BEFA UNIT I

BUSINESS
INTRODUCTION

Human beings are continuously engaged in some activity or other in order to satisfy their unlimited
wants. Every day we come across the word 'business' or 'businessman' directly or indirectly. Business
has become essential part of modern world.

Business is an economic activity, which is related with continuous and regular production and
distribution of goods and services for satisfying human wants.

All of us need food, clothing and shelter. We also have many other household requirements to be
satisfied in our daily lives. We met these requirements from the shopkeeper. The shopkeeper gets from
wholesaler. The wholesaler gets from manufacturers. The shopkeeper, the wholesaler, the manufacturer
are doing business and therefore they are called as Businessman.

DEFINITIONS
Stephenson defines business as, "The regular production or purchase and sale of goods undertaken with
an objective of earning profit and acquiring wealth through the satisfaction of human wants."

Dicksee defines business as "a form of activity conducted with an objective of earning profits for the
benefit of those on whose behalf the activity is conducted."

Lewis Henry defines business as, "Human activity directed towards producing or acquiring wealth
through buying and selling of goods."
Thus, the term business means continuous production and distribution of goods and services with the
aim of earning profits under uncertain market conditions.

CHARACTERISTICS:
1. Exchange of goods and services
All business activities are directly or indirectly concerned with the exchange of goods or services for
money or money's worth.

2. Deals in numerous transactions

In business, the exchange of goods and services is a regular feature. A businessman regularly deals
in a number of transactions and not just one or two transactions.

3. Profit is the main Objective

The business is carried on with the intention of earning a profit. The profit is a reward for the services
of a businessman.

4. Business skills for economic success

Anyone cannot run a business. To be a good businessman, one needs to have good business qualities
and skills. A businessman needs experience and skill to run a business.

5. Risks and Uncertainties

Business is subject to risks and uncertainties. Some risks, such as risks of loss due to fire and theft can
be insured. There are also uncertainties, such as loss due to change in demand or fall in price cannot
be insured and must be borne by the businessman.

6. Buyer and Seller

Every business transaction has minimum two parties that is a buyer and a seller. Business is nothing
but a contract or an agreement between buyer and seller.

7. Connected with production

Business activity may be connected with production of goods or services. In this case, it is called as
industrial activity. The industry may be primary or secondary.

1
 BEFA UNIT I
8. Marketing and Distribution of goods
Business activity may be concerned with marketing or distribution of goods in which case it is called
as commercial activity.

9. Deals in goods and services

In business there has to be dealings in goods and service. Goods may be
divided into following two categories :-
1. Consumer goods : Goods which are used by final consumer for consumption are called
consumer goods e.g. T.V., Soaps, etc.

2. Producer goods : Goods used by producer for further production are called producers goods
e.g. Machinery, equipments, etc. Services are intangible but can be exchanged for value like
providing transport, warehousing and insurance services, etc.

10. To Satisfy human wants

The businessman also desires to satisfy human wants through conduct of business. By producing and
supplying various commodities, businessmen try to promote consumer's satisfaction.

11. Social obligations

Modern business is service oriented. Modern businessmen are conscious of their social responsibility.
Today's business is service-oriented rather than profit- oriented.

STRUCTURE OF BUSINESS FIRM

A business firm is an organization that uses resources to produce goods and services that are sold to
consumers, other firms, or the government. Most businesses exist because a group of people working
together can be more effective than a group of people working individually.

Firms are grouped into three types: sole proprietorships, partnerships, and companies.
A sole proprietorship is a business that is owned by one individual. This owner makes all the business
decisions, receives all the profits or losses of the firm, and is legally responsible for the debts of the
firm.

A type of business organization in which two or more individuals pool money, skills, and other
resources, and share profit and loss in accordance with terms of the partnership agreement. In absence
of such agreement, a partnership is assumed to exit where the participants in an enterprise agree to
share the associated risks and rewards proportionately.

A company is a legal entity, allowed by legislation, which permits a group of people, as shareholders,
to apply to the government for an independent organization to be created, which can then focus on
pursuing set objectives, and empowered with legal rights which are usually only reserved for
individuals, such as to sue and be sued, own property, hire employees or loan and borrow money.

2
 BEFA UNIT I
THEORY OF FIRM

The following are the various theories of the firm.

1. Profit Maximization Theory

Profit maximization is one of the most common and widely accepted objectives of a firm. According
to the profit maximization theory, the main aim of the firm is to produce large amount of profits.
Profit is considered as the internal source of funds and the market value of the firm also rely mainly
on the profits earned by the firm. in order to survive in the market, it is very essential for the firms to
earn profits. Profits are obtained by deducting total revenue from the total cost i.e.,
Profit = Total revenue – total cost

2. Baumol‟s Theory of Sales Revenue Maximization

According to Baumol, maximization of sales revenue is the main objective of the firms in the
competitive markets. It's based on the theory that, once a company has reached an acceptable level of
profit for a good or service, the aim should shift away from increasing profit to focus on increasing
revenue from sales. According to the theory, companies should do so by producing more, keeping
prices low, and investing in advertising to increase product demand. The idea is that applying this
sales revenue maximization model will improve the overall reputation of the company and, in turn,
lead to higher long-term profits.
He found that sales volumes helps in finding out the market leadership in competition. According to
him, in large organization, the salary and other benefits of the managers are connected with the sales
volumes instead of profits. Banks give loans to firms with more sales. So, managers try to maximize
the total revenue of the firms. The volume of sales represents the position of the firm in the market.
The managers‘ performance is measured on the basis of the attainment of sales and maintain
minimum profit. Thus, the main aim of the firm is to maximize sales revenue and maintain minimum
profits for satisfying shareholders.

3. Marris theory of Growth Maximization

According to Marris, owners/shareholders strive for attaining profits and market share and mangers
strive for better salary, job security and growth. These two objectives can be attained by maximizing
the balanced growth of the firm. The balanced growth of the firm relies mainly on the growth rate of
demand for the firm‘s products and growth rate of capital supplied to the firm. if the demand for the
firm‘s product and the capital supplied to the firm grows at the same rate then the growth rate of the
firm will be considered as balanced.
Marris found that the firms faces two difficulties while attaining the objectives of maximization of
balanced growth which are managerial difficulties and financial difficulties. For maximizing the
growth of the firm the managers should have skills, expertise, efficiency and sincerity in them. The
prudent financial policy of the firm depends on at least three financial ratios which restricts the growth
of the firm. 1. Debt-Equity Ratio 2. Liquidity Ratio, 3. Retention Ratio.

4. Williamson‟s Model of Managerial Utility Functions

Williamson‘s model combined profits maximization and growth maximization objectives. According
to the model of managerial utility functions, managers makes use of their discretionary powers
for maximizing their own utility function and maintains minimum profits for satisfying shareholders.

 Minimum profits for minimum investment and growth of the firm.

 Managers want to maximize their own utility (satisfaction).
 Satisfaction or utility of managers depends on three variables.
1. Staff salaries, S: Includes management salaries, administration expenses, selling
expenditure. More the staff exp. more sales. Power and prestige of managers increases
with S.
2. Management emoluments, M: i.e., luxury offices, fancy cars. Perks.

3
 BEFA UNIT I
3. Discretionary investments, D: Amount spent at his own discretion,
e.g. on latest equipment, furniture, decoration material etc. to satisfy ego and give them a
sense of pride. These give a boost to the manager‘s esteem and status in the organization.
 Managers use that combination of above variables that maximizes their own satisfaction.
The Williamson‘s model is written as, UM =
f(S,M,D)
Where, UM = Utility of Manager, S = Salaries, M = Managerial emoluments, D =
Discretionary power for investments.

5. Behavioral Theories

According to the behavioral theories, the firm tries to attain a satisfactory behaviour instead of
maximization. There are two important behavioral models,
1. Simon‘s satisfying model and 2. model developed by Cyest and March.
The Simon‘s satisfying model states that firms carry out their operations under
‗bounded rationality‘ and can only attain a satisfactory level of profit, sales and growth. Simon
carried out a research and found that modern business does not have adequate information and is
uncertain about future due to which it is very difficult to attain profit, sales and growth objectives.
The model developed by Cyest and March states that firms should be oriented towards multi-goal and
multi-decisions making. Instead of dealing with uncertainty and inadequate information, the firms
should fulfil the conflicting goals of various stakeholders (such as shareholders, employees,
customers, financiers, government and other social interest groups).

TYPES OF BUSINESS ENTITIES:

I. Sole Proprietorship
The sole trader is the simplest, oldest and natural form of business organization. It is also called sole
proprietorship. ‗Sole‘ means one. ‗Sole trader‘ implies that there is only one trader who is the owner
of the business.
It is a one-man form of organization wherein the trader assumes all the risk of ownership carrying out
the business with his own capital, skill and intelligence. He is the boss for himself. He has total
operational freedom. He is the owner, Manager and controller. He has total freedom and flexibility.
Full control lies with him. He can take his own decisions. He can choose or drop a particular product
or business based on its merits. He need not discuss this with anybody. He is responsible for himself.
This form of organization is popular all over the world. Ex: Restaurants, Supermarkets, pan shops,
medical shops, hosiery shops etc.

Features:
 It is easy to start a business under this form and also easy to close.
 He introduces his own capital. Sometimes, he may borrow, if necessary
 He enjoys all the profits and in case of loss, he lone suffers.
 He has unlimited liability which implies that his liability extends to his personal properties in
case of loss.
 He has a high degree of flexibility to shift from one business to the other.
 Business secretes can be guarded well
 There is no continuity. The business comes to a close with the death, illness or insanity of the
sole trader. Unless, the legal heirs show interest to continue the business, the business cannot
be restored.
 He has total operational freedom. He is the owner, manager and controller.
 He can be directly in touch with the customers.
 He can take decisions very fast and implement them promptly.
 Rates of tax, for example, income tax and so on are comparatively very low.

4
 BEFA UNIT I
Advantages:
1. Easy to start and easy to close: Formation of a sole trader form of organization is relatively
easy even closing the business is easy.

2. Personal contact with customers directly: Based on the tastes and preferences of the
customers the stocks can be maintained.

3. Prompt decision-making: To improve the quality of services to the customers, he can take
any decision and implement the same promptly. He is the boss and he is responsible for his
business Decisions relating to growth or expansion can be made promptly.

4. High degree of flexibility: Based on the profitability, the trader can decide to continue or
change the business, if need be.

5. Secrecy: Business secrets can well be maintained because there is only one trader.

6. Low rate of taxation: The rate of income tax for sole traders is relatively very low.

7. Direct motivation: If there are profits, all the profits belong to the trader himself. In other
words. If he works more hard, he will get more profits. This is the direct motivating factor. At
the same time, if he does not take active interest, he may stand to lose badly also.

8. Total Control: The ownership, management and control are in the hands of the sole trader
and hence it is easy to maintain the hold on business.

9. Minimum interference from government: Except in matters relating to public interest,

government does not interfere in the business matters of the sole trader. The sole trader is free
to fix price for his products/services if he enjoys monopoly market.
10.Transferability: The legal heirs of the sole trader may take the possession of the business.

Disadvantages:
1. Unlimited liability: The liability of the sole trader is unlimited. It means that the sole trader
has to bring his personal property to clear off the loans of his business. From the legal point of
view, he is not different from his business.

2. Limited amounts of capital: The resources a sole trader can mobilize cannot be very large
and hence this naturally sets a limit for the scale of operations.

3. No division of labour: All the work related to different functions such as marketing,
production, finance, labour and so on has to be taken care of by the sole trader himself. There
is nobody else to take his burden. Family members and relatives cannot show as much interest
as the trader takes.

4. Uncertainty: There is no continuity in the duration of the business. On the death, insanity of
insolvency the business may be come to an end.

5. Inadequate for growth and expansion: This from is suitable for only small size, one-man-
show type of organizations. This may not really work out for growing and expanding
organizations.

6. Lack of specialization: The services of specialists such as accountants, market researchers,

consultants and so on, are not within the reach of most of the sole traders.

7. More competition: Because it is easy to set up a small business, there is a high degree of
competition among the small businessmen and a few who are good in taking care of customer
requirements along can service.

8. Low bargaining power: The sole trader is the in the receiving end in terms of loans or
supply of raw materials. He may have to compromise many times regarding the terms and
conditions of purchase of materials or borrowing loans from the finance houses or banks.
5
 BEFA UNIT I
II. Partnership

Partnership is an improved from of sole trader in certain respects. Where there are like-minded
persons with resources, they can come together to do the business and share the profits/losses of the
business in an agreed ratio. Persons who have entered into such an agreement are individually called
‗partners‘ and collectively called ‗firm‘. The relationship among partners is called a partnership.
Indian Partnership Act, 1932 defines partnership as the relationship between two or more persons who
agree to share the profits of the business carried on by all or any one of them acting for all.

Features
1. Relationship: Partnership is a relationship among persons. It is relationship resulting out of
an agreement.
2. Two or more persons: There should be two or more number of persons.
3. There should be a business: Business should be conducted.
4. Agreement: Persons should agree to share the profits/losses of the business
5. Carried on by all or any one of them acting for all: The business can be carried on by all or
any one of the persons acting for all. This means that the business can be carried on by one
person who is the agent for all other persons. Every partner is both an agent and a principal.
6. Unlimited liability: The liability of the partners is unlimited. The partnership and partners, in
the eye of law, and not different but one and the same. Hence, the partners have to bring their
personal assets to clear the losses of the firm, if any.
7. Number of partners: According to the Indian Partnership Act, the minimum number of
partners should be two and the maximum number if restricted, as given below:
 10 partners is case of banking business
 20 in case of non-banking business
8. Division of labour: Because there are more than two persons, the work can be divided among
the partners based on their aptitude.
9. Personal contact with customers: The partners can continuously be in touch with the
customers to monitor their requirements.
10.Flexibility: All the partners are likeminded persons and hence they can take any decision
relating to business.

Partnership Deed
The written agreement among the partners is called ‗the partnership deed‘. It contains the terms and
conditions governing the working of partnership. The following are contents of the partnership deed.
1. Names and addresses of the firm and partners
2. Nature of the business proposed
3. Duration
4. Amount of capital of the partnership and the ratio for contribution by each of the partners.
5. Their profit sharing ration (this is used for sharing losses also)
6. Rate of interest charged on capital contributed, loans taken from the partnership and the
amounts drawn, if any, by the partners from their respective capital balances.
7. The amount of salary or commission payable to any partner
8. Procedure to value good will of the firm at the time of admission of a new partner, retirement
of death of a partner
9. Allocation of responsibilities of the partners in the firm
10.Procedure for dissolution of the firm
11.Name of the arbitrator to whom the disputes, if any, can be referred
to for settlement.
12.Special rights, obligations and liabilities of partners(s), if any.

6
 BEFA UNIT I
Kind Of Partners:
1. Active Partner: Active partner takes active part in the affairs of the partnership. He is also
called working partner.

2. Sleeping Partner: Sleeping partner contributes to capital but does not take part in the affairs
of the partnership.

3. Nominal Partner: Nominal partner is partner just for namesake. He neither contributes to
capital nor takes part in the affairs of business. Normally, the nominal partners are those who
have good business connections, and are well places in the society.

4. Partner by Estoppels: Estoppels means behavior or conduct. Partner by estoppels gives an

impression to outsiders that he is the partner in the firm. In fact be neither contributes to
capital, nor takes any role in the affairs of the partnership.

5. Partner by holding out: If partners declare a particular person (having social status) as
partner and this person does not contradict even after he comes to know such declaration, he
is called a partner by holding out and he is liable for the claims of third parties. However, the
third parties should prove they entered into contract with the firm in the belief that he is the
partner of the firm. Such a person is called partner by holding out.

6. Minor Partner: Minor has a special status in the partnership. A minor can be admitted for
the benefits of the firm. A minor is entitled to his share of profits of the firm. The liability of a
minor partner is limited to the extent of his contribution of the capital of the firm.

Advantages
1. Easy to form: Once there is a group of like-minded persons and good business proposal, it is
easy to start and register a partnership.
2. Availability of larger amount of capital: More amount of capital can be raised from more
number of partners.

3. Division of labour: The different partners come with varied backgrounds and skills. This
facilities division of labour.

4. Flexibility: The partners are free to change their decisions, add or drop a particular product or
start a new business or close the present one and so on.

5. Personal contact with customers: There is scope to keep close monitoring with customers
requirements by keeping one of the partners in charge of sales and marketing. Necessary
changes can be initiated based on the merits of the proposals from the customers.

6. Quick decisions and prompt action: If there is consensus among partners, it is enough to
implement any decision and initiate prompt action. Sometimes, it may more time for the
partners on strategic issues to reach consensus.

7. The positive impact of unlimited liability: Every partner is always alert about his
impending danger of unlimited liability. Hence he tries to do his best to bring profits for the
partnership firm by making good use of all his contacts.

Disadvantages:
1. Formation of partnership is difficult: Only like-minded persons can start a partnership. It is
sarcastically said,‘ it is easy to find a life partner, but not a business partner‘.

2. Liability: The partners have joint and several liabilities beside unlimited liability. Joint and
several liability puts additional burden on the partners, which means that even the personal
properties of the partner or partners can be attached. Even when all but one partner become
insolvent, the solvent partner has to bear the entire burden of business loss.

7
 BEFA UNIT I
3. Lack of harmony or cohesiveness: It is likely that partners may not, most often work as a
group with cohesiveness. This result in mutual conflicts. Lack of harmony results in delay in
decisions and paralyses the entire operations.

4. Limited growth: The resources when compared to sole trader, a partnership may raise little
more. But when compare to the other forms such as a company, resources raised in this form
of organization are limited. Added to this, there is a restriction on the maximum number of
partners.

5. Instability: The partnership form is known for its instability. The firm may be dissolved on
death, insolvency or insanity of any of the partners.

6. Lack of Public confidence: Public and even the financial institutions look at the unregistered
firm with a suspicious eye. Though registration of the firm under the Indian Partnership Act is
a solution of such problem, this cannot revive public confidence into this form of organization
overnight. The partnership can create confidence in other only with their performance.

III. Joint Stock Company

The joint stock company emerges from the limitations of partnership such as joint and several
liability, unlimited liability, limited resources and uncertain duration and so on. Normally, to take part
in a business, it may need large money and we cannot foretell the fate of business. It is not literally
possible to get into business with little money. Against this background, it is interesting to study the
functioning of a joint stock company. The main principle of the joint stock company from is to
provide opportunity to take part in business with a low investment as possible say Rs.1000. Joint
Stock Company has been a boon for investors with moderate funds to invest.

Company Defined
Lord justice Lindley explained the concept of the joint stock company from of organization as „an
association of many persons who contribute money or money‟s worth to a common stock and
employ it for a common purpose‟.
Features

1. Artificial person: The Company has no form or shape. It is an artificial person created by
law. It is intangible, invisible and existing only, in the eyes of law.

2. Separate legal existence: it has an independence existence, it separate from its members. It
can acquire the assets. It can borrow for the company. It can sue other if they are in default in
payment of dues, breach of contract with it, if any. Similarly, outsiders for any claim can sue
it.

3. Voluntary association of persons: The Company is an association of voluntary association

of persons who want to carry on business for profit. To carry on business, they need capital.
So they invest in the share capital of the company.

4. Limited Liability: The shareholders have limited liability i.e., liability limited to the face
value of the shares held by him.

5. Capital is divided into shares: The total capital is divided into a certain number of units.
Each unit is called a share.

6. Transferability of shares: In the company form of organization, the shares can be transferred
from one person to the other. A shareholder of a public company can sell his holding of shares
at his will. However, the shares of a private company cannot be transferred.

7. Common Seal: As the company is an artificial person created by law has no physical form, it
cannot sign its name on a paper; so, it has a common seal on which its name is engraved. The
common seal should affix every document or contract.

8
 BEFA UNIT I
8. Perpetual succession: ‗Members may comes and members may go, but the company
continues for ever.

9. Ownership and Management separated: The shareholders are spread over the length and
breadth of the country, and sometimes, they are from different parts of the world. To
facilitate administration, the shareholder select some among themselves directors to a Board,
which looks after the management of the business. The Board recruits the managers and
employees at different levels in the management. Thus the management is separated from the
owners.

10.Winding up: Winding up refers to the putting an end to the company. Because law creates it,
only law can put an end to it. The company is not affected by the death or insolvency of any
of its members.

11.The name of the company ends with „limited‟: it is necessary that the name of the company
ends with limited (Ltd.) to give an indication to the outsiders that they are dealing with the
company with limited liability and they should be careful about the liability aspect of their
transactions with the company.

Advantages

1. Mobilization of larger resources: A joint stock company provides opportunity for the
investors to invest, even small sums, in the capital of large companies. The facilities rising of
larger resources.

2. Separate legal entity: The Company has separate legal entity. It is registered under Indian
Companies Act, 1956.

3. Limited liability: The shareholder has limited liability in respect of the shares held by him. In
no case, does his liability exceed more than the face value of the shares allotted to him.

4. Transferability of shares: The shares can be transferred to others. However, the private
company shares cannot be transferred.

5. Liquidity of investments: By providing the transferability of shares, shares can be converted

into cash.

6. Inculcates the habit of savings and investments: Because the share face value is very low,
this promotes the habit of saving among the common man and mobilizes the same towards
investments in the company.
7. Democracy in management: the shareholders elect the directors in a democratic way in the
general body meetings.

8. Continued existence: The Company has perpetual succession. It has no natural end. It
continues forever and ever unless law put an end to it.

9. Growth and Expansion: With large resources and professional management, the company
can earn good returns on its operations, build good amount of reserves and further consider
the proposals for growth and expansion.

Disadvantages
1. Formation of company is a long drawn procedure: Promoting a joint stock company
involves a long drawn procedure. It is expensive and involves large number of legal
formalities.

2. High degree of government interference: The government brings out a number of rules and
regulations governing the internal conduct of the operations of a company such as meetings,
voting, audit and so on, and any violation of these rules results into statutory lapses,
punishable under the companies act.
9
 BEFA UNIT I

3. Inordinate delays in decision-making: As the size of the organization grows, the number of
levels in organization also increases in the name of specialization. The more the number of
levels, the more is the delay in decision-making.

4. Lack or initiative: In most of the cases, the employees of the company at different levels
show slack in their personal initiative with the result, the opportunities once missed do not
recur and the company loses the revenue.

5. Lack of responsibility and commitment: In some cases, the managers at different levels are
afraid to take risk and more worried about their jobs rather than the huge funds invested in the
capital of the company lose the revenue.

IV. Limited Liability Company (LLC)

Limited Liability Company is another category of company registered under the Indian New
Companies Act, 2013. There are number of companies available in India including private limited and
public limited ones but Limited Liability Company is a brand new one in the line. It's often called as a
Limited Liability Corporation and its nature of business is quite similar with partnership firm and sole
trade business. Company is an association of persons or an artificial person formed under the Indian
Companies act in order to carry out a certain business. Under the Limited Liability Company Act,
liability is limited among members or partners.
New Companies Act, 2013 has defined all rules and regulations regarding incorporating and
registering all limited liability companies. One should apply to the Registrar of Companies (ROC) by
giving all the details regarding company including name of the company, name and address of board
of directors, location of the company as per the company registration services.
A private company whose owners are legally responsible for its debts only to the extent of the amount
of capital they invested. A Limited Liability Company, also known as an LLC, is a type of business
structure that combines traits of both a sole-proprietorship and a company. An LLC is eligible for
the pass-through taxation feature of a partnership or sole proprietorship, while at the same time
limiting the liability of the owners, similar to a company. As the LLC is not considered a separate
entity, the company does not pay taxes or take on losses. Instead, this is done by the owners as they
have to report the business profits, or losses, on their personal income tax returns. However, just like
company, members of an LLC are protected from personal liabilities, thus the name Limited Liability.

A limited liability company is an U.S. form of privately owned company that combines the limited
liability of a company with the simplified taxation of a sole proprietorship or partnership. Owners of a
limited liability company, referred to as an ―LLC,‖ report the company‘s profits and losses on their
personal income tax returns, rather than preparing separate corporate tax returns. This is known as
―pass-through taxation.‖ LLC owners are referred to as ―members,‖ and the company may be owned by
a single individual, two or more individuals, or by a company or another LLC.

Features
1. Limited liability: As the name implies, members‘ liabilities for the debts and obligations of
the LLC are limited to their own investment.

2. Pass-through taxation: For taxation purposes, income from your business can be treated as
your own personal income, and is therefore not subject to certain corporate taxes for which
companies are liable.

3. Separate Legal Entity: A LLP is a legal entity and a juristic person established under the
Act. Therefore, a LLP has wide legal capacity and can own property and also incur debts.
However, the Partners of a LLP have no liability to the creditors of a LLP for the debts of the
LLP.

4. Uninterrupted Existence: A LLP has 'perpetual succession', that is continued or

uninterrupted existence until it is legally dissolved. A LLP being a separate legal person, is
unaffected by the death or other departure of any Partner. Hence, a LLP continues to be in
existence irrespective of the changes in ownership.
10
 BEFA UNIT I

5. Audit not Required: A LLP does not require audit if it has less than Rs.
40 lakhs of turnover and less than Rs.25 lakhs of capital contribution. Therefore, LLPs are
ideal for startups and small businesses that are just starting their operations and want to have
minimal regulatory compliance related formalities.

6. Easy Transferability: The ownership of a LLP can be easily transferred to another person
by inducting them as a Partner of the LLP. LLP is a separate legal entity separate from its
Partners, so by changing the Partners, the ownership of the LLP can be changed.

7. Owning Property: A LLP being an artificial judicial person, can acquire, own, enjoy and
sell, property in its name. No Partner can make any claim upon the property of the LLP - so
long as the LLP is a going concern.

Advantages
1. Limited liability: As the name implies, members‘ liabilities for the debts and obligations of
the LLC are limited to their own investment.

2. Pass-through taxation: For taxation purposes, income from your business can be treated as
your own personal income, and is therefore not subject to certain corporate taxes for which
companies are liable.

3. Limitless ownership: Some legal structures limit the number of people allowed to file as
owners. With an LLC, there is no limit to the number of owners. An LLC can have one
member or hundreds of members.

4. Allocation flexibility: In an LLC, the amount of money that owners invest into the business
doesn‘t need to equal their percentage of ownership. When an LLC is formed, members create
an operating agreement, in which different percentages of company profits and losses can be
assigned to owners regardless of the amounts of their initial investments.

5. Freedom in management: Unlike standard companies, LLCs are not required to have a
board of directors, annual meetings, or strict book requirements. This can free up a lot of time
and stress to let you run your business on your own terms. As you can imagine, this can be an
important advantage of a limited liability company as well.

Disadvantages

1. Building capital: Unlike companies, which can issue stock in order to

increase funds for their companies, LLCs have to work a little harder to
find investors and sources of capital due to the greater legal obligations to
add a new member to an LLC. If you have a fast growth internet company
that needs venture capital to scale, this limitation is one of the major
disadvantages of a limited liability company.

2. Higher fees: LLCs must typically pay more fees to file as LLCs compared
to some other business entities or sole proprietorships.

3. Government regulation: Because of the protections afforded to LLCs,

some types of businesses are ineligible to file as LLCs. Banks, insurance

11
 BEFA UNIT I
companies, and medical service companies are examples of businesses
that may be barred from filing.

4. Lack of case law: The LLC business form is a relatively new concept. As
a result, not a lot of cases have been decided surrounding LLCs. Case law
is important because of predictability. If you know a court has ruled a
certain way, you can act accordingly to protect yourself.

5. Confusion About Roles: Whereas corporations have specific roles (like

directors, managers, and employees), LLCs generally do not. This can
make it difficult for the company and especially investors to know who‘s in
charge, who can sign certain contracts, etc. Some of this confusion can be
avoided by creating an LLC Operating Agreement.

6. Limited Life: In many jurisdictions, if a member departs the LLC, the LLC
ceases to exist. This is unlike a corporation whose identity is unaffected by
the comings and goings of shareholders. Members of LLCs can combat this
weakness in the Operating Agreement.

SOURCES OF RAISING CAPITAL

Sources of raising long-term capital:

1) Issue of Shares: The amount of capital decided to be raised from members of the public is
divided into units of equal value. These units are known as share and the aggregate values of
shares are known as share capital of the company. Those who subscribe to the share capital
become members of the company and are called shareholders. They are the owners of the
company.

a) Issue of Preference Shares: Preference share have three distinct characteristics.

Preference shareholders have the right to claim dividend at a fixed rate, which is decided
according to the terms of issue of shares. Moreover, the preference dividend is to be paid
first out of the net profit. The balance, it any, can be distributed among other shareholders
that is, equity shareholders. However, payment of dividend is not legally compulsory.
Only when dividend is declared, preference shareholders have a prior claim over equity
shareholders. Preference shareholders also have the preferential right of claiming
repayment of capital in the event of winding up of the company. Preference capital has to
be repaid out of assets after meeting the loan obligations and claims of creditors but
before any amount is repaid to equity shareholders.

b) Issue of Equity Shares: The most important source of raising long- term capital for a
company is the issue of equity shares. In the case of equity shares there is no promise to
shareholders a fixed dividend. But if the company is successful and the level profits are
high, equity shareholders enjoy very high returns on their investment. This feature is very
attractive to many investors even though they run the risk of having no return if the
profits are inadequate or there is loss. They have the right of control over the management
of the company and their liability is limited to the value of shares held by them.

12
 BEFA UNIT I
2) Issue of Debentures: When a company decides to raise loans from the public, the amount of
loan is divided into units of equal. These units are known as debentures. A debenture is the
instrument or certificate issued by a company to acknowledge its debt. Those who invest
money in debentures are known as ‗debenture holders‘. They are creditors of the company.
Debentures carry a fixed rate of interest, and generally are repayable after a certain period.

3) Loans from financial Institutions: Government with the main object of promoting industrial
development has set up a number of financial institutions. These institutions play an important
role as sources of company finance. These institutions provide medium and long-term finance
to industrial enterprises at a reason able rate of interest. Thus companies may obtain direct
loan from the financial institutions for expansion or modernization of existing manufacturing
units or for starting a new unit.

4) Retained Profits: Successful companies do not distribute the whole of their profits as
dividend to shareholders but reinvest a part of the profits. The amount of profit reinvested in
the business of a company is known as retained profit.
5) Public Deposits: An important source of medium – term finance which companies make use
of is public deposits. This requires advertisement to be issued inviting the general public of
deposits. Against the deposit, the company mentioning the amount, rate of interest, time of
repayment and such other information issues a receipt.

Sources of raising short-term capital:

1) Trade credit: Trade credit is a common source of short-term finance available to all
companies. It refers to the amount payable to the suppliers of raw materials, goods etc. after
an agreed period, which is generally less than a year. It is customary for all business firms to
allow credit facility to their customers in trade business. Thus, it is an automatic source of
finance.

2) Bank loans and advances: Money advanced or granted as loan by commercial banks is
known as bank credit. Companies generally secure bank credit to meet their current operating
expenses. The most common forms are cash credit and overdraft facilities. Under the cash
credit arrangement, the maximum limit of credit is fixed in advance on the security of goods
and materials in stock.

3) Overdraft: In the case of overdraft, the company is allowed to overdraw its current account
up to the sanctioned limit. This facility is also allowed either against personal security or the
security of assets. Interest is charged on the amount actually overdrawn, not on the sanctioned
limit.

4) Discounting of Bills: Commercial banks also advance money by discounting bills of

exchange. A company having sold goods on credit may draw bills of exchange on the
customers for their acceptance. A bill is an order in writing requiring the customer to pay the
specified amount after a certain period (say 60 days or 90 days). After acceptance of the bill,
the company can drawn the amount as an advance from many commercial banks on payment
of a discount. The amount of discount, which is equal to the interest for the period of the bill,
and the balance, is available to the company. Bill discounting is thus another source of short-
term finance available from the commercial banks.

5) Short term loans from finance companies: Short-term funds may be available from finance
companies on the security of assets. Some finance companies also provide funds according to
the value of bills receivable or amount due from the customers of the borrowing company,
which they take over.

13
 BEFA UNIT I
NON-CONVENTIONAL SOURCES OF FINANCE

1. Venture capital

Venture capital is financing that investors provide to start-up companies and small businesses that are
believed to have long-term growth potential. Venture capital generally comes from venture capital
firms, which comprise of professionally well-off investors, investment banks and any other financial
institutions. However, it does not always take just a monetary form; it can be provided in the form of
technical or managerial expertise.
Though it can be risky for the investors who put up the funds, the potential for above-average returns
is an attractive payoff. For new companies or ventures that have a limited operating history (under
two years), venture capital funding is increasingly becoming a popular – even essential – source for
raising capital, especially if they lack access to capital markets, bank loans or other debt instruments.
The main downside is that the investors usually get equity in the company, and thus a say in company
decisions.
In a venture capital deal, large ownership chunks of a company are created and sold to a few investors
through independent limited partnerships that are established by venture capital firms. Sometimes
these partnerships consist of a pool of several similar enterprises. One important difference between
venture capital and other private equity deals, however, is that venture capital tends to focus on
emerging companies seeking substantial funds for the first time , while private equity tends to fund
larger, more established companies that are seeking an equity infusion or a chance for company
founders to transfer some of their ownership stake.

2. Angel Investors
An angel investor is a person who invests in a business venture, providing capital for start-up or
expansion. Angel investors are typically individuals who have spare cash available and are looking for
a higher rate of return than would be given by more traditional investments. An angel investment is a
form of equity financing - the investor supplies funding in exchange for taking an equity position in
the company.

3. Private Equity
Private equity is capital that is not noted on a public exchange. Private equity is composed of funds
and investors that directly invest in private companies, or that engage in buyouts of public companies,
resulting in the delisting of public equity. Institutional and retail investors provide the capital for
private equity, and the capital can be utilized to fund new technology, make acquisitions, expand
working capital, and to bolster and solidify a balance sheet.
Private equity comes primarily from institutional investors and accredited investors, who can dedicate
substantial sums of money for extended time periods. In most cases, considerably long holding
periods are often required for private equity investments, in order to ensure a turnaround for distressed
companies or to enable liquidity events such as an initial public offering (IPO) or a sale to a public
company.

4. IPO
An initial public offering, or IPO, is the very first sale of stock issued by a company to the public.
Prior to an IPO the company is considered private, with a relatively small number of shareholders
made up primarily of early investors (such as the founders, their families and friends) and professional
investors (such as venture capitalists or angel investors). The public, on the other hand, consists of
everybody else – any individual or institutional investor who wasn‘t involved in the early days of the
company and who is interested in buying shares of the company. Until a company‘s stock is offered
for sale to the public, the public is unable to invest in it. You can potentially approach the owners of a
private company about investing, but they're not obligated to sell you anything. Public companies, on
the other hand, have sold at least a portion of their shares to the public to be traded on a stock
exchange. This is why an IPO is also referred to as "going public."

14
 BEFA UNIT I
ECONOMICS

INTRODUCTION

The English word economics is derived from the ancient Greek word oikonomikos—meaning the
management of a family or a household. Economics is the study of how individuals and societies
make decisions about way to use scarce resources to fulfil wants and needs. Economics deals with
individual choice, money and borrowing, production and consumption, trade and markets,
employment and occupations, asset pricing, taxes and much more.
As an individual, for example, you constantly face the problem of having limited resources with
which to fulfil your wants and needs. As a result, you must make certain choices with your money –
what to spend it on, what not to spend it on, and how much to save for the future. You'll probably
spend part of your money on relative necessities such as rent, electricity, clothing and food. Then you
might use the rest to go to the movies, dine out or buy a smart phone. Economists are interested in the
choices you make, and investigate why, for instance, you might choose to spend your money on a new
mobile phone instead of replacing your old pair of shoes. The underlying essence of economics is
trying to understand how individuals, companies, and nations as a whole behave in response to certain
material constraints.

DEFINITIONS
1. Adam Smith‟s Definition:- Adam Smith, considered to be the founding father of modern
Economics, defines Economics as “the study of the nature and causes of nations‟ wealth or
simply as the study of wealth”. The central point in Smith‘s definition is wealth creation. He
assumed that, the wealthier a nation becomes the happier are its citizens. Thus, it is important to
find out, how a nation can be wealthy. Economics is the subject that tells us how to make a nation
wealthy. Adam Smith‘s definition is a wealth-centred definition of Economics.
2. Alfred Marshall‟s Definition:- Alfred Marshall also stressed the importance of wealth. But he
also emphasised the role of the individual in the creation and the use of wealth. He defines:
“Economics is a study of man in the ordinary business of life. It enquires how he gets his
income and how he uses it. Thus, it is on the one side, the study of wealth and on the other and
more important side, a part of the study of man”.
3. Lionel Robbins‟ Definition:- In his book „Essays on the Nature and Significance of the
Economic Science‟, published in 1932, Robbins gave a definition which has become one of the
most popular definitions of Economics. According to Robbins, “Economics is a science which
studies human behaviour as a relationship between ends and scarce means which have
alternative uses”.

SIGNIFICANCE OF ECONOMICS
1. Allows to know the basics of human needs, production, distribution, reuse and better use of
resources.
2. It provides the basis for exchange of goods and services between individuals, organizations
and even countries.
3. Generates systems, techniques and public policies to improve social welfare.
4. Help to set target prices of goods and services.
5. Adjust political, financial and even social imbalances.
6. Provides knowledge and techniques that prevent crises and help them out.
7. It uses econometric techniques to predict future economic conditions that could harm or
benefit certain situations in ascertain place, and how to maximize the benefits and problems
mystify.
8. As you can see, economics is a science that encompasses us completely.
9. To be an expert in this field you can study a university degree in economics, in this course the
student will learn how the economy moves and how to generate the best social conditions.

15
 BEFA UNIT I
MICRO AND MACRO ECONOMICS
The whole economic theory is broadly divided into two parts – Micreconomics and Macro
economics.These two terms were at first used by Ragner Frisch in 1933. But these two words became
popular worldwide and most of the economist using nowadays. The term ‗micro‘ and ‗macro‘ were
derived from Greek words ‗Mikros‘ and‗Makros‘ meaning ‗small‘ and ‗large‘ respectively. So micro
economics deals with the analysis of an individual unit and macro economics with economy as a whole.
For example, in micro economics we study how price of goods or factors of production are determined. In
macro economics we study what are the causes of high or low level of employment.So, according to
Edwin Mansfield – ―Micro economics deals with the economic behaviour of individual units such as
consumers, firms, and resource owners; while macro economics deals with behaviour of economic
aggregates such as gross national product and the level of employment.

Meaning of Micro – economics

The term micro was originated from Greek word ‗Mikros‘ which means small. Hence,
microeconomics is concerned on small economic units like as individual consumer, households, firms,
industry etc.
Microeconomics may be defined as the branch of economic analysis which studies about the
economic behaviour of individual economic unit may be a person, a particular households, a particular
firm and an industry. The main objective of micro – economics is to explain the principles, problems
and policies related to the optimum allocation of resources. According to K. E. Boulding,
―Microeconomics is the study of particular firm, particular households, individual price, wage,
income of the industry and particular commodity‖.
It is the study of individual tree not a whole forest. Hence, microeconomics tries to explain how an
individual allocates his money income among various needs as well as how an individual maximize
satisfaction level from the consumption of available limited resources. Microeconomics also explains
about the process of determination of individual price with interaction of demand and supply. It helps
to determine the price of the product and factor inputs. Therefore, it is also called as price theory or
demand and supply theory. Simply microeconomics is microscopic study of the economy.

Meaning of Macro - economics

The term macro- economics is derived from Greek word ― Makros‖, which means― big‖. Hence, macro-
economics studies not individual units but all the units combined together or the economy as a whole.
Since it studies the economy in aggregate. It studies national income, national output, general price
level, total employment, total savings, total investment and so on. It is also called ―aggregate
economics‖ or the ―income theory‖.

According to K.E. Boulding –‖ Macro- economics deals not with individual quantities but with
aggregate of these quantities, not with individual incomes, but with national income, not with
individual prices but with price level, not with individual output but with national output.‖

J.M. Keynes made and outstanding contribution in the development of macro- economics. It is also
known as Keynesian Phenomenon.

NATIONAL INCOME
In every country goods and services are produced in agriculture sector, industrial sector and service
sector. The total value of final goods and services produced in a country in a year is called national
income. National income was first calculated in India by Dadabai Noaroji in 1876. In our country
national income is calculated every year by Central Statistical Organization (CSO).It includes
payments made to all resources in the form of wages, interest, rent and profits.
According to Marshall: ―The labour and capital of a country acting on its natural resources produce
annually a certain net aggregate of commodities, material and immaterial including services of all
kinds. This is the true net annual income or revenue of the country or national dividend.‖ In this
definition, the word ‗net‘ refers to deductions from the gross national income in respect of
depreciation and wearing out of machines. And to this, must be added income from abroad.

16
 BEFA UNIT I

Land, Labour, Capital, Organization

Rent, Wages, Interest, Profits

HOUSEHOLDS BUSINESS
FIRMS
Goods and Services

Payment for goods and services

Circular Flow of National Income :-

National income is a flow of money payments resulting from the productive resources of a country
during a year. It has the concept of circular flow in this sense that the economic transactions which are
made in a country during a particular year appears in different ways. The expenditure of one person is
the income of another person, and his expenditure is also equal to value of goods and services. To
explain this idea we assume that there is economy where are only two sectors in the economy.
1. Firms.
2. Households.
Firms are required to produce goods. Households own the various factors of production. Firms require
the services of households to produce goods. The firms hire the services of households to produce
goods. These goods are again supplied to the households. When households sector purchases the
goods it makes the payments. Similarly firms make the payment in the shape of rent, wages, and
interest to the households against their services.
In this way the sum of prices of the goods and services must be equal to the sum of the reward for the
services of factors of production.
So income flows from firms to households in exchange for these services and again the expenditure
flows from households to firms. The goods which are produced by the firms these are purchased by
the household. The flow of income flows from firms to household and flow of expenditure from
household to firms will be equal. This is called circular flow of national income.

National income can be calculated on the basis of:

1. Flow of goods and services
2. Flow of income
3. Flow of expenditure on goods and services
CONCEPTS OF NATIONAL INCOME

There are various concepts of National Income. The main concepts of NI are: GDP, GNP, NNP, NI,
PI, DI, and PCI. These different concepts explain about the phenomenon of economic activities of the
various sectors of the economy.

1. Gross Domestic Product (GDP)

Gross domestic product- the market value of all final goods and services produced in a country during
a specific period of time which is usually one year.
GDP is measured using market values, and not quantities. Production is measured in quantities, but
then those quantities have to be changed to account for their value. In economics we use prices to
place values on the final goods, so total production times price will give us the total value. Final
goods and services vs intermediate goods or services. A product is a final good or service when it is
purchased by the final user. Intermediate products are used as an input to produce another good or
service such as sugar being purchased to make soda. Sugar is an intermediate good, while soda is a
final good.

17
 BEFA UNIT I
GDP only includes the value of final goods, intermediate goods are not included. GDP only includes
current production, and ignores the sale of used goods. If you purchase a bike in 2011, then that
purchase is included in 2011 GDP measure, not 2010 or 2012. Also, if you sell that bike at any time in
the future, the sale of that bike is not included in GDP.
An equation for GDP and some actual values:
GDP = C + I + G + NX
The GDP equation shows us that GDP is equal to consumption expenditure (C) plus investment
expenditure (I) plus government expenditure (G) plus net exports (NX = Exports - Imports).

2. Gross National Product (GNP)

Gross National Product is the total market value of all final goods and services produced annually in a
country plus net factor income from abroad. Thus, GNP is the total measure of the flow of goods and
services at market value resulting from current production during a year in a country including net
factor income from abroad. The GNP can be expressed as the following equation:

GNP=GDP+NFIA (Net Factor Income from Abroad)

NFIA = Income earned by Indians in abroad through jobs or businesses – Income earned by
foreigners in India by jobs or businesses.

3. Net National Product (NNP)

Net National Product is the market value of all final goods and services after allowing for
depreciation. It is also called National Income at market price. When charges for depreciation are
deducted from the gross national product, we get it. Thus,

NNP=GNP-Depreciation
4. National Income (NI)
National Income is also known as National Income at factor cost. National income at factor cost
means the sum of all incomes earned by resources suppliers for their contribution of land, labor,
capital and organizational ability which go into the years net production. Hence, the sum of the
income received by factors of production in the form of rent, wages, interest and profit is called
National Income. Symbolically,

NI=NNP + Subsidies given by Govt. - Indirect Taxes

5. Personal Income (PI)

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

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

Transfer Payments

6. Disposable Income (DI)

The income left after the payment of direct taxes from personal income is called Disposable Income.
Disposable income means actual income which can be spent on consumption by individuals and
families. Thus, it can be expressed as:

DI=PI-Direct Taxes

7. Per Capita Income (PCI)

Per Capita Income (average income) of a country is derived by dividing the national income of the
country by the total population of a country. Thus,

PCI=Total National Income/Total National Population

18
 BEFA UNIT I
IMPORTANCE OF NATIONAL INCOME

The following points highlight the top eleven reasons for growing importance of national income
studies in recent years.

1. Economic Policy:
Economic policy refers to the actions which Govt. Takes in the economic feild such as Tax policy,
Money supply policy, Interest rate policy etc. National income figures are an important tool of
macroeconomic analysis and policy.
National income estimates are the most comprehensive measures of aggregate economic activity in an
economy. It is through such estimates that we know the aggregate yield of the economy and can lay
down future economic policy for development.

2. Economic Planning:
National income statistics are the most important tools for long-term and short- term economic
planning. A country cannot possibly frame a plan without having a prior knowledge of the trends in
national income. The Planning Commission in India also kept in view the national income estimates
before formulating the five-year plans.

3. Economy‟s Structure:
National income statistics enable us to have clear idea about the structure of the economy. It enables
us to know the relative importance of the various sectors of the economy and their contribution
towards national income. From these studies we learn how income is produced, how it is distributed,
how much is spent, saved or taxed.
4. Inflationary and Deflationary Gaps:
Inflationary gap means the amount by which the total demand is higher than the total supply.
Deflationary gap means the amount by which the total demand is less than the total supply. National
income and national product figures enable us to have an idea of the inflationary and deflationary
gaps. For accurate and timely anti- inflationary and deflationary policies, we need regular estimates of
national income.

5. Budgetary Policies:
Modern governments try to prepare their budgets within the framework of national income data and
try to formulate anti-cyclical policies according to the facts revealed by the national income estimates.
Even the taxation and borrowing policies are so framed as to avoid fluctuations in national income.

6. National Expenditure:
National income studies show how national expenditure is divided between consumption expenditure
and investment expenditure. It enables us to provide for reasonable depreciation to maintain the
capital stock of a community. Too liberal allowance of depreciation may prove harmful as it may
unnecessarily lead to a reduction in consumption.

7. Distribution of Grants-in-aid:
National income estimates help a fair distribution of grants-in-aid by the federal governments to the
state governments and other constituent units.

8. Standard of Living Comparison:

National income studies help us to compare the standards of living of people in different countries and
of people living in the same country at different times.

9. International Sphere:
National income studies are important even in the international sphere as these estimates not only help
us to fix the burden of international payments equitably amongst different nations but also enable us
to determine the subscriptions and quotas of different countries to international organisations like the
UNO, IMF, IBRD. etc.

19
 BEFA UNIT I
10. Defense and Development:
National income estimates help us to divide the national product between defence and development
purposes. From such figures we can easily know how much can be spared for war by the civilian
population.

11. Public Sector:

National income figures enable us to know the relative roles of public and private sectors in the
economy. If most of the activities are performed by the state, we can easily conclude that public sector
is playing a dominant role.

INFLATION
Inflation is defined as a sustained increase in the general level of prices for goods and services in a
county, and is measured as an annual percentage change. Under conditions of inflation, the prices of
things rise over time. Put differently, as inflation rises, every rupee you own buys a smaller
percentage of a good or service. When prices rise, and alternatively when the value of money falls you
have inflation.
The value of a rupee (or any unit of money) is expressed in terms of its purchasing power,
which is the amount of real, tangible goods or actual services that money can buy at a moment in
time. When inflation goes up, there is a decline in the purchasing power of money. For example, if the
inflation rate is 2% annually, then theoretically a Rs.1 chocolate will cost Rs.1.02 in a year. After
inflation, your rupee does not go as far as it did in the past.

FEATURES OF INFLATION
Following are the main features of inflation:

1. Inflation is always accompanied by a rise in the price level. It is a process of uninterrupted

increase in prices.

2. Inflation is a monetary phenomenon and it is generally caused by excessive money supply.

3. Inflation is essentially an economic phenomenon as it originates in the economic system and
is the result of action and interaction of economic forces.

4. Inflation is a dynamic process as observed over the long period.

5. A cyclical movement of prices is not inflation.

6. Pure inflation starts after full employment.

7. Inflation may be demand-pull or cost-push.

TYPES OF INFLATION
1. Creeping Inflation: This is also known as mild inflation or moderate inflation. This type of
inflation occurs when the price level persistently rises over a period of time at a mild rate.
When the rate of inflation is less than 10 per cent annually, or it is a single digit inflation rate, it
is considered to be a moderate inflation.

2. Galloping Inflation: If mild inflation is not checked and if it is uncontrollable, it may assume
the character of galloping inflation. Inflation in the double or triple digit range of 20, 100 or 200
percent a year is called galloping inflation . Many Latin American countries such as Argentina,
Brazil had inflation rates of 50 to 700 percent per year in the 1970s and 1980s.

3. Hyperinflation: It is a stage of very high rate of inflation. While economies seem to survive
under galloping inflation, a third and deadly strain takes hold when the cancer of hyperinflation
strikes. Nothing good can be said about a market economy in which prices are rising a million
or even a trillion percent per year . Hyperinflation occurs when the prices go out of control and
the monetary authorities are unable to impose any check on it. Germany had witnessed
hyperinflation in 1920‘s.
20
 BEFA UNIT I

4. Stagflation: It is an economic situation in which unemployment increases along with rising

inflation causing demand to remain stagnant in a given period. In fact, it is an indication of an
inefficient market, as traditionally, there is an inverse relationship between unemployment rates
and inflationary pressures. Stagflation was witnessed by developed countries in 1970s, when
world oil prices rose dramatically.

5. Deflation: Deflation is the reverse of inflation. It refers to a sustained decline in the price level
of goods and services. It occurs when the annual inflation rate falls below zero percent (a
negative inflation rate), resulting in an increase in the real value of money. Japan suffered from
deflation for almost a decade in 1990s.

MONEY SUPPLY AND INFLATION

Inflation refers to a sustained rise in the prices of goods and services. When inflation occurs, the
buying value of a currency unit erodes, meaning that a person needs more money to buy the same
product. Most economists suggest there is a direct relationship between the amount of money in an
economy, known as the money supply, and inflation levels. Understanding the relationship between
money supply and inflation is far from easy or predictable, since inflation can easily be influenced by
other factors as well.
The relationship between money supply and inflation is explained differently depending on the type of
economic theory used. In the quantity of money theory, also called monetarism, the relationship is
expressed as MV=PT, or Money Supply (the amount of money in circulation) x Velocity of
circulation (the speed with which money flows round the economy)=Price Level x Transactions or
output. The Velocity and Transactions are considered to be constants, so according to this
explanation, supply and prices have a direct relationship. MV represents supply of money and PT
represents demand for money. Assuming V and T are constant, price level varies in direct proportion
to the quantity of money. If supply of money increases, there is inflation or rise in prices. In
Keynesian theory, while there is still a relationship between money supply and inflation, it is not the
only large factor that can affect inflation and prices. Generally, the Keynesian theory stresses the
relationship between total or aggregate demand and inflationary changes.
For example, assume a very small economy that has a money supply of Rs.50 and only two people
i.e., Farmer and Mechanic. Farmer goes to Mechanic for getting his tractor repaired and paid Rs. 50.
In turn, Mechanic purchases rise worth of Rs. 40 from Farmer. After few months, again Mechanic
purchases maize worth of Rs. 10. These are the transactions taken place in our imaginary economy in
a year.

MV = PT

M = Money supplied, V = Velocity ( The rate at which money is exchanged from one transaction to
another), P = Average general price, T = No. of transactions.

MV = Total money supply; PT = Value of all the transactions (Value of goods and services produced,
i.e., GDP)

M = 50 V = ? P = (50+40+10)/3 transactions = 33.33 T = 3

V = PT/M
50 x V = 33.33 x 3 V =
100/50 = 2
If money supplied is increased by 100%, then price level also increases by 100% when V and T are
constant.

MV = PT 100
x2=Px3
P = 200/3 = 66.67
Changes in money supply are often used to try and control inflationary conditions. Central bank will
generally lower lending rates and increase interest. When inflation drops below a target level, these
standards are generally relaxed in an attempt to stimulate the economy.

21
 BEFA UNIT I
BUSINESS CYCLE

Business cycles, also called trade cycles or economic cycles, refer to perpetual features of the
economic environment of a country. In simple words, business cycles can be defined as fluctuations in
the economic activities of a country. The economic activities of a country include total output, income
level, prices of products and services, employment, and rate of consumption. All these activities are
interrelated; if one activity changes, rest of them would also show changes.These changes in the
economic activities together produce a bigger change in the overall economy of a nation. This overall
change in an economy is termed as a business cycle. Business cycles are generally regular and
periodical in nature.

Definition: Lord Keynes defines business cycle as ― a business cycle is composed of periods of good
trade characterized by rising prices and low unemployment percentage, altering with periods of bad
trade characterized by falling prices and high unemployment percentage‖.

CHARACTERISTICS OF A BUSINESS CYCLE

1. Cyclical movements: When excess movement in one direction, say depression tends to bring
into operations not only in its remedy but also a stimulus to an excess movement in the other
direction, say boom, the movement is said to be cyclical. It is like the movement of a
pendulum. The movement in one direction tends to automatically generate a movement in the
opposite direction of prosperity in the economy sow the seeds of depression also.
2. International in nature: it is very likely that boom in the economy of one country boom in
another country. Different countries are linked with one another through international trade
and foreign exchange. This implies that prosperity in one country contributes to prosperity in
other countries also.
3. Varying degree of impact: Since periods of business cycles are more likely to be different,
they tend to vary in the degree of their impact on an economy. Business cycles may affect
different industries in an economy in varying degrees.
4. Irregular patterns: No two business cycles are similar in rhythm. There is no fixed pattern
governing each business cycle.
5. Wave like movement: Business cycles reflect a wavelike movement that implies a
composite photograph of all the recorded cycles. One complete round from boom to
depression and depression to boom is called business cycle.
6. Fluctuation in productive capacities: Production capacities undergo wild fluctuations are
measured in terms of unemployment.
7. Fluctuations in price levels: The upward phase of cycle is identified with expansion of
production capacities, diminishing unemployment and rise in prices. On the other hand, the
downward phase of cycle is identified with contraction of production capacities, increasing
unemployment and fall in prices.
8. Every cycle has four distinct phases: (a) depression, (b) revival, (c) prosperity or boom, and
(d) recession.
PHASES OF A BUSINESS CYCLE

(a) Prosperity/Expansion/Boom : In this stage increase production, high capital investment in

basic industries, expansion of the bank credit, high prices, high profit, full employment.

(b) Recession : This stage is characterized by liquidation in the stock market, strain in the banking
system and some liquidation of bank loan, small fall in price, sharp reduction in demand for capital
equipment and abandoning of relatively new projects. Unemployment leads to full income
expenditure, price & profits. It is cumulative effect once a recession starts it goes on gathering
momentum and finally assumes the shape of depression.

(c) Depression/Slump : It is a protective period in which Business activities in the country is far
below the normal. It is characterized by a sharp deduction of production, mass unemployment, low
employment, falling prices, falling profits, low wages, and contraction of credit, high rate of business
failures and an atmosphere of all round pessimism and despair all construction activities come to a
more or less complete stand still during depression. The consumer goods industries and however, not
much affected.
22
 BEFA UNIT I

(d) Recovery : It implies increase in business activity after the lowest point of depression has been
reached. The entrepreneur began to feel that the economic situation was after all not so bad. This leads
to new innovation in business activities. The industrial production picks up slowly and gradually. The
volume of employment also straightly increases. There is a slow rise in prices accompanied by a small
rise in profit. Wages also raise new investment takes place in capital goods industries. The bank also
expands credit. Pessimism is gradually replaced by an atmosphere of all round cautious hope.

23
 BEFA UNIT I
B U S I N E S ECONOMICS

INTRODUCTION

Business Economics, also called Managerial Economics, is the application of economic theory and
methodology to business. Business involves decision- making. Decision making means the process of
selecting one out of two or more alternative courses of action. The question of choice arises because
the basic resources such as capital, land, labor and management are limited and can be employed in
alternative uses. The decision-making function thus becomes one of making choice and taking
decisions that will provide the most efficient means of attaining a desired end, say, profit
maximization. Different aspects of business need attention of the chief executive. He may be called
upon to choose a single option among the many that may be available to him. It would be in the
interest of the business to reach an optimal decision- the one that promotes the goal of the business
firm. A scientific formulation of the business problem and finding its optimal solution requires that
the business firm is he equipped with a rational methodology and appropriate tools.

Economic theory underscores the fact that each firm in the industry operates under competitive conditions and hence
tries to operate more efficiently to withstand the competition. The indicator of efficiency is profits. The assumption
here is that each firm has one man as the owner and entrepreneur, and that his sole aim is to maximize profits. As
time passed, one man firms were replaced by partnerships and giant companies and the structure of the firm changed
to include the owner/entrepreneur/shareholders on the one hand and that managers on the other. The responsibility of
the owners/entrepreneur/shareholders got bifurcated. The day to day affairs of the firm were looked after by the
managers and owners/entrepreneur/shareholders took organizational decisions aimed at maximizing profits. The goals
of the owners/entrepreneurs/shareholders are called organizational goals while the goals of the managers are referred to
as Business goals also known as operational goals.

DEFINITIONS
According to E. F. Brigham and J. L. Pappas, "Managerial Economics is the application of
Economic theory and methodology to business administration practise."
According to McNair and Meriam, "Managerial Economics consists of the use of Economic modes
of thought to analyse business situations."
According to M. H. Spencer and L. Siegelman, "Managerial Economics is the integration of
economic theory with business practise for the purpose of facilitating decision making and forward
planning."
According to Hauge, "Managerial Economics is concerned with using logic of economics,
mathematics & statistics to provide effective ways of thinking about business decision problems."
According to Joel Dean, "The purpose of Managerial Economics is to show how economic analysis
can be used in formulating business policies."

NATURE OF BUSINESS ECONOMICS

Business economics is, perhaps, the youngest of all the social sciences. Since it originates from
Economics, it has the basis features of economics, such as assuming that other things remaining the
same. This assumption is made to simplify the complexity of the Business phenomenon under study in
a dynamic business environment so many things are changing simultaneously. This set a limitation
that we cannot really hold other things remaining the same. In such a case, the observations made out
of such a study will have a limited purpose or value. Managerial economics also has inherited this
problem from economics.
The other features of managerial economics are explained as below:
(a) Microeconomics in nature: Business economics is concerned with finding the solutions for
different managerial problems of a particular firm. Thus, it is more close to microeconomics.
(b) Operates against the backdrop of macroeconomics: The macroeconomics conditions of the
economy are also seen as limiting factors for the firm to operate. In other words, the managerial
economist has to be aware of the limits set by the macroeconomics conditions such as government
industrial policy, inflation and so on.
(c) Normative economics: Economics can be classified into two broad categories normally. Positive
Economics and Normative Economics. Positive economics describes ― what is‖ i.e., observed
economic phenomenon. The statement ― Poverty in India is very high‖ is an example of positive
economics. Normative economics describes ―what ought to be‖ i.e., it differentiates the ideals form

24
 BEFA UNIT I
the actual. Ex: People who earn high incomes ought to pay more income tax than those who earn low
incomes. A normative statement usually includes or implies the words ‗ought‘ or ‗should‘. They
reflect people‘s moral attitudes and are expressions of what a team of people ought to do.

(d) Prescriptive actions: Prescriptive action is goal oriented. Given a problem and the objectives of
the firm, it suggests the course of action from the available alternatives for optimal solution. It does
not merely mention the concept, it also explains whether the concept can be applied in a given context
on not. For instance, the fact that variable costs as marginal costs can be used to judge the feasibility
of an export order.

(e) Applied in nature: ‗Models‘ are built to reflect the real life complex business situations and
these models are of immense help to managers for decision-making. The different areas where models
are extensively used include inventory control, optimization, project management etc. In Business
economics, we also employ case study methods to conceptualize the problem, identify that alternative
and determine the best course of action.

(f) Offers scope to evaluate each alternative: Business economics provides an opportunity to
evaluate each alternative in terms of its costs and revenue. The Business economist can decide which
is the better alternative to maximize the profits for the firm.

(g) Interdisciplinary: The contents, tools and techniques of Business economics are drawn from
different subjects such as economics, management, mathematics, statistics, accountancy, psychology,
organizational behavior, sociology and etc.

(h) Assumptions and limitations: Every concept and theory of Business economics is based on
certain assumption and as such their validity is not universal. Where there is change in assumptions,
the theory may not hold good at all.
SCOPE OF BUSINESS ECONOMICS

The main focus of Business economics is to find the solution to Business problems for which the
Business economist makes use of the concepts, tools and techniques of economics and other related
disciplines.

1. Demand Analyses and Forecasting:

A firm can survive only if it is able to the demand for its product at the right time, within the right
quantity. Understanding the basic concepts of demand is essential for demand forecasting. Demand
analysis should be a basic activity of the firm because many of the other activities of the firms depend
upon the outcome of the demand forecast. Demand analysis provides:

a) The basis for analyzing market influences on the firms; products and thus helps in the
adaptation to those influences.
b) Demand analysis also highlights for factors, which influence the demand for a product. This
helps to manipulate demand. Thus demand analysis studies not only the price elasticity but
also income elasticity, cross elasticity as well as the influence of advertising expenditure.
With the advent of computers, demand forecasting has become an increasingly important
function of Business economics.

25
 BEFA UNIT I
2. Price determination:
Pricing decisions have been always within the preview of Business economics. Pricing policies are
merely a subset of broader class of Business economic problems. Price theory helps to explain how
prices are determined under different types of market conditions. Competition analysis includes the
anticipation of the response of competing firms‘ pricing, advertising and marketing strategies.
Product line pricing and price forecasting occupy an important place here.

3. Production and cost analysis:

Production analysis is in physical terms. While the cost analysis is in monetary terms. Cost concepts
and classifications, cost-out-put relationships, economies and diseconomies of scale and production
functions are some of the points constituting cost and production analysis.

4. Resource Allocation:
Business Economics is the traditional economic theory that is concerned with the problem of optimum
allocation of scarce resources. Marginal analysis is applied to the problem of determining the level of
output, which maximizes profit. In this respect, linear programming techniques are used to solve
optimization problems. In fact, linear programming is one of the most practical and powerful
managerial decision making tools currently available.

5. Profit analysis:
Profit making is the major goal of firms. There are several constraints here on account of competition
from other products, changing input prices and changing business environment hence in spite of
careful planning, there is always certain risk involved. Business economics deals with techniques of
averting of minimizing risks. Profit theory guides in the measurement and management of profit, in
calculating the pure return on capital, besides future profit planning.

6. Investment decisions:
Capital is the foundation of business. Lack of capital may result in small size of operations.
Availability of capital from various sources like equity capital, institutional finance etc. may help to
undertake large-scale operations. Hence efficient allocation and management of capital is one of the
most important tasks of the managers. The major issues related to capital analysis are:
1. The choice of investment project
2. Evaluation of the efficiency of capital
3. Most efficient allocation of capital
Knowledge of capital theory can help very much in taking investment decisions. This involves, capital
budgeting, feasibility studies, analysis of cost of capital etc.

7. Forward planning:
Strategic planning provides management with a framework on which long-term decisions can be made
which has an impact on the behavior of the firm. The firm sets certain long-term goals and objectives
and selects the strategies to achieve the same. Strategic planning is now a new addition to the scope of
Business economics with the emergence of multinational corporations. The perspective of strategic
planning is global.

THE ROLE OF BUSINESS ECONOMIST

The role of business economist can be summarized as follows:

1. He studies the economic patterns at macro-level and analysis it‘s significance to the specific
firm he is working in.
2. He has to consistently examine the probabilities of transforming an ever- changing economic
environment into profitable business avenues.
3. He assists the business planning process of a firm.
4. He also carries cost-benefit analysis.
5. He assists the management in the decisions pertaining to internal functioning of a firm.
6. In addition, a business economist has to analyze changes in macro- economic indicators such
as national income, population, business cycles, and their possible effect on the firm‘s
functioning.
7. He is also involved in advising the management on public relations, foreign exchange, and
trade.
26
 BEFA UNIT I
8. He guides the firm on the likely impact of changes in monetary and fiscal policy on the firm‘s
functioning.
9. The most significant function of a business economist is to conduct a detailed research on
industrial market.
10.He must be vigilant and must have ability to cope up with the pressures.
11.He also provides management with economic information such as tax rates, competitor‘s
price and product, etc.

MULTI-DISCIPLINARY NATURE OF BUSINESS ECONOMICS

Many new subjects have evolved in recent years due to the interaction among basic disciplines. While
there are many such new subjects in natural and social sciences, Business economics can be taken as
the best example of such a phenomenon among social sciences. Hence it is necessary to trace its roots
and relationship with other disciplines.

1. Relationship with economics:

The relationship between Business economics and economics theory may be viewed from the point of
view of the two approaches to the subject Viz. Micro Economics and Marco Economics.
Microeconomics is the study of the economic behavior of individuals, firms and other such micro
organizations. Business economics is rooted in Micro Economic theory. Business Economics makes
use to several Micro Economic concepts such as marginal cost, marginal revenue, elasticity of
demand as well as price theory and theories of market structure to name only a few. Macro theory on
the other hand is the study of the economy as a whole. It deals with the analysis of national income,
the level of employment, general price level, consumption and investment in the economy and even
matters related to international trade, Money, public finance, etc.

2. Relationship with accounting:

Business economics has been influenced by the developments in management theory and accounting
techniques. A proper knowledge of accounting techniques is very essential for the success of the firm
because profit maximization is the major objective of the firm. Business Economist requires a proper
knowledge of cost and revenue information and their classification.

3. Relationship with mathematics:

The use of mathematics is significant for Business economics in view of its profit maximization goal
long with optional use of resources. The major problem of the firm is how to minimize cost, how to
maximize profit or how to optimize sales. Mathematical concepts and techniques are widely used in
economic logic to solve these problems. Geometry, Algebra and calculus are the major branches of
mathematics which are of use in Business economics.

4. Relationship with Statistics:

A successful businessman must correctly estimate the demand for his product. Statistical methods
provide and sure base for decision-making. Thus statistical tools are used in collecting data and
analyzing them to help in the decision making process. Statistical tools like the theory of probability
and forecasting techniques help the firm to predict the future course of events. Business Economics
also make use of correlation and multiple regressions in related variables like price and demand to
estimate the extent of dependence of one variable on the other.

5. Relationship with Operations Research:

The development of techniques and concepts such as linear programming, inventory models and game
theory is due to the development of this new subject of operations research in the post-war years.
Operations research is concerned with the complex problems arising out of the management of men,
machines, materials and money.Operation research provides a scientific model of the system and it
helps Business economists in the field of product development, material management, and inventory
control, quality control, marketing and demand analysis.

7. Relationship with Computer Science:

Computers are used in data and accounts maintenance, inventory and stock controls and supply and
demand predictions. What used to take days and months is done in a few minutes or hours by the
computers. In fact computerization of business activities on a large scale has reduced the workload of
Business personnel.
27
 BEFA UNIT II
DEMAND ANALYSIS
In common parlance, demand means the desire for an object. But in economics demand is something
more than this. According to Stonier and Hague, ―Demand in economics means demand backed up by
enough money to pay for the goods demanded‖. This means that the demand becomes effective only it if
is backed by the purchasing power. In addition to this, there must be willingness to buy a commodity.
Thus demand in economics means the desire backed by the willingness to buy a commodity and the
purchasing power to pay.
In the words of ―Benham‖ ―The demand for anything at a given price is the amount of it which will be
bought per unit of time at that Price‖.
Hence, demand refers to the amount of commodity which an individual consumer is willing to purchase at
given price in a given period. The demand is said to exist when the following three conditions are
fulfilled.
1. Desire to purchase
2. Ability to pay
3. Willing to pay
Ex: A beggar may have desire to purchase a car but he cannot pay money for it.
Ex: A miser does not purchase a car but he can pay money for it.

DEMAND FUNCTION
Demand function is a function which describes a relationship between one variable and its determinants.
The demand function for a good relates the quantity of good which consumers demand during a given
period to the factors which influence the demand. Quantity demanded is dependent variable and all the
factors are independent variables. The factors can be built up into a demand function. The demand
function can be mathematically expressed as follows:
Q = f(P, I, T, P1..Pn, EP, EI, A, O)
Q = Quantity demanded
f = Function of
P = Price of goods itself
I = Income of consumers
T = Taster and preferences
P1..Pn = Price of related goods
EP = Expectation about future price
EI = Expectation about future income
A = Advertisement
O = Other factors

LAW OF DEMAND:
Law of demand shows the relationship between price and quantity demanded of a commodity in the
market. In the words of Marshall, ―the amount demand increases with a fall in price and diminishes with a
rise in price‖.The law of demand states that “ other things remaining constant, the higher the price of
the commodity, the lower is the demand and lower the price, higher is the demand”. It is called as
ceteris paribus (Latin phrase meaning other things constant.)
The law of demand may be explained with the help of the following demand schedule.

28
 BEFA UNIT II

Demand Schedule: Demand Curve:

Price of Apple Quantity

(In. Rs.) Demanded
2 6
3 4
4 3
5 2
6 1

When the price falls from Rs. 6 to 5, quantity demand increases from 1 to 2. In the same way as price
falls, quantity demanded increases. On the basis of the demand schedule, we can draw the demand curve.
The above demand curve shows the inverse relationship between price and quantity demanded of apple.
It is downward sloping.
Assumptions:
Law of demand is based on certain assumptions:
1. There is no change in consumers taste and preferences.
2. Income should remain constant.
3. Prices of other goods should not change.
4. There should be no substitute for the commodity
5. The commodity should not confer at any distinction
6. The demand for the commodity should be continuous
7. People should not expect any change in the price of the commodity

EXCEPTIONS TO LAW OF DEMAND

According to law of demand, other things being constant, as the price increases, the demand for the
commodity decreases and vice-versa. But this is not true all the time. In some cases, as the price
increases, the demand for the commodity will also increase and the demand decreases when the price
decreases. All these cases are considered as exceptions to the law of demand.
When price increases from OP to Op1, quantity demanded also increases from OQ to OQ1 and vice versa.
The following are the exceptions to the law of demand.
1. Giffen goods or Giffen paradox:
The Giffen good or inferior good or cheap good is an exception to the law of demand. The demand for
these goods varies directly with the variations in prices i.e., there exists direct relation between the
quantity demanded and the price of the commodity. Giffen goods may or may not exist in the real world.
Giffen goods are named after Sir Robert Giffen. He has conducted a survey on American laboring
families who consume bread and meat. The survey revealed that they spend more of their income on
bread because it is their staple food or main food and less of their income on meat. When price of bread
increases, after purchasing bread, they don‘t have surplus money to buy meat. So, the rise in the price of
bread forced the people to buy more bread by reducing the consumption of meat and thus raised the
demand for bread. The goods like bajra, barley, gram, millets, vegetables fall under the category of Giffen
goods.
2. Goods of status
In some situations, certain commodities are demanded just because they are expensive or prestige goods
and are usually used as status symbols to display one‘s wealth in the society. Examples of such
commodities are diamonds, air conditioned car, duplex houses etc. as the price of these commodities
increase, they are more considered as status symbols and hence their demand gets raised. This goes
against the law of demand.
29
 BEFA UNIT II
3. Ignorance:
Sometimes, the quality of the commodity is Judged by its price. Consumers think that the product is
superior if the price is high. As such they buy more at a higher price.
4.consumer expectations of future prices
If the price of the commodity is increasing, the consumers will buy more of it because of the fear that it
increase still further. Similarly, if the consumer expects the future prices to decrease, he may not purchase
the commodity thinking that the good may be of bad quality. This violates the law of demand.
5. Fear of shortage:
During the times of emergency of war, People may expect shortage of a commodity. At that time, they
may buy more at a higher price to keep stocks for the future.
6. Necessaries:
In the case of necessaries like rice, vegetables etc. people buy more even at a higher price.

DETERMINANTS OF DEMAND
There are several factors or determinants that affect the individual demand and market demand for a
product. These factors are economic, social as well as political factors. The effect of all the factors on the
amount demanded for the commodity is called Demand Function. These factors
are as follows:
1. Price of the Commodity:
The most important factor-affecting amount demanded is the price of the
commodity. The amount of a commodity demanded at a particular price is more
properly called price demand. The relation between price and demand is called the
Law of Demand. The demand for a commodity varies inversely with its price. A
decrease in price increases the purchasing power of consumers and an increase in
the price decreases the purchasing power of the consumers.
2. Income of the Consumer:
The second most important factor influencing demand is consumer income. Individual consumer‘s
income determines his purchasing ability. When other things remaining constant, if income increases,
demand increases and vice-versa. An increase in income makes an individual to buy many commodities.
The effect of income on demand can be analysed for normal goods, perishable goods and inferior goods.
a) Normal goods: Usually, the demand for a normal good goes
in the same direction with consumer‘s income i.e., demand
for normal goods is directly related to consumer‘s income.
Income Demand
1000 1
2000 2

b) Perishable goods: For perishable goods like foods, fruits, meat, vegetables, milk etc., whose
life is very short, the quantity demanded raises with an increase in income, but after a certain
level it remains constant even though the income raises.
Demand for
Income
milk in Kg.
1000 1
2000 2
3000 3
4000 4
5000 4

30
 BEFA UNIT II

c) Inferior goods: The goods for which the demand decreases even though the income level
increases are inferior goods or cheap good or ordinary goods.
Demand for
Income (Rs.)
ordinary ice-cream
100 1
200 2
300 3
400 1

3. Prices of related goods:

In a given market, if the price of one good influences the quantity demanded
of another good, these two goods are said to be related goods. Two commodities in a given market are
related to each other either as Substitutes or Complementary goods.
a. Substitutes: When a want can be satisfied by alternative similar
goods, they are said to be substitutes to each other. Ex: Tea and
Coffee, Santhoor soap and Lux soap etc. The below graph
indicates that as the price of coffee increases, the demand for tea
increases.

Price of Coffee (Rs.) Demand for Tea

5 50
6 80

There is direct relation between price of coffee and demand for Tea.
b. Complementary goods: When a want can be satisfied by two
or more goods in a combination. These goods are termed as
complementary goods. In other words, if the price of one good
increases, the demand for another good will decrease. Ex:
Bread and Butter, Pen and Ink, Car and Petrol, Sugar and Tea
and Shoe and Socks etc. The below table and graph indicate the
indirect relationship between price of one good and demand for
one good.
Price of Sugar (Rs.) Demand for Tea
30 50
50 20

4. Tastes and habits of the Consumers:

Irrespective of price of good and income levels of consumers, demand for many goods depends on
consumers‘ tastes and habits. For example, the demand for ice-creams, chocolates, alcohol, tea, cigarettes
etc depend on individual tastes and habits. In cases like, a strict vegetarian does not demand for meant at
any price, whereas a non-vegetarian will buy meat at any price.
5. Wealth:
The amount demanded of commodity is also affected by the amount of wealth as well as its distribution.
The wealthier are the people; higher is the demand for normal commodities. If wealth is more equally
distributed, the demand for necessaries and comforts is more. On the other hand, if some people are rich,
while the majorities are poor, the demand for luxuries is generally higher.
6. Population:
Increase in population increases demand for necessaries of life. The composition of population also
affects demand. Composition of population means the proportion of young and old and children as well as
the ratio of men to women. A change in composition of population has an effect on the nature of demand
31
 BEFA UNIT II
for different commodities.
7. Government Policy:
Government policy affects the demands for commodities through taxation. Taxing a commodity increases
its price and the demand goes down. Similarly, financial help from the government increases the demand
for a commodity while lowering its price.
8. Expectations regarding the future prices and incomes:
If consumers expect changes in price of commodity in future, they will change the demand at present
even when the present price remains the same. Similarly, if consumers expect their incomes to rise in the
near future they may increase the demand for a commodity just now.
9. Climate and weather:
The climate of an area and the weather prevailing there has a decisive effect on consumer‘s demand. In
cold areas woolen cloth is demanded. During hot summer days, ice is very much in demand. On a rainy
day, ice cream is not so much demanded.
10. State of business:
The level of demand for different commodities also depends upon the business conditions in the country.
If the country is passing through boom conditions, there will be a marked increase in demand. On the
other hand, the level of demand goes down during depression.
ELASTICITY OF DEMAND

Elasticity of demand explains the relationship between a change in price and consequent change in
amount demanded. ―Marshall‖ introduced the concept of elasticity of demand. Elasticity of demand
shows the extent of change in quantity demanded to a change in price.

Definition Of Elasticity Of Demand:

In the words of ―Marshall‖, ―The elasticity of demand in a market is great or small according as the
amount demanded increases much or little for a given fall in the price and diminishes much or little for a
given rise in Price‖

Elastic demand: A small change in price may lead to a great change in quantity demanded. In this case,
demand is elastic.

In-elastic demand: If a big change in price is followed by a small change in demanded then the demand
in ―inelastic‖.

32
 BEFA UNIT II

TYPES OF ELASTICITY OF DEMAND:

There are four types of elasticity of demand:

1. Price elasticity of demand

2. Income elasticity of demand
3. Cross elasticity of demand
4. Advertisement elasticity of demand

I. Price elasticity of demand:

Marshall was the first economist to define price elasticity of demand. Price elasticity of demand measures
changes in quantity demand to a change in Price. It is the ratio of percentage change in quantity
demanded to a percentage change in price.
Proportionate change in the quantity demand of commodity
Ep = Price elasticity =
Proportionate change in the price of commodity

Q2 − Q1 Q1 = Old demand
Q2 = New demand
EP = Q1
p1 = Old price
P2 − P1 p2 = New price
P1

33
 BEFA UNIT II
There are five cases of price elasticity of demand

A. Perfectly elastic demand:

When small change in price leads to an infinitely large change is quantity demand, it is called perfectly or
infinitely elastic demand. In this case E=∞. Sometimes, even there is no change in the price, the demand
changes in huge quantity. In case of perfect elastic demand, the demand for a commodity changes even
though there is no change in price. This elasticity is very rarely found in practice. We can see a straight
line demand curve parallel to the X- axis.
Price Demand
10 100
10 1000

Ep = ((Q2 − Q1)/Q1) /((P2 − P1)/P1)

𝐸𝐸 = (1000 − 100)/100 /(10 − 10)/10 = ∞

The demand curve is horizontal straight line. It shows the at Rs. 10 price any
quantity is demanded and if price increases, the consumer will not purchase the
commodity.

B. Perfectly Inelastic Demand

A commodity is said to have perfectly inelastic demand, when even a

large change in price of the commodity causes no change in the quantity
demanded. The elasticity coefficient of perfectly in elastic demand is Ep =
0.

The shape of the demand curve for perfectly inelastic is vertical as shown below.

Price Demand
10 100
20 100
Ep = ((Q2 − Q1)/Q1) /((P2 − P1)/P1)

𝐸𝐸 = (100 − 100)/100 /(20 − 10)/10 = 0

When price increases from Rs. 10 to Rs.20, the quantity demanded remains the same. In other words the
response of demand to a change in Price is nil. In this case ‗E‘=0.

C. Relatively elastic demand:

Demand changes more than proportionately to a change in price. i.e. a

small change in price leads to a very big change in the quantity
demanded. In this case E > 1. This demand curve will be flatter.

34
 BEFA UNIT II
Price Demand
10 300
15 100

Ep = ((Q2 − Q1)/Q1) /((P2 − P1)/P1)

𝐸𝐸 = (100 − 300)/300 /(15 − 10)/10 = −1.34

When price increases from Rs.10 to Rs.15, quantity demanded decreases from 300units to 100units which
is larger than the change in price.

D. Relatively in-elastic demand.

Quantity demanded changes less than proportional to a change in price. A large change in price leads to
small change in quantity demanded. Here E < 1. Demanded carve will be
steeper.

Price Demand
10 100
15 80

Ep = ((Q2 − Q1)/Q1) /((P2 − P1)/P1)

𝐸𝐸 = (80 − 100)/100 /(15 − 10)/10 = −0.40

When price increases from Rs.10 to Rs.15 quantity demanded decreases from
100units to units, which is smaller than the change in price

E. Unitary elasticity of demand:

The change in demand is exactly equal to the change in price. When both
are equal, E=1 and elasticity is said to be unitary.

Price Demand
10 200
15 100

Ep = ((Q2 − Q1)/Q1) /((P2 − P1)/P1)

𝐸𝐸 = (100 − 200)/200 /(15 − 10)/10 = −1

When price increases from Rs.10 to Rs.15, quantity demanded decreases from 200units to 100units. Thus
a change in price has resulted in an equal change in quantity demanded so price elasticity of demand is
equal to unity.

II. Income elasticity of demand:

Income elasticity of demand shows the change in quantity demanded as a result of a change in income.
Income elasticity of demand may be slated in the form of a formula.
Proportionate change in the quantity demand of commodity
EI = Income Elasticity =

35
 BEFA UNIT II
Proportionate change in the income of the people

Income elasticity of demand can be classified in to five types.

A. High income elasticity of demand:

In this case, an increase in come brings about a more than proportionate increase in quantity demanded.
Symbolically it can be written as EI > 1. This elasticity can be observed in the case of non-necessary
goods such as TV, AC etc.

Income Demand
1000 1
2000 3

EI = ((Q2 − Q1)/Q1) /((I2 − I1)/I1)

EI = (3 − 1)/1 /(2000 − 1000)/1000 = 2

It shows high-income elasticity of demand. When income increases from Rs.1000 to Rs.2000, Quantity
demanded increases from 1 unit to 3 units.

B. Low income elasticity of demand:

When income increases quantity demanded also increases but less than proportionately. In this case E <
1. The necessary goods such as rice, vegetables etc, have this type of
elasticity.

Income Demand
1000 1
3000 2

EI = ((Q2 − Q1)/Q1) /((I2 − I1)/I1)

EI = (2 − 1)/1 /(3000 − 1000)/1000 = 0.50

An increase in income from Rs.1000 to Rs.3000, brings an increase in quantity demanded from 1 unit to
2 units, But the increase in quantity demanded is smaller than the increase in income. Hence, income
elasticity of demand is less than one.

C. Unitary income elasticity of demand:

A commodity is said to possess unitary income elasticity of demand, when the percentage change in the
quantity demanded of a commodity and the percentage change in the consumer‘s income are equal. The
elasticity coefficient is equal to one. . EI = 1 and its demand curve is at an angle of 45 0 as shown below.

Income Demand
1000 1
2000 2

EI = ((Q2 − Q1)/Q1) /((I2 − I1)/I1)

EI = (2 − 1)/1 /(2000 − 1000)/1000 = 1

When income increases from Rs. 1000 to Rs.2000, Quantity demanded also increases from 1 unit to 2
36
 BEFA UNIT II
units.

D. Zero income elasticity of demand:

Quantity demanded remains the same, even though money income increases. Symbolically, it can be
expressed as EI=0. Suppose, even our income increases, we don‘t purchase medicines in larger quantity.
It can be depicted in the following way:

Income Demand
1000 1
2000 1

EI = ((Q2 − Q1)/Q1) /((I2 − I1)/I1)

EI = (1 − 1)/1 /(2000 − 1000)/1000 = 0

As income increases from OY to OY1, quantity demanded never changes.

E. Negative Income elasticity of demand:

When an increase in consumer‘s income causes a decrease in the quantity demanded of a commodity and
vice-versa, then the commodity is said to have negative income elasticity of demand. Ex: Inferior goods
or low quality goods have negative income elasticity because the want to buy high quality goods as
income increases. In this case, income elasticity of demand is negative. i.e., EI < 0.

Income Demand
1000 2
2000 1

EI = ((Q2 − Q1)/Q1) /((I2 − I1)/I1)

EI = (1 − 2)/2 /(2000 − 1000)/1000 = −0.50
When income increases from Rs. 1000 to Rs.2000, demand falls from 2 units to 1 unit.

III. Cross elasticity of Demand:

A change in the price of one commodity leads to a change in the quantity demanded of another
commodity. This is called a cross elasticity of demand. The formula for cross elasticity of demand is:
Proportionate change in the quantity demand of commodity ―X”
EC = Cross elasticity =
Proportionate change in the price of commodity ―Y”

a. In case of substitutes, cross elasticity of demand is positive. Eg: Coffee

and Tea

When the price of coffee increases, Quantity demanded of tea increases. Both
are substitutes.

b. In case of compliments, cross elasticity is negative. If an increase in the

price of one commodity leads to a decrease in the quantity demanded of another
and vice versa.

When price of car goes up, the quantity demanded of petrol decreases. The cross-
demanded curve has negative slope.

37
 BEFA UNIT II

IV. Advertisement elasticity of demand:

It refers to increase in the sakes revenue because of change in the advertising expenditure. In other words,
there is a direct relationship between the amount of money spent on advertising and its impact on sales.
Advertising elasticity is always positive.
Proportionate change in the quantity demand of commodity
EA = Advertisement elasticity =

Proportionate change in advertisement costs

Q
1

O
l
d

d
e
m
a
n
ELASTICITY
d OF DEMAND

1) Point Elasticity of Demand: Q

Point elasticity is the price elasticity o f demand at a2 specific point on the
demand curve instead of over a range of it. A demand curve does not
have the same elasticity throughout its entire =length. In general,
elasticity differs at different points on a given demand curve. Point
elasticity does not hold good in the case of perfectlyNelastic and perfectly
inelastic. In these cases, the demand curves possess e a single elasticity
throughout its entire length. w
It can be observed that elasticity at point C where the demand curve
touches the X axis is equal to zero and at point D d where the demand
curve meets the price axis, the elasticity is infinity.e At mid point P, the
elasticity is equal to one. At all the points between Pmand C, the elasticity
is greater than zero and less than one and at all thea points between P and D, the elasticity is higher than
one and less than infinity. Thus the range of values of n elasticity is between zero and infinity.
d
The following graph simplifies the concept of point elasticity. To
calculate point elasticity at any point on the demand curve, the
below equation is used. We take mid - point of the demand curve as
point C where elasticity is one. When we move to the right direction
from point C, elasticity of demand decreases i.e., E <1 and elasticity
of demand increases i.e., E>1, when we move to the left direction
from the point C

38
 BEFA UNIT II
The elasticity at point C can be calculated as:
Ed = CE/CA = 40/40 = 1
Elasticity at point D can be calculated as under:
Ed = DE/DA = 20/60 = 0.33 ( E<1)
Elasticity at point B can be calculated as under:
Ed = BE/BA = 60/20 = 3 (E>1)
Elasticity at point A can be calculated as under:
Ed = AE/A = 80/0 = ∞
Elasticity at point E can be calculated as under:
Ed = E/EA = 0/80 = 0

2) Arc Elasticity or Mid–Point Method:

Arc elasticity of demand is the average elasticity over a segment of the demand curve. In point elasticity,
we find elasticity on straight line demand curve. We cannot always find a demand curve in the form of
straight line. A demand curve is not linear. So, how do we find elasticity on such a curve?. What we do is
that we have to identify two points, say point A and point B and then draw a chord (a straight line joining
two points on a curve) between these two points. Join these two points with a straight line. What happens
is we get a straight line with arc (a part of a curve). Now, how do we find elasticity between these two
points?. We have a formula for that: The following graph presents the clear meaning of the arc elasticity.

FACTORS AFFECTING ELASTICITY OF DEMAND

Elasticity of demand depends on many factors.

1. Nature of commodity:
Elasticity or in-elasticity of demand depends on the nature of the commodity i.e. whether a commodity is
a necessity, comfort or luxury, normally; the demand for Necessaries like salt, rice etc is inelastic. On the
other band, the demand for comforts and luxuries is elastic.
2. Availability of substitutes:
Elasticity of demand depends on availability or non-availability of substitutes. In case of commodities,
which have substitutes, demand is elastic, but in case of commodities, which have no substitutes, demand
is in elastic.

3. Variety of uses:
If a commodity can be used for several purposes, than it will have elastic demand. i.e. electricity. On the
other hand, demanded is inelastic for commodities, which can be put to only one use.

39
 BEFA UNIT II
4. Postponement of demand:
If the consumption of a commodity can be postponed, than it will have elastic demand. On the contrary, if
the demand for a commodity cannot be postpones, than demand is in elastic. The demand for rice or
medicine cannot be postponed, while the demand for Cycle or umbrella can be postponed.

5. Amount of money spent:

Elasticity of demand depends on the amount of money spent on the commodity. If the consumer spends a
smaller for example a consumer spends a little amount on salt and matchboxes. Even when price of salt or
matchbox goes up, demanded will not fall. Therefore, demand is in case of clothing a consumer spends a
large proportion of his income and an increase in price will reduce his demand for clothing. So the
demand is elastic.

6. Time:
Elasticity of demand varies with time. Generally, demand is inelastic during short period and elastic
during the long period. Demand is inelastic during short period because the consumers do not have
enough time to know about the change is price. Even if they are aware of the price change, they may not
immediately switch over to a new commodity, as they are accustomed to the old commodity.

7. Range of Prices:

Range of prices exerts an important influence on elasticity of demand. At a very high price, demand is
inelastic because a slight fall in price will not induce the people buy more. Similarly at a low price also
demand is inelastic. This is because at a low price all those who want to buy the commodity would have
bought it and a further fall in price will not increase the demand. Therefore, elasticity is low at very him
and very low prices.

SIGNIFICANCE/IMPORTANCE OF ELASTICITY OF DEMAND

(or)
ELASTICITY OF DEMAND IN DECISION-MAKING
The concept of elasticity is very useful to the producers and policy makers alike. It is very valuable tool to
decide the extent of increase or decrease in price for a desired change in the quantity demanded for the
products and services in the firm or the economy. The practical importance of this concept will be clear
from the following application.

1. Price fixation:
A knowledge of elasticity of demand may help the businessman to make a decision whether to cut or
increase, the price of his product or to shift the burden of any additional cost of production on to the
consumers by charging high price. Each seller under monopoly and imperfect competition has to take into
account elasticity of demand while fixing the price for his product. If the demand for the product is
inelastic, he can fix a higher price.

2. Production:
The elasticity of demand helps the businessman to decide about production. A businessman choose the
optimum product mix on the basis of elasticity of demand for various products. The products having more
elastic demand are preferred by the businessman. The sale of such products can be increased with a little
reduction in their prices. Hence elasticity of demand helps the producers to take correct decision
regarding the level of output to be produced.

3. prices of factors of production:

A factor with an inelastic demand can always command a higher price as compared to a factor relatively
elastic demand. This helps the trade unions in knowing that where they can easily get the wage rate
increased. Bargaining capacity of trade unions depend upon elasticity of demand for workers services.
Elasticity of demand also helps in the determination of rewards for factors of production. For example, if
the demand for labour is inelastic, trade unions will be successful in raising wages. It is applicable to
other factors of production.

40
 BEFA UNIT II
4. International Trade:
Elasticity of demand helps in finding out the terms of trade between two countries. Terms of trade refers
to the rate at which domestic commodity is exchanged for foreign commodities. Terms of trade depends
upon the elasticity of demand of the two countries for each other goods. A country will benefit from
international trade when it fixes lower price for exports items whose demand is price elastic and high
price for those exports whose demand is inelastic.

5. Tax policies:
The government can impose higher taxes and collect more revenue if the demand for the commodity on
which a tax is to be levied is inelastic. On the other hand, in case of a commodity with elastic demand
high tax rates may fail to bring in the required revenue for the government. Elasticity of demand helps the
government in formulating tax policies. For example, for imposing tax on a commodity, the Finance
Minister has to take into account the elasticity of demand.

6. Nationalization of public utilities:

The nationalization of public utility services can also be justified with the help of elasticity of demand.
Demand for public utilities such as electricity, water supply, post and telegraph, public transportation etc.,
is generally inelastic in nature. If the operation of such utilities is left in the hands of private individuals,
they may exploit the consumers by charging high prices. Therefore, in the interest of general public, the
government owns and runs such services.
DEMAND FORECASTING
Forecasting is predicting or expecting the needs of the consumers in future. Forecasting the demand for its
products is the essential function for an organization irrespective of its nature. Forecasting customer
demand for products and services is a proactive process of determining what products are needed, where,
when and in what quantities. So, demand forecasting is a customer focused activity. It supports other
planning activities such as capacity planning, inventory planning and even overall business planning.
Many organizations follow it as a custom to completely and accurately forecast the demand of its
products regularly. Demand forecasting is not helpful at the firm level but also at national level. The need
for demand forecasting arises due to the following purposes.

 It serves as a road map for production plans.

 It plays a significant role in situations of uncertain production or demand.
 It facilitates the managers to line up their business activities.
 It is a basis for export and import policy and fiscal policy.
 It can help businessman to take decisions regarding inputs of production process such as labor,
capital etc.

CHARACTERISTICS OF GOOD DEMAND FORECASTING

1. It is in terms of specific quantitiesIt is undertaken in an uncertain atmosphere.
2. A forecast is made for a specific period of time which would be sufficient to take a decision and put it
into action.
4 .It is based on historical information and the past data.
5 .It tells us only the approximate demand for a product in the future.
6 .It is based on certain assumptions.
7 .It cannot be 100% precise as it deals with future expected demand
Demand forecasting is the activity of estimating the quantity of a product or service that consumers will
purchase. Demand forecasting involves techniques including both informal methods, such as educated
guesses, and quantitative methods, such as the use of historical sales data or current data from test
markets. Demand forecasting may be used in making pricing decisions, in assessing future capacity
requirements, or in making decisions on whether to enter a new market.

41
 BEFA UNIT II

STEPS IN DEMAND FORECASTING

1. Determining the objectives

The first step in this regard is to consider the objectives of sales forecasting carefully.

2. Period of forecasting
Before taking up forecasting, the company has to decide the period of forecasting — Whether it is a short-
term forecast or long-term research.

3. Scope of forecast
The next step is to decide the scope of forecasting— Whether it is for the products, or for a particular area
or total industry or at the national/international level.

4. Sub-dividing the task

Sub-dividing the task into homogeneous groups, according to product, area, activities or consumers. The
figure of sales forecasting shall be the sum total of the sales forecasts of all the groups.

5. Identify the variables

The different variables or factors affecting the sales should be identified so that due weight age may be
given to those different factors.

6. Selecting the method

Appropriate method of sales forecasting is selected by the company taking into account all the relevant
information, purpose of forecasting and the degree of accuracy required.

7. Collection and analysis of data

Necessary data for the forecast are collected, tabulated, analyzed and cross-checked. The data are
interpreted by applying the statistical or graphical techniques, and then to draw necessary deductions
there from.

8. Study of correlation between sales forecasts and sales promotion plans

Making the forecast reliable, the sales promotion plans such as advertising, personal selling and other
sales programmes should be reviewed. A study of correlation between sales forecasts and sales promotion
plans should be made in order to establish their role in promoting the sales.

9. Competitors activities
Volume of sales of a company is largely affected by the activities of competitors and, therefore, the
forecaster must also study the competitors‘ activities, policies, programmes and strategies.

10. Preparing final sales forecasts

The preliminary sales forecasts figure should be reviewed and final sales forecast figures should be
arrived at after making all adjustments.

11. Evaluation and adjustments

The figures of final sales forecasts form the basis for the operations of the company in the next period.
The actual sales performance in the forthcoming period should be reviewed and evaluated from time to
time viz, monthly, quarterly, half-yearly or yearly and so on. The forecast figures should be revised in the
light of difficulties experienced during actual performance. At the end of the forecast period, actual
performance should be reviewed and rectified while forecasting the demand for the next period.
42
 BEFA UNIT II

METHODS OF FORECASTING:

Several methods are employed for forecasting demand. All these methods can be grouped under survey
method, statistical method and other methods. Survey methods and statistical methods are further
subdivided in to different categories.

I. Survey Method:
A. Survey of buyers intention:

To anticipate what buyers are likely to do under a given set of circumstances, a most useful source of
information would be the buyers themselves. It is better to draw a list of potential buyers. Approach each
buyer to ask how much does he plans to buy of the given product at a given point of time under particular
conditions.

1. Census method:

If the company wishes to elicit the opinion of all the buyers, this method is called census method. This
method is not only time-consuming but also costly. Suppose there are 10,000 buyers for a particular
product. if the company gets the opinion of all these ten thousand customers, this method is known as
census method.

2. Sample method:

If the company selects a group of buyers who can represent the whole population, this method is called
the sample method. A survey of buyers based on sample basis can be completed faster with relatively
lower cost. Normally a questionnaire is designed to elicit the information. There are specialized
organizations to collect the information from the potential buyers, ex: ORG-Marg. Etc.

B. Sales force opinions:

The sales people are those who are in constant touch with the main and large buyers of a particular
market, and hence they constitute anther valid source of information about the likely sales of a product.
the sales force is capable of assessing the likely reactions of the customers of their territories quickly,
given the company‘s strategy. It is less costly as the survey can be conducted instantaneously through
telephone, fax or video-conference, and so on. The data thus collected, forms another valid source of
reliable information.
43
 BEFA UNIT II
II. Statistical Methods:

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

A. Trend projection methods

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

2. Least squares method:

Here, certain statistical formulas are used to find the trend line which best fits the available data. It is
assumed that there is a proportional change in sales over period of time. In such a case, the trend line
equation is in linear form.

The estimating linear trend equation of sales is written as: S = x + y(T), where x and y have been
calculated form past data, S is sales and T is the year number for which the forecast is made. To find the
values of x and y, the following equations have to be used.
ΣS = Nx + yΣT
ΣST = xΣT + yΣT 2
Where S is the sales; T is the year number, N= number of years.

3. Times series analysis:

Time series forecasting is the use of a model to predict future values based on previously observed values.
The first step in making estimates for the future consists of gathering information from the past. In this
connection one usually deals with statistical data which are collected, observed or recorded at successive
intervals of time. Such data are generally referred to as time series. Thus when we observe numerical data
at different points of time the set of observations is known as time series. It may be noted that any or all
of the components may be present in any particular series. The components are Secular trend(Long term
trend), Seasonal trend , Cyclical trend (periods in the business cycle such as prosperity, decline,
depression, improvement), Irregular trend(also called as erratic or accidental or random variations in
business). From the following equation future sales can be measured. The constants T,S,C,I. are
calculated from past data.
Y = Future sales
T = Secular trend
Y=T+S+C+I S = Seasonal trend
C = Cyclical trend
I = Irregular trend

44
 BEFA UNIT II
4. Moving average method:

This method considers that the average of past events determine the future events. As the name itself
suggests, under this method, the average keeps on moving depending up on the number of years selected.
This method is easy to compute.

5. Exponential Smoothing

It is the most popular technique used for short-run forecasts. Unlike in moving average method, in this
method, all time periods are given varying weights. Recent values are given higher weights and distance
past values are given lower values. The reason is that the recent past reflects more in nearest future.

The following formula is used for exponential smoothing.

If α is higher, higher weight is given to the most recent information. α is calculated on the basis of
past data. If there were fluctuations in past data, the α value is high.
C. Barometric techniques:

Under the barometric technique, one set of data is used to predict another set. In other words, to forecast
demand for a particular product or service, use some other relevant indicator (which is known as
barometer) of future demand. Ex: The demand for cable TV may be linked to the number of new houses
occupied in a given area or demand for new houses in a particular area.

D. Correlation and Regression method:

Correlation and regression methods are statistical techniques. Correlation describes the degree of
association between two variables such as sales and advertisement expenditure. When the two variables
tend to change together, then they are said to be correlated. The extent to which they are correlated is
measured by correlation coefficient. Of these two variables, one is dependent variable and the other is
independent. If the high values of one variable are associated with the high values of another, they are
said to be positively correlated. Similarly, if the high values of one variable are associated with the low
values of another, then they are said to be negatively correlated. Correlation coefficient ranges between
+1 and -1. When the correlation coefficient is zero, it indicates that the variables under study are not
related at all.

In regression analysis, an equation is estimated which ‗best fits‘ in the sets of observations of dependent
variables and independent variables. The best estimate if the true underlying relationship between these
variables is thus generated. The dependent (unknown) variable is then forecast based on this estimated
equation, for a given value of the independent (known) variable. With the help of the following equation
future sales can be calculated. Y = Dependent variable
X = Independent variable
Y = a + bX a & b = Constants

45
 BEFA UNIT II
a & b values can be calculated with the following equations.

ΣY = Na + bΣX
ΣXY = aΣX + bΣX2

III. Other Methods

a) Experts opinion:

Well-informed persons are called experts. Experts constitute yet another source of information. These
persons are generally the outside experts and they do not have any vested interests in the results of a
particular survey.
b) Test marketing:

It is likely that opinions given by buyers, salesmen or other experts may be, at times, misleading. This is
the reason why most of the manufacturers favour to test their product or service in a limited market as
test-run before they launch their products nationwide. Based on the results of test marketing, valuable
lessons can be learnt on how consumers react to the given product and necessary changes can be
introduced to gain wider acceptability. To forecast the sales of a new product or the likely sales of an
established product in a new channel of distribution or territory, it is customary to find test marketing in
practice.

c) Controlled experiments:

Controlled experiments refer to such exercises where some of the major determinants of demand are
manipulated to suit to the customers with different tastes and preferences, income groups, and such
others. It is further assumed that all other factors remain the same. In this method, the product is
introduced with different packages, different prices in different markets or same markets to assess which
combination appeals to the customer most.

d) Judgment approach:

When none of the above methods are directly related to the given products or services, the management
has no alternative other than using its own judgment.

SUPPLY

In economics, we have two forces: the producer, who makes things, and the consumer, who buys
them. Supply is the producer's willingness and ability to supply a given good at various price points,
holding all else constant. An increase in price will increase producers' revenues, so they'll be willing to
supply more; a decrease in price will reduce revenues, and so producers will supply less.

LAW OF SUPPLY

Definition: Law of supply states that other factors remaining constant, price and quantity supplied of a
good are directly related to each other. In other words, when the price paid by buyers for a good rises,
then suppliers increase the supply of that good in the market.

In the Words of Dooley, ―The law of supply states that other things remaining the same, higher the prices
the greater the quantity supplied and lower the prices the smaller the quantity supplied‖.

Assumption of the Law :

1. It is assumed that incomes of buyers and sellers remain constant.
46
 BEFA UNIT II
2. It is assumed that the tastes and preferences of buyers and sellers remain constant.
3. Cost of all the factors of production is also assumed to be constant.
4. It is also assumed that the level of technology remains constant.
5. It is also assumed that the commodity is divisible.
6. Law of supply states only a static situation.

Description: Law of supply depicts the producer behavior at the time of changes in the prices of goods
and services. When the price of a good rises, the supplier increases the supply in order to earn a profit
because of higher prices.

Price (Rs) Quantity Supplied

2 0
4 3
6 6
8 9

The above diagram shows the supply curve that is upward sloping (positive relation between the price and
the quantity supplied). When the price of the good was at P4, suppliers were supplying Q3 quantity. As
the price starts rising, the quantity supplied also starts rising.

SUPPLY FUNCTION

The supply function is the mathematical expression of the relationship between supply and those factors
that affect the willingness and ability of a supplier to offer goods for sale.

SX = Supply of goods X

PX = Price of goods X

PF = Factor input employed (used) for production.

· Raw material
· Human resources
· Machinery

O = Factors outside economic sphere.

T = Technology.
t = Taxes.
S = Subsidies
47
 BEFA UNIT II

There is a functional (direct) relationship between price and supply.

48
 BEFA UNIT II

DETERMINANTS OF SUPPLY

1. Number of Sellers
Greater the number of sellers, greater will be the quantity of a product or service supplied in a market and
vice versa. Thus increase in number of sellers will increase supply and shift the supply curve rightwards
whereas decrease in number of sellers will decrease the supply and shift the supply curve leftwards. For
example, when more firms enter an industry, the number of sellers increases thus increasing the supply.

2. Prices of Resources
Increase in resource prices increases the production costs thus shrinking profits and vice versa. Since
profit is a major incentive for producers to supply goods and services, increase in profits increases the
supply and decrease in profits reduces the supply. In other words supply is indirectly proportional to
resource prices. Increase in resource prices reduces the supply and the supply curve is shifted leftwards
whereas decrease in resource prices increases the supply and the supply curve is shifted rightwards.

3. Taxes and Subsidies

Taxes reduces profits, therefore increase in taxes reduce supply whereas decrease in taxes increase
supply. Subsidies reduce the burden of production costs on suppliers, thus increasing the profits.
Therefore increase in subsidies increase supply and decrease in subsidies decrease supply.

4. Technology
Improvement in technology enables more efficient production of goods and services. Thus reducing the
production costs and increasing the profits. As a result supply is increased and supply curve is shifted
rightwards. Since technology in general rarely deteriorates, therefore it is needless to say that
deterioration of technology reduces supply.

5. Suppliers' Expectations
Change in expectations of suppliers about future price of a product or service may affect their current
supply. However, unlike other determinants of supply, the effect of suppliers' expectations on supply is
difficult to generalize. For example when farmers suspect the future price of a crop to increase, they will
withhold their agricultural produce to benefit from higher price thus reducing the supply. In case of
manufacturers, when they expect the future price to increase, they will employ more resources to increase
their output and this may increase current supply as well.

6. Prices of Related Products

Firms which are able to manufacture related products (such as air conditioners and refrigerators) will the
shift their production to a product the price of which increases substantially related to other related
product(s) thus causing a reduction of supply of the products which were produced before. For example a
firm which produces cricket bats is usually able to manufacture hockey sticks as well. When the price of
hockey sticks increases, the firm will produce more hockey sticks and less cricket bats. As a result, the
supply of cricket bats will be reduced.

7. Prices of Joint Products

When two or more goods are produced in a joint process and the price of any of the product increases, the
supply of all the joint products will be increased and vice versa. For example, increase in price of meat
will increase the supply of leather.

49
 BEFA UNIT II
ADDITIONAL IMPORTANT INFORMATION

TYPES OF DEMAND

1. Consumer goods demand Vs Producer goods demand

Consumer goods are those goods which satisfy the human needs. These goods are available for
ultimate consumption and give direct satisfaction. Ex: Rice, Bread, Apple etc.
Producer goods are those goods which are used to produce consumer goods and these goods give
indirect satisfaction to consumers.
2. Autonomous demand Vs Derived demand
The direct demand for goods and services is called as autonomous demand. It is independent demand.
Ex: The demand for college is autonomous demand.
The demand for goods whose demand depends upon the demand of main goods is called as derived
demand. Ex: The demand for canteen food is derived demand. Because, if there is no demand for
college, there will be no demand for canteen food.
3. Durable goods demand Vs Perishable goods demand
Durable goods are those goods which give services for longer period. Ex: TV. Computer, Furniture
etc.
Perishable goods are those goods whose life may be in hours or days. Ex: Milk, Bread, Fish etc.
4. Firm demand Vs Industry demand
The firm is a single business unit. The quantity of goods demanded by a single firm is called firm
demand.
Industry refers to the group of companies producing similar goods. The quantity demanded by industry
(all companies) is called industry demand. Ex: Demand for computers by one college is called firm
demand. Demand for computers by all colleges is called industry demand.
5. Short – run demand Vs Long – run demand
Short – run refers to shorter duration. In short-run, additional changes cannot be initiated in terms of
expansion of the business. In this period, the firm can adjust their production by changing variable
factors such as materials and labor. Fixed factors such as capital, technology etc, cannot be changed.
The long-run is a period relatively long so that all factors of production including capital can be
adjusted to meet the market requirements.
6. New demand Vs Replacement demand
New demand refers to the demand for the new products and it is the addition to the existing stock.
In replacement demand, the item is purchased to maintain the asset in good condition.
Ex: The demand for car is new demand and the demand for spare part is called replacement demand.
7. Total Market demand Vs Segment Market demand
The demand for product in the entire market is called total market. The demand for product in
particular location, from particular age group or income group of people is called segment market
demand.
Ex: The demand for sugar in entire Telangana state is total market demand for sugar. The demand for
sugar in Hyderabad is segment market demand.

FACTORS GOVERNING/INFLUENCING DEMAND FORECASTING

1. Types of Goods:
Types of goods affect the demand forecasting process to a larger extent. Goods can be producer‘s goods,
consumer goods, or services. Apart from this, goods can be established and new goods. Established goods
are those goods which already exist in the market, whereas new goods are those which are yet to be
introduced in the market.

Information regarding the demand, substitutes and level of competition of goods is known only in case of
established goods. On the other hand, it is difficult to forecast demand for the new goods. Therefore,
forecasting is different for different types of goods.

50
 BEFA UNIT II

2. Competition Level:
Competition level influences the process of demand forecasting. In a highly competitive market, demand
for products also depends on the number of competitors existing in the market. Moreover, in a highly
competitive market, there is always a risk of new entrants. In such a case, demand forecasting becomes
difficult and challenging.

3. Price of Goods:
Price acts as a major factor that influences the demand forecasting process. The demand forecasts of
organizations are highly affected by change in their pricing policies. In such a scenario, it is difficult to
estimate the exact demand of products.

4. Level of Technology:
Level of technology constitutes an important factor in obtaining reliable demand forecasts. If there is a
rapid change in technology, the existing technology or products may become obsolete. For example, there
is a high decline in the demand of floppy disks with the introduction of compact disks (CDs) and pen
drives for saving data in computer. In such a case, it is difficult to forecast demand for existing products
in future.

5. Economic Viewpoint:
Economic view point plays a crucial role in obtaining demand forecasts. For example, if there is a
positive development in an economy, such as globalization and high level of investment, the demand
forecasts of organizations would also be positive.

6. Time Period of Forecasts:

Time period acts as a crucial factor that affects demand forecasting. The accuracy of demand forecasting
depends on its time period.

a. Short Period Forecasts:

Refers to the forecasts that are generally for one year and based upon the judgment of the experienced
staff. Short period forecasts are important for deciding the production policy, price policy, credit policy,
and distribution policy of the organization.

b. Long Period Forecasts:

Refers to the forecasts that are for a period of 5-10 years and based on scientific analysis and statistical
methods. The forecasts help in deciding about the introduction of a new product, expansion of the
business, or requirement of extra funds.

7. Level of Forecasts:
Level of forecasts influences demand forecasting to a larger extent. A demand forecast can be carried at
three levels, namely, macro level, industry level, and firm level. At macro level, forecasts are undertaken
for general economic conditions, such as industrial production and allocation of national income. At the
industry level, forecasts are prepared by trade associations and based on the statistical data.

Moreover, at the industry level, forecasts deal with products whose sales are dependent on the specific
policy of a particular industry. On the other hand, at the firm level, forecasts are done to estimate the
demand of those products whose sales depend on the specific policy of a particular firm. A firm considers
various factors, such as changes in income, consumer‘s tastes and preferences, technology, and
competitive strategies, while forecasting demand for its products.

8. Nature of Forecasts:
Nature of forecasts constitutes an important factor that affects demand forecasting. A forecast can be
specific or general. A general forecast provides a global picture of business environment, while a specific
forecast provides an insight into the business environment in which an organization operates. Generally,
organizations opt for both the forecasts together because over-generalization restricts accurate estimation

51
 BEFA UNIT II
of demand and too specific information provides an inadequate basis for planning and execution.

52
 BEFA UNIT III
PRODUCTION

Production is the transformation or conversion of resources into commodities over time. Economists view
production as an activity through which utility is created or enhanced for a product. A firm is a business unit
which undertakes the activity of transforming inputs into output of goods and services.

FACTORS OF PRODUCTION

Factors of production is an economic term that describes the inputs that are used in the production of goods or
services in order to make an economic profit. The factors of production include land, labor, capital and
entrepreneurship. These production factors are also known as management, machines, materials and labor, and
knowledge has recently been talked about as a potential new factor of production.

1. Land
Land is short for all the natural resources available to create supply. It includes raw land and anything that
comes from the land. It can be a non-renewable resource.That includes commodities such as oil and gold. It can
also be a renewable resource, such as timber. Once man changes it from its original condition, it becomes a
capital good. For example, oil is a natural resource, but gasoline is a capital good. Farmland is a natural
resource, but a shopping center is a capital good.
The income earned by owners of land and other resources is called rent.

2. Labour
Labor is the work done by people. The value of labor depends on workers' education, skills, and motivation. It
also depends on productivity. That measures how much each hour of worker time produces in output.
The reward or income for labor is wages.

3. Capital
Capital is short for capital goods. These are man-made objects like machinery, equipment, and chemicals, that
are used in production. That's what differentiates them from consumer goods. For example, capital goods
include industrial and commercial buildings, but not private housing. A commercial aircraft is a capital good but
a private jet is not.
The income earned by owners of capital goods is called interest.

4. Entrepreneurship
Entrepreneurship is the drive to develop an idea into a business. An entrepreneur combines the other three
factors of production to add to supply. The most successful are innovative risk-takers.
The income entrepreneurs earn is profits.

53
 BEFA UNIT III

PRODUCTION FUNCTION

The production function expresses a functional relationship between physical inputs and physical outputs of a
firm at any particular time period. The output is thus a function of inputs. So, production function is an input –
output relationship. Mathematically production function can be written as
Q = Output
Q= f (L1,L2 C,O,T) f = Function of
Here output is the function of inputs. Hence output becomes the dependent variable and L1 = Land
inputs are the independent variables. L2 = Labour
C = Capital
Definition : O = Organization
Samueson defines the production function as “The technical relationship which revealsTthe maximum
= Technology
amount of output capable of being produced by each and every set of inputs”

Michael R Baye defines the production function as” That function which defines the maximum amount
of output that can be produced with a given set of inputs.”

Assumptions:
Production function has the following assumptions.

1. The production function is related to a particular period of time.

2. There is no change in technology.
3. The producer is using the best techniques available.
4. The factors of production are divisible.
5. Production function can be fitted to a short run or to long run.

54
 BEFA UNIT III
PRODUCTION FUNCTION WITH ONE VARIABLE INPUT

The law of variable proportions which was earlier called as “Law of diminishing returns has
played a vital role in the modern economics theory. Assume that a firms‟ production function consists of fixed
quantities of all inputs (land, equipment, etc.) except labour which is a variable input. If you go on adding the
variable input, say, labor, the total output in the initial stages will increase at an increasing rate, and after
reaching certain level of output the total output will increase at declining rate. If variable factor inputs are added
further to the fixed factor input, the total output may decline. This law is of universal nature and it proved to be
true in agriculture.

Assumptions of the Law:

The law is based upon the following assumptions:

1. Only one factor is varied
2. The scale of output is unchanged
3. The technique of production is unchanged
4. All units of factor input varied are homogeneous
Three stages of law:
The behaviour of the Output when the varying quantity of one factor is combined with a fixed quantity of the
other can be divided in to three district stages. The three stages can be better understood by following the table.

55
 BEFA UNIT III

From the above graph the law of variable proportions operates in three stages. In the first stage,
total product increases at an increasing rate. The marginal product in this stage increases at an increasing rate
resulting in a greater increase in total product. The average product also increases. This stage continues up to
the point where average product is equal to marginal product. The law of increasing returns is in operation at
this stage. The law of diminishing returns starts operating from the second stage onwards. At the second stage
total product increases only at a diminishing rate. The average product also declines. The second stage comes to
an end where total product becomes maximum and marginal product becomes zero. The marginal product
becomes negative in the third stage. So the total product also declines. The average product continues to
decline.

We can sum up the above relationship thus when „AP‟ is rising, “MP‟ rises more than “AP; When „AP” is
maximum and constant, „MP‟ becomes equal to „AP‟ when „AP‟ starts falling, „MP‟ falls faster than
„AP‟.Thus, the total product, marginal product and average product pass through three phases, viz., increasing
diminishing and negative returns stage. The law of variable proportion is nothing but the combination of the law
of increasing and demising returns.

PRODUCTION FUNCTION WITH TWO VARIABLE INPUTS

Isoquants analyse and compare the different combinations of capital & labour and output. The term isoquant
has its origin from two words “iso” and “quantus”. „iso‟ is a Greek word meaning „equal‟ and „quantus‟ is a
Latin word meaning „quantity‟. Isoquant therefore, means equal quantity. An isoquant curve is therefore called
as iso-product curve or equal product curve or production indifference curve.

Thus, an isoquant shows all possible combinations of two inputs, which are capable of producing equal or a
given level of output. Since each combination yields same output, the producer becomes indifferent towards
these combinations.

Assumptions:

1. There are only two factors of production, viz. labour and capital.
2. The two factors can substitute each other up to certain limit
3. The shape of the isoquant depends upon the extent of substitutability of the two inputs.
4. The technology is given over a period.

56
 BEFA UNIT III
For example:- Now the firm can combine labor and capital in different proportions and can maintain specified
level of output say, 10 units of output of a product X. It may combine alternatively as follows:

In the below table, combination „A‟ represent 1 unit of capital and 10 units of labour and produces „10‟ units of
a product. All other combinations in the table are assumed to yield the same given output of a product say „10‟
units by employing any one of the alternative combinations of the two factors labour and capital. If we plot all
these combinations on a paper and join them, we will get a curve called Iso-quant curve as shown below.
Labour is on the X-axis and capital is on the Y-axis. IQ is the Iso-Quant curve which shows all the alternative
combinations A, B, C, D which can produce 10 units of a product.

Features of an ISOQUANT:

1. Downward sloping:-If one of the inputs is reduced, the other input has to be
increased. There is no question of increase in both the inputs to yield a given output.

2. Don’t touch the axes:- The isoquant touches neither X-axis nor Y-axis, as both inputs
are required to produce a given product.If an isoquant is touching the X-axis, it means
output is possible even by using a factor(Ex: Labor alone without using capital). But,
this is unrealistic.

3. Don’t intersect:- Iso-quants representing different levels of output never intersect or

touch or be tangent to each other. If they intersect to each other, they have a common
point on them which means that the same amount of labor and capital produce two
different levels of output.

4. Convex to origin:-Isoquants are convex to the origin. It is because the inputs factor
are not perfect substitutes. One input factor is substituted by other input factor in a
decreasing marginal rate.The convexity of isoquant suggests that MRTS is diminishing
which means that as quantities of one factor-labor is increased , the less of another
factor-capital will be given up, if output level is to be kept constant.

5. Upper isoquants represent higher level of output:- Each isoquant represents a

different quantity of output. Higher isoquants indicate a higher level of output.

57
 BEFA UNIT III
LAW OF RETURNS TO SCALE

The concept of variable proportions is a short-run phenomenon as in these period fixed factors cannot be
changed and all factors cannot be changed. On the other hand in the long-term all factors can be changed as
made variable. When we study the changes in output when all factors or inputs are changed, we study returns to
scale. An increase in the scale means that all inputs or factors are increased in the same proportion. In variable
proportions, the cooperating factors may be increased or decreased and one faster (Ex. Land in agriculture (or)
machinery in industry) remains constant so that the changes in proportion among the factors result in certain
changes in output. In returns to scale, all the necessary factors or production are increased or decreased to the
same extent so that whatever the scale of production, the proportion among the factors remains the same.

Assumptions
1. Technique of production is unchanged
2. All units of factors are homogeneous
3. Returns are measured in physical terms

When a firm expands, its scale increases all its inputs proportionally, then technically there are three
possibilities.

1. Law of increasing returns to scale:- if a proportionate/percentage increase

in the output is larger than the proportionate/percentage increase in inputs, there
are increasing returns.

For example: If a 5% increase in inputs, results in 10% increase in the

output, a firm is said to attain increased returns.

If PFC > 1, it means increasing returns to scale

If PFC = 1, it means constant returns to scale
If PFC < 1, it means decreasing returns to scale

2. Law of constant returns to scale:- if the proportionate increase in all the inputs
is equal to the proportionate increase in output, then situation of constant returns to
scale occurs.

For Example:- If the inputs are increased at 10% and if the resultant output also
increases a 10% then the organization is said to achieve constant returns to scale.

3. Law of decreasing returns to scale:- if the proportionate increase in output is

less than the proportionate increase in input, then a situation of decreasing returns
to scale occurs.
For Example:- If the inputs are increased by 10% and if the resultant output increases only by 5% then the organization
is said to achieve decreasing returns toscale.

58
 BEFA UNIT III

the following table illustrates these laws clearly.

From the above table it is clear that with 1 unit of capital and 3 units of labor, the firm produces 50 units of
output. When the inputs are doubled 2 units of capital and 6 units of labor, the output has gone up to 120 units.
Thus when inputs are increased by 100%, the output has increased by 140%. That is , output has increased by
more than double. This is governed by law of increasing returns to scale.

When the inputs are further doubled that is to 4 units of capital and 12 units of labor, the output has gone to 240
units. Thus, when inputs are increased by 100%., the output has increased by 100%. That is, output has
doubled. This governed by law of constant returns to scale.

When the inputs further doubled, that is, to 8 units of capital and 24 units of labor, the output has gone up to
360 units. Thus, when inputs are increased by 100%, the output has increased by only 50%. This is governed by
law of decreasing returns to scale.

DIFFERENT TYPES OF PRODUCTION FUNCTIONS

1. Cobb-Douglas Production Function

This production function was proposed by C. W. Cobb and P. H. Dougles. This famous statistical
production function is known as Cobb-Douglas production function. Originally the function is applied on the
empirical study of the American manufacturing industry from 1899 to 1922. Cobb – Douglas production
function takes the following
mathematical form.
Q = Total production/Output
a = Total factor productivity/Multi -factor productivity
Q = aLb KC (The ratio of output to the sum of associated labor and capital
inputs). Productivity is measure of efficiency of labor/machines etc, in
Q = 1.01L0.75K0.25 converting input into output.

𝐮
L = Index of employment of labor = Labour units K
The above production function shows = Index of employment of capital = Capital unitsb =
that 1% change in labor input, capital Output elasticity of labor (1% change in labor
remaining the same, is associated with a results in b% change in output)
c = Output elasticity of capital (1% change in capital results in c% change
0.75 percent change in output. in output)
Similarly, 1% change in capital, labor remaining the same, is associated with a 0.25 percent change in output.

59
 BEFA UNIT III
Assumptions:
It has the following assumptions
1. The function assumes that output is the function of two factors viz. capital and labour.
2. It is a linear homogenous production function of the first degree
3. There are constant returns to scale b+c=1
4. All inputs are homogenous
5. There is perfect competition
6. There is no change in technology
7. Both L&K should be positive for to Q to exist. If either of these is zero, Q will be zero. This implies
that both labor and capital will be combined to get output.

2. Leontief Production Function:

Leontief production function, also known as Fixed Proportion Production Function, uses fixed proportion of
inputs having no substitutability between them. It is regarded as the limiting case for constant elasticity of
substitution.
The production function can be expressed as follows:

Where, q = quantity of output produced

Z1 = utilized quantity of input 1
Z2 = utilized quantity of input 2
a and b = constants

For example, tyres and steering wheels are used for producing cars. In such a case, the production function can
be as follows:

Q = min (z1/a, Z2/b)

Q = min (number of tyres used, number of steering wheels used).

60
 BEFA UNIT III
Suppose that the inputs "tires" and "steering wheels" are used in the production of a car (for simplicity of the
example, to the exclusion of anything else). Then in the above formula q refers to the number of cars produced
i.e., one in our example, z1 refers to the number of tires used, and z2 refers to the number of steering wheels
used. Assuming that each car is produced with 4 tires and 1 steering wheel, the Leontief production function is
Number of cars = Min{¼ times the number of tires, 1 times the number of steering wheels}.

In the above given figure, OR shows the fixed Tyres-Wheels ratio, if a firm wants to produce 1 car, then 4 tyres
and 1 wheel must be used.
Similarly, for the production of 3 cars and 4 cars, 12 tyres and 3 wheel and 16 tyres and 4 wheel must be
employed respectively.

3. CES Production Function

Definition: The Constant Elasticity of Substitution Production Function or CES implies, that any change in
the input factors, results in the constant change in the output. In CES, the elasticity of substitution is constant
and may not necessarily be equal to one or unity.
In constant elasticity of substitution production function, all the input factors are taken into the consideration
such as raw material, technology, labor, capital, etc. The marginal product of one factor increases with the
increase in the value of the other factors of production. Also, the marginal product of labor and capital will be
positive in case of constant returns to scale.
The constant elasticity of substitution production function can be expressed algebraically as:

61
 BEFA UNIT III
TYPES OF COSTS

Profits are the difference between selling price and cost of production. In general the selling price is not within
the control of a firm but many costs are under its control. The firm should therefore aim at controlling and
minimizing cost. The various relevant concepts of cost are:

1. Opportunity costs and Outlay costs:

Opportunity costs refer to the „costs of the next best alternative foregone‟. We have scarce resources
and all these have alternative uses. Where there is an alternative, there is an opportunity to reinvest the
resources. In other words, if there are no alternatives, there are no opportunity costs. It is necessary that we
should always consider the cost of the next best alternative foregone before committing the funds on a given
option. In other words, the benefits from the present option should be more than the benefits of the next best
alternative. Opportunity cost is said to exist when the resources are scarce and there are alternative uses for
these resources. If there is no alternative, Opportunity cost is zero.
For example: if a firm owns a land, there is no cost of using the land (i.e., the rent) in firm‟s account.
Bust the firm has an opportunity cost of using this land, which is equal to the rent foregone by not letting the
land out on (the return of second best alternative is regarded as the cost of first best alternative) rent.

Out lay costs are as actual costs which are actually incurred by the firm. these are the payments made
for labour, material, plant, building, machinery traveling, transporting etc., These are all those expenses
appearing in the books of account, hence based on accounting cost concept.

2. Explicit costs and Implicit costs:

Explicit costs are also called as out-of-pocket cost that involve cash payments. These are the actual or
business costs that appear in the books of accounts. These costs include payment of wages and salaries,
payment for raw-materials, interest on borrowed capital funds, rent on hired land, Taxes paid etc.

Implicit costs are also called as imputed costs which don‟t involve payment of cash as they are not
actually incurred. They would have been incurred had the owner not been in possession of the facilities. Ex:
Interest on own capital, saving in terms of salary due to own supervision and rent of own building etc.

3. Historical costs and Replacement costs:

Historical cost is the original cost that has been originally spent to acquire the asset. of an asset.
Historical valuation is the basis for financial accounts.
A replacement cost is the price that is to be paid currently to replace the same asset. A replacement cost
is a relevant cost concept when financial statements have to be adjusted for inflation.

4. Short – run costs and Long – run costs:

Short-run is a period during which the physical capacity of the firm remains fixed. Any increase in
output during this period is possible only by using the existing physical capacity more extensively. So short run
cost is that which varies with output when the plant and capital equipment are constant.
Long run is defined as a period of adequate length during which a company may alter all factors of
production with high degree of flexibility.

5. Out-of pocket costs and Books costs:

Out-of pocket costs also known as explicit costs are those costs that involve current cash payment
such as purchase of raw material, payment of salary rents payment, interest on loan etc.
Book costs also called implicit costs do not require current cash payments. Depreciation, unpaid
interest, salary of the owner is examples of back costs.

6. Fixed costs, Variable costs and Semi-variable costs:

Fixed cost is that cost which remains constant for a certain level to output. It is not affected by the
changes in the volume of production but fixed cost per unit decreases, when the production is increased. Fixed
cost includes salaries, Rent, Administrative expenses depreciations etc.
Variable is that which varies directly with the variation in output. An increase in total output results in
an increase in total variable costs and decrease in total output results in a proportionate deccease in the total
variables costs. The variable cost per unit will be constant. Ex: Raw materials, labour, direct expenses, etc.

Semi-variable costs refer to such costs that are fixed to some extent beyond which they are variable. Ex:
telephone charges, Electricity charges, etc.
62
 BEFA UNIT III
7. Past costs and Future costs:
Past costs also called historical costs are the actual cost incurred and recorded in the book of account
these costs are useful only for valuation and not for decision making.

Future costs are costs that are expected to be incurred in the futures. They are not actual costs. They are
the costs forecasted or estimated with rational methods. Future cost estimate is useful for decision making
because decision are meant for future.

8. Separable costs and Joint costs:

The costs which can be traced or identified directly with a particular unit, department, or a process of
production are called separable costs or direct costs or traceable costs.

The costs which cannot be identified directly with a particular unit, department or a process of the
production are called joint costs or indirect costs or common costs. These costs are apportioned among various
departments. Ex: Rent, Electricity, Administration salaries, Research and Development expenses etc.

9. Avoidable costs and Unavoidable costs:

Avoidable costs are those costs, which can be reduced if the business activities of a concern are
curtailed. For example, if some workers can be retrenched with a drop in production, the wages of the
retrenched workers are escapable costs.
Unavoidable costs are those that are essential for the sustenance of the business activity and hence they
have to be incurred.

10. Controllable costs and Uncontrollable costs:

Controllable costs are ones, which can be regulated by the executive who is in charge of it. Direct
expenses like material, labour etc. are controllable costs.

Some costs are not directly identifiable with a process of product. They are apportioned to various
processes or products in some proportion. These apportioned costs are called uncontrollable costs.

11. Incremental costs and Sunk costs:

Incremental cost also known as differential cost is the additional cost due to a change in the level or
nature of business activity. The change may be caused by adding a new product, adding new machinery,
replacing a machine by a better one etc.

Sunk costs are those which are not altered by any change – They are the costs incurred in the past. This
cost is the result of past decision, and cannot be changed by future decisions. Investments in fixed assets are
examples of sunk costs. Once an asset is bought, the funds are blocked forever. They can neither be changed
nor controlled.

12. Total costs, Average costs and Marginal costs:

Total cost is the total expenditure incurred for the input needed for production. It may be explicit or
implicit. It is the sum total of the fixed and variable costs.

Average cost is the cost per unit of output. It is obtained by dividing the total cost (TC) by the total
quantity produced (Q)

Marginal cost is the additional cost incurred to produce an additional unit of output.

13. Accounting costs and Economic costs:

Accounting costs are the costs recorded for the purpose of preparing the profit & loss account and
balance sheet to meet the legal, financial and tax purpose of the company. The accounting concept is a historical
concept and records what has happened in the post.

Economic cost refers to cost of economic resources used in production including opportunity cost.
Economics concept considers future costs and future revenues, which help future planning, and choice, while
the accountant describes what has happened, the economics aims at projecting what will happen.

63
 BEFA UNIT III
14. Urgent costs and Postponable costs:

Urgent cost are those costs such as raw materials, wages and son, necessary to sustain the productivity.

Postponable costs are those costs which can be conveniently postponed. For example, white washing
the building etc.

COST-OUTPUT RELATIONSHIP

The cost-output relationship plays an important role in determining the optimum level of production.
Knowledge of the cost-output relationship helps the manager in cost control, profit prediction, pricing,
promotion etc. Output is an important factor, which influences the cost. Considering the period the cost function
can be classified as (a) short-run cost function and (b) long-run cost function. In the short run, the costs can be
classified into fixed costs and variable costs. The cost-output relationship in the short run is governed by certain
restrictions in terms of fixed costs whereas in the long run, the cost-output relationship studies the effect of
varying the size of plants upon its cost.

I. Short-run Cost Function:

Under short run cost-output relation, costs in short run are classified into fixed costs and variable costs.
Labour is the variable factor while capital is the fixed factor. Total fixed cost remains constant while variable
cost changes with the variation in units if labour. The fixed costs may be ascertained in terms of total fixed cost
and average fixed cost per unit. The variable cost can be determined in terms of average variable cost, total
variable cost. The below table explains the behavior of costs in the short run. From the below it is clear that:

Total

 Total fixed costs remain fixed irrespective of increase or decrease in production activity.
 Average fixed cost per unit declines as the volume of production increases. As production increases, the
fixed costs are spread over a great number of units. There is inverse relationship between average fixed
cost and volume of production.
 The total variable cost increases proportionately with production. But, the rate of increase is not
constant.
 The total cost increases with the volume of production.
 The average total cost decreases up to certain level of
production. After this level, it rises steeply. It results in flat
U-shaped curve. The lowest point of AFC curve denotes the
ideal level of production.
 Marginal cost is the change in total cost due to one unit
change in output.

64
 BEFA UNIT III
The short-run cost-output relationship can be shown graphically as follows.

 From this graph, it is noticed that as the production increases, the AFC will continue to decrease. Hence,
the AFC curve will slope downwards and it appears to meet the X axis but it never meets the X axis.
 The AVC curve is U-shaped curve indicating that the AVC curve tends to fall in the beginning when
output increases but after a particular level of output, it rises because of the application of law of returns
or law of variable proportions or law of diminishing returns.
 The ATC curve initially declines and then rises upward. As long as AVC declines the ATC will also
decline.
 MC is the change in total cost resulting from a unit change in output. It decreases up to certain level of
output but later rises steeply.

II. Long-run Cost Function:

Long run refers to that period of time over which all factors are variable. It has no fixed cost. Over
a long period, the size of the plant can be changed, unwanted buildings can be sold staff can be increased or
reduced. The long run enables the firms to expand and scale of their operation by bringing or purchasing larger
quantities of all the inputs. Thus in the long run all factors become variable.

In the long run a firm has a number of alternatives in regards to the scale of operations. For each
scale of production or plant size, the firm has an appropriate short-run average cost curves. The short-run
average cost (SAC) curve applies to only one plant whereas the long-run average cost (LAC) curve takes in to
consideration many plants.

If we assume that there are many plant sizes, each suitable for a certain level of output, we will get many SAC
curves intersecting each other. As the number of plant sizes increases, the points of intersection of SAC curve
will come closer. And, if we assume that there are large number (say, infinite number) of plant sizes the
intersection points will be so near to each other that we get almost a continuous curve. Thus continuous curve is
known as the Long-run Average Cost (LAC) curve or the Envelope curve (as it envelopes the family of short-
run Average Cost Curves).

The long-run cost-output relationship is shown graphically with the help of “LCA‟ curve.

The above figure shows how LAC curve envelopes

several short-run average cost (SAC) curves. Suppose, the
firm is producing an output of OQ1 units on a plant of
SAC1, if it wants to produce O Q2 units of output, either
it can operate on SAC1 by over utilizing SAC1 plant or by
acquiring a bigger size palntSAC2 and operate on it. It
will be less costly to operate on SAC2. If it wants to
produce O Q3 units of output, it can operate on the
bigger size plant SAC3 at least cost. Q3A3 is the least
cost at the output OQ3 and the firm attains optimum
output in the long-run at OQ3 level of output. If it
operates on SAC2 to produce OQ3 units of output, the
cost will be prohibitively high being Q3A33. It is to be
notes that there is only one short-run average cost curve
SAC3 which is tangential to the long-run average cost
curve at its minimum point. All other SAC curves are
tangential to the LAC curves at higher than their
minimum average cost points.

65
 BEFA UNIT III

MARKET
Market is a place where buyer and seller meet, goods and services are offered for the sale and transfer of
ownership occurs. A market may be also defined as the demand made by a certain group of potential buyers for
a good or service. The former one is a narrow concept and later one is a broader concept. Economists describe a
market as a collection of buyers and sellers who transact over a particular product or product class (the housing
market, the clothing market, the grain market etc.). For business purpose we define a market as people or
organizations with wants (needs) to satisfy, money to spend, and the willingness to spend it. Broadly, market
represents the structure and nature of buyers and sellers for a commodity/service and the process by which the
price of the commodity or service is established. In this sense, we are referring to the structure of competition
and the process of price determination for a commodity or service. The determination of price for a commodity
or service depends upon the structure of the market for that commodity or service (i.e., competitive structure of
the market). Hence the understanding on the market structure and the nature of competition are a pre-requisite
in price determination.
Different Market Structures
Market structure describes the competitive environment in the market for any good or service. A market
consists of all firms and individuals who are willing and able to buy or sell a particular product. This includes
firms and individuals currently engaged in buying and selling a particular product, as well as potential entrants.
The determination of price is affected by the competitive structure of the market. This is because the firm
operates in a market and not in isolation. In making decisions concerning economic variables it is affected, as
are all institutions in society by its environment.

PERFECT COMPETITION
Perfect competition refers to a market structure where competition among the sellers and buyers prevails in its
most perfect form. In a perfectly competitive market, a single market price prevails for the commodity, which is
determined by the forces of total demand and total supply in the market.
Characteristics Of Perfect Competition
The following features characterize a perfectly competitive market:
a) A large number of buyers and sellers: The number of buyers and sellers is large and the share of each
one of them in the market is so small that none has any influence on the market price.
b) Homogeneous product: The product of each seller is totally undifferentiated from those of the others.
c) Free entry and exit: Any buyer and seller is free to enter or leave the market of the commodity.
d) Perfect knowledge: All buyers and sellers have perfect knowledge about the market for the
commodity.
e) Indifference: No buyer has a preference to buy from a particular seller and no seller to sell to a
particular buyer.
f) Non-existence of transport costs: Perfectly competitive market also assumes the non-existence of
transport costs.
g) Perfect mobility of factors of production: Factors of production must be in a position to move freely
66
 BEFA UNIT III
into or out of industry and from one firm to the other.
Perfect competition: The individual firm
AR(Average revenue) curve and MR(Marginal Revenue) curve under perfect competition becomes equal to
D(Demand) curve and it would be a horizontal line or parallel to the X-axis. The curve simply implies that a
firm under perfect competition can sell as much quantity as it likes at the given price determined by the industry
i.e. a perfectly elastic demand curve.

Perfect competition: The firm and the industry

Price is determined by the market forces, that is, demand and supply for a given product or service. As
discussed above, firms have no control over the prices they charge for their products. The ultimate price that
determines the quantity demanded is equal to the quantity supplied. This price is also called equilibrium price,
as it balances the forces of demand and supply. The figure shows how the price is determines. DD is the
demand curve and SS is the supply curve. Rs. 6 is the price at which DD and SS intersect each other. At Rs. 6,
60 units are supplied and demanded.
If the price increases to Rs.8, supply will also increase and hence the price is likely to fall down.
If the price decreases to Rs. 4, supply will decrease and hence the price is likely to go up.

67
 BEFA UNIT III

Price-Output Determination Under Perfect Competition

In this market, the price is determined by supply and demand forces. Marshal who propounded the theory says
that the price is determined by the equilibrium between demand and supply.
The pricing of commodity under perfect competition can be determined
in three periods of time.
a) Very short period (Market Period)
Market period is too short period to increase the supply. The market
period is so short that supply of the commodity is limited to existing stock.
During the market period, say a single day, the supply of a commodity is
perfectly inelastic.

In this figure quantity is represented along X-axis and price is

represented along Y-axis. MS is the very short period supply curve. DD is
demand curve. It intersects supply curve at E. The price is OP. The quantity is OM. D1 D1 represents increased
demand. This curve cuts the supply curve at E1. Even at the new equilibrium, supply is OM only. But price
increases to OP1. So, when demand increases, the price will increase but not the supply. If demand decreases
new demand curve will be D2 D2. This curve cuts the supply curve at E2. Even at this new equilibrium, the
supply is OM only. But price falls to OP2. Hence in very short period, given the supply, it is the change in
demand that influences price. The price determined in a very short period is called Market Price.

b) Short Period
Short period is not too long period to install new capital
equipments. It is also not sufficient period to permit the new firms to enter
the industry to increase the supply of the commodity in the market. Hence
the firm can increase the supply of a commodity in the short period only
by making intensive use of the given plants and equipments and
increasing the units of variable factors.
As a result of this, the short period supply of a commodity will be
relatively less elastic.

In the diagram MS is the market period supply curve. DD is the initial demand curve. It intersects MS curve at
E. The price is OP and output OM. Suppose demand increases, the demand curve shifts upwards and becomes
D1D1. In the very short period, supply remains fixed on OM. The new demand curve D1D1 intersects MS at
E1. The price will rise to OP1. This is what happened in the very short-period.
As the price rises from OP to OP1, firms expand output. As firms can vary some factors but not all, the law of
variable proportions operates. This results in new short-run supply curve SS. It interests D1 D1 curve at E2. The
price will fall from OP1 to OP2.

68
 BEFA UNIT III

c) Long Period
In Long run, the Firm‟s output (supply) can be changed by both the
variable factors and fixed factors i.e. all factors become variable.
There is enough time for new Firms to enter the Industry. Further, if
the demand is increased, the supply can be increased or decreased
according to the demand. For Long run equilibrium, long run marginal
cost (LMC) is equal to MR and LMC curve cut the MR curve from
below. In case of long run equilibrium, all the firms will earn only
normal profits.

Take the case when the Firm earn super-normal profit-Then the existing Firm will increase their production and
new Firm will enter the Industry. Consequently, the total supply will increase and price fall down and further
results in normal profit for the firm
On the contrary, if the firm is incurring losses, Then some Firm will leave the Industry which will reduce the
total supply. And due to decrease in supply, price will rise and once again Firm will begin to earn normal profit.
Firm equilibrium is at the minimum point of its LAC and at this point the Firm will get the normal profits. If
AR (price) rises to OP1, then Firm‟s LMC cuts its MR1 at E1 and the firm gets super-normal profit but again
come to OP yielding normal profits as stated before. And at price OP 2, firm incurs losses but again rise to level
OP to maintain the equilibrium at normal profit
Firm‟s equilibrium: MC=MR=AR= min LAC

MONOPOLY
„mono‟ means single and „poly‟ means seller. The term monopoly refers to that market in which a single firm
controls the whole supply of a particular product which has no close substitutes. Monopoly emerges in firms
such as transport, water and electricity supply etc.
Features:
1. Single person or a firm: A single person or a firm controls the total supply of the commodity. There
will be no competition for monopoly firm. The monopolist firm is the only firm in the whole industry.
2. No close substitute: The goods sold by the monopolist shall not have close substitutes. Even if price of
monopoly product increases, people will not go in far substitute. For example: If the price of electric
bulb increases slightly, consumer will not go in for kerosene lamp.
3. Large number of Buyers: Under monopoly, there may be a large number of buyers in the market who
compete among themselves.
4. Price Maker: Since the monopolist controls the whole supply of a commodity, he is a price-maker, and
then he can alter the price.
5. Supply and Price: The monopolist can fix either the supply or the price. He cannot fix both. If he
charges a very high price, he can sell a small amount. If he wants to sell more, he has to charge a low
price. He cannot sell as much as he wishes for any price he pleases.
6. Downward Sloping Demand Curve: The demand curve (average revenue curve) of monopolist slopes
downward from left to right. It means that he can sell more only by lowering price.

Monopoly refers to a market situation where there is only one seller. He has complete control over the supply
of a commodity. He is therefore in a position to fix any price. Under monopoly there is no distinction between
a firm and an industry. This is because the entire industry consists of a single firm.
Being the sole producer, the monopolist has complete control over the supply of the commodity. He has also the
power to influence the market price. He can raise the price by reducing his output and lower the price by
increasing his output. Thus he is a price-maker. He can fix the price to his maximum advantages. But he cannot
fix both the supply and the price, simultaneously. He can do one thing at a time. If he fixes the price, his output
will be determined by the market demand for his commodity. On the other hand, if he fixes the output to be
sold, its market will determine the price for the commodity. Thus his decision to fix either the price or the
output is determined by the market demand.
The market demand curve of the monopolist (the average revenue curve) is downward sloping. Its
corresponding marginal revenue curve is also downward sloping. But the marginal revenue curve lies below the

69
 BEFA UNIT III
average revenue curve as shown in the figure. The monopolist faces the down-sloping demand curve because to
sell more output, he must reduce the price of his product. The firm‟s demand curve and industry‟s demand
curve are one and the same. The average cost and marginal cost curve are U shaped curve. Marginal cost falls
and rises steeply when compared to average cost.
Under monopoly, demand curve is average revenue curve.

Price-Output Determination Under Monopoly

The monopolistic firm attains equilibrium when its marginal cost becomes
equal to the marginal revenue. The monopolist always desires to make
maximum profits. He makes maximum profits when MC=MR. He does not
increasing his output if his revenue exceeds his costs. But when the costs
exceed the revenue, the monopolist firm incur loses. Hence the monopolist
curtails his production. He produces up to that point where marginal cost is
equal to the marginal revenue (MR=MC). Thus, the point is called equilibrium
point. The price output determination under monopoly may be explained with
the help of a diagram.
In the diagram, the quantity supplied or demanded is shown along X-axis. The cost or revenue is shown along
Y-axis. AC and MC are the average cost and marginal cost curves respectively. AR and MR curves slope
downwards from left to right. AC and MC are U shaped curves. The monopolistic firm attains equilibrium
when its marginal cost is equal to marginal revenue (MC=MR). Under monopoly, the MC curve may cut the
MR curve from below or from a side. In the diagram, the above condition is satisfied at point E. At point E,
MC=MR. The firm is in equilibrium. The equilibrium output is OM. Up to OM output, MR is greater than MC
and beyond OM, MR is less than MC. Therefore, the monopolist is will be in equilibrium at output OM where
MR=MC and profits are maximized.
The above diagram (Average revenue) = MQ or OP
Average cost = MR
Profit per unit = Average Revenue-Average cost=MQ-MR=QR
Total Profit = QR x SR=PQRS
If AR > AC; Abnormal or super normal profits.
If AR = AC; Normal Profit
If AR < AC ; Loss

MONOPOLISTIC COMPETITION
Perfect competition and pure monopoly are rare phenomena in the real world. Instead, almost every market
seems to exhibit characteristics of both perfect competition and monopoly. Hence, in the real world, it is the
state of imperfect competition lying between these two extreme limits that work. Edward. H. Chamberlain
developed the theory of monopolistic competition, which presents a more realistic picture of the actual market
structure and the nature of competition.
Features/Characteristics
The important characteristics of monopolistic competition are:
1. Existence of Many firms: Industry consists of a large number of sellers, each one of whom does not
feel dependent upon others. Every firm acts independently without bothering about the reactions of its
rivals. The size is so large that an individual firm has only a relatively small part in the total market, so
that each firm has very limited control over the price of the product. As the number is relatively large, it
is difficult for these firms to determine its price- output policies without considering the possible
reactions of the rival forms. A monopolistically competitive firm follows an independent price policy.
70
 BEFA UNIT III
2. Product Differentiation: product differentiation is the essential feature of monopolistic competition.
Products can be differentiated by means of unique facilities, advertising, brand loyalty, packing,
pricing, terms of credit, superior maintenance service, convenient location and so on. Through heavy
advertisement budgets, Pepsi and Coca-Cola make it very expensive for a third competitor to enter the
cola market on such a big scale. The following example illustrate how the firms differentiate
themselves from others in a monopolistic environment.
 In hotel industry, some hotels have spacious swimming pools, gyms, cultural programs etc. The
customers who value these facilities don‟t bother about price changes.
 The colleges who provide best infrastructure and placements in various reputed companies
have demand from the student community irrespective of an increase in tuition fee.
 Cell phones which have unique features have demand from the public even price increases.
3. Large Number of Buyers: There are large number of buyers in the market. But the buyers have their
own brand preferences. So, the sellers are able to exercise a certain degree of monopoly over them.
Each seller has to plan various incentive schemes to retain the customers who patronize his products.
4. Free Entry and Exist of Firms: As in the perfect competition, in the monopolistic competition too,
there is freedom of entry and exit. That is, there is no barrier as found under monopoly.
5. Selling costs: Since the products are close substitutes, much effort is needed to retain the existing
consumers and to create new demand. So, each firm has to spend a lot on selling cost, which includes
cost on advertising and other sale promotion activities.
6. Imperfect Knowledge: Imperfect knowledge about the product leads to monopolistic competition. If
the buyers are fully aware of the quality of the product, they cannot be influenced much by
advertisement or other sales promotion techniques.
7. The Group: Under perfect competition, the term industry refers to all collection of firms producing a
homogenous product. But under monopolistic competition, the products of various firms are not
identical though they are close substitutes.
Price – Output Determination Under Monopolistic Competition
Under monopolistic competition, Since different firms produce different varieties of products, different
prices for them will be determined in the market depending upon the demand and cost conditions. Each firm
will set the price and output of its own product. Here also the profit will be maximized when marginal revenue
is equal to marginal cost MR=MC . The demand curve for the firm in case of monopolistic competition is
just similar to that of monopoly.
The degree of elasticity of demand of a firm in monopolistic competition depends upon the extent to
which the firm can resorts to product differentiation. The greater the ability of the firm to differentiate the
product, the less elastic the demand is. The firm‟s influence to increase the price depends upon the extent to
which it can differentiate the product.
a) Short-run
In the short-run, the firm is in equilibrium when marginal Revenue =
Marginal Cost. In the figure, AR is the average revenue curve. MR
marginal revenue curve, MC marginal cost curve, AC average cost curve,
MR and MC interest at point E where output is OM and price MQ (i.e.
OP). Thus, the equilibrium output is OM and the price is MQ or OP. When
the price (average revenue) is above average cost, a firm will be making
supernormal profit. From the figure it can be seen that AR is above AC in
the equilibrium point. As AR is above AC, this firm is making abnormal
profits in the short-run. The abnormal profit per unit is QR, i.e., the
difference between AR and AC at equilibrium point and the total supernormal profit is OR x OM. This total
abnormal profits is represented by the rectangle PQRS. The firm may make supernormal profits in the short-run
if it satisfies the following two conditions.
a) MR = MC
b) AR > AC

71
 BEFA UNIT III

b Long–run
More and more firms will be entering the market having been attracted by
supernormal profits enjoyed by the existing firms in the industry. As a result,
competition become s intensive on one hand, forms will compete with one
another for acquiring scare inputs pushing up the prices of factor inputs. On
the other hand, on the entry of several firms, the supply in the market will
increase, pulling down the selling price of the products. In order to cope with
the competition, the firms will have to increase the budget on advertising. The
entry of new firms continue till the supernormal profits of the firms completely eroded and ultimately firms in
the industry will earn only normal profits. Those firms which are not able to earn at least normal profits will get
closed. Thus in the long-run, every firm in the monopolistic competitive industry will earn only normal profits,
which are just sufficient to stay in the business. It is be noted that normal profits are part of average costs.
In the long-run, in order to achieve equilibrium position, the firm has to fulfill the following conditions:
a) MR = MC
b) AR = AC at the level of equilibrium level of output.

OLIGOPOLY
The term oligopoly is derived from two Greek words, oligos meaning a few, and pollen meaning to sell.
Oligopoly is the form of imperfect competition where there are a few sellers in the market, producing either a
homogeneous product or producing products, which are close but not perfect substitute of each other.
Features
1. Monopoly Power:
There is a clement of monopoly power in oligopoly. Since there are only a few firms and each firm has
a large share of the market. In its share of the market, it controls the price and output. Thus an
oligopoly has some monopoly power.

2. Interdependence of Firms:
Under oligopoly, there are only a few firms, each producing a homogeneous or slightly differentiated
product. Since the number of firms is small, each firm enjoys a large share of the market and has a
significant influence on the price and output decisions. Thus, there is interdependence of firms. No firm
can ignore the actions and reactions of rival firms under oligopoly.

3. Conflicting Attitude of Firms:

Under oligopoly, two types of conflicting attitudes are found in the firms. On the one hand, firms
realize the disadvantages of mutual competition and desire to combine to maximize their joint profits.
This tendency leads to the formation of collusion. On the other hand, the desire to maximize one‟s
individual profit may lead to conflict and antagonism; the firms come into clash with one another on
the question of distribution of profits and allocation of markets. Thus, there is an existence of two
opposing attitudes among the firms.

4. Few firms. In this market, only few sellers are found:

For example, the market for automobiles in India exhibits oligopolistic structure as there are only few
producers of automobiles. If there are only two firms, it is called „duopoly‟.

72
 BEFA UNIT III
5. Nature of product:
If the firms product homogeneous product, it becomes pure oligopoly. The firms with product
differentiation constitute impure oligopoly.

6. Interdependence among firms:

In oligopoly market, each firm treats the other as its rival firm. It is for this reason that each firm while
determining price of its product, takes into account the reaction of the other firms to its own action.

7. Large number of consumers:

In this market, there are large numbers of consumers to demand the product.

TYPES OF PRICING
Firms set prices for their products through several alternative means. The important pricing methods followed
in practice are shown in the chart.

A. Cost Based Pricing

1. Full cost pricing:-Under this method, price is just equal to the average cost.
2. Cost plus pricing:- Here, the average cost is ascertained and then a conventional margin added to the
cost to arrive at the price. In other words, find out the product unit‟s total cost and add a percentage of
profit to arrive at the selling price. It is commonly followed in departmental stores and other retail
shops. This method is simple to be administered. It may be very difficult to find the selling price in
advance due to complexity of the nature of the project.
3. Marginal cost pricing Break even pricing or Target profit pricing :- In this method, selling price
is fixed in such a way that it covers full variable or marginal cost and contributes towards recovery of
fixed costs. in the stiff competition, marginal cost offers a guidelines as to how far the selling price can
be lowered.
B. Competition based pricing
Here the price of product is set based on what the competitor charges for a similar product. In other words, a
reduction in the price of products by the competitor will force us to follow suit. In such a case, how far we can
go on reducing the price?. Here the marginal cost concept comes handy. As long as the price covers the
marginal cost, continue to sell. If not, better stop selling. It is because, every unit sold at less than marginal cost
results in loss.
1. Sealed bid pricing:- This method is more popular in tenders and contracts. Each contracting firm
quotes its price in a sealed cover called “tender”. All the tenders are opened on a scheduled date and the
person who quotes the lowest price is awarded the contract.
2. Going rate pricing:- Here the prevailing market price is charged. Suppose, when one wants to buy or
sell gold, the prevailing market rate at a given point of time is taken as the basis to determine the price.

73
 BEFA UNIT III
C. Demand Based Pricing
1. Perceived value pricing:- This method considers the buyer‟s perception of the value of the product as
the basis of pricing. Here the pricing rule is that the firm must develop procedures for measuring the
relative value of the product as perceived by consumers.
2. Price discrimination Differential pricing :- Price discrimination refers to the practice of charging
different prices to customers for the same good. In involves selling a product or service for different
prices in different market segments. Price differentiation depends on geographical location of the
consumers, type of consumer, purchasing quantity, season, time of the service etc. E.g. Telephone
charges, APSRTC charges.
D. Strategy based pricing
1. Skimming pricing:- The company follows this method when the product is for the first time
introduced in the market. Under this method, the company fixes a very high price for the product. this
strategy is mostly found in case of technology products. When Samsung introduces a new cell phone
model, it fixes a high price because of the uniqueness of the product.
2. Penetration pricing:- This is exactly opposite to the market skimming method. Here, a low price is
fixed for the product in order to catch the attention of consumers, once the product image and
credibility is established, the seller slowly starts jacking up the price to reap good profits in future. The
Rin washing soap perhaps falls into this category. This soap was sold at a rather low price in the
beginning and the firm even distributed free samples. Today, it is quite an expensive brand and yet it is
selling very well.
3. Two-part pricing:- Under this strategy, a firm charges a fixed fee for the right to purchase its goods,
plus a per unit charge for each unit purchased. Entertainment houses such as country clubs, athletic
clubs, etc, usually adopt this strategy. They charge a fixed initiation fee or membership fee plus a
charge, per month or per visit, to use the facilities.
4. Block pricing:- We see block pricing in our day-to-day life very frequently. Four Santhoor soaps in a
single pack with nice looking soap box or five Maggi packets in a single pack with an attractive bowl
indicate this pricing method. The total value of the goods includes consumer‟s surplus as the consumer
is given soap box and bowl along with the products freely. By selling certain number of units of a
product as one package, the firm earns more than by selling unit wise.
5. Commodity bundling:- Commodity bundling means the practice of bundling two or more different
products together and selling them at single „bundle price‟. For example tourist companies offer the
package that includes the travelling charges, hotel, meals and sight-seeing etc, at a bundle price instead
of pricing each of these services separately.
6. Peak load pricing:- Under this method, high price is charged during the peak times than off-peak
times. RTC increases charges during festivals, Railways charge more fares during tatkal time. During
seasonal period when demand is likely to be higher, a firm may increase profits by peak load pricing.
7. Cross subsidization:- The process of charging high price for one group of customers in order to
subsidize another group.
8. Transfer pricing:- Transfer pricing means a price at which one process forwards their output work-
in- progress to the next process for further processing. It is an internal pricing technique.

74
 BEFA UNIT III

PRODUCT LIFE CYCLE BASED PRICING

Companies must adapt to the stages of the product life cycle to effectively sell and promote their products.
Depending on the product life cycle stage, a company will develop branding techniques and an appropriate
pricing model. Understanding each stage helps businesses increase profits.

The stages of a product life cycle govern how a product is priced, distributed, and promoted. A new product
goes through multiple stages during the course of its life cycle, including an introduction stage, growth stage,
maturity stage and a decline stage. As a product ages, companies look for new ways to brand it, and
also explore pricing changes. Market and competitor research help businesses assess the proper course of action
to maintain product profitability.

Introduction Stage
A new product may simply be either another brand name added to the existing ones or an altogether new
product. Pricing a new brand for which there are many substitutes available in market is not a big problem as
pricing a new product for which close substitutes are not available.
There are two type of pricing strategies for new product.
1. Skimming price policy:- Selling a product at a high price, sacrificing high sales to gain a high profit,
therefore „skimming‟ the market. Usually employed to reimburse the cost of investment of the original
research into the product - commonly used in electronic markets when a new range, such as DVD players,
are firstly dispatched into the market at a high price.
2. Penetration price policy:- This pricing policy is adopted generally in the case of new product for which
substitutes are available. This policy requires fixing a lower initial price designed to penetrate the market as
quickly as possible.

Growth Stage
During the growth stage, a company aims to develop brand recognition and increase their customer base. The
quality of their product is often improved based on early reviews, and technical support is usually enhanced.
Pricing remains generally stable as demand continues with minimal competition. A larger distribution network
is formed to keep up with the pace of demand.
Maturity Stage
In the maturity stage, the steady sales start to decline and companies face greater challenges in the marketplace.
Competitors will often introduce rival products with the intent of grabbing some of the market share. This is the
product life cycle stage in which the customer base is heavily fought over and price decreases most often occur.
Additional features are added to distinguish a product from its competitors. Companies run promotions during
this stage that highlight the primary differences between their product and their competitor‟s products.
Decline Stage
In the decline stage, a company will make important decisions regarding the future of their product. They can
choose to create new iterations of the product with new features, or they can reduce the price and offer it at a
discount. A company may choose to discontinue the product altogether, either disposing of their inventory or
selling it to another company who is willing to manufacture and market it. Promotion at this stage will depend
on whether a company chooses to continue its product, and how they plan to re-market it.

75
 BEFA UNIT III

BREAK EVEN ANALYSIS

BEP analysis is also called as CVP analysis. The BEP can be defined as that level of sales at which total
revenues equals total costs and the net income is equal to zero. This is also known as no-profit no-loss point.

Break-even analysis refers to analysis of costs and their possible impact on revenues and volume of the firm.
Hence, it is also called the cost-volume-profit (CVP) analysis. A firm is said to attain the BEP when its total
revenue is equal to total cost(TR=TC).

The main objective of the Break Even Analysis is not only to spot the BEP but also to develop an understanding
of the relationships of cost, volume and price within a company‟s practical range of operations.

Assumptions of Break-Even Analysis

1. All cost are divided into fixed and variable

2. Fixed costs remain constant whereas variable costs vary
3. Selling price remains constant
4. There will be no change in the operating efficiency

Key terms used in Break-even Analysis

1. Fixed cost(FC):- Fixed cost remains fixed in the short-run. These costs must be borne by the firm ever there
is no production. Example: Rent, Insurance, Depreciation, permanent employees‟ salaries. Etc. Fixed cost
per units varies.
2. Variable costs(VC):- The costs which vary in direct proportion to the production/sales volume are called as
variable costs. variable cost per unit is fixed. Examples for variable costs: cost of direct material, cost direct
labor, direct expenses, operating supplies such as oil, grease etc.

3. Total cost(TC):- The total of fixed cost and variable costs. TC=FC+VC

4. Total revenue:- The sales amount of goods sold in the market.(Selling Price per unit x No of units sold).

5. Contribution:- The excess of sales revenue over variable cost(C=S-V).

6. P/V Ratio(Profit/Volume Ratio):- The ratio between the contribution and sales:
F

7. Margin of Safety sales(M/S sales):- The excess of actual total sales over break even sales.

76
 BEFA UNIT III
8. Break-even point BEP :- The point where total revenue is just equal to the total cost is called Break-even
point. At break-even point, there is not profit or no loss to the business. Break-even point can be calculated
in units as well as in sales.
BEP = FIXED COST / CONTIBUTION
OR
= FIXED COST/ PV RATIO

Important notes:

 At BEP sales, Total sales=Total cost F+V . At this stage, total contribution S-V is equal to fixed
cost. So, there is no profit or no loss. Hence, C=F.
 Below the BEP sales, total contribution is not equal to total fixed cost. Hence, C˂F.
 Beyond BEP sales M/S sales , since fixed cost is recovered at BEP sales, C=P.
 In total sales, C=F+P
 In BEP sales, C=F
 Below the BEP sales, C=F-P; C˂F
 In M/S sales, C=P
 M/S sales =Total sales-BEP sales
 BEP sales=Total sales-M/S sales
 Total sales=BEP sales+M/S sales

We understood from the above BEP graph that:

 In the above figure, units of products/sales are shown on the horizontal axis OX and costs and revenues
are shown on vertical axis OY.
 The variable cost line is drawn first. It increases along with volume of production and sales.
 The total cost line is parallel to variable cost line. It is derived by adding total fixed costs line to the
total variable cost line.
 The total revenue line (TR) starts from point (0) and increases along with volume of production or sales
intersecting total cost line at point BEP.
 To the right of the BEP is profit zone and to the left of the BEP is the loss zone.
 A perpendicular from the BEP to the horizontal axis at point „M‟ shows „OM‟ is the quantity produced
at „ OP‟ the cost at BEP.
 The angle formed by the point of intersection of total revenue and total cost line at BEP is called angle
of incidence. The greater the angle of incidence, the higher is the magnitude of profit once the fixed
costs are observed.
 Margin of safety refers to the excess of production or sales over and above the BEP. The margin of
safety „MN‟ is the difference between ON and OM (ON-OM=MN). The sales value at ON is OQ.

77
 BEFA UNIT III

SIGNIFICANCE OF BREAK-EVEN ANALYSIS

1) To ascertain the profit on a particular level of sales volume or a given capacity of production.
2) To calculate sales required to earn a particular desired level of profit.
3) To compare the product lines, sales area, method of sale for individual company.
4) To compare the efficiency of the different firms.
5) To decide whether to add a particular product to the existing product line or drop one from it.
6) To decide to „make or buy‟ a given component or spare part.
7) To decide what promotion mix will yield optimum sales.
8) To assess the impact of changes in fixed cost, variable cost or selling price on BEP and profits during a
given period.

LIMITATIONS OF BREAK-EVEN ANALYSIS

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

PROBLEMS AND SOLUTIONS:

1. A firm has a fixed cost of Rs. 10,000, selling price per unit is Rs.5 and variable cost per unit is Rs. 3.
a. Determine break-even point in terms of volume and also sales value.
b. Calculate the margin of safety considering that the actual production is 8000 units
BEP= FIXED COST / CONTRIBUTION

SALES *****
(-) VARIABLE COST ***
CONTRIBUTION *****
(-) FIXED COST ****
PROFIT ***
C= 5-3 = 2 RS
BEP= FC/C
= 10000/2
= 5000

B) Margin of safety= total sales- BEP 8000-5000= 3000units MOS

= 40000-25000
= 15000

78
 BEFA UNIT III

2. A high-tech rail can carry a maximum of 36,000 passengers per annum at a fare of Rs. 400. The variable cost
per passenger is Rs. 150 while the fixed costs are Rs.25,00,000 per year. Find the break-even point in terms
of number of passengers and also in terms of fare collections.
Sol_ BEP= 2500000/ 400-150
= 2500000/250
=10000 passengers

3. Srikanth Enterprises deals in the supply of hardware parts of computer. The following cost data is available
for two successive periods.
Year I Rs Year II
Rs
Sales 50,000 1,20,000
Fixed costs 10,000 20,000
Variable cost 30,000 60,000
Determine 1. Break-even point, 2. Margin of safety
Sol BEP= FC/ pv ratio

Pv ratio= contribution/ sales

= S- VC / Sales
I = 0.4 yearII=0.5

BEP= 25000 =40000

MOS= sales - BEP

yrI= 25000 yrII=80000

Profit = Contribution - FC

Yr I=10000 yrII= 40000

79
 BEFA UNIT III

4. From the following data, calculate,

a. P/V Ratio, b. Profit
When:
Sales are Rs. 20,000
Fixed expenses Rs. 4,000,
Break-even point Rs. 10,000

Sol) BEP = FC/ pv ratio

10000= 4000/ pv ratio

P/V ratio =0.4

Profit= C- FC

C= total sales* P/V ratio

20000*0.4
C=8000
P=4000

MoS=total sales -BEP

=10000

b. What is profit when total sales are Rs. 20000?.

Total sales = BEP sales + Margin of safety sales
Note:- Contribution of total sales includes profit and fixed cost. = C = (P+F)
Contribution of total sales = Total sales x P/V ratio

5. A company shows the trading results for two periods:

Period Sales Profit
Period I Rs. 20,000 Rs. 1000
Period II Rs. 10,000 Rs. 400

FC= I is 4000
Fc for II is 200
Calculate P/V Ratio.
Pv ratio= Contribution / sales
C= FC+ P

Period I= 0.25
II=0.06

108
 BEFA UNIT III

ECONOMIES OF SCALE

Production may be carried on a small scale or o a large scale by a firm. When a firm expands its size of
production by increasing all the factors, it secures certain advantages known as economies of production.
Marshall has classified these economies of large-scale production into internal economies and external
economies.

Internal economies result from an increase in the scale of output of a firm and cannot be achieved unless
output increases. Hence internal economies depend solely upon the size of the firm and are different for
different firms.

External economies are those benefits, which are shared in by a number of firms or industries when the scale
of production in an industry or groups of industries increases. Hence external economies benefit all firms within
the industry as the size of the industry expands.

I. Internal Economies:
A). Technical Economies.
Technical economies arise to a firm from the use of better machines and superior techniques of
production. As a result, production increases and per unit cost of production falls. A large firm, which employs
costly and superior plant and equipment, enjoys a technical superiority over a small firm. This increases the
productive capacity of the firm and reduces the unit cost of production.

B). Managerial Economies:

These economies arise due to better and more elaborate management, which only the large size firms
can afford. There may be a separate head for manufacturing, assembling, packing, marketing, general
administration etc. Each department is under the charge of an expert. Hence the appointment of experts,
division of administration into several departments, functional specialization and scientific co-ordination of
various works make the management of the firm most efficient.

C). Marketing Economies:

The large firm reaps marketing or commercial economies in buying its requirements and in selling its
final products. The large firm generally has a separate marketing department. It can buy and sell on behalf of
the firm, when the market trends are more favorable. In the matter of buying, they could enjoy advantages like
preferential treatment, transport concessions, cheap credit, prompt delivery and fine relation with dealers.
Similarly it sells its products more effectively for a higher margin of profit.

D). Financial Economies:

The large firm is able to secure the necessary finances either for fixed capital purposes or for working
capital needs more easily and cheaply. It can barrow from the public, banks and other financial institutions at
relatively cheaper rates.

E). Risk bearing Economies:

As there is growth in the size of the firm, there is increase in the risk also. The firm can insure its assets
against the hazards of fire, theft and other risks. More often, they deal in more than one product to offset the
losses by the profits from the sale of others.

F). Economies of Research:

A large firm possesses larger resources and can establish its own research laboratory and employ
trained research workers. The firm may even invent new production techniques for increasing its output and
reducing cost.

G). Economies of welfare:

A large firm can provide better working conditions in-and out-side the factory. Facilities like subsidized
canteens, crèches for the infants, recreation room, cheap houses, educational and medical facilities tend to
increase the productive efficiency of the workers, which helps in raising production and reducing costs.

109
 BEFA UNIT III
II. External Economies.

A). Economies of Concentration:

When an industry is concentrated in a particular area, all the member firms reap some common
economies like skilled labour, improved means of transport and communications, banking and financial
services, supply of power and benefits from subsidiaries. All these facilities tend to lower the unit cost of
production of all the firms in the industry.

B). Economies of Information

The industry can set up an information centre which may publish a journal and pass on information
regarding the availability of raw materials, modern machines, export potentialities and provide other
information needed by the firms. It will benefit all firms and reduction in their costs.

C). Economies of Welfare:

An industry is in a better position to provide welfare facilities to the workers. It may get land at
concessional rates and procure special facilities from the local bodies for setting up housing colonies for the
workers. It may also establish public health care units, educational institutions both general and technical so that
a continuous supply of skilled labour is available to the industry. This will help the efficiency of the workers.

D). Economies of Disintegration:

The firms in an industry may also reap the economies of specialization. When an industry expands, it
becomes possible to split up some of the processes which are taken over by specialist firms. For example, in the
cotton textile industry, some firms may specialize in manufacturing thread, others in printing, still others in
dyeing, some in long cloth, some in dhotis, some in shirting etc. As a result, the efficiency of the firms
specializing in different fields increases and the unit cost of production falls.

Thus internal economies depend upon the size of the firm and external economies depend upon the size of
industry.

DISECONOMIES OF SCALE
Internal and external diseconomies are the limits to large-scale production. It is possible that expansion of a
firm‟s output may lead to rise in costs and thus result diseconomies instead of economies. When a firm expands
beyond proper limits, it is beyond the capacity of the manager to manage it efficiently. This is an example of an
internal diseconomy. In the same manner, the expansion of an industry may result in diseconomies, which may
be called external diseconomies.

A). Financial Diseconomies:

For expanding business, the entrepreneur needs finance. But finance may not be easily available in the
required amount at the appropriate time. Lack of finance retards the production plans thereby increasing costs
of the firm.

B). Managerial diseconomies:

There are difficulties of large-scale management. Supervision becomes a difficult job. Workers do not
work efficiently, wastages arise, decision-making becomes difficult, coordination between workers and
management disappears and production costs increase.

C). Marketing Diseconomies:

As business is expanded, prices of the factors of production will rise. The cost will therefore rise. Raw
materials may not be available in sufficient quantities due to their scarcities. Additional output may depress the
price in the market. The demand for the products may fall as a result of changes in tastes and preferences of the
people. Hence cost will exceed the revenue.

D). Technical Diseconomies:

There is a limit to the division of labour and splitting down of production processes. The firm may fail
to operate its plant to its maximum capacity. As a result cost per unit increases. Internal diseconomies follow.

E). Diseconomies of Risk-taking:

As the scale of production of a firm expands, risks also increase with it. Wrong decision by the
management may adversely affect production. If large firms are affected by any disaster, natural or human, the
economy will be put to strains.

110
 BEFA UNIT IV
INTRODUCTION TO ACCOUNTING
The purpose of any business is to make profits for that some business activities are to be conducted.
You may involve in transactions daily. Any human activity directed at making profit is called business.
Business is of different types. It may be trading activity or manufacturing activity. Business may require
capital which may be owner‟s capital and borrowed capital. Transactions involve exchange of value like
purchase of goods, sale of goods for cash or credit and payment of expenses in the course of production
and distribution.

BOOK-KEEPING AND ACCOUNTING

Book – Keeping: Book – Keeping involves the chronological recording of financial transactions in a
set of books in a systematic manner.
Accounting: Accounting is concerned with the maintenance of accounts giving stress to the design of
the system of records, the preparation of reports based on the recorded date and the interpretation of the
reports

DIFFERENCE BETWEEN BOOK-KEEPING AND ACCOUNTING:

BOOK-KEEPING ACCOUNTING

Concerned with recording of Concerned with classifying, summarizing, analyzing and

1
transactions interpreting the data and communicating to the end users

Book-keeper maintains the

2 Accountant maintains the accounts of whole organization
accounts of particular section

He works under an accountant 3 He directs and reviews the work of book-keeper

He has higher level of knowledge, conceptual

He has limited knowledge 4
understanding, analytical skills

His work is clerical in nature 5 His work is executive in nature

111
 BEFA UNIT IV

SYSTEMS OF BOOK-KEEPING:

1. Single entry system

 It is incomplete system of double entry system.
 Only cash and personal accounts are maintained.
2. Double entry system
 It is only the system that records two aspects of a transaction.
 In this system, the transactions are recorded with the help of “Debit-Credit rules”.
Definition of Accounting:
American Institute of Certified Public Accountants (AICPA): “The art of recording, classifying and
summarizing in a significant manner and in terms of money transactions and events, which are in part at
least, of a financial character and interpreting the results thereof.”
Thus, accounting is an art of identifying, recording, summarizing and interpreting business transactions
of financial nature. Hence accounting is the Language of Business.

BRANCHES OF ACCOUNTING
1. Financial Accounting: The purpose of Accounting is to ascertain the financial results i.e. profit or
loass in the operations during a specific period. It is also aimed at knowing the financial position, i.e.
assets, liabilities and equity position at the end of the period. It also provides other relevant information
to the management as a basic for decision-making for planning and controlling the operations of the
business.

2. Cost Accounting: The purpose of this branch of accounting is to ascertain the cost of a product /
operation / project and the costs incurred for carrying out various activities. It also assist the
management in controlling the costs. The necessary data and information are gatherr4ed form financial
and other sources.

3. Management Accounting : Its aim to assist the management in taking correct policy decision and to
evaluate the impact of its decisions and actions. The data required for this purpose are drawn accounting
and cost-accounting.

FUNCTIONS OF AN ACCOUNTANT
1. Designing Work : It includes the designing of the accounting system, basis for identification and
classification of financial transactions and events, forms, methods, procedures, etc.

2. Recording Work : The financial transactions are identified, classified and recorded in appropriate
books of accounts according to principles. This is “Book Keeping”. The recording of transactions tends
to be mechanical and repetitive.

3. Summarizing Work : The recorded transactions are summarized into significant form according to
generally accepted accounting principles. The work includes the preparation of profit and loss account,
balance sheet. This phase is called „preparation of final accounts‟

112
 BEFA UNIT IV
4. Analysis and Interpretation Work: The financial statements are analysed by using ratio analysis,
break-even analysis, funds flow and cash flow analysis.

5. Reporting Work: The summarized statements along with analysis and interpretation are
communicated to the interested parties or whoever has the right to receive them. For Ex. Share holders.
In addition, the accou8nting departments has to prepare and send regular reports so as to assist the
management in decision making. This is „Reporting‟.

6. Preparation of Budget : The management must be able to reasonably estimate the future
requirements and opportunities. As an aid to this process, the accountant has to prepare budgets, like
cash budget, capital budget, purchase budget, sales budget etc. this is „Budgeting‟.

7. Taxation Work : The accountant has to prepare various statements and returns pertaining to income-
tax, sales-tax, excise or customs duties etc., and file the returns with the authorities concerned.

8. Auditing : It involves a critical review and verification of the books of accounts statements and reports
with a view to verifying their accuracy. This is „Auditing‟.

USERS OF ACCOUNTING INFORMATION

1. Managers : These are the persons who manage the business, i.e. management at the top, middle and
lower levels. Their requirements of information are different because they make different types of
decisions.
Accounting information also helps the managers in appraising the performance of subordinates.
As such Accounting is termed as “ the eyes and ears of management.”

2. Investors : Those who are interested in buying the shares of company are naturally interested in the
financial statements to know how safe the investment already made is and how safe the proposed
investments will be.

3. Creditors : Lenders are interested to know whether their load, principal and interest, will be paid when
due. Suppliers and other creditors are also interested to know the ability of the firm to pay their dues in
time.

4. Workers : In our country, workers are entitled to payment of bonus which depends on the size of
profit earned. Hence, they would like to be satisfied that he bonus being paid to them is correct. This
knowledge also helps them in conducting negotiations for wages.

5. Customers : They are also concerned with the stability and profitability of the enterprise. They may be
interested in knowing the financial strength of the company to rent it for further decisions relating to
purchase of goods.
6. Government: Governments all over the world are using financial statements for compiling statistics
concerning business which, in turn, helps in compiling national accounts. The financial statements are
useful for tax authorities for calculating taxes.

7. Public : The public at large interested in the functioning of the enterprises because it may make a
substantial contribution to the local economy in many ways including the number of people employed
and their patronage to local suppliers.

8. Researchers: The financial statements, being a mirror of business conditions, is of great interest to
scholars undertaking research in accounting theory as well as business affairs and practices.

113
 BEFA UNIT IV

ADVANTAGES OF ACCOUNTING
1. Provides for systematic records: Since all the financial transactions are recorded in the books, one
need not rely on memory. Any information required is readily available from these records.

2. Facilitates the preparation of financial statements: Profit and loss accountant and balance sheet can
be easily prepared with the help of the information in the records. This enables the trader to know the
net result of business operations (i.e. profit / loss) during the accounting period and the financial
position of the business at the end of the accounting period.

3. Provides control over assets: Book-keeping provides information regarding cash in had, cash at bank,
stock of goods, accounts receivables from various parties and the amounts invested in various other
assets. As the trader knows the values of the assets he will have control over them.

4. Provides the required information: Interested parties such as owners, lenders, creditors etc., get
necessary information at frequent intervals.

5. Comparative study: One can compare the present performance of the organization with that of its
past. This enables the managers to draw useful conclusion and make proper decisions.

6. Less Scope for fraud or theft: It is difficult to conceal fraud or theft etc., because of the balancing of
the books of accounts periodically. As the work is divided among many persons, there will be check and
counter check.

7. Tax matters: Properly maintained book-keeping records will help in the settlement of all tax matters
with the tax authorities.
8. Ascertaining Value of Business: The accounting records will help in ascertaining the correct value of
the business. This helps in the event of sale or purchase of a business.

9. Documentary evidence: Accounting records can also be used as an evidence in the court to substantiate
the claim of the business. These records are based on documentary proof. Every entry is supported by
authentic vouchers. As such, Courts accept these records as evidence.
10. Helpful to management: Accounting is useful to the management in various ways. It enables the
management to assess the achievement of its performance. The weakness of the business can be
identified and corrective measures can be applied to remove them with the helps accounting.

LIMITATIONS OF ACCOUNTING
1. Does not record all events: Only the transactions of a financial character will be recorded under
book-keeping. So it does not reveal a complete picture about the quality of human resources, location
advantage, business contacts etc.

2. Does not reflect current values: The data available under book-keeping is historical in nature. So
they do not reflect current values. For instance, we record the value of stock at cost price or market
price, whichever is less. In case of, building, machinery etc., we adopt historical cost as the basis. In
fact, the current values of buildings, plant and machinery may be much more than what is recorded in
the balance sheet.

3. Estimates based on Personal Judgment: The estimate used for determining the values of various
items may not be correct. For example, debtor are estimated in terms of collectability, inventories are
based on marketability, and fixed assets are based on useful working life. These estimates are based
on personal judgment and hence sometimes may not be correct.

4. Inadequate information on costs and Profits: Book-keeping only provides information about the
overall profitability of the business. No information is given about the cost and profitability of
114
 BEFA UNIT IV
different activities of products or divisions.

ACCOUNTING PRINCIPLES

Accounting principles are the rules and regulations which are followed by the accountants at the time of
recording the accounting transactions. They help in measuring, recording and summarizing the
transactions. These principles are termed as “ Generally Accepted Accounting Principles (GAAP) “ which
are basic assumptions.

Accounting Concepts:

1. Business Entity Concept: In this concept “Business is treated as separate from the proprietor”. All
the Transactions recorded in the book of Business and not in the books of proprietor. The proprietor is
also treated as a creditor for the Business.

2. Going Concern Concept: This concept relates with the long life of Business. The assumption is that
business will continue to exist for unlimited period unless it is dissolved due to some reasons or the
other.

3. Money Measurement Concept: In this concept “Only those transactions are recorded in accounting
which can be expressed in terms of money, those transactions which cannot be expressed in terms of
money are not recorded in the books of accounting”.

4. Cost Concept: Accounting to this concept, can asset is recorded at its cost in the books of account. i.e.,
the price, which is paid at the time of acquiring it. In balance sheet, these assets appear not at cost price
every year, but depreciation is deducted and they appear at the amount, which is cost, less
classification.

5. Accounting Period Concept: every Businessman wants to know the result of his investment and
efforts after a certain period. Usually one-year period is regarded as an ideal for this purpose. This
period is called Accounting Period. It depends on the nature of the business and object of the proprietor
of business.

6. Dual Aspect Concept: According to this concept “Every business transactions has two aspects”, one
is the receiving benefit aspect another one is giving benefit aspect. The receiving benefit aspect is
termed as “DEBIT”, where as the giving benefit aspect is termed as “CREDIT”. Therefore, for every
debit, there will be corresponding credit.

7. Matching Cost Concept: According to this concept “The expenses incurred during an accounting
period, e.g., if revenue is recognized on all goods sold during a period, cost of those good sole should
also be charged to that period.

8. Realization Concept: According to this concept revenue is recognized when a sale is made. Sale is
considered to be made at the point when the property in goods posses to the buyer and he becomes
legally liable to pay.

115
 BEFA UNIT IV

Accounting Conventions:

1. Full Disclosure: According to this convention accounting reports should disclose fully and fairly the
information. They purport to represent. They should be prepared honestly and sufficiently disclose
information which is if material interest to proprietors, present and potential creditors and investors.
The companies ACT, 1956 makes it compulsory to provide all the information in the prescribed form.

2. Materiality: Under this convention the trader records important factor about the commercial activities.
In the form of financial statements if any unimportant information is to be given for the sake of clarity
it will be given as footnotes.

3. Consistency: It means that accounting method adopted should not be changed from year to year. It
means that there should be consistent in the methods or principles followed. Or else the results of a
year Cannot be conveniently compared with that of another.

4. Conservatism: This convention warns the trader not to take unrealized income in to account. That is
why the practice of valuing stock at cost or market price, whichever is lower is in vague. This is the
policy of “playing safe”; it takes in to consideration all prospective losses but leaves all prospective
profits.

ELEMENTS OF FINANCIAL STATEMENTS

Entity:- An entity is an economic unit which performs economic activities. Ex: Tata Steel, H.M.T. Ltd.

Business transaction:- A transaction is an exchange of goods or services for cash or credit. It involves
transfer of money or money‟s worth that brings about change in the financial position of a business.

Trade debtors:- Trade debtors are the persons from whom the amount are due for goods sold or services
rendered on credit basis.

Trade creditors:- Trade creditors are those to whom the amounts are due for goods purchased or services
rendered on credit basis.

Goods:- Goods are those with which the business firm trades. They are meant for resale.

Assets:- Assets are those which yield future economic benefits.

Current Assets:- current assets are those assets which are held in cash or which are likely to be converted
into cash during the financial year.

Fixed Assets:- Fixed assets are those assets which are not held for resale in normal course of business.

Tangible Fixed Assets:- The assets that can be visible, seen and touched are called as “ Tangible Fixed
Assets”.land & building furniture

Intangible fixed assets:- The assets that cannot be visible, seen and touched are called as “ Intangible
Fixed Assets”. good will & patents , trademark

Liabilities:- The financial obligations of the firm are called liabilities.

116
 BEFA UNIT IV
Current Liabilities:- The liabilities which fall due in a short period are known as “ Current Liabilities”.

Long term liabilities:- The liabilities which fall due for payment in a relatively short period are called as
long term liabilities.

Purchases:- The total amount of goods obtained by an enterprise for resale either for cash or credit.

Sales:- The amount for which goods are sold or services are rendered either for cash or credit is called as
sales.

Expenditure:- The amount incurred in the process of acquiring goods, assets or services.

Revenue:- The amount charged for the goods sold or services rendered by an enterprise.

Capital: Capital is the amount invested by the owner/propietor in the firm. It is a liability to the firm.

Drawings: cash or goods withdrawn by the proprietor from the Business for his personal or Household is
termed to as “drawing”.

Reserve: An amount set aside out of profits or other surplus and designed to meet contingencies.

Account: A summarized statements of transactions relating to a particular person, thing, Expense or

income.

Discount: There are two types of discounts..

cash discount: An allowable made to encourage frame payment or before the expiration of the
period allowed for credit.
Trade discount: A deduction from the gross or catalogue price allowed to traders who buys them for
resale.

CLASSIFICATION OF ACCOUNTS
All business transactions are classified into three categories:
1.Those relating to persons(Natural persons, artificial persons and representative persons)
2.Those relating to property(Assets)
3.Those relating to income & expenses
Thus, three classes of accounts are maintained for recording all business transactions. They are:
1.Personal accounts
2.Realaccounts
3.Nominal accounts

1. Personal Accounts :Accounts which are transactions with persons are called “Personal Accounts” . In
accounting, all natural persons and all the firms are considered as persons.
A separate account is kept on the name of each person for recording the benefits received from ,or given
to the person in the course of dealings with him.
E.g.: Krishna‟s A/C, Gopal‟s A/C, SBI A/C, Nagarjuna Finanace Ltd.A/C, Obul Reddy & Sons A/C ,
HMT Ltd. A/C, Capital A/C, Drawings A/C etc.

2. Real Accounts: The accounts relating to properties or assets are known as “Real Accounts” .Every
business needs assets such as machinery , furniture etc, for running its activities .A separate account is
maintained for each asset owned by the business .
E. g.: cash A/C, furniture A/C, building A/C, machinery A/C etc.
117
 BEFA UNIT IV

NominalAccounts:Accounts relating to expenses, losses, incomes and gains are known as “Nominal
Accounts”. A separate account is maintained for each item of expenses, losses, income or gain.E.g.:
Salaries A/C, stationery A/C, wages A/C, postage A/C, commission A/C, interest A/C, purchases A/C,
rent A/C, discount A/C, commission received A/C, interest received A/C, rent received A/C, discount
received A/C.

Before recording a transaction, it is necessary to find out which of the accounts is to be debited and which
is to be credited. The following three different rules have been laid down for the three classes of
accounts….

DEBIT, CREDIT RULES

Debit the receiver

Personal Accounts

Credit the giver

Debit what comes in

Real Accounts

Credit what goes out

Debit all expenses/losses

Nominal Accounts

Credit all incomes/gains

118
 BEFA UNIT IV
Identification of the accounts involved in each transaction:

1. Consider that the transaction is committed by the firm and it is being recorded in the books of the
firm.

2. see whether it is cash transaction or credit transaction.

a. A transaction that refers to a person and doesn‟t refer to the term “ cash “ is called credit transaction

b. A transaction which is not credit transaction is called cash transaction

3. If the transaction is credit one, first find whether the „ personal A/C‟ is to be debited or credited and
next find which account is to be credited or debited.

4. If it is a cash transaction, first find whether the „ cash A/C‟ is to be debited or credited and next find
which account is to be credited or debited.

5. Debit means entering the amount on the left side of an account.

6. Credit means entering the amount on the right side of account.

ACCOUNTING EQUATION

The basic accounting equation, also called the balance sheet equation, represents the relationship between
the assets, liabilities, and owner's equity of a business. It is the foundation for the double-entry
bookkeeping system. For each transaction, the total debits equal the total credits. It can be expressed as
further more.

Assets = Liabilities + Equity

In a company, capital represents the shareholders' equity. Since every business transaction affects at least
two of a company‟s accounts, the accounting equation will always be “in balance,” meaning the left side
should always equal the right side. Thus, the accounting formula essentially shows that what the firm
owns (its assets) is purchased by either what it owes (its liabilities) or by what its owners invest (its
shareholders equity or capital).

119
 BEFA UNIT IV
For example: A student buys a computer for Rs.1000. To pay for the computer, the student uses Rs.400
in cash and borrows Rs.600 for the remainder. Now his assets are worth Rs.1000, liabilities are Rs.600,
and equity Rs.400.
The formula can be rewritten:

Assets - Liabilities = (Shareholders' or Owners' Equity)

Sometimes we expand the Accounting Equation to show all the Equity components. This is called the

Expanded Accounting Equation.

Now it shows owners' interest is equal to property (assets) minus debts (liabilities). Since in a company,
owners are shareholders, owner's interest is called shareholders' equity.
Every accounting transaction affects at least one element of the equation, but always balances. Simplest
transactions also include:

Example 1: Prepare the Accounting Equation on the basis of following:

1. Mr. Shiraz Khan started business and introduced capital Rs. 1,00,000 in cash.
2. Purchased goods in cash Rs. 50,000.
3. Purchased from Bismillah Furnitures Rs. 20,000.
4. Sold goods costing Rs. 25,000 for Rs. 35,000.
5. Paid Bismillah Furnitures in cash.

120
 BEFA UNIT IV

Example 2: Prepare the Accounting Equation on the basis of following:

1. Issuing shares for cash or other assets Rs.6000
2. Buying assets by borrowing money Rs.10000
3. Selling assets for cash Rs. 900
4. Buying assets by paying cash Rs.600 and by borrowing money 400.
5. Earning revenues Rs.700

121
 BEFA UNIT IV

JOURNAL
The first step in accounting therefore is the record of all the transactions in the books of original entry
viz., Journal and then posting into ledges.
The word Journal is derived from the Latin word „journ‟ which means a day. Therefore, journal means a
„day Book‟ in day-to-day business transactions are recorded in chronological order.
Journal is treated as the book of original entry or first entry or prime entry. All the business transactions
are recorded in this book before they are posted in the ledges. The journal is a complete and
chronological(in order of dates) record of business transactions. It is recorded in a systematic manner. The
process of recording a transaction in the journal is called “JOURNALISING”. The entries made in the
book are called “Journal Entries”.
The proforma of Journal is given below.

Date Particulars L.F Debit Amount Credit Amount

Journalize the following examples:

Example 1. Journalize the following transactions in the books of Mr. Ram
2015 Jan 1 Business started with Rs. 10,000
“ 2 Cash deposited in the bank Rs. 5,000
“ 5 Purchases Rs. 3,000
“ 8 Sales Rs. 4,000
“ 10 Cash drawn from the bank Rs. 1,000

Solution: Journal entries in the book of Mr.Ram

Dr Cr
Date Particulars LF
Amount Amount
Cash A/C 10000
Dr
2015 Jan 1 10000
To Capital A/C
(Being the business started)
Bank A/C Dr 5000
“2 To Cash A/C 5000
(Being Cash deposited in the bank)
Purchases A/C 3000
Dr Example 2.
“5 3000
To Cash A/C Journalize
(Being purchases made on the cash basis)
Cash A/C 4000 the following
Dr transactions
“8 4000 in the books
To Sales A/C
(Being sales made on the cash basis) of Sri Laxmi
& Co.
Cash A/C 1000
Dr
“ 10 To Bank A/C 1000
(Being cash withdrawn from the bank)
122
 BEFA UNIT IV

2015 Jan 1 Business started with Rs. 10,000 Cash and Furniture Rs. 5,000
“ 2 Goods purchased from Mr. Sathish Rs. 2,000
“ 5 Rent paid Rs. 1,000
“ 8 Goods sold to Mr. Ramya Rs. 4,000
“ 10 Goods sold and cheque received Rs. 1,000

123
 BEFA UNIT IV

Example 3. Enter the following transactions in Journal

2015 Jan 1 Purchased office furniture Rs. 2000 and paid through cheque.
“ 2 Cash sales Rs. 3000
“ 5 Wages paid Rs. 1000
“ 8 Telephone bill paid Rs. 500
“ 10 Cash sales Rs. 2000 and credit sales Rs. 2000 to Sunil.

124
 BEFA UNIT IV

Example 4. Journalize the following transactions.

2015 Jan 1 Salaries paid Rs. 2000
“ 2 Paid for advertisement Rs. 3000
“ 5 Purchased a car for office use Rs. 100000
“ 8 Paid insurance premium Rs. 500
“ 10 Returned goods to Suresh Rs. 100

125
 BEFA UNIT IV

Example 5. Journalize the following transactions.

2015 Jan 1 Goods returned from Ram Rs. 200
“ 2 Cash withdrawn for personal use Rs. 3000
“ 5 Loan borrowed from SBH Rs. 100000
“ 8 Interest received Rs. 500
“ 10 Discount paid Rs. 100

126
 BEFA UNIT IV

SUBDIVISION OF JOURNAL
Small businesses record all transactions in a single journal but large companies record their transactions in
different journals according to their nature. The journal is sub-divided into eight parts. They are;

1. Purchase book (where all credit purchases are recorded)

2. Sales book (where all credit sales are recorded)
3. Purchase returns book (where the particulars of goods returned to suppliers are recorded)
4. Sales returns book (where the particulars of goods returned from customers are recorded)
5. Bills receivable book (where the details of bills received are recorded)
6. Bills payable book (where the details of bills payable are recorded)
7. Cash book (where all the cash transaction are recorded)
8. Proper journal (where the transactions which are not recorded in the above books are recorded)

127
 BEFA UNIT IV

LEDGER

All the transactions in a journal are recorded in a chronological order. After a certain period, if we want to
know whether a particular account is showing a debit or credit balance it becomes very difficult. So, the
ledger is designed to accommodate the various accounts maintained the trader. It contains the final or
permanent record of all the transactions in duly classified form. “A ledger is a book which contains
various accounts.” The process of transferring entries from journal to ledger is called “POSTING”.

Posting is the process of entering in the ledger the entries given in the journal. Posting into ledger is done
periodically, may be weekly or fortnightly as per the convenience of the business. The following are the
guidelines for posting transactions in the ledger.

1. After the completion of Journal entries only posting is to be made in the ledger.

2. For each item in the Journal a separate account is to be opened. Further, for each new item a new
account is to be opened.

3. Depending upon the number of transactions space for each account is to be determined in the
ledger.

4. For each account there must be a name. This should be written in the top of the table. At the end
of the name, the word “Account” is to be added.

5. The debit side of the Journal entry is to be posted on the debit side of the account, by starting
with “TO”.

6. The credit side of the Journal entry is to be posted on the debit side of the account, by starting
with “BY”.

Proforma for ledger: LEDGER BOOK ------------- Account

Date Particulars JF Amount Date Particulars JF amount

To By

128
 BEFA UNIT IV
Example:

Enter the following transactions in journal and post them into ledger:

2017 Jan. 1 Mr. Rameh started business with cash Rs.100,000

2 He purchased furniture for Rs.20,000
3 He purchased goods for Rs.60,000
5 He sold goods for cash Rs.80,000
6 He paid salaries Rs.10,000
Solution:

Journal Entries

Date Particular L.F Amount Amount

2017
Jan. 1 Cash A/C ................................................... Dr. 100,000
To Capital 100,000
(Being capital brought in)
2 Furniture A/C. ............................................. Dr. 20,000
To Cash A/C 20,000
(Being furniture purchased for cash)
3 Purchases A/C ............................................ Dr. 60,000
To Cash A/C 60,000
(Goods purchased for cash)
5 Cash A/C ................................................... Dr. 80,000
To Sales A/C 80,000
(Sold goods for cash)
6 Salaries A/C ............................................... Dr. 10,000
To Cash A/C 10,000
(Salaries paid)

Ledger
Cash Account
Date Particular Amount Date Particulars Amount
2017 2017
Jan.1 To Capital A/C 100,000 Jan.2 By Furniture A/C 20,000
Jan.5 To Sales A/C 80,000 Jan.3 By Purchases A/C 60,000
Jan.6 By Salaries A/C 10,000
By Balance c/d 90,000
180,000 180,000

129
 BEFA UNIT IV
Capital Account

Date Particular Amount Date Particulars Amount

2017 2017
Jan.6 To Balance c/d 100,000 Jan.1 By Cash A/C 100,000
100,000 100,000
Furniture Account

Date Particular Amount Date Particulars Amount

2017 2017
Jan.2 To Cash A/C 20,000 Jan.6 By Balance c/d 20,000
20,000 20,000

Purchases Account

Date Particular Amount Date Particulars Amount

2017 2017
Jan.3 To Cash A/C 60,000 Jan.6 By Balance c/d 60,000
60,000 60,000

Sales Account

Date Particular Amount Date Particulars Amount

2017 2017
Jan.6 To Balance c/d 80,000 Jan.5 By Cash A/C 80,000
80,000 80,000

Salaries Account

Date Particular Amount Date Particulars Amount

2017 2017
Jan.6 To Cash A/C 10,000 Jan.6 By Balance c/d 10,000
10,000 10,000

130
 BEFA UNIT IV
TRIAL BALANCE
According to double entry system every debit has corresponding credit. All the debit balances are equal to
credit balances. If they don‟t agree, it is understood that some mistakes are committed somewhere. Trial
Balance is a statement in which debit and credit balances of all ledger accounts are shown to list the
arithmetical accuracy of the books of accounts.
Features of trial balance
 It is not account.
 It contains debit and credit balances of accounts.
 It helps in preparation of final accounts.
 Both debit and credit side of a trial balances are always equal.
Format of the trial balance

Debit Credit
Particulars Amount Amount

Format of Trial Balance as on December 31st, 201X

Debit balances Rs Credit balances Rs

Debtors xxxx Creditors xxxx
All assets xxxx All liabilities xxxx
All expenses xxxx All incomes and gains xxxx
All losses xxxx Profits account xxxx
Purchases xxxx Loan account xxxx
Sales returns xxxx Bank over draft xxxx
Drawings xxxx Sales xxxx
stock xxxx Purchase returns xxxx
Bills receivables xxxx Provision for doubtful debts xxxx
Prepaid expenses xxxx Provision for discount on debtors xxxx
Incomes receivables xxxx All reserves and surpluses xxxx
All intangible assets xxxx Bills payables xxxx
Outstanding expenses xxxx
Incomes received in advance xxxx
Capital xxxx
xxxx xxxx

131
 BEFA UNIT IV
Prepare the Trial Balances for the following examples:

Example 1. Prepare a trial balance as on 31-12-2014 from the below information.

Particulars Rs Particulars Rs
Sundry debtors dr 32000 Bills payable cr 7500
Stock dr 22000 Purchases dr 218870
Cash in hand dr 35 Cash at bank dr 1545
Plant and machinerydr 17500 Sundry creditors cr 10650
Trade expenses dr 1075 Sales cr 234500
Salaries dr 2225 Carriage outward dr 400
Rent dr 900 Discounts Dr 1100
Capital Cr 79500 Premises dr 34500

132
 BEFA UNIT IV

Example 2. Make a trial balance from the below balances of accounts.

Particulars Rs Particulars Rs
Capital Cr 100000 Machinery dr 30000
Stock Dr 16000 Wages dr 50000
Carriage inward Cr 500 Salaries dr 5000
Factory rent dr 2400 Repairs dr 400
Fuel and power dr 2500 Buildings dr 40000
Sundry debtors dr 20000 Sales cr 203600
Purchases dr 122000 Creditors cr 12500
Returns outwards cr 2000 Returns inwards dr 3600
Drawings dr 2000 Discount allowed dr 750
Discount received cr 250 Office expenses dr 1000
Manufacturing expenses dr 600 Bills payable cr 3000
Bills receivable dr 5000 Cash in hand dr 2400
Cash at bank dr 15400 Office rent dr 1800

133
 BEFA UNIT IV
FINAL ACCOUNTS

In every business, the business man is interested in knowing whether the business has resulted in
profit or loss and what the financial position of the business is at a given time. In brief, he wants to know
(i)The profitability of the business and (ii) The soundness of the business.

The trader can ascertain this by preparing the final accounts. The final accounts are prepared from
the trial balance. Hence the trial balance is said to be the link between the ledger accounts and the final
accounts. The final accounts of a firm can be divided into two stages. The first stage is preparing the
trading and profit and loss account and the second stage is preparing the balance sheet.
TRADING ACCOUNT

The first step in the preparation of final account is the preparation of trading account. The main
purpose of preparing the trading account is to ascertain gross profit or gross loss as a result of buying and
selling the goods.

Finally, a ledger may be defined as a summary statement of all the transactions relating to a person ,
asset, expense or income which have taken place during a given period of time. The up-to-date state of
any account can be easily known by referring to the ledger.

PROFIT AND LOSS ACCOUNT:

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

134
 BEFA UNIT IV

Format of Trading and Profit & Loss A/C of ……….for the year ending ……………..
Particulars Amount Particulars Amount
To Opening stock xxxx By Sales xxxx
To Purchases xxxx Less: Returns xxxx xxxx
Less: Returns xxxx xxxx By Closing stock xxxx
To Carriage inwards xxxx By Gross loss (c/d) xxxx
To Freight, cartage xxxx
To Customs duty xxxx
To Clearing charges xxxx
To Octroi xxxx
To Wages xxxx
To Gas, water, coal, light xxxx
To Factory rent xxxx
To Works manager salary xxxx
To Factory supervision xxxx
To consumable stores xxxx
To Plant depreciation xxxx
To Gross profit (c/d) xxxx
xxxx xxxx
To Gross loss(b/d) xxxx By Gross profit(b/d) xxxx
To Salaries xxxx By Discount received xxxx
To Rent, Taxes xxxx By Interest received xxxx
To Insurance xxxx By Dividend received xxxx
To Printing stationery xxxx By Rent received xxxx
To Advertisement xxxx By Commission received xxxx
To Carriage outward xxxx By Net loss (c/d) xxxx
To Bad debts xxxx xxxx
To Repairs xxxx xxxx
To Depreciation xxxx xxxx
To Discount allowed xxxx xxxx
To Commission allowed xxxx xxxx
To Interest paid xxxx xxxx
To Provision for doubtful debts xxxx xxxx
To Postage xxxx xxxx
To General expenses xxxx xxxx
To Net profit (c/d) xxxx xxxx
xxxx xxxx

135
 BEFA UNIT IV
BALANCE SHEET:

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

A balance sheet is an item wise list of assets, liabilities and proprietorship of a business at a certain state.

Balance Sheet of……………....company as on ……………..

Capital & Liabilities Amount Assets Amount
Capital xxxx Land and buildings xxxx
Add: Net profit xxxx Furniture xxxx
xxxx Plant and machinery xxxx
Less: Drawings xxxx xxxx Land xxxx
Loans xxxx Vehicles xxxx
Bank Over Draft xxxx Debtors xxxx
Bills payable xxxx Investments xxxx
Creditors xxxx Bills receivables xxxx
Outstanding expenses xxxx Goodwill xxxx
Incomes received in advance xxxx Patents xxxx
All reserves xxxx Copyright xxxx
Trade marks xxxx
Prepaid expenses xxxx
Incomes receivables xxxx
Securities xxxx
Closing stock xxxx
Cash in hand xxxx
Cash at bank xxxx
xxxx xxxx

136
 BEFA UNIT IV
IMPORTANT ADJUSTMENTS:

1. Outstanding expenses
a) Add to respective expense account in Trading & Profit & Loss account
b) Show as a liability in Balance Sheet
Note:- If it is given only in trial balance, show as a liability in the balance sheet

2. Prepaid expenses
a) Deduct from the respective expenses account in Trading and P/L account
b) Show as an asset in Balance Sheet
Note:- If it is given only in trial balance, show only as an asset in B/S

3. Accrued incomes or incomes receivables

a) Add to the respective income A/C in P/L Account
b) Show as an asset in B/S
Note:- If it is only given in trial balance, show as an asset in B/S

4. Incomes received in advance

a) Deduct from the respective income A/C in P/L Account
b) Show as a liability in B/S
Note:- It is given only in trial balance, show as a liability in B/S

5. Closing stock
a) Show on the credit side of trading A/C
b) Show as an asset in B/S
Note:- If it is given only in trial balance, show as an asset in B/S

6. Interest on capital
a) Show on the debit side of P/L A/C
b) Add to capital in B/S
Note:- If it is given only in trial balance, show only in P/L A/C

7. Depreciation
a) Show on the debit side of P/L A/C
b) Deduct from respective asset in B/S
Note:- If it is given only in trial balance, show only on the debit side of P/L A/C)

8. I) Bad debts ( when given only in adjustments)

a) Show on the debit side of P/L A/C
b) Deduct from debtors in B/S

II) Bad debts ( when given only in trial balance )

Show on the debit side of P/L A/C only

137
 BEFA UNIT IV
III) Bad debts ( when given in both trial balance and adjustments)

a) Add “ Bad debts given in adjustments” to “ Bad debts in trial balance” on the debit side of P/L
A/C
b) Deduct “ Bad debts in adjustments” from the debtors in B/S

9. Provision/Reserve for bad debts (RBD)

A) When RBD is given only in trial balance

a) Deduct from the debtors in B/S

B) When RBD is given only in adjustments

a) Show on the debit side of P/L A/C

b) Deduct from the debtors in B/S
C) When RBDs are given in both trial balance (RBD old) and adjustments (RBD New)

a) Compare both RBDs, show the difference on the debit side of P/L A/C if RBD new is excess
than RBD old. Show the difference on the credit side of P/L A/C in RBD old is excess than
RBD new.

b) Deduct always only RBD new from debtors in B/S

PROCEDURE FOR PREPARING TRADING ACCOUNT

1. Show opening stock and net purchases ( purchases less purchase returns) on the debit side.

2. Show net sales (sales – sales returns) and the closing stock given in the adjustments on the credit
side.

3. Show all the direct expenses with adjustments on the debit side.

4. Balance the account and carry forward the balance to P/L A/C

PROCEDURE FOR PREPARING PROFIT AND LOSS ACCOUNT

1. Show all the remaining expenses with adjustments on the debit side.

2. Show all the remaining incomes with adjustments on the credit side

3. See whether all adjustments are taken once in any of the Trading Account and Profit & Loss
Account

4. Balance the P/L A/C and transfer the balance to capital in B/S

138
 BEFA UNIT IV

PROCEDURE FOR PREPARING BALANCE SHEET

1. Show all the assets with adjustments on the assets side.

2. Show all the liabilities with adjustments on the liabilities side.

3. See whether all items of trial balance are taken once and whether all adjustments are taken twice.

4. Add both the columns of assets and liabilities.

Example 1: From the following trial balance and additional
information of Mr. Arun, prepare his final accounts for the year ending
31-3-2015.
Particulars Rs Particulars Rs
Building 280000 Capital 250000
Furniture 60000 Sales 265000
Opening stock 25000 Bank loan 100000
Advertising 5000 Commission 6000
Salaries 14000 Creditors 8000
Wages 3000
Purchases 190000
Discount 4000
Bad debts 2000
Interest on loan 6000
Returns inwards 10000
Debtors 30000
629000 629000
Adjustments:
1. Stock on 31-3-2015 was Rs. 35000.
2. Wages outstanding Rs. 1000.

139
 BEFA UNIT IV

Example 2: From the following data and additional information of Mr.

Kiran, prepare his final accounts for the year ending 31-3-2015.
Building 70000 Carriage inwards 1291
Furniture 1640 Establishment expenses 2135
Debtors 15600 Carriage outwards 800
Creditors 18852 Insurance 783
Stock 15040 Interest (Cr) 340
Cash in hand 988 Bad debts 613
Cash at bank 24534 Audit fee 400
Bills receivables 5844 General expenses 3050
Purchases 85522 Discount (Dr) 945
Sales 121850 Investments 8922
Capital 92000 Returns inwards 285
Bills payable 6250 Rent 900
Adjustments:
1. Stock on 31-3-2015 was Rs. 35000.
2. Prepaid insurance Rs. 100.
3. Depreciation on furniture Rs. 10%
4. Interest accrued but not received Rs. 100

140
BEFA UNIT IV

141
 BEFA UNIT IV
Example 3: From the following trial balance and additional information,
prepare final accounts for the year ending 31-12-2014.
Particulars Rs Particulars Rs
Sundry debtors 64000 Discount received 9000
Stock (1-1-2014) 44000 Bank over draft 15000
Cash in hand 3160 Long term loan 25300
Wages 35000 Sales 365000
Trade expenses 2150 Capital 150000
Gas, water, power 4450
Sales returns 800
Bank charges 1800
Purchases 237740
Advertisements 2200
Premises 160000
Drawings 9000
564300 564300
Adjustments:
1. Bank charges outstanding Rs.150,
2.Write off bad debts Rs. 500
3. Provide 5% for doubtful debts.

142
 BEFA UNIT IV

Example 4: From the following data prepare final accounts for the year ending 31-12-
2014.

Particulars Rs Rs
Drawings and capital 12000 80000
Opening stock 12000
Investments 30600
Stationery 12000
Carriage 3000
Returns 6000 2600
Purchases and sales 120000 160000
Loans 2400 10000
Debtors and creditors 60000 25000
Discount allowed 2200
Freight in 10400
Freight out 6000
Charity 28000
Reserve for doubtful debts 2000
Bills payables 25000
304600 304600
Adjustments:
1. Closing stock Rs. 20000
2. Appreciate investment by 10%
3. Maintain reserve for doubtful debts at the rate of 5%
4. Provide 5% as interest on capital

143
BEFA UNIT IV

144
 BEFA UNIT IV

ACCOUNTING PROCESS/CYCLE

Accounting process involves a sequence of activities which are repeated in every accounting period. So it
is known as accounting cycle.

Journalizing

Final Ledger
Accounts Posting

Trial
Balance

145
 BEFA UNIT V

RATIOS
Absolute figures are valuable but they standing alone convey no meaning unless compared with another.
Accounting ratio show inter-relationships which exist among various accounting data. When relationships
among various accounting data supplied by financial statements are worked out, they are known as
accounting ratios.
What is a ratio?
Ratio analysis is a means for financial analysis. Ratio is a mathematical relationship between two
accounting figures. They show the relationship between two items in a more meaningful way which help
us to draw certain conclusions. Ratios may be used to compare the previous data, to compare one firm
with another firm etc. the ratios can be expressed as percentage or proportion or times based on the nature
of ratio.

TYPES OF
RATIOS

Liquidity Liverage Turnover Profitability

Ratios Ratios Ratios Ratios

LIQUIDITY RATIOS
Liquidity ratios express the ability of the firm to meet its short-term Obligations as when they become
due. Creditors are interested to know whether the firms is in a position to meet its commitments on time
or not. These ratios help in identifying the danger signals for the firm in advance. The important liquidity
ratios are given below.
1. Current Ratio:- It is also called as working capital ratio. It is the ratio between current assets and
current liabilities. The firm is in comfortable position if its current ratio is 2:1. It means for every rupee of
current liability, there should be two rupees worth of current assets.
Current assets = Cash + cash in bank + marketable securities + short term investments + bills receivables
+debtors + inventory + stock + work-in-progress + pre-paid expenses + incomes
receivable (accrued income) etc.
Current liabilities = Expenses payable + bills payable + creditors + short term loans + income tax to be
paid + dividend payable + bank overdraft + long term loans and debentures to be
paid within one year + provision for tax + short term advances etc.
2. Quick Ratio:- It is also called as working Acid test ratio or liquid ratio. It is the ratio between quick
assets and current liabilities. The firm is in comfortable position if its current ratio is 1:1. It means for
every rupee of current liability, there should be one rupee worth of quick assets. Quick assets can be
converted into cash quickly.
Quick assets = All current assets except stock and prepaid expenses.

146
 BEFA UNIT V

Example 1:
From the Balance Sheet of XYZ Co. Ltd., calculate liquidity ratios.
(Rs. in thousands)
Capital & Liabilities Amount Assets Amount
Land and
Preference share capital 100 225
Buildings
Plant and
Equity share capital 150 machinery 250

Furniture and
General reserve 250 Fixtures 100

Debentures 400 Stock 250

Creditors 200 Debtors 125
Bills payable 50 Cash at Bank 250
Outstanding expenses 50 Cash in hand 125
Profit and loss account 100 Prepaid expenses 50
Marketable securities
Bank loan(Long term) 200 125

1500 1500

ACTIVITY RATIOS/TURNOVER RATIOS

Activity ratios are classed as Turnover ratios. These ratios tell how active the firm is in selling stocks,
collecting money from debtors and paying to creditors. They are given below.
1. Inventory Turnover Ratio:- It is also called as Stock turnover ratio. It indicates the number of times
the average stock is being sold during a given accounting period. The higher the ratio, the better is the
performance of the firm in selling its stock. It is the rate at which inventories are converted into sales and
then to cash.

Cost of goods sold = Opening stock + Purchases + Manufacturing expenses –

Closing stock
(or)
Note 1. When cost of goods sold is not given, sales amount should be taken into account.
2. When opening stock is not given, closing stock is considered as ‘average stock’.

147
 BEFA UNIT V
Solution:

Example 1:A firm sold goods worth Rs. 500000 and its gross profit is 20% of sales value. The
inventory at the beginning of the year was Rs. 16000 and at end of the year was 14000. Compute
inventory turnover ratio and also the inventory holding period.
𝐸 Example
A firm’s sales during the year was Rs. 400000 of which 60% were credit sales. The balance of debtors
at the beginning and ending year were 25000 and 15000 respectively. Calculate debtors turnover ratio of
the firm. Also find out debt collection period.

Example:

A firm’s purchases during the year was Rs. 400000 of which 50% were credit purchases. The balance
of creditors at the beginning and ending year were 30000 and 10000 respectively. Calculate creditors
turnover ratio of the firm. Also find out creditors payment period.

CAPITAL STRUCTURE RATIOS:

Capital structure ratios are also called as leverage ratios. These ratios focus on the long term solvency of
the firm. The long term solvency of the firm always reflected in its ability to meet its long term
commitments such as payment of interest periodically without fail, repayment of principal as and when
the become due. The below are the most commonly used capital structure rations.
1. Debt-Equity Ratio:- It is the ratio between outsider’s funds(Debt) and insider’s funds (Equity). It is a
measure of solvency. This ratio is used to measure the firm’s obligations to creditors in relation to the
owners’ funds. The standard ratio is 1:1. this means for every rupee of debt, there should be one rupee
worth internal funds. A high D/E ratio implies that the creditors stake is more as compared to that of
owners.

148
 BEFA UNIT V
Problem 1:- The following an extract of a balance sheet of a company
during the last year. Compute current ratio and quick ratio.
Land and buildings 50000 Plant and 100000
machinery

Furniture and fixtures 25000 Closing stock 25000

Sundry debtors 12500 Wages prepaid 2500

Sundry creditors 8000 Rent outstanding 2000

149
 BEFA UNIT V

Problem 2:- Calculate inventory turnover ratio and Average period of holding the stocks.
Sundry debtors 45000 Closing stock 30000

Sales 400000 Sales returns 20000

Stock as on 1-1- 40000 Stock as on 31-12- 60000
2014 2014

150
 BEFA UNIT V

Problem 3:- Given the following data, calculate debtors and creditors turnover ratios.
Debtors as on 1-1-2014 8000 Debtors as on 31-12-2014 16000

Creditors as on 1-1-2014 32000 Purchases (60% credit) 150000

Furniture and fixtures 25000 Cash 5000

Creditors as on 31-12-2015 26000

Sales (75% credit) 250000

151
BEFA UNIT V

152
 BEFA UNIT V

Problem 4:- Given the following data, calculate current ratio and quick ratio
Capital 360000 Debentures 420000
Reserve fund 240000 Creditors 36000
Bank over draft 60000 Rent outstanding 6000
Provision for taxation 78000 Land and buildings 440000

Plant and 235000 Furniture and fixtures 140000

machinery
Motor vehicles 105000 Stock 60000
Sundry debtors 90000 Short term investments 75000

Cash at bank 30000 Cash in hand 25000

153
 BEFA UNIT V

Problem 5:- Given the following data, calculate Debt-equity ratio, Interest coverage ratio and Proprietary
funds to total assets ratio.
Liabilities and Capital Rs Assets Rs
Share Capital: Motor vehicles 105000
10% Preference Capital 60000 Plant and machinery 235000
Equity shares Capital 300000 Sundry debtors 90000
Reserve fund 240000 Land and buildings 440000
Bank over draft 60000 Furniture and 140000
fixtures
Provision for taxation 78000 Stock 60000
15% Debentures 420000 Short term investments 75000

Creditors 36000 Cash in hand 25000

Rent outstanding 6000 Cash at bank 30000
1200000 1200000
EBIT = Rs. 204000

154
 BEFA UNIT V

Example 6: Calculate Gross Profit Margin, Net Operating Margin and Operating Ratio
given the following information.
Sales 1000000 Cost of goods 600000
sold

Selling and Administrative costs 200000 Depreciation 100000

155
 BEFA UNIT V
Example 7: prepare a balance sheet from the following particulars.
Stock velocity :6
Gross profit margin : 20%
Capital turnover ratio :2
Fixed assets turnover :4
Debt collection period : 2 months
Creditors payment period : 73 days
Gross profit : Rs. 60000
Excess of closing stock over opening was : Rs. 5000

Solution

156
BEFA UNIT V

157
BEFA UNIT V

158
 BEFA UNIT V

USES OR ADVANTAGES OR IMPORTANCE OF RATIO ANALYSIS

Ratio Analysis stands for the process of determining and presenting the relationship of items and groups
of items in the financial statements. It is an important technique of financial analysis. It is a way by which
financial stability and health of a concern can be judged. The following are the main uses of Ratio
analysis:
(a)Useful in financial position analysis: Accounting reveals the financial position of the concern. This
helps banks, insurance companies and other financial institution in lending and making investment
decisions.
(ii) Useful in simplifying accounting figures: Accounting ratios simplify, summaries and systematic
the accounting figures in order to make them more understandable and in lucid form.

(iii) Useful in assessing the operational efficiency: Accounting ratios helps to have an idea of the
working of a concern. The efficiency of the firm becomes evident when analysis is based on
accounting ratio. This helps the management to assess financial requirements and the capabilities of
various business units.
(iv) Useful in forecasting purposes: If accounting ratios are calculated for number of years, then a
trend is established. This trend helps in setting up future plans and forecasting.
(v) Useful in locating the weak spots of the business: Accounting ratios are of great assistance in
locating the weak spots in the business even through the overall performance may be efficient.
(vi) Useful in comparison of performance: Managers are usually interested to know which
department performance is good and for that he compare one department with the another department
of the same firm. Ratios also help him to make any change in the organisation structure.

LIMITATIONS OF RATIO ANALYSIS

1. False results if based on incorrect accounting data: Accounting ratios can be correct only if the
data (on which they are based) is correct. Sometimes, the information given in the financial
statements is affected by window dressing, i. e. showing position better than what actually is.
2. No idea of probable happenings in future: Ratios are an attempt to make an analysis of the past
financial statements; so they are historical documents. Now-a-days keeping in view the
complexities of the business, it is important to have an idea of the probable happenings in future.
3. Variation in accounting methods: The two firms’ results are comparable with the help of
accounting ratios only if they follow the some accounting methods or bases. Comparison will
become difficult if the two concerns follow the different methods of providing depreciation or
valuing stock.
4. Price level change: Change in price levels make comparison for various years difficult.
5. Only one method of analysis: Ratio analysis is only a beginning and gives just a fraction of
information needed for decision-making so, to have a comprehensive analysis of financial
statements, ratios should be used along with other methods of analysis.
6. No common standards: It is very difficult to by down a common standard for comparison
because circumstances differ from concern to concern and the nature of each industry is different.
7. Different meanings assigned to the some term: Different firms, in order to calculate ratio may
assign different meanings. This may affect the calculation of ratio in different firms and such ratio
when used for comparison may lead to wrong conclusions.
8. Ignores qualitative factors: Accounting ratios are tools of quantitative analysis only. But
sometimes qualitative factors may surmount the quantitative aspects. The calculations derived
from the ratio analysis under such circumstances may get distorted.
9. No use if ratios are worked out for insignificant and unrelated figure: Accounting ratios
should be calculated on the basis of cause and effect relationship. One should be clear as to what
cause is and what effect is before calculating a ratio between two figures.

159
 BEFA UNIT V
FUNDS FLOW ANALYSIS

INTRODUCTION

Balance sheet and profit and loss A/C show the financial status and profitability of the firm respectively.
Balance sheet discloses the value of fixed assets as well as current assets, the decrease or increase of all
assets and liabilities can be ascertained by comparing with the previous balance sheet. But it does not
disclose the reasons for increasing or decreasing the assets/liabilities. However, the “ Funds flow
statement” is to be prepared to know such reasons. In this concept fund means “ net working”.

What is ‘FUND’ and ‘FLOW’ ?

A layman can describe word FUND as cash or cash equivalents. In technical terms, the word FUND
means „Net Working Capital‟.

Funds may mean:

 Cash only
 Net working capital, i.e. current assets less current liabilities
 Total resources or total funds
 Internal resources only
 Net worth, i.e. owner‟s equity capital plus reserves

The term FLOW refers to change or transfer. The term „Fund flow‟ or „Flow of funds‟ may thus mean
transport of:

 One asset to another

 One liability to another
 Assets to liabilities or vice versa
 The changes in working capital is also an inflow or outflow of funds, and thus it is called fund
flow.

“ Fund” is considered as working capital while preparing “ Funds flow statement”. Fund flow
means change in the working capital. In other words, any increase or decrease in working capital means
“flow of funds”. Any transaction which has one current account and the other non-current account results
in change in the working capital.

160
 BEFA UNIT V

Current accounts:- Current assets accounts and current liabilities accounts are called current accounts.
Assets which are converted into cash within a year are called current assets. Liabilities which are to be
paid within a year are called current liabilities.

Non-current account:- Accounts which are not current accounts are called non-current accounts. For
example, fixed assets accounts long term liabilities accounts, and capital & reserves accounts.
Preparation of funds flow statements

Funds flow statement is prepared by observing the items taken place during the periods of two
balance sheets along with the adjustments into consideration.

Three statements are to be prepared.

I. Statement of changes in working capital

II. Statement of funds from operations
III. Funds flow statement

161
 BEFA UNIT V

I. Statement of changes in working capital:- this statement reveals the net change in the working
capital (CA – CL) . Current assets and current liabilities are as follows.

FORMAT OF STATEMENT OF CHANGES IN WORKING CAPITAL

Previous Current Working capital
Particulars
year year Increase Decrease
A. Current Assets
Cash in hand xxx xxx
Cash at bank xxx xxx
Bills receivables xxx xxx
Debtors etc xxx xxx
A xxx xxx
B. Current Liabilities
Bills payables xxx xxx
Creditors xxx xxx
Bank overdraft etc. xxx xxx
xxx xxx
B
Working capital (A – B) xxx xxx
Increase/Decrease in working capital
xxx xxx
B/F
xxx xxx xxx xxx

162
 BEFA UNIT V

Procedure for preparation

1. The figures of current assets and current liabilities of two balance sheets given are recorded in
the respective columns provided. Don‟t take the adjustments. Then find working capital and
increase/decrease in working capital.
2. By observing the current assets and current liabilities, the differences are shown in the working
capital columns against to the each account and balance those columns. Increase or decrease in
working capital can be recognized as follows:

II. Statement of funds from operations

FORMAT OF FUNDS FROM OPERATIONS

Particulars Rs Rs
Net profit xxx
Add:
Provision for depreciation xxx
Amortization of goodwill, patents,
xxx
etc.
Preliminary expenses xxx
Loss on sale of investments xxx
Loss on sale of fixed assets xxx
Provision for tax xxx
Discount on issues of debentures xxx xxx
Less:
Dividend from investments xxx
Profit on sale of investments xxx
Profit on sale of fixed assets xxx
Interest received xxx xxx
Funds from operations xxx

163
 BEFA UNIT V

Procedure for preparation

1. Prepare the accounts for the items given in the adjustments to know the hidden information.
Generally, the hidden information is as follows:
a) Purchase price of a fixed asset
b) Sale value of a fixed asset
c) Profit/loss on sale of a fixed asset
d) Depreciation provided on a fixed asset
e) Depreciation of the asset sold
f) Provision for tax for the year
g) Tax paid during the year
h) Dividend proposed during the year
i) Dividend paid during the year
2) By observing balance sheets and accounts for adjustments, non-Operating expenses and non-cash
payment items (debit items of profit and loss account ) are to be added to given net profit and all
non-operating incomes & non-cash received items (credit items of profit and loss A/C) are to be
deducted from given net profit to find the funds from operations.

Dr Fixed Asset A/C Cr

Particulars Amount Particulars amount
To Balance b/d *** By Depreciation ***
(opening) *** ( for asset sold)
To P/L A/C (profit) *** By Bank ( sale value) ***
To Bank (purchase) By P/L A/C (loss) ***
By Balance c/d ***
*** ***

Dr Cumulative Depreciation A/C Cr

Particulars Amount Particulars amount
To Fixed Asset A/C *** By Balance b/d ***
(Depreciation of Asset (opening) ***
sold) *** By P/L A/C (provided)
To Balance c/d (closing) *** ***

Dr Provision for Tax A/C Cr

Particulars Amount Particulars amount
To Bank A/C (paid) *** By Balance b/d ***
To Balance c/d (closing) *** (opening) ***
*** By P/L A/C (provided) ***

Note:- When tax paid is not given, it is considered that the tax provided in the previous
year is paid in the current year.

164
 BEFA UNIT V
Dr Proposed Dividend A/C Cr
Particulars Amount Particulars amount
To Bank A/C (paid) *** By Balance b/d ***
To Balance c/d (closing) *** (opening) ***
*** By P/L A/C (provided) ***

Note:- When dividend paid is not given, it is considered that the dividend proposed in the previous year
is paid in the present year.
Note:- It can be found even if any one of the items is not given in the above said accounts.
2. In case provision for tax and proposed dividend are taken as current liabilities, there is no need to
prepare those accounts. These should be shown in the “ statement of changes in working capital”
only.
If these both are taken as an appropriation of profit (unlike current liabilities), there is a
need to prepare their accounts to know the hidden information. Provision for tax and proposed
dividend are to be added to the net profit to know the funds from operations and tax paid &
dividend paid are shown on the applications‟ side in the funds flow statement.

III. Funds Flow Statement

FORMAT OF FUNDS FLOW STATEMENT
Particulars Amount
SOURCES OF FUND
Issue of shares xxx
Issue of debentures xxx
Sale of investments xxx
Long-term loans xxx
Non-operating incomes xxx
Funds from operations xxx
Decrease in working capital xxx
Total Sources xxx
APPLICATION OF FUND
Redemption of pref. shares xxx
Redemption of debentures xxx
Purchase of investments xxx
Purchase of fixed assets xxx
Payment of long-term loans xxx
Payment of tax xxx
Payment of dividend xxx
Increase in working capital xxx
Total Uses xxx

Procedure for preparation

1. By examining the non-current assets and liabilities, show as a source if cash comes and as an
application if cash goes out.

165
 BEFA UNIT V
2. Show non-operating income as a source and non-operating expenses as an application.
3. Through adjustment items, if cash comes in show as a source and if cash goes out show as an
application.
4. If goodwill shows increase, take on the applications‟ side.
Note:- In order to say in single sentence, except the items taken in the “ statements of changes in
working capital and funds from operations”, take as a source when cash comes through all other
items and take as an application when cash goes out through all other items.

PRACTICE PROBLEMS

1. Prepare:
1. Statement of changes in working capital and
2. Funds flow statement from following balance sheets of Vijaya Mitra Ltd., as on 31-03-2016
and 31-03-2017:
Liabilities 31-03-2016 31-03-2017
Equity capital 200000 300000
Preference capital 200000 100000
Profit and loss 50000 75000
account 40000 60000
General resource 10000 50000
Unsecured loans 40000 5000
Current liabilities
Total 540000 590000
Assets 31-03-2016 31-03-2017
Land and buildings 100000 80000
Plant and Machinery 90000 120000
Cash at Bank 60000 40000
Stock 120000 140000
Sundry Debtors 30000 50000
Vehicles 140000 160000
Total 540000 590000

Adjustments:
1. Dividend declared and paid Rs. 25000
2. Additional plant purchased Rs. 5000
3. Tax paid during the year Rs. 45000

166
 BEFA UNIT V
Solution:

STATEMENT OF CHANGES IN WORKING CAPITAL

Previous Current Working capital
Particulars
year year Increase Decrease
A. Current Assets
Cash at bank 60000 40000 20000
Stock 120000 140000 20000
Debtors 30000 50000 20000
A 210000 230000
B. Current Liabilities
Current liabilities 40000 5000 35000
40000 5000
B
Working capital (A – B) 170000 225000
Increase in working capital B/F 55000 - 55000
225000 225000 75000 20000

FUNDS FROM OPERATIONS

Particulars Amount Amount
Net profit (75000-50000) 25000
Add:
General reserve 20000
Provision for dividend 25000
Provision for tax 45000
Depreciation on plant 20000 110000
Funds from
135000
operations

FUNDS FLOW STATEMENT

Particulars Amount
SOURCES OF FUND
Issue of equity capital 100000
Unsecured loans procured 40000
Sale of land and building 20000
Funds from operations 135000
Total Sources 295000
APPLICATION OF FUND
Redemption of pref. capital 100000
Purchase of vehicles 20000
Purchase of plant 50000
Dividend paid 25000
Tax paid 45000
Increase in working capital 55000
Total Uses 295000

167
 BEFA UNIT V

Working notes:
Plant and Machinery A/C
Particulars Amount Particulars Amount
To Opening By P&L A/C (Depn.)
balance 90000 b/f 20000
To Bank
(purchase) 50000 By Closing balance 120000
140000 140000

Dividend A/C
Particulars Amount Particulars Amount
By P&L A/C (provi.)
To Bank A/C 25000 b/f 25000
25000 25000

Tax A/C
Particulars Amount Particulars Amount
By P&L A/C (provi.)
To Bank A/C 45000 b/f 45000
45000 45000

2. Prepare a funds flow statement from the following balance sheets

Liabilities 31-3-16 31-3-17 Assets 31-3-16 31-3-17
E.S.C 100000 200000 Machinery 120000 160000
P.S.C 170000 180000 Furniture 240000 140000
P & L A/C 260000 350000 Goodwill 12000 4000
G.R 110000 230000 Patents 8000 1000
9% Debentures 60000 140000 Cash 415000 1023000
Creditors 80000 200000 Preliminary 5000 2000
Bills payable 20000 30000 exp.
800000 1330000 800000 1330000

1. Depreciation on Machinery Rs. 15000 and on Furniture Rs. 12000

2. Dividend paid Rs. 18000

168
 BEFA UNIT V
Solution:
STATEMENT OF CHANGES IN WORKING CAPITAL
Previous Current Working capital
Particulars
year year Increase Decrease
A. Current Assets
Cash 415000 1023000 608000
A 415000 1023000
B. Current Liabilities
Credotors 80000 200000 120000
Bills payables 20000 30000 10000
100000 230000
B
Working capital (A – B) 315000 793000
Increase in working capital B/F 478000 - 478000
793000 793000 608000 608000

FUNDS FROM OPERATIONS

Particulars Amount Amount
Net profit (350000-260000) 90000
Add:
General reserve 120000
Provision for dividend 18000
Depreciation on furniture 12000
Depreciation on machinery 15000
Goodwill written off 8000
Patents written off 7000
Preliminary expenses 183000
3000
written off
Funds from operations 273000

FUNDS FLOW STATEMENT

Particulars Amount
SOURCES OF FUND
Issue of equity capital 100000
Issue of preference capital 10000
Issue of debentures 80000
Sale of furniture 88000
Funds from operations 273000
Total Sources 551000
APPLICATION OF FUND
Purchase of machinery 55000
Dividend paid 18000
Increase in working capital 478000
Total Uses 551000

169
 BEFA UNIT V
Working Notes:
Machinery A/C
Particulars Amount Particulars Amount
To Opening balance 120000 By P&L A/C (Depn.) 15000
To Bank (purchase)
b/f 55000 By Closing balance 160000
175000 175000

Furniture A/C
Particulars Amount Particulars Amount
To Opening balance 240000 By P&L A/C (Depn.) 12000
By Bank (Sale) b/f 88000
By Closing balance 140000
240000 240000

Dividend A/C
Particulars Amount Particulars Amount
By P&L A/C (provi.)
To Bank A/C 18000 b/f 18000
18000 18000

3. Balance sheets of M/s. Divya as on 1st January 2016 and 1st January 2017 were as follows:
Liabilities 2016 2017 Assets 2016 2017
Creditors 40000 44000 Cash 12000 27000
Overdraft 2000 3000 Debtors 30000 50000
Long term loan 40000 50000 Stock 35000 25000
Capital 125000 150000 Machinery 80000 55000
Reserves 10000 10000 Land 40000 50000
P& L 15000 30000 building 35000 80000

232000 287000 232000 287000

During the year machine costing Rs. 10000 (accumulated depreciation Rs. 3000) was sold
for Rs. 5000.

170
 BEFA UNIT V
Solution:
STATEMENT OF CHANGES IN WORKING CAPITAL
Previous Current Working capital
Particulars
year year Increase Decrease
A. Current Assets
Cash 12000 27000 15000
Debtors 30000 50000 20000
Stock 35000 25000 10000
A 77000 102000
B. Current Liabilities
Credotors 40000 44000 4000
Overdraft 2000 3000 1000
42000 47000
B
Working capital (A – B) 35000 55000
Increase in working capital B/F 20000 20000
55000 55000 35000 35000

FUNDS FROM OPERATIONS

Particulars Rs Rs
Net profit (30000-15000) 15000
Add:
General reserve
Provision for dividend
Depreciation on furniture
Depreciation on machinery 18000
Loss on sale of machinery 2000 20000
Funds from operations 35000

FUNDS FLOW STATEMENT

Particulars Amount
SOURCES OF FUND
Issue of capital 25000
Long-term loan 10000
Sale of machinery 5000
Funds from operations 35000
Total Sources 75000
APPLICATION OF FUND
Purchase of land 10000
Purchase of building 45000
Increase in working capital 20000
Total Uses 75000

171
 BEFA UNIT V
Working Notes:
Machinery A/C
Particulars Amount Particulars Amount
To Opening
balance 80000 By P&L A/C (Depn.) 3000
By P&L A/C (loss on sale) 2000
By Bank (sale) 5000
By Closing balance 55000
By P&L A/C (Depn.) b/f 15000
80000 80000

4. Prepare a funds flow statement from the following:

Liabilities 2002 2003 Assets 2002 2003
Share capital 200000 250000 Cash 30000 47000
Creditors 70000 45000 Debtors 120000 115000
Retained 10000 23000 Stock 80000 90000
earnings Land 50000 66000

280000 318000 280000 318000

Solution:
STATEMENT OF CHANGES IN WORKING CAPITAL
Previous Current Working capital
Particulars
year year Increase Decrease
A. Current Assets
Cash 30000 47000 17000
Debtors 120000 115000 5000
Stock 80000 90000 10000
A 230000 252000
B. Current Liabilities
Creditors 70000 45000 25000
B 70000 45000
Working capital (A – B) 160000 207000
Increase in working capital B/F 47000 - 47000
207000 207000 52000 52000

FUNDS FROM OPERATIONS

Particulars Rs Rs
Net profit (23000-10000) 13000
Funds from operations 13000

172
 BEFA UNIT V
FUNDS FLOW STATEMENT
Particulars Amount
SOURCES OF FUND
Issue of capital 50000
Funds from operations 13000
Total Sources 63000
APPLICATION OF FUND
Purchase of land 16000
Increase in working capital 47000
Total Uses 63000

5. From the information given below, prepare funds flow statement of Global Co. Ltd.
Liabilities I year II year Assets I year II year
Share capital Goodwill 190000 140000
Equity capital 450000 600000 Plant 160000 250000
Preference capital 225000 150000 Building 240000 195000
Profit and loss A/C 60000 75000 Inventories 92000 235000
Proposed dividend 55000 67000 trade 175000 125000
Trade creditors 72000 90000 Debtors 45000 57000
Bills payable 32000 25000 Bills receivables 52000 77000
Provision for tax 60000 72000 cash
954000 1079000 954000 1079000
Additional information:
1. An interim dividend of Rs. 35000 has been paid in II year.
2. Payment of income tax Rs. 52000 was paid during II year.
3. Depreciation of Rs. 35000 and Rs. 42000 have been charged on plant and building
respectively in II year.
4. A part of the plant worth Rs. 20000was sold for Rs. 30000.

Solution:
STATEMENT OF CHANGES IN WORKING CAPITAL
Previous Current Working capital
Particulars
year year Increase Decrease
A. Current Assets
Cash 52000 77000 25000
Inventories 92000 235000 143000
Debtors 175000 125000 50000
Bills receivables 45000 57000 12000
A 364000 494000
B. Current Liabilities
Credotors 72000 90000 18000
Bills payables 32000 25000 7000
104000 115000
B
Working capital (A – B) 260000 379000
Increase in working capital B/F 119000 119000
379000 379000 187000 187000

173
 BEFA UNIT V

FUNDS FROM OPERATIONS

Particulars Rs Rs
Net profit (75000-60000) 15000
Add:
Goodwill written off 50000
Provision for dividend 47000
Provision for tax 64000
Depreciation on plant 35000
Depreciation on building 42000 238000
Less: 253000
Profit on sale of plant 10000 10000
Funds from operations 243000

FUNDS FLOW STATEMENT

Particulars Amount
SOURCES OF FUND
Issue of equity capital 150000
Sale of building 3000
Sale of plant 30000
Funds from operations 243000
Total Sources 426000
APPLICATION OF FUND
Redemption of preference shares 75000
Purchase of plant 145000
Dividend paid 35000
Tax paid 52000
Increase in working capital 119000
Total Uses 426000

Working Notes:
Plant A/C
Particulars Amount Particulars Amount
By P&L A/C
To Opening balance 160000 (Depn.) 35000
To P & L A/C
(porofit) 10000 By Bank (Sale) 30000
To Bank (purchase)
b/f 145000 By Closing balance 250000
315000 315000

Building A/C
Particulars Amount Particulars Amount
To Opening balance 240000 By P&L A/C (Depn.) 42000
By Bank (Sale) b/f 3000
By Closing balance 195000
240000 240000

174
 BEFA UNIT V

Proposed dividend A/C

Particulars Amount Particulars Amount
To Bank A/C 35000 By Opening balance 55000
To Closing By P&L A/C (provi.)
balance 67000 b/f 47000
102000 102000

Provision for tax A/C

Particulars Amount Particulars Amount
To Bank A/C 52000 By Opening balance 60000
To Closing By P&L A/C (provi.)
balance 72000 b/f 64000
124000 124000

ADVANTAGES OF FUND FLOW STATEMENTS

1. Funds flow statement reveals the net result of Business operations done by the company during the
year.

2. In addition to the balance sheet, it serves as an additional reference for many interested parties like
analysts, creditors, suppliers, government to look into financial position of the company.

3. The Fund Flow Statement shows how the funds were raised from various sources and also how those
funds were deployed by a company.

4. It reveals the causes for the changes in liabilities and assets between the two balance sheet dates.

5. Funds flow statement helps the management in deciding its future course of plans and also it acts as a
control tool for the management.

Disadvantages of Fund Flow Statements

1. Funds Flow statement has to be used along with balance sheet and profit and loss account for
inference of financial strengths and weakness of a company it cannot be used alone.

2. Fund Flow Statement does not reveal the cash position of the company, and that is why company has
to prepare cash flow statement in addition to funds flow statement.

3. Funds flow statement only rearranges the data which is there in the books of account and therefore it
lacks originality.

4. Funds flow statement is basically historic in nature, that is it indicates what happened in the past and it
does not communicate anything about the future, only estimates can be made based on the past data
and therefore it cannot be used the management for taking decision related to future.

175
 BEFA UNIT V
CASH FLOW ANALYSIS

INTRODUCTION

A Cash Flow Statement is a statement showing changes in cash position of the firm from one period to
another. It explains the inflows (receipts) and outflows (disbursements) of cash over a period of time. The
inflows of cash may occur from sale of goods, sale of assets, receipts from debtors, interest, dividend,
rent, issue of new shares and debentures, raising of loans, short-term borrowing, etc. The cash outflows
may occur on account of purchase of goods, purchase of assets, payment of loans loss on operations,
payment of tax and dividend, etc

The cash flow statement shows how much cash comes in and goes out of the company over the quarter or
the year. At first glance, that sounds a lot like the income statement in that it records financial
performance over a specified period. But there is a big difference between the two.

What distinguishes the two is accrual accounting, which is found on the income statement. Accrual
accounting requires companies to record revenues and expenses when transactions occur, not when cash
is exchanged. At the same time, the income statement, on the other hand, often includes non-cash
revenues or expenses, which the statement of cash flows does not include.

Just because the income statement shows net income of Rs.10 does not mean that cash on the balance
sheet will increase by Rs.10. Whereas when the bottom of the cash flow statement reads Rs.10 net cash
inflow, that's exactly what it means. The company has Rs.10 more in cash than at the end of the last
financial period. You may want to think of net cash from operations as the company's "true" cash profit.

Because it shows how much actual cash a company has generated, the statement of cash flows is critical
to understanding a company's fundamentals. It shows how the company is able to pay for its operations
and future growth.

Indeed, one of the most important features you should look for in a potential investment is the company's
ability to produce cash. Just because a company shows a profit on the income statement doesn't mean it
cannot get into trouble later because of insufficient cash flows. A close examination of the cash flow
statement can give investors a better sense of how the company will fare.

OBJECTIVES OF CASH FLOW STATEMENT

1. Highlighting cash flow from different activities

2. Short-term Planning
3. Cash Flow information helps to understand liquidity
4. Efficient cash management
5. Prediction of sickness
6. Comparison with budget
7. Cash position

CURRENT ASSESTS AND CURRENT LIABILITIES

CURRENT ASSETS CURRENT LIABILITIES

1. Cash in hand 1. Bills payables
2. Cash at bank 2. Creditors
3. Bills receivables 3. Outstanding expenses
4. Debtors 4. Dividends to be paid

176
 BEFA UNIT V
5. Short term advances 5. Bank over draft
6. Short term investments 6. Short term loans
7. Inventories or stock 7. Provisions for current assets (ex: RBD)
8. Pre- paid expenses 8. Taxes to be paid
9. Incomes to be received 9. Provision for tax
10. Loose tools, etc. 10. Proposed dividend

The general rules that develop from the above discussion are:

1. An increase in current assets leads to decrease in cash.

2. A decrease in current assets leads to an increase in cash.

3. An increase in current liabilities leads to an increase in cash.

4. A decrease in current liabilities leads to a decrease in cash.

PREPARING A CASH FLOW STATEMENT

Cash flow statements have three distinct sections, each of which relates to a particular component –
operations, investing and financing – of a company's business activities.

The indirect method of presentation is very popular, because the information required for it is
relatively easily assembled from the accounts that a business normally maintains in its chart of
accounts. The indirect method is less favoured by the standard-setting bodies, since it does not give a
clear view of how cash flows through a business. The alternative reporting method is the direct
method.

Three Sections of the Cash Flow Statement

Companies produce and consume cash in different ways, so the cash flow statement is divided into
three sections: cash flows from operations, financing and investing. Basically, the sections on
operations and financing show how the company gets its cash, while the investing section shows how
the company spends its cash.

1. Operating Activities: Operating activities include cash flows from all standard business operations.
Cash receipts from selling goods and services represent the inflows. The revenues from interest and
dividends are also included here. The operational expenditures are considered as outflows for this
section. Although interest expenses fall under this section but the dividends are not included
.Dividends are considered as a part of financing activity in financial accounting terms.
2. Investing Activities: Investing activities include transactions with assets, marketable securities and
credit instruments. The sale of property, plant and equipment or marketable securities is a cash inflow.
Purchasing property, plant and equipment or marketable securities are considered as cash outflows.
Loans made to borrowers for long-term use is another cash outflow. Collections from these loans,
however, are cash inflows.

3. Financing Activities: Financing activities on the statement of cash flows are much more defined in
nature. The receipts come from borrowing money or issuing stock. The outflows occur when a
company repays loans, purchases treasury stock or pays dividends to stockholders. As the case with

177
 BEFA UNIT V
other activities on the statement of cash flows depend on activities rather than actual general ledger
accounts.
CASH FLOW STATEMENT FORMAT
Cash Flow Statement of -------------- Company for the year ended -------
Particulars Rs. Rs.
A. Cash Flow from Operating Activities
Net Profit xxx
Adjustments: (to convert net profit to cash provided by
operating activities)
Goodwill written off xxx
Loss on sale of investments xxx
Loss on sale of fixed assets xxx
Preliminary expenses written off xxx
Discount on issue of debentures xxx
Provision for tax xxx
Patents written off xxx
Transfer to reserve xxx
Provision for dividend xxx
Loss on sale of fixed assets/investments xxx
Profit on sale of fixed assets/investments (xxx)
Profit from investments (xxx)
Increase in current liabilities xxx
Decrease in current liabilities (xxx)
Increase in current assets (xxx)
Decrease in current assets xxx
Cash from operations xxx
B. Cash Flows from Investing Activities
Purchase of fixed assets (xxx)
Proceeds from sale of fixed assets xxx
Purchase of long-term investments (xxx)
Proceeds from sale of long-term investments xxx
Cash from investing activities xxx
C. Cash Flows from Financing Activities
Issue of shares xxx
Issue of debentures xxx
Share capital repaid (xxx)
Debentures repaid (xxx)
Cash from financing activities xxx
Net increase/decrease in cash xxx
Cash at the beginning of the year xxx
Cash at the end of the year xxx

Procedure for preparation

1. Prepare accounts for adjustments to find hidden information.
2. Observe balance sheets and accounts for adjustments. Adjust non-cash items, non-operating items
and current assets & current liabilities to net profit except cash and bank balances.
3. Observe all fixed assets and their adjustment accounts. Show purchase and sale of assets.

178
 BEFA UNIT V
4. Observe all capital & long-term liabilities and their adjustment accounts. Show capital & loans
received and repaid.

ADVANTAGES OF CASH FLOW STATEMENT

1. It shows the actual cash position available with the company between the two balance sheet dates
which funds flow and profit and loss account are unable to show. So it is important to make a cash
flow report if one wants to know about the liquidity position of the company.

2. It helps the company in accurately projecting the future liquidity position of the company enabling
it arrange for any shortfall in money by arranging finance in advance and if there is excess than it can
help the company in earning extra return by deploying excess funds.

3. It acts like a filter and is used by many analyst and investors to judge whether company has prepared
the financial statements properly or not because if there is any discrepancy in the cash position as
shown by balance sheet and the cash flow statement, it means that statements are incorrect.

DISADVANTAGES OF CASH FLOW STATEMENT

1. Since it shows only cash position, it is not possible to deduce actual profit and loss of the company by
just looking at this statement.

2. In isolation this is of no use and it requires other financial statements like balance sheet, profit and
loss etc…, and therefore limiting its use.

PRACTICE PROBLEMS AND SOLUTIONS

1. From the following balance sheets as on 31-12-2016 and 31-12-2017. You are required to prepare
a cash flow statement.
Liabilities 31-12-2016 31-12-2017
Share capital 100000 150000
Profit and loss A/C 50000 80000
General reserve 30000 40000
12% Bonds 50000 60000
Sundry creditors 30000 40000
Outstanding expenses 10000 15000
Total 270000 385000
Assets 31-12-2016 31-12-2017
Fixed assets 100000 150000
Goodwill 50000 40000
Inventories 50000 80000
Bank 10000 15000
Bills receivables 10000 20000
Sundry debtors 50000 80000
Total 270000 385000

179
 BEFA UNIT V

Solution:

Cash Flow Statement for the year ended 31-12-2017

Particulars Rs. Rs.
A. Cash Flow from Operating Activities
Net Profit (80,000 - 50,000) 30000
Adjustments:
Goodwill written off 10000
Transfer to reserve 10000
Increase in creditors 10000
Increase in outstanding expenses 5000
Increase in inventory (30,000)
Increase in receivables (10,000)
Increase in debtors (30,000)
Cash from operations (5,000)

B. Cash Flows from Investing Activities

Purchase of fixed assets (50,000)
Cash from investing activities (50,000)

C. Cash Flows from Financing Activities

Issue of shares 50,000
Issue of bonds 10,000
Cash from financing activities 60,000
Net increase in cash 5,000
Bank at the beginning of the year 10,000
Bank at the end of the year 15,000

2. Prepare a cash flow statement from the following balance sheets of Kumar Ltd.
Liabilities 2016 2017 Assets 2016 2017
Capital 150000 175000 Land & Building 110000 150000
Loan from bank 160000 100000 Machinery 200000 140000
Creditors 85000 93000 Stock 50000 45000
Outstanding expenses 5000 7000 Debtors 70000 80000
Bills payable 50000 40000 Cash 15000 22000
Long term loan -------- 25000 Pre – paid expenses 5000 3000
450000 440000 450000 440000
Net profit during the year 2017 was Rs/ 60000. During 2017 machinery costing Rs. 25000
( accumulated depreciation Rs. 10000) was sold for Rs. 25000. The tax payable and dividend
payable were Rs. 50000 and Rs. 35000 respectively during 2017.

180
 BEFA UNIT V

Solution:

Cash Flow Statement for the year ended 31-12-2017

Particulars Rs. Rs.
A. Cash Flow from Operating Activities
Net Profit 60000
Adjustments:
Depreciation on machinery 45000
Profit on sale of machinery (10000)
Provision for tax 50000
Provision for dividend 35000
Increase in creditors 8000
Increase in outstanding expenses 2000
Decrease in bills payable (10000)
Decrease in stock 5000
Increase in debtors (10000)
Decrease in prepaid expenses 2000
Cash from operations 177000

B. Cash Flows from Investing Activities

Purchase of land and building (40000)
Sale of machinery 25000
Cash from investing activities (15000)
C. Cash Flows from Financing Activities
Bank loan repaid (60000)
Long-term loan repaid 25000
Tax paid (50000)
Dividend paid (35000)
Drawings (35000)
Cash from financing activities (155000)
Net increase/decrease in cash 7000
Cash at the beginning of the year 15000
Cash at the end of the year 22000

Working notes:
Note: For working notes given in the problem, accounts are to be prepared to extract the hidden
information.
Machinery Account
Particulars Amount Particulars Amount
To Opening balance 200000 By Bank (Sales) 25000
To P & L A/C (Profit) 10000 By Depreciation B/F 45000
By Closing balance 140000
210000 210000

181
 BEFA UNIT V

Tax Account
Particulars Amount Particulars Amount
To Bank Account 50000 By P & L A/C (provided) B/F 50000
50000 50000

Dividend Account
Particulars Amount Particulars Amount
To Bank Account 35000 By P & L A/C (provided) B/F 35000
35000 35000

3. From the following balance sheets of 1993 and 1994, prepare the cash flow statement.
Liabilities 2016 2017 Assets 2016 2017
Equity capital 20000 25000 Plant 46000 45000
Debentures 15000 12000 Debtors 9000 7000
Creditors 16000 18000 Stock 5000 9000
Profit and loss A/C 11000 14000 Cash 2000 8000
62000 69000 62000 69000

Solution:
Cash Flow Statement for the year ended 31-12-2017
Particulars Rs. Rs.
A. Cash Flow from Operating Activities
Net Profit (14000-11000) 3000
Adjustments:
Increase in creditors 2000
Decrease in debtors 2000
Increase in stock (4000)
Cash from operations 3000

B. Cash Flows from Investing Activities

Sale of plant 1000
Cash from investing activities 1000
C. Cash Flows from Financing Activities
Issue of equity capital 5000
Debentures repaid (3000)
Cash from financing activities 2000
Net increase/decrease in cash 6000
Cash at the beginning of the year 2000
Cash at the end of the year 8000

182
 BEFA UNIT V

4. Prepare a cash flow statement from the following balance sheets as on 31-12-2016 and 31-12-
2017.
Liabilities 2016 2017 Assets 2016 2017
Share capital 100000 150000 Fixed assets 100000 150000
Profit and loss A/C 50000 80000 Goodwill 50000 40000
General reserve 30000 40000 Inventories 50000 80000
6% bonds 50000 60000 Debtors 50000 80000
Creditors 30000 40000 Bills receivables 10000 20000
Outstanding 10000 15000 Bank 10000 15000
expenses 270000 385000 270000 385000

Solution:
Cash Flow Statement for the year ended 31-12-2017
Particulars Rs. Rs.
A. Cash Flow from Operating Activities
Net Profit (80000-50000) 30000
Adjustments:
General Reserve 10000
Goodwill written off 10000
Interest on bonds (50000x6/100) 3000
Increase in creditors 10000
Increase in outstanding expenses 5000
Increase in inventory (30000)
Increase in debtors (30000)
Icrease in bills receivables (10000)
Cash from operations (2000)

B. Cash Flows from Investing Activities

Purchase of fixed assets (50000)
Cash from investing activities (50000)
C. Cash Flows from Financing Activities
Issue of equity capital 50000
Issue of bonds 10000
Interest on bonds paid (3000)
Cash from financing activities 57000
Net decrease in cash 5000
Bank at the beginning of the year 10000
Bank at the end of the year 15000

183
 BEFA UNIT V

5. Financial statements of Mr. Ram are as follows

Liabilities 2016 2017 Assets 2016 2017
Bills payable 29000 25000 Cash 40000 30000
Capital 731000 615000 Debtors 20000 17000
Stock 8000 13000
Buildings 92000 80000
machinery 600000 500000
760000 640000 760000 640000
Additional information:
a) Proprietor has not taken any drawings.
b) There are no purchases and sales in buildings and machinery.
Prepare cash flow statement.

Cash Flow Statement for the year ended 31-12-2017

Particulars Rs. Rs.
A. Cash Flow from Operating Activities
Net Profit (116000)
Adjustments:
Depreciation on buildings 12000
Depreciation on machinery 100000
Decrease in bills payable (4000)
Decrease in debtors 3000
Increase in stock (5000)
Cash from operations (10000)

B. Cash Flows from Investing Activities

0
Cash from investing activities 0
C. Cash Flows from Financing Activities
0
Cash from financing activities 0
Net decrease in cash (10000)
Cash at the beginning of the year 40000
Cash at the end of the year 30000

Working Notes:

Capital Account
Particulars Amount Particulars Amount
To P & L A/C (loss) By Opening
B/F 116000 balance 731000
To Closing balance 615000
731000 731000

184
 BEFA UNIT V

DIIFERENCES BETWEEN FUNDS FLOW STATEMENT AND CASH FLOW STATEMENT

Table of Difference between Funds Flow Statement and Cash Flow Statement

Basis of
Cash Flow Statement Funds Flow Statement
Difference

1. Meaning of Funds means only cash which is a Fund means net working capital (i.e. current
fund component of net current assets. assets minus current liabilities).

2. Objective Its objective is to know about the Its objective is to know about the changes
changes occurred in cash position occurred in net working capital between
between two balance sheet dates. two balance dates.
3. Basis of Increase in current liability or Increase in current liability and decrease in
preparation decrease in current asset (except cash) current asset results in a decrease in net
results in an increase in cash. working
4. Effect of Effect of a transaction on cash is Effect of a transaction on net working
transaction considered. capital is considered.

5. Utility Cash flow statement is useful for Fund flow statement is useful for long-term
short-term analysis. analysis

6. Statement of No such statement is prepared A separate statement for changes in

changes in separately in cash flow statement. working capital is prepared in fund flow
Working statement or analysis.
Capital

7 Cash Opening and closing balances of cash Such balances of cash are shown in
Balances are shown in this statement statement of changes in working capital.

185