Managerial Economics

Unit - 1
Unit - 1
General Foundation of Managerial Economics
– Economic approach, Circular flow of activity,
Nature of the firm, Forms of organizations,
Objectives of firms – demand analysis and
estimation – Individual, market and firm
demand, Determinants of demand, Elasticity
measures and business decision making,
Demand estimation and forecasting – Theory
of the firm – Production functions in the short
and long run, Cost concepts. Short run and
long run costs.
Managerial decision areas
• assessment of investible funds
• selecting business area
• choice of product
• determining optimum output
• determining price of product
• determining input-combination and
technology
• sales promotion
Managerial Economics
Managerial Economics is a science which deals
with the application of economics theory in
managerial practice. It is the study of allocation
of resources available to a firm among its
activities. To be very precise, Managerial
Economics is ‘Economics applied in decision-
making’. It fills the gap between economic
theory and managerial practice.
Managerial Economics - Definition
“Managerial Economics is the integration of
economic theory with business practice for the
purpose of facilitating decision-making and
forward planning by management.”
- Spencer & Siegelman
“The purpose of Managerial Economics is to
show how economic analysis can be used in
formulating business policies.”
-Joel Dean
Managerial Economics
Economic Theories,
Business management
Concepts, Methodology
Decision Problems
and Tools

Managerial Economics
Application of Economics
in analyzing and solving
Business problems

Optimum solutions to
business problems
 Relationship to….
1. Production management (strategic
decisions, operating decisions and control
decisions).

2. Marketing management (marketing strategy

decisions, pricing decisions, value chain
analysis, cost analysis.)

3. Finance management (financial decisions)

 Relationship to….
4. Personnel management(strategic human
resource, planning models, HR-performance
management )

5. Operation research (advanced analytical

methods to make better economic and
business decisions).
MICRO ECONOMICS
Micro-economics is a branch of economics that
studies the behavior of how the individual
modern household and firms make decisions to
allocate limited resources.
Typically, it applies to markets where goods or
services are being bought and sold. Micro-
economics examines how these decisions and
behaviors affect the supply and demand for
goods and services, which determines prices,
and how prices in turn, determine the quantity
supplied and quantity demanded of goods and
services.
MACRO ECONOMICS
Macroeconomics is a branch of economics dealing
with the performance, structure, behavior, and
decision-making of the entire economy. This
includes a national, regional, or global economy.
Macroeconomics study aggregated indicators such
as GDP, unemployment rates, and price indices to
understand how the whole economy functions.
Macroeconomics develop models that explain the
relationship between such factors as national
income, output, consumption, unemployment,
inflation, savings, investment, international trade
and international finance.
Characteristics of Managerial Economics
• It involves an application of Economic theory –
especially, micro economic analysis to practical
problem solving in real business life. It is
essentially applied micro economics.
• It is a science as well as art facilitating better
managerial discipline. It explores and enhances
economic mindfulness and awareness of business
problems and managerial decisions.
• It is concerned with firm’s behaviour in optimum
allocation of resources. It provides tools to help in
identifying the best course among the alternatives
and competing activities in any productive sector
whether private or public.
Scope of Managerial Economics
1. Demand Analysis and Forecasting
2. Cost Analysis
3. Production and Supply Analysis
4. Pricing Decisions, Policies and Practices
5. Profit Management, and
6. Capital Management
1. Demand Analysis & Forecasting
A business firm is an economic organism which
transforms productive resources into goods
that are to be sold in a market. A major part of
managerial decision-making depends on
accurate estimates of demand. Before
production schedules can be prepared and
resources employed, a forecast of future sales is
essential. This forecast can also serve as a guide
to management for maintaining or
strengthening market position and enlarging
profits.
2. Cost Analysis
A study of economic costs, combined with the
data drawn from the firm’s accounting records,
can yield significant cost estimates that are
useful for management decisions. The factors
causing variations in costs must be recognized
and allowed for if management is to arrive at
cost estimates which are significant for planning
purposes. An element of cost uncertainty exists
because all the factors determining costs are
not always known or controllable.
3. Production & Supply Analysis
Production analysis is narrower in scope than cost
analysis. Production analysis frequently proceeds in
physical terms while cost analysis proceeds in
monetary terms. Production analysis mainly deals
which different production functions and their
managerial uses.
Supply analysis deals with various aspects of supply
of a commodity. Certain important aspects of supply
analysis are: Supply schedule, curves and function,
Law of supply and its limitations, Elasticity of supply
and Factors influencing supply.
4. Pricing Decisions, Policies and Practices
Pricing is a very important area of Managerial
Economics. In fact, price is the genesis of the
revenue of a firm and as such the success of a
business firm largely depends on the
correctness of the price decisions taken by it.
The important aspects dealt with under this
area are: Price Determination in various Market
Forms, Pricing Methods, Differential Pricing,
Product-line Pricing and Price Forecasting.
5. Profit Management
Business firms are generally organised for the
purpose of making profits and, in the long run,
profits provide the chief measure of success. In
this connection, an important point worth
considering is the element of uncertainty
existing about profits because of variations in
costs and revenues which, in turn, are caused
by factors both internal and external to the firm.
If knowledge about the future were perfect,
profit analysis would have been a very easy task.
6. Capital Management
Of the various types and classes of business
problems, the most complex and troublesome
for the business manager are likely to be those
relating to the firm’s capital investments.
Relatively large sums are involved, and the
problems are so complex that their disposal not
only requires considerable time and labour but
is a matter for top-level decision. Briefly,
capital management implies planning and
control of capital expenditure.
What is Decision-making?
Decision-making is the process of selecting a
particular course of action from among the
various alternatives. Every business manager
has to work on uncertainties and the future
cannot be precisely predicted by anyone. If
everything could be predicted accurately, then
decision-making would become a very simple
process.
What is Decision-making?
Alternative
Selection of a Execution of
course of Action Result of Action
particular Action Action
available

Full Realisation
of objective

Action A Partial
Decision Chosen
Action B realisation of
Making Action
Action C objective

Non-
realisation of
objective
Basic Economic Tools in Managerial Economics

1. Opportunity cost principle

2. Incremental principle
3. Principle of time perspective
4. Discounting principle, and
5. Equi-marginal principle
1. Opportunity Cost Principle
 The opportunity cost of the funds employed
in one’s own business is the interest that could
be earned on those funds had they been
employed in other ventures.
 The opportunity cost of the time an
entrepreneur devotes to his own business is the
salary he could earn by seeking employment.
 The opportunity cost of using a machine to
produce one product is the earnings forgone
which would have been possible from other
products.
2. Incremental Principle
Incremental concept is closely related to the
marginal costs and marginal revenues, for of
economic theory. In actual business situations,
it often becomes difficult to apply the concept
of marginalism which has to be replaced by
incrementalism, for in real world business, one
is concerned with not ‘unit change’ but ‘chunk
change’. For instance, in a construction project,
the labour which a contractor may change is
not by one but by tens.
3. Principle of Time Perspective
The economic concepts of the long run and the
short run have become part of everyday
language. Managerial economists are also
concerned with the short-run and long-run
effects of decisions on revenues as well as costs.
The really important problem in decision-
making is to maintain the right balance
between the long-run and the short-run
considerations.
4. Discounting Principle
One of the fundamental ideas in economics is
that a rupee tomorrow is worth less than a
rupee today. This seems similar to saying that a
bird in hand is worth two in the bush. A simple
example would make this point clear.
5. Equi-marginal Principle
This principle deals with the allocation of the
available resources among the alternative
activities. It should be clear that if the value of
the marginal product is higher in one activity
than another, an optimum allocation has not
been attained. It would, therefore, be
profitable to shift labour from low marginal
value activity to high marginal value activity,
thus increasing the total value of all products
taken together.
Circular Flow of Economic Activities
Economic resources

Purchasing goods & services

Household Firm
Income payment of wages, rent,
dividend & interests
Goods & Services

Imports Foreign Countries Exports

Taxes Government Expenditure

Savings Banks Investments

Basic Economic activities
Production: The use of economic resources in
the creation of goods and services for the
satisfaction of human wants.
Consumption: The using up of goods and
services by consumer purchasing or in the
production of other goods.
Employment: The use of economic resources in
production; engagement in activity.
Income Generation: The production of
maximum amount an individuals.
Circular Flow of Production

Economic Resources

Households Producing Units

Goods and Services

Circular Flow of Income

Income flow of wages

Interests & rents

Producing Units House holds

Purchase of
Goods and Services
NATURE OF THE FIRM
Since modern firms can only emerge when an
entrepreneur of some sort begins to hire people,
Coase's analysis proceeds by considering the
conditions under which it makes sense for an
entrepreneur to seek hired help instead of
contracting out for some particular task.
The traditional economic theory of the time
suggested that, because the market is "efficient"
(that is, those who are best at providing each good
or service most cheaply are already doing so), it
should always be cheaper to contract out than to
hire.
Forms of Organisation
1. Sole proprietorship / Single ownership
2. Partnership
3. Joint Stock Companies
4. Cooperative organisation
5. State and central Government owned
1. Sole proprietorship
A sole proprietorship is a business with one owner
who operates the business on his or her own or
employ employees. It is the simplest and the most
numerous form of business organization in the
United States, however it is dangerous as the sole
proprietor has total and unlimited liability. Self-
contractor is one example of a sole proprietorship.
In this type, the single ownership where an
individual exercises and enjoys these rights in his
own interest. It does well for those enterprises
which require little capital and lend themselves
readily to control by one person.
2. Partnership
A single owner becomes inadequate as the size of the
business enterprise grows. He may not be in a position
to do away with all the duties and responsibilities of the
grown business. At this stage, the individual owner
may wish to associate with him more persons who have
either capital to invest, or possess special skill and
knowledge to make the existing business still more
profitable. Such a combination of individual traders is
called Partnership.
Partnership may be defined as the relation between
persons who have agreed to share the profits of a
business carried on by all or any of them acting for all.
Individuals with common purposes join as partners and
they put together their property ability, skill, knowledge,
etc., for the purpose of making profits
3. CORPORATION
It is a form of private ownership which contains
features of large partnership as well as some features
of the corporation. A corporation is a limited liability
entity doing business owned by multiple shareholders
and is overseen by a board of directors elected by the
shareholders. It is distinct from its owners and can
borrow money, enter into contracts, pay taxes and be
sued. The shareholders gain from the profit through
dividend or appreciation of the stocks but are not
responsible for the company’s debts.
4. Public Limited Company
A public enterprise is one that is (1) Owned by the
state, (2) Managed by the state or (3) Owned and
managed by the state.
Public enterprises are controlled and operated by the
Government either solely or in association with
private enterprises. It is controlled and operated by
the Government to produce and supply goods and
services required by the society. Limited companies
which can sell share on the stock exchange are Public
Limited companies. These companies usually write
PLC after their names.
5. Private Limited Companies
These are closely held businesses usually by family,
friends and relatives. Private companies may issue
stock and have shareholders. However, their shares
do not trade on public exchanges and are not issued
through an initial public offering. Shareholders may
not be able to sell their shares without the agreement
of the other shareholders.
Objectives of Firm
1. Maximization of the sales revenue
2. Maximization of firm’s growth rate
3. Maximization of Managers utility function
4. Making satisfactory rate of Profit
5. Long run Survival of the firm
6. Entry-prevention and risk-avoidance
Conflict in McDonald and Pizza Hut
The rapid growth of franchising during the last two decades
can be explained largely by the mutual benefits the
franchising partners receive. The franchiser increases sales
via an ever-expanding network of franchisees. The parent
collects a fixed percentage of the revenue that each
franchisee earns (as high as 15 to 20 per cent, depending on
the terms of the contract). The individual franchisee
benefits from the acquired know-how of the parent (the
franchiser), its advertising and promotional support and
from the ability to sell a well-established product or service.
Nonetheless, economic conflicts frequently arise between
parent and individual franchisees. Disputes can occur even
in the loftiest of franchising realms: the fast food industry.
The case in point
Conflict in McDonald and Pizza Hut
is the turmoil in the early 1990s between one of the
franchisee outlets of the McDonald and the Mac itself in the
USA. The franchisee outlet was controlled by Chart House.
The key issue centred on the operating autonomy of the
franchisee.
The conflict between parent and individual franchisee were
numerous. First, the parent insisted on periodic remodelling
of the premise, which the franchisee resisted. Secondly, the
franchisee favoured raising prices on best selling items which
the parent opposed – it wanted to expand promotional
discounts. Third, the parent sought longer store hours and
multiple express lines to cut down on lunchtime congestion.
Many franchisees resisted both the moves.
Conflict in McDonald and Pizza Hut
Yet another known name in the fast food industry, Pizza Hut
faced a similar problem in the late 1990s in Thailand. The
Bangkok branch of the US food franchisee broke away from
Thailand’s Pizza Plc., as the later said that after working
together for 20 years, it would no longer work on the terms
of the US franchiser. The US franchiser wanted certain
changes in the operations of the chain in the same line of
Mac franchiser, which the franchisee objected to. As a
result, the franchiser decided to rebrand 116 new pizza
parlours across the country.
How would one explain these conflicts? What is their
economic source? What ca the parent and the franchisee do
to promote cooperation?
Conflict in McDonald and Pizza Hut
Above all, if franchising is a profitable activity, why are there
so many conflicts?

(McDonald levies a franchisee fee of $ 12,500, a royalty of 3

per cent, a marketing fee of 3 per cent.)
Consumer’s desire for a particular product
depends on

 ability to buy
 willingness to buy
 time period
Demand
Demand is the quantity of a good or service that customers
are willing and able to purchase during a specified period
under a given set of economic conditions. Conditions to be
considered include the price of the good in question, prices
and availability of related goods, expectations of price
changes, consumer incomes, consumer tastes and
preferences, advertising expenditures, and so on. The
amount of the product that consumers are prepared to
purchase, its demand, depends on all these factors.
Demand Schedule
Quantity
Price Demanded Per
Month

1 $320,000 1000
2 $300,000 2000
3 $280,000 3000
4 $260,000 4000
5 $240,000 5000
6 $220,000 6000
7 $200,000 7000
8 $180,000 8000
 Demand

Rs. 11 Rs. 11

Rs. 10 Rs. 10
Law of Demand
– there is an inverse relationship between price and
quantity demanded.

 as the quantity demanded rises, the price falls

 as the price rises, the quantity demanded falls
 as income rises, the demand for the product rises
 as supply rises, the demand rises
Elasticity
Elasticity is a central concept in the theory of supply and
demand. In this context, elasticity refers to how supply and
demand respond to various factors, including price as well as
other stochastic principles. One way to define elasticity is the
percentage change in one variable divided by the percentage
change in another variable (known as arc elasticity, which
calculates the elasticity over a range of values, in contrast
with point elasticity, which uses differential calculus to
determine the elasticity at a specific point). It is a measure of
relative changes.
Concept of Elasticity
• Price Elasticity of Demand
• Income Elasticity of Demand
• Cross Elasticity of Demand
1. Price Elasticity of Demand
Price elasticity of demand is the change in quantity of a
commodity demanded to the change in its price. The degree
of change in the demand of different commodities due to
change in the price of the commodities may vary. In certain
cases, the changes in demand may be at higher rates.

Percentagechangein quantity demanded

Priceelasticityof demand= .
Percentagechange in price
2. Income Elasticity of Demand
Income elasticity of demand is the degree of responsiveness
of demand to the change in income.
The income elasticity of demand is a measure of the extent to
which the demand for a good changes when income changes,
other things remaining the same.
Percentagechangein quantity demanded
Incomeelasticityof demand = .
Percentagechangein income
3. Cross Elasticity of Demand
The responsiveness of demand to change in prices of related
goods is called cross elasticity of demand (related goods may
be substitutes or complementary goods). In other words, it is
the responsiveness of demand for commodity X to the change
in the price of commodity Y.
Percentagechangein quantity demandedof a good
Cross elasticityof demand = .
Percentagechangein price of one
of its substitutes or complements
Elasticity Demand
 elastic
 inelastic
 unitary
1. Elastic Demand
An elastic demand is one in which the change in quantity
demanded due to a change in price is large.
2. Inelastic Demand
An economic term used to describe the situation in which the
supply and demand for a good or service are unaffected
when the price of that good or service changes.
The most famous example of relatively inelastic demand is
that for gasoline. As the price of gasoline increases, the
quantity demanded doesn't decrease all that much. This is
because there are very few good substitutes for gasoline and
consumers are still willing to buy it even at relatively high
prices.
3. Unitary elastic
If the elasticity coefficient is equal to one, demand is unitarily
elastic as shown in below figure. For example, a 10% quantity
change divided by 10 % price change is one. This means that a
one percent change in quantity occurs for every one percent
change in price.
3. Unitary elastic (Example)
Consider a situation in which milk costs Rs. 10 per liter. A
grocer notices that he is not selling as much milk as he would
like, so he puts the milk on sale, dropping the price to Rs. 7
per liter. With unitary elasticity, the number of sales would
double because the price was cut in half. So if the grocer
would sell 100 liter of milk at Rs. 10, that would lead to
revenues of Rs. 1,200. Cutting the price to Rs. 7 would then
yield sales of 200 liter, still leading to revenues of Rs. 1,200 .
Determinants of Demand
• Changes of Income
• Changes of Taste or Preferences
• Changes of Prices of Related Goods
• Changes of Price Expectations
• Changes of Size of Population

Look at the relationship between the quantity demanded

and each of the determinants in turn – separately – price
quantity relationship in the demand curve….
Factors Affecting Elasticity Of Demand
1. Availability of Substitutes
2. Postponement of Consumption
3. Proportion of Expenditure
4. Nature of the Commodity
5. Different Uses of the Commodity
6. Change in Income
7. Habits
8. Distribution of Income
9. Price Level
DEMAND FORECASTING
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.
Necessity for forecasting demand
Often forecasting demand is confused with forecasting sales.
But, failing to forecast demand ignores two important
phenomena. There is a lot of debate in demand-planning
literature about how to measure and represent historical
demand, since the historical demand forms the basis of
forecasting. The main question is whether we should use the
history of outbound shipments or customer orders or a
combination of the two as proxy for the demand.
Demand Forecasting Methods
FORECASTING METHODS

Survey Method Statistical Method

Opinion Consumers' Trend Barometric

Survey Interview projection method

Correlation
& Regression
Complete Sample End-use
enumeration survey method
Concept of Supply
Supply is defined as the quantity of a product that a producer
is willing and able to supply onto the market at a given price
in a given time period.

Note: Throughout this study companion, the terms firm,

business, producer and seller have the same meaning.

Supply is the amount of a good that producers are willing and

able to offer for sale at various price.
Concept of Supply
The law of Supply
All else equal, the quantity supplied is positively
related to price.
Prices quantity supplied
Prices quantity supplied
The law of supply explains that if people are willing to pay
more money for a product, a company will produce or
manufacture more of that product to capitalize on the
increased revenue.
The opposite also holds true that as the price of a product
drops, a company is likely to manufacture less of that
product. In fact, if sales drop too far, the company may
discontinue the product altogether.
Determinants of Supply
• Market price
• Input prices
• Technology (new production methods)
• Expectations
• Number of producers
Equilibrium of Supply and Demand
A situation in which the supply of an item is exactly
equal to its demand. Since there is neither surplus nor
shortage in the market, price tends to remain stable
in this situation.
Equilibrium of Supply and Demand
A situation in which the supply of an item is exactly equal to
its demand. Since there is neither surplus nor shortage in the
market, price tends to remain stable in this situation.
Price

Supply

Equilibrium price Equilibrium

$2.00

Demand

Equilibrium
quantity
0 1 2 3 4 5 6 7 8 9 10 11 12 13 Quantity
THEORY OF FIRM
The theory of the firm consists of a number of
economic theories that describe the nature of the
firm, company, or corporation, including its existence,
behaviour, structure, and relationship to the market.
In simplified terms, the theory of the firm aims to
answer these questions:
1. Existence
2. Boundaries
3. Organization
4. Heterogeneity of firm actions / performances
Production
Production refers to the transformation of inputs or
resources into outputs or goods and services.
Production process is a process in which economic
resources or inputs (composed of natural resources
like labour, land and capital equipment) are
combined by entrepreneurs to create economic
goods and services (outputs or products).
Production
Theory of Production
Production theory generally deals with quantitative
relationships, that is, technical and technological
relationships between inputs, especially labour and
capital, and between inputs and outputs.
An input is a good or service that goes into the
production process. As economists refer to it, an
input is simply anything which a firm buys for use in
its production process. An output, on the other hand,
is any good or service that comes out of a production
process.
In the manager’s effort to minimise production costs, the
fundamental questions faces are:
(a) How can production be optimized or costs minimised?
(b) What will be the behaviour of output as inputs increase?
(c) How does technology help in reducing production costs?
(d) How can the least-cost combination of inputs be achieved?
Short Run Production Function
The short run is defined in economics as a period of time
where at least one factor of production is assumed to be in
fixed supply i.e. it cannot be changed. We normally assume
that the quantity of capital inputs (e.g. plant and machinery)
is fixed and that production can be altered by suppliers
through changing the demand for variable inputs such as
labour, components, raw materials and energy inputs. Often
the amount of land available for production is also fixed.
The time periods used in textbook economics are somewhat
arbitrary because they differ from industry to industry. The
short run for the electricity generation industry or the
telecommunications sector varies from that appropriate for
newspaper and magazine publishing and small-scale
production of foodstuffs and beverages.
Long Run Production
In the long-run, both capital (K) and labour (L) is included in
the production function, so that the long-run production
function can be written as:
A production function is based on the following assumptions:
(i) perfect divisibility of both inputs and output;
(ii) there are only two factors of production – capital (K) and
labour (L);
(iii) limited substitution of one factor for the other;
(iv) a given technology.
COST CONCEPT
The term cost simply means cost of production. It is the
expenses incurred in the production of goods. It is the
sum of all money-expenses incurred by a firm in order to
produce a commodity. Thus it includes all expenses from
the time the raw material are bought till the finished
products reach the wholesaler.
A managerial economist must have a proper
understanding of the different cost concept which are
essential for clear business thinking. The cost concept
which are relevant to business operation and decision
can be grouped on the basis of their propose under two
overlapping categories:
1. Concept used for accounting purpose
2. Concept used in economics analysis of the business
THEORY OF COST
Business decisions are generally taken based on the
monetary values of inputs and outputs. Note that the
quantity of inputs multiplied by their respective unit
prices will give the monetary value or the cost of
production. Production cost is an important factor in all
business decisions, especially those decisions
concerning:
(a) the location of the weak points in production
management;
(b) cost minimisation
(c) finding the optimal level of output;
(d) determination of price and dealers’ margin; and,
(e) estimation of the costs of business operation.
Various Types of Costs
1. Opportunity Cost vs Outlay Cost
2. Past Cost vs Future Cost
3. Traceable vs Common Cost
4. Out-of-Pocket vs Book-Cost
5. Incremental Cost vs Sunk Cost
6. Escapable vs Unavoidable Cost
7. Shut Down and Abandonment Costs
8. Urgent and Postponable Costs
9. Controllable and Non-Controllable costs
10. Replacement vs Historical Cost
11. Private and Social Cost
12. Short-run and Long-run Costs
13. Fixed cost and Variable Cost
1. Opportunity Cost vs Outlay Cost
Outlay costs are those costs which involve financial
expenditure at some time and hence are recorded in the
books of account.
Opportunity costs are those costs of “displaced
alternatives”. They represent only sacrificed alternatives
and hence are not recorded in any financial account.
The economic principle behind cost in the modern sense
is not the pain or strain involved, nor the money cost
involved in producing a thing.
2. Past Cost vs Future Cost
Past costs, as the name itself implies, are those costs
which have been actually incurred in the past and find
entry in the books of accounts. Those costs are incurred
by the firm at the time of purchase of various items of
plant equipment, etc.
From the decision-making point of view, future cost is
more important. Future costs are those costs which are
likely to be incurred in future periods or to be very
precise, the costs that are contemplated to be incurred
in future periods. Since future is uncertain, these costs
are only estimations and they are not accurate figures.
3. Traceable vs Common Costs
When the cost can be easily identified with an unit of
operation, it is called traceable cost or direct cost. For
example, when the total cost of production per unit has
to be arrived at, it has to be broken into cost of raw
materials, cost of labour, etc.
Non-traceable costs are called common costs which are
not traceable to any one unit of operation. They cannot
be attributed to a product, a department or a process.
4. Out-of-Pocket vs Book-Costs
Out-of-pocket cost denotes immediate current payment.
Hence it is called cash cost. For example, the cost of
raw material or the wages to labour require immediate
payment.
On the other hand, book-cost is one which need not be
immediately made. For instance, depreciation does not
require immediate cash payment and it is not taken into
the current expenditure account.
5. Fixed Cost and Variable Cost
Variable costs are those costs that vary depending on
a company's production volume; they rise as production
increases and fall as production decreases.
Variable costs differ from fixed costs such as rent,
advertising, insurance premiums and loan payments etc.
which tend to remain the same regardless of production
output.
6. Incremental Cost vs Sunk Cost
Incremental cost refers to the additional cost incurred due to
a change in the level or nature of activity. A change in the
activity connotes addition of a product, change in distribution
channel, expansion of market, etc. Incremental cost are also
known as differential costs. Incremental cost measures the
difference between old and new total costs.
Sunk costs are the costs which remain unaltered even after a
change in the level or nature of business activity. These are
known as specific costs. The best of the sunk cost is
depreciation. Incremental cost are very useful in business
decision, but sunk costs appear to be irrelevant to managerial
decisions, as they do not change with the changing business
activity.
7. Urgent and Postponable Costs
As the name itself implies, urgent costs are those costs which
are incurred to keep the continuance of operations of the
firm. It is the money spent on materials and labour.
Postponable costs can be post-poned temporarily. For
example, the cost on maintenance of building can be
postponded. Painting and white washing can be postponed.
COST AND OUTPUT RELATIONSHIP
Now you will also come to know about cost and output
relationship. Cost and revenue are the two major factors
that a profit maximizing firm needs to monitor
continuously. It is the level of cost relative to revenue
that determines the firm’s overall profitability. In order to
maximize profits, a firm tries to increase its revenue and
lower its cost. While the market factors determine the
level of revenue to a great extent, the cost can be
brought down either by producing the optimum level
of output using the least cost combination of inputs,
or increasing factor productivities, or by improving
the organizational efficiency. The firm’s output level is
determined by its cost. The producer has to pay for
factors of production for their services.