Managerial Economics

Managerial Economics is a field

of study concerning the application of economic principles of decision making. It is the integration of economic theory with business practice for the purpose of facilitating decision making and forward planning by management Micro and Macro originated by Ragnar Firsch in 1933. Derived from Greek words MIKROS and MAKROS which mean small and large respectively. Micro economics is concerned with the analysis of the behavior of the individual, decision making and the problem of resource allocation. Macro economics deals with the aggregate behavior of the economy as a whole. Managerial economics is economics applied to the analysis of business problems and decision making. It has a close connection with Economic theory, Operations research, Statistics, Mathematics and theory of decision making. Managerial economics is multi disciplinary in character.

Scope of Managerial Economics          

Objectives of a business firm Demand Analysis & Demand forecasting Production Cost Competition Pricing Output Profit Investment & Capital budgeting Product policy, Sales promotion and Market strategy

Constraints of the firm  Internal Imposed by organisation itself.  External Beyond the control of management and includes resource constraints. quantity or quality constraints. legal constraints.

Role of Managerial Economics 1. 2. 3. 4. 5. 6. 7. 8. 9. 10.

Demand forecasting Production scheduling Industrial Market Research Economic analysis of the competing companies Investment appraisal Security management analysis and forecasts Foreign exchange management Advice on trade Environmental forecasting Pricing and the related decisions

Profit Maximization Profit is defined as revenue minus cost. Economists recognize the other costs defined as implicit costs. These costs are not reflected in cash outlays by the firm and includes managers time and talent. Profit plays two important roles in a market economy. 1. Changes in profit signal, producers to change rate of production. 2. Profit is a reward to the Entrepreneurs for taking risks. Profit is a reward for risk and uncertainty It is a compensation for frictional factors like population, capital, production techniques, form of organization and consumer wants.

PROFIT POLICY  To maintain good labour relations and restrain the demands of organised labour.  To discourage new competition  To maintain business Goodwill with customers.  To maintain good public relations.

Reasonable Profits of Standards        

Attract Equity capital. Inter firm comparison. Comparison of profits of the firm. To finance growth from internal sources. Avoiding high tax and Govt intervention. Avoiding risk. Enlightened self interest of survival. Idealism and service motivation.

Guidelines for profit policy  Does not weaken the inner strength of the concern . Ex Sales Service and R&D.  Long term profitability , capital should be kept in tact . Ex; Expansion , Financial need .  Urgent need to update the technology and product line .  Harmonious labor relation .



Goodwill in society .

Behavioral Theories  Managerial and Behavioral theories of firm, assume owners and managers to be separate entities in large corporations with different goals and motivation.

There is a dichotomy. 1 Berle and Means and later developed by Gal braith ( B-M-G) Hypothesis. States 1) That owner controlled firms have higher profit than manager controlled firms AND 2) That managers have no incentive for profit Maximization.

2 Baumol’s hypothesis of sales revenue maximization. a) salary and other earnings of managers are more closely related to sales revenue than to profits. b) Banks and financial corporations look at sales revenue while financing the corporation. c) Trend in sales revenue is a readily available indicator of the performance of the firm. d) Increase in Sales revenue enhances the prestige of managers while profits go to the owners. e) Managers find profit Maximization a difficult objective to fulfill consistently. f) Growing sales strengthen competitive spirit of the firm in the vice versa.

market and

3) Robin Marries Hypothesis of Maximization of firms growth rate : Managers maximize the firms balanced growth rate subject to Managerial and financial constraints. G=G = G D c Where GD is growth rate of demand for firm product. GC is growth rate of Capital supply to the firm. Managers utility function Um = F ( salary, power, job security ,prestige, status) ssspp Owners utility function Uo = F( Output ,Capital, market share, profit, public esteem) ppcmo

4 Williamson Hypothesis of maximization of managerial utility function ( u ) U= F (s , m , I ) d Where s is additional expenditure on staff m is Managerial emoluments I Is discretionary investments d Managers maximize (U) subject to a satisfactory profit. 5 C yert – March hypothesis of satisfying behavior. 6 Rothschilds Hypothesis of long run survival and market share goals.

Managerial Economic Principles  Opportunity cost  Incremental cost  Discounting principle  Concept of time  Equi-marginal principle

 (cdeio)

Demand analysis Demand means the quantity of the commodity which an individual consumer or a household willing to purchase at a particular price. A consumers desire to buy a product can be translated into effective demand only if he has the money income to pay for the product. The fundamental objective of demand theory is to identify and analyze the basic determinants of consumer needs and wants. An understanding of the forces behind demand is a powerful tool for managers.

Why Demand Analysis ? The main purposes are the following, namely  To understand why a consumer behaves as he does.  To know the factors that govern in his choice to expand or contract demand for various goods  To appreciate why a consumer generally buys more of a goods for a fall in price.  Demand for a product has to be a combination of two forces of a consumer, desire to buy, ability to buy the product and willing to spend.

Factors that play an important role in determining the demand 1. Price acts as signals to guide consumer decisions. 2. Tastes and preferences 3. Social – Cultural backgrounds of individuals 4. Income level 5. Prices of related products 6. Population 7. Government policy 8. Climate and weather 9. State of business 10. Invention and Innovations 11. Advertisement and sales propaganda

Demand function

Dx = f ( Px , Py , Pz ……Pn, I, T.A) where Dx = Amount demanded per unit of commodity x Px= Price of commodity x Py , Pz ……Pn = Prices of substitutes or complements I = Income of individual or household T = Tastes and preferences of individual of household A = Amount spent annually on advertisement

Theory of Law Demand

      

According to theory of law of demand other things remaining same (ceteris paribus) quantity demanded per unit at time will be greater lower the price and smaller, higher the price. Law of demand describes the general tendency of consumer behavior in demanding a commodity in relation to the changes in its price. Assumptions: No change in fashions No Change in tastes and preferences Prices of commodities related to the commodity in demand should not change There should be no change in the wealth of consumers No change in size, age composition and sex ratio of the population No change in government policy No change in weather conditions

Exceptions  Special type of inferior goods or Giffen goods Ex:- Cheap bread and cake, vegetable ghee and pure ghee.  Articles of distinction or SNOB appeal or VEBLEN conspicuous consumption.  Expectation of rise and fall in price in future.  Ignorance on the part of consumer about quality or psychological bias or Illusion .

Why demand curve slopes downwards from left to right Demand curve is a graphical presentation of a demand schedule. The demand curve has a negative slope. It slopes downwards from left to right, representing an inverse relationship between price and demand. A demand curve is a locus of points showing various alternative price – quantity combinations. Individuals demand curve for a product can be obtained by plotting the data. On X axis demand and on Y axis price per unit are to be taken.

Each point on the demand curve shows one particular price – quantity combination. Combination at each point, decreasing price of Tea and increasing number of cups of Tea.

Reasons:  Substitution effect 

Income effect



Law of diminishing marginal Utility



Consumption by marginal Consumers

Types of Demand  Direct demand and Derived demand.  Domestic demand and Industrial demand .  Autonomous demand and Induced demand .  Perishable demand and Durable demand .  New demand and Replacement demand.  Final demand and Intermediate demand .  Individual demand and Market demand.  Short run demand and Long run demand.

Elasticity of Demand  The term Elasticity refers to measure the responsiveness of demand to the changes in price. It measures the responsiveness of demand for a commodity to changes in the variables confined to its demand function.

Elasticity of demand = % change in Quantity demanded % change in determinant of demand Factors influencing Elasticity of demand :  Nature of Commodity  Availability of Substitutes  Nature of uses  Consumers Income  Height of price and range of price change

      

Proportion of Expenditure Durability of the commodity Influence of habit and custom Complementary goods Time Possibility of postponement Recurrence of demand Price Elasticity Defined as ratio of the relative change in demand and price variables. A price change can either increase or decrease total revenue, depending on the nature of demand function. The uncertainty involved in pricing decisions could be reduced if managers had a method of measuring the probable effect of price changes on total revenue. One such measure is price elasticity of demand. The extent of response of demand for a commodity to a given change in price, other demand determinants remaining constant is termed as price elasticity of demand .

Price elasticity of demand =% Change in quantity demanded % Change in price

INCOME ELASTICITY OF DEMAND Measures the degree of responsiveness of demand for a good to changes in the consumer’s income. Defined as a ratio percentage or proportional change in the quantity demanded to the percentage or proportional change in income. Income elasticity= %change in quantity demanded %change in income

Cross Elasticity of Demand  Refers to the degree of responsiveness of demand for a commodity to a given change in the price of some related commodity.  Cross elasticity= %change in demand for X %change in price of Y

PRACTICAL UTILITY  To the Businessmen.  To the Government and finance ministerTaxation of inelastic goods. Ex- sugar, cigars.  International trade - Export Import policies.  Policy makers – In solving the mystery of how farmers may remain poor despite a bumper crop.  To the Trade Unions- When industry’s product is fairly elastic and the Trade Unions in wage bargaining.

Types of Elasticity  Perfectly elastic Consumers have infinite demand at a particular price and none at all at an even slightly higher than this given price. e= ∞  Perfectly inelastic Demand remains unchanged, whatever be the change in price. e=0.  Relatively elastic Quantity demanded changes by a larger percentage than does price. e >1.  Unitary elastic Quantity demanded changes by exactly the same percentage as does price. e=1.  Relatively inelastic Quantity demanded changes by a smaller percentage than does price. e < 1.

Graphical Presentation of Types of Elasticity

Perfect elastic inelastic

Perfectly inelastic

Relatively elastic

Relatively inelastic

Unitary

Demand Forecasting Demand forecasting is an estimate of demand during a specified future period based on a proposed marketing plan and a particular uncontrollable and competitive forces. Demand forecasting refers to predicting the future which form basis for planning, production, purchase planning, manpower planning and financial planning.

Importance        

Determining the sales territories. Helpful in deciding to enter a new market or not. Helpful in determining how much capacity to be built up. In deciding the number of salesmen required to achieve the sales objective. Preparing standards. Assessing the effect of a proposed marketing programme. Product mix decisions. Deciding the channels of Distribution.

Demand forecasting procedure  Determine the objectives and purpose for which the forecasts are to the used.  Determining the relative importance of the factors which affect sales of each product.  Selecting the appropriate forecasting method.  Collecting and analysing the data.  Making assumptions regarding the effect of factors.  Making specific forecasts relating to the products and territories involved.  Periodically review and revising the forecasts.

Methods of Forecasting Opinion polling methods:  Survey of buyers intention or consumer ‘s sample survey method.  Executive judgement method.  Delphi method.  Naive model.  Simple trend analysis.  Market test method.  End use method.

Statistical methods:

 Time-series analysis.  Leading indicator method.  Regression method.  Simultaneous equation method.  Smoothing techniques.

 Survey of buyers intentions or consumer sample survey method. a) customers are asked to communicate their buying intentions in coming period. b) Identify potential buyers – industrial demand forecasting. Demerits: 1. Expensive and time consuming. 2. Customers may tend to exaggerate their requirement. 3. Not useful for household customer goods.  Executive judgement method. Involves combining and averaging the sales projection of executives in different departments to come up with forecast. Merits: 1. Forecasting made quickly and economically. 2. Specialized persons therefore estimate would be much more reliable than consumers survey. Demerit: 1. Very subjective and lacks scientific validity.

 Delphi method Developed by Olaf Heimer, Dalkey and Gorden at Rand Corporation in the late 1940 in area of Technological forecasting. It consists of an attempt to arrive at a consensus in an uncertain area by questioning by group of experts repeatedly until the responses appear to converge along a single line.

The coordinator provides each expert with the responses of others including their reasoning. Each expert is given the opportunity to react to the information or considerations advanced by others.

 Naive Models: Based exclusively on historical observation of sales (for other variables such as earnings, cash flows etc.). They do not explain the underlying casual relationship which produces the variable being forecast. Merit: It is inexpensive to develop, store data and operate. Demerit: It does not consider any possible casual relationships that underly the forecasting variable.  Simple Trend Analysis: Assumes that future sales will be determined by the same variables that caused part sales and that the relationship among the variables will remain the same. Merit: Useful for products with a history of stable demand than for products with erratic sales patterns. Demerit: Cannot be used to forecast sales of a new product because past sales data are absent.

 End use method: a) Sales are projected through survey of its end users. b) Commodity is used for final consumption or intermediary consumption. c) Domestic market or international market.

Statistical Methods  Time series analysis: A time series is set of data collected over a period of time. Is commonly used when several years of data exist and when trends are both clear and relatively stable since “TSA” totally dependant upon historical data, its implicit assumption is that the past is a good guide to future. A time series is composed of four basic elements, namely, Trend , Seasonal, Cyclic and Erratic events.

 Leading indicator method or Barometric method: A forecasting method, where data is forecasted through anticipatory data.

 Regression method: Relevant variables have to be included with practical considerations and relevant data have to be obtained. Econometric models are useful and identify functional relationship between variables.

Ex: 1. Personal disposable income towards demand . 2. Agricultural or Farm incomes towards demand for agricultural equipment, fertilizers, etc. 3. Construction contracts for demand towards building material.

 Simultaneous equations method or Complete systems approach:

for

Sophisticated method normally used at macro level forecasting the economy.

 Smoothing Techniques: Moving averages and Exponential smoothing. Exponential smoothing is a short run forecasting technique. It uses a weighted average of past data as the basis for a forecast. The procedure gives heaviest weight to more recent information and smaller weights to observations in the more distinct past. Moving averages are averages that are updated as new information is received. Most recent observations, drops the oldest observation.

Demand Forecasting for a New Product  Evolutionary approach  Substitution approach  Growth curve approach  Opinion polling approach  Sales experience approach  Vicarious approach

Criteria of a Good Forecasting Method  Accuracy  Simplicity  Economy  Quickness  Flexibility  Plausibility

Production Function Production function refers to the functional relationship, under the given technology between the physical rates of input and output of a firm per unit of time. The study of production function is directed towards establishing the maximum output which can be achieved with a given set of resources and with a given state of technology. Q = f ( m, l, k )

Production Function with one Variable Input or Law of Variable Proportions  This law states that as more and more of one factor input is employed, all other input quantities constant a point will eventually be reached where additional quantities of varying input will yield diminishing marginal contribution to the total product.    

Assumptions: 1. Applicable only for short run decisions. 2. Constant technology. 3. Homogeneous factors.

 Production Function with two Variable Inputs  The firm increases its output by using more of two inputs that are substitutes for each other. Ex: Labour and Capital

Cobb-Douglas Production Function This is a multiplicative form of production function because it accurately characterizes many production processes. Q=a[ Lb K l -b ] Where Q is the quantity of output L units of labour K units of capital a , a constant b, a parameter

Properties 1. Both L and K should be positive for Q to exist. 2. If we look at the parameters, we find that their sum b+1-b=1. This means that the function in original form assumes constant returns to scale. In later version of Cobb-Douglas Production Function the functional form was a rewritten as Q = a L α K β Where If α + β could be greater than, equal or Less than 1. When

α + β = 1 returns to scale are constant.

When

α + β > 1 returns to scale are increasing.

When

α + β < 1 returns to scale are decreasing.

3. Parameters represent factor shares in output. 4. Short term relationships of inputs and outputs can be calculated. Marginal product of labour MPL = α ( Q / L) Marginal product of capital MPK= β ( Q / K) 5. Elasticity of substitutes is unity. Importance  It is convenient for international and inter-industry comparisions.  It is used to investigate the nature of long run production function.  Least cost input combinations for a given output.

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Returns to Scale

Three phases of returns in the long run: 1. The law of increasing returns 2. The law of constant returns 3. The law of decreasing returns

The Law of Increasing Returns: It describes increasing returns to scale. There are increasing returns to scale when a given percentage increase in input will lead to a greater relative percentage increase in the resultant output. Algebraically,

∆Q.> ∆F Q F

, Where x ∆Q.= Proportionate change in out put Q

and ∆F = Proportionate. F Marshall explains increasing returns in terms of ‘increased efficiency’ of labour and capital in the improved organisation with the expanding scale of output and employment of factor input. It is referred to as ‘the economy of organisation’ in the earlier stages of expansion. Increasing returns may be attributed to improvements in large scale operation, division of labour, use of sophisticated machinery, better technology, etc. Increasing returns to scale are due to indivisibilities and economics of scale and technological advancement.

 The Law of Constant Returns: The process of increasing returns to scale cannot go on forever. It may be followed by constant returns to scale. As the firm continues to expand its scale of operations, it gradually exhausts the economies responsible for the increasing returns. Then, the constant returns may occur. There are constant returns to scale when a given percentage increase in inputs leads to the same percentage increase in output. Algebraically, ∆Q = ∆F Q

It implies that the doubling of factor inputs

F

doubles the output. P F C =1 under constant returns to scale Constant returns to scale are quite often assumed in economic theoretical models for simplification. Assumption is based on the following conditions:

   

1. 2. 3. 4.

All factors are homogeneous All factors are perfectly substitutable All factors are infinitely divisible The supply of all factors is perfectly elastic at the given prices.

The Law of Decreasing Returns: As the firm expands, it may encounter growing diseconomies of the factors employed. As such when powerful diseconomies are met by feeble economies of certain factors, decreasing returns to scale set in. There are decreasing returns to scale when the percentage increase in output is less than the percentage increase in input. Algebraically, ∆Q < ∆F Thus, P F C < 1 under decreasing returns to scale. Q F

1. 2. 3. 4.

5.

Economists generally consider the following causes for the decreasing returns to scale : Though all physical factor inputs are increased proportionately, organisation and management as a factor cannot be increased in equal proportion. Business risk increases more than proportionately when the scale of production is enhanced. An entrepreneurial efficiency has its own physical limitations. When scale of production increases beyond a limit, growing diseconomies of large scale production set in. The increasing difficulties of managing a big enterprise. The problem of supervision and coordination becomes complex and intractable in a large scale of production. A very large enterprise may become unwidely to manage. Imperfect substitutability of factors of production causes diseconomies resulting in a declining marginal output.

Economies of Scale Can be classified as Internal and External. Internal Economies of Scale are those which arise from the firm

.

increasing its plant size External Economies arise outside the firm from improvement or deterioration of the environment in which the firm operates. Internal Economies: Real Economies Pecuniary Economies Labour Economies

Technical Economies: These are associated with the fixed capital, which includes machinery and equipment. The main sources of technical economies are : 1.

Specialization

2.

Indivisibilities

3.

Economies of large machines, general purpose machinery and initial fixed costs.

Marketing Economies: It is associated with the marketing activity of the firm is known as marketing economies. 1. Economies on advertising and their selling activities. 2. Economies due to exclusive dealers with after sale service obligation. 3. Economies due to variation in models and designs.

Financial Economies Managerial Economies Transport and Storage Economies Diseconomies: Management Co-ordination Decision making Increase investment, Increase in risks Labor diseconomies Scarcity of factor supplies Financial difficulties Marketing Diseconomies

Short run - Long run costs Short run costs are those that can vary with the degree of utilisation of plant and other factors fixed. These include fixed costs and variable cost. Short run costs include the following :    

Average fixed cost Average variable cost Average total cost Marginal cost

Long run costs: in the long run ,the firm is not tied to a particular plant capacity. The long run average cost curve is the envelop of the various short run average cost curves. It is drawn as tangent to SAC.

Cost function The relationship between cost and its determinants is known as cost function. Productivities of factors of production, Output per unit of factor , Learning effect, Breadth of product range, Geographical location, Institutional factors, Firms discretionary policies. (etc)

Diagram

SAC 1

SAC 2

SAC 3 LAC

Features  Tangent curve  Envelope curve  Planning curve  Minimum cost combination  Flatter U-shape

Supply Function Supply of commodity means that amount of that commodity which produces are able and willing to offer for sale at a given price. Supply function is an algebraic expression relating to quantity of a commodity which a seller is willing and able to supply. fx= f ( p x FE, F P ,PR ,W,E,N) Where p x is product price FE is factor productivities or State of Technology F P is factor prices PR prices of other products related in production W is weather, strikes and other short-run forces E is firm’s expectations about future prospects for prices, costs, sales and state of economy in general. N is number

Law of Supply “Other things remaining the same, as the price of the commodity rises, its supply increases: and as the price falls, its supply declines.” Limitations: 1. 2. 3. 4.

Future prices Agricultural output Subsistence farmers Factors other than price not remaining constant

Market Structure The term ‘Market’ refers to an arrangement whereby the buyers and sellers come in close contact with each other directly or indirectly to sell and buy goods. Market Structure has four main characteristics: 1. Number and size distribution of sellers 2. Number and size distribution of buyers 3. Product differentiation 4. Conditions of entry and exit

Perfect Competition Competition exists among sellers and buyers. A single market price prevails for the commodity, determined by demand and supply forces in the market. Every buyer and seller is a price taker. Features: 1. 2. 3. 4. 5. 6.

Large number of sellers and buyers Easy entry and exit Product is homogeneous Perfect knowledge of market conditions Non-government intervention Absence of transport cost

Monopoly Single seller has control over the entire market supply, as there are no close substitutes for his products and there are barriers to the entry of rival producers. Features: 1. Only one seller in the market of a particular good or service 2. There exists factors that prevent the entry of other firms 3. Product is highly differentiated from other goods 4. Entry is prohibited or difficult 5. There are no rivals or direct competition of the firm 6. Firm is the price maker

Monopolistic Competition A market with a blending of monopoly and competition is described as monopolistic competition. Features: 1. 2. 3. 4. 5. 6.

It has elements of both monopoly and perfect competition Many buyers and that the resources can be easily transferred into and out of industry. It assumes that there are large number of small sellers, actions of any single seller do not have a significant affect on other sellers in the market. Each seller resorts to advertising and sales promotion efforts. Easy entry and exit Imperfect knowledge of the buyers

Oligopoly Large number of sellers, few number of sellers hold market share. Features: 1. 2. 3. 4. 5. 6. 7. 8.

Few number of sellers Inter-dependence Product may be either homogenous or differentiated Condition of entry difficult Advertising and selling costs have strategic importance Involves an unspecified number of buyers but only a small number of sellers Each firm sticks to its own price – price rigidity Constant fear of retaliation from rivals, if it reduces the price

Kinky Demand Curve Firstly initiated by Hall and Hitch. Later on developed by Prof. Paul Sweezy. It does not explain how prices and output are determined under oligopoly, rather it seeks to explain why once a price, quantity combination has been established, a firm will avoid changing it. A “KDC” Is set to occur when there is a sudden change in the slope of demand curve. This gives rise to a Kink i.e. sharp corner in the demand curve and at this Kink the firm sticks to its price. We would get such a curve when it is assumed that the rivals will lower their prices, when the oligopolist lowers his own price but that rivals will not raise their price when the oligopolist raises his own price.

KDC DC

P

K DC

Drawbacks: 1. 2.

Quantity

It explains the reluctance of oligopolists to change price, it provides no insight into understanding how the price was originally determined. No emperical research so as to verify the predictions.

Pricing Policy Pricing policy plays an important role in a business because the long run survival of a business depends upon the firm’s ability to increase its sales and derive the maximum profit from the existing and new capital investment. Objectives of pricing: 1. 2. 3. 4. 5.

Provide an incentive to producer for adopting improved technology and maximizing production. Encourage optimum utilitization of resources Work towards better balance between demand and supply Promote exports Avoid adverse effects on the rest of the economy

Types of Pricing Cost plus or full cost pricing Under this method cost of a product is estimated and a margin of some kind of profit is added on the basis of which the price is determined. Transfer Pricing When two or more inter-dependent departments are concerned, pertains to the price to be put on the goods or services transferred by one dept. to another. It refers to the price which one unit of an organization charges for a product or service supplied to another sub-unit of the same organization. Loss Leader Pricing Selling a product below its cost. It is used to drive competitors out of the market. During introduction of a new product a firm may use this pricing and utilizing the same as a promotional campaign.

Types of Pricing Competitive Pricing: When a company sets its price mainly on consideration of what its competitors are charging, its pricing policy under such a situation is called competitive pricing or competition – oriented pricing. The following are the two types of competitive pricing.  

Going rate pricing Sealed bid pricing

New Product Pricing:  Skimming pricing  Penetration pricing

Types of Pricing  Product Line Pricing: It involves determination of prices of individual products and study of the inter-relationship between multiple product costs and multiple product demands. Administrative Pricing: The prices are fixed and enforced by the government. The major characteristics are the following:  They are fixed by the govt.  They are statutory  They are regulatory in nature  They are meant as corrective measures  They are the outcome of the price policy of the govt.

Price Discrimination Means charging different prices and it takes various forms.  On the basis of customer  On the basis of product version  On the basis of place  On the basis of time Product life-cycle pricing

Application of Marginal Costing  Helps in the preparation of break-even analysis which shows the effect of increasing or decreasing production activity on the profitability of the company.  Segregation of expenses as fixed and variable helps the management to exercise control over expenditure.  Marginal costing helps the management in taking a number of business decisions like make or buy, discontinuance of a particular product, replacement of machines, etc.

Applications of Marginal Costing 1. Key factor or limiting factor: Any factor concerned with production or sales which imposes ‘limits’ on the production or sales can be called ‘limiting factor’ or key factor. It can be limited sales, limited production, limited raw materials in use or limited finance. 2. Make or buy decision: Many durable products are assembled by using a large number of parts or components. Some of them may be made by the firm which is assembling the product. It may buy some products from outside. When an assembling firm receives an offer from outside for a component it is already making, the ‘make or buy decision’ must be taken. Marginal Costing helps in taking the make or buy decision. 3. Fixation of selling price: Marginal costing technique is widely used in the area of determining selling price. Prices will have to be fixed in different situations, under specific constraints, etc. Total cost must be recovered and profit also to be made by fixing appropriate selling price.

Applications of Marginal Costing 4. Export decision: When idle capacity still exists, exporting is usually the most profitable strategy. So companies which have already recovered their fixed costs from local sales can export just above their variable cost and still make good profits. This is generally termed as dumping. 5. Sales mix or product decision: When a firm sells two or more products, the ratio of different products in the total sales is called sales mix or product mix. The firm should always design a product mix which maximizes the profit. 6. Product elimination decision: When two or more products are sold by a firm as a sales mix, situations may arise where it may be felt that a particular product has to be eliminated. Elimination may be with or without replacement

Applications of Marginal Costing 7. Plant merger decision: Two or more plants may be operating under the same management producing similar products. It may also be possible for one firm to acquire another competing firm. Marginal costing helps in making such decisions. 8. Plant purchase decision: Purchasing plant is a long-term capital expenditure decision involving investment and the required return on investment. Here, effective contribution from the plant and the contribution as a percentage on investment are the deciding factors. 9. Further processing decision: Two or more products may be produced in a joint process. The decision to further process or not depends on the overall contribution received. If further processing can result in additional contribution from the product, it is desirable. 10. Shut down decision: When a firm is running at loss, the management will have to decide upon its shut down. It may be complete shut down or partial or temporary shut down.

Cost Control It is a search for carrying production in economic ways. It refers to a comparison of actual and standard costs and then taking action on any variations which have arisen.  It implies efforts to be made for achieving a target goal or cost minimization. The following steps should be observed:  

1. 2. 3. 4.

Determine clearly the objective i.e. predetermined the desired results. Measure the actual performance Investigate into the causes of failure to perform according to plan Institute corrective action

Profit Planning  Profit is difference between total sales revenue and total cost of production.  Planning refers to regulation of profit, sales volume and input quantity.  Profit planning is an integral part of business policy and planning.  Profit planning cannot be done without proper profit forecasting.  Profit forecasting means projection of futures earnings taking into consideration all the factors affecting the size of the business profits.

Decision Making Make or Buy: The following two factors are to be considered –  Whether surplus capacity is available  The marginal cost – compare variable cost and offer price Product-mix: Many times the management has to take a decision whether to produce one product or another instead. Generally decision is made on the basis of contribution of each product. If there is a shortage, say, raw materials and or time ,then, the respective constraints will become key factors. The following factors are to be considered as an optimal product-mix.  An objective function  The constraints within which the objective function is to be achieved.

Decision Making Ex: two products a and b. Find the most profitable product when the plant capacity is limited. Selling price (Rs.) a and b are Rs.2 and Rs. 2.50 Variable cost (Rs.) 1 and 1.5 respectively Machine hours 2 and 1 respectively. Shut Down: If the products are making a contribution towards fixed expenses or if selling price is above the marginal cost, it is preferable to continue because the losses are minimized.

Decision Making  In making shut down decisions non-cost factors are also to be taken into consideration, namely, interest of the workers, competitors, nature of plant and machinery. Shut down point = total fixed cost – shut down cost contribution per unit Expand or Contract Decision:  Additional fixed expenses to be incurred  Possible decrease in selling price due to increase in production  Whether the demand is sufficient to absorb the increased production

CVP  Cost-Volume-Profit Analysis deals with how costs and profits change with a change in volume. It analyzes the effects on profits of changes in such factors as variable costs, fixed costs, selling prices, volume, and the mix of products sold.

 It is an extension of marginal costing. It makes use of principles of marginal costing. It is useful in making short-run decisions.

 C V P equation : Sales = variable expenses + fixed expenses + profit

Break-Even Analysis Break-even analysis is a study of revenues and costs of a firm in relation to its volume of sales, determination of that volume at which the firm costs and revenues will be equal. Assumptions:         

The cost function and the revenue function are linear The total cost is divided into fixed and variable costs The selling price is constant The volume of sales and the volume of production are identical Average and marginal productivity of factors are constant The product-mix is stable in the case of a multi-product firm Factor price is constant Company manufactures a single product In case of a multi product company, sales mix remain unchanged

Break-Even Analysis  Limitations: It is static in character Costs cannot be classified accurately Applicable only in short run Variable cost line need not necessarily be a straight line because of possibility of operation of law of increase or decrease in returns  Selling price will not be a constant factor  Ignores capital employed in business  It is based on accounting data    

Break-Even Analysis  Managerial Uses:  Margin of safety – extent to which the firm can afford a decline in sales before it starts incurring losses  Target profit – volume of sales necessary to achieve a target profit  Change in prices  Change in costs  Expand or contract  Drop and or add decisions  Make or buy decisions  Choosing promotional mix  Equipment selection  Improving profit performance

Break-Even Chart  It is graphical representation of cost volume profit relationship. Angle of incidence: Angle at which total sales line cuts total cost line.

sales aoi bep

cost fe

output

Break-Even Chart Assumptions:  Costs are either classified as fixed or variable, at least they can be so classified for the purposes of this analysis.  Fixed and variable costs are clearly separated.  Selling price is constant, regardless of the level of output  There is one product, or a constant sales-mix if more than one product is involved  Production and sales are equal, and as a result all fixed costs incurred in the period covered by the analysis will be deducted from the revenue realised in the same period.