Engineering Economics & Financial Accounting

UNIT-I

INTRODUCTION

Managerial Economics – Relationship with other disciplines – Firms: - Types, Objective and Goals –

Managerial Decisions – Decision Analysis

Managerial economics (meaning and nature)

MEANING

Managerial economics is economics applied in decision making. It is the branch of economics which serves as

a link between abstract theory and managerial practice.

It is based on the economic analysis for identifying problems,organizing information and evaluating

alternatives.

DEFINITIONS OF MANAGERIAL ECONOMICS

―Managerial economics is the of economic modes of thought to analyse business situation‖

-Mc.Nair and Meriam

―Managerial economics is the integration of economic theory with business practice for the purpose of

facilitating decision making and forwardplanning by the management.‖

NATURE OF MANAGERIAL ECONOMICS

1. It is microeconomic in character as it concentrate only on the study of the firm not on the working of

the economy

2. It takes help from the macroeconomics to understand the environment in which the firm operates‘

3. It is normative rather than positive i.e., it gives answer for the question what ought to be than what is

,was.

4. It is both conceptual and metrical.

5. It focuses mainly on the theory of the firm than on distribution‘

6. Knowledge of managerial economics helps in making wise choices.i.e., choices among scarcity of

resources.

7. It is goal oriented i.e., aims at achievement of objectives.

SIGNIFICANCE OF MANAGERIAL ECONOMICS

1. It helps in decision making

2. Decisionmaking means a balance between simplification of analysis to be manageable and

complication of factors in hand

3. It helps the manager to become an more competent builder

4. It helps in providing most of the concepts that are needed for the analysis of business problems,the

concepts such as elasticity of demand ,fixed, variable cost, SR and LR costs, opportunity costs,NPV

etc.,

5. It helps in making decisions in the following.

Wh at sho u ld b e th e p ro d u c t m ix ?

Wh ich is th e p r o d u c tio n tec h n iq u e ?

Wh at is th e i/p m ix at least c o s t?

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Wh at sho u ld b e th e le v el o f o u tp u t an

d p ric e? Ho w to ta k e in v es tm e n t d ec

is io n s ?

Ho w m u ch s h o u ld th e fir m adv ertis e

Ma na g er ia l Ec o n o m ics r ela t ed w ith ot he r discip lines

Ma na g er ia l Ec o n o m ics a nd Tr a d itio n a l Eco n o m ics

Economics and Managerial economics both are facing identical problems,i.e., problem of scarcity and

resource allocation. Since labour and capital are always limited it must find way for effective utilizing of

these resources.

ITS MAIN CONTRIBUTION TO MANAGERIAL ECONOMICS

HELP I N U N D ER STA N D I N G THE M A R KET C ON D I TI ON S A N D THE GEN

ER A L EC ON OM I C EN V I R ON M EN TWI TH I N WHICH THE F I R M OP ER A

TES.

TO P R OV I D E THE P HI LOSOP HY F OR U N D ER STA N D I N G A N D A N A LY

SI N G THE RESOU R C E A LLOC A TI ON P R OBLEM S

MA N A GER I A L EC ON OM I C S A N D OP ER A TI ON S R ESEA R C H

Both operations research and managerial economics are concerned with taking effective decisions,

managerial economics is a fundamental academic subject which seeks to understand and to analyse the

problems of business decision making while OR is an activity carried out by functional specialist within

the firm to help the manager to do his job of solving decision problems.


OR m o dels lik e que uing ,linea r pro g r a m m ing etc.., are w ide ly use d in m a na g er ia

l ec o no m ics Mo del bu ild in g , eco no m ic m o dels a re m o re g ener a l a nd co nfine

d to bro a d eco no m ic decis io n m a k ing

MA N A GER I A L EC ON O M I C S A N D M A THEM A TI C S

Mathematics is closely related to managerial because managerial economics ,being conceptual but

also metrical.Its metrical property is used to estimate and predict the relevant economic factors for

decision making and forward planning


Geo m etr y , alg eb ra a n d c alc u lu s

Lo g ar ith m s and e x p o n e n tia l, v ec to rs a n d d eterm in a n ts ,in p u t - o u tp u t ta b les e tc.,

Ev en OR ca n b e in c lu d ed a s a p art o f m ath em atica l exe rcis e

MANAGERIAL ECONOMICS AND STATISTICS

Statistics is widely used in managerial economics. It is mainly needed for a correct judgement and decision

making


To ha n d le th e u n fo res een c irc u m s tan ce s th e theor y proba b ility is m ain ly u s ed .

MA N A GER I A L EC ON OM I C S A N D THE THE OR Y OF D EC I SI ON M A KI N G

The theory of decision making is relatively a new subject that has significance for managerial economics.

Much of economic theory is based on the single goal MAXIMISATION OF PROFIT, but theory of decision

making recognizes the multiplicity of goals and the pervasiveness of uncertainity

ROLE OF MANAGERIAL ECONOMIST IN BUSINESS

The task of organizing and processing information and then making an intelligent decision based upon two

general forms

Ta s k o f m a k in g S p e cific d ec

is io n s Ta s k o f m a k in g G en

e r a l d ecis io n s

Sp ec if ic de cis io n s in clu d e

Pr o d u ctio n s ch ed u lin g

Dem a n d fo r eca s tin g

Ma r ke t r es ea r c h

Eco n o m ic a n a ly s is o f th e in d u s tr y

In ve s tm e n t a p p r a is a l

Sec u r ity m a n a g em e n t appra is a l

Ad vic e o n tr a d e

Ad vic e o n fo r eig n exc h a n g e m a n a g em e n t

Pr ic in g a n d re la ted d ecis io n s

Gener a l d ec is io ns in clu d e

An a lys in g th e ge n e r a l ec o n o m ic c o n d itio n o f th e eco n o m y

An a lyz in g th e de m a n d fo r th e p r o d u ct

An a lys in g th e g e n e r a l m a r ket c o n d itio n o f th e eco n o m y

MEA N I N G OF F I R M

Definitio n o f fir m

A firm is th e sm all b u s in e s s u n it in v o lv e d in pr o d u cin g th e pr o f it

Bu s in es s (c o m p an y , en terp ris e o r f irm ) is a leg ally reco g n ized o rg a n izatio n d es ig n

e d to p ro v id e g o o d s o r ser v ic es , o r b o th , to co n s u m ers , b u s in e s s e s an d g o v er

n m en tal en titie s .[ 1 ] Bu s in e s s e s are p r ed o m in an t in cap ita lis t eco n o m ies . Mo s t b u

s in es s e s are p riv ately o w n ed . A b u s in e s s is ty p ically fo rm ed to ear n p r o f it

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that will increase the wealth of its owners and grow the business itself. The owners and operators of a business

have as one of their main objectives the receipt or generation of a financial return in exchange for work and

acceptance of risk. Notable exceptions include cooperative enterprises and state-owned enterprises.

Businesses can also be formed not-for-profit or be state-owned.

The etymology of "business" relates to the state of being busy either as an individual or society as a whole,

doing commercially viable and profitable work. The term "business" has at least three usages, depending on

the scope — the singular usage (above) to mean a particular company or corporation, the generalized usage to

refer to a particular market sector, such as "the music business" and compound forms such as

agribusiness, or the broadest meaning to include all activity by the community of suppliers of goods and

services. However, the exact definition of business, like much else in the philosophy of business, is a matter of

debate and complexity of meanings.

Types of firms

So le pro p rieto rs h ip:

A s o le p ro p r ie to r s h ip is a b u s in e s s o w n ed b y o n e p er s o n . T h e o w n er m a y

o p era te o n h is o r h er o w n or m a y e m p lo y o th er s . T h e o w n er o f th e b u s in e s

s h as p ers o n a l liab ility o f th e d eb ts in c u rre d b y th e bu s in e s s .

Pa rtner s h ip:

A p artn er s h ip is a fo r m o f b u s in es s in w h ich two o r m o re p e o p le o p era te f o r the c o

m m o n g o a l w h ic h is o ften m ak in g p ro f it. In m o s t fo rm s o f p artn er s h ip s , eac h p

a rtn er h as p er s o n a l lia b ility o f th e d e b ts in c u rr ed b y th e b u s in es s . T h ere are th r ee

ty p ical clas s ific atio n s o f p a rtn er s h ip s : g e n e ral p artn er s h ip s , lim ited p ar tn er s h ip s

, an d lim ited lia b ility partne r s h ip s .

Co rp o ra t io n:

A co rp o ratio n is e ith er a lim ited o r u n lim ited lia b ility en tity th a t h a s a s e p ara te

leg al p ers o n a lity fro m its m e m b ers . A co rp o ratio n ca n b e o rg a n ize d fo r - p r o

fit o r n o t- f o r - p r o f it. A co rp o ratio n is ow n e d b y m u ltip le s h are h o ld er s an d is

o v er s ee n b y a b o ar d o f d ir ecto r s , w h ich h ir es th e b u s in e s s 's man ag er ia l s taf

f. In ad d itio n to p riv a te ly o w n e d c o r p o rate m o d els , th e re are s tate - o w n e d c

o r p o rate mo d els .

Co o pe ra t iv e:

Often r e ferr ed to a s a "c o - o p ", a c o o p er ativ e is a lim ited lia b ility en tity th a t c

an o r g an ize f o r - p r o fit or n o t- fo r - p ro f it. A co o p e rativ e d iffe rs fr o m a co rp o ra

tio n in th a t it h as m e m b ers , as o p p o s e d to sh a reh o ld ers , w h o s h are d ec is io

n - m ak in g au th o r ity . Co o p er ativ es are ty p ica lly clas s ified as eith e r co n s u m er co

o p era tiv es o r w o r k er co o p er ativ e s . C o o p er ativ es are fu n d am en ta l to th e id e o

lo g y o f eco n o m ic de m o cracy .

Co n v e n tio n al th eo ry of fir m ass u m es pro f it m ax im izatio n is th e s o le o b jec tiv e o f b u s in

es s f irm s . Bu t rece n t res ea rch es o n th is is s u e re v ea l th a t th e o b jectiv e s th e f irm s pu r s u

e are m o re than o n e. Som e im p o rta n t

ob jec tiv e s , o th er th a n pro f it m ax im izatio n are:

(a) Max im izatio n of th e s ale s re v e n u e

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(b) Maximization of firm‘s growth rate (c)

Maximization of Managers utility function

(d) Making satisfactory rate of Profit

(e) Long run Survival of the firm

(f) Entry-prevention and risk-avoidance

Profit Business Objectives:

Profit means different things to different people. To an accountant ―Profit‖ means the excess of revenue

over all paid out costs including both manufacturing and overhead expenses. For all practical purpose,

profit or business income means profit in accounting sense plus non-allowable expenses.

Economist‘s concept of profit is of ―Pure Profit‖ called ‗economic profit‘ or ―Just profit‖. Pure profit is a

return over and above opportunity cost, i. e. the income that a businessman might expect from the second

best alternatives use of his resources.

Sales Revenue Maximisation:

The reason behind sales revenue maximisation objectives is the Dichotomy between ownership &

management in large business corporations. This Dichotomy gives managers an opportunity to set their goal

other than profits maximisation goal, which most-owner businessman pursue. Given the opportunity,

managers choose to maximize their own utility function. The most plausible factor in manager‘s utility

functions is maximisation of the sales revenue.

The factors, which explain the pursuance of this goal by the managers are following:.

Firs t: Salary and o th e rs ear n in g s o f m an ag ers are m o re clo s ely rela ted to sa le s rev en

u e than to p r o fits Seco n d : Ba n k s a n d fin a n cial c o r p o r atio n s lo o k a t sa le s rev en u

e w h ile fin a n c in g th e c o rp o ra tio n .

Th ir d : T re n d in sa le s rev e n u e is a rea d ily ava ila b le in d ica to r of th e p erf o rm an ce o f th e fir m .

Ma x im is a tio n o f F ir m s Gro w th r a te :

Man a g er s m ax im ize firm ‘ s b alan ce g r o w th ra te s u b jec t to m an ag er ia l & fin an c ial c

o n s tra in s b a la n c e gro w th r ate d ef in ed a s :

G = G D – GC

Wh ere G D = G ro w th rate o f d em an d o f f ir m ‘ s p ro d u c t & G C= g r o w th ra te o f ca

p ital s u p p ly o f cap ital to th e f irm .

In s im p le w o rd s , A firm g ro w th ra te is b a lan ce d w h en d em an d fo r its p r o d u ct &

s u p p ly o f cap ita l to th e firm in crea s e at th e s a m e tim e.

Ma x im is a tio n o f M a na g eria l U tilit y func tio n:

Th e m an ag er s e ek to m ax im ize th e ir o w n u tility fu n ctio n s u b je ct to th e m in im u m lev el o

f p r o fit. Ma n a g e rs utility fun ctio n is e x p res s as :

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U. f(S, M, ID) Where S = additional

expenditure of the staff

M.Managerial emoluments

ID = Discretionary Investments

The utility functions which manager seek to maximize include both quantifiable variables like salary and slack

earnings; non- quantifiable variables such as prestige, power, status, Job security professional excellence

etc.

Long run survival & market share:

According to some economist, the primary goal of the firm is long run survival. Some other economists have

suggested that attainment & retention of constant market share is an additional objective of the firm‘s. the firm

may seek to maximize their profit in the long run through it is not certain.

Entry-prevention and risk-avoidance, yet another alternative objectives of the firms suggested by some

economists is to prevent entry-prevention can be:

1. Profit maximisation in the long run

2. Securing a constant market share

3. Avoidance of risk caused by the unpredictable behavior of the new firms

Micro economist has a vital role to play in running of any business. Micro economists are concern with all the

operational problems, which arise with in the business organization and fall in with in the preview and control

of the management. Some basic internal issues with which micro-economist are concerns:

i. Choice of business and nature of product i.e. what to produce

ii. Choice of size of the firm i. e how much to produce

iii. Choice of technology i.e. choosing the factor-combination

iv. Choose of price i.e. how to price the commodity

v. How to promote sales

vi. How to face price competition

vii. How to decide on new investments

viii. How to manage profit and capital

ix. How to manage inventory i.e. stock to both finished & raw material

UNIT –II

DEMAND AND SUPPLY ANALYSIS

Demand – Types of demand – Determinants of demand – Demand Function – Demand elasticity -

Demand forecasting – Supply – Determinants of supply – Supply function – Supply elasticity

Definition of demand

The amount of a particular economic good or service that a consumer or group of consumers will want to

purchase at a given price.

The demand curve is usually downward sloping, since consumers will want to buy more as price decreases.

Demand for a good or service is determined by many different factors other than price, such as the price of

substitute goods and complementary goods. In extreme cases, demand may be completely unrelated to price,

or nearly infinite at a given price.

Along with supply, demand is one of the two key determinants of the market price.

Meaning of Demand

Demand:The term 'demand' is defined as the desire for a commodity which is backed by willingness to buy

and ability to pay for it.

The Law of Demand

The law of demand states that, if all other factors remain equal, the higher the price of a good, the less

people will demand that good.

In other words, the higher the price, the lower the quantity demanded. The amount of a good that buyers

purchase at a higher price is less because as the price of a good goes up, so does the opportunity cost of buying

that good.

As a result, people will naturally avoid buying a product that will force them to forgo the consumption of

something else they value more. The chart below shows that the curve is a downward slope.

Determinants of demand

General factors

? Change in the number of buyers

? Change in consumer incomes

? Change in consumer tastes

? Change in the prices of complementary and substitute goods

Additional factors related to luxury goods and durables

? Change in consumer expectations in future income

? Change in consumer expectations of future prices

Additional factors related to market demand

Po p u latio n

So c ial, ec o n o m ic an d dem o g rap h ic fac to rs

Price o f the c o m m o dit y

Th e c o n s u m er w ill b u y m o re o f a c o m m o d ity w h en its p rice d e clin e s a n d v ice v er

s a,b eca u s e it in c rea s es h is p u r ch a s in g p o w e r. H e can th e refo r e b u y m o re of it.Price

a n d th e

De m an d va ry in v er s e ly .

Inc o m e of the co n s u m er

Th e co n s u m er w ill b u y m o re o f a co m m o d ity w h en h is in co m e in cr eas es a n d v iceV

e rs a. Bo th d em an d an d in co m e o f th e c o n s u m e r m o v e in th e s am e d irec tio n .It m ay

b e rev ers e fo r in fer io r go o d s h ere d em an d w ill in cre as e w ith d ecr eas e in th e in c o m

e an d v ice - v er s a.

Price o f th e re la te d g o o d s

Wh en a ch a n g e in th e p rice o f o n e co m m o d ity in f lu en ces th e d e m an d o f th e

o th er c o m m o d ity an d s o th e co m m o d ities are in terre la ted . T h es e rela te d co m m o d

itie s are o f tw o ty p es : s u b s titu te s an d co m p lem en ts .

Wh en th e p rice o f o n e c o m m o d ity an d th e q u a n tity d em a n d e d o f o th er c o

m m o d ity are m o v e is sam e direc tio n , it is c alled a s s u b s titu te s

When the price of one commodity and the quantity demanded of other commodity are move is

opposite direction, it is called as complementary

Taste and preferences

If the consumer taste and preferences are favour of a commodity results in greater demand,

And if it against the commodity it results in smaller demand for the commodity.

Additional factors such as expectation in income and prices

In case the consumer expects a higher income in future ,he spends more at present and thereby the

demand for the good increases and vice versa.

Similarly if the consumer expects future prices of the good to increase he would rather like to buy the

commodity now more than on later, This will increase the demand for the commodity.

FUNCTIONS OF DEMAND

Demand function -- a behavioral relationship between quantity consumed and a person's maximum

willingness to pay for incremental increases in quantity. It is usually an inverse relationship where at higher

(lower) prices, less (more) quantity is consumed. Other factors which influence willingness-to- pay are

income, tastes and preferences, and price of substitutes

Individual Demand function

Qdx = f(Px, Y, P1……Pn-1, T, A ,Ey, Ep, u)

Where

Qdx= qty demanded for the product X

Px = price of the product

Y = level of household income

P1….Pn-1 = price of all the other related products

T = tastes of the consumer

A = advertising

Ey = consumer‘s expected future income

Ep= consumer‘s expected future price

U.all those determinants that are not covered in the list determinants

Market Demand function

Qdx = f(Px, Y, P1……Pn-1, T, A ,Ey, Ep, P, D, u)

Qdx,Px,Y,P1…Pn-1,T,A, Ey,Ep,U are the same as the individual demand function

P = population

D = distribution of consumers in various categories such as income, age, sex etc.,

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ELASTICITY OF DEMAND

If price rises by 10% - what happens to demand?

We know demand will fall

By more than 10%?

By less than 10%?

Elasticity measures the extent to which demand will change

elasticity is the ratio of the percent change in one variable to the percent change in another variable. It is a tool

for measuring the responsiveness of a function to changes in parameters in a unit-less way. Frequently used

elasticities include price elasticity of demand, price elasticity of supply, income elasticity of demand,

elasticity of substitution between factors of production and elasticity of intertemporal substitution

% of change in determinant Z

PRICE ELASTICITY OF DEMAND

Price elasticity of demand

Price elasticity of demand measures the percentage change in quantity demanded caused by a percent change

in price. As such, it measures the extent of movement along the demand curve. This elasticity is almost always

negative and is usually expressed in terms of absolute value. If the elasticity is greater than 1 demand is said to

be elastic; between zero and one demand is inelastic and if it equals one, demand is unit- elastic.(Represented

by 'PED'

E=

Proportionate change in qty demanded of good x

Proportionate change in price of good x

Calculating the Percentage Change in Quantity Demanded

The formula used to calculate the percentage change in quantity demanded is:

[QDemand(NEW) - QDemand(OLD)] / QDemand(OLD)

Calculating the Percentage Change in Price

Similar to before, the formula used to calculate the percentage change in price is:

[Price(NEW) - Price(OLD)] / Price(OLD)

PEoD = (% Change in Quantity Demanded)/(% Change in Price)

ELASTIC DEMAND - a change in price, results in a greater than proportional change in the quantity

demanded ED>1.

INELASTIC DEMAND - a change in price results in a less than proportional change ED<1.

UNITARY DEMAND - a change in price results in n equal proportional change ED=1.

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PERFECTLY ELASTIC DEMAND - demand changes even when price remains unchanged. ED=

PE RFE CT L Y IN E L A ST IC D E MA N D - ch a n g e in pr ice d o es n o t re s u lt in any cha

n g e.

ED =0

Inc o m e ela s tic it y of dem a nd

In c o m e elas tic ity o f d em an d m eas u re s th e p ercenta g e ch an g e in d em an d cau s e d b y a

p erce n t c h an g e in in c o m e. A ch an g e in in c o m e cau s e s th e de m an d cu r v e to s h ift reflec

tin g th e ch an g e in d em an d . Y E D is a meas u rem en t o f h o w far th e c u r v e s h if ts h o r

iz o n ta lly alo n g th e X - ax is . In co m e ela s tic ity can b e u s e d to cla s s ify g o o d s a s n

o r m al o r in fer io r. W ith a n o rm al g o o d d em a n d v ar ie s in th e s am e d ir ectio n a s in

c o m e . With an in fer io r g o o d dem an d an d in c o m e m o v e in o p p o s ite d ire ctio n s .(R ep r es

e n te d b y 'Y E D ') [2 ]

Th e Inc o m e E las ticity of D e m an d : r es p o n s iv e n e s s o f dem an d

to c h a n g es in in co m es

No rm al G o o d – d em an d r is es

as in c o m e ris es a n d v ice v ers a

In fer io r G o o d – d em an d

f alls as in c o m e ris es a n d

v ice v ers a

A po s itiv e s ig n d e n o tes a n o rm al goo d

A neg a tiv e s ig n de n o tes a n in fer io r g o o d

MEA SU R I N G THE INC OM E EL A STI C I TY

In c o m e elas tic ity o f d e m an d (Y ed ) m eas u r es th e rela tio n s h ip b e tw een a ch a n g e in q u an

tity d e m an d ed an d a ch a n g e in rea l in c o m e

Yed = % cha n g e in d em an d

% cha n g e in in co m e

TY PE S O F IN CO M E E L A ST

ICIT Y PO SIT IV E IN CO ME E L

A ST ICIT Y

A ris e in in c o m e w ill cau s e a r is e in d

em an d A fall in in c o m e w ill cau s e a fa

ll in d em an d

Diag r am of p o s itiv e in c o m e ela s ticity

NEGATIVE INCOME ELASTICITY

An increase in income will result in a decrease in demand.

A decrease in income will result in a rise in demand.

ALSO known as INFERIOR GOODS

Diagram of negative income elasticity

Therefore income elasticities can be of

For normal goods(Low income elasticity)

i.e.,relative change in quantity demanded is less change in income that is E<1

BETWEEN 0 & 1

+0.5 +0

For luxury goods(high income elasticity)

MORE THAN 1

+2,+5,+27

For inferior goods(Negative income elasticity)

CAN BE A DECIMAL OR A VALUE LESS THAN 1

ZERO INCOME ELASTICITIES

This occurs when a change in income has NO effect on the demand for goods.

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A rise of 5% income in a rich country will leave the Demand for toothpaste unchanged

A RELATIONSHIP BETWEEN QTY DEMANDED AND INCOME

Cross price elasticity of demand

Cross price elasticity of demand measures the percentage change in demand for a particular good caused by a

percent change in the price of another good. Goods can be complements, substitutes or unrelated. A change in

the price of a related good causes the demand curve to shift reflecting a change in demand for the original

good. Cross price elasticity is a measurement of how far, and in which direction, the curve shifts horizontally

along the x-axis. A positive cross-price elasticity means that the goods are substitute

goods.(Represented by 'XED')

Cross Elasticity:

The responsiveness of demand of one good to changes in the price of a related good – either a

substitute or a complement

In economics, the cross elasticity of demand or cross-price elasticity of demand measures the

responsiveness of the demand for a good to a change in the price of another good.

It is measured as the percentage change in demand for the first good that occurs in response to a percentage

change in price of the second good. For example, if, in response to a 10% increase in the price of fuel, the

demand of new cars that are fuel inefficient decreased by 20%, the cross elasticity of demand would be

−20%/10% = −2.

The formula used to calculate the coefficient cross elasticity of demand is

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% of change in demand of one good

%of change in the price

TYPES OF CROSS ELASTICITY

NEGATIVE SUBSTITUTION ELASTICITY

the two goods, fuel and cars(consists of fuel consumption), are complements; that is, one is used with the

other. In these cases the cross elasticity of demand will be negative, as shown by the decrease in demand for

cars when the price of fuel increased.

INFINITE Substitution elasticity

Where the two goods are substitutes the cross elasticity of demand will be positive, so that as the price of one

goes up the demand of the other will increase. For example, in response to an increase in the price of

carbonated soft drinks, the demand for non-carbonated soft drinks will rise. In the case of perfect

substitutes, the cross elasticity of demand is equal to positive infinity.

ZERO SUBSTITUTION ELASTICITY

Where the two goods are independent, the cross elasticity of demand will be zero: as the price of one good

changes, there will be no change in demand for the other good.

DEMAND FORECASTING METHODS

There are several assumptions about forecasting:

1. There is no way to state what the future will be with complete certainty. Regardless of the methods that we

use there will always be an element of uncertainty until the forecast horizon has come to pass.

2. There will always be blind spots in forecasts. We cannot, for example, forecast completely new

technologies for which there are no existing paradigms.

3. Providing forecasts to policy-makers will help them formulate social policy. The new social policy, in turn,

will affect the future, thus changing the accuracy of the forecast.

OPINION POLLING METHODS

EXPERTS OPINION METHOD

Genius forecasting - This method is based on a combination of intuition, insight, and luck. Psychics and

crystal ball readers are the most extreme case of genius forecasting. Their forecasts are based exclusively on

intuition. Science fiction writers have sometimes described new technologies with uncanny accuracy

CONSUMER ‘S SURVEY METHOD

In this method consumer‘s are contacted personally to disclose their future plans so that we can

able to forecast the future because they are ultimate targeters/buyers

COMPLETE ENUMERATION SURVEY

14

Here all the units of consumers are taken into account without any cutshorts

So here large number of consumers will be there to get the unbiased information .The main

Advantage of this method is its accuracy and its main drawback is it is time consuming one.

SURVEY METHOD

Here from the total population certain number of units will be selected as sample units, then the opinion

collection will be made. This methopd is less tedious and less costly than the above method.

STATISTICAL METHODS

Fitting trend line by observation

This method of estimating trend is elementary,easy and quick.It involves merely plotting of annual sales on

graph and then estimating just by observation where the trend line lies.

Trend extrapolation - These methods examine trends and cycles in historical data, and then use

mathematical techniques to extrapolate to the future. The assumption of all these techniques is that the forces

responsible for creating the past, will continue to operate in the future. This is often a valid assumption when

forecasting short term horizons, but it falls short when creating medium and long term forecasts. The further

out we attempt to forecast, the less certain we become of the forecast

Simulation methods - Simulation methods involve using analogs to model complex systems. These

analogs can take on several forms. A mechanical analog might be a wind tunnel for modeling aircraft

performance. An equation to predict an economic measure would be a mathematical analog. A

metaphorical analog could involve using the growth of a bacteria colony to describe human population

growth. Game analogs are used where the interactions of the players are symbolic of social interactions

Trend Analysis: Uses linear and nonlinear regression with time as the explanatory variable, it is used

where pattern over time have a long-term trend. Unlike most time-series forecasting techniques, the Trend

Analysis does not assume the condition of equally spaced time series.

Nonlinear regression does not assume a linear relationship between variables. It is frequently used when time

is the independent variable.

Simple Moving Averages : The best-known forecasting methods is the moving averages or simply takes a

certain number of past periods and add them together; then divide by the number of periods. Simple Moving

Averages (MA) is effective and efficient approach provided the time series is stationary in both mean and

variance. The following formula is used in finding the moving average of order n, MA(n) for a period t+1,

Exponential Smoothing Techniques: One of the most successful forecasting methods is the exponential

smoothing (ES) techniques. Moreover, it can be modified efficiently to use effectively for time series with

seasonal patterns. It is also easy to adjust for past errors-easy to prepare follow-on forecasts, ideal for

situations where many forecasts must be prepared, several different forms are used depending on presence of

trend or cyclical variations. In short, an ES is an averaging technique that uses unequal weights; however, the

weights applied to past observations decline in an exponential manner

Smoothing techniques are used to reduce irregularities (random fluctuations) in time series data. They

provide a clearer view of the true underlying behavior of the series. Moving averages rank among the most

popular techniques for the preprocessing of time series. They are used to filter random "white noise" from the

data, to make the time series smoother or even to emphasize certain informational components

contained in the time series.

Exponential smoothing is a very popular scheme to produce a smoothed time series. Whereas in moving

averages the past observations are weighted equally, Exponential Smoothing assigns exponentially

decreasing weights as the observation get older. In other words, recent observations are given relatively more

weight in forecasting than the older observations. Double exponential smoothing is better at handling trends.

Triple Exponential Smoothing is better at handling parabola trends.

Least-Squares Method: To predict the mean y-value for a given x-value, we need a line which passes

through the mean value of both x and y and which minimizes the sum of the distance between each of the

points and the predictive line. Such an approach should result in a line which we can call a "best fit" to the

sample data. The least-squares method achieves this result by calculating the minimum average squared

deviations between the sample y points and the estimated line. A procedure is used for finding the values of a

and b which reduces to the solution of simultaneous linear equations. Shortcut formulas have been developed

as an alternative to the solution of simultaneous equations..

Regression and Moving Average : When a time series is not a straight line one may use the moving

average (MA) and break-up the time series into several intervals with common straight line with positive

trends to achieve linearity for the whole time series. The process involves transformation based on slope and

then a moving average within that interval. For most business time series, one the following

transformations might be effective

ARIMA METHOD

A couple of notes on this model.

The Box-Jenkins model assumes that the time series is stationary. Box and Jenkins recommend

differencing non-stationary series one or more times to achieve stationarity. Doing so produces an ARIMA

model, with the "I" standing for "Integrated".

Some formulations transform the series by subtracting the mean of the series from each data point. This yields

a series with a mean of zero. Whether you need to do this or not is dependent on the software you use to

estimate the model.

Box-Jenkins models can be extended to include seasonal autoregressive and seasonal moving average terms.

Although this complicates the notation and mathematics of the model, the underlying concepts for seasonal

autoregressive and seasonal moving average terms are similar to the non-seasonal autoregressive and moving

average terms.

The most general Box-Jenkins model includes difference operators, autoregressive terms, moving average

terms, seasonal difference operators, seasonal autoregressive terms, and seasonal moving average terms. As

with modeling in general, however, only necessary terms should be included in the model

There are five stages of analysis in this method:

Removal of trend

Model identification

16

Parameter estimation

Verification

Forecasting

MEANING OF SUPPLY

What is Supply?

Supply is the quantity of a good or service a firm is willing to produce at all prices.

What is the law of Supply?

If nothing else changes, firms are willing to supply a greater quantity of good or service at higher prices than

lower.

Determinants of Supply

Productivity (Improvements in machines and production processes of a good or service)

Inputs ( Change in the price of inputs required to produce the good or service.)

Government Actions (Subsidies, Taxes and Regulations)

Technology (Improvements in machines and production processes of a good or service)

Outputs ( Price changes in other products produced by the firm)

Expectations (outlook of future prices and profits)

Size of Industry (Number of firms

Change in the number of suppliers

Any factor that increases the cost of production decreases supply.

Any factor that decreases the cost of production increases supply.

SUPPLY FUNCTION

Sx = f(Px,Py, Pz,……..;Pf ,O,T)

Sx=Amount supplied of good x

Px= Price of good X

Py,Pz= Prices of other goods in the market

Pf = Prices of factors of production

O = objective of the producer

T = State of technology used by the producer to produce good x

Elasticity of supply

Responsiveness of producers to changes in the price of their goods or services. As a general rule, if prices rise

so does the supply.

Elasticity of supply is measured as the ratio of proportionate change in the quantity supplied to the

proportionate change in price. High elasticity indicates the supply is sensitive to changes in prices, low

elasticity indicates little sensitivity to price changes, and no elasticity means no relationship with price. Also

called price elasticity of supply.

Price elasticity of supply measures the relationship between change in quantity supplied and a change in price.

The formula for price elasticity of supply is:

Percentage change in quantity supplied / Percentage change in price

The value of elasticity of supply is positive, because an increase in price is likely to increase the quantity

supplied to the market and vice versa.

FACTORS THAT DETERMINE ELASTICITY OF SUPPLY

The elasticity of supply depends on the following factors

The value of price elasticity of supply is positive, because an increase in price is likely to increase the quantity

supplied to the market and vice versa. The elasticity of supply depends on the following factors:

SPARE CAPACITY

How much spare capacity a firm has - if there is plenty of spare capacity, the firm should be able to increase

output quite quickly without a rise in costs and therefore supply will be elastic

STOCKS

The level of stocks or inventories - if stocks of raw materials, components and finished products are high then

the firm is able to respond to a change in demand quickly by supplying these stocks onto the market - supply

will be elastic

EASE OF FACTOR SUBSTITUTION Consider the sudden and dramatic increase in demand for petrol

canisters during the recent fuel shortage. Could manufacturers of cool-boxes or producers of other types of

canister have switched their production processes quickly and easily to meet the high demand for fuel

containers?

If capital and labour resources are occupationally mobile then the elasticity of supply for a product is likely to

be higher than if capital equipment and labour cannot easily be switched and the production process is fairly

inflexible in response to changes in the pattern of demand for goods and services.

TIME PERIOD

Supply is likely to be more elastic, the longer the time period a firm has to adjust its production. In the short

run, the firm may not be able to change its factor inputs. In some agricultural industries the supply is fixed and

determined by planting decisions made months before, and climatic conditions, which affect the production,

yield.

Economists sometimes refer to the momentary time period - a time period that is short enough for supply to be

fixed i.e. supply cannot respond at all to a change in demand.

ILLUSTRATING PRICE ELASTICITY OF SUPPLY

When supply is perfectly inelastic, a shift in the demand curve has no effect on the equilibrium quantity

supplied onto the market. Examples include the supply of tickets for sports or musical venues, and the short

run supply of agricultural products (where the yield is fixed at harvest time) the elasticity of supply = zero

when the supply curve is vertical.

When supply is perfectly elastic a firm can supply any amount at the same price. This occurs when the firm

can supply at a constant cost per unit and has no capacity limits to its production. A change in demand alters

the equilibrium quantity but not the market clearing price.

When supply is relatively inelastic a change in demand affects the price more than the quantity supplied. The

reverse is the case when supply is relatively elastic. A change in demand can be met without a change in

market price.

UNIT-III

PRODUCTION FUNCTION AND COST ANAYSIS

Production Function – Returns of Scale – Production optimization – Least cost output – isoquants –

Managerial uses of production function. Cost concepts – Cost function – Types of cost –

Determinants of cost – Short run and Long run cost curves – Cost output Decision – Estimation of

Cost.

A production function is a function that specifies the output of a firm, an industry, or an entire economy for all

combinations of inputs. This function is an assumed technological relationship, based on the current state of

engineering.

CONCEPT OF PRODUCTION FUNCTION

The production function relates the output of a firm to the amount of inputs, typically capital and labor

In a general mathematical form, a production function can be expressed as:

Q = f(X1,X2,X3,...,Xn)

where:

Q = quantity of output

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X1,X2,X3,...,Xn = quantities of factor inputs (such as capital, labour, land or raw materials). This general

form does not encompass joint production; that is a production process that has multiple co-products or

outputs

COBB-DOUGLAS PRODUCTION FUNCTION

A standard production function which is applied to describe much output two inputs into a production process

make. It is used commonly in both macro and micro examples.

For capital K, labor input L, and constants a, b, and c, the Cobb-Douglas production function is:

f(k,n) = bkanc

If a+c=1 this production function has constant returns to scale. (Equivalently, in mathematical language, it

would then be linearly homogenous.) This is a standard case and one often writes (1-a) in place of c.

Log-linearization simplifies the function, meaning just that taking logs of both sides of a Cobb-Douglass

function gives one better separation of the components.

In the Cobb-Douglass function the elasticity of substitution between capital and labor is 1 for all values of

capital and labor

STAGES IN PRODUCTION FUNCTION

To simplify the interpretation of a production function, it is common to divide its range into 3 stages. In Stage

1 (from the origin to point B) the variable input is being used with increasing output per unit, the latter

reaching a maximum at point B (since the average physical product is at its maximum at that point). Because

the output per unit of the variable input is improving throughout stage 1, a price-taking firm will always

operate beyond this stage.

In Stage 2, output increases at a decreasing rate, and the average and marginal physical product are declining.

However the average product of fixed inputs (not shown) is still rising, because output is rising while fixed

input usage is constant. In this stage, the employment of additional variable inputs increases the output per unit

of fixed input but decreases the output per unit of the variable input. The optimum input/output combination

for the price-taking firm will be in stage 2, although a firm facing a downward- sloped demand curve might

find it most profitable to operate in Stage 1. In Stage 3, too much variable input is being used relative to the

available fixed inputs: variable inputs are over-utilized in the sense that their presence on the margin obstructs

the production process rather than enhancing it. The output per unit of both the fixed and the variable input

declines throughout this stage. At the boundary between stage 2 and stage 3, the highest possible output is

being obtained from the fixed input

RETURNS TO SCALE

In production, returns to scale refers to changes in output subsequent to a proportional change in all inputs

(where all inputs increase by a constant factor). If output increases by that same proportional change then there

are constant returns to scale (CRTS). If output increases by less than that proportional change, there are

decreasing returns to scale (DRS). If output increases by more than that proportion, there are increasing

returns to scale (IRS)

Short example: where all inputs increase by a factor of 2, new values for output should be:

Twice the previous output given = a constant return to scale (CRTS)

Less than twice the previous output given = a decreased return to scale (DRS)

More than twice the previous output given = an increased return to scale (IRS)

when we increase all inputs by a multiplier of m. Suppose our inputs are capital or labor, and we double each

of these (m = 2), we want to know if our output will more than double, less than double, or exactly double.

This leads to the following definitions:

Increasing Returns to Scale

When our inputs are increased by m, our output increases by more than m.

Constant Returns to Scale

When our inputs are increased by m, our output increases by exactly m.

Decreasing Returns to Scale

When our inputs are increased by m, our output increases by less than m.

Our multiplier must always be positive, and greater than 1, since we want to look at what happens when we

increase production. An m of 1.1 indicates that we've increased our inputs by 10% and an m of 3 indicates that

we've tripled the amount of inputs we use. Now we will look at a few production functions and see if we have

increasing, decreasing, or constant returns to scale. Note that some textbooks use Q for quantity in the

production function, and others use Y for output. It does not change this analysis any, so use whatever your

professor uses

Opportunity cost = economic cost

Cost is foregone benefit of a resource in it‘s best alternative use

Cost = market price only when price reflects value of marginal product (perfect competition)

Fixed costs

do not change when the quantity of output produced Changes

These cost exist whether production occurs or not.

In the long-run there are no fixed costs.

Can be both cash and non-cash expenses.

E.g., depreciation on tractors and buildings, etc.

Variable Costs

These costs exist only if production occurs.

E.g., fuel for tractor, seed, etc.

Total Fixed Costs (TFC)

The summation of all fixed and sunk costs to production.

Total Variable Costs (TVC)

The summation of all variable costs to production.

Total Costs (TC)

The summation of total fixed and total variable costs.

TC=TFC+TVC

Accounting or actual costs

The total amount of money or goods expended in an endeavour. It is money paid out at some time in the past

and recorded in journal entries and ledgers.

Opportunity Costs

The value of the product not produced because an input was used for another purpose.

The income that would have been received if the input had been used in its most profitable

alternative use.

It denotes the real cost of using an input.

Sunk Costs

Is an expenditure that cannot be recovered.

In essence, it becomes part of fixed costs.

E.g., pre-harvest costs.

Transaction cost

a transaction cost is a cost incurred in making an economic exchange (restated: the cost of

participating in a market). For example, most people, when buying or selling a stock, must pay a

commission to their broker

Short run costs vs long run costs

The short run is a period of time sufficiently short that only some of the variables can be changed.

In the short-run, there are many ways to choose how to produce.

Maximize output.

Utility maximization of the manager.

Profit maximization.

23

Profit ( ) is def in ed a s to ta l re v e n u e m in u s total co s t, i.e., = TR – T C.

Wh en ex a m in in g o u tp u t, w e w an t to s e t o u r p r o d u c tio n le v e l w h ere MR = MC w h e n MR

> A V C in

th e s h o r t - r u n .

If MR A V C, w e w o u ld w an t to s h u t d o w n .

Wh y ?

If w e can n o t s et M R ex ac tly eq u a l to M C, w e w an t to p r o d u ce at a le v e l w h ere MR is

a s clo s e a s

po s s ib le to MC, w h er e MR > MC.

Su p p o s e MR < MC.

Th is im p lie s th a t by pro d u c in g m o re o u tp u t, y o u ha v e a g rea ter a d d itio n o f c o s t th a n y o u d

o r ev en u e.

Hen ce y o u w o u ld n o t m ak e th e ch a n g e.

Su p p o s e MR > MC.

Th is im p lie s th a t by pro d u c in g m o re o u tp u t, y o u ha v e a g rea ter a d d itio n o f re v e n u e th an y

o u d o c o s t.

Hen ce y o u w o u ld m a k e th e c h a n g e.

Yo u w o u ld s to p in cre as in g o u tp u t a t th e p o in t w h ere th e tra d e - o ff in a d d itio n al re v e n u

e is ju s t eq u a l

to th e tra d e - o ff in a d d itio n a l c o s ts .

Th e lo n g r u n is a p er io d o f tim e th at a ll v ar iab le s ca n be ch a n g e d .

To m ax im ize p ro f its , th e farm er s h o u ld p ro d u ce w h e n s e llin g p r ice is g re ater th an A T

C at th e

pro d u c tio n le v e l w h e re MC = MR.

To m in im ize lo s s e s , th e fa rm er s h o u ld n o t p ro d u ce w h e n s ellin g p rice is les s th a n A

T C, i.e.,

sh u td o w n th e b u s in es s .

Th e lo n g ru n av e rag e co s t (L RA C) cu r v e is th e en v e lo p e o f th e s h o rt r u n a v era g e c

o s t c u rv es w h e n

th e s ize o f th e o p er atio n is a llo w e d to in cr e as e o r de crea s e.

No te th at a s h o rt r u n av era g e co s t cu r v e ex is ts fo r ev e ry p o s s ib le farm s ize, as d ef in e d b y th

e am o u n t

of fix e d in p u t a v aila b le.

In a c o m p etitiv e m ark et, th e lo n g ru n optim al p r o d u c tio n w ill o ccu r at th e lo w e s t p o in t o n th e

L RA C,

i.e., eco n o m ic pro f its are d r iv en to z ero

A m eas u re o f s ize in th e lo n g ru n b e tw een o u tp u t an d c o s ts as farm s iz e in crea s es (E

O S) is th e

fo llo w in g :

EO S = p erce n t c h a n g e in c o s ts d iv id e d by perc e n t ch an g e in o u tp u t v alu e

If th is ra tio o f E O S is le s s th a n o n e, th e n th ere a re d e crea s in g co s ts to e x p an d in g p

ro d u c tio n , i.e.,

in c rea s in g retu r n s to s iz e.

If th is ra tio is eq u a l to o n e, th en th e re a re co n s ta n t c o s ts to ex p an d in g p r o d u ctio n , i.e.,

co n s ta n t

retu rn s to s iz e.

If th is ra tio is g rea ter th a n o n e, th en th ere are in crea s in g co s ts to e x p a n d in g p ro d u c tio

n , i.e.,

decre as in g re tu rn s to s iz e.

Av era g e Fix e d C o s ts (A FC)

Th e to ta l f ix ed c o s ts divide d b y ou tp u t.

Av era g e V ariab le C o s ts (A V C)

Th e to ta l v ar iab le c o s ts d iv id e d b y ou tp u t.

Av era g e T o tal C o s ts (A T C)

Th e to ta l c o s ts d iv id e d by output.

Th e s u m m atio n o f av erag e f ix e d co s ts a n d av era g e v ar ia b le c o s ts , i.e., A T C=A FC+A V C

24

Marginal Costs

The change in total costs divided by the change in output.

TC/ Y

Th e ch an g e in to ta l v aria b le co s ts d iv id e d b y th e ch an g e in o u tp u t.

TV C/ Y

MC w ill m eet A V C a n d A T C fr o m bel o w at th e c o rre s p o n d in g m in i m u m po in t o f ea ch .

As o u tp u t in cr eas es A FC go e s to zer o .

As outp u t in cr eas es , A V C and A T C ge t clo s e r to eac h o th er.

ISOQU A N T

In eco n o m ics , an is o q u a n t ( d er iv ed fr o m q u an tity an d th e G reek w o r d is o , m e an in g

eq u a l) is a

co n to u r lin e d raw n th ro u g h th e s et o f p o in ts at w h ic h th e s am e q u an tity o f o u tp u t is p ro d u ce d w h ile

ch a n g in g th e q u an tities o f tw o o r m o re in p u ts .[1 ] [2 ] W h ile an in d iffere n ce cu

rv e m ap p in g h e lp s to so lv e th e u tility - m a x im izin g p ro b lem o f co n s u m ers , th

e is o q u an t m ap p in g d ea ls w ith th e c o s t - min i m izatio n p r o b le m o f p ro d u ce

rs . Is o q u a n ts are ty p ica lly d raw n o n cap ital - la b o r g ra p h s , s h o w in g th e tec h

n o lo g ica l tra d e o ff b e tw ee n cap ita l an d la b o r in th e p r o d u c tio n fu n c tio n , a n

d th e d ecr ea s in g marg in al re tu rn s o f b o th in p u ts . A d d in g o n e in p u t w h ile h

o ld in g th e o th er c o n s tan t ev e n tu a lly lea d s to d ecrea s in g m arg in al o u tp u t, an

d th is is refle cte d in th e s h a p e o f th e is o q u a n t. A fa m ily o f

25

isoquants can be represented by an isoquant map, a graph combining a number of isoquants, each

representing a different quantity of output. Isoquants are also called equal product curves.

An isoquant shows the extent to which the firm in question has the ability to substitute between the

two different inputs at will in order to produce the same level of output. An isoquant map can also

indicate decreasing or increasing returns to scale based on increasing or decreasing distances

between the isoquant pairs of fixed output increment,as you increase output. If the distance between

those isoquants increases as output increases, the firm's production function is exhibiting decreasing

returns to scale; doubling both inputs will result in placement on an isoquant with less than double the

output of the previous isoquant. Conversely, if the distance is decreasing as output increases, the firm is

experiencing increasing returns to scale; doubling both inputs results in placement on an isoquant with

more than twice the output of the original isoquant.

As with indifference curves, two isoquants can never cross. Also, every possible combination of

inputs is on an isoquant. Finally, any combination of inputs above or to the right of an isoquant results in

more output than any point on the isoquant. Although the marginal product of an input decreases as you

increase the quantity of the input while holding all other inputs constant, the marginal product is never

negative in the empirically observed range since a rational firm would never increase an input to

decrease output.

SHORT RUN AND LONG RUN COST CURVES

26

short-run cost curves are normally based on a production function with one variable factor of

production that displays first increasing and then decreasing marginal productivity. Increasing

marginal productivity is associated with the negatively sloped portion of the marginal cost

curve,while decreasing marginal productivity is associated with the positively sloped portion.

Theaverage fixed cost (AFC) curve is the cost of the fixed factor of production divided by

thequantity of units of the output, while the average variable cost (AVC) curve cost traces out theper

unit cost of variable factor of production. The U-shaped average total cost (ATC) curve isderived by

adding the average fixed and variable costs. The marginal cost (MC) intersects both the AVC and ATC

curves at their minimum points. Declining average total costs are explained as the result of spreading

the fixed costs over greater quantities and, at low quantities, the result of the increasing marginal

productivity, in addition. Increasing average costs occur when the effect of declining marginal

productivity overwhelms the effect of spreading the fixed costs.

The long-run cost curves, usually presented in a separate diagram, are also expressed most

commonly in their average, or per unit, form, represented here in Figure 2. The long-run average cost

(LRAC) curve is shown to be an envelope of the short-run average cost (SRAC) curves, lying

everywhere below or tangent to the short-run curves. The firm is constrained in the shortrun in selecting

the optimal mix of factors of production and so will never be able to find a cheaper mix than can be

found in the long-run when there are no constraints. If there are a discrete number of plant sizes

available, the LRAC will be the scalloped curve obtained by joining those parts of the SRAC curves that

represent the lowest cost of production for a given quantity.

27

UNIT –IV

PRICING

Determinants of Price – Pricing under different objectives and different market structures – price

discrimination – Pricing methods in practice – Role of government in pricing control.

‗The price of a product or service is the number ofmonetary units a customer has to pay to receiveone unit of

that product or service‘ (Simon 1989).

This was the traditional definition, but in the1990s a broader interpretation of the priceconcept became

customary. Illustrative of this

broader view is Hutt and Speh‘s observation that‗the cost of an industrial good includes much

more than the seller‘s price‘ (Hutt and Speh 1998)

The simplest way to set price is through uniform pricing. At the profit- maximizing uniform price, the

incremental margin percentage equals the reciprocal of the absolute value of the price elasticity of demand.

The most profitable pricing policy is complete price discrimination, where each unit is priced at the benefit

that the unit provides to its buyer. To implement this policy, however, the seller must know each potential

buyer‘s individual demand curve and be able to set different prices for every unit of the product.

The next most profitable pricing policy is direct segment discrimination. For this policy, the seller must be

able to directly identify the various segments. The third most profitable policy is indirect segment

discrimination. This involves structuring a set of choices around some variable to which the various segments

are differentially sensitive. Uniform pricing is the least profitable way to set a price.

A commonly used basis for direct segment discrimination is location. This exploits a difference between free

on board and cost including freight prices. A commonly used method of indirect segment

discrimination is bundling. Sellers may apply either pure or mixed bundling.

Pricing is the process of determining what a company will receive in exchange for its products. Pricing factors

are manufacturing cost, market place, competition, market condition, and quality of product. Pricing is also a

key variable in microeconomic price allocation theory. Pricing is a fundamental aspect of financial

modeling and is one of the four Ps of the marketing mix. The other three aspects are product, promotion,

and place. Price is the only revenue generating element amongst the four Ps, the rest being cost centers.

Pricing is the manual or automatic process of applying prices to purchase and sales orders, based on factors

such as: a fixed amount, quantity break, promotion or sales campaign, specific vendor quote, price

prevailing on entry, shipment or invoice date, combination of multiple orders or lines, and many others.

Automated systems require more setup and maintenance but may prevent pricing errors. The needs of the

consumer can be converted into demand only if the consumer has the willingness and capacity to buy the

product. Thus pricing is very important in marketing.

Transfer pricing refers to the pricing of contributions (assets, tangible and intangible, services, and funds)

transferred within an organization (a corporation or similar entity). For example, goods from the production

division may be sold to the marketing division, or goods from a parent company may be sold to a foreign

subsidiary. Since the prices are set within an organization (i.e. controlled),

Cost plus pricing method

The Cost Plus (CP) method, generally used for the trade of finished goods, is determined by adding an

appropriate markup to the costs incurred by the selling party in manufacturing/purchasing the goods or

services provided, with the appropriate markup being based on the profits of other companies comparable to

the tested party. For example, the arm's length price for a transaction involving the sale of finished clothing to

a related distributor would be determined by adding an appropriate markup to the cost of materials, labour,

manufacturing, and so on.

Price skimming is a pricing strategy in which a marketer sets a relatively high price for a product or

service at first, then lowers the price over time. It is a temporal version of price discrimination/yield

management. It allows the firm to recover its sunk costs quickly before competition steps in and lowers the

market price.

Price skimming is sometimes referred to as riding down the demand curve. The objective of a price skimming

strategy is to capture the consumer surplus. If this is done successfully, then theoretically no customer will pay

less for the product than the maximum they are willing to pay. In practice, it is almost impossible for a firm to

capture all of this surplus.

Cost-plus pricing is a pricing method used by companies. It is used primarily because it is easy to

calculate and requires little information. There are several varieties, but the common thread in all of them is

that one first calculates the cost of the product, then includes an additional amount to represent profit. It is a

way for companies to calculate how much profit they will make. Cost-plus pricing is often used on

government contracts, and has been criticized as promoting wasteful expenditures.

The method determines the price of a product or service that uses direct costs, indirect costs, and fixed costs

whether related to the production and sale of the product or service or not. These costs are converted to per

unit costs for the product and then a predetermined percentage of these costs is added to provide a profit

margin

Target rate of return pricing is a pricing method used almost exclusively by market leaders or

monopolists. You start with a rate of return objective, like 5% of invested capital, or 10% of sales revenue.

Then you arrange your price structure so as to achieve these target rates of return.[1]

For example, assume a firm invests $100 million in order to produce and market designer snowflakes, and

they estimate that with demand for designer snowflakes being what it is, they can sell 2 million flakes per year.

Joint Products are two or more products, produced from the same process or operation, considered to be of

relative equal importance. Pricing for joint products is a little more complex than pricing for a single product.

To begin with there are two demand curves. The characteristics of each demand curve could be different.

Demand for one product could be greater than for the other product. Consumers of one product

could be more price elastic than the consumers of the other product (and therefore more sensitive to changes

in the product's price).

Dual pricing

Even within a country, differentiated pricing may be established to ensure that citizens receive lower prices

than non-citizens; this is known as dual pricing. This is particularly common for goods that are subsidized or

otherwise provided by the state (and hence paid by taxpayers). Thus Finns, Thais, and Indians (among others)

may purchase special fare tickets for public transportation that are available only to citizens. Many countries

also maintain separate admission charges for museums, national parks and similar facilities, the usually

professed rationale being that citizens should be able to educate themselves and enjoy the country's natural

wonders cheaply, but other visitors should pay the market rate

Premium pricing

For certain products, premium products are priced at a level (compared to "regular" or "economy"

products) that is well beyond their marginal cost of production. For example, a coffee chain may price regular

coffee at $1, but "premium" coffee at $2.50 (where the respective costs of production may be $0.90 and

$1.25).

A market economy is economy based on the power of division of labor in which the prices of goods and

services are determined in a free price system set by supply and demand.[1]

This is often contrasted with a planned economy, in which a central government determines the price of goods

and services using a fixed price system. Market economies are also contrasted with mixed economy where the

price system is not entirely free but under some government control or heavily regulated, which is sometimes

combined with state-led economic planning that is not extensive enough to constitute a planned economy.

In the real world, market economies do not exist in pure form, as societies and governments regulate them to

varying degrees rather than allow self-regulation by market forces.[2][3] The term free-market economy is

sometimes used synonymously with market economy,[4] but, as Ludwig Erhard once pointed out, this does

not preclude an economy from having socialist attributes opposed to a laissez-faire system.[5] Economist

Ludwig von Mises also pointed out that a market economy is still a market economy even if the government

intervenes in pricing.[6]

Different perspectives exist as to how strong a role the government should have in both guiding the market

economy and addressing the inequalities the market produces. For example, there is no universal agreement

on issues such as central banking, and welfare. However, most economists oppose protectionist tariffs.[7]

The term market economy is not identical to capitalism where a corporation hires workers as a labour

commodity to produce material wealth and boost shareholder profits.[8] Market mechanisms have been

utilized in a handful of socialist states, such as China, Yugoslavia and even Cuba to a very limited extent.

It is also possible to envision an economic system based on independent producers, cooperative, democratic

worker ownership and market allocation of final goods and services; the labour-managed market economy is

one of several proposed forms of market socialism.[9]

1.Uniform pricing.

(a) Uniform pricing: a pricing policy where a seller charges the same price

for every unit of the product.

2. Profit maximizing price(incremental margin

percentage rule): A price where the incremental margin percentage (i.e., price lessmarginal cost divided by

the price)

is equal to the reciprocal of the absolute value of the price elasticity of demand. This is the rule ofmarginal

revenue equals the marginal cost.

i.Price elasticity may very along a demand curve, marginal cost changes with scale of production. The above

proceduretypically involves a series of trials and errors with different prices.

ii. Intuitive factors that underlie price elasticity: direct and indirect substitutes, buyers‘ prior commitments,

search cost.

(c)Price adjustments following changes in demand and cost. i. To maximize profits, a seller should consider

both demand and costs.

ii. A seller should adjust its price to changes in either the price elasticity or the marginal cost. iii.

It must consider the effect of the price change on the quantity demanded.

iv. If demand ismore elastic (price elasticity will be a largernegative number), the seller should aim for a lower

incrementalmargin percentage, and not necessarily a lower price, andlikewise,

v.If demand isless elastic, the seller should aim for a higherincremental margin percentage, and not

necessarily a higherprice.

vi. A seller should not necessarily adjust the price by the same amount as a change in marginal cost.

(d) Special notes.

i.Only the incremental margin percentage (i.e., price less marginal cost divided by the price) is relevant to

pricing.

(1). Contribution margin percentage (i.e., price less averagevariable cost divided by the price) is not relevant to

pricing.

(2). Variable costs may increase or decrease with the scale of production, and hence, marginal cost will not be the

same as average variable cost.

ii. Setting price by simply marking up average cost will not maximize profit. Problems of cost plus pricing: (1). In

businesses with economies of scale, average cost depends on scale, but scale depends on price. It is a circular

exercise.

(2). Cost plus pricing gives no guidance as to the markup on average cost.

(e)Limitations of uniform pricing (incremental margin percentage rule).

i.The inframarginal buyers do not pay as much as they will be

willing to pay. A seller could increase its profit by taking some

of the buyer surplus

In economics, market structure (also known as the number of firms producing identical products.)

Mo no p o lis t ic c o m petit io n, als o ca lled co m p etitiv e m ark e t, w h ere th ere are a s m all n u m b

er o f

de p en d e n t firm s w h ich ea ch h a v e a v ery lar g e p ro p o r tio n o f th e m ark et s h

ar e an d p r o d u c ts f ro m dif fere n t c o m p an ies a re differe n t.

32

Olig o p o ly , in w h ic h a m ark et is d o m in ate d b y a s m all n u m b er of firm s w h ich own m o re th an

4 0 % o f

th e m ark et s h are.

Olig o ps o n y, a m ark et, w h ere m an y seller s can b e pr es e n t b u t m eet o n ly a few bu y ers .

Mo no p o ly , wh ere th e re is o n ly on e p ro v id e r of a p r o d u ct o r s erv ice.

Natu r al m o n o p o ly , a m o n o p o ly in w h ich ec o n o m ies o f s ca le ca u s e eff ic ie n

cy to in crea s e co n tin u o u s ly w ith th e s ize o f th e f irm . A firm is a n atu ra l m o

n o p o ly if it is ab le to s er v e th e en tir e mark et d em an d at a lo w er co s t th a n any co

m b in atio n of tw o o r m o re s m aller, m o re sp ec ialize d f irm s .

Mo no p s o ny, w h en th ere is o n ly on e b u y er in a m ark et.

Th e im p erf ectly co m p etitiv e s tr u c tu re is q u ite id e n tica l to th e rea lis tic m ark et c o n d

itio n s w h ere s o m e mo n o p o lis tic c o m p etito rs , m o n o p o lis ts , o lig o p o lis ts , a n d d u o

p o lis ts e x is t an d d o m in a te th e m ark e t co n d itio n s . T h e e le m en ts o f Mar k e t S tr u ctu

re in c lu d e th e n u m b er an d s iz e d is tr ib u tio n o f firm s , en try co n d itio n s , an d th e e x

te n t of d iffere n tia tio n .

Th es e s o m ew h at a b s tract co n cer n s ten d to d eterm in e s o m e b u t n o t a ll d eta ils o f a s p

ecif ic c o n cre te m ark e t sy s tem w h ere b u y ers an d se lle rs ac tu ally m eet a n d c o m m it to tra

d e . Co m p etitio n is u s efu l bec au s e it re v ea ls actu al c u s to m er d e m an d an d in d u ce s th

e s eller (o p era to r) to p r o v id e s er v ice q u a lity lev els an d p r ice le v e ls th a t b u y ers (

cu s to m e rs ) w a n t, ty p ica lly s u b jec t to th e s eller‘ s fin an cia l n ee d to c o v er its c o s ts

. In o th e r wo rd s , co m p etitio n c an alig n th e s eller‘ s in tere s ts w ith th e b u y er ‘ s in te

res ts an d c an ca u s e th e s e lle r to rev ea l h is tru e c o s ts an d o th er p r iv a te in fo rm atio

n . In th e ab s e n c e o f p erf ect c o m p etitio n , th r ee b a s ic ap p ro ach es ca n b e a d o p te d to

d e al w ith p r o b lem s rela te d to th e co n tr o l o f m ark et p o w er an d a n a s y m m etry betw e en

th e g o v e rn m en t an d th e o p erato r w ith re s p ec t to o b jectiv es a n d in fo rm atio n : (a ) s

u b jec tin g th e op erato r to c o m p etitiv e p r es s u res , (b ) g ath erin g in f o rm atio n o n th e

o p era to r a n d th e m ark et, an d ( c) ap p ly in g in ce n tiv e re g u la tio n .[1 ]

Quick Reference to Basic Market Structures

Market Structure Seller Entry Barriers Seller Number Buyer Entry Barriers Buyer Number

Perfect Competition No Many No Many

Monopolistic competition No Many No Many Oligopoly Yes Few No Many

Oligopsony No Many Yes Few

Monopoly Yes One No Many

Monopsony No Many Yes One

The correct sequence of the market structure from most to least competitive is perfect competition, imperfect

competition,oligopoly, and pure monopoly.

The main criteria by which one can distinguish between different market structures are: the number and size of

producers and consumers in the market, the type of goods and services being traded, and the degree to which

information can flow freely.

Price discrimination.

33

Pricing policy where a seller sets different incremental margins on various units of the same or similar

product.

(a) To earn a higher incremental margin from buyers with higher benefit,and a smaller margin from buyers

with lower benefit.

Complete price discrimination: the pricing policy where a seller prices each unit of output at the buyer‘s

benefit and sells a quantity where the marginal benefit equals the marginal cost.

(a) All the buyer surplus is extracted. Every buyer is charged the maximum she is willing for pay for each unit.

(b) Economically efficient quantity: all the opportunity for additional profit through changes in sales is

exploited.

(c) Extracts a higher price for units that would be sold under uniform pricing and extends sales by selling

additional units that would not be sold.

Reasons Price Discrimination

? Occurs when different net prices are charged for the same good

– Suppose consumers differ in their distance from the point of sale: If differences in prices exactly reflect

transport costs, prices are not discriminatory

– Suppose consumers buy nearly identical variants of the same basic good. If the difference in price between

variants exactly equals the cost of characteristics that are in one but not the other, prices are not

discriminatory

First Degree Price Discrimination

? Every consumer pays his own reservation price

Marginal Revenue = Average Revenue

– Most profitable type of pricing

– Same quantity is sold as in competition

? Possible examples: small town doctor, shoe

repair shop, piano teacher

Valuebased more than cost based pricing often helps build profits.

�Firms charge different customers different prices, which is known as price discrimination.

This chapter also looks at pricing within a firm called transfer pricing.

�Pricing techniques that are used by many multi product firms, such as fullcost pricing and target return

pricing

Second Degree Price Discrimination

? Consumers distinguished by the quantity of the good they consume

– Quantity discounts

– Two‐part tariffs

? Examples: software site licenses, toothpaste

Third Degree Price Discrimination

? Consumers are divided into groups or market segments according to some observable characteristic, and

each is charged a different price

– Higher price is given to buyers with less elastic demand

? Examples: airlines, student and senior

discounts

some pricing strategies for Smart Marketers.

Price-lining:

Price-lining features products at a limited number of prices, reflecting varying product quality or product

lines. This strategy can help smart marketers sell top quality produce at a premium price and an ―economy

line‖, e.g., overripe or smaller fruits. Price-lining can also make shopping easier for consumers and sellers

because

there are fewer prices to consider and handle.

Single-pricing:

The single-price strategy charges customers the same price for all items. Items are packaged in different

volumes based on the single price for which they would be sold. With such a policy the variety of offerings is

often limited. The strength is being able to avoid employee error and facilitate the speed of transactions. Also,

customers know what to expect. There are no surprises for customers.

Loss-leader pricing: A less-than-normal markup or margin on an item is taken to

increase customer traffic. The loss-leaders should be well-known, frequently purchased

items. The idea is that customers will come to buy the ―leaders‖ and will also purchase

regularly priced items. If customers only buy the ―loss leaders,‖ the marketer is in

trouble.

��Odd-ending pricing: Odd-ending prices are set just below the dollar figure, such as $1.99

a pound instead of $2.00. Some believe that consumers perceive odd-ending prices to be

substantially lower than prices with even-ending. However, it might not be suitable in

some markets. For example, in a farmers‘ market situation, products should be priced in

round figures to speed up sales and eliminate problem with change.

��Quantity discount pricing: A quantity discount is given to encourage customers to buy in

larger amounts, such as $2.00 each and three for $5.00. Gross margins should be

computed on the quantity prices.

��Volume pricing: Volume pricing uses the consumer's perception to the business's

advantage, and no real discount is given to customers. Rather than selling a single item

for $2.50, two are priced for $4.99 or $5.00.

��umulative pricing: Price discount is given based on the total volume purchased over a

period of time. The discount usually increases as the quantity purchased increases. This type

of pricing has a promotional impact because it rewards a customer for being a loyal buyer.

��Trade discount/Promotional allowances: Price is reduced in exchange for marketing

services performed by buyers or to compensate buyers for performing promotional

services.

��sh discount: A discount is given to buyers who pay their bills within a specified

period of time to encourage prompt payment.

35

UNIT –V

FINANCIAL ACCOUNTING (ELEMENTARY TREATMENT)

Balance Sheet and related concepts – Profit & Loss Statement and related concepts –

Financial Ration Analysis – Cash flow analysis – Funds flow analysis – Comparative

financial statements – Analysis & Interpretation of Financial statements. Investments –

Risks and return evaluation of investment decision –m Average rate of return – Payback

period – Net present Value – Internal rate of return

Introduction to the profit and loss account

Richard Bowett introduces the important concept of the profit and loss account:

Introduction - the Meaning of Profit

The starting point in understanding the profit and loss account is to be clear about the meaning of "profit".

Profit is the incentive for business; without profit people wouldn't‘t bother. Profit is the reward for taking risk;

generally speaking high risk = high reward (or loss if it goes wrong) and low risk = low reward.

36

People won‘t take risks without reward. All business is risky (some more than others) so no reward means no

business. No business means no jobs, no salaries and no goods and services.

This is an important but simple point. It is often forgotten when people complain about excessive profits and

rewards, or when there are appeals for more taxes to pay for eg more policemen on the streets.

Profit also has an important role in allocating resources (land, labour, capital and enterprise). Put simply,

falling profits (as in a business coming to an end eg black-and-white TVs) signal that resources should be

taken out of that business and put into another one; rising profits signal that resources should be moved into

this business. Without these signals we are left to guess as to what is the best use of society‘s scarce resources.

People sometimes say that government should decide (or at least decide more often) how much of this or that

to make, but the evidence is that governments usually do a bad job of this e.g. the Dome.

The Task of Accounting - Measuring Profit

The main task of accounts, therefore, is to monitor and measure profits.

Profit = Revenue less Costs

So monitoring profit also means monitoring and measuring revenue and costs. There are two parts to this:-

1. Recording financial data. This is the =book-keeping‘ part of accounting.

2. Measuring the result. This is the =financial‘ part of accounting. If we say =profits are high‘ this begs the

question ‗high compared to what?‘ (You can look at this idea in more detail when covering Ratio Analysis)

Profits are ‗spent‘ in three ways.

1. Retained for future investment and growth.

2. Returned to owners eg a =dividend‘.

3. Paid as tax.

Parts of the Profit and Loss Account

The Profit & Loss Account aims to monitor profit. It has three parts.

1. The Trading Account.

This records the money in (revenue) and out (costs) of the business as a result of the business‘ ‗trading‘ ie

buying and selling. This might be buying raw materials and selling finished goods; it might be buying goods

wholesale and selling them retail. The figure at the end of this section is the Gross Profit.

2. The Profit and Loss Account proper

This starts with the Gross Profit and adds to it any further costs and revenues, including overheads. These

further costs and revenues are from any other activities not directly related to trading. An example is income

received from investments.

37

3. The Appropriation Account. This shows how the profit is =appropriated‘ or divided between the three uses

mentioned above.

Uses of the Profit and Loss Account.

1. The main use is to monitor and measure profit, as discussed above. This assumes that the information

recording is accurate. Significant problems can arise if the information is inaccurate, either through

incompetence or deliberate fraud.

2. Once the profit(loss) has been accurately calculated, this can then be used for comparison ie judging how

well the business is doing compared to itself in the past, compared to the managers‘ plans and compared to

other businesses.

3. There are ways to =fix‘ accounts. Internal accounts are rarely =fixed‘, because there is little point in the

managers fooling themselves (unless fraud is going on) but public accounts are routinely ‗fixed‘ to create a

good impression out to the outside world. If you understand accounts, you can usually (not always) spot these

‗fixes‘ and take them out to get a true picture.

Example Profit and Loss Account:

An example profit and loss account is provided below:

'000 £'000

evenue 2,500 10,000 ost of Sales ,500 6,000

ross Profit ,000 4,000

ross profit margin (gross profit / revenue) 0% 40%

perating Costs ales and distribution ,260 1,010

inance and administration 70 555

ther overheads 70 895

epreciation 35 210

otal Operating Costs ,035 2,670

perating Profit (gross profit less operating costs) ,965 1,330 perating profit margin (operating profit / revenue) 5.7% 13.3%

nterest 450) (475)

rofit before Tax ,515 855

axation 455) (255)

rofit after Tax

38

,060 600

ividends 50 400

etained Profits 10 200

In this series of articles we will also discuss:

1. Balance Sheet Explained

2. Trading and Profit and Loss Account

3. Adjustments of Final Accounts

Previously while discussing the basic accounting equation it was noted that A - L = P, where A represents

assets (property and possession) owned by the business; L represents liabilities (claims against the business of

the creditors) and P represents the proprietor's funds (equity) in the business.,

Accounting Concept of Income

The concept of 'income' is different to the economists and accountants. Economists concept of income is that

of 'real income' meaning thereby the increase-in real terms of the ownership funds between two points of time.

In accounting the term income is known as 'net profit'. It was stated earlier :

Sales - Merchandising cost = Gross profit and Gross profit - Expenses of doing business = Net profit In

other words, Revenue - Expenses = Net profit.

These terms are explained below:

Revenue

It is the monetary value of the products sold or services rendered to the customers during the period. It results

from sales services and source like interest, dividend and commission etc. For example, sales affected by the

business and charge made for services rendered by the business constitutes revenue. However, all cash receipt

may nott be revenue.

Thus, money borrowed leads to cash receipt but it does not constitute revenue. Similarly additional capital

brought in increases proprietor's funds but it is not revenue.

Expenses/Cost of (doing business)

Expenditure incurred by the business to earn revenue is termed as expense or cost of doing business. Examples

of expenses are raw materials consumed, salaries, rent, depreciation, advertisement etc.

Cash v/s Accrual Basis of Accounting

Small business, individual professionals and non-trading concerns usually adopt cash basis of accounting.

Under this system, incomes are considered to have been earned only when received ill cash and expenses are

considered to have been incurred only actually paid. Hence, under this system the profit or loss of an

accounting period is the difference between incomes received and the expenses paid. Though the cash basis

of accounting is simple (no adjustment is required) but il loses its comparability.

Under accrual basis all incomes are credited to the period in which earned irrespective of the fact whether

received or not. Similarly, all expenses are debited to the period in which incurred irrespective of the fact

whether paid or not. It is a scientific basis of accounting, though a bit difficult.

Matching Concept. Requires that expenses should be matched to the revenues of the appropriate accounting

period. So we must determine what are the revenues earned during a particular accounting period and the

expenses incurred to earn these revenues.

It is the matching concept which justifies accrual basis of accounting.

Accruals and Deferrals

Accounting is expected to measure or ascertain the net income of the business during the accounting period.

Normally, it is the calendar year (1st January to 31st December) but in other cases it may be Financial year (Ist

April to 31st March) or any other period according to the convention of the business community of the area.

The combined impact of matching concept and the accounting period concept on accounting has resulted in

accruals and deferrals.

Accrued or Outstanding expenses

It is the term which denotes that expenditure has been incurred during the accounting period but the same has

not been paid in cash e.g. Salary, Rent, Wage etc. becoming due but not paid.

Deferred or pre-paid expenses

It is the term which denotes that payment in cash has been made "in advance but the full benefit of this

payment has not been reaped by the current accounting period, e.g., Insurance paid in advance.

Accrued or outstanding Income

It is the term which denotes that the income has been earned but the cash has not been received against the

same. Income has accrued due but not received e.g. Interest on investments etc.

Differed or Received in-advance Income

It is the term which denotes income which has been received (in cash) in advance but it has not been earned so

far e.g. rent received in advance. All the accruals and deferrals arc not be adjusted at the end of the accounting

period (end-period adjustments) in order to find out the income of the business during the period under review.

The procedure of ascertaining (i) business income and (ii) financial position is being described, in detail

below:

In fact, these arc two most important of many objectives of book-keeping. In order to know the profits earned

by him he prepares a trading and loss account and in order to know the financial position of his business on the

last day of the financial period he prepares a balance sheet.

Such accounts are called 'Final Accounts'. Preparation of final accounts is the concluding step of

accounting cycle. In fact, final accounts include a number of accounts (i) Manufacturing/ Production account,

(ii) Trading account, (iii) Profit and loss account and (iv) Balance sheet.

Practically balance sheet is a statement but for accounting purposes here it is treated as a part vital accounts.

The preparation of above all or any of the above accounts depends upon the nature of the business being

carried on by the business concerned. In case of a manufacturing business manufacturing account, trading

account, profit and loss account and balance sheet form the parts of final accounts whereas in case of trading

business all other accounts are prepared with the exception of manufacturing account. Each of these accounts

provide a specific vital information to businessman to help to control and organize the business activities in a

batter way.

Cash Flow Statement

Complementing the balance sheet and income statement, the cash flow statement (CFS), a mandatory part of a

company's financial reports since 1987, records the amounts of cash and cash equivalents entering and leaving

a company. The CFS allows investors to understand how a company's operations are running,

where its money is coming from, and how it is being spent. Here you will learn how the CFS is structured

and how to use it as part of your analysis of a company. A cash fl ow statement is one of the most

important fi nancial statements for a project

or business. The statement can be as simple

as a one page analysis or may involve several

schedules that feed information into a central

statement.

A cash fl ow statement is a listing of the fl ows of cash into and out of the business or project. Think of it as

your checking account at the bank. Deposits are the cash infl ow and withdrawals (checks) are the cash outfl

ows. The balance in your checking account is your net cash fl ow at a specifi c point in time.

A cash fl ow statement is a listing of cash fl ows that occurred during the past accounting period. A

projection of future fl ows of cash is called a cash FIow budget. You can think of a cash fl ow budget as a

projection of the future deposits and withdrawals to your checking account.

A cash fl ow statement is not only concerned with the amount of the cash fl ows but also the timing of the

fl ows. Many cash fl ows are constructed with multiple time periods. For example, it may list monthly

cash infl ows and outfl ows over a year‘s time. It not only projects the cash balance remaining at the end

of the year but also the cash balance for each month.

41

Working capital is an important part of a cash fl ow analysis. It is defi ned as the amount of money needed to

facilitate business operations and transactions, and is calculated as current assets (cash or near cash assets) less

current liabilities (liabilities due during the upcoming accounting period). Computing the amount of working

capital gives you a quick analysis of the liquidity of the business over the future accounting period. If working

capital appears to be suffi cient, developing a cash fl ow

The Structure of the CFS

The cash flow statement is distinct from the income statement and balance sheet because it does not include

the amount of future incoming and outgoing cash that has been recorded on credit. Therefore, cash is not the

same as net income, which, on the income statement and balance sheet, includes cash sales and sales made on

credit. (To learn more about the credit crisis, read Liquidity And Toxicity: Will TARP Fix The Financial

System?)

Cash flow is determined by looking at three components by which cash enters and leaves a company: core

operations, investing and financing,

Operations

Measuring the cash inflows and outflows caused by core business operations, the operations component of

cash flow reflects how much cash is generated from a company's products or services. Generally, changes

made in cash, accounts receivable, depreciation, inventory and accounts payable are reflected in cash from

operations.

Cash flow is calculated by making certain adjustments to net income by adding or subtracting differences in

revenue, expenses and credit transactions (appearing on the balance sheet and income statement) resulting

from transactions that occur from one period to the next. These adjustments are made because non-cash items

are calculated into net income (income statement) and total assets and liabilities (balance sheet). So, because

not all transactions involve actual cash items, many items have to be re-evaluated when calculating cash flow

from operations.

For example, depreciation is not really a cash expense; it is an amount that is deducted from the total value of

an asset that has previously been accounted for. That is why it is added back into net sales for calculating cash

flow. The only time income from an asset is accounted for in CFS calculations is when the asset is sold.

Changes in accounts receivable on the balance sheet from one accounting period to the next must also be

reflected in cash flow. If accounts receivable decreases, this implies that more cash has entered the company

from customers paying off their credit accounts - the amount by which AR has decreased is then added to net

sales. If accounts receivable increase from one accounting period to the next, the amount of the increase must

be deducted from net sales because, although the amounts represented in AR are revenue, they are not cash.

An increase in inventory, on the other hand, signals that a company has spent more money to purchase

42

more raw materials. If the inventory was paid with cash, the increase in the value of inventory is deducted

from net sales. A decrease in inventory would be added to net sales. If inventory was purchased on credit, an

increase in accounts payable would occur on the balance sheet, and the amount of the increase from one year

to the other would be added to net sales.

The same logic holds true for taxes payable, salaries payable and prepaid insurance. If something has been

paid off, then the difference in the value owed from one year to the next has to be subtracted from net

income. If there is an amount that is still owed, then any differences will have to be added to net earnings.

Investing

Changes in equipment, assets or investments relate to cash from investing. Usually cash changes from

investing are a "cash out" item, because cash is used to buy new equipment, buildings or short-term assets

such as marketable securities. However, when a company divests of an asset, the transaction is considered

"cash in" for calculating cash from investing.

Financing

Changes in debt, loans or dividends are accounted for in cash from financing. Changes in cash from

financing are "cash in" when capital is raised, and they're "cash out" when dividends are paid. Thus, if a

company issues a bond to the public, the company receives cash financing; however, when interest is paid to

bondholders, the company is reducing its cash.

Analyzing an Example of a CFS

Let's take a look at this CFS sample:

From this CFS, we can see that the cash flow for FY 2003 was $1,522,000. The bulk of the positive cash flow

stems from cash earned from operations, which is a good sign for investors. It means that core operations are

generating business and that there is enough money to buy new inventory. The purchasing of new equipment

shows that the company has cash to invest in inventory for growth. Finally, the amount of cash available to the

company should ease investors' minds regarding the notes payable, as cash is plentiful to cover that future

loan expense.

Of course, not all cash flow statements look this healthy, or exhibit a positive cash flow. But a negative

cash flow should not automatically raise a red flag without some further analysis. Sometimes, a negative cash

flow is a result of a company's decision to expand its business at a certain point in time, which would be a good

thing for the future. This is why analyzing changes in cash flow from one period to the next gives the investor

a better idea of how the company is performing, and whether or not a company may be on the brink of

bankruptcy or success.

Tying the CFS with the Balance Sheet and Income Statement

As we have already discussed, the cash flow statement is derived from the income statement and the balance

sheet. Net earnings from the income statement is the figure from which the information on the CFS is

deduced. As for the balance sheet, the net cash flow in the CFS from one year to the next should equal the

increase or decrease of cash between the two consecutive balance sheets that apply to the period that the cash

flow statement covers. (For example, if you are calculating a cash flow for the year 2000, the balance sheets

from the years 1999 and 2000 should be used.)

Conclusion

A company can use a cash flow statement to predict future cash flow, which helps with matters in budgeting.

For investors, the cash flow reflects a company's financial health: basically, the more cash available for

business operations, the better. However, this is not a hard and fast rule. Sometimes a negative cash flow

results from a company's growth strategy in the form of expanding its operations.

By adjusting earnings, revenues, assets and liabilities, the investor can get a very clear picture of what some

people consider the most important aspect of a company: how much cash it generates and, particularly, how

much of that cash stems from core operations.

FINANCIAL STATEMENT ANALYSIS

MEANING

‖Tearing apart‖ the financial statements and looking

at the relationships

Who analyzes financial statements?

Internal users (i.e., management)

External users (emphasis of chapter)

Examples?

Investors, creditors, regulatory agencies & …

stock market analysts and

auditors

What do internal users use it for?

Planning, evaluating and controlling company operations

What do external users use it for?

Assessing past performance and current financial position and making

predictions about the future profitability and solvency of the company as

well as evaluating the effectiveness of management

44

METHODS OF FINANCIAL STATEMENTS ANALYSIS

Horizontal Analysis

Vertical Analysis

Common-Size Statements

Trend Percentages

Ratio Analysis

HORIZONTAL ANALYSIS(COMPARATIVE STATEMENTS)

Using comparative financial statements to calculate dollar or percentage changes in a financial Statement

item from one period to the next

VERTICAL ANALYSIS (COMMON SIZE STATEMENTS)

For a single financial statement, each item

is expressed as a percentage of a significant total,

e.g., all income statement items are expressed as a percentage of sale

45

TREND PROJECTION METHOD

Show changes over time in given financial statement items (can help evaluate financial information of

several years)

RATIO ANALYSIS

Expression of logical relationships between items in a financial statement of a single period (e.g.,

percentage relationship between revenue and net income)

Liquidity Ratios

Indicate a company‘s short-term debt-paying ability

l Equity (Long-Term Solvency) Ratios

Show relationship between debt and equity financing in a company

Profitability Tests

Relate income to other variables

Market Tests

Help assess relative merits of stocks in the marketplace

CAPITAL BUDGETING

Development of a written investment policy, which is reviewed by independent

professional advisers (including legal experts as required), approved by the board,

and reviewed annually.

2. Ensuring that the written investment policy addresses the following issues

(discussed further in Section D):

¦ investment committee functions and structure;

¦ investment philosophy and objectives;

¦ attitude to risk and process for managing risk;

¦ decision rights; and

¦ process for evaluating and managing investments.

3. Establishment of an investment committee if major investment is being proposed.

Key roles of the investment committee would be to:

¦ establish the overall methodology, processes and controls which govern

46

investments;

¦ ensure that robust processes (eg evaluation of fi t with the NHS foundation

trust‘s overall strategy, use of appropriate independent professional advisers)

are followed; and

¦ evaluate, scrutinise and monitor investments.

4. Confirmation that the NHS foundation trust has the legal power to make the

proposed investment.

5. Engagement early on in the investment evaluation process of independent external

advisers with demonstrated expertise in advising on transactions of the size and

nature being proposed.

6. Rigorous evaluation of all proposed major investments using a thorough evaluation,

execution, and monitoring process, such as the one described in Appendix 1.

Risk Evaluation for Investment

Decisions by NHS Foundation Trusts

D.Key elements of investment policy

A best practice investment policy will contain the following elements:

(i) Investment committee functions and structure

Typically the functions of the investment committee will be to approve investment and

borrowing strategy and policies, approve performance benchmarks, review performance

against the benchmarks, ensure proper safeguards are in place for security of the NHS

foundation trust‘s funds, monitor compliance with treasury policies and procedures,

approve proposals for acquisition and disposal of assets above a de minimis amount

and approve external funding arrangements within their delegated authority.

The investment committee will comprise executive and non-executive directors, with a

majority of non-executive directors. It should be chaired by a non-executive director with

relevant investment decision-making experience. It may be a committee of the board,

or the board itself in the case of smaller NHS foundation trusts.

(ii) Investment philosophy and objectives

A best practice statement of investment philosophy and objectives will provide the

criteria for selecting the NHS foundation trust‘s investments, and address the following:

1. the statutory and principal purpose of the NHS foundation trust – the provision

of goods and services for the health service in England;

2. the NHS foundation trust‘s corporate strategy (including geographic and

service focus);

3. target rates of return for investments and explanation of how rates of return

will be calculated (eg return net of any cross-subsidies); and

4. time frame for realising the desired return on investments.

06 – 07

(iii) Attitude to risk and process for managing risk

Risk refers to the probability of an adverse outcome that is different from the expected

outcome and the potential impact of such an outcome. Some major categories of

investment risk include:

1. Strategic: risks associated with a particular strategy, for instance, overcapacity,

product or service line obsolescence, competitor reactions;

2. Financial: risks associated with the fi nancial structure of a business, the fi nancial

47

transactions made by the business, and the fi nancial systems which are in place,

for instance, interest rate risk, foreign exchange risk and credit risk;

3. Operational: risks associated with the operational and administrative procedures

of a business, such as, clinical operations, supply chain management, IT systems,

recruitment, labour management and post-merger integration process;

4. Regulatory and political: risks posed by potential changes in the regulatory

and political environment, such as, tariff changes, policy changes and changes

in healthcare targets;

5. Reputational: risks to the perceived quality or brand of an institution, for instance,

through bad press resulting from association with a failed joint venture;

6. Contingent: risks that will only come into existence if a certain contingent

event takes place, for instance, guarantees of a joint venture that are only

payable if it defaults.

Risk management refers to the collective set of processes, working practices and

tools used to minimise the probability and impact of adverse outcomes. It entails:

¦ identifying potential sources of risk;

¦ estimating value at risk, calculated as probability of loss x severity of loss;

¦ implementing controls to minimise probability and severity of loss.

It is best practice to defi ne in the investment policy the NHS foundation trust‘s principles

for managing risk aligned with its corporate strategy. Examples of risk management

principles include:

¦ guidelines on identifi cation of different types of risk;

¦ methodology for calculating value at risk;

¦ expected returns of individual investments for a given risk level – higher risk

investments require higher expected returns;

¦ aggregate targeted rate of return across the portfolio of investments;

¦ limitations on the locations and types of investments that can be pursued. For instance,

the policy may specify that investments in overseas ventures should only be within

the ‗core competence‘ of the organisation and within stated risk concentrations for

each geography;

¦ guidelines for asset diversifi cation outside core operations. For instance, specifying

that either the organisation will not diversify outside the health sector in England,

or specifying limits on concentration of risk in a particular technology or sector.

A best practice investment policy will provide the criteria for categorising investments

by level of risk (eg high, medium and low risk). Criteria for assessing riskiness of an

investment include:

¦ fi nancial magnitude of deal;

¦ probability of loss;

¦ complexity of the deal structure;

¦ distance from an NHS foundation trust‘s core capabilities and operations;

¦ fi nancing arrangements, for instance, type of debt fi nance;

¦ geographic location, for instance, investment in a highly competitive, uncertain,

or unfamiliar territory will increase risk;

¦ degree of operating risk assumed, be it construction risk or cost overrun risk,

for example;

48

¦ level of post-investment management required (eg post acquisition integration).

Best practice is to scrutinise investments in proportion to risk. For example, an

NHS foundation trust board may accept ‗routine scrutiny‘ for low-risk investments

(eg decisions delegated to the investment committee, with a short-form business

case), but require ‗special scrutiny‘ for high-risk investments (eg engagement of

external independent advisers for in-depth business case, and main board approval).

While it is for NHS foundation trusts to determine their own thresholds for each

level of risk and associated scrutiny, the approach used by Monitor for its own risk

assessment may provide a useful reference point (see Section E).

It is best practice for NHS foundation trusts to seek advice from appropriate

independent external advisers (eg risk management consultants) when developing

their approach to managing risk.

Risk Evaluation for Investment

Decisions by NHS Foundation Trusts

(iv) Decision rights

A best practice investment policy will defi ne clearly the roles, responsibilities and

approval limits of the various committees and individuals with investment oversight.

These are likely to include the board, investment committee, fi nance director, and

business development group, if one exists. For example, the board might be required

to approve the written investment policy and all ‗high risk‘ investments, while the

investment committee might approve all other investments and ensure that investment

decisions follow the guidelines laid out in the written investment policy.

(v) Process for evaluating and managing investments

A robust investment policy will explain the internal processes for evaluating, executing,

and performance managing investments. The extent of review/due diligence needs to

be appropriate to the investment proposed. For example, all major investments would

be expected to undergo detailed business case evaluation and challenge.

An example of a robust framework for evaluating and managing investments is set out in

Appendix 1. This framework describes the key phases in making a major investment

decision: preliminary review, detailed review, and execution and monitoring. For each

of these phases it provides a list of key questions that board members will ask and

also lists the types of external advisers that will likely be engaged.

This risk evaluation framework is an indication of the type of analysis required at each of

the three stages of investment appraisal. If an NHS foundation trust is unclear about how

to apply the framework to a particular investment appraisal they should seek

professional advice.

08 – 09

Each potential project's value should be estimated using a discounted cash flow (DCF) valuation, to find its net

present value (NPV). (First applied to Corporate Finance by Joel Dean in 1951; see also Fisher separation

theorem, John Burr Williams: Theory.) This valuation requires estimating the size and timing of all of the

incremental cash flows from the project. These future cash flows are then discount [disambiguation

needed]ed to determine their present value. These present values are then summed, to get the NPV. See

also Time value of money. The NPV decision rule is to accept all positive

49

NPV projects in an unconstrained environment, or if projects are mutually exclusive, accept the one with the

highest NPV(GE)

The NPV is greatly affected by the discount rate, so selecting the proper rate - sometimes called the hurdle rate

- is critical to making the right decision. The hurdle rate is the minimum acceptable return on an investment. It

should reflect the riskiness of the investment, typically measured by the volatility of cash flows, and must take

into account the financing mix. Managers may use models such as the CAPM or the APT to estimate a

discount rate appropriate for each particular project, and use the weighted average cost of capital (WACC) to

reflect the financing mix selected. A common practice in choosing a discount rate for a project is to apply a

WACC that applies to the entire firm, but a higher discount rate may be more appropriate when a project's risk

is higher than the risk of the firm as a whole.

Internal rate of return

The internal rate of return (IRR) is defined as the discount rate that gives a net present value (NPV) of zero. It

is a commonly used measure of investment efficiency.

The IRR method will result in the same decision as the NPV method for (non-mutually exclusive) projects in

an unconstrained environment, in the usual cases where a negative cash flow occurs at the start of the project,

followed by all positive cash flows. In most realistic cases, all independent projects that have an IRR higher

than the hurdle rate should be accepted. Nevertheless, for mutually exclusive projects, the decision rule of

taking the project with the highest IRR - which is often used - may select a project with a lower NPV.

In some cases, several zero NPV discount rates may exist, so there is no unique IRR. The IRR exists and is

unique if one or more years of net investment (negative cash flow) are followed by years of net revenues. But

if the signs of the cash flows change more than once, there may be several IRRs. The IRR equation generally

cannot be solved analytically but only via iterations.

One shortcoming of the IRR method is that it is commonly misunderstood to convey the actual annual

profitability of an investment. However, this is not the case because intermediate cash flows are almost never

reinvested at the project's IRR; and, therefore, the actual rate of return is almost certainly going to be lower.

Accordingly, a measure called Modified Internal Rate of Return (MIRR) is often used.

Despite a strong academic preference for NPV, surveys indicate that executives prefer IRR over

NPV[citation needed], although they should be used in concert. In a budget-constrained environment,

efficiency measures should be used to maximize the overall NPV of the firm. Some managers find it

intuitively more appealing to evaluate investments in terms of percentage rates of return than dollars of NPV.

Capital budgeting (or investment appraisal) is the planning process used to determine whether a firm's long

term investments such as new machinery, replacement machinery, new plants, new products, and research

development projects are worth pursuing. It is budget for major capital, or investment, expenditures.[1]

Many formal methods are used in capital budgeting, including the techniques such as

Accounting rate of return

Net present value

50

Internal rate of return Modified

internal rate of return

These methods use the incremental cash flows from each potential investment, or project Techniques based on

accounting earnings and accounting rules are sometimes used - though economists consider this to be

improper - such as the accounting rate of return, and "return on investment." Simplified and hybrid methods

are used as well, such as payback period and discounted payback period.

Each potential project's value should be estimated using a discounted cash flow (DCF) valuation, to find its net

present value (NPV). (First applied to Corporate Finance by Joel Dean in 1951; see also Fisher separation

theorem, John Burr Williams: Theory.) This valuation requires estimating the size and timing of all of the

incremental cash flows from the project. These future cash flows are then discount [disambiguation

needed]ed to determine their present value. These present values are then summed, to get the NPV. See

also Time value of money. The NPV decision rule is to accept all positive NPV projects in an unconstrained

environment, or if projects are mutually exclusive, accept the one with the highest NPV(GE)

NET PRESENT VALUE

The NPV is greatly affected by the discount rate, so selecting the proper rate - sometimes called the hurdle rate

- is critical to making the right decision. The hurdle rate is the minimum acceptable return on an investment. It

should reflect the riskiness of the investment, typically measured by the volatility of cash flows, and must take

into account the financing mix. Managers may use models such as the CAPM or the APT to estimate a

discount rate appropriate for each particular project, and use the weighted average cost of capital (WACC) to

reflect the financing mix selected. A common practice in choosing a discount rate for a project is to apply a

WACC that applies to the entire firm, but a higher discount rate may be more appropriate when a project's risk

is higher than the risk of the firm as a whole.

Internal rate of return

Main article: Internal rate of return

The internal rate of return (IRR) is defined as the discount rate that gives a net present value (NPV) of zero. It

is a commonly used measure of investment efficiency.

The IRR method will result in the same decision as the NPV method for (non-mutually exclusive) projects in

an unconstrained environment, in the usual cases where a negative cash flow occurs at the start of the project,

followed by all positive cash flows. In most realistic cases, all independent projects that have an IRR higher

than the hurdle rate should be accepted. Nevertheless, for mutually exclusive projects, the decision rule of

taking the project with the highest IRR - which is often used - may select a project with a lower NPV.

In some cases, several zero NPV discount rates may exist, so there is no unique IRR. The IRR exists and is

unique if one or more years of net investment (negative cash flow) are followed by years of net revenues. But

if the signs of the cash flows change more than once, there may be several IRRs. The IRR equation generally

cannot be solved analytically but only via iterations.

One shortcoming of the IRR method is that it is commonly misunderstood to convey the actual annual

profitability of an investment. However, this is not the case because intermediate cash flows are almost

51

never reinvested at the project's IRR; and, therefore, the actual rate of return is almost certainly going to be

lower. Accordingly, a measure called Modified Internal Rate of Return (MIRR) is often used.

Despite a strong academic preference for NPV, surveys indicate that executives prefer IRR over

NPV[citation needed], although they should be used in concert. In a budget-constrained environment,

efficiency measures should be used to maximize the overall NPV of the firm. Some managers find it

intuitively more appealing to evaluate investments in terms of percentage rates of return than dollars of NPV.

Average rate of return

Hide links within definitionsShow links within definitions

Definition

Method of investment appraisal which determines return on investment by totaling the cash flows (over the

years for which the money was invested) and dividing that amount by the number of years.

One way of measuring an investment's profitability.To calculate,one takes the total net earnings,divides by the

total number of years the investment was held,and then divides that answer by the investment's initial

acquisition cost.

Example: Rainer spent $800,000 to buy an apartment building. After deducting all operating expenses, real

estate taxes, and insurance, she receives $65,000 in the first year, $71,000 in the second year, $69,000 in the

third year, and $70,000 in the fourth year. The total net earnings are $275,000. Divide that number by the 4

years being analyzed, to reach $68,750 as an average annual return. Divide $68,750 by the initial $800,000

investment to calculate the average rate of return of 8.59 percent.

Drawback: The procedure does not take into account the time value of money.The $65,000 received in the first

year was more valuable than the $70,000 received in the fourth year,because the $65,000 could have been

invested to earn still more money.

Payback period in capital budgeting refers to the period of time required for the return on an investment to

"repay" the sum of the original investment. For example, a $1000 investment which returned $500 per year

would have a two year payback period. The time value of money is not taken into account. Payback period

intuitively measures how long something takes to "pay for itself." All else being equal, shorter payback

periods are preferable to longer payback periods. Payback period is widely used due to its ease of use despite

recognized limitations, described below.

The term is also widely used in other types of investment areas, often with respect to energy efficiency

technologies, maintenance, upgrades, or other changes. For example, a compact fluorescent light bulb may be

described of having a payback period of a certain number of years or operating hours, assuming certain costs.

Here, the return to the investment consists of reduced operating costs. Although primarily a financial term, the

concept of a payback period is occasionally extended to other uses, such as energy payback period (the period

of time over which the energy savings of a project equal the amount of energy expended since project

inception); these other terms may not be standardized or widely used.

Payback period as a tool of analysis is often used because it is easy to apply and easy to understand for most

individuals, regardless of academic training or field of endeavour. When used carefully or to compare similar

investments, it can be quite useful. As a stand-alone tool to compare an investment with "doing nothing,"

payback period has no explicit criteria for decision-making (except, perhaps, that the payback period should

be less than infinity).

The payback period is considered a method of analysis with serious limitations and qualifications for its use,

because it does not properly account for the time value of money, risk, financing or other important

considerations, such as the opportunity cost. Whilst the time value of money can be rectified by applying a

weight average cost of capital discount, it is generally agreed that this tool for investment decisions should not

be used in isolation. Alternative measures of "return" preferred by economists are net present value and

internal rate of return. An implicit assumption in the use of payback period is that returns to the investment

continue after the payback period. Payback period does not specify any required comparison to other

investments or even to not making an investment.

There is no formula to calculate the payback period, excepting the simple and non-realistic case of the initial

cash outlay and further constant cash inflows or constant growing cash inflows. To calculate the

payback period an algorithm is needed. It is easily applied in spreadsheets. The typical algorithm reduces to

the calculation of cumulative cash flow and the moment in which it turns to positive from negative.

Additional complexity arises when the cash flow changes sign several times, that is it contains outflows in the

midst or at the end of the project lifetime. The modified payback period algorithm may be applied then.

Firstly, the sum of all of the cash flows is calculated. Then the cumulative positive cash flows are determined

for each period. The modified payback period is calculated as the moment in which the cumulative positive

cash flow exceeds the total cash outflow.

Engineering Economics & Financial Accounting

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