 6 7 4

212
Solution

1 1
Internal Mid value (X) f f 
x x

0-10 5 0.2000 3 0.6000

10-20 15 0.0666 6 0.4000

20-30 25 0.0400 7 0.2800

30-40 35 0.0285 4 0.1143

1
f = 20  f    1.3943
x

 1
 f  
H.M. = Reciprocal 
x
 f 
 
 
 1.3943
= Reciprocal  
 20 
1
= Reciprocal (0.069715) =
0.069715
H = 14.34
Relation between AM, GM and HM
A harmonic mean (HM) is lower than the Geometric Mean (GM) Since the
G.M.is lower than the arithmetic mean (AM)

i.e H.M < G.M < X

10.5.4 Median

The Median as the name suggests is the middle value of a series arranged
in any order of magnitudes.
The total no. of item is odd then there is a only on middle value that middle
value is to be considered as median

Suppose the no. of item are even, then there are two middle values.
Median is the average of two middle values. According to Bowler, if the no.

213
of the groups are ranked in order according to the measurement under
consideration, then the measurement of the number most nearly one-half is
the median.
Ungrouped Data
1 First arrange the given data either in ascending order (or ) in
descending order
th
 n 1 
2 Median = the size of   item.
 2 
Example 10.18 Compute median of 25,30,15,45,18,7,10,38,12
Solution

Here n = 9
Arrange the given data into ascending order
7, 10, 12, 15, 18, 20,25,38,45
th
 n 1 
Median = Size of   item
 2 
th
 9 1 
= Size of   item
 2 
= Size of 5th item is 18.
Median = 18
Example 10.19 Compute median of the following data 15,20,8,5,31,45,
76,63
Solution

Here n = 8
Arrange the data in ascending order
5, 8,15,20,31,45,63,76
th
n
Median = Size of   item
2
th
8
= Size of   item
2

214
 8
= Size of  4 th item is 20
2
th
n 
=   1  4  1  5 th item is 31
2 
= Average of 4th and 5th item
20  31 51
= 
2 2
Median = 25.5
Grouped Data
The mode of grouping can be in the form of a discrete frequency
distribution or continuous frequency distribution.
(i) Calculate the cumulative frequency
th
 N 1
(ii) The value of   item is found out
 2 
th
 N 1
iii) To locate the value corresponding to   item
 2 
Example 10.20 Compute the Median of the following:

(Mark) X 45 55 65 75 85 95

F 3 4 5 2 3 6

Solution

X Frequency (f) Cumulative (cf)

45 3 3

55 4 7

65 5 12

75 2 14

85 3 19

95 6 25

N= 25

215
Here N = 25
th
 N 1
Median = Size of  
 2 
th
 25  1 
= Size of   item
 2 
= Size of (13)th item

Median = 75
Continuous series
th
N
i) Compute the Value of   item which corresponds to the internal
2
called median class internal
N
 c. f
ii) Median = l 2 c
f
l - lower limit of the median class interval
N/2 - item whose value has to be inter related

c.f - cumulative frequency of class preceding to median class interval

f - Frequency of the median class
c - length of the class interval
Example 10.21 Compute the median to the following

Value Frequency

Less than 100 40

100-200 89

200-300 148

300-400 64

400 and above 39

216
Solution

X Frequency (F) Cumulative c.f

Less than 100 40 40

100-200 89 19

200-300 148 277

300-400 64 341

400 and above 39 N=380

N
Median class interval = Size of th item
2
380
= Size of th item
2
= Size of 190th item
Median class interval is 200-300
N
 c.f
Median = l 2 xc
f
190  129
l = 200 Median = 200  x 100
148
N 61
= 190 = 200  x 100
2 148
c.f=129 = 200  41.22

f =148 Median = 241.22

c = 100
Example 10.22 Calculate median to the following

Age No. of persons

Below 10 2

Below 20 5

217
 Below 30 9

Below 40 12

Below 50 14

Below 60 15

Below 70 15.5

70 and over 15.6

Solution

Age No. of persons (f) c.f

Below 10 2 2

Below 20 5 5

Below 30 9 9

Below 40 12 12

Below 50 14 14

Below 60 15 15

Below 70 15.5 15.5

70 and over 15.6 15.6

Median class interval

th
N
= Size of   item
2
th
 15.6 
= Size of   item
 2 

= Size of 7.8th item

218
Median class interval is 20-30
N
 c.f
Median = l  2 c
f
l = 20
th
N
  = 7.8
2
7. 8  5
Median = 20   10 f=4
4
28
= 20  CF =5
4
= 20  7 C=10

Median = 27

Merits of Median
1. It is easy to calculate and is readily understood
2. It is not at all affected by items on the extremes.
3. It can be computed for distributions which have open-ended classes
4. It is centrally located
5. Median is the only average which can be used while dealing with
qualitative data
6. It cannot be measured quantitatively but still can be arranged in an
ascending or a descending order.
Demerits of Median
1. In case of even number of observations, median cannot be
determined exactly.
2. Median does not send itself to algebraic treatment in so satisfactory
a manner as the Arithmetic mean, the geometric mean or harmonic
means do
3. As compared with arithmetic average it affected much by
fluctuations of sampling.
4. It is not based on all the items of the series.
10.5.5 Mode

The mode refers to that value in a distribution which occurs most

frequently. It is an actual value which has the highest concentration of items

219
in and around it. It shows the centre of Concentration of frequencies in and
around a given value. However, it is not the centre of gravity as the
arithmetic mean i.e whereas the mean is influenced by extreme values the
mode is not.
Calculation of Mode – Individual Case

For determining mode count the number of times the various values
repeat themselves and the Value occurring maximum number of times is
the mode value. The more often the mode value appears relatively. The
more valuable the measure is an average to represent data.
Example 10.23 Calculate mode of the following

Data
1 2 3 4 5 6 7 8 9 10
Sl.No

Marks
10 27 24 12 27 27 20 18 15 30
obtained

Solution

Size of item No. of time occurs

10 1

12 1

15 1

18 1

20 1

24 1

27 3

30 1

Total 10

Since the item 27 occurs the maximum number of times mode is 27

220
Discrete series
In discrete series quite often mode can be determined just by inspection.
Mode is the item, which occurs maximum number of items.
Example 10.24 Calculate mode of the following:
Size of Garment : 28 29 30 31 32 33
No. of person wearing : 10 20 40 65 50 15
Solution
Here 31 occurs maximum number of times 31 is mode
Grouping method
The grouping method is to find mode the following cases are applicable for
applying grouping
Method
i) If the most frequency value occurs at starting or at ending of the
distribution,
ii) Maximum frequency is repeated
iii) If there is an irregulation in the distribution.
The procedure for preparing grouping table. The frequencies in
column

i) are the original frequencies

ii) is obtained by combining the frequencies two by two If we leave the first
iii) Frequency and combine the remaining frequencies two by two we get
column
iv) Grouping of three frequencies
v) Grouping of three leaving the first

vi) Grouping of three leaving the first two

Then we prepare the table of analysis from this we can calculate the modal
class interval. This method is applicable either discrete (or) continuous
method.

221
Continuous Series
f1  f0
Mode = L c
2f1  f0  f 2

Where L – Lower limit of the modal class interval

f1 – frequency of the modal class
fo – frequency of the class preceding the modal class. (premodal)

f2- frequency of the class succeeding the modal class ( Post Model)
C – length of the class interval
Example 10.25 Calculate mode of the following data

Marks 10-20 20-30 30-40 40-50 50-60

No. of Pupils 9 11 10 12 8

Solution
Here most frequency occurs at the interval 30-40. i.e 30-40 is modal class
interval.

Marks Frequency

10-20 9

20-30 11

30-40 20

40-50 12

50-60 8

TOTAL 60

Modal class interval in 30-40

f1  f0
Mode = l c
2f1  f0  f 2

l = 30

222
f1 = 20
f0 = 11
f2 = 12
20  11
Mode = 30   10
2  20  11  12
9
= 30   10
40  11  12
9
= 30   10
17
90
= 30 
17
= 30 + 5.294 = 35.294

Mode = 35.294
Example 10.26 Find mode of the following

Size (x) 1 2 3 4 5 6 7 8 9 10

Frequencies (f) 3 8 15 23 35 40 32 28 20 45

Solution

Here we see that the distribution is not regular since frequencies are
increasing steadily up to 40 and then decreases. Here we cannot say 45 as
maximum frequency and 10 is not mode. We use the grouping method.
Grouping Table

Of three Of three
Of two Of two Of three
Frequency Leave leave
Size X leaving
(1) (2) (4) the 1st the first
first (3)
(5) two (6)

1 3 11

2 8 23 26

3 15 38

4 23 58 46

223
5 35 75 98 73

6 40 72 107

7 32 60 80 100

8 28 48 93

9 20 65 65 79

10 45 59

11 14 20

12 6

In the above table maximum frequency in column no. (1) to (6) should be
marked.
Analysis Table

Maximum Value or combination of values

Column No. (1) Frequency of x giving max frequencies
(2) (3)

1 45 10

2 75 5,6

3 72 6,7

4 98 4,5,6

5 107 5,6,7

6 100 6,7,8

We find that the value 6 is repeated for maximum number of times and
hence the made is 6
Example 10.27 Calculate mode from the following

Mark 0-5 5-10 10-15 15-20 20-25 25-30 30-35 35-40

F 9 12 15 16 17 15 10 13

224
Solution
Grouping Data

Grouping

Class Of two Of three Of three

Frequency of two Of three
leaving leaving
(2) Leave the first
(1) (4)
1st (3) 1st two

0-5 9 21 36

5-10 12 27 43

10-15 15 31 48

15-20 16 33

20-25 17 32 48

25-30 15 25 42

35-40 10 23 38

45-50 13

Table of Analysis

Columns Size Grouping Containing Maximum Frequency

1 20-25

2 15-20 20-25 25-30

3 15-20 20-25

4 20-25 25-30

5 5-10 10-15 15-20

6 10-15 15-20 20-25

No. of times the

1 2 4 5 2
size occurs

225
The size group of 20-25 has occur frequently and therefore it is this group
which contains the mode.
f1  f0
Mode = l c
2f1  f 0  f 2
17  16
= 20  5
2 17  16 15
1
= 20  5
34  31
1
= 20  5
3
5
= 20   20  1.66
3
Mode = 21.67
Example 10.28 Calculate mode of the following data

0- 50- 100- 150- 200- 250- 300- 350- 400-

Mark
50 100 150 200 250 300 350 400 &above

F 5 14 40 91 150 87 60 38 15

Solution

Maximum frequency appears at the class interval 200-250.

Model class interval is 200-250

C.I. F

0 – 50 5

50 – 100 14

100 – 150 40

150 – 200 91

200 – 250 150

250 – 300 87

226
 300 – 350 60

350 – 400 38

400 – above 15

l = 200, f1 = 150, f0 = 91, f2=87, C=50

f1  f 0
Mode = l  c
2 f1  f 0  f 2
150  91
= 200   50
2 150  91 87
59
= 200   50
300  178
59
= 200   50
300  178
2950
= 200 
122
= 200 + 24.18
Mode = 224.18
Merits of Mode

1. Mode is readily comprehensible and easy to calculate

2. Mode is not at all affected by extreme values
3. Open-end class also do not pose any problem in the location of
mode
4. It can be used to describe qualitative phenomenon
5. The value of mode can be determined graphically whereas the value
of mean cannot be graphically ascertained.
Demerits of Mode

1 The value of mode cannot be determined always. In some cases we

may have a bimodal series
2 It is not capable of algebraic manipulations
3 The value of mode is not based on each and every item of the series

227
 4 It is not rigidly defined measure
5 While dealing with quantitative data, the disadvantages of the mode
out weight its good features and hence it is seldom used.
LET US SUM UP
In this unit we have discussed the average. Data analysis grouped and
ungrouped data. We discussed the concept mean, its types like geometric
mean, Harmonic mean, relation between A.M & H.M. We discussed various
types of measures of central tendency and measures of dispersion.
CHECK YOUR PROGRESS

1) Calculate mean median of the following data

Income 0-50 50-100 100-150 150-200 200-250 Over-250

Frequency 90 150 100 80 70 10

2) Final Missing frequency to the following No. of accidents

No. of accidents: 0 1 2 3 4 5
Frequency 46 ? ? 25 10 3
3) Calculate simple and weighted Average to the following data

Price per ton (Rs.); 45.60 50.70 42.75

Tons Purchased; 135 40 25
GLOSSARY
:
Arithmetic Mean the Arithmetic Mean (AP) or called
average is the ratio of all observations to
the total number of observations
:
Ungrouped data Ungrouped data is the type of distribution
in which the data is individually given in a
raw form.. Ungrouped data is the data you
first gather from an experiment or study.
:
Median Median is the middle number in a sorted
list of numbers. The median can be used to
determine an approximate average,

228
 or mean.

SUGGESTED READINGS

1. Arora, P.N. & S. Arora, (2007) ,Statistics for Management, latest

Edition, S. Chand & Company Ltd., New Delhi.
2. D.C.Sancheti, V.K.Kapoor,( 2014), Business Mathematics, 11th
edition, Reprint, Sultan Chand and Sons, New Delhi.

3. Gupta, B.N., (2015), Business Statistics, First Revised Edition,

SBPD, New Delhi.
4. JK. Sharma, (2009), Business Mathematics Theory And
Applications, 13th Edition, ANE Books, New Delhi.
5. S. P. Gupta, (2012), Statistical Methods, 42nd Revised Edition Sultan
Chand & Sons Pvt. Ltd., New Delhi.
6. https://www.investopedia.com/terms/a/arithmeticmean.asp
7. https://www.cuemath.com/numbers/relation-between-am-gm-hm/
ANSWERS TO CHECK YOUR PROGRESS

1. Mean =196, Median =105

2. 76, 38
3. 46.25, 46.23

229
Unit 11

DATA ANALYSIS: MEASURES OF

DISPERSION
STRUCTURE
Overview
Learning Objectives
11.1 Introduction

11.2 Measures of Dispersion

11.2.1 Range
11.2.2 Quartile Deviation

11.2.3 Mean Deviation

11.2.4 Standard Deviation
11.2.5 Combined Standard Deviation

11.2.6 Coefficient of Variation

11.3 Lorenz Curve
Let Us Sum Up
Check Your Progress
Glossary
Suggested Readings
Answers to Check Your Progress
OVERVIEW

The measure of dispersion displays and gives us an idea about the variation
and central value of an individual item. We will discuss the measures of
dispersion like range, quartile deviation, mean deviation, standard deviation
and drawing Lorenz curve in this unit.
LEARNING OBJECTIVES

After completing this unit, you should be able to,

 to explain the measures of dispersion. such as range, quartile deviation,

230
 mean deviation and standard deviation
 to demonstrate the process to draw lorenz curve
11.1 INTRODUCTION

Measures of dispersion describe the spread of the data. They include the
range, interquartile range, standard deviation and variance. The measure of
dispersion indicates the scattering of data. It explains the disparity of data
from one another, delivering a precise view of the distribution of data. The
measure of dispersion displays and gives us an idea about the variation and
central value of an individual item. In other words, Dispersion is the extent
to which values in a distribution differ from the average of the distribution. It
gives us an idea about the extent to which individual items vary from one
another and from the central value. There are four commonly used
measures to indicate the variability (or dispersion) within a set of measures.
They are: 1. Range 2. Quartile Deviation 3. Mean Deviation 4. Standard
Deviation. Here, in the following pages are dedicated to depict the
measures of dispersion.
11.2 MEASURES OF DISPERSION
Meaning and Definition

The various measures of central value discussed in the previous chapter

give us are single figure that represents the entire data. But the average
alone cannot adequately describe a set of observations unless all the
observations are the same. It is necessary to describe the variability or
dispersion of the observations. In two or more distributions the central
value may be the same but still there can be wide disparities in the
formation of distribution. It helps us the studying this important characteristic
of a distribution.
According to A.L Bowker

“Dispersion is the measure of the variation of the items”.

“Dispersion or spread is the degree of the scatter or variation of the variable
about a central value.
Significance of Measuring Variation

a) To determine the reliability of an average

b) To serve as a basis for the control of variability

231
 c) To compare two or more series with regard to their variability
d) To facilitate the use of other statistical measured
Properties of a Good Measure of Variation

1) It should be simple to understand

2) It should be easy to compute
3) It should be rigidly defined

4) It should be based on each and every item

5) It should be amenable to further algebraic treatment
6) It should have sampling stability
Methods of Studying Dispersion can be classified into
1) The Range
2) The Quartile deviation
3) The mean deviation on average Deviation
4) The standard deviation
5) Lorenz curve (Graphical representation)
11.1.1 Range

Range is the simplest method of studying dispersion. It is defined as the

difference between the value of the smallest item and the value of the
largest item included in the distribution.
Range = L-S
L S
Co-efficient of range =
LS

Example 11.1

Find the range of the following

Day Mon Tue Wed Thur Fri Sat

Price 200 210 208 160 220 250

Also find co efficient of range

232
Solution
Range = L-S
= 250 - 160

Range = 90
L S
Co-efficient of range =
LS
250  160
=
250  160
90
=  0.22
410
Example 11.2 Calculate the range from following

Marks 10-20 20-30 30-40 40-50 50-60

No. of pupils 8 10 12 8 4

Solution
L = 60 Range = L-S

S = 10 = 60-10 = 50
LS
Co-efficient of range =
LS
60 10 50
=  = 0.714
60  10 70

11.1.2 Inter Quartile Range or Quartile Deviation

Quartile Deviation is a measure of dispersion based on the third quartile

(Q3) and the first Quartile (Q1). It is also called Semi- inter quartile range
because it represents the average difference between two quartiles.
Q3  Q1
Quartile Deviation (Q.D) =
2
Q3  Q1
and Coefficient of Q.D =
Q3  Q1

233
Individual Case

 N 1
th

Q1 = Size of the   item

 4 

 N 1
th

Q3 = Size of the 3   item

 4 
Q3  Q1
Q.D =
2
Example 11.3 Calculate Q.D of the following

Days of a week 1 2 3 4 5 6 7

No. of units sold 12 45 20 28 40 15 30

Solution

First arrange the given data in the ascending data

N=7 12,15,20,28,30,40,45
th
 N 1
Q1 = Size of   item
 4 
th
 7 1
= Size of   item
 4 
Q1 = 15
th
 n 1
Q3 = Size of 3   item
 4 
th
 7 1
= Size of   item
 4 
= Size of 6th item

Q3 = 40
Q 3  Q1
Q.D =
Q 3  Q1
40 15 25 5
=  
40  15 55 11

234
 Q 3  Q1
Co-efficient of Q.D =
Q 3  Q1
40  15 25 5
=  
40  15 55 11

= 0.455
Discrete Case

In this case

N 1
th
Q1 = Size of item
4
th
 N 1 
Q3 = Size of 3   item
 4 

Locate the value of Q1& Q3 from the cumulative frequency column

Q 3  Q1
Q.D =
2
Example 11.4 Calculate Q.D to the following data

Marks 10 20 30 40 50 60

Frequency 4 7 15 8 7 2

Solution
Here N = Ef = 43

 N 1 
th

Q1 = Size of   item
 4 
Q1 = size of 11th item Q = 20

Marks Frequency C.F

10 4 4

20 7 11

30 15 26

235
 40 8 34

50 7 41

60 2 43

Q3  Q1
Q.D =
2
40  20
=
2
QD = 10
Q3  Q1
Coefficient of QD =
Q3  Q1
40  20 20
= 
40  20 60

Coefficient of Q.D = 0.333

Quartile Deviation – Continuous case
th
N
Q1 = Size of   item = 3 Quartile range
rd

4
th
N 
Q3 = Size of 3    item = 1st Quartile range
 4 
Q3  Q1
Q.D =
2
N
3  c. f .
Q3 = l  4 c
f
N
 c. f .
Q1 = l  4 c
f
Q3  Q1
Co efficient of Q.D =
Q3  Q1

236
Example 11.5 Calculate the Q.D to the following

Wages Less than 35 35-37 38-40 41-43 Over 43

No. of Persons 14 62 99 18 7

Solution

Wages F CF

Less than 35 14 14

35-37 62 76

38-40 99 175

41-43 18 193

Over 43 7 200

 f  N  200

th
N
Q1 = Size of   item
4
th
 200 
= Size of   item
 4 

= Size of 50th item

Q1 Range is 35-37
N
 c.f
Q1 = l 4 c
f
50  14
= 35  3
62
= 35+ 1.74
Q1 = 36.74`

237
Q3 Range
th
N
Q3 = Size of 3   item
4

= Size of 150th item

Q3 Range is 38-40
N
3    c. f
l  
4
Q3 = c
f
150  76
= 38  3
99
74
= 38  3
99
= 38 +2.24
Q3 = 40.24
40.24  36.74
Q.D =
2
3.5
=  7.5
2
QD = 1.75
Merits of Q.D
1. It has special utility in measuring variation in case of open and
distributions
2. It is also useful in erratic or badly skewed distributions where the
other measures of Dispersion would be worked by extreme values.
3. It is not affected by the presence of extreme values
Limitations of QD
1. It is not capable of mathematical manipulation
2. Its value is very much affected by sampling fluctuations
3. It is in fact not a measure of dispersion as it really does not show the
scatter around an Average but rather a distance on a scale.

238
11.1.3 Mean Deviation
It is also known as the average deviation. It is the average difference
between the items in a distribution. There is an advantage in taking the
deviation from median because the sum of deviations of items from median
is minimum when signs are ignored.
Computation work in Mean Deviation
1 1
M.D. =  X A or  D
n n
Where D = X A

Where X  A

M .D.
i) Co-efficient of M.D =
Median
Example 11.6 Calculate Mean Deviation from mean

No. of workers in a group 14,18,12,10,16

Solution
Given the data 14,18,12,10,16
x
Mean X =  
n
70
=
5
Mean X  = 14

 X X
M.D =
n
12
=
5
M.D = 2.4

Value X X- X |X- X |

14 0 0

18 4 4

239
 12 -2 2

10 4 4

16 2 2

 X X 8

Discrete Series
f D
Mean Deviation =
f
|D| denotes deviation from Median or Mode.
Example 11.7

X 10 11 12 13 14

F 3 12 18 12 3

Solution
First calculate median from given data
N 1
Median = Size of th item
2
40  1
= Size of th item
2
= Size of 34.5th item
Median = 12

X F D=X-A |D| F|D|

10 3 -2 2 6

11 12 -1 1 12

12 18 0 0 0

13 12 1 1 12

14 3 2 2 6

 f D  36

240
  f X A
M.D =
f
36
=  0.75
48
M.D = 0.75
Example 11.8 Calculate Mean Deviation from Median to the data

Size 0-10 10-20 20-30 30-40 40-50 50-60

f 7 12 18 25 16 14

Solution

X F C.F.

0 – 10 7 7

10 – 20 12 19

20 – 30 18 37

30 – 40 25 62

40 – 50 16 78

50 – 60 14 92

60 – 70 8 100

N = 100

First Calculate Median to given data

th
N
N = 10 Median = Size of   item
2
th
 100 
= Size of   time
 2 

= 50th item
Median class internal is 30-40

241
 N
 c.f
Median = l 2 c
f
50  37
= 30   10
25
= 30 + 5.2 Median = 35.2
Mean Deviation from Median

Mid Value D =
Internal f F |D|
X X – 35.2

0-10 5 -30.2 7 211.4

10-20 15 -20.2 12 242.4

20-30 25 -10.2 18 183.6

30-40 35 0.2 25 5.0

40-50 45 9.8 16 156.8

50-60 55 19.8 14 277.2

60-70 65 29.8 8 289.4

N = 100  f D = 1314.80

f D
D about Median =
f
1314.8
=
100
M.D = 13.148
Merit of Mean Deviation

1. It is very simple to calculate

2. It is simple to understand and easy to compute

3. Anyone familiar with concept of average can readily appreciate the
meaning of average deviation

242
Limitations
1. It is based on each and every item of the data
2. Mean deviation is less affected by the value of extreme items than the
standard deviation
3. Since deviations are taken from central value comparison about
formation of different distribution can easily be made
11.1.4 Standard Deviation
It is known as root mean square deviation. It measures the absolute
dispersion. The greater the standard deviation, for the greater will be the
magnitude of the deviation of the Values from their mean. It is usually
deviation by the Greek letter “ “
Individual Observations

(i) Calculate actual mean of the series i.e. X

(ii) Take deviations of the items from mean i.e. d = X - X
(iii) Square the deviations and obtain the total d2
(iv) Divide d2 by total no. of observations

 d2
S.D () =
n

Variance = (2)= (SD)2

Suppose deviations taken from assumed mean A i.e d= X-A

d2  d 
2

S.D =  
n  n 

Example 11.9 Calculate S.D of the following 4, 10, 6, 8,12

Solution

N=5
x 4  10  6  8  12
X = 
n 5
40
= 8
5

243
 d2 40
 = 
n 5
= 8  2.83

 = 2.83
Example 11.10 Calculate the S.D of the following by direct method

8,9,15,23,5,11,19,8,10,12
Solution

X X2

8 64

9 81

15 225

23 529

5 25

11 121

19 361

8 64

10 100

12 144

x = 120 x2 = 1714

 x2   x 
2

S.D. () =   , n = 10
N  N 
2
1714  120 
=  
10  10 
= 171.4  144

= 27.4
S.D. () = 5.23

244
Discrete / Continuous Series
There are three methods to find out S.D in discrete and continuous series
a. Direct Method

b. Deviation method
c. Step – Deviation method
a. Direct Method
2
 fx 2   fx 
 =   N = f
f  f 

b. Deviation Method
2
 fd 2   fd 
 =   d=x-A
f  f 

c. Step deviation method

2
 fd' 2   fd'  xA
=   c d’ =
f  f  c

Example 11.11 Calculate S.D to the following by deviation method

X 10 11 12 13 14 Total

F 3 12 18 12 3 48

Solution

X f d = X-A d2 fd fd2

10 3 0 0 0 0

11 12 1 1 12 12

12 18 2 4 36 72

13 12 3 9 36 108

14 3 4 16 12 36

N = 48  fd  96  fd2  228

245
 2
 fd2   fd 
 =  
N  N 
2
228  96 
=  
48  48 

= 4.75  ( 2) 2

= 4.75  4

= 0.75

S.D. () = 0.866

Example 11.12 Calculate S.D to the following by deviation method

Class interval 1-4 5-8 9-12 13-16 17-20

Frequency 4 11 14 6 1

Solution

Class Mid Value xA

f d=X-A d fd’2
interval X 4

1-4 2.5 4 0 0 0

5-8 6.5 11 14 1 11

9-12 10.5 14 8 2 56

13-16 14.5 6 12 3 54

17-20 18.5 1 16 4 16

 f  36  fd = 61  fd' 2 = 137

2
 fd2   fd 
 =   c
f  f 
2
137  61 
=   3
36  36 

= 3.815  2.87

246
 = 0.945
 = 0.9743
Example 11.13 Calculate S.D from the following data

Age 20-25 25-30 30-35 35-40 40-45 45-50

No. of Persons 170 110 80 45 40 35

Solution
Mid- x  22.5
Age point f d= fd fd2
X 5
20-35 22.5 170 0 0 0
25-30 27.5 110 1 110 110
30-35 32.5 80 2 160 320
35-40 37.5 45 3 135 405
40-45 42.5 40 4 160 640
45-50 47.5 35 5 165 825
 f  480  fd  730  fd2  2300
2
 fd 2   fd 
S.D. () =   c
f  f 
2
2300  730 
=   5
480  480 

= 4.79  (1.52) 2  5

= 4.79  2.31

= 2.48  5

= 1.57 x 5
= 7.87
11.1.5 Combined Standard Deviation

We can compute combined standard deviation of two or three

groups. It is denoted by the 12 and is computed as follows

n1 12  n 2  22  n1d12  n 2 d 22
12 =
n1  n 2

247
12 - Combined S.D
1 - S.D of 1st group
2 - S.D of 2nd group
d1 = x 1 – x12 = d2 = x 1 – x12
x12 = Combined Mean

Example 11.14
The following are some of the particulars of the distribution of weight of
Boys and girls in a class

Boys Girls

Number 100 50

Mean Weight 60 Kg 45 Kg

Variance 9 4

1. Find combined S.D for the above data

2. Which of the two distributions is more variables
Solution
Given n1 = 100 n2 = 50
x 1 = 60 x 2 = 45

12 = 9  22 = 4
 1 =9  2 =2

n1 12  n 2  22  n1d12  n 2 d 22
Combined S.D (n)=
n1  n 2

n1 x1  n 2 x 2
x12 =
n1  n 2

100  60  50  45
=
100  50
6000  22 50
x12 =  55
150

248
 d1 = x1  x12 d2 = x 2  x12

= 60  55  5 = 45  55

d1 = 5 d2 =10
d12 =25 d22 = 100

n1 12  n 2  22  n1 d12  n 2 d 22
S.D (12) =
n1  n 2

100  9  50  4  100  25  50 100

=
100  50

900  200  2500  5000

=
150

8600
=  57.3 = 7.57
150
1
ii) C.V (Boys) =  100
x1
3
=  100  5
60
2
C.V (Girls) =  100
x2
2
=  100  4.44
45
Since coefficient of variation is more for distribution of weight of boys hence
this distribution shows greater variance.
Merits of S.D

1. It is possible to calculate combined S.D of two or more groups

2. It is based on arithmetic mean
3. It is least affected by sampling variations

4. It is amenable to algebraic manipulation

5. It can be safely used for testing significance

249
6. It enables us to determine the reliability of the means of two or more
different series.
Demerits of S.D

1. It is also affected by extreme values

2. It gives undue importance to the items away from the arithmetic mean
and less importance to the items near the mean

3. It is neither easy to understand nor simple to calculate

11.1.6 Co- Efficient of Variation

C.V. =  100
x
 - Standard deviation
x - Mean of the data
Example 11.15: Calculate the co-efficient of variable to following data

Boys Girls

Mean weight 60 45

Number 100 50

Variance 9 4

Solution

Boys Girls
Given x 1 =60 x 2 =45

n1=100 n2=50
12 = 9  22 = 4

Coefficient of variance (CV) =  100
x
3
(Boys) =  100  5
60

Coefficient of variance (CV) =  100
x2

250
 2
=  100
45
= 4.44
Relation between the measures of dispersion
1) Q.D = 2/3 SD (or) S.D =3/2 Q.D
2) M.D =4/5 SD (or) S.D =5/4 M.D
Q.D = Quartile Deviation
M.D = Mean Deviation
11.3 LORENZ CURVE

It is graphic method of showing the concentration of ownership of economic

quantities. Such as income and wealth. If the cumulative distribution of the
amount of the variable concerned is plotted on an ordinate against the
cumulative distribution of the individual processing the amount on the other
ordinate the resultant curve is Lorenz curve.
The Steps involved in drawing of Lorenz Curve
1. The size of items and frequencies are both cumulated

2. Calculate the percentages for each item taking the totals equal to
hundred
3. Percentages of the value of the variable and number of persons are
plotted on a graph
4. The percentages can be 0 to 100 on both axis as usual starting from the
origin

5. A straight line joining 100 of y axis and 0 of X-axis in cause of latter of

two forms show line of equal distribution.
6. The greater is the distance between the curve and line of equal
distribution, the greater is the dispersion.

251
Example 11.16 Draw the Lorenz curve to the following

Standard minute
Table A No. of Table B No. of
produced per operator
operators Operators
per day

300 10 4

320 32 11

340 20 11

360 18 9

380 2 10

400 5 12

420 5 12

440 5 11

460 3 10

480. 0 5

500 0 5

Solution

Calculations for cumulative percentage totals

Standard Table A Table B

minute
produced Cumulative Cum
per Totals % No. of Cum Cum No. of Cum Cum
operator Operators Total % Operator Total %
per day

300 300 6.82 10 10 10 4 4 4

320 620 14.09 32 42 42 11 15 15

340 960 21.81 20 62 62 11 26 26

360 1320 30.00 18 80 80 9 35 35

380 1700 38.63 2 82 82 10 45 45

252
400 2100 47.73 5 87 87 12 57 57

420 2520 57.27 5 92 92 12 69 69

440 2960 67.27 5 97 97 11 80 80

460 3420 77.72 2 100 100 10 90 90

480. 3900 88.63 0 0 0 5 95 95

500 4400 100 0 0 5 100 100

120
100
80
60
40
20
0
1 2 3 4 5 6 7 8 9 10 11

Series1 Series2 Series3

LET US SUM UP

We discussed various types of measures of dispersion like, range, quartile

deviation, standard deviation, mean deviation and Lorenz curve. We
discussed the various methods like individual case, discrete case and
continuous case to find measure, which is discussed earlier. The concept
Lorenz curve has been discussed and we understood the procedure to draw
the Lorenz curve.
CHECK YOUR PROGRESS

1) Calculate S.D of the following data

X : 4-5 14-5 24-5 34-5 44-5 54-5 64-65

F: 1 5 12 22 17 9 4
2) Calculate coefficient of variance to the following data
12, 8, 3, 15, 6, 4, 10
3) Find combined mean and S.D to the following
No. of mean boys 280 350
Mean 45 54

253
 Standard Deviation 6 4
4) Calculate mean deviation from median to the following data
Size 4 6 8 10 12 14 16

f 1 4 5 3 2 1 4
5) Draw the Lorenz curve
Income Group A Group B

20 10 16
40 20 14
80 40 10
100 50 6
160 80 4
GLOSSARY

Range : Range is the simplest method of studying

dispersion. It is defined as the difference
between the value of the smallest item and the
value of the largest item included in the
distribution.

Quartile Deviation : Quartile Deviation is a measure of dispersion

based on the third quartile (Q3) and the first
Quartile (Q1). It is also called Semi- inter quartile
range because it represents the average
difference between two quartiles.

Mean Deviation : It is also known as the average deviation. It is the

average difference between the items in a
distribution

Standard Deviation : It is known as root mean square deviation. It

measures the absolute dispersion. The greater
the standard deviation, for the greater will be the
magnitude of the deviation of the Values from
their mean. It is usually deviation by the Greek
letter “ “

254
SUGGESTED READINGS
1. Arora, P.N. & S. Arora, (2007) ,Statistics for Management, latest
Edition, S. Chand & Company Ltd., New Delhi.
2. D.C.Sancheti, V.K.Kapoor,( 2014), Business Mathematics, 11th
edition, Reprint, Sultan Chand and Sons, New Delhi.
3. Gupta, B.N., (2015), Business Statistics, First Revised Edition,
SBPD, New Delhi.
4. JK. Sharma, (2009), Business Mathematics Theory And
Applications, 13th Edition, ANE Books, New Delhi.

5. S. P. Gupta, (2012), Statistical Methods, 42nd Revised Edition Sultan

Chand & Sons Pvt. Ltd., New Delhi.
6. https://epgp.inflibnet.ac.in/Home/ViewSubject?catid=ahLCajOqz6/G
WFCSpr/XYg==
7. https://www.wallstreetmojo.com/lorenz-curve/
ANSWERS TO CHECK YOUR PROGRESS

1. S.D = 1325 ,
2. Coefficient of variance = 49%
3. Mean =50, S.D =12
4. Mean Deviation3.2
120
100
80
60
40
20
0
1 2 3 4 5 6 7 8 9 10 11

Series1 Series2 Series3

5.

255
Unit 12

BIVARIATE ANALYSIS: CORRELATION

STRUCTURE

Overview
Learning Objectives
12.1 Bivariate (or) Two-way frequency distribution

12.2 Correlation
12.3 Types of correlation
12.4 Analytical Statistics

12.5 Methods of studying correlation

12.5.1 Graphical method
12.5.2 Scatter diagram

12.6 Algebraic Methods

12.6.1 Karl Pearson's Method
12.6.2 Rank Correlation Method

12.6.3 Concurrent Deviation Method

12.7 Probable Error
Let Us Sum Up

Check Your Progress

Glossary
Suggested Readings

Answers to check your progress

OVERVIEW
This unit deals with the concept bivariate analysis. We would deal with the
concept of correlation, types of correlation, various methods of correlation
and correlation coefficient. We would also discuss about rank correlation
and its classifications. We would explain the concept regression, regression
coefficient, regression lines like x on y and y on x. We would also discuss
various methods to find out the regression equation.

256
LEARNING OBJECTIVES
After reading this unit, you should be able to,
 explain the bivariate analysis.
 explain the meaning of correlation.,
 discuss various methods to find correlation coefficient
 illustrate bivariate table. discuss applications of correlation.
12.1 BIVARIATE OR TWO-WAY FREQUENCY DISTRIBUTION
Sometimes two frequency distributions which have some relationship are
put together in the form of a two-way frequency distribution. Such a
distribution is also called Bivariate or cross-classified table. It helps in
analyzing the broad relationship between two given variables. In many
situations simultaneous study of two variables becomes necessary. For
example, we want to classify data relating to age of husbands and age of
wives or data relating to marks in statistics and marks in accountancy or
height and weight of students. The data so classified on the basis of two
variables give rise to what is called a bivariate distribution. If the data
corresponding to one variable x is grouped into m classes and the data
corresponding to the other variable y is grouped into n classes then variate
table will consist of m x n cells. By using different values (x,y) of the
variables and using tally marks we can form bivariate frequency distribution.
Bivariate frequency distribution is also called bivariate frequency table or
correlation table. The frequency distribution of the values of the variable x
together with their frequency totals is called marginal distribution of x and
the frequency distribution of the values of the variable y together with their
frequency total is called marginal distribution of y.
12.2 CORRELATION

Correlation is a statistical technique which measures and analyses the

degree or the extent to which two variables occurs with reference to each
other. Correlation means that between two series or group of data there
exists some casual connection. According to YaLun Chou, "Correlation
analysis attempts to determine the degree of relationship between
variables".

257
12.3 TYPES OF CORRELATION
1. Positive correlation

The correlation is said to be positive when an increase (decrease) in the

value of one variable is accompanied by an increase (decrease) in the value
of other variable.
2. Negative correlation

The correlation as said to be negative when the increase (decrease) in the

value of one variable is accompanied by a decrease (increase) in the value
of other variable.
3. Simple correlation
Under simple correlation, the relationship is confined to two variables.
4. Multiple correlation

The relationship between more than two variables in considered.

5. Linear correlation
When the variations in the values of two variables are in a constant ratio,
there will be linear correlation between them; correlation generally speaks
only to a linear relationship.
For example

x y ratio

30 10 1/3

90 30 1/3

150 50 1/3

210 70 1/3

6. Non-Linear correlation
In non-linear (or) curvilinear correlation, the amount of change in one
variable does not bear a constant ratio to the amount of change in the other
related variable.

258
For example
x y

45 8

50 15

55 25

65 38

7. Partial correlation and total correlation

There are two types of multiple correlation analysis. Under partial

correlation the relationship of two or more variables is examined excluding
some other variables included for calculation of total correlation. For
example, coefficient of correlation between yield of wheat and chemical
fertilizers excluding the effect of pesticides and manures is called partial
correlation. The total correlation is based on the relevant variables, which,
however, is normally not feasible.
12.4 ANALYTICAL STATISTICS

Figure 12.1

259
12.5 METHODS OF STUDYING CORRELATION

Figure 12.2
12.5.1 Graphical Method
The pure graphic method is the extension of earlier graphic methods. Under
these two or more variables are plotted in a graph paper arithmetic or semi-
logarithmic.
Inference about the nature and extent of correlation is drawn roughly by
observing the direction and closeness of the two curves. If the two curves
move in the same direction, the correlation is positive. If they move in
different directions, the correlation is negative and if the two curves show no
definite pattern but move cress-cross or there are erratic fluctuations in the
curves showing no similarity, then, there may be an absence of correlation
or a very low degree of correlation.

It can be used for both simple as well as multiple correlation. But the main
drawback is that we can draw only a rough estimate about the nature of
correlation and exact degree of correlation cannot be ascertained.

260
 Figure 12.3 Figure 12.4

Figure 12.5
12.5.2 Scatter Diagram
Scatter diagram or pictogram is a graphic device of finding out correlation
between two variables only. One variable, normally is an independent
variable or time as the case may be, is plotted on the horizontal axis. This
is also called predicting variable. The other variable known as dependent
variable or the variable to be predicted is shown on the vertical axis. The
movements of the pairs of these variables shown by dots on the graph
reveal whether they move in symmetry in the same or the opposite
direction.
Perfect correlation showing almost a regular and measured movement will
have dots in a straight line in a diagonal form which may be rising or falling
to the right depending on the nature of correlation. The scatter diagram
may take the following shapes.

261
 Figure 12.6 Figure 12.7

Figure 12.8
The shape of the trend line drawn between the scatter of points tells
whether the correlation is linear or curve - linear. The scatter diagram may
therefore, be used to estimate the values of the dependent variable when
values of the independent variable are given. However the main drawback
of scatter diagram is that the degree of correlation cannot be exactly
ascertained.
12.6 ALGEBRAIC METHODS

These methods are based on Mathematical formulae. The

relationship is expressed by the coefficient of correlation as indicated earlier
in the range of -1 to 1. The following are the main algebraic methods.

i) Karl Pearson’s method

ii) Rank correlation method
iii) Concurrent Deviation method.

262
12.6.1 Karl Pearson’s Method
It is based on co-variance of the concerned variables. There are two
categories of formula which can be obtained under.

i) Direct Method
ii) Indirect method/ Deviation method
Direct Method

Correlation coefficient

r(x,y) =
Cov( x, y )

 xy
 x . y N. x  y

Where x = x  x, y = yy

x = standard deviation of x, y = standard deviation of y.

N XY   X   Y 
(or) r 
N X 2   X 2 . N. Y 2   Y 2

Example 12.1 Calculate coefficient of correlation to the following data.

Given N = 50 x = 75, y = 80, x2 = 130, y2 = 140, xy = 120

Solution
Given N = 50 X2 = 130
X = 75 Y2 = 140
Y = 80 XY = 120
N xy   x   y 
r =
N x 2   x 2 . N. y 2   y 2

50 x 120  (75)(80)
=
6500  5625 . 7000  6400

r = 0 (zero correlation)
Example 12.2 Calculate coefficient of correlation to the following:

X 3 7 8 10 12

Y 6 2 1 5 4

263
Solution

X Y X2 Y2 XY

3 6 9 36 18

7 2 49 4 14

8 1 64 1 8

10 5 100 25 50

12 4 144 16 48

X=40 Y=18 X2=366 Y2=82 XY=138

N xy   x   y 
r =
N x 2   x 2 . N. y 2   y 2

5 x 138  40 x 18
=
5 ( 366 )  ( 40 ) 2 . 5 ( 82 )  (18 ) 2
690  720
=
1830  1600 . 410  324

 30  30
= 
230 . 86 15 .16 x 9.27

 30
=
140.58
r = -0.213 (negative correlation)
Deviation method
N d x d y  (  d x ) (  d y )
r =
N d x 2   d x 2 . 
N d y 2   d y 2 
In case the frequency is being allotted we use the formula,
N fd x d y  (  fd x ) (  fd y )
r =
N fd x 2   fd x 2 . 
N fd y 2   fd y 2 
Here dx = X-A, dy = Y-A, A is assumed Average in X and Y.

264
Example 12.3 Calculate the coefficient of correlation to the following.

X 12 9 8 10 11 13 7

Y 14 8 6 9 11 12 3

Solution

Assumed values of X and Y.

X 
 X  70  10
n 7

Y 
 Y  63  9
n 7

X Y dx = X- X dy = Y- Y dx2 dy2 dxdy

12 14 2 5 4 25 10

9 8 -1 -1 1 1 1

8 6 -2 -3 4 9 6

10 9 0 0 0 0 0

11 11 1 2 1 4 2

13 12 3 3 9 9 9

7 3 -3 -6 9 36 18

N=7 dx=0 dy=0 dx2=28 dy2=84 dxdy=46

N d x d y  (  d x ) (  d y )
r =
N d x 2   d x 2 . 
N d y 2   d y 2 
7 ( 46)  0(0)
=
7 (28)  0. 7 (84)  0

322 322
= 
196 x 588 14 x 24 .25

322
=
339.48
r = 0.97 (positive correlation)

265
Example 12.4 A computer, while calculating the correlation coefficient
between two variables X and Y from 25 pairs of observations obtained
the following results.

N = 25, X =125   2 = 650,  2 = 460 and 

508
It was, however discovered at the time of checking that two pairs of
observations were wrongly correctly copied. They were taken as (6,14) and
(8,6) While the correct values were (8,12) and (6,8). Prove that correlation
2
coefficient for correct value is .
3
Solution

Incorrect values Correct values

X Y X2 Y2 XY X Y X2 Y2 XY

6 14 36 196 84 8 12 64 144 96

8 6 64 36 48 6 8 36 64 48

14 20 100 232 132 14 20 100 208 144

Correct X = 125 - (Incorrect value) + (correct value)

= 125 - (6 x 8) + (6+8)
X = 125
Correct Y = 100 - (14+6) + (12+8)

Y = 100
Correct X2 = 650 - (100) + (100)
X2= 650

Correct Y2 = 460 - (232) + 208

= 436
Correct XY = 508 - 132 + 144

= 520

266
 N xy  (  x ) (  y )
r =
N x 2   x 2 . N y 2   y 2

25 x 520  (125 ) (100 )

=
25 x 650  (125 ) 2 . 25 x 436  (100 ) 2
13000  12500
=
16250  15625. 10900  10000

500 500 2
=  
625 . 900 25 x 30 3

2
r = Hence proved
3
Two-Way Frequency Table:
Calculation of Correlation in Grouped Data
Example 12.5 Calculate correlation coefficient by Karl pearson's
method.

X
200-300 300-400 400-500 500-600 600-700 Total
Y

10-15 - - - 3 7 10

15-20 - 4 9 4 3 20

20-25 7 6 12 5 - 30

25-30 3 10 19 8 - 40

Total 10 20 40 20 10 100

Solution

Here N = f = 100
Step I: Find dx

XA
Class Interval Mid value X dx  , A = 250
100

200-300 250 0

267
 300-400 350 1

400-500 450 2

500-600 550 3

600-700 650 4

Step II: Find dy

YA
Class interval Mid value Y dy  , A =12.5
5

10-15 12.5 0

15-20 17.5 1

20-25 22.5 2

25-30 27.5 3

dx
0 1 2 3 4 f fdy fdy2 fdxdy
dy

0 - - - 3 7 10 0 0 0

1 - 4 9 4 3 20 20 20 46

2 7 6 12 5 - 30 60 120 90

3 3 10 19 8 - 40 120 360 216

f fdy fdy2
f 10 20 40 20 10
=100 =200 =500

fdx
fdx 0 20 80 60 40
=200

18 fdx2
fdx2 0 20 160 160
0 =520

fdxd 11 fdxdy
0 46 180 12
y 4 =352

268
 N fd x d y  (  fd x ) (  fd y )
r =
N fd x 2   fd x 2 . 
N fd y 2   fd y 2 
100 x 352  200 x 200
=
100 x 520  (200 ) 2 . 100 x 500  (200 ) 2
35200  40000
=
52000  40000. 50000  40000

 7500
=
12000 . 10000

r = -6.8
12.6.2 Rank Correlation Method

Spearman's rank correlation coefficient is defined as

6 x  d2
 = 1
n(n 2  1)

Where d = difference between the ranks, n = number of observations

There are 3 types in rank correlation
i) Rank already given in the problem.
ii) Rank to be given to the problem
iii) Repeated ranks.
Example 12.6 Find rank correlation coefficient from the following
ranks

Rank in X 6 5 3 10 2 4 9 7 8 1

Rank in Y 3 8 4 9 1 6 10 7 5 2

Solution

Rank in X (R1) Rank in Y (R2) d=R1-R2 d2

6 3 3 9

5 8 -3 9

3 4 -1 1

269
10 9 1 1

2 1 1 1

4 6 -2 4

9 10 -1 1

7 7 0 0

8 5 3 9

1 2 -1 1

d2=36

6 x  d2
 = 1
n(n 2  1)
6 x 36 216
= 1  1
10(10 2  1) 990

 = 0.782
Example 12.7 Calculate rank correlation coefficient to the following
data

X 10 17 12 23 14 16 20

Y 15 8 10 12 16 7 5

Solution

X Rank in X (R1) Y Rank in Y (R2) d=R1-R2 d2

10 7 15 2 5 25

7 3 8 5 -2 4

12 6 10 4 2 4

23 1 12 3 -2 4

14 5 16 1 4 16

16 4 7 6 -2 4

270
 20 2 5 7 -5 25

d2=82

6 x  d2
 = 1
n(n 2  1)
6 x 82
= 1
7(7 2  1)
492 492
= 1  1 
7 x 48 336

= 1 - 1.46
 = -0.46
Ranks are repeated

In case of repeated ranks we can calculate correction factor by using the

formula

m(m 2  1)
CF 
12

Where m = no. of times repeated.

Example 12.8 Calculate rank correlation coefficient to the following
data.

X 10 17 12 23 14

Y 15 8 10 12 16

Solution

X Rank in X (R1) Y Rank in Y (R2) d=R1-R2 d2

7 4 4 5 -1 1

10 2.5 7 3.5 -1 1

13 1 10 2 -1 1

5 5 12 1 4 16

10 2.5 7 3.5 -1 1

271
 d2=20

Correction factor in X series: 10 is repeated 2 times

m(m 2  1)
m = 2 CF =
12
2( 4  1) 2x3 1
=  
12 12 2
y is repeated (ie) m = 2

m(m 2  1) 2( 4  1) 2x3 1
CF = =  
12 12 12 2

 = 1

6  d2  CF in X  CF in Y 
n(n 2  1)

 1 1
6 20  
 2 2 
= 1
5 (5 2  1)
6[21]
= 1
5x24
126
= 1
120
= 1 - 1.05
 = 0.05
12.6.3 Concurrent Deviation Method

Under this method only the direction of change in the concerned variables is
taken into account. For each term the change is considered with reference
to the previous value, which may be either in plus (+) or minus (-).

When it is desired to study only the nature of correlation and not its degree,
the method of concurrent deviation is the easiest. It is a simple method
applicable to individual measurements. To compute the coefficient of
correlation by this method, the deviations are not taken from the arithmetic
average but from the preceding item and the size of the deviation is not
taken into consideration but only its direction indicated by ‘+’ sign in the
case of increase and’-’ sign in the case of decrease and ‘=’ when there is no
rise or fall. All the pairs are then carefully observed. Those having the

272
same sign for both items in the pair i.e., + + or - - or = =, known as
concurrent deviations are marked ‘c’ in the column of ‘concurrent Deviation‘.
If the change is in the reverse direction, (+ - ,or - + ) it is indicated by a
negative signs (-).
We use the formula

 2C  N 
rc     
 N 
Where rc = Coefficient of concurrent deviations

C = No of concurrent Deviations
N = No of pairs of deviations compared.
The meaning of + signs both inside and outside the under - root is that the
2C  N
value of would be positive when both the signs are positive and it
N
would be negative are negative the limits of coefficient of correlation
calculated by this method are + 1.
Example 12.9 Compute the coefficient of concurrent deviation from the
following data.

Month Jan Feb Mar Apr May June July

Subject output of
8.5 9.2 9.3 8.5 7.2 5.9 5.1
steel

Relative
60 65 61 74 92 157 130
un-employed in steel

August Sep. Oct. Nov. Dec.

6.6 7.9 7.6 8.2 9.2

106 58 80 52 45

Solution
Computation of coefficient of correlation

273
 Month Output of steel Unemployed in steel Concurrent

Jan 8.5 60

Feb 9.2 + 65 + +

Mar 9.3 + 61 -

Apr 8.5 - 74 +

May 7.2 - 92 +

June 5.9 - 157 +

July 5.1 - 130 - +

Aug 6.6 + 106 -

Sep 7.9 + 58 -

Oct 7.6 - 80 +

Nov 8.2 + 52 -

Dec 9.2 + 45 -

Number of pairs of deviations N = 11, No. of concurrent deviation C = 2

 2C  N 
rc =   
 N 

 4  11   7
=    =    
 11   11 

=  0.6364

rc = -0.798
Example 12.10 Coefficient correlation between x and y is 0.28, their
covariance is 7.6. If the variance of X is 9. Find the standard deviation
of Y series.

Solution
Given r = 0.28
cov (X,Y) = 7.6 y = ?

274
 var (X) = x2 = 9
x = 3
cov ( X, Y ) 7.6
r = 
x.y 3 x .y

3 x y x 0.28 = 7.6
7.6
y =
3 x 2.8

y = 9.048
Example 12.11 Calculate coefficient of correlation to the following data

N = 10 X = 140 Y = 150 (X-10)2 = 180(Y-15)2 = 225

(X-10) (Y-15) = 60
Solution
Given, N = 10 X = 140; Y = 150
Let dx = X-10dy = Y-15
dx = (X-10) = (X)-10N = 140-100= 40
dy = (Y-15) = (Y)-15N = 150-150 = 0

dx2 = (X-10)2 = 180

dy2 = (Y-15)2 = 225
dxdy = (X-10) (Y-15) = 60
N d x d y  (  d x ) (  d y )
r =
N d x 2   d x 2 .  
N d y 2   d y 2

10 x 60  40 x 0
=
10 x 10  ( 40 ) 2 . 10 x 225  0
600
=
1800  1600 x 2250

600 600
=   0.894
200 x 2250 670 .82

r = 0.894

275
12.7 PROBABLE ERROR
It is denoted by P.E and is defined as
1 r 2
P.E= 0.6745
N

The upper and lower limits are

P = r + P.E P - correlation in the population
Example 12.12 If r = 0.6 and N = 64 find out probable error and
determine the limits for population.

Solution
1 r 2
P.Er = 0.6745 x
N

1  ( 0. 6 ) 2
= 0.6745 x
64
0.6745 x 0.64
=
8
P.Er = 0.054

limits of population correlation = 0.6 + P.E.

= 0.6 + 0.054
= 0.6 + 0.054 = 0.654

and 0.6 - 0.054 = 0.546

Merits of Correlation
1. It is simplest of all the methods.

2. When the number of items is very large, this method may be used to form
a quick idea about the degree of relationship before making use of more
complicated Methods.

Demerits of correlation
1. This method does not differentiate between small and big changes.
2. The results obtained by this method are only a rough indicator of the
presence or absence of correlation.

276
LET US SUM UP
The unit twelve revealed the bivariate analysis with Correlation. The
meaning, types and manipulation of Karl Pearson Correlation Coefficient
and Spearman Rank Correlation co efficient were presented with relevant
examples.
CHECK YOUR PROGRESS

1. Compute coefficient correlation between X and Y

X 2 4 5 6 8 11

Y 18 12 10 8 7 5

2. Compute the coefficient correlation by concurrent deviation method

X 60 55 50 56 30 70 40 35 80 80 75

Y 65 40 35 75 63 80 35 20 80 60 50

3. Calculate spearman's rank correlation between X and Y

X 52 53 42 60 45 41 37 38 25 27

Y 65 68 43 38 77 48 35 30 25 50

4. Calculate spearman's rank correlation

X 50 55 65 50 55 60 50 65 70 75

Y 110 110 115 125 140 115 130 120 115 160

5. If r = 0.8 and N = 16 then find probable Error and limits of PE.

GLOSSARY

Correlation : Correlation is measures and analyses the

degree or the extent to which two variables
relation occurs with reference to each
other. Correlation means casual
connection.

Partial Correlation : Partial correlation is the relationship of two

or more variables is examined excluding
some other variables included for
calculation of total correlation.

277
Scatter Diagram Scatter diagram or pictogram is a graphic
device of finding out correlation between
two variables only.

Spearman Rank Spearman's rank correlation coefficient is

Correlation defined as

6 x  d2
 = 1 where d =
n(n 2  1)
difference between the ranks, n = number
of observations.

SUGGESTED READINGS

1. Arora, P.N. & S. Arora, (2007) ,Statistics for Management, latest

Edition, S. Chand & Company Ltd., New Delhi.
2. D.C.Sancheti, V.K.Kapoor,( 2014), Business Mathematics, 11th
edition, Reprint, Sultan Chand and Sons, New Delhi.
3. Gupta, B.N., (2015), Business Statistics, First Revised Edition,
SBPD, New Delhi.
4. JK. Sharma, (2009), Business Mathematics Theory And
Applications, 13th Edition, ANE Books, New Delhi.
5. S. P. Gupta, (2012), Statistical Methods, 42nd Revised Edition Sultan
Chand & Sons Pvt. Ltd., New Delhi.
6. https://www.simplypsychology.org/correlation.html
7. https://epgp.inflibnet.ac.in/Home/ViewSubject?catid=ahLCajOqz6/G
WFCSpr/XYg==
ANSWERS TO CHECK YOUR PROGRESS

1. r=—0.92
2. r=0.774
3. r=-0.539
4. r-0.155
5. Probable Error =0.06 limits are 0.74 and0.86

278
 BLOCK 4

INDEX NUMBERS

Unit 13: Bivariate Analysis: Regression

Unit 14: Index Numbers
Unit 15: Index in Business and Financial Market
Unit 16: Time Series

279
Unit 13

BIVARIATE ANALYSIS: REGRESSION

STRUCTURE

Overview
Learning Objectives
13.1 Introduction

13.2 Regression Analysis

13.3 Types of Regression Analysis
13.3.1 Uses of regression analysis

13.3.2 Principles of least squares

13.4 Methods of representing Regression lines
13.4.1 Graphical methods

13.4.2 Algebraic Methods

13.4.3 Standard Error Estimate
Let Us Sum Up

Check Your Progress

Glossary
Suggested Readings

Answers to check your progress

OVERVIEW
This unit aids the learners to give a simple explanation of bivariate analysis
with regression. The regression as a tool to be used in data analysis for
finding the prediction, impact and implication of variable one on another
which is presented in this unit.
LEARNING OBJECTIVES

After completing this unit, you should be able to,

 comprehend the tool as a bivariate analysis
 enable the students to use the regression in their data analysis

280
13.1 INTRODUCTION
Bivariate Regression Analysis is a type of statistical analysis that can be
used during the analysis and reporting stage of quantitative research.
Essentially, Bivariate Regression Analysis involves analysing two variables
to establish the strength of the relationship between them. The two
variables are frequently denoted as X and Y, with one being an independent
variable (or explanatory variable), while the other is a dependent variable
(or outcome variable).. Regression analysis is a way of mathematically sorting
out which of those variables does indeed have an impact. It answers the
questions: Which factors matter most? Which can we ignore? How do those
factors interact with each other? And, perhaps most importantly, how certain
are we about all of these factors?
13.2 REGRESSION ANALYSIS
Regression analysis is used widely for deriving an appropriate functional
relationship between variables. It is a mathematical measure expressing an
average of relationship between two or more variables in terms of the
original units of the data. The variable predicted on the basis of other
variables is called the ‘dependent ‘ or the’ explained’ variable and the others
the’ independent’ or the ‘predicting variable. The equation, linear or
otherwise is called the regression equation or explaining equation.
Meaning

The literal meaning of regression is “moving backward”,” going back” or “the

return to the mean value”,. According to Francis Gaton, “The law of
regression tells heavily against the full hereditary transmission of any gift
the more bountifully the parent is gifted by nature, the more will be his good
fortune if he begets a son who is endowed yet more largely.”
Regression is the measure of the average relationship between two or more
variables in terms of the original units of the data. In regression analysis
there are two types of variables. The variables whose value is influenced or
is to be predicted is called dependent variable and the variable(s) which
influence (s) the value or used for prediction, is called independent variable.
In regression analysis independent variable is also known as regressor or
predictor or explain or while dependent variable is also known as regressed
predicated or explained variable.

281
13.3 TYPES OF REGRESSION ANALYSIS
i) Simple and Multiple
The regression analysis confined to the study of only two variables at a time
is termed as Simple regression. For example the influence of advertising
expenditure on sales turnover. In correlation it does not matter which one is
dependent variable and which one is an independent variable. But in
regression analysis obviously the sales turnover is dependent variable
which derives impulses for change from advertising expenditure. On the
other hand, the regression analysis for studying more than two variables at
a time is known as multiple regression. One variable is a dependent
variable the remaining variables are independent ones.
ii)Total and Partial Regression
In the case of total relationship all the important variables are
considered. Normally, they take the form of a multiple relationship because
most economic and business phenomena are affected by a multiplicity of
causes. In the case of partial relationship one or more variables are
considered but not all.
The total relationship can be expressed as

y = f(x, C and P)
While partial relationships are
y = f(x but not i and P)

y = f(i but not x and p)

y = f(p) but not t and x)
Linear and Non - Linear Regression

If the given bivariate data are plotted on a graph, the points so

obtained will form a path called the ‘curve of regression ‘. If the path is a
Straight line, the a curve is the equation of straight line. If may be noted in
case of linear regression , the values of the dependent variable increase by
a constant absolute amount for a unit change in the value of the
independent variable. The regression is termed as non-linear if the curve of
regression is not a straight line, in such a case the regression equation will
be a function involving terms of the higher order of the type x2,x3.

282
13.3.1 Uses of Regression Analysis
1. It provides estimates of values of the dependent variable from values of
the independent variable.

2. It obtains a measure of the error involved in using the regression line as a

basis for estimation.
3. With the help of regression coefficients we can calculate the correlation
coefficient.
4. It is widely used in statistical estimation of demand curves, supply curves,
production functions, cost function, consumption functions etc.,

5. It can be used for estimation of future production income profits and

population which are indispensable for efficient planning of an economy and
of are of primary importance to a businessmen.
13.3.2 Principles of Least Squares
Regression refers to an average of relationship between a dependent
variable and one or more independent variable such relationship is
generally expressed by a line of regression drawn by the “method of least
squares”, This line of regressions can be drawn graphically or derived
algebraically in the form of an equation of line by any one of the methods.

A line fitted by the method of least squares is the line of best fit.
i) The algebraic sum of deviation is the individual observations, vertical
or horizontal as the case may be is equal to zero. i.e., (x-xe) = 0 (or) (y-ye)
= 0.
ii) The sum of the squares of all these deviations is less than the sum
of the squares of deviations from any other line (y - ye)2is minimum.

iii) There are two lines of regression

a. Regression line of x on y
b. Regression line of y on x.
iv) Two lines of regression meet at the mean values, i.e., X and Y .

283
13.4 METHODS OF REPRESENTING REGRESSION LINES
Methods

Graphic Algebraic

Regression
Scatter Three dimensional Regression equation
diagram
equations through
diagram through regression
normal equations
coefficients

With step
Bydirect
deviation

Figure 13.1
13.4.1 Graphical Method
Scatter Diagram
Under this method the points are plotted on the a graph paper representing
various pairs of values of the concerned variables. These points give a
picture of a scatter diagram with several points scattered around. A
regression line may be drawn in between these points either by free hand or
by a scale rule in such a way that the squares of the vertical or the
horizontal distances between the points and the lines if regressions so
drawn is the least. It should be drawn carefully as the line of best fit leaving
equal number of points on both sides on such a manner that the sum of the
squares of the distances is the least. A nonlinear freehand curve will have a
greater element of subjectivity and therefore normally a straight line is
drawn.

13.4.2 Algebraic Methods

Under this method, the equation of line is derived by some suitable method.
It has been classified as

i) Regression equation
ii) Regression coefficients.

284
 i) Regression equation

General Equation Y = a+bX X = c + dY

Normal Equations Y = na+bX X = NC + dX2

XY = aX + bX2 XY = CY + dY2

Example 13.1 Find the regression equation of income (Y) on years of

service (X).

Years of service 11 7 9 5 8 6 10

Income 10 8 6 5 9 7 11

Solution

X Y X2 XY

11 10 121 110

7 8 49 56

9 6 81 54

5 5 25 25

8 9 64 72

6 7 36 42

10 11 100 110

X = 56 Y=56 X2=476 XY=469

i) Regression line of X on Y is

X = a + bY
X = na + bY
XY = aY + bY2
56 = 7a + 56b …(1)
469 = 56a + 476 …(2)

285
Solving (1) & (2) we get a=2 b = 0.75
 Regression of X on Y is
X = 2 + 0.75 Y
ii) Regression equation of Y on X
Y = a + bX
Y = na + bX …(3)

XY = aY + bY2 …(4)

56 = 7a + b56 …(5)
469 = 56a + 476b…(6)
(5) x 8, 56a + 448b = 448
56a + 476b = 469
(-) - 28b = -21
 21 3
b = 
 28 4
b = 0.75
7a + 56 (0.75) = 56
7a = 56 - 42

7a = 14
a = 2
 Regression equation of Y on X is

Y = 2 + (0.75) X
Example 13.2 A summary data is given by

N = 120 (For x), X = 510, Y = 7,140, X2 = 4150

N = 102 (For y), XY = 54900 Y2 = 7,40,200

Estimate the two regression line of equations by using regression
coefficients.

Solution

X
 X  510 Y
Y
n 120 n

286
 7140
X 5 Y  70
102
Regression coefficients X on Y is
N XY   X  Y 
bxy =
N Y 2   Y 2
102 x 54900  510 x 7146
=
102 x 740200  (7140)2
1958400
=
24520 ,800

bxy = 0.08
Regression line of X on Y is
X  X  b xy ( Y  Y )

X5  0.08 ( Y  70 )

X = 5 + 0.087 - 70 x 0.08
X = 0.08Y - 5.6
Regression coefficient of Y on X is
N XY   X Y 
bYX =
N X 2   X2
102 x 54900  510 x 7140
=
102 x 4150  (510) 2
1958400
=  12
1,63,200

byx = 12

Regression equations of Y on X is
Y Y  b YX ( X  X)

Y - 70 = 12 (X-5)
Y - 70 = 12X - 60
Y = 12 X - 60 + 70
Y = 12X + 10

287
Example 13.3 Compute the two regression lines to the following data

X 2 3 4 5 7

Y 6 5 1 2 9

Also given correlation coefficient is r = 0.8

Solution

X Y X2 Y2

2 6 4 36

3 5 9 25

3 3 9 9

5 2 25 4

7 9 49 81

96 155

X 
 x  20  4 Y
25
5
,
n 5 5
2
x 
 X2    X 
 
n  n 

96
  ( 4) 2
5

 19 .2  16  3.2

x = 1.78
2
y 
 Y2    Y 
 
n  n 

155
  (5 ) 2
5

 31  25  6  2.45

288
 y = 2.45
Regression line of X on Y.
σX
X- X = rx (Y  Y)
σY
1.78
X-4 = 0.8 x ( Y  5)
2.45
X-4 = 0.58 (Y.5)

X = 4 + 0.58Y - 0.58 x 5 = 0.58Y + 4 - 2.91

X = 0.58Y + 1.09
Regression line of Y on X
Y
Y- Y = r x (X  X )
X
2.45
Y-5 = 0.8 x ( X  4)
1.78
Y-5 = 1.101 (X-4)
Y = 5 + 1.101X - 1.101 x 4
= 1.101X + 5 - 4.404
Y = 1.101X + 0.59
Example 13.4 Compute two regression lines from the given data

X Y

Arithmetic Mean 36 85

Standard deviation 11 8

Correlation coefficient is 0.66. Also estimate value of X when Y = 75.

Solution

Given X = 36 Y = 85
x = 11 y = 8; r = 0.66
The regression line of X on Y

289
 
X- X = r. x ( Y  Y )
y

11
X-36 = 0.66 x ( Y  85)
8
X-36 = 0.91 (Y-85)
X = 36 + 0.91Y - 77.14
X = 0.91Y - 41.13
The regression line of Y on X
σy
Y- Y = r. (X  X)
σx

8
Y-85 = 0.66 x ( X  36)
11
Y-85 = 0.48 x (X-17.28)
Y = 85 + 0.48X - 17.28
Y = 0.48 X + 67.72

When Y = 75
X = 0.91 x 75 - 41.13
= 68.25 - 41.13

X = 27.12
Example 13.5 Regression line of X on Y is 5X-Y = 22. Regression line
of Y on X is 64 x -45Y = 24 also given var(X) = 25. Find i) X & Y

ii) Coefficient of correlation between X and Y iii) Standard deviation of Y.

Solution
The two regression lines are

5X - Y = 22 (A)
64X - 45Y = 24 (B)
since it passes through ( X , Y )

5X - Y = 22 (1)
64 X - 45 Y = 24 (2)

290
(1) x 45; 225 X - 45 Y = 990
64 X - 45 Y = 24
(-) 161 X = 996
996
X =
161
X = 6
5X - Y = 22
5 x 6 - 22 = Y

Y = 30 - 22
Y = 8
Therefore Mean of X = 6 and Mean of Y = 8
ii) Assume eqn. (A) as X on Y
5X = Y + 22
Y 22
X = 
5 5
1
bxy =
5
Assume equation (B) as Y on X
45Y = 64X - 24
64 24
Y = X 
45 45
64
byx =
45
 The correlation coefficient = b xy .b yx

1 64
r = x
5 45

64 8
= 
225 15

r = 0.53

291
 x
we know that bxy = r.
y

1 8 5
 x
5 15 y

1 3 1 3
  
y 8 x5 y 40

40
Therefore y = y = 13.3
3
13.4.3 Standard Error of an Estimate
The standard error estimate of Y for given X
2
Syx =
 ( Y  Ye )
N

Standard error estimate of X on Y

2
Syx =
 ( Y  Ye )
N
2
(or) Syx =
 Y  a Y  b XY
N

 X2  a X  b XY
Sxy =
N

Example 13.6 Calculate standard error estimate of X on Y and Yon X.

X 6 2 10 4 8

Y 9 11 5 8 7

Solution

X Y X2 Y2 XY

6 9 36 81 54

2 11 4 121 22

10 5 100 25 50

4 8 16 64 32

292
 8 7 64 49 56

X=30 Y=40 X2=220 Y2=340 XY=214

Let us consider Regression line of X on Y

X = a + bY
The normal equations are
X = na - bY

XY = aY + bY2

5a + 40b = 30 …(1)
40a + 340b = 214 …(2)
(1) x (8)  40a + 320b = 240
-40a + 340b = 214
(-)
20b = 26
 26
b =
20
b = -1.3
5a = 30 - 40b
= 30 - 40 (-1.3)

= 30 + 52
5a = 82 => a = 16.4
 Standard Error estimate of X on Y
2
 X  a X  b XY
Sxy =
N

220  16 .4(30 )  ( 1.3) (214 )

=
5

220  492  278 .2

=
5

293
 6 .2
=  1.24  1.11
5

Sxy = 1.11
Standard Error estimate of Y on X
2
Syx =
 Y  a Y  b XY
N

340  (1.3) X 40  ( 1.3) (214 )

=
5

340  52  278 .2
Syx =
5

670 .2
=  134 .04
5

Syx = 11.58
Regression coefficients bxy and byxin case of grouped data.
We use the formula
N fdxdy   fdx   fdy  ix
bxy = x
N fdy 2   fdy 
2 iy

N fdxdy   fdx   fdy  iy

byx = x
N fdx 2   fdx 2 ix

Example 13.7 Calculate the coefficients of regressions to the following

data

Y 1 2 3 4

10 3 2 - -

20 2 3 1 -

30 - 1 1 3

40 - - 3 1

294
Solution
Find dy

YA YA
Y Y-A dy = X dx =
10 10

10 0 0 1 0

20 10 1 2 1

30 20 2 3 2

40 30 3 4 3

dx
2
0 1 2 3 F fdy fdy fdxdy
dy

0 3 2 - - 5 0 0 0

1 2 3 1 - 6 6 6 5

2 - 1 1 3 5 10 20 24

3 - - 3 1 4 12 36 27

f fdy fdy
2
f 5 6 5 4
=20 =28 =62

fdx
fdx 0 6 10 12
=28

fdx
2
2
fdx 0 6 20 36
=62

fdxdy
fdxdy 0 5 24 27
=56

Regression coefficients of X on Y
N fdxdy   fdx   fdy  ix
bxy = x
N fdy 2   fdy 
2 iy

20 x 56  (28) (28) 1
= x
2
20 x 62  (28) 10

295
 1120  784 1
= x
1240  784 10

336 1 336
= x 
456 10 4560
bxy = 0.074
N fdxdy   fdx   fdy  iy
bxy = x
N fdx 2   fdx 2 ix

20 x 56  (28) (28) 10
= x
20 x 62  (28) 2 1

1120  784 3360

= x 10   7.368
1240  784 456

byx = 7.4
LET US SUM UP
This unit dealt with the various methods of calculating correlation and
regression coefficients. We have discussed the method of forming
regression line of x on y and y on x. We have also discussed about the
standard error concept in this unit.
CHECK YOUR PROGRESS
1) Calculate the two regression lines of

X Y

Mean 65 67

S.D 2.5 3.5

r = 6.7

2) Two regression lines are

3x + 2y = 26 and 6x + y = 31find
i) Mean of x and y

ii) Correlation coefficient.

3) Find two Regression coefficients if given
x= 50 ; x = 5; y = 60 ; y = 6 xy = 350

296
 variance of x = 4 ; variance of y =9.
4. The correction coefficient of x and y is 0.6
If x = 1.50 ;y = 2.00 x = 10 and y = 20.

find the regression lines of x on y and y on x.

5) Calculate the regression coefficients bxy and byx to given data.

X
90-100 100-110 110-120 120-130
Y

50-55 4 7 5 2

55-60 6 10 7 4

60-65 6 12 10 7

65-70 3 8 6 3

GLOSSARY

Regression : Regression refers to an average of relationship

between a dependent variable and one or more
independent variable such relationship is generally
expressed by a line of regression drawn by the
“method of least squares”.:

Variables : Entities whose behavior is being studied.

Binary variable : A variable that takes only two values, usually

coded as zero and one.

Continuous : A variable that can take any take the value of any
variable
real number within an interval.

Dummy variable : Another label for binary variables that take the
value zero or one. A variable used to represent
qualitative attributes and structural breaks in the

297
 equations.

SUGGESTED READINGS

1. D.C.Sancheti, V.K.Kapoor,( 2014), Business Mathematics, 11th

edition, Reprint, Sultan Chand and Sons, New Delhi.
2. JK. Sharma, (2009), Business Mathematics Theory And
Applications, 13th Edition, ANE Books, New Delhi.

3. S. P. Gupta, (2012), Statistical Methods, 42nd Revised Edition Sultan

Chand & Sons Pvt. Ltd., New Delhi.
4. Gupta, B.N., (2015), Business Statistics, First Revised Edition,
SBPD, New Delhi.
5. Arora, P.N. & S. Arora, (2007) ,Statistics for Management, latest
Edition, S. Chand & Company Ltd., New Delhi.
6. http://www.stat.yale.edu/Courses/1997-98/101/linreg.htm
7. https://epgp.inflibnet.ac.in/Home/ViewSubject?catid=ahLCajOqz6/G
WFCSpr/XYg==
ANSWERS TO CHECK YOUR PROGRESS
1. a. y=26.72+0.571x b. x=1.2y-5.8
2. a Mean of x=4 Mean of y=7 b. correlation Coefficient = -0.5
3. bxy =0.556 and byx = 1.25
4. x=1+0.45y and y =12+0.8x
5. bxy = 0.041 and byx =0.152

298
Unit 14

INDEX NUMBERS
STRUCTURE

Overview
Learning Objectives
14.1 Introduction

14.2 Definitions
14.3 Uses of Index Numbers
14.4 Classification of Index Numbers

14.5 Construction of An Index Number

14.6 Methods of Calculation
14.6.1 Simple Aggregative Method

14.6.2 Simple Relative Method

14.6.3 Use of Geometric Mean for Calculating Price Index
14.7 Weighted Methods

14.7.1 Weighted Relatives Method

14.7.2 Weighted Aggregative Method
14.8 Quantity Index

14.9 Index Number Tests

Let Us Sum Up
Check Your Progress

Glossary
Suggested Readings
Answers to check your progress

OVERVIEW

In this unit we have given the definition of index numbers. We shall discuss
the methods of calculation and explained the weighted methods. Business
index numbers will be discussed at the end this unit.

299
LEARNING OBJECTIVES
After reading this unit, you should be able to:
 define index number
 explain the use of index number in business
 illustrate how to construct an index number from the given data
 differentiate between the aggregate and average relative method
 explain the difference between the simple and weighted method.
14.1 INTRODUCTION

Historically, the first index was constructed in 1764 to compare the Italian
price index in 1750 with the price level in 1500. Though originally developed
for measuring the effect of change in prices, index numbers have today
become one of the most widely used statistical devices and there is hardly
any field where they are not used. Newspapers headline the fact that prices
are going up or down, that industrial production raising or falling, imports are
increasing or decreasing, the crimes are rising on a particular period
compared with the previous period as disclosed by index numbers. They
are used to feel the pulse of the economy and they have come to be used
as indicators of inflationary or deflationary tendencies.
If one wants to get an idea as to what is happening to an economy, he
should look to important indices like the index number of industrial
production, agricultural, production, business activity etc…

“Index numbers are devices for measuring differences in the magnitude of a

group of related variables”
According to Spiegel, an index number is a statistical measure designed to
show changes in variable or a group of related variables with respect to
time, geographic location or other characteristics such as income profession
etc. Index numbers, in effect relative a variable or variables in a given
period to the same variable or variables in another period, called has period
An index, the simplified name for index numbers, which in computed from a
single variable called a invariant index whereas an index which is
constructed from a group of variables is considered a composite index.
 Index numbers are specialized averages.
 Index numbers measure the net change in a group of related variables

 Index numbers measure the effect of changes over a period of time.

300
14.2 DEFINITIONS
“It is a numerical value characterizing the change in complex economic
phenomena over a period of time or space.”

“An index number is a statistical measure of fluctuations in a variable

arranged in the form of a series and using base period for making
comparisons “

“It is a measure over time designed to show average changes in the price
quantity value of a group of items.”
14.3 USES OF INDEX NUMBERS

 They help in framing suitable policies.

 It provides a good basis of comparisons.
 It forms a scientific measure of change and therefore
 Constitutes suitable bases for comparison over time or space.
 There are indispensable tools of economic and business analysis.
 They are important in forecasting future economic activity.
 By using of percentage relative, we can reduce the physical
 units such as numbers, meters into a common measure for
purposes of calculation.
 In business the use of index number is made of quantity
 and value indices of input and outputs.
 In the economy as a whole the index numbers of overall business
activity are called ‘barometers of economic change’ or business
’barometers’.
14.4 CLASSIFICATION OF INDEX NUMBERS

Index numbers may be classified in terms of what they measure.

i. Price index ii. Cost of living index.
iii. Value index iv. Quantity index.

v. Diffusion index vi. Others.

i) Price index: This compares the prices at some time or at a certain place
for a group of commodities with prices in the base period or a given place,
as the case may be. For measuring the value of money it is the general
price index, which is used. There are separate price indices representing
the purchasing power of different sections called the cost of living indices of
say industrial workers or agricultural labourers. These are complied for

301
shares and debentures of different industrial groups. Of all index numbers,
price index is the most important and common useful in business and
economic fields.

ii) Cost of Living Index: These are in fact indices of consumer

expenditure. A change in the total expenditure is reflected, a part of which
may be due to change in price of the commodities consumed and a part
may be due to other non-price factors which influence consumer
expenditure such as the size of the family, the change in attitude towards
thrift etc. Price factor is most important in the short period.

iii) Value Index: This compares the total value of some period with the total
value in the base period. As we know the total value is the sum of price of
each item and quantity dealt and therefore useful only in very selected
cases like sales of departmental stores, inventory, foreign trade etc. Both
the total value of the product and value – added may be taken.
iv) Quantity Index: This measures changes in the value of goods
produced, purchased or sold during some period compared with any other
period. Since the quantities are embodied in the form of weights in the price
index formulae, much attention will not be paid to these indices.
v) Diffusion Index: It summarizes changes in a group of economic series
indicating the turning point of an economic cycle. This has been dealt in
detail in the chapter on forecasting.

vi) Others: There can be any number of index numbers to measure relative
changes in profit, yields etc.
14.5 CONSTRUCTION OF AN INDEX NUMBER

Index number is a useful technique of expressing change in a group

phenomenon but its actual usefulness for analytical and predictive purposes
will depend upon the care exercised in the choice of the method and the
manner in which it is complied.
i) Clarity About Purpose: The need for defining the purpose arises
because the choice of method shall depend upon the purpose. For
example, the cost of living index will have different set of commodities; price
quotations and weights compared with a general wholesale price index.
Again the cost of living index for workers in an industrial town will have
different requirements than for agricultural workers.

302
ii) Base Period: The general rule is that the base period should be a
normal period. Sometimes an average of few years is taken as the base so
that the abnormality of any one-year is removed. The need for a normal
base period is emphasized because the index will be overstated if the value
in the base period is too high. A distant period makes the index number
irrelevant for short period comparisons. This is because among other things,
the habits tastes undergo change and should be reflected by a change in
the composition and the weights assigned to various commodities.
However for a long-term view the near base does not serve the purpose.
For this we can resort to the method of splicing where by the index numbers
based on a new can be adjusted to given new series on an earlier base, a
compromise solution to a distant and a near base period has been found in
the system of chain base.
iii) Selection of Items: Index numbers obviously are calculated to
represent the average of change in a group phenomenon with several
component parts. If the number of the components is too large a choice of
some representative items has to be made. Above all for sensitive items the
number of items should be limited so that the results can be used for
decision if required to those items. However the items in each set should
represent the phenomenon as well the direction of change the choice of
items should also be related to the end purpose. But for calculation of
wholesale price index those item should be included which enter a big way
into business transactions of the country. A proper choice will extend to the
selection of proper brand, variety and pattern of the product; those, which
are most commonly used, should get a priority over uncommon items.
iv) Price Quotation: It should be relevant to the purpose for example retail
prices are more appropriate than wholesale prices for calculations of cost of
living index. But there are several retailers. A choice has to be made from
amongst them. Here also the choice should be relevant to the region for
which the index is meant. Price quotations can be widely different e.g.,
closing, opening average of the day or a week etc., these again can be with
or without certain discounts or concessions delivery etc., all these have to
be decided for home and defined to avoid ambiguity. Price quotations have
to be with reference to a certain quantity of tones, quintals, kilograms with a
higher measure say quintal in place of kilogram of a given commodity an
implicit weight is embodied such measures should be relevant to the basic
purpose and be related with the quantity units of other commodities covered
in the calculation. The manner of quotations can also be different there may

303
be money price for a quantity or number of unit for a given unit of money.
Whatever way be the mode of expression, it should be uniform for an items
and should preferably be in money price per unit of commodity.

v) Choice of Average: As a rule geometric mean is the most approximate

for averaging percentage relatives. In it there is no question of negative
figures, where geometric average is not suitable. An additional advantage of
geometric average is that it renders the index reversible. It is because of the
use of geometric mean in the fisher’s ideal formula that it stands valid for
time reversal test. The index of the current item the base price gives the
result in the inverse form. However geometric mean is somewhat difficult to
use in the manual process of calculation. In practice the arithmetic mean,
the mode and the median are also used.
vi) Choice of Weights: Allotment of explicit weights is according to the
relative importance of various elements of a phenomenon and constitutes
very important aspect of calculations of index numbers, the common
choices are:
(i) Quantity of the base period or current period.
(ii) Price of base period or the current period in the case of quantity
index.
(iii) Value, it Quantity x price of the base period or the current period.
(iv) Average price, Quantity or value of the base period, the Current or
any other suitable period depending, upon the purpose of index
compilation.
The choice of any one will depend on the purpose and the availability of
data.
vii) Choice of Method: There are various methods of calculating index
numbers given in the section, which follows. Some of these are simple to
use but lack scientific basis and sophistication. Some are more
sophisticated but are difficult to prepare. A compromise has often to be
struck considering the purpose, availability of data and the resources at
availability of data and the resources at the disposal.
Notations
I = index number in general some time suffixed by the relevant current year
as I7 7

304
For the year 1977, also with the base year as I77-70 for the current year 1977
with the base year 1970.
V = value Index

P = price Index
Q = Quantity Index
P0 = Price per unit in the base year

P1 = Price per unit in the current year

q0 = Quantity per unit in the base year
q1 = Quantity per unit in the current year
14.6 METHODS OF CALCULATION
The index numbers are calculated on the basis of the aggregates of
values of a group of variable for the base period and the current period
while under the relatives method the ratios of the values for the current
period over the values of the base period called “relatives” are first
computed and then the index numbers are calculated by taking an average
of there relatives.
Price Index Method

It can be broadly divided into simple and weighted and each can
then be divided into aggregative and price relative methods. Major
discussion is being given on price indices because of their importance in
practical use.

4.6.1 Simple Aggregative Method

Simple aggregative method, the aggregative price of various
commodities in the given year is expressed as a percentage of the same in
the base year. The formula is

P1
P01 = x 100
P0
Where, p1 = aggregate of prices for the current period
p0 = aggregate of prices for the base period.

305
Example 14.1
Calculate price index using simple aggregative method.

Commodities Vegetable Oil Butter Biscuits Bread

1970 5.0 20.0 10.0 0.70

1975 7.50 21.00 12.50 1.00

1977 10.75 23.00 14.25 0.95

Solution
Consider 1970 as base year, 1975 as current year with 1970 as base year,
1977 as current year with 1970 as base year.

Commodities Unite 1970 (p0) 1975 (p1) 1977 (p2)

Vegetable oil Kg. 5.0 7.50 10.75

Butter Kg. 20.0 21.00 23.00

Biscuits Kg. 10.0 12.50 14.25

Total p0 = 35.70 p1 =42.00 p2 = 48.95

 p1
P = ×100
01 p
0
42.00
= ×100
35.7
P = 117.64
01
 p2
P = ×100
02 p
0
48.95
= ×100
35.70
P = 137.114
02

306
Example 14.2
From the following data construct an index for 1999 taking 1998 as base:

Commodity Price in 1998 Price in 1999

A 50 70

B 40 60

C 80 90

D 110 120

E 20 20

Solution

Commodity Price in 1998 Price in 1999

A 50 70

B 40 60

C 80 90

D 110 120

E 20 20

p0 = 300 p1 = 360

P02 
p 2
100
p 0

360
 100
300
P01  120

14.6.2 Simple Relative Method

In this method the price of each item in the current year is expressed as a
percentage of the price in the base year. This is known as price relative and

307
 Price in the current year
Price Relative = ×100
Price in the base year
P1
 ×100
P0
Price relatives are pure numbers independent of units’ measurement. The
average of price relatives by using some suitable measure of central
tendency gives the index number. The index number is called simple
Average of Relative Index if simple average is used. Thus simple Relative
index is
1
P01 =  (price relative)
n
1  P1 
P01 =  ×100 
n  P0 
Solution
We solve the problem given in the previous example (12.1)

Price Relatives (Base 1970)

Commodities
1975 1979

7.50 10.75
Vegetable Oil ×100 = 150 ×100 = 250
5 5

21 23
Butter ×100 = 105 ×100 = 115
20 20

12.50 14.25
Biscuits ×100 = 125 ×100 = 142.51
10 10

1
×100 = 142.86 0.95
Bread 0.70 ×100 = 135.71
0.70

Total 522.86 608.22

Index number of price for 1975 with 1970 as base

308
 1  P1 
P01 =  ×100 
n  P0 
522.86
= = 130.715
4
Index number of price for 1977with 1970 as base

1  P2 
P01 =  ×100 
n  P0 
608.22
= = 152.06
4
14.6.3 Use of Geometric Mean for Calculating Price Index
As indicated in this unit, an average that the geometric mean is useful in
averaging rates, ratios and percentages. It is particularly suitable for the
construction of index numbers because index numbers show percentage
changes rather than absolute amounts of change. The formula for simple
G.M of relative’s index is

P = Product of price relatives

01
P 
 log  1 ×100 
logP =  P0 
01 n
 logP P
where P = 1 ×100
n P
0
  logP 
P = Antilog 
01  n 
The only drawback of the use of geometric mean is the conversion of
relatives into logarithms of relatives.
Example 14.3

Compute a price index for the following by

a) Simple aggregative method and

b) Average of price relative method by using both arithmetic mean and
geometric mean.

309
 Commodity: A B C D E F

Price in 1971: 20 30 10 25 40 50

Price in 1976: 25 30 15 35 45 55

Solution

P
Commodity
Price in Price in P = 1 × 100 log P
1971 P0 1976 P1 P
0

A 20 25 125 2.0969

B 30 30 100 2.0000

C 10 15 150 2.1761

D 25 35 140 2.1461

E 40 45 112.5 2.0511

F 50 55 110 2.0414

Total 175 205 737.5 12.5116

a) Simple aggregative index:

 P1
= ×100
 P0
205
= ×100
175
= 117.43
b) i) Arithmetic mean of price relatives index:
1 737.5
=  P01 = = 122.92
n 6

ii) Geometric mean of price relatives index:

  logP  12.5116 
= Antilog   = Antilog 
 6   6 
= Antilog(2.0853)
= 121.7

310
Harmonic Mean
Another ratio average, the harmonic mean is also used in case of relatives.
It was indicated in the chapter an averages that geometric mean gives
higher importance to lower values and therefore its value is lower than that
of the arithmetic mean. The harmonic mean gives lower weightage to
higher values and therefore the value of harmonic mean. This will be
revealed in the following example. The formula for calculation of simple
harmonic mean of relatives is
n n
 
P = =
01  P   1
P = 1 ×100  P
 P
0 
P
Where P = 1 ×100
P
0

Example 14.4

Calculation of simple price index number using arithmetic, geometric and

harmonic average from the following data

Gold Silver Copper

Commodities

1971 210 740 85

1976 650 1260 195

Solution:

Commodities Unit
Price in Price in P = P1/P0) ×100  log P
1971 1970

A Kg 210 650 309.52 2.947

B Kg 740 1260 170.97 2.2311

C Kg 85 195 229.43 2.3604

Total 709.20 7.4386

709.20
Price index (A.M) = = 236.40
3

311
 Price Index (G.M)
1 
= Antilog   (logP)
n 
 7.822 
= Antilog 
 3 
= 229.5
3
Price index (H.M) = = 229.87
1.3641

Thus,
P01 (A.M)  P01 (G.M)  P01 (H.M)
Example 14.5
From the data given below calculate the whole rate prices index numbers
for the years 1976 and 1977 taking 1975 as base year. Use average
Relative method.

Commodity A B C D E

Price in 1975 (Rs.) 80 120 40 100 200

Price in 1976 (Rs.) 120 150 80 750 240

Price in 1977 (Rs.) 140 180 100 240 300

Solution:

1975 (Base yr) 1976 1977

Price Price Relative Price Relative

Relative
Commodity (P0) (P1) (P1/ P0)x100 P1 (P1/ P0 )x100

A 80 100 120 150 140 175

B 120 100 150 125 180 150
C 40 100 80 200 100 250
D 100 100 150 150 240 240
E 200 100 240 120 300 150

Total 500 745 965

Average of
100 149 193
Relatives

312
Year : 1975 1976 1977
Price Index Number : 100 149 193
Example 14.6 From the following average of three groups of
commodities find out index number using mean, median and
geometric mean.

Group 1971 1972 1973 1974

A 8 12 16 20

B 32 40 48 60

C 16 20 32 40

Solution:

1971 1972 1973 1974

Group
Price Relative Price Relative Price Relative Price Relative

A 8 100 12 150 16 200 20 250

B 32 100 40 125 48 150 60 187.5

C 16 100 20 125 32 200 40 250

Total of
300 400 550 687.5
Relatives

Arithmetic
Mean of 100 133.3 183.3 227.2
relatives

Median of
100 125 200 250
relatives

Geometric
mean of 100 132.82 181.66 227.15
relative

14.7 WEIGHTED METHODS

Under weighted methods, appropriate importance is attached to the

variables of relatives as the case may be.

313
14.7.1 Weighted Relatives Method
Weighted average of relatives index is obtained by multiplying the relatives
with the weights assigned to each commodity and then summing these
products and finally dividing these totals for each weighted A.M
 (Price relative)× w
P01 (AM) =
w

P 
  1 ×100 w
 P0 
= 
w
 PW
=
W

where
P
P = 1 ×100
P
0

  w.logp 
P01 (G.M) = Antilog  
 w 
Example 14.7 Construct an index number for the following data using
the data.

Commodities A B C D

Current year (1977) 5.20 3.75 1.95 8.10

Base Year (1973) 4.25 2.95 2.15 8.85

Weights 30 40 15 15

Solution:

Base Price
Current year relative Weights PW
Commodities year
Price P1 W
Price 1977 P= × 100
1973 P0

A 5.20 4.25 122.4 30 3672

314
B 3.75 2.95 127.1 40 5084

C 1.95 2.15 90.7 15 1360.5

D 8.10 8.85 91.52 15 1372.8

11489.3

Weighted average of price relatives

 (Price Relative) x Weight
=
 (Weight)
11489.3
=
100
= 114.89
Example 14.8 The Price of agricultural commodities for 1966 -67 and
for the month of December 1970 are given below along with the value
of these commodities in 1966 –67

Price in Value of
Commodities Unit Rs. Dec 1970
1966 -67 Output

Rice Md 13.75 13.75 8,364

Wheat Md 9.70 9.70 2.207

Jowar Md 6.03 8.00 8.76

Cotton 984 lb 466.00 433.00 701

Tea Lb 1.25 1.75 534

Calculate the weighted index number of prices of these commodities for

December 1970 taking 1966 – 67 as base.
Solution:

Since the value of output represent the base period values ( p0 , q0), the
required weighted index number may be obtained as the weighted A.M of
price relatives .Using value of output as weights.

315
 Prices
Price
Commodities Unit 1966– Dec Weight relative PW
67 1979 W P
(1) (2) P = 1 ×100 (7)
p0 P1 (p0 q0) P
0
(3) (4) (5)

Rice Md 13.75 13.75 8,364 100.00 8,36,400

Wheat Md 9.70 9.70 2,207 100.00 2,20,700

Towar Md 6.03 8.00 8.76 132.67 116,18.92

784
Cotton 466 433 701 92.92 65,136.92
lb

Tea Lb 1.25 1.75 534 140 74,760

12,682 13,13,215.8

Weighted index number

 (Price Relative) x Weight
=
 (Weight)
13,132,15.8
=
12,682
= 103.549
14.7.2 Weighted Aggregative Method

This method provides usage of appropriate weight for each

commodity with a view to have influence of each commodity on the index
usually the quantities consumed sold or some typical year are used as
weights.
 P1w
Weighted Aggregative price Index = P01 100
 P0 w

Laspeyre’s Method

This is an aggregate index with specific weights as quantities of the

base year (q0). The method is named after a German economist Etienne

316
Laspeyre’s who formulated it in 1871,

 P1q0
P (La) = ×100
01  P0q0

Example 14.9: Construct index number for 1977 with 1973 as base ,
using Laspeyre’s formula from the following.

Commodity A B C D

1973 2.0 1.8 3.5 2.8

Price
1977 2.5 3.2 4.8 4.0

1973 10 16 8 12
Quant
ity
1977 12 10 8 10

Solution:

Avg. Measure
Base Year 1973
(1977) year P0 q0
Commodity
Price Quantity P1 q0
Price p0 Quantity q0
p1 q1

A 2.0 10 2.5 12 20 25

B 1.8 16 3.2 10 8.8 1.2

C 3.5 8 4.8 8 28 38.4

D 4.4 12 4.0 10 33.06 48

110.4 162.6

  P0 q0 162.6
P01(La) = =
 P0 q0 110.4
P01(La) = 147

317
Paasche’s Method
Under this method the weights are equal to the quantities of the given year
and not that of the base year as in the case of Laspeyr’s method. Therefore
q1 is substituted index given earlier. This method is named after the German
statisticians paasche’s law formulated it in 1874

P01 ( pa ) 
 Pq 1 1
100
Pq 0 1

Example 14.10 Using Laspeyre’s and paasche’s method, calculate the

index number

1999 2000
Commodity
Price Quantity Price Quantity

A 2 8 4 6

B 5 10 6 5

C 4 14 5 10

D 2 19 2 13

Solution:

1999 2000

Commodity P1 q0 P0 q0 P1q1 P0 q1
Price Price
Quantity q0 Quantity q1
p0 p1

A 2 8 4 6 32 16 24 12

B 5 10 6 5 60 50 30 25

C 4 14 5 10 70 56 50 40

D 2 19 2 13 38 38 26 26

Σ P1
P1q0 = P0q0 P1q1
q0 =
160 = 130 =103
200

318
 i) Laspeyre’s Method
 P1q0
P (La) = ×100
01  P0 q0
200
P = ×100
01 100

ii) Paasche’s Method

 P1q1
P (Pa) = ×100
01  P0q1
130
= ×100
103
P01 = 126.21

iii) Fisher’s Method

It is given by geometric method of Laspeyre’s and paasche’s formula
symbolically

 P1q0  P1q0
P (F) = La ×Pa = × ×100
01  P0q0  P0 q0

It is known as ‘Ideal’ due to the following reasons

i) It is free from bias.

ii) It is based on the geometric mean, theoretically which
considered to be the best average for constructing index
numbers.
iii) It confirms to certain tests of consistency which we will discuss
later.

iv)This formula takes into account the influence of the current as well as the
base year.
iv) Drobish and Bowely Method

To take into account the influence of the base as well as current

Periods, Drobish and Bowery suggested the arithmetic average of the
Laspeyre’s and paasche’s Indices
  P1q0  P1q1 
P01(DB) 1/2  +  ×100
  P0 q0  P0 q1 

319
 The formula sometimes is known as
La + Pa
=
2

v) Marshall And Edge Worth Method

If we take w = (q0 + q1) / 2 in the general weighted aggregative
formula, i.e., with weights as the arithmetic average of the base year
quantities and the current quantities, the marshell Edge worth formula is
obtained as
 P1(q0 + q1)/2
P (ME) = ×100
01  P0 (q0 + q1)/2

Example 14.11 Calculate Fisher’s ideal index not and also applying
Bowley’s method, Marshall edge worth method to find the index most
to the following data.

Base year Current year

Commodity
Price per Expenditure Price per Expenditure per
unit per unit unit unit

A 2 40 5 75

B 4 16 8 40

C 1 10 2 24

D 5 25 10 60

Solution:

Commodity P0 q0 P1 q1 P1q 0 P0q 0 P1q 1 P0q 1

A 2 20 5 15 100 40 75 40

B 4 4 8 05 32 16 40 16

C 1 10 2 12 20 10 24 10

D 5 05 10 06 50 25 60 25

320
  P1q 0 ΣP0q0 P1q 1  P0q 1
=202 =91 =199 =92

 P1q0  P1q0
P (F) = × ×100
01  P0 q0  P0 q1

202199
= × ×100
91 92
= 2.1912 ×100
P (F) = 219.12
01

 P q Pq 
P (DB) = 1/2  1 1 +  1 0  ×100
01  
 P q
0 1
P q 
0 0
 202 199 
= 1/2  + ×100
 91 92 

= 1/2(2.1917 + 2.1630)×100
= 2.1913 ×100
P (DB) = 219.13
01

 P1(q0 + q1)
P (ME) = ×100
01  P0 (q0 + q1)
5 × (20 +15) + 8 × (4 + 5) + 2 × (10 +12) +10 × (5 + 6)
= ×100
2 × (20 +15) + 4 × (4 + 5) +1× (10 +12) + 5 × (5 + 6)
5(35) + 8(9) + 2(22) +10(11)
= ×100
2(35) + 4(9) +1(22) + 5(11)
401
= ×100
183
= 2.1913 ×100
P (Me) = 219.12
01

i) Walsch’s Method
Instead of using arithmetically crossed weighted aggregative as in
M.E Formula, Walsch’s used geometrically crossed weighted aggregative

i.e. Put W = q0q1 in general weighted/

ii) Aggregative Formula

 P1 q0q1
P (Wa) = ×100
01  P0 q0q1

iii) Kelly ‘S Method

This method is also known as fixed weight aggregative index number.

321
  P1q
P (k) = ×100
01  P0q

Here weights are quantities, which may refer to some period (not
necessarily the base year or Current year) and are kept constant for all
periods. The A.M or G.M of the quantities of two, three or more years can
be used as weights.
Example 14.12 The following figures relate to the prices and quantities
of certain commodities. Construct an index number for the year 1975
taking 1970 as the base year from the following data.

Commodity Qty Consumed Price in 1970 Price in 1975

A 50 32 40

B 35 30 42

C 55 16 24

D 45 40 52

E 15 35 42

Solution:
Since the weights here are fixed (neither relating to the current year nor
base year). We use Kelley’s method.

Prices
Qty
Commodity P1 q P0 q
consumed 1970 1975
(P0) (P1)

A 50 32 40 2000 1600

B 35 30 42 1050 1050

C 55 16 24 1320 880

D 45 40 52 2340 1800

322
 E 15 35 42 630 525

 P1q
P01(K) = ×100
 P0q
7340
= ×100 = 125.36
5855
Example 14.13 Construct the index number of price from the following
data by applying
1. Laspeyre’s method 2. Paache’s Method
3. Fisher’s method 4. Bowley’s Method
5. Marshall edge worth method

Commodity 1968 1973

Price Qty Price Qty

A 1 6 3 5

B 3 5 8 5

C 4 8 10 6

Solution

1968 1973
Commodity P1q0 P0q0 P1q1 P0q0
P0 Q0 P1 Q1

A 1 6 3 5 18 6 15 5

B 3 5 8 5 40 15 40 15

C 4 8 10 6 80 32 60 24

 P1q0  P0 q0  P1q1  P0 q0
Total
= 138 = 53 = 115 = 44

323
i) Laspeyre’s Method
 P1q0
P (La) = ×100
01  P0 q0
138
= ×100
53
P01(La) = 2.6037

ii) Paasche’s Method

 P1q1
P (Pa) = ×100
01  P0q1
115
= ×100
44
P01(Pa) = 261.36

iii) Fisher’s Method:

P (F) = La×Pa
01
= 260.37× 261.36
P01(F) = 260.86

iv) Bowley’s Method:

La + Pa
P01(DB) =
2
26.37 + 261.36
=
2
P01(DB) = 260.86

v) Marshall Edge Worth Method:

 P1(q0 + q1)
P (ME) = ×100
01  P0 (q0 + q1)
138  115
= ×100
53  44
253
= ×10
97
= 2.6082×100
P (ME) = 260.82
01

324
14.8 QUANTITY INDEX
It measure average change in quantities and permit comparison of physical
quantity of goods mounted or consumed or marketed or distributed in the
given year with reference of any base year. Quantity index numbers can
also obtained aggregative or relative method. Quantity index number
formula may be obtained by replacing P by Q and Q by P in price index No.
formulae,
 q1q0
Thus quantity relative =
 q0q0

P1q0
Simple aggregative quantity index = ×100
P q
0 0

Simple A.M. of Quantity relative index

1  q1 
=  ×100
n  q0 
i) Quantity index ( Average weighted relative)
q 
  1 ×100  q0P0
 q0 
= 
 q0P0

ii) Laspeyre’s quantity index

 q1p0
Q (La) = ×100
01  q0P0

iv) iii) Paasche’s Quantity index

v)  q1P1
Q (Pa) = ×100
01  q0P1

iv) Fisher’s ideal index

 q1P0  q1P0
Q (F) = × ×100
01  q0P0  q0P1

v) Marshall Edge worth

 q1(P0 +P1)
Q (ME) = ×100
01  q0 (P0 +P1)

325
Example 14.14

Year Commodity I Commodity II Commodity III

1968 5 10 8 6 6 3

1974 4 12 7 7 5 4

Prepare the quantity index by applying

i) Laspeyre’s method ii) Paasche’s Method
iii) Fisher’s method iv) Marshall edge worth method

1968 1974
Commodity q1P0 q0P0 q1P1 q0P1
P0 q0 P1 q1

I 5 10 4 12 60 50 48 40

II 8 6 7 7 56 48 49 42

II 6 3 5 4 24 18 20 15

Total 140 116 117 97

 q1p0
Q (La) = × 100
01  q0P0
140
=
× 100 = 120.68
116
 q1p0
Q (La) = × 100
01  q0P0
117
= × 100 = 120.62
97
Q = L ×P = 120.68 × 120.62
01
Q (F) = 120.65
01
 q (P0 + P1)
Q (ME) = 1 × 100
01  q0 (P0 + P1)
140 + 117
= × 100
116 + 97
257
= × 100
213
= 1.2066 × 100
Q (ME) = 120.66
01

326
Example 14.15 Using paasche’s formula complete the quantity index
and price index for 1970 with 1966 as the base year

Qty Units Value

Commodity
1966 1970 1966 1970

A 100 150 500 900

B 80 100 150 500

C 60 72 150 360

D 30 33 360 297

Solution:
 P1q1
Paasche’s Price index P (Pa) =
01
×100
 P0q1

 q1P1
Paasche’s Quantity index Q (Pa) =
01
×100
 q0P1

We can find the values of Po and P1using the relation:

P0q0 Value in 1966
P0 = =
q0 Quantity in 1966

Commodity q0 q1 P0q0 q1P1 P0 P1

P0q1 q0P1
(1) (2) (3) (4) (5) =4/2 =5/3

A 100 150 500 900 5 6 750 600

B 80 100 320 500 4 5 400 400

C 60 72 150 360 2.5 5 180 300

D 30 33 360 297 12 9 396 270

2057 1726 1570

327
Paasche’s Price index
2057
P (Pa) = ×100
01 1726
= 119.18
Paasche’s quality index
2057
Q01(Pa) = ×100
1726
= 131.02
14.9 INDEX NUMBER TESTS

There are 5 tests which have been developed for this purpose.
i) The unit test
ii) The commodity order Reversal test
iii) The time reversal test
iv) Factor Reversal test
v) The circular test.
i) Unit Test
This requires the index numbers to be independent of the units in
which the prices and quantities of various commodities are quoted. This
test is satisfied by all formulae expect the simple aggregate index since the
price relatives are substituted for absolute prices either explicitly in the case
of relative method, or implicitly as in aggregative methods.

ii) Commodity Order Reversal Test

This requires that the index number should be independent of the
order in which the different commodities are considered. This is satisfied by
all index numbers.
iii) Time Reversal Test
This test implies that if the script of any index formula be
interchanged then the resulting index should be the reciprocal of the original
index.
In Symbols

P01 x P10 = 1 (Omitting the factor 100 from each index)

Where P01 – index for the current period 1 based on the base period 0.

328
 P10 – index for current period 0 and base period 1.
If can be easily verified that simple geometric mean of price relatives
index, weighted aggregative formula, weighted Geometric mean of relatives
formula, Marshall- Edge worth formula, watch’s formula, Fisher’s index.
iv) Factor Reversal Test
This test states that an index of price when multiplied by an index or
quantity, with the same base, given years the true value ratio as the product
of price and quantity in the value of the commodity.
 P1q1
V =
01  P q
0 0

Then P01 x Q01 = V01

Where Q01 is the quantity index for the current year with reference to the
base year fisher Index number satisfies Factor Reversal Test.
v) Circular Test
This is another test for the adequacy of an index Number. It is
based on the shift ability of the base and is merely, an extension of the time
reversal test. According to this test index should not work in a circular
fashion.

Symbolically
P01 x P12 x P23 x ……..x Pn-1 n x Pn,0 = 1 1
Also Pn,0 x P0,n = 1.
1
There fore P0,n = ........... 2
P
n.0

From (1) and (2), We get P0, n = P01xP12 x.......xPn-1.n

Example 14.16 Verify that the Time Reversal test and Factor Reversal
test to the following:

1974 1975
Commodities
ty Price Qty Price

X 50 32 50 30

329
 Y 35 30 40 25

Z 55 16 50 18

1974 1975
Commodities P0 q1 P0 q0 P1 q0 P1 q1
q0 P0 q1 P1

X 50 32 50 30 1600 1500 1500 1500

Y 35 30 40 25 1200 1050 875 1000

Z 55 16 50 18 800 880 990 900

3600 3530 3365 3400

 P1q0  P1q1 3365 3430

P = × = ×
01  P0q0  P0 q1 3530 3600

 P0q1  P0q0 3600 3530

P = × = ×
10  P1q1  P1q0 3400 3365

3365 3430 3600 3530

P ×P = × × ×
01 10 3530 3600 3400 3365

Therefore P01xP10 = 1
There fore Fishers index satisfies Time Reversal test.

330
  q1P0  q1q1
Q = ×
01  q0P0  q0P1

3600 3400
P = ×
10 3530 3365

3400 3430 3600 3400

P ×Q = × × ×
01 10 3530 3600 3530 3365

3400 3400 3400  P1q1

= × = = =V
3530 3330 3530  P q 01
0 0
Therefore P01 x Q01 = V01 (Value ratio),
The factor Reversal test is satisfied.
Example 14.17 Verify Fisher ideal index satisfies both Factor Reversal
test and time Reversal test to the following:

Price Number of units Base

Commodity
Base Base Base Currents

A 6 10 50 56

B 2 2 100 120

C 4 6 60 60

D 10 12 30 24

E 8 12 40 36

331
Solution

Price No. of units

Base Current
Commodity Base Current
period P0 q0 P0 q1 P1 q0 P1q1
Period Period period

P0 q0 q1
P1

A 6 10 50 56 300 336 500 560

B 2 2 100 120 200 240 200 240

C 4 6 60 60 240 240 360 360

D 10 12 30 24 300 240 360 288

E 8 12 40 36 320 288 480 432

1360 1344 1900 1880

P01 
 P1q0   p1q1  1900 1880
 P0q0  p0q1 1360 1344

q01 
 q1P0   q1P1  1344 1880
 q0 P0  q0 P1 1360 1900
1900 1880 1344 1880
P01 q01  
1360 1344 1360 1900
This shows that Fisher’s index satisfies factor reversal test

1900 ×1880 1344 ×1880

P ×P =
01 10 1360 ×1344 1360 ×1900
= 1

P0 X P10 = 1 this shows that Fisher ideal index satisfies

time reversal test

332
 3365× 3400 3600× 3530
P ×P =
01 10 3560× 3800 3400× 3365
=1

Fisher’s index satisfies time reversal test

 q1P0  q1P1
Q = ×
01  q0P0  q0P1

3600× 3400
=
3530× 3365
3365× 3400 3600× 3400
P ×Q = ×
01 01 3530× 3600 3530× 3365
3600× 3400 3400  q1P1
= = = =V
3530× 3365 3530  q P 01
0 0
P01XQ 01 = V01 (Value Ratio)
The factor reversal test is satisfied
Examples 14.18 Verify Fisher’s ideal index satisfy both Factor
Reversal test and time Reversal test to the following data.

Price Base Number Base of Units

Commodity
Base Current Base Current

A 6 10 50 56

B 2 2 100 120

C 4 6 60 60

D 10 12 30 24

E 8 12 40 36

Solution

333
 Price No. of Units

Curr
Commodity Base Current Base P0q0 P0q1 P1q0 P1q1
ent
Period Period Perio
Perio
P0 P1 d q0
d q1

A 6 10 50 56 300 336 500 560

B 2 2 100 120 200 240 200 240

C 4 6 60 60 240 240 360 360

D 10 12 30 24 300 240 360 288

E 8 12 40 36 320 288 480 432

134 190 188

1360
4 0 0

 P1q0  P1q0 1900×1880

P = × =
01  P0 q0  P0 q0 1360×1344

 q1P0  q1P0 1344×1880

Q = × =
01  q0P0  q0P0 1360×1900

1900×1880 1344×1880
P ×Q = ×
01 01 1360×1344 1360×1900
1880  P1q3
= =
1360  P q
0 0

This shows that Fisher’s index satisfies factor reversal test

 P1q0  P1q0 1344×1360

P = × =
01  P0q0  P0q0 1880×1900

1900×1880 1344×1880
P ×P = ×
01 10 1360×1344 1880×1900
= 1

334
P01 X P10 = 1 This Shows that Fisher’s ideal index Satisfies time
reversal test
LET US SUM UP

This unit covers the basic concept of index numbers. It helps the learners to
understand various types of index numbers like value index quantity index
cost of living index, consumer price index, wholesale price index. It also
helps the learners to calculate index numbers using various methods.
CHECK YOUR PROGRESS

1. Construct index number of price from the following data by applying (i)
Laspeyre’s method (ii) Paasche’s Method

Base Year Current Year

Commodities
Price Qty Price Qty

A 2 8 4 6

B 5 10 6 5

C 4 14 5 10

D 2 19 2 13

2. Calculate Fisher’s ideal index to the following:

1974 1976
Article
Price Qty Price Qty

A 5 50 4 48

B 8 48 7 49

C 6 18 5 20

3. Compute Laspeyre’s and paasche’s Quantity index to the following data:

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 Quantity
Base Price current
Item
year year
Base year Current year

1 2 5 20 15

2 4 8 4 5

3 1 2 10 12

4 5 10 5 6

GLOSSARY

Price index : A price index (plural: "price indices" or

"price indexes") is a normalized average
(typically a weighted average) of price
relatives for a given class of goods

Quantity index : A volume index or quantity index is a

numerical time series measure designed to
help compare how the production of some
class of goods and/or services, taken as a
whole, differs between time periods or
geographical locations.

Value index : A value index is a measure (ratio) that

describes change in a nominal value relative
to its value in the base year. The index point
figure for each point in time tells what
percentage a given value is at that point in
time of its respective value at the base point
in time.

Consumer price index : The Consumer Price Index (CPI) is a

(CPI) measure that examines the weighted
average of prices of a basket
of consumer goods and services, such as
transportation, food, and medical care.

Whole Sale price index : A wholesale price index (WPI) is

336
(WPI) an index that measures and tracks the
changes in the price of goods in the stages
before the retail level. This refers to goods
that are sold in bulk and traded between
entities or businesses (instead of between
consumers).

SUGGESTED READINGS
1. Arora, P.N. & S. Arora, (2007) ,Statistics for Management, latest
Edition, S. Chand & Company Ltd., New Delhi.
2. D.C.Sancheti, V.K.Kapoor,( 2014), Business Mathematics, 11th
edition, Reprint, Sultan Chand and Sons, New Delhi.
3. Gupta, B.N., (2015), Business Statistics, First Revised Edition,
SBPD, New Delhi.
4. JK. Sharma, (2009), Business Mathematics Theory And
Applications, 13th Edition, ANE Books, New Delhi.
5. S. P. Gupta, (2012), Statistical Methods, 42nd Revised Edition Sultan
Chand & Sons Pvt. Ltd., New Delhi.
6. https://www.tutorhelpdesk.com/homeworkhelp/Statistics-/Uses-Of-
Index-Numbers-Assignment-Help.html
7. https://homework1.com/statistics-homework-help/tests-of-
consistency-of-index-number/
ANSWERS TO CHECK YOUR PROGRESS
1.P01 (La) =125, P01 (Pa) =126.2
2.P01 (F) =120.6

3.Laspeyre’s Quantity Index Q01 =101.09

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Unit 15

INDEX IN BUSINESS AND FINANCIAL

MARKET
STRUCTURE
Overview
Learning Objectives
15.1 Introduction
15.2 Business Index Numbers
15.2.1 Consumer Price Index Numbers
15.2.2 Construction of a Consumer Price Index
15.2.3 Methods of Construction
15.2.4 Wholesale Price Index
15.3 Nifty Index
15.3.1 Significance of Nifty Index
15.3.2 NIFTY Sectoral Indices
15.3.3 NIFTY Thematic Indices
15.4 Production Index
15.4.1 Index of Industrial Production
15.4.2 Index of Industrial Production Importance

Let Us Sum Up
Check Your Progress
Glossary

Suggested Readings
Answers to check your progress
OVERVIEW

Index-focused financial products, which improve research and analysis on

stock picking, help investors make better financial decisions in both

338
the short term and long term periods. In this unit we have given the
definition of Business index, Nifty Index and Production Index numbers.
LEARNING OBJECTIVES

After reading this unit, you should be able to:

 explain the use of index number in business.
 to learn about nifty index and production index
15.1 INTRODUCTION
In business, an index is an information source that can be used by
corporate decision-makers to observe trends over time. An index usually
includes a base value, which represents the key element to which other
values will be compared. Indexes of sufficient data quality to ensure
accurate projections can come from a variety of sources. Index-focused
financial products, which improve research and analysis on stock picking,
help investors make better financial decisions in both the short term and
long term periods. So, in this unit an attempt is made to explain the
business index, Nifty index and Production Index.
15.2 BUSINESS INDEX NUMBERS
15.2.1 Consumer Price Index Numbers

The consumer price index numbers also known, as cost of living index
numbers, generally intended to represent the average change over time in
the prices paid by the ultimate consumer of a specified basket of goods and
services. The need for constructing consumer price indices arises because
the general index numbers fail to give an exact idea of the effect of the
change in the general price level on the cost of living of different classes of
people in different manners. Different classes of people consume different
types of commodities. It helps us in determining the effect of rise and fall in
prices on different classes of consumers living in different areas. The
construction of such an index is of great significance because very often the
demand for higher wage is based on the cost of living index and the wages
and salaries in most countries are adjusted in accordance with the
consumer price index.
It should be carefully noted that the cost of living index doesn’t measure the
actual cost of living. Its objective is to find out how much the consumers of a
particular class have to pay more for a certain basket of goods and series in
a given period compared to the base period. At present the three terms,

339
namely cost of living index, consumer price index and retail index are in use
in different countries with practically no difference in their connotation.
It should be clearly understood at the very outset that two different indices
representing two different geographical areas could not be used to compare
actual living cost of the two areas.
Uses of Consumer Price Index

1. The most common use of these indices is in wage negotiations and

wage contracts.
2. It also used to measure changing purchasing power of the currency,
real income etc.,
3. The index numbers are also used for analyzing markets for
particular kinds of goods and services.
4. At Government level, the index numbers are used for wage policy,
price policy, and rent control, taxation and general economic
policies.
15.2.2 Construction of A Consumer Price Index
(i) To decide the particular class of people for which the index
number is intend such as industrial worker, government
employees, low income or middle-income class people etc.,
(ii) To decide their geographical region of stay or a city an industrial
area etc.,

(iii) It is generally constructed for each weak.

15.2.3 Methods of Construction
There are familiar two methods to construct index numbers.

i) Aggregate Expenditure method (or) Weighted Aggregate method

This method is based upon Laspeyr’s Method. The various items or
commodities are assigned weights an the basis of quantity consumed to the
base year.

340
 Cost of living Index
 P1q0
= ×100
 P0q0
Total expenditure in current year
= ×100
Total expenditure in the base year

ii) Family Budget Method or Method of Weighted Relations

Under this method, the cost of living Index is the weighted average of price
relatives, the weights being the quantities consumed in the base year.
Thus if we write I or P = ( P1/ P0 )X 100 and W = P0 q 0 ,
then
 PW  P1q0
Cost of Living Index = or ×100
W  P0q0

Uses
(a) The reciprocal of cost of living index is used to measure the
purchasing power of money.
(b) They are used to find real wages’ by the technique of deflation.
(c) In Conjunction with other tools such as indices of wholesale prices,
wages, profits, productions, employment etc., they serve as an
economic indicator for the analysis of price situation.
(d) Such index numbers provide guidelines to the government for
deciding clearness allowance and general economic policies.
Example 15.1 Calculate consumer price index from the following data
of average monthly family consumption expenditure on food items of
industrial laborer’s in Faridabad.

Qty 1977 Price

1970 price in
Commodity Consumed Unit in current
Base year
in Base year year

Wheat 40 Kg 0.90 1.29

Pulses 5 Kg 1.50 3.20

Oils 2 Kg 4.00 9.10

341
 Gar 2 Kg 1.75 2.35

Clothing 4 Kg 3.25 5.50

Fire Wood 30 6.40 10.5.

Solution

Price Price in
Qty Aggregate
in Current Aggregate
consumed expenditure
Commodity UNIT Base Year expenditure
in Base Base Year
Year (P1 q0)
Year q0 (P1 ) (P0 q0)
(P0 )

Wheat 40 Kg 0.90 1.29 36 51.6

Pulses 5 Kg 1.50 3.20 7.5 16

Oils 2 Kg 4.60 9.10 9.2 18.2

Gur 2 Kg 1.75 2.75 3.5 4.7

Clothing 4 Kg 3.25 5.50 13 22

Fire Wood 30 Kg 6.40 10.50 192 315

261.2 427.5

i) Aggregate Expenditure method:

Cost of Living index
 P1q0
= ×100
 P0q0
427.5
= ×100
261.2
= 163.7
ii) Family Budget Method:

Price
Qty Price Price
relative W=P0q
Commodity Base Unit Current relative PW
P=P1/ P2 0
year(W) Year year
x100

Wheat 40 Kg 0.90 1.29 143.3 36 51.588

Pulses 5 Kg 1.50 3.20 213.3 7.5 15.997

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 Oils 2 Kg 4.60 9.10 197.8 9.2 18.198

Gur 2 Kg 1.75 2.35 134.3 3.5 4.700

Clothing 4 Kg 3.25 5.50 160.2 13 21.996

Firewood 30 Kg 6.40 10.50 164.1 192 315.072

261.1 427.551

Aggregate Expenditure method

Cost of Living index
 PW
= ×100
W
427.55
= ×100
261.2
= 163.7
Example 15.2 Calculate the cost the living index from the following
data:

Qty. Consumed per

Price Per unit (R) Given
Item year in the given
Base year year
year

Rice 2(1/2 )q.hr x 12 12 25

Pulses 3Kg x 12 0.4 0.6

Oil 2Kg x12 1.5 2.2

Clothing 6metresx12 0.75 1.0

Housing 0 20 per moth 30/moth

Miscellaneous 0 10 per month 15/moth

Solution

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 Price in
Qty
Price in current year
Items consumed in
Base year P0 P q1
the year q1
P1 P0q0

Rice 30 12 25 360 750

Pulses 36 0.4 0.6 14.4 21.6

Oils 24 1.5 2.2 36 52.8

Clothing 72m 0.75 10 54 720

Housing -- 20 30 240 360

Miscellaneous -- 10 150 120 180

824.4 1436.4

 P1q1
= ×100
P q
0 1

1436.4
Cost Living index = ×100
82.4
= 174.24
Example 15.3 The following shows the consumer price index numbers
compute the overall consumer price index from the given data.

Item Weight Group index

Food 58.55 91.4

Clothing 5.37 106.5

Fuel and light 6.15 102.2

Hosing 9.61 100.0

Miscellaneous 20.32 100.3

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Solution

Item W Group index IW

Food 58.55 91.4 5351.47

Clothing 5.37 1065 571.905

Fuel & Light 6.15 102.2 628.53

Housing 9.61 100 961

Miscellaneous 20.32 100.3 2038.096

W= 100 IW = 9551.001

Consumer Price Index


 IW  9551.001  95.51
W 100

Example 15.4 From the following data relating to working class

consumer price index of a city, calculate index numbers for 1972 and
1973.

House
Group Food Clothing Fuel Miscellaneous
Rent

Weights
group 48 18 7 13 14
indices

1972 110 120 110 100 110

1973 130 125 120 100 135

Two wages were increased by 8% in1973 is this increase sufficient

Solution

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 Index for Index for 1972 1973
Group Weight
1971(P) 1973(P) PW PW

Food 48 110 130 5280 6240

Clothing 18 120 125 2160 2250

Fuel 7 110 120 770 840

House Rent 13 100 100 1300 1000

Miscellaneous 14 110 135 1540 1890

11050 12520

Index Number for 1972 

 PW  11050 /100  110.50
W
Index Number for 1973 = 
 PW  12520 /100  125.20
W
The increase of price from 1972 to 1973

125.2
= X 100 = 113.3
i.e an increase of 13.3% Hence the wage increase is not sufficient.
15.2.4 Whole Sale Price Index
Wholesale price index is that index which is calculated on the basis of
wholesale price. It is calculated in a similar way to the retail price index. It
is computed an weekly basis and compiled by E.A to Government of India.
Wholesale prices is calculated, asseparate index Number for each group,
on the basis of A.M of price relatives of items in the group. There are 72
items and 16 groups for monthly index. Sensitive whole sale index is based
on 23 selected commodities with 46 quotations. Whole sale prices indices
are classified into groups and sub groups as indicated below, with weights
in parenthesis.

i). Primary Articles It consists of the following

a) Food articles. b) Non- Food articles c) Minerals
ii). Fuel, power, Light and Lubricants.

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 iii). Manufacturing Products
a) Food products b) Textiles c) Chemicals Basic d) Minerals
e) Machinery and Transport equipment f) Miscellaneous

Another classification of the commodities included in the WPI is as follows:

i) Commodities with Administered prices: Petroleum Products, crude,
fertilizers, cement, electricity, iron, etc.

ii) Seasonal items: Sugar, Edible oils, cereals and pulses, etc.,)
iii) All other commodities: Govt. of India have released a new series of
WPI with 1981-82 the base year in July 1989, the new series, which
replaces the old series with 1970-71 as base year, has a larger coverage of
items, their grades. This can be seen from the following table.

Weights No. of Items No. of quotations

Group of
Items 1970- 1981- 1970-
1981-82 1970-71 1981-82
71 82 71

1.Primary
41.67 32.30 80 93 411 54
Articles

2.Fuel,
Light,
8.46 10.66 10 20 30 73
Power
Lubricants

3.Manufac-
ture 49.87 57.04 270 334 854 1779
products

All Commo
100.00 100.00 360 447 1295 2371
-dities

Source

Economic survey 1989-90 GOVT of India, As can be seen, much more

emphasis has been laid on manufactured articles as revealed by the
weightage assigned, number of items and quotations induced in 1981-82
series. Pace of industrializations in sought to be reflected there by. The
WPI for week ended August 24,1991 was 207.7.

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Example 15.5 Calculation of fixed base relative based on Averages
wholesale price of certain essential commodities.

a) Data (with 1928 -100)

Essential
1928 1929 1930 1931 1932 1933 1934
Commodities

1.Rice 7.3(100) 7.7 5.8 4.1 4.2 4.1 3.7

2.Wheat 7.7(100) 5.5 3.6 2.7 3.4 3.2 2.8

3.Linseed 7.0(100) 8.0 6.5 4.2 3.5 3.4 3.6

4.Gur 6.5(100) 7.3 6.2 4.2 3.5 3.1 4.1

5.Cotton 34.1(100) 29.8 17.3 13.3 14.8 12.9 13.3

6.Tobacco 17.3(100) 17.1 14.5 11.6 4.9 4.9 5.8

b) Fixed base relatives with (chain base relatives noted in brackets)

(Base year 1920=100)

Essential
commoditie 1928 1929 1930 1931 1932 1933 1934
s

Rice 100 105 79(75) 56(71) 59(10 56(95) 51(90)

5)

Wheat 100 71 47(65) 38(75) 44(12 42(94) 36(88)

6)

Linseed 100 114 93(81) 60(65) 50(83 49(97) 51(106)

)

Gur 100 112 95(85) 65(68) 54(13 48(88) 63(132)

)

Cotton 100 87 51(58) 39(77) 43(11 38(87) 39(102)

1)

Tobacco 100 100 84(85) 67(80) 28(42 28(100) 33(116)

)

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c) Averages of relatives with chain base averages noted in brackets

600 589 449 325 278 261 27

a) Total
(100) (589) (449) (436) (450) (561) (634)

(100) (98) 75 54 46 44 45
b) G. M
100 (98) (75) (73) (92) (94) (106)

c) G.M of
100 97 72 53 45 42 44
Relatives

d) Median 100 102 92 58 47 45 45

Note:
The Calculations in the above table are easily understand. While the fixed
based relatives given in brackets are computed as Pk / P0 X 100 the chain
base relatives are computed as PK / PK-1 X 100

15.3 NIFTY INDEX

In order to understand what is nifty, we need to understand briefly the

Indian stock exchanges first. Now, let’s discuss the two major stock
exchanges in India i.e the ‘Bombay stock exchange’ and the ‘National stock
exchange’ along with their indexes.
Bombay stock exchange is an Indian stock exchange located at Dalal
Street, Mumbai, Maharashtra. It was established in 1875 and is Asia’s
oldest stock exchange. It is the world’s fastest stock exchange, with a
median trade speed of 6 microseconds. The BSE is the world’s 10th largest
stock exchange with an overall market capitalization of $2.29 Trillion as of
April 2018. More than 5500 companies are publicly listed on the BSE.
Sensex, also called BSE 30, is the market index consisting of 30 well-
established and financially sound companies listed on Bombay Stock
Exchange (BSE).
a) The 30 companies are selected on the basis of the free-float market
capitalization.

349
 b) These are different companies from the different sectors
representing a sample of large, liquid and representative companies.
c) The base year of Sensex is 1978-79 and the base value is 100.

d) It is an indicator of market movement.

e) If the Sensex goes down, this tells you that the stock price of most of
the major stocks on the BSE has gone down. If Sensex goes up, it
means that most of the major stocks in BSE went up during the
given period.
For example, suppose the Sensex is 31,500 today. If Sensex drops
to31,250 tomorrow, it means that the majority of the 30 companies’ financial
condition is not good i.e. their share price is falling.
The National Stock Exchange (NSE) is the leading stock exchange of
India, located in Mumbai, Maharashtra, India. It was started to end the
monopoly of the Bombay stock exchange in the Indian market. NSE was
established in 1992 as the first demutualized electronic exchange in the
country. It was the first exchange in the country to provide a modern, fully
automated screen-based electronic trading system which offered the easy
trading facility to the investors spread across the length and breadth of the
country. NSE has a total market capitalization of more than US$ 2.27 trillion,
making it the world’s 11th-largest stock exchange as of April 2018. NSE’s
index, the NIFTY 50, is used extensively by investors in India and around
the world as a barometer of the Indian capital markets.
NIFTY or Nifty 50
Nifty, also called NIFTY 50, is the market index consisting of 50 well-
established and financially sound companies listed on National Stock
Exchange of India (NSE). The base year is taken as 1995 and the base
value is set to 1000.Nifty is calculated using 50 large stocks that are actively
traded on the NSE. The 50 companies are selected on the basis of the free-
float market capitalization. Here, the 50 top stocks are selected from
different 24 sectors. Nifty is owned and managed by India Index Services
and Products (IISL). Since inception in 1995, Nifty has given a return of
11.13% CAGR (till April 30, 2018).
1. If Nifty goes up, this means that the stock price of most of the major
stocks on NSE has gone up.

350
 2. On the other hand, if nifty goes down, this tells you that the stock
price of most of the major stocks on NSE has gone down.
15.3.1 Significance of Nifty Index

1. The Financial market indexes are the barometer for market behavior. It
gives a general idea about whether most of the stocks have gone up or
gone down.

2. Often, Market Index is used as a benchmark portfolio performance.

3. It is used as a reflector of investor’s sentiments.
4. Market indexes are used for sorting and comparison of the various
companies.
5. Indices act as an underlying for Index Funds, Index Futures, and
Options.
6. They are used in passive fund management by Index funds.
7. The index can give a comparison of returns on investments in stock
markets as opposed to asset classes such as gold or debt.
15.3.2 NIFTY Sectoral Indices
NSE Indices has developed a series of sectoral indices that represent the
collective performance of stocks in respective sectoral index. All sectoral
indices are capped as per the details provided under ‘Index characteristics’
on subsequent paragraphs.
1. NIFTY Auto: The index is designed to reflect the behaviour and
performance of the Automobiles sector which includes
manufacturers of cars & motorcycles, heavy vehicles, auto
ancillaries, tyres, etc. The index comprises of maximum of 15 stocks
and base date of the index is January 1, 2004.
2. NIFTY Bank: The index is designed to reflect the behaviour and
performance of the large and liquid banks. The index comprises of
maximum of 12 stocks and base date of the index is January 1,
2000.
3. NIFTY Consumer Durables: The index aims to reflect the
performance of stocks belonging to Consumer Durables industry.
The index comprises of maximum of 15 stocks and base date of the
index is April 1, 2005 and a base value of 1000 points.

351
4. NIFTY Financial Services: The index is designed to reflect the
behaviour and performance of the Indian financial market such as
banks, financial institutions, housing finance, other financial services
companies etc. The index comprises of maximum of 20 stocks.
(Other variant: NIFTY Financial Services 25/50 – Details given
below)
5. NIFTY FMCG: The index is designed to reflect the behaviour and
performance of Fast Moving Consumer Goods (FMCG). They are
those goods and products, which are nondurable, mass consumption
products and available off the shelf. The index comprises of
maximum of 15 companies. 6. NIFTY IT: The index is designed to
reflect the behaviour of companies engaged into activities such as IT
infrastructure, IT education and software training, networking
infrastructure, software development, hardware, IT support and
maintenance etc. The index comprised of 20 companies. The base
value of the index was revised from 1000 to 100 with effect from May
28, 2004
7. NIFTY Media: The NIFTY Media Index is designed to reflect the
behavior and performance of sectors such as media &
entertainment, printing and publishing. The index comprises of
maximum of 15 companies. 8. NIFTY Metal: The NIFTY Metal Index
is designed to reflect the behavior and performance of the metals
sector including mining. The index comprises of maximum of 15
stocks.
9. NIFTY Oil & Gas: The index aims to reflect the performance of
stocks belonging to Oil, Gas and Petroleum industry. The index
comprises of maximum of 15 stocks and base date of the index is
April 1, 2005 and a base value of 1000 points.
10. NIFTY Pharma: The NIFTY Pharma Index is designed to reflect the
behavior and performance of the companies that are engaged into
manufacturing of pharmaceuticals. The index comprises of maximum
of 10 stocks.
11. NIFTY PSU Bank: The NIFTY PSU Bank Index is designed to reflect
the behavior and performance of the public sector banks. Effective
December 27, 2019, all Public Sector Banks that are traded (listed &
traded and not listed but permitted to trade) at the National Stock

352
 Exchange (NSE) are eligible for inclusion in the index subject to
fulfilment of other inclusion criteria namely listing history and trading
frequency. The base date of the index is January 1, 2004 and base
value of 1000 points.
12. NIFTY Private Bank: The NIFTY Private Bank Index is designed to
reflect the behavior and performance of the banks from private
sector. The index comprises of 10 stocks and weights of each
company in the index were capped at 25% (until March 29, 2019).
13. NIFTY Realty: The NIFTY Realty Index is designed to reflect the
behavior and performance of the companies that are engaged into
construction of residential & commercial real estate properties. The
index comprises of maximum of 10 stocks.
15.3.3 NIFTY Thematic Indices
NSE Indices has developed a series of thematic indices that represent the
collective performance of stocks in respective theme of the index. These
thematic indices are capped as per the details provided under ‘Index
characteristics’ on subsequent pages.
1. NIFTY Commodities: The index is designed to reflect the behaviour
and performance of a diversified portfolio of companies representing
the commodities segment which includes sectors like Oil, Petroleum
Products, Cement, Power, Chemical, Sugar, Metals and Mining. The
index comprises of maximum of 30 stocks. Weights of constituents
of NIFTY Commodities are capped at 10% (maximum capping limit).
2. NIFTY Energy: The index is designed to reflect the behaviour and
performance of companies that represents petroleum, gas and
power sector. The index comprises of maximum of 10 stocks.
Weights of each stock in NIFTY Energy index are calculated based
on its free-float market capitalization such that no single stock shall
be more than 33% and weights of top 3 stocks cumulatively shall not
be more than 62% at the time of rebalancing.
3. NIFTY India Consumption: The index is designed to reflect the
behavior and performance of a diversified portfolio of companies
representing the domestic consumption sector which includes
sectors like Consumer Non-durables, Healthcare, Auto, Telecom
Services, Pharmaceuticals, Hotels, Media & Entertainment, etc.
Companies with domestic operating revenue of more than 50% are

353
 considered eligible for inclusion in the index. The index comprises of
maximum of 30 stocks. Weights of constituents of NIFTY India
Consumption index are capped at 10% (maximum capping limit).
4. NIFTY Infrastructure: The index is designed to reflect the behaviour
and performance of companies that represents infrastructure sector
such as power, port, air, roads, Further, effective September 27,
2019, the index is computed with maximum of 30 companies and
weights of each company in the index are capped at 20% (from 34%
earlier).
5. NIFTY MNC: The index is designed to reflect the behaviour and
performance of companies in which the foreign shareholding is over
50% and/ or the management control is vested in the foreign
company. The index comprises of maximum of 15 companies and
base date of the index is January 2, 1995 and base value of 1000
points. Further, effective September 28, 2018, the index is computed
with maximum of 30 companies and weights of each company in the
index are capped at 10%. At the time of rebalancing of shares/
change in index constituents/ change in investable weight factors
(IWFs), the weightage of the index constituent (where applicable) is
capped at 10%. Weightage of such stock may increase beyond 10%
between the rebalancing periods.
6. NIFTY PSE: The index is designed to reflect the behaviour of public
sector enterprises (PSE) companies. Companies with 51% of their
outstanding share capital held by the Central Government and/or
State Government, directly or indirectly are considered as PSEs.
The index comprises of maximum of 20 companies. Weights of each
stock in NIFTY PSE index are calculated based on its free-float
market capitalization such that no single stock shall be more than
33% and weights of top 3 stocks cumulatively shall not be more than
62% at the time of rebalancing.
7. NIFTY Services Sector: The NIFTY Services Index is designed to
reflect the behavior and performance of service sectors services
sector like computers – software, IT education and training, banks,
telecommunication services, financial institutions, power, media,
courier, shipping etc. The index comprises of maximum of 30
companies. Weights of each stock in NIFTY Services Sector index
are calculated based on its free-float market capitalization such that

354
 no single stock shall be more than 33% and weights of top 3 stocks
cumulatively shall not be more than 62% at the time of rebalancing
15.4 PRODUCTION INDEX

The production index is a business cycle indicator which aims to measure

changes in value added at factor cost of industry and construction over a
given reference period. It does this by measuring changes in the volume of
output and activity at close and regular intervals, usually monthly. In order to
calculate a genuine value added indicator data would be needed for an
industry's gross output as well as for the inputs used in the production of
these outputs. Such data are generally not available on a monthly (or
quarterly) basis. In practice, suitable proxy values for the calculation of the
production index are needed.
 The production index should also take into account:
 Changes in type and quality of the commodities and of the input
materials;
 Changes in stocks of finished goods and services, and work in
progress;
 Changes in technical input-output relations (processing techniques);
 Services, such as assembly of production units, repairs or planning.
Within industry, these may include:
a) gross production values (deflated);

b) production volumes (physical quantities data);

c) turnover (deflated);
d) work input;

e) raw material input;

f) energy input.
Within construction they may consist of:

a) Input data (consumption of typical raw materials, energy or labour);

b) Output data (production quantities, deflated production values, or
deflated sales values).

355
In construction, separate production indices for building construction
and civil engineering are calculated, according to the Classification of types
of construction (CC).

15.4.1 Index of Industrial Production

The Index of Industrial Production (IIP) is an index that indicates the
performance of various industrial sectors of the Indian economy. It is
calculated and published by the Central Statistical Organisation (CSO)
every month. It is a composite indicator of the general level of industrial
activity in the economy.
Official Definition – As given by CSO
“It is a composite indicator that measures the short-term changes in the
volume of production of a basket of industrial products during a given period
with respect to that in a chosen base period.” Index of Industrial Production
Published by CSO
IIP is a composite indicator measuring changes in the volume of production
of a basket of industrial products over a period of time, with respect to a
chosen base period. It is compiled and published on a monthly basis by the
CSO with a time lag of six weeks from the reference month. This index
gives the growth rates of different industry groups of the economy over a
specified time period.
The industry groups that it measures are classified under the following:
(a) Broad sectors like manufacturing, mining, and electricity.

(b) Use-based sectors like capital goods, basic goods, intermediate goods,
infrastructure goods, consumer durables, and consumer non-
durables.
The eight core industries of India represent about 40% of the weight of
items that are included in the IIP. The Eight Core Sectors/Industries are:
Electricity, Steel, Refinery products, Crude oil, Coal, Cement, Natural gas,
Fertilizers

356
15.4.2 Index of Industrial Production Importance
1. The Index is used by government agencies and departments such
as the Finance Ministry and the RBI for policymaking.

2. It is also used for estimating the Gross Value Added of the

manufacturing sector quarterly.
3. Also, the Index is used by business analysts, financial experts, and
the private industry for multiple purposes.
4. It is the only measure of the physical volume of production.

5. It is also extremely useful for the projection of advance GDP

estimates.
The latest change in the IIP was made in 2017. Any index is to be subject to
changes and modifications like changing the base year, including more
items in the basket, etc. The new and current base year for IIP is 2011 – 12.
The previous base year was 2004 – 05. Another change was the inclusion
and deletion of certain items in the data series. Some items introduced:
Refined palm oil, Surgical accessories, Cement clinkers. Some items
removed: Chewing tobacco, Toothbrush, Calculators, Fans, Watches, Pens
,This is the 9th base year revision ever since IIP was first published in 1950.
The first base year was 1937.

357
LET US SUM UP
This unit covers the basic concept of Business index, Nifty index and
Production Index numbers. It helps the learners to understand various types
of index numbers in Business and Nifty. It also helps the learners to
calculate Business index numbers.
CHECK YOUR PROGRESS

1. Calculate cost of living index Number to the following:

Group Index NO Weights

Food 350 10

Fuel 150 2

Clothing 200 2

House rent 150 2

Miscellaneous 225 4

2 Compute by Fisher’s index formula the Quantity index from the data
given:

Commodity Price Total value Price Total value

A 10 100 8 96

B 16 96 14 98

C 12 96 10 40

3 Calculate Fisher’s ideal index from the following data and prove that it
satisfies both the Time Reversal and Factor Reversal Tests.

Commodity Price Expenditure Price Expenditure

A 8 80 10 120

B 10 120 12 96

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 C 5 40 5 50

D 4 56 3 60

E 20 100 25 150

4 Construct cost of living index though following indices:

Year Food Clothing Fuel Miscellaneous Rent

1995 100 100 100 100 100

1996 105 98 100 110 104

1997 110 102 101 115 112

1998 112 105 103 120 115

GLOSSARY

Index : An index is an indicator or measure of

something. In finance, it typically refers to
a statistical measure of change in a
securities market.

Business Index : A statistical compilation that provides a

context for economic or financial
conditions is called as Business Index

Nifty Index :The NIFTY share market index is a

benchmark standard against which all
equity markets in India are measured.

Production Index The production index is a business cycle

indicator which aims to measure changes
in value added at factor cost of industry
and construction over a
given reference period.

Index of Industrial The Index of Industrial Production (IIP) is

Production an index which shows the growth rates in

359
 different industry groups of the economy in
a stipulated period of time.

SUGGESTED READINGS

1. Arora, P.N. & S. Arora, (2007) ,Statistics for Management, latest

Edition, S. Chand & Company Ltd., New Delhi.
2. D.C.Sancheti, V.K.Kapoor,( 2014), Business Mathematics, 11th
edition, Reprint, Sultan Chand and Sons, New Delhi.
3. Gupta, B.N., (2015), Business Statistics, First Revised Edition,
SBPD, New Delhi.

4. JK. Sharma, (2009), Business Mathematics Theory And

Applications, 13th Edition, ANE Books, New Delhi.
5. S. P. Gupta, (2012), Statistical Methods, 42nd Revised Edition Sultan
Chand & Sons Pvt. Ltd., New Delhi.
6. https://www.toppr.com/guides/fundamentals-of-business-
mathematics-and-statistics/index-numbers-cma/
7. https://www.investopedia.com/terms/i/ipi.asp
ANSWERS TO CHECK YOUR PROGRESS
1. Cost of living Index =270

2. Q01 (F) =120.65

3. P01 (F) =112.8
4. Cost of living Index for 1997=108.27 , cost of Living Index for
1998=110.73

360
Unit 16

TIME SERIES
STRUCTURE

Overview
16.1 Introduction
16.2 Essential Requirements of a Time Series

16.3 Definitions and uses of Time series

16.4 Models of Decomposition
16.5 Components of Time Series

16.6 Secular Trend

16.7 Seasonal variations
16.8 Cyclical variations

16.9 Irregular variations

16.10 Measurement of Trend
16.10.1 Graphical Method

16.10.2 Semi-Average Method

16.10.3 Moving Averages Method
16.10.4 Method of Least Squares

16.11 Measurement of Seasonal Variations

16.11.1 Simple Average method
16.11.2 Ratio-to-Trend method

16.11.3 Ratio-to-Moving Average method

16.11.4 Link Relative Method
Let Us Sum Up

Check Your Progress

Glossaries
Suggested Readings

361
Answers to check your progress
OVERVIEW

In this unit we discuss the time series and utility of time series. We learn the
components of time series. We will compute measurement of trend using
moving average method semi average method, method of least square we
will also discuss measurement of cyclical variation, irregular variations. We
discuss the concept of irregular variations.
Learning objectives
Afte completing this unit, you should be able to:

 explain the various types of trend line.

 discuss about seasonal variations and cyclical variations.
 compute trend using different methods.
16.1 INTRODUCTION
One of the most important tasks before economists and businessmen these
days is to make estimates for the future. However, the first step in making
estimates for the future consists of gathering information from the past. In
this connection one usually deals with statistical data which are collected,
observed or recorded at successive intervals of time. Such data are
generally referred to as "time series". Thus when we observe numerical
data at different points of time, the set of observations is known as "times
series". For example, if we observe production, sales, population, imports,
exports etc at different points of time, say over the last 5 or 10 years, the set
of observation formed shall continue time series. Hence, in the analysis of
time series, time is the most important factor because the variable is related
to time which may be either year, month, week, day, hour or even minutes
of seconds.
Time series data are of two kinds, viz., period data and point data. Period
data refers to the accumulated value of a flow variable during a particular
period. For example, in India the rice production was of 49 million tonnes
during 1976-77. This data refers to the total rice production during the
period, April 1, 1976 through March 31, 1977. In contrast to such data, We
have point data, which refers to the value of a 'stock variable' at a point of
time. For example the quantity of money in circulation in India was Rs. 14,
495 crores as on the last Friday of January 1977.

362
16.2 ESSENTIAL REQUIREMENTS OF A TIME SERIES
 A time series must consist of a homogeneous set of values.
 Data should be available for a sufficiently long period, say of 7 to 10
terms.
 The time elapsing between various values must as far as possible
be equal. i.e., we have chronologically ordered data recorded. Daily,
weekly, monthly, quarterly, yearly and so on.
 But if the data are recorded say, monthly, the internal between two
successive figures must be exactly one month.
 The gaps, if any in the data should be made up by interpolation.
16.3 DEFINITIONS AND USES OF TIME SERIES

Kenny and Keeping - "A set of data depending on the time is called a
series” Croxton and Coude - " A time series consists of data arranged
chronologically” Patterson = "A time series consists of statistical data which
are collected, recorded, observed over successive increments".
Ya - Lunchou - "A time series may be defined as a collection of data
belonging to different time periods, of some economic variables".
Uses of Time Series are Given Below

Recording: Before analysis the facts must be recorded diligently and

carefully to accomplish the purpose in hand. There for, the purpose of
systematic recording of facts is automatically accomplished in the process.
Data should be related to a given phenomenon, it is sometimes used for
different time periods, is spaced equally with reference to the Period and
observed under a well-defined and consistent system.

Comparison: Once the data is systematically recorded comparisons over

i.e., between one period and the other become possible. This may go
continuously. Actually the time series analysis is only a means of more
scientific comparisons after considering the various components of the
variables to know how they have behaved over a period of time. It is also
enable to make geographical or regional comparisons amongst data acted
on the basis of time. In large majority of cases the recording of data
chronological, the other modes of classification are intervened.
iii) Evaluation:

The review and evaluation of progress in any field of economic and

business activity is largely dome on the basis of the time series data
collected on a given phenomenon. For example the progress of plans is

363
judged by the yearly rates of growth in gross national product (GNP) The
various business and accounting ratios used for evaluation of business
progress are based on time series data, say on sales, capital employed,
profits, inventories, etc. An important ratio, the turnover ratio is based on
sales to capital employed. Similarly, profitability is calculated by taking the
ratio of profit to the capital employed. A ratio of one year can then be
compared with similar ratio for other years.
iv) Forecasting:

A very important use of time series data is towards forecasting. The likely
value of a variable in future. In most cases it is the projection of trend fitted
into the values regarding a variable over a sufficently long period by any of
the methods discussed later. Adjustments for seasonal and cyclical
character introduce further improvement in the forecasts based on the
simple projection of the trend. The importance of forecasting in business
and economic fields lies on account of its role in planning and evaluation. It
is suitably interpreted, after consideration of the other forces, say political,
social, governmental policies, etc. The statistical techniques can be of
immense help for decision making.
16.4 MODELS OF DECOMPOSITION

The decomposition refers to segregation of various components. The four

components of time series refered above can be considered to be
interacting in an additive or multipicative fashion to produce the observed
values in time series.
a) Additive model: In this model we assume that the observed value is sum
of four components.
O = T+S+C+1 (or) Y=T+S+C+I
Where O (or) Y = observed value of time series

T-secular trend component

S-Seasonal component
C-Cyclic component

E (or) I=Erratic or Irregular component

364
Note:
Under the additive procedure only additive values are added to or deducted
from the trend value to reach observed value.

b) Multiplicative Model: This model assumes that the value of the trend (T)
in a time series is multiplied by the rates of three components shown
below.
O=TxSxCxI
Y=TxSxCxI

Where - is the actual trend value and S, C and I are the rates or the indices.
16.5 COMPONENTS OF TIME SERIES
It is customary to classify the fluctuations of time series into four basic types
of variations. The components or elements of time series are,
a) Secular trend (T)
b) Seasonal variations (S)
c) Cyclical variations (C)
d) Irregular variations (I)
d) Irregular variations (I)
Components

Long term Short term

Secular Cyclical Seasonal Irregular of Erratic

Regular

13.6 SECULAR TREND Figure 16.1

It is derived from Latin word 'SAECULUM' which means generation or age. "Trend means
general direction and shape of time series". - M. Melnyk. Trend is the result of those force

365
16.6 SECULAR TREND
It is derived from Latin word 'SAECULUM' which means generation or age.
"Trend means general direction and shape of time series". - M. Melnyk.
Trend is the result of those force which show a persistent growth or a
persistent decline in an evolutionary. Continuous and irreversible fashion.
There is essential regularity and continuity despite some sudden and
frequent changes in between. A study of secular Trend is useful for the
following purposes:
 For describing the underlying pattern of behaviour which has
characterised the series in the past.
 For studying the influence of seasonal, cyclical and irregular forces
of change.
 For extrapolation, on the assumption that the past behaviour will
continue in the future. We can thereby fore cast the future
behaviour. Secular trend movements are attributable to factors such
as population changes, technological progress and large-scale,
shifts in consumer tastes.
The presence of more people means that more food, clothing, housing are
necessary. Technological change, discovery and expansion of natural
resources, mass production methods, improvements in the business
organisations are causes or the growth or decline of many economic time
series. In some cases, growth in one series involves decline in another.
There are all orts of trends, some series increase slowly and some increase
fast, others decrease at varying rates, some remain relatively constant for
long periods of time, and some after period of growth or decline reverse
themselves and enter a period of decline or growth.
There are two types:

i) Linear trend (or) Straight line trends.

ii) Non-linear trends.
Secular trend refers to the general tendency of the data to grow or decline
over a long period of time. Generally speaking the longer the period
covered, the more significant the trend. When the period is short, the
secular movements can not be expected to reveal themselves clearly and
the general drift on the series may be unduly influenced by the cyclical
fluctuations. This would make it difficult to separate the various series of
variations in time series. Another point worth mentioning is that for

366
concluding whether the data in showing an upward tendency or down
tendency, it is not necessary that the rise or fall must continue in the same
direction throughout the period. As long as we can say that the period as a
whole was characterised by an upward movement or by a downward
movement, we say that a secular trend was present.
16.7 SEASONAL VARIATIONS
These are those periodic movements in business activity which occur
regularly every year and have their origin in the nature of the year itself.
Since these variations repeat during a period of 12 months they can be
predicted fairly accurately. Nearly every type of business activity is
susceptible to seasonal influence to a greater or lesser degree and as such
these variations are regarded as normal phenomenon recurring every year.
Although the word "Seasonal" seems to imply a connection with the season
of the year, the term is meant to include any kind of variation which is of
periodic nature and whose repeating cycles are of relatively short duration.
It is evident when the data are recorded at weekly or monthly or quarterly
intervals. As a result seasonal variations do not appear in series of annual
figures.
a) Climate and weather conditions:

The most important factor causing seasonal variations is the climate.

Changes in the climate and whether conditions such as rainfall, humidity,
heat, etc., act on different products and industries differently. For example,
during winter there is greater demand for woolen clothes, hot drinks etc.,
whereas in summer cotton clothes, cold drinks have a greater sale. The
effect of the climate is that there are generally two seasons in agriculture -
the growing season and harvesting season - which directly affect the
income of the former which, in turn, affects the entire business activity.
b) Customs, tradition and habits: Though the nature is primarily
responsible for seasonal variations in time series, customs, traditions and
habits also have their impact. For example, on occasions like Deepawali,
Dusserah, Christmas etc., there is a big demand for sweets and also there
is a large demand for cash before the festivals because people want money
for shopping and gifts. The students buy books in the first few months of the
opening of schools and colleges and thus the sale of books.
The study and measurement of seasonal patterns constitute a very
important part of analysis of time series. In some cases, seasonal patterns

367
themselves are of primary concern because little, if any, intelligent planning
or scheduling can be done without a knowledge based adequate statistical
measures of seasonal patterns. In other cases it may not be of immediate
concern, but it must be measured to facilitate the study of other types of
variations based on adequate statistical measure of seasonal pattern. An
accurate knowledge of seasonal behaviour is an aid in mitigating and
ironing out seasonal movements thorough business policy, seasonal indices
are also helpful in scheduling purchases, inventory control, personal
requirement, seasonal financing, and selling and advertising programmes.
16.8 CYCLICAL VARIATIONS

Cyclic variations like seasonal variations, refer to recurring pattern of

changes in events over a period extending beyond a year. The cyclical
movements have been defined as: "Up and down movements which are
different from seasonal fluctuations, in that they extend over larger period of
time - usually two or more years". - Lincoin. L.Chao.
Most of the time series relating to economics and business show some kind
of cyclical or oscillatory variation. These are long term movements that
represent consistently recurring rises and declines in activity. A business
cycle consists of the recurrence of the up-and-down movements of a
business activity from some sort of statistical trend or 'normal'. The
knowledge of cyclical fluctuations is very useful in predicting the turning
points in business activity. The information can be used for policies aimed at
stabilizing business activity. Actually, for forecasting purposes the seasonal
factor has to be considered with reference to the basic forces of cyclical
variations. Also, cyclical factor must be taken note of in appraising an
observed value. This will help in finding out the influence of irregular forces
of change.

Figure 16.2

368
There are 4 dwell-defined periods or phases in the business cycle, namely
a) Prosperity
b) Decline

c) Depression
d) Improvement
Each phase changes gradually into the phase which follows it in the order
given, in the prosperity phase of the business cycle, the public is optimistic.
Business is booming, prices are high and profits are easily mad. There is
considerable expansion of business activity which leads to an over
development. It is then difficult to secure deliveries and there is shortage of
transportation facilities, which had tendency to cause large inventories to be
accumulated during the time of highest prices. Wages increase and labour
efficiency decreases. The strong demand for money causes interest rates to
rise to a high level while doubt enters the hanker's mind as to the
advisability of granting further loans. The study of cyclical variations is
extremely useful in framing suitable policies for stabilizing the level of
business activity. i.e. for avoiding periods of booms and depressions as
both are bad for an economy - particularly depression which brings about a
complete disaster and shatters the economy.
Despite the great importance of measuring cyclical variation, they are the
most difficult type of economic fluctuations to measure is because of the
following two reasons:
i. Business cycles do not show regular periodicity - they differ widely in
timing, amplitude and pattern which makes their study very tough
and tedious.
ii. Business cyclical variations are mixed with erratic, random or
irregular, forces which make it impracticable to isolate, seperately
the effect of cyclical and irregular forces.
16.9 IRREGULAR VARIATIONS
These are also called "erratic", accidental random, refer to such variations in
business activity which do not repeat in a definite pattern. In fact the
category labelled irregular variations is really intended to include all types of
variations other than those accounting for the trend, seasonal and cyclical
movement. Irregular movements, on the hand, are considered to be largely
random. These are caused by such isolated special occurrences as floods,

369
earth quakes, strikes and wars. Sudden changes in demand or very rapid
technological progress may also be included in this category. Quantitatively
it is almost impossible to separate out the irregular movements and the
cyclical movements. Therefore, while analysing the time series the trend
and seasonal variations are measured separately and the cyclical and
irregular variations are left altogether. There are two reasons for recognizing
irregular movements.
i) To suggest that on occasions it may be possible to explain certain
movements in the data due to specific causes and to simplify further
analysis.
ii) To emphasise the fact that predictions of economic conditions are
always subject to degree of error owing to the unpredictable erratic
influences which may enter? Seasonal variations are by no means
always so uniform in amplitude and timing that their identification
can be made with certainty.
Another difficulty arises because the four components of time series data
are not mutually independent of one another. An exceedingly severe
seasonal influence may aggravate or even precipitates a change in the
cyclical movement. Conversely cyclical influence may seriously affect the
seasonal movement. A very rapidly rising trend virtually eliminates seasonal
and cyclical variations.

Figure 16.3

Example
16.1 Fit a
trend line to
the
1991 1992 1993 1994 1995 1996 1997 1998 1999
following
data by the
freehand
method:Year

370
Production
of steel
20 22 24 21 23 25 23 26 25
(Million
Tonnes)

- Actual line .... Trend line

Figure 16.4
16.10 MEASUREMENT OF TREND

Trend is measured in four ways such as graphical method, Semi average

method, Moving averages method and Method of least squares
16.10.1 Graphical method
Example 16.2 Fit a straight line by Graphical Method

Year 1962 1963 1964 1965 1966 1967 1968 1969 1970

Value 64 80 77 80 78 42 45 20 30

- Actual line .... Trend line

371
16.10.2 Semi Average Method
When this method is used, the given data is divided into two parts.
Preferably with same number of years. For example, the number of years is
when i.e, 18 then are two equal parts of each 9 years. In case of odd
number of years like 9, 13, 17 etc., two equal parts can be made simply by
submitting the middle year. After the data have been divided into two parts,
an average of each part is obtained. We thus get two points. Each point is
lotted at the mid-point of the class interval covered by the respective part
and then the two points are joined by a straight line which gives us the
required trend line. The line can be extended downwards of upwards to get /
to predict future values.
Example 16.3 Fit a trend line to the following data by method of semi-
Averages.

Year 1993 1994 1995 1996 1997 1998 1999

Sales
Of 102 105 114 110 108 116 112
Firms

Solution: Since seven years are given, the middle year shall be left out and
the average of the first three years and last three shall be obtained.
102  105  114 321
The average of the first three years is   107.
3 3
108  116  112 336
The average of last three years is   112.
3 3
Thus we get two points 107 and 112 which shall be plotted corresponding to
their respective middle years i.e., 1994 and 1998

Figure 16.6

372
Even number of years
When there are even numbers of years like 6,8,10 etc., equal parts can
easily be formed and an average of each part is obtained. However, when
the average is to be centered there would be some problem in case of
number of years i.e. 8,12, etc.
Example 16.4 fit trend line by the method of semi averages to the data
given below:

Year 1992 1993 1994 1995 1996 1997 1998 1999

Sales 412 438 444 454 470 482 490 500

Solution: The average of first 4 years is 437 and that of the last years is
485.5. These two points shall be taken corresponding to the middle periods
1st July 1993 and 1st July 1997.

- Actual line .... Trend line

Example 16.5 the sales of commodity in tones varied from January

1999 to December 1999 in the following manner.

280 300 280 270 240 280

230 230 220 200 210 200

Fit a trend line by the method of semi-averages.

Solution: The first half is 280,300,280,270,240, & 280.
1650
The average of the the first half   275 .
6
The second half is 230,230,220,200,210,&200.
1290
The average of the second half =  215.
6

373
These two figures namely, 275 and 215, shall be plotted at the middle of
their respective periods, i.e., middle of March - April and that of September -
October 1999.

Figure 16.8
16.10.3 Moving Averages Method

When a trend is to be determined by the method of moving averages, the

average value for a number of years is secured and this average is taken as
the normal or trend value for the unit of time falling at the middle of the
period covered in the calculation of the averages. The effects of averaging
are to give a smoother curve, lessening the influence of the fluctuations that
pull the annual figures away from the general trend.

While applying the method, it is necessary to select a period for moving

average such as 3-yarly, 5yearly, 8yearly moving averages etc., the period
of moving average is to be decided in the light of the length of the cycle.
Since it is most commonly applied to data which are characterized by
cyclical movements, it is necessary to select a period for moving average
which coincides with the length of the cycle. The danger is more severe; the
shorter time period represented the average. Ordinarily the period will range
between three and ten years for general business series but even longer
periods are required for certain types of data.

The 3 yearly moving averages shall be computed as follows.

abc bcd cde def
, , , .....
3 3 3 3
5yearly moving Average is
abcde bcdef
, ,......etc.,
5 5

374
Example 16.6 Calculate the 3 yearly moving Averages to the following
data:

Year 1985 1986 1987 1988 1989 1990 1991 1992

Production 15 21 30 36 42 46 50 56

Year 1993 1994 1995 1996 1997 1998 1999

Production 63 70 74 82 93 95 102

Solution:

3 yearly 3 yearly
Year Production Moving Moving
Total Avg.

1985 15 - -

1986 21 66 22

1987 30 87 29

1988 36 108 36

1989 42 124 41.33

1990 46 138 46

1991 50 152 50.67

1992 56 169 56.33

1993 63 189 63

1994 70 207 69

1995 74 226 75.33

1996 82 246 82

1997 93 267 89

1998 95 287 95.67

1999 102 - -

375
 Figure 16.9
Example 16.7 Calculate 4 yearly moving averages of the following
data relating to bank deposits:

Year 1960 1961 1962 1963 1964 1965 1966 1967

Deposits 960 976 973 996 1024 1040 1088 1128

Year 1968 1969 1970 1971 1972 1973 1974 1975

Deposits 1144 1120 1140 1168 1196 1212 1200 1180

2 item 4 year
4 year Moving Moving
Year Deposits Moving Total of Average
Total Col (3) Centered
Centered (4)/8

(1) (2) (3) (4) (5)

1960 960 - - -

1961 976 3916 7896 987

1962 973 3980 8024 1003

1963 996 4044 8192 1024

1964 1024 4148 8428 1053.5

376
1965 1040 4280 8680 1085

1966 1088 4400 8880 1110

1967 1128 4400 9012 1126.5

1968 1144 4532 9104 1138

1969 1120 4572 9196 1149.5

1970 1140 4624 9340 1167.5

1971 1168 4716 9492 1186.5

1972 1196 4776 9564 1195.5

1973 1212 4788 - -

1974 1200 - - -

1975 1180 - - -

Figure 16.10
16.10.4 Method of Least Squares

This method is most widely used in practice. It is a mathematical method

and with its help a trend line is fitted to the data in such a manner that the
following two conditions are satisfied.
i. ( y  y c) 0 (Sum of deviation of the actual values of y and the
computed values of y is zero).
ii. ( y  y c)
2
 0 is least.

I.e. sum of the squares of deviations of the actual and computed values is
least from this line and hence the name method of least squares. The line

377
obtained by this method is known as "the line of best fit'. It may be used to
fit either straight line trend or parabolic trend.
The straight line is represented by the equation.
y c  a  bx ..... (1)

In order to determine the values of constants a and b the following two

normal equations are to be solved.

 y  Na  b x .... (i)

 xy  a x  b x 2
....(ii)

Where x represents the number of years.

Suppose  x  0, then
From (i)  y  Na
a 
y
N

From (ii)  xy  b x 2
b
 xy
x 2

Puts the value of a and b in (1) we get required straight fit.

Example 13.8 Below are the figures of production (in thousand
quintals) of sugar factory.

Year 1992 1993 1994 1995 1996 1997 1998

Production 80 90 92 83 94 99 92

Solution No. of year = 7 (odd): Middle year 1995 is taken as origin

Trend

Production yc
Year (x) X=x-1995 Xy X2 Values
(y)
y c  a  bx

1992 80 -3 -240 9 84

1993 90 -2 -180 4 86

378
1994 92 -1 -92 1 88

1995 83 0 0 0 90

1996 94 1 94 1 92

1997 99 2 198 4 94

1998 92 3 276 9 96

 y  630 x  0  xy  56
 xy  28
Equation of the straight line is
Y=a+bx

x  0 a 
y b
 xy
N x 2

630 56
a b
7 28
A=90 b= 2
x  3 : y c  90  2(3)  84 Similarly

x  2 : y c  90  2( 2)  86 x  1; y c  92

x  1 : y c  90  2(1)  88 x  2 : y c  94

Figure 16.11
Example 16.9 Fit a straight line trend by method of least squares to the
following data

Year 1989 1990 1991 1992 1993 1994 1995 1996

Earnings 38 40 65 72 69 60 87 95

379
Do not plot the trend values on the graph.
Solution

Here the number of data = 8 (even)

There are two middle years.

The origin is
1992  1993
 1992.5
2
x  1992.5
x
1 /2

x  1992.5
Year Y x xy x2
1 /2

1989 38 -7 -266 49

1990 40 -5 -200 25

1991 65 -3 -195 9

1992 72 -1 -72 1

1993 69 1 69 1

1994 60 3 180 9

1995 87 5 435 25

1996 95 7 665 49

 y  526 x  0  xy  616 x 2
 168

Y=a++bx
Since x  0
:. a 
y
N
526
a  65.75.
8

b
 xy
x 2

380
 b = 3.667
:. Y = 65.75 + 3.667x
Example 16.10 Fitting a non-linear trend (2nd degree parabola) to the
following data:

Year 1994 1995 1996 1997 1998 1999

Prices 100 107 128 140 181 192

Solution

The second degree parabola,

Y = a + bx + cx2
The normal equations are

 y  na  b  x  c  x 2

 xy  a  x  b  x  x  x 2 3

x y ax  bx  cx

2 2 3 4

Prices x  1996.5
Year x X2 X3 Xy X2y X4
y 1 /2

1994 100 -5 25 -125 -500 2500 625

1995 107 -3 9 -27 -321 963 81

1996 128 -1 1 -1 -128 128 1

1997 140 1 1 1 140 140 1

1998 181 3 9 27 543 1629 81

1999 192 5 25 125 960 4800 625

 y 848  x 0  x 2
70 x 3
0  xy 694  x y 10160
2

x 4
1414

Since

 x 0 & x 3
0

381
 b 
 xy
x 2

694

70
B = 9.91.

a
 y  c x 2

N
848  c .70

6
6 a + 70 c = 848
 2 ; 3a + 35c = 424 ----(1)

c
N  x y   x  y 
2 2

N x   x 
4 2 2

6  10,160  70 848

6  1414  (70)2
60960 59360 1600

8484  4900 3584

= 0.45

Put the value of c in (1)

3a + 35c = 424
3a = 424 - 35c

3a = 424 - 35 (.45)
3a = 424 - 15.625
3a = 408.375

A = 424/3 a = 136.13
The required 2nd degree equation is y=136.13 + 9.91x + 0.45x2

382
Examples 16.11: Fit a parabolic curve of 2nd degree to the data given
below and estimate the value for 1979 and comment it?

Year 1973 1974 1975 1976 1977

Sales 10 12 13 10 8

Solution

X=x-
Year Y Xy X2 X3 X4 X2y
1975

1973 10 -2 -20 4 -8 16 40

1974 12 -1 -12 1 -1 1 12

1975 13 0 0 0 0 0 0

1976 10 1 10 1 1 1 10

1977 8 2 16 4 8 16 32

 y  53  x 0  xy  6 x 2
10 x 3
0
x 4
 34  x y 94
2

The 2nd degree parabolic equation is

Y= a+bx+cx2
The normal equations are

y na bx  c x 2

xy ax  bx  c x 2 3

x y ax  bx  c x
2 2 3 4

Since

383
 x  0 & x 3
0

 b
xy
x 2

6

10

b 0.6
N x 2 y x 2 y
c
n x 4  ( x 2 ) 2

5 94 1053

5 34 ( 10 ) 2
c  0.857

a
y c x 2

53 0.857 10

a 12.34

The second degree parabolic trend equation is yc = 12.314 – 0.6 x – 0.857

x2
When 1973; x = -2 yc = 10.086
1974; x= -1 yc = 12.057
16.11 MEASUREMENT OF SEASONAL VARIATIONS
Most of phenomenon in economics and business show seasonal patterns.
When data are expressed annually there is no seasonal variations.
However, monthly or quarterly data frequently exhibit strong seasonal
movements and considerable interest attaches to devising a pattern of
averages seasonal variations. In order to analyze seasonal variation, it is
necessary to assume that the seasonal pattern is super imposed on a
series of values and is Independent of these in the sense that the, same
pattern is super imposed irrespective of the level of the level of the series.

Before attempting to measure reasonal variation certain preliminary

decisions are to be made. For example, it is necessary to decide whether

384
weekly, quarterly, monthly indexes are required. To obtain a static
description of a pattern of seasonal variation it will be desirable to first free
the data from the effects of trend, cycles and irregular variation. Once other
components have been eliminated, we can calculate, in index form a
measure of seasonal variations which is usually referred to as a seasonal
index.

For monthly data, a seasonal index consists of 12 numbers one for each
month of a year, or a number of years that has taken place typically in each
month. Thus a second index may be specific or typical. A specific seasonal
index is obtained by averaging a number of specific seasonal. Seasonal
indexes are given as percentages of their average, i.e. each month is
represented by a figure expressing it as a percentage of the average month.
There are many of the simpler methods were devised prior to the
development of electronic computers and were designed to sacrifice
precision for ease of computation. Any acceptable modern method for
computing such an index probably will be programmed for a computer
solution. The method should be designed to meet the following criteria.
i) It should measure only the seasonal forces in the data.
ii) It should modify the erratic fluctuations in the data with an
acceptable system of averaging.
iii) It should recognize slowly changing seasonal patterns that may be
present and modify the index to keep up with those changes.
The following methods are used for measuring seasonal variations.
i) Method of simple averages
ii) Ratio-to-trend method
iii) Ratio-to-moving average
iv) Link-relation methods
16.11.1 Simple Averages Method
This is the simple method to obtain seasonal index.
i) Arrange the unadjusted data by years and months.
ii)Find the monthly total.
iii)
Divide each total by the number of years for which data are given.
iv)Obtain an monthly averages by dividing the total of monthly
averages by 12.
v) Seasonal index for particular month

385
 Monthlyaveragesfor that particularmonth
  100
Averageof monthly Averages

Example 16.12: Assuming that trend is absent; determine if there is

any seasonality in the data given below.

Year 1stQr 2ndQr 3rdQr 4thQr

1996 3.7 4.1 3.3 3.5

1997 3.7 3.9 3.6 3.6

1998 4.0 4.1 3.3 3.1

1999 3.3 4.4 4.0 4.0

What are the seasonal indices for various quarters?

st nd rd th
Year 1 Qr 2 Qr 3 Qr 4 Qr

1996 3.7 4.1 3.3 3.5

1997 3.7 3.9 3.6 3.6

1998 4.0 4.1 3.3 3.1

1999 3.3 4.4 4.0 4.0

Total 14.7 16.5 14.2 14.2

Average 3.675 4.125 3.55 14.2

Seasonal Index 98.66 110.74 95.30 95.30

Quarterly Average
Seasonal Index =
Averageof Averages
3.675  4.125  3.55  14.2
Average of Averages =
4
14.9
=  3.725
4
3.675100
Seasonal index for 1st Quarter =  98.66
3.725
4.125 100
Seasonal index for 2nd Quarter =  110.74
3.725

386
 3.55 100
Seasonal index for 3rd Quarter =  95.30
3.725
14.2 100
Seasonal index for 4th Quarter =  95.30
3.725
Example 16.13 Compute the seasonal index for I, II, III, and IV quarts
for the following data assuming that there is no trend

Year
Quarter
1995 1996 1997 1998 1999

1st 42 40 45 41 44

2nd 35 37 36 35 38

3rd 39 38 38 36 38

4th 41 38 40 40 42

Solution:

Quarter
Year
1st 2nd 3rd 4th

1995 42 35 39 41

1996 40 37 38 39

1997 45 36 38 40

1998 41 35 36 40

1999 44 38 38 42

Total 212 181 189 201

Mean 42.4 36.2 37.8 40.2

42.4  36.2  37.8  40.2

Mean of Means =
4

387
 156.6
=  39.15  39.2
4
42.4
Seasonal index for 2 nd Quarter = 100  108.16
39.2
37.8
Seasonal index for 3rd Quarter = 100  96.43
39.2
37.8
Seasonal index for 3rd quarter = 100  96.43
39.2
40.2
Seasonal index for 4th Quarter = 100  102.55
39.5
16.11.2 Ratio -To- Trend Method
This method is also relatively simple and it assumes that seasonal
variation is constant of trend for a given month. This method isolates the
seasonal factor as follows.
T  S C l
 S C l
T
When ratio are averaged, random elements are supposed to be eliminated,
Ratio to trend method way be sufficient for a time series that are not subject
to significant cyclical or irregular variations and for which trend can be
calculated reasonably accurately.
Steps for ratio- to trend methods

 Trend values are calculated (if they are not given) by using the
method of least squares preferably.
 The original data month by month (or quarter by quarter) is divided
by corresponding trend values and the ratio is multiplied by 100.
 These figures calculated for various years for months or quarters are
averaged with median or mean , if necessary to free the values form
irregular or cyclical fluctuations.
 The seasonal index is calculated as a percentage of the mean value
for the months. The sum 1of values must be equal to 1200or 100 An
adjustment is made if necessary by multiplying each index by 1200/
(Sum of 12 mean values) for monthly values or 400/(Sum of mean
values) for quarter values. This gives the final seasonal index.

388
Example 16.14 Calculate the seasonal variation for the following data
of sales in thousands of rupees of a firm by ratio-to-trend method.
Year 1st Qr 2nd Qr 3rd Qr 4th Qr

30 40 36 34
1989
34 52 50 44
1990
40 58 54 48
1991
54 76 68 62
1992
80 92 86 82
1993

Solution
Find trend values by the method of least squares. Assuming a straight line
trend.
Step
Year Yearly Yearly X' =x-A x'2
x'y
X Total mean y A=1991
140 35 -2 -70 4
1989
180 45 -1 -45 1
1990
200 50 0 0 0
1991
260 65 1 65 1
1992
340 85 2 170 4
1993
280 0 120 10
Total

y  280 x' 0 x' y  120 x 12

 10
Here N=5
Since
x0

b 
xy a
y
x 2
n
120 280
b a
10 5
b  12 a  56
y  56  12( x 1991)
12
Quarter increment   3.
4

389
The trend values are given by putting X=1989,1990,1991,1992,1993
X=56+12x-2=32 for 1989
Similarly, Y=44,56,68,80 for 1990,1991,1992,and 1993

Actual Trend
Tabulating
yearly values
year
values
35 32
1989
45 44
1990
50 56
1991
65 68
1992
85 80
1993

Calculation of quarterly trend values

Consider 1989.Trend value 32 corresponds to the middle quarter of
1989
I,e half 2nd and half of 3rd quarterly increment=3
Trend value of 2nd quarter =32-3/2=30.5
Trend value of 3rd quarter =32+3/2=33.5
Here the trend value of the 1 st Quarter is 30.5-3=27.5 and
Trend value for the 4th quarter is 33.5+=36.5
Since the quarterly trend is3
Year 1st Qr 2nd Qr 3rd Qr 4th Qr

27.5 30.5 33.5 36.5

1989
39.5 42.5 45.5 48.5
1990
51.5 54.5 57.5 60.5
1991
63.5 66.5 69.5 72.5
1992
75.5 78.5 81.5 84.5
1993

Quarterly values percentage of trend values

Step2:
For the quarter of 1989 the percentage is
30
100  109.09
27.5
Percentage of trend value for the 2nd quarter
40
100  131.15
30.5

390
Proceeding in this way we have the following 7 quarterly trend values.

Year 1stQr 2ndQr 3rdQr 4thQr

1989 109.09 131.15 107.46 93.15

1990 86.08 122.35 109.89 90.72

1991 77.67 106.42 93.91 79.34

1992 85.04 114.29 105.52 97.04

1993 105.96 117.20 105.52 97.04

Total 463.04 591.41 514.62 445.7

Mean 92.73 118.28 102.92 89.14

Adjusted
seasonal 92.01 117.36 102.12 88.45
index

Find total of the means

92.73 + 118.28+102.92+89.14=403.12
Since this total is not 400, adjust each mean by multiplying each mean by
400
the factor
403.12
Example 16.15 Compute the seasonal index for the following data
assuming that there is no need to adjust the data for the trend.

Quarter 1993 1994 1995 1996 1997 1998

1st 3.5 3.5 3.5 4.0 4.1 4.2

2nd 3.9 4.1 3.9 4.6 4.4 4.6

3rd 3.4 3.7 3.7 3.8 4.2 4.3

4th 3.6 4.8 4.0 4.5 4.5 4.7

391
 Quarters
Year
1stQr 2ndQr 3rdQr 4thQr

1993 3.5 3.9 3.4 3.6

1994 3.5 4.1 3.7 4.8

1995 3.5 3.9 3.7 4.0

1996 4.0 4.6 3.8 4.5

1997 4.1 4.4 4.2 4.5

1998 4.2 4.3 4.3 4.7

Total 22.8 25.2 23.1 26.1

Mean 3.8 4.2 3.85 4.35

3.8  4.2  3.85  4.35

The Mean of means =
4
16.20
=  4.05
4
Quarterly index
Seasonal index =  100
Central mean

3.8
Seasonal index for 1st Quarter =  100  93.83
4.05
4.2
Seasonal index for 2nd Quarter =  100  103.70
4.05
3.85
Seasonal index for 3rd Quarter =  100  95.06
4.05
4.35
Seasonal index for 4th Quarter =  100  107.41
4.05

Quarter Seasonal Indices

1st 93.80

2nd 103.70

392
 3rd 95.06

4th 107.41

Example 16.16
Find seasonal variations by the ratio-to-trend method from the
following data.

Quarters
Year
1st 2nd 3rd 4th

1973 60 80 72 68

1974 68 104 100 88

1975 80 116 108 96

1976 108 152 136 124

1977 160 184 172 164

Solution:

First of all we determine the trend values for the yearly averages (y) by
fitting a linear trend using the method of least squares.

Quarterly
Original Trend
Year x Average for the xy X2
number x values
year y

1973 -2 280/4=70 -140 4 64

1974 -1 360/4= 90 -90 1 88

1975 0 400/4=100 0 0 112

1976 1 520/4=130 120 1 136

1977 2 680/4=170 340 4 160

Total 0 560 240 10 560

The straight line y=a +bx, normal equations for estimation a and b are

393
  y  Na  b x
 xy  a  x  b x 2
y  xy
a  b
N  x2
580 246
a  112 b  24
11

Trend line is yc= 112+24x yearly increment in the trend value b=24

Thus the increment per quarter is 24/4=6. Now determine quarterly trend
values.
For 1973, the trend value for the middle half of second quarter and
half of third quarter of 1973 is 64. Since the quarterly increment is 6, we
obtain trend values for second and third quarter of 1973 as 64-3 and 64+3,
i.e.61 and 67 consequently 1st quarter is 61-6-55 and 4th quarter is 67+6=73.
Calculation of Seasonal Variations
Trend Values

Year 1stQr 2ndQr 3rdQr 4thQr

1973 55 61 67 73

1974 79 85 91 97

1975 103 109 115 121

1976 127 133 139 145

1977 151 157 163 169

Year 1stQr 2ndQr 3rdQr 4thQr

1973 109.09 131.15 107.45 93.15

1974 86.07 122.35 109.89 90.72

1975 77.67 106.42 93.91 79.33

1976 85.04 114.28 97.84 85.52

394
1977 105.96 117.20 105.52 97.04

Total 463.83 591.40 514.62 445.76

Average
92.766 118.28 102.92 89.152
(A.M)

Seasonal
index 92.024 117.33 102.1 88.439
(adjusted)

Since the total of the seasonal index is 403.122, each index has to be
adjusted by multiplying it by a constant.
400 400
k   0.992
Total of indices 493.122

16.11.3 The Ratio – Moving Average Method

It is mostly widely used method for measuring seasonal variations.

This is called “Percentage of moving” average method. This method
consists of the following steps:
i) Find the centered 12 month average (or) centered 4 quarter moving
average as the case may be. Thus the centered 12 month
approximate Tc.
ii) Express the Original data for each month as a percentage of the
centered 12 month moving average corresponding to it.
iii) Divide the original value for each month by the corresponding 12
months moving average.
iv) Average the percentages obtained above to eliminate irregular
fluctuations by choosing a suitable average. It may be mean or
media. Median is more suitable since we assume that high or
extremely low values of seasonal factors. The elimination of
extremes is done while we are averaging all January, February and
the like. It can be achieved by an appropriate choice of the average.
Median is suitable since it is not affected by extremes.
v) If the total of all these average is not equal to 1200 or 100 percent,
an adjustment is made to eliminate the discrepancy. The
adjustment is done by multiplying the average of each month

395
 obtained in step (4) by 1200 (the total of the median (or) modified
mean for 12 months).
Example 16.7 Compute seasonal indices for the following data using
the ratio-to-moving-average method.

Quarters
Year
1stQr 2ndQr 3rdQr 4thQr

1996 78 72 71 73

1997 75 78 76 71

1998 78 73 73 77

4 figure
4 figure 2 figure
Year Given data moving
moving total moving total
average

1996 1stQr 78 - -

2ndQr 72 - -

3rdQr 71 354 645/8= 80.625

4thQr 73 291 588/8= 73.5

599/8 =
1997 1stQr 75 297
74.875

602/8 =
2ndQr 78 302
75.375

603/8 =
3rdQr 76 300
75.375

601/8 =
4thQr 71 303
75.125

396
 593/8 =
1998 1stQr 78 298
74.125

2ndQr 73 295 596/8 = 74.5

3rdQr 73 301 -

4thQr 77 - -

Quarters
Year
1stQr 2ndQr 3rdQr 4thQr

71 73
100  88.06 100  99.32
1996 - - 80.625 73.05

75 78 76 71
100  100.17 100  103.65 100  100.83 100  94.51
1997 74.875 75.25 75.375 75.125

78 73
100  105.23 100  97.99
1998 74.125 74.05 - -

Quarter
Year
1stQr 2ndQr 3rdQr 4thQr

1996 - - 88.06 99.32

1997 100.17 103.65 100.83 94.51

1998 105.23 97.99 - -

Total 205.40 201.64 188.89 193.83

Mean 102.70 100.82 94.45 96.93

397
 102.70  100.82  94.45  96.93
Mean of the means =
4
394.90
=  98.72
4
Quarter Adjusted seasonal index
102.70
1stQr -  100  104.03
98.72
100.82
2ndQr -  100  102.13
98.72
94.45
3rdQr -  100  95.67
98.72
96.93
4thQr -  100  98.19
98.72
Example 16.18 Calculate seasonal indices by the ratio to moving
average method from the following data.

Year
Quarter
1972 1973 1974 1975

1stQr 75 86 90 100

2ndQr 60 65 72 78

3rdQr 54 63 66 72

4thQr 59 80 85 93

Ratio to
Sum of 4 Qr moving
4 Qr average
Year Quarter Price two 4 Qr moving
moving (7) =
(1) (2) (3) moving Avg (6)=
total (4) ( 3)
total (5) (5) (8)  100
(6)

1stQr 75 - - - -
1972
2ndQr 60 248 507 63.375 85.21

398
 3rdQr 54 259 523 65.375 90.25

4thQr 59 264 537 67.125 128.12

1stQr 86 273 567 70.875 91.71

2ndQr 65 294 592 74.000 85.13

1973
3rdQr 63 298 603 75.375 106.14

4thQr 80 305 613 76.625 117.45

1stQr 90 308 621 77.625 92.75

2ndQr 72 313 636 79.500 83.02

1974
3rdQr 66 323 652 81.500 104.29

4thQr 85 329 664 83.000 120.48

1stQr 100 335 678 84.750 92.03

2ndQr 78 343 - - -
1975
3rdQr 72 - - - -

4thQr 93 - - - -

Calculation for Seasonal Index

Average
Seasonal index =  100
GrandTotal

Quarters
Year
1stQr 2ndQr 3rdQr 4thQr Total

1972 - - 85.21 90.25

1973 128.12 91.71 85.13 106.14

1974 117.45 92.75 83.02 104.29

1975 120.48 92.03 - -

Total 366.05 276.49 253.36 300.68

399
Average 122.017 92.163 84.453 100.227 398.86

Seasonal
122.366 92.426 84.694 100.514 400
index

Grand Average = 398.86/4 = 99.715

Example 16.19 Using 4 quarterly moving averages in respect of the
following data. Find (i) the trend (iii) short term fluctuations (iii)
seasonal variations.

Year 1stQr 2ndQr 3rdQr 4thQr

1971 35 86 67 124

1972 38 109 91 176

1973 47 158 104 26

1974 61 177 134 240

1975 72 206 141 307

Solution:
Computation of 4 Quarters moving average and short term fluctutations.

4 Qr
4 Qr Sum of two Short – term
Quarterly Yt moving
Year (1) moving 4 Qr moving fluctuations
(2) (3) Avg (6)
total (4) totals (5) (7) = (3) – (6)
= (5) /8
st
1 Qr 35 - - - -
nd
2 Qr 86 312 627 78.37 -11.37
1971
rd
3 Qr 67 315 653 81.62 42.38
th
4 Qr 124 338 700 87.50 -49.50
st
1 Qr 38 362 776 97.00 12.00
nd
1972 2 Qr 109 414 837 104.62 -13.62
rd
3 Qr 91 423 895 111.87 64.13

400
 th
4 Qr 176 472 957 119.62 -72.62
st
1 Qr 47 485 1020 127.50 30.50
nd
2 Qr 158 535 1084 135.50 -31.50
1973
rd
3 Qr 104 549 1117 139.62 86.38
th
4 Qr 226 568 1166 145.75 -84.75
st
1 Qr 61 598 1210 151.25 25.75
nd
2 Qr 177 612 1235 154.37 -20.37
1974
rd
3 Qr 134 623 1275 159.37 80.63
th
4 Qr 240 652 1311 163.87 -91.87
st
1 Qr 72 659 1385 173.12 32.88
nd
2 Qr 206 726 - - -
1975
rd
3 Qr 141 - - - -
th
4 Qr 307 - - - -

Calculation for Seasonal Index Fluctuations

Deviations from Trend

Quarters
Year
1stQr 2ndQr 3rdQr 4thQr

1971 - - -11.37 42.38

1972 -49.50 12.00 -13.62 64.13

1973 -72.67 30.50 -31.50 86.38

1974 -84.75 25.75 -20.37 80.63

1975 -91.87 32.88 - -

Total -298.74 101.13 -76.86 273.52

401
Average -74.68 25.28 -19.21 68.38

Adjustment 0.06 0.06 0.06 0.06

Seasonal
-74.62 25.34 -19.15 68.44
fluctuation

Remarks
i) Here we have used the additive model.
ii) Adjustment = Grand Average with opposite sign.

= -(-0.23 / 4) = 0.06
iii) Seasonal index = Average for each quarter + Adjustment.
16.11.4 Link Relative Method

Amongst all the methods of measuring of measuring seasonal

variations, link relative method is the most difficult one. When this method is
adopted we have to follow the steps.
i) Calculate link relatives of the seasonal figures. Link relatives are
calculated by divided the figure of each season by the figure of the
immediately preceding season and multiplying it by 100.
Current season' s figure
 100
Pr eviousseason' s figure

ii) Calculate average of the link relatives for each season.

iii) Convert these averages into chain relatives on the base of the first
season.
iv) Calculate the chain relatives of the first season on the base of the
first season.
v) For correction the chain relative of the first season is calculated by
first method is deducted from the chain relative calculated by the
second method. The difference is divided by number of seasons.
vi) Express the corrected chain relatives as percentages of their
averages.

402
 Example 16.20 Apply the method of link relatives to the following data
and calculate seasonal indices

Year
Quarter
1995 1996 1997 1998 1999

1st Qr 6 5.4 6.8 7.2 6.6

2nd Qr 6.5 7.9 6.5 5.8 7.3

3rd Qr 7.8 8.4 9.3 7.5 8.0

4th Qr 8.7 7.3 6.4 8.5 7.1

Solution
Calculation of seasonal indices by the method of link relatives.

Quarters
Year
st nd rd th
1 Qr 2 Qr 3 Qr 4 Qr

1995 - 108.3 120.0 111.5

1996 621 146.3 106.3 86.9

1997 93.2 95.6 143.1 68.8

1998 1125 80.6 129.3 113.3

1999 77.6 110.6 109.6 88.8

Arithmeti
345.4 541.4 608.3 469.3
c  86.35  108.28  121.66  93.86
4 5 5 5
average

100108.28 121.66108.28 93.86131.73

Chain  108.26  131.73  123.65
100 100 100 100
relatives

Correcte
100 108-1.675 = 106.605 131.73- 3.35 = 128.36 123.64 – 5.025 =
d chain

403
relatives 118.615

100100 106.605100
Seasona  88.18  94.01
128.38 118.615
113.4 113.4 100  113.21 100  104.60
l indics
113.4 113.4

Calculations

Chain relative of the 1stQr = 100

Chain relative of the 1stQr = (86.35x123.64) / 100 = 106.7

Difference between these chain relatives = 106.7 – 100 = 6.7

Difference per quarter = 6.7/4 = 1.675
Adjusted chain relatives are obtained by subtracting 1 x 1.675, 2x 1.675,
3x 1.675 from the chain relatives of the 2nd,3rd and 4th quarters.
Average of corrected chain relatives = (100+106.65+128.38+118.615) /4
= 453.6 / 4 = 113.4
correctchainrelatives
Seasonal variation index =  100
113.4
Example 16.21 Calculate seasonal index by method of link relative for
the given data.

Year
Quarter
1972 1973 1974 1975

1stQr 75 86 90 100

2ndQr 60 65 72 78

3rdQr 54 63 66 72

4thQr 59 80 85 93

Solution:

Computation of seasonal indices

404
Link relatives

Quarter
Year
st nd rd th
1 Qr 2 Qr 3 Qr 4 Qr

59
60 59  100  109.26
1972 -  100  80  100  90 54
75 60

86
 145.76
1973 56 75.58 96.92 126.96

1974 112.50 80 91.67 128.79

1975 117.65 78 92.31 129.17

Total 375.01 353.58 370.90 464.20

Arithme
tic
125.303 78.395 92.725 123.55
averag
e

Chain 100 78.395 78.38592.725 78.692123.55

 78.395  72.692  89.811
relative 100 100 100 100
s

Adjuste
78.395-3.134 = 72.692- 6.268 = 89.811 – 9.402 =
d chain 100
75.261 66.424 80.409
relative

Season 100 75.261 66.424 80.409

60.323
100  124.187 100  93.405 100  24.91 80.525 100  99.857
al 80.53 80.523
indices

Adjustment of chain relatives

Chain relative of the 1stQr = 100
The difference is due to the presence of trend.

405
 112.536  100
Adjustment factor =  3.134
4
LET US SUM UP
We have learn the definition of time series and its applications. The time
series components are secular trend, seasonal variation, cyclical variation
and irregular variations. The phases of business cycle are also explained in
this unit. The methods for calculating trend are graphical, semi average,
moving average and method of least squares. The methods for calculating
seasonal variation are simple average, ratio to trend, ratio to moving
average and link relative method. The methods are illustrate with examples.
CHECK YOUR PROGRESS

1) You are given the annual profit figures for a certain firm for the years
1970 to 1976. Fit a straight line trend to the data and the estimate the
expected profit for the year 1977.

Year 1970 1971 1972 1973 1974 1975 1976

Profit 60 72 75 65 80 85 95

2) Fit the straight line of the type y = a + bx to the following

Year X 1967 1968 1969 1970 1971 1972 1973 1974 1975

Production
11 13 15 14 15 16 16 17 18
Y

3) Find out seasonal indices by ratio-to trend method from the following
data:

Year 1st Qr 2nd Qr 3rd Qr 4th Qr

1966 36 34 38 32

1967 38 48 52 42

1968 42 56 50 52

19669 56 74 98 62

406
 1970 82 90 88 80

4) From the data given below calculate seasonal indices for 1st , 2nd 3rd and
4th quarters assuming the trend Is absent

Quarter/year 1994 1995 1996 1997 1998

1st Qr 40 42 41 45 44

2nd Qr 35 37 35 36 38

3rd Qr 38 39 38 36 38

4th Qr 40 38 40 41 42

5) Find seasonal Indices by ratio- to trend method to the following :

Year 1st Qr 2nd Qr 3rd Qr 4th Qr

1995 30 40 36 34

1996 34 52 50 44

1997 40 58 54 48

1998 54 76 68 62

1999 80 92 86 82

GLOSSARY

Time Series : Time series is a sequence taken at

successive equally spaced points in time.
Thus it is a sequence of discrete-time data.

Seasonal variations : It is a variable element in the time-series

analysis of forecasting, and refers to the
phenomenon where the production and plan
of product change on a
certain seasonal trend depending to the
characteristics of the product.

407
Cyclical variations : Cyclical variations are due to the ups and
downs recurring after a period from time to
time. These are due to the business cycle
and every organization has to phase all the
four phases of a business cycle some time
or the other.

Trend : The trend is the component of a time

series that represents variations of low
frequency in a time series, the high and
medium frequency fluctuations having been
filtered out. The trend shows the general
tendency of the data to increase or decrease
during a long period of time.

SUGGESTED READINGS
1. Arora, P.N. & S. Arora, (2007) ,Statistics for Management, latest
Edition, S. Chand & Company Ltd., New Delhi.
2. D.C.Sancheti, V.K.Kapoor,( 2014), Business Mathematics, 11th
edition, Reprint, Sultan Chand and Sons, New Delhi.

3. Gupta, B.N., (2015), Business Statistics, First Revised Edition,

SBPD, New Delhi.
4. JK. Sharma, (2009), Business Mathematics Theory And
Applications, 13th Edition, ANE Books, New Delhi.
5. S. P. Gupta, (2012), Statistical Methods, 42nd Revised Edition Sultan
Chand & Sons Pvt. Ltd., New Delhi.
6. https://www.wallstreetmojo.com/time-series/
7. https://www.brainkart.com/article/Measurements-of-Trends--
Methods-of-measuring-Seasonal-Variations-By-Simple-
Averages_39019/
ANSWERS TO CHECK YOUR PROGRESS

1. Y= 76+4.857x
2. Y =15+0.733x
3. 100.03,109.54,103.14,87.28
4. IQe + 108.16, IIQr =92.35, III Qr= 96.43, IVQe =102.55
5. 62.05,117.36, 102.12, 84.47

408
 BLOCK 5
HYPOTHESIS

Unit 17: Introduction to Hypotheses, Sources and

Types
Unit 18: Testing of Hypotheses: Applying T-Statistic
Unit 19: Testing of Hypotheses: applying F-Statistic for
two Population Variances and Analysis of
Variance (ANOVA)

409
Unit 17

INTRODUCTION TO HYPOTHESES,
SOURCES AND TYPES
STRUCTURE
Overview
Learning Objective
17.1 Introduction

17.2 Meaning& Definition of Hypothesis

17.3 Types of Hypothesis
17.4 Sources and Basic concepts

17.4.1 Sources
17.4.2 Assumptions of Statistical Hypothesis
17.4.3 Level of Significance

17.4.4 One- and Two-Tailed Tests

17.4.5 Type I error and Type-II error
17.4.6 Power of test
17.4.7 Degree of freedom
17.4.8 Critical Region
17.4.9 Critical Value
17.5 Testing Hypothesis and its Classification
17.6 Procedures for Testing Hypothesis with illustration
17.7 Limitations of Hypothesis testing

Let Us Sum Up
Check Your Progress
Glossary

Suggested Readings
Answers to Check Your Progress

410
OVERVIEW
The student can perform all test of Hypothesis and mitigate the errors
because of understanding basic concepts of hypothesis. Student can
calculate all confidence interval for a population and aware of Type-I and
Type-II errors. Students enable to judge a good decision about the fact
taken based on test statistic results.
LEARNING OBJECTIVE
After reading this unit, you should be able to
 learn the basic concepts about the hypothesis and testing
hypothesis
 reveal the different types of hypothesis and limitations of hypothesis
 understand the procedure of hypothesis formulation for framing in
needs.
17.1 INTRODUCTION
The first method that can be considered a hypothesis test is related back to
John Arbuthnot in 1710. However, the modern form of statistical hypothesis
testing originated from the combination of work from R. A. Fisher, Jerzy
Neyman and Egon Pearson. It can be considered one of the first statistical
inference methods and it is till this day widely used. Examples for
applications can be found in all areas of science, including medicine,
biology, business, marketing, finance, psychology and social sciences.
Specific examples in biology include the identification of differentially
expressed genes or pathways, in marketing it is used to identify the
efficiency of marketing campaigns or the alteration of consumer behavior ,
in medicine it can be used to assess surgical procedures, treatments or the
effectiveness of medications, in pharmacology to identify the effect of drugs
and in psychology it has been used to evaluate the effect of
meditation.(Frank Emmert-Streib and Matthias Dehmer 2019)

The purpose of hypothesis testing is to determine whether there is enough

statistical evidence in favor of a certain belief about a parameter. For
example: Is there statistical evidence in a random sample of potential
customers that support the hypothesis that more than 10% of the potential
customers will purchase new products. Is a new drug effective in curing a
certain disease? A sample of patients is randomly selected. Half of them are
given the drug while the other half are given a placebo. The improvement in

411
the patient’s conditions is then measured and compared. A key component
in hypothesis testing is of course a ‘hypothesis’. The hypothesis is a
quantitative statement we formulate about the population value of the test
statistic.
Hypothesis gives the direction of research, specifies the sources of data,
determines the data needs, determines the type of research, aids to do
appropriate techniques of research and make contribution to the
development of theory. Further it guides the direction of the study taken for
the analytical purpose, and identifies facts that are relevant and those are
not. Lastly but importantly, testing of a hypothesis with required apt test
statistic provides a framework for confirming and organizing results for
conclusion about a fact or phenomena.
17.2 MEANING & DEFINITION OF HYPOTHESIS
Meaning
Hypothesis is a tentative statement showing the relationship between two or
more variables, the reliability and validity of which is to be tested and
verified. It expresses the nature and degree of relationship between
variables. There are different ways presenting the meaning of hypothesis as
follows:
 Hypotheses are assumptions,
 Hypotheses are tentative statements,

 Hypotheses are propositions,

 Hypotheses are answering the questions,
 Hypotheses are proposed solution to a problem,

 Hypotheses are statements which are to be tested,

 Hypotheses are to be accepted or rejected,
 Hypotheses are to be verified empirically on the basis of sample.

In addition with the above meaning the following sentences also gives the
meaning based on its functional dimension “A hypothesis is an educated
prediction that can be tested” (study.com).“A hypothesis is a proposed
explanation for a phenomenon” (Wikipedia). “A hypothesis is used to define
the relationship between two variables” (Oxford dictionary Hence, a
hypothesis is a quantitative statement about a population stated in terms of

412
a parameter. A test of hypothesis is a statistical procedure used to make a
decision about the assumed value of a parameter. Decision is based on
observed values/ manipulated of a statistic compared with tabulated values
of the concerned statistic.
Hypothesis testing is start by making a set of two statements about the
parameter(s) in question.A procedure that enables us to agree (or disagree)
with the statistical hypothesis is called a test of the hypothesis or testing of
hypothesis
Definition

Lundberg (1942) defines hypothesis as “a tentative generalization, the

validity of which remains to be tested”. The other person Walpole stated that
“Hypothesis is a supposition or proposed explanation made on the basis of
limited evidence as a starting point for further investigation” Goode and Hatt
define it as “a proposition which can be put to a test to determine its
validity”.
17.3 TYPES OF HYPOTHESES
According to the nature and situation, hypothesis may be grouped as simple
or Composite, Parametric and Non-parametric, or Null or Alternative.
a. Simple and Composite hypothesis
If a hypothesis is concerning sample statistic or population parameter only,
then it is called simple hypothesis. For example, “population standard
deviation conforms to sample standard deviation” is a simple hypothesis.” If
a hypothesis forms a statement about any sample statistic or parameter and
form of distribution, it is called composite hypothesis. For example,
“population follows normal distribution with mean = 25 “is a composite
hypothesis.”
b. Parametric and Non-parametric hypothesis

A hypothesis which specifies only the Parameter or statistic of either the

sample or population is called parametric hypothesis. If a hypothesis
specifies only the form of the distribution, it is non-parametric. For example,
the hypothesis “Mean of the population is 2300” is a parametric hypothesis,
while “population is normal” is non-parametric.
.

413
c. Null and alternative hypothesis
A null hypothesis is statistical hypothesis which states that the difference
between the sample statistic or population parameter is nil, or statistically
insignificant. Usually null hypotheses are formed for significance testing.
Any hypothesis other than null hypothesis is called an alternative
hypothesis. The null hypothesis is denoted by Ho and alternative hypothesis
by H1.
The other form of classification stated the type of hypothesis as follows:
1. Descriptive Hypotheses

2. Relational Hypotheses
3. Causal Hypotheses
4. Working Hypotheses
5. Null hypotheses
6. Statistical Hypotheses
7. Common sense Hypotheses
8. Complex Hypotheses
9. Analytical Hypotheses
Descriptive Hypotheses are propositions that describe the characteristics
(such as size, form or distribution) of a variable. `The variable may be an
object, person, organization, situation or event.
Examples are:

1. The rate of employment among arts graduates is higher than that of

commerce graduates.
2. The public enterprises are more amenable for centralized planning.
3. The Educational system is not oriented to human resource needs of
a country
Relational Hypotheses are propositions, which describe the
relationship between two variables. The relationship suggested may be
positive or negative correlation or causal relationship. The following are
some examples,

1. “Families with higher incomes spend more for recreation.”

2. “Participative management promotes motivation among executives.”

414
 3. “Upper-class people have fewer children than lower-class people.”
4. “Labour productivity decreases as working duration increases.”
Causal hypotheses states that the existence of, or a change in, one variable
causes or leads to an effect on another variable. The first variable is called
the independent variable, and the latter variable is called the dependent
variable. While planning the study of a problem, hypotheses are formed.
Initially they may not be very specific. In such cases, they are referred to as
“Working Hypotheses” which are subject to modification as the investigation
proceeds. Null Hypotheses are hypothetical statements denying what are
explicitly indicated in working hypotheses. They do not, nor were ever
intended to exist in reality. They state that no difference exists between the
parameter and the statistic being compared to it.
If the hypothesis is stated in terms of population parameters (such as mean
and variance), the hypothesis is called Statistical hypothesis. Data from a
sample (which may be an experiment) are used to test the validity of the
hypothesis. For example: To examine the wages of men and women are
equal. One hypothesis might claim that wages of men and women are
equal, while the alternative might claim that men make more than women.
Common sense hypotheses represent the common sense ideas. They state
the existence of empirical uniformities perceived through day to day
observations. Complex hypotheses aim at testing the existence of logically
derived relationships between empirical uniformities. For example, in the
early state human ecology described empirical uniformities in the
distribution of land values, industrial concentrations, types of business and
other phenomena. Analytical hypotheses are concerned with the
relationship of analytic variables. These hypotheses occur at the highest
level of abstraction. These specify relationship between changes in one
property and changes in another.
17.4 SOURCES AND BASIC CONCEPTS

17.4.1 Sources of Hypothesis

1. Observation –based on the behavior pattern

2. Relation between the variables is hypothesized
3. Intuitions and personal experiences

4. Findings of earlier studies

5. State of Knowledge – the theorems may be modified

415
 6. Culture –castes, beliefs, habits leads presumed statements
7. Contribution of research – the rejection of certain hypothesis may
lead to further research

8. Theory –large concerns earn more profit, return on capital is an

index of business success
17.4.2 Assumptions of Statistical Hypothesis Testing

Statistical hypothesis testing requires several assumptions. These

assumptions include considerations of the level of measurement of the
variable, the method of sampling, the shape of the population distribution,
and the sample size. The specific assumptions may vary, depending on the
test or the conditions of testing. However, without exception, all statistical
tests assume random sampling. Tests of hypotheses about means also
assume interval-ratio level of measurement and require that the population
under consideration be normally distributed or that the sample size be larger
than 50. Based on the data, one can test the hypothesis according to the
requirement of the fact or phenomena needed to analysis which in turn is
lead towards the test statistic. Hence, in the testing hypothesis assumptions
some are common and some are specific depends on the test statistic to be
used in a hypothesis testing.
17.4.3 Level of Significance
A null hypothesis when proved true is to be accepted. But there is a remote
probability that it may be wrongly rejected. Such a probability is called level
of significance. Level of significance is the probability with which a null
hypothesis is rejected. Therefore, level of significance is the risk; a
statistician is running in his decisions. Generally statistical hypothesis tests
are conducted at a given level of significance. If level of significance is not
specified, it is taken as 5 %. Level of significance is denoted as α (alpha). It
is usually determined before conducting the statistical test.
17.4.4 One- and Two-Tailed Tests
One-tailed test: A type of hypothesis test that involves a directional research
hypothesis. It specifies that the values of one group are either larger or
smaller than some specified population value.
Right-tailed test: A one-tailed test in which the sample outcome is
hypothesized to be at the right tail of the sampling distribution.

416
Left-tailed test: A one-tailed test in which the sample outcome is
hypothesized to be at the left tail of the sampling distribution.
Two-tailed test: A type of hypothesis test that involves a no directional
research hypothesis. We are equally interested in whether the values are
less than or greater than one another. The sample outcome may be located
at both the lower and the higher ends of the sampling distribution

17.4.5 Type I and Type II errors

Null hypothesis is the starting point in significance testing. A null hypothesis
may lead to take a decision on four possibilities:

 Null hypothesis - proved true - Accepted

 Null Hypothesis - proved wrong - Rejected
 Null Hypothesis - proved true - Rejected
 Null hypothesis - proved wrong - Accepted
First and second possibilities of decisions are correct. But the third and
fourth possibilities of decisions are errors. Rejecting a true null hypothesis is
termed as Type I error. Accepting a hypothesis which is proved wrong is
called as Type-II error. Of these two errors, Type II errors is more serious
and far reaching than Type I error

17.4.6 Power of a Test

The measure of how well the test is working is called power of a test. We
used to name in symbol asα is Type I error, and β is Type II error. The
smaller the β, the better it is. Or (1- β) i.e. the probability of rejecting a false
hypothesis should be as large as possible. Therefore, a high value for (1- β)
means the test is working properly. Hence (1- β) is the power of a test.
17.4.7 Degrees of Freedom

While selecting items of statistical process, we have limited freedom.

Degree of freedom is the number of independent choices in determining
observations. In the case of individual observations, degree of freedom is
total number of observations less the number of constraints. Usually it is
equal to n-1.In some cases it differ based on the sample statistic used in

417
hypothesis. For example, in the case of Chi-square test, degree of freedom
is equal to number of column minus one multiplied with the number of rows
minus one (column – 1 x row – 1). Degree of freedom is denoted by υ (nu).
17.4.8 Critical Value
The critical value is the value of the test statistic which separates the
rejection region from the acceptance region. It is determined by the level of
significance and the nature of the test. For Example, if it is a large sample
test, the critical value at the level of significance of five percent (= 0.05) will
be 1.96. The purpose of critical value is to decide about the fact of H0 and
gives the information about the acceptance region and rejection region.
Critical value separates total region into acceptance region and rejection
region. In simple way to understand the critical value is given statistical
Table Value.
17.4.9 Critical Region
Critical region corresponds to a predetermined level of significance, and
acceptance region is corresponds to the value of 1 – level of significance.
17.5 TESTING HYPOTHES IS AND ITS CLASSIFICATION

17.6 PROCEDURES FOR TESTING HYPOTHESIS

The following are the steps to be followed when testing hypothesis

Step-1: Specify 𝐻0 and 𝐻1, the null and alternate hypothesis, and an
acceptable level of 𝜶.

418
Step-2: Determine an appropriate sample-based test statistics and the
rejection region for 𝐻0.
Step-3: Collect the sample data and calculate the test statistics.

Step-4: Make a decision to either reject or fail to reject 𝐻0.

Step-5: Interpret the result in common language suitable for practitioners.
Example for Hypothesis testing: Step by step procedure

A coffee vendor nearby Saidapet railway station has been having average
sales of 500 cups per day. Because of the development of a new Saidapet
metro station nearby, it expects to increase its sales. During the first 12
days, after the inauguration of the metro station , the daily sales were as
under: 550 570 490 615 505 580 570 460 600 580 530 526 On the basis of
this sample information, can we conclude that the sales of coffee have
increased? Consider 5% level of confidence.
Solution
Hypothesis Testing: 5 Steps

The following five steps are followed when testing hypothesis

Step 1: Specification of hypothesis and acceptable level of 𝛂

Let us consider the hypotheses for the given problem as follows.

𝐻0: 𝜇 = 500 cups per day. That is, the null hypothesis is that sales
average 500 cups per day and they have not increased.
𝐻1: 𝜇> 500 cubs per day. That is the alternative hypothesis is that
the sales have increased.
Given the acceptance level of 𝛼 = 0.05 (𝑖. . , 5% 𝑙 𝑣 𝑙 𝑠𝑖𝑔𝑛𝑖 𝑖 𝑛 )
Step 2: Sample-based test statistics and the rejection region for
specified 𝐇𝟎
𝐷 𝑔 𝑑 𝑚 =𝑛 − 1 = 12 − 1 = 11.As 𝐻1 is one-tailed, we shall
determine the rejection region applying one tailed in the right tail because
𝐻1 is more than at 5% level of Significance. Using table of − 𝑑𝑖𝑠 𝑖 𝑢 𝑖 𝑛
for 11 degrees of freedom and with 5% level of significance,
𝑅: > 1.796
Step 3: Collect the sample data and calculate the test statistics
Given the sample as 550 570 490 615 505 580 570 460 600 580 530 526

419
The sample size is small and the population standard deviation is not
known, so use − 𝑠 .

Sample X X X (X  X ) 2

1 550 2 4

2 570 22 484

3 490 −58 3364

4 615 67 4489

5 505 −43 1849

6 580 32 1024

7 570 22 484

8 460 −88 7744

9 600 52 2704

10 580 32 1024

11 530 −18 324

12 526 −22 484

𝑛=12 𝑋𝑖=6576 (𝑋𝑖−𝑋)2 =23978

x  N  n
The test statistics =
S
X 6576
X   548
n 12

( X  X )2 23978
  46.68 𝑚𝑝𝑙 # 𝑿𝒊𝑿𝒊− 𝑿 (𝑿𝒊−
S= n 1 12 1

 548  500  12
=
46.68

420
 t= =3.558

Step 4: Make a decision to either reject or fail to reject H0

The observed value of = 3.558 which is in the rejection region and

thus 𝐻0 is rejected at 5% level of significance.
Step 5: Final comment and interpret the result

We can conclude that the sample data indicate that coffee sales
have increased.
17.7 LIMITATIONS OF HYPOTHESIS TESTING
The limitations of hypothesis testing are:

1. Hypothesis testing should not be used in mechanical fashion. They

are to be designed according to situation.
2. They simply indicates the magnitude of difference, and do not reveal
reasons for difference.
3. Results of significance tests are based on probabilities, and as such
cannot be expressed with full certainty.

4. It is not entirely correct. In the case of small samples, probability of erring

inferences is higher.
All these limitations suggest that in problems of statistical
significance, inference techniques may be combined with adequate basic
knowledge of subject matter along with the ability of good decision making.
LET US SUM UP

The unit gave the meaning of hypothesis and testing of hypothesis.

The type of hypothesis is briefly explained. The meaning of basic concepts
which are related with testing of hypothesis such as type-I and type-II error,
level of significance, power of test, degree of freedom, critical region, and
critical value are presented. The procedure of testing hypothesis is depicted
with an example for clear understanding. Lastly the limitation of testing of
hypothesis was revealed for a caution in testing a hypothesis.

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CHECK YOUR PROGRESS
Choose the correct answer

1. _________is a tentative statement showing the relationship between two

or more variables, the reliability and validity of which is to be tested and
verified.
a) Sampling b) Skewness

c) Hypothesis d) Kurtosis
2. If a hypothesis is concerning sample statistic or population parameter
only, then it is called _________.

a) simple hypothesis b) parameter hypothesis

c) null hypothesis d) alternate hypothesis
3. The null hypothesis is denoted by ________
a) Ha b) Ho
c) H1a d) H2
4. A null hypothesis when proved true is to be _________
a) rejected b) removed
c) accepted. d) checked
5. A ---------------------in which the sample outcome is hypothesized to be at
the right tail of the sampling distribution.
a) Left-tailed test b) Two-tailed test
c) Right-tailed test d) one-tailed test
GLOSSARY

Hypothesis : Hypothesis is an assumption that

is made on the basis of some
evidence. This is the initial point of
any investigation that translates
the research questions into a
prediction.

Critical Region : A critical region, also known as

the rejection region, is a set of

422
 values for the test statistic for
which the null hypothesis is
rejected.

Critical Values : If a test statistic on one side of

the critical value results in
accepting the null hypothesis, a
test statistic on the other side will
result in rejecting the null
hypothesis

Test Statistic :A test statistic is a random

variable that is calculated from
sample data and used in a
hypothesis test.

Power of test :1 – β is termed the power of the

test. A test's power is the
probability of correctly rejecting the
null hypothesis when it is false

SUGGESTED READINGS

1. Arora, P.N. & S. Arora, (2007) ,Statistics for Management, latest

Edition, S. Chand & Company Ltd., New Delhi.
2. D.C.Sancheti, V.K.Kapoor,( 2014), Business Mathematics, 11th
edition, Reprint, Sultan Chand and Sons, New Delhi.
3. Gupta, B.N., (2015), Business Statistics, First Revised Edition,
SBPD, New Delhi.

4. JK. Sharma, (2009), Business Mathematics Theory And

Applications, 13th Edition, ANE Books, New Delhi.
5. S. P. Gupta, (2012), Statistical Methods, 42nd Revised Edition Sultan
Chand & Sons Pvt. Ltd., New Delhi.
6. https://epgp.inflibnet.ac.in/Home/ViewSubject?catid=ahLCajOqz6/G
WFCSpr/XYg==
7. https://nptel.ac.in/courses/111102143
ANSWERS TO CHECK YOUR PROGRESS
3) b 4) c 5) c
1) c 2) a

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Unit 18

TESTING OF HYPOTHESES: APPLYING T-

STATISTIC
STRUCTURE
Overview
Learning Objectives
18.1 Introduction

18.2 t-test meaning, assumptions and Properties

18.3 One Sample test for population mean with solved examples
18.4 Two Sample t-test for Independent Samples with solved examples

18.5 Paired Sample t-test with solved examples

Let Us Sum Up
Check Your Progress

Glossary
Suggested Readings
Answers to Check Your Progress
OVERVIEW
This unit focuses on the hypothesis testing with t-test for one sample, two
sample of independent and paired. The t-distribution has a different value
for each degree of freedom and when degrees of freedom are infinitely
large, the t-distribution is equivalent to normal distribution and the
probabilities shown to normal distributions are applicable. The problems are
explained step by step for easy way to follow for the self-learner.
LEARNING OBJECTIVES

After reading this unit, you should be able to

 give knowledge of testing hypothesis with t-test statistic and

 enable the learners to utilize in their management decision when
need arise.

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18.1 INTRODUCTION
The t-test is a parametric test of difference, meaning that it makes the same
assumptions about your data as other parametric tests. When choosing a t-
test, you will need to consider two things: whether the groups being
compared come from a single population or two different populations, and
whether you want to test the difference in a specific direction. It is often
used in hypothesis testing to determine whether a process or treatment
actually has an effect on the population of interest, or whether two groups
are different from one another.
18.2 t-test MEANING, ASSUMPTIONS AND PROPERTIES

The t-Distribution, also known as Student’s t-Distribution is the probability

distribution that estimates the population parameters when the sample size
is small and the population standard deviation is unknown.
Unfortunately, there are times, however, when the sample sizes are not
large. This is true when it is expensive to get sample points, which is often
the case in the behavioral studies (among many other situations). In general
hypothesis testing becomes very difficult, but there is an important special
case which has been extensively tabulated, namely the case when the
underlying population is normal (but of unknown variance). We define the
Student t-distribution If we have a sample of size n from a normal
distribution with mean µ and unknown variance σ2 we study t = √ and
compare this to the Student t-distribution with n − 1 degrees of freedom.
For example, if n = 30 then the critical values for the Student t-distribution
are 2.045 (for α = .025, which gives us a critical region of size .05 for a two-
tail test) and 2.756 (for α = .005, which gives us a critical region of size .01
for a two-tail test); these are close to the corresponding values from the
standard normal, which are 1.960 for α = .025 and 2.576 for α = .005.
Properties of t- Distribution

1. The shape of the student distribution is bell-shaped and symmetrical

with mean zero.
2. Student distribution ranges from –∞ to ∞ (infinity).
3. The shape of the t-distribution changes with the change in the
degrees of freedom.
4. The variance is always greater than one and can be defined only
when the degrees of freedom ν ≥ 3 and is given as: Var (t) = [ν/ν -2]

425
 5. It is less peaked at the center and higher in tails, thus it assumes
platykurtic shape.
6. The t-distribution has a greater dispersion than the standard normal
distribution. And as the sample size ‘n’ increases, it assumes the
normal distribution. Here the sample size is said to be large when n
≥ 30.
The following are the important applications of t-distribution:
It complies with the central limit theorem which says that the distribution
approaches the standard normal distribution as long as the sample size is
large. Thus, student distribution is the statistical measure that compares the
observed data with the expected data obtained with a specific hypothesis. It
aids to test significance of the mean of a random sample, to test the
difference between means of the two sample when they are independent
and when they are paired or dependent sample and, to test the significance
of observed correlation coefficient.
The t-table
The t-table gives over a range of values ofν the probabilities of exceeding
by chance values of t at different levels of significance. The t-distribution
has a different value for each degree of freedom and when degrees of
freedom are infinitely large, the t-distribution is equivalent to normal
distribution and the probabilities shown to normal distributions are
applicable.
18.3 ONE SAMPLE TEST FOR POPULATION MEAN WITH SOLVED
EXAMPLES
ONE-SAMPLE T-TEST (NORMALLY DISTRIBUTED POPULATION, Σ IS
UNKNOWN)

For the one-sample situation, the typical concern in research is examining a

measure of central tendency (location) for the population of interest. The
best-known measures of location are the mean and median. For example of
a one-sample situation, (a) we might want to know if the average waiting
time in a doctor’s office is greater than one hour, (b) if the average refund
for a year divid end return is different from Rs50, 000, (c) if the average
expenditure on consumer necessary goods assessment for similar
residential properties is less than Rs12000 per month, and or (d) if the
average growth of roses is 4 inches or more after two weeks of treatment
with a certain fertilizer. One early concern should be whether the data are

426
normally distributed. If normality can safely be assumed, then the one-
sample t-test is the best choice for assessing whether the measure of
central tendency, the mean, is different from a hypothesized value.

Null and Alternative Hypotheses setting for one sample test is as the basic
null hypothesis is that the population mean is equal to a hypothesized value,
𝐻0: 𝜇 = 𝐻hypothesized value

With three common alternative hypotheses, H :𝜇≠ 𝐻hypothesized value,

H :𝜇<, 𝐻hypothesized value or 𝐻 : 𝜇>𝐻hypothesized value, one of which is
chosen according to the nature of the experiment or study.
One-Sample t-Test Assumptions
The key assumption relates to normality or no normality of the data. One of
the reasons for the popularity of the t-test is its robustness in the face of
assumption violation. However, if an assumption is not met even
approximately, the significance levels and the power of the t-test are
invalidated. Unfortunately, in practice it often happens that more than one
assumption is not met. Hence, take the steps to check the assumptions
before you make important decisions based on these tests. The
assumptions of the one-sample t-test are: 1. the data are continuous (not
discrete). 2. The data follow the normal probability distribution. 3. The
sample is a simple random sample from its population. Each individual in
the population has an equal probability of being selected in the sample.
To test the significance of the mean of a random sample:
The mean of sample drawn from a normal population deviates significantly
from a stated value (the hypothetical value) of the population means, when
x   n
the variance of population is unknown the t-test statistic: t= S

Where X is mean of the sample, μ is actual mean of the population or

hypothetical mean of the population, ‘n’ the sample size, and S is the
standard deviation of the sample.If the calculated value of | | exceeds the
t0.05 we say that the difference between X and μ is significant at 5% level. If
it exceeds the t0.01 we say that the difference is significant at one percent
level. If | |≤ t0.05 or t0.01 we conclude that the difference between X and μ is
not significant and hence the sample might have been drawn from the
population with mean equal to μ.

427
Example 18.1 A professor wants to know if her/his introductory
statistics class has a good grasp of basic math. Six students are
chosen at random from the class and given a math proficiency test.
The professor wants the class to be able to score above 70 on the test.
The six students get scores of 62, 92, 75, 68, 83, 95. Can the professor
have 90 percent confidence that the mean score for the class on the
test would be above 70?
Solution:
Step1:

Null hypothesis: H 0: μ = 70
Alternative hypothesis: H a : μ > 70
Step2: The number of degrees of freedom for the problem is 6 – 1 = 5. The
value in the t‐table for t o.o5 is 1.476 is the critical value in the t- table.
Step3: First, compute the sample mean and standard deviation:

X X X X2

62 -17.17 294.81

92 12.83 164.61

75 -4.17 17.39

68 -11.17 124.77

83 3.83 14.67

95 15.83 250.59

X  475 X 2  866.82

X 475
X   79.17
n 6

X 2 866.82
S=   173.364 , S=13.17
n 1 5
Next, to compute the t‐value:t = √
substitute the values in the formula

428
Step4: To take a decision about the hypothesis, the computed t‐value of
1.71 will be compared to the critical 1.476. Because the computed t‐value of
1.71 is larger than the critical value in the table, the null hypothesis can be
rejected
Step5: The professor has evidence that the class mean on the math test
would be at least 70.
Example 18.2 The manufacturer of a certain make of electric bulbs
claims that his bulbs have a mean life of 25 months with a standard
deviation of 5 months. A random sample of 6 such bulbs gave the
following values. Life of months 24, 26, 30,20,20,18 can you regard the
producer’s claim to be valid at 1% level of significance.
Solution:
H0  there is no significance difference in the mean life of bulbs in sample
and the populations.
H1  there is a significant difference in the mean life of bulbs in sample and
the populations.

X X X X2

29 +1 1

26 +3 9

30 +7 49

20 -3 9

20 -3 9

18 -5 25

X  138 X 2  102

t=
x  N  n , N=25
S

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 X 138
X    23
n 6

X 2 102
S=   20.4 S=4.517
n 1 5
23  25 2  2.449
t= 6  1.084
4.517 4.517
  n 1  6 1  5  From table-t: forD.F  5; t0.01  4.032 , The
calculated value of ‘t’ is less than the table value. Therefore, the null
hypothesis is accepted, the producer’s claim is true.
Example 18.3 Assume that Chennai city health department wishes to
determine if the mean bacteria count per unit volume of water at a
Marina beach is within the safety level of 200. A researcher from
Biotech department collected 10 water samples of unit volume and
found the bacteria count to be: 170 195 214 199 186 205 213 190 191
185. Does the data indicate that the bacteria count is within the safety
level? Test at the = .01 level. Assume that the measurements
constitute a sample from a normal population.
Solution:
Step: 1To Formulate the hypotheses, for the bacteria count to be within the
safety level, we must have that µ ≤ 200, and so if µ > 200 we are out of the
safety level.
So, the Null hypotheses: H0: µ > 200, Alternate Hypothesis: H1: µ ≤ 200.
Step: 2Given sample size is 10 that are n; therefore t-distribution will have 9
that are n-1 degrees of freedom. Since H1 is one-tailed to the left, we need
to construct a left-handed critical region.
Using a statistics table, one finds that, with 9 degrees of freedom, t ≤ −2.821
gives us a critical region of size α = .01.
Step: 3

Given sample mean is 194.8 and a sample variance is 172.66. Now we

calculate t- test statistic:

430
 X X X X2

170 -24.8 615.04

195 0.2 0.04

214 19.2 368.64

199 4.2 17.64

186 -8.8 77.44

205 10.2 104.04

213 18.2 331.24

190 -4.8 23.04

191 -3.8 14.44

185 -9.8 96.04

X  1948 X 2  1647.6

X 1948
X    194.8
n 10

X 2 1647.6
S=   183.06
n 1 9
S =13.53
194.8  200 5.2  3.16
t= 10   1.22
13.53 13.53
Step: 4 since t = −1.22 is greater than the tabulated t value -2.821.
Therefore “t“ is outside of our critical region, we fail to reject the null
hypothesis.
Step: 5 so, cannot conclude that the true mean is within the safety level.
Example 18.4 Let us take a Multinational company wants to improve
sales. Past sales data indicate that the average sale was $100 per
transaction. After given training to the sales team, recent sales data
(taken from a sample of 25 salesmen) indicates an average sale of

431
$130, with a standard deviation of $15. Did the training work? Test
your hypothesis at a 5% alpha level.
Solution

Step 1: Write your null hypothesis statement (How to state a null

hypothesis). The accepted hypothesis is that there is no difference in sales,
so:H0: μ = $100. Write your alternate hypothesis. This is the one you’re
testing. You think that there is a difference (that the mean sales increased),
so:H1: μ > $100.
Step 2: Find the t-table value. You need two values to find this:

The alpha level: given as 5% in the question. The degrees of freedom,

which is the number of items in the sample (n) minus 1: 25 – 1 = 24.Look up
24 degrees of freedom in the left column and 0.05 in the top row. The
intersection is 1.711.This is your one-tailed critical t-value.What this critical
value means is that we would expect most values to fall under 1.711. If our
calculated t-value (from Step 3) falls within this range, the null hypothesis is
likely true.
Step 3: Identify the following pieces of information you’ll need to calculate
the test statistic. The question should give you these items:
1. The sample means (x). This is given in the question as $130.
2. The population means (μ). Given as $100 (from past data).
3. The sample standard deviation(s) = $15.
4. Number of observations (n) = 25.
Insert the items from above into the t score formula.
x   n
t=
S
t = (130 – 100) / ((15 / √ (25)) ,t = (30 / 3) = 10this is your calculated t-
value.
Step 4: Compare calculated t value with tabulated t value. The calculated
value from Step 3 does not fall into the range calculated in Step 2, so we
can reject the null hypothesis. The calculated t -value of 10 falls into the
rejection region (the left tail).
Step 5: In means that, it’s highly likely that the mean sale is greater. The
sales training was probably a success.

432
Example 18.5 A Little League baseball coach wants to know if his team
is representative of other teams in scoring runs. Nationally, the
average number of runs scored by a Little League team in a game is
5.7. He chooses five games at random in which his team scored 5, 9, 4,
11, 8 runs. Is it likely that his team's scores could have come from the
national distribution? Assume an alpha level of 0.05. What is a 95
percent confidence interval for runs scored per team per game?
Solution:
Step1: Because the team's scoring rate could be either higher than or lower
than the national average, the problem calls for a two‐tailed test. First, state
the null and alternative hypotheses:
Null hypothesis: H 0: μ = 5.7
Alternative hypothesis: H a : μ ≠ 5.7
Step 2: Now, look up the critical value from the t‐table (Table 3 in "Statistics
Tables"). You need to know two things in order to do this: the degrees of
freedom and the desired alpha level. The degrees of freedom are 5 – 1 = 4.
The overall alpha level is 0.05, but because this is a two‐tailed test, the
alpha level must be divided by two, which yields 0.025. The tabled value
for t .025,4is 2.776
Step 3: Next compute the sample mean and standard deviation:

X X X X2

5 2.12 4.49

9 1.6 2.56

4 -3.4 11.56

11 3.6 12.96

8 0.06 0.0036

X  37 X 2  31.57

X 37
X   7.4
n 5

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 X 2 31.57
S=   7.89
n 1 4
S =2.88, Next, the t‐value:

Step 4: The computed t of 1.32 is smaller than the 2.776 the t-table value,
so you cannot reject the null hypothesis
Step5: The mean of this team is equal to the population mean. The coach
cannot conclude that his team is different from the national distribution on
runs scored.
What is a 95 percent confidence interval for runs scored per team per
game?

Formula: where a and b are the limits of the

confidence interval, is the sample mean, is the value from the t‐table
corresponding to half of the desired alpha level at n – 1 degrees of
freedom, s is the sample standard deviation, and n is the size of the sample.

A 95 percent confidence level is equivalent to an alpha level of 0.05. Half of

0.05 is 0.025. The t‐value corresponding to an area of 0.025 at either end of
the t‐distribution for 4 degrees of freedom ( t .025,4) is 2.776. The interval may
now be calculated:

The interval is fairly wide per team per game, mostly because n is small.
Example 18.6 A sample of 4 observations from a normal population
gives mean 1.75 and variance 0.6875. Test the hypothesis that the
population mean is 2.
Solution
Step 1: H0 : μ= 2

H1 : μ≠ 2

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Step 2: Significance level α =0.05, Since the given test is two tailed test
hence the critical value for 5% level of significant with 3 df is obtained from
the tables of t - distribution and is 3.183.

Difference
t
x  
Step 3: t  n
stderror or S

Difference =1.75-2 =0.25 and the Standard error = =0.4793, t=

√
=0.52
Step4: Since 0.52 < 3.183 hence the null hypothesis is not rejected.
Step 5: At 5% level of significance we do not reject null hypothesis hence
we conclude that the population mean is 2.
Example 18.7 A sample of 4 observations from a normal population
gives mean 1.75 and variance 0.6875. Test the hypothesis that the
population mean is 2.
Solution:
Here, Given n  4, x  1.75, S 2  0.6875, S  0.8292,   2 and  0.05, df  n  1  3

Ho :   2
So
H1 :   2
Difference  x    0.25

S 0.8292
SE  
n1 3
Under H o the test statistic is

Difference
t   0.52
S .E
Since the given test is two tailed test hence the critical value for 5%
level of significant with 3 df is obtained from the tables of t- distribution and
is 3.183. Since the calculated t value is 0.52 < 3.183, hence the null
hypothesis is not rejected.
So, At 5% level of significance we do not reject null hypothesisand we
conclude that the population mean is 2.

435
Example 18.8 Stenographer claims that she can take dictations at the
rate of more than 135 words per minute. Of the 12 tests given to her
she could perform an average of 120 words with standard deviation of
40. Is her claim valid? (α = .01)
Solution:

This is one tailed test. Ho = There is no significant difference.

Ha= There is a significant difference.

Her claim that she can take dictations at more than 135/minute is valid
X= 120, μ = 135 n = 12 s =40
Therefore Standard Error = = = = = 12.06
√ √ √

t –statistic = = = = 1.24

Degree of freedom = n-1 = 12-1 = 11, given level of significance = .01 ,

table value of t (for one tailed test) = 2.178. The calculated value 1.24 is
less than the table value 2.178. So, we accept the Ho. The stenographer
can type at an average 120 words per hour.
Example 18.9 A soap manufacturing company was distributing a
particular brand of soap through a Number of retail shops. Before a
heavy advertisement campaign, the mean sale per week per shop was
140 dozen. After the campaign, samples of 20 shops were taken and
mean sale was found by 147 dozen with standard deviation 16. Can
you consider the advertisement effective?
Solution:
Ho: There is No significant difference before advertisement and after
advertisement
Ha: There is a significant difference before advertisement and after
advertisement.

Given values are μ = 140, ¯x = 147, σ = 16, n = 20.

Therefor Standard Error =√ =√ =√ = = 3.67

t –statistic = = = = 1.91

Degrees of freedom = 20 - 1 = 19, so the table value of‘t’ at 5% level of

significance is 2.093.

436
Hence, the decision about the test statistic result is the calculated value is
numerically less than the table value. That is the calculated t value 1.91 is
less than the given table value for 19 degrees of freedom at five percent
level of significance 2.093.Symbolically tcalculated value

<t table value so, we ACCEPT the null hypothesis. There is no significant
difference between before advertisement and after advertisement
.Therefore, the advertisement is not effective.
Example 18.10 The specimens of copper wires drawn from a large lot
have the following breaking strength (in kg. weight):578, 572, 570, 568,
572,578,570, 572,596,544. Test (using Student's t-statistic) whether the
mean breaking strength of the lot may be taken to be 578 kg. Weight
(Test at 5 per cent level of significance).

Solution:
Taking the null hypothesis that the population mean is equal to
hypothesised mean of 578 kg., we can write:
H o :   o  578 kg.

H a :   o =578kg

As the sample size is small (since n=10) and the population standard
deviation is not known, we shall use t-test assuming normal population and
x 
shall work out the test statistic t as under: t 
s / n
To find x and  s we make the following computations:

S.No. Xi (Xi  X) ( Xi  X)2

1 578 6 36

2 572 0 0

3 570 -2 4

4 568 -4 16

5 572 0 0

6 578 6 36

7 570 -2 4

437
8 572 0 0

9 596 24 576

10 544 -28 784

x (xi  x)
2
N=10 i  5720  1456

 X 
X i

5720
 572 kg.
n 10

and s 
 ( Xi  X ) 2


1456
 12.72 kg.
n 1 10  1
572  578
Hence, t  1.488
12.72 / 10

Degree of freedom = (n-1) = (10-1) = 9

As H a is two-sided, we shall determine the rejection region applying two-
tailed test at 5 per cent level of significance, and it comes to as under, using
table of t-distribution for 9 d.f.:
R : t calculated  2.262 (table value)

As the Calculated t value less than the table value and it (i.e., -1.488) is in
the acceptance region, we accept H o at 5 per cent level and conclude that
the mean breaking strength of copper wires lot may be taken as 578 kg
weight.
Example 18.11 A researcher from Tamil Nadu Agricultural University
studies the effect of exposure of lucerne flowers to different
environmental conditions. The researcher chose 10 vigorous plants
with freely exposed flowers at the top and flowers hidden as much as
possible at the bottom. Finally he determined the number of seeds set
per two pods at each location and the data were:

Plant 1 2 3 4 5 6 7 8 9 10

Top flowers 4.8 5.2 5.7 4.2 4.8 3.9 4.1 3.0 4.6 6.8

Bottom flowers 4.4 3.7 4.7 2.8 4.2 4.3 3.5 3.7 3.1 1.9

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Test the hypothesis of no difference between population means against the
alternative that top flowers set more seeds for   0.05.

Solution
Null hypothesis: H o :   0
Alternative hypothesis: H 1 :   0

The sample of differences (top flowers - bottom flowers) is

0.4, 1.5, 1.0, 1.4, 0.6, -0.4, 0.6, -0.7, 1.5, 4.9.and Therefore the mean is
(0.4+ 1.5+ 1.0+ 1.4+ 0.6+ (-0.4) + 0.6+ (-0.7) + 1.5+ 4.9) divided by 10 (The
number of observation) . So x =1.08

s   ( Xi  X ) 2


7.115
 1.54.
n 1 10  1
1.08  0
Test statistic: t   2.22
1.54 / 10

The given significance level is 5%, the critical region for One-tailed test is
2.132. Reject H o if Calculatedt2.132 . Since calculated t value 2.22 is
greater than tabulated t value 2.132, the null hypothesis is rejected.
18.4 TWO SAMPLE T-TEST FOR INDEPENDENT SAMPLES WITH
SOLVED EXAMPLES
TESTING DIFFERENCE BETWEEN MEANS OF TWO SAMPLES
(INDEPENDENT)

In Many decision-situations, we may be interested in knowing whether the

parameters of two populations are alike or different. In such a situation two-
sample independent t-test can be run on sample data from a normally
distributed numerical outcome variable to determine if its mean differs
across two independent groups. For instance, we may be interested in
testing whether female workers earn less than male workers for the same
job. Another example, we could see if the mean sale of a product differs
between current year and previous year by collecting a sample of each year
data from sales records.
Hypotheses
Ho: The population mean of a group equals to population mean of other
group, or μ1 = μ2

439
HA: The population mean of a group does not equal to population mean of
the other group, or μ1 ≠ μ2
This test can also be conducted with a directional alternate
hypothesis:
Ho: The population mean of one group equals the population mean of the
other group, or μ1 = μ2
Ha: The population mean of one group is greater than the population mean
of the other group, or μ1 > μ2
The test statistic for a two-sample independent t-test is calculated by taking
the difference in the two sample means and dividing by either the pooled or
unpooled estimated standard error. The estimated standard error is an
aggregate measure of the amount of variation in both groups.
Degrees of freedom: Varies by conditions, but the basic rule of thumb for
hand calculations is the smaller of n1 – 1 and n2 – 1, where n is the sample
size for each group.

The assumption underlying in two sample test is random samples,

Independent observations, the population of each group is normally
distributed, and the population variances are equal.
Example 18.12 A new drug is proposed to lower total cholesterol. A
randomized controlled trial is designed to evaluate the efficacy of the
medication in lowering cholesterol. Thirty participants are enrolled in
the trial and are randomly assigned to receive either the new drug or a
placebo. The participants do not know which treatment they are
assigned. Each participant is asked to take the assigned treatment for
6 weeks. At the end of 6 weeks, each patient's total cholesterol level is
measured and the sample statistics are as follows.

Treatment Sample Mean Standard

Size Deviation

New Drug 15 195.9 28.7

Placebo 15 227.4 30.3

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Is there statistical evidence of a reduction in mean total cholesterol in
patients taking the new drug for 6 weeks as compared to participants taking
placebo? We will run the test using the five-step approach.
Step 1. Set up hypotheses and determine level of significance
H0: μ1 = μ2 H1: μ1 < μ2 α=0.05
Step 2. Select the appropriate test statistic.

Because both samples are small (< 30), we use the t test statistic. Before
implementing the formula, we first check whether the assumption of equality
of population variances is reasonable. The ratio of the sample variances,
s12/s22 =28.72/30.32 = 0.90, which falls between 0.5 and 2, suggesting that
the assumption of equality of population variances is reasonable. The
appropriate test statistic is:

.
Step 3. Set up decision rule.
This is a lower-tailed test, using a t statistic and a 5% level of significance.
The appropriate critical value can be found in the t Table (in More
Resources to the right). In order to determine the critical value of t we need
degrees of freedom, df, defined as df=n1+n2-2 = 15+15-2=28. The critical
value for a lower tailed test with df=28 and α=0.05 is -1.701 and the
decision rule is: Reject H0 if t < -1.701.
Step 4. Compute the test statistic.
We now substitute the sample data into the formula for the test statistic
identified in Step 2. Before substituting, we will first compute Sp, the pooled
estimate of the common standard deviation.

Now the test statistic,

441
Step 5. Conclusion.
We reject H0 because -2.92 < -1.701. We have statistically significant
evidence at α=0.05 to show that the mean total cholesterol level is lower in
patients taking the new drug for 6 weeks as compared to patients taking
placebo, p < 0.005.The clinical trial in this example finds a statistically
significant reduction in total cholesterol.
Example 18. 13 Sample of sales in similar shops in two towns are
taken for a new product with the following results:

Town Mean sales Variance Size of sample

A 57 5.3 5
B 61 4.8 7
Is there any evidence of difference in sales in the two towns? Use 5
per cent level of significance for testing this difference between the means
of two samples.
Solution: Taking the null hypothesis that the means of two populations do
not differ we can write:
H o : 1  2
H a : 1  2
and the given information as follows:
Sample from town Aas sample one X 1  57  2 s1  5.3 n1  5
Sample from town Bas sample two X 2  61  s 2  4 .8
2
n2  7
Since in the given question variances of the population are not known and
the size of samples is small, we shall use t-test for difference in means,
assuming the populations to be normal and can work out the test statistic t
as under:
X1  X 2
t
(nl  1) 2
s1  (n2  1) s22 1 1
 
n1  n2  2 n1 n2
with d.f. = (n1  n2  2)
57  61
  3.053
4( 5.3)  6( 4.8) 1 1
 
572 5 7
Degrees of freedom = ( (n1  n2  2)  5  7  2  10 .As H a is two-sided, we shall
apply a two-tailed test for determining the rejections at 5 per cent level
which come to as under, using table of t-distribution for 10 degrees of
freedom: R : t  2.228

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The observed value of t is- 3.053 less than the tabulated value of t and
which falls in the rejection region and thus, we reject H o and conclude that
the difference in sales in the two towns is significant at 5 per cent level.
Example 18. 14 A group of seven-week-old chickens reared on a high
protein diet weigh 12, 15, 11,16,14,14, and 16 ounces; a second group
of five chickens, similarly treated except that they receive a low
protein diet, weigh 8,10,14,10 and 13 ounces. Test at 5 per cent level
whether there is significant evidence that additional protein has
increased the weight of the chickens. Use assumed mean (or A 1 ) = 10
for the sample of 7 and assumed mean (or A 2 ) = 8 for the sample of 5
chickens in your calculations.

Solution: Taking the null hypothesis that additional protein has not
increased the weight of the chickens we can write:
Ho :  1   2
H a :  1   2 (as we want to conclude that additional protein has
increased the weight of chickens)

Since in the given question variances of the populations are not known and
the size of samples is small, we shall use t-test for difference in means,
assuming the populations to be normal and thus work out the test statistic t
as under:
X1  X2
t
( n 1  1) s 1  ( n 2  1) 2 s 2
2
1 1
 
n1  n2  1 n1 n2
with d. f. = ( n 1  n 2  2 )
From the sample data we work out X 1 , X 2 ,  2 s1 and  2 s 2 (taking high
protein diet sample as sample one and low protein diet sample as sample
two) as shown below:
Sample one Sample two
X 1i  A 1 S. X 2i  A 2
S. X 1i X 2i
(X 1i  A 1 )2 No. (X 2i  A 2 )2
No. (A 1  10) (A 2  8)
1. 12 2 4 1. 8 0 0
2. 15 5 25 2. 10 2 4
3. 11 1 1 3. 14 6 36
4. 16 6 36 4. 10 2 4
5. 14 4 16 5. 13 5 25
6. 14 4 16
7. 16 6 36

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n1  7; n 2  5;
( X 1i
 A1 )  28;  X  A )  134 1i ( X  A )  15;  X
1
2
2i 2 2i
 A2 ) 2  69

∴ X1 A
 ( X  A )  10  28  14 ounces
1i 1
1
n1 7

X 2  A2 
(X 2i  A2 )
8
15
 11 ounces
n2 5

 S2i  (X li  A1 ) 2   ( X li

 A1 ) / n1
(n1  1)
134  (28) 2 / 7
  3.667 ounces
7 1

 2
s2 
(X 2i
 A2 ) 2   ( X 2i

 A2 ) / n2
2

(n2  1)
69  (15) / 5 2

  6 ounces
5 1
14  11
Hence, t 
(7  1)(3.667)  (5  1)(6) 1 1
 
752 7 5
3 3
   2.381
4.6  .345 1.26
Degrees of freedom = ( n 1  n 2  2 )  10 ,As H a is one-sided, we shall apply
a one-tailed test (in the right tail because H a is of more than type) for
determining the rejection region at 5 per cent level which comes to as
under, using table of t-distribution for 10 degrees of freedom:
R: t > 1.812 .The observed value of t is 2.381 greater than the tabulated
value of t and calculated t which falls in the rejection region and thus, we
reject H 0 and conclude that additional protein has increased the weight of
chickens, at 5 per cent level of significance.
18.5 PAIRED SAMPLE T-TEST WITH SOLVED EXAMPLES
HYPOTHESIS TESTING FOR COMPARING TWO RELATED SAMPLES
(PAIRED)
Paired t-test is a way to test for comparing two related samples, involving
small values of n that does not require the variances of the two populations
to be equal, but the assumption that the two populations are normal must
continue to apply. For a paired t-test, it is necessary that the observations in
the two samples be collected in the form of what is called matched pairs i.e.,
"each observation in the one sample must be paired with an observation in
the other sample in such a manner that these observations are somehow
"matched" or related, in an attempt to eliminate extraneous factors which

444
are not of interest in test."1such a test is generally considered appropriate in
a before-and-after-treatment study. For instance, we may test a group of
certain students before and after training in order to know whether the
training is effective, in which situation we may use paired t-test. To apply
this test, we first work out the difference score for each matched pair, and
then find out the average of such differences, D , along with the sample
variance of the difference score. If the values from the two matched
samples are denoted as X i and Yi and the differences by D i (D i  X i  Yi ),
then the mean of the differences i.e.,

D
Di
n
and the variance of the differences or

( diff . ) 2

D 2
i  ( D ) 2 .n
n 1
Assuming the said differences to be normally distributed and
independent, we can apply the paired t-test for judging the significance of
mean of differences and work out the test statistic t as under:
D0
t with (n-1) degrees of freedom
 diff / n
where D = Mean of differences
 diff .  Standard deviation of differences.
n=Number of matched pairs

Example 18.15 Memory capacity of 9 students was tested before and

after training. State at 5 per cent level of significance whether the
training was effective from the following scores:
Student 1 2 3 4 5 6 7 8 9
Before 10 15 9 3 7 12 16 17 4
After 12 17 8 5 6 11 18 20 3
Use paired t-test.
Solution: take the score before training as X and the score after training as
Y and then taking the null hypothesis that the mean of difference is zero, we
can write:
H 0 : 1  2 which is equivalent to test H0 : D  0
H a : 1  2 (as we want to conclude that training has been effective)

445
As we are having matched pairs, we use paired t-test and work out the test
statistic t as under:
D0
t
 diff / n
To find the value of t, we shall first have to work out the mean and
standard deviation of differences as shown below:
Score before Score after Difference
Difference
Student Training Training ( D i  X i  Yi ) Squared
Xi Yi D2i
1 10 12 -2 4
2 15 17 -2 4
3 9 8 1 1
4 3 5 -2 4
5 7 6 1 1
6 12 11 1 1
7 16 18 -2 4
8 17 20 -3 9
9 4 3 1 1
N=9  D i  7  D i  29
2

∴Mean of Differences of D 
 Di

7
 0.778 and standard deviation of
n 9
differences or

 diff . 
D 2
i  ( D) 2 .n
n 1
29  ( .778) 2  9

91
 2.944  1.715
0.778  0 .778
Hence, t   1.361
1.715 / 9 0.572
Degrees of freedom = n -1 = 9 - 1 = 8.
As H a is one-sided, we shall apply a one-tailed test (in the left tail
because H a is of less than type) for determining the rejection region at 5 per
cent level which comes to as under, using the table of t-distribution for 8
degrees of freedom:
R: t < - 1.860
The observed value of t is - 1.361 which is in the acceptance region
and thus, we accept H 0 and conclude that the difference in score before

446
and after training is insignificant i.e., it is only due to sampling fluctuations.
Hence we can infer that the training was not effective.
Example 18.16 The sales data of an item in six shops before and after
a special promotional campaign are:
Shops A B C D E F
Before the promotional
53 28 31 48 50 42
campaign
58 29 30 55 56 45
After the campaign
Can the campaign be judged to be a success? test at 5 per cent level of
significance. use paired t-test.
Solution: Let the sales before campaign be represented as X and the sales
after campaign as Y and then taking the null hypothesis that campaign does
not bring any improvement in sales, we can write:
H 0 : 1  2 Which is equivalent to test H 0 : D  0
H 0 : 1  2 (as we want to conclude that campaign has been a
success).

Because of the matched pairs we use paired t-test and work out the
test statistic 't' as under:
D0
t
 diff . / n
To find the value of t, we first work out the mean and standard deviation of
differences as under:
Sales before Sales after
Difference Difference
Shops Campaign Campaign ( Di  X i  Yi ) D2i
Xi Yi
A 53 58 -5 25
B 28 29 -1 1
C 31 30 1 1
D 48 55 -7 49
E 50 56 -6 36
F 42 45 -3 9
n =6  D  21  D
i
2
i 121

D
D i

21
 3.5
∴ n 6

 diff . 
D 2
i  ( D) 2 .n

121  (3.5) 2  6
 3.08
n 1 6 1

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 3.5  0 3.5
Hence, t    2.784
3.08 / 6 1.257
Degree of freedom = (n-1) = 6 - 1 = 5

As H a is one - sided, we shall apply a one-tailed test (in the left tail because
H a is of less than type) for determining the rejection region at 5 per cent
level of significance which come to as under, using table of t-distribution for
5 degrees of freedom:
R :t   2.015
The observed value of t is  2.784 which fall in the rejection region and
thus, we reject H 0 at 5 per cent level and conclude that sales promotional
campaign has been a success. The values happen to be positive; one must
simply know the degrees of freedom for using such a distribution.
LET US SUM UP
From this unit students are learned and enable to solve the one sample t-
test, two sample t-test for independent and paired samples. If the groups
come from a single population (e.g. measuring before and after an
experimental treatment), perform a paired t-test. If the groups come from
two different populations (e.g. two different species, or people from two
separate cities), perform a two-sample t-test (a.k.a. independent t-test).If
there is one group being compared against a standard value (e.g.
comparing the acidity of a liquid to a neutral pH of 7), perform a one-
sample t-test.
CHECK YOUR PROGRESS
1. The mean number of sick days an employee takes per year is believed
to be about ten. Members of a personnel department do not believe this
figure. They randomly survey eight employees. The number of sick days
they took for the past year are as follows: 12; 4; 15; 3; 11; 8; 6; 8.
Let x=x= the number of sick days they took for the past year. Should the
personnel team believe that the mean number is ten?
2. Your quantitative technique professor claims that 60 percent of the
students who take her hypothesis testing class go through life feeling
more enriched. For some reason that she can't quite figure out, most
people don't believe her. You decide to check this out on your own. You
randomly survey 64 of her past studied quantitative technique students
and find that 34 feel more enriched as a result of her class. Now, what
do you think?

448
3. A Nissan Motor Corporation advertisement read, “The Average man's
I.Q. is 107. The average brown trout’s I.Q. is 4. So why can’t man catch
brown trout?” Suppose you believe that the brown trout’s mean I.Q. is
greater than four. You catch 12 brown trout. A fish psychologist
determines the I.Q.s as follows: 5; 4; 7; 3; 6; 4; 5; 3; 6; 3; 8; 5. Conduct
a hypothesis test of your belief.
GLOSSARY
Population : In statistics, a population includes all members of a
defined group that we are studying for data driven
decisions.
Sample statistic : A sample statistic (or just statistic) is defined as any
number computed from your sample data.
Degrees of : In statistics, the number of degrees of freedom is
Freedom the number of values in the final calculation of a
statistic that are free to vary. The number of
independent ways by which a dynamic system can
move, without violating any constraint imposed on
it, is called number of degrees of freedom. Degree
of freedom of an estimate is the number of
independent pieces of information that went into
calculating the estimate.
Level of : Level of significance is also called the significance
Significance level, and is the probability of rejecting the null
hypothesis given that it is true (a type I error). It is
usually set at or below 5%.
SUGGESTED READING
1. Arora, P.N. & S. Arora, (2007) ,Statistics for Management, latest
Edition, S. Chand & Company Ltd., New Delhi.
2. D.C.Sancheti, V.K.Kapoor,( 2014), Business Mathematics, 11th
edition, Reprint, Sultan Chand and Sons, New Delhi.

3. Gupta, B.N., (2015), Business Statistics, First Revised Edition,

SBPD, New Delhi.
4. JK. Sharma, (2009), Business Mathematics Theory And
Applications, 13th Edition, ANE Books, New Delhi.
5. S. P. Gupta, (2012), Statistical Methods, 42nd Revised Edition Sultan
Chand & Sons Pvt. Ltd., New Delhi.
6. https://www.statisticshowto.com/probability-and-statistics/t-test/

449
 7. https://statisticsbyjim.com/hypothesis-testing/t-tests-1-sample-2-
sample-paired-t-tests/
8. https://www.statisticshowto.com/probability-and-
statistics/hypothesis-testing/degrees-of-freedom/#WhatDF
ANSWERS TO CHECK YOUR PROGRESS

1. tstat= - 1.1200 Look up the t value of - 1.1200, with n - 1, or 7

degrees of freedom, and the probability, or p value, is 0.2997. The
significance level of the test is 0.05. The p value is higher than the
significance, therefore, the null hypothesis is not rejected
2. Let P′ = the proportion of students who feel more enriched as a
result of taking Elementary Statistics. Z=1.12, p-value = 0.1308. Do
not reject the null hypothesis. The p-value is greater than 0.05.
There is insufficient evidence to conclude that less than 60 percent
of her students feel more enriched.
3. t = 1.95, p-value = 0.076, Reject the null hypothesis. There is
insufficient evidence to conclude that the average IQ of brown trout
is not four.

450
Unit 19

TESTING OF HYPOTHEISES: APPLYING F-

STATISTIC FOR TWO POPULATION
VARIANCES AND ANALYSIS OF
VARIANCE (ANOVA)
STRUCTURE

Overview
Learning Objectives
19.1 Introduction
19.2 F-test meaning, assumptions and Properties
19.3 Applying F-test for two population variance
19.4 ANOVA: Meaning and applying one way
19.5 ANOVA-Two way
19.6 Nexus between F test and ANOVA
Let Us Sum Up

Check Your Progress

Glossary
Suggested Readings

Answers to check your progress

OVERVIEW

F-test was initially used to verify the hypothesis of equality between two
variances, but is now mostly used in the context of analysis of variance.
This unit reveals about the F statistic tool used in testing hypothesis. In
addition, one-way and two way ANOVA role in testing hypothesis presented
with relevant examples.

LEARNING OBJECTIVES

After reading this unit, you should be able to

 make the learners to use the tools wherever necessary
 increase the efficiency of learners in testing a hypothesis

451
  aids the learner for applying the knowledge wherever necessary
in research.
19.1 INTRODUCTION

Years ago, statisticians discovered that when pairs of samples are taken
from a normal population, the ratios of the variances of the samples in each
pair will always follow the same distribution. Not surprisingly, over the
intervening years, statisticians have found that the ratio of sample variances
collected in a number of different ways follow this same distribution. The
name was coined by George W. Snedecor in honour of Sir Ronald A Fisher
r. Fisher initially developed the statistic as the variance ratio in the 1920s.
Here, this unit attempts to depict the same with suitable examples.
19.2 F-TEST MEANING, ASSUMPTIONS AND PROPERTIES

When we use the F-test, we presume that

 The populations are normal;
 Samples have been drawn randomly;
 Observations are independent; and
 There is no measurement error.
The object of F-test is to test the hypothesis whether the two samples are
from the same normal population with equal variance or from two normal
populations with equal variances. F-test was initially used to verify the
hypothesis of equality between two variances, but is now mostly used in the
context of analysis of variance. The following examples illustrate the use of
F-test for testing the equality of variances of two normal populations.
19.3 APPLYING F-TEST FOR TWO POPULATION VARIANCE
F-TEST FOR TESTING THE EQUALITY OF VARIANCE OF TWO
NORMAL POPULATIONS

When we want to test the equality of variances of two normal populations,

we make use of F-test based on F-distribution. In such a situation, the null
hypothesis happens to be H 0 :  2 p1   2 p 2 , where 2 p1 and  2 p 2
representing the variances of two normal populations. This hypothesis is
tested on the basis of a given set of sample data and the test statistic F is
found, by using  2 s 1 and  2 s 2 the sample estimates for  2 p 1 and  2 p 2
respectively, as stated below:

452
 F
 2 s1
where  2 s1 
X 1i  X 1 )2
and  2 s 2 
X 2i  X 2 )2
 2s2 (n1  1) (n2  1)
While calculating F,  s1 is treated >  s 2 which means that the numerator is
2 2

always the greater variance. Tables for F-distribution have been prepared
by statisticians for different values of F at different levels of significance for
different degrees of freedom for the greater and the smaller variances. By
comparing the observed value of F with the corresponding table value, we
can infer whether the difference between the variances of samples could
have arisen due to sampling fluctuations. If the calculated value of F is
greater than table value of F at a certain level of significance for (
(n1  1) and (n2  2) degrees of freedom, we regard the F-ratio as significant.
Degrees of freedom for greater variance is represented as v 1 and for
smaller variance as v2 . On the other hand, if the calculated value of F is
smaller than its table value, we conclude that F-ratio is not significant. If F-
ratio is considered non-significant, we accept the null hypothesis, but if F-
ratio is considered significant, we then reject H0 (i.e., we acceptHa ).
Assumptions
Several assumptions are made for the test. Your population must be
approximately normally distributed (i.e. fit the shape of a bell curve) in order
to use the test. Plus, the samples must be independent events. In addition,
you’ll want to bear in mind a few important points:
1. The larger variance should always go in the numerator (the top
number) to force the test into a right-tailed test. Right-tailed tests are
easier to calculate.
2. For two-tailed tests, divide alpha by 2 before finding the right critical
value.
3. If you are given standard deviations, they must be squared to get the
variances.
4. If your degrees of freedom aren’t listed in the F Table, use the larger
critical value. This helps to avoid the possibility of Type I errors.
Steps involved in calculating F-statistic:
The following are few steps used in finding the f-statistic:
1. State the null hypothesis and the alternate hypothesis.
2. Calculate the F value. The F Value is calculated using the formula F =
(SSE1 – SSE2 / m) / SSE2 / n-k, where SSE = residual sum of squares,
m = number of restrictions and k = number of independent variables.

453
3. Find the F Statistic (the critical value for this test). The F statistic formula
is:
F Statistic = variance of the group means / mean of the within
groupvariances.
You can find the F Statistic in the F-Table.
4. Support or Reject the Null Hypothesis
Illustration 19.1 Two random samples drawn from two normal
populations are:
Sample
20 16 26 27 23 22 18 24 25 19
1
Sample
27 33 42 35 32 34 38 28 41 43 30 37
2
Test using variance ratio at 5 per cent and 1 per cent level of significance
whether the two populations have the same variances.
Solution:
We take the null hypothesis that the two populations from where the
samples have been drawn have the same variances i.e., H0 :  2 p1   2 p2 .
From the sample data we work out  2 s1 and  2 s 2 . The number of
observation n1= 10 and n2= 12

Sample-1 Sample-2

( X 1i  X 1 ) ( X 2i  X 2 )
X 1i or ( X 1i  X 1 ) 2 X 2i or ( X 2i  X 2 ) 2
( X 1i  22) ( X 2i  35)

20 -2 4 27 -8 64

16 -6 36 33 -2 4

26 4 16 42 7 49

27 5 25 35 0 0

23 1 1 32 -3 9

22 0 0 34 -1 1

18 -4 16 38 3 9

454
24 2 4 28 -7 49

25 3 9 41 6 36

19 -3 9 43 8 64

30 -5 25

37 2 4

X 1i
 220 and  ( X 1i  X 1 ) 2  120 X 2i
 420 (X 2i
 X 2 ) 2  314

n1  10 n2  12

X 420
 X1i X2    35
2i
220
X1    22; n2 12
n1 10

X1 
X 1i

220
 22;
n1 10

X2 
X 2i

420
 35
n2 12

 2

(X 1i  X 1 )2

120 120
  13.33
n1  1 10  1 9
s1
∴

and  s2 
(X 2i  X 2 )2

314
 28.55
n2  1 12  1

 2s2
Hence, F  ( 2 s 2   2 s1 )
 2 s1

28.55
  2.14
13.33
Degree of freedom in sample 1 = (n1  1)  10  1  9
Degree of freedom in sample 2 = (n2  1)  12  1  11 , As the variance
of sample 2 is greater variance, hence v1  11; v2  9 . The table value of F at 5
per cent level of significance for v 1  11 and v 2  9 is 3.11 and the table
value of F at 1 per cent level of significance for V1  11 and v 2  9 is 5.20.

455
Since the calculated value of F = 2.14 which is less than 3.11 and also less
than 5.20, the F ratio is insignificant at 5 per cent as well as at 1 per cent
level of significance and as such we accept the null hypothesis and
conclude that samples have been drawn from two populations having the
same variances.
Solved Example 19.2
Given n 1  9 ; n 2  8 ,  ( X 1i  X 1 ) 2  184  ( X 2 i  X 2 ) 2  38
,
Apply F-test to judge whether there is any significant difference at 5 per cent
level.
Solution
We start with hypothesis that the difference is not significant and
hence, H 0 :  2 p1   2 p 2 . To test this, we work out the F-ratio as under:

 2 s1  ( X 1i  X 1 ) /(n1  1)
2

F 
 2 s 2  ( X 2i  X 2 ) 2 /(n2  1)
184 / 8 23
   4.25
38 / 7 5.43
v1  8 being the number of d.f. for sample one
v2  7 being the number of d.f. for sample two.

The Table value of ‘F’ at 5 per cent level for v 1  8 and v 2  7 is 3.73. Since
the calculated value of F is greater than the table value, the F ratio is
significant at 5 per cent level. Accordingly we reject null hypothesis: H 0 and
conclude that the difference is significant.
19.4 ANOVA: MEANING AND APPLYING ONE WAY
ANALYSIS OF VARIANCE: Meaning, Definition, Features Basic Principle
Of ANOVA, Assumptions And Steps In Applying One Way
Analysis of variance, abbreviated as ANOVA, is an extremely useful
technique for researchers in the field of economics, biology, education,
psychology, sociology, business and industry and in researches of several
other disciplines. This technique is used when multiple samples cases are
involved. Using this technique, one can draw inferences about whether
sample has been drawn from populations having the same mean.
The ANOVA technique is important in the context of all those situations
where we want to compare more than two populations such as comparing
the yield of crop from several varieties of seeds, analyzing the gasoline

456
mileage of four automobiles, studying the saving habits of five groups of
self-help women groups and so on.
Prof. R.A.Fisher was the first man to use the term Variance, and further
developed a very elaborate theory concerning ANOVA and its applications
in practical field. Professor Snedcor and many others added their
contribution to this technique after Fisher.

ANOVA is plays a vital role in procedure for testing the difference among
different groups of data for homogeneity. ANOVA do the total amount of
variation in a set of data are broken down in to two types, that amount which
can be attributed to chance and that amount which can be attributed to
specified causes. There may be variation between samples and also within
sample items. ANOVA consists in splitting the variance for analytical
purpose. Hence, ANOVA is a method of analyzing the variance to which
a response is subject into its various components corresponding to
various sources of variation. By using this method, manager of a big
concern can analyse the performance of various salesmen of his concern in
order to know, whether their performances differ significantly.
If we take on only one factor and investigate the differences amongst its
various categories having numerous possible values, then we are needed to
use one way ANOVA.
Definition of ANOVA

Analysis of variance may be defined as a technique which analyses the

variance of two or more comparable series (or samples) for determining the
significance of differences in their arithmetic means and for determining
whether different samples under study are drawn from same population or
not, with the of the statistical technique, called F – test.
Features of Analysis of Variance
1. It makes statistical analysis of variance of two or more samples.
2. It tests whether the difference in the means of different sample is
due to chance or due to any significance cause.
3. It uses the statistical test called, F – Ratio.
Basic principle of ANOVA

The basic principle of ANOVA is to test for differences among the means of
the populations by examining the amount of variation within each of these
samples, relative to the amount of variations between the samples. In terms

457
of variation within the given population, it is assumed that the observations
differ from the means of this population only because of random effects, ie,
there are influences, which are unexplainable, whereas in examining
differences between populations we assume that the difference between the
mean of the population and the grand mean is attributable to what is called
a specific factor, or what is technically described as treatment effect. Thus
while assuming these populations has the same variance, we also assume
that all factors other than the one or more being tested are effectively
controlled. This, in other words, means that we assume the absence of
many factors that might affect our conclusions concerning the factors to be
studied.
The total variance in the joint sample is partitioned into two parts
 Variance between samples
 Variance Within samples.
Variance between samples is due to different treatments, while within
samples variance is due to the random unexplained disturbance. Using
these two variances, we define the test statistic as F value = variance
between samples/variance within samples.
Using this method, we wish to test that all population means are the same
or not.
Test in ANOVA
Statistical test applied in ANOVA is F test. The test statistic is F value which
is the ratio between variance between samples and variance within
samples. If the F test statistic value is less than the corresponding table
value of F, we accept null hypothesis. In that case, we conclude that
samples do not differ significantly or both samples belong to population with
same values.
Assumptions in ANOVA
 Populations from which samples have been drawn are normally
distributed.
 Populations from which the samples are drawn have same variance.
 The observations are non-correlated random variables.
 Any observation is the sum of the effects of the factors influencing it.
 The random errors are normally distributed with mean 0 and
acommon variance d

458
Classification of One way ANOVA
One way ANOVA considers only one factor and there we assume that
reason for variations in the factor may be due to variance between samples
and variance within samples.
1. There are three types of variances in one way classification of
ANOVA.
2. Variances between sample - MSC This is the most important
variances in ANOVA. And is the net variation of different samples
mean from the grand mean (mean of mean)
3. Variances within samples - MSE This is the net result of variation
between observation of each sample and the sample mean. This is
also called residue variance.
4. Total variance - this is the sum total of all variances for all
observations taken together. It is also called variance about sample
and is used to ascertain residue variance. (residue variance = total
variance - between variance)
F ratio in one way ANOVA is computed as a ratio between variance
between samples and variance within samples thus,
VARIANCE BETWEEN SAMPLES MSC
F ratio = 
VARIANCE WITHIN SAMPLES MSE
Steps in one way ANOVA
Form ho that there is no significant difference between samples
1. Compute mean of each samples - x1 x2 x3 .......... ..
2. Calculate grand mean = mean of sample means = x
3. Obtain sum of square between samples = SSC =
n1  x1  x   n2  x2  x   n3  x3  x 
2 2 2

SSC
4. Ascertain Mean square between samples = MSC = =
C 1
5. Obtain sum of square within samples = SSE=
n1 x  x2   n2 x  x2  ........
2 2

SSE
6. Compute mean square within samples =MSE=
N C
7. Where N = Total number of observations and C= number of columns
MSC
8. Calculate F ratio = MSE
9. Compare with F table value and decide fate of ho
10. Present the result in ANOVA table

459
Example: 19.3 Following are the sales by 3 salesmen. Is A better
performer than b and c?
Sales
A B C
6 5 5
7 5 4
3 3 3
8 7 4
Solution
Ho: No significant difference, A is not a better performer. All are equal
Given Sales:
A B C
6 5 5
7 5 4
3 3 3
8 7 4
Total 24 20 16

24
x1   6 x 2  20 / 4  5 x 3 16 / 4
4
6 5 4
Mean of means = 5
3
Sum of square between = n1  x1  x   n2  x2  x   n3  x3  x 
2 2 2

Sum of square between = SSC= 4(6-5)2+4(5-5)2+4(4-5)2=8

SSC 8
Mean sum of square = =  4 Sum of square within = SSE =
C 1 3 1
(6-6)2+(7-6)2+(3-6)2... ... ... = 24 mean square within = MSE =
SSE 24
  2.67
N C 12 3
F ratio = MSC/ MSE = 4/2.67 = 1.5 ,
F table value = 4.26 Calculated value 1.5 is less than F table value = 4.26
Difference is not significant. Ho is accepted, A is not a better performer. All
are equal.
Short-cut method
The above explained method of ANOVA involves much calculation. To
simplify calculation, the following short-cut method may be employed:
Steps

460
 ( SUMOF ALL OBSERVATIO NS )2
1. Find correction factor = T2/n =
TOTAL NUMBER OF ITEMS
2. Find sum of squares total = SST= sum of squares of all observations -
T2/n
3. Obtain sum of square columns = SSC =
(COLUMN 1 TOTAL) 2 COLUMN 21 TOTAL) 2
 ........
n n
SSC
4. Find mean square column = MSC=
C 1
5. Obtain sum of squares within= SSE= SST- SSC
SSC
6. Find mean square within =
N C
MSE
7. Find f ratio = MSE
8. Present the result in ANOVA table
9. Compare with f table value and decide the fate of ho
Example 19.4 Following are the score of three Batsman. Examine
whether B is the best among the three.

A B C

30 51 44

27 47 35

42 37 41

48 36

42

Total 99 225 156

T = Sum of all observations = 480,

480x480
T2/N = = SST = Sum of squares of all observation
12

= T2/N = 578

461
 ( 99 )2 ( 156 ) 2
(225) 2 4 - 19200 = 276
SSC = 3 + +
5
SSE = SST - SSC = 578 -276 = 302
SSC 276
MSC =   138
C 1 2
SSE 302
MSE= =   33.56
N C 9

Source of Sum of Degree of Mean

F ratio
variation squares freedom squares

Between
samples SSC = 276 C-1=2 138 138
Fc=  4.11
Within SSE = 302 N- C = 9 33.56 33.56
sample

Table value of F, at 5% level of significance, degree of freedom C-1 x N - C

= 2,9 = 4.26. Calculated value is less than table value. Therefore we accept
the hypothesis that the performances of batsmen are equal.
Example: 19.5: Set up an analysis of variance table for the following per
acre production data for three varieties of wheat, each grown on 4 plots,
and state if the variety differences no significant.

Per acre production data

Plot of land Variety of wheat
A B C
1 6 5 5
2 7 5 4
3 3 3 3
4 8 7 4
Solution
We can solve the problem by the direct method or by short-cut method, but
in each case we shall get the same result. We below both the methods.
Solution through direct method: First we calculated the mean of each of
these samples:
6 7 38
X1  6
4

462
 553 7 5 43 4
X2  5 4X3 
4 4
X  X2  X3
Mean of the sample means or X  1
k
654
 5
3
Now we work out SS between and SS within samples:
SS between  n1 ( X 1  X ) 2  n2 ( X 2 ) 2  n3 ( X 3  X ) 2
= 4(6-5)2 + 4(5-5)2 +4(4-5)2
=4+0+4
=8
SS within   ( X 1i  X 1 ) 2   ( X 2i  X 2 ) 2   ( X 3i  X 3 ) 2 , i=1, 2, 3, 4
={(6-6)2 + (7-6)2+ (3-6)2 + (8-6)2}+{5-5)2 + (5-5)2 + (3-5)2 + (7-5)2} + {(5-4)2+
(4-4)2 + (3-4)2 + (4-4)2}
= {0 + 1 + 9 + 4} + {0 + 0 + 4 + 4} + { 1 + 0 + 1 + 0}
= 14 + 8 + 2 = 24
SS for total variance   ( X ij  X ) 2 i = 1, 2, 3...
j = 1, 2, 3 ...
=(6-5)2 + (7-5)2 + (3-5)2 + (8-5)2 + (5-5)2 + (5-5)2 + 3-5)2 + (7-5)2 + (5-5)2 +
(4-5)2 + (3-5)2 + (4-5)2
=
1+4+4+9+0+0+4+4+0+1+4+1
= 32
Alternatively, it (SS for total variance) can also be worked out thus:
= 8 + 24
= 32
We can now set up the ANOVA table for this problem:

5% F-limit
Source of
SS d.f. MS F-ratio (from the F-
Variation
table)

(3 - 1) = 8/2 =
Between 2 4.00
8 4.00/2.67 =
sample
Within (12 - 3) = 24/9 = 1.5
24 F(2,9) = 4.26
sample 9 2.67

(12 - 1) =
Total 32
11

463
The above table shows that the calculated value of F is 1.5 which is less
than the table value of 4.26 at 5% level with d.f. being v 1  2 and v 2  9 and
hence could have arisen due to chance. This analysis supports the null-
hypothesis of no difference is sample means. We may, therefore, conclude
that the difference in wheat output due to varieties is insignificant and is just
a matter of chance.
Solution through short-cut method: In this case we first take the total of all
the individual values of n item and call it as T.
T in the given case = 60
and n=12
Hence, the correction factor = (T)2/n = 60  60 / 12  300. Now total SS, SS
between and SS within can be worked out as under:
(T ) 2
Total SS   X 2 ij  i = 1, 2, 3, ...
n
j = 1, 2, 3, ...
= (6)2+ (7)2+ (3)2 + (8)2 + (5)2 + (5)2 + (3)2 + (7)2+(5)2+(4)2+ (3)2+(4)2 -
 60  60 
 
 12 
= 332 - 300 = 32
(T j ) 2 (T ) 2
SS between   
nj n
 24  24   20  20   16  16   60  60 
    
 4   4   4   12 
= 144 + 100 + 64 - 300
=8

(T j ) 2
SS within   X 2 ij   = 332 – 308 = 24
nj
It may be noted that we get exactly the same result as we had obtained in
the case of direct method. From now onwards we can set up ANOVA table
and interpret F-ratio in the same manner as we have already done under
the direct method.
19.5 ANOVA-Two way
Two-way ANOVA technique is used when the data are classified on the
basis of two factors. For example:
1. The agricultural output may be classified on the basis of different
varieties of seeds and also on the basis of different varieties of fertilizers
used.

464
2. A business firm may have its sales data classified on the basis
different salesmen and also on the basis of sales in different regions.
3. In a factory, the various units of a product produced during a certain
period may be classified on the basis of different varieties of machines used
and also on the basis of different grades of labour.
Such a two-way design may have repeated measurements of each factor or
may not have repeated values. The ANOVA technique is little different in
case of repeated measurements where we also compute the interaction
variation. We shall now explain the two-way ANOVA technique in the
context of both the said designs with the help of examples.
In two way ANOVA, 3 variables are analyzed - variance between columns
(MSC), variance between rows (MSR) and variance within or residue
(MSE). Since calculations are more complex in two way ANOVA, we use-
short-cut method.
Steps in two way classification

Form ho that all column samples and row samples are equal
(TOTAL OF ITEMS) 2
TOTAL NUMBER OF ITEMS
Compute T2/n =
Find SST = Sum of squares of all observations- T2/ n
(COLUMN TOTAL) 2
 ..............  T2/n
NO OF COLUMN ITEMS
Find SSC = Obtain mean square
SSC
column = MSC =
C 1
( ROW TOTAL) 2
 .............. T2/n
NO.OF ROW ITEMS
Find SSR =
SSR
Obtain mean square row = MSR =
R 1

Find SSE = SST - SSC + SSR

SSE
Obtain mean square residue =
N C

MSE MSR
Find two F rations = Fc = MSC and Fr = MSE
Present the results in ANOVA table
Compare with 2 F table values and decide fate of ho

465
Anova Table
The results obtained from analysis of variance - whether one way
classification or two way classifications can be presented in a table called
ANOVA table. It shows sum of variances, sum of squares, degrees of
freedom, type of variance and f ratio, along with table values. It facilitates
comprehension, comparison and analysis
Analysis of variance Table for Two-way ANOVA
Degree
Source of Sum of of Mean square
F-ratio
Variation squares (SS) Freedo (MS)
m (d.f.)
Between (T j ) 2 (T ) 2 SS between columns MS between columns
Columns  nj

n (c -1) (c  1) MS residual
treatmen
t
Between (Ti ) 2 (T ) 2
Rows  ni

n (r - 1)
SS between rows MS between rows
treatmen (r  1) MS residual
t
Total SS -
(SS between SS residual
Residual (c - 1) (r
columns +
or error - 1) (c  1) (r  1)
SS between
rows)
(T ) 2
Total X 2
ij 
n
c.r  1)

In the table c = number of columns, r = number of rows

SS residual = Total SS - (SS between columns + SS between rows).
Thus, MS residual or the residual variance provides the basis for the F-ratio
concerning variation between columns treatment and between rows
treatment. MS residual is always due to the fluctuations of sampling, and
hence serves as the basis for the significance test. Both the F-ratios are
compared with their corresponding table values, for given degrees of
freedom at a specified level of significance, as usual and if it is found that
the calculated F-ratio concerning variation between columns is equal to or
greater than its table value, then the difference among columns means is
considered significant. Similarly, the F-ratio concerning variation between
rows can be interpreted.
Example 19.6 Set up an analysis of variance table for the following
two-way design results
Per Acre production Data of Wheat (in metric tonnes)

466
 Varieties of seeds A B C
Varieties of fertilizers
W 6 5 5
X 7 5 4
Y 3 3 3
Z 8 7 4
Also state whether variety differences are significant at 5% level.
Solution:
As the given problem is a two-way design of experiment without repeated
values, we shall adopt all the above stated steps while setting up the
ANOVA table as is illustrated on the following page. ANOVA table can be
set up for the given problem as shown in Table 11.5.
From the said ANOVA table, we find that differences concerning
varieties of seeds are insignificant at 5% level as the calculated F-ratio of 4
is less than the table value of 5.14, but the variety differences concerning
fertilizers are significant as the calculated F-ratio of 6 is more than its table
value of 4.76.
(b) ANOVA technique in context of two-way design when repeated
values are there: In case of a two-way design with repeated measurements
for all of the categories, we can obtain a separate independent measure of
inherent or smallest variations. For this measure we can calculate the sum
of squares and degrees of freedom in the same way as we had worked out
the sum of squares for variance within samples in the case of one-way
ANOVA. Total SS, SS between columns and SS between rows can also be
worked out as stated above. We then find left-over degrees of freedom
which are used for what is known as "interaction variation" (Interaction is the
measure of inter relationship among the two different classifications), After
making all these computations, ANOVA table can be set up for drawing
inferences. We illustrate the same with an example.
Computations for Two-way ANOVA (in a design without repeated
values)
( T ) 2 60  60
Step (i) T = 60, n = 12, :. Correction factor = n  12  300

Step (ii) Total SS (36 + 25 + 25 + 49 + 25 + 16 + 9 + 9 + 9 + 64 + 49 +16)-

 60  60 
 
 12 
= 332 - 300
= 32

467
Step (iii) SS between columns treatment
 24  24 20  20 16  16   60  60 
 4  4
 
4   12 
= 144 + 100 + 64 - 300
=8
Step (iv) SS between rows treatment
 16  16 16  16 9  9 19  19   60  60 
 3  3  3  3    12 

= 85.33 + 85.33 + 27.00 + 120.33 - 300

= 18
Step (v) SS residual or error = Total SS - (SS between columns + SS
between rows)
= 32 - (8 + 18)
=6
Computations for Two-way ANOVA (in design with repeated values)
187  187
Step (i) T = 187, n = 18, thus, the correction factor =  1942.72
18
Step(ii) Total SS = [(14)2+(15)2+(12)2+(11)2+(10)2+(11)2+(10)2+(9)2+(7)2+
 (187)2 
(8)2+(11)2+(11)2+(11)2+(11)2+(10)2+(11)2+(8)2+(7)2] -  
 18 
=(2019 - 1942.72)
= 76.28
Step (iii) SS between columns
 73  73 56  56 58  58   (187) 
2

(i.e., between drugs) =    

 6 6 6   18 
= 888.16 + 522.66 + 560.67 - 1942.72
= 28.77
Step (iv) SS between rows
 70  70 59  59 58  58   (187) 
2

(i.e., between people) =    

 6 6 6   18 


=816.67+580.16+560.67-1942.72
= 14.78
Step (v) SS within samples = (14-14.5)2+(15-14.5)2+(10-9.5)2+(9-
9.5)2+1(11-11)2+(11-11)2+(12-11.5)2+(11-11.5)2(7-7.5)2+(8-7.5)2+(10-
10.5)2+(11-10.5)2(10-10.5)2+(11-10.5)2+(11-11)2+(11-11)2++(8-7.5)2+(7-7.5)2
= 3.50
Step (vi) SS for interaction variation = 76.28 - [28.77 + 14.78 + 3.50]
= 29.23

468
The Anova Table
Source of
SS d.f. MS F-ratio 5%F-Limit
variation
Between
28.77 14.385
Columns (i.e., F(2,9)=
28.77 (3 - 1) = 2 2 0.389
Between 4.26
= 14.385 = 36.9
drugs)
Between rows 14.78 7.390
F(2,9)=
(i.e., between 14.78 (3 - 1) = 2 2 0.389
4.26
People) = 7.390 = 19.0
4* 29.23
Interaction
4
Within 29.23* 7.308 F(4,9) =
Samples 3.50 0.389 3.63
(18 - 9)= 3.50
(Error)  0.389
9 9
(18 - 1) =
Total 76.28
17
These figures are left-over figures and have been obtained by subtracting
from the column total the total of all other value in the said column. Thus,
interaction SS = (76.28) - (28.77 + 14.78 + 3.50) = 29.23 and interaction
degrees of freedom = (17) - (2+2+9) = 4.
The above table shows that all the three F-ratios are significant of 5% level
which means that the drugs act differently, different groups of people are
affected differently and the interaction term is significant. In fact, if the
interaction term happens to be significant, it is pointless to talk about the
differences between various treatments i.e., differences between drugs or
differences between groups of people in the given case.
Example 19.7 From the following data on production by 4 machines by 5
workers, test
a) Whether productivity differs between machines
b) Whether workers differ in productivity
Machines

Weeks a b c d

1 44 38 47 36

2 46 40 52 43

469
 3 34 36 44 32

4 43 38 46 33

5 38 42 49 39

Solution:
Coding may be applied to reduce the data size. Thus, deducting 41 from all
the values, coded data will be as below:
Ho : Productivity does not differ between machines. Workers do not differ in
productivity
Let us apply coding method and subtract 41 from all the values

A B C D TOTAL
3 -3 6 -5 1
5 -1 11 2 17
-7 -5 3 -9 -18
2 -3 5 -8 -4
-3 1 8 -2 4
0 -11 33 -22 0
T2
0
N= 20, T=Sum of all the value= 3+5-7 .....+8-2=0 N

SST = sum of squares of all values = [32+52+.....+(-2)2]-02=574

( zx1)2 (x2)2 T 2 (0) 2 (11) 2 (33) 2 (22) 2
SSC=   .....     0  338.8
n1 n2 N 5 5 5 5
SSR =
(x1)2 (x2)2 T 2 (1) 2 (17) 2 (18) 2 (4) 2 (4) 2
  .....      0  161.5
n1 n2 N 4 4 4 4 4
SSE=SST-SSC-SSR = 574 - (338.8-161.5) = 73.7
SSC 338.8
MSC =   112.93;
C 1 3
SSR 161.5
MSR =   40.38
R 1 4
SSE 73.7
MSE =   6.14
(C  1)(R  1) 12

470
 Source of Sum of degree of Mean
F ratio
variation squares freedom squares

Fc=
Between
338.8 3 112.93 12.93
columns  1 8.39
6.14

Fr=
Between
161.5 4 40.8 10.8
rows  6 68
6.14

Residual 73.7 12 6.14

Total 574 19 -

Between columns

Degree of freedom = (3,12) Table value of f= 3.49

Calculated value of Fc = 18.39 which is greater than the table value.
We reject the hypothesis. Mean of columns are not equal. Mean
productivity is not the same for different machines.
Between rows
Degree of freedom (4,12) Table value of F = 3.26

Calculated value of Fr= 6.58 which is greater than the table value.
We reject the hypothesis. Mean of rows are not equal. Workers do
differ in productivity.
19.6 NEXUS BETWEEN F TEST AND ANOVA

The Analysis of Variance (ANOVA) is the process of assigning the total

variation into its components, in an experimental setup and each
component is tested separately for its significance. The test is a test for
Variance, a function of the corresponding sum of squares(SS). Each
component SS is tested with respect to the Error Sum Squares (ESS). The
ratio of these two sums of squares is the same as the ratio of two variances
and therefore is a F- Test.
A simple example is the ANOVA for a two -way classification
experimental set up. The resultant Total Sum of Squares (TSS) is split up

471
into two components as the Between Sum Squares(BSS) and the Within
Sum of Squares (WSS). The remainder is the ESS which is used for testing
each of the other two.

The F-Test used for testing any Null hypothesis based on the
equality of any two variances, which may not be the results of an ANOVA.
Meanwhile, if the basic Null Hypothesis in a two way classification or any
ANOVA is to test the Homogeneity of Means of the Classes into which the
experimental set up has been designed. In other words if you are comparing
K different “ Treatments “, then the Null will be something like Ho:
M1=M2=…..Mk=M against an Alternative that it's is not equal. But this is
actually done by measuring the Variations in each Treatment group, and
hence the ANOVA is used.
LET US SUM UP
Statistical test applied in ANOVA is F test. The test statistic is F value which
is the ratio between variance between samples and variance within
samples. This unit given the knowledge of F test, One way and Two way
ANOVA. The suitable examples are presented for understanding the usage
of tools in testing a hypothesis.

CHECK YOUR PROGRESS

1. A special fertilizer was experimented on four fields a, b, c and d. in each

field 4 beds were prepared and fertilizer was used. The yield in fields is
significant or not (the value of f at 5% level of significance for v2 = 3 and
v1= 12 is 8.74)
A B C D
8 9 3 3
12 4 8 7
1 7 2 8
3 1 5 2

2.Three varieties Of wheat - A,B, and C were sown in plots each and the
following yields in quintals per acre were obtained.

Varieties
plots a b c
1 10 9 4
2 6 7 7
3 7 7 7
4 9 5 6

472
Set up a table of analysis of variance and find out whether there is a
significant difference between the mean yields of the three varieties. (The
table value of F at 5% level is 4.26)
3.Set a table of analysis of variance for the following data

Variety
Plots a b c d
1 200 230 250 300
2 190 270 300 270
3 240 150 145 180
Test whether the varieties are different
1. Following figures relate to production in kilogram of three varieties a, b
and c of wheat sown in 12 plots.

A B C
14 14 18
16 13 16
18 15 16
22 19 20
Is there significant difference in the production of three varieties?
GLOSSARY

Grand Mean : The grand mean is the mean of

sample means or the mean of all
observations combined,
irrespective of the sample.

Total Variation : The total variation (not variance)

is comprised the sum of the
squares of the differences of each
mean with the grand mean.

Between-group variability : refers to variations between the

distributions of individual groups
(or levels) as the values within
each group are different.

473
Within Group Variation : The variation due to differences
within individual samples, denoted
SS(W) for Sum of Squares Within
groups

Decision Rule for F-test : The decision will be to reject the

null hypothesis if the test statistic
from the table is greater than the F
critical value with k-1 numerator
and N-k denominator degrees of
freedom.

F statistic : Between group variability / Within

group variability.

SUGGESTED READING

1. Arora, P.N. & S. Arora, (2007) ,Statistics for Management, latest

Edition, S. Chand & Company Ltd., New Delhi.
2. D.C.Sancheti, V.K.Kapoor,( 2014), Business Mathematics, 11th
edition, Reprint, Sultan Chand and Sons, New Delhi.
3. Gupta, B.N., (2015), Business Statistics, First Revised Edition,
SBPD, New Delhi.

4. JK. Sharma, (2009), Business Mathematics Theory And

Applications, 13th Edition, ANE Books, New Delhi.
5. S. P. Gupta, (2012), Statistical Methods, 42nd Revised Edition Sultan
Chand & Sons Pvt. Ltd., New Delhi.
6. https://epgp.inflibnet.ac.in/Home/ViewSubject?catid=ahLCajOqz6/G
WFCSpr/XYg==
7. https://www.cuemath.com/data/f-test/
ANSWERS TO CHECK YOUR PROGRESS

1. Calculated F0t statistic = 3.40 < f(3, 6),0.05 = 4.7571, the null hypothesis is
not rejected and we conclude that there is significant difference in the mean
yield by using of fertilizer among the three fields.

474
2. F statistic =2.62, F0.05 =4.26 for v1=2 and v2=9 , the calculated value is
less than the table value. The hypothesis holds true.
(i)As F0I = 0.377 < f(4, 8),0.05 = 3.838, the null hypothesis is not rejected and
conclude that there is no significant difference among the mean disinfection
scores of inspectors. f(4, 8),0.05 = 3.838 (for inspectors)
(ii) As F0R = 10.49 > f(2, 8),0.05 = 4.459, the null hypothesis is rejected and we
conclude that there exists significant difference in atleast one pair of
Multispecialty Hospital over their mean disinfection scores. f(2, 8),0.05 = 4.459
(for Multispecialty Hospital)

3.F Statistic = MSTr/MSE =25.17, F (critical) with 2 and 6 DF at 5% level of

significance Using F table is = 5.14. We reject H0 at α level of significance
-  F (observed) > F(critical)  In our example 25.17 > 5.14

475
476
477
 SYLLABUS
Course Title : Information Systems for Managers

Course Code : MSPS 15

Course Credit: 3
Course Objective :
CO 1. Create conceptual understanding Information system and its strategic uses in
an organization
CO 2. State out the fundamental principles of computer system, techniques to
monitor the database and the procedure for office communications
CO 3. Examine the application of information system, decision and expert support
system
CO 4. Describe the planning and development of information system and alternative
approaches for system development
CO 5. Paraphrase ethical challenges and the risk involved in information technology

BLOCK 1 Information System

Information system: Managers’ view – Concepts of systems and Organizations –
Strategic uses of Information Technology.

BLOCK 2 Computer System Recourses

Computer System Resources: Computer Hardware and Computer Software – File
and DBMS – Distributed System – Internet and Office Communications.

BLOCK 3 Applications of Information System

Application of Information System to functional Business Areas: Operational
Information System – Tactical and Strategic Information System – Decision support
system and expert system.

BLOCK 4 Planning & Development

Planning and development of Information system: Information system planning –
System Analysis and design – Alternative application development approaches.
BLOCK 5 Security and Ethical Challenges
Security and Ethical Challenges: IS controls - facility control and procedural control -
Risks to online operations - Denial of service, spoofing - Ethics for IS professional -
Societal challenges of Information technology.

References:
1. Arpita Gopal, (2009), MIS for Strategic Business Processes, latest Edition,
McGraw Hill Education, India
2. Brien, Marakas, Behl,( 2017), Management Information Systems, latest Edition,
TMH, India
3. Goyal .D P (2010), Management Information Systems–Managerial
Perspective, 3rd Edition MacMillan, Chennai
4. Gupta A K, Sharma, (2012), Management of Systems, latest Edition,
Macmillan, Chennai
5. Jawadekar, (2012), MIS Text and Cases, latest Edition, TMH, India
6. Joseph P T,( 2012), E-Commerce, an Indian Perspective, PHI, India
7. Laudon & Laudon, (2018) Management Information Systems, latest Edition,
Pearson, India
8. Milind M Oka (2012), “Cases in Management Information system , latest
Edition, ‘Everest Publication, India
9. Murthy,( 2013), Management Information System, latest Edition Himalaya,
Publication, India
10. Nina Godbole & Sunit Belapure (2012), “ Cyber Security” latest Edition, Wiley
India
11. Nirmala Bagchi, (2012), Management Information Systems, latest Edition,
Vikas Publication, India
12. Sandra Senf (2016), Information Technology Control and Audit, 4 th edition,
Auerbach Publications, Florida.
13. https://openstax.org/books/introduction-business/pages/13-3-management-
information-systems
14. https://nptel.ac.in/courses/106105175
15. https://smallbusiness.chron.com/management-information-system-2104.html
16. https://www.simplilearn.com/types-of-information-systems-and-applications-
article
Course Outcome :
CLO 1. Comprehend management and uses of information System for the making
managerial decisions.
CLO 2. Review the application of DBMS and Office Communications.
CLO 3. Acquire a real-world application of Information systems and Decision
Support System in a business
CLO 4. Recognize the planning and development of IT and its alternative
approaches
CLO 5. Outline the role of the ethical, social, and security challenges of
information systems.
 CONTENT

BLOCK 1 INFORMATION SYSTEM

UNIT 1 INTRODUCTION TO INFORMATION SYSTEM 2

1.1 Introduction 3

1.2 Why Information Systems? 4

1.3 Objectives of Information Systems 7

UNIT 2 INTRODUCTIONS TO MANAGEMENT INFORMATION 12

SYSTEM

2.1 Introductions 13

2.2 Emergence of Management Information Systems 13

2.3 Definition of Management Information Systems 15

2.4 Elements of Management Information Systems 16

Scope of Management Information Systems
2.5 17

UNIT 3 CONCEPTS OF SYSTEM AND ORGANIZATIONS 25

3.1 Organization 26

3.2 Types of Organization 27

3.3 Benefits of Organization 28

3.4 Information flow in an organization 29

UNIT4 STRATEGIC USES OF INFORMATION TECHNOLOGY 34

4.1 Strategic Uses of Information Technology 35

4.2 Modern Information Systems in Organization 36

4.3 Knowledge Work and Office Automation Systems 39

4.4 Management Information System 39

4.5 Systems Concept 40

 4.6 Sales and Marketing Systems 42

4.7 Manufacturing and Production Systems 43

4.8 Finance and Accounting Systems 44

4.9 Human Resources Systems 45

BLOCK 2 COMPUTER SYSTEM RECOURSES

UNIT 5 COMPUTER HARDWARE 51

5.1 Computer Hardware 52

5.2 Classifications of Computers 58

5.3 Hardware Technology Requirements for Electronic 59

Commerce and the Digital Firm

UNIT 6 COMPUTER SOFTWARE 63

6.1 Evolution of Computer Software 63

6.2 Classification of Computer Software 67

UNIT 7 DBMS 76

7.1 Database Concepts 76

7.2 Database Models 79

UNIT 8 DISTRIBUTED SYSTEMS 87

8.1 Distributed Systems 88

8.2 Internet 93

BLOCK 3 APPLICATIONS OF INFORMATION SYSTEM

UNIT 9 APPLICATIONS OF INFORMATION SYSTEMS TO 101

BUSINESS PART-1

9.1 Marketing and Sales 102

9.2 Procurement 105

 9.3 Warehousing 109

UNIT 10 APPLICATIONS OF INFORMATION SYSTEM TO 114

BUSINESS PART-2

10.1 Production 115

10.2 Finance 122

10.3 Human Resources 125

10.4 Tactical and Strategic Information System 126

10.5 Decision Support System 127

10.6 Executive Support System 128

PLANNING& DEVELOPMENT OF INFORMATION
BLOCK 4
SYSTEM

UNIT 11 PLANNING OF INFORMATION SYSTEM 134

11.1 Information System Planning 134

11.2 Challenges in Information Systems Planning 136

UNIT 12 DEVELOPMENT OF INFORMATION SYSTEM 141

12.1 Need for System Analysis and Design 141

12.2 Procedure of Analyzing Existing System 143

12.3 Steps in System Analysis and Design 145

12.4 Computer System Design 147

12.5 Data Specifications 149

UNIT 13 OVERVIEW OF ALTERNATIVE APPLICATION 154

13.1 Traditional System Lifecycle 154

13.2 Prototyping 156

UNIT 14 ALTERNATIVE APPLICATION DEVELOPMENT 162

APPROACH
 16.1 Application Software Package 162

16.2 End-User Development 163

16.3 Outsourcing 165

BLOCK 5 SECURITY AND ETHICAL CHALLENGES

UNIT 15 SECURITY AND ETHICAL CHALLENGES 171

15.1 Security and Ethical Challenges 171

15.2 IS Control: Facility Control & Procedural Control 173

15.3 Application Reliability and Data Entry Controls 174

15.4 Types of Spoofing 180

UNIT 16 SOCIETAL CHALLENGES OF INFORMATION SYSTEM 184

16.1 Ethics For Is Professional 184

16.2 Societal Challenges of Information System 188

16.3 Ethical Analysis 190

Plagiarism Report 193

 BLOCK 1

INFORMATION SYSTEM

Unit 1: Introduction to Information System

Unit 2: Introduction to Management Information System

Unit 3: Concepts of System and Organisation

Unit 4: Strategic Uses of Information Technology

1
Unit 1

INTRODUCTION TO INFORMATION
SYSTEM
STRUCTURE

Overview

Learning Objectives

1.1 Introduction

1.2 Why Information Systems?

1.3 Objectives of Information Systems

Let Us Sum Up

Check Your Progress

Glossary

Suggested Readings
Answers to check your progress

OVERVIEW
An information system is a set of interrelated components that collect,
manipulate, and disseminate data and information and provide a
feedback mechanism to meet an objective. We all interact daily with
information systems, both personally and professionally. An information
system will support the decision making and control in an organization.
In addition to supporting decision making it also helps in coordinating
and controlling the organization. The information system may also help
managers and workers in analyzing the problems, visualizing the
complex subjects and it helps to create new products.
Information systems contain information about significant people, places
and things within the organization or in the environment surrounding it.
By information we mean data that have been shaped into a form that is
meaningful and useful to human beings. Data, in contrast, are streams
of raw facts representing events occurring in organizations or the
physical environment before they have been organized and arranged
into a form that people can understand and use.
Brief example contrasting information to data may prove useful.
Supermarket checkout counters ring up millions pieces of data, such as
product identification numbers or the cost of each item sold. Such pieces

2
of data can be totaled and analyzed to provide meaningful information
such as the total number of bottles of dish, detergent sold at a particular
store, which brands of dish detergent where selling the most rapidly at
that store or sales territory, or the total amount spent on that brand of
dish detergent at that store or sales region.
Three activities in an information system produce the information. One is
Input – it captures or collects raw data from within the organization or
from its external environment. Second is processing - converts the raw
data into meaningful information. Third is output – transfers the
processed information to the people who will use it or to the activities for
which it will be used. Information system also require feedback, which is
output that is returned to appropriate members of the organization, to
help them evaluate or correct the input stage.

LEARNING OBJECTIVES

After reading this unit, you should be able to,

• define IS and the importance of IS and its mergence in the global
economy
• explain the role of information systems in today’s competitive
business environment.

1.1 INTRODUCTION
“The good old days – when programmers and management did’nt
interface with information system – are gone. Now all projects, even
those involving changes to existing systems, are reviewed by a steering
committee made up mostly of managers. To top it off, they are not even
the managers who will use the systems they approve. Rather, they are
senior managers – planners and strategists, not the ones who are
actually on the manufacturing floor or in the warehouse.”
The lifeblood of any organization is the flow of intelligence, information
and data. This “plasma” moves along channels from point to point
through the interrelated network of the operating elements of the
organization. It is important to recognize that a tremendous number of
these pieces of information, these bits of data, are generated almost
every minute of every day in the interaction of an organization with its
environment. Every activity in every organization contributes to the
generation of the information system.

What is an information system?

An information system can be defined technically as a set of interrelated
components that collect (or retrieve), process, store, and distribute

3
information to support decision making and control in an organization. In
addition to supporting decision making, coordination, and control,
information systems may also help managers and workers analyze
problems, visualize complex subjects, and create new products.

Figure 1.1: Components of Information system

1.2 WHY INFORMATION SYSTEMS?
Until the 1980’s, there was little need for this Discipline or course.
Managers generally did not need to know about how information was
collected, processed, and distributed in their organizations, and the
technology involved was minimal. Information itself was not considered
an important asset for the firm. The management process was
considered a face-to-face, personal art and not a far-flung, global
coordination process. But today few managers can afford to ignore how
information is handled by their organization.
Three powerful worldwide changes have altered the environment of
business. The first change is the emergence and strengthening of the
global economy. The second change is the transformation of industrial
economies and societies into knowledge - based economy. The third
change is the transformation of the business enterprise. These changes
in the business environment and climate, pose a number of new
challenges to business-to-business firms and their management.

4
Functions of Information System

Figure 1.2: Functions of an Information System

Emergence of the Global Economy

Globalization of the world’s industrial economies greatly enhances the
value of information to the firm and offers new opportunities to business.
Today, information systems provide the communication and analytic
power that firms need for conducting trade and managing business on a
global scale. To coordinate its worldwide network of distributors,
companies like Nu Skin had to develop global information systems that
can track orders, deliveries and payment, communicate with distributors
and suppliers, operate 24 hours a day in different national environments
and service local as well as international management reporting needs.
In short, controlling the far-flung global corporation is a major business
challenge that requires powerful information system responses.
Globalization and information technology are new threats to domestic
business firms; because of global communication and management
systems, customers now can shop in a worldwide marketplace,
obtaining price and quality in forces firms to play in open, unprotected
worldwide markets, firms need powerful information and communication
systems.
Transformation of Industrial Economies in to Knowledge Based
Economy
The knowledge and information revolution began at the turn of the
twentieth century and has gradually accelerated. By 1976 the number of
white-collar workers employed in offices surpassed the number of farm
workers, service workers and blue-collar workers employed in
manufacturing. Today most people no longer work in farms or factories
but instead are found in sales, education, health care, banks, insurance

5
firms and law firms; they also provide business services like copying,
computer software or deliveries. Because the productivity of employees
will depend on the quality of the systems serving them, management
decisions about information technology are critically important to the
prosperity and survival of a firm. Consider also that the growing power of
information technology makes possible new services of great economic
value. Credit cards, overnight package delivery, and worldwide
reservation systems are examples of services that are based on new
information technologies, Information and technology that delivers it
have become critical, strategic resources for business firms and their
managers.

Transformation of the Business Enterprise

The third major change in the business environment is the very nature of
organization and management. There has been a transformation in the
possibilities for organizing and managing. Some firms have begun to
take advantage of these new possibilities.
The purpose of a business firm is to show a profit by creating value
through the production of services and products. The purpose of
management is to plan, organize, coordinate, and lead the members of
the firm in order to achieve profitable value creation. Information
technology has transformed how the firm creates value and how
managers manage in each levels of Management. It is described as a
pyramid structure.

Figure 1.3: Transformation of the Business Enterprise

The traditional business firm was - and still is - a hierarchical,
centralized, structured arrangement of specialists that typically relies on
a fixed set of standard operating procedures to deliver a mass-produced
product (or service). The new style of business firm is a flattened (less

6
hierarchical), decentralized, flexible arrangement of generalists who rely
on real time (nearly instant) information to deliver mass-customized
products and services uniquely suited to specific markets or customers.
This new style of organization is not firmly entrenched, it is still evolving.
Nevertheless, the direction is clear. This new direction would be
unthinkable without information technology.
The traditional management group relied - and still does- on formal
plans, a rigid division of labour, formal rules, and appeals to loyalty to
ensure the proper operation of a firm. The new manager relies on
informal commitments and networks to establish goals (rather than
formal planning), a flexible arrangement of teams and individuals
working in task forces, a customer orientation to achieve coordination
among employees, and appeals to professionalism and knowledge to
ensure proper operation of the firm. Once again, information technology
makes this style of management possible.
1.3 OBJECTIVES OF INFORMATION SYSTEMS
Requests for information systems are typically motivated by one of three
general objectives:
Solve a Problem
An activity, process, or function that does not now or may not in the
future meet performance standards or expectations unless remedial
actions are taken.
Example: Reduce excessive data entry errors by eliminating the manual
entry of sales details.
Capitalize on an Opportunity
A change to expand or improve business performance and competitive
achievements
Example: Capture a large base of customers by offering a new airline
frequent flier program focusing on discounted airfares.

Respond to a Directive
An order, request, or mandate originating from a legislative or
management authority to provide information, perform in a certain
manner, or alter either information or performance.
Example: Report annually to the Indian Revenue Service, using
prescribed formats, interest earned on savings, checking, and time
deposit accounts. To achieve these objectives, firmly typically undertake
projects for one or more of the following reasons-the five C’s:

7
 Capability

Communication

Competitiveness

Control

Cost

5C’s: Reasons for Initiating Information Systems Projects.

Capability
Greater Processing Speed: Using the computer’s inherent ability to
calculate, sort, and retrieve data and information when greater speed
that of people doing the same tasks is desired.
Increased Volume: Providing the capacity to process a greater amount
of activity, perhaps to take advantage of new business opportunities.
Often a result of growth that causes business to exceed the capacities
and procedures underlying the achievements to date.
Faster Information Retrieval: Locating and retrieving information from
storage. Conducting complex searches.

Control
Greater accuracy and improved Carrying out computing consistency
better security steps, correctly and in the same way each time.
Better Security Safe guarding sensitive and important data in a form that
is accessible only to authorized personnel.

Communication
Enhanced Communication Speeding the flow of information and
messages between remote locations as well as within offices. Includes
the transmissions of documents within offices.
Integration of Business Area: Coordinating business activities taking
place in separate areas of an organization, through capture and
distribution of information.

Cost
Cost Monitoring: Tracking the cost of labour, goods and facilities to
determine how actual costs compare with expectations.
Cost Reduction: Using computing capability to process at a lower cost
than possible with other methods, while maintaining accuracy and
performance levels.

8
Competitive advantage
Lock in Customers: Changing the relationship with and services
provided to customers in such a way that they not choose to change
suppliers. Improve Arrangements with changing the pricing, Suppliers
service, or delivery arrangements, or relationship between suppliers and
the organization to benefit the firm. New Product Development:
Introducing new products with characteristics that use or are influenced
by information technology.

Activity 1
Standard International (SI) is subsidiary to a large manufacturing firm: it
is responsible for marketing, sales, and distribution outside the United
States. Standard International does not develop products: the parent
firm creates all products it sells. SI has operations in 30 countries. In
virtually all these countries the local SI operation is treated legally as a
subsidiary of Standard International.
Recently a new president took control of SI. Historically the firm’s
systems were oriented to finance and accounting because the
technology group reports to the vice president of finance. Accounting
applications are important because so many different currencies are
involved. The new president, however, is impatient and feels that
technology should be able to do something for marketing and sales.
She asked you to consult with SI in the hope of finding a strategic
application technology: “I want something that will give us a competitive
edge, “she said. How does it establish and maintain a competitive
advantage?

LET US SUM UP
We have discussed about the Information System and the Emergence of
Global Economy. IS made transformation in the Business enterprise and
Managers manage in each level of Management. WE have discussed
about the objectives of IS and the 5 C’s which initiates the Information
system projects across Globe.

CHECK YOUR PROGRESS

Choose the Correct Answer:

1) An information system can be defined technically as a set of
____________ Components

a) Interrelated b) correlated

c) Unrelated d) Semi- related

9
2) The main objectives of Information System
a) Communication b) Solve a Problem
c) Responsiveness d) linkage function

3) Productivity of employees will depend on the _________ of the

systems
Serving them
a) Communication b) Quality
c) Quantity d) Cost
4) ________ tracking the cost of labour, goods and facilities to
determine how actual costs compare with expectations.

a) Cost Monitoring b) Cost Reduction

c) Quantity d) Cost
5) The purpose of management is to plan, organize, coordinate, and
lead the members of the firm in order to achieve profitable
_____________

a)Value creation b) cost reduction

c) Quality d) Money

GLOSSARY

Output : An output is data that a computer

sends. Computers only work with
digital information.

Capability : The ability to perform or achieve

certain actions or outcomes.

Communication : Communication is simply the act of

transferring information from one
place, person or group to another.

Competitiveness : The ability of a business to deliver

better value to customers than
competitors.

Control : Control is a function of

management which helps to check
errors in order to take corrective
actions

10
 SUGGESTED READINGS
1. Bentley Trevor J (1986) Management Information Systems & data
processing, 2nd edition, Holt, Rinehart and Winston publications,
University of California. ISBN 0039106888, 9780039106881.
2. Donald W. Kroeber (1986) Computer-Based Information Systems: A
Management Approach, Subsequent edition, Macmillan Publications,
University of Virginia. ISBN 0023668407, 9780023668401.
3. Gordon B.Davis (2013) Management Information Systems, 1 st Edition,
TMH Publications, India. ISBN 007066241X.
4. Joel E. Ross (1970) Management by Information System, illustrated
edition, Prentice-Hall publications, University of Wisconsin,ISBN
0135486289, 9780135486283.
5. Kenneth C. Loudon & Jane P. Loudon (2014) Management Information
Systems, 13th Edition, Pearson Publications, USA.

ANSWERS TO CHECK YOUR PROGRESS

1)a 2) b 3)b 4)a 5)a

11
Unit 2

INTRODUCTION TO MANAGEMENT
INFORMATION SYSTEM
STRUCTURE

Overview

Learning Objectives

2.1 Introduction

2.2 Emergence of Management Information Systems

2.3 Definition of Management Information Systems

2.4 Elements of Management Information Systems

2.5 Scope of Management Information Systems

Let Us Sum Up

Check Your Progress

Glossary

Suggested Readings

Answers to check your progress

OVERVIEW
Information processing is a major societal activity. A significant part of an
individual working and personal time is spent in recording, searching for,
and absorbing information. As much as 80% of a typical executive’s time
is processing and communication information. More than 50% of the
United States workforce is employed in jobs that involve some form of
information processing. A large proportion of these employees are
“knowledge workers”; their duties involve the production and use of
information outputs – documents, reports, analyses, plans, etc.
Computers have become an essential part of organizational information
processing because of the power of technology and the volume of data
processed. Today, computerized processing of transaction data is a
routine activity of large organizations. Moreover, the capability to
automate information processing has permitted an expansion in the
scope of formalized organizational information use. The current
challenge in information processing is to use the capabilities of
computers to support knowledge work, including managerial activities
and decision making. The wide variety of computer resources to perform

12
transaction processing, to provide processing for formal information and
reporting system and to accomplish managerial-decision support are
broadly classified as the organization’s management information system.
MIS is a broad concept rather than a single system. Some MIS activities
are highly integrated with routine data processing, while other MIS
applications are designed for a particular knowledge work activity or
decision-making function. The office use of computer and
communication technology to support person-to-person communications
and clerical support is also included in this text as part of management
information systems.

LEARNING OBJECTIVES

After reading this unit, you should be able to,

• define management information systems
• explain the nature and scope of information systems
• discuss the classification of information systems.

2.1 INTRODUCTION
Management’s job is to make sense out of the many situations faced by
organizations, make decisions, and formulate action plans to solve
organizational problems. Managers perceive business challenges in the
environment; they set the organizational strategy for responding to those
challenges; and they allocate the human and financial resources to
coordinate the work and achieve success. Throughout, they must
exercise responsible leadership.
They must also create new products and services and even re-create
the organization from time to time. A substantial part of management
responsibility is creative work driven by new knowledge and information.
Information technology can play a powerful role in helping managers
design and deliver new products and services and redirecting and
redesigning their organizations.

2.2 EMERGENCE OF MANAGEMENT INFORMATION SYSTEMS

As the business survives and grows, supervision of the activities
associated with it develops beyond the scope of one man. He finds that
he must be in more than one place at the same time to plan, direct,
coordinate, analyze, and control (i.e., to manage) all the different
activities of his enterprise. The face-to-face encounters for solving
problems, transferring information, and checking on performance that
were adequate when the business was very small become too
numerous and time-consuming. In other words, the one-man owner-

13
manager finds himself over his head in a complex network of interrelated
duties that must be discharged. His response is predictable and
practical. He recognizes his need for help if his business is to continue to
grow, and he hires another man to assist him in his management
functions. It should be recognized that because he was the sole owner-
manager, all his actions up to this point were, by definition,
management. But, with a second manager on this scene, managing
begins to require more definition.
Suddenly, problems of authority and responsibility, and communication
and organization, begin to assume serious proportions. Where does one
man’s area of authority and responsibility begin and where does the
others man’s end? Who tells whom to do what? Who reports to whom?
The whole spectrum of organizational problems appears on the horizon,
and the need for a Management Information System (MIS) begins to
take shape.
Ideally, the evolution of an MIS would be guided by knowledgeable
people, careful to structure the information system to meet the objectives
of the organization and the realities of its internal and external
environment. But experience indicates that an MIS evolves in fits and
starts to meet sudden and to respond to unforeseen crisis.
The result, as may be expected, is a system that grows with little
attention to the overall needs of the total organization. It usually takes
shape as a patchwork of information subsystems, some connecting with
others, some overlapping, some duplicating, and many working at cross-
purposes.
As the organization develops, the managers establish better
communications channels to meet their needs for accurate, timely
information. Formal, semiformal, and even informal reporting habits are
standardized, proceduralized, and scheduled. Information flows are
structured for early warning of problems, quick response to crisis, and
clear pathways for management directives to the critical action points of
the organization. A viable Management Information System is born!
The criterion for an effective Management Information System is that it
provides accurate, timely, and meaningful data for management
planning, analysis, and control to optimize the growth of the
organization. Neither the glamour of the equipment nor the
sophistication of the decision techniques can offset the failure of a
Management Information System to meet that test. It must enhance the
management of the organization.

14
 Figure 2.1 Management Information System

2.3 DEFINITION OF MANAGEMENT INFORMATION SYSTEMS

Information System-Webster Definition:

“Knowledge communicated by others or obtained by study and
Investigation”
Using this definition what are the source of information received by the
typical business? One important channel of information is the mail. Each
day hundreds or even thousands of items of information come into a
business via the United States post office. Much of this information is
routine-such as orders for products, invoices for material purchased,
confirmation of goods shipped, bills of lading, or checks in payment of
accounts. Some of the information entering a business through the mails
is less routine –for example letters of complaint, requests for job
interviews, or requests for information about former employees.
The definition of a management information system by Davis Olson as
the term is generally understood is an integrated, user-machine
interactive system for providing information to support operations,
management, and decision-making functions in an organization. The
system utilizes computer hardware and software; manual procedures;
models for analysis planning, control and decision making; and a
database. The fact that it is an integrated system does not mean that it is
single, monolithic structure; rather, it means that the parts fit into overall
design.

15
2.4 ELEMENTS OF MANAGEMENT INFORMATION SYSTEMS

Figure 2.2 Structure of MIS

The information system of an organization would be probably operates
on the following infrastructure. Inquiry may be processed in the
infrastructure to provide output to the users.

Information system is built by the following pillars (Infrastructure):

Hardware

Software

Procedures

Database

And Users [operational personnel, managers, system analyst etc.

Hardware
Hardware refers to physical computer equipment and associated
devices.

Hardware must provide for major functions:

Input and Output

Storage for data and programs

16
 Central processor (computation, control and primary storage)

Software
Software is broad term given to the instructions that direct the operation
of the hardware. The software can be classified into two major types:
system software and application software.

Database
The database contains all date utilized by application software. An
individual set of stored data is often referred to as a file. The physical
existence of stored data is evidenced by the physical storage media
(computer tapes, disk packs, diskettes, etc..) used for secondary
storage.

Procedures
Formal operating procedures are physical components because they
exist in a physical form such as a manual or instruction booklet. Three
major types of procedures are required.
1. User instructions (for users of the application to record data, or use
the result)

2. Operating instructions for computer personnel.

3. Non requiring information usually is not subject to automation.

Activity 1
Auto zip sells accessories for cars through a chain of stores on the West
Coast. The company started a catalog sales division 4 years ago that
now accounts for 25 percent of sales. Customers like the convenience of
calling a toll-free number and having the parts they delivered via UPS or
an overnight carrier such as Federal Express.
The president of Auto zip realizes that the firm needs to have a presence
on the internet. He is trying to decide whether to accept orders on the
web, and if so, how. He is caught between two positions offered by his
staff. The marketing vice president advocates taking orders on the Web.
Her reasoning is: What have we got to lose? We have everything to
gain; it’s another market channel and our competitors are already there
or will be soon. We save money because customers act as their own
order entry personnel.
The controller disagrees. His reasoning is: Any advantage we gain will
be temporary: it is so easy to set up a system to order on the web that
everyone will take Web orders and we won’t gain a sustainable
advantage.

17
The president has to make a decision. First, should Autozip accept
orders on the Web, and second, if so, how?

2.5 SCOPE OF MANAGEMENT INFORMATION SYSTEMS

Structurally an organization’s information systems are a collection of
business information systems for marketing, manufacturing, personnel,
purchasing and other business functions. Each of these basic business
functions comprises transaction level activities, routine decision making
and the occurrence of unique decision requirements and
office/departmental support applications. It makes sense that the various
business functions in an organization will need information systems
support. Managers realize that it is impossible and undesirable to
attempt to build a monolithic information system.
Management Information Systems develop in response to the needs of
management for accurate, timely and meaningful data in order to plan,
analyze and control the organization’s activities and thereby optimize its
survival and growth. The MIS accomplishes this mission for
management by providing means for input, helps management respond
to current and future changes in the internal and external environment of
the organization.

Financial Information
Every company has a financial information system .The basis of this
system is to plan and to find out the best way in tracking out the
accounting system and the methodology to be adopted in the financial
management to be followed by the organization.

Personnel Information
The personnel information system is concerned with the flow of
information about people working in organization. Almost every company
maintains records of its personnel.

Logistics Information
A logistic system like the other two major systems is principally
concerned with recurring, documentary, internal and historical
information of the solutions to the logistics.

Marketing Information
A marketing information system tends to help in handling the entire
activity of marketing and sales functions completely with the detail effort
of coordinating various information activities.

18
Research and Development
Many companies have management system for exchanging information
on the results of research findings and further research areas to the new
product development.
MIS is used in the field of Accounting, computer Science, Operational
research, Behavioral science and Management.

Figure 2.3 Scope of research

The value of information is rarely determined on the basis of the
information alone. Here we see where the information is from.
1. Meeting and Other Interpersonal Communications Such as

Immediate coworkers and staff

Peers form other functions

Task forces or ad hoc committees

Communication meetings

Meetings for ongoing committees

2. Characteristics of Effective Meeting

Communication

Management by walking around

Interactions

3. Reports: Useful & Otherwise

Research questions on reports

Types of information in reports

19
 Operating information

Status information

Benchmark comparisons

Reference information

Types of reports

Daily reports

Weekly reports

Monthly reports

Other reports

4. Electronic technologies

Internet and electronic media are used to communicate others.

The most common types of information systems used in business
organizations are electronic commerce systems, transaction processing
systems, management information systems, and decision support
systems. In addition, some organizations employ special-purpose
systems such as artificial intelligence systems, expert systems, and
virtual reality systems. Together, these systems help employees in
organizations accomplish both routine and special tasks-from recording
sales, to processing payrolls, to supporting decisions in various
departments, to providing alternatives for large-scale projects and
opportunities.

CASE STUDY
From Teaspoons to Satellites
In 1984, two young women and a man sat on their living room floor,
using teaspoons to fill jars and containers with skin care products. They
were the founder’s of Nu Skin International, a producer of additive-free
skin care products aimed at aging baby boomers. Initially Nu Skin’s
founders Blake. Roney and Sandie Tillotson promoted Nu Skin products
themselves. They sold their wares at mails and airports and to family
and friends- wherever people congregated.
Demand for the product spread like wildfire. Ten years later, Nu Skin’s
revenues have soared to over $500 million. Roney and Sandie Tillotson
preside over a vast network of Nu Skin distributors in Canada, Mexico,
Hong Kong, Taiwan, Japan, Australia, and New Zealand. While one Nu
Skin distributor hosts a live satellite broadcast to thousands of
distributors all across North America his Taiwanese counterpart can

20
transmit an order via voice mail on high-speed links to Nu Skin’s
headquarters in Provo, Utah. New technologies and information systems
have made that spectacular growth possible.
Without the cash or resources of giant cosmetics companies, Roney and
Sandie Tillotson, and other co-founders decided that they could build
their company through network marketing. Nu skin creates networks of
distributors who could be responsible for promoting and selling Nu Skin
products on a commission basis. Distributors in turn could create
“downlines” or networks of distributors working under them. Some
distributors have tens of thousands of people working under them on
three continents. To keep the distributors happy and the sales and
distribution network humming Nu Skin’s managers believed that it was
all important to get distributors their commission checks on time.
Nu Skin built a seamless compensation system. No matter how many
people or how many different countries were in a distributors “downlines”
empire, Nu Skin paid the distributor once a month with one check. (Most
other multi level marketing companies write the distributors one check
for each market. ) Nu Skin continually upgraded its information systems
to make sure that it could handle its sky rocketing volume of sales
transaction and commission checks as the company grew monthly at
double digit rates. Nu Skin upgraded its computer hardware and
software multiple times. The company now runs a $3.5 million Sequoia
mainframe computer that keeps records of every sales transaction for
the past fourteen months and calculates commissions for 250,000 active
distributors. Each distributor is eligible for commissions on six levels of
sales. The information system crunches the numbers and transmits the
results back to each Nu Skin market. It cuts checks in U.S dollars,
Australian dollars, Yen, Pesos- whatever the local currency is Nu Skin
also developed an application that translates prompts on the computer
screen into various foreign languages. If a distributor in Tokyo or Mexico
city needs to check personal and group sales volumes, he or she simply
calls the local office. An agent accesses the companies mainframe
computer, pulls up a screen in the appropriate language, and relays the
requested information directly back to the distributor, no translations are
needed.
Nu Skin developed a voice information program (VIP) to connect
distributors to its down lines. A distributor can use telephone, voice mail,
or facts for prospecting, recruiting and keeping in touch with its down
lines. A future called business card lets a prospective distributor call an
800 number and listen to a tape about Nu Skin business opportunities.

21
The system captures the prospect’s phone number so that the distributor
can immediately make a follow – up call. Some distributors, such as Lien
Yu Shing in Taiwan, use VIP every month to place their orders.
Within three years, Nu Skin plans to move into at least 6 to 12 new
countries, with the main push in Europe. The technological infrastructure
is in place. With its for- reaching information systems, Nu Skin can open
a new market in 90 days- without a teaspoon is sight.
Nu Skin’s reliance on information systems to drive its basic operations
demonstrates how information systems can help both small and large
companies compete in today’s global business environment. Information
systems help firms like Nu Skin extend their reach to faraway locations,
offer new products and services, reshape jobs and workflows, and
perhaps profoundly change the way they conduct business. Information
systems understanding are essential for today’s managers.

Will most organizations need information systems to survive?

LET US SUM UP
We have discussed the vital role of information in an organization. The
information systems have become essential for helping organizations
deal with changes in global economies and the business enterprise.
Information systems provide firms with communication and analytic tools
for conducting trade and managing business on a global scale.
Information systems are the foundation of new knowledge based
products and services in knowledge economies and help firms manage
their knowledge assets. Then the manager who is the organizer knows
all information, and talented person. He should have skill to manage
everything and have courage to solve problems. And he should be a
good communicator.
Powerful computers, software and networks, including the internet , have
helped organizations become more flexible, eliminate layers of
management , separate work from location, coordinate with suppliers
and customers, and restructure work flows, giving new powers to both
line workers and management. Information technology provides
managers with tools for more precise planning forecasting and
monitoring of the business. To maximize the advantages of information
technology, there is a much greater need to plan the organization’s
information architecture and information technology infrastructure.

22
CHECK YOUR PROGRESS

Choose the Correct Answer:

1. ________ is the Information about people working in organization.
a) Personnel Information b) Marketing Information

c) Financial Information d) Pricing information

2. __________ is a Characteristics of Effective Meeting.

a) Teaching b) Communication

c) Budgeting d) controlling

3. __________ reports are sent on daily basis

a) Daily reports b) Weekly reports

c) Monthly reports d) other reports
4. A __________ system tends to help in handling the entire activity of
marketing and sales functions

a) Marketing Information b) Personnel Information

c) Pricing Information d) Financial Information
5. An individual set of stored data is often referred to as a
file__________

a) Software b) Database

c) Storage Unit d) Compact Disk

GLOSSARY

Database : A database is a data structure that stores

organized information.
Most databases contain multiple tables,
which may each include several different
fields.

Business Management : Managing the coordination and

organization of business activities.

Data : Data is a collection of facts, such as

numbers, words, or even like
measurements, observations or just
descriptions of things.

Secondary storage : Refers to storage devices

23
 and storage media that are not always
directly accessible by a computer.

Operations : The actions and decisions made by

participants and members of a business
that affect the production, distribution,
service, management, etc.

Software : Instructions that tell a computer what to

do. Software comprises the entire set
of programs, procedures.

Production : Production is a process of combining

various material inputs and immaterial
inputs (plans, know-how) in order to
make something for consumption

SUGGESTED READINGS

1. Bentley Trevor J (1986) Management Information Systems &

data processing, 2nd edition, Holt, Rinehart and Winston
publications, University of California. ISBN 0039106888,
9780039106881.
2. Donald W. Kroeber (1986) Computer-Based Information
Systems: A Management Approach, Subsequent
edition, Macmillan Publications, University of Virginia. ISBN
0023668407, 9780023668401.
3. Gordon B.Davis (2013) Management Information Systems, 1 st
Edition, TMH Publications, India. ISBN 007066241X.
4. Joel E. Ross (1970) Management by Information System,
illustrated edition, Prentice-Hall publications, University of
Wisconsin,ISBN 0135486289, 9780135486283.
5. Kenneth C. Loudon & Jane P. Loudon (2014) Management
Information Systems, 13th Edition, Pearson Publications, USA.

ANSWERS TO CHECK YOUR PROGRESS

1) a 2) b 3) a 4)a 5)b

24
Unit 3

CONCEPTS OF SYSTEM AND

ORGANIZATIONS
STRUCTURE

Overview

Learning Objectives

3.1 Organization

3.2 Types of Organization

3.3 Benefits of Organization

3.4 Information flow in an Organization

Let Us Sum Up

Glossary

Check Your Progress

Suggested Readings

Answers to check your progress

OVERVIEW
It is often said that good people can make organization pattern work.
Some even assert that vagueness in organization is a good thing in that
it forces teamwork, however, there can be no doubt that good people
and those who want to cooperate will work together most effectively if
they know the parts they are to play in any team operation and the way
their roles relate to one another. This is as true in business or
government as in football or in a symphony orchestra. Designing and
maintaining these systems of roles is the managerial function of
organizing.

In this sense that we think of organization as

• The identification and classification of required activities
• The grouping of activities necessary to attain objectives
• The assignment of each grouping to a manager with the authority
necessary to supervise it, and
• The provision for coordination horizontally and vertically in the
organization structure.

25
LEARNING OBJECTIVES

After reading this unit, you should be able to

• define the organisation
• classify the organization
• classify the types of organization and explain the benefits of
organization.

3.1 ORGANISATION

Figure 3.1 Organizational Chart

According to Lewis H. Haney, “Organization is a harmonious
adjustment of specialized parts for the accomplishment of some
common purpose or purposes”.
Louis A. Allen has defined organization as “the process of identifying
and grouping the work to be performed, defining and delegating
responsibility and authority and establishing relationship or the purpose
of enabling people to work most effectively together in accomplishing
objectives”.

Organization can also be defined as

Determining what tasks are to be done, who is to do them, how the tasks
are to be grouped, who reports to whom, and where decisions are to be
made.

26
 It is a management function involving assigning duties, grouping
tasks, delegating authority and responsibility and allocating resources to
carry out a specific plan in an efficient manner.
Process of identifying and grouping the work to be performed,
defining and delegating responsibility and authority and establishing
relationships for the purpose of enabling people to work most effectively
together in accomplishing objectives.
In a nutshell, organization refers to grouping of activities and
resources in a logical fashion.
Organization aims at finding out the objectives, grouping the activities
aimed at theory achievement, assigning them for performance and
coordinating them. It is important for the following reasons.
a) Organizations pervade all the important phases of human life. A
man is born in organization (hospitals and clinics). He is educated in an
organization (schools, colleges and universities). He works in an
organization (office factories and business).

b) Knowledge of organization helps the manager to work effectively.

c) Organization satisfies and sometimes frustrates, if is not well
organized.

3.2 TYPES OF ORGANIZATION

The two types of an organization are

Formal organization

Informal organization

Figure 3.2 Types of Organization

Formal Organization
Formal organization means the intentional structure of roles in a formally
organized enterprise. Describing an organization as “formal” however
does not mean there is anything inherently inflexible or unduly confining

27
about it. If a manager is to organize well, the structure must furnish an
environment in which individual performance, both present and future,
contributes most effectively to group goals.
Formal organization must be flexible. There should be room for
discretion, for advantageous utilization of creative talents, and for
recognition of individual likes and capacities in the most formal of
organizations. Yet individual efforts in a group situation must be
channeled toward group and organization goals.
Although the attainment of goals must be the reason for any cooperative
activity, we must look further for principles to guide the establishment of
effective formal organization. These principles pertain to the unity of
objectives and organizational efficiency.

Informal Organization
Chester Barnard, author of the management classics. “The Functions
of the Executive,” described informal organization as many joint personal
activity without conscious joint purpose, even though contributing to joint
results. Thus the informal relationships established i n the group of
people playing chess during lunchtime may aid in the achievement of
organizational goals. It is much easier to ask for help on an organization
problem from someone you know personally, even if she may be in a
different department, than from someone you know only as a name on
an organization chart. More recently, Keith Davis of Arizona State
University, who has written extensively on the topic and whose definition
will be used here as described the informal organization as a network of
personal and social relations not established or required by the formal
organization but arising spontaneously as people associate with one-
another. Thus, informal organization –relationships not appearing on an
organization chart-might include the machine shop group, the sixth floor
crowd, the Friday evening bowling gang, and the morning coffee
regular’s.

3.3 BENEFITS OF ORGANIZATION

The process of organizing helps an individual to develop a clear
picture of the tasks he or she is expected to accomplish.
The process of organizing supports planning and control activities by
establishing accountability and an appropriate line of authority.
Organizing creates channels of communication and thus supports
decision-making and control.

28
 The process of organizing helps maintain the logical flow of work
activities. By doing so, it helps individuals and workgroups to easily
accomplish their tasks.
Organizing helps an organization to make efficient use of its resources
avoid conflict and duplication of effort.
Organization coordinates activities that are diverse in nature and helps
to build harmonious relationships among members involved in those
activities.
The process of organizing helps to managers to focus task efforts such
that they are logically and efficiently related to a common goal.

3.4 INFORMATION FLOW IN AN ORGANIZATION

Hierarchy is the existence of superior/ subordinate relationships,
resulting in a “chain of command“; this means that multiple “levels“ of
personnel exists in an organization. In a small organization perhaps
there are only two levels: the owner-boss and a few employees. In a
large organization many levels: at the lowest level are workers, who
carry out the primary activities; at the second level are group leaders,
department heads, or supervisors; at the middle level there is a series of
managers; and at the highest level there is a superstructure of division
heads, vice presidents, senior vice presidents, and president reports to
the board of directors, the highest level as a company.
In a large organization a dozen or more hierarchical levels may be
present. A chart of organization for medium-sized company is shown in
figure 3.1. Only the marketing, accounting, and information systems
functions are portrayed in detail. The hierarchy of an organization affects
its information systems; the hierarchical structure is the fundamental
framework around which the information system is organized. With few
expectations and without regard to what other information flows may
also exist, the information system is organized to pass information
upward along the lines of the hierarchy. Information is usually
summarized at each level as it flows up; information provided by
organization units at one level is combined at that level and then flows
up to the next level, and at that next level a similar combining and
upward flow takes place. Thus fewer details are provided to each
successively higher level.
Information also flows downward along hierarchical lines in the form of
directives, policies, and action guidelines; these types of information are
less likely to be generated by the computer system and are usually
downward flows constitute an important part of information and

29
communication systems because they channel and direct the activities
of managers at each lower level.
The major organization unit that is concerned with the development of
information systems usually is the computer information systems
department, which is often unaware of the importance of downward-
flowing information and which devotes none of its systems development
efforts to this information flow. When these downward flows are not
properly developed, managers at each level usually are consistent in
their criticism of “the lack of communication from above.” Downward -
flowing information systems merit more attention on the part of both
managers and information systems specialists.
Information flows are not restricted to paths up and down the hierarchy.
Information also flows laterally within an organization, particularly in
transactions processing information system. These lateral information
flows are often extensive, and they help explain the complexity of
information systems in organizations.
People in any work setting, large or small, must have available to them
the right information at the right time and in the right place if they are to
perform effectively. This is made possible by information systems that
use the latest in information technology to collect, organize, and
distribute data in such a way that they become meaningful as
information. Such systems have the potential to make major
contributions to performance in organizations. However the following
factors are considered essential to their success:

Technical quality of the system

Participation and involvement of users in the system design and

Management support

Activity 1
A car company was in trouble. It become clear that it had to compete not
only against U.S carmakers but also against auto manufacturers
throughout the world. Drastic steps were necessary. One of the best way
was to replace the bureaucratic structure. Previously it took 5 years to
produce a new model. The old approaches are as follows: the product
Planners developed the general concept of the new model, which was
then given to the designers. After that, engineers got involved,
developing specifications for manufacturing and for various suppliers .
This process was sequential, with little communications, among the
groups. If a problem was discovered at the manufacturing stage,

30
designers & engineers had to be involved in again doing the problem.
What changes can be in order to compete with other companies?

LET US SUM UP
Over time, information systems have come to play a larger role in the life
of organizations. There is a growing interdependence between business
strategy, rules, and procedures, on the other hand, and information
systems software, hardware, data, and telecommunications, on the
other. A change in any of these components often requires changes in
other components. This relationship becomes critical when management
plans for the future. What a business would like to do in 5 years is often
dependent on what its systems will be able to do.

CHECK YOUR PROGRESS

Choose the Correct Answer:

1. Grapevine communication exists more in __________

a) Formal organization b) Informal organization

c) Industrial organization d) semi-formal organization

2. Roles are clearly defined in the ____________

a) Formal organization b) Informal organization

c) Industrial organization d) semi-formal organization

3. Flexibility is seen more in __________ organizations

a) Formal organization b) Informal organization

c) Industrial organization d) semi-formal organization

4. __________ of organization helps the manager to work effectively.

a) Place b) Management

c) Information system d) Database

5. The process of organizing helps maintain the ________ of work
activities.

a) Logical flow b) analytical flow

c) Procedural flow d) systematic flow

GLOSSARY

Computer : Computer is an electronic device

which is used for fast calculation..

31
Marketing : Marketing is the process of
interesting potential customers and
clients in your products and/or
services.

Finance : Finance is a broad term that

describes activities associated with
banking, leverage or debt, credit,
capital markets, money, and
investments.

Logistics : Logistics refers to the overall

process of managing how
resources are acquired, stored,
and transported to their final
destination.

Operations : The actions and decisions made

by participants and members of a
business that affect the production,
distribution, service, management,
etc.

Input: : Input is to provide or give

something to the computer, in
other words, when a computer or
device is receiving a command or
signal from outer sources, the
event is referred to as input to the
device.

SUGGESTED READINGS
1. Bentley Trevor J (1986) Management Information Systems &
data processing, 2nd edition, Holt, Rinehart and Winston
publications, University of California. ISBN 0039106888,
9780039106881.
2. Donald W. Kroeber (1986) Computer-Based Information
Systems: A Management Approach, Subsequent
edition, Macmillan Publications, University of Virginia. ISBN
0023668407, 9780023668401.
3. Gordon B.Davis (2013) Management Information Systems, 1 st
Edition, TMH Publications, India. ISBN 007066241X.

32
 4. Joel E. Ross (1970) Management by Information System,
illustrated edition, Prentice-Hall publications, University of
Wisconsin,ISBN 0135486289, 9780135486283.
5. Kenneth C. Loudon & Jane P. Loudon (2014) Management
Information Systems, 13th Edition, Pearson Publications, USA.

ANSWERS TO CHECK YOUR PROGRESS

1) b 2) a 3) b 4) c 5)a

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Unit 4

STRATEGIC USES OF INFORMATION

TECHNOLOGY
STRUCTURE

Overview

Learning Objectives

4.1Strategic Uses of Information Technology

4.2 Modern Information Systems in Organization

4.2.1 Transaction Processing Systems

4.3 Knowledge Work and Office Automation Systems

4.4 Management Information System

4.4.1 Characteristics of MIS

4.5 Systems Concept

4.6 Sales and Marketing Systems

4.7 Manufacturing and Production Systems

4.8 Finance and Accounting Systems

4.9 Human Resources Systems

Let Us Sum Up

Glossary

Check Your Progress

Suggested Readings

Answers to check your progress

OVERVIEW
Management information systems are built for use by an identified
organization. Hence it is very important to understand the organization -
its primary goals and objectives, structure, dynamics, scale of operation,
culture, tradition, social setting, level of competition, value system and
the environment. An MIS well designed from the technical
considerations may fail if the dynamics of the organization are not
properly understood. In this chapter we will present a quick overview of
modern organizations and concept of system.

34
LEARNING OBJECTIVE

After reading this unit, you should be able to,

• explain the Management Information System concept
• categorize the types of information system
• explain the concept of system.

4.1 STRATEGIC USES OF INFORMATION TECHNOLOGY

Information technology plays an important role in delivering value for a
business and supporting organizational transformation. To achieve
that, chief information officers have become key members of board
teams developing and delivering strategic solutions for the business.
The aim is to make an organization more competitive by aligning
business strategy with IT strategy.

Support Innovation
Organizations that want to improve their innovation capabilities and
develop new products or services for the market can use cloud
computing to speed up the process. Cloud computing enables
organizations to rent additional IT resources during the development
project on a pay-as-you-go basis, rather than investing in fixed
resources. Organizations can use the additional resources to run pilot
programs or speed up development. This provides an important strategic
advantage by enabling the organization to get new products to market
quickly, ahead of the competition.

Improve Responsiveness
Cloud computing enables organizations to scale up their IT resources
quickly in response to changing market conditions. Organizations that
offer products and services online may find it difficult to handle a surge
in traffic, which could result in lost business. Adding resources from the
cloud provides a strategic advantage by enabling them to respond to
changes in demand, increase revenue and maintain customer
satisfaction.

Increase Collaboration
IT solutions that improve collaboration in an organization can provide an
important competitive advantage. Issuing field service teams with smart
phones, for example, enables service engineers to provide a faster,
more efficient service to customers. Engineers working on a customer
site can set up voice or video conference calls with product or technical
experts at headquarters to discuss and resolve a complex issue, rather

35
than delaying a repair. Offering customer superior service provides a
strategic advantage by differentiating an organization from competitors.

Enhance Customer Insight

Collecting and analyzing data to gain greater insight into customers’
needs and preferences provides a strategic advantage. By using
powerful analytics software, organizations can develop customized
offers and personalized communications that help to increase customer
satisfaction and foster loyalty.

Introduce New Business Models

Organizations can use IT to make strategic changes to their business
models. A company that traditionally sold products through retail outlets
might use IT to develop an e-commerce model that enables it to reach a
wider market, reduce its distribution costs and offer a more convenient
service to customers.

4.2 MODERN INFORMATION SYSTEMS IN ORGANIZATION

There are 4 main types of information systems serving different
organizational levels; operational level systems, knowledge level
systems, management level systems, and strategic level systems.

Figure 4.1 Modern Information Systems in Organization

Operational-level systems support operational managers by keeping
track of the elementary activities and transactions of the organizations,
such as sales, receipts, cash deposits, payroll, credit decisions, and the
flow of materials in a factory. The principle purpose of systems at this
level is to answer routine questions and to track the flow of transactions
through the organization. How many parts are in inventory? What is the
size of the payroll this month? To answer these kinds of questions,
information generally must be easily available, current, and accurate.

36
Examples of operational level systems include a system to record bank
deposits from automatic teller machines or one that tracks the number of
hours worked each day by employees on a factory floor.
Knowledge-level systems support knowledge and data workers in an
organization. The purpose of knowledge level systems is to help the
business firm integrate new knowledge into the business and to help the
organization control the flow of paper work. Knowledge level systems,
especially in the form of work stations and office systems, are the
fastest-growing applications in business today.
Management-level systems are designed to serve the monitoring,
controlling, decision making, and administrative activities of middle
managers. The principal question addressed by such systems is: Are
things working well? These systems compare the current days’ output
with that of a month or year ago. Management level systems typically
provide periodic reports rather than instant information on operations.
Strategic-level systems help senior management tackle and address
strategic issues and long term trends, both in the firm and in the external
environment. Their principal concern is matching changes in the external
environment with existing organizational capability. What will
employment levels be in five years? What products should we be
making in five years?
Information systems may also be differentiated by functional specialty.
Major organizational functions, such as sales and marketing,
manufacturing, finance, accounting, and human resources, are each
served by their own information systems.
There are six major types of information systems in contemporary
organizations:

Transaction processing system (TPS) at the operational level.

Knowledge work systems (KWS) and

Office automation systems (OAS) at the knowledge level.

Management information systems (MIS) and

Decision support systems (DSS) at the management level.

Executive support systems (ESS) at the strategic level

37
 Figure 4.2 Six major types of information systems
4.2.1 Transaction Processing Systems
Transaction processing systems are the basic business systems that
serve the operational level of the organization. A transaction processing
system is a computerized system that performs and records the daily
routine transactions necessary to the conduct of the business. Examples
are sales order entry, hotel reservation systems, client information (for
public agencies), payroll, employee record keeping, and shipping.
At the operational level, tasks, resources, and goals are predefined and
highly structured. The decision to grant a credit to a customer, for
instance, is made by a lower level supervisor according to predefined
criteria. The decision, in that sense, has been “programmed”. All that
must be determined is whether the customer meets the criteria. Two
features of TPS are noteworthy. First, many TPS span the boundary
between the organization and its environment. They connect customers
to the firm’s ware house, factory, and management. If TPS do not work
well, the organization fails either to receive inputs from the environment
(orders) or to deliver outputs (assembled goods). Second, TPS are
major procedures of information for the other types of systems. TPS can
be viewed as “organizational message processing systems”, informing
managers about the status of internal operations and about the firm’s
relations with the external environment and supporting other information
systems that facilitate management decision making.

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4.3 KNOWLEDGE WORK AND OFFICE AUTOMATION SYSTEMS
KWS and OAS serve the information needs at the knowledge level of the
organization. Knowledge work systems aid knowledge workers, whereas
office automation systems primarily aid data workers (although they are
also used extensively by knowledge workers).
In general, knowledge workers are people who hold formal university
degrees and who are all often members of a recognized profession, like
engineers, doctors, lawyers, and scientists. Their jobs consist primarily
of creating new information and knowledge. Data workers typically have
less formal, advanced educational degrees and tend to process rather
than create information. They consist primarily of secretaries,
accountants, filing clerks, or managers whose jobs are principally to use,
manipulate, or disseminate information. Office automation systems are
information technology applications designed to increase the productivity
of data workers in the office by supporting the coordinating and
communicating activities of the typical office. OAS coordinate diverse
information workers, geographic units and functional areas: the systems
communicate with customers, suppliers, and other organization outside
the firm, and serve as a clearing house for information and knowledge
flows.
Typical office automation systems handle and manage documents
(through word processing, desktop publishing, and digital filing),
scheduling (through electronic calendars), and communication (through
electronic mail, voice mail, or video conferencing). Word processing
refers to the software and hardware that creates, edits, formats, stores,
and prints documents. Desktop publishing produces professional
publishing quality documents by combining output from word processing
software with design elements, graphics, and special layout features.
The role of knowledge work and office automation systems in the firm
cannot be underestimated. As the economy shifts from relying on
manufactured goods to producing services, knowledge, and information,
the productivity of individual firms and the entire economy will
increasingly depend on knowledge level systems. This is the one reason
knowledge level systems have been the fastest growing applications
over the last decade and are likely to grow in future.

4.4 MANAGEMENT INFORMATION SYSTEM

A MIS is an integrated, user-machine system for providing information to
support operations, management, and decision making functions in an
organization. The system utilizes computer hardware and software;
manual procedures; models for analysis, planning, control and decision

39
making and a data base. The purpose of a computer based information
system is to collect, store , and disseminate information from an
organization’s environment and internal operations for the purpose of
supporting organizational functions and decision making,
communication, coordination, control, analysis and visualization.
MIS serve the management level of the organization, providing
managers with reports and in some cases, with online access to the
organization’s current performance and historical records. Typically, they
are oriented almost exclusively to internal, not environmental or external,
events. MIS primarily serve the functions of planning, controlling and
decision making at the management level. Generally they are dependent
on underlying transaction processing systems for their data.
MIS summarize and report on the basic operations of the company. The
basic transaction data from TPS are compressed and are usually
presented in long reports that are produced on a regular schedule. MIS
usually serves managers interested in weekly, monthly, and yearly
results not day-to-day activities.

4.4.1 Characteristics of MIS

MIS support structured and semi structured decision at the operational
and management control levels. However they are also useful for
planning purposes of senior management staff.

MIS rely on existing corporate data and data flows.

MIS have little analytical capability.

MIS generally aid in decision making using past and present data.
MIS are relatively inflexible.

MIS require a lengthy analysis and design process.

Information requirements are known and stable.

4.5 SYSTEMS CONCEPT

Figure 4.5 relationships between different IS

40
 Figure 4.6 TPS and MIS
Above figures illustrates how the systems serving different levels in the
organization are related to one another. TPS are typically a major source
of data for other systems, whereas ESS is primarily a recipient of data
from lower-level systems. The other types of systems may exchange
data with each other as well.
Data may also be exchanged among systems serving different
functional areas. For example, an order captured by sales system may
be transmitted to a manufacturing system as a transaction for producing
or delivering the product specified in the order.
It is definitely advantageous to have some measure of integration among
these systems so that information can flow easily between different parts
of the organization.
But integration costs money, and integrating many different systems is
extremely time consuming and complex. Each organization must weigh
its needs for integrating systems against the difficulties of mounting a
large-scale systems integration effort.
Information systems can be classified by the specific organizational
function they serve as well as by organizational level. We now describe
typical information systems that support each of the major business
functions and provide examples of functional applications for each
organizational level.

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4.6 SALES AND MARKETING SYSTEMS

Table 4.1 Examples of Manufacturing And Production Information

Systems

System Description Organizational Level

Order processing Enter, process, and Operational

Track orders

Market analysis Identify customers and Knowledge

markets using data on
demographics,
markets, consumer
behavior, and trends.

Pricing analysis Determine prices for Management

products and services

Sales trend Prepare 5-year sales Strategic

forecasting forecast

The sales and marketing function is responsible for selling the

organization’s products or services. Marketing is concerned with
identifying the customers for the firm’s products or services, determining
what they need or want, planning and developing products and services
to meet their needs, and advertising and promoting these products and
services.
Sales are concerned with contacting customers, selling the products
and services, taking orders, and following up on sales. Sales and
marketing information systems support these activities.
Below shows that information systems are used in sales and marketing
in a number of ways. At the strategic level, sales and marketing systems
monitor trends affecting new product and sales opportunities, support
planning for a new products and services, and monitor the performance
of competitors.
At the management level, sales and marketing systems support
advertising and promotional campaigns and pricing decisions. They
analyze sales performance and the performance of the sales staff.
Knowledge-level sales and marketing systems support market research
and marketing analysis workstations.

42
At the operational level, sales and marketing systems assist in locating
and contracting prospective customers, tracking sales, processing
orders, and providing customer service support.
It shows the output of a typical sales information system at the
management level. The system consolidates data about each item sold
(such as the product code, product description, and amount of sales) for
further management analysis.
Company managers examine these sales data to monitor sales activity
and buying trends. The window on Management describes some typical
sales and marketing systems that might be found in a small business.

4.7 MANUFACTURING AND PRODUCTION SYSTEMS

The manufacturing and production function is responsible for actually
producing the firm’s goods and services. Manufacturing and production
activities deal with the planning, development, and maintenance of
production facilities.
And also the establishment of production goals; the acquisition, storage,
and availability of production materials; and the scheduling of
equipment, facilities, materials, and labor required to fashion finished
products.
Manufacturing and production information systems support these
activities. Table shows some typical manufacturing and production
information systems arranged by organizational level.
Strategic-level manufacturing systems deal with the firm’s long-term
manufacturing goals, such as where to locate new plants or whether to
invest in new and manufacturing technology.
At the management level, manufacturing and production systems
analyze and monitor manufacturing and production costs and resources.
Knowledge manufacturing and production process, and operational
manufacturing and production systems create and distribute design.
knowledge or expertise to drive the production process, and operational
manufacturing and production systems deal with the status of production
tasks.

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Table 4.2 Examples of Manufacturing And Production Information
Systems

System Description Organizational

Level

Machine control Control the actions of Operational

machines and equipment

Computer-aided Design new products Knowledge

design (CAD) using the computer

Production planning Decide when and how many Management

Products should be produced

Facilities location Decide where to locate Strategic

new production facilities

Data about each item in inventory, such as the number of units depleted
because of a shipment or purchase or the number of units replenished
by reordering or returns, are either scanned or keyed into the system.
The inventory master file contains basic data about each item, including
the unique identification code for each item, the description of the item,
the number of units on hand, the number of units on order, and the
reorder point (the number of units in inventory that triggers a decision to
reorder to prevent a stock out). Companies can estimate the number of
items to reorder or they can use a formula for calculating the least
expensive quantity to reorder called the economic order quantity. The
system produces reports such as the number of each item available in
inventory, the number of units of each item to reorder, or items in
inventory that must be replenished.

4.8 FINANCE AND ACCOUNTING SYSTEMS

The finance function is responsible for managing the firm’s financial
assets, such as cash, stocks, bonds, and other investments, in order to
maximize the return on these financial assets. The finance function is
also in charge of managing the capitalization of the firm (finding new
financial assets in stocks, bonds or other forms of debt). In order to
determine whether the firm is getting the best return on its investment,

44
the finance function must obtain a considerable amount of information
from sources external to the firm.
The accounting function is responsible for maintaining and managing the
firm’s financial records-receipts, disbursements, depreciation, payroll-to
account for the flow of funds in a firm. Finance and accounting share
related problems-how to keep track of a firm’s financial assets and fund
flows. They provide answers to questions such as these: What is the
current inventory of financial assets? What records exist for
disbursements, receipts, payroll, and other fund flows?
Table 4.3 shows some of the typical finance and accounting information
systems found in large organizations. Strategic-level systems for the
finance and accounting function establish long-term investment goals for
the firm and provide long-range forecasts of the firm’s financial
performance. At the management level, information systems help
managers oversee and control the firm’s financial resources. Knowledge
systems support finance and accounting by providing analytical tools
and workstations for designing the right mix of investments to maximize
returns for the firm. Operational systems in finance and accounting track
the flow of funds in the firm through transactions such as paychecks,
payments to vendors, securities reports, and receipts. Review Figure
4.3, which illustrates a payroll system, a typical accounting TPS found in
all businesses with employees.

Table 4.3 Examples of Finance and Accounting Information

Systems

System Description Organizational Level

Accounts receivable Track money owed the firm Operational

Portfolio analysis Design the firm’s portfolio of Knowledge

investments

Budgeting Prepare short-term budgets Management

Profit planning Plan long-term profits Strategic

4.9 HUMAN RESOURCES SYSTEMS

The human resources function is responsible for attracting, developing,
and maintaining the firm’s workforce. Human resources information
systems activities such as identifying potential employees, maintaining

45
complete records on existing employees, and creating programs to
develop employees’ talents and skills.
Strategic-level human resources systems identify the employee
requirements (skills, educational level, types of positions, number of
positions, and cost) for meeting the firm’s long-term business plans. At
the management level, human resources systems help managers
monitor and analyze the recruitment, allocation, and compensation of
employees. Knowledge systems for human resources support analysis
activities related to job design, training, and the modeling of employee
career paths and reporting relationships. Human resources operational
systems track the recruitment and placement of the firm’s employees.
Human resources TPS for employee record keeping maintains basic
employee data, such as the employee’s name, age, sex, marital status,
address, educational background, salary, job title, date of hire, and date
of termination. The system can produce a variety of reports, such as lists
of newly hired employees, employee who are terminated or on leaves of
absence, employees classified by job type or educational level, or
employee job performance evaluations. Such systems are typically
designed to provide data that can satisfy federal and state record
keeping requirements for Equal Employment Opportunity (EEO) and
other purposes.

CASE STUDY
The West American Hospital Association is an organization of hospitals
in the greater Los Angeles area, including Palm Springs and San Diego
to the east and south and kern county to the north. Included among its
several activities are support of research projects at laboratories at
several hospitals and medical schools, dissemination of research
findings, and provision of medical specialists to outlying, smaller
institutions.
Of growing concern to the association has been the problem of whole
blood distribution among the hospitals in the southern California area.
Blood supplies are maintained by most hospitals but, through necessity
brought by perishability and uncertain demand, these are small in
quantity and often do not include an adequate representation of different
blood types. As a result, most hospitals particularly the smaller ones,
often find it necessary to locate quantities of whole blood on an
emergency basis, telephoning each nearby hospital and supply point
until some can be found with which the holding institution can part
without endangering their own operations. Delivery is affected by
automobile. This procedure is time consuming and expensive.

46
The problem of the association is rectified by a computer system which
has been installed by the Los Angeles Metropolitan hospital. That
hospital has installed a fairly large computer system for research,
statistical and operational uses and has offered the services of this
system to the Hospital Association for purposes the association deems
appropriate. The computer system has the ability to handle
teleprocessing on a real time basis. This means the computer users can
enter data, programs, and perform other work with the system using
remote terminals that employ typewriters or other input-output devices. A
perspective user need only dial the appropriate number on a telephone
associated with his terminal and he has the use of system through his
input output device, which is connected to the computer by telephone
lines. The computer system operates so fast that many such terminals
can be using the computer at once with no appreciable time delay for
anyone user. Moreover, the computer system is able to handle these
teleprocessing functions while at the same time performing the tasks
required of it by metropolitan hospital of Los Angeles.
The hospital Association is considering the establishment of a
centralized whole blood distribution center to serve the emergency
needs of the member of the hospitals. Blood of each type must be
replenished each day to bring it to specified quantity. All withdrawals and
receipts must be immediately recorded so that any hospital can
determine immediately the type and amounts of blood available.
Deliveries can be made on an emergency basis by helicopter provided
by the California highway patrol. The association has hired a professor
from a nearby college with an extensive data processing program to
advise it as to how the computer system at Los Angeles Metropolitan
hospital could be used in the operation of the centralized blood bank
system.

LET US SUM UP
One reason why information systems play a larger role in organizations,
and why they affect more people, is the growing power and declining
cost of information technology- the computers and peripheral devices
that make up the core of information systems. Today because of the
growing technology, many new hardware and software have come into
exist. This new hardware power makes powerful, easy to use software
available to complete novices. In a few hours, relatively unskilled
employees can be taught word processing, project scheduling, spread
sheet preparation, and telecommunication applications on a
microcomputer. Now it is possible for end users to design their own

47
applications and simple systems without the help of professional
programmers.

CHECK YOUR PROGRESS

Choose the Correct Answer:

1. _____________help senior management tackle and address

strategic issues in a firm.

a)Strategic-level systems b)Operational-level systems
c) Management-level systems d) financial -level system.
2. The _________is responsible for maintaining and managing the firm’s
financial records-receipts, disbursements, depreciation, payroll-to
account for the flow of funds in a firm.

a) Marketing function b) Accounting Function

c) Managerial function d) Sales function

3. __________ is used by senior managers to make important decisions.

a) Executive-support systems b) Decision-support systems

c) Sales Systems d) Accounting system

4. The ___________ is responsible for selling the organization’s
products or services.

a) Sales and marketing function b) Accounting function

c) Managerial function d) Personnel function

5) Identifying potential employees, maintaining complete records on
existing employees is maintained by__________

a) Strategic-level systems b) HRIS

c) Operational-level systems d) Management-level systems

GLOSSARY

TPS : An information processing system for

business transactions involving the
collection, modification and retrieval
of all transaction data.

DSS : A decision support system (DSS) is

a computerized program used to
support determinations, judgments,
and courses of action in an

48
 organization or a business.

MIS : Management Information

Systems (MIS) is the study of
people, technology, organizations,
and the relationships among them.

System Concept : System concept of MIS is, therefore

one of optimizing the output of
the organization by connecting the
operating subsystems through the
medium of information exchange.

SUGGESTED READINGS
1. Kenneth C. Loudon & Jane P. Loudon (2014) Management
Information Systems, 13th Edition, Pearson Publications, USA.
2. Gordon B.Davis (2013) Management Information Systems, 1st
Edition, TMH Publications, India. ISBN 007066241X
3. Bentley Trevor J (1986) Management Information Systems &
data processing, 2nd edition, Holt, Rinehart and Winston
publications, University of California. ISBN 0039106888,
9780039106881.
4. Donald W. Kroeber (1986) Computer-Based Information
Systems: A Management Approach, Subsequent
edition, Macmillan Publications, University of Virginia. ISBN
0023668407, 9780023668401.
5. Joel E. Ross (1970) Management by Information System,
illustrated edition, Prentice-Hall publications, University of
Wisconsin,ISBN 0135486289, 9780135486283.

ANSWERS TO CHECK YOUR PROGRESS

1) a 2) b 3) a 4)a 5)b

49
 BLOCK 2

COMPUTER SYSTEM RECOURSES

Unit 5: Computer Hardware

Unit 6: Computer Software

Unit 7: Database Management System

Unit 8: Distributed System

50
Unit 5

COMPUTER HARDWARE
STRUCTURE

Overview

Learning Objectives

5.1 Computer Hardware

5.1.1 CPU and Primary Storage

5.1.2 Arithmetic-Logic and Control Unit

5.1.3 Primary Storage

5.1.4 Secondary Storage

5.1.5 Input Devices

5.1.6 Output Devices

5.2 Classifications of Computers

5.3 Hardware Technology Requirements for Electronic Commerce

and the Digital Firm

Let Us Sum Up

Glossary
Check Your Progress

Suggested Readings

OVERVIEW
Computer system includes both hardware and software. Computer
hardware includes central processing unit, storage unit, input devices
and output devices. Any organization and management should possess
right knowledge about Computer Hardware and its usage in the
Organization for a successful business with Information Technology

LEARNING OBJECTIVES

After reading this unit, you should be able to,

• explain the components of hardware
• classify the types of computers
• differentiate between primary and secondary storage units.

51
5.1 COMPUTER HARDWARE
The hardware components of a computer system consist of five main
elements. They are,

1. Central processing unit

2. Primary storage

3. Secondary storage

4. Input devices

5. Output devices.
The central processing unit manipulates raw data into a more useful
form and controls the other parts of the computer system. Primary
storage temporarily stores data and program instructions during
processing, whereas secondary storage devices store data and
programs when they are not being used in processing. Input devices,
such as a keyboard or mouse, convert data and instructions into
electronic form for input into the computer. Output devices, such as
printers and video display terminals, convert electronic data produced by
the computer system and display them in a form that people can
understand. Communications devices provide connections between the
computer and communications networks. Buses are circuitry paths for
transmitting data and signals among the parts of the computer system.

5.1.1 CPU and Primary Storage

The central processing unit (CPU) is the part of the computer system
where the manipulation of symbols, numbers, and letters occurs, and it
controls the other parts of the computer system. Located near the CPU
is primary storage, where data and program instructions are stored
temporarily during processing. Three kinds of buses link the CPU,
primary storage, and the other devices in the computer system. The data
bus moves data to and from primary storage. The address bus transmits
signals for locating a given address in primary storage, indicating where
data should be placed. The control bus transmits signals specifying
whether to read or write data to or from a given primary storage address,
input device, or output device. The characteristics of the CPU and
primary storage are very important in determining a computer’s speed
and capabilities.

5.1.2 Arithmetic-Logic and Control Unit

The arithmetic-logic unit (ALU) performs the computer’s principal logical
and arithmetic operations. It adds, subtracts, multiplies, and divides,

52
determining whether a number is positive, negative, or zero. The control
unit coordinates and controls the other parts of the computer system. It
reads a stored program, one instruction at a time, and directs other
components of the computer system to perform the program’s required
tasks.

5.1.3 Primary Storage

Primary storage has three functions. It stores all or part of the program
that is being executed. Primary storage also stores the operating system
programs that manage the operation of the computer. Finally, the
primary storage area holds data that the program is using. Data and
programs are placed in primary storage before processing, between
processing steps, and after processing have ended, prior to being
returned to secondary storage or released as output.
Internal primary storage is often called RAM, or random access memory.
It is called RAM because it can directly access any randomly chosen
location in the same amount of time. RAM is volatile: its contents will be
lost when the computer’s electric supply is disrupted by a power outage
or when the computer is turned off. ROM, or read-only memory, can only
be read from; it cannot be written to. ROM chips come from the
manufacturer with programs already built in, or stored. ROM is used in
general-purpose computer to store important or frequently used
programs, such as computing routines for calculating the square roots of
numbers.

Figure 5.1 Primary Storage & Secondary Storage

5.1.4 Secondary Storage

Most of the information used by a computer application is stored on
secondary storage devices located outside of the primary storage area.
Secondary storage is used for relatively long-term storage of data
outside the CPU. Secondary storage is nonvolatile and retains data even

53
when the computer is turned off. The most important secondary storage
technologies are magnetic disk, optical disk, magnetic tape.

Magnetic Disk
The most widely used secondary-storage medium today is magnetic
disk. There are two kinds of magnetic disks: floppy disks (used in PC’s)
and hard disks (used on large commercial disk drives and PC’s). Large
mainframe or midrange systems have multiple hard disk drives because
they require immense disk storage capacity in the gigabyte and tetra
byte range. PC’s also use floppy disks, which are removable and
portable, with a storage capacity up to 2.8 megabytes, and they have a
much slower access rate than hard disks.

Optical Disks
Optical disks, also called compact disks or laser optical disks, use laser
technology to store data at densities many times greater than those of
magnetic disks. They are available for both PC’s and large computers.
Optical disks can store massive quantities of data, including not only text
but also pictures, sound, and full-motion video, in a highly compact form.
The most common optical disk system used with PC’s is called CD-ROM
(compact disk read-only memory). A 4.75-inch compact disk for PC’s
can store up to 660 megabytes, nearly 300 times more than a high-
density floppy disk. Optical disks are most appropriate for applications
where enormous quantities of unchanging data must be stored
compactly for easy retrieval, or for storing graphic images and sound.
CD-ROM is read-only storage. WORM (write once/read many) and CD-
R (compact disk-recordable) optical disk system allow users to record
data only once on an optical disk. Digital video disks (DVD), also called
digital versatile disks, are optical disks the same size as CD-ROM but of
even higher capacity. They can hold a minimum of 4.7 gigabytes of data,
enough to store a full-length, high-quality motion picture.

Magnetic Tape
Magnetic tape is an older storage technology that still is used for
secondary storage of large volumes of information. More and more
organizations are moving away from using the old reel-to-reel magnetic
tapes and instead are using mass-storage tape cartridges that hold far
more data than the old magnetic tapes.

5.1.5Input Devices
An input device is a computer hardware component that converts input
data into a machine-readable binary code and transmits them to the

54
CPU, where they may be used in processing or may be sent to storage
for later use. The computer is useless without data to process. The input
of data is the first step in data processing operations and requires the
conversion of facts and figures in alphabetical and numerical form into a
form the computer can use. This, as we saw earlier, means converting
all data into the binary digits 1 to 0, which can be represented by
electrical impulses. Input devices gather data and convert them into
electronic form for use by the computer.
Keyboards remain the principal method of data entry for entering text
and numerical data into a computer. However, pointing devices such as
the computer mouse and touch screens, are becoming popular for
issuing commands and making selections in today’s highly graphic
computing environment.

Figure 5.2 Input Devices

Pointing Devices
A computer mouse is a handled device with point-and-click capabilities
that is usually connected to the computer by a cable. The computer user
can move the mouse around on a desktop to control the cursor’s
position on a computer display screen, pushing a button to select a
command. The mouse also can be used to “draw” images on the screen.
Trackballs and touch pads often are used in place of the mouse as
pointing devices on laptop PCs.

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Touch Screens
It allows user to enter limited amounts of data by touching the surface of
a sensitized video display monitor with a finger or a pointer. Touch
screens often are found in information kiosks in retail stores, restaurants,
and shopping malls.

Source Data Automation

It captures data in computer-readable form at the time and place they
are created. The principal source of data automation technologies are
optical character recognition, magnetic ink character recognition, pen-
based input, digital scanners, voice input, and sensors.

Optical Character Recognition (OCR)

The devices translate specially designed marks, characters, and codes
into digital form. The most widely used optical code is the bar code,
which is used in point-of-sale systems in supermarkets and retail stores.
Bar codes also are used in hospitals, libraries, military operations, and
transportation facilities. The codes can include time, date, and location
data in addition to identification of data. The information makes them
useful for analyzing the movement of items and determining what has
happened to them during production or other processes.

Magnetic Ink Character Recognition (MICR)

This technology is used primarily in cheque processing for the banking
industry. The bottom portion of a typical cheque contains characters
identifying the bank, checking the account number, and cheque number
that are preprinted using a special magnetic ink. A MICR reader
translates these characters into digital form for the computer.
Handwriting-recognition devices such as pen-based tablets, notebooks,
and notepads are promising new input technologies, especially for
people working in the sales or service areas or for those who have
traditionally shunned computer keyboards. These pen-based input
devices convert the motion made by an electronic stylus pressing on a
touch-sensitive tablet screen into digital form. For instance, the united
parcel service replaced its driver’s clipboard with a battery-powered
delivery information acquisition device (diad) to capture signatures along
with other information required for pickup and delivery.

Digital Scanners
These translate images such as pictures or documents into digital form
and are an essential component of image-processing systems. Voice
input devices convert spoken words into digital form for processing by

56
the computer. Voice recognition devices allow people to enter data into
the computer without using their hands, making them useful for
inspecting and sorting items in manufacturing and shipping and for
dictation. Microphones and tape cassette players can serve as input
devices for music and other sounds.

Sensors
These are devices that collect data directly from the environment for
input into a computer system. For instance, farmers can use sensor to
monitor the moisture of the soil in their fields to help them with irrigation.

5.1.6 Output Devices

The major data output devices are cathode ray tube terminals,
sometimes called video display terminals and printers.

Figure 5.3 Output Devices

Cathode Ray Tube (CRT)

This is probably the most popular form of information output in modern
computer systems. It works much like a television picture tube, with an
electronic gun shooting a beam of electrons to illuminate the pixels on
the screen. It has more pixels per screen, the higher the resolution, or
clarity, of the image on the screen. Laptop computer use flat panel
displays, which are less bulky than CRT monitors.

Printers
These produce a printed hard copy of information output. They include
impact printers (such as a dot matrix printer) and non-impact printers
(laser, inkjet, and thermal transfer printers). Most printers print one
character at a time, but some commercial printers print an entire line or
page at a time. In general, impact printers are slower than non-impact
printers. High-quality graphics documents can be created using plotters
with multicolored pens to draw (rather than print) computer output.

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Plotters are much slower than printers but are useful for outputting large-
size charts, maps, or drawings.

Voice Output Device

It converts digital output data into intelligible speech. For instance whe n
you call for information on the telephone, you may hear a computerized
voice respond with the telephone number you requested.
Audio output such as music and other sounds can be delivered by
speakers connected to the computer, microfilms have been used to
store large quantities of output as microscopic filmed documents, but
they are being replaced by optical disk technology.

Interactive Multimedia (Communications Devices)

The processing, input, output, and storage technologies described can
be used to create interactive multimedia applications that integrate
sound, full-motion video, or animation with graphics and text. Multimedia
technologies facilitate the integration of two or more types of media,
such as text, graphics, sound, voice, full-motion video, still video, or
animations, into a computer based application. Multimedia is becoming
the foundation of new consumer products and services, such as
electronic books and newspapers, electronic classroom presentation
technologies, full-motion video conferencing, imaging, graphics design
tools, and computer games. Many web sites use multimedia.

5.2 CLASSIFICATION OF COMPUTERS

Computers represent and process data the same way, but there are
different classifications. We can use size and processing speed to
categorize contemporary computers as mainframes, midrange
computers, PC’s, workstations, and supercomputers. Managers need to
understand the capabilities of each of these types of computers and why
some types are more appropriate for certain processing work than
others.
A mainframe is the largest computer, a powerhouse with massive
memory and extremely rapid processing power. It is used for very large
business, scientific, or military applications where a computer must
handle massive amounts of data or many complicated processes.
A midrange computer is less powerful, less expensive, and smaller
than a mainframe; it is capable of supporting the computing needs of
smaller organizations of managing networks of other computers.
Midrange computers can be minicomputers, which are used in systems
for universities, factories, or research laboratories; or they can be

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servers, which are used for managing internal company networks or web
sites.
A personal computer (PC), which is sometimes referred to as a
microcomputer, is one that can be placed on a desktop or carried from
room to room. Smaller laptop PCs are often used as portable desktops
on the road. PCs are used as personal machines as well as in business.
A workstation also fits on a desktop but has more powerful
mathematical and graphics processing capability than a PC and can
perform more complicated tasks than a PC in the same amount of time.
Workstations are used for scientific, engineering, and design work that
requires powerful graphics or computational capabilities.
A supercomputer is a highly sophisticated and powerful computer that
is used for tasks requiring extremely rapid and complex calculations with
hundreds of thousands of variable factors. Supercomputers traditionally
have been used in scientific and military work, such as classified
weapons, research and weather forecasting, which use complex
mathematical models, but they are starting to be used in business for the
manipulation of vast quantities of data. Supercomputers use parallel
processing and can perform billions and even trillions of calculations per
second, many times faster than the largest mainframe.
5.3 HARDWARE TECHNOLOGY REQUIREMENTS FOR
ELECTRONIC COMMERCE AND THE DIGITAL FIRM
Electronic commerce and electronic business are placing heavy new
demands on hardware technology because organizations are replacing
so many manual and paper-based processes with electronic ones.
Companies are processing and storing vast quantities of data for data
intensive applications, such as video or graphics, as well as for
electronic commerce. Much larger processing and storage resources are
required to handle the surge in digital transactions flowing between
different parts of firms and between firms and their customers and
suppliers.
Although electronic commerce and electronic business may be reducing
the role of paper, data of all types (such as purchase orders, invoices,
requisitions, and work orders) must be stored electronically and
available whenever needed. Customers and suppliers doing business
hour of the day or night, and they demand 24-hour availability. For
business to occur 24hours a day anywhere in our electronic world, all
possibly relevant data must be stored for on-line access and all these
data must be backed up.

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 Figure 5.4 Types of Computers

LET US SUM UP
Computer hardware technology constitutes the underlying physical
foundation for the firm’s information technology (IT) infrastructure. The
other components of it infrastructure-software, data, and networks-
require computer hardware for their storage or operation. The modern
computer system has six major hardware components: a central
processing unit (CPU), primary storage, input devices, output devices,
secondary storage, and communications devices.
CHECK YOUR PROGRESS
Choose the Correct Answer:
1_________ is not a primary storage device
a) RAM b) ROM

c) Compact disk d) DVD

2. ________ is a highly sophisticated and powerful computer that is
used for tasks requiring extremely rapid and complex calculations with
hundreds of thousands of variable factors.
a) Personal Computer b) Mainframe

c)Supercomputers d) Personal Computer

3. _________ uses laser technology to store data at densities many
times greater than those of magnetic disks.
a) Optical disks b) printers

c) Cathode Ray Tube d) Mainframe

4. ALU Stands for ___________

a) Arithmetic logic unit b) Arithmetic Functional Unit

c) Arithmetic legal unit d) Arithmetic lethal Unit

5. Technologies facilitate the integration of two or more types of media

a)Multimedia b) Workstation

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c) Super computer d) Software technologies

GLOSSARY

Hardware : Hardware is the physical

components of a computer such as
the machine and wiring, or tools and
machinery, or heavy military
equipment.

CPU : A central processing unit (CPU) is

the electronic circuitry within a
computer that carries out the
instructions of a computer program
by performing the basic arithmetic,
logical, control and input/output (I/O)
operations specified by the
instructions

Magnetic Disk : A magnetic disk is a storage device

that uses a magnetization process
to write, rewrite and access data.

Mainframe : A mainframe is a large

computer system designed to
process very large amounts of data
quickly

Midrange computer : A midrange computer is often used

as a server, which means it provides
storage, processing power, and
other functions to users connected
to it by a network.

Digital Scanners : An electronic device that generates

a digital representation of an image
for data input to a computer

Sensors : A sensor is a device that detects the

change in the environment and
responds to some output on the
other system.

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SUGGESTED READINGS
1. Bentley Trevor J (1986) Management Information Systems &
data processing, 2nd edition, Holt, Rinehart and Winston
publications, University of California. ISBN 0039106888,
9780039106881.
2. Donald W. Kroeber (1986) Computer-Based Information
Systems: A Management Approach, Subsequent
edition, Macmillan Publications, University of Virginia. ISBN
0023668407, 9780023668401.
3. Gordon B.Davis (2013) Management Information Systems, 1 st
Edition, TMH Publications, India. ISBN 007066241X.
4. Joel E. Ross (1970) Management by Information System,
illustrated edition, Prentice-Hall publications, University of
Wisconsin,ISBN 0135486289, 9780135486283.
5. Kenneth C. Loudon & Jane P. Loudon (2014) Management
Information Systems, 13th Edition, Pearson Publications, USA.

ANSWERS TO CHECK YOUR PROGRESS

1) c 2) c 3) a 4)a 5)a

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Unit 6

COMPUTER SOFTWARE
STRUCTURE

Overview

Learning Objectives
6.1 Evolution of Computer Software
6.2 Classification of Computer Software
6.2.1 Operating Systems
6.2.2 Control Programs
6.2.3 Service Programs
6.2.4 Programming Languages
6.2.5 Packaged Software
Let Us Sum Up

Glossary

Check Your Progress

Suggested Readings

Answers to check your progress

OVERVIEW
The purpose of computer software is to simplify the control of the
computer. Computer software includes system software and application
software. The managers should have basic understanding of computer
software and hardware so that they can make better decisions.

LEARNING OBJECTIVES

After reading this unit, you should be able to,

• trace the evolution of computer software
• categorize computer software
• familiarize with types of computers.
6.1 EVOLUTION OF COMPUTER SOFTWARE
The evolution of programming has paralleled the evolution of computer
hardware, since one depends upon the other. First generation software
utilized a certain amount of built in directions and instructions in the
hardware. The purpose of system software is to simplify the control of
the computer. System software functions as an intermediary between
the application programmer and user who communicates in words and

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numbers, and the computer, which response to electrical impulses. In
order to control a computer, two different types of system software are
needed. They are operating system and a programming language. Other
system capabilities, such as time sharing or data communications, also
may be required, depending on the application and the hardware
configuration. During the later stages of the first generation, assemblers
and compilers were developed in elementary form. Early instructions or
programs for the computer were in machine language, comprehensible
only to the computer for which they were designed. This form is rarely
used today, usually being replaced by symbolic coding which permits
simpler description of instruction to the machine.
In the late 1950’s, the potential of universal symbolic language was
obvious, that a number of attempts have been made to develop a
language. A number of such languages are in use today, each oriented
to certain specific characteristics or requirements. Languages such as
FAP and AUTOCODER were early languages, which had algorithmic
capabilities, but were basically machine or assembler oriented. Algebraic
languages, which could be readily prepared from algebraic expressions
or equations, such as ALGOL or FORTRAN, were developed for the
conversion of these expressions into computer instructions. FORTRAN
literally means formula translation and has been developed into an
accepted universal language capable of utilization on many computers.
Although excellent for conversion of mathematical terminology,
FORTRAN is not basically oriented towards business language. For this
reason, COBOL (common business oriented language) was developed
and is now perhaps the most broadly utilized universal language for
business application. Program is prepared in symbolic language; it is
processed by another program, the assembler, which converts the
symbolic instructions into a form suitable for execution on the computer.
Simultaneously, the assembler package can also review any errors and
provide other diagnostic information, even preparing graphic flow charts
if desired. The output of the assembler is written in absolute code, and
the symbolic language is replaced by either absolute or re-locatable
addresses.
When universal languages are utilized in preparation of a program, an
assembler is not used to convert the actual machine instructions. In this
case, a compiler program is utilized. As in the case of the assembler, the
compiler does transform the programs from a form easily read by
programmers into one capable of being read by the computer. However,
while the symbolic input program for the assembler is very dependent
upon the computer is being utilized, the compiler program is relatively

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computer independent. The second generation was the batch process,
in which input material was introduced, processing accomplished, and
output physically removed from the computer. Actually, this is stacked
processing, in which a series of jobs are introduced without operator
intervention. True dependent- and with proper choice of higher level
languages will run on other computers with only minimal changes. The
input program for both is called the source program, and the output is
termed the object deck.
Second-generation computers carried both assemblers and compilers to
a sophisticated level of development. The number of built in instructions
in equipment was generally reduced because of inflexibility. These
instructions were replaced by early operating systems, which had sets of
basic instructions, and input output, control systems-as well as
programs. The second generation was the batch process, in which input
material was introduced; batch processing involves the processing of a
stack of similar jobs, and the completing of the same phase across each
job, then returning to the second phase of each job in the batch. For
both stack and processing, however, simple operating systems are
useful.
Third generation computer makes the use of operating systems almost
indispensable for the largest- size machine. Without a machine operated
system, operator inefficiencies would greatly offset the higher cost of the
hardware. Operating systems have become increasingly complex,
including for families such as IBM 360 COS (Compatible operating
system-a series of programs which allowed emulation mode to operate
1401 programs on the 360); BOS (basic operating system- disc oriented
one of the early 360 operating systems, no longer used); DOS (disc
operating system); TOS (tape operating system); and TSS (time sharing
system).
The most comprehensive operating system for the IBM 360 series is
OS/360. This is tremendously flexible system with largest configuration
of this series, spanning a range from the model 50 upward. Initially,
OS/360 had been intended to service the entire range of IBM 360’s, but
the system itself requires a substantial memory dedication- exceeding in
some cases 128k. In addition, the OS requires substantial peripheral
equipment in memory to properly utilize its dynamic capabilities.
Accordingly, model 360/50 is one of the smallest to utilize the OS, and
its utility becomes much greater as the systems increase in size. OS/360
has a modular organization, so that the system can be implemented in
several versions to various levels of sophistication. The system utilizes a

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job control language offering great flexibility over operation of the
machine. OS/ 360 has a definite data management structure, which is
flexible, but dependable. Accordingly, the programmer is able to utilize
the characteristics of OS/360 to enhance the capabilities of the program,
while reducing its overall size. While OS/360 is perhaps the most widely
known operating system, other computers have had similar operating
systems developed for optimal utilization of their hardware.

Evolution of Computers

Figure 6.1 Evolutions of Computers

During the first generation, software was so elementary that it cost less
than 10 percent of the combined hard ware-setup charge. During the
1960’s this increased to as much as 50percent of the package set up
cost. The software portion of the picture is increasing and software costs
will continue to absorb more and more of the overall system costs.
There has been an unfortunate on implication on the part of many
sources that the availability of larger capacities somehow result in lower
soft ware costs, or at least bring about less dependence upon soft ware.
Typical of these allegations is the description of a terminal in every
manager’s office, and therefore of less demand upon programming.
Upon examination, this falls apart. The software required operating the
basic computer calculation is still basically the same as it always was.
Compilers and assemblers is also software and require constant
improvement, even though they continually give better results. The
operating systems are highly complex, and also require maintenance
and improvement. Finally, the introduction of the remote aspect (i.e.,
terminals) results in a tremendous software requirement for the
communications transfer of information and interface with the computer.
Unfortunately, experience thus far-as could have been predicted is that
the simpler the man-machine interface (in terms of the man’s view), the

66
more difficult the programming to accomplish it. That is, if management
chooses to speak directly to the computer in reasonably pragmatic
English, the programming implications are fantastic. While this is within
the realm of the state-of-the-art, it usually produces completely
unacceptable cost levels. While it is possible that the continual
development of larger machines will ultimately permit a breakthrough in
terms of direct communication with the equipment, the overhead for this
software master operating system will be substantial-and perhaps too
expensive for general use. Further, when such a system is developed, it
will be operable only on the new and ultrahigh-capacity equipment and
this will preclude use on current third-generation equipment.
Accordingly, the economic implications of utilization of the yet-to-be
developed utopian system will have to pass another economic barrier.
From the practical viewpoint, management should consider the cost of
programming in terms of what is relatively available today, and not look
toward pie-in-the-sky developments many years down the road. Actually,
the programming situation is improving-in step with hardware. As
hardware is becoming more modular, and higher-Level languages are
becoming truly interchangeable; the package program has become
practical in many areas. For many portions of MIS, it is possible that
substantial portions of the program may be prepared in a generalized
form.

6.2 CLASSIFICATION OF COMPUTER SOFTWARE

The Computer software is classified into systems software and
application software. Examples of system software are the operating
system which directs and assists the execution of application programs,
utility programs which do common tasks such as sorting, compilers
which translate programs coded by the programmer into machine-level
instructions, and data base management system which manage storage
and access to data bases. System software is required for data
communications. System software is usually purchased rather than
developed by internal personnel. The operating system is sometimes
included in the price of the hardware and provided by the hardware
vendor. Database management system software is usually purchased
separately, either from the hardware vendor or from independent
software vendors.
Application software is usually referred to simply as programs or codes.
This may use hundreds of different programs to process pay, maintain
inventory records, schedule productions, analyze sales, aid decision
making, and otherwise support the managerial and operational activities

67
in an organization. Application software may be developed uniquely for
the using organization by in- house (or contractual) personnel or it may
be purchased in ready-to-use packages. Application software includes
computer programs written for an individual application such as payroll
processing or personal skill analysis. They generally require system
software in their execution. For example the application program specify
reading data from a record stored on a disk; the operating system
provides the instructions to manage the physical reading of the record
from disk storage

Figure 6.2: Classification of Computer Software

6.2.1 Operating Systems

Each different computer, or, in the case of microcomputer, each different
microprocessor, requires a unique set of binary codes to make it
function. Operating system converts more or less standard instructions
into these unique codes to make the operation transparent to the
programmer or user. That is, the programmer or user is unaware of the
peculiar requirements of the computer. For example, control program/
microcomputers is a popular microcomputer operating system. The
apple control program / microcomputer will translate the application
program into a code understood by its 6502 micro processor and the
Tandy control program / microcomputer will translate the same program
into a code understood by its Zilog 80 microprocessor. The compatibility
problem is not quite as simple as this example might indicate, however,
since there are often several versions of an operating system.
The purpose of an operating system is to make the job of the
application- software programmer easier. This is especially evident in
the one function of operating system just discussed- that of translating
application programs in to binary code. The operating system also
includes programs that relieve programmers of the responsibility of

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including routine, repetitive, or purely ‘’housekeeping’’ functions in
application programs. Control programs and service are two types of
such systems software.

Figure 6.3 Operating Systems

6.2.2 Control Programs

Control program manages the input, output, and storage of data required
by application programs. These programs are concerned with the actual
physical location of data as well as with the logical and hierarchical
relationships (data elements, records, and files) that determine the
organization of data in storage. Control programs schedule input and
output according to assigned priority of, standing instructions. They also
maintain logs on the machine and peripheral time required for various
applications and/ or accounts. This latter function is especially important
when the computer center is operated as a profit center and must bill
other departments for services rendered. Control programs account for
one-third to one -half of the processing required for a typical business
application.

6.2.3 Service Programs

Service programs provide commonly used routines that might otherwise
have to be included in the application software. For example, it is often
necessary to sort data according to alphabetical or numerical sequence
or to merge two sorted data’s set into a single sequential list. Many

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operating systems permit the application programmer to call up a service
program to perform these tasks with only one or two statements.
There are also service programs in operating systems to reformat data
for a different medium (e.g., from tape to disk) and to detect errors in
application programs. System software can detect only syntax errors. It
cannot detect logical errors-programming statements that follow all the
rules but have been used in a manner that will produce the desired
output.

6.2.4 Programming Languages

It has already been noted that systems software provides an interface
between the words and numbers used by programmers and the binary
code used by the computer. The systematic set of procedures and rules
governing the use of such words and numbers is called a programming
language. Programming languages are classified as machine,
assembler, or high level. These classes are also called first, second, and
third generation, respectively, to acknowledge both their relative age and
sophistication. In this vein, some recent, very sophisticated high-level
languages are called fourth generation in recognition of the advances
they represent over other, third generation, high level languages.

Programming Languages

Figure 6.4 Programming Languages

Machine Languages
The first generation of computer languages is called machine language
because they use the binary code—1’s and 0’ s—understood directly by
the computer and do notion fact require the services of an operating
system. Machine language instructions are typically in two 4 and 5 - bit
parts: an operation code, which tells what is to be done, and an operand,
which tells where to store the results. For example, a machine language

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code to “store a value called x in register 11011” might be written 1100
11011. Although, technically speaking, machine languages are in binary
code, most computers accept the decimal (base 10) or hexadecimal
(base 16) equivalents of these codes. Languages using non-binary
equivalents are still referred to as machine languages.
Every computer has its own more or less unique machine language,
which is determined by the A.L.U circuitry. All computers ultimately
operate in machine language, but almost none still require the
programmer to use one. Instead, system software translates other,
easier-to-use languages in to machine languages.

Assembler Languages
The second generation of computer languages freed the programmer
from the tedious, error -prone binary instructions and was the first to
require an operating system. This generation is called assembler, or
sometimes, symbolic languages. Assembler languages substitute short
alphabetic expressions for the operation code. For example, add x
means add the variable previously defined as x to the value currently
stored in an accumulator register.
Although not strictly a machine language, most assembler are
nonetheless machine- oriented. That is, each computer has unique
assembler language symbolic expressions that correspond to machine
language instructions on a one- to-one basis. A portion of the operating
system known as a language translator performs the conversion of
symbolic instructions into machine language instructions.
Some assembler languages use macroinstructions that generate two or
more machine language instructions from a single assembler language
statement. For example, the macro instructions add a, b, c which means,
add the variable a to the variable b and call the result c,” replaces three
simple instructions to load a into a register, add b to it and store the
result.
An exception to the general rule of unique assembler languages is found
in the very recent (1983) language c. The language c is sometimes
described as a “portable” assembler language because there are
versions of it available for many computers, from micros to super
computers. C is very powerful language used most often by system
programmers for writing system software.

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High Level Languages
The third generation of computer languages is called high level and was
the first to free programmers from specific hardware requirements,
although there were (and often still are) minor differences in high level
languages among the various makes and models of computers.
In compiling high level or source program it is translated entirely into a
machine language or object program prior to execution. Interpreters
translate and execute one program statement at a time. Until recently,
most high level languages were compiled for more efficient use of C.P.U
time. Now, however the extremely high speeds of the latest computer
hardware and certain inherent advantages to interpreting have spurred a
renewed interest in interpretive languages. Many fourth-generation
languages are of the interpretive variety.
High level languages may also be classified as procedure- oriented or
problem-oriented.

6.2.5 Packaged Software

At one time, in house development was the normal approach to the
automation of standard business applications. However, as competition
in the computer industry grew, manufacturers began to offer application
software and other services to make their products more attractive. And
as the number of computer users grew, they soon constituted so large a
market that “third-party” (other than the manufacturer or the user) firms
found it profitable to develop and market application software. Today a
user who wishes to purchase a software package can choose from
among thousands of programs written for dozens of different application
areas and virtually every make, model, and size of computer.
The sets of computer program instructions that direct the operation of
the hardware are called software. A set of instructions for a special task
is termed a routine; a complete set of instructions to execute a related
set of tasks is a program. Software instructions are termed code.
Software programs vary widely in size. For example, a very simple
application program may consist of a few hundred lines of instructions in
programming language, while the larger application program or system
software program may consist of tens of thousands of lines of
instructions.
An application system consists of a set of programs and related manual
procedures to accomplish information processing. The cost of
developing a large application system can be very high.

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The main advantage of developing a system ”in house” is to obtain a
unique system designed to fit specific needs of an organization. In many
cases, it is more appropriate to lease or buy application software. There
is a growing trend toward purchasing generalized application packages
(such as payroll, accounts receivable, production scheduling) and using
internal development personnel to tailor the packages to unique
organizational needs. Application packages are sold or leased from
companies, which specialize in software development; application
packages for small (personal) computers are sold in computer stores, by
mail, and other similar channels.

Activity 1
When you buy personal productivity software, we recommend that you
do so in the form of a suite. A software suite is bundled software that
comes from the same publisher and costs less than buying all the
software pieces individually choose one personal productivity suite either
from Microsoft office or coral we perfect office. Determine the individual
price for each piece of software included in it. Now, perform a price
companion. How much cheaper is the entire suite? Can you think you a
situation in which someone would buy the individual pieces as opposed
to the entire suite? If so, please describe it.

LET US SUM UP
The computer software is classified into systems software and
application software. A computer is directed by software instructions.
Most programming of instructions is done in high level languages which
trade off programmer productivity against extra machine resources and
numbers of types of high-level languages used in information processing
applications are also described.

CHECK YOUR PROGRESS

Choose the Correct Answer:

1. _________ language because they use the binary code—1’s and 0’

a) Machine language b) Assembler Languages

c) High level language d) Low-Level languages

2. ____________converts more or less standard instructions into these
unique codes to make the operation transparent to the programmer
or user.

a) Operating system b) control system

c) Service system d) logical system

73
3. _________ referred to simply as programs or codes.

a) Customized software b) system software

c) Application software d) Paid software

4. The third generation of computer languages is called _____________

a) Machine language b) Assembler Languages

c) High level language d) Low-Level languages

5. Symbolic languages are also called as ___________

a) Machine language b) Assembler Languages

c) High level language d) Low-Level languages

GLOSSARY

Workstation System software : Workstation, a high

performance computer system that
is basically designed for a single
user and has advanced graphics
capabilities, large storage capacity,
and a powerful microprocessor.

Optical Disks : An optical disk drive (ODD) uses a

laser light to read data from or write
data to an optical disc.

Application software : Application software, or app for

short, is software that performs
specific tasks for an end-user.

Pointing devices : A generic term for any device (e.g. a

graphics tablet, mouse, stylus, or
trackball) used to control the
movement of a cursor on a
computer screen.

Operating systems : An operating system, or "OS," is

software that communicates with the
hardware and allows other
programs to run.

Touch screens : A touch screen is a computer

display screen that is also an input
device. The screens are sensitive to

74
 pressure; a user interacts with the
computer by touching pictures or
words on the screen.

Assembler : An assembler is a program that

converts assembly language into
machine code. It takes the basic
commands and operations from
assembly code and converts them
into binary code

SUGGESTED READINGS
1. Bentley Trevor J (1986) Management Information Systems &
data processing, 2nd edition, Holt, Rinehart and Winston
publications, University of California. ISBN 0039106888,
9780039106881.
2. Donald W. Kroeber (1986) Computer-Based Information
Systems: A Management Approach, Subsequent
edition, Macmillan Publications, University of Virginia. ISBN
0023668407, 9780023668401.
3. Gordon B.Davis (2013) Management Information Systems, 1 st
Edition, TMH Publications, India. ISBN 007066241X.
4. Joel E. Ross (1970) Management by Information System,
illustrated edition, Prentice-Hall publications, University of
Wisconsin,ISBN 0135486289, 9780135486283.
5. Kenneth C. Loudon & Jane P. Loudon (2014) Management
Information Systems, 13th Edition, Pearson Publications, USA.

ANSWERS TO CHECK YOUR PROGRESS

1) a 2) a 3) c 4) c 5) b

75
Unit 7
DATABASE MANAGEMENT SYSTEM
STRUCTURE

Overview

Learning Objectives

7.1 Database Concepts

7.2 Database Models

7.2.1 Hierarchical Database Model

7.2.2 Network Database Model

7.2.3 Relational Database Model

Let Us Sum Up

Glossary

Check Your Progress

Suggested Readings

Answers to check your progress

OVERVIEW
In the previous unit, we had discussed the hardware and software
components of Computer. Database Management System is one of the
software components of Computer. More specifically it is the application
software. The features of database management system are discussed
here. Database management system is classified into hierarchical,
network and relationship database management system. Internet
applications are explained at the end of this unit.
LEARNING OBJECTIVES

After reading this unit, you should be able to,

• discuss database concepts
• classify database management systems
• explain the applications of internet.

7.1 DATABASE CONCEPTS

• Database concepts is rooted in an attitude of sharing common data
resources
• Releasing the control of those data resources to a common
responsible authority.

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• Cooperating in the maintenance of those shared data resources.

If data is a valued, shared resource in the organization, it must be

managed like any other asset such as men, materials, machines and
money. Management in its fullest sense involves the establishment of
appropriate organizational arrangements and the institution of system-
based tools and procedures. A Database Management System (DBMS)
is a software system that manages the creation and use of databases.
All access to the database is through the database management
software; and access language facilities are provided for application
programmer users and end users who formulate queries. Thus,
application programmers define a user schema or user view as a logical
model of the data to be processed by the application program. The
programmer writes instruction using a programming language interface
to the database management system, which handles the translation to
internal schema of physical storage. All data validation and authorization
checks of user authority to access a data item are handled through the
DBMS. A person wishing to access the database for a query or special
report uses a database query language to formulate the request and
format the output. Thus, the database management system may be
viewed as the only door to the physical storage of data in the database.
The database administrator is the person who has authority over
definition and use of the database.
DBMS greatly facilitate the physical implementation of a logical design.
Thus DBMS is a set of computer programs that controls the creation,
maintenance, and use of the databases of users and computer-using
organizations. It allows different user application programs to easily
access the same database. A DBMS also simplifies the process of
retrieving information from databases in the form of files and records.
Instead of having to write computer programs to extract information,
users can ask simple questions in a query language. Thus, many DBMS
packages provide fourth generation languages and other application
development programs.
A DBMS can be envisioned as an additional layer of software between
file-access software and application programs. Ideally, DBMS software
provides data independency, which provides data for different
applications where the applications access the data of different purposes
by using different search strategies. Computer program independence,
which allows application programs to be coded in different languages
and allows for modification of a database without requiring modifications
to application programs unless specific data elements or data structures
used by the applications program are modified.

77
A DBMS reduces the complexity of application programs. They no
longer have to cope with the physical locations and structures of the files
and records. With a DBMS, any data element or combination of data
elements can be used to index a group of data from a record or records.
The DBMS, in conjunction with the file-access software, handles the
necessary logistics of retrieving and storing specified data elements in
the proper physical locations within the database.
Many vendors and software companies offer sophisticated
advancements to their DBMS software packages in the form of query
languages. A “query language” is a set of easy-to-use computer
instructions. These instructions are designed to allow a person who is
not trained in computer programming to retrieve, modify, add, or delete
selected data elements on the basis of stated conditions.
The use of query languages or fourth generation languages becoming
increasingly popular because of the proliferation of computer terminals,
personal problems, ad hoc retrieval requests from all levels within an
organization, and the ever-improving software packages readily
available for most user applications. Such advancements place the
computer in the hands of the user and help remove the aura of mystery
that surrounds computers.
Thus, a DBMS allows the users of a database to view the database in
terms of applications necessary to support their departmental or
functional area. Their access to the database is not complicated by other
data elements in the database. This means that data elements can be
added to or deleted from the database without affecting any application
programs other than those that use the data elements being added or
deleted. A DBMS greatly reduces the difficulty of both establishing and
modifying integrated files.
Advantages of a DBMS
• Complexity of the organization’s information system environment
can be reduced by central management of data, access,
utilization, and security.
• Data redundancy can be reduced by eliminating all of the
isolated files in which the same data elements are repeated.
• Data confusion can be eliminated by providing central control of
data creation and definitions.
• Program-data dependence can be reduced by separating the
logical and physical aspects of data.
• Program development and maintenance costs can be radically
reduced.

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 • Flexibility of information systems can be greatly enhanced by
permitting rapid and inexpensive ad hoc queries of very large
pools of information.
• Access and availability of information can be increased.
• Security and privacy can be controlled.

Disadvantages
• Costs are high.
• Security is difficult to maintain.
• A consequence of security breaches may be severs.
• Greater control over data is required.

7.2 DATABASE MODELS

The major database models used in the industry are as follows:

1) Hierarchical data model

2) Network data model

3) Relational data model

7.2.1 Hierarchical Database Model (HDBM)

A hierarchical view of data base model is like an organizational chart. As
an example, this view is useful for a bill-of-material application in
manufacturing where an inventory must be kept of all the components
and sub-assemblies necessary to manufacture a product. This present
data to users is a tree-like structure. Within each record, data elements
are organized into pieces of records called segments. To the user, each
record looks like an organization chart with one top-level segment called
the root. An upper segment is connected logically to a lower segment in
a parent-child relationship. A parent segment can have more than one
child but a child can have only one parent.
In the HDBM the data is stored in the hierarchical form recognizing the
fact that each of the levels is bounded by the parent-child relation to the
earlier level. The typical characteristics of the HDBM are:

1) HDBM starts with a root and has several roots.

2) A root will have several branches.

3) Each branch is connected to one and only one root.

4) A branch has several leaves and a set of leaves are connected
to one branch.

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 Figure 7.1 Hierarchical Database Model (HDBM)

7.2.2 Network Database Model (NDBM)

Network DBMS is a variation of hierarchical DBMS. Indeed, databases
can be translated from hierarchical to network and vice versa in order to
optimize processing speed and convenience. Whereas hierarchical
structures depict one-to-many relationships, network structures depict
data logically as many-to-many relationships.
Database integrity is used in its broadest sense to imply the
completeness, soundness, purity, veracity and confidentiality of data.
Database integrity involves:
Protecting the existence of the database through physical security, and
backup and recovery measures.
Maintaining the quality of the database through input validation,
diagnostic routines to ensure that the data always conforms to its
definition, and controlling processes which update the database.
Maintaining the privacy of the stored data through isolation, access
regulation, encryption, and monitoring.
The NDBM interconnects the entities of an organization into a network.
The data model is shown by an arrangement of the blocks. The block
represents an entity or a record. The collection of the blocks is called as
the area of database. The NDBM uses the blocks, the area and the
arrows to represent the database of the organization. The method,
popularly known as the Bachman’s diagram was suggested by
Mr.C.W.Bachman.
The NDBM deals with the set and the records. A component, a part, a
subassembly and an assembly area are the records. A record located at
the tail of the arrow is known as a member record, and a record at the
head of the arrow is known as an owner. An arrow connecting the owner
to a member is a set. For example, the component in the part is a set.

80
 The set may have more than one member occurrence, i.e., a
component may be used in more than one part. The same is true for the
part subassembly set and subassembly-assembly set, and so on. Every
owner is a member besides being the owner and also is a member of
the set. If all the relationships are to be shown, then the model is
equivalent to a network. Hence, the data model is known as the NDBM
Simple Network Data Base model

Figure. 7.2 Simple Network Data Base model

NDBS with an example

Figure 7.3 NDBS

81
7.2.3 Relational Database Model (RDBM)
In the RDBM, the concept of two dimensional tables is used to show the
relation. For example, consider the following database having the
component name and the component number in the table form.

Component Number Component Name

100 Washer

102 Nut

109 Bolt

111 Screw
RDBM model uses theories of relational algebra in representing the data
in various tables. In RDBM, the relation is shown in a table; attribute is
shown in the column and record in the row of the table. The values of
attributes are taken from a domain. The set of attributes is record and
the record is identified by a unique key known as the primary key.
Latest RDBMS
The latest RDBMS allows an on-line maintenance, rapid recovery and
software-based fault tolerance. These features ensure the availability of
the database round the clock as the database maintenance is possible
on-line when the system is in use. The maintenance activity consists of
the following tasks:
a) Backup
b) Diagnostics
c) Integrity changes
d) Recovery
e) Design changes
f) Performance tuning
The rapid recovery feature allows the system administrator to provide a
’time’ to go back for recovery of the data if the system fails due to the
power failure or network crash. Based on this, time system automatically
goes back and collects all the changes and writes to the disk.
The characteristics of the modern RDBMS includes hardware
independence, software independence, workability under a client-server
architecture, a control feature of integrity, security and autonomy and
built-in communication facilities to achieve and open the system feature
for the MIS. It, therefore, provides a very efficient and effective tool to a
skillful designer, developer and user for handling the information needs
of the business enterprise. Eifcodd prescribes 12 rules to determine how

82
relational a DBMS product is. If these twelve rules are satisfied, the
DBMS product is fully relational. The rules are as under:
1. The information rule

2. The guaranteed access rule

3. Systematic treatment of null values.

4. Active on-line catalog based on the relational model.

5. The comprehensive data sub-language rule.

6. The view up-dating rule.

7. High level insert, up-date, and delete

8. Physical data independence.

9. Logical data independence

10. Integrity independence

11. Distribution independence

12. The non-subversion rule.

These rules can be explained as follows:

Information Rule
Information in database is represented by values in column positions
within rows of tables and this is the only way it can be done.

Guaranteed Access Rule

Every individual scalar value in the database is uniquely addressable by
a primary key, containing table, column and row identities.

Systematic Traditional of Null Values

Missing or inapplicable information is termed as null value which is
distinct from zero. DBMS should provide systematic method of handling
null values in contrast to value zero.

Active on-line Catalog

The DBMS supports on-line catalog accessible to authorized users.

Sublanguage Rule
DBMS must support one relational language which helps data definition,
manipulation security, integrity constraints, and begin, commit, and
rollback operations.

83
View update Rule

All possible views must be updateable by the system.

High level ‘Insert, Update, and Delete’

DBMS must support all the three at a time required by the three different
operators.

Physical Data Independence

It does not matter for the application how data is physically stored in
database.

Logical Data Independence

The data store and its application is not determined by the logic applie d
in use of data.
Integrity Independence
Integrity or rules of constraints must be possible to handle without
affecting the application.

Distribution Independence

DBMS should function with no error even though the data is distributed.

Non-Subversion Rule
A low level interface provided by the DBMS should not subvert the
system’s relational security or integrity constraint.
Advantages of RDBMS against HDBMS and NDBMS
Some of the major advantages of RDBMS against HDBMS and NDBMS
are:

Scalable high performance.

System-based integrity, security and autonomy.

Longer availability of time to the users.

Handles simultaneously the multiple RDBMS.

LET US SUM UP
Database Management system is a software system that manages the
creation and use of databases. It may be hierarchical, network or
relational. Distributed systems have computers located at various
physical sites at which organization does business and these computers
are linked by telecommunication lines in order to support some business
processes. Internet is often referred to as the network of networks which
has a wide range of applications.

84
CHECK YOUR PROGRESS

Choose the Correct Answer:

1. An upper segment is connected logically to a lower segment in a

parent-child relationship _________

a) Hierarchical data model b)Network data model

c)Relational data model d) Information System Model

2. Network structures depict data logically as many-to-many
relationships.___________

a) Hierarchical data model b)Network data model

c)Relational data model d) Information System Model

3. Set of attributes is record and the record is identified by a unique key
known as the primary key.____________
a) Hierarchical data model b) Network data model

c) Relational data model d) Information System Model

4. A tree-like structure is found in______________

a) Hierarchical data model b) Network data model

c) Relational data model d) Information System Model

5. _________ is used in its broadest sense to imply the completeness,
soundness, purity, veracity and confidentiality of data.

a) Database integrity b) Database piracy

c) Database privacy d) Database security

GLOSSARY

Distributed system : A distributed system, also known

as distributed computing, is
a system with multiple components
located on different machines that
communicate and coordinate actions
in order to appear as a single
coherent system to the end-user.

Domain name : A domain name is a unique name

that identifies a website. For
example, the domain name of the
Tech Terms Computer Dictionary is

85
 "techterms.com."

Local area networks (LAN) : "Local Area Network" A LAN is

a network of connected devices that
exist within a specific location. LANs
may be found in homes, offices,
educational institution, or other
areas.

Internet : The Internet is a vast network that

connects computers all over the
world. Through the Internet, people
can share information and
communicate from anywhere with
an Internet connection

Minicomputer : Minicomputer, Computer that is

smaller, less expensive, and less in
size but more powerful than
a mainframe or supercomputer, but
more expensive and more powerful
than a personal computer

SUGGESTED READINGS
1. Bentley Trevor J (1986) Management Information Systems &
data processing, 2nd edition, Holt, Rinehart and Winston
publications, University of California. ISBN 0039106888,
9780039106881.
2. Donald W. Kroeber (1986) Computer-Based Information
Systems: A Management Approach, Subsequent
edition, Macmillan Publications, University of Virginia. ISBN
0023668407, 9780023668401.
3. Gordon B.Davis (2013) Management Information Systems, 1 st
Edition, TMH Publications, India. ISBN 007066241X.
4. Joel E. Ross (1970) Management by Information System,
illustrated edition, Prentice-Hall publications, University of
Wisconsin,ISBN 0135486289, 9780135486283.
5. Kenneth C. Loudon & Jane P. Loudon (2014) Management
Information Systems, 13th Edition, Pearson Publications, USA.

ANSWERS TO CHECK YOUR PROGRESS

1) a 2) b 3) c 4) a 5)a

86
Unit 8

DISTRIBUTED SYSTEM
STRUCTURE

Overview

Learning Objectives

8.1 Distributed System

8.1.1 Characteristics of Distributed System

8.1.2 Distributed System Architecture

8.1.3 Reasons for Designing Distributed System

8.1.4 Advantages and Disadvantages of Distributed System

8.2 Internet

8.2.1 The Domain Name System

8.2.2 Internet News Group Organization

8.2.3 Features of Internet

Let Us Sum Up

Glossary

Check Your Progress

Suggested Readings

Answers to check your progress

OVERVIEW
In the previous unit the features of database management system were
discussed where Database management system is classified into
hierarchical, network and relationship database management system.
The significance of distributed system and Internet applications are
explained in this unit.
LEARNING OBJECTIVES

After reading this unit, you should be able to,

• discuss distribution system in detail
• classify database management systems
• explain the applications of internet.

87
8.1 DISTRIBUTED SYSTEM
It is an application system in which the processing power is distributed to
multiple sites, which are then tied together via telecommunications lines.
Distributed systems have computers (of same size) located at various
physical sites at which the organization does business, and these
computers are linked by telecommunications lines in order to support
some business process. This system is the most commonly used
architecture for workgroup computing.
A distributed system interconnects locations that have computer
capability to capture and store data, to process data, and to send data
and information to other systems. The range of computing capabilities
varies. Some locations use terminals, other microcomputers, and still
others large computer systems. There is no requirement that all
equipment be from the same manufacturer. In fact, it is expected that
several makes of autonomous hardware will be involved. This allows
users to have the type of equipment most suitable for their needs.
All locations in distributed processing are called as nodes. They have
the ability to capture and process data where events are occurring. That
is, if a specific location uses a minicomputer, users enter data and
process it on their minicomputer. They receive rapid responses to
inquiries, store data in the system, and prepare reports as the need
arises. However, they can also transmit data or reports from their system
to another one linked into the network, the collection of interconnected
systems.
Large organizations are establishing networks to interconnect multiple
sales and manufacturing locations. Sales, accounting, and technical
information are readily accessible from multiple locations. Even word-
processing facilities are linked into the network. Corporate management,
at the top of the network, is able to interact with other locations in the
network while having its own independent information system. At the
same time, terminals at field sales offices are able to access information
in the system.

8.1.1 Characteristics of Distributed System

Distributed processing is closely linked to the communication of data. In
fact, a data communication system is the backbone of distributed
processing and the resource that makes it workable. But communication
is only one feature of distributed processing.

A distributed processing system includes:

88
Multiple general-purpose processing components
The processing systems can be assigned specific tasks on a
dynamic basis. The systems need not to be of a common make or size.

High-level operating system

Individual processing nodes have their own operating systems that
are designed for the specific computer. But there is also a network
operating system that links together and integrates control of the
distributed components.

Physical distribution of components

Individual computers and processing units are physically
separated. They interact with one another through a communications
network.

System transparency
Users do not know the location of a computer in the distributed
system or anything about its manufacturer, model, local operating
system, speed or size. All services are requested by name. The
distributed operating system performs all activities involving physical
locations and processing attributes in order to satisfy the user’s request.

Dual component roles

Individual processing components can operate independently of
the distributed system framework. Yet they can be brought in as an
integral element in the meeting of a network user’s needs.
These characteristics stress the independence of the components in a
distributed environment. Individual elements are not permanently linked
to the network, as may be the case in communications networks.
Excluded from classification as distributed processing systems are the
following:
• A multifunction mainframe that distributes processing between
separate input/output and peripheral processors.
• A front-end processor that controls communications functions for
the system to which it is attached.
• A collection of remote terminals that collect and transmit data to a
host system.
• The interconnections of multiple host computers that transmit
messages and perform dedicated functions and tasks.

89
 • A personal computer that can be partitioned, i.e., able to operate
several different processing sessions simultaneously by using a
special operating system.
• Although these applications can be quite useful, they do not meet
the definition of a distributed processing system.

8.1.2 Distributed System Architecture

In the distributed system architecture multiple, independent CPU are
connected to each other via communications lines. Each CPU
represents processing power, each terminal device represents power to
enter and retrieve data, each input device represents power to input
data, and each output device represents the capability to receive output.
All these devices can be grouped in one location (centralized); they can
also be dispersed, so that the power is distributed in different locations.
There are a number of variations of distributed systems depending on
the distribution of hardware and data:
• Separate computer system in each location

• Each system has own data

• Systems share data

• Systems share data managed by a designated computer

• Central computer with

• Input/output devices in other locations connected to central

computer
• Data preparation and data equipment at other locations
When physically separated computers are interconnected through
communication facilities, the configuration is called distributed
computing. Distributed computers may be organized as a hierarchy or a
ring. A hierarchy of processors is shown in the figure. The lowest level of
processor consists of microcomputers or minicomputers which has some
local data storage and perform local processing. Tasks too large to be
processed in this level or requiring data not available in the local
database are transmitted to a higher level regional or centralized
computer. The highest level in the hierarchy of process has the capacity
to handle large-scale problems.
Alternatively, there may be ring structure of minicomputers of equal
power and a large central processor. Each minicomputer does local
processing and access data from the other locations as required. The

90
way a distributed processing system is configured usually depends on
the needs of the application.
Local area networks (LANs) are the most prevalent form of distributed
systems for workgroup processing. A LAN connects independent
microcomputers by using cables and processor cards that are inserted in
the expansion slots of the micros. For some systems, the cables are
telephone-type wire; with others, coaxial cable (cables used for tv) is
required. In general, the microcomputers must reside within several
thousand feet of each other. The LAN supports hardware sharing, e-
mail, and workgroup database processing. It connects five user
microcomputers with a special microcomputer called a file server. The
file server contains the database on its disk and processes that
database in accordance with the requests from the other
microcomputers. It also schedules and supervises the processing of
requests for the graphics plotter.
Suppose a company maintains three ware houses in geographically
separated locations. All of the micros in a ware house are connected via
a LAN. Most of the time, the users of the micros need only to
communicate with other micros at the same site. Upon occasions,
however, it is necessary for a micro to communicate with another micro
in a different ware house. Wide area networks are basically networks of
LAN. In general, the system is designed so that micros that need to
communicate frequently are attached to the same LAN. The
independent LANs can communicate however, so that it is possible for a
micro on one LAN to communicate with a micro on another LAN. The
computers that connect the LAN together are called as gateway
computers.
Besides LAN and wide area network, a third network alternative is the
private branch exchange (PBX). A modern PBX is an extension to the
older telephone oriented switching systems. Such PBXs allow for the
transmission of data as well as voice signals and thus provide a medium
for microcomputers to communicate. Most PBX systems provide far less
data transmission capacity than a LAN, and so they currently are used
for low-volume applications such as e-mail.

8.1.3 Reasons for Designing Distributed System

i)Local Processing With Communications Capability

Analysts design distributed systems when it is desirable or necessary to
capture and process data locally but also to communicate with other
locations. For example, data transactions occurring during the day can

91
be captured by direct entry into a microcomputer or a terminal connected
to a minicomputer and stored on magnetic disk. At the end of the day,
summary reports on transactions that have occurred are printed, but the
stored transaction data remain on disk. Changes and corrections to
transactions are made as they appear necessary after the transaction
register is scanned. If the system is, for example, a retail system, the
transaction files can be processed at the end of the month to produce
monthly statements for mailing to customers. At the same time,
customer accounts are updated to show new purchases, payments,
credits, and adjustments and to produce a new account balance, all of
which happens at the local level. Periodically throughout the month,
information on inventory levels can be sent to a central system at the
regional ware house that handles all purchasing of merchandise for the
firm. This process can be performed daily, weekly, or at whatever time
interval management finds appropriate.
At the end of the month, the national and regional sales offices receive
reports generated by the local system that summarize sales, inventory,
payments, and accounts receivable information. In this way the central
office receives all the information it needs, while the local offices are
able to capture and process operating data in the manner best suited to
their activities.

ii) Linking Different Makes of Equipment

There are few limits on the brands of equipment necessary to operate in
a distributed environment. The size of the system needed can vary
dramatically between nodes in a common network. Even the software
will be different. In this way, local operations can be tailored to their own
unique characteristics.
At the same time, through communications capabilities, the data or local
processing results can be transmitted throughout the network to other
systems of different sizes or even those made by other manufacturers.

iii) Sharing Loads

An important advantage of distributed systems is the ability to share
work between sites. Load sharing permits one site to transport data to
another node, through communication lines, and have it processed here.
The results are stored at the remote site and recalled to the originator
when the system is free.
Load sharing also provides operating reliability by ensuring that other
equipment is available for use if the local system is inoperable.
Processing can be done elsewhere in the network and results retrieved

92
when the system is again running. Sometimes a terminal is kept on hand
to link with other systems when the local computer system is unusable.

iv)Sharing Software
Sometimes software is the reason for developing distributed systems.
Some software packages run only on certain makes or sizes of
equipment. Budget constraints may also prohibit one site from
purchasing expensive software packages. However, if another site in
network has a specific package on its system, user in a distributed
system are usually able to run the software. Software sharing permits a
remote user to access the computer system to another node, enter data,
and have it run on the remote computer, using the software stores on
that system. As the results are generated, they are stored and later
downloaded (transmitted back) to the originating system.

8.1.4 Advantages and Disadvantages of Distributed System

Advantages of Distributed System

Increased service and responsiveness to local users.

Improved local morale because of local involvement.

Ability to adapt to the organizational structure.

Less vulnerable to downtime or catastrophe at central site

Increased manageability because the pieces of the system are

smaller.

Reduced computing cost

Disadvantages of Distributed System
Very dependent on high quality telecommunication lines, which are
quite vulnerable
Utilizes technologies those are relatively new and not well
understood.

Greater security risks because of easy accessibility.

Local sites may deviate from central standards, marking an
integrated system impossible.
Greater required coordination across organizational boundaries
and geographic locations.

Increased communication costs.

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8.2 INTERNET
The internet is often referred to as the network of networks- a
communication medium made possible by computers and networks.
People often exchange all kinds of information, in innumerable social
contexts, on the internet. Research and information pass back and forth
ceaselessly. It is a fluid and dynamic environment: it has no definite
boundaries, its limitations imposed only by available software and
hardware technology. It has been used exhaustively by scientific and
academic communities for many years. With recent surge in interest by
business and government, the internet or its successor network will be of
major importance in tomorrow’s world.

8.2.1 The Domain Name System

When an internet site is established on the network, it is given a unique
address. Whenever someone wants to access the site, the person has
to specify the address of the computer. Initially, these addresses were
numbers, called internet protocol (IP) addresses, but soon people
started realizing that humans preferred names, computers on the
internet were then also given names, called domain names.
When you use the domain name in accessing a computer on the
internet, the domain name is translated by the domain name system
program into the host’s corresponding address. In the domain name
“incometax.gov.in” for example, the internet host is “income tax”. This is
a government agency (indicated by “gov”). In other words, a domain
name contains information about the computer system.
Just as regular mail addresses are subdivided into countries containing
smaller units, such as state and city, domain names are divided into
various level domains. The last word in the domain name is the top-level
domain. The top-level domain can be either geographical location or
countries and territories the host computer is located in. They include the
following:

Aq Antarctica Fr France Nz New

Zealand

Ar Argentina Gr Greece Pr Puerto rico

At Austria Hk Hong kong Pt Portugal

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 Au Australia Hu Hungary Se Sweden

Be Belgium Ie Ireland Sg Singapore

Br Brazil Il Israel Tn Tunisia

Ca Canada In India Tw Taiwan

Ch Switzerland It Italy Uk United

kingdom

Cl Chile Jp Japan Us United

states

De Germany Ke Korea Ve Venezuela

Dk Denmark Mx Mexico Za South Africa

Es Spain Nl The
netherland

Fi Finland No Norway

If a geographical location is not specified, it is assumed to be the United

States. In fact. Within the United States, most of the networks use
“organizational” identification for the top-level domain instead.

8.2.2 Internet News group Organization

Anyone on the internet can start a newsgroup on any topic of interest.
Although there are some newsgroups that are moderated, in general
newsgroups are a forum where almost anything goes. In fact, there is no
guarantee that articles in a newsgroup will stay on the supposed subject
of the group. It is up to the users to use the forum wisely. There is no
one person or organization that controls or regulates newsgroups. For
the most part, it is an open and uncensored environment. News is
received through newsfeeds. At each site, a person known as the news
administrator or as a group is responsible for what newsgroups a site
receives and how the newsfeed is operated. A site may choose to
restrict the flow of news or to receive every conceivable group. A typical
site subscribes to over 1500 newsgroups.
The news administrator also decides how long to keep the news articles.
This depends on things such as the amount of local space available to

95
store the newsgroup articles and the amount of traffic on the particular
newsgroup. A news article may be stored for just a few days or up to
months. If you don’t look at a newsgroup for a while, you will miss topics
of discussion as they come and go.

8.2.3 Features of Internet

Simplicity of Use
In general the software that accesses the internet is comparatively
simple to use. The reasons for this and their implications can best be
illustrated by looking at the example of the www.
Netscape and Microsoft provide the products (www browsers) that are
used by the vast majority of people who access the www.These
products are increasingly designed for the mass consumer and not the
specialist. A core objective of the products is that they are intuitive to use
with a short learning curve. In addition to this objective is the
requirement for browsers to operate on a wide range of different
suppliers computing products and operating systems. Once the basic
principles of using a browser have been learnt, this knowledge is
transferable across most of the computing platforms that a user is likely
to encounter. A further implication of the simplicity of the browser
software is the ability of the same product to be used both horizontally
and vertically within an organization. It is increasingly likely that the CEO
and a lowly grade clerical employee will use the same interface on their
desktops.
Breadth of Access
Like the telephone network, the internet operates globally. Once
connected, the scope of access is not conditioned by geographic
boundaries. Unlike the telephone network, the costs involved in global
connection are not related to the distances involved. Conducting
transactions with the adjacent office costs the same as contacting the
farthest continent.
No other communications medium has had access to such a large
audience and range of people which increases the ability to leverage the
value of information to a scale that has never been possible.

Synergy with Other Media

Internet services have demonstrated a high degree of synergy with other
media, as can be seen from the following examples.
Book, magazine and newspaper publishers have used the www to
supplement and extend their written products. The financial times, Wall

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street journal and numerous other publications produce both an
electronic and paper version of their products.
Publishers of software and games now deliver their products
directly over internet.
Entertainment companies regularly provide extracts of their films
and music recordings to promote the real products.

Low Relative Cost

There are many factors that support the conclusion that the costs
involved in conducting a process using internet technology will be less
that those involved in using other methods.
It is often the case that in addition to being simplified, the process
can be transferred outside the organization to be completed by the
customer. It is thought that the cost of processing a banking transaction
is over 100 times less expensive if it is conducted via the www rather
than using a traditional bank branch and teller.
This argument of cost reduction is strongest where it is possible to
undertake a process solely using the internet. The situation becomes
complex when facilities have to be retained to conduct the process using
both traditional and internet techniques.

Flexibility of Communication
The continuing releases of both Microsoft and netscape www browsers
will greatly extend the ways in which individuals can communicate. They
are:
Exchange text with each other.

Conduct voice communications.

Use a shared ‘whiteboard’ upon which they could all contribute

Have immediate access to a common base of shared information.

Activity
Which is the better internet software tool, Internet Explorer or Netscape
Communicator? To prepare your analysis, use articles from computer
magazines and the web and examine the software’s features and
capabilities. If possible, use presentation software to present your
findings to the class.

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LET US SUM UP
Database Management system is a software system that manages the
creation and use of databases. It may be hierarchical, network or
relational. Distributed systems have computers located at various
physical sites at which organization does business and these computers
are linked by telecommunication lines in order to support some business
processes. Internet is often referred to as the network of networks which
has a wide range of applications.

CHECK YOUR PROGRESS

Choose the Correct Answer:

1. _________ is an application of the internet

a) Breadth of Access b) Simplicity of Use

c) Both a and b c) None of the above

2. A __________ connects independent microcomputers by using
cables and processor cards that are inserted in the expansion slots of
the micros.
a) WAN b) LAN

c) MAN d) interlinked network

3.___________ system in which the processing power is distributed to
multiple sites, which are then tied together via telecommunications lines.

a) Distributed System b) Database Management System

c) RDBMS d) Integrated System

4. LAN Stands for __________

a) Local area network b) Low area network

c) Logical area network d) Legal area network

5. WAN stands for___________

a) Wide angle network b) Wide area network

c) World angle network d) Web area network

GLOSSARY

Newsgroups : Newsgroup, Internet-based

discussion group, similar to a
bulletin board system (BBS), where
people post messages concerning
whatever topic around which

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 the group is organized.

Domain name : A domain name is a unique name

that identifies a website. For
example, the domain name of the
Tech Terms Computer Dictionary is
"techterms.com".

Local area networks (LAN) : "Local Area Network" A LAN is

a network of connected devices that
exist within a specific location. LANs
may be found in homes, offices,
educational institution, or other
areas.

Internet protocol : "Internet Protocol." IP provides a

standard set of rules for sending
and receiving data over the Internet.
It allows devices running on
different platforms to communicate
with each other as long as they are
connected to the Internet.

Centralized systems : In a centralized system, all users

are connected to a central network
owner or “server”. The central owner
stores data, which other users can
access, and also user information.
A centralized system is easy to set
up and can be developed quickly

SUGGESTED READINGS
1. Bentley Trevor J (1986) Management Information Systems &
data processing, 2nd edition, Holt, Rinehart and Winston
publications, University of California. ISBN 0039106888,
9780039106881.
2. Donald W. Kroeber (1986) Computer-Based Information
Systems: A Management Approach, Subsequent
edition, Macmillan Publications, University of Virginia. ISBN
0023668407, 9780023668401.
3. Gordon B.Davis (2013) Management Information Systems, 1 st
Edition, TMH Publications, India. ISBN 007066241X.

99
 4. Joel E. Ross (1970) Management by Information System,
illustrated edition, Prentice-Hall publications, University of
Wisconsin,ISBN 0135486289, 9780135486283.
5. Kenneth C. Loudon & Jane P. Loudon (2014) Management
Information Systems, 13th Edition, Pearson Publications, USA.

ANSWERS TO CHECK YOUR PROGRESS

1) c 2) b 3) a 4) a 5) b

100
 BLOCK 3

APPLICATIONS OF INFORMATION
SYSTEM

Unit 9 : Application of IS In Business Areas- Part I

Unit 10 : Application of IS In Business Areas- Part II

101
Unit 9

APPLICATION OF INFORMATION
SYSTEM IN BUSINESS AREAS - PART I
STRUCTURE

Overview

Learning Objectives

9.1 Marketing and Sales

9.1.1 Customer Inquiry and Sales Offer Processing

9.1.2 Quotation Follow-up

9.1.3 Order Entry and Order Verification

9.1.4 Customer Relationship Management (CRM)

9.2 Procurement

9.2.1 Order Scheduling

9.2.2 Purchasing

9.2.3 Delivery Monitoring

9.2.4 Goods Receiving Control

9.3 Warehousing

9.3.1 Material Valuation

9.3.2 Inventory Control

9.3.3 Support of Processes in the Warehouse

Let Us Sum Up

Check Your Progress

Glossary

Suggested Readings

Answers to check your progress

OVERVIEW
Information system finds its applications in our every walk of life. It plays
a vital role in today’s business. In this unit, we will discuss the
application of information system in business. Especially in the functional
areas of business, viz. marketing, procurement, warehousing,

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production, finance and human resources. In this chapter, we will look in
detail how IS is applied to Marketing, Procurement and Warehousing.

LEARNING OBJECTIVES

After reading this unit, you should be able to,

• Discuss the marketing and sales functions
• explain the stages in procurement
• list out the functions in warehousing.

9.1 MARKETING AND SALES

The marketing and sales function include

i) Customer inquiry and sales offer processing

ii) Quotation follow-up

iii) Order entry and order verification

iv) Customer relationship management (CRM)

9.1.1 Customer Inquiry and Sales Offer Processing

Very powerful tools are available to handle sales offers. If they are
combined one may speak of closed sales offer systems that support the
sales force when visiting the customer. One also refers to this as
Computer Aided Selling (CAS).
Imagine that the salesperson of a printing machine manufacturer wants
to sell the owner of a private copy shop near a university various devices
(copiers, sorting equipment). She carries a notebook with her. During the
first phase she interviews the owner of the copy service shop by using a
stored checklist. She records, e.g., the number of copies made each
day, information about the quality requirements of customers, the
average size of the lecture notes and term papers to be copied, etc.
With the use of an electronic product catalogue products meeting the
needs of the copy shop are projected onto the screen. They appear as
photographic pictures and also as diagram sketches. After a pre-
selection by the customer the system puts together an arrangement of
equipment during the configuration process. In doing so it examines
many conditions and thus ensures that on the one hand the required
technical performance (operational capacity, quality, maximum footprint)
is delivered and on the other hand that the chosen components can be
integrated.
While using a stored price list for the individual components the
application system calculates in the next phase the offer price. Since this

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price is way too high for the customer, the system generates a leasing
contract with low monthly payments. As a special service, the application
system calculates the cost effectiveness of alternative machine
configuration in the copy shop under differing assumptions. Example it
may analyze that after the investment in the extra high capacity device
twice as many new students may be acquired as customers or that sales
may go down by 20% since the costs for using newly installed machines
in the university library have been lowered. In the next step the offer is
printed out and is stored on the notebook. Finally, the salesperson
transmits the offer the potentially the order (e.g., using a wireless
modem) to the central of her printing machine manufacturing company.

9.1.2 Quotation Follow-Up

This program evaluates periodically the provided offer and quotations
and makes available offer and quotation reminders to the sales
department when needed. The appropriate salesperson will then contact
the customer accordingly.

9.1.3 Order Entry and Order Verification

The order entry system is one of those points where many and important
external data are entered into the information systems of an enterprise.
Here we are concerned with efficient entry of information, but we also
want to assure the accuracy of the information.

A Practical Example
Ford-Werke AG in Germany has its central parts administration
integrated with the ordering systems of the Ford dealers. The integrated
system is called DARTS (Dealer Application Remote Terminal System).
An order scheduling program running on a computer in a dealership
makes suggestions when and in which amounts accessories and spare
parts should be ordered. The dealer authorizes or modifies these
suggestions and stores the final orders in the dealership’s computer.
Periodically the central DARTS computer fetches the orders
automatically from the dealers’ computers and transmits these
collectively to the order processing programs in the central spare parts
administration of Ford Motor Works in Cologne.
Important components are the various verification features. They must
assure that as few incorrect data as possible enter the integrated
system. The technical verification examines whether the desired variant
may be delivered or whether maybe an error occurred during the
configuration by the salesperson or whether a mistake was made by the
customer. For example, a medical device intended for export to

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Germany may be specified with an adaptor that works fine in the United
States, but does not meet the specifications of the German electricity
grid. During the credit assessment one checks whether after acceptance
and delivery of the order the customer would exceed a credit limit such
that payment may be jeopardized. The due date verification module
checks whether the customer’s desired delivery date may be kept. In
order to do this we first will have to query the inventory status starting
with the finished products, on to intermediate products and up to
externally procured parts. If one does not have enough supplies then the
system has to estimate whether the required production processes may
finish on time.

9.1.4 Customer Relationship Management (CRM)

Customer Relationship Management is a customer-oriented approach
that attempts to develop and tighten long-term, profitable customer
relations via individual marketing, sales and service concepts through
the use of modern information and communication technologies. The
challenge for information systems in this area can be seen in the need to
horizontally integrate partial systems for the pre-sale, sale and post-sale
phases (e.g., warranty and returns processing). But also vertical
integration helps, since the captured information serves to provide those
responsible for marketing and sales with important information about
preferences and behaviour of customers.

Figure 9.1Functions of CRM

A few examples of concrete functions of CRM systems are:

1. Storage of characteristics of the customer’s business and its contact
persons such that knowledge is preserved even when salespeople quit
2. Updating of the customer relationship (what and when did the
customer buy from us?)

105
3. Analysis of the customer data, e.g., through the use of database
marketing
4. Suggestions for the sales department that certain campaigns or
special offers are necessary, e.g., support when a trade exhibit is
forthcoming or when for equipment one year after installation a general
overhaul is recommended

5. Selection of holiday gifts that fit the customer’s profile

9.2 PROCUREMENT

The Procurement Functions include

i) Order scheduling

ii) Purchasing

iii) Delivery monitoring

iv) Goods receiving control

9.2.1 Order Scheduling

Order scheduling, in principle, is concerned with the “programming” of
the geometric presentation.
First the system determines for each part the safety stock. The
entrepreneur determines the number of days te during which he/she
would like to remain ready for delivery, even when his own supplies are
delayed due to disruptions (e.g., a strike at the supplier’s). The
application system multiplies te with the observed average daily outward
stock movement from the warehouse and thus calculates e. In more
sophisticated versions e may be amplified through the use of statistical
methods when the forecasting for outward stock movement is
associated with large uncertainties (large differences between forecast
and actual calculations, registered by the system itself).
For the prediction of outward stock movement one differentiates
between program control and demand control. In the program-controlled
calculation the demand for component assembly groups and parts is
computed based on the planned sales and the production program.
With the demand-controlled forecast the information system observes
the outward stock movement and thus determines future demand. Table
shows as an example how input data concerning material movements
may be created.

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Delivery to customer - Finished product Shipping logistics

inventory or invoice processing

Customer returns + Finished product People-generated

inventory warehouse inflow notices

Delivery by + Raw material, Incoming goods inspection

supplier sourced parts test

+/- Shop inventory People-generated

warehouse outflow

notices

Inflow to and outflow +/- Shop inventory Shop floor scheduling

Inventory differences +/- Miscellaneous Inventory

warehouses

Warehouse transfer +/- Miscellaneous People-generated notices

houses

Legend: + : Inflow to, -: Outflow from

In many firms the core of the procedure is the first order exponential
smoothing in accordance with the formula:

The symbols denote:

= Predicted demand for period i

= Predicted demand for period i-1

= Actual demand in period i-1

= Smoothing parameter
The demand for period i is estimated by correcting the predicted value
for the period i-1 by the fraction of the thereby occurring prediction error.
The size of determines how sensitive the forecasting process will react
on the newest observations. The smaller is, the stronger the forecast
values of the past are taken into account. Looking at the formula gives
us an indication of this effect, e.g., if one assigns to be as small as
possible, i.e. zero: Now the system picks the old forecast value also as

107
the new predicted value, i.e. the last observation M i-1 does no longer
play any role. For more complicated demand processes (cyclical trend,
seasonal dependencies, overlap of trend and season or demand thrusts
through sales campaigns) the exponential smoothing has to be
enhanced.
The order scheduling program finds the intersection L (desired delivery
date) of the outward stock movement line with the parallel to the x axis
that marks the safety stock, and moves to the left from this point by the
amount of the reorder time tw . In doing so the order date TBis specified.
This is the point in time when an order will have to be placed such that
after the reorder time period has passed the ordered parts will arrive on
time. The x-coordinate value TBcorrespondents to the y-coordinates s.
This is the reorder level.
In the next step a low-cost order quantity Q is calculated. If the part is
obtained through in-house production, then the order for a finished
product will have to be transferred to the application system Primary
Requirements Planning. For an intermediate good or single part the
transfer data will need to be sent to the application system Material
Requirements Planning. If we are dealing with an external procurement,
however, then material scheduling will pass along the data to the
purchasing system.

Oracle Advanced Supply Chain Planning

Figure 9.2 Oracle Advanced Supply Chain Planning

108
9.2.2 Purchasing
One need to distinguish whether a) only one supplier is under
consideration, b) the systems may determine a supplier on its own (in a
module supplier selection) or c) the choice becomes the duty of the
purchasing officer. In the cases) a) and b) the computer can print the
order and store it in a temporary reservation file. In case c) the
purchasing officer is presented with the choice of suppliers on the
monitor. The orders may only be triggered when a human being has
entered his/her decision into the computer. In some firms the application
system transmits its orders, e.g., via the Extranet to the computer of the
supplier (interorganizational integration or supply chain management,
respectively).
During the classical procurement process the ordering entity, e.g., a raw
material warehouse, enters an order request into the system. This
request is processed at the PC of an employee within the purchasing
department (checking against the purchasing budget, choice of supplier,
where appropriate a modification may be made in the computer-
suggested lot size) and is then passed along to the supplier. In case of
the so-called desktop purchasing in our example the warehouse
scheduler places the order without the participation of the purchasing
department. The rules via which the purchasing department employee
checked the order request are now depicted in an electronic program.
As long as there is no interference the computer of the warehouse
scheduler transmits the order in electronic form to the supplier.
The purchasing or procurement function is according to many observers
once of the partial systems of a manufacturing firm that are drastically
changed by the Internet (“electronic procurement”). We may distinguish
among various levels
1. Information collection from WWW presentations: The
purchaser acquires on the Internet the newest product descriptions and
prices, investigates potential suppliers, etc.
2. Internet-Shops: Buyers visit virtual show rooms on the Internet
and order directly.
3. Internet-Shopping Malls: Here several Internet shops are brought
together in a portal. The buyer may thus inquire about the availability
and conditions of a multitude of potential suppliers.
4. Internet Request for Proposals: The buyer may post his needs
on an Internet portal. An intermediary compares the specification with

109
the tender of potential suppliers and transfers the inquiry with the
request to make an offer.
5. Internet Market Places: One may see them as a further
development of Internet requests for proposals. The main difference is
that the potential suppliers after the request for proposals have the
possibility to examine the offers of the other competitors and to improve
their own in favour of the buyer without interference by the market place
operator (online purchase auction).

9.2.3 Delivery Monitoring

The program “order monitoring” controls in regular intervals the “external
procurement orders”, created by the program “order disposition”. If
delivery due dates are surpassed, then reminders are sent to the
suppliers. Each occurring reminder is registered in the supplier master
data. For example, the increase in the total number of reminders may
influence the supplier choice during the next purchasing cycle.

9.2.4 Goods Receiving Control

Subjects of the goods receiving control are the quantity and quality
control. The application system is supplied with the goods receiving
information that, the order schedule program produces. The goods
receiving control may thus recognize whether or not a delivery was
ordered at all and whether the delivered quantities are in agreement with
ordered quantities.
9.3 WAREHOUSING
The functions of warehousing include material valuation, inventory
control and support of processes in the warehouse.

9.3.1 Material Valuation

The application system extracts valuation approaches from the material
master data such as (with externally procured material) the prices from
the order or delivery, permanently stored stock prices or the newest
costs based on a product costing analysis. One may also consider a
simple evaluation calculation such as with smoothened averages (with
each inward flow an average price is calculated).

9.3.2 Inventory Control

Mechanized inventory control is in principle very easy. One follows the
following formula:

New inventory = old inventory + inflows - outflows

Complications, however, may arise, e.g.:

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 Aside from the ‘bureaucratically’ managed, i.e. using stock
requisitions and delivery notes, warehouses there is shop floor stock for
which not every single movement is accompanied by a book entry.
One has to consider reservations, i.e. parts, that are physically still
in the warehouse even though they are already encumbered and may
only be delivered for a specific purpose.
Stock-taking as an example demonstrates how information systems
trigger processes carried out by men and thus makes essential
contributions to the orderliness of companies (concurrence between
“book inventory balance” and actual “inventory”). Occasions requiring
inventories that applications systems are capable of determining
themselves are:

1. Exceeding of set maximum stock levels

2. Falling below a minimum level (it is recommendable to conduct an
inventory when few items are in stock because then the effort to count is
small)

3. The information of book inventories below zero

4. Within a parts or item category a certain number of fluctuations has
occurred (with this a certain probability exists that an error occurred
during the postings)
5. With a parts or item category no fluctuations were observable over
a longer period of time (possibly this parts or item category does no
longer exist)
6. Control via computer-generated random numbers to ensure the so-
called surprise effect when there is risk of theft

7. Activation on an appointed data

The inventory is conducted either by counting everything or through
sampling. During the sampling inventory the information system
determines a suitable sample size using methods of mathematical
statistics and extrapolates the counted results.

9.3.3 Support of Processes in the Warehouse

When combining business administration processes with technical
information systems many opportunities for efficient warehouse
management arise. Among them are:
1. Information systems administer high rack storage areas. Palettes
are being transported automatically to available storage locations using
horizontal and vertical movement. The individual palettes are not sorted

111
based on any particular order (so-called random or chaotic storage).
Since the computer stores an image of the warehouse, the system is
capable of finding available positions any time.
2. During stock withdrawal “position” as part of a consignment (order
or shipping process) are fetched (partially) automatically from their
storage location, sorted and are being transported to the location for
packing and shipping.

A Practical Example
Avon CosmeticsTM opens the shipping cartons that had arrived folded
with an automated machine. Also automatically each carton is marked
with a bar code that identified it as part of a customer order. A control
system reads this bar code and delivers the carton over belts, gates and
switches only to those unloading/loading locations whether there are
ordered parts/items. The employees handling the consignment receive a
graphical presentation on a monitor that shows to which shelf location
and space they have to move. This shelf space is being illuminated at
the right moment and on a digital display the employee sees how many
units (e.g., lip sticks, tubes) will have to be picked and be placed into the
carton. After this is done the employee pushes a button to report the
process as completed. The carton is then transported automatically to
the next location. In that way a sort of “consignment progress control”
occurs. The system transmits data to a logistics manager who is then
informed of which shipping tasks are forthcoming and how he/she is to
manage these shipments.

LET US SUM UP
In this unit we have discussed the application of information system in
business. In marketing the information system finds its application in
customer inquiry and sales offer processing, quotation follow up, order
entry and order verification and customer relationship management. It is
helpful and goods receiving control in procurement function. The
warehousing functions include material valuation, inventory control and
support of processes in the warehouse.

CHECK YOUR PROGRESS

Choose the Correct Answer

1. Analysis of the customer data is a function of ____________
a) Order scheduling b)CRM

c) Procurement d) DBMS
2. Purchasing is a function of_____________

112
a) Order scheduling b)CRM

c)Procurement d) Information System

3. The order for a finished product will have to be transferred to the
application system Primary Requirements Planning.
a) Order scheduling b)Material Requirements Planning
b) Primary Requirements d) Procurement Planning

4. Customer Inquiry and Sales Offer is also called __________

a) Order scheduling b)CRM

c)Procurement d) Computer Aided Selling

5. Quotation follow-up is a function of ___________

a) Marketing b) Financing

c) Operation d) Personnel

GLOSSARY

Order scheduling : Order scheduling is an additional

process in the processing of sales
documents or purchasing
documents that helps to optimize
the delivery dates for each item

Purchasing : Purchasing is the process a

business or organization uses to
acquire goods or services to
accomplish its goals.

Delivery monitoring : Delivery monitoring or tracking

software, which reports real-time
order progress, can provide
valuable visibility to both customers
and businesses

Goods receiving control : All goods are received at the

centralized receiving department
within specified time only, under the
supervision of the receiving clerk

SUGGESTED READINGS
1. Bentley Trevor J (1986) Management Information Systems &
data processing, 2nd edition, Holt, Rinehart and Winston

113
 publications, University of California. ISBN 0039106888,
9780039106881.
2. Donald W. Kroeber (1986) Computer-Based Information
Systems: A Management Approach, Subsequent
edition, Macmillan Publications, University of Virginia. ISBN
0023668407, 9780023668401.
3. Gordon B.Davis (2013) Management Information Systems, 1 st
Edition, TMH Publications, India. ISBN 007066241X.
4. Joel E. Ross (1970) Management by Information System,
illustrated edition, Prentice-Hall publications, University of
Wisconsin,ISBN 0135486289, 9780135486283.
5. Kenneth C. Loudon & Jane P. Loudon (2014) Management
Information Systems, 13th Edition, Pearson Publications, USA.
ANSWERS TO CHECK YOUR PROGRESS

1) b 2) c 3) c 4) d 5)a

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Unit 10

APPLICATION OF INFORMATION
SYSTEM IN BUSINESS AREAS - PART II
STRUCTURE

Overview

Learning Objectives

10.1 Production

10.1.1 CIM

10.1.2Primary Requirements Planning/MRP II

10.1.3 Material Requirements Planning/MRP I

10.1.4Throughput Scheduling

10.1.5 Capacity Balancing

10.1.6Availability Check
10.1.7 Order Clearance

10.1.8 Job Shop Scheduling

10.1.9 Computer Aided Manufacturing

10.1.10 Production Progress Control

10.2 Finance

10.1.1Cost Center Accounting

10.1.2Production Cost Accounting

10.1.3Supplier Accounts Auditing

10.1.4General Accounting

10.1.5Accounts Receivable

10.1.6Accounts Payable

10.3 Human Resources

10.3.1Work Schedule Management

10.3.2Payroll Accounting

10.3.3Reporting Programs

10.3.4Special Action Programs

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10.4 Decisions-Support Systems

10.5 Executive Support Systems

Let Us Sum Up

Check Your Progress

Glossary

Suggested Readings

Answers to check your progress

OVERVIEW
Information system finds its applications in our every walk of life. It plays
a vital role in today’s business. In this unit, we will discuss the
application of information system in business. Especially in the functional
areas of business, viz. marketing, procurement, warehousing,
production, finance and human resources. In this chapter, we will look in
detail how IS is applied to Marketing, Procurement and Warehousing.
LEARNING OBJECTIVES
After reading this unit, you should be able to,
• evaluate the functions of production.
• evaluate the functions of finance and human resources.

10.1 PRODUCTION
The production function includes CIM, MRP I, MRP II, throughout
scheduling, cap acing balancing, availability check, order clearance, job
shop scheduling, CIM, Computer aided quality assurance and
production data entry.

10.1.1 Computer Integrated Manufacturing(CIM)

Information processing in the production area is earmarked in that
business management data processing, technical data processing, as
well as physical production processes have to be integrated. The
underlying concept is labeled Computer Integrated Manufacturing (CIM).

On the business management side (in the narrow sense) we have to

manage production planning and control (PPC). Plant maintenance
planning and control are omitted here. PPC constitutes the transaction
chain in the flow of orders. The transaction chain that connects the
design, the physical manufacturing and the quality control of the product
is linked by the so-called C techniques. At the cross-over point
Computer Aided Manufacturing (CAM) the two chains are so intertwined

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that a separation into the business management and technical parts is
barely recognizable.
This illustration is of relevance mainly to firms, e.g., in the mechanical
engineering industry, that manufacture products that have been ordered
that have been ordered by customers on an individual basis or with
certain variants in job-shop manufacturing settings. For firms that turn
out mainly mass-produced items for an “anonymous” market, such as
cleaning detergent, other configurations of the building blocks will have
to be chosen.
A very difficult problem in the conceptualization of application systems in
the production area is the intensive reciprocal interaction among the
individual systems. Basically, one should depict. CIM as one huge
simultaneous model. Figure 5.3 shows just one example of the effects of
integration: If one increases the lot size, this implies that one is willing to
put up with increased inventories that tie up more capital. However due
to shorter set-up times, bottlenecks are better utilized. Thereby the
throughput times of orders decline initially during the manufacturing
process. After exceeding a minimal value, cycle times will tend to
increase again, because lots will increasingly have to wait directly at the
manufacturing unit where a larger and previously scheduled lot is being
processed for a longer period of time.
The production flow depends on various factors, e.g., lot size at various
manufacturing levels, production sequences, as well as the choice of
constructive variants and alternatives in conjunction with work flow,
plans and schedules. Even with the largest available computers today it
is still impossible to master a simultaneous optimization. During the
course of several decades a sequence of the modules established itself
that was considered practical in many respects, but not always optimal.
It is based on the following considerations.

10.1.2 Primary Requirements Planning/MRP II

Primary demand planning balances roughly desired sales or production
quantities, respectively, with available manufacturing capacities. This
early-on coordination of available capacity and capacity requirements is
to avoid that the floor shop is inundated with unrealistically planned
production orders. For this one may use, e.g., sales forecasts based on
statistics. These systems are referred to as Manufacturing Resources
Planning (MRP II). We need to distinguish between. MRP II and MRP I
“Material Requirements Planning”

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10.1.3 Material Requirements Planning/MRP I
The demand for final products (derived from order entry, sales planning
or primary demand planning) must be broken down (“bill of materials
explosion”) into its components (secondary demand).
It is organized as a building block parts list, i.e. one recognizes (in the
shape of the dashed rectangles) from which subordinate parts each
respective supra-ordinate part is assembled. The application system,
e.g., determines that per passenger car five wheels are needed,
including the spare. The assembly team “wheel” would subdivide this
again into one rim, one tire and four clamping bolts, etc. In that way one
would calculate first the gross requirements of the assembly teams and
the component parts. The application system examines also whether or
not cost-effective bulk order may be placed through bundling of
demands for different future time period. In several industries, e.g.,
aluminum, glass, optics, paper and textile, we may specify through
rather complicated mathematical procedures how parts (e.g., paper
webs) will have to be cut out of larger raw material units (e.g., paper
master rolls) such that waste is minimized. During such materials
demand planning the transition to the subsequent time scheduling is
implemented in that the system considers the associated lead time. This
is the time span by which the sub-ordinate component has to be
available earlier than the supra-ordinate component such that the
subsequently requisitioned parts may be assembled in a timely fashion.
The results of the procedure are roughly planned work, manufacturing or
production orders, respectively, or (with external procurement)
requirements to be transferred to order scheduling.
10.1.4 Throughput Scheduling
Whereas volume planning determined availability scheduling, i.e. those
points in time at which a part is to be delivered, through forward-shifting,
throughput scheduling has to generate the starting dates of the
individual work processes.

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 Figure 10.1 Throughput Scheduling
A method for this is backward scheduling that calculates from the
delivery deadline found in material requirements planning toward the
present. An example in figure 5.5 is the work order M is assembly
requiring the finished products of the work orders A, B and C. One
should note that in this phase waiting periods, as they tend to come
about through capacity bottlenecks, are not considered. In other words:
We work here with the simplified assumption “capacity is infinite”. With
other, more complicated and computation-intensive methods this
simplification is not applied, as they conduct simultaneous scheduling
and capacity planning.
Particularities occur when the applications system determines that a
work process should have started several days or weeks ago “prior to
the present” (sometimes students gain such knowledge as well during
the manufacture of the product “examination”!). In order to avoid revising
the hitherto production planning because of the later delivery date, the
application system will attempt to shorten the throughput time in
comparison to the planned values. For examples, it may test whether
several machines are available for a work process and then split a lot
onto two or more manufacturing resources that then “divide” the work
among themselves. The system then has to determine through the use
of parameters defined by manufacturing management the trade-off
between lead-time reduction and the additional expenses for setting up a
second, third, etc. machine.

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10.1.5 Capacity Balancing
If in the throughput scheduling no attention had been paid to capacities,
it may occur that in individual periods certain work places are heavily
overloaded whereas others are underutilized.

Figure 10.2 Capacity Balancing

Here capacity balancing is put into place. You recognize at first glance
that, e.g., one needs to tip the peak in period 10 into the valley of period
10. People recognize this due to their pattern recognition capabilities in
which they are clearly superior to a computer. This is why in many cases
one will not attempt to automate capacity balancing, but to show the
capacity “mountains” on the monitor of a control station called Leitstand
(see section 10.4.8) and to deliver appropriate information above which
individual production and customer orders contribute to the work-load
during a particular time period. Based on this information a manager can
decide on the rescheduling measures.

10.1.6 Availability Check

It would be awkward if a computer triggered the start of a work order that
could not be executed because during the same time period a needed
machine is down for maintenance or repair, externally procured material
did not arrive in a timely fashion due to tardiness of the supplier or a
control program (NC-program) has not been written yet. Maybe
employees with the right qualifications are on holiday on that particular
day. It is the goal of an availability check to set aside such production
orders for which any resources might be missing.

10.1.7 Order Clearance

The order clearance process chooses (while being controlled by
parameters) a subset of those orders which have passed the availability

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check for actual production. For example, all work orders are selected
that have to start within the time span “clearance day + ten working
days” according to throughput scheduling.

10.1.8 Job Shop Scheduling

One of the tasks of floor shop scheduling is to find a machining
sequence for the orders at a work place that fulfills certain goals as well
as possible. Such goals may be the minimal overall lead time of the lots,
maximal capacity balancing, minimal capital commitment, minimal set-up
costs, and maximal adherence to schedules or also simplicity of control
processes. Since the emphasis on goals may vary greatly in various
industries, in different strategic circumstances or varying economic
conditions very complex control tasks arise.
Control approaches may be structured according to whether the next lot
to be machined at equipment that just was freed up is to be determined
or whether it is more important to assign appropriate manufacturing
resources to upcoming production orders when there are several to
choose from. The latter plays a role in rolling mills or also in the paper
industry and here especially with regard to cutting problems.
By using priority rules it becomes possible to consider that actual
emphasis of the different goals. One may apply, e.g., a computer-based
control system such that at a bottleneck the system chooses the very lot
among a set of waiting ones that fits best for the actual set-up condition
of the manufacturing resources. In this way it is possible to keep the set-
up costs low. On the other hand, if one decides to prioritize the lot that
ties up the largest amount of capital, it is possible to guide capital -
intensive products through the shop in shorter time and as a result
reduce the typing-up of capital.
When a largely automatic control is not (yet) possible due to the outlined
complexity, often production control stations (so-called Leitstands) are
utilized that support scheduling by a person. With suitable user
interfaces, control station personnel will be able to evaluate the current
manufacturing situation (e.g., capacity balancing of bottlenecks, idle
machines, late orders, minimum inventory levels, resources not
available).
Shop floor control issues documents necessary for production (job
tickets, time tickets, material documents, quality control receipts, etc.). It
is practical to make these machine-readable (e.g., in that they feature a
magnetic strip), since when they return from the manufacturing since
they may be read into the computer system again (“return data carrier”).

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Some firms do not issue such documents; instead employees identify on
their screens what they should produce and how (“paperless factor”).

10.1.9 Computer Aided Manufacturing

The term Computer Aided Manufacturing (CAM) does not only comprise
the information systems support of physical production in the narrow
sense, but also systems serving the automation of the functions
transporting, warehousing, testing and packing. CAM administers
numerically controlled machines (CNC, DNC machines), as well as
manufacturing cells and flexible manufacturing systems, processes (e.g.,
in the chemical industry), robots and various types of transportation
systems. One might add the administration of warehouses, especially
buffer warehouses in manufacturing.
The position of CAM as a manufacturing information system in the
manufacturing execution is characterized by two attributes:
1. One attempts to accompany the material flow with CAM over several
phases. A comprehensive CAM system sets up manufacturing
resources with tools automatically captures their down times and
machining times, recognizes worn-out or defective tools and exchanges
these. Moreover, work pieces or the material are taken from the
warehouse in accordance with the production schedules. Next they are
passed on to the manufacturing resources in a suitable sequence (e.g.,
in a flexible manufacturing system such that as few set-up processes as
possible are required) and the physical manufacturing processes are
controlled (e.g., the setting of a spot weld by a robot or the drilling speed
of a drill).
Beyond that driverless transportation systems are directed, finished
products are packaged and made available for shipment. In that way
one arrives at the “sparsely populated factory” in which people carry out
merely controlling tasks. Coordination is often the duty of a host
computers or a production control system consisting of several
networked computers. A control system as a CAM component may not
be seen as comparable to a control station as part of a production
planning and control system.
with preliminary reservation data of the placed production orders. One of
the challenges in the further development of production data entry
systems is to capture as much data as possible automatically, e.g., from
production equipment, transportation equipment or automated testing
machines (machine data logging) or directly emanating from a process
(process data logging). It is possible, e.g., in a pharmaceutical company

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to register the quantity of the manufactured granulated material at a
weighing station that is coupled to a computer.
On the other hand it is important to examine, especially with machine
data and process data logging, the flood of largerly automatically
received data for their correctness and plausibility. This is necessary
since, similar to the order entry, process data logging is an important
entry point to integrated information systems. Consequently, errors
occurring during the data capture may easily trigger numerous
erroneous after-effects.

CAM FLOW CHART

Figure 10.3 Cam

10.1.10 Production Progress Control

The application system production monitoring utilizes the production,
machine and process logged data to recognize production progress. If
missed deadlines are looming, it issues reminders.

10.2 FINANCE
In comparison to other areas we find relatively few administration and
scheduling systems in the finance area (excluding accounting). An
important, although difficult task, is the finance and liquidity scheduling.
Here we are concerned with predicting the likely revenues and outlays
and, depending on the accounting balance, deciding about use of
available funds or about getting a short term loan. Especially
international firms utilize a cash management system for this purpose.

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Above all it is the duty of the computer to predict the extends and dates
of payments. In integrated information systems we may draw, e.g., upon
the following data: sales plan, goods on order, account receivable,
accounts payable, purchase commitments, costs projections, regularly
recurring payments (e.g., wage and salary payments or rents) and
investment plans.

10.2.1 Cost Center Accounting

Information systems-supported cost accounting is largely a recreation of
the procedure as it is conducted manually by the employees. For the
machine hourly rate we have the advantage that in the CIM conception
machine times may be determined easily and rationally through the
integration with programs in the production area. Similar things may be
said about target costs that, e.g., may be calculated by multiplying the
actual times (registered exactly in the production data entry) with the
target prices. Finally, integrated information systems make it possible to
determine aside from cost deviations also deviations of consumed
quantities, as well as capacities and thus being able to deliver
suggestions for an interpretation for the target vs. actual deviation.
Altogether integrated information systems enable cost center accounting
to work with very differentiated data. Those, in turn, make it possible to
apply individual direct cost and product profitability calculations.

10.2.2 Product Cost Accounting

Preliminary Costing
For preliminary costing three data groups are at out disposal within an
integrated concept:

1. Material master data

2. Parts lists or bills of materials

3. Task schedules with the work processes, manufacturing resources
to be utilized and the corresponding times (component routing)
The preliminary costing program passes “bottom-up” through the parts
list, from the component part to the finished product, and merges
component by component. This is done while utilizing the latest actual
costs per activity output unit (e.g., per manufacturing minute) which have
been determined by the cost center accounting program. Figure 5.9
depicts this procedure schematically.

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Post Costing Analysis
The post costing analysis program also uses many data from the
production area. Data pertaining to material movement and time tickets
or wage slips (delivered from the production data entry and pay
accounting in machine-readable form) generate the direct costs that are
posted to the cost object accounts. As far as one wants to consider
indirect costs, if at all, this occurs through adding overhead charges to
the direct costs and by costing the usage times registered by the
production data entry system (e.g., via machine hourly rates).

10.2.3 Supplier Accounts Auditing

Supplier accounts auditing is another good example for how most of the
data are made available in machine-readable format in an integrated
information system: The prices in the material master records, supplier-
dependent conditions in the supplier master records, the order and
goods receiving data in the preliminary data registers and the entered
supplier invoices or the electronically transmitted ANSI X12 or EDIFACT
invoices.
The application system is capable of conducting a number of checks
with the preliminary registered data, especially on:

1. Concurrence between delivered and invoiced quantities

2. Concurrence between prices and conditions of the offers and their
delivery

3. Correctness of the supplier invoice

In case of differences the system dispatches a message to the
responsible employee who then will address the discrepancy. If
problems cannot be solved, he/she would block the invoice and trigger
further clearing.

10.2.4 General Accounting

The structure of general accounting programs is determined by the
method of double book keeping. A large amount of the input data is
being delivered by other programs, including, e.g., condensed
accounting records from accounts receivable and accounts payable
programs or material postings from the material valuation program.
Characteristic for an integrated information system are the excellent
reconciliation capabilities that enhance the security in accounting (e.g.,
between general accounting and sub-ledger accounting or between
receivable accounts of billing and the sum of the debitors’ postings). But

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even the input of booking procedures that still need to be handled
manually has been streamlined, for example in that the accountant is
being guided from posting to posting and thus is being made aware of
any erroneous entries right away.

10.2.5 Accounts Receivable

Accounts receivable manages the preliminary data registry debitors.
Business transactions are transmitted as transfer data by the billing
program and are then posted by the application system into the
receivable accounts. When due dates are exceeded ready-for-shipment
reminders are issued through the use of stored text modules. In
accordance with the respective reminder level (e.g., first and second
reminder) the program applies formulations of varying degrees of
“sternness”. Received customer payments are registered and the
corresponding preliminary data registries are erased.

10.2.6 Accounts Payable

The accounts payable program is rather similar to the accounts
receivable program. A module, however, is to be considered through
which payments may be processed at an optimal point in time. Here it is
appropriate to build in a parameter through which management may
provide general guidelines pertaining to the conduct of payments. Then
it is possible to pay with or without cash discounts depending on a firm’s
liquidity.

10.3 HUMAN RESOURCES

10.3.1 Work Schedule Management

By using information systems it becomes possible to capture times sheet
data efficiently and very accurately. The two main demands for flextime
systems “sufficient information of the employee about the status of
his/her time sheet account” and “transfer of the time sheet data into
payroll accounting” are thus fulfilled much easier. Such modules gain
increasing importance as firms introduced more and more multifaceted
work schedule models.

A Practical Example
The employee carries a machine-readable company identification card
that features a magnetic strip or even a chip. This will be entered into a
card reader when he/she arrives for work and when he/she leaves. The
electronic system reads the individual’s identification number and stores
it with the correct time. At the same time the system checks the arrives-
leaves cycle and makes the employee aware of any discrepancies. The

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latter may be the case, e.g., when the employee forgot to enter his
“leaves’” data to the information system the prior evening. At the same
time it is possible to display to the employee the accumulated total work
time during a given month, as well as the target/actual comparison.

10.3.2 Payroll Accounting

Under the label payroll accounting we may group the programs for
payroll (for wages and salaries), training and development allowance,
and commission accounting. Their structure may be determined by wage
agreements and legal stipulations.
Among the tasks of payroll accounting programs is the determination of
the gross pay based on activity and time sheet data or quantitative
performance, marginal return or sales performance (as with commission
accounting), the determination of extra pay, such as on holidays, the
computing of net pay and net salaries while considering taxes, social
insurance contributions and other deductions. Moreover, such programs
also take into account the determination of payroll deductions such as
the gradual paying back of pay advances or personal loans from the
employer. Difficulties with payroll accounting programs are not so much
with their development but rather with the ongoing changes that are
often determined late by the legislator, especially concerning the tax
laws. Consequently, the support and care for such systems is rather
expensive.

10.3.3 Reporting Programs

Within the human resources area a multitude of notifications, in part due
to legal reporting requirements, have to be made by the employer. Often
such reports are just printouts of certain fields within personnel data
bases. Examples are various reports pertaining to employments
statistics and notifications about wage and salary changes to all
employees.

10.4 TACTICAL AND STRATEGIC INFORMATION SYSTEM

Strategic information
All organizations plan their strategy according to their needs and
requirements. The strategic information refers to what an organization
wants to achieve in the short or long term. The following is the input to
formulate the strategic information of an organization:
External input: Macroeconomic environment, what competitors are
doing, change in government policies, etc.

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Internal input: Company vision and mission, top management input,
audits and feedback, learning from the past, future challenges, etc.
Collating all this input helps an organization plans its strategy. These
strategies have no meaning at all if they are not properly supported by
means to achieve them. This is actually tactical information which is
nothing more than the enablers to actually implement the strategies.

Figure 10.4 Strategic Planning Model

Tactical information
An organization needs to do a necessary and sufficiency check for this
tactical information. The necessary and sufficiency check actually helps
an organization to establish that the tactical information is actually
necessary and sufficient for implementation of a strategy.
The basic difference between strategic and tactical information can be
explained with a simple example of a steel making company.
The steel making company produces different grades of steel at the
lowest cost and is a benchmark in the industry. The company wants to
sustain the identity of being the lowest cost producer of steel for the long
term. So this particular objective of the company should be termed as
strategic information as it qualifies as a long-term goal of the company.
Now the company analyzes that it can achieve its target of being the
lowest cost producer only if it is able to secure a long-term supply of
cheaper raw materials. The long-term supply of cheaper raw materials
can, in turn, only be ensured if the company has its’ own source of raw

128
materials and it is not dependent on other suppliers. The raw material for
the steel company is iron ore, coal, and limestone. All these are natural
resources available in the Earth’s crust. Therefore, the company decides
to acquire new mines so that raw material security can be ensured in the
future. This, in turn, supports its strategy of lowest cost producer of steel.
Therefore it can be termed as tactical information.

10.5 DECISIONS-SUPPORT SYSTEMS

Any system that supports a decision is a decision support system (DSS).
Like MIS, DSS serve the management level of the organization.
Information systems support decisions in vastly different ways, and DSS
are a class of systems that supports decisions in a unique way (at least
when compared to the past). DSS help managers make decisions that
are semi structured, unique, or rapidly changing, and easily specified in
advance. DSS have to be responsive enough to run several times in a
day in order to correspond to changing conditions. While DSS use
internal information from TPS and MIS, they often bring in information
from external sources, such as current stock prices or product prices of
competitors
Clearly, by design, DSS have more analytical power than other systems;
they are built explicitly with a variety of models to analyze data. Second,
DSS are designed so that users can work with them directly; these
systems explicitly include user-friendly software. This requirement
follows both from their purpose (to inform personal decision making by
key actors) and from the method of design. Third, these systems are
interactive; the user can change assumptions and include new data.

Figure 10.5 Decision-Support Systems

Characteristics of DSS
• DSS offer users flexibility, adaptability, and a quick response.
• DSS allow users to initiate and control the input and output.

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 • DSS operate with little or no assistance from professional
• programmers.
• DSS provide support for decisions and problems whose solutions
• cannot be specified in advance.
• DSS use sophisticated analysis and modeling tools.

10.6 EXECUTIVE SUPPORT SYSTEMS

Senior managers use a category of information systems called
executive support systems (ESS) to make decisions. ESS serves the
strategic level of the organization. They address unstructured decisions
and create a generalized computing and communications environment
rather than providing any fixed application or specific capability. ESS are
designed to incorporate data about external events such as new tax
laws or competitors, but they also draw summarized information from
internal MIS and DSS. They filter, compress, and track critical data,
emphasizing the reduction of time and effort required to obtain
information useful to executives. Although they have limited analytical
capabilities, ESS employs the most advanced graphics software and can
deliver graphs and data from many sources immediately to a senior
executive’s office.
Unlike the other types of information systems, ESS is not designed
primarily to solve specific problems. Instead ESS provides a generalized
computing and telecommunications capacity that can be applied to a
changing array of problems. While DSS are designed to be highly
analytical, ESS tends to make less use of analytical models. Instead,
they deliver information to mangers on demand and on highly interactive
basis.
ESS should answer the following questions: what should we be in? What
are the competitors doing? What is the impact on earnings of proposed
changes in the investment tax credit? Etc.

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 Figure 10.6 Executive Support Systems

LET US SUM UP
In this unit we have discussed the application of information system in
business. The production function includes CIM, MRPI, MRPII,
throughout scheduling, capacity balancing, availability check, order
clearance, job shop scheduling, CAM. Computer Aided quality
Assurance and production data entry. The finance function includes cost
center accounting, product cost accounting, supplier accounts auditing,
accounts receivable and accounts payable. Work schedule
management, payroll accounting, reporting program and employee’s
tasks assignments are some of the Human resource functions.

CHECK YOUR PROGRESS

Choose the Correct Answer:

1. Primary resource planning is also called as ____________

a) Manufacturing Resources Planning b) Material Resources Planning

c) Capacity Balancing d) Special Action Programs

2.Transfer of the time sheet data into payroll accounting are thus fulfilled
much easier by _________

a) Work Schedule Management b) Order Scheduling

c) Capacity Balancing d) Material Resources Planning

3. The production flow depends on factors like__________

a) Lot size b) Production Sequences

c) Both a and b d) None of the above

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4.To find a machining sequence for the orders is called____________

a) Work Schedule Management b) Order Scheduling

c)Job scheduling d) Material Resources Planning

5. __________ may group the programs for payroll training and
development allowance, and commission accounting.

a) Work Schedule Management b) Payroll accounting

c) Job scheduling d) Management accounting

GLOSSARY

Computer Aided Selling : The term sales support involves

using computer-based tools and
methods to optimize sales
processes and in doing so increase
sales. Sales support is a central
component of Customer
Relationship Management (CRM)
and should be used in all areas of
sales. From acquiring new
customers to the processing of
existing customer enquiries. The
basic motivation behind sales
support is improve the efficiency of
sales processes, to increase service
quality and sell more of your own
products and services

Computer Integrated The manufacturing approach of

Manufacturing : using computers to control entire
production process. This integration
allows individual processes to
exchange information with each
part. Manufacturing can be faster
and less error-prone by the
integration of computers.

Customer Relationship CRM stands for “Customer

Management : Relationship Management” and
refers to all strategies, techniques,
tools, and technologies used by
enterprises for developing, retaining

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 and acquiring customers.

Production Planning : Production planning is the is

the planning and allocation of raw
materials, workers, and workstations
to fulfill manufacturing orders on
time. Production plans are usually
set by the production managers who
supervise the shop floor. A
good production plan makes the
best use of available resources to
deliver orders on time

SUGGESTED READINGS
1. Bentley Trevor J (1986) Management Information Systems &
data processing, 2nd edition, Holt, Rinehart and Winston
publications, University of California. ISBN 0039106888,
9780039106881.
2. Donald W. Kroeber (1986) Computer-Based Information
Systems: A Management Approach, Subsequent
edition, Macmillan Publications, University of Virginia. ISBN
0023668407, 9780023668401.
3. Gordon B.Davis (2013) Management Information Systems, 1 st
Edition, TMH Publications, India. ISBN 007066241X.
4. Joel E. Ross (1970) Management by Information System,
illustrated edition, Prentice-Hall publications, University of
Wisconsin,ISBN 0135486289, 9780135486283.
5. Kenneth C. Loudon & Jane P. Loudon (2014) Management
Information Systems, 13th Edition, Pearson Publications, USA.

ANSWERS TO CHECK YOUR PROGRESS

1) a 2) a 3) c 4)a 5) b

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 BLOCK 4

PLANNING & DEVELOPMENT OF IS

Unit 11: Planning of Information System

Unit 12: Development of Information System

Unit 13: Overview of Alternative Application

Unit 14: Alternative Application Development Approach

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Unit 11

PLANNING OF INFORMATION SYSTEM

STRUCTURE

Overview

Learning Objectives

11.1 Information System Planning

11.2 Challenges in Information Systems Planning

Let Us Sum Up

Check Your Progress

Glossary

Suggested Readings

Answers to check your progress

OVERVIEW
Information system planning is part of business planning concerned with
deploying firm’s information systems resources, including people,
hardware and software. In the eighties the system was developed with
the assumption that information needs do not change often. But the late
nineties have seen the revolutions in information technology.
LEARNING OBJECTIVES
After reading this unit, you should be able to,
• discuss the challenges in information system planning
• explain Planning of Information system.

11.1 INFORMATION SYSTEMS PLANNING

Planning is the process of deciding what will be done, who will do it,
when they will do it, how will it be done, and what are the desired results.
At strategic levels, the questions are about the firm’s overall priorities
and goals for the information systems and technical and organizational
approaches that will be used. At project levels, the questions boil dow n
to two types of concerns: first, what specific capabilities are required in
each system, and second, who will do what and when will they do it to
produce the specific results needed in a specific project, such as
building a new sales tracking system or retraining users of a system that
has been changed.

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Information Systems Planning should be an integral part of business
planning. Business Planning is the process of identifying the firm’s goals,
objectives and priorities, and developing action plans for the
accomplishing those goals and objectives. Information systems planning
is the part of business planning concerned with the deploying the firm’s
information systems resources, including people, hardware, and
software. The goals, objectives, and priorities of the business should
drive all the plans. Furthermore, although each plan is produced by
specialists in a particular department, all the plans should support the
same strategy and goals. From this viewpoint, the unique aspect is that
it concentrates on Information System projects.
Needs and Objectives
• To ensure that Information System both complements and assists in
the achievement of our business goals.
• To ensure that the use of scarce resources are maximized within a
business.
• To maximize the benefits of changing technology.
• To take account of the different viewpoints of business
professionals and IT professionals
Many prescriptions for project planning call for starting with a search for
problems needing solutions. By the time a company is ready to do
project planning, it is far too late to search for problems needing
solutions. In fact, we already have that at hand- it evolved from business
objectives to MIS objectives, from business strategic plans to MIS
strategic plans, from business operating plans to MIS operating plans.
We know that project we are working on and what the general needs
and objectives are. We now need to refine these statements of need.
The statement of general needs and objectives is almost always too high
level and vague to be implemented. The process of refining these vague
requirements is crucial factor in project success. These key steps should
be taken:
1. The problem statement must be made comprehensible to those who
will design and implement the MIS. For example, the management need
may be for an in-depth market analysis. The computer specialists may
have no idea what all that includes; hence the importance of breaking
down the idea “market analysis” to include and define “competition”,
“market share”, “distribution channels”, “sales force size”, and so on. In
other words, first determine the user’s needs in specific terms.
2. Input. From the user’s perspective, what items can the user
reasonably are expected to provide? Human-to-machine interface may

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be important, and if it is, these requirements need to be detailed during
this phase. For example, if a clerk will be the user, very clear messages
prompting for input are required.
3. How the system will work should be specified only in very general
terms at this time. In fact, the designers should concentrate on “what”
the system should do and leave as implementation details as reasonable
to the specialists who will actually produce the MIS. For example, a
permanent payroll record may be a valid need or objective. But the
internal format in which the file is maintained is probably a too much
detail for this phase of design.
4. Output. If the user has expectations about, or requirement for, the
results of the system, those need to be detailed. For example, sample
user reports should be drawn up to this stage and taken for the future
users for approval.

5. Budgets are a key part of detailing the needs of a project.

In summary, the management statement of the problem must be taken
and broken down into a language the computer specialists will
understand. It must also be clarified by making more specific statements
of requirements and then reviewing these with the managers who
originally posed the problem.

ISP Planning Types

Top-Down Planning A generic information systems planning
methodology that attempts to gain a broad understanding of the
information system needs of the entire organization.
Bottom-up Planning generic information systems planning
methodology that identifies and defines information system development
projects based upon solving operational business problems or taking
advantages of some business opportunities.

11.2 CHALLENGES IN INFORMATION SYSTEMS PLANNING

The specific steps and procedures for creating an Information System
plan vary from company to company, depending on factors such as the
way the company manages its various planning and control cycles and
the extent to which IT professionals are centralized or dispersed in to
business units.

Difficulty in Foreseeing and Assessing Opportunities

It is sometimes said that strategies become apparent only after they
have been accomplished. Consider the Sabre Reservation system,

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which is often considered a major factor in American Airlines competitive
success. That system was not initially designed as a major competitive
strategy. Rather, it evolved through four distinct stages over 30 years. It
began in the early 1960s as a response to American Airlines inability to
use manual methods to monitor its inventory of available seats. Although
a technical achievement for the time, it was a far cry for the powerful
system later accused of presenting biased displays to travel agents so
they would see and select American Airlines flights for their clients. The
point of the example is that it is usually difficult to forese e the way
information system innovations will develop. As with many complex
products, users typically identify new uses and possible improvements
that the inventor never imagined. Consequently, Information System
plans should be reviewed periodically and systems should be designed
to be flexible and extendable.
Difficulty in Assuring Consistency with Organizational Plans and
Objectives
A fundamental problem with Information System planning is that
individual departments within companies have their own priorities and
business practices and often have difficulty working toward a mutually
beneficial plan. This issue is especially significant if a large organization
attempts to develop an information architecture and infrastructure that
spans departmental boundaries. Even if mutual benefits seem likely, the
process of developing the plans takes a lot of time and effort, and the
rewards may be distributed unevenly.

Difficulty in Building Systems

Large information systems are complex creations that often take years
to build and involve many organizational, political, and technical
tradeoffs. In many system development efforts, only a small cadre truly
understands what the system is trying to do and how it will operate.
Bank of America, Chemical bank and the London Stock Exchange who
have suffered costly project failures but are never reported and for every
unreported failure there are many semi failures, systems that were
developed and installed but never came close to accomplishing their
goals. The difficulty of building systems is one of the reasons Information
System investments require management attention.

Difficulty in Maintaining Information System Performance

The products and services produced by the information system may not
have the cost, quality, responsiveness, reliability, and conformance
expected by its customers. The business processes within the system

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may lag in productivity, flexibility, or security. Participants can cause
problems due to anything from inattention to criminality. The information
in the system can cause problems due to anything from occasional
inaccuracy to fraud. Furthermore, the technology can impede or stop the
business process by degrading or failing. Each of these problems can be
planned, but at the cost of more effort, more attention, more expense,
and less flexibility.

Difficulty in Collaborating with System Builders

Business professionals and IT professionals sometimes talk past each
other as if they come from different worlds. No specialists talking to
lawyers, doctors, or scientists often recognize the resulting frustrations.
Specialists may have trouble translating their specialized knowledge and
worldview into terms no specialists genuinely understand. No specialists
may feel they can’t speak the lingo and can’t even explain their
concerns, no less engage in a genuine dialogue about alternatives. Even
if they trust the specialists, they are left with a queasy feeling of
operating too much on trust and too little on mutual understanding.

LET US SUM UP
Information system planning is an integral part of business planning. It
can be carried out in two ways. They are top-down planning and bottom-
up planning. Attaining a genuine dialogue is important because the
business professionals and the IT professionals each bring knowledge
and understanding essential for system success. Many IT professionals
have worked on different types of information systems and may be able
to suggest approaches the business professionals would not have
imagined.

CHECK YOUR PROGRESS

Choose the Correct Answer:

1.____________ Information systems planning methodology that
attempts to gain a broad understanding of the information system needs
of the entire organization.

a) Bottom-up planning b) Top-Down Planning

c) Parallel planning d) system planning

2. ____________ Generic information systems planning methodology
that identifies and defines information system development projects
based upon solving operational business problems Discuss the
challenges in information system planning

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a) Bottom-up planning b) Top-Down Planning

c) Parallel planning d) System planning

3. Business _________ is the process of identifying the firm’s goals,
objectives and priorities, and developing action plans for the
accomplishing those goals and objectives.

a)Planning b) Organizing

c) Controlling d) Staffing
4. A medium for transporting output of a system to the input to another
system is_____________

a)Counter measure b) Interface

c) Parallel planning d) System planning

5. What part of documentations offers both a pictorial and written
description of system___________?

a) System's abstract b) System's narrative

c) Problem definition d) System's overview

GLOSSARY

System's abstract : An abstract system is a

system which exists in a
conceptual, abstract world. Abstract
systems are composed
from abstract components.

Bottom-up planning : Bottom-Up Planning is a method

of planning, defining objectives and
ways to achieve them through
the bottom up. First, relatively close
targets at lower levels of the
organizational hierarchy are set.
They are then gradually integrated
into the framework of global goals
and global strategy at higher and
higher levels.

Top-Down Planning : Top-down planning traditionally

involves defining organizational
goals on a high level and breaking
them down into specific objectives

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 which are then addressed in
phases. As the name indicates, top-
down planning is an approach that
aims at moving gradually from
the top to the lower levels of a given
hierarchy.

Interface : The term "interface" can refer to

either a hardware connection or
a user interface

Collaboration : Collaboration means 'to work with

another person or group in order to
achieve or do something'. That
sounds disarmingly simple. But then
when you strip back what business
is all about, it fundamentally comes
down to coordinating the efforts of
the company's employees to provide
goods and services.

SUGGESTED READINGS
1. Bentley Trevor J (1986) Management Information Systems &
data processing, 2nd edition, Holt, Rinehart and Winston
publications, University of California. ISBN 0039106888,
9780039106881.
2. Donald W. Kroeber (1986) Computer-Based Information
Systems: A Management Approach, Subsequent
edition, Macmillan Publications, University of Virginia. ISBN
0023668407, 9780023668401.
3. Gordon B.Davis (2013) Management Information Systems, 1 st
Edition, TMH Publications, India. ISBN 007066241X.
4. Joel E. Ross (1970) Management by Information System,
illustrated edition, Prentice-Hall publications, University of
Wisconsin,ISBN 0135486289, 9780135486283.
5. Kenneth C. Loudon & Jane P. Loudon (2014) Management
Information Systems, 13th Edition, Pearson Publications, USA.

ANSWERS TO CHECK YOUR PROGRESS

1) b 2) a 3) a 4)b 5)d

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Unit 12

DEVELOPMENT OF INFORMATION
SYSTEM
STRUCTURE

Overview

Learning Objectives

12.1 Need for System Analysis and Design

12.2 Procedure of Analyzing Existing System

12.3 Steps in System Analysis and Design

12.4 Computer System Design

12.5 Data Specifications

Let Us Sum Up

Check Your Progress

Glossary

Suggested Readings

Answers to check your progress

OVERVIEW
Information system planning is part of business planning concerned with
deploying firm’s information systems resources, including people,
hardware and software. The late nineties have seen the revolutions in
information technology. The system analyst has now to play the role of
business analyst, technology expert and consultant, giving a solution to
the business needs of information requirement.
LEARNING OBJECTIVES

After reading this unit, you should be able to

• explain the need for system analysis and design
• list out the steps in system analysis and design
12.1 NEED FOR SYSTEM ANALYSIS AND DESIGN
When you are asked to computerize a system, as a requirement of the
data processing or the information need, it is necessary to analyze the
system from different angles. While satisfying such need, the analysis of
the system is the basic necessity for an efficient system design. The
need for analysis stems from the following point of view.

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System Objective
It is necessary to define the system objectives. Many a times, it is
observed that the systems are historically in operation and have lost
their main purpose of achievement of the objectives. The users of the
system and the personnel involved are not in a position to define the
objectives. Since you are going to develop a computer based system, it
is necessary to redefine or reset the objectives as a reference point in
the context of current business requirement.
System Boundaries
It is necessary to establish the system boundaries which would define
the scope and the coverage of the system. This helps to sort out and
understand the functional boundaries of the system, the department
boundaries in the system, and the people involved in the system. It also
helps to identify the inputs and the outputs of the various subsystems,
covering the entire systems.
System Importance
It is necessary to understand the importance of the system in the
organization. This would throw more light on its utility and would help the
designer to decide the design features of the system. It would be
possible then to position the system in relation to the other systems for
deciding the design strategy and development.
Nature of the System
The analysis of the system will help the system designer to conclude
whether the system is a closed type or an open, and a deterministic or a
probabilistic. Such an understanding of the system is necessary, prior to
design the process to ensure the necessary designing architecture.
Role of the System as an Interface
The system, many a times, acts as an interface to other systems. Hence
through such an interface, it activates or promotes some changes in the
other systems. It is necessary to understand the existing role of the
system, as an interface, to safeguard the interests of the other systems.
Any modifications or changes made should not affect the functioning or
the objectives of the other systems.
Participation of the Users
The strategic purpose of the analysis of the system is to seek the
acceptance of the people to a new development. System analysis
process provides a sense of participation of the people. This helps in
breaking the resistance to the new development and it also ensures the
commitment of the new system.

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Understanding of Resource Needs
The analysis of systems helps in defining the resource requirements in
terms of hardware and software. Hence, if any additional resources are
required, this would mean an investment. The management likes to
evaluate the investment from the point of view of return on such
investments. If the return on the investment is not attractive, the
management may drop the project.
Assessment of Feasibility
The analysis of the system helps to establish the feasibility from different
angles. The system should satisfy the technical, economic and
operational feasibility. Many times, the systems are feasible from the
technical and economic point of view; but they may be infeasible from
the operational point of view. The assessment of feasibility will save the
investment and the system designer’s time. It would also save the
embarrassment to the system designer as he is viewed as the key figure
in such projects.
12.2 PROCEDURE OF ANALYSING EXISTING SYSTEM
When the objectives of information system are finalized, as the first step
towards development, it is necessary to analyze the existing system.

Such an analysis helps in achieving the following:

• Understanding the existing system.
• Understanding the objectives achieved by the existing system.
• Evaluating the system for computerization and its placement in
the total MIS design.
• Knowing whether the system is feasible, technically and
operationally.
• Are the information needs fully justified?
• If so is the cost of system design justified to increase the value of
information.

The step-by step procedure for analyzing existing system is given below
1.Carry out the analysis of the system at a place where the system is
functioning. This step will ensure that the analyst is accepted as one of
those operating the system.
2.Note down the key personnel in the system besides the head of the
department. The key personnel are those who contribute towards the
system operations.
3.Spend some time with the operating personnel and observe the
system to understand the finer details of the system.

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4.Define the scope of the system and its objective. The scope will cover
the boundaries of the system. Further, one should identify the problems
faced in the system which cause difficulties in achieving the objective.
5.Collect all the documents which are raised in the system. These
documents carry data from one point to another. The documents could
be printed or handwritten. While collecting the documents, the analyst
should note down that raises the document, the purpose it achieves, and
the manner in which it is distributed.
6.Collect separately outputs such as the statements, reports, memos,
etc. made in the system to throw more light on the information it
generates. If these reports and the statements are sent to other
departments, make note of it. Also find out if any register or notebook is
maintained at previous points, which act as data storage and reference.
Note down against each such document, its use.
7.Make a list of rules, formulae, guidelines, policies, etc. which are used
in running the system.
8.Note down the check points and the controls used in the system to
ensure the data flow is complete, processing of the data is correct and
the analysis is precise.
9.Study the flow of data in the system in units, summary and aggregates
from document to document and from one stage to the other.
10.Make a small system note as a base document and seek an
appointment with each head of the department to discuss the system. In
the discussion, ensure that your system view and understanding is the
same as that of the head of the department. Ascertain from him whether
he has any other objectives which the system should achieve.

12.Examine whether the achievement of the systems objectives is

feasible in the present system. This means, examining whether
adequate data exists, whether it can be preceded by the rules, methods,
model, already there to generate information. If so, will the information
be correct, precise and complete. Further, can it be processed on time to
be useful to the user or the decision maker?
13.If there are problems in the feasibility of implementation, then
examine whether the present system can be modified with the
introduction of documents, controls, procedures and systems. If not,
redefine the scope of the system and objectives in the light study.

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14.Draw a revised system flowchart to indicate how the system runs the
major steps of processing the information. This chart should include all
the modifications which had been suggested and accepted.
15.Discuss the flowchart with the personnel operating the system so that
they understand the system. Impress upon them that they should run the
system as per the flowchart, and resist any deviations there from that
would cause a disturbance in the system. Explain the modified system in
such a way that the user would appreciate the changes.
16.Make a list of outputs containing information. Get the contents of the
reports approved by the head of the department.
17.Analyze the requirements of the information and reports from the
utility point of view. More the information, higher is the cost of
generation. Decide the utility based on the value of the information.

18.Compare the cost of the old and the new system, and benefit offered.
19.Obtain approval of the new system from the users and top
management.
20. Write a system manual for use of the people in the department and
for reference to the other users of the system.

12.3 STEPS IN SYSTEM ANALYSIS AND DESIGN

The Steps in system analysis and design are given below

Requirement Analysis
Requirement Definition

System Design

Input Design

Process Design

Output Design

System development

structuring the modules

Developing

Unit Testing

Integration of the Modules

System Testing

Implementation

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 Maintenance
The requirement analysis is carried out from the top downwards in the
organization hierarchy, linking the goals and the objectives of the
business organization, with the strategy mix decide to achieve them. In
this phase the information needs of the individuals, groups and functions
are analyzed from a decision making or a support point of view. Such
information needs would fully satisfy the operational and management
information needs. Once the needs are justified, the next step is to
define those clearer terms for the purpose of development. The
requirement definition brings clarity in the content and its application in
various ways.
The third step is to design a physical and a logical system through which
the outputs are designed. The processes which would give the outputs
are determined, and the data which would be required by these
processes is finalized in terms of definition, source, and quality. And
further, the collection, creation, validation, and storage of the input data
is also decided.
The fourth step is to break the system design into modules in the
hierarchical top-down structure to facilitate the development efforts as
well as its implementation.
Once the modules are developed, the unit testing is carried out to
confirm data transaction and outputs validity and accuracy. In testing,
the transaction level processes are checked to confirm the input-
process-output relation, and the data storage and the transaction level
updating.
When the unit testing is over and the module level processing is
confirmed, the modules are put together to generate the information as
determined in the requirement definition. The process of putting the
modules together is a process of integration. It is intended to produce
the results of data integration.
The system so developed is tested as a whole for several aspects such
as information, quality, performance, utility, user acceptance and so on.
Once the system testing is complete, the system is implemented at site,
on the hardware and software platform. The implementation step has its
own procedure starting from the installation of the hardware and the
software, training the users, and then shifting to a fully designed system.
While implementing the system some minor modifications, may be
required for ease of acceptance of the user.
Even after complete installation, the system may require modifications or
changes in terms of functions and features over a period of time. The
process of introducing these new requirements without disturbing the

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time tested basic system is called maintenance. Such changes are
required swiftly and hence they are required to be carried out very
easily. The system is designed keeping this natural requirement in post
implementation period.
A good system design and its implementation has high user acceptance
because it helps solve the problems in business performance, and
meets the information needs, within a sensible time scale, with an
assured quality and security of information.
Activity
Assume you have been asked to develop an information system for
processing the result of your class. Which method would you prefer for
developing such a system? Also conduct a feasibility study and prepare
a feasibility report
12.4 COMPUTER SYSTEM DESIGN
After analyzing the system by way of structured analysis, the next task of
the designer is to design a computer system. The computer system
design consists of five major steps, viz., designing the output, the input,
the processing, the data specifications, and the procedure specifications.
Output Design
The output should be able to communicate information to the users in
the organization effectively. The information, as an output, can be
printed, displayed or stored. If it is necessary to print the information, as
a report, then the designer has to decide the format of the report. If it is
to be displayed, then the designer has to provide a screen format.
The output design requires determining the reports, the screens, the
contents of the reports and the screen, and the layout of the contents.
While designing the report and the screen formats, the designer should
pay attention to the concepts of information presentation so that the
utility of the system is not reduced because of a noise, an information
overload, an incomplete coverage, an inadequate references, etc. The
attention should also be given to the security of information through
access control. The designer should decide an appropriate balance
between the print reports and the display screens. The layout of the
report, whether it is printed or displayed, must satisfy some basic
features. Each report should have an appropriate title with a period
reference, date of processing and a system title. The pages should
number, with the title repeated and at the end of the processing it should
provide the statistics such as number of records, items, etc.
The layout should be such that the readability will be from left to right
and from top to bottom. Each column and row should have meaningful
titles. The layout should provide sub-totals and grand totals with the

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reference to the unit such as class, group or family. It should provide
suitable blank spaces to enhance readability. If any abbreviations are
used, the expanded forms should be given alongside. As far as possible,
the abbreviations should be universal and common to all reports to avoid
confusion. A good layout improves the utility of the information reports
by highlighting the areas of concern where the attention of the
management and its response is required immediately.
In many cases, the design of pre-printed forms is an easy solution for a
good layout .The use of the pre-printed stationary saves the printing time
and enforces standardization in the information layout. With the use of
the pre-printed stationary, the main user can blank out certain columns
and rows, or certain results to avoid an exposure to the unwanted users.
This saves the duplicate printing and the additional programming effort
required for it.
Input design
In this phase, the designer’s task is to identify those data items that will
be an input to the system. The designer finds a linkage to the input data
from the output. Once the data items are identified, it is necessary to find
the documents from where these data will be taken. A document
containing several data items will be treated as a record in the system.
To obtain the sales information, the system must consider the Order
Acceptance, the Invoice and the Debit Note records containing the
related data items.
The guidelines for selecting the data item from the document and
grouping them into a record are as follows:
1. Only the data items which have a current and a prospective use
should be included; the others should be ignored.
2. The data items from a document should be a grouped together and
arranged in logical order of its use in processing. For example, a
document number or a product code should be at the beginning of the
record.
3. The grouping of the data items should be in line with its application
and not in line with their placement in the report format. For example, the
invoice amount, the discount, the taxes, etc. should be grouped
together.

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Process Design
After the output and the input design, the designer has to develop a
process design which will specify the various steps that will convert input
data into outputs.
The process design deals with the following two types of processes, viz.,
computing and decision making.

1. Computation process for the net value of invoice:

Quantity*Rate = Amount

Amount+10 %( Amount) = Gross amount

Gross Amount+6% (Gross Amount) = Net value

2. Decision making for the choice of the invoice processing:

If the customer is of a type ‘Industry’ then follow the invoice

Process - A.
If the customer is of a type ‘Distributor’, then follow the invoice
process - B.
If the customer is of a type ‘OEM’ then follow the invoice process—C,
and so on.
As a part of the process design, the designer has to decide the source of
the data items, viz., the documents and the files will be used for storage
of the record and for retrieval, their organization becomes an important
factor. The designer classifies the files as master file(s) and transaction
files and also decides their use in the system in a logical sequence. The
files can be organized in a number of ways. The organization of the files
relates to the storage of data items and its recording layout on the
magnetic media.
The files can be organized either in random ordered fashion or in
indexed sequential fashion. Each file organization has its own
advantages related to access and processing. A data processing
situation dictates the type of the organization. In database environment,
data and records are arranged in a table form.
12.5 DATA SPECIFICATIONS
Having identified data items at atomic level and configuring them into a
set to form a record of an input entity, it is necessary to design
specifications for each data item. These specifications of the items will
be followed uniformly at all places wherever they are used. The
specification is expressed in terms of length of an item in terms of
characters, its nature in terms of numeric or alpha numeric known as

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picture. A data item have some value and hence it would have some
conditions and validity.
For example, date is an item having eight characters, presented in
numeric value with two spaces after date and two spaces after month,
followed by a year mentioned in four numeric characters. The data will
not have null value and has no upper value. The order of data
presentation is day, month and year.
The specifications are used for error checking, control and processing. A
data item before it is accepted as an input is checked against
specifications. If there is a violation, it is corrected through a formal
process of editing before acceptance.
Procedure Design
This phase specifies how the computer system will function from data
entry to the output stage. The procedure indicates the logic of data
processing and the flow of system control from one step to the other.
Since the process design is complete, each process will be a step in the
procedure design of the computer system. Each of such processes will
be implemented through a computer program.
The procedure design steps will be shown in the computer system
flowchart. In all the system design procedures, there are broad steps
which are required to complete the design procedure.
A flow chart of the system using all the specifications of process design
and procedure design guides the designer, the analyst and the
programmer in developing the system. It provides a logical overview of
the system. The guidelines for drawing the system flow chart are as
under:
1. Identify the start and the end of the system.
2. Identify the inputs, in terms of the data and the documents entering
in the system, in their logical order. Determine the transaction and the
master files in the system.
3. Identify the output at each stage and decide the media for
processing and storage.

LET US SUM UP
System analysis plays a vital role in the development of information
systems. The major activities in system analysis and design are
requirement analysis, requirement definition, system design, system
development, unit testing system testing, implementation and
maintenance.

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CHECK YOUR PROGRESS

Choose the Correct Answer:

1. _________ Specifies the various steps that will convert input data into

outputs.

a) Input design b) Output Design

c) Process Design d) Procedure Design

2. _________ indicates the logic of data processing and the flow of
system control from one step to the other.

a) Input design b) Output Design

c) Procedure Design d) Process Design

3.The _________ are used for error checking, control and processing
data.
a) Input design b) Output Design

c) Data Specifications d) Process Design

4. Which of the following activities does not belong to the implementation
phase of the SDLC?

a) Program testing b) Output Design

c) Data Specifications d) Process Design

5. In the ___________ designer’s task is to identify those data items that
will be an input to the system.

a) Input design b) Output Design

c) Procedure Design d) Process Design

GLOSSARY

System Design : System design is the process of

defining the components, modules,
interfaces, and data for a system to
satisfy specified
requirements. System development
is the process of creating or altering
systems, along with the processes,
practices, models, and
methodologies used to develop
them.

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Data Specifications : In computing, a data definition
specification (DDS) is a guideline to
ensure comprehensive and
consistent data definition. A
comprehensive data definition
specification encompasses
enterprise data the hierarchy
of data management, prescribed
guidance enforcement and criteria
to determine compliance.

System Analysis : Systems analysis is "the process of

studying a procedure or business in
order to identify its goals and
purposes and create systems and
procedures that will achieve them in
an efficient way". The field of system
analysis relates closely to
requirements analysis or to
operations research.

Procedure Design : Procedures are the rules, standards,

methods design to increase the
effectiveness of the information
system. The procedures detail about
the tasks to be performed in using
the system. They serve as the ready
recovers for the designers as well
as for the users.

Maintenance: : Maintenance is the process of

maintaining something or
somebody. It may mean the state of
being maintained. The term also
refers to looking after somebody
financially, i.e., the provision of
financial support of a person.
Specifically, providing them with
living expenses.

Unit Testing : Unit testing is a type of software

testing where individual units or

153
 components of software are tested.
The purpose is to validate that each
unit of the software code performs
as expected. Unit Testing is done
during the development (coding
phase) of an application by the
developers

SUGGESTED READINGS
1. Bentley Trevor J (1986) Management Information Systems &
data processing, 2nd edition, Holt, Rinehart and Winston
publications, University of California. ISBN 0039106888,
9780039106881.
2. Donald W. Kroeber (1986) Computer-Based Information
Systems: A Management Approach, Subsequent
edition, Macmillan Publications, University of Virginia. ISBN
0023668407, 9780023668401.
3. Gordon B.Davis (2013) Management Information Systems, 1 st
Edition, TMH Publications, India. ISBN 007066241X.
4. Joel E. Ross (1970) Management by Information System,
illustrated edition, Prentice-Hall publications, University of
Wisconsin,ISBN 0135486289, 9780135486283.
5. Kenneth C. Loudon & Jane P. Loudon (2014) Management
Information Systems, 13th Edition, Pearson Publications, USA.

ANSWERS TO CHECK YOUR PROGRESS

1) c 2) c 3) c 4) a 5)a

154
Unit 13

OVERVIEW OF ALTERNATIVE
APPLICATION
STRUCTURE

Overview

Learning Objectives

13.1 Traditional System Life cycle

13.2 Prototyping

Let Us Sum Up
Check Your Progress

Glossary

Suggested Readings

Answers to check your progress

OVERVIEW
One important thing to know about building a new information system is
that this process is one kind of planned organizational change. System
builders must understand how a system will affect the organization as a
whole.
LEARNING OBJECTIVES

After reading this unit, you should be able to,

• explain the stages in traditional systems life cycle
• discuss the steps in prototyping.

13.1 TRADITIONAL SYSTEMS LIFECYCLE

The systems lifecycle is the oldest method for building information
systems and is still used today for medium or large complex systems
projects. The lifecycle for an information system has six stages:

(1) Project definition,

(2) Systems study,

(3) Design,

(4) Programming,

(5) Installation, and

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(6) Post implementation. Figure below illustrates these stages. Each
stage consists of basic activities that must be performed before the next
stage can begin. The lifecycle methodology has a very formal
division of labour between end users and information systems
specialists. Technical specialists such as systems analysts and
programmers are responsible for much of the systems analysis, design,
and implementation work; end users are limited to providing information
requirements and reviewing the technical staff’s work.

Figure 13.1 Stages of the Systems Lifecycle

Stages of the Systems Lifecycle

The project definition stage determines whether the organization has a
problem and whether that problem can be solved by building a new
information system or by modifying an existing one. The systems study
stage analyzes the problems of existing systems (manual or automated)
in detail, identifies objectives to be attained by a solution to these
problems, and describes alternative solutions. Much of the information
gathered during the systems study phase will be used to determine
information system requirements.

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The design stage produces the design specifications for the solution.
The lifecycle emphasizes formal specifications and paperwork, so many
design documents are generated during this stage. The programming
stage translates the design specifications produced during the design
into software program code. Systems analysts work with programmers
to prepare specifications for each program in the system.
The installation stage consists of the final steps to put the new or
modified system into operation: testing, training, and conversion. The
post implementation stage consists of using and evaluating the systems
after it is installed and is in production. Users and technical specialists
will go through a formal post implementation audit that determines how
well the new system has met its original objectives and whether any
revisions or modifications are required. After the system has been fine-
tuned it will need to be maintained while it is in production to correct
errors, meet requirements, or improve processing efficiency. Over time,
the system may require so much maintenance to remain efficient and
meet user objectives that it will come to the end of its useful life span.
Once the system’s lifecycle comes to an end, a completely new system
is called for and the lifecycle may begin again.

Limitations of the Lifecycle Approach

The systems lifecycle is still useful for building large complex systems
that require a rigorous and formal requirements analysis, predefined
specifications, and tight controls over the systems-building process.
However, the systems lifecycle approach is costly, time consuming, and
inflexible. Volumes of new documents must be generated and steps
repeated if requirements and specifications need to be revised. Because
of the time and cost to repeat the sequence of lifecycle activities, the
methodology encourages freezing of specifications early in the
development process, discouraging change. The lifecycle approach is
also not suitable for many small desktop systems, which tend to be less
structured and more individualized.

13.2 PROTOTYPING
Prototyping consists of building an experimental system rapidly and
inexpensively for end users to evaluate. By interacting with the
prototype, users can get a better idea of their information requirements.
The prototype endorsed by the users can be used as a template to
create the final system.
The prototype is a working version of an information system or part of
the system, but it is meant to be only a preliminary model. Once

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operational, the prototype will be further refined until it conforms
precisely to users’ requirements. Once the design has been finalized,
the prototype can be converted to a polished production system.
The process of building a preliminary design, trying it out, refining it, and
trying again has been called an iterative process of systems
development because the steps required to build a system can be
repeated over and over again. Prototyping is more explicitly iterative
than the conventional lifecycle, and it actively promotes system design
changes. It has been said that prototyping replaces unplanned rework
with planned iteration, with each version more accurately reflecting
users’ requirements.

Steps in Prototyping
Below figure shows a four-step model of the prototyping process, which
consists of the following:

Figure 13.2 Steps in Prototyping

Step 1: Identify the user’s basic requirements. The system designer
(usually an information systems specialist) works with the user only long
enough to capture his or her basic information needs.
Step 2: Develop an initial prototype. The system designer creates a
working prototype quickly, using fourth-generation software, interactive
multimedia, or computer aided software engineering (CASE) Tools.

158
Step 3: Use the prototype. The user is encouraged to work with the
system in order to determine how well the prototype meets his or her
needs and to make suggestions for improving the prototype.
Step 4: Revise and enhance the prototype. The system builder notes all
changes the user requests and refines the prototype accordingly. After
the prototype has been revised, the cycle returns to Step 3. Step 3 and 4
are repeated until the user is satisfied.
When no more iterations required, the approval prototype then becomes
an operational prototype that furnishes the final specifications for the
application. Sometimes the prototype itself is adopted as the production
version of the system.

Advantages and Disadvantages of Prototyping

Prototyping is most useful when there is some uncertainty about
requirements or design solutions. Prototyping is especially helpful in
designing an information system’s end-user interface (the part of the
system that end users interact with, such as on-line display and data-
entry screens, reports, or Web pages). When prototyping encourages
end-user participation in building a system, it is more likely to produce
systems that fulfill user requirements.
However, rapid prototyping can gloss over essential steps in systems
development. If the completed prototype works reasonably well,
management may not believe there is a need for reprogramming,
redesign, or full documentation and testing to build a polished production
system. Some of these hastily constructed systems may not easily
accommodate large quantities of data or a large number of users in a
production environment. Prototyping may also slow the development
process if there are large numbers of end users to satisfy.

LET US SUM UP
The traditional systems life-cycle--the oldest method for building
systems--breaks the development of an information system into six
formal stages:
(1) Project definition, (2) systems study, (3) design, (4) Programming, (5)
installation, and (6) post implementation. The stages must proceed
sequentially and have defined outputs; each requires formal approval
before the next stage can commence. The system lifecycle is useful for
large projects that need formal specifications and tight management
control over each stage of system-building. However, this approach is
very rigid and costly and is not well suited for unstructured, decision-

159
oriented applications where requirements cannot be immediately
visualized.
Prototyping consists of building an experimental system rapidly and
inexpensively for end users to interact with and evaluate. The prototype
is refined and enhanced until users are satisfied that it includes all of
their requirements and can be used as a template to create the final
system. Prototyping encourages end-user involvement in systems
development and iteration of design until specifications are captured
accurately. The rapid creation of prototypes can result in systems that
have not been completely tested or documented or that are technically
inadequate for a production environment.

CHECK YOUR PROGRESS

Choose the Correct Answer:

1. The _________stage consists of the final steps to put the new or

modified system into operation: testing, training, and conversion.

a) Installation b) Programming

c) Post implementation d)Prototyping

2. _________stage consists of using and evaluating the systems after it

is installed and is in production.

a) Installation b) Programming

c) Post implementation d) Prototyping

3. The __________ stage translates the design specifications produced

during the design into software program code.

a) Installation b) Programming

c) Post implementation d)Prototyping

4. ________ consists of building an experimental system rapidly

and inexpensively for end users to interact with and evaluate.

a) Installation b) Programming

c) Post implementation d)Prototyping

5. The _________ stage produces the design specifications for the

solution

a) Installation b) Programming

c) Post implementation d) System design

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GLOSSARY

Post implementation : A Post Implementation review is

conducted after completing the
project. Its activities aim to
evaluate whether project objectives
were met, how effectively the
project was run, lessons for the
future, and the actions required to
maximize the benefits from the
project outputs

System testing : System testing is defined

as testing of a complete and fully
integrated software product.
This testing falls in black-
box testing wherein knowledge of
the inner design of the code is not
a pre-requisite and is done by
the testing team.

Installation : Installation refers to the particular

configuration of a software or
hardware with a view to making it
usable with the computer. A soft or
digital copy of the piece of software
(program) is needed to install it.
There are different processes
of installing a piece of software
(program).

System design : System design is the process of

defining the components, modules,
interfaces, and data for a system to
satisfy specified
requirements. System development
is the process of creating or
altering systems, along with the
processes, practices, models, and
methodologies used to develop
them.

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Programming : Programming is the process of
creating a set of instructions that
tell a computer how to perform a
task. Programming can be done
using a variety of
computer programming languages,
such as JavaScript, Python, and
C++.

SUGGESTED READINGS
1. Bentley Trevor J (1986) Management Information Systems &
data processing, 2nd edition, Holt, Rinehart and Winston
publications, University of California. ISBN 0039106888,
9780039106881.
2. Donald W. Kroeber (1986) Computer-Based Information
Systems: A Management Approach, Subsequent
edition, Macmillan Publications, University of Virginia. ISBN
0023668407, 9780023668401.
3. Gordon B.Davis (2013) Management Information Systems, 1 st
Edition, TMH Publications, India. ISBN 007066241X.
4. Joel E. Ross (1970) Management by Information System,
illustrated edition, Prentice-Hall publications, University of
Wisconsin,ISBN 0135486289, 9780135486283.
5. Kenneth C. Loudon & Jane P. Loudon (2014) Management
Information Systems, 13th Edition, Pearson Publications, USA.

ANSWERS TO CHECK YOUR PROGRESS

1) a 2) c 3) b 4)d 5)d

162
Unit 14

ALTERNATIVE APPLICATION
DEVELOPMENT APPROACH
STRUCTURE

Overview

Learning Objectives

14.1 Application Software Package

14.2 End-User Development

14.3 Outsourcing
Let Us Sum Up

Check Your Progress

Glossary

Suggested Readings
Answers to check your progress

OVERVIEW
Systems differ in terms of their size and technological complexity, and in
terms of the organizational problems they are meant to solve. Because
there are different kinds of systems, a number of methods have been
developed to build systems. This unit describes these alternative
methods: the traditional systems, prototyping, application software
packages, end-user development, and outsourcing.

LEARNING OBJECTIVES

After reading this unit, you should be able to,

• list out the benefits of end user development and outsourcing.
• demonstrate the application of various software packages
• identify the appropriate software for user.

14.1 APPLICATION SOFTWARE PACKAGES

Information systems can be built using software from application
software packages. There are many applications that are common to all
business organizations--for example, payroll, accounts receivable,
general ledger, or inventory control, For such universal functions with
standard procedures, a generalized system will fulfill the requirements of
many organizations.

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If a software package can fulfill most of an organization’s requirements,
the company does not have to write its own software. The company can
save time and money by using the prewritten, predesigned, pretested
software programs from the package. Package vendors supply much of
the ongoing maintenance and support for the system, providing
enhancements to keep the system in line with ongoing technical and
business developments.
If an organization has unique requirements that the package does not
address, many packages include capabilities for customization.
Customization features, allow a software package to be modified to meet
an organization’s unique requirements without destroying the imaginary
of the packaged software. If a great deal of customization is required,
additional programming and customization work may become so
expensive and time consuming that they eliminate many of the
advantages of software packages. The initial purchase price of the
package can be deceptive because of these hidden implementation
costs.

Selecting Software Packages

When a system is developed using an application software package,
systems analysis will include a package evaluation effort. The most
important evaluation criteria are the functions provided by the package,
flexibility, user-friendliness, hardware and software resources, database
requirements, installation and maintenance effort, documentation,
vendor quality, and cost. The package evaluation process often is based
on a Request for proposal (REP), which is a detailed list of questions
submitted to packaged software vendors.
When a software package solution is selected, the organization no
longer has total control over the system design process. Instead of
tailoring the system design specifications directly to user requirements,
the design effort will consist of trying to mold user requirements to
conform to the features of the package. If the organization’s
requirements conflict with way the package works and the package
cannot be customized, the organization will have to adapt to the
package and change its procedures.

14.2 END-USER DEVELOPMENT

Some types of information systems can be developed by end users with
little or no formal assistance from technical specialists. This
phenomenon is called end-user development. Using fourth-generation
languages, graphics languages, and PC software tools, end users can

164
access data, create reports, and develop entire information systems on
their own, with little or no help from professional systems analysts or
programmers. Many of these end-user developed systems can be
created much more rapidly than with the traditional systems, lifecycle.
Below figure illustrates the concept of end-user development.

Figure 14.1 End user development cycle

Benefits and Limitations of End-User Development

Many organizations have reported gains in application development
productivity by using fourth-generation tools that in a few cases have
reached 300 to 500 percent. (Glass, 1999; Green, 1984-85; Harel,
1985). Allowing users to specify their own business needs improves
requirements gathering and often leads to a higher level of user
involvement and satisfaction with the system. However, fourth-
generation tools still cannot replace conventional tools for some
business applications, because they cannot easily handle the processing
of large numbers of transactions of applications with extensive
procedural logic and updating requirements.
End-user computing also poses organizational risks because it occurs
outside of traditional mechanisms for information system management
and control. When systems are created rapidly, without a formal
development methodology, testing and documentation may be
inadequate. Control over data can be lost in systems outside the

165
traditional information systems department. When users create their own
applications and files, it becomes increasingly difficult to determine
where data are located and to ensure that the same piece of information
is used consistently throughout the organization.

Managing End-User Development

To help organizations maximize the benefits of end-user applications
development, management should control the development of end-user
applications by requiring cost justifications of end-user information
system projects and by establishing hardware, software, and quality
standards for user-developed applications.
When end-user computing first became popular, organizations used
information centers to promote standards for hardware and software so
that end users would not introduce many disparate and incompatible
technologies into the firm (Fuller and Swanson, 1992). Information
centers are special facilities housing hardware, software, and technical
specialists to supply end users with tools, training, and expert advice so
they can create information system applications on their own or increase
their productivity. The role of information centers is diminishing as end
users become more computer literate, but organizations still need to
closely monitor and manage end-user development.

14.3 OUTSOURCING
If a firm does not want to use its internal resources to build or operate
information systems, it can hire an external organization that specializes
in providing these services to do the work. The process of turning over
an organization’s computer center operations, telecommunications
networks, or applications development to external vendors is called
outsourcing. Subscribing companies use the software and computer
hardware provided by the application service provider as the technical
platform for their system. In another form of outsourcing, a company
hires an external vendor to design and create the software for its
system, but that company would operate the system on its own
computer. The Window on Management describes how one start-up
company benefited from outsourcing its Web site.
Outsourcing has become popular because some organizations perceive
it as more cost-effective than maintaining their own computer center or
information systems staff. The provider of outsourcing services benefits
from economies of scale (the same knowledge, skills, and capacity can
be shared with many different customers) and is likely to charge
competitive prices for information systems services. Outsourcing allows

166
a company with fluctuating needs for computer processing to pay for
only what it uses rather than to build its own computer, center, which
would be underutilized when there is no peak load. Some firms
outsource because their internal information systems staff cannot keep
pace with technological change or innovative business practices or
because they want to free up scarce and costly talent for activities with
higher payback.
Not all organizations benefit from outsourcing, and the disadvantages of
outsourcing can create serious problems for organizations if they are not
well understood and managed. When a firm allocates the responsibility
for developing and operating its information systems to another
organization. It loses control over its information systems function. If the
organization lacks the expertise to negotiate a sound contract, the firm’s
dependency on the vendor could result in high costs or loss of control
over technological direction. Firms should be especially cautious when
using an outsourcer to develop or to operate applications that give it
some type of competitive advantage.

Activity
Some have said that the best way to reduce system development costs
is to use application software packages. Do you agree? Why or why
not?

LET US SUM UP
Developing an information system using an application software
package eliminates the need for writing software programs when
developing an information system. Using a software package cuts down
on the amount of design, testing, installation, and maintenance work
required to build a system. Application software packages are helpful if a
firm does not have the internal information systems staff or financial
resources to custom-develop a system. To meet an organization’s
unique requirements, package may require extensive modifications that
can substantially raise development costs.
End-user development is the development of information systems by
end users, either alone or with minimal assistance from information
systems specialists. End-users developed systems can be created
rapidly and informally using fourth-generation software tools. The
primary benefits of end-user development are improved requirements
determination, reduced application backlog, and increased end-user
participation in, and control of, the systems development process.
However, end-user development, in conjunction with distributed

167
computing, has introduced new organizational risks by propagating
information systems and data resources that do not necessarily meet
quality assurance standards and that are not easily controlled by
traditional means.
Outsourcing consists of using an external vendor to build (or operate) a
firm’s information systems. The work is done by the organization’s
internal information systems staff. Outsourcing can save application
development costs or allow firms to develop applications without an
internal information systems staff. However, firms risk losing over their
information systems and becoming too dependent on external vendors.

CHECK YOUR PROGRESS

Choose the Correct Answer:

1.___________ is a detailed list of questions submitted to packaged
software vendors

a) Request for proposal b) internet protocol

c) Domain name d) Spoofing

2.The process of turning over an organization’s computer center
operations, telecommunications networks, or applications development
to external vendors is called _______________

a)Outsourcing b) Internal Resourcing

c) Internal audit d) System testing

3. __________ are special facilities housing hardware, software,

and technical specialists to supply end users with tools, training, and

expert advice.

a) Information centers b) Outsourcing

c) Remote sensing d) Internal Resourcing

4.The document listing all procedure and regulations that generally govern
an organization is the___________

a) Administrative policy manual b) Personal policy book

c) Procedures log d) Organization manual

5.During what phase, the requirements analysis is
performed___________

a) System investigation phase b) System analysis phase

c) System development phase d) System design phase

168
GLOSSARY

System life cycle : System life cycle (SLC) is an

organizational process of
developing and
maintaining systems. It helps in
establishing a system project plan,
because it gives overall list of
processes and sub-processes
required for developing a system

System testing : System testing is defined

as testing of a complete and fully
integrated software product.
This testing falls in black-
box testing wherein knowledge of
the inner design of the code is not
a pre-requisite and is done by
the testing team.

Unit testing : Unit Testing is a type of software

testing where individual units or
components of a software are
tested. The purpose is to validate
that each unit of the software code
performs as expected. Unit Testing
is done during the development
(coding phase) of an application by
the developers

Outsourcing : Outsourcing is the practice of

passing individual tasks, subareas,
or business processes over to a
third-party and thereby receiving
the results from outside of your
own company. Services that your
company was responsible for
fulfilling will now be provided by a
specialized service provider.

Procedures log : Identifying someone trying to

169
 establish a connection to a
computer. During logon
procedures, two requests are made
from the individual trying to gain
access: a preauthorized account
(or user) name and a preset
password

Information centers : A place where members of

the public can obtain information
regarding an area, organisation
activity etc.

SUGGESTED READINGS
1. Bentley Trevor J (1986) Management Information Systems &
data processing, 2nd edition, Holt, Rinehart and Winston
publications, University of California. ISBN 0039106888,
9780039106881.
2. Donald W. Kroeber (1986) Computer-Based Information
Systems: A Management Approach, Subsequent
edition, Macmillan Publications, University of Virginia. ISBN
0023668407, 9780023668401.
3. Gordon B.Davis (2013) Management Information Systems, 1 st
Edition, TMH Publications, India. ISBN 007066241X.
4. Joel E. Ross (1970) Management by Information System,
illustrated edition, Prentice-Hall publications, University of
Wisconsin,ISBN 0135486289, 9780135486283.
5. Kenneth C. Loudon & Jane P. Loudon (2014) Management
Information Systems, 13th Edition, Pearson Publications, USA.

ANSWERS TO CHECK YOUR PROGRESS

1) a 2) a 3) a 4)d 5)b

170
 BLOCK 5

SECURITY AND ETHICAL

CHALLENGES

Unit 15: Security and Ethical Challenges

Unit 16: Societal Challenges of Information
System

171
Unit 15

SECURITY AND ETHICAL CHALLENGES

STRUCTURE

Overview

Learning Objectives

15.1 Security and Ethical Challenges

15.2 IS Control: Facility control & Procedural Control

15.3 Application Reliability and Data Entry Controls

15.4 Types of Spoofing

Let us sum up

Check Your Progress

Glossary

Suggested Readings

Answers to check your progress

OVERVIEW
Any business faces social and ethical challenges in this society.
Information system as well faces various challenges. Overcoming these
have paved way for a successful development of IS. This unit details out
various IS control and ethics for IS professional.

LEARNING OBJECTIVES

After reading this unit, you should be able to,

• define IS and the ethical challenges
• explain the IS control procedures

15.1 SECURITY AND ETHICAL CHALLENGES

Ever get the feeling somebody is trailing you on the Web, watching your
every click? Wonder why you start seeing display ads and pop-ups just
after you’ve been scouring the Web for a car, a dress, or cosmetic
product? Well, you’re right: your behavior is being tracked, and you are
being targeted on the Web so that you are exposed to certain ads and
not others. The Web sites you visit track the search engine queries you
enter, pages visited, Web content viewed, ads clicked, videos watched,
content shared, and the products you purchase. Google is the largest
Web tracker, monitoring thousands of Web sites. As one wag noted,

172
Google knows more about you than your mother does. In March 2009,
Google began displaying ads on thousands of Google-related Web sites
based on their previous online activities. To parry a growing public
resentment of behavioral targeting, Google said it would give users the
ability to see and edit the information that it has compiled about their
interests for the purposes of behavioral targeting. Behavioral targeting
seeks to increase the efficiency of online ads by using information that
Web visitors reveal about themselves online, and if possible, combine
this with offline identity and consumption information gathered by
companies such as Acxiom.
The growing use of behavioral targeting techniques shows that
technology can be a double-edged sword. It can be the source of many
benefits (by showing you ads relevant to your interests) but it can also
create new opportunities for invading your privacy, and enabling the
reckless use of that information in a variety of decisions about you.
Online advertising titans like Google, Microsoft, and Yahoo are all
looking for ways to monetize their huge collections of online behavioral
data. While search engine marketing is arguably the most effective form
of advertising in history, banner display ad marketing is highly inefficient
because it displays ads to everyone regardless of their interests. Hence
the search engine marketers cannot charge much for display ad space.
However, by tracking the online movements of 200 million U.S. Internet
users, they can develop a very clear picture of who you are, and use that
information to show you ads that might be of interest to you. This would
make the marketing process more efficient and more profitable for all the
parties involved. But this solution also creates an ethical dilemma, pitting
the monetary interests of the online advertisers and search engines
against the interests of individuals to maintain a sense of c ontrol over
their personal information and their privacy. Two closely held values are
in conflict here. As a manager, you will need to be sensitive to both the
negative and positive impacts of information systems for your firm,
employees, and customers. You will need to learn how to resolve ethical
dilemmas involving information systems.

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 Figure 15.1 Ethical Challenges
Ethics refers to the principles of right and wrong that individuals, acting
as free moral agents, use to make choices to guide their behaviors.
Information systems raise new ethical questions for both individuals and
societies because they create opportunities for intense social change,
and thus threaten existing distributions of power, money, rights, and
obligations. Like other technologies, such as steam engines, electricity,
the telephone, and the radio, information technology can be used to
achieve social progress, but it can also be used to commit crimes and
threaten cherished social values. The development of information
technology will produce benefits for many and costs for others. Ethical
issues in information systems have been given new urgency by the rise
of the Internet and electronic commerce. Internet and digital firm
technologies make it easier than ever to assemble, integrate, and
distribute information, unleashing new concerns about the appropriate
use of customer information, the protection of personal privacy, and the
protection of intellectual property. Other pressing ethical issues raised by
information systems include establishing accountability for the
consequences of information systems, setting standards to safeguard
system quality that protects the safety of the individual and society, and
preserving values and institutions considered essential to the quality of
life in an information society. When using information systems, it is
essential to ask, “What is the ethical and socially responsible course of
action?”

15.2 FACILITY CONTROL AND PROCEDURAL CONTROL

Controls are constraints and other restrictions imposed on a user or a
system, and they canbe used to secure systems against the risks just

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discussed or to reduce damage caused to systems, Applications, and
data.
Controls are implemented not only for access but also to implement
policies and ensure that nonsensical data is not entered into corporate
databases.
Physical facility control is methods that protect physical facilities and
their contents from loss and destruction. Computer centers are prone to
many hazards such as accidents, thefts, fire, natural disasters,
destructions etc. Therefore, physical safeguards and various control
procedures are required to protect the hardware, software and vital data
resources of computer using organizations.
Procedural control methods provide maximum security to operation of
the information system. Standard procedures are developed and
maintained manually and built in software help display so that everyone
knows what to do. It promotes uniformity and minimize the chance of
error and fraud. It should be kept up to date so that correct processing of
each activity is made possible.
15.3 APPLICATION RELIABILITY AND DATA ENTRY CONTROLS
The most reliable programs consider every possible misuse or abuse. A
highly reliable program includes code that promptly produces a clear
message if a user either makes an error or tries to circumvent a process.
For example, a Web site invites users to select a username and
password, and the operators demand passwords that are not easy to
guess. The application should be programmed to reject any password
that has fewer than a certain number of characters or does not include
numerals. A clear message then must be presented, inviting the user to
follow the guidelines.
Controls also translate business policies into system features. For
example, Blockbuster Video uses its IS to implement a policy limiting
debt for each customer to a certain level. When a renter reaches the
debt limit and tries to rent another DVD, a message appears on the cash
register screen: “Do not rent!” Thus, the policy is implemented by using a
control at the point of sale. Similar systems do not allow any expenditure
to be committed unless a certain budgetary item is first checked to
ensure sufficient allocation. A spending policy has been implemented
through the proper software.

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Access Controls
Unauthorized access to information systems, usually via public networks
such as the Internet, does not always damage IT resources. However, it
is regarded as one of the most serious threats to security because it is
often the prelude to the destruction of Web sites, databases, and other
resources, or theft of valuable information.
Access controls are measures taken to ensure that only those who are
authorized have access to a computer or network, or to certain
applications or data. One way to block access to a computer is by
physically locking it in a facility to which only authorized users have a
key or by locking the computer itself with a physical key. However, in the
age of networked computers, this solution is practical only for a limited
number of servers and other computers. Therefore, these organizations
must use other access controls, most of which rely on software. Experts
like to classify access controls into three groups: what you know, what
you have, and who you are.
1. “What you know” includes access codes such as user IDs, account
numbers, and passwords.
2. “What you have” is some kind of a device, such as a security card,
which you use directly, or which continuously changes coordinated
access codes and displays them for you.

3. “Who you are” includes your unique physical characteristics.

The most common way to control access is through the combination of a
user ID and a password. While user IDs are usually not secret,
passwords are. IS managers encourage users to change their
passwords frequently, which most systems easily allow, so that others
do not have time to figure them out and to limit the usefulness of stolen
passwords. Some organisations have systems that force users to
change their passwords at preset intervals, such as once a month or
once every three months. Some systems also prevent users from
selecting a password that they have used in the past, to minimise the
chance that someone else might guess it, and many require a minimum
length and mix of characters and numerals. Access codes and their
related passwords are maintained either in a special list that becomes
part of the operating system or in a database that the system searches
to determine whether a user is authorised to access the requested
resource.
A more secure measure than passwords is security cards, such as
RSA’s SecureID. The device is distributed to employees who need

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access to confidential databases, usually remotely. Employees receive a
small device that displays a 6-digit number. Special circuitry changes the
number both at the server and the device to the same new number
every minute. To gain access, employees enter at least one access
code and the current number. The device is small enough to be carried
on a key chain or in a wallet. This two-factor access control increases
the probability that only authorised people gain access. This is an
example of using both what you know and what you have.
In recent years, some companies have adopted physical access controls
called bio-metrics. A bio-metric characteristic is a unique physical,
measurable characteristic of a human being that is used to identify a
person. Characteristics such as fingerprints, retinal scans, or voice prints
can be used in bio-metrics. They are in the class of “who you are.” When
a fingerprint is used, the user presses a finger on a scanner or puts it
before a digital camera. The fingerprint is compared against a database
of digitised fingerprints of people with authorised access. A growing
number of laptop computers have a built-in fingerprint scanner for the
same purpose. The procedure is similar when the image of a person’s
retina is scanned. With voice recognition, the user is instructed to utter a
word or several words. The intonation and accent are digitised and
compared with a list of digitised voice samples.

Risk to Online Operations

• Massive movement of operation to the internet has attracted
hackers who try to interrupt such operation daily.
• To unauthorized access, data theft, and defacing of web pages.
There has been a surge in denial of service attacks hijacking of
computers

Denial of Service (DOS):

• Too many requests are received to log on to a Web site’s pages
• If perpetrated from multiple computers it is called distributed
denial of service (DDOS)
A “denial of service” or DoS attack is used to tie up a website’s
resources so that users who need to access the site cannot do so. Many
major companies have been the focus of DoS attacks. Because a
DoSattack can be easily engineered from nearly any location, finding
those responsible can be extremely difficult.
A bit of history: The first DoS attack was done by 13-year-old David
Dennis in 1974. Dennis wrote a program using the “external” or “ext”

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command that forced some computers at a nearby university research
lab to power off
DoS attacks have evolved into the more complex and sophisticated
“distributed denial of service” (DDoS) attacks. The biggest attack ever
recorded — at that time — targeted code-hosting-service GitHub in
2018. We’ll discuss DDoS attacks in greater detail later in this article.
Attackers include hacktivists (hackers whose activity is aimed at
promoting a social or political cause), profit-motivated cybercriminals,
and nation states.

Denial of service attacks explained

DoS attacks generally take one of two forms. They either flood web
services or crash them.

Flooding attacks
Flooding is the more common form DoS attack. It occurs when the
attacked system is overwhelmed by large amounts of traffic that the
server is unable to handle. The system eventually stops.
An ICMP flood — also known as a ping flood — is a type of DoS attack
that sends spoofed packets of information that hit every computer in a
targeted network, taking advantage of misconfigured network devices.
A SYN flood is a variation that exploits a vulnerability in the TCP
connection sequence. This is often referred to as the three-way
handshake connection with the host and the server. Here’s how it works:
The targeted server receives a request to begin the handshake. But, in a
SYN flood, the handshake is never completed. That leaves the
connected port as occupied and unavailable to process further requests.
Meanwhile, the cybercriminal continues to send more and more
requests, overwhelming all open ports and shutting down the server.

Crash attacks
Crash attacks occur less often, when cybercriminals transmit bugs that
exploit flaws in the targeted system. The result? The system crashes.
Crash attacks — and flooding attacks — prevent legitimate users from
accessing online services such as websites, gaming sites, email, and
bank accounts.

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How a DoS attack works
Unlike a virus or malware, a DoS attack doesn’t depend on a special
program to run. Instead, it takes advantage of an inherent vulnerability in
the way computer networks communicate.
Here’s an example. Suppose you wish to visit an e-commerce site in
order to shop for a gift. Your computer sends a small packet of
information to the website. The packet works as a “hello” – basically,
your computer says, “Hi, I’d like to visit you, please let me in.”
When the server receives your computer’s message, it sends a short
one back, saying in a sense, “OK, are you real?” Your computer
responds — “Yes!” — and communication is established.
The website’s homepage then pops up on your screen, and you can
explore the site. Your computer and the server continue communicating
as you click links, place orders, and carry out other business.
In a DoS attack, a computer is rigged to send not just one “introduction”
to a server, but hundreds or thousands. The server — which cannot tell
that the introductions are fake — sends back its usual response, waiting
up to a minute in each case to hear a reply. When it gets no reply, the
server shuts down the connection, and the computer executing the
attack repeats, sending a new batch of fake requests.
DoS attacks mostly affect organizations and how they run in a
connected world. For consumers, the attacks hinder their ability to
access services and information.

How to help prevent DoS attacks?

If you rely on a website to do business, you probably want to know about
DoS attack prevention.
A general rule: The earlier you can identify an attack-in-progress, the
quicker you can contain the damage. Here are some things you can do.

Method 1: Get help recognizing attacks

Companies often use technology or anti-DDoS services to help defend
themselves. These can help you recognize between legitimate spikes in
network traffic and a DDoS attack.

Method 2: Contact your Internet Service provider

If you find your company is under attack, you should notify your Internet
Service Provider as soon as possible to determine if your traffic can be
rerouted. Having a backup ISP is a good idea, too. Also, consider

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services that can disperse the massive DDoS traffic among a network of
servers. That can help render an attack ineffective.

Method 3: Investigate black hole routing

Internet service providers can use “black hole routing.” It directs
excessive traffic into a null route, sometimes referred to as a black hole.
This can help prevent the targeted website or network from crashing.
The drawback is that both legitimate and illegitimate traffic is rerouted in
the same way.

Method 4: Configure firewalls and routers

Firewalls and routers should be configured to reject bogus traffic.
Remember to keep your routers and firewalls updated with the latest
security patches.

Method 5: Consider front-end hardware

Application front-end hardware that’s integrated into the network before
traffic reaches a server can help analyze and screen data packets. The
hardware classifies the data as priority, regular, or dangerous as they
enter a system. It can also help block threatening data.

Spoofing
Spoofing is a type of scam in which criminals attempt to obtain
someone's personal information by pretending to be a legitimate
business, a neighbor, or some other innocent party.

How Spoofing Works?

There are several kinds of spoofing, including email spoofing, text
message spoofing, caller ID spoofing, and URL and GPS spoofing. In
short, if there's a form of online communication, spoofers are trying to
scam their way into it—and into your identity and your assets.

Special Considerations
Be skeptical whenever you receive a message asking for personal
information and only download files from trusted sources. Install antivirus
software on any computers you use and keep it up to date.
If you get an inquiry seeking personal information, don’t provide it. Hang
up (or log off) and then look up the phone number or customer service
email address from the entity purportedly contacting you for your
personal information.
If you think you’ve been spoofed, you can file a complaint at the FCC's
Consumer Complaint Center. The FCC doesn't act on individual

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complaints but will add that information to its database. If you've lost
money because of spoofing, the FCC recommends contacting your local
police.

15.4 TYPES OF SPOOFING

Email Spoofing
Sometimes referred to as phishing, this tactic is used by both dishonest
advertisers and outright thieves. The spoofer sends out emails with a
falsified “From:” line to try to trick victims into believing that the message
is from a friend, their bank, or some other legitimate source. Any email
that asks for your password, Social Security number, or any other
personal information could be a trick.

Text Message Spoofing

Sometimes referred to as smishing, this is similar to email spoofing. The
text message may appear to come from a legitimate source, such as
your bank. It may request that you call a certain phone number or click
on a link within the message, with the goal of getting you to divulge
personal information.

Caller ID Spoofing
Here, the spoofer falsifies the phone number from which they are calling
in hope of getting you to take their call. On your caller ID, it might appear
that the call is coming from a legitimate business or government agency,
such as the Internal Revenue Service. Note that the IRS says it doesn't
call taxpayers to tell them they owe taxes without first sending them a bill
in the mail.
Neighbor Spoofing
This is a type of caller ID spoofing in which the call will appear to be from
someone you know or a person who lives near you. The Federal
Communications Commission (FCC) says that the Truth in Caller ID Act
prohibits "anyone from transmitting misleading or inaccurate caller ID
information with the intent to defraud, cause harm or wrongly obtain
anything of value." If they're caught (and that's a big "if"), the spoofer can
face penalties of up to $10,000 for each violation.

URL Spoofing
URL spoofing happens when scammers set up a fraudulent website to
obtain information from victims or to install malware on their computers.
For instance, victims might be directed to a site that looks like it belongs
to their bank or credit card company and be asked to log in using their

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user ID and password. If the person falls for it and actually logs in, the
scammer could use the information the victim typed in to log into the real
site and access their accounts.

GPS Spoofing
GPS spoofing has a somewhat different purpose. It attempts to trick a
GPS receiver into believing it is in a different location or headed in a
different direction, by broadcasting bogus GPS signals or other means.
At this point, GPS spoofing is more likely to be used in warfare or by
gamers than to target individual consumers, although the technology
exists to make anyone vulnerable.

LET US SUM UP
Information system has various societal and Ethical challenges. There
are two types of IS control Procedural Control and Facility control. There
are 5 moral dimensions on societal challenges on IS. They are
Information rights and obligations, Property rights and obligations,
Accountability and control, system quality and Quality of life.

CHECK YOUR PROGRESS

Choose the Correct Answer:

1. _________ occurs when the attacked system is overwhelmed by
large amounts of traffic that the server is unable to handle.
a) Crash attack b) Flooding Attack
c) Spoofing d) GPS Spoofing
2. __________happens when scammers set up a fraudulent website
to obtain information from victims or to install malware on their
computers.
a) Neighbor spoofing b)URL spoofing
c) GPS Spoofing d)Crash attack
3. _________ occur less often, when cybercriminals transmit bugs that
exploit flaws in the targeted system.

a) Flooding Attack b) Crash attacks

c) Spoofing d) Profiling
4.__________ attempts to trick a GPS receiver into believing it is in a
different location or headed in a different direction, by broadcasting
bogus GPS signals or other means.
a) Crash attack b) Flooding Attack
c) Spoofing d) GPS Spoofing

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5. The spoofer sends out emails with a falsified “From:”___________

a) Flooding Attack b) Crash attacks

c) Spoofing d) e- mail spoofing

GLOSSARY

Spoofing : Spoofing is a specific type of cyber-

attack in which someone attempts
to use a computer, device, or
network to trick other computer
networks by masqueradingasa
legitimate entity.

Flooding attacks : Flood attacks are also known as

Denial of Service (DoS) attacks. In
a flood attack, attackers send a
very high volume of traffic to a
system so that it cannot examine
and allow permitted network traffic.

Online Operations: : Online means that a computer,

device, or a person is connected to
a network, and usually
this means the Internet. While off-
line means the computer, device,
or person is not connected to a
network, cannot be reached, and
cannot communicate with any other
computer or device.

Control : Control is power to direct, or an

accepted comparison model in an
experiment, or a device used for
regulation. Control is defined as to
command, restrain, or manage.

GPS Spoofing : GPS spoofing is an attack in which

a radio transmitter located near the
target is used to interfere with a
legitimate GPS signals. The
attacker can transmit no data at all
or could transmit inaccurate

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 coordinates.

Neighbor spoofing : Neighbor spoofing is when you get

a call from an unknown number
that looks a lot like the numbers
where you live. The incoming call
will have the same area code and
maybe the same prefix (the three
numbers after the area code) as
your number.

SUGGESTED READINGS
1. Bentley Trevor J (1986) Management Information Systems &
data processing, 2nd edition, Holt, Rinehart and Winston
publications, University of California. ISBN 0039106888,
9780039106881.
2. Donald W. Kroeber (1986) Computer-Based Information
Systems: A Management Approach, Subsequent
edition, Macmillan Publications, University of Virginia. ISBN
0023668407, 9780023668401.
3. Gordon B.Davis (2013) Management Information Systems, 1 st
Edition, TMH Publications, India. ISBN 007066241X.
4. Joel E. Ross (1970) Management by Information System,
illustrated edition, Prentice-Hall publications, University of
Wisconsin,ISBN 0135486289, 9780135486283.
5. Kenneth C. Loudon & Jane P. Loudon (2014) Management
Information Systems, 13th Edition, Pearson Publications, USA.

ANSWERS TO CHECK YOUR PROGRESS

1)b 2) b 3) b 4)d 5) d

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Unit 16

SOCIETAL CHALLENGES OF
INFORMATION SYSTEM
STRUCTURE

Overview

Learning Objectives

16.1 Ethics for IS Professional

16.2 Societal Challenges of Information System

16.3 Ethical Analysis

Let us sum up

Check Your Progress

Glossary

Suggested Readings
Answers to check your progress

OVERVIEW
Information system has posed new challenges for the protection of
individual and society. Information sent over this vast network of
networks may pass through many different computer systems before it
reaches its final destination. Each of these systems is capable of
monitoring, capturing, and storing communications that pass through it.
LEARNING OBJECTIVES

After reading this unit, you should be able to

• discuss the ethics for IS Professional
• explain the model for ethical, social and political issues

16.1 ETHICS FOR INFORMATION SYSTEM PROFESSIONAL

The field of ethics (or moral philosophy) involves systematizing,
defending, and recommending concepts of right and wrong behavior.
Philosophers today usually divide ethical theories into three general
subject areas: meta ethics, normative ethics, and applied ethics. Meta
ethics investigates where our ethical principles come from, and what
they mean. Normative ethics takes on a more practical task, which is to
arrive at moral standards that regulate right and wrong conduct.

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This may involve articulating the good habits that we should acquire, the
duties that we should follow, or the consequences of our behavior on
others. Finally, applied ethics involves examining specific controversial
issues, such as abortion, infanticide, animal rights, environmental
concerns, homosexuality, capital punishment, or nuclear war.
There are ethical, social, and political levels of analysis for each of the
five moral dimensions of information systems.
Privacy is the claim of individuals to be left alone, free from surveillance
or interference from other individuals or organizations, including the
state. Information technology and systems threaten individual claims to
privacy by making the invasion of privacy cheap, profitable, and
effective.
The claim to privacy is protected in the U.S., Canadian, and German
constitutions in a variety of different ways, and in other countries through
various statutes.
The Privacy Act of 1974 regulates the federal governments' collection
use, and disclosure of information. Most American and European privacy
law is based on the principles of Fair Information Practices (FIP) set
forth in 1973 to govern the collection and use of information about
individuals. This report states that an individual has an interest in the
information gathered about his or her and the record may not be used to
support other activities without the individual's consent.
The Gramm-Leach-Bliley Act of 1999 requires financial institutions to
disclose their policies for protecting the privacy of nonpublic personal
information and to allow customers to opt out of information-sharing
arrangements with nonaffiliated third parties.
The Health Insurance Portability and Accountability Act of 1996 (HIPAA),
gives patients access to their personal medical records maintained by
healthcare providers and the right to authorize how protected information
about themselves can be used or disclosed, and limits the disclosure of
personal information about patients to the minimum amount necessary
to achieve a given purpose.
European privacy protection is much more stringent than in the United
States. The European Directive on Data Protection requires companies
to inform people when they collect information about them and to
disclose how it will be stored and used. Customers must provide their
informed consent (consent given with knowledge of all the facts needed
to make a rational decision) before any company can legally use data
about them.
EU member nations cannot transfer personal data to countries that don't
have similar privacy protection regulations. To work with Europeans

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privacy laws, the U.S. Department of Commerce developed a safe
harbor framework for U.S. firms. A safe harbor is a private, self -
regulating policy and enforcement mechanism that meets the objectives
of government regulators and legislation but does not involve
government regulation or enforcement. U.S. firms must be certified by
public accounting firms to be "safe harbor" for personal data on
Europeans, and this certification is recognized (but not enforced) by the
Department of Commerce.
Ethical Analysis- Professional code of conduct
The Internet poses new challenges to the protection of individual privacy
because information can easily be monitored, captured, and stored as it
passes through its network of computer systems. Companies can record
a user's on-line activities, such as what files were accessed, or which
Web sites were visited. Web sites can learn the identity of their visitors if
the visitors voluntarily register at the site or they can capture information
about visitors without their knowledge using "cookie" technology.
Cookies are tiny files deposited on a computer hard drive when a user
visits certain Web sites that track visits to the Web site. Some
companies use Web bugs, which are tiny graphic files embedded into e -
mail messages and Web pages to monitor who is reading the e-mail
message or Web page.

How Cookies Identify Web Visitors

Figure 16.1: How Cookies Identify Web Visitors

➢ P3P enables Web sites to translate their privacy policies into a
standard format that can be read by the user’s Web browser software.
The user’s Web browser software evaluates the Web site’s privacy
policy to determine whether it is compatible with the user’s privacy
preferences.

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Most Internet businesses do little to protect their customers' privacy
other than the publication of privacy statements. Some e-commerce
sites add opt-out selection boxes to their privacy statement, which, when
accepted by a visitor, permit the collection of personal information.
Privacy advocates promote the wider use of an opt-in model of informed
consent in which businesses are prohibited from collecting information
unless specifically allowed by the consumer. Spyware is small
applications that can secretly install itself on an Internet user's computer
by piggybacking on larger applications. Once installed, the spyware calls
out to Web sites to send banner ads and other unsolicited material to the
user, and it can also report the user's movements on the Internet to
other computers.
In addition to legislation, new technologies are available to protect user
privacy during interactions with Web sites, including encrypting email,
anonymizing Web surfing, preventing cookies, and eliminating spyware.
The Platform for Privacy Preferences (P3P) is a standard for
communicating a Web site's privacy policy to Internet users to help them
select the level of privacy they wish to maintain when interacting with the
Web site.

Figure 16. 2: The P3P Standard

➢ P3P enables Web sites to translate their privacy policies into a
standard format that can be read by the user’s Web browser software.
The user’s Web browser software evaluates the Web site’s privacy
policy to determine whether it is compatible with the user’s privacy
preferences.

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Meanwhile the elements that describe ethical behavior in the profession,
in general these codes assert that IT professionals need to commit to:
➢ Integrity
➢ Competence
➢ Professional responsibilities
➢ Work responsibilities
➢ Societal responsibilities
Specific guidance stems from these general principles. Some common
commitments between the three codes are to:

Maintain technical competence

Avoid injury to others

Avoid injury to their property,

Avoid injury to their reputation,

Avoid injury to their employment

Reject bribes, kickbacks, etc.

16.2 SOCIETAL CHALLENGES OF INFORMATION SYSTEM

Model for Ethical, Social and Political Issues

Ethical, social, and political issues are closely linked. The ethical
dilemma you may face as a manager of information systems typically is
reflected in social and political debate. One way to think about these
relationships is given in the below figure. Imagine society as a calm
pond on a summer day, a delicate ecosystem in partial equilibrium with
individuals and with social and political institutions. Individuals know how
to act in this pond because social institutions (family, education,
organizations) have developed well-honed rules of behavior, and these
are supported by laws developed in the political sector that prescribe
behavior and promise sanctions for violations. Now toss a rock into the
center of the pond. What happens? Ripples, of course.
There are five main moral dimensions that tie together ethical, social,
and political issues in an information society. These moral dimensions
are:
• Information rights and obligations
• Property rights and obligations
• Accountability and control
• System quality
• Quality of life

189
Figure 16. 3 The relationship between ethical, social, and political Issues
in an information society.
The introduction of new information technology has a ripple effect,
raising new ethical, social, and political issues that must be dealt with on
the individual, social, and political levels. These issues have five moral
dimensions: information rights and obligations, property rights and
obligations, system quality, quality of life, and accountability and control.
There are five main moral dimensions for these issues that tie together
ethical, social, and political issues in an information society. These moral
dimensions are:
1. Information rights and obligations. What information rights do
individuals and organizations possess with respect to themselves? What
can they protect?
2. Property rights and obligations. How will traditional intellectual
property rights be protected in a digital society in which tracing and
accounting for ownership is difficult and ignoring such property rights is
so easy?
3. Accountability and control. Who can and will be held accountable
and liable for the harm done to individual and collective information and
property rights?
4. System quality. What standards of data and system quality
should we demand to protect individual rights and the safety of society?
5. Quality of life. What values should be preserved in an
information- and knowledge-based society? Which institutions should we
protect from violation? Which cultural values and practices are
supported by the new information technology?

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Key Technology Trends That Raise Ethical Issues
• Doubling of computer power
• More organizations depend on computer systems for Critical
operations
• Rapidly declining data storage costs
• Organizations can easily maintain detailed databases on
individuals

Networking advances and the Internet

• Copying data from one location to another and accessing
personal data from remote locations are much easier

Advances in data analysis techniques

• Companies can analyze vast quantities of data gathered on

Individuals for:
Profiling
• Combining data from multiple sources to create dossiers of
detailed information on individuals
Non obvious relationship awareness (NORA)
• Combining data from multiple sources to find obscure hidden
connections that might help identify criminals or terrorists

16.3 ETHICAL ANALYSIS

A Five-Step Process

1. Identify and clearly describe the facts.

2. Define the conflict or dilemma and identify the

Higher-order values involved.

3. Identify the stakeholders.

4. Identify the options that you can reasonably take.

5. Identify the potential consequences of your options.

LET US SUM UP
Information system has various societal and Ethical challenges. There
are two types of IS control Procedural Control and Facility control. There
are 5 moral dimensions on societal challenges on IS. They are
Information rights and obligations, Property rights and obligations,
Accountability and control, system quality and Quality of life.

191
CHECK YOUR PROGRESS

Choose the Correct Answer:

1. ___________ type of caller ID spoofing in which the call will appear
to be from someone you know or a person who lives near you.
a) Neighbor spoofing b) URL spoofing
c) GPS Spoofing d) System quality
2. The spoofer sends out emails with a falsified “From:” line to try to
trick victims into believing that the message is from a friend, their bank,
or some other legitimate source.
a) Neighbor spoofing b) e-mail spoofing
c) GPS Spoofing d) Profiling
3. ________ investigates where our ethical principles come from, and
what they mean

a) Applied ethics b) Normative ethics

c) Metaethics d) Facility control
4. Information systems support an organization's business operations,
managerial decision making and strategic competitive advantage. Such
system is called ___________

a) Business process reengineering b) Globalization

c) Roles of information systems d) Competitive advantage

5. Mistakes made in the system analyses stage show up in_______

a) System design b) System development

c) Implementation d) All the above

GLOSSARY

Accountability : Accountability is an essential part of

an information security plan. The phrase
means that every individual who works with
an information system should have specific
responsibilities for information assurance.

System development : Systems development is the process of

defining, designing, testing and implementing a
new software application or program.

Control : Control is power to direct, or an accepted

comparison model in an experiment, or a
device used for regulation. Control is defined

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 as to command, restrain, or manage.

Applied ethics : Information ethics has been defined as "the

branch of ethics that focuses on the
relationship between the creation,
organization, dissemination, and use
of information, and the ethical standards
and moral codes governing human conduct in
society".

Normative ethics : Normative ethics, that branch

of moral philosophy, or ethics, concerned with
criteria of what is morally right and wrong. It
includes the formulation of moral rules that
have direct implications for what human
actions, institutions, and ways of life should be
like.

Meta ethics : Meta ethics is the study of moral thought and

moral language.

SUGGESTED READINGS
1. Bentley Trevor J (1986) Management Information Systems &
data processing, 2nd edition, Holt, Rinehart and Winston
publications, University of California. ISBN 0039106888,
9780039106881.
2. Donald W. Kroeber (1986) Computer-Based Information
Systems: A Management Approach, Subsequent
edition, Macmillan Publications, University of Virginia. ISBN
0023668407, 9780023668401.
3. Gordon B.Davis (2013) Management Information Systems, 1 st
Edition, TMH Publications, India. ISBN 007066241X.
4. Joel E. Ross (1970) Management by Information System,
illustrated edition, Prentice-Hall publications, University of
Wisconsin,ISBN 0135486289, 9780135486283.
5. Kenneth C. Loudon & Jane P. Loudon (2014) Management
Information Systems, 13th Edition, Pearson Publications, USA.

ANSWERS TO CHECK YOUR PROGRESS

1)a 2) b 3) c 4)c 5)c

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