Managerial Economics is a field of study concerning the

application of economic principles of decision making. It is the

integration of economic theory with business practice for the
purpose of facilitating decision making and forward planning by
management
Micro and Macro originated by Ragnar Firsch in 1933. Derived from
Greek words MIKROS and MAKROS which mean small and large
respectively.
Micro economics is concerned with the analysis of the behavior of
the individual, decision making and the problem of resource
allocation.
Macro economics deals with the aggregate behavior of the economy
as a whole.
Managerial economics is economics applied to the analysis of
business problems and decision making. It has a close connection
with Economic theory, Operations research, Statistics, Mathematics
and theory of decision making.
Managerial economics is multi disciplinary in character.
Scope of Managerial Economics
 Objectives of a business firm
 Demand Analysis & Demand forecasting
 Production
 Cost
 Competition
 Pricing
 Output
 Profit
 Investment & Capital budgeting
 Product policy, Sales promotion and Market strategy
 Constraints of the firm
 Internal
Imposed by organisation itself.
 External
Beyond the control of management and includes

resource constraints.

quantity or quality constraints.

legal constraints.
 Role of Managerial Economics
1. Demand forecasting
2. Production scheduling
3. Industrial Market Research
4. Economic analysis of the competing companies
5. Investment appraisal
6. Security management analysis and forecasts
7. Foreign exchange management
8. Advice on trade
9. Environmental forecasting
10. Pricing and the related decisions
 Profit Maximization
Profit is defined as revenue minus cost. Economists recognize the
other costs defined as implicit costs. These costs are not reflected in
cash outlays by the firm and includes managers time and talent.

Profit plays two important roles in a market economy.

1. Changes in profit signal, producers to change rate of production.

2. Profit is a reward to the Entrepreneurs for taking risks.

Profit is a reward for risk and uncertainty

It is a compensation for frictional factors like population, capital,

production techniques, form of organization and consumer wants.
 PROFIT POLICY
 To maintain good labour relations and
restrain the demands of organised labour.
 To discourage new competition
 To maintain business Goodwill with
customers.
 To maintain good public relations.
Reasonable Profits of Standards
 Attract Equity capital.
 Inter firm comparison.
 Comparison of profits of the firm.
 To finance growth from internal sources.
 Avoiding high tax and Govt intervention.
 Avoiding risk.
 Enlightened self interest of survival.
 Idealism and service motivation.
 Guidelines for profit policy
 Does not weaken the inner strength of the concern .
Ex Sales Service and R&D.

 Long term profitability , capital should be kept in tact .

Ex; Expansion , Financial need .

 Urgent need to update the technology and product line .

 Harmonious labor relation .

 Goodwill in society .
 Behavioral Theories
 Managerial and Behavioral theories of firm,
assume owners and managers to be
separate entities in large corporations with
different goals and motivation.
 There is a dichotomy.
1 Berle and Means and later developed by Gal braith ( B-M-G) Hypothesis.
States 1) That owner controlled firms have higher profit than manager controlled
firms AND
2) That managers have no incentive for profit Maximization.

2 Baumol’s hypothesis of sales revenue maximization.

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

f) Growing sales strengthen competitive spirit of the firm in the market and
vice versa.
3) Robin Marries Hypothesis of Maximization of firms growth rate :

Managers maximize the firms balanced growth rate subject to

Managerial and financial constraints.
G=G = G
D c
Where GD is growth rate of demand for firm product.
GC is growth rate of Capital supply to the firm.

Managers utility function Um = F ( salary, power, job security ,prestige,

status) ssspp
Owners utility function Uo = F( Output ,Capital, market share, profit,
public esteem) ppcmo
4 Williamson Hypothesis of maximization of managerial utility function ( u )

U= F (s , m , I )
d
Where s is additional expenditure on staff
m is Managerial emoluments
I Is discretionary investments
d

Managers maximize (U) subject to a satisfactory profit.

5 C yert – March hypothesis of satisfying behavior.

6 Rothschilds Hypothesis of long run survival and market share goals.

 Managerial Economic Principles
 Opportunity cost

 Incremental cost

 Discounting principle

 Concept of time

 Equi-marginal principle

 (cdeio)
 Demand analysis
Demand means the quantity of the commodity which an
individual consumer or a household willing to purchase at
a particular price.

A consumers desire to buy a product can be translated

into effective demand only if he has the money income to
pay for the product.

The fundamental objective of demand theory is to identify

and analyze the basic determinants of consumer needs
and wants.

An understanding of the forces behind demand is a

powerful tool for managers.
 Why Demand Analysis ?

The main purposes are the following, namely

 To understand why a consumer behaves as he does.
 To know the factors that govern in his choice to expand or contract
demand for various goods
 To appreciate why a consumer generally buys more of a goods for a
fall in price.
 Demand for a product has to be a combination of two forces of a
consumer, desire to buy, ability to buy the product and willing to
spend.
Factors that play an important role in determining the
demand
1. Price acts as signals to guide consumer decisions.
2. Tastes and preferences
3. Social – Cultural backgrounds of individuals
4. Income level
5. Prices of related products
6. Population
7. Government policy
8. Climate and weather
9. State of business
10. Invention and Innovations
11. Advertisement and sales propaganda
 Demand function

Dx = f ( Px , Py , Pz ……Pn, I, T.A)
where
Dx = Amount demanded per unit of commodity x

Px= Price of commodity x

Py , Pz ……Pn = Prices of substitutes or complements

I = Income of individual or household

T = Tastes and preferences of individual of household

A = Amount spent annually on advertisement

 Theory of Law Demand
According to theory of law of demand other things remaining same
(ceteris paribus) quantity demanded per unit at time will be greater
lower the price and smaller, higher the price.
Law of demand describes the general tendency of consumer
behavior in demanding a commodity in relation to the changes in its
price.
Assumptions:
 No change in fashions
 No Change in tastes and preferences
 Prices of commodities related to the commodity in demand should not
change
 There should be no change in the wealth of consumers
 No change in size, age composition and sex ratio of the population
 No change in government policy
 No change in weather conditions
 Exceptions
 Special type of inferior goods or Giffen goods
Ex:- Cheap bread and cake, vegetable ghee and pure ghee.

 Articles of distinction or SNOB appeal or VEBLEN conspicuous

consumption.

 Expectation of rise and fall in price in future.

 Ignorance on the part of consumer about quality or psychological bias

or Illusion .
 Why demand curve slopes
downwards from left to right

Demand curve is a graphical presentation of a demand schedule. The

demand curve has a negative slope. It slopes downwards from left to
right, representing an inverse relationship between price and demand.

A demand curve is a locus of points showing various alternative price

– quantity combinations.

Individuals demand curve for a product can be obtained by plotting the

data.
On X axis demand and on Y axis price per unit are to be taken.
 Each point on the demand curve shows one particular price – quantity
combination. Combination at each point, decreasing price of Tea and
increasing number of cups of Tea.

Reasons:
 Substitution effect

 Income effect

 Law of diminishing marginal

Utility

 Consumption by marginal
Consumers
 Types of Demand
 Direct demand and Derived demand.

 Domestic demand and Industrial demand .

 Autonomous demand and Induced demand .

 Perishable demand and Durable demand .

 New demand and Replacement demand.

 Final demand and Intermediate demand .

 Individual demand and Market demand.

 Short run demand and Long run demand.

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

Elasticity of demand = % change in Quantity demanded

% change in determinant of demand
Factors influencing Elasticity of demand :
 Nature of Commodity
 Availability of Substitutes
 Nature of uses
 Consumers Income
 Height of price and range of price change
 Proportion of Expenditure
 Durability of the commodity
 Influence of habit and custom
 Complementary goods
 Time
 Possibility of postponement
 Recurrence of demand
Price Elasticity
Defined as ratio of the relative change in demand and price
variables.
A price change can either increase or decrease total revenue,
depending on the nature of demand function. The uncertainty involved
in pricing decisions could be reduced if managers had a method of
measuring the probable effect of price changes on total revenue. One
such measure is price elasticity of demand.
The extent of response of demand for a commodity to a given
change in price, other demand determinants remaining constant is
termed as price elasticity of demand .
 Price elasticity of demand =% Change in quantity demanded
% Change in price

INCOME ELASTICITY OF DEMAND

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

 Refers to the degree of responsiveness of

demand for a commodity to a given change
in the price of some related commodity.

 Cross elasticity= %change in demand for X

%change in price of Y
 PRACTICAL UTILITY
 To the Businessmen.
 To the Government and finance minister-
Taxation of inelastic goods. Ex- sugar,
cigars.
 International trade - Export Import policies.
 Policy makers – In solving the mystery of
how farmers may remain poor despite a
bumper crop.
 To the Trade Unions- When industry’s
product is fairly elastic and the Trade
Unions in wage bargaining.
 Types of Elasticity
 Perfectly elastic
Consumers have infinite demand at a particular price and none at all
at an even slightly higher than this given price. e= ∞
 Perfectly inelastic
Demand remains unchanged, whatever be the change in price. e=0.

 Relatively elastic
Quantity demanded changes by a larger percentage than does
price. e >1.
 Unitary elastic
Quantity demanded changes by exactly the same percentage as
does price. e=1.

 Relatively inelastic
Quantity demanded changes by a smaller percentage than does
price. e < 1.
 Graphical Presentation of Types of Elasticity

Perfect elastic Perfectly inelastic Relatively elastic Relatively inelastic Unitary

inelastic
 Demand Forecasting
Demand forecasting is an estimate of demand
during a specified future period based on a
proposed marketing plan and a particular
uncontrollable and competitive forces.

Demand forecasting refers to predicting the

future which form basis for planning,
production, purchase planning, manpower
planning and financial planning.
 Importance
 Determining the sales territories.
 Helpful in deciding to enter a new market or not.
 Helpful in determining how much capacity to be built up.
 In deciding the number of salesmen required to achieve the sales
objective.
 Preparing standards.
 Assessing the effect of a proposed marketing programme.
 Product mix decisions.
 Deciding the channels of Distribution.
 Demand forecasting procedure
 Determine the objectives and purpose for which
the forecasts are to the used.
 Determining the relative importance of the factors
which affect sales of each product.
 Selecting the appropriate forecasting method.
 Collecting and analysing the data.
 Making assumptions regarding the effect of
factors.
 Making specific forecasts relating to the products
and territories involved.
 Periodically review and revising the forecasts.
 Methods of Forecasting
Opinion polling methods:

 Survey of buyers intention or consumer ‘s sample survey method.

 Executive judgement method.

 Delphi method.

 Naive model.

 Simple trend analysis.

 Market test method.

 End use method.

Statistical methods:

 Time-series analysis.

 Leading indicator method.

 Regression method.

 Simultaneous equation method.

 Smoothing techniques.
 Survey of buyers intentions or consumer sample survey method.
a) customers are asked to communicate their buying intentions in
coming period.
b) Identify potential buyers – industrial demand forecasting.

Demerits: 1. Expensive and time consuming.

2. Customers may tend to exaggerate their requirement.
3. Not useful for household customer goods.
 Executive judgement method.
Involves combining and averaging the sales projection of executives
in different departments to come up with forecast.

Merits: 1. Forecasting made quickly and economically.

2. Specialized persons therefore estimate would be much
more reliable than consumers survey.

Demerit: 1. Very subjective and lacks scientific validity.

 Delphi method

Developed by Olaf Heimer, Dalkey and Gorden at Rand Corporation

in the late 1940 in area of Technological forecasting.

It consists of an attempt to arrive at a consensus in an uncertain

area by questioning by group of experts repeatedly until the responses
appear to converge along a single line.

The coordinator provides each expert with the responses of others

including their reasoning. Each expert is given the opportunity to react
to the information or considerations advanced by others.
 Naive Models:

Based exclusively on historical observation of sales (for other variables

such as earnings, cash flows etc.). They do not explain the underlying
casual relationship which produces the variable being forecast.

Merit: It is inexpensive to develop, store data and operate.

Demerit: It does not consider any possible casual relationships that

underly the forecasting variable.

 Simple Trend Analysis:

Assumes that future sales will be determined by the same
variables that caused part sales and that the relationship among the
variables will remain the same.

Merit: Useful for products with a history of stable demand than for
products with erratic sales patterns.
Demerit: Cannot be used to forecast sales of a new product because past
sales data are absent.
 End use method:
a) Sales are projected through survey of its end users.
b) Commodity is used for final consumption or intermediary
consumption.
c) Domestic market or international market.
 Statistical Methods
 Time series analysis:

A time series is set of data collected over a period of time. Is

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

 Leading indicator method or Barometric method:

A forecasting method, where data is forecasted through

anticipatory data.
 Regression method:

Relevant variables have to be included with practical considerations

and relevant data have to be obtained.

Econometric models are useful and identify functional relationship

between variables.

Ex: 1. Personal disposable income towards demand .

2. Agricultural or Farm incomes towards demand for agricultural

equipment, fertilizers, etc.

3. Construction contracts for demand towards building material.

 Simultaneous equations method or Complete systems approach:

Sophisticated method normally used at macro level forecasting

for the economy.

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

Moving averages are averages that are updated as new information is

received. Most recent observations, drops the oldest observation.
 Demand Forecasting for a New Product

 Evolutionary approach

 Substitution approach

 Growth curve approach

 Opinion polling approach

 Sales experience approach

 Vicarious approach
 Criteria of a Good Forecasting Method
 Accuracy

 Simplicity

 Economy

 Quickness

 Flexibility

 Plausibility
 Production Function
Production function refers to the functional relationship, under the
given technology between the physical rates of input and output of a
firm per unit of time.

The study of production function is directed towards establishing the

maximum output which can be achieved with a given set of resources
and with a given state of technology.

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

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

 Production Function with two Variable Inputs

 The firm increases its output by using more of two inputs that are
substitutes for each other. Ex: Labour and Capital
 Cobb-Douglas Production Function
This is a multiplicative form of production function because it accurately characterizes many
production processes.

Q=a[ Lb K l -b ]

Where Q is the quantity of output

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

Where If α + β could be greater than, equal or Less than 1.

When α + β = 1 returns to scale are constant.

When α + β > 1 returns to scale are increasing.

When α + β < 1 returns to scale are decreasing.

3. Parameters represent factor shares in output.

4. Short term relationships of inputs and outputs can be calculated.

Marginal product of labour MPL = α ( Q / L)
Marginal product of capital MPK= β ( Q / K)

5. Elasticity of substitutes is unity.

Importance

 It is convenient for international and inter-industry comparisions.

 It is used to investigate the nature of long run production function.
 Least cost input combinations for a given output.
 Returns to Scale
 Three phases of returns in the long run:
 1. The law of increasing returns
 2. The law of constant returns
 3. The law of decreasing returns

The Law of Increasing Returns:

It describes increasing returns to scale. There are increasing returns to scale when a given
percentage increase in input will lead to a greater relative percentage increase in the
resultant output.

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

Q F Q

and ∆F = Proportionate.
F
Marshall explains increasing returns in terms of ‘increased efficiency’ of labour and capital in the
improved organisation with the expanding scale of output and employment of factor input. It
is referred to as ‘the economy of organisation’ in the earlier stages of expansion.

Increasing returns may be attributed to improvements in large scale operation, division of labour,
use of sophisticated machinery, better technology, etc. Increasing returns to scale are due to
indivisibilities and economics of scale and technological advancement.
 The Law of Constant Returns:
The process of increasing returns to scale cannot go on
forever. It may be followed by constant returns to scale.
As the firm continues to expand its scale of operations, it
gradually exhausts the economies responsible for the
increasing returns. Then, the constant returns may occur.
There are constant returns to scale when a given
percentage increase in inputs leads to the same
percentage increase in output.

Algebraically, ∆Q = ∆F It implies that the doubling of factor inputs

Q F
doubles the output. P F C =1 under constant returns
to scale
Constant returns to scale are quite often assumed in
economic theoretical models for simplification. Assumption
is based on the following conditions:
 1. All factors are homogeneous
 2. All factors are perfectly substitutable
 3. All factors are infinitely divisible
 4. The supply of all factors is perfectly elastic at the given prices.

The Law of Decreasing Returns:

As the firm expands, it may encounter growing diseconomies of the factors
employed. As such when powerful diseconomies are met by feeble
economies of certain factors, decreasing returns to scale set in. There are
decreasing returns to scale when the percentage increase in output is less
than the percentage increase in input.

Algebraically, ∆Q < ∆F Thus, P F C < 1 under decreasing returns to scale.

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

Internal Economies of Scale are those which arise from the firm
.
increasing its plant size External Economies arise outside the firm
from improvement or deterioration of the environment in which the firm
operates.

Internal Economies:

Real Economies
Pecuniary Economies
Labour Economies
 Technical Economies:

These are associated with the fixed capital, which includes

machinery and equipment. The main sources of technical
economies are :

1. Specialization

2. Indivisibilities

3. Economies of large machines, general purpose machinery and initial

fixed costs.
 Marketing Economies:

It is associated with the marketing activity of the firm is known as

marketing economies.

1. Economies on advertising and their selling activities.

2. Economies due to exclusive dealers with after sale service obligation.

3. Economies due to variation in models and designs.

 Financial Economies

Managerial Economies

Transport and Storage Economies

Diseconomies:
Management
Co-ordination
Decision making
Increase investment, Increase in risks
Labor diseconomies
Scarcity of factor supplies
Financial difficulties
Marketing Diseconomies
 Short run - Long run costs
Short run costs are those that can vary with the degree of utilisation of
plant and other factors fixed. These include fixed costs and variable
cost.
Short run costs include the following :

 Average fixed cost

 Average variable cost
 Average total cost
 Marginal cost

Long run costs:

in the long run ,the firm is not tied to a particular plant capacity.
The long run average cost curve is the envelop of the various short run
average cost curves. It is drawn as tangent to SAC.
 Cost function
The relationship between cost and its determinants is known as cost
function.
Productivities of factors of production,

Output per unit of factor ,

Learning effect,

Breadth of product range,

Geographical location,

Institutional factors,

Firms discretionary policies. (etc)

 Diagram

SAC 3
SAC 1 SAC 2
LAC
 Features
 Tangent curve

 Envelope curve

 Planning curve

 Minimum cost combination

 Flatter U-shape
 Supply Function
Supply of commodity means that amount of that commodity
which produces are able and willing to offer for sale at a
given price.

Supply function is an algebraic expression relating to quantity of

a commodity which a seller is willing and able to supply.
fx= f ( p x FE, F P ,PR ,W,E,N)
Where
p x is product price
FE is factor productivities or State of Technology
F P is factor prices
PR prices of other products related in production
W is weather, strikes and other short-run forces
E is firm’s expectations about future prospects for prices, costs,
sales and state of economy in general.
N is number
 Law of Supply
“Other things remaining the same, as the price of the commodity
rises, its supply increases: and as the price falls, its supply declines.”

Limitations:

1. Future prices
2. Agricultural output
3. Subsistence farmers
4. Factors other than price not remaining constant
 Market Structure
The term ‘Market’ refers to an arrangement whereby the buyers and
sellers come in close contact with each other directly or indirectly to
sell and buy goods.

Market Structure has four main characteristics:

1. Number and size distribution of sellers
2. Number and size distribution of buyers
3. Product differentiation
4. Conditions of entry and exit
 Perfect Competition
Competition exists among sellers and buyers. A single market price
prevails for the commodity, determined by demand and supply
forces in the market. Every buyer and seller is a price taker.

Features:

1. Large number of sellers and buyers

2. Easy entry and exit
3. Product is homogeneous
4. Perfect knowledge of market conditions
5. Non-government intervention
6. Absence of transport cost
 Monopoly
Single seller has control over the entire market supply, as there are
no close substitutes for his products and there are barriers to the
entry of rival producers.

Features:
1. Only one seller in the market of a particular good or service
2. There exists factors that prevent the entry of other firms
3. Product is highly differentiated from other goods
4. Entry is prohibited or difficult
5. There are no rivals or direct competition of the firm
6. Firm is the price maker
 Monopolistic Competition
A market with a blending of monopoly and competition is described
as monopolistic competition.

Features:

1. It has elements of both monopoly and perfect competition

2. Many buyers and that the resources can be easily transferred into
and out of industry.
3. It assumes that there are large number of small sellers, actions of
any single seller do not have a significant affect on other sellers in
the market.
4. Each seller resorts to advertising and sales promotion efforts.
5. Easy entry and exit
6. Imperfect knowledge of the buyers
 Oligopoly
Large number of sellers, few number of sellers hold market share.

Features:

1. Few number of sellers

2. Inter-dependence
3. Product may be either homogenous or differentiated
4. Condition of entry difficult
5. Advertising and selling costs have strategic importance
6. Involves an unspecified number of buyers but only a small number of
sellers
7. Each firm sticks to its own price – price rigidity
8. Constant fear of retaliation from rivals, if it reduces the price
 Kinky Demand Curve
Firstly initiated by Hall and Hitch. Later on developed by Prof. Paul
Sweezy. It does not explain how prices and output are determined
under oligopoly, rather it seeks to explain why once a price, quantity
combination has been established, a firm will avoid changing it.

A “KDC” Is set to occur when there is a sudden change in the slope of

demand curve. This gives rise to a Kink i.e. sharp corner in the
demand curve and at this Kink the firm sticks to its price.

We would get such a curve when it is assumed that the rivals will lower
their prices, when the oligopolist lowers his own price but that rivals
will not raise their price when the oligopolist raises his own price.
 KDC
DC

P K

DC

Quantity
Drawbacks:

1. It explains the reluctance of oligopolists to change price,

it provides no insight into understanding how the price
was originally determined.
2. No emperical research so as to verify the predictions.
 Pricing Policy
Pricing policy plays an important role in a business because the long
run survival of a business depends upon the firm’s ability to increase
its sales and derive the maximum profit from the existing and new
capital investment.

Objectives of pricing:

1. Provide an incentive to producer for adopting improved technology

and maximizing production.
2. Encourage optimum utilitization of resources
3. Work towards better balance between demand and supply
4. Promote exports
5. Avoid adverse effects on the rest of the economy
 Types of Pricing
Cost plus or full cost pricing
Under this method cost of a product is estimated and a margin of some kind
of profit is added on the basis of which the price is determined.
Transfer Pricing
When two or more inter-dependent departments are concerned, pertains to
the price to be put on the goods or services transferred by one dept. to
another. It refers to the price which one unit of an organization charges
for a product or service supplied to another sub-unit of the same
organization.

Loss Leader Pricing

Selling a product below its cost. It is used to drive competitors out of the
market. During introduction of a new product a firm may use this pricing
and utilizing the same as a promotional campaign.
 Types of Pricing
Competitive Pricing:

When a company sets its price mainly on consideration of what its

competitors are charging, its pricing policy under such a situation is
called competitive pricing or competition – oriented pricing. The
following are the two types of competitive pricing.

 Going rate pricing

 Sealed bid pricing

New Product Pricing:

 Skimming pricing
 Penetration pricing
 Types of Pricing
 Product Line Pricing:
It involves determination of prices of individual products and study of the
inter-relationship between multiple product costs and multiple product
demands.

Administrative Pricing:
The prices are fixed and enforced by the government. The major
characteristics are the following:
 They are fixed by the govt.
 They are statutory
 They are regulatory in nature
 They are meant as corrective measures
 They are the outcome of the price policy of the govt.
 Price Discrimination
Means charging different prices and it takes various forms.
 On the basis of customer
 On the basis of product version
 On the basis of place
 On the basis of time

Product life-cycle pricing

 Application of Marginal Costing
 Helps in the preparation of break-even analysis which shows the effect
of increasing or decreasing production activity on the profitability of the
company.

 Segregation of expenses as fixed and variable helps the management

to exercise control over expenditure.

 Marginal costing helps the management in taking a number of

business decisions like make or buy, discontinuance of a particular
product, replacement of machines, etc.
 Applications of Marginal Costing
1. Key factor or limiting factor:
Any factor concerned with production or sales which imposes ‘limits’ on
the production or sales can be called ‘limiting factor’ or key factor. It
can be limited sales, limited production, limited raw materials in use or
limited finance.

2. Make or buy decision:

Many durable products are assembled by using a large number of
parts or components. Some of them may be made by the firm which is
assembling the product. It may buy some products from outside. When
an assembling firm receives an offer from outside for a component it is
already making, the ‘make or buy decision’ must be taken. Marginal
Costing helps in taking the make or buy decision.

3. Fixation of selling price:

Marginal costing technique is widely used in the area of determining
selling price. Prices will have to be fixed in different situations, under
specific constraints, etc. Total cost must be recovered and profit also to
be made by fixing appropriate selling price.
 Applications of Marginal Costing
4. Export decision:
When idle capacity still exists, exporting is usually the most profitable
strategy. So companies which have already recovered their fixed costs
from local sales can export just above their variable cost and still make
good profits. This is generally termed as dumping.

5. Sales mix or product decision:

When a firm sells two or more products, the ratio of different products
in the total sales is called sales mix or product mix. The firm should
always design a product mix which maximizes the profit.

6. Product elimination decision:

When two or more products are sold by a firm as a sales mix,
situations may arise where it may be felt that a particular product has
to be eliminated. Elimination may be with or without replacement
 Applications of Marginal Costing
7. Plant merger decision:
Two or more plants may be operating under the same management
producing similar products. It may also be possible for one firm to
acquire another competing firm. Marginal costing helps in making such
decisions.

8. Plant purchase decision:

Purchasing plant is a long-term capital expenditure decision involving
investment and the required return on investment. Here, effective
contribution from the plant and the contribution as a percentage on
investment are the deciding factors.

9. Further processing decision:

Two or more products may be produced in a joint process. The
decision to further process or not depends on the overall contribution
received. If further processing can result in additional contribution from
the product, it is desirable.

10. Shut down decision:

When a firm is running at loss, the management will have to decide
upon its shut down. It may be complete shut down or partial or
temporary shut down.
 Cost Control
 It is a search for carrying production in economic ways.
 It refers to a comparison of actual and standard costs and then
taking action on any variations which have arisen.
 It implies efforts to be made for achieving a target goal or cost
minimization.
The following steps should be observed:

1. Determine clearly the objective i.e. predetermined the desired

results.
2. Measure the actual performance
3. Investigate into the causes of failure to perform according to plan
4. Institute corrective action
 Profit Planning
 Profit is difference between total sales revenue and total cost of
production.

 Planning refers to regulation of profit, sales volume and input quantity.

 Profit planning is an integral part of business policy and planning.

 Profit planning cannot be done without proper profit forecasting.

 Profit forecasting means projection of futures earnings taking into

consideration all the factors affecting the size of the business profits.
 Decision Making
Make or Buy:
The following two factors are to be considered –

 Whether surplus capacity is available

 The marginal cost – compare variable cost and offer price

Product-mix:
Many times the management has to take a decision whether to produce one
product or another instead. Generally decision is made on the basis of
contribution of each product. If there is a shortage, say, raw materials and
or time ,then, the respective constraints will become key factors.
The following factors are to be considered as an optimal product-mix.
 An objective function
 The constraints within which the objective function is to be achieved.
 Decision Making
Ex: two products a and b. Find the most profitable product when the plant
capacity is limited.
Selling price (Rs.) a and b are Rs.2 and Rs. 2.50
Variable cost (Rs.) 1 and 1.5 respectively
Machine hours 2 and 1 respectively.

Shut Down:
If the products are making a contribution towards fixed expenses or if
selling price is above the marginal cost, it is preferable to continue
because the losses are minimized.
 Decision Making
 In making shut down decisions non-cost factors are also to be taken into
consideration, namely, interest of the workers, competitors, nature of plant
and machinery.

Shut down point = total fixed cost – shut down cost

contribution per unit
Expand or Contract Decision:

 Additional fixed expenses to be incurred

 Possible decrease in selling price due to increase in production
 Whether the demand is sufficient to absorb the increased production
 CVP
 Cost-Volume-Profit Analysis deals with how costs and profits change
with a change in volume. It analyzes the effects on profits of changes in
such factors as variable costs, fixed costs, selling prices, volume, and
the mix of products sold.

 It is an extension of marginal costing. It makes use of principles of

marginal costing. It is useful in making short-run decisions.

 C V P equation :
Sales = variable expenses + fixed expenses + profit
 Break-Even Analysis
Break-even analysis is a study of revenues and costs of a firm in relation to its volume of
sales, determination of that volume at which the firm costs and revenues will be equal.

Assumptions:

 The cost function and the revenue function are linear

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

 It is static in character
 Costs cannot be classified accurately
 Applicable only in short run
 Variable cost line need not necessarily be a straight line because of
possibility of operation of law of increase or decrease in returns
 Selling price will not be a constant factor
 Ignores capital employed in business
 It is based on accounting data
 Break-Even Analysis
 Managerial Uses:
 Margin of safety – extent to which the firm can afford a decline in sales before it
starts incurring losses
 Target profit – volume of sales necessary to achieve a target profit
 Change in prices
 Change in costs
 Expand or contract
 Drop and or add decisions
 Make or buy decisions
 Choosing promotional mix
 Equipment selection
 Improving profit performance
 Break-Even Chart
 It is graphical representation of cost volume profit relationship.
Angle of incidence:
Angle at which total sales line cuts total cost line.

sales

aoi cost
bep
fe

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