1.

OPPORTUNITY COST :
Since productive resources are limited, the production of one commodity can only be at the cost of another. The commodity that is sacrificed is the opportunity cost of the commodity produced. Thus, economist define the cost of production of a particular product as the value of the foregone alternative products, that resource used in its production could have produced.

The opportunity cost of a product, is therefore, the opportunity lost of not being able to produce some other

EXAMPLE : If Rs. 20 lakhs are invested in project A at a 10 per cent rate of return, and if this amount was not invested in project A, it would have been invested in project B at 9 per rate of return. Then the opportunity cost of Rs. 20 lakh in project A is 9 per cent, which is the value of this amount in its next best alternative use.

2. MARGINAL PRINCIPLE & DECISION RULE

The concept of marginal value is widely used in economic analysis, for example marginal utility in consumer analysis, marginal cost in production analysis and marginal revenue in pricing theory. The term marginal refers to the change in total quality or value due to a one unit change in its determinants.

For example the change in total product caused as a result of one additional unit of variable factor employed in combination with fixed factors is called marginal product. MP= TPn TPn-1 in the same way marginal cost can (MC)
can be defined as the change in total cost as a result of producing one additional unit of a commodity.

MC= TCn TCn-1

where, TPn = Total production at the cost of n units. TPn-1 = Total production at the cost of n-1 units. TCn = Total Cost of producing n units, & TCn-1 = Total cost of producing n-1 units

Suppose Total Cost (TC) of producing 100 units of a commodity is Rs. 2500 and total cost of 101 units is Rs. 2550. Then, TCn =Rs.2550, TCn-1 = Rs. 2500. Then, MC = Rs. 2550 - Rs.2500 = Rs. 50.

Similarly, total revenue (TR) of a firm depends on the total number of units it sells at some point of time. So MR can be defined as the change in TR due to the sale of one additional unit of a product. It can also be defined as :
Where, units, units. MR = TRn TRn-1 TRn = Total Revenue from the sale of n TRn-1 = Total Revenue from the sale of n-1

 The

Decision Rule :

MR > MC A business activity must be carried out MR = MC Profit maximizing output

INCREMENTAL PRINCIPLE AND DECISION RULE

The concept of incremental value is similar to the concept of marginal value but with a difference. marginal principle can be applied only where MC and MR can be calculated precisely. In general, however, firms find it difficult to estimate MC & MR. The reason is that most business firms produce and sell their products in bulk, not in terms of units unless, of course, it is the case of production and sell of such large-unit goods as airplanes, ships large buildings turbines, etc.

The incremental principle is applied to business decisions which involve bulk production and a large increase in total cost and total revenue. Such as increase in total cost and total revenue is called incremental cost and incremental revenue respectively, related to incremental output.

INCREMENTAL COST : Let us first explain the concept of incremental cost. Conceptually, incremental costs can be defined as the costs that arise due to a business decision. For example, suppose a firm decides to increase production by adding a new plant to the existing capacity. This decision increases the firms total cost of production from Rs. 100 million to Rs. 115 million. Then Rs. 115 million Rs. 100 million =Rs. 15 million is the incremental

COMPONENTS OF INCREMENTAL COST

There are three major Components of Incremental Cost (IC) :
1. 2. 3.

Present Explicit Costs, Opportunity Cost and Future Costs.

Present Explicit Costs include a) Fixed Cost : Fixed cost is the cost of the plant and building, b) Variable cost : Variable cost is the cost of direct labour and materials and overheads like electricity and indirect labour. Opportunity Cost : Opportunity cost refers to expected income foregone from the second best use of the resources involved in the present decision.

Future Cost : Future costs of a business decision include depreciation and advertising costs if the product does not sell as well as expected.

THE INCREMENTAL REVENUE : The increase in the total revenue resulting from a business decision is called incremental revenue. Example : Suppose that after the installation of the new plant, the total production increases and the firm is able to sell the incremental product. As a result, the firms total sales revenue increases, let us suppose, from Rs. 130 million to Rs. 150 million. Rs. 150 million - Rs. 130 million =Rs. 20 million is the incremental revenue.

CONTRIBUTION ANALYSIS
The contribution of a business decision can be defined as the difference between the incremental revenue and the incremental cost associated with that particular decision. Contribution analysis is generally applied to analyse the contribution made by a business decision to overhead costs and revenue to work out the net result of that particular business decision.

There are three major Components of Incremental Cost (IC) : 1) Present Explicit Costs : Fixed Cost, & Variable cost. 2) Opportunity Cost and 3) Future Costs.

The relevant incremental revenue includes Explicit Present Revenue, A Possible Opportunity Revenue, & A Possible Future Revenue It is a useful technique for taking a decision on : Whether or not to accept a project, Whether or not to introduce a new project, Whether or not to accept a fresh order, Whether or not to add an additional plant, Whether to make or to buy and so on.

The Use of the Contribution analysis: The Use of the Incremental Concept in business decision is called incremental reasoning. The incremental reasoning is used in accepting or rejecting a business proposition or option. For instance, suppose that in our example, the firm is considering whether or not to install a new plant.

As noted above , the firm estimates an incremental cost of installing a new plant at Rs. 15 million and an incremental revenue of Rs. 20 million. The incremental revenue exceeds the incremental cost by Rs. 5 million which means a 33.33 per cent return on the investment in the new plant. The firm will accept the proposition of installing a new plant.

THE EQUI MARGINAL PRINCIPLE

The equi-marginal principle was originally associated with consumption theory and the law is called the law of equimarginal utility. The law of equi-marginal utility states that a utility maximising consumer distributes his consumption expenditure between various goods and services he/she consumes in such a way that the marginal utility derived from each unit of expenditure on various goods and service is the same . This pattern of consumption expenditure

The law of equi-marginal principle was over time applied by business managers to allocation of resources between their alternative uses with a view to maximise profit in case a firm carries out more than one business activity. Example : Suppose a firm has a total capital of Rs. 100 million which it has the option of spending on three projects A, B, and C. Each of these projects requires a unit expenditure of Rs. 10 million.

UNITS OF EXPENDITUR E (RS. 10 MILLION )

Ist

MARGINAL PRODUCTIVITY (MP )

PROJECT A
501

PROJECT B
403

PROJECT C
354

2nd

452

306

307

3rd

355

209
10

2010
15

4th

208
10

5th

12

Going by the equi-marginal principle, the firm will allocate its total resources (Rs. 100 million) among the projects A, B, & C in such a way that marginal product of each project is the same, i.e., MPA = MPB = MPC The firm will spend 1st, 2nd, 5th & 8th unit of finance on project A, 3rd, 6th & 9th unit on project B and 4th, 7th & 10th unit on project C.

Of the total finances of Rs. 100 million, a profit maximizing firm would invest Rs. 40 million in project A, Rs. 30 million each in project B & C This pattern of investment maximizes the firms productivity gains.

This principle suggests that a profit maximizing firm allocates its resources in a proportion such that : MPA = MPB = MPC = = MPN If the cost of the project (COP) varies from project to project, then resources are so allocated that MP per unit of COP is the same. MPA MPB MPC MPN COPA COPA COPA COPA

TIME PERSPECTIVE IN BUSINESS DECISION

All business decisions are taken with a certain time perspective. All business decisions do not have the same time perspective. Some have short-run outcome or pay off, therefore, involve short-run time perspective. For example, a decision to buy explosive material for manufacturing crackers involves short run demand prospects.

There are, however, a large number of business decisions which have long run repercussions, e.g., investment in plant, building , machinery, land, spending on labour welfare activities, expansion of the scale of production, introduction of a new product and advertisement.
The introduction of a new product may not be profitable in the short run but may prove very profitable in the long-run.

For example, the introduction of a newly designed laptop computer - a book size laptop priced at Rs. 10,000 may not succeed in the market quickly and smoothly. It may be difficult to even cover the variable costs because potential buyers may be uncertain about its usefulness, quality , serviceability and cost of operation. But in the long run, it may enjoy a roaring business.

Determination of time perspective is of great significance especially where projections are involved. In a business decision regarding the establishment of a management institute, projecting a short-run demand and taking a short-run time perspective will be unwise, and in buying explosive materials for manufacturing crackers for deepawali, a long-run time perspective is unwise.

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