Unit-1

Managerial Economics:

Managerial economics, used synonymously with business economics. It is a branch of

economics that deals with the application of microeconomic analysis to decision-making
techniques of businesses and management units. It acts as the via media between economic
theory and pragmatic economics. Managerial economics bridges the gap between "theory and
practice". Managerial economics can be defines as:
According to Spencer and Siegelman:
“The integration of economic theory with business practice for the purpose of facilitating
decision-making and forward planning by management”.
According to McGutgan and Moyer:
“Managerial economics is the application of economic theory and methodology to decision-
making problems faced by both public and private institutions”.
Managerial economics studies the application of the principles, techniques and concepts of
economics to managerial problems of business and industrial enterprises. The
term is used interchangeably with micro economics, macro economics, monetary economics.
Nature of Managerial Economics:
To know more about managerial economics, we must know about its various characteristics. Let
us read about the nature of this concept in the following points:

 Art and Science: Managerial economics requires a lot of logical thinking and creative
skills for decision making or problem-solving. It is also considered to be a stream of
science by some economist claiming that it involves the application of different economic
principles, techniques and methods to solve business problems.
 Micro Economics: In managerial economics, managers generally deal with the problems
related to a particular organisation instead of the whole economy. Therefore it is
considered to be a part of microeconomics.

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  Uses Macro Economics: A business functions in an external environment, i.e. it serves
the market which is a part of the economy as a whole. Therefore, it is essential for
managers to analyse the different factors of macroeconomics such as market conditions,
economic reforms, government policies, etc. and their impact on the organisation.
 Multi-disciplinary: It uses many tools and principles belonging to various disciplines
such as accounting, finance, statistics, mathematics, production, operation research,
human resource, marketing, etc.
 Prescriptive / Normative Discipline: It aims at goal achievement and deals with
practical situations or problems by implementing corrective measures.
Management Oriented: It acts as a tool in the hands of managers to deal with business-
related problems and uncertainties appropriately. It also provides for goal establishment,
policy formulation and effective decision making.
 Pragmatic: It is a practical and logical approach towards the day to day business
problems.

Principles of Managerial Economics

The great macroeconomist N. Gregory Mankiw has given ten principles to explain the
significance of managerial economics in business operations.
These principles are classified as follows:

1. Principles of How People Make Decisions: To understand how the decision making
takes place in real life, let us go through the following principles:
 People Face Tradeoffs: To make decisions, people have to make choices where
they have to select among various options available.
 Opportunity Cost: Every decision involves an opportunity cost which the cost of
those options which we let go while selecting the most appropriate one.
1.

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  Rational People Think at the Margin: People usually think about the margin or
the profit they will earn before investing their money or resources at a particular
project or person.
 People Respond to Incentives: Decisions making majorly depends upon the
incentives associated with a product, service or activity. Negative incentives
discourage people whereas positive incentives motivate them.
. Principles of How People Interact: Communication and market affect business
operations. To justify the statement, let us see the following related principles:
 Trade Can Make Everyone Better off: This principle says that trade is a
medium of exchange among people. Everyone gets a chance to offer those
products or services which they are good at making. And purchase those products
or services too which others are good at manufacturing.
 Markets Are Usually A Good Way to Organize Economic Activity: Markets
mostly acts as a medium of interaction among the consumers and the producers.
The consumers express their needs and requirement (demands) whereas the
producers decide whether to produce goods or services required or not.
 Governments Can Sometimes Improve Market Outcomes: Government
intervenes business operations at the time of unfavourable market conditions or
for the welfare of society. One such example is when the government decides
minimum wages for labour welfare.
3.Principles of How Economy Works As A Whole: The following principle explains the role
of the economy in the functioning of an organization:
 A Country’s Standard of Living Depends on Its Ability to Produce Goods and
Services: For the growth of the economy of a country, it is essential that the organisations
are efficient enough produce goods and services. It ultimately meets the consumer’s
demand and improves GDP to raise the country’s standard of living.
 Prices Rise When the Government Prints Too Much Money: If there are surplus
money available with people, their spending capacity increases, ultimately leading to a
rise in demand. When the producers are unable to meet the consumer’s demand, inflation
takes place.
 Society Faces a Short-Run Tradeoff Between Inflation and Unemployment: To
reduce unemployment, the government brings in various economic policies into action.
These policies aim at boosting the economy in the short run. Such practices lead to
inflation.
Scope of Managerial Economics
Managerial economics is widely applied in organizations to deal with different business issues.
Both the micro and macroeconomics equally impact the business and its functioning.
Following points illustrate its scope:

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 1. Micro-Economics Applied to Operational Issues: To resolve the organisation’s internal
issues arising in business operations, the various theories or principles of microeconomics
applied are as follows:
 Theory of Demand: The demand theory emphasises on the consumer’s behaviour
towards a product or service. It takes into consideration the needs, wants,
preferences and requirement of the consumers to enhance the production process.
 Theory of Production and Production Decisions: This theory is majorly
concerned with the volume of production, process, capital and labour required,
cost involved, etc. It aims at maximising the output to meet the customer’s
demand.
 Pricing Theory and Analysis of Market Structure: It focuses on the price
determination of a product keeping in mind the competitors, market conditions,
cost of production, maximising sales volume, etc.
 Profit Analysis and Management: The organisations work for profit. Therefore
they always aim at profit maximisation. It depends upon the market demand, cost
of input, competition level, etc.
 Theory of Capital and Investment Decisions: Capital is the most critical factor
of business. This theory prevails the proper allocation of the organisation’s capital
and making investments in profitable projects or venture to improve
organisational efficiency.
. Macro-Economics Applied to Business Environment: Any organisation is much
affected by the environment it operates in. The business environment can be classified as
follows:
 Economic Environment: The economic conditions of a country, GDP, economic
policies, etc. indirectly impacts the business and its operations.
 Social Environment: The society in which the organisation functions also affects
it like employment conditions, trade unions, consumer cooperatives, etc.
 Political Environment: The political structure of a country whether authoritarian
or democratic, political stability, attitude towards the private sector influences
organizational growth and development.

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Managerial economics provide an essential tool for determining the business goals and targets,
the actual position of the organization and what the management should do fill the gap between
the two.
Importance of Managerial Economics
Business and industrial enterprise aims at earning maximum proceeds. A good decision requires
fair knowledge of the aspects of economic theory and tools of economic analysis, which are
directly involved in the process of decision making. Since managerial economics is concerned
with such aspects and tools of analysis, it is pertinent to the decision making process.
Spencer and Siegelman have described the importance of managerial economics in a business
and industrial enterprise as follows:
1. Accommodating traditional theoretical concepts to the actual business behavior and
conditions
Managerial economics amalgamates tools, techniques, models and theories of traditional
economics with actual business practices and with the environment in which firm has to operate.
According to Edwin Mansfield, “ Managerial Economics attempts to bridge the gap between
purely analytical problems that intrigue many economic theories and the problems of policies
that management must face.”
2. Estimating economic relationships
Managerial economics estimates economic relationships between different business factors such
as income, elasticity of demand, cost volume, profit analysis etc.
3. Predicting relevant economic quantities
Managerial economics assist the management in predicting various economic such as cost, profit,
demand, capital, production, price etc. As a business manager has to function in an environment
of uncertainty, it is imperative to anticipate the future working environment in terms of the said
quantities.
4. Understanding significant external forces
The management has to identify all the important factors that influence a firm. These factors can
broadly be divided into two categories. Managerial economics plays an important role by
assisting management in understanding these factors.
 External factors
A firm cannot exercise any control over these factors. The plans, policies and programmes of the
firm should be formulated in the light of these factors. Significant external factors impinging on
the decision making process of a firm are economic system of the country, business cycles,
fluctuations in national income and national production, industrial policy of the government,
trade and fiscal policy of the government, taxation policy, licensing policy, trends in foreign
trade o the country, general industrial relation in the country and so on.
 Internal factors
These factors fall under the control of a firm. These factors are associated with business
operation, knowledge of these factors aids the management in making sound business decisions.
5. Basis of business policies

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Managerial economics is the founding principle of business policies. Business policies are
prepared based on studies and findings of managerial economics, which cautions the
management against potential upheavals in national as well as international economy.
Thus, managerial economics is helpful to the management in its decision making process.
Role and Responsibilities of Managerial Economist
The Role of the Managerial Economist  as follows:
A managerial economist's main role is to improve the quality of policy making as it affects short
term operation and long range planning. He has a significant role to play in assisting the
management of a firm in decision making and forward planning by using specialised skills and
techniques.
               The factors which influence a business over a period may lie within the firm or outside
the firm. These factors can be divided into two categories:
(i) External and
(ii) internal.
            The external factors lie outside the control of the firm and these factors constitute
‘Business Environment’. The internal factors lie within the scope and operation of a firm and
they are known as ‘Business Operations’.
1. External Factors:
            The prime duty of a managerial economist is to make extensive study of the business
environment and external factors affecting the firm’s interest, viz., the level and growth of
national income, influence of global economy on domestic economy, trade cycle, volume of
trade and nature of financial markets, etc. They are of great significance since every business
firm is affected by them. These factors have to be thoroughly analyzed by the managerial
economist and answers to the following questions have also to be found out:
(i) What are the current trends in the local, regional, national and international economies? What
phase of trade cycle is going to occur in the near future?
(ii) What about the change in the size of population and the resultant change in regional
purchasing power?
(iii) Is competition likely to increase or decrease with reference to the products produced by the
firm?
(iv) Are fashions, tastes and preferences undergoing any change and have they affected the
demand for the product?
(v) What about the availability of credit in the money and capital markets?
(vi) Is there any change in the credit policy of the government?
(vii) What are the strategies of five year plan? Is there any special emphasis for industrial
promotion?
A managerial economist has to answer to all these and similar questions. The role of the
managerial economist is not to take decisions but to analyse, conclude and recommend. 
2. Internal Factors:

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                The managerial economist can help the management in making decision regarding the
internal operations of a firm in respect of such problems as cost structure, forecasting of demand,
price, investment, etc. Some of the important relevant questions in this connection are as follows:
(i) What should be the production schedule for the coming year?
(ii) What should be the profit budget for the coming year?
(iii) What type of technology should be adopted in the specific process and specify it?
(iv) What strategies have to be adopted for sales promotion, inventory control and utilisation of
manpower?
(v) What are the factors influencing the input cost?
(vi) How different input components can be combined to minimise the cost of production?
1. Analysis of Business Operation.
The meaning of internal factors or business activities is from those who come under a particular
religion or within its working area.
The use of business management is controlled by them, such as production quantity determined
pricing, expansion, and contraction of business production method used in the firm whether to
use installed capacity. finance capital and profit management and business use and internal
elements Come under In this case.
2. Analysis of External Factors
Business firm decisions do not affect the internal Factors only. But also affected by External
Factors.
The external conditions are neither under the control of the firm nor in their working area. For
example, business cycles, government policies, monetary policy, fiscal policy, national income,
foreign trade policy, the value of government of labour law, all this is harmful, which affect the
firm’s future planning and decisions.
3. Specific Functions of Managerial Economist
The managerial economist goes into future decisions by analyzing the internal elements and
external elements in professional firms.
but nowadays his work has increased and the statements do a specific job. Which provides
benefits to the government, businessmen, individuals, and industrialists, including the following.
1. Surveying different markets.
2. Predicting the industry’s total demand for business.
3. Analyzing pricing in different industries, finding a suitable solution to the problem.
4. Analysis of valuables and actions in competitive firms.
5. Evaluation and analysis of capital projects in productive work.

Responsibilities of A Managerial Economist

The managerial economist offers a lot of support to the highest management in future planning
and decision making by looking at the advice in financial matters. He may prove to be
unsuccessful in his advice work. When he is fully aware of his responsibility and
successfully completes his loyalty.
Some of the important duties performed by managerial economist are as follows:
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1. Study of the Business Environment:
Every firm has to take into consideration such external factors as the growth of national income,
volume of trade and the general price trends, for its policy decision.
A firm works within a business environment. The basic elements of business environment for a
firm are the trend of growth of national economy and world economy and phase of the business
cycle in which the economy is moving.
2. Business Plan and Forecasting:
The business economists can help the management in the formulation of their business plan by
forecasting and economic environment. The management can easily decide the timing and
locating of their specific action. The managerial economist has to interpret the national economic
trends and industrial outlook for their relevance to the firm in which he is working.
He advises top management by means of short, business like practical notes. In a partially
controlled economy like India, the business economist translates the government’s intentions in
business jargon and also transmits the reaction of the industry to propose changes in government
policy.
3. Study of Business Operations:
The business economist can also help the management in decision making relating to the internal
operations of a firm, i.e., in deciding about price, rate of operations, investment and growth of
the firm for offering this advice: the economist has specific analytical and forecasting techniques
which yield meaningful conclusions.
What will be the reasonable sales and profit budget for the next year? What are the suitable
production schedules and inventory policies? What changes in wage and price policies are
imperative now? What would be the sources of finance? Thus, he is trained to answer such
questions posed by the top management.
4. Economic Intelligence:
The business economist also provides general intelligence services by supplying the management
with economic information of general interest so that they can talk intelligently in conferences
and seminars. They are also supplied the facts and figures for preparing the annual reports of the
firm. Those facts and figures are collected by the business economist as he understands the
literature available on business activities.
5. Specific Functions:
Business economists are now performing specific functions as consultants also. Their specific
functions are demand forecasting, industrial market research, pricing problems of industry,
production programmes, investment analysis and forecasts. They also offer advice on trade and
public relations, primary commodities and capital projects in agriculture, industry, transport and
tourism and also of the export environment.

6. Participation in Public Debates:

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The business economists participate in public debates organized by different agencies. Both
governments and society seek their advice. Their practical experience in business and industry
gives value to their observation. In nut shell a business economist can play a multi-faceted role.
He is not only an analyst of current trends and policies for his employers but also a bridge
between the businessmen in the specific industry and the government. He acts as a spokesman of
his firm and interpreter of the Government.

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 Unti-2
Demand forecasting:
Definition: Demand Forecasting refers to the process of predicting the future demand for the
firm’s product. In other words, demand forecasting is comprised of a series of steps that involves
the anticipation of demand for a product in future under both controllable and non-controllable
factors.
The business world is characterized by risk and uncertainty, and most of the business decisions
are taken under this scenario. An organization come across several risks, both internal or external
to the business operations such as technology, attrition, unrest, employee grievances, recession,
inflation, modifications in the government laws, etc.
Predicting the future demand for a product helps the organization in making decisions in
one of the following areas:
 Planning and scheduling the production and acquiring the inputs accordingly.
 Making the provisions for finances.
 Formulating a pricing strategy.
 Planning advertisement and implementing it.
Demand forecasting holds significance in the businesses where large-scale production is
involved. Since the large-scale production requires a long gestation period, a good deal of
forward planning should be done. Also, the potential future demand should be estimated to avoid
the conditions of overproduction and underproduction. Most often, the firms face a question of
what would be the future demand for their product as they have to acquire the input (labor and
raw material) accordingly.
Objectives of Demand Forecasting

Demand forecasting is one of the significant components in the success of any business. All
organisational activities, whether they are short-term business operations or long-term strategic
decisions, are dependant on it.

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These objectives are illustrated under the following categories further sub-divided into points:

Short-Term Objectives: To ensure the effective working of the organisation, estimation of sales
for the past six months is done. Let us now go through the following purpose of demand
forecasting in the short run:

 Formulation of Production Policy: Demand forecasting aims at meeting the demand by

ensuring uninterrupted production and supply of goods and services.
 Formulation of Price Policy: It helps in formulating an effective price mechanism to
deal with the market fluctuations and conditions like inflation.
 Maximum Utilization of Machines: It streamlines the production process and operations
such that there is the optimum utilisation of machines.
 Proper Control of Sales: Forecasting the regional sales of a particular product or service
provides a base for setting a sales target and evaluating the performance.
 Regular Supply of Material: Sales forecast determines the level of production, leading
to the estimation of raw material. Thus, a continuous supply of raw material and inventory
management can be done.
 Arrangement of Finance: To maintain short-term cash in the organisation it is essential
to forecast the sales as well as liquidity requirement accordingly.
 Regular Availability of Labor: Estimation of the production capacity provides for the
acquisition of suitable skilled and unskilled labour.

Long-Term Objectives: Demand forecasting is inevitable for the long-term existence of an

organisation. Following objectives justify the statement:

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  Long-Term Finance Management: Forecasting sales for the long-term contributes to
long-term financial planning and acquisition of funds at reasonable rates and suitable terms
and conditions.
 Decisions Regarding Production Capacity: Demand forecast determines the production
level, which provides a base for decisions related to the expansion of the production unit or
size of the plant.
 Labour Requirement: Demand forecasting initiates the expansion of business, thus
leading to the estimation of required human resource to accomplish business goals and
objectives.

Estimating demand with accuracy requires a lot of expertise and knowledge. Therefore experts
are hired by the business organizations to ensure better results and proper utilization of
resources.

Factors Influencing Demand Forecasting:

Demand forecasting is a proactive process that helps in determining what products are needed
where, when, and in what quantities. There are a number of factors that affect demand
forecasting.
Some of the factors that influence demand forecasting are shown in Figure-2:

The various factors that influence demand forecasting (“as shown in Figure-2) are
explained as follows:
i. Types of Goods:
Affect the demand forecasting process to a larger extent. Goods can be producer’s goods,
consumer goods, or services. Apart from this, goods can be established and new goods.
Established goods are those goods which already exist in the market, whereas new goods are
those which are yet to be introduced in the market.
Information regarding the demand, substitutes and level of competition of goods is known only
in case of established goods. On the other hand, it is difficult to forecast demand for the new
goods. Therefore, forecasting is different for different types of goods.
ii. Competition Level:
Influence the process of demand forecasting. In a highly competitive market, demand for
products also depend on the number of competitors existing in the market. Moreover, in a highly

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competitive market, there is always a risk of new entrants. In such a case, demand forecasting
becomes difficult and challenging.
iii. Price of Goods:
Acts as a major factor that influences the demand forecasting process. The demand forecasts of
organizations are highly affected by change in their pricing policies. In such a scenario, it is
difficult to estimate the exact demand of products.
iv. Level of Technology:
Constitutes an important factor in obtaining reliable demand forecasts. If there is a rapid change
in technology, the existing technology or products may become obsolete. For example, there is a
high decline in the demand of floppy disks with the introduction of compact disks (CDs) and pen
drives for saving data in computer. In such a case, it is difficult to forecast demand for existing
products in future.
v. Economic Viewpoint:
Play a crucial role in obtaining demand forecasts. For example, if there is a positive development
in an economy, such as globalization and high level of investment, the demand forecasts of
organizations would also be positive.
Process of Demand Forecasting

Demand forecasting is not based on assumptions but is a systematic and scientific process of
estimating future sales and performance as well as directing the resources accordingly.

The steps involved in a standard demand forecasting process are as follows:

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Setting the Objectives: The purpose for which the demand forecasting is being done must be
clear. Whether it is for short-term or long-term, the market share of the product, the market share
of the organisation, competitors share, etc. By all these aspects, the objectives for forecasting are
framed.
Determining the Time Perspective: The defined objectives are supported by the period for
which the forecasting is being done. The demand for a commodity varies with the change in its
determinants over the period.
There is a negligible change in price, income or other factors in the short run. But, the
organisation may notice a considerable difference in these determinants over a long-term,
affecting the demand of a commodity.
Selecting a Suitable Demand Forecasting Method: Demand forecasting is based on specific
evidence and is determined using a particular technique or method. The method of prediction
must be selected wisely. It is dependant on the information available, the purpose of predicting
and the period it is done for.
Collecting the Data: Forecasting is based on past experiences and data. This data or information
can be primary or secondary. Primary data comprises of the information directly collected by the
analysts and researchers; whereas secondary data includes the physical evidence of the past
performance, sales trend in the past years, financial reports, etc.
Estimating the Results: The data so collected is arranged in a systematic and meaningful
manner. The past performance of a product in the market is analysed on this basis. Accordingly,
future sales prediction and demand estimation are done. The results soo drew must be in a format
which is easy to understand and apply by the management.
Techniques & Methods of Demand Forecasting
Different organisations rely on different techniques to forecast demand for their products or
services for a future time period depending on their requirements and budget.
Methods of demand forecasting are broadly categorised into two types. Let us discuss these
techniques & methods of demand forecasting in detail:
1. Qualitative Techniques
o Survey Methods

2. Quantitative Techniques
o Time Series Analysis
o Smoothing Techniques
o Barometric Methods
o Econometric Methods

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Methods of Demand Forecasting
Qualitative Techniques
Qualitative techniques rely on collecting data on the buying behaviour of consumers from
experts or through conducting surveys in order to forecast demand.These techniques are
generally used to make shortterm forecasts of demand.
Qualitative techniques are especially useful in situations when historical data is not available; for
example, introduction of a new product or service. These techniques are based on experience,
judgment, intuition, conjecture, etc.
Survey Methods
Survey methods are the most commonly used methods of forecasting demand in the short run.
This method relies on the future purchase plans of consumers and their intentions to anticipate
demand.
Thus, in this method, an organization conducts surveys with consumers to determine the demand
for their existing products and services and anticipate the future demand accordingly. The two
types of survey methods are explained as follows:
 Complete enumeration survey: This method is also referred to as the census method of
demand forecasting. In this method, almost all potential users of the product are
contacted and surveyed about their purchasing plans.

Based on these surveys, demand forecasts are made. The aggregate demand forecasts are
attained by totalling the probable demands of all individual consumers in the market.

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  Sample survey: In this method, only a few potential consumers (called sample) are
selected from the market and surveyed. In this method, the average demand is calculated
based on the information gathered from the sample.

Opinion poll
Opinion poll methods involve taking the opinion of those who possess knowledge of
market trends, such as sales representatives, marketing experts, and consultants.
The most commonly used opinion polls methods are explained as follows:
 Expert opinion method: In this method, sales representatives of different organisations
get in touch with consumers in specific areas. They gather information related to
consumers’ buying behaviour, their reactions and responses to market changes, their
opinion about new products, etc.

 Delphi method: In this method, market experts are provided with the estimates and
assumptions of forecasts made by other experts in the industry. Experts may reconsider
and revise their own estimates and assumptions based on the information provided by
other experts.

 Market studies and experiments: This method is also referred to as market experiment

method. In this method, organisations initially select certain aspects of a market such as
population, income levels, cultural and social background, occupational distribution, and
consumers’ tastes and preferences.

Among all these aspects, one aspect is selected and its effect on demand is determined
while keeping all other aspects constant.
Quantitative Techniques
Quantitative techniques for demand forecasting usually make use of statistical tools. In these
techniques, demand is forecasted based on historical data.
These methods are generally used to make long-term forecasts of demand. Unlike survey
methods, statistical methods are cost effective and reliable as the element of subjectivity is
minimum in these methods. Let us discuss different types of quantitative methods:
Time Series Analysis
Time series analysis or trend projection method is one of the most popular methods used by
organisations for the prediction of demand in the long run. The term time series refers to a
sequential order of values of a variable (called trend) at equal time intervals.
Using trends, an organisation can predict the demand for its products and services for the
projected time. There are four main components of time series analysis that an organisation must
take into consideration while forecasting the demand for its products and services. These
components are:

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  Trend component: The trend component in time series analysis accounts for the gradual
shift in the time series to a relatively higher or lower value over a long period of time.
 Cyclical component: The cyclical component in time series analysis accounts for the
regular pattern of sequences of values above and below the trend line lasting more than
one year.
 Seasonal component: The seasonal component in time series analysis accounts for
regular patterns of variability within certain time periods, such as a year.
 Irregular component: The irregular component in time series analysis accounts for a
short term, unanticipated and non-recurring factors that affect the values of the time
series.
Smoothing Techniques
In cases where the time series lacks significant trends, smoothing techniques can be used for
demand forecasting. Smoothing techniques are used to eliminate a random variation from the
historical demand.
This helps in identifying demand patterns and demand levels that can be used to estimate future
demand. The most common methods used in smoothing techniques of demand forecasting are
simple moving average method and weighted moving average method.
The simple moving average method is used to calculate the mean of average prices over a
period of time and plot these mean prices on a graph which acts as a scale.

For example, a five-day simple moving average is the sum of values of all five days divided by
five.
The weighted moving average method uses a predefined number of time periods to calculate the
average, all of which have the same importance.

For example, in a four-month moving average, each month represents 25% of the moving
average.
Barometric Methods
Barometric methods are used to speculate the future trends based on current developments.
This methods are also referred to as the leading indicators approach to demand forecasting.
Many economists use barometric methods to forecast trends in business activities. The basic
approach followed in barometric methods of demand analysis is to prepare an index of relevant
economic indicators and forecast future trends based on the movements shown in the index.

The barometric methods make use of the following indicators:

 Leading indicators: When an event that has already occurred is considered to predict the
future event, the past event would act as a leading indicator.

For example, the data relating to working women would act as a leading indicator for the

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 demand of working women hostels.

 Coincident indicators: These indicators move simultaneously with the current event.

For example, a number of employees in the non-agricultural sector, rate of

unemployment, per capita income, etc., act as indicators for the current state of a nation’s
economy.

 Lagging indicators: These indicators include events that follow a change. Lagging

indicators are critical to interpret how the economy would shape up in the future. These
indicators are useful in predicting the future economic events.

For example, inflation, unemployment levels, etc. are the indicators of the performance of
a country’s economy.
Econometric Methods
Econometric methods make use of statistical tools combined with economic theories to assess
various economic variables (for example, price change, income level of consumers, changes in
economic policies, and so on) for forecasting demand.
The forecasts made using econometric methods are much more reliable than any other demand
forecasting method. An econometric model for demand forecasting could be single equation
regression analysis or a system of simultaneous equations. A detailed explanation of regression
analysis is given in the next section.
 Regression Analysis: The regression analysis method for demand forecasting measures
the relationship between two variables. Using regression analysis a relationship is
established between the dependent (quantity demanded) and independent variable
(income of the consumer, price of related goods, advertisements, etc.).
For example, regression analysis may be used to establish a relationship between the income of
consumers and their demand for a luxury product. In other words, regression analysis is a
statistical tool to estimate the unknown value of a variable when the value of the other variable is
known.
After establishing the relationship, the regression equation is derived assuming the relationship
between variables is linear.
The formula for a simple linear regression is as follows:
Y =a + bX
Where Y is the dependent variable for which the demand needs to be forecasted; b is the slope of
the regression curve; X is the independent variable; and a is the Y-intercept. The intercept a will
be equal to Y if the value of X is zero.
Criteria Of A Good Demand Forecasting Method
A prediction or estimation of future demand for the product is known as demand forecasting.
Generally every business firm predicts a number of related forecasts. Since the future is

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uncertain, these forecasts may not be hundred percent correct. But every firm tries to obtain the
forecasts as precisely as possible. A demand forecast is said to be good or efficient when
the expected market demand is very near or equal to the actual market demand. This may be
estimated closely if proper method of demand forecasting is chosen. However, the following are
the criteria of a good demand forecasting method.
The criteria of a good demand forecasting method in economics:
1. Accuracy:
Accuracy denotes near to actual demand. A firm should forecast its demand very close to the
actual market demand so that required quantities could be made available for the market.
Inaccurate forecast may cost huge to the firm. It may create over or under production. Forecast
should be explicit. For example, there would be an increase in sales in the next year than the
current is not a good forecast but  there would be an increase in sales by 20% in the next year is
an accurate forecast.
2. Longevity or Durability :
Demand forecast generally takes huge time, money and planning. Since a forecast takes a lot of
time and money, it should be usable for longer span of time or  multiple years. A forecast for
short span of time may not be effective for the organization.
3. Flexibility or Scale-ability
A demand forecast should be flexible and adaptable to any kind of changes. Now a days there is
a rapid change in the tastes and preferences of consumers. This affects the demand for different
products up to a great extent. Therefore, the demand forecasts made by a firm should be able to
reflect those changes accordingly. Apart from this, a business firm, while making forecasts,
should consider various business risks that may take place in the future.
4. Acceptability and Simplicity:
Acceptability is one of the most important criterion of a good demand forecasting method.
That means a forecast should be acceptable to all. It should also be as simple as possible.  A
business firm should forecast its market demand by using simple and easy methods so that the
organizations do not face any complexities. However, some companies generally prefer
advanced statistical methods, which may prove difficult and complex.
5. Availability:
A good a good demand forecasting method should have adequate and up-to-date data
available. The forecasts should be done in timely manner so that necessary arrangements could
be made related to the market demand. Data should be available to the decision makers at all
time.
6. Plausibility and Possibility:
It denotes that the demand forecasts should be reasonable, so that they are easily understood by
individuals who will use it. Again, it should have the quality of application in the changing
business conditions.
 
7. Economy:

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A good demand forecasting method should have a relationship with costs and benefits. It
should be economically effective. The forecasting should be made in such a way that the costs do
not exceed the benefits that will be derived from it. Costs should be less and benefits should be
high.
8. Yielding quick results:
A good demand forecasting method should yield quick result rather than taking longer period to
respond. It should match with the changing business environment.
9) Maintenance of timeliness:
It should take care of timelines. Data should be available to users as and when requires so that
decision making does not hamper.
How to forecast demand for new products
The method or techniques should be carefully tailored for the product. Joel Dean makes six
possible approaches towards forecasting of new products. They are as follows:
1. The Evolutionary approach in forecasting demand
The principle behind this approach is that the demand for a new product is only an outgrowth
and evolution of the existing product. It means that the demand conditions of the existing product
should be taken into account while accessing the demand for the product.
Examples: Color TV sets from black and white TV sets; Left-side steering cars from right-side
steering cars, etc. But this approach is useful only when the new product is very close to the old
existing product.
2. Substitute approach in forecasting demand
By this the new product is analyzed as a substitute for the old existing product or service.
3. Growth curve approach in forecasting demand
The estimates of rate of growth and ultimate level of demand for the new product will be
established on the basis of some growth patterns of an already established product.
For example, the average sales of Talcum powder will give an idea as to how a new cosmetic
will be received in the market.
4. Opinion Poll approach in forecasting demand
Under this, the demand for the new product will be estimated by making direct enquiries from
the ultimate consumers. This is done by sample survey method. But, this is a very complicated
process as there will be problems of sampling, probing the real intentions of the consumers, etc..
5. Sales Experience approach in forecasting demand
According to Sales experience approach method, samples of new products shall be offered in a
sample market to forecast demand. This is done through distributive channels like departmental
stores or cooperative society, etc., or by direct mailing. Total demand is predicted on the basis of
the sample market. But, the difficulty in this lies in determining the allowance to make for the
immaturity of the sample market and full-fledged market.
6. Vicarious approach in forecasting demand
Through vicarious approach method, the reaction of the customer towards new product can be
found out indirectly through the specialized dealers who are able to judge the needs, tastes and
preferences of customers.
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 Unit-3
Concept of Cost:
According to the Chartered Institute of Management Accountants, cost is “the amount of
expenditure (actual or notional) incurred on or attributable to a specified thing or
activity.” Similarly, according to Anthony and Wilsch “cost is a measurement in monetary
terms of the amount of resources used for some purposes.”
Cost has been defined by the Committee on Cost Terminology of the American Accounting
Association as “the foregoing, in monetary terms, incurred or potentially to be incurred in the
realisation of the objective of management which may be manufacturing of a product or
rendering of a service.”
From the above, it may be stated that cost means the total of all expenses incurred for a product
or a service. Thus, cost of an article means the actual outgoings or ascertained changes incurred
in its production and sale activities. In short, it is the amount of resources used up in exchange
for some goods or services.
The so-called resources are expressed in terms of money or monetary units. What we stated
above will not be a meaningful one until the same is used with an adjective only, i.e. when it
communicates the meaning for which it is intended.
Thus, when we say Prime Cost or Works Cost or Fixed Cost etc., we want to explain a particular
meaning which is essential while computing, measuring or analysing the various aspects of cost.
Classification of Cost:
Classification of costs implies the process of grouping costs according to their common
characteristics. A proper classification of costs is absolutely necessary to mention the costs with
cost centres. Usually, costs are classified according to their nature, viz., material, labour, over-
head, among others. An identical cost figure may be classified in various ways according to the
needs of the firms.
The above classification may be outlined as:

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However, the classification of cost may be depicted as given:
(a) According to Elements:
Under the circumstances, costs are classified into three broad categories Material, Labour and
Overhead. Now, further subdivision may also be made for each of them. For example, Material
may be subdivided into raw materials, packing materials, consumable stores etc. This
classification is very useful in order to ascertain the total cost and its components. Same
classification may also be made for labour and overhead.
(b) According to Functions:
The total costs are divided into different segments according to the purpose of the firm. That is
why costs are grouped as per the requirements of the firm in order to evaluate its functions
properly. In short, the total costs include all costs starting from cost of materials to the cost of
packing the product.
It takes the cost of direct material, direct labour and chargeable expenses and all indirect
expenses under the head Manufacturing/Production cost.

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At the same time, administration cost (i.e. relating to office and administration) and Selling and
Distribution expenses (i.e. relating to sales) are to be classified separately and to be added in
order to find out the total cost of the product. If these functional classifications are not made
properly, true cost of the product cannot accurately be ascertained.
(c) According to Variability:
Practically, costs are classified according to their behaviour relating to the change (increase or
decrease) in their volume of activity.
These costs as per volume may be subdivided into:
(i) Fixed Cost;
(ii) Variable Cost;
(iii) Semi-variable Cost.
Fixed Costs are those which do not vary with the change in output, i.e., irrespective of the
quantity of output produced, it remains fixed (e.g., Salaries, Rent etc.) up to a certain limit. It is
interesting to note that if more units are product, fixed cost per unit will be reduced, and, if less
units are produced, obviously, fixed cost per unit will be increased.
Variable Costs, on the other hand, are those which vary proportionately with the volume of
output. So the cost per unit will remain fixed irrespective of the quantity produced. That is, there
is no direct effect on the cost per unit if there is a change in the volume of output (e.g. price of
raw material, labour etc.,).
On the contrary, semi-variable costs are those which are partly fixed and partly variable (e.g.
Repairs of building).
(d) According to Controllability:
Costs may, again, be subdivided into two broad categories according to the performance done by
any member of the firm.
They are:
(i) Controllable Costs; and
(ii) Uncontrollable Costs.
Controllable Costs are those costs which may be influenced by the decision taken by a specified
member of the administration of the firm or, it may be stated, that the costs which at least partly
depend on the management and is controllable by them, e.g. all direct costs, direct material,
direct labour and chargeable expenses (components of Prime Cost) are controllable by lower
management level and is done accordingly.
Uncontrollable Costs are those which are not influenced by the actions taken by any specific
member of the management. For example, fixed costs, viz., rent of building, payment for salaries
etc.
(e) According to Normality:
Under this condition, costs are classified according to the normal needs for a given level of
output for a normal level of activity produced for such output.
They are divided into:
(i) Normal Costs; and
(ii) Abnormal Costs.
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Normal Costs are those costs which are normally required for a normal production at a given
level of output and which is a part of production.
Abnormal Costs, on the other hand, are those costs which are not normally required for a given
level of output to be produced normally, or which is not a part of cost of production.
(f) According to Time:
Costs may also be classified according to the time element in it. Accordingly, costs are
classified into:
(i) Historical Costs; and
(ii) Predetermined Costs.
Historical Costs are those costs which are taken into consideration after they have been incurred.
This is possible particularly when the production of a particular unit of output has already been
made. They have only historical value and cannot assist in controlling costs.
Predetermined Costs, on the other hand, are the estimated costs. Such costs are computed in
advanced on the basis of past experience and records. Needless to say here that it becomes
standard cost if it is determined on scientific basis. When such standard costs are compared with
the actual costs, the reasons of variance will come out which will help the management to take
proper steps for reconciliation.
(g) According to Traceability:
Costs can be identified with a particular product, process, department etc. They are
divided into:
(i) Direct (Traceable) Costs; and
(ii) Indirect (Non-Traceable) Costs.
Direct/Traceable Costs are those costs which can directly be traced or allocated to a product, i.e.
it includes all traceable costs, viz., all expenses relating to cost of raw materials, labour and other
service utilised which can be traced easily.
Indirect/Non-Traceable Costs are those costs which cannot directly be traced or allocated to a
product, i.e. it includes all non-traceable costs, e.g. salary of store-keepers, general
administrative expenses, i.e. which cannot properly be allocated directly to a product.
(h) According to Planning and Control:
Costs may also be classified into:
(i) Budgeted Costs; and
(ii) Standard Costs.
Budgeted Costs refer to the expected cost of manufacture computed on the basis of information
available in advance of actual production or purchase. Practically, budgeted costs include
standard costs, both are predetermined costs and their amount may coincide but their objectives
are different.
Standard Costs, on the other hand, is a predetermination of what actual costs should be under
projected conditions serving as a basis of cost control and, as a measure of product efficiency,
when ultimately aligned actual cost. It supplies a medium by which the effectiveness of current
results can be measured and the responsibility for derivations can be placed.
Standard Costs are predetermined for each element, viz., material, labour and overhead.
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Standard Costs include:
(i) The cost per unit is determined to make an estimated total output for the future period
for:
(a) Material;
(b) Labour; and
(c) Overhead.
(ii) The cost must depend on the past experience and experiments and specification of the
technical staff.
(iii) The cost must be expressed in terms of rupees.
(i) According to Management Decisions: Under this, costs may also be classified as:
(a) Marginal Cost:
Marginal Cost is the cost for producing additional unit or units by segregation of fixed costs (i.e.,
cost of capacity) from variable cost (i.e. cost of production) which helps to know the
profitability. Moreover, we know, in order to increase the production, certain expenses (fixed)
may not increase at all, only some expenses relating to materials, labour and variable expenses
are increased. Thus, the total cost so increased by the production of one unit or more is the cost
of marginal unit and the cost is known as marginal cost or incremental cost.
(b) Differential Cost:
Differential Cost is that portion of the cost of a function attributable to and identifiable with an
added feature, i.e. the change in costs as a result of change in the level of activity or method of
production.
(c) Opportunity Cost:
It is the prospective change in cost following the adoption of an alternative machine, process,
raw materials, specification or operation. In other words, it is the maximum possible alternative
earnings which might have been earned if the existing capacity had been changed to some other
alternative way.
(d) Replacement Cost:
It is the cost, at current prices, in a particular locality or market area, of replacing an item of
property or a group of assets.
(e) Implied Cost:
It is the cost used to indicate the presence of arbitrary or subjective elements of product cost
having more than usual significance. It is also called notional cost, e.g., interest on capital —
although no interest is paid. This is particularly useful while decisions are taken regarding
alternative capital investment projects.
(f) Sunk Cost:
It is the past cost arising out of a decision which cannot be revised now, and associated with
specialised equipment’s or other facilities not readily adaptable to present or future purposes.
Such cost is often regarded as constituting a minor factor in decisions affecting the future.
Concept of Costs
It is a commonly accepted fact that physical inputs or resources are important for enhancing
production. We, however, tend to miss out on the financial aspect of this rule. Some of the most
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important decisions pertaining to business often relate to the cost of production, instead of
physical resources themselves. Hence, it is important for producers to understand cost analysis.
Let’s understand the general concept of costs for that.
Concept of Costs
In order to understand the general concept of costs, it is important to know the following types of
costs:
1. Accounting costs and Economic costs
2. Outlay costs and Opportunity costs
3. Direct/Traceable costs and Indirect/Untraceable costs
4. Incremental costs and Sunk costs
5. Private costs and Social costs
6. Fixed costs and Variable costs

Concept of Costs in terms of Treatment

1. Accounting costs
Accounting costs are those for which the entrepreneur pays direct cash for procuring resources
for production. These include costs of the price paid for raw materials and machines, wages paid
to workers, electricity charges, the cost incurred in hiring or purchasing a building or plot, etc.
Accounting costs are treated as expenses. Chartered accountants record them in financial
statements.
2. Economic costs
There are certain costs that accounting costs disregard. These include money which the
entrepreneur forgoes but would have earned had he invested his time, efforts and investments in
other ventures. For example, the entrepreneur would have earned an income had he sold his
services to others instead of working on his own business

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Similarly, potential returns on the capital he employed in his business instead of giving it to
others, the output generated by his resources which he could have used for others’ benefits, etc.
are other examples of economic costs.
Economic costs help the entrepreneur calculate supernormal profits, i.e. profits he would earn
above the normal profits by investing in ventures other than his.
Concept of Costs in terms of the Nature of Expenses
1. Outlay costs
The actual expenses incurred by the entrepreneur in employing inputs are called outlay costs.
These include costs on payment of wages, rent, electricity or fuel charges, raw materials, etc. We
have to treat them are general expenses for the business.
2. Opportunity costs
Opportunity costs are incomes from the next best alternative that is foregone when the
entrepreneur makes certain choices.
For example, the entrepreneur could have earned a salary had he worked for others instead of
spending time on his own business. These costs calculate the missed opportunity and calculate
income that we can earn by following some other policy.
Concept of Costs in terms of Traceability
1. Direct costs
Direct costs are related to a specific process or product. They are also called traceable costs as
we can directly trace them to a particular activity, product or process.
They can vary with changes in the activity or product. Examples of direct costs include
manufacturing costs relating to production, customer acquisition costs pertaining to sales, etc.
2. Indirect costs
Indirect costs, or untraceable costs, are those which do not directly relate to a specific activity or
component of the business. For example, an increase in charges of electricity or taxes payable on
income. Although we cannot trace indirect costs, they are important because they affect overall
profitability.
Concept of Costs in terms of the Purpose
1. Incremental costs
These costs are incurred when the business makes a policy decision. For example, change of
product line, acquisition of new customers, upgrade of machinery to increase output are
incremental costs.
2. Sunk costs
Suck costs are costs which the entrepreneur has already incurred and he cannot recover them
again now. These include money spent on advertising, conducting research, and acquiring
machinery.
Concept of Costs in terms of Payers
1. Private costs
These costs are incurred by the business in furtherance of its own objectives. Entrepreneurs
spend them for their own private and business interests. For example, costs of manufacturing,
production, sale, advertising, etc.
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2. Social costs
As the name suggests, it is the society that bears social costs for private interests and expenses of
the business. These include social resources for which the firm does not incur expenses, like
atmosphere, water resources and environmental pollution.
Concept of Costs in terms of Variability
1. Fixed costs
Fixed costs are those which do not change with the volume of output. The business incurs them
regardless of their level of production. Examples of these include payment of rent, taxes, interest
on a loan, etc.
2. Variable costs
These costs will vary depending upon the output that the business generates. Less production
will cost fewer expenses, and vice versa, the business will pay more when its production is
greater. Expenses on the purchase of raw material and payment of wages are examples of
variable costs.
COST OUTPUT RELATIONSHIP IN THE SHORT RUN
In the short-run a change in output is possible only by making changes in the variable inputs like
raw materials, labour etc. Inputs like land and buildings, plant and machinery etc. are fixed in the
short-run. It means that short-run is a period not sufficient enough to expand the quantity of fixed
inputs. Thus Total Cost (TC) in the short-run is composed of two elements – Total Fixed Cost
(TFC) and Total Variable Cost (TVC).
TFC remains the same throughout the period and is not influenced by the level of activity. The
firm will continue to incur these costs even if the firm is temporarily shut down. Even though
TFC remains the same fixed cost per unit varies with changes in the level of output.
On the other hand TVC increases with increase in the level of activity, and decreases with
decrease in the level of activity. If the firm is shut down, there are no variable costs. Even though
TVC is variable, variable cost per unit is constant.
So in the short-run an increase in TC implies an increase in TVC only. Thus:
TC = TFC + TVC
TFC = TC – TVC
TVC = TC – TFC
TC = TFC when the output is zero.
The graph below shows Short-run cost output relationship.

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        In the graph X-axis measures output and Y-axis measures cost. TFC is a straight line
parallel to X-axis, because TFC does not change with increase in output.
          TVC curve is upward rising from the origin because TVC is zero when there is no
production and increases as production increases. The shape of TVC curve depends upon the
productivity of the variable factors. The TVC curve above assumes the Law of Variable
Proportions, which operates in the short-run.
          TC curve is also upward rising not from the origin but from the TFC line. This is because
even if there is no production the TC is equal to TFC.
          It should be noted that the vertical distance between the TVC curve and TC curve is
constant throughout because the distance represents the amount of fixed cost which remains
constant. Hence TC curve has the same pattern of behaviour as TVC curve.
Short-run Average Cost and Marginal Cost
        The concept of cost becomes more meaningful when they are expressed in terms of per unit
cost. Cost per unit can be computed with reference to fixed cost, variable cost, total cost and
marginal cost. The following diagram reveals the relationship that exists among these concepts:

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Average Fixed Cost (AFC):  Average fixed cost is obtained by dividing the TFC by the number
of units produced. Thus:    

                     AFC = TFC/Q                        where, ‘Q’ refers quantity of production.

          Since TFC is constant for any level of activity, fixed cost per unit goes on diminishing as
output goes on increasing. The AFC curve is downward sloping towards the right throughout its
length, with a steep fall at the beginning.
Average Variable Cost (AVC): Average Variable Cost is obtained by dividing the TVC by the
number of units produced. Therefore:
 
                        AVC =  TVC / Q
          Due to the operation of the Law of Variable Proportions
AVC curve slopes downwards till it reaches a certain level of output and then begins to rise
upwards.
Average Total Cost (ATC): Average Total Cost or simply Average Cost is obtained by dividing
the TC by the number of units produced. Thus:

                      ATC =  TC / Q
           The ATC curve is very much influenced by the AFC
and AVC curves. In the beginning both AFC curve and AVC curve decline and therefore ATC
curve also declines. The AFC curve continues the trend throughout, though at a diminishing rate.
AVC curve continues the trend till it reaches a certain level and thereafter it starts rising slowly.
Since this rise initially is at a rate lower than the rate of decline in the AFC curve, the ATC curve
continues to decline for some more time and reaches the lowest point, which obviously is further
than the lowest point of the AVC curve. Thereafter the ATC curve starts rising because the rate
of rise in the AVC curve is greater than the rate of decline in the AFC curve.
Marginal Cost (MC): Marginal Cost is the increase in TC as a result of an increase in output by
one unit. In other words it is the cost of producing an additional unit of output.

                                      
          MC is based on the Law of Variable Proportions. A downward trend in MC curve shows
decreasing marginal cost (i.e. increasing marginal productivity) of the variable input. Similarly
an upward trend in MC curve shows increasing marginal cost (i.e. decreasing marginal
productivity). MC curve intersects both AVC and ATC curves at their lowest points.
          The relationship between AVC, AFC, ATC and MC can be summed up as follows.
1. If both AFC and AVC fall ATC will also fall because ATC = AFC + AVC
2. When AFC falls and AVC rises (a) ATC will fall where the drop in AFC is more than the rise
in AVC  (b) ATC remains constant if the drop in AFC = the rise in AVC, and (c) ATC will rise
where the drop in AFC is less than the rise in AVC.

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3. ATC will fall when MC is less than ATC and ATC will rise when MC is more than ATC. The
lowest ATC is equal to MC.
          The following Table illustrates cost output relationship in the short-run, with reference to
different concepts of cost.
Cost-Output Relation during Long Run or Long Run Cost Curves:
Long period gives sufficient time to business managers to change even the scale of production.
All the factors of production are variable. All the costs are variable costs and there is no fixed
cost. The supply of goods can be adjusted to their demands because scale of production and
factors of production can be changed. In the long run we can study the long run average cost
curve and long run marginal cost curve.
I. Long Run Average Cost (LAC):
In the long run, all the factors of production are variable and the firm has a variety of choices to
select the size of the plants and the factors of production to be employed. Various short run
average cost curves represent the various sizes of the plants available to a firm. We can get the
long run average cost curve with the help of all the short run average cost curves. The long run
average cost curve envelopes all the short run average cost curves in it. It is also called an
‘Envelope Curve’ or ‘Planning Curve’.
The long run average cost curve is also a flat U-shaped curve as shown in the following
diagram:

The diagram shows long run cost on OY-axis and output on OX-axis. SAC, SAC 1, SAC2,
SAC3 and SAC4 are short run average cost curves which represent the different size of plants.
LAC has been drawn by combining all those points of least cost of producing the corresponding
output. The least per unit cost of production is OQ, OQ1, OQ2, OQ3, OQ4, and OQ5 respectively.
II. Long Run Marginal Cost (LMC):
The long run marginal cost is an addition to the long run total cost when an additional unit of a
commodity is produced. It is calculated as the short run marginal cost is calculated. Long run
marginal cost curve is also U-shaped but the fall and rise in the marginal cost curve is not sharp
but it is gradual.

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The LAC and LMC can be seen from the following diagram:

The diagram shows that LAC and LMC are shown on OY- axis while output is shown on OX-
axis. The shape of LAC and LMC are U-shaped. The relation between LAC and LMC is the
same as is between short run average cost (SAC) and short run marginal cost (SMC) curves. The
LMC curve cuts the LAC curve from its minimum point.
Why LAC Curve is U-Shaped?
In the short run SAC curve is U-shaped because the laws of return operate but in the long run
LAC is also U-shaped because the laws of return of scale operate, namely, law of increasing
returns to scale, law of constant returns to scale and the law of diminishing returns to scale.
As the level of output is expanded or scale of operation is increased by the large firm they will
enjoy economies of scale but if these firms produce beyond their installed capacity then they
might get diseconomies of scale. Economies of scale bring down the fall in unit cost and
diseconomies results into rise in it.
Economies of Scale: Internal and External
Prof. Stigler defines economies of scale as synonyms with returns to scale.
As the scale of production is increased, up to a certain point, one gets economies of scale.
Beyond that, there are its diseconomies to scale Marshall has classified economies to scale into
two parts as under:
Internal and External Economies of Scale: An Overview
An economy of scale is a microeconomic term that refers to factors driving production costs
down while increasing the volume of output. There are two types of economies of scale: internal
and external economies of scale. Internal economies of scale are firm-specific—or caused
internally—while external economies of scale occur based on larger changes outside the firm.
Both result in declining marginal costs of production, yet the net effect is the same.
Economist Alfred Marshall first differentiated between internal and external economies of scale.
He suggested broad declines in the factors of production—such as land, labor, and effective
capital—represented a positive externality for all firms. These externality arguments are offered
in defense of public infrastructure projects or government research.

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Types of Economies and Diseconomies of scale
Types of Economies of scale
Economies of scale are of two types
1. Internal Economies of Scale
2. External Economies of Scale

 
Economies of Scale:
Economies of scale are the results of the operation of laws of return to scale in long run.
They are of two types:
(1) Internal economies of scale
(2) External economies of scale.
(1) Internal Economies:
Internal economies of scale are those economies which are on account of the size and operations
of an individual firm itself and not from the outside factors.
These economies may be of following categories:
(a) Managerial economies.
(b) Marketing economies.
(c) Specialisation economies.
(d) Technical economies.
(a) Managerial Economies:
Managerial economies means that with the expansion of the output on account of the change in
scale of production the whole expanded scale is looked after by the personnel in the organisation
and administrative cost decreases with the increase in output.
(b) Marketing Economies:
Marketing economies are concerned with the bulk purchases of raw material while producing on
the large scale leads to decrease in the cost of production. Selling in lot saves time, money and
energy. Transportation cost will also be reduced.

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(c) Specialisation Economies:
Specialisation economies are on account of division of labour and specialisation when large scale
production is carried on. The cost of production reduces due to specialisation and division of
labour in a business firm.
(d) Technical Economies:
Technical economies arise on account of large scale production in the use of plant, machinery
and work processes. Advanced technology is used which reduces the cost of production when the
production is carried on large scale.
(2) External Economies:
External economies arise on account of the external factors and they are enjoyed by all the firms
in the area or industry as a whole. When an area is industrially well developed then there will be
development of labour market, banking, insurance, financial institutions, means of
communication and transportation, social overhead and cheap water, electricity and ancillaries.
When a new firm or new industrial unit is set up all these benefits will be available in that area.
All these facilities will reduce the cost of production of all the industrial units in that area.
As a result of all the internal and external economies the unit cost of production falls and the
LAC and LMC will also fall.
Diseconomies of Scale:
Diseconomies means the losses incurred by the firms or industrial units in an area.
These diseconomies are of two types:
(1) Internal diseconomies of scale.
(2) External diseconomies of scale.
(1) Internal Diseconomies:
These diseconomies are concerned with the size and operation of individual firm or industry.
These diseconomies are of the following categories:
(a) Managerial diseconomies
(b) Technical diseconomies
(c) Marketing diseconomies
(d) Specialisation diseconomies.
(a) Managerial Diseconomies:
When the size of operation of a firm increases the span of control becomes large and thereby the
employer-employee relations are adversely affected leading to increase in the cost of production.
It is resulted into managerial diseconomies.
(b) Technical Diseconomies:
Under technical diseconomies when the output is taken on large scale after a given point the
break down rate may increase in the cost of production.
(c) Marketing Diseconomies:
Marketing diseconomies arise on account of the adverse effect on the control and coordination
over marketing activities because of the large scale production and it increases the cost of
production.

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(d) Specialisation Diseconomies:
Specialisation diseconomies are concerned with the division of labour and specialisation
introduced by a firm with the operation of the large scale production. But after a point due to
monotony, fatigue and lack of coordination between different layers of personnel administration
the cost of production increases that gives birth to these diseconomies.
(2) External Diseconomies:
Such loss or external diseconomies are incurred by business firms or industrial units in an area.
Concentration and localisation of industries adversely affect the industrial peace in that area and
strikes, lockouts, go slow tactics, gheraos, industrial accidents, emergence of dirty colonies,
water pollution, air pollution, etc., increase the cost of production of all firms and industrial
units. Means of communication and transportation are overburdened.
Hence, the internal and external diseconomies will increase the LAC curve and LMC curve
upward and the cost will increase.
Definition of Cost Control
Cost Control is a process which focuses on controlling the total cost through competitive
analysis. It is a practice which works to maintain the actual cost in agreement with the
established norms. It ensures that the cost incurred on an operation should not go beyond the pre-
determined cost.
Cost Control involves a chain of functions, which starts from preparation of the budget in
relation to the operation, thereafter evaluating the actual performance, next is to compute the
variances between the actual cost & the budgeted cost and further, to find out the reasons for the
same, finally to implement the necessary actions for correcting discrepancies.
The major techniques used in cost control are standard costing and budgetary control. It is a
continuous process as it helps in analysing the causes for variances which control wastage of
material, any embezzlement and so on.
Definition of Cost Reduction
Cost Reduction is a process, aims at lowering the unit cost of a product manufactured or service
rendered without affecting its quality by using new and improved methods and techniques. It
ascertains substitute ways to reduce the cost of a unit. It ensures savings in per unit cost and
maximisation of profits of the organisation.
Cost Reduction aims at cutting off the unnecessary expenses which occur during the production,
storing, selling and distribution of the product. To identify cost reduction, the following are the
major elements:
 Savings in per unit cost.
 No compromise with the quality of the product.
 Savings are non-volatile in nature.
Tools of cost reduction are Quality operation and research, Improvement in product design, Job
Evaluation & merit rating, variety reduction, etc.

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While cost control, regulates the action to keep the cost elements within the set limits, cost
reduction refers to the actual permanent reduction in the unit cost. At this juncture, it would be
desirable to know the difference between cost control and cost reduction, so read out the article.
Comparison Chart
BASIS FOR
COST CONTROL COST REDUCTION
COMPARISON

Meaning A technique used for A technique used to economize the unit

maintaining the costs as per the cost without lowering the quality of the
set standards is known as Cost product is known as Cost Reduction.
Control.

Savings in Total Cost Cost Per Unit

Retention of Quality Not Guaranteed Guaranteed

Nature Temporary Permanent

Emphasis on Past and Present Cost Present and Future Cost

Ends when The pre-determined target is No end

achieved.

Type of Function Preventive Corrective

Concept of Cost Function:
The relationship between output and costs is expressed in terms of cost function. By
incorporating prices of inputs into the production function, one obtains the cost function since
cost function is derived from production function. However, the nature of cost function depends
on the time horizon. In microeconomic theory, we deal with short run and long run time.
Cq = f(Qf Pf)
Where Cq is the total production cost, Qf is the quantities of inputs employed by the firm, and
Pf is the prices of relevant inputs. This cost equation says that cost of production depends on
prices of inputs and quantities of inputs used by the firm.
Importance of Cost Function:
The study of business behaviour concentrates on the production process—the conversion of
inputs into outputs—and the relationship between output and costs of production.
We have already studied a firm’s production technology and how inputs are combined to
produce output. The production function is just a starting point for the supply decisions of a firm.
For any business decision, cost considerations play a great role.
Cost function is a derived function. It is derived from the production function which captures the
technology of a firm. The theory of cost is a concern of managerial economics. Cost analysis

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helps allocation of resources among various alternatives. In fact, knowledge of cost theory is
essential for making decisions relating to price and output.
Whether production of a new product is a wiser one on the part of a firm greatly depends on the
evaluation of costs associated with it and the possibility of earning revenue from it. Decisions on
capital investment (e.g., new machines) are made by comparing the rate of return from such
investment with the opportunity cost of the funds used.
The relevance of cost analysis in decision-making is usually couched in terms of short and long
periods of time by economists. In all market structures, short run costs are crucial in the
determination of price and output. This is due to the fact that the basis for cost function is
production and the prices of inputs that a firm pays.
On the other hand, long run cost analysis is used for planning the optimal scale of plant size. In
other words, long run cost functions provide useful information for planning the growth as well
as the investment policies of a firm. Growth of a firm largely depends on cost considerations.
Types of Cost Functions:
1. Linear Cost Function:
A linear cost function may be expressed as follows:
TC = k + ƒ (Q)
where TC is total cost, k is total fixed cost and which is a constant and ƒ(Q) is variable cost
which is a function of output.
It may alternatively be expressed as:
TC = Y = a + bQ.

If we apply the linear cost function in the cricket bat example we observe that the cost curve
assumes the existence of a linear production function. If a linear cost function is found to exist,
output of cricket bat would expand indefinitely and there would be a one-to-one correspondence
(relationship) between total output and total cost.
In other words, diminishing returns to the variable factor would not be observed. Such a function
would exist for the cricket bat factory only if the relevant range of output under consideration
was very small.
2. Quadratic Cost Function:

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If there is diminishing return to the variable factor the cost function becomes quadratic. There is
a point beyond which TPP is not proportionate. Therefore, the marginal physical product of the
variable factor will diminish.
And if TPP actually falls MPP will be negative. In other words, there is a point beyond which
additional increases in output cannot be made. So costs rise beyond this point, but output cannot.
Such cost function is illustrated in Fig. 15.4.

We have noted that if the cost function is linear, the equation used in preparing the total cost
curve in Fig. 15.2 is sufficient. But the quadratic cost function has one bend – one bend less than
the highest exponent of Q.
Total cost is equal to fixed cost when Q — 0, i.e., when no output is being produced. However,
as Q increases, fixed cost remains unchanged. Therefore, increases in total costs are traceable to
changes in variable cost.
3. Cubic Cost Function:
In traditional economics, we must make use of the cubic cost function as illustrated in Fig. 15.5.
Such a cost function is not of much empirical use. It does not provide statistically significant
improvements over the linear or quadratic cost function. Moreover, it is very difficult to
calculate, interpret and apply, to test statistical hypothesis regarding cost behaviour in
manufacturing concerns.

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UNIT – IV Production analysis: Basic concepts and types – Law of variable proportions -
Factors of production and returns to scale – Cobb-Douglas production function – Opportunities
for multiple products – Policy on adding new products and dropping old products.

UNIT – V Nature of profits: Different views of profits – Profit functions –Measurement of

Profit - Policies on profit maximization – Profit planning – Managerial uses of break even
analysis.
UNIT – IV
Production: Meaning, Definition, Types and Factors
Meaning of Production:
Since the primary purpose of economic activity is to produce utility for individuals, we count as
production during a time period all activity which either creates utility during the period or
which increases ability of the society to create utility in the future.
Business firms are important components (units) of the economic system.
They are artificial entities created by individuals for the purpose of organising and facilitating
production. The essential characteristics of the business firm is that it purchases factors of
production such as land, labour, capital, intermediate goods, and raw material from households
and other business firms and transforms those resources into different goods or services which it
sells to its customers, other business firms and various units of the government as also to foreign
countries.
Definition of Production:
According to Bates and Parkinson:
“Production is the organised activity of transforming resources into finished products in the form
of goods and services; the objective of production is to satisfy the demand for such transformed
resources”.
According to J. R. Hicks:
“Production is any activity directed to the satisfaction of other peoples’ wants through
exchange”. This definition makes it clear that, in economics, we do not treat the mere making of
things as production. What is made must be designed to satisfy wants.
What is not Production?
The making or doing of things which are not wanted or are made just for the fun of it does not
qualify as production. On the other hand, all jobs which do aim at satisfying wants are part of
production.
Three Types of Production:
For general purposes, it is necessary to classify production into three main groups:
1. Primary Production:
Primary production is carried out by ‘extractive’ industries like agriculture, forestry, fishing,
mining and oil extraction. These industries are engaged in such activities as extracting the gifts
of Nature from the earth’s surface, from beneath the earth’s surface and from the oceans.
2. Secondary Production:

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This includes production in manufacturing industry, viz., turning out semi-finished and finished
goods from raw materials and intermediate goods— conversion of flour into bread or iron ore
into finished steel. They are generally described as manufacturing and construction industries,
such as the manufacture of cars, furnishing, clothing and chemicals, as also engineering and
building.
3. Tertiary Production:
Industries in the tertiary sector produce all those services which enable the finished goods to be
put in the hands of consumers. In fact, these services are supplied to the firms in all types of
industry and directly to consumers. Examples cover distributive traders, banking, insurance,
transport and communications. Government services, such as law, administration, education,
health and defence, are also included.
Production Function
When most people think of fundamental tasks of a firm, they think first of production.
Economists describe this task with the production function, an abstract way of discussing how
the firm gets output from its inputs. It describes, in mathematical terms, the technology available
to the firm.
The technological relationship between inputs and output of a firm is generally referred to as the
production function. The production function shows the functional relationship between the
physical inputs and the physical output of a firm in the process of production. To
quote Samuelson, "The production function is the Technical relationship telling the maximum
amount of output capable of being produced by each and every set of specified inputs. It is
defined for a given set of technical knowledge."
According to Stigler, "the production function is the name given to the relationship between the
rates of input of productive services and the rate of output of product. It is the economist's
summary of technical knowledge.
Production is the transformation of inputs into outputs. Inputs are the factors of production --
land, labor, and capital -- plus raw materials and business services.
The transformation of inputs into outputs is determined by the technology in use. Limited
quantities of inputs will yield only limited quantities of outputs. The relationship between the
quantities of inputs and the maximum quantities of outputs produced is called the "production
function."
But how do these outputs change when the input quantities vary? Let's take a look at an example
of a production function.
In general, we would allow for varying amounts of land, labor and capital. However, in this
example, labor will be the only input, for the sake of simplicity.
The main theme of production function is to get the maximum production with the present given
set of variable.
Eg: a firm can use the more labour and less machines OR it can use less labour and more
machines to get maximum production. Here which is suited best and how to find the best
alternative choice is the main aim of production function.

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In a general mathematical form, a production function can be expressed as:
   

 Q=output/quantity
 LB = Land & Buildings.
 L = Labour.
 K = capital.
 M = raw material.
 t= time.

Law of Variable Proportions

Law of Variable Proportions occupies an important place in economic theory. This law is also
known as Law of Proportionality.
Keeping other factors fixed, the law explains the production function with one factor variable. In
the short run when output of a commodity is sought to be increased, the law of variable
proportions comes into operation.
Definitions:
“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.” Benham
“An increase in some inputs relative to other fixed inputs will in a given state of technology
cause output to increase, but after a point the extra output resulting from the same additions of
extra inputs will become less and less.” Samuelson
Assumptions:
Law of variable proportions is based on following assumptions:

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(i) Constant Technology:
The state of technology is assumed to be given and constant. If there is an improvement in
technology the production function will move upward.
(ii) Factor Proportions are Variable:
The law assumes that factor proportions are variable. If factors of production are to be combined
in a fixed proportion, the law has no validity.
(iii) Homogeneous Factor Units:
The units of variable factor are homogeneous. Each unit is identical in quality and amount with
every other unit.
(iv) Short-Run:
The law operates in the short-run when it is not possible to vary all factor inputs.
Explanation of the Law:
In order to understand the law of variable proportions we take the example of agriculture.
Suppose land and labour are the only two factors of production.
By keeping land as a fixed factor, the production of variable factor i.e., labour can be
shown with the help of the following table:
This law of variable proportion shows the input and output relationship with one variable
factor. e.g. labour.
Illustration:

Solution:
From the above given data, we should find out the average production and the marginal
production.

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Points to remember:
1. point out the maximum value in the marginal production Colum.
2. point out the maximum value relating to the marginal production value in the average
production Colum.
3. At this intersection point indicates best number of employees employed to have the
maximum production

3 stages of the production with Graph analysis:

(Stage 1): The maximum value of the marginal product is at 4 and maximum value of the
average product relating to the marginal product Colum is 3. This is intersection point where the

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maximum 6 units of production can be done by employing 2 labours. Up to this point it is called
as increasing returns stage.
(Stage 2): when we employee more than 2 laboursie. 3 labours total production is raising but the
marginal production is falling down from 4 to 3 and average product is nearly same. So this stage
is stated as decreasing returns to the production.
(Stage 3):  at 6 labours employed the marginal production is -1 units and the  curve is cutting the
X axis and moving down to the negative position. Hence this stage is stated as the negative
returns in the production.
Applicability of the Law of Variable Proportions:
The law of variable proportions is universal as it applies to all fields of production. This law
applies to any field of production where some factors are fixed and others are variable. That is
why it is called the law of universal application.
The main cause of application of this law is the fixity of any one factor. Land, mines, fisheries,
and house building etc. are not the only examples of fixed factors. Machines, raw materials may
also become fixed in the short period. Therefore, this law holds good in all activities of
production etc. agriculture, mining, manufacturing industries.
1. Application to Agriculture:
With a view of raising agricultural production, labour and capital can be increased to any extent
but not the land, being fixed factor. Thus when more and more units of variable factors like
labour and capital are applied to a fixed factor then their marginal product starts to diminish and
this law becomes operative.
2. Application to Industries:
In order to increase production of manufactured goods, factors of production has to be increased.
It can be increased as desired for a long period, being variable factors. Thus, law of increasing
returns operates in industries for a long period. But, this situation arises when additional units of
labour, capital and enterprise are of inferior quality or are available at higher cost.
As a result, after a point, marginal product increases less proportionately than increase in the
units of labour and capital. In this way, the law is equally valid in industries.
Law of Returns to Scale : Definition, Explanation and Its Types!
In the long run all factors of production are variable. No factor is fixed. Accordingly, the scale of
production can be changed by changing the quantity of all factors of production.
Definition:
“The term returns to scale refers to the changes in output as all factors change by the same
proportion.” Koutsoyiannis
“Returns to scale relates to the behaviour of total output as all inputs are varied and is a long run
concept”. Leibhafsky
Returns to scale are of the following three types:
1. Increasing Returns to scale.
2. Constant Returns to Scale
3. Diminishing Returns to Scale
Explanation:
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In the long run, output can be increased by increasing all factors in the same proportion.
Generally, laws of returns to scale refer to an increase in output due to increase in all factors in
the same proportion. Such an increase is called returns to scale.
Suppose, initially production function is as follows:
P = f (L, K)
1. Increasing Returns to Scale:
Increasing returns to scale or diminishing cost refers to a situation when all factors of production
are increased, output increases at a higher rate. It means if all inputs are doubled, output will also
increase at the faster rate than double. Hence, it is said to be increasing returns to scale. This
increase is due to many reasons like division external economies of scale. Increasing returns to
scale can be illustrated with the help of a diagram 8.

 
In figure 8, OX axis represents increase in labour and capital while OY axis shows increase in
output. When labour and capital increases from Q to Q 1, output also increases from P to P 1 which
is higher than the factors of production i.e. labour and capital.
2. Diminishing Returns to Scale:
Diminishing returns or increasing costs refer to that production situation, where if all the factors
of production are increased in a given proportion, output increases in a smaller proportion. It
means, if inputs are doubled, output will be less than doubled. If 20 percent increase in labour
and capital is followed by 10 percent increase in output, then it is an instance of diminishing
returns to scale.
The main cause of the operation of diminishing returns to scale is that internal and external
economies are less than internal and external diseconomies. It is clear from diagram 9.

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In this diagram 9, diminishing returns to scale has been shown. On OX axis, labour and capital
are given while on OY axis, output. When factors of production increase from Q to Q 1 (more
quantity) but as a result increase in output, i.e. P to P 1 is less. We see that increase in factors of
production is more and increase in production is comparatively less, thus diminishing returns to
scale apply.
3. Constant Returns to Scale:
Constant returns to scale or constant cost refers to the production situation in which output
increases exactly in the same proportion in which factors of production are increased. In simple
terms, if factors of production are doubled output will also be doubled.
In this case internal and external economies are exactly equal to internal and external
diseconomies. This situation arises when after reaching a certain level of production, economies
of scale are balanced by diseconomies of scale. This is known as homogeneous production
function. Cobb-Douglas linear homogenous production function is a good example of this kind.
This is shown in diagram 10. In figure 10, we see that increase in factors of production i.e. labour
and capital are equal to the proportion of output increase. Therefore, the result is constant returns
to scale.
 

Cobb-Douglas Production Function

The below mentioned article provides a close view on the Cobb-Douglas Production
Function.

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The Cobb-Douglas production function is based on the empirical study of the American
manufacturing industry made by Paul H. Douglas and C.W. Cobb. It is a linear homogeneous
production function of degree one which takes into account two inputs, labour and capital, for
the entire output of the .manufacturing industry.
The Cobb-Douglas production function is expressed as:
Q = ALa Cβ
where Q is output and L and С are inputs of labour and capital respectively. A, a and β are
positive parameters where = a > O, β > O.
The equation tells that output depends directly on L and C, and that part of output which cannot
be explained by L and С is explained by A which is the ‘residual’, often called technical change.
Opportunities for Multiple Products:
1. Excess Capacity:
The underlying reason for adding a new product to the line is to increase profits and/or
competitive strength. The object is to utilise the existing excess capacity.
Suppose a firm is producing X and Y, but at present a certain amount of capacity remains un-
utilised. It can be fruitfully utilised by producing a new product Z in a more or less costless
fashion. Thus, the existence of excess capacity provides a ground for adding a new product in the
line.
2. Secular Shifts:
Secular shifts in the shape of development of substitutes (e.g., synthetic products in place of jute)
– technological change in production or selling, shifts in raw material supply, new competitive
use of raw materials, changes in the location of markets, and new kinds of transportation — a
few instances cited by Dean —create excess capacity and call for new product-line decisions.
3. Vertical Integration:
Vertical integration is the joining of two or more companies in the same trade but in different
processes within that trade, for example, the amalgamation of a pig iron manufacturing company
and a company owning iron ore or coking coal. It is an important source of excess capacity and
thus promotes multiple-product lines.
If there is an abundant supply of iron ore, the company may produce finished steel also. Vertical
integration can either be backward or forward or both. A case of perfect vertical integration of
backward type is Reliance Industries Ltd. The earlier textile company has gone into production
of raw materials and now going in for production of petrochemicals, the source of raw materials.
Since raw materials and intermediate products need to be bought or sold, a firm finds it advanta-
geous to expand its own product range to take advantage of low cost, good quality and assured
supplies of raw materials and thus to fulfil its contracts as per schedule.
4. Research:
Research creates excess capacity by making current products and their production obsolete. It is
thus an internal source of secular shifts in technology and demand. It also helps a company to
develop new products to mop up excess capacity.
In fact, an important source of diversification is research. Large firms can afford to spend
considerable sums on research in their main products and this often leads to the discovery of new
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products. Research is usually carried out to protect demand from invasion by competitors’ new
substitutes.
Policy (Criteria) on Multiple Products:
Adding New Products:
We live in a dynamic world. In this modern world product monopolies (like Coca-cola or IBM)
are transitory (non-permanent) phenomena and new product development is a permanent thing in
competitive rivalry of firms. Therefore, economically sound decisions on additions to the
company’s product coverage are obviously of great importance.
Top management faces three problems in formulating policy on adding new products:
(1) Identifying potential product additions,
(2) Appraising these proposals and making the product selection, and
(3) Launching each new product venture in a way that gives it a strong chance of success.
The first, maintaining a flow of promising proposals, is principally a question of lowering the
proportion of unrealistic schemes and raising the proportion of realistic suggestions.
The third problem involves questions of refinement of the product design, selection of market
targets, methods of distribution, pricing the new product, and making capital expenditures for
production and marketing facilities. These are both problems of marketing and of capital
budgeting.
The second problem is the central one. And there are three relevant criteria here: first, standard
of prospective profits from the candidate (potential) product; second, considerations of product-
line strategy; and third, specific criteria of acceptability of new products.
1. Standards of Profitability:
The pivotal test for the addition of a new product is its profitability. One relevant criterion that is
often used is based on standard marginal analysis, viz., the marginal profit contribution of
production of X from using input i must be equal to that in Y using the same input.
The relevant concept here is incremental return over the appropriate time period, i.e., what
addition the product makes to enterprise profits over its life cycle. There is also the need to
consider and compare profitability of alternative opportunities.
2. Product Strength:
Multiple-product ‘strategy’ is mainly concerned with the company’s long-run purposes in
product diversity. Diversification is just the opposite of specialisation. Diversification of
products, either by the individual firm extending its range or by the merging of firms with
different products, is the outcome of several factors.
Writes S. E. Thomas, “Specialisation results in production and administrative economies; it
has the disadvantages that a decline in the demand for the product involves the firm in
heavy losses and in high costs in changing its line of production. Diversification avoids the
risk of having all of one’s eggs in one basket.”
The major purposes of product strategy is to make money, at least in the long run. But this is not
the whole truth. Usually, in an established concern, product-line strategy has historical roots —
sometimes in the company’s original objectives, whether it is profit or sales-maximization or

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satisficing, but often later in a basic merger or in an empire builder’s dream (take the Tatas, for
example).
The outer limits of a product line are usually framed in terms of common raw materials, produc-
tion processes, distribution channels or final uses.
These alternative technical criteria are sometimes contradictory. However, ultimately the
product- line strategy is determined by the competitive relationships in terms of tactics or
increasing profits and rivals’ reactions to those tactics. In short, diversification is undertaken to
smooth out trade fluctuations.
Its aim is to merge into one group of companies engaged in different trades so that when one
trade is declining another trade is approaching maximum activity; thus a textile manufacturing
company may amalgamate with an engineering company.
3. Acceptance Criteria for New Products:
There is also need to have supplemental standard for acceptability for new products.
A candidate product can be compared with the existing product line in terms of:
1. Interrelationship of demand characteristics with the existing line;
2. Use of the company’s distinctive know-how;
3. Use made of common production facilities;
4. Use of common distribution channels;
5. Use of common raw materials; and
6. Benefits to existing products.
These criteria are listed by Joel Dean and can supplement estimates of the direct profits
expected after adding the new product:
i. Interrelationship of Demand Characteristics:
The relation of the demand characteristics of the new product with that of the existing group of
the products is the primary criterion of product acceptability. True, the right combination of
products in the product line has powerful promotional value particularly in the case of
complimentary goods.
Thus, if a company producing bread can also produce butter it can attract some additional
customers and raise its sales to existing customers. Similarly, a book publishing company may
first publish a title on mathematics and then on economics.
ii. Distinctive Know-how:
New products must make use of the company’s distinctive and almost personal source of
differential advantage. Suppose a company has a distinctive know-how which it sells in the open
market, viz., engineering skill. This skill is required in the design of processing equipment for
petroleum industry.
The company also carries out fabrication and construction activities. But these are subsidiary to
its main activities, viz., selling or principal product, viz., technical pioneering skill. One of the
company’s product-line specifications is that if a new product is developed, it must utilize its
principal product fully. In this case, it must be a suitable vehicle for the sale of its main asset or
service.
iii. Common Production Facilities:
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A third criterion of new product admissibility is that the candidate product should use existing or
closely similar production facilities. It is actually concerned with the economies of mopping up
excess capacity, which are short-lived. For example, a newspaper company can print magazines
or accept outside work, as the Statesman has been doing.
A firm that has plant and equipment capable of producing a different product has not only a
motive but also the means for extending the range of its products.
If it buys components from other firms it may, as it grows, find it profitable to make them itself
and even to become a market supplier. With growth, the amount of waste left may be used in the
production of something different from the product which gave rise to it.
iv. Common Distribution Channels:
The next criterion is that the new product must permit effective marketing through the same dis-
tribution channels used by the company’s existing products. This is also another way of using
unused capacity and it is a matter of economies of scale in distribution.
v. Common Raw Materials:
Companies may also turn out product additions using the same basic raw material or its by-
products. For example, a company producing asbestos may also turn out products that not only
use asbestos wastes, but also the short fibres and other wastes that are left after the regular
asbestos products have been manufactured.
vi. Benefits to Present Product Line:
Finally, the new product may confer a number of benefits to existing products.
Writes Dean, “Old products are a generic class subject to continual evolution. The
educational benefits from an added product, either in research, production methods, or
even demand interdependence, do not apply only to the present products. Often more
importantly these benefits apply to the projected path of development of these existing
products”.
Dropping Old Products:
The problem of determining what products should be dropped is just the converse of the problem
of selecting products for additions. Of course, there are three major differences.
We may group them under the following questions:
(1) How does the problem arise?
(2) What are the choices?
(3) How should the problem be solved?
How does the Problem Arise?
There are three major sources of this problem:
(1) Firstly, indiscriminate, not selective, product additions which lead to financial losses may in-
duce a company to drop a (a few) product(s). An example is not bringing out the second edition
of a book which moves slowly and thus leads to capital erosion.
(2) Second, it may be due to careless acquisitions, resulting from mergers designed to acquire
one group of suitable products. Alternatively, it may result from backward integration that mis-
fired and produced unforeseen by-products or unforeseen excess capacity.

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(3) Thirdly, candidates for deletion also come from product obsolescence caused by basic
changes in consumer taste or by striking improvement in rival’s products.
What are the Choices?
In general, when a product’s profit or sales behaviour is absolutely or relatively
unsatisfactory, there are four choices:
(1) Improve the present operation and keep the product;
(2) keep on making it but sell it in bulk for others to market;
(3) Keep on selling it but buy it from others who can produce it more advantageously; and
(4) Stop manufacturing it and stop selling it.
How should the Problem be Solved?
The main economic difference between dropping and adding a product is, of course, sunk cost.
Product deletions that are decided upon solely on the basis of net profit, with no considerations
given to the fact that costs are sunk, can lead to short-run losses.
In fact, long-run and sunk-cost functions are not reversible and specialised capital is not perfectly
mobile. So the possibility of salvaging product-line mistakes by partial retreat should be explored
before considering total elimination.

UNIT – V
Nature and Concept of “Profit”
Meaning and Definition of Profit:
“The share of the national income that goes to the entrepreneur is known as Profit”.
The term “Profit” is usually understood to mean the difference between the total sale-proceeds
obtained by a businessman and his total expenses of production. It is the surplus that remains in
the hands of the businessman after paying rent, wages, interest on borrowed capital etc.
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In other words, we can say that Profit is the surplus of income over expenses of production
according to a businessman. It is the amount left with him after he has made payments for all
factor services used by him in the process of production. But he may not have been careful in
calculating all such expenses of production in the economic sense. Therefore, economists regard
businessman’s Profit as “Gross Profit”.
Definitions:
Important definitions of Profit as given by different authors are as follows:
1. According to Prof. Marshall – “Profit is the earning of management”.
2. According to Walker – “Profit is the rent of ability”.
3. According to Croome – “Profit is the reward for uninsured risks”.
4. According to Ely – “Profit is a surplus over and above the expenses of production”.
5. As Taussig has said – “Profit is a mixed and vexed income.”
6. According to Prof. J. K. Mehta – “The element of uncertainty introduces a fourth category of
sacrifice in the productive activities of man in a dynamic world. This category is risk-taking or
uncertainty bearing. It is remunerated by Profit.”
Since economists are of this opinion that
Profit = Gross Profit – (Rent + Wages + Interest)
Elements of Profits:
Essential elements of Profits are as follows:
1. Profits Include Some Reward for Risk-Taking and Uncertainty-Bearing:
One of the important functions of an entrepreneur is to assume the risks of production. And for
this risk-taking he gets some income.
2. Profits Include some Income which Businessmen Manage to Secure:
This is an important question as to how a businessman should secure Profits? In order to secure
profits the businessmen either tries on account of their monopolistic control over supply or
because of the existence of imperfect competition. In real life, every businessman is often able to
secure some monopolistic or semi-monopolistic control over the markets. Therefore, he is
normally in a position to charge a slightly higher price than would be possible under perfect
competition. He therefore, earns some extra income.
3. The Existence of Market Imperfections may Swell Profits in another Way:
Competition in the market for labour or for any other factor of production may be, and is often,
imperfect, as a result of which an employer is in a position to exploit the situation and pay those
factors an amount of remuneration which may be less than the values of their respective marginal
net products. The difference will be his profits.
4. Profits often Contain Large Amounts of Fortuitous Gains:
These gains arise from mere good luck in certain enterprises. A sudden shift in demand may
drive up prices, and so may bring large gains to the entrepreneurs.
Characteristics of Profit:
Profit as we have seen is the reward for enterprise which goes to the entrepreneur- owner
(individual or collective) of the firm. The reward for an entrepreneur cannot be determined in
advance. The reward for entrepreneur depends on his calculations regarding future business
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expectations. If these calculations prove correct, he may earn profit but if they prove wrong he
has to bear losses also.
The important characteristics or peculiarities of Profit are as follows:
1. Profit is a Residual Reward:
It means profit is received by the entrepreneur as a residual surplus, which is left over after
meeting all the business expenses from the sales receipts.
2. It is not Contractual or Pre-Determined Payment:
Remember Profit is not like rent, wages, interest and Profit a pre-determined contractual
payment. Therefore, it can be said that it is not an explicit cost.
3. It is the End Result of Business:
In profit other factors rewards such as rent, wages and interest are received by their agents during
the process of production. Profit is realised by the entrepreneur only after the completion of the
business, i.e., after completing the sales and meeting all the expenses.
4. Profit is a Dynamic Concept:
Profit depends on many factors such as entrepreneur’s organisational ability, changes in market
demand and supply conditions, element of monopoly power, innovation such as production of
new items, discovery of new-markets, new modes of advertising and sales propaganda etc. and
many other dynamics changes in the economy.
5. It is not Determined through Formal Factors of Market:
In all other factor prices are determined in a formal market.
For example:
Rent is determined in the land market, wages in the labour market and interest in the capital
market. There is no such formal entrepreneurial market for determination of profit.
6. Profit is not Fixed Income, it is Uncertain and Fluctuating:
Profit being a residual income cannot be fixed in a pre-determined manner. It varies from time to
time. It will be high during a period of prosperity. It declines during recession. There may be
even losses during a depression. Here, other factor incomes are generally stable over a period of
time, Profit is widely fluctuating. Nature of Profit:
The nature of Profit has even been the most perplexed and troubled problem in the opinion of the
economists. In early days, the classical economists regarded Profit as accruing to the capitalist
who supplied capital and owned the business, Profits are determined after making all necessary
payments from the total income of the business. It is the demand and supply of entrepreneur.
Regarding Nature of Profit Prof. Taussig has said that it is a “mixed and vexed income.’ Walker
looked upon “Profit as the reward of the entrepreneur with a superior ability than others”.
According to Clark, Knight and Schumpeter – “It is an income which arises out of change,
uncertainty and friction inherent in a dynamic world, and which the belated operation of
competitive forces tends to eliminate.”
In this connection the Marxian economists Veblen and Hobson are of this opinion that “Profit is
an unearned income and attribute it to the existence of institutional monopolies established by a
few capitalists. Monopoly profits arise because a monopolist is able to restrict output and keep
the price of his product much above the average cost of production.”
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Profit Function Equation
A profit function is a function that focuses on business applications. The primary purpose for a
business is to sell a product or service in order to make a profit, which is the revenue a company
receives for selling a product or service less the cost for creating a product or service.
The profit function equation is made up of two primary functions: the revenue function and the
cost function. If x represents the number of units sold, we will name these two functions as
follows: R(x) = the revenue function; C(x) = the cost function. Therefore, our profit function
equation will be as follows: P(x) = R(x) - C(x).
The Measurement of Profit

The problem of profit measurement has always been a difficult affair. In the present business
world, the tendency is to discard the word ‘profit’ and use a neutral expression as “business
income”. In the accounting sense, profit is an ex-post concept. Accountants follow conventions
and define their terms by enumeration.
Conventional accounting is largely concerned with historical profits rather than anticipated
profits. Economists disagree with conventional techniques and they define their terms func-
tionally. For an economist, profit is an ex-ante concept.
It is a surplus in excess of all opportunity costs or the difference between the cash value of an
enterprise at the beginning and end of a period. From the management point of view, economic
profits are a better reflection of profitability of business. The economist is basically interested in
the theoretical analysis of profit.
Most business owners understand profitability from a fundamental standpoint. If the revenue
from sales covers your expenses, you’re turning a profit. Profits mean positive cash flow.
Positive cash flow helps keep your business in operation. Profitableness tends to be one of the
primary goals of business owners. They seek to have a profitable experience and capitalize on
material gain.
However, business owners should look beyond a simple profit dollar amount. The basic dollar
amount doesn’t indicate why the business is profitable. Analyzing key metrics can help business
owners determine whether their company is healthy, and profitability is sustainable. By
calculating and comparing metrics, owners can identify the areas of the business that are working
well — and those that need improvement.
Broadly speaking, there are three primary ways to determine whether you’re a profitable
business: margin or profitability ratios, break-even analyses, and return on asset assessments.
In this article, we’ll provide you with a breakdown of everything you need to know to run a
financial profitability analysis. The financial ratios and figures that we’ve included will not only
provide you with an accurate measure of profitability but help predict future profitability as well.
Margin or profitability ratios
Perhaps the best way to determine whether you run a profitable business is by running margin
ratios, also referred to commonly as profitability ratios. To run these figures, you’ll first need to
calculate three things from your income statement:
1. Gross Profit = Net Sales – Cost of Goods Sold
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 2. Operating Profit = Gross Profit – (Operating Costs, Including Selling and Administrative
Expenses)
3. Net Profit = (Operating Profit + Any Other Income) – (Additional Expenses) – (Taxes)
All three of these figures provide you with a way to express profit from a dollar perspective. We
can take this a step further by turning these figures into ratios. Doing so is beneficial because it
allows you to analyze your company more accurately. Ratios help you measure efficiency much
better than straight dollar amounts.
For instance, in Q1, you may have a higher gross profit margin than in Q4, even though you
earned more money (from a dollar amount perspective) in Q4. Additionally, ratios allow you to
compare your company to others in your industry.
Just because a company earns more profit doesn’t mean it’s financially healthy. Margin ratios are
a far better predictor of health and long-term growth than mere dollar figures.
Below, we’ll look at how you can turn things like gross and net profit into ratios so that you can
better analyze your company’s financial health. One ratio is not better than the other. All three
will help give you an accurate look at the inner-workings of your business.
Gross profit margin ratio
If you sell physical products, gross margin allows you to hone in on your product
profitability. Your total gross profit is sales revenue minus your cost of goods sold.
Cost of goods sold represents how much your company paid to sell products during
a given period.
In other words, it’s profit after deducting direct materials, direct labor, inventory,
and product overhead. It does not consider your general business expenses. The
formula to calculate the gross profit margin ratio is:
Gross Profit Margin Ratio = (Gross Profit ÷ Sales) × 100 
If the gross profit margin is high, it means that you get to keep a lot of profit
relative to the cost of your product. One of the primary things you want to concern
yourself with is the stability of this ratio.
Your gross margins shouldn’t fluctuate drastically from one period to the other.
The only thing that should cause a severe fluctuation would be if the industry that
you’re part of experiences a widespread change that directly impacts your pricing
policies or cost of goods sold.
Operating profit margin ratio
The operating margin provides you with a good look at your current earning
power. Unlike gross profit, which you would prefer to be stable, an increase in the
operating profit margin illustrates a healthy company. The formula to calculate the
operating margin is:
Operating Profit Margin Ratio = (Operating Income ÷ Sales) × 100 

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The operating margin gives you a good look at how efficient you are. If you’re looking to
compare your returns to others in the industry, this is the best ratio to do so, as it shows your
ability to turn sales into pre-tax profits. Many individuals in corporate finance find this to be a
much more objective evaluation tool than the net profit margin ratio.
One of the things that can keep this ratio stagnant is an increase in operating expenses. If you
suspect that some operating costs are creeping up, you should perform a comparative analysis of
your operating expenses.
A comparative analysis is a side-by-side percentage comparison of two or more years of data.
It’s a little more time-consuming than a basic ratio calculation, but it’s not too bad if you can
export the data from your accounting software.
After you plug in the numbers, scan your comparative analysis for the biggest
percentage changes over time. Doing so will allow you to identify the reason for
the expense increase and determine if it’s worth being concerned about.
Net profit margin ratio
Net profit margin, sometimes referred to as just “profit margin,” is the big-picture view of your
profitability. Some industries — like financial services, pharmaceuticals, medical, and real estate
— have sky-high profit margins, while others are more conservative. Use industry standards as a
benchmark, and perform an internal year-over-year comparison to assess your performance. The
formula to calculate the net profit margin ratio is:
Net Profit Margin Ratio = (Net Income ÷ Sales) × 100 
Net profit margin is similar to operating profit margin, except it accounts for earnings after taxes.
It demonstrates how much profit you can extract from your total sales.
 Profit Policies:
It is generally held that the main motive of a firm is to make profits. The volume of profit made
by it is regarded as a primary measure of its success. Economic theory advocates profit
maximisation as the chief policy of a firm. Modem business enterprises do not accept this view
and relegate the profit maximisation theory to the back ground. This does not mean that modem
firms do not aim at profits. They do aim at maximum profits but aim at other goals as well. All
these constitute the profit policy.
(i) Industry Leadership:
Industry leadership may involve either the achievement of the maximum sales volume or the
manufacture of the maximum product lines. For the attainment of leadership in the industry,
there has to be a satisfactory level of profit consistent with capital invested, labour force
employed and volume of output produced.
(ii) Restricting the Entry:
If a firm follows a policy of restricting its profit, no competitors are likely to enter the market.
Reasonable profits which guarantee its survival and growth are essential. According to Joel
Dean, “Competitors can invade the market as soon as they discover its profitability and find
ways to shift the patents and make necessary changes in design, technique, and production plant
and market penetration.”

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(iii) Political Impact:
High profits are considered to be suicidal for a firm. If the government comes to know that the
firms are earning huge returns, it may resort to high taxation or to nationalisation. High profits
are often considered as an index of monopoly power and to prevent the government may
introduce price control and profit regulation policies.
(iv) Consumer Goodwill:
Consumer is the foundation of any business. For maintaining consumer goodwill, firms have to
restrict the profit. By maintaining low profit, the firms may seek the goodwill of the consumers.
Consumer goodwill is valued so much these days that firms often make organised efforts through
advertisements.
(v) Wage Consideration:
Higher profits may be taken as an evidence of the ability to pay higher wages. If the labour
associations come to know that the firms are declaring higher dividends to the shareholders,
naturally they demand higher wages, bonus, etc. Under these circumstances in the interest of
harmonious relations with employees, firms keep the profit margin at a reasonable level.
(vi) Liquidity Preference:
Many concerns give greater importance to capital soundness of a firm and hence prefer liquidity
to profit maximisation. Liquidity preference means the preference to hold cash to meet the day to
day transactions. The first item that attracts one’s attention in the balance sheet is the ratio of
current assets to current liabilities. In order to give capital soundness, the business concerns keep
less profit and maintain high cash.
(vii) Avoid Risk:
Avoiding risk is another objective of the modem business for which the firms have to restrict the
profit. Risk element is high under profit maximisation. Managerial decision involving the setting
up of a new venture has to face a number of uncertainties. Very often experienced managements
avoid the possibility of such risks. When there is oligopolistic uncertainty, firms may focus
attention at minimising losses. The guiding principle of business economics is not maximisation
of profit but the avoidance of loss.
a. Alternative Profit Policies:
Economists have suggested different profit policies which business firms may adopt as an alter-
native to profit maximisation.
These alternative profit policies are listed below:
Prof. K. Rothschild observes, “Profit maximisation has until now served as the wonderful market
key that opened all doors leading to an understanding of the behaviour of the entrepreneur. It was
always realised that family pride, moral and ethical considerations, poor intelligences and similar
factors may modify the results built on the maximum profit assumption, but it was right by
assuming that these disturbing phenomena are sufficiently exceptional to justify their exclusion
from the main body of price theory. But there is another motive which cannot be so lightly
dismissed and which is probably a similar order of magnitude as the desire for maximum profits,
namely the desire for secure profits”. He has suggested that the primary motive of an enterprise
is long run survival.
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According to him, the assumption of profit maximisation is no doubt valid to the situation of
perfect competition or monopolistic competition. Under monopolistic condition, the aim of the
firm is to secure monopoly profits. In the case of oligopoly, he says that the assumption of profit
maximisation is not sufficient.
W.J. Baumol puts forth the maximisation of sales as the ultimate aim of the firm. He says while
maximising sales the producer will not regard costs incurred as output and profits to be made. If
the sales of the company increase, it means that the producer is not only covering costs but also
making a usual rate of return on investment. Baumol’s theory of sales maximisation as a rational
behaviour of the producer is considered as an alternative to the theory of profit maximisation.
Benjamin Higgins, MekinReder and Tibor Scitovsky have developed another alternative to the
theory of profit maximisation, that of utility maximisation, if the producer is supposed to
maximise his satisfaction. In this approach, they have introduced leisure as a variable. Leisure is
an essential ingredient of an individual welfare. If more work is put in by the producer, the less
leisure he will be able to enjoy. It is said that the producer would get maximum satisfaction
where his net profit is optimum.
Donaldson and Lorsch are of the opinion that career managers prefer policies that favour long
term stability and growth of their firms which are possible only when they get maximum current
profits. For the survival, self sufficiency and success, the top managers strive hard and augment
corporate wealth. The more the wealth, the greater the assurance of the means of survival.
b. Aims of Profit Policy:
The firm seeks to achieve many objectives and profit making is the main objective but it is not
the only objective. Profit making is no doubt necessary. In addition to adequate profit, the firm
often pursues multiple and even contradictory objectives. If a firm makes sufficient profits, it can
give good dividends and attractive salaries, etc. The firm can fix a target rate for profits as its
investment. There is a problem in determining the target rate of profits.
They are:
(i) Competitive rate of profit
(ii) Historical profit rate
(iii) Rate of profit sufficient enough to protect the equity, and
(iv) Plough back of profit rate.
Competitive rate of profit is the rate earned by other companies in the same industry or of
selected companies in other industries working under similar conditions. It may be slightly
different from the rate of profit of other companies.
Historical rate of profit is the rate of profit determined as the basis of past earnings in the normal
times. The rates should be sufficient enough to attract equity capital, have provided adequate
dividend to share holders and have not encouraged much competition.
Rate of profit sufficient enough to protect the equity is the rate sufficient enough to attract equity
capital and the rate of return on investment should protect the interest of present shareholders.
Plough back of profit late is that late of profit Which should be such that there is a surplus after
paying the dividends to finance further growth of the industry. Cyert and March have focused on
five aims which represent main operative organisational goals.
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They are:
(i) Production goal
(ii) Inventory goal
(iii) Sales goal
(iv) Marketing share goal and
(v) Profit goal
Production Goal:
The firms want to maintain the production of the product at a stable level to ensure stable
employment and growth. The basic requirement is that the production does not fluctuate.
Inventory Goal:
To ensure a complete and convenient stock of inventory throughout the production, a minimum
level of inventory has to be maintained so that the firm can prevent fluctuations in prices.
Sales Goal:
It is considered as very important from the point of view of stability and survival of the firm.
Increasing sales mean progress of the firm. Sales strengthen the organisation. The more are the
sales, the more is the profit.
Market Share Goal:
Company sales do not reveal how well the company is performing. If the company’s market
share goes up, the company is gaining as a competitor, if it goes down the company is losing
relative to competitors.
Profit Goal:
Profits are a function of the chosen price, advertising and sales promotion budgets. Normal profit
is essential not only to pay dividends but also to ensure additional resources for reinvestment.
Profit Planning and Control:
Profit planning is a disciplined method whereby the environments encroaching on an
organisation are analysed, the available resources and internal competence identified, agreed
objectives established and plans made to achieve them. Profit planning is largely routine and
covers a definite time span.
Strategy is a word often used in conjunction with profit planning. Profit planning and strategy
formulation are complementary. Profit planning is often a reasonable substitute for the fair and
imagination need of the entrepreneurs.
Essential Elements in Profit Planning:
The following are the essential elements in profit planning:
1. Objectives and results are established and measured at all management levels.
2. The role of the chief executive is often vital in ensuring success.
3. The system should become the major framework in guiding and controlling management
performance.
4. The system should be totally pervasive, especially in framing objectives.
5. The system is recognised as the key method of management in the organisation.
6. Planners have been trained in economics or associated disciplines.

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7. Budgeting, cost control, and contribution analyses are the key elements in controlling a profit
plan.
Steps in Profit Planning:
Some rudimentary form of planning may already be in existence in most organisations. Many of
the techniques used in profit planning may be in use. The following activities will need to be
introduced or improved or enhanced if they are undertaken at present.
1. Establish Suitable Objectives:
Objectives can cover many factors of the business survival, profits or increase in net worth. The
way in which objectives are determined is nearly as important as the types that are pursued. It
will be essential to take account of past performance, resource availability, management
competence, environment changes, competitors’ activities and so on. Objectives should not be
imposed.
2. Establish Suitable Control System:
Profit planning and control may have grown out of budgetary control systems. It is necessary to
have some form of budgetary cost control, plan monitoring and management information
systems which will serve to enable profit planning to be effective.
3. Establishing Job Responsibilities:
Often job responsibilities are too imprecise to provide the information on which performance
standards can be established and then judged. It is necessary to have job breakdowns in such
detail that the need for resources can be identified.
4. Carry Out a Situation Audit:
It entails an audit of all the factors both internal and external that will have an influence on
company affairs. It should include establishing the skills of competition, the economic situation
which will impinge on company performance and the potential and actual social, technological
and cultural changes to be accommodated.

5. Gap Analysis:
This is an activity where the desired company objectives are compared with the probable results
of continuing current trends. A gap will almost certainly be obvious between the two. Profit
planning is largely concerned with how the gap can be closed.
6. Establishing Base Data:
Often the base data essential for profit planning is either nonexistent or set out in a way that is
inappropriate for planning purposes. The data include product and operational costs, production
speeds, material utilisation, labour efficiency, etc.
7. Establish Appropriate Plans and Strategies:
The management should ensure that there is plan integration. Strategies are the results of
choosing between alternatives in the use of the company resources through which it is hoped that
the corporate objectives will be achieved. They can be highly complex and appropriate
alternatives need to be set out.
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Need for Profit Planning:
The need for profit planning arises:
(i) To improve management performance.
(ii) To ensure that the organisation as a whole pulls in the right direction.
(iii) To ensure that objectives should be set which will stretch but not overwhelm managers.
(iv) To encourage strict evaluation of manager’s performance in monetary terms.
(v) To run a company in a more demanding way.
The following points highlight the two main policies on profit maximization. The policies
are: 1. Setting Profit Standards 2. Profits for Control.
Profit Maximization: Policy # 1.
Setting Profit Standards:
If we consider the above six factors we observe that many companies, particularly big ones, do
not operate on the principle of maximizing profit in terms of marginal cost and marginal revenue
but rather set standards or targets of reasonable (satisfactory) profits.
This problem arises only in the real world of imperfect competition. In pure competition, prices
have to be set close to the cost level and a firm can stay solvent only by trying to maximize
profits. But multi-product companies may have a substantial monopoly position. They enjoy
considerable pricing discretion both in the short run as well as in the long run. Such firms have to
make crucial policy decisions on profit standards.
Forms of Standard:
Profit standards can be formulated in aggregate rupee terms (like Rs. 10,000 per annum), as a
percentage of sales (like 12% of total sales revenue), or as a return on investment (like 10% on
capital employed). They can be formulated for individual products or the whole product line for
multi-product firm.
The form of profit standard that is appropriate depends on the use to which it is put. If the object
is to discourage potential competitors, revenue on investment is the relevant standard, if, of
course, entrants have similar costs. But if the object is to please the customers or to beat down
suppliers, percentage, margins over unit cost in relation to the rupees they spend, is usually
appropriate.
Dean has argued that “ratios of profits to sales are an eccentric standard of profitability. They
vary widely among firms that have the same return on invested capital when there are differences
in vertical integration of production processes, depth of mechanization, and capital structure and
turnover. Since conventional net profits are principally an investor’s income, return on capital is
the most important form of profit standard from the owners’ viewpoint.”
Four major criteria are used for setting profit standard:
(1) The Capital-attracting rate of return:
Here the question is: what it takes to attract outside capital. A profit standard can be formulated
in terms of the cost of new capital in the capital market. The capital-attracting rate depends on
the company’s capital structure.
(2) The ‘plough-back’ rate:

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The second standard is in terms of the aggregate profits that must be retained in the business to
finance a desired rate of growth without resorting to the capital market.
(3) Normal earnings:
The third criterion of reasonable profits is normal earnings of the company or of any industry
group, conceived in terms of some average level over a normal period. In this context a strictly
autonomous standard, such as the firm’s own past earnings, has enough validity.
(4) Reasonable earnings:
The final criterion is based on the results of surveys to find the public’s idea of a fair profit.
Profit Maximization: Policy # 2.
Profits for Control:
There are often deviations from the profit motive.
Three reasons account for this affair:
(1) Managers and executives spend most of their energy in expanding sales volume and product
lines than in raising profitability.
(2) Subordinates spend lot of time, money and energy to do jobs perfectly regardless of cost and
usefulness.
(3) Lower management feels insecure most of the time. There is always a fear of loss of jobs.
They attempt to play safe because there is no reward for imaginative ventures.
There is need to counter tendencies which run contrary to profit-maximization. So there is need
to exercise controls over executive performance. Two methods may be used for the purpose.
1. Firstly, there is need to re-align managerial organization “to shift the basic breakdown of
operating responsibility from a functional basis (e.g., marketing, versus production, versus
finance) to a commodity basis. The effect is to break the company up into several integral
operating units (divisions) and give the executive, authority over all functions in his
divisions, and make him responsible for profits.”
Of course, these divisional managers have to operate under a higher executive echelon.
2. Secondly, there is needed to reorient company 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.”
Managerial Uses of Break-Even Analysis
Meaning of Break-Even Point:
Break-even point represents that volume of production where total costs equal to total sales
revenue resulting into a no-profit no-loss situation.
If output of any product falls below that point there is loss; and if output exceeds that point there
is profit.
Thus, it is the minimum point of production where total costs are recovered. Therefore, at break-
even point.
Sales Revenue – Total Cost
or, Sales – Variable Cost = Contribution = Fixed Cost

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It can be concluded that at break-even point the contribution earned just covers the fixed cost
and, at levels below the point, contribution earned is not sufficient to match the fixed cost and, at
levels above the point, contribution earned more than recovers the fixed cost.

P is the break-even point in the break-even chart where OS and CT—being the sales line and
total cost line—intersects. Loss results in the left side of P, i.e., before the break-even point is
reached, and, beyond P, profit starts to generate. Break-even point has a wide use in the field of
marginal costing and helps to decide the product mix, fixation of selling price, steps to be taken
in long-term planning etc.
Break-even point can be ascertained by using the following formula:

Managerial Uses of Break-Even Analysis:

To the management, the utility of break-even analysis lies in the fact that it presents a
microscopic picture of the profit structure of a business enterprise. The break-even analysis not
only highlights the area of economic strength and weakness in the firm but also sharpens the
focus on certain leverages which can be operated upon to enhance its profitability.
It guides the management to take effective decision in the context of changes in government
policies of taxation and subsidies.
The break-even analysis can be used for the following purposes:
(i) Safety Margin:
The break-even chart helps the management to know at a glance the profits generated at the
various levels of sales. The safety margin refers to the extent to which the firm can afford a
decline before it starts incurring losses.
The formula to determine the sales safety margin is:
Safety Margin= (Sales – BEP)/ Sales x 100
From the numerical example at the level of 250 units of output and sales, the firm is earning
profit, the safety margin can be found out by applying the formula
Safety Margin = 250- 150 / 250 x 100 =40%

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This means that the firm which is now selling 250 units of the product can afford to decline sales
upto 40 per cent. The margin of safety may be negative as well, if the firm is incurring any loss.
In that case, the percentage tells the extent of sales that should be increased in order to reach the
point where there will be no loss.
(ii) Target Profit:
The break-even analysis can be utilised for the purpose of calculating the volume of sales
necessary to achieve a target profit.
When a firm has some target profit, this analysis will help in finding out the extent of
increase in sales by using the following formula:
Target Sales Volume = Fixed Cost + Target Profit / Contribution Margin per unit
By way of illustration, we can take Table 1 given above. Suppose the firm fixes the profit as Rs.
100, then the volume of output and sales should be 250 units. Only at this level, it gets a profit of
Rs. 100. By using the formula, the same result will be obtained.
(iii) Change in Price:
The management is often faced with a problem of whether to reduce prices or not. Before taking
a decision on this question, the management will have to consider a profit. A reduction in price
leads to a reduction in the contribution margin.
This means that the volume of sales will have to be increased even to maintain the previous level
of profit. The higher the reduction in the contribution margin, the higher is the increase in sales
needed to ensure the previous profit.
The formula for determining the new volume of sales to maintain the same profit, given a
reduction in price, will be as follows:
New Sales Volume = Total Fixed Cost = Total Profit/ New Selling price – Average Variable
Cost
For example, suppose a firm has a fixed cost of Rs. 8,000 and the profit target is Rs.20, 000. If
the sales price is Rs.8 and the average variable cost is Rs. 4, then the total volume of sales should
be 7,000 units on the basis of the formula given under target price.
Suppose the firm decides to reduce the selling price from Rs.8 to Rs. 7, then the new sales
volume should be on the basis of the above formula:
New Sales Volume = 8,000 + 20,000/7-4 = 9,300
From this, we can infer that by reducing the price from Rs. 8 to Rs. 7, the firm has to increase the
sales from Rs. 7,000 to Rs 9,330 if it wants to maintain the target profit of Rs. 20,000. In the
same way, the sales executive can calculate the new volume of sales if it increases the price.
(iv) Change in Costs:
When costs undergo change, the selling price and the quantity produced and sold also undergo
changes.
Changes in cost can be in two ways:
(i) Change in variable cost, and
(ii) Change in fixed cost.
(i) Variable Cost Change:

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An increase in variable costs leads to a reduction in the contribution margin. This reduction in
the contribution margin will shift the break-even point downward. Conversely, with the fall in
the proportion of variable costs, contribution margins increase and break-even point moves
upwards.
Under conditions of changing variable costs, the formula to determine the new quantity or
the new selling price is:
(a) New Quantity or Sales Volume = Contribution to Margin/ Present Selling Price – New
Variable Cost Per Unit
(b) New Selling Price = Present Sale Price +New Variable Cost-Present Variable Cost
Example:
The contribution margin is Rs. 64,000, the present sale price is Rs.10 and the present variable
cost is Rs.6. If the variable cost per unit goes up from Rs.6 to Rs. 7, what will be the new sales
volume and price?
New Sales Volume = 64,000/ 10-7 = 64,000 /3 = 21,300 units
New Sales Price = (10+7-6) = Rs. 11.
(ii) Fixed Cost Change:
An increase in fixed cost of a firm may be caused either due to a tax on assets or due to an
increase in remuneration of management, etc. It will increase the contribution margin and thus
push the break-even point upwards. Again to maintain the earlier level of profits, a new level of
sales volume or new price has to be found out.
New Sales Volume = Present Sale Volume +
(New Fixed Cost + Present Fixed Costs)/ (Present Selling Price-Present Variable Cost)
New Sale Price = Present Sale Price +
(New Fixed Costs – Present Fixed Costs)/ Present Sale Volume
Example:
The fixed cost of a firm increases from Rs. 5,000 to Rs. 6,000. The variable cost is Rs. 5 and the
sale price is Rs. 10 and the firm sells 1,000 units of the product
New Sales Volume = 1,000 + 6,000 – 5,000/ 10 – 5 =1,000 + 1,000/ 5 = 1,000 + 200=1,200 units
New Sale Price = 10 + 6,000 – 5,000/ 1,000 = 10 + 1,000/ 1,000= Rs.10 + Re1
= Rs. 11
(v) Decision on Choice of Technique of Production:
A firm has to decide about the most economical production process both at the planning and
expansion stages. There are many techniques available to produce a product. These techniques
will differ in terms of capacity and costs. The breakeven analysis is the most simple and helpful
in the case of decision on a choice of technique of production.
For example, for low levels of output, some conventional methods may be most probable as they
require minimum fixed cost. For high levels of output, only automatic machines may be most
profitable. By showing the cost of different alternative techniques at different levels of output,
the break-even analysis helps the decision of the choice among these techniques.
(vi) Make or Buy Decision:

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Firms often have the option of making certain components or for purchasing them from outside
the concern. Break-even analysis can enable the firm to decide whether to make or buy.
Example:
A manufacturer of car buys a certain components at Rs. 20 each. In case he makes it himself, his
fixed and variable cost would be Rs. 24,000 and Rs.8 per component respectively.
BEP = Fixed Cost/ Purchase Price – Variable Cost
= 24,000/ 20-8 = 24,000/ 12 = 2,000 units
From this, we can infer that the manufacturer can produce the parts himself if he needs more than
2,000 units per year. However, certain considerations need to be taken account of in a buying
decision, such as
(i) Is the required quality of the product available?
(ii) Is the supply from the market certain and timely?
(iii) Do the supplies of the components try to take any monopoly advantage?
(vii) Plant Expansion Decisions:
The break-even analysis may be adopted to reveal the effect of an actual or proposed change in
operation condition. This may be illustrated by showing the impact of a proposed plant on
expansion on costs, volume and profits. Through the break-even analysis, it would be possible to
examine the various implications of this proposal.
Example:
A company has the capacity to produce goods worth of Rs. 40 crores a year. For this has incurred
a fixed cost of Rs 20 crores, the variable costs being 60% of the sales revenue. Now company is
planning to incur an additional Rs. 6 crores in feed costs to expand its production capacity from
Rs. 40 crores to Rs.60 crores. The survey shows that the firm’s sales can be increased from Rs.
40 crores to Rs. 50 crores. Should the firm go in for expansion?
ВЕР at present capacity = Fixed cost/ Margin Contribution% = Rs. 10 crores/ 40% =Rs25Crores
ВЕР at the proposed capacity = Rs 16 crores/40%= Rs 40 crores.
Increase in break-even point = Rs 40 crores-Rs. 25 crores = Rs. 15 crores.
Thus we can infer that the firm should go in for expansion only if its sales expand by more than
Rs. 15 crores from its earlier level of Rs. 40 crores.
(viii) Plant Shut Down Decisions:
In the shut down decisions, a distinction should be made between out of pocket and sunk costs.
Out of pocket costs include all the variable costs plus the fixe cost which do not vary with
output. Sunk fixed costs are the expenditures previously made but from which benefits still
remain to be obtained e.g. depreciation.
(ix) Advertising and Promotion Mix Decisions:
The main objective of advertisement is to stimulate or increase sales to all customers-former,
present and future. If there is keen to undertake vigorous campaign of advertisement. The
management has to examine those marketing activities that stimulate consumer purchasing and
dealer effectiveness.
The break-even point concept helps the management to know about the circumstances. It enables
him not only to take appropriate decision but by showing how these additional fixed cost would
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influence BEPs. The advertisement pushes up the total cost curve by the amount of
advertisement expenditure.
(x) Decision Regarding Addition or Deletion of Product Line:
If a product has outlive utility in the market immediately, the production must be abandoned by
the management and examined what would be its consequent effect on revenue and cost.
Alternatively, the management may like to add a product to its existing product line because it
expects the product as a potential profit spinner. The break-even analysis helps in such a
decision.
Example:
A fan manufacturer possesses the following data regarding his firm:
Total Fixed Cost = Rs. 1, 50,000
Volume of Sales = 5, 00,000 units

The manufacturer is considering whether or not to drop heaters from its product line and replace
it with a fancy kind of fan.
He knows that if he takes the decision of dropping heaters and replaces it with fancy fans
his output and cost data would be:
Total Fixed Cost = Rs. 1, 50,000
Likely Volume of Sales = Rs. 5, 00,000

To find out the impact of proposed change, we need to compare profits in the two situations.
Firstly, we have to find out the contribution ratio of each product.

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Therefore, the contribution ratio of the entire product line = 0.167+ 0.12+ 0.08 = 0.367
Total Contribution = Rs.5, 00, 00 × 0.367 = Rs 1,83,500
Profit = Total Contribution – Total Fixed Cost
= Rs. 1, 83,500 – Rs. 33,500.
We have to follow the similar analysis for the second situation:
Contribution Ratio of Ordinary Fans = 360 – 240/ 360 × 50a% = 0.167
Contribution Ratio of Exhaust Fans = 600 – 360/ 600 × 20% = 0.08
Contribution Ratio of Fancy Fans = 850 – 450/ 850 × 30% = 0.141
Thus the contribution ratio of the entire product line = 0.167+0.08+0.141 = 0.388.
Total Contribution =Rs. 5, 00,000 x 0.388=Rs. 1, 94,000
Profit= Rs. 1, 94,000— Rs. 1, 50,000=Rs 44,000
From the above analysis, we can infer that the manufacturer should drop heaters from his product
line and add fancy fens to his product line so as to earn more profit.
Limitations:
We may now mention some important limitations which ought to be kept in mind while
using break-even analysis:
1. In the break-even analysis, we keep everything constant. The selling price is assumed to be
constant and the cost function is linear. In practice, it will not be so.
2. In the break-even analysis since we keep the function constant, we project the future with the
help of past functions. This is not correct.
3. The assumption that the cost-revenue-output relationship is linear is true only over a small
range of output. It is not an effective tool for long-range use.
4. Profits are a function of not only output, but also of other factors like technological change,
improvement in the art of management, etc., which have been overlooked in this analysis.
5. When break-even analysis is based on accounting data, as it usually happens, it may suffer
from various limitations of such data as neglect of imputed costs, arbitrary depreciation estimates
and inappropriate allocation of overheads. It can be sound and useful only if the firm in question
maintains a good accounting system.
6. Selling costs are specially difficult to handle break-even analysis. This is because changes in
selling costs are a cause and not a result of changes in output and sales.
7. The simple form of a break-even chart makes no provisions for taxes, particularly corporate
income tax.
8. It usually assumes that the price of the output is given. In other words, it assumes a horizontal
demand curve that is realistic under the conditions of perfect competition.
9. Matching cost with output imposes another limitation on break-even analysis. Cost in a
particular period need not be the result of the output in that period.
10. Because of so many restrictive assumptions underlying the technique, computation of a
breakeven point is considered an approximation rather than a reality.
Assumptions Underlying Break-Even Analysis:
The break-even analysis is based on certain assumptions.
They are:
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(i) All costs can be separated into fixed and variable components,
(ii) Fixed costs will remain constant at all volumes of output,
(iii) Variable costs will fluctuate in direct proportion to volume of output,
(iv) Selling price will remain constant,
(v) Product-mix will remain unchanged,
(vi) The number of units of sales will coincide with the units produced so that there is no opening
or closing stock,
(vii) Productivity per worker will remain unchanged,
(viii) There will be no change in the general price level.

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