Economics - Principles of Decision Making - Notes - Economics, Study notes of Economics

Download Economics - Principles of Decision Making - Notes - Economics and more Study notes Economics in PDF only on Docsity! Principles of Decision Making A business firm is always profit motivated. Profit seeking is the main guiding force of any business undertaking. The classical economists have opined that profit maximization is the sole objective of the business firm in a capitalist economy. But, in real business, profit is not an end in itself. The survival of the business depends on the firm’s ability to earn some profit so as to keep the business alive. In this context, it is worth mentioning that the reasonable profit is the righteous reward of the entrepreneur for his entrepreneurial, organizational risk taking activity. Hence, there is a need for rational profit policy and planning for a modern business firm. Most of the firms have many goals of primary importance other than profit. Hence, the firms are interested in putting a limit on their profits. The main reasons for limiting or controlling profits are:- (i) Maintaining business goodwill A policy of limiting profit may be followed by a firm in order to win appreciation of consumers and earn business reputation and maintain business goodwill in the market. By keeping a low profit margin, the firm may create a good impression on the consumers and enjoy their patronage. Thus, the firm may be in a position to maintain a stable price for its product which will definitely fetch consumer’s appreciation by restricting profit margin an inflationary situation. (ii) Wage Consideration Trade unions will demand high wages, if the firm maintains high profits which may inflate costs and further complicate the management of business problem. Profit control is also an important objective of running a business. (iii) Avoiding government’s Intervention High profits may attract high taxation. Again, high profits may be taken as an index of monopoly power which may attract government’s attention and investigation and its eventual control. (iv) Minimization Risk The risk element tends to be high under profit maximization. Hence, it is imperative not to go in for maximization of profits but be satisfied with a reasonable profitability of the business venture for minimizing risk. (v) Reduction of Potential Competition High profitability of the business may attract new competitors to enter the field and share the market. Only a fair profit may be earned by the concerned firm to discourage new entry in its production line. (vi) Leadership in the Market Firm may seek to maximize sales and capture the market rather than maximize its profits to dominate the market and acquire leadership (vii) Enlightened Self-interest of Survival The firm in its own interest, for survival, would limit its profits and try to see that its existence becomes permanent in the market so that it can earn a regular flow of business income in the long term. It also implies considerations to prevent loss instead of maximum return. (viii) Liquidity Preference In banking business greater emphasis is placed on liquidity rather than profitability. A bank arranges its assets in the ascending order of liquidity and descending order of profitability. II CRITERIA FOR RATE OF PROFIT Various criteria may be employed to determine the rate of return on investment and decide the most acceptable rate of profit. The main criteria of rate of profit are:- (i) Competitive rate of profits, (ii) Historical profit rate, (iii) Sufficient earning to protect the equity; and (iv) Plough back of profit rate. (i) Competitive Rates of Profit AVC = 10 AVC = 10 AVC = 10 TFC = 6000 TFC = 8000 TFC = 10000 (µ = TFC) Rate of output (Q) λ = Q (P – AVC) PE = λ λ - µ Firms Firms X Y Z X Y Z 2000 60000 60000 60000 1.11 1.16 1.20 4000 120000 12000 12000 1.05 1.07 1.07 It follows that at the same rate of output, and to the profit costs, elasticity (PE) of firm Z tends to higher than that of firm Y. Similarly, the profit elasticity of firm Y tends to be higher than that of firm X. This is because the fixed costs of firm Z is greater than that of firm Y. Similarly, the fixed cost of firm Y is greater than that of firm X. Besides, with the increase in the rate of output, PE tends to diminish in all the cases and the difference in the profit elasticities among the firms also narrows down, profit elasticity is also indicative of operating leverage of the firms. The firm having larger and higher fixed costs relative to variable costs is regarded as highly leveraged. In other words, there is a direct relationship between elasticity leverage. III Break-even Analysis Assumptions The main assumptions of break-even analysis are:- 1. All costs are either perfectly variable or absolutely fixed over the entire range of the volume of production. 2. All revenue is perfectly variable with the physical volume of production. 3. The volume of sales and the volume of production are equal. Everything produced is sold and there is no change in the closing inventory. 4. In the case of multi-product firms, the product-mix should be stable. For a multi- product firm, the BEP is determined by dividing total fixed costs by an average ratio of variable profit (contribution) to sales. If each product has the same contribution ratio, the BEP is unaffected by changes in the product-mix. However, if different products have different contribution ratios, a shift in the product-mix may cause a shift in the break- even point. Break-even point is normally explained in terms of physical units because it is convenient for the single-product firm. The break-even volume is the number of units of product which must be sold to earn enough revenue just to cover fixed and variable cost. The selling price of a unit covers not only its variable cost but also keeps a margin to contribute towards the fixed costs. The break-even point is reached when sufficient number of units has been sold so that the total contribution margin of the units sold is equal to the fixed costs. The formula for calculating the Break-even point is: Fixed Costs FC BEP = ---------------------------------- = ------------- Contribution margin per unit SP – VC Where BEP = Break-even point, FC = Fixed Cost, SP = Sales price, and VC = Variable cost per unit. Example: Suppose the fixed costs of a factory are Rs. 10,000 per year, the variable cost are Rs. 2 per unit and the selling price is Rs. 6 per unit. The break- even point would be: Example : Calculate the break-even point from the following information Sales Rs. 40,000 Variable costs Rs. 24,000 Fixed Costs Rs. 12,000 The contribution ratio is (40,000 – 24,000)/40,000 = 0.4 Fixed Costs 12,000 BEP = ---------------------------------- = ------- = Rs. 30,000 Contribution margin per unit 0.4 It will be clear from the following calculation that at sales valued Rs. 30,000 (BEP), there is no-profit no-loss: Sales value Rs. 30,000 Less: Variable costs (0.6*30,000) Rs. 18,000 Fixed costs Rs. 12,000 ----------- ------------ Net profit --- Nil ---------- ------------ Example : Sales were Rs. 60,000, variable cost 36,000 and Fixed cost Rs. 20,000. Find out the BEP. Solution: Sales: 60,000 Fixed cost: 20,000 Variable costs: 36,000 60,000 – 36,000 Contribution ration = ----------------------- = 0.4 60,000 Fixed Cost BEP = ------------------------ Contribution margin 20,000 = ---------------------- = 50,000 0.4 Sales = 50,000 Less: Variable Cost (0.6 x 50,000) = 30,000 Fixed Cost = 20,000 -------- --------- Net Profit Nil Nil -------- --------- Multi-product Manufacturer and Break-even Analysis. Most manufacturers produce more than one type of product. The determination of BEP in such cases is illustrated below: Example : A manufacturer makes and sells tables, lamps and chairs. The cost accounting department and the sales department have supplied the following data: Product Selling price VC per %of rupee per unit unit sales volume 25 5 35 – 25 1 Chair – --------- x 100 = ---- x 100 = 28.57 per cent 35 7 Now, we multiply the contribution percentage of each of the products by the percentage of sales volume for that particular product and add the figure and it gives the total contribution per rupee of sales volume for table, lamps and chairs: Contribution % of Sales Tables 25.00% * 20% = 5.00% Lamps 20.00% * 30% = 6.00% Chairs 28.57% * 50% = 14.28% ------------ 24.28% or say 25% ----------- This 25 per cent is the total contribution per rupee of overall sales given the present product sales mix. (1) BEP:- The BEP of the firm may now be calculated as under: BEP = Fixed Costs = 20,000 Contribution ratio 25% (2) Profit:- Calculation of profit or loss at various volumes can also be made easily. If the firm produces at 80 per cent of capacity (assuming the same product mix), the profit will be calculated as under: Profit = Total Revenue – Total Costs = 80% of (3,00,000) – Fixed costs – Variable costs = 2,40,000 – 20,000 – 75% of (3,00,000) = 2,40,000 – 20,000 – 1,25,000 = Rs. 5,000 (loss). Break-even Charts