Unit 3Fundamental Economic

Concepts Used In Business Decisions

By: Zainul Lamak

Why Study Economic Principles ?•Modern business conditions are changing so fast and becoming so competitive and complex that personal business sense, intuition and experience alone are not sufficient to make appropriate business decisions. It is in this area of decision making that economic analysis contribute a great goal

Process of decision making i. Determining and Defining the Objective

ii. Collection and analysis of the information regarding the objective

iii. Inventing, developing and analyzing possible course of action

iv. Selecting the best available alternative

Levels of Business Decisions Simple Business Decisions i. ‘Rule of Thumb’ ii. Used for simple day to day decision making

Managerial Business Decisions i. Sophisticated approach ii. Used for tackling complex business issues

Table Of ContentsSr. No. Principles

1 Opportunity Cost

2 Marginal Principle and Decision Rule

3 Incremental Principle and Decision Rule

4 Contribution Analysis

5 The Equi-Marginal Principle

6 Time perspective in Business decision

Basic Types of Costs

Fixed Costs Variable Costs

• Plant and machinery• Salaries• Utility Services• Leases

• Wages• Electricity

Charges• Transport

Charges• Raw material

cost

1. The Opportunity Cost•The cost involved in any decision consists

of the sacrifices of alternatives required by that decision.

•The opportunity cost of a choice is the value of the alternative forgone.

•Expresses basic relationship between ‘scarcity’ and ‘choice’

20 M 18

M 16 M

Expansion

New Production Unit

Buying Shares in another firm

Expected Revenues from Investment Options

Option 1

Option 2

Option 3

20 M 18

M 16 M

Expansion

New Production Unit

Buying Shares in another firm

Expected Revenues from Investment Options

Option 1

Option 2

Option 3

To achieve option 1, Option 2 becomes the OPPORTUNITY COST

18 M

18 M

Expansion

New Production Unit

Opt

ion

1

Opt

ion

2

Economic Gain/Profit

The difference between actual earning and its opportunity cost is called economic gain/profit

16 M

Buying Shares in another firm

Opt

ion

3

2 M

Parameters• Opportunity costs are not restricted to

monetary or financial costs

• Other aspects such as pleasure, time lost and output forgone are considered too

• For example, Appointing a new manager in the business

Appointing a new ManagerOption A Option B• Promotion of an internal

employee to a managerial position with experience but without qualification

• the opportunity cost for promoting an internal employee to a managerial post is the lack of required qualification

• Appointing a new employee with the required qualification

• The opportunity cost for recruiting a new employee is the experience and commitment of the present internal employee towards the business

2. Marginal Principle •Widely used term in Economics

•The term ‘Marginal’ refers to the change in total quantity or value due to one-unit change in its determinant

•This could be an increasing or a decreasing change

Elements of Marginal Principle•Total Cost of Production (TCn)•Total Revenue (TRn)•Marginal Cost (MC)•Marginal Revenue (MR)•Total Cost for producing an additional

unit of the commodity (TCn-1)•Total Revenue by selling an additional

unit of the commodity (TRn-1)

•Total Cost of Production (TCn) - The total cost of production of a

commodity depends on the number of units produced.

example, if 300 units are produced at Rs.20 each then the Total Cost amounts to Rs.6000

•Total Revenue (TRn) - The total revenue of the firm depends

on the total number of units it sells. example, 300 units sold at Rs.35 each

amounts to a Total Revenue of Rs.10,500

•Marginal Cost (MC) - The marginal cost is the change in

the total cost as a result in producing an additional unit.

example, Total cost of producing 300 units is Rs.6000 and the total cost of producing an additional unit is 6020.

[ MC = TCn – TCn-1 ] MC = 6020 – 6000 MC = 20

•Marginal Revenue - The Marginal revenue is the revenue

collected due to a sale of an additional unit.

Example, Total Revenue earned by selling 350 units is Rs.10,500 and the Total revenue earned by selling and additional unit is 10,535

[ MR = TRn – TRn-1 ] MR = 10535 – 10500 MR = 35

Limitations1. It can only be applied where the management has the

Total Cost (TC) and Total Revenue (TR) data for each and every unit of output is recorded or where the management is fully aware of the cost of producing one additional unit and the price expected to be received from the sale of that unit.

Business that manufactures large units: i . Airplanes ii . Ships iii . Buildings iv . Turbines … etc.

2. The concept of ‘Marginal’ value, when used in cost analysis, reduces the value of MC to the change in variable cost only. Therefore, marginal analysis can only be applied to a situation in which only the variable cost changes

3. Incremental Principle• Incremental principle is the opposite of marginal

principle

• Incremental principle is applied to business decision that involves bulk production and constant change in total cost and the total revenue

• Data is easily available

• Combination of fixed and variable cost

Elements of Incremental Principle•Incremental Cost - The total change in cost is called the

incremental cost - Incremental cost can be defined as

the cost that arises due to a business decision

Current Production Cost 100 M

Incremental Cost

Incremental Cost

New Production Cost 115 M

100 M 15 M

15 Million is the Incremental cost

Incremental Cost

Elements of Incremental Principle•Incremental Revenue

- When a business decision is successfully implemented, it results in a significant increase in the total revenue

- This increase in the revenue is termed as incremental revenue

Current Revenue 130 M

Incremental Revenue

Incremental Revenue

Revenue after successful implementation of Incremental cost - 150 M

130 M 20 M

20 Million is the Incremental revenue

Incremental Revenue

Incremental Reasoning

•Conclusions based on incremental concept (Incremental Cost + Incremental Revenue) in business decision is termed as Incremental reasoning

•Incremental Reasoning is used in accepting or rejecting a business proposition

Incremental Reasoning for setting up a new plant

Incremental Reasoning

20 M 15 M

Incremental Cost

Incremental Revenue

5 M

Excess Incremental revenue

5 million/15 million = 33.33 % gross profit on investment

According to the incremental reasoning the firm should immediately accept the proposition

Close StudyMarginal Principle Incremental Principle• Marginal Value is

calculated for an additional unit produced

• Fixed cost must remain the same

• A theoretical concept and difficult to calculate in real life

• Incremental Value is calculated for bulk production and large total cost

• Fixed cost is tentative to change

• Used in Business decision more frequently and easy to calculate

4. Contribution Analysis

•The analysis of a business decision between Incremental Revenue and Incremental Cost

•Generally applied to analyze the contribution made by overheads costs and revenue

It is a useful technique for taking business decision on:

•Whether or not to accept a project ?•Whether or not to introduce a new

product ?•Whether or not to accept a new order ?•Whether or not to add an additional

plant ?•Whether to make or buy ?

Costs taken into consideration for Contribution Analysis•Incremental Costs i. Present Explicit Costs a. Explicit variable costs . Direct labour cost . Direct material cost . Direct variable overheads b. Fixed Costs . New additional equipment . New additional personnel

ii. Opportunity Cost iii. Future Incremental Costs . Depreciation . Reserves . Advertising

Costs NOT taken into consideration for Contribution Analysis

i. Committed Costs . Payments of old debts . Committed raise in salaries

ii. Sunk Costs . Building . Plant and Machinery . Non-recoverable advance payments

Revenues taken into consideration for Contribution Analysis

Incremental Revenues

i. Present Explicit Revenue

ii. Possible Opportunity Revenue

iii. Possible future revenue

5. The Equi-Marginal Principle•Allocation of available resources amongst

the alternative activities

•An input should be so allocated that the value added by the last unit is the same in all cases

•Goal of maximizing profits

Consumer point of view•Every commodity will have different utility

for different consumer.

•The consumer will want to purchase both commodities and will want to reap highest possible marginal utility

•This is possible when the consumer complies his purchase of commodities in a way that gives maximum value

Units Marginal utility of Apples

Marginal Utility of Oranges

1 10 8

2 8 6

3 6 4

4 4 2

5 2 0

6 0 -2

7 -2 -4

8 -4 -6

Example

Business point of view•When a business intends to start a new

project and get and faces problems of resource allocation between its alternatives

•Equi-Marginal principle helps in deciding how much resources to allocate in which project by studying the marginal utility of each project.

Units of expenditure

(Rs. 10 Million)

Marginal Productivity

Project A Project B Project C

1st 50 40 352nd 45 30 303rd 35 20 204th 20 10 155th 10 0 12

6. Time Perspective•All business decision are taken within a

certain time limit

•Time perspective i. Short run ii. Long run

• Determination of time perspective is of great significance specially where projects are involved

•Short RunA decision to buy explosive materials for manufacturing crackers involves short run demand prospect

•Long RunSpending on labor welfare. i. Will result in expense initially ii. Will increase productivity in long run

Thank You