LECTURE NOTES

ON
BUSINESS ECONOMICS & FINANCIAL ANALYSIS

Prepared
BY

G.Ramesh
Assistant Professor

Department of Management Studies

Vardhaman College of Engineering
 INTRODUCTION TO BUSINESS AND ECONOMICS
The term ‘business’ means to be ‘busy’ or ‘occupied’. In practice, business includes
certain economic activities in which people are busy or engaged. Such activities relate
to production, distribution, trading or exchange of goods and services to satisfy the
needs of people so as to earn income or profit.
Business refers to the economic activities concerned with the production and
exchange of goods and services, primarily pursued with the objective of earning profits.
A business (or firm) is an enterprise that provides products or services desired
by customers. Along with the large, well-known businesses such as – The Coca-Cola
Company and IBM, there are many thousands small businesses that provide employment
opportunities and produce products or services that satisfy customers.
Definition of Business
“Business may be defined as human activity directed towards or acquiring wealth
through buying and selling of goods.” – Lewis H. Haney
“Business may be defined as an activity in which different persons exchange
something of value, whether goods or services, for mutual gain or benefit” – Peterson
and Plowman
“Business is an enterprise engaged in the production and distribution of goods
for sale in the market or rendering service for a price.” – R. N. Owens
“Business is an institution organized and operated to provide goods and services
to society under the incentive of private gain.” —B.O. Wheeler.
“All the activities including the production and sale of goods or services may be
classified as business activities.” —William Spriegel

Stephenson defines business as, "The regular production or purchase and sale of
goods undertaken with an objective of earning profit and acquiring wealth through the
satisfaction of human wants."
According to Dicksee, "Business refers to a form of activity conducted with an
objective of earning profits for the benefit of those on whose behalf the activity is
conducted."
Lewis Henry defines business as, "Human activity directed towards producing or
acquiring wealth through buying and selling of goods."
Feature of business
1. Exchange of goods and services: All business activities are directly or indirectly
concerned with the exchange of goods or services for money or money's worth.
2. Deals in numerous transactions: In business, the exchange of goods and
services is a regular feature. A businessman regularly deals in several
transactions and not just one or two transactions.
3. Profit is the main objective: The business is carried on with a motive to earn a
profit. The profit is a reward for the services of a businessman.
4. Business skills for economic success: Anyone cannot run a business. To be a
good businessman, one needs to have good business qualities and skills. A
businessman needs experience and skill to run a business.
5. Risks and Uncertainties: Business is subject to risks and uncertainties. Some
risks, such as risks of loss due to fire and theft can be insured. There are also
uncertainties, such as loss due to change in demand or fall in price cannot be
insured and must be borne by the businessman.
6. Buyer and Seller: Every business transaction has a minimum of two parties that
is a buyer and a seller. Business is nothing but a contract or an agreement
between buyer and seller.
7. Connected with production: The business activity may be connected with the
production of goods or services. In this case, it is called as industrial activity. The
industry may be primary or secondary.
8. Marketing and Distribution of goods: The business activity may be concerned
with marketing or distribution of goods in which case it is called a commercial
activity.
9. To satisfy human wants: The businessman also desires to satisfy human wants
through the conduct of business. By producing and supplying various
commodities, businessmen try to promote consumer's satisfaction.
10. Social obligations: Modern business is service-oriented. Modern businessmen
are conscious of their social responsibility. Today's business is service-oriented
rather than profit-oriented.
 BUSINESS STRUCTURE

Business structure refers to the legal structure of an organization that is recognized

in a given jurisdiction. An organization’s legal structure is a key determinant of the activities
that it can undertake, such as raising capital, responsibility for obligations of the business, as
well as the amount of taxes that the organization owes to tax agencies.

Sole Proprietorship

Sole Proprietorship in simple words is a one-man business organisation. Furthermore, a sole

proprietor is a natural person(not a legal person/entity) who fully owns and manages this type
of entity. In fact, the business and the man are the same, it does not have a separate legal entity.
In addition, a sole proprietorship usually does not have to be incorporated or registered. Thus,
it is the simplest form of business structure and the ideal choice to run a small business or
medium scale business. Let us look at some important features of a proprietorship.

Features of Sole Proprietorship

1] Lack of Legal Formalities: A sole proprietorship does not have a separate law to govern it.
And so there are not many special rules and regulations to follow. Furthermore, it does not
require incorporation or registration of any kind. In fact, in most cases, we need only the license
to carry out the desired business.
And just like in its formation, there is hardly any legal process involved in its closure. All in all, it
allows for ease of doing business with minimum hassles.
2] Liability:Since there is no separation between the owner and the business, the
personal liability of the owner is also unlimited. So if the business is unable to meet its own
debts or liabilities, it will fall upon the proprietor to pay them. For instance, he may have to sell
all of his personal assets (like his car, house, other properties etc) to meet the debts or liabilities
of the business.
3] Risk and Profit: The business owner is the only risk bearer in a sole proprietorship. Since he
is the only one financially invested in the company. As a result, he must also bear all the risk. In
other words, if the business fails or suffers losses he will be the one affected.
However, he also enjoys all the profits from the business. He does not have to share his profits
with any other stakeholders since there are none. So he must bear the full risk in exchange for
enjoying full profits.
4] No Separate Identity: In legal terms, the business and the owner are one and the same. No
separate legal identity will be bestowed upon the sole proprietorship. So the owner will be
responsible for all the activities and transactions of the business.
5] Continuity: As seen above the business and the owner has one identity. So a sole
proprietorship is entirely dependent on its owner. The death, retirement, bankruptcy. insanity,
imprisonment etc will have an effect on the sole proprietorship. In such situations, the
proprietorship will cease to exist and the business will come to an end.
6] All Profits or Losses to the Proprietor:Being the sole owner of the enterprise, the
proprietor enjoys all the profits earned and bears the full brunt of all losses incurred by the
enterprise.

Advantages:
1. Simple Form of Organisation:Proprietorship is the simplest form of organisation. The
entrepreneur can start his/her enterprise after obtaining license and permits. There is no need
to go through the legal formalities. For starting a small enterprise, no formal registration is
statutorily needed.
2. Owner’s Freedom to Take Decisions:The owner, i.e. the proprietor is free to make all decisions
and reap all the fruits of his labour. There is no other person who can interfere or weigh him
down.
3. High Secrecy:Secrecy is another major advantage offered by proprietorship. This is because
the whole business is handled by the proprietor himself and, as such, the business secrets are
known to him only.Added to it, the proprietor is not bound to reveal or publish his accounts. In
present day business atmosphere, the less a competitor knows about one’s business, better off
one is. What the competitors can make is guesstimates only.

4. Tax Advantage:As compared to other forms of ownership, the proprietorship form of

ownership enjoys certain tax advantages. For example, a proprietor’s income is taxed only

once while corporate income is, at occasions taxed twice, say, double taxation.
5. Easy Dissolution:In proprietorship business, the entrepreneur is all in all. As there are no co-
owners or partners, therefore, there is no scope for the difference of opinion in the case the
proprietor/entrepreneur-wants to dissolve the business. It is due to the easy formation and
dissolution, proprietorship is often used to test the business ideas.
Disadvantages:
1. Limited Resources:A proprietor has limited resources at his/her command. The proprietor
mainly relies on his/her funds and savings and, to a limited extent, borrowings from relatives
and friends. Thus, the scope for raising funds is highly limited in proprietorship. This, in turn’
deters the expansion and development of an enterprise.
2. Limited Ability:Proprietorship is characterised as one-man show. One man may be expert in
one or two areas, but not in all areas like production, finance, marketing, personnel, etc. Then,
due to the lack of adequate and relevant knowledge, the decisions taken by him be imbalanced.
3. Unlimited Liability:Proprietorship is characterised by unlimited liability also. It means that
in case of loss, the private property of the proprietor will also be used to clear the business
obligations. Hence, the proprietor avoids taking risk.

4. Limited Life of Enterprise Form:The life of a proprietary enterprise depends solely upon

the life of the proprietor. When he dies or becomes insolvent or insane or permanently

incapacitated, there is very likelihood of closure of enterprise. Say, enterprise also dies with

its proprietor.

PARTNERSHIP

A partnership is created when two or more people come together intending to operate a
business and decide to share the profits, risks, and liabilities. It exists even if the parties involved
don’t have a written contract and might not even be aware that they’ve created a partnership.

A partnership is a kind of business where a formal agreement between two or more people
is made who agree to be the co-owners, distribute responsibilities for running an

organization and share the income or losses that the business generates.

In India, all the aspects and functions of the partnership are administered under ‘The Indian

Partnership Act 1932’. This specific law explains that partnership is an association between

two or more individuals or parties who have accepted to share the profits generated from

the business under the supervision of all the members or behalf of other members.
Features of Partnerships

1. Agreement
The definition of the partnership itself makes it clear that there must exist an agreement
between partners to work together and share profits amongst them. Partners may make such
an agreement either orally or in writing. If it exists in written form, we refer to such an
agreement as a partnership deed.

Such written or oral agreement between partners must ensure that they are clear on
their status as partners of their firm. This includes details pertaining to their work as partners,
the firm’s businesses, their profit and loss sharing ratio, etc.

2. Business
The existence of a business is an essential feature of partnerships. There can be no formal
partnership under the Partnership Act if the partners carry out charitable activities. Section 2
says that business includes any trade, profession or occupation. What is essential is that the
firm must work with the intention of earning profits.
3. Profit sharing
A partnership does not exist unless partners share the profits of their firm. A person who works
for the partnership business without having a share in its profits may be an employee, but not
a partner. It is noteworthy to point out that the law only requires the sharing of profits amongst
partners. Consequently, all partners need not share losses as well.

4. Principal-agency relationship
A partnership firm’s business may be conducted either by all partners together or by one
partner acting on behalf of all others. We commonly refer to such a peculiar relationship
between partners as the principle of agency.

This principle means that all partners are agents for each other. The decisions of one partner
taken in the ordinary course of business will bind other partners as well. All partners are liable
for acts of the firm individually and severally.

5.Two or More Persons: In order to manifest a partnership, there should be at least two (2)
persons possessing a common goal. To put it in other words, the minimal number of partners
in an enterprise can be two (2). However, there is a constraint on their maximum number of
people

Sharing of Profit: Another significant component of the partnership is, the accord between
partners has to share gains and losses of a trading concern. However, the definition held in
the Partnership Act elucidates – partnership as an association between people who have
consented to share the gains of a business, the sharing of loss is implicit. Hence, sharing of
gains and losses is vital.

Mutual Business: The partners are the owners as well as the agent of their firm. Any act
performed by one partner can affect other partners and the firm. It can be concluded that
this point acts as a test of partnership for all the partners.
TYPES OF PARTNER
Active or managing partner
An active partner participates in a company's management. Referred to as material
participants, active partners invest in the partnership and participate in its day-to-day
activities to maximise their returns. They typically hold some of the most important
positions and can serve in various roles, including those of a manager, advisor, organiser and
controller of the company's operations. The active partner may withdraw compensation
from the business, subject to the partnership deed's terms and conditions. Additionally, they
are completely liable for any debts.
An active partner participates in a company's management. Referred to as material
participants, active partners invest in the partnership and participate in its day-to-day
activities to maximise their returns. They typically hold some of the most important
positions and can serve in various roles, including those of a manager, advisor, organiser and
controller of the company's operations. The active partner may withdraw compensation
from the business, subject to the partnership deed's terms and conditions. Additionally, they
are completely liable for any debts.
They serve as agents and manage everyday tasks on behalf of all the other partners. Any
decision made by an active partner in the regular course of business is binding on the
company and other partners. When leaving the partnership firm, an active partner publicly
announces their intention to resign from the company to release themselves from
responsibility for the actions of the remaining partners. Without issuing public notification,
they would still be responsible for the actions of the other partners post-retirement.
2. Inactive or sleeping partner
An inactive partner is not involved in the day-to-day operations of the partnership firm. But
other partners might consult with them when making important decisions for the company.
Similar to other partners, a sleeping partner contributes a fair portion of capital to the
business and shares its gains and losses. Outsiders may not be aware of this partner's
relationship, but they invest in the company and are responsible for paying off any debts on
the company's behalf. They have limited financial obligations and liability to the business.
A person who is financially capable and interested in the company but cannot work full-time
in the business can take on the role of an inactive partner. The actions of all the other
partners are binding on them. Unlike an active partner, it is not necessary for a sleeping
partner to give public notice if they choose to leave the partnership. The firm cannot allow
them to withdraw compensation because they are not involved in the day-to-day
management of the company. If the partnership agreement does pay inactive partners, it is
not deductible under the Income Tax Act of 1961.
3. Nominal partner
A nominal partner has no substantial stake in a partnership firm. They do not participate in
the operation of the company and merely lend their name to it. They make no capital
investments in the company and hence do not share in its profits. But the nominal partner is
still responsible for the actions of any other partners when dealing with third parties and
outsiders. They are also responsible for paying the firm's debts back to its creditors.
The company might increase its sales or gain greater market credibility by leveraging the
nominal partner's name. For instance, a business can establish a partnership with a celebrity
or business tycoon. This can provide value to the company and improve its brand image by
leveraging the individual's notoriety and goodwill. The nominal partner may agree to this
arrangement in exchange for money or any other form of compensation.
4. Partner by estoppel or holding out
A partner who indicates through their words, deeds or conduct that they are a partner in the
firm is a partner by estoppel. Even if they are not actually a partner in the company, they may
have presented themselves in a way that legally binds them to become a partner by estoppel.
Also, if a company names a person as a partner and the person knows this but does not object
to or reject the partnership, people can assume their consent, and thus they legally become
a partner by estoppel for that firm. Later, they cannot deny being a partner.
Although this partner does not participate in the firm's management or capital contributions,
they are nevertheless responsible for the credits and loans the company obtains. There are
two basic requirements for establishing a partner by estoppel—the individual represents
they are a partner of a firm either orally, in writing or via their conduct, and a third party
acts with knowledge of that representation. The individual who introduces themselves as a
partner is responsible for any financial losses caused to the third party because of the
representation, provided the third party can establish it in court.
5. Partner in profits only
A partner who enters the partnership firm as a 'partner in profits only' partakes in profits
but is not responsible for any losses. Even when engaging with third parties, they are only
accountable for their profit-making activities and do not share any other liabilities. They do
not participate in firm management and are not accountable for the company's business
decisions. These types of partners often join a company for its money and goodwill.
They are accountable to third persons for their acts of gain, though. This means a third party
could hold this partner responsible if the business suffers a loss and the other partners go
bankrupt. The third party may not concern themselves with the internal arrangement of only
sharing profits because it is a private arrangement among the partners. When other partners
cannot pay up, the 'partner in profits only' becomes accountable for the firm's liabilities.
They can then reimburse the third party for their losses or contributions to the firm.
6. Minor as a partner
A minor, or someone under the age of 18, cannot be a formal partner in any partnership firm
as per the Contract Act. But, if other business partners agree, they may still be eligible for a
partnership. A minor may partake in a company's profits, but they are only liable for their
capital contribution if the company suffers a loss. After reaching maturity or turning 18, a
minor partner has six months to determine whether they want to stay on as a partner or
leave the firm. They declare this by a public notice in both situations.
They become subject to the firm's unlimited liability as of the day they gained the benefits of
a partnership if they fail to offer any notice within six months or decide to stay. Additionally,
they gain the right to actively participate in running the company's operations. If a minor
chooses not to become a partner, their liabilities and rights remain those of a minor until the
day of public notification. Any actions the company takes after the notice date are not subject
to liability for their share.
7. Secret partner
A secret partner is a partner whose affiliation with the company is unknown to the broader
public. The secret partner occupies the space between the active and sleeping partners. They
invest capital, enjoy profits, share losses, take part in business management and are subject
to unlimited liability. But they keep their membership a secret from outsiders and other
parties. A silent partner is similar to a secret partner but does not have the right to take part
in business management
PARTNERSHIP DEED
A partnership is a kind of business where a formal agreement between two or more people
is made. They agree to be co-owners, distribute responsibilities for running an organisation
and share the income
e or losses that the business generates. These features of partnerships are documented in
a document which is known as partnership deed.
Partnership deed is a partnership agreement between the partners of the firm which
outlines the terms and conditions of the partnership between the partners. The purpose of a
partnership deed is to provide clear understanding of the roles of each partner, which
ensures smooth running of the operations of the firm.

REGISTRATION OF PARTNERSHIP DEED:

All the rights and responsibilities of each member are recorded in a document known as a
Partnership Deed. This deed can be oral or written; however, an oral agreement is of no use
when the firm has to deal with tax. A few essential characteristics of a partnership deed are:

• The name of the firm.

• Name and addresses of the partners.
• Nature of the business.
• The term or duration of the partnership.
• The amount of capital to be contributed by each partner.
• The drawings that can be made by each partner.
• The interest to be allowed on capital and charged on drawings.
• Rights of partners.
• Duties of partners.
• Remuneration to partners.
• The method used for calculating goodwill.
• Profit and loss sharing ratio
 Joint-Stock Company

A Joint-Stock Company is co-owned by its shareholders. A shareholder’s stake depends on

the number of stocks owned by them. They are liable only to the extent of shareholding. Also,
stockholders can transfer their shares without any restriction.

This structure is chosen by a company to raise extensive capital—by issuing shares and
debentures to the public. These organizations resemble a corporate structure but, at the
same time, relish privileges of limited liability.

Joint-Stock Company Features

This ownership model differs from other structures due to its characteristics:

• Limited Liability: In this ownership model, shareholders have limited liability. Even if
the business suffers massive losses, shareholders’ personal wealth is insulated from it.
• Separate Legal Entity: The identity of the business is independent of its members.
• Voluntary Association: There is no restriction on the entry and exit of shareholders.
• Stock Transferability: Shareholders can sell their stocks to new investors—no permission
required.
• Perpetual Succession: These companies are separate legal entities; therefore, the
retirement, insolvency, or death of a member does not impact business continuity.
• Incorporation: The formation is a lengthy process—legally compliant with the Joint-Stock
Companies Act 1844. It, therefore, requires extensive documentation.
• Number of Members: The minimum number of members required is one—there is no
upper limit.
• Capital Acquisition: The company can issue shares and debentures —to raise capital.
 Types of Joint Stock Companies

Joint-stock companies are classified based on the following criteria:

1 – Based on Incorporation

• Registered Company: Any corporation incorporated under the Companies Act of a

particular state is called a registered company.
• Chartered Company: It is incorporated under the royal charter duly signed by the king of
the state where it is formed. These companies enjoy special privileges in executing
commercial business operations. The East India Company is one such example.
• Statutory Company: When the Parliament passes a special act in a company’s favor, it is
called a statutory company. These companies facilitate public utilities and amenities. The
act documents company’s rights, responsibilities, powers, and objectives.

2 – Based on the Number of Members

• Private Company: A private limited company satisfies three conditions: a) It limits the
number of members—specified in the relevant Companies Act b) It restricts the right to
transfer shares and c)prohibits any invitation to the public—issuance of shares
or debentures.
• Public Company: Generally, there is no upper limit on the number of members in
a publicly-traded company. Shareholders are free to purchase and sell company shares.
In addition, these companies can issue shares or debentures to the public.

3 – Based on Liability

• Unlimited Liability Company: In such a company, shareholders’ liabilities extend to

personal property and assets.
• Limited Liability Company: This is the most common business ownership model. The
liability is limited to the extent of the value of shares held by shareholders.
• Company Limited by Guarantee: The shareholders have to pay a fixed amount in the
event of liquidation. The specific amount is documented in the Memorandum of
Association.

4 – Based on Ownership

• Government Company: It is a company in which not less than 51% of the shares are held
by the central or state government or a combination of central or state governments.
• Non-Government Company: The majority stake is owned by private individuals or
institutions.
 Advantages

A Joint-Stock Company structure has the following merits:

• Capital Accumulation: The company issues shares and debentures to the public—
considerable capital is raised. The funds are used for business operations and expansion.
• Limited Liability of Members: In limited liability companies, shareholders are protected.
Business losses cannot impact shareholders’ personal property or assets.
• Share Transferability: The stockholders can sell off their shares to the other investors
without any restrictions.
• Shareholders’ Rights: Stockholders have the right to elect the Board of Directors—they
have a say in decision-making.
• Transparency: These companies disclose their financial reports and records to the
public—to ensure complete transparency.

Disadvantages

This ownership structure has the following demerits:

• Excessive Legal Formalities: The incorporation and administration of a joint-stock

company involve elaborate legal formalities.
• Costly Affair: The cost of formation and administration is quite high.
• Conflict of Interest: There may be disagreements and conflicts of interest between the
stakeholders (owners, employees, the Board of Directors, lenders, etc.).
• No Confidentiality: Financial reports must be disclosed to the public. There is a lack of
discretion.
• Double Taxation: Since the company’s profits and dividends (when declared) are taxable,
shareholders are subject to double taxation.

MEANING OF CORPORATION:

A corporation is a legal entity that is separate and distinct from its owners or stockholders.
It is an artificial being, created operation of law, having the right of succession and the
powers, attributes, and properties expressly authorized by law or incident to its existence.

The corporation is indeed a constitutionally formed company that has the ability to possess
possessions and borrow money. It’s a group of people who are currently expected to operate
as if they’re a single entity, with relevant provisions that are distinct from the groups that
make up the business.

Legalists is a term that is typically used to describe companies. This implies that companies,
like citizens, can enter into agreements, make loans funds, possess goods, bring lawsuits,
collect income, and initiate or suffer proceedings. Companies are in a number of different
forms, but the most proportion was employed for commercial purposes. The corporate
framework legislation, often known as community legislation, is by far the most special niche
of an organization.
Characteristics of Corporation
• A corporation is an artificial being with a personality separate and apart from its
individual shareholders or members.
• It is created by the operation of law. This means it cannot come into existence by mere
agreement of the parties as in the case of business partnerships. Corporations require
special authority or grant from the State, either by a special incorporation law that
directly creates the corporation or by means of general corporation law.
• It enjoys the right of succession. A corporation has the capacity for continued
existence regardless of the death, withdrawal, insolvency or incapacity of the
individual shareholders or members. The transfer of ownership of shares of stock
does not dissolve the corporation.
• It has the powers, attributes and properties expressly authorized by law or incident to
its existence. For example, an investment by a transportation company in an insurance
corporation designed to reduce insurance costs, may be interpreted as an act that is
reasonably requisite and necessary to carry out the business of land transportation.
It is because insurance costs from part of the legitimate expenses of a transportation
owner.

Advantages of a Corporation
• The corporation has the legal capacity to act as a legal entity.
• Shareholders have limited liability.
• It has continuity of existence.
• Shares of stock can be transferred without the consent of the other shareholders.
• Its management is centralized in the board of directors.
• Shareholders are not general agents of the business.
• Greater ability to acquire funds.

Disadvantages of a Corporation
• A corporation is relatively complicated in formation and management.
• There is a greater degree of government control and supervision.
• It requires a relatively high cost of formation and operation.
• It is subject to heavier taxation than other forms of business organizations.
• Minority shareholders are subservient to the wishes of the majority.
• In large corporations, management and control have been separated from ownership.
• Transferability of shares permits the uniting of incompatible and conflicting elements
in one venture.

TYPES OF CORPORATIONS

Publicly Held Corporation

A publicly held corporation is a corporation whose stock is sold to and owned by the public
instead of private investors. The shares of such corporations are traded on a public stock
exchange (e.g., the New York Stock Exchange or NASDAQ in the United States).
Closely Held Corporation
A closely held corporation is a corporation whose shares of common stock are owned by
relatively few individuals and are generally unavailable to outsiders.

Limited Liability Company (LLC)

A form of business organization with the liability-shield advantages of a corporation and
the flexibility and tax pass-through advantages of a partnership.

S Corporation
An S corporation is a special structure of business ownership by which the business can
avoid double taxation because it is not required to pay corporate income tax on the profits
of the company. All profits/losses are passed on directly to the shareholders of the
company. Unlike a C Corporation, an S Corporation must not have more than 100
shareholders and must have only one class of stock.

Professional Corporation
A professional corporation is a corporation consisting of professionals who are licensed to
practice a particular profession such as accountants, lawyers and doctors. These
professionals can form a corporation and take advantage of the various benefits of the
corporate structure such as limited liability of shareholders, continuity of life and
centralized management. However, shares in a professional corporation can only be
transferred to other individuals licensed to practice in the same profession.

Nonprofit Corporation
A nonprofit corporation is an organization formed for serving a purpose of the public other
than for the accumulation of profits. These corporations enjoy tax-exempt status; however,
specific requirements and limitations are imposed on their activities. Nonprofit
corporations are generally those that serve a scientific, literary, education, artistic or
charitable purpose that benefits the public.

LIMITED LIABILITY COMPANY: meaning

A limited Liability Company is a type of business company where owners don’t have to pay
for the company’s liability and debt. It is not a corporation, and it falls in the category of
hybrid entities. It means that LLC has the characteristics of both corporations and sole
proprietorship. It provides the advantage of limited responsibility like corporations and
single taxes like the partnership and sole proprietorship.

Characteristics of Limited Liability Company

Separate Legal Entity
As a separate legal entity means that LLC is legally divided and separate from its owners. In
simple words, LLC can run its business operations and carry on even if all the members have
withdrawn from it. When then do, it would recruit and hire new people, buy and sell assets,
and other stock of the company. In case of any misconduct, LLC would defend itself in the
court of law.
Protect Limited Liability
One of the most popular characteristics of LLC is the limited liability of its members. If the
company is involved in any kind of litigation or found guilty of bankruptcy, then its members
don’t have to pay from their income and assets. Its members won’t be responsible for the
company’s action. Banks and creditors can’t accuse its members of the company’s default
and come after its members.

LLC members will be liable and have to take responsibility for the misconduct and
wrongdoings of other LLC members. It is not like a partnership, where every partner is liable
for the actions of other partners.

Flexible Taxation
The characteristics of LLC that we have discussed so far provide the advantages of a
corporation. Taxation is one of those things that don’t go well with corporations, because
they have to pay double taxes. IRS doesn’t have a specific provision for the LLC, whether to
tax like corporation or partnership.

If you’re planning to tax like a partnership, then you have to pass the taxes through the
personal tax return of its members. That’s how you would be able to avoid double taxes,
because LLC doesn’t pay income taxes.

Operation & Management Flexibility

When we talk about the functionality of corporations, then there are so many formalities are
involved like an annual board meeting, shareholders meetings, and other meetings where
corporations are legally bound to record every minute of the meetings.

The functionality of LLC is much simpler and easier where it doesn’t have to conduct
meetings and record every minute of it. Management of record and other operations are also
much simpler than the corporation. The roles of members are also flexible comprising of
casual day to day activities. But it’s important to be familiar with the LLC laws of the country
before starting it.

Types of Limited Liability Company

Single Member LLC
Single Member LLC, as the name implies, is comprised of only one member. However, the
law doesn’t treat single-member LLC a separate legal entity. Therefore, its income has to pass
through the tax return of its member for taxes.

Multi-member LLC
Multi-member LLC is comprised of more than one member. Unlike single-member LLC, the
law treats multi-member LLC a separate legal entity. Therefore, they can enjoy the
advantages of corporations and partnerships.
Non-profit LLC
As the name implies, such companies are not for profit. Therefore, they can enjoy the no tax
benefits like churches and can have limited liability and flexibility like partnerships and
corporations. But some countries do not allow the formation of non-profit LLC.

Professional Limited Liability Company

People having a professional license like the doctor, engineer, architect, or lawyer can create
PLLC. The purpose of creating professional LLC is to provide medical, legal, and other
services.

Advantages of Limited Liability Company

Tax Option
LLC has an option of taxation that whether they want to be taxed like a partnership or
corporation; single taxes or double taxes depending on their choice. Usually LLC prefers
single taxes.

Unlimited Members
LLC doesn’t have a restriction on the number of its members. They can have as many
members as they want. They also have flexibility over the membership style like trusts,
estate, organization, etc.

Flexible Management
The management of LLC also has the flexibility of choosing the management style whatever
they choose. Like corporations, they don’t have to follow the pre-decided set of rules.

Fewer Formalities
Another for the flexible management style of LLCs that they involve fewer formalities. They
don’t have to conduct monthly and annual meetings, prepare reports, calling all the
shareholders for the meetings, and record and documenting everything.

Safe Personal Asset

One of the most important benefits of LLCs, that your assets like house, car, and bank balance
remain safe like corporate shareholders. In case of bankruptcy like sole proprietorship and
partnership, you have to liquidate your asset to meet the demands of creditors. But it doesn’t
happen in the case of LLC.

Disadvantages of Limited Liability Company

Expensive
Although LLC has many tax and liability benefits; but it is very difficult to raise capital for the
company. People prefer investing their capital in corporations rather than LLC because they
see LLC as a risky investment.

Ownership Transfer
It’s very difficult to transfer your ownership in LLC than corporations. That’s why people
prefer corporations, where transferring ownership is much easier.
Limited Life
Factors like no board of directors and difficulty in transferring ownership make the life of
LLC limited.

THEORIES OF THE FIRM

Profit Maximisation Theory

Business is for profit; so the golden rule of business is that, one who takes risks will reap
profits. This seems logical, doesn’t it? This is the most conventional thought, and also the
most widely accepted objective of a firm. Traditionally economists assumed that generation
of the largest amount of absolute profit over a period of time is the single most important
objective of a business organisation. This thought is based on the belief that an individual
would risk one’s capital and time for uncertain returns, only with the expectation of
generating profits. Thus, traditionally the efficiency of a firm is measured in terms of its profit
generating capacity; profit is the only internal source of funds; even the market value of a
firm is largely dependent upon profits earned. Another argument in favour of this objective
is that, profit is must for long-term survival of any business. Normally profit may be stated
as following:

Profit = Total Revenue – Total Cost …(1)

Nobel Laureate Milton Friedman supported profit maximisation on the ground that its
validity cannot be judged by opinions of some executives; rather its ultimate test of validity
is that it has greater ability to predict future business trends and practices. Others argue that
whatever may be stated as the objective of firm, the bottom line of balance sheet will always
be important, that is the profit earned. However, certain pertinent questions arise in
accepting profit maximisation as the objective of the firm. First of all, which measure of profit
to consider among gross profit, net profit, net profit after tax, and net profit before tax? The
list would go on. Another question is which period of time to take into account among current
year, next year, next five years, and next 10 years? When we talk of future profit then concept
of time value of money comes in. Often managers have reported that the pressure to focus
on short-term profit has led them to take such decisions which ultimately have adversely
affected the long-term growth of the company. At the same time, validity of profit
maximisation may also be questioned in competitive markets, because it may be simply
impossible to maximise profits in modern times of high customer awareness and highly
competitive markets

As is clear from the above discussion, accepting maximisation of profit as the objective of the
firm leaves various questions unanswered, and may even lead to a situation that answers to
all of these questions would vary from firm to fi rm. All these, and similar questions gave rise
to another objective of firm, namely maximisation of sales revenue. This objective finds
particular relevance in firms which face tough competition and in which ownership is
segregated from managers.
 2. Baumol’s Theory of Sales Revenue Maximisation
Baumol raised serious questions on the validity of profit maximization as an objective of
the fi rm. He stressed that in competitive markets, firms would rather aim at maximizing
revenue, through maximization of sales. According to him, sales volumes, and not profi t
volumes, determine market leadership in competition. He further stressed that in large
organizations, management is separate from owners. Hence, there would always be a
dichotomy of managers’ goals and owners’ goals. Manager’s salary and other benefits are
largely linked with sales volumes, rather than profits.
Baumol hypothesised that managers often attach their personal prestige to the company’s
revenue or sales; therefore they would rather attempt to maximize the firm’s total revenue,
instead of profits. Moreover, sales volumes are better indicator of firm’s position in the
market, and growing sales strengthen the competitive spirit of the fi rm. Since operations of
the firm are in the hands of managers, and managers’ performance is measured in terms of
achieving sales targets, therefore it follows that management is more interested in
maximising sales, with a constraint of minimum profit. Hence, the objective is not to
maximise profit, but to maximise sales revenue, along with which, firms need to maintain a
minimum level of profit to keep shareholder satisfid. This minimum level of profit is
regarded as the profit constraint. However, empirical evidence to support above arguments
of Baumol is not sufficient to draw any definite conclusion. Whatever research has been done
is based on inadequate data; hence the results are inconclusive.
3. Marris’ Hypothesis of Maximisation of Growth Rate:
Working on the principle of segregation of managers from owners, Marris proposed that
owners (shareholders) aim at profits and market share, whereas managers aim at better
salary, job security and growth. These two sets of goals can be achieved by maximising
balanced growth of the firm (G), which is dependent on the growth rate of demand for the
firm’s products (GD) and growth rate of capital supply to the firm (GC). Hence, growth rate
of the firm is balanced when the demand for its product and the capital supply to the firm
grow at the same rate.
Marris further said that firms face two constraints in the objective of maximisation of
balanced growth, which are as follows:
(i) Managerial Constraint: Among managerial constraints, Marris stressed on the importance
of the role of human resource in achieving organisational objectives. According to him, skills,
expertise, efficiency and sincerity of team managers are vital to the growth of the fi rm. Non
availability of managerial skill sets in required size creates constraints for growth;
organisations on their high levels of growth may face constraint of skill ceiling among the
existing employees. New recruitments may be used to increase the size of the managerial
pool with desired skills; however new recruits lack experience to make quick decisions,
which may pose as another constraint
(ii) Financial Constraint This relates to the prudence needed in managing financial
resources. Marris suggested that a prudent financial policy will be based on at least three
financial ratios, which in turn set the limit for the growth of the fi rm. In order to prove their
discretion managers will normally create a trade off and prefer a moderate debt equity ratio
(r1), moderate liquidity ratio (r2) and moderate retained profit ratio (r3). (Let us mention
here that the ratios used in the financial constraint are dealt with in detail in any standard
textbook on Financial Management and are beyond the scope of this book). However, a brief
description is given hereunder:
(a) Debt equity ratio (r1) This is the ratio between borrowed capital and owners’
capital. High value of debt equity ratio may cause insolvency; hence, a low
value of this ratio is usually preferred by managers to avoid insolvency.
However, a low value of r1 may create a constraint to the growth of the firm in
terms of dependence on high cost capital, i.e., equity.
(b) Liquidity ratio (r2) This is the ratio between current assets and current
liabilities and is an indicator of coverage provided by current assets to current
liabilities. According to Marris, a manager would try to operate in a region
where there is sufficient liquidity and safety and hence would prefer a high
liquidity ratio. But a high r2 would imply low yielding assets, since liquid
assets either do not earn at all (like cash and inventory), or earn low returns
(like short-term securities).
(c) Retention ratio (r3) This is the ratio between retained profits and total profits.
In other words, it is the inverse of dividend payout ratio, i.e., the retained
profits are that portion of net profit which is not distributed among
shareholders. A high retention ratio is good for growth, as retained profits
provide internal source of funds. However, a higher r3 would imply greater
volume retained profits, which may antagonize the shareholders. Hence,
managers cannot afford to keep a very high value of retention ratio.
Williamson’s Model of Managerial Utility Function
Oliver Williamson’s model is a combination of the objectives of profit maximisation and
growth maximisation. Williamson emphasized upon the fact that in modern businesses,
ownership is separate from management and modern managers have discretionary powers
to set the goals of fi rms. He further said that managers would apply their discretionary
power in such a way, as to maximise their own utility function, with the constraint of
maintaining minimum profi t to satisfy shareholders. The utility function of managers,
namely Um, is dependent upon managers’ salary (measurable); job security, power, status,
professional satisfaction (all non-measurable); and the power to influence firm’s objectives.
To formalize the model, Williamson took measurable proxy variables like perks of the
manager, office facilities like company car, and slack payments like a luxurious environment
in the office, and expenditure that takes place at the discretion of the manager, heading a
large pool of workers, which is directly related to his power and status. Slack payments are
the ones whose removal may not make the manager leave the company, but their presence
not only ensures stable and better performance, but is also preferred by the manager, as
these payments are generally far less conspicuous than monetary benefits.
Behavioural Theories
Behavioural theories of objectives of firms postulate that firms aim at satisficing behaviour,
rather than maximisation. Here we would discuss two of the most important of such models,
namely Simon’s satisficing1 model and the model developed by Cyert and March.
Herbert Simon’s research focused on decision-making in organisations and his contribution
to behavioural theories is renowned as “bounded rationality”. According to his Satisficing
Model, the biggest challenge before modern businesses is lack of full information and
uncertainty about future. Because of this, firms have to incur costs in acquiring information
in the present. In the face of both these aspects, the objective of maximising either profit, or
sales, or growth is not possible. In fact, they act as constraints to rational decision-making by
any firm, because of which, the firm has to operate under “bounded rationality” and can only
aim at achieving a satisfactory level of profit, sales and growth. Simon has suggested that
managers would set an aspiration level and then aim to achieve it. If their behaviour or
performance exceeds the aspiration level, the target is increased; if it fails to meet the aspired
level, the target is brought down and a search behaviour is adopted simultaneously to find
the deviation in the behaviour pattern from the aspiration level.
The model developed by Cyert and March is a step ahead of Simon’s theory. It added that
apart from dealing with inadequate information and uncertainty, businesses also have to
satisfy a variety of stakeholders, who have different and oft-conflicting goals. Such
stakeholders would include shareholders, employees, customers, financiers, government,
and other social interest groups. All of these groups have their own goals; hence a firm cannot
have a single objective, and has to aim at a multi-dimensional goal. In other words, firms
need to have multi goal and multi decision-making orientation. However, in order to achieve
such multiplicity of goals and decisions, firms have to face many conflicts and have to develop
means to resolve them. Thus, according Cyert and March, a firm’s behaviour is ‘satisficing
behaviour’, i.e., it aims at satisfying all stakeholders. To meet this objective, managers form
an aspiration level on basis of their past experience, past performance of the firm,
performance of other similar firms, and future expectations. These aspiration levels are
revised and modified on the basis of achievements and changes in business environment.
Cyert and March further suggest that the excess profit that firms accumulate during an
industrial boom is used to monetarily resolve conflicting demands by the following means:
i. Making cash payments in the form of bonuses, dividends, etc. ii. Side payments in the form
of general expenditure, to improve the overall work atmosphere. iii. Slack payments that
bring in a sense of happiness and satisfaction to the stakeholders. However, the Cyert March
hypothesis has been criticised on the same lines as Simon’s model, that it lacks objectivity
and cannot be used to predict a firm’s future direction. It fails to recognise interdependence
of firms, and it may not even work under dynamic business environments.

NATIONAL INCOME MEANING

National Income of any country means the complete value of the goods and services
produced by any country during its financial year. It is thus the consequence of all economic
activities that are running in any country during the period of one year. It is valued in terms
of money. In short one can say that the national income of any country is the total amount of
income that is accrued by it through various economic activities in one year. It is also helpful
in determining the progress of the country.
The meaning of national income is the aggregate income of the economy. Calculating it is a
challenging task as a lot of numbers have to be added up. It is a rather complex accounting
process and takes a lot of time. What would we know if we knew a country's national income?
Well, we would gain a better understanding of quite a few things, such as the following:
National income is the sum of all the income made in the economy on an aggregate level. It
is an essential measure of economic performance.
A nation’s income is a fundamental indicator of its economic structure. For example, if you
are an investor who wants to expand your company's horizons within the international
market, you would emphasize the national income of the country you are going to invest in.
Therefore, a country’s national income accounting is critical for its development and
planning from international and national perspectives. Calculating a nation’s income is an
effort that requires rigorous work.

Concept of National Income

National income accounting comprises of four concepts of calculations- GDP, NDP, GNP, NNP.
Here, we discuss them and other related terms in a very objective way.
1. Factor cost is the input cost that producer has to incur in the process of
production. It includes cost of capital – loan inetrest, prices of raw materials,
labour, power, rent, etc. Can be termed as Production cost.
2. Market cost is calculated after adding indirect taxes to the factor cost of the
product. It is basically the cost at which the goods reach the market. Also
termed as EX-FACTORY PRICE. In India we calculate income at factor cost
because of non-uniform taxes.
3. National Income:The sum total of factor of incomes accruing to the residents
of the country, both from their activities within and outside the economic
territory is the national income of the country.
4. National income is calculated for a particular period, normally a financial year
(In India, financial year means April 1 to March 31 of next year). Net factor
income from abroad is added to the domestic product to get the value of
National Income.
5. National Income = C + I + G + (X – M)
Where,C = Total consumption expenditure
I = Total investment expenditure
G = Total government expenditure ; X – M = Export – Import
 Gross Domestic Product (GDP)

In the contemporary world, we most often use Gross Domestic Product (GDP) as a
measurement of a nation’s income. No matter what your background is, it is highly likely that
you have come across this term at least once in your life. In a closed economy, GDP measures
the total income of every agent and the total expenditure made by every agent.

Gross Domestic Product (GDP) is the market value of all final goods and services produced
within a country’s borders in a given period of time.

Gross domestic product is the value of all final goods and services produced within the
boundary of a nation during one year. In India one year means from 1st April to 31st March
of the next year. GDP calculation includes income of foreigners in a Country but excludes
income of those people who are living outside of that country.

GDP = (P*Q)

Where,

GDP = gross domestic product

P = Price of goods and services
Q= Quantity of goods and services

GDP is made up of 4 Components

a. consumption
b. investment
c. government expenditure
d. net foreign exports of a country
GDP = C+I+G+(X-M)
Where,
C=Consumption
I=Investment
G=Government expenditure
(X-M) =Export minus import

Gross National Product (GNP): Gross national product (GNP) is another metric that
economists use to evaluate a nation’s income. It is different from GDP with some minor
points. Unlike GDP, the gross national product doesn’t limit a nation’s income to its borders.
Therefore, citizens of a country can contribute to the country’s gross national product while
producing abroad.

Gross national product (GNP) is a metric to evaluate the total market value of goods and
services made by a country’s citizens regardless of the country’s borders.

GNP can be found with a few additions and subtractions to GDP. For calculating the GNP, we
aggregate GDP with any other output produced by the citizens of the country outside of the
country’s borders, and we subtract all output made by the foreign citizens within a country’s
borders.

Is market value of final goods and services produced in a year by the residents of the country
within the domestic territory as well as abroad. GNP is the value of goods and services that
the country's citizens produce regardless of their location.

GNP=GDP+NFIA

Or

GNP=C+I+G+(X-M) +NFIA

Where,
C=Consumption
I=Investment
G=Government expenditure
(X-M) =Export minus import
NFIA= Net factor income from abroad.

Net National Product (NNP) :

All of the national income metrics are rather similar, and obviously, net national product
(NNP) is not an exception. NNP is more similar to GNP than to GDP. NNP also takes any
output outside a country’s borders into account. In addition to that, it subtracts the cost of
depreciation from GNP.
Net national product (NNP) is the total amount of output produced by a country’s citizens
minus the cost of depreciation.
 Is market value of net output of final goods and services produced by an economy during a
year and net factor income from abroad.
NNP=GNP-Depreciation
or, NNP=C+I+G+(X-M) +NFIA- IT-Depreciation
Where,
C=Consumption
I=Investment
G=Government expenditure
(X-M) =Export minus import
NFIA= Net factor income from abroad.

IT= Indirect Taxes

Symbolically or as per the formula

NI=NNP +Subsidies-Interest Taxes
or, GNP-Depreciation +Subsidies-Indirect Taxes
or, NI=C+G+I+(X-M) +NFIA-Depreciation-Indirect Taxes +Subsidies

Personal Income (PI): Is the total money income received by individuals and households of
a country from all possible sources before direct taxes. Therefore, personal income can be
expressed as follows:

PI=NI-Corporate Income Taxes-Undistributed Corporate Profits- Social Security

Contribution +Transfer Payments.

Disposable Income (DI) : It is the income left with the individuals after the payment of direct
taxes from personal income. It is the actual income left for disposal or that can be spent for
consumption by individuals.
Thus, it can be expressed as:

DI=PI-Direct Taxes

Per Capita Income (PCI): It is calculated by dividing the national income of the country by
the total population of a country.
Thus, PCI=Total National Income/Total National Population

Measurement or methods or Approach of National Income

The measurement of national income is a complex task, without a doubt. There are few ways
to measure a nation’s income, but they are more or less similar to each other. We call these
measurement tools national income metrics.

No matter what the metric used to measure the national income is, the idea behind what to
measure is more or less the same. What is a better way than following the very thing that we
use for the exchange in an economy to understand the income in an economy? In any
economy, every transfer, every flow of money leaves a trail behind. We can explain the
general flow of money with the circular flow diagram.

As demonstrated in Figure 1, there is a continuous flow of money as spending, expenses,

profits, income, and revenue. This flow happens due to goods, services, and factors of
production. Understanding this flow helps us to gauge the size and structure of the economy.
These are the things that contribute to a nation’s income.

There are three methods of measurement of the national income of a country.

o Income Method
o Product or Value Added Method
o Expenditure Method

Income Method of National Income Measurement

o The income method of national income calculation is used at the distribution level.
The national income is estimated using this method as a flow of factor incomes.
o Labor, capital, land and entrepreneurship are the four important production
components.
o Labor is compensated with wages and salaries. Capital is compensated with interest.
The land is compensated with rent, and entrepreneurship is compensated with profit.
 o Moreover, certain self-employed individuals, such as doctors, lawyers and
accountants, use their labor and capital. The earnings of such people are classified as
mixed-income.
o The Net Domestic Product (NDP) at factor costs is the sum of these factor incomes.
o National Income using the Income method is calculated as follows:

Net national income = Employee compensation + Operating surplus (w + R + P + I) + Net

income + Net factor income from abroad

Where,

o W stands for wage and salaries.

o R stands for income from rental sources.
o P stands for profit.
o I stand for mixed income.

Product/ Value Added Method of National Income Measurement

o The national income, in this case, is estimated at the production level. The national
income is estimated using this method as a flow of goods and services.
o We determine the fiscal value of all final goods and services produced in a country’s
economy for a year. The word “final goods” refers to commodities consumed right
away rather than being engaged in a subsequent manufacturing process.
o Intermediate goods are those goods that are made use of in the manufacturing
process.
o Since the value of intermediate products is already included in the value of final
goods, we do not have to consider the value of intermediate goods in national income;
if taken into account, the value of the goods would be counted twice.
o To avoid duplication in counting, we can use the value-added approach, which
computes the value-addition (i.e., the value of the final product plus the value of the
intermediate product) at every stage of production and then adds them together to
get the Gross Domestic Product.
o The sum-total is the GDP at market prices considering that the monetary value is
measured at market prices.
o National Income using Product/ Value Added method can be calculated as follows:

National Income = Gross national product – Cost of Capital – Depreciation – Indirect Taxes

Expenditure Method of Measuring National Income

o The expenditure method can determine national income during the disposition
phase. The national income is calculated using the expenditure method as a flow of
expenditure.
o The gross domestic product (GDP) is the sum of all the private consumption
expenditures.
o The factors such as government consumption expenditure, gross capital formation
(public and private) and net exports must be considered here.
 o National Income using the Expenditure technique can be calculated as follows:

National Income = National Product = National Expenditure

Importance of National Income

Setting Economic Policy: National Income indicates the status of the economy and can give a
clear picture of the country’s economic growth. National Income statistics can help
economists in formulating economic policies for economic development.

Inflation and Deflationary Gaps: For timely anti-inflationary and deflationary policies, we
need aggregate data of national income. If expenditure increases from the total output, it
shows inflammatory gaps and vice versa.

Budget Preparation: The budget of the country is highly dependent on the net national
income and its concepts. The Government formulates the yearly budget with the help of
national income statistics in order to avoid any cynical policies.

Standard of Living: National income data assists the government in comparing the standard
of living amongst countries and people living in the same country at different times.

Defense and Development: National income estimates help us to bifurcate the national
product between defense and development purposes of the country. From such figures, we
can easily know, how much can be set aside for the defense budget.

Money supply
Money supply in an economy is the total volume of currency in circulation at a particular
point in time. It can include cash and its equivalents like currency notes, coins, and bank
deposits. It is a critical concept that greatly impacts a country’s financial and economic
situation.
The supply of money is closely related to inflation and consumption. Therefore, the
government, especially a country’s central bank, controls the circulation of money through
its monetary policy. The supply of money measurement include M0, M1, M2, M3, and M4
types, based on its liquidity.
An increase in the supply implies that people are spending more, which increases the
demand for products and services in the economy. As a result, high demand contributes to a
rise in prices. Therefore, the high circulation of money will lead to higher inflation rates.
In such situations, the central banks will introduce a contractionary monetary policy to
reduce consumer spending. It is usually done by increasing interest rates on consumer loans.
Hence, customers will stop borrowing and have to cut down on spending. Thus, it reduces
money circulation.
However, prolonged periods of reduced supply are also equally harmful. If customers give
up spending altogether, the economy will become stagnant, leading to mass unemployment.
Therefore, the government will introduce an expansionary monetary policy, where the
interest rates on borrowing will be decreased. As a result, people will borrow more and
spend more. Central banks also inject additional money into the economy.

Measurement

Since the supply of money is an important economic parameter, governments constantly

monitor and regulate it. Therefore, they measure the amount of money frequently to keep it
in check. Standard measures of money supply include M1, M2, M3, and M4.

The measurement of the supply begins with the M0 or monetary base. It denotes the amount
of currency in circulation, i.e., currency bills, coins, and bank reserves.
• M1 money supply: Also called the ‘narrow money,’ it includes M0 and other highly liquid
deposits in the bank.
• M2 money supply: It is perhaps the most commonly accepted measure because it consists of
M1 in addition to marketable securities and less liquid deposits.
• M3 money supply: Known as ‘broad money,’ it constitutes M2 and money market funds
like mutual funds, repurchase agreements, commercial papers, etc.
• M4 money supply: It comprises M3 and all other least liquid assets, usually
outside commercial banks.
• Thus, the above types of money supply measurements and their formulas can be
summarized as follows:

• M0 = Currency notes + coins + bank reserves

• M1 = M0 + demand deposits

• M2 = M1 + marketable securities + other less liquid bank deposits

• M3 = M2 + money market funds

• M4 = M3 + least liquid assets

These measures of money supply usually vary depending on the country. For example, the
Federal Reserve usually focuses on M1 and M2 types to monitor the U.S. money supply,
whereas the Bank of England measures M4 types too.

Determinants of Money Supply

1. High-powered money – Cash and its equivalents available with the public and bank
deposits are included in high-powered money. Since they are highly liquid, they directly
affect the supply of money in an economy.
2. Level of commercial bank reserves – The central bank mandates commercial banks to hold a
fixed percentage of deposits as reserves in case of any emergency. Banks lend the excess
reserve amount to consumers, increasing money circulation.
3. Reserve ratio – It is the ratio of cash reserve to deposits, as instructed by the central bank. If
the central bank increases the ratio, banks will have to hold more money in reserves,
reducing banks’ lending capabilities.
4. Liquid cash held by the public – If the people have more liquid cash at home, they will only
spend a small portion required. However, if the same cash is deposited in the bank, the
supply in the economy will be high.

INFLATION MEANING

Inflation is an economic indicator that indicates the rate of rising prices of goods and services
in the economy. Ultimately it shows the decrease in the buying power of the rupee. It is
measured as a percentage.
This quantitative economic measures the rate of change in prices of selected goods and
services over a period of time. Inflation indicates how much the average price has changed
for the selected basket of goods and services. It is expressed as a percentage. Increase in
inflation indicates a decrease in the purchasing power of the economy.

This percentage indicates the increase or decrease from the previous period. Inflation can be
a cause of concern as the value of money keeps decreasing as inflation rises.

Inflation is calculated using the Consumer Price Index (CPI). Inflation can be calculated for
any product by following these steps.

• Determine the rate of the product at an earlier period.

• Determine the current rate of the product
• Use the inflation rate formula (Initial CPI – Final CPI/ Initial CPI)*100. Here CPI is the
rate of the product.
• This gives the increase/decrease percentage in the price of the product. One can use
this to compare the inflation rate over a period of time.

Types of Inflation

The three types of Inflation are Demand-Pull, Cost-Push and Built-in inflation.
• Demand-pull Inflation: It occurs when the demand for goods or services is higher
when compared to the production capacity. The difference between demand and
supply (shortage) result in price appreciation.
• Cost-push Inflation: It occurs when the cost of production increases. Increase in
prices of the inputs (labour, raw materials, etc.) increases the price of the product.
• Built-in Inflation: Expectation of future inflations results in Built-in Inflation. A rise in
prices results in higher wages to afford the increased cost of living. Therefore, high
wages result in increased cost of production, which in turn has an impact on product
pricing. The circle hence continues.
Causes of Inflation
• Monetary Policy: It determines the supply of currency in the market. Excess supply of
money leads to inflation. Hence decreasing the value of the currency.
• Fiscal Policy: It monitors the borrowing and spending of the economy. Higher
borrowings (debt), result in increased taxes and additional currency printing to repay
the debt.
• Demand-pull Inflation: Increases in prices due to the gap between the demand
(higher) and supply (lower).
• Cost-push Inflation: Higher prices of goods and services due to increased cost of
production.
• Exchange Rates: Exposure to foreign markets are based on the dollar value.
Fluctuations in the exchange rate have an impact on the rate of inflation.
Business Cycle

First, we will provide the definition of a business cycle. Business cycles refer to short-term
fluctuations in the level of economic activity in a given economy. An economy may
experience long-term growth where its national output or GDP increases. However, while
this economic growth happens, it is often interrupted momentarily by a series of business
cycles where economic activity rises or declines.
A business cycle is completed when it goes through a single boom and a single contraction
in sequence. The time period to complete this sequence is called the length of the business
cycle.
A boom is characterized by a period of rapid economic growth whereas a period of relatively
stagnated economic growth is a recession. These are measured in terms of the growth of the
real GDP, which is inflation-adjusted.
Business cycles refer to short-term fluctuations in the level of economic activity in a given
economy.
Stages or phases of the Business Cycle
In the diagram above, the straight line in the middle is the steady growth line. The business
cycle moves about the line. Below is a more detailed description of each stage in the business
cycle:

1. Expansion

The first stage in the business cycle is expansion. In this stage, there is an increase in positive
economic indicators such as employment, income, output, wages, profits, demand, and
supply of goods and services. Debtors are generally paying their debts on time, the velocity
of the money supply is high, and investment is high. This process continues as long as
economic conditions are favorable for expansion.

2. Peak

The economy then reaches a saturation point, or peak, which is the second stage of the
business cycle. The maximum limit of growth is attained. The economic indicators do not
grow further and are at their highest. Prices are at their peak. This stage marks the reversal
point in the trend of economic growth. Consumers tend to restructure their budgets at this
point.

3. Recession

The recession is the stage that follows the peak phase. The demand for goods and services
starts declining rapidly and steadily in this phase. Producers do not notice the decrease in
demand instantly and go on producing, which creates a situation of excess supply in the
market. Prices tend to fall. All positive economic indicators such as income, output, wages,
etc., consequently start to fall.

4. Depression

There is a commensurate rise in unemployment. The growth in the economy continues to

decline, and as this falls below the steady growth line, the stage is called a depression.

5. Trough

In the depression stage, the economy’s growth rate becomes negative. There is further
decline until the prices of factors, as well as the demand and supply of goods and
services, contract to reach their lowest point. The economy eventually reaches the trough. It
is the negative saturation point for an economy. There is extensive depletion of national
income and expenditure.

6. Recovery

After the trough, the economy moves to the stage of recovery. In this phase, there is a
turnaround in the economy, and it begins to recover from the negative growth rate. Demand
starts to pick up due to low prices and, consequently, supply begins to increase. The
population develops a positive attitude towards investment and employment and
production starts increasing.

CAUSES OF BUSINESS CYCLES

The cyclic pattern of changes that occurs in the economy is caused by many factors in
combination. There are internal factors within the economy that may be causing these changes.
And there are also external factors which may lead to a boom or bust of an economy. Let us take
a look at all the causes of business cycles.
Internal Causes of Business Cycles

These endogenous factors can cause changes in the phases of the firm and the economy in
general. Let us take a look at the internal causes of business cycles.

1] Changes in Demand
Keynes economists believe that a change in demand causes a change in the economic activities.
When the demand in an economy increases the firms start producing more goods to meet the
demand.

There is more output, more employment, more income, and higher profits. This will lead to a
boom in the economy. But excessive demand may also cause inflation.

On the other hand, if the demand falls, so does the economic activity. This may lead to a bust,
which if it continues for a longer period of time may even lead to depression in the economy.

2] Fluctuations in Investments
Just as fluctuations in demand, fluctuations in investment is one of the main causes of business
cycles. The investments will fluctuate on the basis of a lot of factors such as the rate of interest
in the economy, entrepreneurial interest, profit expectation, etc.

An increase in investment will lead to an increase in economic activities and cause expansion.
A decrease in investment will have the opposite effect and may cause a trough or even
depression

3] Macroeconomic Policies
The monetary policies and the economic policies of a nation will also result in changes in the
phases of a business cycle. So if the monetary policies are looking to expand economic activities
by promoting investment, then the economy booms. On the other hand, if there is an increase
in taxes or interest rates we will see a slowdown or a recession in the economy.

4] Supply of Money
There is another belief that says that business cycles are purely monetary phenomena. So
changes in the money supply will bring about the trade cycles. An increase of money in the
market will cause growth and expansion.

But too much money supply may also cause inflation which is adverse. And the decrease in the
supply of money will initiate a recession in the economy.
External Causes of Business Cycles

1] Wars
During times of wars and unrest, the economic resources are put to use to make special goods
like weapons, arms, and other such war goods. The focus shifts from consumer products and
capital goods. This will lead to a fall in income, employment, and economic activity. So the
economy will face a downturn during war times.

And later post-war the focus will be on rebuilding. Infrastructure needs to be reconstructed
(houses, roads, bridges, etc). This will help the economy pick up again as progress is being
made. Economic activity will increase as effective demand will increase.

2] Technology Shocks
Some exciting and new technology is always a boost to the economy. New technology will mean
new investment, increased employment, and subsequently higher incomes and profits. For
example, the invention of the modern mobile phone was the reason for a huge boost in the
telecom industry.

3] Natural Factors
Natural disasters like floods, droughts, hurricanes, etc can cause damage to the crops and huge
losses to the agricultural sector. Shortage of food will cause a surge in prices and high inflation.
Capital goods may see a reduction in demand as well.

4] Population Expansion
If the population growth is out of control that might be a problem for the economy. Basically of
the population growth is higher than the economic growth the total savings of an economy will
start dwindling. Then the investments will reduce as well and the economy will face depression
or a slow down.

Features of a Business Cycle

1. Occurs Periodically: The different phases of a Business Cycle occur from time to time.
Although, at certain times, these periods will vary according to the Economic
conditions of the industry. This duration may last as long as 10-12 years. The intensity
of the phases will also change depending on the Economy. For example, at times, the
firm will see massive growth followed by a short span of depression.
2. Synchronous: Another advantageous and prominent feature of the Business Cycle is
that it is synchronic. The features of a Business Cycle are not restricted to a single firm
or industry. They originate in a free Economy and are prevalent. If there is any kind
of disturbance or Business boom in one industry, it will affect the other firms too.
Since different kinds of industries are interrelated, the Business in one firm disturbs
that in another firm.
 3. Major Sectors are Affected: It’s been noticed that fluctuations occur not only at the
level of production but also in other variables such as employment, consumption,
investment, rate of interest, and price level. The investment and consumption of
durable consumer goods like houses and cars are continually affected by the
periodical fluctuations. As the process of consumption is deferred the courses of the
Business Cycle are also affected widely.
4. Profit Variation: Another significant feature of the Business Cycle is that the profits
fluctuate more than any other income source. This makes any kind of Business a
tricky and uncertain profession for many. It is difficult to predict Economic
conditions. In situations of depression, profits may even become harmful. That is why
many Businesses go bankrupt.
5. Worldwide Impact: Business Cycles are international in nature. If depression occurs
in one country, then it is bound to spread to other nations too. This happens mainly
because the countries depend on each other for import and export trades. The 1930
depression in the USA and Great Britain shook the entire world and resulted in a
recession.

Role of Business economists:

Business Economist should study the environment .he should take decision
regarding business operations
➢ Market Analysis: Business economists assess market conditions to identify
opportunities and threats. They analyze supply and demand dynamics, market
competition, and consumer behavior to help businesses understand their
target markets.

➢ Forecasting: Business economists use economic models and data to make

predictions about future economic conditions. This forecasting helps
businesses plan for changes in the business environment and make strategic
decisions.
➢ Cost-Benefit Analysis: They evaluate the costs and benefits of various business
decisions, such as investment projects, pricing strategies, or expansion plans.
This analysis helps companies determine whether an action is economically
viable.
➢ Pricing Strategies: Business economists can assist in setting optimal pricing
strategies by considering factors like production costs, competition, and
 consumer demand. They help businesses maximize profitability while
remaining competitive.
➢ Risk Management: They assess economic risks that may affect a company, such
as currency fluctuations, interest rate changes, or geopolitical developments.
By identifying risks, they can help companies develop strategies to mitigate
them.
➢ Policy Analysis: Business economists monitor and analyze government
policies, regulations, and economic trends that may impact a company's
operations. They provide insights on how to adapt to changing regulatory
environments.
➢ Financial Planning: Business economists help businesses make financial
decisions, including budgeting, capital allocation, and investment strategies.
They also assist in capital structure decisions, like debt vs. equity financing.
➢ Supply Chain Management: They analyze the global supply chain and logistics,
assessing the economic impact of supply chain disruptions and suggesting
ways to optimize operations for efficiency and cost-effectiveness.
➢ Competitive Analysis: Business economists study the competitive landscape
to help companies understand their position in the market. They provide
insights on how to gain a competitive advantage and sustain it over time.
➢ Economic Research: They conduct economic research to support various
aspects of a business, including market research, industry analysis, and
evaluating the impact of economic policies.
➢ Business Strategy: Business economists contribute to the formulation of
overall business strategies by providing insights into macroeconomic
conditions, industry trends, and potential challenges or opportunities.
➢ Communication: They present their findings and recommendations to senior
management and other stakeholders in a clear and understandable manner.
Effective communication is essential for decision-makers to act on the
economist's insights.

Non –Conventional sources of Finance

Non conventional sources are different from conventional sources such as owners
capital and borrowed capital, usually company use the following non conventional
sources of finance

1. Leasing
2. Franchising
3. Forfeiting
4. Peer-to-peer Platform
5. Crowd funding
6. Angel Investors
7. Venture Capitalists
Leasing

1. A lease is defined as an agreement between the lessor (owner of the asset) and the
lessee (user of the asset), wherein, the lessor purchases an asset for the lessee and
allows him to use it in exchange of periodic payments called lease rentals or
minimum lease payments (MLP).
2. The lessee is bound to pay the lease rental to the lessor for the use of the assets.
After the end of the period of the contract, the asset is transferred back to the lessor.
3. It refers to the renting of an asset for a certain period of time.
4. Parties involved include lease broker, lessor, lessee, and the lease assets.

Advantages
Lessee acquires the asset with a lower
investment
Simple documentation process
Does not dilute the capital structure
Risk of obsolescence is born by the lesser Lessee cannot become the owner of the asset
Lease rentals are deductible for
computing taxable profits
Disadvantages
May impose certain restrictions on the use of the
assets
Normal business may be impacted in the case of
non-renewal of lease
Higher payout obligation in case equipment not
found
Regular maintenance of the asset
Franchising

1. Franchising is the model in which the Company that does not have enough capital to
expand, gives its franchise rights to an individual or a company.
2. The company giving rights is called ‘franchisor’ while the company being given the
franchise is called ‘franchisee’.
3. It is an arrangement where one party grants or licenses some rights and authorities
to another party.
4. Franchising is a well-known marketing strategy to expand the business.

Advantages
Helps in expanding business
Builds a brand name and goodwill
Less efforts by franchisee for startup
Zero cost involved for training and assistance
as it is provided by the franchisor
Types of Franchise:
Disadvantages
Franchisor own goodwill may suffer in case
of failure by the franchisee
Lack of secrecy
Lack of autonomy to the franchisee
Sharing of royalty and profits with the
franchisor

1. Product franchise: An agreement where manufacturers allow retailers to

distribute their products and use names and trademarks.
2. Business format franchise: An agreement in which the franchisor provides the
franchisee with an established business, including name and trademarks for the
franchisee to run independently.
3. Management franchise: The franchisee provides the management expertise,
format and/ or procedure for conducting the business.

Forfeiting

1. It is a form of financing of receivables arising out of international business. Wherein,

a bank or financial institution undertakes the purchase of trade bills or promissory
notes without recourse to the seller.
2. Purchases are made through discounting of the documents, hence covering the
entire risk of payment failure at the time of collection.
3. All risks become the full responsibility of the purchase
4. Forfeiture pays cash to the seller after the discounting of the said notes or bills.
Advantages
Immediate funds available for the exporters
Commercial bank can gain when the currency
values appreciate
Letter of credit provides great help
Disadvantages
It is not available for deferred payments
Only selected currencies are considered for
forfeiting
No international credit agency to guarantee
in case of default

Peer-to-peer (P2P) Lending

1. Peer-to-peer lending is a form of direct lending of money to businesses or

individuals without any official participation of any financial institution as an
intermediary in the agreement
2. It is generally done through online platforms that relate lenders with potential
borrowers
3. Peer-to-peer lending offers both secured and unsecured loans. However, most of the
loans are unsecured personal loans. Secured loans are an exception and are usually
backed by luxury goods.
Advantages
High returns to the investors as
there are no middlemen involved
More accessible sources of funding
because of less complexity
Disadvantages
Credit risk because of low credit rating buyers
Government do no provide any insurance or protection
on such types of loan. It is not allowed in many countries

Services provided by P2P Platforms:

1. Finding new lenders and borrowers

2. Verification of borrower identity, bank account, income, and employment history
3. Legal compliance and reporting
4. Performing borrower credit checks and sorting out the unqualified ones
5. Servicing loans, providing customer service to borrowers, and attempting to collect
payments from borrowers who are in default

Crowdfunding

1. It is the practice of funding a project by raising money from a large group of people.
2. It is a way of raising capital using the social networking sites like Facebook or
Twitter or by using some popular crowdfunding websites
3. Crowdfunding helps improve the presence of small businesses and startups across
social media, it increases their investment base, and funding prospects.
4. Various types of crowdfunding include debt-based, equity-based, cause-based,
rewards-based, software value token, litigation, etc.
Advantages
Quick way to raise finance
Feedback and expert guidance
accompanies funding
Great way to test public reaction
Easy to track progress
Cheap source of finance
Disadvantages
Public may not show interest in all the projects
Significant resources needed for marketing
about projects
It may not result in comprehensive financing
Reputation of a business can be severely affected
Lack of project secrecy

Venture Capital

1. It refers to that capital and knowledge which are given for the formation and setting
up of companies, especially to those who possess any new methodologies or
technology.
2. It is not merely a way of acquiring funds into a new firm but also a parallel support
of the skills required to set up the firm, devising its marketing strategy, organizing,
and its management as well.

Advantages Disadvantages
Feeds wealth and expertise into the business Autonomy and control is shared with
venture capitalists
No obligation to repay the money Process is lengthy and complex
A large sum of equity finance is available Uncertain forms of financing
It provides valuable information, resources, and Benefits are available only in the long-run
technical assistance

Angel Investors

1. They are an individual or a group of individuals who invest their own money
2. They invest in the early stages of the company and in return opt for a share in the
company
3. Angel investors typically invest less money that the venture capitalists
4. They are not involved much in the functions and management of the company.
However, they may advise and ask for reports and status.

Advantages Disadvantages
No need for collateral like personal Not suitable for investments below INR 5 lakhs or above
assets INR 15 lakhs
No repayments or interest on It takes longer to find a suitable angel investor
borrowings
Better discipline due to outside Less structural support available
vigilance

Source of capital for a company

➢ Equity Capital: Common Stock: Companies can issue common stock to raise capital
from investors. Investors who purchase common stock become partial owners of the
company and may receive dividends and have voting rights.
➢ Preferred Stock: Preferred stock is a type of equity that gives investors preference
over common stockholders in terms of dividends and assets in case of liquidation.
➢ Debt Capital: Bank Loans: Companies can borrow money from banks or financial
institutions through various types of loans, such as term loans, revolving credit lines,
and working capital loans.
➢ Bonds: Companies can issue bonds in the debt market, which are essentially loans
from investors. They pay periodic interest to bondholders and repay the principal
amount at maturity.
➢ Private Placements: Companies can raise debt capital through private placements by
selling bonds or other debt instruments to institutional investors or private lenders.
➢ Convertible Debt: This is a type of debt that can be converted into equity (usually
common stock) at a specified conversion price and time.
➢ Retained Earnings:
 ➢ Companies can reinvest their profits (retained earnings) into the business for growth
and expansion. This is a common source of internal financing.
➢ Venture Capital: Startups and high-growth companies can raise capital from venture
capitalists, who provide funding in exchange for equity ownership. Venture capital is
often used to fund innovative and high-potential businesses.
➢ Angel Investors: Angel investors are individuals who invest their personal funds in
early-stage or startups in exchange for equity. They may also provide guidance and
mentorship to the company.
➢ Crowd funding: Crowd funding platforms allow companies to raise capital from a
large number of individual investors or backers. It is often used for specific projects,
products, or initiatives.
➢ Private Equity: Private equity firms invest in established companies, often by
acquiring a controlling stake, to facilitate growth and operational improvements.
➢ Grants and Subsidies: Some companies, particularly those in certain industries or
engaged in research and development, may receive grants, subsidies, or incentives
from government agencies, foundations, or non-profit organizations.
➢ Strategic Partnerships and Alliances: Companies can enter into partnerships or
alliances with other businesses, where they may receive capital infusion, access to
resources, or co-development opportunities.
➢ Asset Sales: Companies can sell non-core assets, such as real estate, subsidiaries, or
intellectual property, to generate capital.
➢ Initial Public Offering (IPO): Going public through an IPO involves selling shares to
the public for the first time on a stock exchange, providing access to a broader base
of investors.
➢ Strategic Investments: Larger corporations may invest in or acquire smaller
companies to access new technologies, markets, or synergies.

INTRODUCTION TO BUSINESS ECONOMICS

Business economics. Or managerial economics for that matter, is essentially
economics applied to business decision making. Application of economics to business
decision making has increased immensely in the recent past. The reason is that business
decision making has, of late, become an increasingly complex affair due to ever growing
complexity of the business world. The growing complexity of the business world can be
attributed to the rapid growth of large scale industries, emergence of variety of industries,
diversification and expansion of business activities, expansion of investment avenues and
opportunities, growth of multinational corporations and globalization of business activities
adding new dimensions to business competition. Business is an economic activity subject to
economic laws. Therefore, the growing complexity of the modern business world and the
business problem arising out of it can be analyzed and understood better by applying
economic laws and theories. This fact has necessitated the extensive and intensive
application of economic laws, theories and tools of analysis to the process business decision
making and it has proved to be immensely helpful in finding out an appropriate solution to
business problems. However, before we proceed to analyze how economics contributes to
business decision making.
Business Economics consists of that part of economic theory which helps the business
manager to take rational decisions. Economic theories help to analyze the practical problems
faced by a business firm. Business Economics integrates economic theory with business
practice. It is a special branch of economics that bridges the gap between abstract theory and
business practice. It deals with the use of economic concepts and principles for decision
making in a business unit. It is also called Managerial Economics or Economics of the Firm.
Managerial Economics is economics applied in business decision-making. Hence it is also
called Applied Economics.
DEFINITION OF BUSINESS ECONOMICS
According to Spencer and Siegelman, Business economics is "the integration of economic
theory with business practice for the purpose of facilitating decision making and forward
planning by management".
According to Mc Nair and Meriam, "Business economics deals with the use of economic
modes of thought to analyze business situation".

Nature of Business Economics or Features or Characteristics:

(a) Close to Microeconomics: Managerial economics is concerned with finding the
solutions for different managerial problems of a particular firm. Thus, it is more close
to microeconomics.
(b) Operates against the backdrop of Macroeconomics: The macroeconomics
conditions of the economy are also seen as limiting factors for the firm to operate. In
other words, the managerial economist has to be aware of the limits set by the
macroeconomics conditions such as government industrial policy, inflation and so on.
(c) Normative statements: A normative statement usually includes or implies the words
‘ought’ or ‘should’. They reflect people’s moral attitudes and expressions of what a
team of people ought to do. For instance, it deals with statements such as ‘Government
of India should open up the economy’. Such statement are based on value judgments
and express views of what is ‘good’ or ‘bad’, ‘right’ or ‘ wrong’. One problem with
normative statements is that they cannot to verify by looking at the facts, because they
mostly deal with the future. Disagreements about such statements are usually settled
by voting on them.
(d) Prescriptive actions: Prescriptive action is goal oriented. Given a problem and the
objectives of the firm, it suggests the course of action from the available alternatives
for optimal solution. It does not merely mention the concept, it also explains whether
the concept can be applied in a given context on not. For instance, the fact that variable
costs are marginal costs can be used to judge the feasibility of an export order.
(e) Applied in nature: ‘Models’ are built to reflect the real life complex business situations
and these models are of immense help to managers for decision-making. The different
 areas where models are extensively used include inventory control, optimization,
project management etc. In managerial economics, their also employ case study
methods to conceptualize the problem, identifythe alternatives and determine the best
course of action.
(f) Offers scope to evaluate each alternative: Managerial economics provides an
opportunity to evaluate each alternative in terms of its costs and revenue. The
managerial economist can decide which is the better alternative to maximize the
profits for the firm.
(g) Interdisciplinary: The contents, tools and techniques of managerial economics are
drawn from different subjects such as Economics, Management, Mathematics,
Statistics, Accountancy, Psychology, Organizational Behaviour, Sociology, etc.
(h) Assumptions and limitations: Every concept and theory of managerial economics is
based on certain assumption and as such their validity is not universal. Where there is
change in assumptions, the theory may not hold good at all.

SCOPE OF BUSINESS ECONOMICS

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

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

Managerial decision areas:

• Production
• Control of costs
• Determination of price of a
Concepts and given product or services Optimum
Applied for
Techniques of • Make or buy decisions
Managerial economics • Solutions
to Inventory decision
• Capital management
• Profit planning and
management
• Investment decision
SCOPE OR SUBJECT MATTER OF BUSINESS ECONOMICS
1. Demand Analysis and Forecasting or Demand Decisions
2. Cost and Production Analysis or Input – Output Decisions.
3. Pricing Decision, Policies and Practise
 4. Profit Management
5. Capital Management
6. Economic Forecasting and Forward Planning

1. Demand Analysis and Forecasting:

A business firm is an economic organisation, which transforms productive resources
into goods that are to be sold in a market. A major part of managerial decision-making
depends on accurate estimates of demand. This is because before production schedules can
be prepared and resources are employed, a forecast of future sales is essential. This forecast
can also guide the management in maintaining or strengthening the market position and
enlarging profits. The demand analysis helps to identify the various factors influencing
demand for a firm’s product and thus provides guidelines to manipulate demand. Demand
analysis and forecasting, thus, is essential for business planning and occupies a strategic
place in managerial economics.
2. Cost and Production Analysis:

A study of economic costs, combined with the data drawn from the firm’s accounting
records, can yield significant cost estimates. These estimates are useful for management
decisions. The factors causing variations in costs must be recognized and thereby should be
used for taking management decisions. This facilitates the management to arrive at cost
estimates, which are significant for planning purposes. An element of cost uncertainty exists
in this because all the factors determining costs are not always known or controllable.
Therefore, it is essential to discover economic costs and measure them for effective profit
planning, cost control and sound pricing practices. Production analysis is narrower in scope
than cost analysis. In production analysis of inputs and output relationships between is
examine. How much change in either one input or all inputs leading to change in outputs is
study.

3. Pricing Decisions, Policies and Practices:

Pricing is a very important area of managerial economics. In fact price is the origin of
the revenue of a firm. As such the success of a business firm largely depends on the accuracy
of price decisions of that firm. The important aspects dealt under area, are as follows: Price
determination in various market forms, Pricing methods, Differential pricing, product-line
pricing and price forecasting.

4. Profit Management:

Business firms are established with the objective of making profits and it is thus the
chief measure of success. For maximizing profits the firm needs to take care of pricing, cost
aspects and long-range decisions, i.e., it has to evaluate its investment decisions and carry
out the best policy of capital budgeting for the firm under a given set of conditions. If we
know the future, profit analysis would be an easy task. However, in a world of uncertainty
our expectations are not always realized, so that profit planning and measurement constitute
a difficult area of Managerial Economics. The important aspects covered under this area are:
nature and measurement of profit and profit policies, techniques of profit planning like
break-even analysis or cost-volume-profit analysis, cost control techniques, cost reduction,
etc.

5. Capital Management:
Still another most challenging problem for a modern business manager is of planning
capital investment. Investments are made in the plant and machinery and buildings which
are very high. Therefore, capital management requires top-level decisions. It means capital
management i.e., planning and control of capital expenditure. It deals with Cost of capital,
Rate of return and selection of projects, etc.
6. Economic Forecasting and Forward Planning:
Economic forecasting leads to forward planning. The firm operates in an environment
which is dominated by the external and internal factors. The external factors include major
forces such as government policy, competition, employment, labour, price and income levels
and so on. These influence its decisions relating to production, human resources, finance and
marketing. The internal factors include its policies and procedures relating to finance,
people, market and products. It is necessary to forecast the trends in the economy to plan for
the future in terms of investments, profits, products and markets. This will minimise the risk
and uncertainty about the future.
THE OBJECTIVES OF BUSINESS ECONOMICS:
1. To integrate economic theory with business practice.
2. To apply economic concepts: and principles to solve business problems
3. To employ the most modern instruments and tools to solve business problems.
4. To allocate the scarce resources in the optimal manner
5. To make overall development of a firm.
6. To minimize risk and uncertainty
7. To help in demand and sales forecasting
8. To help in formulating business policies.
9. To help in profit maximization.
10. To help in operation of firm by helping in planning, organizing, controlling etc.

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

Demand refers to how much (quantity) of a product or service is desired by buyers. The
quantity demanded is the amount of a product people are willing to buy at a certain price. Demand
for a good by a consumer is not the same thing as his desire to buy it. A desire becomes a demand
only when it is effective which means that, given the price of the good, the consumer should be
both willing and able to pay for the quantity which he wants to buy.
Thus three things are essential for a desire for a commodity to become effective demand
• Desire of a consumer to buy the commodity
• Willingness of a consumer to buy the commodity
• Ability of a consumer (having sufficient purchase power or money) to buy the commodity

DEFINITION OF DEMAND
According to Ferguson, “Demand refers to quantities of a commodity that the consumers are able
and willing to buy at each possible price during a given period of time, other things being equal.”

DEMAND FUNCTION:
In demand analysis, one should recognise that at any point in time the quantity of a given
product that will be purchased by the consumers depends on a number of key variables or
determinants. In technical jargon, it is stated in terms of demand function for the given product. A
demand function in mathematical terms expresses the functional relationship between the demand
for the product and its various determining variables.
Qd= f( P,I,Ps, Pc, A, T, S,S&W, Ep, Ei, O)
Where
Qd= Quantity Demand
f= Functional Relationship
P = Price of the Product
I = Income level of consumer
Ps = Price of Substitute commodity
Pc = price of Complementary commodity
A = Amount spent on Advertisement
T= Taste and Preference of the consumer
S = Size and Composition of population
S&W = Season and Weather
Ep = Expected Price in future
Ei = Expected Income in future
O = Other Factors

Determinates of Demand
➢ Price of the product: The price of a product or service is generally inversely proportional
to the quantity demanded while other factors are constant. Rational consumer always
preferred to purchase more quantity when the price of the commodity is low and vice versa.

➢ Income level of consumer: The level of income of individuals determines their purchasing
power. Generally, income and demand are directly proportional to each other. This implies
that rise in the consumers’ income results in rise in the demand for a commodity.
➢ Price of Substitute commodity: The related goods are generally substitutes and
complementary goods. The demand for a product is also influenced by the prices of
substitutes. When a want can be satisfied by alternative similar goods, they are called
substitutes, such as coffee and tea. If the Price coffee quantity demanded of tea also
increases since consumer shifty for coffee to tea leading to direct relationship between
substitute goods.

➢ Price of Complementary Commodity: The demand for a product is also influenced by

the prices of complementary goods. The complementary goods are the goods which are
used by consumer together at same time. Whenever the price of one good and the demand
of another good are inversely related then the goods are said to be complementary, such as
car and petrol. If the price of the car increases, the quantity of demanded of petrol is
deceases and vice versa.

➢ Amount spent on Advertisement: In modern times, the preferences of consumers can be

altered by advertisement and sales propaganda. Advertisement helps in increasing demand
by informing the potential consumers about the availability of the product, by showing the
superiority of the product, and by influencing consumer choice against the rival products.
The demand for products like detergents and cosmetics is mainly caused by advertisement.
Hence amount spent on advertisement is having direct relationship with quantity demanded
of the commodity.

➢ Taste and Preference of the consumer: The demand for a product depends upon tastes
and preferences of the consumers. If the consumers develop taste for a commodity they
buy whatever may be the price. A favorable change in consumer preference will cause the
demand to increase. Likewise an unfavorable change in consumer preferences will cause
the demand to decrease.

➢ Size and Composition of population: Increase in population raises the market demand,
while decrease in population reduces the market demand. Composition of population i.e.
ratio of males, females, children and number of old people in the population also affects
the demand for a commodity.

➢ Season and Weather: Seasonal factors also affect the demand. The demand for certain
items purely depends on climatic and weather conditions. For example, the growing
demand for cold drinks during the summer season and the demand for sweaters during the
winter season.

➢ Expected Price in Future:One of the determinate demand buyers' expectations about

future price of the commodity. If a buyer expects the price of a good to go down in the
future, they hold off buying it today, so the demand for that good today decreases. On the
 other hand, if a buyer expects the price to go up in the future, the demand for the good
today increases.

➢ Expected Income in future: If one expects an increase in future income, his demand at
present would also increase. On the other hand, if one expects a decline in future income
earnings, his demand at present would fall and he would rather want to save some money
to take care of future expenses and uncertainties.

Nature and Types of Demand

1. Consumer Goods Demand Vs Producer Goods Demand:
Consumer goods refers to such products and services which are capable of
satisfying human need. Goods can be grouped under consumer goods and producer goods.
Consumer goods are those which are available for ultimate consumption. These give direct
and immediate satisfaction. Example are bread, apple, and rice and so on. Producer goods
are those which are used for further processing or production of goods/services to earn
income. Example are machinery or a tractor, and such others.

2. Autonomous Demand Vs Derived Demand: .

Autonomous demand refers to the demand for products and services directly. The
demand for the services of a super speciality hospital can be considered as autonomous
whereas the demand for the hotels around that hospital is call a derived demand. In case of
a derived demand, the demand for a product arises out of the purchase of a parent product.
If there is no demand for houses, there may not be demand for steel, cement, bricks and so
on. Demand for houses is autonomous whereas demand for these inputs is derived demand.

3. Durable Goods Demand Vs Perishable Goods Demand:

Here the demand for goods is classified based on their durability. Durable goods
are those goods which give service relatively for a long period. The life of perishable goods
is very less may be in hours or days. Example of perishable goods are milk, vegetables,
fish, and such. Rice , wheat , sugar, and so on. such others can be examples of durable
goods.
4. Firm Demand Vs Industry Demand:
The firm is a single business units whereas industry refers to the group of firms
carrying on similar activity. The quantity of goods demanded by a single firm is called firm
demand and the quantity demanded by the industry as a whole is called industry demand.
One construction company may use 100 tonnes of cement during a given month which is
firm demand. The construction industry in a particular state may have used ten million
tonnes which is industry demand.
 5. Short – run Demand Vs Long – run Demand:
Joel Dean defines short – run demand as ‘the demand with its immediate reaction
to price changes, income fluctuations and so on. Long run demand is that demand which
will ultimately exist as a result of the changes in pricing, promotion or product
improvement, after enough time is allowed to let the market adjust itself to the given
situation.

6. New Demand Vs Replacement Demand:

New demand refers to the demand for the new products and it is the addition to the
existing stock. In replacement demand, the item is purchased to maintain the asset in good
condition. The demand for cars is new demand and the demand for spare parts is
replacement demand.

7. Total Market Vs Segment Market Demand:

Consider the consumption of sugar in a given region. The total demand for sugar in
the region is the total market demand. The demand for sugar comes from the sweet making
industry from this region is the segment market demand. The market segmentation concept
is very useful because it enables the study of its specific requirements, if any, such as taste
and preferences, and so on. A markets segment can be defined in terms of specific criteria
such as location, age, sex or income and so on. The aggregate demand of all the segment
markets is called the total market demand.

LAW OF DEMAND
The law of demand is one of the most important laws of economics theory. According to
law of demand, other things being equal, if the price of a commodity falls, the quantity demanded
of it will rise and if the price of a commodity rises, its quantity demanded will decline. Thus, there
is an inverse relationship between price and quantity demanded, other things being same.
Definition of law of demand
According to Marshal, “The law of demand states that other things being equal the quantity
demanded increases with a fall in price & diminishes when price increases.”
According to Ferguson, “According to the law of demand, the quantity demanded varies
inversely with price.”
The law of demand may be explained with the help of demand schedule.

Price of Apple (in. Quantity Demanded

Rs.) (in Units)
 10 1

8 2

6 3

4 4

2 5

Assumptions of Law of Demand:

➢ No change in Income level of consumer

➢ No change in Price of Substitute commodity
➢ No change in Price of Complementary Commodity
➢ No change in the Amount spent on Advertisement
➢ No change in Taste and Preference of the consumer
➢ No change in Size and Composition of population
➢ No change in Season and Weather
➢ No change in Expected Price in Future
➢ No change in Expected Income in Future

Exceptions to the law of Demand:

There are certain exceptions to the law of demand in other words, the law of demand
is not applicable in the following cases.
 ➢ Giffen Goods: People whose incomes are low purchase more of a commodity such as
broken rice, barley, Java , bread, potato etc (which is their staple food) when its price rises.
Inversely when its price falls, instead of buying more, they buy less of this commodity and
use the savings for the purchase of better goods such as meat. This phenomenon is called
Giffens paradox and such goods are called Giffen goods.
➢ Veblen Goods: Products such as jewels, diamonds and so on confer distinction on the part
of the user. In such case, the consumers tend to buy more goods when price increased and
less purchase when price decreased. Such goods are called Veblen Goods. Or prestige
good which shows their status.
➢ Speculative Effect: If the price of the commodity is increasing the consumers will buy
more of it because of the fear that it increase still further in future and vice versa, example
price of shares, etc.
➢ Fear Shortages: If the consumers fear that there may be shortage of goods, then law of
demand does not applicable. They may tend to buy more than what they require
immediately, even if the price of the product increases.
➢ In case of ignorance of price changes/ impulse buying: When the customer is not
familiar with the changes in the price, he tends to buy even if there is increase in price.
Consumers tend to buy more even the price is high because of impulse behaviour.
➢ Necessities: In the case of necessities like salt, match box etc., demand would not change
even price of these items changes.

ELASTICITY OF DEMAND
Prof. Marshall introduced the concept of elasticity of demand to measure the change in demand.
Thus elasticity of demand is the measurement of the change in demand in response to a given
change in the price of a commodity. It measures how much demand will change in response to a
certain increase or decrease in the price of a commodity.
Elasticity of demand is defined as the ratio of the percentage change in quantity demanded to the
percentage change in the demand determinant under consideration.

DEFINITIONS OF ELASTICITY OF DEMAND

According to E.K. Estham “Elasticity of demand is measure of the responsiveness of quantity
demanded to a change in price”
According to Prof.Benham “The concept relates to the effect of a small change in price upon the
amount demanded”.
According to Prof.Boulding. “The elasticity of demand may be defined as the percentage change
in the quantity demanded which would result from percent change in price.”
TYPES OF ELASTICITY OF DEMAND:
1. Price elasticity of demand
2. Income elasticity of demand
3. Cross elasticity of demand
4. Promotional elasticity of demand

1. Price elasticity of demand:Elasticity of demand in general refers to price elasticity of demand.

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

OR

Where:

Q1 = Quantity demand before change

Q2 = Quantity demand after change

P1 = Price before change

P2 = Price after change

2.Income elasticity of demand: Income elasticity of demand refers to the change in quantity
demand of a commodity in response to a given change income.

OR

Where:

Q1 = Quantity demand before change

Q2 = Quantity demand after change

I1 = Income before change

I2 = Income after change

3. Cross elasticity of demand: Cross elasticity of demand refers to the change in quantity
demanded of a one commodity in response to a change in the price of a related good, which may
be substitute or complementary.
 OR

Where:

Qx1 = Quantity demand of X commodity before change

Qx2 = Quantity demand of X commodity after change

Py1 = Price of Y commodity before change

Py2 = Price of Y commodity after change

4. Promotional/Advertising elasticity of demand: It refers to increase in the sales revenue

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

Where:

Q1 = Quantity demand before change

Q2 = Quantity demand after change

A1 = Advertising expenditure before change

A2 = Advertising expenditure after change

Measurement Elasticity of Demand

1. Perfectly elasticity of demand

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

1. Perfectly Elastic Demand (Ep = ∞): When any quantity can be sold at a given price and when
there is no need to reduce price, the demand is to be perfectly elastic. In such cases, even a small
increase in price will lead to complete fall in demand. The shape of demand curve is horizontal. In
simple words where no reduction in price is needed to cause an increase in quantity demanded.

2. Perfectly Inelastic Demand (Ep = 0): In perfectly inelastic demand the demand of a commodity
does not changes, whatever be the change in its price. Arithmetically, it is known as zero elastic demand.
The shape of demand curve is vertical. In simple words where a change in price, however large,
causes no change in quantity demanded.

3. Relatively elastic of demand (Ep> 1): Demand changes more proportionately than to change in
price. i.e., a small change in price leads to a very big change in the quantity demanded. The shape of
demand curve is semi – horizontal or flat. In simple word the demand is said to be relatively elastic
when the change in demand is more than the change in the price.

Relatively inelastic of demand (Ep< 1): The

quantity demanded changes less proportionately
than to a change in price, a large change in price leads to a small change in amount demanded. The shape
of demand curve is semi - variable or steep. In simple word the demand is said to be relatively inelastic
when the change in demand is less than the change in the price.
 Unitary elastic demand (Ep =1): In
unitary elastic demand proportionate
change in the price of a commodity and proportionate change in its demand are equal. It is called as unitary
elastic demand. The shape of demand curve is rectangular hyperbola. In simple word the elastic in demand
is said to be unitary when the change in demand is equal to the change in price.

FACTORS DETERMINING ELASTICITY OF DEMAND

1. Nature of commodity: According to the nature of satisfaction the goods give, they may
be classified into luxury, comfort or necessary goods. In general, luxury and comfort goods
are price elastic, while necessary goods are price inelastic. Thus, for example, the demand
for food grains, cloth, salt etc. is generally inelastic while that for radio, furniture, car, etc.
is elastic.
2. Substitutes: Demand is elastic for those goods which have substitutes and inelastic for
those goods which have no substitutes. The availability of substitutes, thus, determines the
elasticity of demand. For instance, tea and coffee are substitutes. The change in the price
of tea affects the demand for coffee. Hence, the demand for coffee is elastic.
3. Number of Uses: Elasticity of demand for any commodity depends on its number of uses.
Demand is elastic; if a commodity has more uses and inelastic if it has only one use. As
coal has multiple uses, if its price falls it will be demanded more for cooking, heating,
industrial purposes etc. But if its price rises, minimum will be demanded for every purpose.
 4. Postponement: Demand is more elastic for goods the use of which can be postponed. For
example, if the price of silk rises, its consumption can be postponed. The demand for silk
is, therefore, elastic. Demand is inelastic for those goods the use of which is urgent and,
therefore, cannot be postponed. The use of medicines cannot be put off. Hence, the demand
for medicines is inelastic.
5. Raw Materials and Finished Goods: The demand for raw materials is inelastic but the
demand for finished goods is elastic. For instance, raw cotton has inelastic demand but
cloth has elastic demand. In the same way, petrol has inelastic demand but car itself has
only elastic demand.
6. Price Level: The demand is elastic of the goods at higher prices but inelastic of the goods
at lower prices.
7. Nature of Expenditure: The elasticity of demand for a commodity also depends as to how
much part of the income is spent on that particular commodity. The demand for such
commodities where a small part of income is spent is generally highly inelastic i.e.
newspaper, boot-polish etc. On the other hand, the demand of such commodities where a
significant part of income is spent, elasticity of demand is very elastic.
8. Habit farming characteristic: In case of habit farming characteristic goods like tobacco,
cigarettes, alcohol etc. demand is inelastic for the reason even price increases the demand
remain same.

Significance and Importance of Elasticity of demand

a. Planning the levels of output and price:

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

b. Price fixation:
The manufacturer can decide the amount of price that can be fixed for his product
based on the concept of elasticity. If there is no competition, in other words in the case of
a monopoly, the manufacture is free to fix his price as long as it does not attract the attention
of the government. When there are close substitutes, the product is such that its
consumption can be postponed, it cannot be put to alternative uses and so on, then the price
of the product cannot be fixed very highly.
 c. Price of factors of production:
The factors of production are land, labour, capital, organization and technology.
These have a cost: hence manufacturers have to pay rent, wages, interest, profits and price
for these factors of production. Elasticity of demand help to determinant how much should
be paid for these factors of production.
d. Government policies:
1. Tax policies: Government extensively depends on this concept to finalize its polices
relating to taxes and revenues. Where the product is such that the people cannot
postpone its consumptions, the government tends to increase its price, such as petrol
and diesel, cigarettes, and so on.
2. Raising bank deposits: If the government wants to mobilize larger deposits from the
consumer it propose to raise the rates of fixed deposits marginally and vice versa.
3. Public utilities: Government uses the concept of elasticity in fixing charges for the
public utilities such as elasticity tariff, water charges, ticket fare in case of road or rail
transport .
e. Forecasting demand:
Income elasticity is used to forecast demand for a particular product or services.
The demand for the products can be forecast at a given income level. The trader can
estimate the quantity of goods to be sold at different income levels to realize the targeted
revenue.

DEMAND FORECASTING
Future is uncertain. There is great deal of uncertainty with regard to demand. Since the
demand is uncertain, production, cost, revenue, profit etc. are also uncertain. Through forecasting
it is possible to minimise the uncertainties.

Demand forecasting can be defined as a process of predicting the future demand for an
organisation’s goods or services. It is also referred to as sales forecasting as it involves anticipating
the future sales figures of an organisation.

Demand forecasting helps an organisation to take various business decisions, such as

planning the production process, purchasing raw materials, managing funds and deciding the price
of its products. Demand can be forecasted by organisations either internally by making estimates
called guess estimate or externally through specialised consultants or market research agencies.

Definition of demand forecasting

According to Evan J. Douglas, “Demand estimation (forecasting) may be defined as a process of

finding values for demand in future time periods.”
According to Cundiff and Still, “Demand forecasting is an estimate of sales during a specified
future period based on proposed marketing plan and a set of particular uncontrollable and
competitive forces.”

Need of Demand Forecasting

✓ Fulfilling objectives: It implies that every business unit starts with certain pre-decided
objectives. Demand forecasting helps in fulfilling these objectives. An organization
estimates the current demand for its products and services in the market and move forward
to achieve the set goals.
✓ Preparing the budget: Demand forecasting plays a crucial role in making budget by
estimating costs and expected revenues. For instance, an organization has forecasted
that the demand for its product, which is priced at Rs. 10, would be 1, 00, 000 units.
In such a case, the total expected revenue would be 10* 100000 = Rs. 10, 00, 000. In
this way, demand forecasting enables organizations to prepare their budget.

✓ Stabilizing employment and production: It helps an organization to control its

production and recruitment activities. Producing according to the forecasted demand of
products helps in avoiding the wastage of the resources of an organization. This further
helps an organization to hire human resource according to requirement. For example, if an
organization expects a rise in the demand for its products, it may opt for extra labor to
fulfill the increased demand.

✓ Expanding organizations: It implies that demand forecasting helps in deciding about the
expansion of the business of the organization. If the expected demand for products is
higher, then the organization may plan to expand further. On the other hand, if the demand
for products is expected to fall, the organization may cut down the investment in the
business.

✓ Taking Management Decisions: It helps in making critical decisions, such as deciding

the plant capacity, determining the requirement of raw material, and ensuring the
availability of labor and capital.

✓ Evaluating Performance: Helps in making corrections. For example, if the demand for
an organization’s products is less, it may take corrective actions and improve the level of
demand by enhancing the quality of its products or spending more on advertisements.

Basis of demand forecasting:

Level of forecasting :
Firm level : It refers to forecasting of demand by an individual firm for its products. Most
important category for a manager for taking important decisions related to marketing and
production.

Industry level: It refers to demand forecasting of a product in an industry as a whole. It provides

insights into the growth pattern of an industry, relative contribution of the industry in national
income.

Economy (Macro) level:It refers to forecasting of aggregate demand in the economy. It helps in
various policy formulations at government level.

Time period involved:

Short-term forecasting: It involves anticipating demand for a period not exceeding one year. It is
focused on the short term decisions (for example, arranging finance, formulating production
policy, making promotional strategies, etc.) of an organisation.

Long-term forecasting: It involves predicting demand for a period of 5-7 years and may extend
for a period of 10 to 20 years. It is focused on the long-term decisions (for example, deciding the
production capacity, replacing machinery, etc.) of an organisation.

Nature of products:
Consumer goods: The goods that are meant for final consumption by end users are called
consumer goods. These goods have a direct demand. Generally, demand forecasting for these
goods is done while introducing a new product or replacing the existing product with an improved
one.

Capital goods: These goods are required to produce consumer goods; for example, machinery.
Thus, these goods have a derived demand. The demand forecasting of capital goods depends on
the demand for consumer goods. For example, prediction of higher demand for consumer goods
would result in the anticipation of higher demand for capital goods too.
DEMAND FORECASTING METHODS
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. As
consumers generally plan their purchases in advance, their opinions and intentions may be sought
to analyse trends in market demand.

Survey of Buyers’ Intentions Method: It is also known as consumers’ expectations or opinions

survey. It is commonly used method for sales forecasting. A sale is the result of consumer intention
to buy the product. Many companies conduct periodical survey of consumers’ buying interest to
know when and how much they will buy.

Census Method: The census method is also called as a Complete Enumeration Survey Method wherein
each and every item in the universe is selected for the data collection. The universe might constitute a
particular place of group of people or any specific locality which is the complete set of items and which
are of interest in any particular situation.
The census methods is most commonly used by the government in connection with the national population,
housing census, agriculture census, etc. where the vast knowledge about these fields is required. Whenever
the entire population is studied to collect the detailed data about every unit, then the census method is
applied.

Sample Methods: Useful data for forecasting demand can also be obtained from surveys of consumer
plans. Unlike the complete enumeration method, under the sample survey method, only a few potential
consumers from the relevant market selected through an appropriate sampling method are interviewed. The
survey may be conducted either through direct interview or mailed questionnaire to the sample consumers.

SALES FORCE METHODS: Sometimes, it is called sales force estimate method. Company can
ask, either all or some of salesmen, to estimate demand for a given time. Each sales representative
estimates how much each current and prospective customer will buy the company’s product. They
are offered certain incentives to encourage them better estimate.

Here, for estimating the future demand, the company’s sales force opinions are taken as a
base. Since salesmen have direct and close contact with customers, competitors, dealers, and
overall market environment, they can provide more reliable estimates of the future sales.

STATISTICAL METHODS

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

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

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

b. Least squares methods: This technique uses statistical formulae to find the trend line
which best fits the available data. The trend line is the estimating equation, which can be
used for forecasting demand by extrapolating the line for future.
The equation for straight line trend is
S= a+bT
 the value of “a” and “b are calculate by using the following two normal equations.

S= forecasted sale
T = year number for which sales being forecasted.
n = number of years of data given the problem.

c. Time series analysis: Where the surveys or market tests are costly and time consuming,
statistical and mathematical analysis of past sales data offers another method to prepare the
forecasts, that is, time series analysis. One major requirement to administer this technique
is that the product should have actively been traded in the market for quite some time in
the past.
The following are the four major components analysed from time series while forecasting
the demand:
Tends (T): It also called the long term trend. The result of basic developments in the
population, capital formation and technology. These development relate to over a period
of long time say five to ten years, not definitely overnight. The trend is considered
statistically significant when it has reasonable degree of consistency. A significant trend is
central and decisive factor considered while preparing a long range forecast.
Cyclic Trend (C): It is seen in the wave like movement of sales. The sales data is quite
often affected by swings in the levels of general economic activity, which tend to be
somewhat periodic. These could be related to the business cycles in the economy such as
inflation or recession.
Seasonal Trend (S): It refers to a consistent pattern of sales movements within the year.
More goods are sold during the festival seasons. The seasonal component may be related
to weather factors, holidays, etc.
Erratic Trend (E): It results from the sporadic occurrence of strikes, riots, and so on. These
erratic components can even damage the impact of more systematic components and thus
make the forecasting process much more complex.

Classical time series analysis involves procedures for decomposing the original sales series
(Y) into the components T,C,S,E. There are different models in the time series analysis.
While one model states that these components interact linearly, that is,
Y = T+C+S+E, another model states that Y is the product of all these component that is,
 d. Moving average method: A moving average is a technique that calculates the overall trend
in sales volume from historical data of the company. This techniques is very useful for
forecasting short – term trends. It is simply the average of select time periods. It called
moving as a new demand number is calculated for an upcoming time period.

Moving Average = (n1+n2+n3+ …….)/n

e. Exponential smoothing: It uses all the time series values to generate a forecast with lesser
weights given to the observations further back in time. Exponential smoothing is actually
a way of “smoothing” out the data by eliminating much of the “noise”( random effects).

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

3 Correlation and regression methods: correlation and regression methods are statistical
techniques. Correlation describes the degree of association between two variable such as sales and
advertisement expenditure. When the two variable tend to change together, then they are said to
be correlated.
Regression method: An equation is estimated which best fits in the sets of observations of
dependent variables and independent variables. The best estimate of the true underlying
relationship between these variables is thus generated. The dependent (unknown) variable is the
forecast based on this estimated equation for a given value of the independent (known) variable.
The method of least squares is applied most in regression.

4. Simultaneous equation method:Under simultaneous equation model, demand forecasting

involves the estimation of several simultaneous equations. These equations are often the behavioral
equations, market-clearing equations, and mathematical identities.

The regression technique is based on the assumption of one-way causation, which means
independent variables cause variations in the dependent variables, and not vice-versa. In simple
terms, the independent variable is in no way affected by the dependent variable. For example, D =
a – bP, which shows that price affects demand, but demand does not affect the price, which is an
unrealistic assumption.

Other methods

Expert opinion methods:

 Well informed persons are called experts; experts constitute yet another source of
information. These persons are generally the outside experts and they do not have any vested
interest in the results of a particular survey. As expert is good at forecasting and analysis the future
trend in a given product or service at a given level of technology. The service of an expert could
be advantageously used when a firm uses general economic forecasting or special industry
forecasting prepared outside the firm.
Delphi Method: It refers to a group decision making technique of forecasting demand. In this
method, questions are individually asked from a group of experts to obtain their opinions on
demand for products in future. These questions are repeatedly asked until a consensus is obtained.
In other words the Delphi method is a structured communication technique, originally developed
as a systematic, interactive forecasting method which relies on a panel of experts.
Advantages:
• Opportunities for large number of people to participate.
• Focus is on “ideas” rather than “individuals”.
• Anonymity for participants which make contributions of ideas as safe activity.
• Opportunities for participants to reconsider their opinions.
• Allows for identification of priorities.

Limitations:
➢ Large amount of time to conduct several rounds.
➢ The complexity of data analysis.
➢ The difficulty of maintaining participant enthusiasm throughout the process.
➢ The problem of keeping statements value free and clearly defined.
➢ Self-reporting data is subject to respondent biases and memories.

Test marketing:
It is likely that opinions given by buyers, salesman or other experts may be, at times,
misleading. This is the reason why most of the manufactures favour to test their product or service
in a limited market as test – run before they launch their product nationwide.
Controlled experiments:
Controlled experiments refer to such exercise where some of the major determinants of
demand are manipulated to suit to the customers with different tastes and preferences, income
groups, and such others. It is further assumed that all other factors remain the same.

Judgmental approach:
When none of the above methods are directly related to the given product or service, the
management has no alternative other than using its own judgment. Even when the above methods
are used, the forecasting process is supplemented with the factor of judgment for the following
reasons
• Historical data for significantly long period is not available
• Turning point in terms of policies or procedures or causal factors cannot be precisely
determined
• Sale fluctuation are wide and significant
• The sophisticated statistical techniques such as regression and so on, may not cover all.

Supply

Supply is an economic principle can be defined as the quantity of a product that a seller
is willing to offer in the market at a particular price within specific time.
The supply of a product is influenced by various determinants, such as price, cost of
production, government policies, and technology. It is governed by the law of supply,
which states a direct relationship between the supply and price of a product, while other
factors remaining the same.
Supply may be defined as a schedule which shows the various amounts of a product
which a particular seller is willing and able to produce and make available for sale in the
market at each specific price in a set of possible prices during a given period.McConnell
Supply refers to the quantity of a commodity offered for sale at a given price, in a given
market, at given time.AnatolMurad

Supply Function
Supply function is the mathematical expression of law of supply. In other words, supply
function quantifies the relationship between quantity supplied and price of a product,
while keeping the other factors at constant.

The law of supply expresses the nature of the relationship between quantity supplied and
price of a product, while the supply function measures that relationship.
The supply function can be expressed as:
Qs = f (Pa, Pb, Pc, T, Tp)
Where,
Qs = Supply
Pa = Price of the good supplied
Pb = Price of other goods
Pc = Price of factor input
T = Technology
Tp = Time Period

Determinants of Supply
Supply does not remain constant all the time in the market. There are many factors that
influence the supply of a product. Generally, the supply of a product depends on its price
and cost of production.
Thus, it can be said that supply is the function of price and cost of production. These factors that
influence the supply are called the determinants of supply.

Determinants of supply are:

• Price of a product
• Cost of production
• Natural conditions
• Transportation conditions
• Taxation policies
• Production techniques
• Factor prices and their availability
• Price of related goods
• Industry structure

Price of a product
The major determinants of the supply of a product is its price. An increase in the price of
a product increases its supply and vice versa while other factors remain the same.
Producers increase the supply of the product at higher prices due to the expectation of
receiving increased profits. Thus, price and supply have a direct relationship.

Cost of production
It is the cost incurred on the manufacturing of goods that are to be offered to consumers.
Cost of production and supply are inversely proportional to each other.

This implies that suppliers do not supply products in the market when the cost of
manufacturing is more than their market price. In this case, sellers would wait for a rise in
price in the future.
The cost of production increases due to several factors, such as loss of fertility of land;
high wage rates of labour; and increase in the prices of raw material, transportation cost,
and tax rate.

Natural conditions
The supply of certain products is directly influenced by climatic conditions. For instance,
the supply of agricultural products increases when the monsoon comes well on time.

On the contrary, the supply of these products decreases at the time of drought. Some of
the crops are climate specific and their growth purely depends on climatic conditions.

For example, Kharif crops are well grown at the time of summer, while Rabi crops are
produced well in the winter season.
Transportation conditions
Better transport facilities result in an increase in the supply of goods. Transport is always
a constraint to the supply of goods. This is because goods are not available on time due to
poor transport facilities.

Therefore, even if the price of a product increases, the supply would not increase.

Taxation policies
Government’s tax policies also act as a regulating force in supply. If the rates of taxes
levied on goods are high, the supply will decrease. This is because high tax rates increase
overall productions costs, which will make it difficult for suppliers to offer products in
the market.

Similarly, reduction in taxes on goods will lead to an increase in their supply in the
market.

Production techniques
The supply of goods also depends on the type of techniques used for production.
Obsolete techniques result in low production, which further decreases the supply of
goods.

Over the years, there has been tremendous improvement in production techniques, which
has led to increase in the supply of goods.

Factor prices and their availability

The production of goods is dependent on the factors of production, such as raw material,
machines and equipment, and labour.
An increase in the prices of the factors of production increases the cost of production.
This will make difficult for firms to supply large quantities in the market.

Price of related goods

The prices of substitutes and complementary goods also influence the supply of a product
to a large extent.

For example, if the price of tea increases, farmers would tend to grow more tea than
coffee. This would decrease the supply of tea in the market.

Industry structure
The supply of goods is also dependent on the structure of the industry in which a firm is
operating. If there is monopoly in the industry, the manufacturer may restrict the supply
of his/her goods with an aim to raise the prices of goods and increase profits.

On the other hand, in case of a perfectly competitive market structure, there would be a
large of number of sellers in the market. Consequently, the supply of a product would
increase.

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

Demand refers to how much (quantity) of a product or service is desired by buyers. The
quantity demanded is the amount of a product people are willing to buy at a certain price. Demand
for a good by a consumer is not the same thing as his desire to buy it. A desire becomes a demand
only when it is effective which means that, given the price of the good, the consumer should be
both willing and able to pay for the quantity which he wants to buy.
Thus three things are essential for a desire for a commodity to become effective demand
• Desire of a consumer to buy the commodity
• Willingness of a consumer to buy the commodity
• Ability of a consumer (having sufficient purchase power or money) to buy the commodity
DEFINITION OF DEMAND
According to Ferguson, “Demand refers to quantities of a commodity that the consumers are able
and willing to buy at each possible price during a given period of time, other things being equal.”

DEMAND FUNCTION:
In demand analysis, one should recognise that at any point in time the quantity of a given
product that will be purchased by the consumers depends on a number of key variables or
determinants. In technical jargon, it is stated in terms of demand function for the given product. A
demand function in mathematical terms expresses the functional relationship between the demand
for the product and its various determining variables.
Qd= f( P,I,Ps, Pc, A, T, S,S&W, Ep, Ei, O)
Where
Qd= Quantity Demand
f= Functional Relationship
P = Price of the Product
I = Income level of consumer
Ps = Price of Substitute commodity
Pc = price of Complementary commodity
A = Amount spent on Advertisement
T= Taste and Preference of the consumer
S = Size and Composition of population
S&W = Season and Weather
Ep = Expected Price in future
Ei = Expected Income in future
O = Other Factors

Determinates of Demand
➢ Price of the product: The price of a product or service is generally inversely proportional
to the quantity demanded while other factors are constant. Rational consumer always
preferred to purchase more quantity when the price of the commodity is low and vice versa.
➢ Income level of consumer: The level of income of individuals determines their purchasing
power. Generally, income and demand are directly proportional to each other. This implies
that rise in the consumers’ income results in rise in the demand for a commodity.

➢ Price of Substitute commodity: The related goods are generally substitutes and
complementary goods. The demand for a product is also influenced by the prices of
substitutes. When a want can be satisfied by alternative similar goods, they are called
substitutes, such as coffee and tea. If the Price coffee quantity demanded of tea also
increases since consumer shifty for coffee to tea leading to direct relationship between
substitute goods.

➢ Price of Complementary Commodity: The demand for a product is also influenced by

the prices of complementary goods. The complementary goods are the goods which are
used by consumer together at same time. Whenever the price of one good and the demand
of another good are inversely related then the goods are said to be complementary, such as
car and petrol. If the price of the car increases, the quantity of demanded of petrol is
deceases and vice versa.
 ➢ Amount spent on Advertisement: In modern times, the preferences of consumers can be
altered by advertisement and sales propaganda. Advertisement helps in increasing demand
by informing the potential consumers about the availability of the product, by showing the
superiority of the product, and by influencing consumer choice against the rival products.
The demand for products like detergents and cosmetics is mainly caused by advertisement.
Hence amount spent on advertisement is having direct relationship with quantity demanded
of the commodity.

➢ Taste and Preference of the consumer: The demand for a product depends upon tastes
and preferences of the consumers. If the consumers develop taste for a commodity they
buy whatever may be the price. A favorable change in consumer preference will cause the
demand to increase. Likewise an unfavorable change in consumer preferences will cause
the demand to decrease.

➢ Size and Composition of population: Increase in population raises the market demand,
while decrease in population reduces the market demand. Composition of population i.e.
ratio of males, females, children and number of old people in the population also affects
the demand for a commodity.

➢ Season and Weather: Seasonal factors also affect the demand. The demand for certain
items purely depends on climatic and weather conditions. For example, the growing
demand for cold drinks during the summer season and the demand for sweaters during the
winter season.

➢ Expected Price in Future:One of the determinate demand buyers' expectations about

future price of the commodity. If a buyer expects the price of a good to go down in the
future, they hold off buying it today, so the demand for that good today decreases. On the
other hand, if a buyer expects the price to go up in the future, the demand for the good
today increases.

➢ Expected Income in future: If one expects an increase in future income, his demand at
present would also increase. On the other hand, if one expects a decline in future income
earnings, his demand at present would fall and he would rather want to save some money
to take care of future expenses and uncertainties.

Nature and Types of Demand

8. Consumer Goods Demand Vs Producer Goods Demand:
Consumer goods refers to such products and services which are capable of
satisfying human need. Goods can be grouped under consumer goods and producer goods.
 Consumer goods are those which are available for ultimate consumption. These give direct
and immediate satisfaction. Example are bread, apple, and rice and so on. Producer goods
are those which are used for further processing or production of goods/services to earn
income. Example are machinery or a tractor, and such others.

9. Autonomous Demand Vs Derived Demand: .

Autonomous demand refers to the demand for products and services directly. The
demand for the services of a super speciality hospital can be considered as autonomous
whereas the demand for the hotels around that hospital is call a derived demand. In case of
a derived demand, the demand for a product arises out of the purchase of a parent product.
If there is no demand for houses, there may not be demand for steel, cement, bricks and so
on. Demand for houses is autonomous whereas demand for these inputs is derived demand.

10. Durable Goods Demand Vs Perishable Goods Demand:

Here the demand for goods is classified based on their durability. Durable goods
are those goods which give service relatively for a long period. The life of perishable goods
is very less may be in hours or days. Example of perishable goods are milk, vegetables,
fish, and such. Rice , wheat , sugar, and so on. such others can be examples of durable
goods.
11. Firm Demand Vs Industry Demand:
The firm is a single business units whereas industry refers to the group of firms
carrying on similar activity. The quantity of goods demanded by a single firm is called firm
demand and the quantity demanded by the industry as a whole is called industry demand.
One construction company may use 100 tonnes of cement during a given month which is
firm demand. The construction industry in a particular state may have used ten million
tonnes which is industry demand.

12. Short – run Demand Vs Long – run Demand:

Joel Dean defines short – run demand as ‘the demand with its immediate reaction
to price changes, income fluctuations and so on. Long run demand is that demand which
will ultimately exist as a result of the changes in pricing, promotion or product
improvement, after enough time is allowed to let the market adjust itself to the given
situation.

13. New Demand Vs Replacement Demand:

New demand refers to the demand for the new products and it is the addition to the
existing stock. In replacement demand, the item is purchased to maintain the asset in good
condition. The demand for cars is new demand and the demand for spare parts is
replacement demand.

14. Total Market Vs Segment Market Demand:

 Consider the consumption of sugar in a given region. The total demand for sugar in
the region is the total market demand. The demand for sugar comes from the sweet making
industry from this region is the segment market demand. The market segmentation concept
is very useful because it enables the study of its specific requirements, if any, such as taste
and preferences, and so on. A markets segment can be defined in terms of specific criteria
such as location, age, sex or income and so on. The aggregate demand of all the segment
markets is called the total market demand.

LAW OF DEMAND
The law of demand is one of the most important laws of economics theory. According to
law of demand, other things being equal, if the price of a commodity falls, the quantity demanded
of it will rise and if the price of a commodity rises, its quantity demanded will decline. Thus, there
is an inverse relationship between price and quantity demanded, other things being same.
Definition of law of demand
According to Marshal, “The law of demand states that other things being equal the quantity
demanded increases with a fall in price & diminishes when price increases.”
According to Ferguson, “According to the law of demand, the quantity demanded varies
inversely with price.”
The law of demand may be explained with the help of demand schedule.

Price of Apple (in. Quantity Demanded

Rs.) (in Units)

10 1

8 2

6 3

4 4

2 5
Assumptions of Law of Demand:

➢ No change in Income level of consumer

➢ No change in Price of Substitute commodity
➢ No change in Price of Complementary Commodity
➢ No change in the Amount spent on Advertisement
➢ No change in Taste and Preference of the consumer
➢ No change in Size and Composition of population
➢ No change in Season and Weather
➢ No change in Expected Price in Future
➢ No change in Expected Income in Future

Exceptions to the law of Demand:

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

➢ Giffen Goods: People whose incomes are low purchase more of a commodity such as
broken rice, barley, Java , bread, potato etc (which is their staple food) when its price rises.
Inversely when its price falls, instead of buying more, they buy less of this commodity and
use the savings for the purchase of better goods such as meat. This phenomenon is called
Giffens paradox and such goods are called Giffen goods.
➢ Veblen Goods: Products such as jewels, diamonds and so on confer distinction on the part
of the user. In such case, the consumers tend to buy more goods when price increased and
less purchase when price decreased. Such goods are called Veblen Goods. Or prestige
good which shows their status.
 ➢ Speculative Effect: If the price of the commodity is increasing the consumers will buy
more of it because of the fear that it increase still further in future and vice versa, example
price of shares, etc.
➢ Fear Shortages: If the consumers fear that there may be shortage of goods, then law of
demand does not applicable. They may tend to buy more than what they require
immediately, even if the price of the product increases.
➢ In case of ignorance of price changes/ impulse buying: When the customer is not
familiar with the changes in the price, he tends to buy even if there is increase in price.
Consumers tend to buy more even the price is high because of impulse behaviour.
➢ Necessities: In the case of necessities like salt, match box etc., demand would not change
even price of these items changes.

ELASTICITY OF DEMAND
Prof. Marshall introduced the concept of elasticity of demand to measure the change in demand.
Thus elasticity of demand is the measurement of the change in demand in response to a given
change in the price of a commodity. It measures how much demand will change in response to a
certain increase or decrease in the price of a commodity.
Elasticity of demand is defined as the ratio of the percentage change in quantity demanded to the
percentage change in the demand determinant under consideration.

DEFINITIONS OF ELASTICITY OF DEMAND

According to E.K. Estham “Elasticity of demand is measure of the responsiveness of quantity
demanded to a change in price”
According to Prof.Benham “The concept relates to the effect of a small change in price upon the
amount demanded”.
According to Prof.Boulding. “The elasticity of demand may be defined as the percentage change
in the quantity demanded which would result from percent change in price.”
TYPES OF ELASTICITY OF DEMAND:
5. Price elasticity of demand
6. Income elasticity of demand
7. Cross elasticity of demand
8. Promotional elasticity of demand

1. Price elasticity of demand:Elasticity of demand in general refers to price elasticity of demand.

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

OR

Where:

Q1 = Quantity demand before change

Q2 = Quantity demand after change

P1 = Price before change

P2 = Price after change

2.Income elasticity of demand: Income elasticity of demand refers to the change in quantity
demand of a commodity in response to a given change income.
 OR

Where:

Q1 = Quantity demand before change

Q2 = Quantity demand after change

I1 = Income before change

I2 = Income after change

3. Cross elasticity of demand: Cross elasticity of demand refers to the change in quantity
demanded of a one commodity in response to a change in the price of a related good, which may
be substitute or complementary.

OR
Where:

Qx1 = Quantity demand of X commodity before change

Qx2 = Quantity demand of X commodity after change

Py1 = Price of Y commodity before change

Py2 = Price of Y commodity after change

4. Promotional/Advertising elasticity of demand: It refers to increase in the sales revenue

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

OR
Where:

Q1 = Quantity demand before change

Q2 = Quantity demand after change

A1 = Advertising expenditure before change

A2 = Advertising expenditure after change

Measurement Elasticity of Demand

6. Perfectly elasticity of demand

7. Perfectly inelasticity of demand
8. Relatively elasticity of demand
9. Relatively inelasticity of demand
10. Unity elasticity of demand

1. Perfectly Elastic Demand (Ep = ∞): When any quantity can be sold at a given price and when
there is no need to reduce price, the demand is to be perfectly elastic. In such cases, even a small
increase in price will lead to complete fall in demand. The shape of demand curve is horizontal. In
simple words where no reduction in price is needed to cause an increase in quantity demanded.
 2. Perfectly Inelastic Demand (Ep = 0): In perfectly inelastic demand the demand of a commodity
does not changes, whatever be the change in its price. Arithmetically, it is known as zero elastic demand.
The shape of demand curve is vertical. In simple words where a change in price, however large,
causes no change in quantity demanded.

3. Relatively elastic of demand (Ep> 1): Demand changes more proportionately than to change in
price. i.e., a small change in price leads to a very big change in the quantity demanded. The shape of
demand curve is semi – horizontal or flat. In simple word the demand is said to be relatively elastic
when the change in demand is more than the change in the price.

Relatively inelastic of demand (Ep< 1): The

quantity demanded changes less proportionately
than to a change in price, a large change in price leads to a small change in amount demanded. The shape
of demand curve is semi - variable or steep. In simple word the demand is said to be relatively inelastic
when the change in demand is less than the change in the price.
 Unitary elastic demand (Ep =1): In
unitary elastic demand proportionate
change in the price of a commodity and proportionate change in its demand are equal. It is called as unitary
elastic demand. The shape of demand curve is rectangular hyperbola. In simple word the elastic in demand
is said to be unitary when the change in demand is equal to the change in price.

FACTORS DETERMINING ELASTICITY OF DEMAND

9. Nature of commodity: According to the nature of satisfaction the goods give, they may
be classified into luxury, comfort or necessary goods. In general, luxury and comfort goods
are price elastic, while necessary goods are price inelastic. Thus, for example, the demand
for food grains, cloth, salt etc. is generally inelastic while that for radio, furniture, car, etc.
is elastic.
10. Substitutes: Demand is elastic for those goods which have substitutes and inelastic
for those goods which have no substitutes. The availability of substitutes, thus, determines
the elasticity of demand. For instance, tea and coffee are substitutes. The change in the
price of tea affects the demand for coffee. Hence, the demand for coffee is elastic.
11. Number of Uses: Elasticity of demand for any commodity depends on its number
of uses. Demand is elastic; if a commodity has more uses and inelastic if it has only one
use. As coal has multiple uses, if its price falls it will be demanded more for cooking,
heating, industrial purposes etc. But if its price rises, minimum will be demanded for every
purpose.
 12. Postponement: Demand is more elastic for goods the use of which can be
postponed. For example, if the price of silk rises, its consumption can be postponed. The
demand for silk is, therefore, elastic. Demand is inelastic for those goods the use of which
is urgent and, therefore, cannot be postponed. The use of medicines cannot be put off.
Hence, the demand for medicines is inelastic.
13. Raw Materials and Finished Goods: The demand for raw materials is inelastic
but the demand for finished goods is elastic. For instance, raw cotton has inelastic demand
but cloth has elastic demand. In the same way, petrol has inelastic demand but car itself
has only elastic demand.
14. Price Level: The demand is elastic of the goods at higher prices but inelastic of the
goods at lower prices.
15. Nature of Expenditure: The elasticity of demand for a commodity also depends
as to how much part of the income is spent on that particular commodity. The demand for
such commodities where a small part of income is spent is generally highly inelastic i.e.
newspaper, boot-polish etc. On the other hand, the demand of such commodities where a
significant part of income is spent, elasticity of demand is very elastic.
16. Habit farming characteristic: In case of habit farming characteristic goods like
tobacco, cigarettes, alcohol etc. demand is inelastic for the reason even price increases the
demand remain same.

Significance and Importance of Elasticity of demand

f. Planning the levels of output and price:

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

g. Price fixation:
The manufacturer can decide the amount of price that can be fixed for his product
based on the concept of elasticity. If there is no competition, in other words in the case of
a monopoly, the manufacture is free to fix his price as long as it does not attract the attention
of the government. When there are close substitutes, the product is such that its
consumption can be postponed, it cannot be put to alternative uses and so on, then the price
of the product cannot be fixed very highly.
 h. Price of factors of production:
The factors of production are land, labour, capital, organization and technology.
These have a cost: hence manufacturers have to pay rent, wages, interest, profits and price
for these factors of production. Elasticity of demand help to determinant how much should
be paid for these factors of production.
i. Government policies:
4. Tax policies: Government extensively depends on this concept to finalize its polices
relating to taxes and revenues. Where the product is such that the people cannot
postpone its consumptions, the government tends to increase its price, such as petrol
and diesel, cigarettes, and so on.
5. Raising bank deposits: If the government wants to mobilize larger deposits from the
consumer it propose to raise the rates of fixed deposits marginally and vice versa.
6. Public utilities: Government uses the concept of elasticity in fixing charges for the
public utilities such as elasticity tariff, water charges, ticket fare in case of road or rail
transport .
j. Forecasting demand:
Income elasticity is used to forecast demand for a particular product or services.
The demand for the products can be forecast at a given income level. The trader can
estimate the quantity of goods to be sold at different income levels to realize the targeted
revenue.

DEMAND FORECASTING
Future is uncertain. There is great deal of uncertainty with regard to demand. Since the
demand is uncertain, production, cost, revenue, profit etc. are also uncertain. Through forecasting
it is possible to minimise the uncertainties.

Demand forecasting can be defined as a process of predicting the future demand for an
organisation’s goods or services. It is also referred to as sales forecasting as it involves anticipating
the future sales figures of an organisation.

Demand forecasting helps an organisation to take various business decisions, such as

planning the production process, purchasing raw materials, managing funds and deciding the price
of its products. Demand can be forecasted by organisations either internally by making estimates
called guess estimate or externally through specialised consultants or market research agencies.

Definition of demand forecasting

According to Evan J. Douglas, “Demand estimation (forecasting) may be defined as a process of

finding values for demand in future time periods.”
According to Cundiff and Still, “Demand forecasting is an estimate of sales during a specified
future period based on proposed marketing plan and a set of particular uncontrollable and
competitive forces.”

Need of Demand Forecasting

✓ Fulfilling objectives: It implies that every business unit starts with certain pre-decided
objectives. Demand forecasting helps in fulfilling these objectives. An organization
estimates the current demand for its products and services in the market and move forward
to achieve the set goals.
✓ Preparing the budget: Demand forecasting plays a crucial role in making budget by
estimating costs and expected revenues. For instance, an organization has forecasted
that the demand for its product, which is priced at Rs. 10, would be 1, 00, 000 units.
In such a case, the total expected revenue would be 10* 100000 = Rs. 10, 00, 000. In
this way, demand forecasting enables organizations to prepare their budget.

✓ Stabilizing employment and production: It helps an organization to control its

production and recruitment activities. Producing according to the forecasted demand of
products helps in avoiding the wastage of the resources of an organization. This further
helps an organization to hire human resource according to requirement. For example, if an
organization expects a rise in the demand for its products, it may opt for extra labor to
fulfill the increased demand.

✓ Expanding organizations: It implies that demand forecasting helps in deciding about the
expansion of the business of the organization. If the expected demand for products is
higher, then the organization may plan to expand further. On the other hand, if the demand
for products is expected to fall, the organization may cut down the investment in the
business.

✓ Taking Management Decisions: It helps in making critical decisions, such as deciding

the plant capacity, determining the requirement of raw material, and ensuring the
availability of labor and capital.

✓ Evaluating Performance: Helps in making corrections. For example, if the demand for
an organization’s products is less, it may take corrective actions and improve the level of
demand by enhancing the quality of its products or spending more on advertisements.

Basis of demand forecasting:

Level of forecasting :
Firm level : It refers to forecasting of demand by an individual firm for its products. Most
important category for a manager for taking important decisions related to marketing and
production.

Industry level: It refers to demand forecasting of a product in an industry as a whole. It provides

insights into the growth pattern of an industry, relative contribution of the industry in national
income.

Economy (Macro) level:It refers to forecasting of aggregate demand in the economy. It helps in
various policy formulations at government level.

Time period involved:

Short-term forecasting: It involves anticipating demand for a period not exceeding one year. It is
focused on the short term decisions (for example, arranging finance, formulating production
policy, making promotional strategies, etc.) of an organisation.

Long-term forecasting: It involves predicting demand for a period of 5-7 years and may extend
for a period of 10 to 20 years. It is focused on the long-term decisions (for example, deciding the
production capacity, replacing machinery, etc.) of an organisation.

Nature of products:
Consumer goods: The goods that are meant for final consumption by end users are called
consumer goods. These goods have a direct demand. Generally, demand forecasting for these
goods is done while introducing a new product or replacing the existing product with an improved
one.

Capital goods: These goods are required to produce consumer goods; for example, machinery.
Thus, these goods have a derived demand. The demand forecasting of capital goods depends on
the demand for consumer goods. For example, prediction of higher demand for consumer goods
would result in the anticipation of higher demand for capital goods too.
DEMAND FORECASTING METHODS
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. As
consumers generally plan their purchases in advance, their opinions and intentions may be sought
to analyse trends in market demand.

Survey of Buyers’ Intentions Method: It is also known as consumers’ expectations or opinions

survey. It is commonly used method for sales forecasting. A sale is the result of consumer intention
to buy the product. Many companies conduct periodical survey of consumers’ buying interest to
know when and how much they will buy.

Census Method: The census method is also called as a Complete Enumeration Survey Method wherein
each and every item in the universe is selected for the data collection. The universe might constitute a
particular place of group of people or any specific locality which is the complete set of items and which
are of interest in any particular situation.
The census methods is most commonly used by the government in connection with the national population,
housing census, agriculture census, etc. where the vast knowledge about these fields is required. Whenever
the entire population is studied to collect the detailed data about every unit, then the census method is
applied.

Sample Methods: Useful data for forecasting demand can also be obtained from surveys of consumer
plans. Unlike the complete enumeration method, under the sample survey method, only a few potential
consumers from the relevant market selected through an appropriate sampling method are interviewed. The
survey may be conducted either through direct interview or mailed questionnaire to the sample consumers.

SALES FORCE METHODS: Sometimes, it is called sales force estimate method. Company can
ask, either all or some of salesmen, to estimate demand for a given time. Each sales representative
estimates how much each current and prospective customer will buy the company’s product. They
are offered certain incentives to encourage them better estimate.

Here, for estimating the future demand, the company’s sales force opinions are taken as a
base. Since salesmen have direct and close contact with customers, competitors, dealers, and
overall market environment, they can provide more reliable estimates of the future sales.

STATISTICAL METHODS

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

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

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

g. Least squares methods: This technique uses statistical formulae to find the trend line
which best fits the available data. The trend line is the estimating equation, which can be
used for forecasting demand by extrapolating the line for future.
The equation for straight line trend is
S= a+bT
 the value of “a” and “b are calculate by using the following two normal equations.

S= forecasted sale
T = year number for which sales being forecasted.
n = number of years of data given the problem.

h. Time series analysis: Where the surveys or market tests are costly and time consuming,
statistical and mathematical analysis of past sales data offers another method to prepare the
forecasts, that is, time series analysis. One major requirement to administer this technique
is that the product should have actively been traded in the market for quite some time in
the past.
The following are the four major components analysed from time series while forecasting
the demand:
Tends (T): It also called the long term trend. The result of basic developments in the
population, capital formation and technology. These development relate to over a period
of long time say five to ten years, not definitely overnight. The trend is considered
statistically significant when it has reasonable degree of consistency. A significant trend is
central and decisive factor considered while preparing a long range forecast.
Cyclic Trend (C): It is seen in the wave like movement of sales. The sales data is quite
often affected by swings in the levels of general economic activity, which tend to be
somewhat periodic. These could be related to the business cycles in the economy such as
inflation or recession.
Seasonal Trend (S): It refers to a consistent pattern of sales movements within the year.
More goods are sold during the festival seasons. The seasonal component may be related
to weather factors, holidays, etc.
Erratic Trend (E): It results from the sporadic occurrence of strikes, riots, and so on. These
erratic components can even damage the impact of more systematic components and thus
make the forecasting process much more complex.

Classical time series analysis involves procedures for decomposing the original sales series
(Y) into the components T,C,S,E. There are different models in the time series analysis.
While one model states that these components interact linearly, that is,
Y = T+C+S+E, another model states that Y is the product of all these component that is,
 i. Moving average method: A moving average is a technique that calculates the overall trend
in sales volume from historical data of the company. This techniques is very useful for
forecasting short – term trends. It is simply the average of select time periods. It called
moving as a new demand number is calculated for an upcoming time period.

Moving Average = (n1+n2+n3+ …….)/n

j. Exponential smoothing: It uses all the time series values to generate a forecast with lesser
weights given to the observations further back in time. Exponential smoothing is actually
a way of “smoothing” out the data by eliminating much of the “noise”( random effects).

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

3 Correlation and regression methods: correlation and regression methods are statistical
techniques. Correlation describes the degree of association between two variable such as sales and
advertisement expenditure. When the two variable tend to change together, then they are said to
be correlated.
Regression method: An equation is estimated which best fits in the sets of observations of
dependent variables and independent variables. The best estimate of the true underlying
relationship between these variables is thus generated. The dependent (unknown) variable is the
forecast based on this estimated equation for a given value of the independent (known) variable.
The method of least squares is applied most in regression.

4. Simultaneous equation method:Under simultaneous equation model, demand forecasting

involves the estimation of several simultaneous equations. These equations are often the behavioral
equations, market-clearing equations, and mathematical identities.

The regression technique is based on the assumption of one-way causation, which means
independent variables cause variations in the dependent variables, and not vice-versa. In simple
terms, the independent variable is in no way affected by the dependent variable. For example, D =
a – bP, which shows that price affects demand, but demand does not affect the price, which is an
unrealistic assumption.

Other methods

Expert opinion methods:

 Well informed persons are called experts; experts constitute yet another source of
information. These persons are generally the outside experts and they do not have any vested
interest in the results of a particular survey. As expert is good at forecasting and analysis the future
trend in a given product or service at a given level of technology. The service of an expert could
be advantageously used when a firm uses general economic forecasting or special industry
forecasting prepared outside the firm.
Delphi Method: It refers to a group decision making technique of forecasting demand. In this
method, questions are individually asked from a group of experts to obtain their opinions on
demand for products in future. These questions are repeatedly asked until a consensus is obtained.
In other words the Delphi method is a structured communication technique, originally developed
as a systematic, interactive forecasting method which relies on a panel of experts.
Advantages:
• Opportunities for large number of people to participate.
• Focus is on “ideas” rather than “individuals”.
• Anonymity for participants which make contributions of ideas as safe activity.
• Opportunities for participants to reconsider their opinions.
• Allows for identification of priorities.

Limitations:
➢ Large amount of time to conduct several rounds.
➢ The complexity of data analysis.
➢ The difficulty of maintaining participant enthusiasm throughout the process.
➢ The problem of keeping statements value free and clearly defined.
➢ Self-reporting data is subject to respondent biases and memories.

Test marketing:
It is likely that opinions given by buyers, salesman or other experts may be, at times,
misleading. This is the reason why most of the manufactures favour to test their product or service
in a limited market as test – run before they launch their product nationwide.
Controlled experiments:
Controlled experiments refer to such exercise where some of the major determinants of
demand are manipulated to suit to the customers with different tastes and preferences, income
groups, and such others. It is further assumed that all other factors remain the same.

Judgmental approach:
When none of the above methods are directly related to the given product or service, the
management has no alternative other than using its own judgment. Even when the above methods
are used, the forecasting process is supplemented with the factor of judgment for the following
reasons
• Historical data for significantly long period is not available
• Turning point in terms of policies or procedures or causal factors cannot be precisely
determined
• Sale fluctuation are wide and significant
• The sophisticated statistical techniques such as regression and so on, may not cover all.

Supply

Supply is an economic principle can be defined as the quantity of a product that a seller
is willing to offer in the market at a particular price within specific time.
The supply of a product is influenced by various determinants, such as price, cost of
production, government policies, and technology. It is governed by the law of supply,
which states a direct relationship between the supply and price of a product, while other
factors remaining the same.
Supply may be defined as a schedule which shows the various amounts of a product
which a particular seller is willing and able to produce and make available for sale in the
market at each specific price in a set of possible prices during a given period.McConnell
Supply refers to the quantity of a commodity offered for sale at a given price, in a given
market, at given time.AnatolMurad

Supply Function
Supply function is the mathematical expression of law of supply. In other words, supply
function quantifies the relationship between quantity supplied and price of a product,
while keeping the other factors at constant.

The law of supply expresses the nature of the relationship between quantity supplied and
price of a product, while the supply function measures that relationship.
The supply function can be expressed as:
Qs = f (Pa, Pb, Pc, T, Tp)
Where,
Qs = Supply
Pa = Price of the good supplied
Pb = Price of other goods
Pc = Price of factor input
T = Technology
Tp = Time Period

Determinants of Supply
Supply does not remain constant all the time in the market. There are many factors that
influence the supply of a product. Generally, the supply of a product depends on its price
and cost of production.
Thus, it can be said that supply is the function of price and cost of production. These factors that
influence the supply are called the determinants of supply.

Determinants of supply are:

• Price of a product
• Cost of production
• Natural conditions
• Transportation conditions
• Taxation policies
• Production techniques
• Factor prices and their availability
• Price of related goods
• Industry structure

Price of a product
The major determinants of the supply of a product is its price. An increase in the price of
a product increases its supply and vice versa while other factors remain the same.
Producers increase the supply of the product at higher prices due to the expectation of
receiving increased profits. Thus, price and supply have a direct relationship.

Cost of production
It is the cost incurred on the manufacturing of goods that are to be offered to consumers.
Cost of production and supply are inversely proportional to each other.

This implies that suppliers do not supply products in the market when the cost of
manufacturing is more than their market price. In this case, sellers would wait for a rise in
price in the future.
The cost of production increases due to several factors, such as loss of fertility of land;
high wage rates of labour; and increase in the prices of raw material, transportation cost,
and tax rate.

Natural conditions
The supply of certain products is directly influenced by climatic conditions. For instance,
the supply of agricultural products increases when the monsoon comes well on time.

On the contrary, the supply of these products decreases at the time of drought. Some of
the crops are climate specific and their growth purely depends on climatic conditions.

For example, Kharif crops are well grown at the time of summer, while Rabi crops are
produced well in the winter season.
Transportation conditions
Better transport facilities result in an increase in the supply of goods. Transport is always
a constraint to the supply of goods. This is because goods are not available on time due to
poor transport facilities.

Therefore, even if the price of a product increases, the supply would not increase.

Taxation policies
Government’s tax policies also act as a regulating force in supply. If the rates of taxes
levied on goods are high, the supply will decrease. This is because high tax rates increase
overall productions costs, which will make it difficult for suppliers to offer products in
the market.

Similarly, reduction in taxes on goods will lead to an increase in their supply in the
market.

Production techniques
The supply of goods also depends on the type of techniques used for production.
Obsolete techniques result in low production, which further decreases the supply of
goods.

Over the years, there has been tremendous improvement in production techniques, which
has led to increase in the supply of goods.

Factor prices and their availability

The production of goods is dependent on the factors of production, such as raw material,
machines and equipment, and labour.
An increase in the prices of the factors of production increases the cost of production.
This will make difficult for firms to supply large quantities in the market.

Price of related goods

The prices of substitutes and complementary goods also influence the supply of a product
to a large extent.

For example, if the price of tea increases, farmers would tend to grow more tea than
coffee. This would decrease the supply of tea in the market.

Industry structure
The supply of goods is also dependent on the structure of the industry in which a firm is
operating. If there is monopoly in the industry, the manufacturer may restrict the supply
of his/her goods with an aim to raise the prices of goods and increase profits.

On the other hand, in case of a perfectly competitive market structure, there would be a
large of number of sellers in the market. Consequently, the supply of a product would
increase.

UNIT - III
THEORY OF PRODUCTION
Production is a process of transforming tangible and intangible inputs into goods or
services. Raw materials, land, labour and capital are the tangible inputs, whereas ideas,
information and knowledge are the intangible inputs. These inputs are also known as factors of
production. For an organisation, the four major factors of production are land, labour, capital,
and organisation. An organisation needs to make an optimum utilisation of these factors to
achieve maximum output.

DEFINITION OF PRODUCTION

According to J.R. Hicks, “Production is an activity whether physical or mental, which is directed to
the satisfaction of other people’s wants through exchange.”

PRODUCTION FUNCTION OR FACTOR OF PRODUCTION :

Production function, basically is an engineering concept but is widely used in economics

for studying production behaviour. The technological relationship between physical inputs and
output is referred to as the production function.
 Production function shows the maximum production or output obtained from a given set
of inputs under the present state of technology. It always refers to a period of time. The
production function can be express mathematically in the form of an equation.

Q = f (L1, L2, K, O, T)

Q = Quantity of output
f = Functional relation
L1 = Land
L2 = labour
K = Capital
O = Organisation
T= Technology

Production Function With One Variable Input:

This also called law of diminishing returns or law of diminishing marginal returns or law
of variable proportions.This law applies in short - run. In short – run, if output has to be increase,
organisation can change only variable inputs because some inputs are fixed in short run. The fixed
inputs are land, building, plant, machinery, capital etc. The variable inputs are labour, raw
materials etc. This production function studies what happen to output if only one input i.e. labour
increase continuously without changing other inputs. If only labour increases to increase output,
first stage output increases at increasing rate, second stages output increase but deceasing rate and
in final stage output falls. This law is of universal nature and it proved to be true in agriculture and
industry also.
Definition
According to G. Stigler“If equal increments of one input are added, the inputs of other production
services being held constant, beyond a certain point the resulting increments of product will
decrease i.e. the marginal product will diminish”.
According to F. Benham“As the proportion of one factor in a combination of factors is increased,
after a point, first the marginal and then the average product of that factor will diminish”.

Units of Total production(tp) Marginal Average product Stages

labour product (ap)
(mp)
0 0 0 0
1 10 10 10 Stages 1
2 22 12 11
3 33 11 11
4 40 7 10 Stages 2
5 45 5 9
6 48 3 8
7 48 0 6.85 Stages 3
 8 45 -3 5.62

From the above table and

graph, one can identify how the law of variable proportions operates in three stages. In the first
stage, total product increases at an increasing rate. The marginal product in this stage increases at
an increasing rate resulting in a greater increase in total product. The average product also
increases. This stage continues up to the point where average product is equal to marginal product.
The law of increasing returns is in operation at this stage. The law of diminishing returns starts
operating from the second stage onwards. At the second stage total product increases only at a
diminishing rate. The average product also declines. The second stage comes to an end where total
product becomes maximum and marginal product becomes zero. The marginal product becomes
negative in the third stage. So the total product also declines. The average product continues to
decline. The reason for increasing rate can seen in first stage because of applying more labour
leading to effective utilization fixed inputs that resulting increasing returns. If more labour applied
in second stage, effective utilization of fixed inputs reaches to maximum, leading to diminishing
returns. Even still more labour is applied, resulting to ineffective utilization of fixed inputs leading
to total product decline. The rational stage of operation of business is up to second stage only.

Production Function With Two Variable Inputs:

Production process that requires two inputs, capital (K) and labour (L) to produce a given
output(Q). There could be more than two inputs in a real life situation, but for a simple analysis,
we restrict the number of inputs to two only. In other words, the production function based on two
inputs can be expressed as

Q = f (K, L)

Where K= capital, L = labour,

Normally, both capital and labour are required to produce a product. To some extent, these
two inputs can be substituted with each other. Hence the producer may choose any combination of
labour and capital that gives him the required number of units of output, from any one combination
of labour and capital out of several such combinations. The alternative combinations of labour and
capital yielding a given level of output are such that if the use of one factor input is increased ,
that of another will decrease and vice versa. However, the units of an input foregone to get one
unit of the other input changes depends upon the degree of substitutability between the two input
factors. Based on the techniques or technology used, the degree of substitutability may vary.

ISO - QUANTS

The term Iso-quants is derived from the words ‘iso’ and ‘quant’ – ‘Iso’ means equal and
‘quant’ implies quantity. Isoquant therefore, means equal quantity. Isoquant are also called iso-
product curve. An isoquant curve show various combinations of two input factors such as capital
and labour, which yield the same level of output.

As an isoquant curve represents all such combinations which yield equal quantity of output.Any
or every combination is a good combination for the manufacturer,hence he prefers all these
combinations equally. An isoquant curve is also called product indifference curve.

An isoquant may be explained with the help of an arithmetical example.

Combinations Labour (units) Capital (Units) Output (quintals)

A 1 10 50

B 2 7 50

C 3 4 50

D 4 2 50

E 5 1 50

Combination ‘A’ represent 1 unit of labour and 10 units of capital and produces ‘50’
quintals of a product.All other combinations in the table are assumed to yield the same given output
of a product say ‘50’ quintals by employing any one of the alternative combinations of the two
factors labour and capital. If we plot all these combinations on a graphic sheet and join them, we
will get smooth curve called Iso-product curve or Iso-quant curve as shown below.
 Labour is on the X-axis and
capital is on the Y-axis. IQ is the ISO-Product curve which shows all the alternative combinations
A, B, C, D, E which can produce 50 quintals of a product.

PROPERTIES OF ISO – QUANT

1. Iso-quant curve slope downward from left to right: Isoquant are downward sloping
curves because if one input increase, the other one reduces. There is no question of increase
in both the inputs to yield a same given output. Hence isoquant slope downward from left
to right. A degree of substitution is assumed between the factors of production.

2. Do not intersect each other: Two isoquant do not intersect with each other. It is because,
each of these denote a particular level of output. Since different iso- quants for different
levels of output, no two iso-quants intersect with each other.
3. Higher isoquant represent higher level of output: The isoquant which is higher stage
has higher output and vice versa. Greater combination of labor and capital makes large
scale of production. So, higher the isoquant curve, greater will be the production level.
4. Do not touch axes:The isoquant touches neither X-axis nor Y- axis, as both inputs are
required to produce a given product.
5. Convex to origin: Isoquant are convex to the origin. It is because the input factors are not
perfect substitutes. One input factor can be substituted by other input factor in a
diminishing marginal rate. If the input factors were perfect substitutes, the isoquant would
be a falling straight line.

ISO COST
Iso- cost refers to that cost curve that represent the combination of inputs that will cost the
producer the same amount of money. In other words, each iso-cost denotes a particular level of
total cost for a given level of production. If the level of production changes, the total cost changes
and thus the iso-cost curve moves upwards, and vice versa.
 Iso-cost curve is the locus traced out by various combinations of L and K, each of which
costs the producer the same amount of money (C).A set of iso-cost lines can be drawn for different
levels of factor prices or different sums of money. The iso- cost line will shift to the right when
money spent on factors increases or firm could buy more as the factor prices are given.

LAW OF RETURNS TO SCALE (or) PRODUCTION FUNCTION WITH ALL

VARIABLE INPUTS
This production function applies in long run. In long run all inputs are variable only which means
that to increase the output all inputs can be changed which is possible in long run because of
enough time is available. But all inputs can be changed simultaneously and proportionally to
change the output. Here organisation experience three types of returns. They are
1. Increasing returns to scale
This states that the volume of output keeps on increasing more proportionately with every
increase in the inputs, Where a given increase in inputs leads to a more than proportionate
increase in the output, the increasing returns to scale is said to experience because of
economies of scale comes to operation like introducing division of labour and other
technological means to increase production. Hence, the total product increases at an
increasing rate.
2. Constant returns to scale
When the scope for division of labour gets restricted, the rate of increase in the total output
remains constant. Constant returns to scale is said to operate states that the rate of
increase/decrease in volume of output is same to that of rate of increase/decrease in inputs.
This is because diseconomies neutralize the economies of scale.
3. Decreasing returns to scale
 Where the proportionate increase in the inputs does not lead to equivalent increase in
output, decreasing returns to scale is said to operate. This results in higher average cost per
unit. Here diseconomies dominates economies of scale.
This law can be illustrated with an example of agricultural land. Take one acre of land. If
you fill the land well with adequate bags of fertilizers and sow good quality seeds, the
volume of output increases the following table illustrates further.
Capital Labor( % of increase Output(in % of Law applicable
(in units) in units) in both inputs units) increase in
output

1 3 --- 50 --- ---

2 6 100 120 140 Increasing returns to scale
4 12 100 240 100 Constant returns to scale
8 24 100 360 50 Decreasing returns to scale

Types of Production Function

Production function on the basis of the time period can be divided into two categories: Short Run
Production Function and Long Run Production Function. In these production functions, the
combination and behaviour of variable factors and fixed factors are different.
1. Short Run Production Function:
Short Run is a period of time where output can only be changed by changing the level of variable
inputs. In the short run, some factors are variable and some are fixed. Fixed factors remain constant
in the short run like land, capital, plant, machinery, etc. Production can be raised by only increasing
the level of variable inputs like labour. Therefore, the situation where the output is increased by
only increasing the variable factors of input and keeping the fixed factors constant is termed as
Short Run Production Function. This relationship is explained by the ‘Law of Variable
Proportions.’
2. Long Run Production Function:
Long Run is a span of time where the output can be increased by increasing all the factors of
production whether it is fixed (land, capital, plant, machinery, etc.) or variable (labour). Long run
is enough time to alter all the factors of production. All factors are said to be variable in the long
run. Therefore, the situation where the output is increased by increasing all the inputs
simultaneously and in the same proportion is termed Long Run Production Function. This
relationship is explained by the ‘Law of Returns to Scale.’
COST
The Institute of Cost and Management Accountants (ICMA) has define cost as “ the amount
expenditure, actual or notional, incurred on or attributable to a specified thing or activity”. It is the
amount of resources sacrificed to achieve a specific objective. A cost must be with reference to the
purpose for which it is used and the conditions under which it is computed. To take decision,
managers wish to know the cost of something.
Cost refer to the expenditure incurred to produce a particular product or services. All cost involve
a sacrifice of some kind or other to acquire some benefit. For example , if I want to eat food, I
should be prepared to sacrifice money.
Cost refers to the amount of expenditure incurred in acquiring something. In business firm, it refers
to the expenditure incurred to produce an output or provide service. Thus the cost incurred in
connection with raw material , labour, other heads constitute the overall cost of production.
COST CONCEPTS OR TYPE OF COST:

A managerial economist must have a clear understanding of the different cost concepts for clear
business thinking and proper application. The several alternative bases of classifying cost and the
relevance of each for different kinds of problems are to be studied. The various relevant concepts
of cost are:

OPPORTUNITY COST:

Opportunity cost is the cost which is sacrificed or foregone because of choosing the best alternative
by ignoring the next best alternative. In simple terms, it is the earning from the second alternative.
It represents the maximum possible alternative income that was have been earned if the resources
were put to alternative use.

Opportunity cost can be distinguished from outlay costs based on the nature of sacrifice. Outlay
costs are those costs that involve cash outflow at some time and hence they are recorded in the
book of account. Opportunity cost refers to earnings/profits that are foregone form alternative
ventures by using given limited facilities for a particular purpose. Hence they would not be
recorded in the books of cost accounts. But they also will be considered in decision making process
of choosing best opportunity.

FIXED COST VS VARIABLE COST

Fixed cost is that cost which remains constant for a certain level to output. It is not affected by the
changes in the volume of production. But fixed cost per unit decrease, when the production is
increased. Fixed cost includes Salaries, Rent, Administrative expenses, depreciation etc.

Variable is that which varies directly with the variation in output. An increase in total output results
in an increase in total variable costs and decrease in total output results in a proportionate decline
in the total variables costs. The variable cost per unit will be constant. Ex: Raw materials, labour,
direct expenses, etc
EXPLICIT AND IMPLICIT COSTS:

Explicit costs are those expenses that involve cash payments. These are the actual or business costs
that appear in the books of accounts. These costs include payment of wages and salaries, payment
for raw-materials, interest on borrowed capital funds, rent on hired land, taxes paid etc.

Implicit costs are the costs of the factor units that are owned by the employer himself. These costs
are not actually incurred but would have been incurred in the absence of employment of self –
owned factors. The examples of implicit costs are rent of own building, interest on capital,
remuneration for owners work etc. A decision maker must consider implicit costs too to find out
appropriate profitability of alternatives.

SHORT – RUN AND LONG – RUN COSTS:

Short-run is a period during which the physical capacity of the firm remains fixed. Any increase
in output during this period is possible only by using the existing physical capacity more
extensively. So short run cost is that which varies with output when the plant and capital equipment
are constant.

Long run costs are those, which vary with output when all inputs are variable including plant and
capital equipment. Long-run cost analysis helps to take investment decisions.

OUT-OF POCKET AND BOOKS COSTS:

Out-of pocket costs also known as explicit costs are those costs that involve current cash payment.
Book costs also called implicit costs do not require current cash payments. Depreciation, unpaid
interest, salary of the owner is examples of book costs.

But the book costs are taken into account in determining the level dividend payable during a period.
Both book costs and out-of-pocket costs are considered for all decisions. Book cost is the cost of
self-owned factors of production.

Sunk cost :
Sunk costs are those which are not altered by any change. They are the costs incurred in the past. This
cost is the result of past decision, and cannot be changed by future decisions. Investments in fixed assets
are examples of sunk costs.

Marginal cost:

Marginal cost is the additional cost incurred to produce additional unit of output or it is the cost of the
marginal unit produced.

COST – OUTPUT RELATIONSHIP IN THE SHORT RUN:

The short run is a period which does not allow changes in the fixed equipment and the size of the business.
In this period, production can be increased to the exlent of unutilized capacity of present fixed production
facilities only.

The cost output relationship in the short run can be studied in term of i) Average fixed cost ii) Average
cost iii) Average total cost.

i) Average fixed cost and output : Average fixed cost is calculated by dividing total fixed cost by
the quantity of output. In short run the average fixed cost go down with increase in output.
The reason is simple to understand the total fixed costs remain the same and do not, vary
with a change in output. In short, there inverse relationship between average fixed cost and
output and this relationship is universal for all types of business. Graphically, the AFC curve is
a downward sloping curve.

ii) Average variable cost and output: Average variable cost (AVC) is calculated by dividing total
variable cost by the quantity of output. As output rises, average variable cost will come down
initially due to operation of low increasing returns but after a point (optimum output level).
It tends to rise steeply because of the operation of law of diminishing returns. In other words
, we would say that average cost curve declines at first, reaches a minimum and then it start
rising. On account of the operation of the law of variable proportions, the AVC curve is always
U – shaped.

iii) Average total cost and output: Average total cost or average cost is calculated by dividing cost
bye the quantity of output. Alternatively, the addition of AFC and AVC gives average cost in
the short run for each output. As the output increases ATC would come down is the initial
stages (as AFC and AVC both fall). A stage will come when the average variable cost may have
 started rising, though the average total cost will continue to fall till the fall in AFC out weights
the rise in AVC. This is way the minimum point of ATC reached for a larger output than the
minimum point of AVC. When fall in AFC becomes equal to rise in AVC, ATC reaches its
minimum point which is the optimum point of output. The important point to note here is
that the turning point in case of average cost would come a bit later them in case of average
variable cost. Since as output increase, variable cost increase faster relatively to fixed costs,
the shape of ATC is governed by AVC.

Relationship of different cost curves in the short period.

All aspects of short period costs like fixed cost(FC), Variable cost (VC), Average fixed cost
(AFC), Average Variable cost (AVC), Average cost (AC) and marginal cost (MC)

Long run average cost curve or envelope curve : long run average cost refers to minimum possible per
unit cost of producing different quantities of output in the long period. In the words of Mansfield, “The
long run average cost curve is that curve which shows the minimum cost per unit of producing each output
dividing long run total cost by the quantity of output produced. It is determined by average cost

By dividing long run total cost by the quantity of output produced. It is the lowest average cost attainable
when all inputs are variable that is when any plant size can be constructed.
MARKET
Market is a place where buyer and seller meet, goods and services are offered for the sale
and transfer of ownership occurs. A market may be also defined as the demand made by a certain
group of potential buyers for a good or service. The former one is a narrow concept and later one,
a broader concept. Economists describe a market as a collection of buyers and sellers who transact
over a particular product or product class (the housing market, the clothing market, the grain
market etc.). For business purpose one can define a market as people or organizations with wants
(needs) to satisfy, money to spend, and the willingness to spend it. Broadly, market represents the
structure and nature of buyers and sellers for a commodity/service and the process by which the
price of the commodity or service is established. In this sense, we are referring to the structure of
competition and the process of price determination for a commodity or service. The determination
of price for a commodity or service depends upon the structure of the market for that commodity
or service (i.e., competitive structure of the market). Hence the understanding on the market
structure and the nature of competition are a pre-requisite in price determination.
MARKET STRUCTURE
Market structure describes the competitive environment in the market for any good or
service. A market consists of all firms and individuals who are willing and able to buy or sell a
particular product. This includes firms and individuals currently engaged in buying and selling a
particular product, as well as potential entrants.

The determination of price is affected by the competitive structure of the market. This is
because the firm operates in a market and not in isolation.
PERFECT COMPETITION
Perfect competition refers to a market structure where competition among the sellers and
buyers prevails in its most perfect form. In a perfectly competitive market, a single market price
prevails for the commodity, which is determined by the forces of total demand and total supply in
the market.
A market structure in which all firms in an industry are price takers and in which there is
freedom of entry into and exit from the industry is called perfect competition. The market with
perfect competition conditions is known as perfect market.
Features of perfectly competition
1. A large number of buyers and sellers: The number of buyers and sellers is large and the
share of each one of them in the market is so small that none has any influence on the
market price.

There should be significantly large number of buyers and sellers in the market. The number
should be so large that it should not make any difference in terms of price or quantity
supplied even if one enters the market or one leaves the market.
2. Homogenous products or services:The products and services of each seller should be
homogeneous. They cannot be differentiated from that of one another. It makes no
difference to the buyer whether he buys from firm X or firm Z. In otherwords, the buyer
does not have any particular preference to buy the goods from a particular trader or
supplier. The price is one and the same in every firm. There are no concessions or
discounts.
3. Freedom to enter or exit the market:There should not be restrictions on the part of the
buyers and sellers to enter the market or leave the market. There should not be any barriers.
The buyers or sellers can enter the market or leave the market whenever they want.
4. Prefect information available to the buyers and sellers:Each buyer and seller has total
knowledge of the prices prevailing in the market at every given point of time, quantity
supplied, costs, demand, nature of product, and other relevant information. There is no
need for any advertisement expenditure as the buyers and sellers are fully informed.
 5. Perfect mobility of factors of production:There should not be any restrictions on the
utilization of factors of production such as land ,labour, capital and so on. In words, the
firm or buyer should have free access to the factors of production. Whenever capital or
labor is required, it should instantly be made available.
6. Each firm is a price taker:An individual firm can alter its rate of production or sales
without significantly affecting the market price of the product.A firm in a perfect market
cannot influence the market through its own individual actions. It has no alternative other
than selling its products at the price prevailing in the market. It cannot sell as much as it
wants at its own set price.
EQUILIBRIUM POINT IN PERFECT COMPETITION MARKET

In this graph, MC curve cuts MR at two points Q and E. At point Q, MC curve equals to MR
but MC curve cuts MR from above. Hence, point Q is not equilibrium point. At point E, MC curve
equals to MR and MC cuts MR from below. Hence, point E is equilibrium point and OM is
equilibrium output.
EQUILIBRIUM PRICE AND OUTPUT DETERMINATION IN CASE OF
PERFECT COMPETITION
SHORT RUN:
The price and output of the firm are determined, under perfect competition, based on the
industry price and its own costs. The industry price has greater say in this process because the firm
own sales are very small and insignificant.

Abnormal or Super normal Profits

The firm demand curve is horizontal at the price determined in the industry (MR = AR =
price). This demand curve is also known as average revenue curve. This is because if all the units
are sold at the same price, on an average , the revenue to the firm equal its price. The firms whose
average revenue is more than average cost, the firms earn abnormal or super normal profits
(AR>AC). In short run, there is no time either new firms enter or old firms exit from the market.
Losses
The firm demand curve is horizontal at the price determined in the industry (MR = AR =
price). This demand curve is also known as average revenue curve. This is because if all the units
are sold at the same price, on an average, the revenue to the firm equal its price. The firms whose
average revenue is less than average cost, the firms suffers losses (AR<AC). In short run, there is
no time either new firms enter or old firms exit from the market.

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

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

EQUILIBRIUM PRICE AND OUT PUT DETERMINATION IN MONOPOLY

Under monopoly, the average revenue curve for a firm is a downward sloping one. It is
because, if the monopolist reduces the price of his product, the quantity demanded increase and
vice- versa. In monopoly, marginal revenue is less than the average revenue because any
monopolist should reduce the price of product if he wants to sell more quantity of output.

The monopolist always wants to maximize his profits. To achieve maximum profits, it is
necessary that the marginal revenue should be more than the marginal cost. In monopoly market,
monopolist always tries to earn abnormal or super normal profits (AR>AC) Here, there is no
difference between short run and long run in monopoly.
MONOPOLISTIC COMPETITION
Monopolistic competition is said to exist when there are many firms and each one produces
such goods and services that are close substitutes to each other. They are similar but not identical.
Product differentiation is the essential feature of monopolistic. Products can be differentiated by
means of unique facilities, advertising, brand loyalty, packaging, pricing, terms of credit, superior
maintenance services, convenient location and so on.
Features of Monopolistic Competition

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

OLIGOPOLY

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

DUOPOLY

Duopoly is a special case of the theory of oligopoly in which there are only two sellers.
Both the sellers are completely independent and no agreement exists between them. Even though

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

chain of reactions. A seller may, however, assume that his rival is unaffected by what he does, in

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

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

Pricing:
Pricing is the process of determining what a company will receive in exchange for its
product or service. A business can use a variety of pricing strategies when selling a product or
service. The price can be set to maximize profitability for each unit sold or from the market overall.
It can be used to defend an existing market from new entrants, to increase market share within a
market or to enter a new market.

PRICING OBJECTIVES:
Pricing objectives refers to the general and specific objectives which a firm sets for itself in
establishing the price of its products or services and these are not much different from the
marketing objectives of a firm or its overall business objectives.
1. To maximise profits

2. To increase sales

3. To increase the market share

 4. To satisfy customers

5. To meet the competition

6. To generate internal resources to finance expansion and growth

7. To maximise the value of the firm for different stakeholders.

Pricing policies:
Pricing policies are intended to bring consistency in the pricing pattern. They define how
to handle complex issue such as price discrimination and price stability.
Pricing policies play a significant role, not only in the case of single – product firms but
also multi – product firms. A multi – product firm faces more challenges such as maintaining price
differentials between related products, especially substitutes such as deluxe models and basic
models.
Factors consider in pricing policies
➢ Competitive Situation

➢ Goal of Profit and Sales

➢ Long Range Welfare of the Firm

➢ Flexibility

➢ Government Policy

➢ Overall Goals of Business

➢ Price Sensitivity

PRICING METHODS

COST – BASED PRICING METHODS

1. Cost plus pricing: This is also called full cost or markup pricing. Here the average cost of
normal capacity of output is ascertained and then a conventional margin of profit is added
to the cost to arrive at the price. In other words, find out the product unit’s total cost and
add percentage of profit to arrive at the selling price.
This method is suitable where the cost keep fluctuating from time to time. It is
commonly followed in departmental stores and other retail shops. This method is simple
to be administered but it does not consider the competition factor. The competitor may
produce the same product at lower cost and thus offer it at a lower price.
 2. Marginal cost pricing: In marginal cost pricing, selling price is fixed in such a way that it
covers fully the variable or marginal cost and contributes towards recovery of fixed costs
fully or partly, depending upon the market situations. In times of stiff competition,
marginal cost offers a guideline as to how far the selling price can be lowered. This is also
called break – even pricing or target profit pricing. Here break – even analysis helps in
taking pricing decisions.

COMPETITION – ORIENTED PRICING:

Some commodities are priced according to the competition in their markets. Thus there are Going
rate method of price and the Sealed bid pricing technique. Under the former a firm prices its new
product according to the prevailing prices of comparable products in the market.
1. Sealed bid pricing: This method is more popular in tenders and contracts. Each
contracting firm quotes its price in a sealed cover called tender. All the tenders are opened
on a scheduled date and the person who quotes the lowest prices, other things remaining
the same, is awarded the contract.
2. Going rate pricing: Here the price charged by the firm is in tune with the price charged
in the industry as a whole. In other words, the prevailing market price at a given point of
time is the guiding factor. When one wants to buy or sell gold, the prevailing market rate
at a given point of time is taken as the basis to determine the price, normally the market
leaders keep announcing the prevailing prices at a given point of time based on demand
and supply positions.

DEMAND – ORIENTED PRICING

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

STRATEGY – BASED PRICING:

1. Market skimming: When the product is introduced for the first time in the market, the
company follows this method. Under this method, the company fixes a very high price for
 the product. The main idea is to charge the customer maximum possible. For example Sony
introduces a particular TV model, it fixed a very high price than other company.
2. Market penetration: This is exactly opposite to the market skimming method. Here the
price of the product is fixed so low that the company can increase its market share. The
company attains profits with increasing volumes and increase in the market share. More
often , the companies believe that it is necessary to dominate the market in the long –run
than making profit in the short-run.
3. Two – part pricing: The firms with market power can enhance profits by the strategy of
two – part pricing. Under this strategy, a firm charges a fixed fee for the right to purchase
its goods, plus a per unit charge for each unit purchased. Entertainment houses such as
country clubs, athletic clubs, golf courses, and health clubs usually adopt this strategy.
They charge a fixed initiation fee plus a charge per month or per visit to use the facilities.
4. Block pricing: Block pricing is another way a firm with market power can enhance its
profits. We see block pricing in out day – to – day life very frequently. Six lux soaps in a
single pack or five magi noodles in a single pack.
5. Commodity bundling: Commodity bundling refers to the practice of bundling two or more
different products together and selling them at a single bundle price. The package deals
offered by the tourist companies, airlines hold testimony to this practice. The package
includes the airfare, hotel, meals, sightseeing and so on.
6. Peak load pricing: During seasonal period when demand is likely to be higher, a firm may
enhance profits by peak load pricing. The firm philosophy is to charge a higher price during
peak times than is charged during off – peak times. APSRTC, Air India, Jet air etc,
7. Cross subsidization: In case where demand for two products produced by a firm is
interrelated through demand or costs, the firm may enhance the profitability of its operation
through cross subsidization.
8. Transfer pricing: Transfer pricing is an internal pricing technique. It refers to a price at
which inputs of one department are transferred to another, in order to maximize the overall
profits of the company. For example kinetic Honda, Hero, Honda.
9. Limit pricing: limit price is a pricing strategy in which a monopoly is selling its products
below the average cost of production to discourage the entrance of new competitors in
market.

PRICING STRATEGIES IN TIMES OF STIFF PRICE COMPETITION

1. Pricing matching: Price matching is a strategy in which a firm promise to match a lower
price offered by any competitor, while announcing its own price. It is necessary that one
should be confident, before this strategy is adopted, that the price cannot be lower in the
market than one offered.
2. Promoting brand loyalty: This is an advertising strategy where the customers are
frequently reminded by the brand value of given product or services. The conviction here
 is that the customers, once they are loyal to the given branded product or services, will not
slip away when the competitors come out with products at lower prices.
3. Time – to – time pricing: This is also called randomized pricing strategy where the firm
varies its prices form time- to – time, say hour – to – hour or day – to –day. This method
offers two advantages. The rival firms can no more play with price cuts. Also customers
cannot learn from experience which firm charges the lowers price in the market.
4. Promotional pricing: To promote a particular product, at time, the firm may offer the
product at the most competitive price. Some time, the price of a particular product is kept
intentionally lower to attract the attention of the customer to other products of the firm.
5. Target pricing: The company operates with a particular targeted profit in mind. Normally
the cost of capital will be one of the yardsticks to guide the targeted rate of return. How
much is the rate of return the other companies are achieving also could be another yardstick
to determine the price. The higher the risk and investment, the higher is the targeted profit
and so is the price.

Product Life Cycle based Pricing

Product life cycle pricing is a strategy for selling products in which pricing correlates with a
product's location in its life cycle. There are four phases within the life cycle, including launch,
growth, maturity and declination. Businesses use product life cycle pricing to better understand
how discounts, clearance prices, new versions and marketing can affect their sales in each phase.
A company may choose to strategize differently depending on the market and how its product
sells.

Here are the four stages of a product life cycle and how sales for a product may look in each one:

Launch or development stage

The launch phase, or development portion of the life cycle, is when the company first introduces
the product to the market. During this time, the business may record few sales, as the consumers
within the market may be reluctant to purchase a new product. This can be especially true when a
product is unique, resulting in lower competition but slower market acceptance.
Early or growth stage

The early stage within the product life cycle comes after the launch and is when demand for the
product or service rises. Experts may call this stage the promotional stage, and it can be when
marketing efforts may show positive results. During this stage of the cycle, competitors may
release their own products to compete with yours.

Mid or maturity stage

The maturity stage, or the regular pricing phase, represents a plateau in the product's sales and
awareness. This is the time in the product life cycle where the product shows acceptable sales and
profits. This may be the phase of the cycle where there is the highest level of competition.
Late or declination stage

Experts may also call the last stage in the product life cycle the clearance phase. It's during this
phase that consumers may choose an alternative product. Many companies plan to remove the
product from production during this stage, as there is less demand for the product. In this stage,
businesses may even lose money by continuing to produce the product.

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

Assumptions:

1. All costs are classified into two – fixed and variable.

2. Fixed costs remain constant at all levels of output.
3. Variable costs vary proportionally with the volume of output.
4. Selling price per unit remains constant in spite of competition or change in the volume of
production.
5. There will be no change in operating efficiency.
6. There will be no change in the general price level.
7. Volume of production is the only factor affecting the cost.
8. Volume of sales and volume of production are equal. Hence there is no unsold stock.
9. There is only one product or in the case of multiple products sales mix remains constant.

Significance of BEA

➢ To ascertain the profit on a particular level of sales volume or a given capacity of

production
➢ To calculate sales required to earn a particular desired level of profit.
➢ To compare the product lines, sales area, methods of sales for individual company.
➢ To compare the efficiency of the different firms
➢ To decide whether to add a particular product to the existing product line or drop one from
it.
➢ To decide to “make or buy” a given component or spare part.
➢ To decide what promotion mix will yield optimum sales.
 ➢ To assess the impact of changes in fixed cost, variable cost or selling price on BEP and
profits during a given period.

Limitations of BEA

▪ Break even point is based on fixed cost, variable cost and total revenue.
▪ A change in one variable is going to affect the BEP
▪ All cost cannot be classified into fixed and variable costs. There may be semi-variable costs
also.
▪ In case of multi-product firm, a single chart cannot be of any use. Series of charts have to
be made use of.
▪ It is based on fixed cost concept and hence holds good only in the short – run.
▪ Total cost and total revenue lines are not always straight as shown in the figure. The
quantity and price discounts are the usual phenomena affecting the total revenue line.
▪ Where the business conditions are volatile, BEP cannot give stable results

Determination of break even point

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

Fixed cost: Expenses that do not vary with the volume of production are known as fixed expenses.
Eg. Manager’s salary, rent and taxes, insurance etc. It should be noted that fixed changes are fixed
only within a certain range of plant capacity.

Variable Cost: Expenses that vary almost in direct proportion to the volume of production or sales
are called variable expenses. Eg. Cost of Raw materials, Labour charges, Electric power and fuel,
packing materials, consumable stores etc. It should be noted that variable cost per unit is fixed.
Contribution: Contribution is the difference between sales and variable costs and it contributed
towards fixed costs and profit. It helps in sales and pricing policies and measuring the profitability
of different proposals. Contribution is a sure test to decide whether a product is worthwhile to be
continued among different products.
Contribution = Sales – Variable cost

Contribution = Fixed Cost + Profit.

Margin of safety: Margin of safety is the excess of sales over the break even sales. It can be
expressed in absolute sales amount or in percentage. It indicates the extent to which the sales can
be reduced without resulting in loss. A large margin of safety indicates the soundness of the
business. The formula for the margin of safety is:
 Profit
Present sales – Break even sales or
P. V. ratio

Margin of safety can be improved by taking the following steps.

1. Increasing production
2. Increasing selling price
3. Reducing the fixed or the variable costs or both
4. Substituting unprofitable product with profitable one.

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

Profit - Volume Ratio is usually called P/ V ratio. It is one of the most useful ratios for studying the profitability
of business. The ratio of contribution to sales is the P/V ratio. It may be expressed in percentage. Therefore,
every organization tries to improve the P/ V ratio of each product by reducing the variable cost per unit or by
increasing the selling price per unit. The concept of P/ V ratio helps in determining break even-point, a desired
amount of profit etc.
BREAK EVEN ANALYSIS (FORMULA)
1.

2.

3.

4.

P/ V RATIO FORMULA
1.

(OR)

2.
 (OR)

3.

SALES REQUIRED TO EARN DESIRE PROFIT (FORMULA)

1.

2.

3.

4.

Margin of safety Formula

1. Margin of safety = Actual sales – Breakeven sales
2.

3.
 UNIT - IV
INTRODUCTION TO ACCOUNTING

Accounting is the science of recording and classifying business transactions and

events primarily of financial character, and the art of making significant summaries,
analysis and interpretations of those transaction and events, and communicating the results
to persons who must make decisions or form judgment.

Meaning and Scope of Accounting

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

safeguard the interests of the business, its proprietors and others connected with the
business transactions. This is done by providing suitable information to the owners,
creditors, shareholders, Government, financial institutions and other related agencies.

Definition of Accounting

The American Accounting Association defines accounting as "the process of

identifying, measuring and communicating economic information to permit informed
judgements and decisions by the users of the information."

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

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

Steps of Accounting

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

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

Objectives of Accounting

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

Limitations of Accounting

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

Significance of accounting:
1. Maintain its own records of business
2. Monitor the business activities
3. Calculate profit or loss for a given period
4. Fulfill legal obligations
5. Show financial position for a given period
6. Communicate the information to the interested parties

Accounting terms
➢ Business transactions: Any exchange of money or money worth is called business
transaction. Events like purchase and sale of goods, receipts and payments of cash for
services.
➢ Debtor : A debtor is a person who owes something to the business.
➢ Creditor: A creditor is a person to whom something is owing by the business
➢ Capital : It is the amount invested by the proprietor in the business. For the business,
capital is a liability towards the owner. Some times it in called owner equity i.e,
 owners claim against the assets. Owner’s equity or capital is always equal to assets
minus liabilities.
➢ Drawing: It is the value of cash or goods withdrawn from the business by the owner
for his personal uses.
➢ Goods : It includes all commodities or articles in which a trader deals.
➢ Assets : These are the material things or possessions or properties of the business
including the amount due to it. Examples are cash and bank balances, land and
buildings, plant and machinery.
➢ Liabilities : The term liabilities denote the amount which the business owes to others
such as loan from bank, creditors for goods supplied, for outstanding expenses.

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

II. Accounting Conventions.

Accounting Concepts: Accounting concepts mean and include necessary assumptions or

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

Accounting Concepts
1. Entity Concept: Separate entity concept implies that business unit or a company is a body
corporate and having a separate legal entity distinct from its proprietors. The proprietors or
members are not liable for the acts of the company. But in the case of the partnership
business or sole trader business no separate legal entity from its proprietors. Here
proprietors or members are liable for the acts of the firm. As per the separate entity concept
of accounting it applies to all forms of business to determine the scope of what is to be
recorded or what is to be excluded from the business books. For example, if the proprietor
of the business invests Rs.50,000 in his business, it is deemed that the proprietor has given
that much amount to the business as loan which will be shown as a liability for the business.
On withdrawal of any amount it will be debited in cash account and credited in proprietor's
capital account. In conclusion, this separate entity concept applies much larger in body
corporate sectors than sole traders and partnership firms.
2. Dual Aspect Concept: According to this concept, every business transaction involves two
aspects, namely, for every receiving of benefit and. there is a corresponding giving of benefit.
The dual aspect concept is the basis of the double entry book keeping. Accordingly for every
debit there is an equal and corresponding credit. The accounting equation of the dual aspect
concept is:
Capital + Liabilities = Assets (or) Assets = Equities (Capital)
(3) Accounting Period Concept: According to this concept, income or loss of a business can
be analyzed and determined on the basis of suitable accounting period instead of wait for a
long period, i.e., until it is liquidated. Being a business in continuous affairs for an indefinite
period of time, the proprietors, the shareholders and outsiders want to know the financial
position of the concern, periodically. Thus, the accounting period is normally adopted for one
year. At the end of the each accounting period an income statement and balance sheet are
prepared. This concept is simply intended for a periodical ascertainment and reporting the
true and fair financial position of the concern as a whole.
(4) Going Concern Concept: It is otherwise known as Continue of Activity Concept. This
concept assumes that business concern will continue for a long period. In other words, under
this assumption, the enterprise is normally viewed as a going concern and it is not likely to
be liquidated in the near future. This assumption implies that while valuing the assets of the
business on the basis of productivity and not on the basis of their realizable value or the
present market value, at cost less depreciation till date for the purpose of balance sheet. It is
useful in valuation of assets and liabilities, depreciation of fixed assets and treatment of
prepaid expenses.
(5) Cost Concept: This concept is based on "Going Concern Concept." Cost Concept implies
that assets acquired are recorded in the accounting books at the cost or price paid to acquire
it. And this cost is the basis for subsequent accounting for the asset. For accounting purpose
the market value of assets are not taken into account either for valuation or charging
depreciation of such assets. Cost Concept has the advantage of bringing objectivity in the
preparation and presentation of financial statements. In the absence of cost concept, figures
shown in accounting records would be subjective and questionable. But due to inflationary
tendencies, the preparation of financial statements on the basis of cost concept has become
irrelevant for judging the true financial position of the business.
(6) Money Measurement Concept: According to this concept, accounting transactions are
measured, expressed and recorded in terms of money. This concept excludes those
transactions or events which cannot be expressed in terms of money. For example, factors
such as the skill of the supervisor, product policies, planning, employer-employee
relationship cannot be recorded in accounts in spite of their importance to the business. This
makes the financial statements incomplete.
(7) Matching Concept: Matching Concept is closely related to accounting period concept. The
chief aim of the business concern is to ascertain the profit periodically. To measure the profit
for a particular period it is essential to match accurately the costs associated with the
revenue. Thus, matching of costs and revenues related to a particular period is called as
Matching Concept.
(8) Realization Concept: Realization Concept is otherwise known as Revenue Recognition
Concept. According to this concept, revenue is the gross inflow of cash, receivables or other
considerations arising in the course of an enterprise from the sale of goods or rendering of
services from the holding of assets. If no sale takes place, no revenue is considered.
(9) Accrual Concept: Accrual Concept is closely related to Matching Concept. According to
this concept, revenue recognition depends on its realization and not accrual receipt.
Likewise cost are recognized when they are incurred and not when paid. The accrual concept
ensures that the profit or loss shown is on the basis of full fact relating to all expenses and
incomes.
(10) Rupee Value Concept: This concept assumes that the value of rupee is constant. In fact,
due to inflationary pressures, the value of rupee will be declining. Under this situations
financial statements are prepared on the basis of historical costs not considering the
declining value of rupee. Similarly depreciation is also charged on the basis of cost price.
Thus, this concept results in underestimation of depreciation and overestimation of assets
in the balance sheet and hence will not reflect the true position of the business.
Accounting Conventions
(1) Convention of Disclosure: The disclosure of all material information is one of the
important accounting conventions. According to this conventions all accounting statements
should be honestly prepared and all facts and figures must be disclosed therein. The
disclosure of financial information’s are required for different parties who are interested in
the welfare of that enterprise. The Companies Act lays down the forms of Profit and Loss
Account and Balance Sheet. Thus convention of disclosure is required to be kept as per the
requirement of the Companies Act and Income Tax Act.
(2) Convention of Conservatism: This convention is closely related to the policy of playing
safe. This principle is often described as "anticipate no profit, and provide for all possible
losses." Thus, this convention emphasize that uncertainties and risks inherent in business
transactions should be given proper consideration. For example, under this convention
inventory is valued at cost price or market price whichever is lower. Similarly, bad and
doubtful debts is made in the books before ascertaining the profit.
(3) Convention of Consistency: The Convention of Consistency implies that accounting
policies, procedures and methods should remain unchanged for preparation of financial
statements from one period to another. Under this convention alternative improved
accounting policies are also equally acceptable. In order to measure the operational
efficiency of a concern, this convention allows a meaningful comparison in the performance
of different period.
(4) Convention of Materiality: According to Kohler's Dictionary of Accountants Materiality
may be defined as "the characteristic attaching to a statement fact, or item whereby its
disclosure or method of giving it expression would be likely to influence the judgment of a
reasonable person." According to this convention consideration is given to all material
events, insignificant details are ignored while preparing the profit and loss account and
balance sheet. The evaluation and decision of material or immaterial depends upon the
circumstances and lies at the discretion of the Accountant.
USERS OF ACCOUNTING INFORMATION:

1. Proprietors: A business is done with the objective of making profit. Its profitability and
financial soundness are, therefore, matter of prime importance to the proprietors who
have invested their money in the business.
2. Managers: In a sole proprietary business, usually the proprietor is the manager. In case
of a partnership business either some or all the partners participate in the management
of the business.
3. Creditors: Creditors are the persons who have extended credit to the company. They are
also interested in the financial statement because they will help them in ascertaining
whether the enterprise will be in a position to meet its commitment towards the both
regarding payment of interest and principal.
4. Prospective investors: A person who is contemplating an investment in a business will
like to known about its profitability and financial position. A study of the financial
statements will help him in this respect.
5. Government: The government is interested in the financial statements of business
enterprise on account of taxation, labour and corporate laws. If necessary, the
government may ask its officials to examine the accounting records of a business.
6. Employees: The employees are interested in the financial statements on account of
various profit sharing and bonus schemes. Their interest may further increase in case
they purchase shares of the companies in which they are employed.

DOUBLE ENTRY SYSTEM:

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

Advantages of double- entry book – keeping

1. Information about every account: Under double entry system, both aspects of a
transaction are being recorded in the books of accounts. Hence information about
every account is available in the books of account as all accounts are to be found in
the ledgers under double entry system.
2. Helps to know the receivables and payables: It helps to know how much is owed to
the creditors and how much is due from the debtors. Also it focuses on the bills
payable and receivables.
3. Arithmetical accuracy: The arithmetical accuracy can be ascertained by preparing a
statement of debits and credits called trial balance and this is possible because both
debit aspects and credit aspects of every transaction are recorded.
4. Helps to locate errors: Trial balance can reveal the errors that creep in account while
recording the business information.
5. Helps to ascertain profit / loss: The profit and loss statement can be prepared without
much difficulty under double entry system.
6. Helps to know the financial position: Double entry system helps to prepare balance
sheet that reveals the financial position of the business as on a particular date.
7. Monitoring and auditing made easier: With double entry system the scope for frauds
and misappropriations is less, provided proper internal audit system is in place.

ACCOUNTING RULES:
Personal Account: These are the accounts of natural persons such as Ram account, Gopal
account. Artificial person such as Uday ltd, Syndicate bank represents personal account.

Rule: “Debit----The Receiver

Credit---The Giver”
Real Accounts: Accounts relating to properties or assets of a trader are known as real
accounts. It includes tangible assets such as Buildings, furniture,. Cash, etc and also intangible
assets such as Goodwill, Trade marks, Patent rights.

Rule: “Debit----What comes in

Credit---What goes out”

Nominal Accounts : Account dealing with expenses, losses, gains and incomes are called
nominal accounts, eg. Salaries, Wages, Commission account etc.

Rule: “Debit----All expenses and losses

Credit---All incomes and gains”

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

Date Particular LF Debit Credit

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

( narration )

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

LEDGER:

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

Drledger a/c Cr
Date Particular JF Amount Date Particular JF Amount

Note:
Dr means debit side it is always start with TO, Cr means credit side it is always start with By
Balancing an account: After all transaction have been posted and the various accounts
prepared they are balanced. The procedure for balancing ledger accounts is as follows.
1. Take the totals of the two sides of the account on a rough sheet.
2. Ascertain the difference between the totals of two sides . the difference is called
“balance”
3. Enter the difference in the amount column of the side showing less total. If the credit
side total is less , write in the particulars column on the credit side of the account , By
balance c/d. similarly if the debit side is less , write on the debit side of the account
To balance c/d.

TRAIL BALANCE

The first step in the preparation of final accounts is the preparation of trail balance. In the
double entry system of book keeping, there will be credit for every debit and there will not
be any debit without credit. When this principle is followed in writing journal entries, the
total amount of all debits is equal to the total amount all credits.

A trail balance is a statement of debit and credit balances. It is prepared on a particular date
with the object of checking the accuracy of the books of accounts. It indicates that all the
transactions for a particular period have been duly entered in the book, properly posted and
balanced. The trail balance doesn’t include stock in hand at the end of the period. All
adjustments required to be done at the end of the period including closing stock are generally
given under the trail balance.

DEFINITION:

J.R.BATLIBOI:

A trail balance is a statement of debit and credit balances extracted from the ledger with a
view to test the arithmetical accuracy of the books.
Thus a trail balance is a list of balances of the ledger accounts’ and cash book of a business
concern at any given date

PROFORMA FOR TRAIL BALANCE:

Trail balance for MR…………………………………… as on …………

NO NAME OF ACCOUNT DEBIT CREDIT

AMOUNT(RS.) AMOUNT(RS.)
(PARTICULARS)

FINAL ACCOUNT

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

Trading account
Trading account is a part of profit and loss account. Trading account is prepared for
ascertaining Gross profit or Gross loss. The difference between the sales and the cost of the
goods sold is gross profit. Cost of good sold can be ascertained by adding opening stock ,
purchases, direct expenses for purchase of goods and deduction there from closing stock.
PROFORMA OF TRADING ACCOUNT
Trading account of ------------- for the year ended 31 march ----
Particular Amount Particular Amount
To opening stock Xxxx By Sales xxxxx
Less; Sales return xxxxx Xxxx
To Purchase xxxx
 Less: purchase return Xxxx
xxxx

To carriage inwards Xxx By closing stock Xxxx

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

PROFIT AND LOSS ACCOUNT

Profit and loss account is prepared to ascertain the net profit or net loss of the
business for a particular period. All indirect expenses such as management and office
expenses, financial expenses, selling and distribution expenses are taken on the debit side.
Gross profit and other items of incomes such as interest received , discount received, etc. are
taken on credit side. The different between two sides is either net profit or net loss which is
transferred to capital account.

The business man is always interested in knowing his net income or net profit.Net
profit represents the excess of gross profit plus the other revenue incomes over
administrative, sales, financial and other expenses. The debit side of profit and loss account
shows the expenses and the credit side the incomes. If the total of the credit side is more, it
will be the net profit. And if the debit side is more, it will be net loss.

PROFORMA OF PROFIT AND LOSS ACCOUNT

Profit and loss of --------------- for the year ended 31 march xxx
Particular Amount Particular Amount
To Salaries xxx By gross profit Xxx
Add : outstanding salaries Xxx
xxx
To Rent Xxx By Discount received Xxx
To Discount allowed Xxx By Interest received Xxx
To Office expenses Xxx By Commission received Xxx
 To Rate and tax Xxx
To Lighting Xxx
To Printing and stationery Xxx
To Postage and telegrams Xxx
To Telephone charges Xxx
To Legal expenses Xxx
To Telephone charges Xxx
To Audit fee Xxx
To General expenses Xxx
To Advertisement Xxx
To Insurance Xxx
To interest on capital Xxx
To deprecation on assets( Xxx
machinery , building , furniture,
land.etc)
To repair Xxx
To carriage outward Xxx
To written off bad debts Xxx
To travelling expenses Xxx
To interest on loan Xxx
To net profit Xxx
Xxxxxx Xxxxxx

BALANCE SHEET:

The second point of final accounts is the preparation of balance sheet. It is prepared
often in the trading and profit, loss accounts have been compiled and closed. A balance sheet
may be considered as a statement of the financial position of the concern at a given date.

DEFINITION:

J.R.Botliboi: A balance sheet is a statement with a view to measure exact financial position of
a business at a particular date.

Thus, Balance sheet is defined as a statement which sets out the assets and liabilities
of a business firm and which serves to as certain the financial position of the same on any
particular date. On the left-hand side of this statement, the liabilities and the capital are
shown. On the right-hand side all the assets are shown. Therefore, the two sides of the
balance sheet should be equal. Otherwise, there is an error somewhere.

PROFORMA OF BALANCE SHEET

Balance sheet of Mr.------------------------------ as on 31 march xxxxx
Liabilities Amount Assets Amount
Capital xxxx Plant and machinery Xxx
Add: interest on capital xxxx Less: depreciation on plant
Net profit xxxx machinery xxx
------
Xxxx Building xxx Xxx
Less: drawings xxxx Less : depreciation on building
Net loss xxxx Xxx xxx Xxx
Reserves Xxx Land xxx
Lonterm Loan Xxx Less ; depreciation on land
xxx
Vehicle
Investment Xxx
Cash in hand
Cash at bank Xxx
Xxx
Xxx
Xxx
Sundry creditor Xxx Sundry debtor xxx
Bills payable Xxx Less : written of bad debts
xxx
Bank overdraft Xxx Xxx
Outstanding expenses Xxx Closing stock Xxx

Bill receivable Xxx

Prepaid expenses Xxx

Xxxxx Xxxxx

Difference between trading account and profit and loss account

Trading account Profit and loss account

It is the first stage of final accounts It is the second stage of the final accounts
 It shows the gross profit and gross loss of It shows the net profit and net loss results
the business.

All direct expenses are considered in it. All expenses connected with sales and
administration of business are considered.

It does not start with the balance of any It always starts with the balance of a trading
account account

Its balance transferred to profit and loss Its balance is transferred to capital account
account as gross profit or gross loss in balance sheet as net profit or net loss.

Difference between trial balance and balance sheet

Trial balance Balance sheet

It is prepared to verify the arithmetical It is prepared to disclose the true financial

accuracy of books of accounts position of the business

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

Auditor need not to sign it. Auditor must sign it.

FINAL ACCOUNTS -- ADJUSTMENTS

We know that business is a going concern. It has to be carried on indefinitely. At the

end of every accounting year the trader prepares the trading and profit and loss account and
balance sheet. While preparing these financial statements, sometimes the trader may come
across certain problems .The expenses of the current year may be still payable or the
expenses of the next year have been prepaid during the current year. In the same way, the
income of the current year still receivable and the income of the next year have been received
during the current year. Without these adjustments, the profit figures arrived at or the
financial position of the concern may not be correct. As such these adjustments are to be
made while preparing the final accounts.

The adjustments to be made to final accounts will be given under the Trial Balance. While
making the adjustment in the final accounts, the student should remember that “every
adjustment is to be made in the final accounts twice i.e. once in trading, profit and loss
account and later in balance sheet generally”. The following are some of the important
adjustments to be made at the time of preparing of final accounts:-

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

(ii)If closing stock is given as adjustment:

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

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

2.OUTSTANDING EXPENSES :-

(i)If outstanding expenses given in Trail Balance: It should be only on the liability side of
Balance Sheet.

(ii)If outstanding expenses given as adjustment :

1. First, it should be added to the concerned expense at the
debit side of profit and loss account or Trading Account.
2. Next, it should be shown at the liabilities side of the Balance Sheet.

3.PREAPID EXPENSES :-

(i)If prepaid expenses given in Trial Balance: It should be shown only in assets side of the
Balance Sheet.

(ii)If prepaid expense given as adjustment :

1. First, it should be deducted from the concerned expenses at the debit side of Profit
and loss account or Trading Account.
 2. Next, it should be shown at the assets side of the Balance Sheet.

4.INCOME EARNED BUT NOT RECEIVED [OR] OUTSTANDING INCOME [OR] ACCURED
INCOME :-

(i)If incomes given in Trial Balance: It should be shown only on the assets side of the Balance
Sheet.

(ii)If incomes outstanding given as adjustment:

1. First, it should be added to the concerned income at the credit side of Profit and loss
account.
2. Next, it should be shown at the assets side of the Balance sheet.

5. INCOME RECEIVED IN ADVANCE: UNEARNED INCOME:-

(i)If unearned incomes given in Trail Balance : It should be shown only on the liabilities side
of the Balance Sheet.

(ii)If unearned income given as adjustment :

1. First, it should be deducted from the concerned income in the credit side of the profit
and loss account.
2. Secondly, it should be shown in the liabilities side of the Balance Sheet.
6. DEPRECIATION:-

(i)If Depreciation given in Trail Balance: It should be shown only on the debit side of the
profit and loss account.

(ii)If Depreciation given as adjustment

1. First, it should be shown on the debit side of the profit and loss account.
2. Secondly, it should be deduced from the concerned asset in the Balance sheet assets
side.
7.INTEREST ON LOAN [OR] CAPITAL:-

(i)If interest on loan (or) capital given in Trail balance:It should be shown only on debit side
of the profit and loss account

(ii)If interest on loan (or)capital given as adjustment :

1. First, it should be shown on debit side of the profit and loss account.
2. Secondly, it should added to the loan or capital in
the liabilities side of the Balance Sheet.

8.BAD DEBTS:-
(i)If bad debts given in Trail balance :It should be shown on the debit side of the profit and
loss account.

(ii)If bad debts given as adjustment:

1. First, it should be shown on the debit side of the profit and loss account.
2. Secondly, it should be deducted from debtors in the assets side of the Balance Sheet.

9.INTEREST ON DRAWINGS :-

(i)If interest on drawings given in Trail balance: It should be shown on the credit side of the
profit and loss account.

(ii)If interest on drawings given as adjustments :

1. First, it should be shown on the credit side of the profit and loss account.
2. Secondly, it should be deducted from capital on liabilities side of the Balance Sheet.
10.INTEREST ON INVESTMENTS :-

(i)If interest on the investments given in Trail balance :It should be shown on the credit side
of the profit and loss account.

(ii)If interest on investments given as adjustments :

1. First, it should be shown on the credit side of the profit and loss account.
2. Secondly, it should be added to the investments on assets side of the Balance Sheet.

Elements of Financial Statements

Assets

Assets are things that a company owns and have value. Assets are typically recorded on the
balance sheet at their original cost (also called historical cost) less accumulated
depreciation, which is an expense that reflects the wear and tears on assets over time.
Assets include fixed assets and current assets.

Typically, businesses like to keep track of their assets in order to measure how much they
are worth or to serve as collateral for borrowing money or other financing activities. Assets
also help investors make decisions on whether the company is doing well financially since
they can see what assets are available to be used for future growth.
Liability

Liabilities are obligations of the business that may need to be paid back over a period of
time. These would include both short-term (current) liabilities such as accounts payable
and long-term liabilities such as mortgages.

Typically, businesses like to keep track of their liabilities in order to measure the total
amount that they owe or are obligated to payout. Liabilities also help investors make
decisions on whether the company is doing well financially. Since they can see how much
debt the business has taken on and if it may be too much to handle.

Equity

Equities are claims by owners of a business on its assets after all debts have been paid off.
These would include things such as common stock, preferred stock, treasury stock (stock
repurchased by a company), and accumulated other comprehensive income (AOCI).

Typically, businesses like to keep track of their equities in order to measure ownership
interest or how many shares of a company an individual has.

Income

Income is money that the company makes from its regular business operations before
accounting for expenses such as taxes, interest payments, and other financing activities.
Income does not include income from other sources such as investments because there
may be no cash inflow to offset any outflow that may occur when these assets are sold
(when funds are pulled out). As a result, it’s helpful to keep track of what an organisation
earned in order to help make better investment decisions in the future.

Expenses

Expenses are money that the company spent on its regular business operations before
accounting for income. Expenses are reduced from total income to derive the net profit or
loss of the business.

FINANCIAL ANALYSIS THROUGH RATIOS

Ratio Analysis
Absolute figures are valuable but they standing alone convey no meaning unless compared with
another. Accounting ratio show inter-relationships which exist among various accounting data.
When relationships among various accounting data supplied by financial statements are worked
out, they are known as accounting ratios.

Accounting ratios can be expressed in various ways such as:

1. a pure ratio says ratio of current assets to current liabilities is 2:1 or

2. a rate say current assets are two times of current liabilities or
3. a percentage say current assets are 200% of current liabilities.
Each method of expression has a distinct advantage over the other the analyst will selected that
mode which will best suit his convenience and purpose.

Uses or Advantages or Importance of Ratio Analysis

Ratio Analysis stands for the process of determining and presenting the relationship of items and
groups of items in the financial statements. It is an important technique of financial analysis. It is
a way by which financial stability and health of a concern can be judged. The following are the
main uses of Ratio analysis:

(i) Useful in financial position analysis: Accounting reveals the financial position of the
concern. This helps banks, insurance companies and other financial institution in lending
and making investment decisions.
(ii) Useful in simplifying accounting figures: Accounting ratios simplify, summaries and
systematic the accounting figures in order to make them more understandable and in lucid
form.

(iii) Useful in assessing the operational efficiency: Accounting ratios helps to have an idea of
the working of a concern. The efficiency of the firm becomes evident when analysis is based
on accounting ratio. This helps the management to assess financial requirements and the
capabilities of various business units.

(iv) Useful in forecasting purposes: If accounting ratios are calculated for number of years,
then a trend is established. This trend helps in setting up future plans and forecasting.
(v) Useful in locating the weak spots of the business: Accounting ratios are of great assistance
in locating the weak spots in the business even through the overall performance may be
efficient.

(vi) Useful in comparison of performance: Managers are usually interested to know which
department performance is good and for that he compare one department with the another
department of the same firm. Ratios also help him to make any change in the organisation
structure.
 Limitations of Ratio Analysis: These limitations should be kept in mind while making use of
ratio analyses for interpreting the financial statements. The following are the main limitations
of ratio analysis.

1. False results if based on incorrect accounting data: Accounting ratios can be correct only
if the data (on which they are based) is correct. Sometimes, the information given in the
financial statements is affected by window dressing, i. e. showing position better than what
actually is.
2. No idea of probable happenings in future: Ratios are an attempt to make an analysis of the
past financial statements; so they are historical documents. Now-a-days keeping in view
the complexities of the business, it is important to have an idea of the probable happenings
in future.
3. Variation in accounting methods: The two firms’ results are comparable with the help of
accounting ratios only if they follow the some accounting methods or bases. Comparison
will become difficult if the two concerns follow the different methods of providing
depreciation or valuing stock.
4. Price level change: Change in price levels make comparison for various years difficult.
5. Only one method of analysis: Ratio analysis is only a beginning and gives just a fraction
of information needed for decision-making so, to have a comprehensive analysis of
financial statements, ratios should be used along with other methods of analysis.
Types of ratios:

1. Liquidity ratios
2. Activity ratios
3. Capital structure ratios
4. Profitability ratios

Liquidity ratios:

Liquidity ratios express the ability of the firm to meet its short term commitments as and when
they become due. Creditor are interested to know whether the firm will be in a position to meet
its commitment on time or not. Liquidity ratio help in identifying the danger signals for the
firm in advance. Apart form the firm itself, all the financing companies offering short term
finances are interested in these ratios.

Liquidity ratios can be classified into two types:

1. Current ratio: current ratio is the ratio between current assets and current liabilities. The
firm is said to be comfortable in its liquidity position if the current ratio2:1.

Current ratio current assets =

current liabilitie s
WHERE :
current assets are whose assets with are converted in to cash with the accounting period or one
year. For example of current assets are sundry debtors, bill receivable, cash in hand , cash at bank,
closing stock, prepaid expenses, etc.

current liabilities: current liabilities are whose which have to pay in the year or pay with in account
period for example, sundry creditor, bill payable, bank overdraft, outstanding expenses, etc.

2. Quick ratio: quick ratio is also called acid test ratio. It measures the firm’s ability to convert
us current assets quickly into cash in order to meet its current liabilities. It is the ratio
between liquid assets and liquid liabilities. It supplements the information given by current
ratio.

Quick ratio or liquid ratio or acid test quick assets ratio:

current liabilitie s
Where:

Quick assets= current assets – (stock + prepaid expenses)

Turnover ratios

It ratios express how active the firm is in terms of selling its stocks collecting its receivables and
paying its creditors. 1. Inventory turnover ratio 2. Debtors turnover ratio.

Inventory turnover ratio; It is also called stock turnover ratio. It indicates the number of times the
average stock is being sold during a given accounting period. It establishes the relation between
the cost of goods sold during a given period and the average amount of inventory outstanding
during that period.
cost of goods sold
1. Inventory turnover ratio = average stock
Average stock = opening stock + closing stock
2
Where : cost of goods sold = sales – gross profit
Cost of goods sold = opening stock+ purchase+ wages+ direct express

2. Debtors turnover ratio: detor turnover ratio reveals the number times the average debtors
are collectied during a given accounting period. In other words. It shows how quickly the
firm is in position to collect its debts. It is necessary to keep close monitoring of realization
of debts because it directly affect the working capital position .
Debtors turnover credits sales or sales ratio=
average debtors
Where :
Credit sales : credit sales refer to goods sold on credit
Average debtors is the average of opening and closing balance of debtors for the given accounting
period

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

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

Debt – equity ratio = debt / equity

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

Interest coverage ratio;

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

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

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

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

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

Gross profit = gross profit

__________ X 100
net sales
where :

gross profit = cost of goods sold – net sales

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

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

Net profit ratio = net profit

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

Operating ratio = operating expenses

________________X 100
Net sales

Earning per share (EPS):

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

EPS = net profit after taxes

________________
Number of shares outsanding
Price / earning ratio
This is share price divided by the earning per share

Price / earning ratio = market price

__________
Earning per share

Importance and Uses of Ratio Analysis

Ratio analysis is important for the company to analyze its financial position, liquidity, profitability,
risk, solvency, efficiency, operations effectiveness, and proper utilization of funds. It also indicates
the trend or comparison of financial results helpful for decision-making for investment by
company shareholders.

1 – Analysis of Financial Statements

Interpretation of the financial statements and data is essential for the firm’s internal and external
stakeholders. With the help of ratio analysis, we interpret the numbers from the balance sheet
and income statements. Every stakeholder has different interests when it comes to financial
results. Equity investors are more interested in the growth of the dividend payments and the
earnings power of the organization in the long run. Creditors would like to ensure that they get
their repayments on their dues on time.

2 – Helps in Understanding the Profitability of the Company

Profitability ratios help to determine how profitable a firm is. Return on Assets and return on
equity helps to understand the ability of the firm to generate earnings. Return on assets is the
total net income divided by total assets. It means how much a company earns a profit for every
dollar of its purchases. Return on equity is net income by shareholders equity. This ratio tells us
how well a company uses its investors’ money. Ratios like the gross profit and net profit margin.
Margins help to analyze the firm’s ability to translate sales to profit.

3 – Analysis of Operational Efficiency of the Firms

Certain ratios help us to analyze the degree of efficiency of the firms. Ratios like account
receivables turnover, fixed asset turnover, and inventory turnover ratio. These ratios can be
compared with the other peers in the same industry and help analyze which firms are better
managed. Second, it measures a company’s capability to generate income by using assets. Third,
it looks at various aspects of the firm, like the time it generally takes to collect cash
from debtors or the period for the firm to convert the inventory to currency. It is why efficiency
ratios are critical, as an improvement will lead to a growth in profitability.

4 – Liquidity of the Firms

Liquidity determines whether the company can pay its short-term obligations or not. We mean
short-term obligations, short-term debts, which one can pay off within 12 months, or
the operating cycle. For example, the salaries due, sundry creditors, tax payable, outstanding
expenses, etc. The current and quick ratios measure the liquidity of the firms.

5 – Helps in Identifying the Business Risks of the Firm

One of the most important reasons to use ratio analysis is that it helps understand the firm’s
business. Calculating the leverages (financial leverage and operating leverages) allows the firm
to understand the business risk, i.e., how its profitability is sensitive to its fixed cost deployment
and outstanding debt.
6 – Helps in Identifying the Financial Risks of the Company

Another importance of ratio analysis is that it helps identify the financial risks. For example,
ratios like leverage ratio, interest coverage ratio, DSCR ratio, etc., help the firm understand how
it depends on external capital and whether it can repay the debt using its wealth.

7 – For Planning and Future Forecasting of the Firm

Analysts and managers can find a trend, use the direction for future forecasting, and be used for
critical decision-making by external stakeholders like investors. For example, they can analyze
whether they should invest in a project or not.

8 – To Compare the Performance of the Firms

The main use of ratio analysis is to compare the strengths and weaknesses of each firm. The ratios
can also be compared to the firm’s previous ratio and help analyze whether the company has
progressed.