Mefa 1 &2 Units
Mefa 1 &2 Units
Mefa 1 &2 Units
UNIT – I
INTRODUCTION TO MANAGERIAL ECONOMICS
MANAGERIAL ECONOMICS
Managerial economics is an offshoot of two distinct disciplines: Economics and
Management. Economics is a study of human activity both at individual and national level.
Every one of us in involved in efforts aimed at earning money and spending this money to
satisfy our wants such as food, Clothing, shelter, and others. Such activities of earning and
spending money are called “Economic activities”.
Management is the science and art of getting things done through people in formally
organized groups. It is necessary that every organization be well managed to enable it to
achieve its desired goals. Management includes a number of functions like planning,
organizing, staffing, directing, and controlling.
Meaning:
Managerial economics has been generally defined as the study of economic theories,
logic and tools of economic analysis, used in the process of business decision making.
Managerial Economics is also called as “Industrial Economics” or “Business Economics” or
“Economics of Management”.
The Economic Principles, Concepts, tools and techniques that can be applied
practically to solve the problems of business is known as Managerial Economics.
Here two aspects are involved i.e.,
Decision Making: It involves selection of best alternative, estimating the cost, and
Forward Planning: It is a projected blue print of operations with their costs and
benefits.
Definition:
1. M. H. Spencer and Louis Siegelman explain the “Managerial Economics is the
integration of economic theory with business practice for the purpose of facilitating
decision making and forward planning by management”.
2. Edurin Mansfield, "Managerial Economics is concerned with the application of
economic concepts and economic analysis to the problem of formulating rational
managerial decisions".
Managerial Problems
Production Decisions
Make-Buy Decisions
Concepts, Inventory Decisions
Tools & applied for Optimum
Investment Decisions
Techniques to Solutions
Profit planning & management
Determination of price of goods
Reduction or control costs
Human Resource Management
1. Demand Decisions: Demand analysis should be a basic activity of the firm because
many of the other activities of the firms depend upon the outcome of the demand
forecast. The implications are like need of customers, change in price or supply. The
impacts of these are assessed and the decisions are taken to maximize the profits.
2. Profit related Decisions: Profit making is the major goal of firms. There are several
techniques such as Break-Even analysis, cost reduction, cost control and ratio analysis
to ascertain level of profits. In BEP we are concerned with profit planning and
control. If a firm produces less than BEP it gets losses.
3. Pricing – Output Decisions: Pricing decisions have been always within the preview
of managerial economics. Here the production is ready and the task is to determine
the price in different market situations as perfect and imperfect market ranging from
monopoly, duopoly and oligopoly. The pricing policies, methods, strategies and
practices constitute part of the study.
Unit-I: Introduction to Managerial Economics 1.3
4. Input – Output Decisions: The costs of inputs in relation to output are studied to
optimize profits. The behaviors of costs at different levels of production are assessed
here. Some costs are fixed, semi-variable and variable. It is necessary to know the
relationship between costs and output both in short and long run.
5. Capital or investment Decisions: Capital is the foundation of business. Lack of
capital may result in small size of operations. Availability of capital from various
sources like equity capital, banks, institutional finance etc. may help to undertake
large-scale operations. Hence efficient allocation and management of capital is one of
the most important tasks of the managers.
6. Economic forecasting & Planning: Economic forecasting leads to forward planning.
The firm operates in an environment dominated by external and internal factors.
External factors include government policies, competition, employment, price and
income levels. Internal factors include policies and procedures relating to production,
finance and marketing. This will minimize the risk & uncertainty about the future.
DEMAND ANALYSIS
Demand means the quantity of goods or service which the consumer would buy in the
market at a given time and given place. Every want supported by the willingness and ability
to buy constitutes demand for a product or service a product or service is said to have demand
when three conditions are satisfied:
Desire for specific commodity
Willingness to pay for it
Ability to pay for certain price, place & time.
Definition:
According to Benham, “The demand for anything, at a given price, is the amount of it,
which well be bought per unit of time at that price.
Demand Schedule:
The tabular presentation of relationship between price and demand for a commodity is
known as Demand Schedule.
Demand Curve:
The graphical representation of demand schedule or relationship between price and
demand for a product is known as Demand Curve
INDIVIDUAL DEMAND
It shows the quantities of demand for a commodity by a particular consumer at
various prices of that commodity.
Ex: Mohan’s demand for milk and Sohan’s demand for milk represent individual demand
schedule and curve.
Y
D
Price
0 Demand X
Individual Demand Curve
Unit-I: Introduction to Managerial Economics 1.5
MARKET DEMAND
The demand of the whole market at various prices of the commodity is known as
market demand. It is shown by market demand schedule and demand curve. By adding
individual demand schedules we get market demand schedule.
Ex: X’s & Y’s demand for milk.
Y D
Price
0 Demand X
Market Demand Curve
INCOME DEMAND
It indicates the relationship between income of the consumer and the quantity of
commodity demanded, other things remaining constant like price, taste, nature, etc.
Income Demand
10,000 100
20,000 200
Y
D
Income
I1
I
D
0 D D1 X
Demand
Unit-I: Introduction to Managerial Economics 1.6
Income Demand
10,000 100
20,000 50
Y
D
Income
0 Demand X
CROSS DEMAND
When a change in the price of one commodity results in the change of demand of
other commodity, it is known as Cross Demand. It indicates how the prices of related goods
are affected by the changes in demand.
Y
D
Price
P1
P
D
0 D D1 X
Demand
Unit-I: Introduction to Managerial Economics 1.7
Y
D
Price
0 Quantity X
DEMAND DISTINCTIONS
1. Consumer goods Vs. Producer goods:
Consumer goods refer to such products and services which are capable of
satisfying human needs. These are available for ultimate consumption. These give direct
and immediate satisfaction. Ex: bread, apple, rice, milk, etc.
Producer goods are those which are used for further process of production of
goods or services to earn income. Ex: machinery, tractor, etc.
DEMAND FUNCTION
It is a function which describes a relationship between one variable and its
determinants. It describes how much quantity of goods are brought at alternative prices of
goods and its related goods, alternative income levels, alternative values of other variables.
Thus the above factors can be built up into a demand function.
Mathematically, the demand function for a product can be explained as:
Qd = f (P, I, T, PR, EP, EI, SP, DC, A, O)
Where,
Qd refers to quantity of demand and it is a function of the various determinants
Demand Determinants:
1. Price of the product (P): The price of the product and its quantity demanded is
inversely related. If there is a fall in the price of the product, there is a rise in the
demand for that product and vice-versa.
2. Income of the consumer (I): A consumer with an average income spends to buy
some commodities. As he becomes richer he spends his money to buy adequate
quantities so that he becomes satisfied quantitatively. Once he is satisfied
quantitatively he spends his increased income to improve quality consumption. The
former type of goods are called inferior goods and latter are called superior goods.
3. Tastes & Preferences (T): Taste and preference depend on the changing life-style,
customs, religious values attached to a good, habit of the people, the general levels of
living of the society and age and sex of the consumers. Change in these factors
changes consumer's taste and preferences.
4. Prices of related goods (PR): Goods and services have two kinds of relationships -
substitute goods or complementary goods. When there is a fall in the price of a
commodity x, the demand for it (x) goes up. This further leads to a fall in the demand
for its substitute goods and vice versa. With a fall in the price of x, increases the
demand for its complementary goods.
Unit-I: Introduction to Managerial Economics 1.9
5. Expected change in future Income (EI): If the consumer expects that his income
will be higher in the future the consumer may buy the good now. In other words
positive expectations about future income may encourage present consumption.
6. Expected change in future Prices (EP): If consumers expect a rise in the price of a
storable good, they would buy more of it at its current price with a view to avoiding
the possibility of price rise future. If he expects a fall in the price of certain goods,
they postpone their purchase to take advantage of lower prices in future.
7. Size of Population (SP): As the consumption habits vary from region to region the
demand for a product depends positively upon the size of population i.e. children and
adults, male and female, rich and poor.
8. Distribution to Customers (DC): The distribution changes from region to region
which depends on the demand for a product and it also changes with the needs of
children and adults, and rich and poor. Thus demand is affected by various sections of
a community.
9. Advertisement (A): Advertisement costs are incurred with the objective of promoting
sale of the product. It helps in increasing the demand for the product through various
media like T.V, radio, newspapers, etc.
10. Other factors (O): With a change in other factors like nature, quality and quantity
also the demand for the product changes from time to time.
LAW OF DEMAND
Law of demand shows the relation between price and quantity demanded of a
commodity in the market with an assumption that all the other demand determinants remain
same or do no change. In the words of Marshall, “the amount demand increases with a fall in
price and diminishes with a rise in price”.
The demand curve slopes downward from left to right and with a fall in price of a
product the demand goes on increasing and vice-versa.
3) Ignorance: Sometimes the quantity of the product is judged by its price. If the
consumer is not aware of the competitive price of the product that is prevailing in the
market, he may purchase more even at a higher price. Consumers think that the
product is superior if the price is high and they buy more at a higher price. Ex:
Exhibitions
4) Speculative Effect or Expected changes in prices: The law of demand does not
operate in case of speculative demand. When there is an expectation of further rise in
the price of a product or service, the demand increases more and more even with a
rise in price. Similarly, if there is an expectation that the price of a product or service
falls in future the demand also falls. Ex: Shares
5) Extra ordinary situations: During the times extra ordinary situations such as
emergency, wars, famines, riots, floods, strikes, etc., the consumer becomes abnormal
and buys products at any price available in the market. Due to the fear of scarcity of
products they buy more at higher prices.
6) Change in tastes and preferences: The changes in consumer needs, fashions, tastes,
preferences, customs, beliefs, etc., are also responsible to make the law of demand
ineffective. The quantity demanded will remain same irrespective of the change in
price.
ELASTICITY OF DEMAND
Elasticity of demand explains the relationship between a change in price and
consequent change in amount demanded. “Marshall” introduced the concept of elasticity of
demand. Elasticity of demand shows the extent of change in quantity demanded to a change
in price.
In the words of “Marshall”, “The elasticity of demand in a market is great or small
according as the amount demanded increases much or little for a given fall in the price and
diminishes much or little for a given rise in Price”.
Elastic demand: A small change or no change in price may lead to a great or infinite
change in quantity demanded. In this case, demand is “Elastic” (Ed>1).
In-elastic demand: If a large change in price is followed by a small change or no
change in quantity demanded then the demand in “Inelastic” (Ed<1).
Unitary demand: If the change in demand is exactly equal or proportionate to the
change in price, then it is “Unitary” (Ed=1).
3. Change in Income: The demand for various commodities are affected in different
degrees due to change in income. The change in income in case of comforts is less
elastic and incase of necessaries it is probably inelastic.
4. Postponement of Consumption: The demand for commodities, whose consumption
can be postponed for sometime, is elastic Ex: VCR, TV, etc. if prices are higher. The
demand for necessities such as food grains are inelastic, they cannot be postponed.
5. Tastes and Preferences: When a customer is particular about his taste and
preference, the product is said to be in elastic. Ex: Colgate, Tate Tea, etc.
6. Complementary products: In case of complementary goods having joint demand the
elasticity is low.
7. Availability of Substitutes: The demand for commodities having substitutes is
elastic, because if there is increase in price of a product, we use other products. Ex:
gas, kerosene, coal, electricity, etc. The commodities having no substitutes are
inelastic.
8. Price level: Generally the demands for very costly or very cheap goods are inelastic.
Ex: Car and salt. The increase in price of car by Rs.10,000 will not make any
difference in its demand. Similarly changes in very cheap goods do not have any
effect on demand.
9. Durability of the product: Where the product is durable in case of consumer
durables such as TC, the demand is elastic. In case of perishable goods it is inelastic.
10. Government Policy: When the policy is liberal, the demand for the product is elastic
demand and vice-versa.
Example:
Price Quantity ∆Q = 2
8 10 ∆P = 4
4 12 P=8
Q = 10
2/10 2 8
Ed = or × = 0.4 (Inelastic)
4/8 4 10
P D
Price
0 Q Q1 X
Quantity
The demand curve DD is horizontal straight line or parallel to X-axis. It shows
the at “OP” price any amount is demand and if price increases, the consumer will not
purchase the commodity.
Price
P1
0 Q X
Quantity
D
P
P1
Price
D
0 Q Q1 X
Quantity
The demand curve DD is in the shape of Rectangular Hyperbola. When price
falls from ‘OP’ to ‘OP1’ quantity demanded increases from ‘OQ’ to ‘OQ1’. Thus a
change in price has resulted in an equal change in quantity.
D
P
D
P1
Price
0 Q Q1 X
Quantity
Here the demand curve is inclined to X-axis or curve will be flatter. When price falls
from ‘OP’ to ‘OP1’, amount demanded increase from ‘OQ’ to ‘OQ1’ which is larger than the
change in price.
P1
Price
0 Q Q1 X
Quantity
Unit-I: Introduction to Managerial Economics 1.14
Here the demand curve is inclined towards Y-axis or the curve will be steeper. When
price falls from ‘OP’ to ‘OP1‘, amount demanded increases from OQ to OQ1, which is
smaller than the change in price.
5/20 5 4000
Ed = or × = 1 (unitary)
1000/4000 1000 20
Quantity
Unit-I: Introduction to Managerial Economics 1.15
(b) Income elasticity of demand less than unity: For a given proportionate rise in the
consumer’s income, there is a smaller proportionate rise in the quantity demanded of a
commodity. The income elasticity of demand is less than unity in case of necessaries.
(EI < 1).
Quantity
(c) Unitary income elasticity: A given proportionate rise in the consumer’s income is
accompanied by an equally proportionate rise in the quantity demanded of a
commodity and vice versa (EI=1).
Quantity
2. Zero Income Elasticity: A given increase in the consumer’s income does not result in
any increase in the quantity demanded of a commodity (E I =0).
Quantity
3. Negative income elasticity: A given increase in the consumer’s money income is
followed by an actual fall in the quantity demanded of a commodity. This happens in
the case of economically inferior goods (E I < 0).
Quantity
The income elasticity of demand is negative, when an increase in income leads
to decrease in quantity demanded.
Unit-I: Introduction to Managerial Economics 1.16
1. Substitutes: Substitutes in consumption are goods that can be used in place of each
other. The cross elasticity for substitutes in consumption is positive. This is because a
rise in the price of good Y will cause people to substitute the cheaper good X for Y.
Example: Pepsi & Coke.
D1 D2
P D
Price
0 Q Q1 X
Quantity
Unit-I: Introduction to Managerial Economics 1.17
2. Complements: Complements are goods that are consumed together. The cross
elasticity for complements in consumption is negative. This is because a rise in the
price of good Y will cause people to consume less of good Y. since they consume X
& Y together, they will consume less of good X as well. Example: Coffee & Sugar.
Quantity
Price of Petrol Price of Car
demanded Car
70 100 10
80 100 20
Y
D2 D1
P D
Price
0 Q Q1 X
Quantity
3. More than Elastic Demand (EA>1): The sales increase at a higher rate than the rate
of increase in advertisement expenditure.
4. Unitary Elasticity of Demand (EA=1): The sales increase in proportion to the
increase in expenditure on advertisement.
DEMAND FORECASTING
Demand Forecasting refers to an estimate of future demand for the product. It is an
“objective assessment of the future course of demand”. Forecasting helps the firm to assess
the probable demand for its products and plan its production accordingly.
Demand forecasting is helpful not only at firm level but also at national level. It is the
key driver for success or failure. It is essential to guard the future against any surprises.
Demand forecast relate to production inventory control, timing, reliability of forecast, etc. It
is an essential element to make business decisions to foresee the future and act accordingly.
4. Test Marketing:
Firms resort to test marketing while launching a new product or likely to change the
design or model of the existing products. This is also known as controlled experimentation
method as the product is likely to be launched in a segmented market to identity its demand
potential. The essential prerequisites of test marketing are that the product price, its design,
quality, level of advertisement and sales promotion campaign should be equal in promotion to
that of what the firm is likely to incur had it been released in the national market.
of the input-output coefficients. Once the demand for the final goods estimated, the demand
for the intermediate product can be easily arrived at using the input-output coefficients.
The basic assumption here is that the relationship between the various factors remains
unchanged in future period also.
Certain statistical formulae are used to find the trend line which fits the available data.
The estimating trend line is projected by a linear equation.
Y = a + bX
where,
Y = future sales
X = period for a certain commodity
a = Y axis intercept i.e, constant
b = Coefficient of the determining variable x
The value of a & b can be calculated as follows:
Σy=Na+bx
Σxy=aΣx+bΣx2
where,
N = No. of years or months for which data is available.
e) Exponential Smoothing:
This technique is an improvement over moving averages method. Unlike in moving
averages method, all the time periods are assigned weights in order that nearest one gets
higher weight and distant one gets lower weight. This method proves more realistic when the
data is consistent all through the year, unaffected by wide seasonal fluctuations. It is used for
short run demand forecasts. The formula for exponential smoothing is:
St + 1 = cSt + (1 – c) Smt
Where,
St + 1 = exponentially smoothed average for a new year
St = actual data in the most recent past
Smt = most recent smoothed forecast
c =smoothing constant
simple method. It is a useful method for short-term forecasting. It is not applicable for long-
term forecasting.
IMPORTANT QUESTIONS
1. Define Managerial Economics? Explain the nature and scope of managerial
economics?
2. What is Demand? Explain the various determinants of demand?
3. What is law of demand? Explain the exceptions of law of demand?
4. What do you understand by elasticity of demand? Explain the factors governing it.
5. What are the types of elasticity of demand? Explain them diagrammatically.
6. Distinguish various types of price elasticity of demand. Discuss the factors on which
the elasticity of demand depends.
7. What is demand forecasting? Explain different methods of demand forecasting.
Unit-II: Theory of Production and Cost Analysis 2.1
UNIT - II
THEORY OF PRODUCTION AND COST ANALYSIS
PRODUCTION FUNCTION
The term Production function refers to the relationship between the inputs and outputs
produced by them in physical terms. The production function may be defined as the
functional relationship between physical inputs (i.e. the factors of production) and physical
outputs (i.e. the quantity of goods produced).
According to Watson - “Production function is the relation between physical inputs
and outputs of a firm”. A production function includes a wide range of inputs like Land,
Labour, Capital, Organization, and Technology. Algebraically, it may be expressed in the
form of an equation as:
Q = f (L, La, K, O, T)
where,
Q stands for the output of a good per unit of time;
f refers to the functional relationship;
L for land (or natural resources);
La for labour (or employees);
K for capital (or investment);
O for organization (or management); and
T for given technology.
ISO – QUANTS
The term ‘Iso’ is derived from a Greek work which means ‘Equal’ and the term
‘Quant’ is derived from a Latin word which means ‘Quantity’. Iso-Quant means equal
quantity throughout the production process. It is defined as a curve which shows different
combinations of two inputs producing same level of output. It is also called ‘Iso-Product
Curve’.
The producer is indifferent as to which combination he uses for producing the same
level of output, so it is also known as ‘Product Indifference Curve’ or ‘Equal Product Curve’
or ‘Production function with two variables’.
Iso-Quant Schedule
Combinations Labour Capital Output (units)
A 1 20 1000
B 2 15 1000
C 3 11 1000
D 4 8 1000
E 5 4 1000
Unit-II: Theory of Production and Cost Analysis 2.2
In the above schedule, there are five possible combinations. All the five combinations
yield the same level of output i.e. 1000 units. 20 units of labour and 1 unit of capital produce
1000 units. 15 units of labour and 2 units of capital also produce 1000 units and so on. All
combination are equally likely because all of them produce the same level of output i.e. 1000
units. Now if plot these combination of labour and capital, we shall get a curve. This curve is
known as an Iso-quant.
The table shows different combinations of input factors to yield an output of 100 units
of output. The degree of convexity of isoquants depends upon the rate at which marginal rate
of technical substitution changes. The greater the rate at which MRTS falls, the greater the
convexity of the isoquants and vice-versa. The graphical representation of an Iso-Product
schedule is Iso-Quant Curve.
Iso-Quant Map:
A group or a set of Iso-Product curves representing different levels of output shown
on a graph is called Iso-Quant Map. A higher Isoquant shows a higher level of output and a
lower Isoquant represents a lower level of output.
Unit-II: Theory of Production and Cost Analysis 2.3
Features of Iso-Quant:
1. Slopes downwards from left to right: Isoquants have negative slope. This is so
because, when the quantity of one factor (say, ‘X’) is increased, the quantity of other
factor (say, ‘Y’) must be reduced, so that total product remains constant. If, however,
the marginal productivity of the factor becomes negative, the isoquant bends back and
acquires positive slope.
2. Do not intersect each other: Intersection of isoquants showing different levels of
output is a logical contradiction. It would mean that isoquants representing different
levels of output are showing the same amount of output at the point of intersection,
which is wrong. Thus, we rule out the following cases in case of isoquants.
3. Do not touch the axes: Isoquants do not touch both x-axis and y-axis as one input
factor (labour) is increasing the other input factor (capital) is decreased in a
proportionate rate.
4. Convex to point of origin: This property of isoquants is based upon the ‘Principle of
Diminishing Marginal Rate of Technical Substitution’. Employment of each
successive unit of one factor (say, labour) will be required to compensate for smaller
and smaller sacrifice of the other factor (say, capital) so as to maintain the same level
of output. Concave shape of the isoquants would be against the above principle of
‘Diminishing Marginal Rate of Technical Substitution’.
ISO - COSTS
Iso-Cost line represents different combinations of two factors which the producer can
get for a certain amount of given money at given prices of the factors. If the production
changes the total cost also changes. Ex: Suppose a producer is having Rs.500. If the price of
units of labour is Rs.10, he can buy 50 units of labour. If the price of unit of capital is Rs.5,
he can buy 100 units of capital. Thus Iso-Cost curve moves upwards.
Capital
Ic3000
Ic2000
Ic1000
0 Labour x
An isocost line (equal-cost line) is a Total Cost of production line that recognizes all
combinations of two resources that a firm can use, given the Total Cost (TC). Moving up or
down the line shows the rate at which one input could be substituted for another in the input
market.
Unit-II: Theory of Production and Cost Analysis 2.4
2-1 1
MRTS = = =1:5
20-15 5
The table presents the ratio of MRTS between two input factors, capital and labour. 5
units of decrease in labour are compensated by an increase of 1 unit of capital i.e. 5:1. It is
also important to note that the marginal rate of technical substitution is the ratio of
marginal productivity of labour to marginal productivity of capital.
C
Capital B
IQ300 units
A
IQ200 units
IQ100 units
0 Ic1000 Ic2000 Ic3000 x
Labour
Unit-II: Theory of Production and Cost Analysis 2.5
When one input is variable and others are held constant, the relations between the
input and the output are divided into three stages. The law of variable proportion may be
explained under the following three stages as shown in the graph.
Stage-I: The total product increases at an increasing rate, the marginal product
increases at an increasing rate resulting in a greater increase in total product. The
average product also increases. This stage continues up to the point where average
product is equal to marginal product. It is known as Stage of Increasing Returns.
Stage-II: The total product increases only at a diminishing rate. The average product
also declines. The second stage comes to an end where total product becomes
maximum and marginal product becomes zero. It is stage of Diminishing Returns.
Stage-III: The marginal product becomes negative, the total product also declines.
The average product continues to decline. This is stage of Negative Returns.
4+8 28 10
5 + 10 38 10 Constant
6 + 12 48 10
7 + 14 56 8
Decreasing
8 + 16 62 6
Output B Constant C
Increasing Decreasing
A D
0 scale of production x
The exponents ‘a’ and ‘1 – a’ are the elasticity of production that is, ‘a’ and ‘1- a’
measure the percentage response of output to percentage changes in labour and capital
respectively. The function estimated for the USA by Cobb and Douglas is:
Q = 1 L0.75 C0.25
R2 = 94.09
This production function shows that a 1 per cent change in labour input, with the
capital remaining constant, is associated with a 0.75 per cent change in output. Similarly, a 1
per cent change in capital, with the labour remaining constant, is associated with a 0.25 per
cent change in output. The coefficient of determination (R2) means that 94 per cent of the
variations on the dependent variable (P) were accounted for, by the variations in the
independent variables (L and C). That is, if L and K are each increased by 20%, then P
increases by 20%.
In these terms, the assumptions made by Cobb and Douglas can be stated as follows:
1. If either labor or capital vanishes, then so will production.
2. The marginal productivity of labor is proportional to the amount of production per
unit of labor.
3. The marginal productivity of capital is proportional to the amount of production per
unit of capital.
COST ANALYSIS
Cost refers to the expenditure incurred to produce a particular product or service. The
costs may be monetary or non-monetary, tangible or intangible etc. The cost of production
includes cost of raw materials, labour, and other expenses. This cost is known as Total Cost
(TC) and it is compared with Total Revenue (TR) which is realized on sale of products and
the difference is Profit (P).
P = TR – TC
Profit is the ultimate aim of any business. The firm should therefore aim at controlling
and minimizing cost.
COST CONCEPTS:
A managerial economist must have a clear understanding of the different cost
concepts for clear business thinking and proper application. The various relevant concepts of
cost are:
The above graph shows the break- even point of an organization. The total revenue
curve (TR) and total cost curve (TC) is given. When they produce 50 units the total cost and
total revenue are equal that is Rs.150000 which is at the intersecting point of the curves.
Breakeven point always denotes the quantity produced or sold to equalize the revenue and
cost.
Unit-II: Theory of Production and Cost Analysis 2.11
When the firm produces less than 50 units the revenue earned is less than the cost of
production (TR<TC) therefore in the initial period the firm incurs loss which is shown in the
graph. Through selling more than 50 units the revenue increases more than the cost of
production therefore the difference increases and provides profit to the organization
(TR>TC).
Contribution = S – V (or) F + P
Contribution per unit = Sales per unit – VC per unit
Contribution Ratio = (S – V / S) x %of sales
Unit-II: Theory of Production and Cost Analysis 2.12
Sales when profit is ‘x’ = Sales – Variable cost = Fixed cost + Profit (or)
S–V=F+P (or)
F+P/S–V (or)
F+P/C
ILLUSTRATIONS
1. If sales are 10,000 units and selling price is Rs. 20 per unit, variable cost Rs. 10 per unit
and fixed cost is Rs. 80,000. Find out BEP in units and sales revenue. What is profit
earned? What should be the sales for earning a profit of Rs. 60,000/-.
Solution:
(a) BEP (units) = FC / Contribution
= 80000 / 10 = 8000 units
Contribution = Sales – VC = 20 – 10 = 10
(iv) Verification:
i) Contribution at BEP – FC = 0
(16000 units x 15) – 240000 = 0
ii) Sales – BEP sales
Unit-II: Theory of Production and Cost Analysis 2.14
3. A firm manufactures two products viz. P and Q. The firm wants to drop the product Q as
it is yielding less contribution per unit and add the product R. By adding the product R,
the new fixed cost is likely to be Rs. 2,50,000/- and the sales volume will increase to
Rs.18,00,000/- Consider the following information and suggest whether the firm should
change the product or not.
Solution:
(a) Existing Product-mix
Contribution ratio for product P & Q =
(Selling price – Variable cost / Selling price) x percentage of total sales
Product P = (80 - 32 / 80) x 0.60 = 0.36
Product Q = (100 - 40 / 100) x 0.40 = 0.24
Recommendation:
The profit in proposed product-mix is higher than the existing product mix and hence the firm
can change the product mix.
Unit-II: Theory of Production and Cost Analysis 2.15
4. A company estimates its fixed costs for the year at Rs. 8, 00,000 and its profit target at
Rs.2,00,000. Each unit of product is sold at Rs. 10 and variable cost per unit is Rs.8.
What sales level must the company achieve in order to realize its profit goal?
Solution:
Sales to get a profit of Rs.200000
S=F+P/C
= 800000 + 200000 / (10-8)
= 1000000 / 2 = 500000 units
Sales = 500000 units x 10 = Rs.5000000
Verify:
Profit = Sales – VC – FC
= 5000000 – (500000 x 8) – 800000
= 5000000 – 4000000 – 800000
= 200000
IMPORTANT QUESTIONS
1. Define production function? What are the types of production function? Explain
Cobb-Douglas production function?
2. Explain the concepts of Iso-Quants and Iso-Costs. Analyze how the manufacturer
reaches the least cost combination of inputs. Illustrate.
3. Define returns to scale. What is the significance of increasing, decreasing and
constant returns to scale?
4. Explain different cost concepts which are essential for business decisions.
5. What are Laws of Variable Proportions? Illustrate with an illustration.
Unit-II: Theory of Production and Cost Analysis 2.16
6. What is meant by Break Even Analysis? Explain its significance and limitations?
7. You are required to calculate.
i. Margin of Safety
ii. Total sales
iii. Variable cost from the following figures;
Fixed costs Rs. 12, 000
Profit Rs. 1, 000
Break-Even Sales Rs.60, 000
10. Sales are Rs. 1, 10,000 Yielding a profit of Rs. 4,000 in period-I; Sales are
Rs. 1, 50,000 with a profit of Rs. 12,000 in period-II. Determine BEP and Fixed Cost.
11. The P/V Ratio of Matrix Books Ltd is 40% and the Margin of safety is 30%. You are
required to work out the BEP and Net Profit, if the Sales Volume is Rs.14,000.
13. A Company prepares a budget to produce 3, 00,000 Units, with fixed costs as Rs. 15,
00,000 and average variable cost of Rs.10 per unit. The selling price is to Yield 20%
profit on Cost. You are required to calculate
a) P/V Ratio
b) BEP in Rs and in Units.
Unit-II: Theory of Production and Cost Analysis 2.17
14. If sales are 20,000 units and selling price is Rs 15 per unit, variable cost Rs. 10 per
unit and fixed cost is Rs. 1, 00,000. Find out BEP in units and in sales rupee value.
What is profit earned? What should be the sales for earning a profit of Rs. 50,000
16. You are given the following information about two companies in 2000