Unit – I

INTRODUCTION TO ENGINEERING ECONOMICS

Economics:

Economics is the science that deals with the production and consumption of goods and services
and the distribution and rendering of these for human welfare.

The following are the economic goals.

 A high level of employment

 Price stability
 Efficiency
 An equitable distribution of income
 Growth

Some of the above goals are interdependent. The economic goals are not always complementary;
in many cases they are in conflict. For example, any move to have a significant reduction in
unemployment will lead to an increase in inflation.

Flow in an Economy:

The flow of goods, services, resources and money payments in a simple economy are shown in
Fig. 1.1. Households and businesses are the two major entities in a simple economy. Business
organizations use various economic resources like land, labour and capital which are provided by
households to produce consumer goods and services which will be used by them. Business
organizations make payment of money to the households for receiving various resources. The
households in turn make payment of money to business organizations for receiving consumer
goods and services. This cycle shows the interdependence between the two major entities in a
simple economy.
 Money payments for consumer goods and services

Consumer goods, services

Businesses Households
1. Consume final goods
1. Provide goods and
and services produced
services to consumers
by business and
2. Use resources, inputs 2. services
Provide productive
provided by inputs to business
households

Money payments for resources, rents, wages, salaries, interest and profit

Economic Resources: Land, Labour and Capital

Fig. 1.1 Flow of goods, services, resources and money payments in a simple
economy.
CONCEPT OF ENGINEERING ECONOMICS

Science is a field of study where the basic principles of different physical systems are formulated
and tested. Engineering is the application of science. It establishes varied application systems
based on different scientific principles.

Managerial Economics : “Managerial Economics is the integration of economic theory with

Business practice for the purpose of facilitating decision making and forward planning By
management.” ___Spence and Siegel

“Managerial economics refers to the application of economic theory and tools of analysis of
decision science to examine how an organization can achieve its aims and objectives more
efficiently.” ____Salvatore

“Managerial economics is the application of economic theory and methodology to business

administration practice.” ___Brigham and Pappas.
 Management Decision Problem

Economic Concept Decision Sciences Tools

Theory of Consumer Behaviors Mathematics

Theory of the firm Statistical Estimation

Theory of Market structure & Pricing Operations Research

Managerial Economics

Use of Economic Concepts and

Decision Science Tools to Solve
Managerial Decision Problems

Optimum Solution to Managerial Problems

Nature of Managerial Economics:

Important features of managerial economics are as under:

Similar to Micro Economics: Managerial economics studies about the firm and scarce
resources for maximizing output, finding solutions to the problem of the firm for maximizing
profit.

Operates against the backdrop of Macroeconomics: The Limiting conditions of

macroeconomics are same for managerial economics. So managerial economist can decide the
strategy to work considering these conditions such as inflation, government etc.

Normative Statement : The statements are usually based on moral attitude and value
judgements

Perspective actions : Managerial economics is goal oriented. The course of action is chosen
from available alternatives.

Applied in nature : The model reflects the real business situations hence are more useful for
decision making in diverse fields. Case study methods are also used to identify and understand
the problem

Interdisciplinary : Managerial Economics uses tools and techniques which are derived from
management economics, statistics, accountancy, sociology and psychology.
Scope of Managerial Economics: Managerial economics has close connection with economic
theory (micro-economics as well as macro-economic), operations research, statistics,
mathematics and the theory of decision-making. Managerial economics also draw together and
relates ideas from various functions areas of management like production, marketing, finance
and accounting, project management etc.

Demand analysis and forecasting: A business firm is an economic organism, which transforms
productive resources into goods that are to be sold in a market.

Cost analysis: The factors causing variations in cost must be recognized and allowed for, if
management is to arrive at cost estimates, which are significant for planning purposes.

Production and Supply analysis: Production analysis deals with different production functions
and other managerial uses. Supply analysis deals with various aspects of supply of a commodity.
Certain important aspects of supply analysis are supply schedule, and functions, law of supply
and its limitation, elasticity of supply of factors influencing supply.

Pricing decisions, policies and practices: The important aspects dealt with under this are price
determination in various market forms, pricing methods, differential pricing, product line pricing
and price forecasting.

Profit Management: Business firms are generally organized for 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.

Types of Efficiency:

Efficiency of a system is generally defined as the ratio of its output to input. The efficiency can
be classified into technical efficiency and economic efficiency.

Technical efficiency:

It is the ratio of the output to input of a physical system. The physical system may be a diesel
engine, a machine working in a shop floor, a furnace, etc.
𝑂𝑢𝑡𝑝𝑢𝑡
Technical efficiency (%) = 𝑥100
𝐼𝑛𝑝𝑢𝑡

The technical efficiency of a diesel engine is as follows:

𝐻𝑒𝑎𝑡 𝑒𝑞𝑢𝑖𝑣𝑎𝑙𝑒𝑛𝑡 𝑜𝑓 𝑀𝑒𝑐ℎ𝑛𝑖𝑐𝑎𝑙 energy Produced
Technical efficiency (%) = 𝑥100
𝐻𝑒𝑎𝑡 𝑒𝑞𝑢𝑖𝑣𝑎𝑙𝑒𝑛𝑡 𝑜𝑓 𝑓𝑢𝑒𝑙 𝑢𝑠𝑒𝑑
In practice, technical efficiency can never be more than 100%. This is mainly due to frictional
loss and incomplete combustion of fuel, which are considered to be unavoidable phenomena in
the working of a diesel engine.

Economic efficiency:

Economic efficiency is the ratio of output to input of a business system.

𝑂𝑢𝑡𝑝𝑢𝑡 𝑊𝑜𝑟𝑡ℎ
Economic efficiency (%) = 𝑥100 = 𝑥100
𝐼𝑛𝑝𝑢𝑡 𝐶𝑜𝑠𝑡

‘Worth’ is the annual revenue generated by way of operating the business and ‘cost’ is the total
annual expenses incurred in carrying out the business. For the survival and growth of any
business, the economic efficiency should be more than 100%.

Economic efficiency is also called ‘productivity’. There are several ways of improving
productivity.

 Increased output for the same input

 Decreased input for the same output
 By a proportionate increase in the output which is more than the proportionate increase in
the input
 By a proportionate decrease in the input which is more than the proportionate decrease in
the output
 Through simultaneous increase in the output with decrease in the input.

Increased output for the same input: In this strategy, the output is increased while keeping the
input constant.

Decreased input for the same output:. In this strategy, the input is decreased to produce the
same output.

Less proportionate increase in output is more than that of the input: Introducing a new product
into the existing product mix of an organization.

When proportionate decrease in input is more than that of the output: Dropping an uneconomical
product from the existing product mix.

Simultaneous increase in output and decrease in input: Let us assume that there are advanced
automated technologies like robots and automated guided vehicle system (AGVS), available in
the market which can be employed in the organization we are interested in. If we employ these
modern tools, then:
  There will be a drastic reduction in the operation cost. Initially, the cost on equipment
would be very high. But, in the long run, the reduction in the operation cost would break-
even the high initial investment and offer more savings on the input.
 These advanced facilities would help in producing more products because they do not
experience fatigue. The increased production will yield more revenue.

In this example, in the long run, there is an increase in the revenue and a decrease in the input.
Hence, the productivity ratio will increase at a faster rate.

Definition and Scope of Engineering Economics:

Definition:

Engineering economics deals with the methods that enable one to take economic decisions
towards minimizing costs and/or maximizing benefits to business organizations.

Scope:

Engineering economics are covered the elementary economic analysis, interest formulae, bases
for comparing alternatives, present worth method, future worth method, annual equivalent
method, rate of return method, replacement analysis, depreciation, evaluation of public
alternatives, inflation adjusted investment decisions, make or buy decisions, inventory control,
project management, value engineering, and linear programming.

Meaning of Demand: Demand in economics is the desire for something plus willingness and
ability to pay a certain price in order to possess it. It means being both willing and able to buy
something just wanting something is not enough. Needing it desperately is also not acceptable
unless you have the money to pay. Thus, demand is a want for something supported by the
money to but it.

Demand Analysis : Demand analysis seeks to identify, analyze and measure the forces and
factors that determine sales.

Law of Demand : The relation of price to sales is known in economics as the law of demand.
The law of demand states that higher the price, lower the demand, and vice-versa other things,
remains the same.

Example:
D1 Demand Curve
Price Quantity
Rs.5 80 Units
Rs.4 100 Units
Rs.3 150 Units
Price
Rs.2 200 Units
D1

Quantity
Exceptions to the Law of Demand :

Veblen or Demonstration Effect: These are some goods, which are purchased mainly for their
‘snob appeal’. They are cases of what veblen, and American economist, called “Conspicuous
consumption”, He thought that some purchases were made not for the direct satisfaction, which
they yield, but for the impression, which they made on other people. EX : Diamonds

Speculative Effect: In the speculative market, a rise in prices is frequently followed by larger
purchases and a fall in prices by small purchases. When share prices rise, people expect further
rise and rush to buy when prices fall, they wait for further fall and stop buying. EX : TCS share
value in stock market

Giffen Goods: The Giffen goods/Inferior goods are exception to the law of demand. When the
price of an inferior good falls, the poor will buy less
and vise versa. Sir Robert Giffen has made a study
on expenditure pattern of workers in Ireland in the D1
th
19 century. He found that when there was an
increase in the price of potatoes; there was more Price
demand for it. This exceptional behavior was found
because of the following reason. Normally, the
working class in Ireland used to have potatoes and D1 Law of demand
meat as daily consumption, potato being the main exception curve
food. When there was an increase in the price of
potatoes, the same quantity was consumed, as it was Demand
an essential item. To buy the same quantity of
potato, more money had to be spent. As a result, less money was available for buying meat.
Due to that, the consumption of meat became less. This led to less satisfaction and less calorie
content in the food. People wanted to compensate this and have purchased more of potatoes.
Thus Giffen has indicated this position as a paradox which is against the normal operation of law
of demand.

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.

Fear of Shortage: During the times of emergency or 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.

Necessaries: In the case of necessaries like rice, vegetables, etc., people buy more even at a
higher price.

Factor Influencing the Demand/Determinants of Demand :

Price of the commodity : The price of a given commodity is an important factor in influencing
its demand. If the price is very high, only a few persons can afford to buy it. Hence, the quantity
of the commodity bought at this high price will be low i.e. the commodity will have a lower
demand and vice versa.

Income of the consumer : Besides the price level, income of the consumer greatly determines
the demand for a commodity. If there is a change in the income of the consumer, then it will
reflect on the demand of the commodity he purchases. A rise in his income will lead to purchase
more units of the commodity and vice versa.

Size and composition of the population : If there is a change in the population of a given
market, there will be a change in demand. Rise in the population will result in increase in
demand and fall will lead to decrease.

Price of substitutes : In case of substitutes of a product, the change in the price of substitute will
affect the demand for the other product.

Price of complementary : The changes in the price of a complementary goods will affect the
demand for primary good.

Tastes and fashions : Changes in tastes and fashions of the society will effect the demand for a
product.

Advertisement and sales promotion : In today’s world, advertisement has a major role in
demand creation for a product. Advertisement creates the awareness about product, so the
consumer will be influenced and the demand for the product goes up.

Quality of product : Any product with proven high quality will have a greater demand.

Season and weather condition : Certain goods are seasonal in nature. They will be demand
only in a particular season. Weather condition also creates demand for some products.

Elasticity of Demand : Elasticity of demand is the measure of the degree of change in the
amount demanded of the commodity in response to a given change in price of the commodity,
price of some related goods, or changes in consumers income.

Types of demand Elasticity

1. Price elasticity of demand

2. Income elasticity of demand

3. Cross elasticity of demand

4. Advertising or promotional elasticity of demand

Price elasticity of demand: The ratio of percentage of changes in demand of a commodity to a
percentage changes in price of goods is called price elasticity.

Pr oportionate changes in quantity demand

Ep=
Pr oportionate changes in price of commod ity

Q 2  Q1
Q1
Ep 
P2  P1
P1

Q
Q1
Ep 
P
P1

Q P
Ep   1
Q1 P

Q p
Ep   1
P Q1

Q1 = Quantity of demand before price change

Q2 = Quantity of demand after price change

P1 = Price charged before price change

P2 = Price charged after price change

Type of price elasticity

1. Perfectly elastic demand

2. Perfectly inelastic demand

3. Unit elasticity demand

4. Relatively elastic demand

5. Relatively inelastic demand

Perfectly elastic demand : E = 
It is one in which a small change in price will cause a large change in amount demanded. A
small rise in price reduces the demand to zero.

Demand is Endless E= 

Price

Demand
Perfectly Inelastic : E= 0

Demand is remains unchanged, whenever be the change in price

Price

Demand

Unit Elasticity demand : E = 1

The percentage of demand changes by exactly demand the same percentage as does the price
changes.

Price

Demand
Relatively Elastic Demand : E > 1

The demand changes by a larger percentage, than does the price changes.

Price

Demand

Relatively Inelastic Demand : E < 1

The demand changes by a small percentage than does the price changes.

Price

Demand

Income Elasticity of Demand :

Income elasticity of demand refers to the percentage change in amount demanded as a result of a
given percentage change income of a consumer.

Pr oportionate changes in quantity of demand

EI=
Pr oportionate changes in income of the consumer

Q 2  Q1
Q1
EI 
I 2  I1
I1
 Q
Q1
EI 
I
I1

Q I
EI   1
Q1 I

Q I
EI   1
I Q1

Q1 = Quantity of demand before income change

Q2 = Quantity of demand after income change

I1 = Original income

I2 = Change in income of the consumer

Type of Income Elasticity of demand :

1. Zero income elasticity

2. Negative income elasticity

3. Positive income elasticity

Zero Income Elasticity : Ei = 0

Where change in income will have no effect on the quantity demand

Ex : Salt Income

Demand
Negative Income Elasticity : Ei < 0

Where a given increase in the consumer’s income is followed by a decline in the quantity
demanded of a commodity

Income

Demand

Ex : An increase in income might lead to shift his demand for bidies to cigarettes

Positive Income Elasticity : Ei = 0

If an increase in income is associated with an increase in quantities demanded

1. Unity income elasticity of demand Ei = 1

2. Income elasticity of demand greater than unity Ei > 1

3. Income elasticity of demand less than unity Ei < 1

Cross Elasticity of Demand :

The effect of a change in the prices of related goods upon the demand for a particular commodity
may be determined by measuring the cross elasticity of demand.

Pr oportionate changes in quantity of demand of a particular commod ity

Ec 
Pr oportionate changes in price of related goods

Q A
QA
Ec 
PB
PB
 Q A P
Ec   B
QA PB

∆QA = Change of demand of given goods

QA = Demand of given goods

∆PB = Change in price of related goods

PB = Price of related goods

Ex : Substitute goods Complementary goods

Price of Price of
Coffee Car

Demand for Tea Demand for petrol

Advertising or Promotional Elasticity of Demand :

This direct relationship between the amount of money spent on advertising and its impact on
sales.

Pr oportionate changes in quantity of demand for particular product X

Ea 
Pr oportionate changes in advertisme nt cos t

(Q 2  Q1 )
Q1
Ea 
(A 2  A1 )
A1

A1 = Amount spent on advertisement before change

A2 = Amount spent on advertisement after change

The Percentage Methods:
Total Outlay Method
Marshall recommended the simplest technique to determine whether demand is elastic or
inelastic. According to his technique, in order to determine the demand elasticity, you have to
examine the change in total outlay of the consumer or total revenue of the firm.

Total Revenue (TR) = (Price (P) × Quantity Sold (Q))

TR = (P × Q)

Marshall has further attributed the following propositions:

(a) ep > 1

 Elastic demand

 The percentage increase in quantity demanded is greater than the percentage fall in price
of a commodity

 Revenue increases because the increase in quantity demanded brings more revenue
irrespective of the decrease in price

 In this case, price and revenue move in opposite directions

(b) ep < 1

 Inelastic demand

 The percentage increase in quantity demanded is less than the percentage decrease in
price

 Revenue decreases because of the fall in price and very small increase in quantity
demanded

 In this case, price and revenue move in the same direction

(c) ep = 1

 Unitary elastic demand

 The percentage increase in quantity demanded equals the percentage decline in price

 Revenue remains the same because the fall in price is offset by the increase in quantity
demanded of the commodity.
Table 1: Total Outlay Method

Price Quantity (in units) Total Outlay (or Elasticity of

revenue) Demand
Original 3 10 30 Unitary elasticity
(price elasticity = 1)
Change 2 15 30
Original 3 10 30 Elastic demand
(price elasticity>1)
Change 2 17 24
Original 3 10 30 Inelastic demand
(price elasticity<1)
Change 2 11 22

Table – 2: Changes in price, outlay and elasticities of demand

Demand If price increases, If prices decreases,

Expenditures Expenditures
Inelastic demand Increase Decrease
Elastic demand Decrease Increase
Unitary demand Remain unchanged Remain unchanged

The following diagram (figure 1) is helpful to understand the relationship between the total
outlay and price elasticity of demand:
When the price decreases from OP3 to OP2, the total outlay rises from OQ2 to OQ1. The portion
UT of the total outlay curve refers to ep > 1.

Suppose the price increases from OP2to OP3. In this case, the total outlay decreases. Note that
between OP2 and OP1 prices, the total outlay does not change or remains constant. The portion
ST of the total outlay curve refers to ep = 1.

Consider a price rise from OP1 to OP2. In this case, the total outlay is constant. Note that
between P1 and any price less than P1, the total outlay decreases. For instance, if the price
decreases from OP1 to OP, the total outlay also decreases from OQ1 to OQ. If price rises from
OP to OP1, total expenditure also rises. The portion RS of the total outlay curve refer to ep < 1.
Point or Geometrical Elasticity Method
If you study the total outlay method carefully, you can understand that the method ignores the
analysis of price range. The total outlay method applies the terms ‘elastic’ and ‘inelastic’ to the
entire demand for a commodity. However, this is not the case in real life economic situations
because in one price range, the demand for a commodity may be elastic and in another price
range, the demand for the same commodity can be inelastic.

The demand curve is said to be linear, when it is a straight line. Graphically, the point elasticity
of a linear demand curve is shown by the ratio of the right segment to the left segment of the
particular point.

If you take a point on the demand curve (for example, midpoint P in figure 2), it divides the
curve into two parts.

Point Elasticity = Lower segment of the demand curve (below the given point) / Upper segment
of the demand curve (above the given point)
Or ep = L/U

Where,

‘ep’ denotes point elasticity

‘L’ denotes the lower segment

‘U’ denotes the upper segment.

Therefore,

1. The point elasticity is unity (ep = 1) at the mid-point (P) of the linear demand curve.

2. ep < 1 at any point to the right of P

3. The point elasticity is greater than unity (ep > 1) at any point to the left of P; at point R, ep =
α; at point M, the ep = 0.

Non-linear demand curve

We have just seen how to measure point elasticity when you have linear demand curve. What
will you do if you have a non-linear demand curve? To measure point elasticity from a non-
linear demand curve, just draw a tangent at the given point and let it touch both the axes.

Now elasticity at P = PM/PR

Rectangular Hyperbola

If your demand curve is a rectangular hyperbola, elasticity of demand is unity throughout the
demand curve. It means that at all points on the demand curve ep= 1. Let us look at a numerical
example to understand this scenario better.
 Table 3
Price of X Quantity of X (Price of X) x (Quantity of
X)
9 1 9
6 1.5 9
3 3 9
2 4.5 9
1 9 9

Hence, we could note that all rectangles have the same area. It implies that the total expenditure
represented by rectangles is constant.
Arc Method
The drawback of the point elasticity method is that it becomes irrelevant when there is a
substantial change in the price and quantity demanded of a commodity. The concept of point
elasticity holds good when a change in price and quantity is immeasurably small. If the change in
price and the consequent change in quantity demanded are substantial, we will have to use more
relevant concept of arc elasticity method for a precise and concrete conclusion.

An arc represents a portion or a segment of a demand curve.

The issue now before us is to derive an appropriate formula for arc elasticity.

The formula under the percentage method is (ΔQ/ΔP) × (P/Q).

Let us calculate elasticity of demand (percentage method) using market demand schedule (table
4) and the market demand curve (figure 5).
 Table 4
Point Price of X Quantity of X
A 4 10
B 3 20
C 2 30

From A to C: ep = (ΔQ/ΔP) × (P/Q) = (20/2) × (4/10) = 4

From C to A: ep = (ΔQ/ΔP) × (P/Q) = (20/2) × (4/30) = 0.66

We get one ep when the price falls and another ep when the price rises. Thus, the formula under
the percentage method gives different results depending on whether the price is increased or
decreased.

How do you resolve this problem? One way to get rid of this problems is to take an average of
prices and quantities and then to measure elasticity at the mid-point of the arc.

Now, the formula becomes:

(ΔQ/ (1/2) (Q1 + Q2)) / (ΔP/ (1/2) (P1 + P2))

When we apply this new version of formula to calculate ep for a movement from A to C or for a
movement from C to A,

We get, ep = (20/ (1/2) (10 + 30)) / (2/ (1/2) (4 + 2)) = (20/20) × (3/2) = 1.5

This is the elasticity of demand at the midpoint, i.e., at point B.

Supply Definition:
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.

Law of Supply:

The basic law of supply is that as the price of a commodity rises, so producers expand their
supply onto the market. A supply curve shows a relationship between price and quantity a firm is
willing and able to sell.

All factors influencing supply are being held constant except price. If the price of the good
varies, we move along a supply curve. In the diagram above, as the price rises from P1 to P2
there is an expansion of supply. If the market price falls from P1 to P3 there would be
a contraction of supply in the market. Businesses are responding to price signals when making
their output decisions.

Explaining the Law of Supply

There are three main reasons why supply curves for most products are drawn as sloping upwards
from left to right giving a positive relationship between the market price and quantity supplied:
The profit motive: When the market price rises (for example after an increase in consumer
demand), it becomes more profitable for businesses to increase their output. Higher prices send
signals to firms that they can increase their profits by satisfying demand in the market.

Production and costs: When output expands, a firm’s production costs rise, therefore a higher
price is needed to justify the extra output and cover these extra costs of production.

New entrants coming into the market: Higher prices may create an incentive for other
businesses to enter the market leading to an increase in supply.

Determinants of Supply:

When price changes quantity supplied will change. That is a movement along the same supply
curve. When factors other than price changes, supply curve will shift. Here are some
determinants of the supply curve.

1. Production cost:

Since most private companies’ goal is profit maximization. Higher production cost will lower
profit, thus hinder supply. Factors affecting production cost are: input prices, wage rate,
government regulation and taxes, etc.

2. Technology:

Technological improvements help reduce production cost and increase profit, thus stimulate
higher supply.

3. Number of sellers:

More sellers in the market increase the market supply.

4. Expectation for future prices:

If producers expect future price to be higher, they will try to hold on to their inventories and
offer the products to the buyers in the future, thus they can capture the higher price.

It is necessary that the managers need to know how much can be produced with a given
set of inputs.

Demand Forecasting : Demand forecasting refers to an estimate of future demand for the
product. “It is an objective assessment of the future course of demand”. It is an vital role in
business decision making. The survival and prosperity of a business firm depend on its ability to
meet the consumers’ needs efficiently and adequately. Demand forecasting has an important
influence on production planning.
Type of Demand Forecasting :

Short – term demand forecasting : Short – term demand forecasting is for a limited period
usually for one year. It relates to policies regarding sales, purchase, price and finances taking
existing production capacity of the firm short term forecasting are essential for formulating
suitable price policies, If the business people expect a rise in the prices of raw materials or
shortages, they may buy early.

Long – term forecasting : In long – term forecasting the business should know that about the
long – term demand for the product planning of a new plant or expansion of an existing unit
depends on long – term demand.

Method of Demand Forecasting :

I. Survey Method : Under this method, information about the consumers’ requirement and
opinion of experts are collected by interviewing them. Survey method can be divided into three
types viz., consumers’ survey method, sales force opinion method and experts’ opinion method.

i) Consumers survey method : In this method, the consumers are contacted personally to know
about their plans and preferences regarding the consumption of the product. A list of all potential
buyers would be drawn and each buyer will be approached and asked how much he plans to buy
the listed product in future.

This method may be undertaken in three ways. Complete enumeration method, sample surveys
method and consumer’s end use method.

a) Complete enumeration method : Under this method all the consumers of the product are
interviewed based on which forecast is made. As first hand information is collected this method
is free from bias. However, this method is impracticable as the consumers are numerous and
scattered.

b) Sample survey method : In this method, a sample of customers is selected for interview. A
sample may be random sampling or stratified sampling. This method is easy, less costly and also
highly useful. Correct sampling and cooperation of the consumers is essential for the success of
this method.

c) End – use method : Under this method, the demand for the product from different sectors such
as industries, consumers, export and import are found out. This data helps in changing the future
course of demand. But for this method industries should provide their production plans and
input-out coefficients.

ii) Sale – Force Opinion method : The men who are closest to the market(viz., salesmen) are
questioned and heir responses (or reactions) are aggregated. The advantages of this method are
that it is cheap and easy, in the sense that it does not involve any elaborate statistical
measurement.

iii) Experts’ Opinion Method : Obtaining views from a group of specialists outside the firm has
possible advantages of speed and cheapness. This method is best suited in situations were
intractable changes are occurring, e.g., forecasting future technological states. It is possible that
in cases where basic data are lacking experts may give divergent views, but even then it is
possible for the manager to adopt his thinking on the basis of these views.

II. Statistical Methods : for forecasting the demand for goods and services in the long – run,
statistical and mathematical methods are used considering the past data.

i) Trend Projection Method : These are generally based on analysis of past sales patterns. These
methods dispense with the need for costly market research because the necessary information is
often already available in company files in terms of different times, that is, a timer series data.

a) Fitting a trend line: Under this method actual sales data is drawn on a chart and estimating by
observation where the trend line lies. That line can be extended further towards a future period
and the corresponding sales graph can be read from the graph.

b) Least square method: This method uses statistical data to find the trend line which best fits the
available data. Here it is assumed that there is proportional (linear) change in sales over a period
of time. In such a case, the trend line equation is in linear form. Where this assumption does not
hold good, the equation can be in non-linear form.

The estimating linear trend equation of sales is written as

S = x + y(T)

Where x and y have been calculated from 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 normal equations have to be
stated and solved:

∑S = N x + y ∑T

∑ST = x ∑T + y ∑ T2

Where S is the sales; T is the year number, n = number of years

c) Time Series Analysis : This method attempts to build seasonal and cyclical variation into the
estimating equation

S=a+b+c

S = Sales, a = Trend, b = Season trend, C = Cycle trend

d) Moving Average Method : This method is based on past sales data and it is used for short –
term forecasting and it is based on assumption that the future is the average of past performance.

ii) Barometric Techniques : Present events are used to predict the directions of change in future.
This is done with the help of economic and statistical indicators. Indicators like building
materials, personal income, agricultural income, employment, gross national income, industrial
production.

Ex : 1. Construction contracts sanctioned, to forecast demand for building

Materials

2. Personal income for predicting the demand for consumer goods

3. Agriculture income to forecast the demand for agricultural inputs

iii) Simultaneous Equation Method : This method is more practical in the sense that it requires
to estimate the future values of only predetermined variables. It is an improvement over
regression method where as in regression equation, the value of both exogenous (Independent)
and endogenous (Dependent) variables have to be predicted. It is no better than regression
method. It inherits all the limitations of regression method. It is difficult to compute where the
number of equations is larger.

iv) Correlation and Regression Methods :

a) Correlation Method: 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. If the high values of one variable are associated with the high values of
another, they are said to be positively correlated.

b) Regress Analysis : This is a statistical technique by which the demand it forecasted with the
help of certain independent variables. There types of regression analysis.

i) Simple Regression : In this analysis is used when the quantity demanded is taken as a function
of a single independent variable

ii) Multiple Regression : In this analysis is used to estimate demand as a function of two or more
independent variables that varies simultaneously.

III. Other Methods :

i) Test Marketing : The manufactures favor 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 consumer reacts 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 Ex: Automobile companies.

ii) Market Experimentation: This method involving giving a sum of money to each consumer
with which he is asked to shop around in a simulated market. Consumer behavior is then studied
by varying the price, quality, packing, advertisement, colour etc.

iii) Judgmental Approach : If the management is unable to use any of the above method they
have to make their own judgment in forecasting the demand

Ex : According to the anticipated changes of the budget, the demand can be estimated depending
upon the change expected, income levels and needs of the customers like Cell phone, Computers
etc.

Factors Governing Demand Forecasting : There are several factors which govern the
forecasting process. There are

a) Nature of Demand : Market demand for particular product or service is not a single number
but it is a function of a number of factors. For instance, higher volumes of sales can be realized
with higher levels of advertising or promotion efforts.

b) Types of Forecast : Base on the period under forecast, the demand forecast can be of two
types i) Short – run forecast ii) Long – run forecast

i) Short – run forecast : A short – range forecast of the total demand for a particular product
helps to provide a basis for ordering raw materials, to plan and schedule production activities, to
seek short – term finance, and so on.

ii) Long – run Forecast : A long – run forecast provides information for major strategic
decisions that result in extension or reduction of limiting resources. A long – run forecast can be
an effective basis to make an allocation for necessary long – run finance.

c) Forecasting Level : Forecasting may be at the firm level, industry level, national level or at the
global level.

Firm level means estimating the demand for the product and services offered by a single firm,

Industry level means the aggregate demand estimated for the goods and services of all the firms
constitutes the industry level.

National level means it is worked out based on level of income and saving of the consumers.

Global level means globalization and deregulation, the entrepreneurs have started exploring the
foreign markets for which the global level forecasts are utilized.
d) Degree of Orientation : Demand forecasts can be worked out based on total sales or
product/service – wise sales for a given time period. Forecasts in terms of total sales can be
viewed as general forecast whereas product/service – wise or region or customer segment – wise
forecast is referred to as specific forecast.

e) Nature of goods : The goods are classified into producer goods, consumer goods, consumer
durables and services. The patterns of forecasting in each of these differ.

f) New Products : It is relatively easy to forecast demand for established products or products
which are currently in use. If a firm wants to deal in detergents, it can find access to the industry
demand for the detergents and market share of each competitor. It is up to this individual new
firm and its ingenuity to create its own customer base by pulling customers of the other
competitors through strategy.

Production Function: The technical relationship which reveals the maximum amount of output
capable of being produced by each and every set of inputs.

Q = f ( L1, L2, C, O, T )

Q = Quantity of Production, L1 = Labour, L2 = Land, C = Capital,

O = Organization, T = Technology

Production function with one variable input and law of returns : The laws of returns states
that when at least one factor of production is fixed or factor input is fixed and all other factors
are vertical, 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 inputs are added further to the fixed factor input, the
total output may decline, this law is universal nature and it proved to be true in agriculture and
industry also, the law of returns is also called the law of variable proportions or the law of
diminishing returns.

Output with fixed capital and variable labour inputs

Units of Total production Marginal Average Stages

labour Production production

0 0 0 0

1 10 10 10 Stage – I

2 22 12 11

3 33 11 11
 4 40 7 10

5 45 5 9 Stage - II

6 48 3 8

7 48 0 6.85

8 45 -3 5.62 Stage - III

Max. Total Output

B
A C

 Stage-I  Stage-II   Stage-III 

Out put TP

Max.
Average AP
Production

X
O D E F

Units of Labour
MP

Production function with two variable inputs and Law of Returns :

We have assumed that a firm increases its output either by using more of one input (Short
– period) production function or by using more of all inputs (Long – period production function).
We shall now concentrate on a firm which increases its outputs by using more of two inputs that
are substitutes for each other say labour (L) and Capital (C). We can now conceive of the
production function in terms of certain fixed inputs and two variable inputs.
Out put form different combination of two inputs

No. of Machines Out Put

8 30 35 40 45

6 25 30 35 40

4 20 25 30 35

2 15 20 25 30

No. of Workers 2 4 6 8

Iso – Quants : Iso means equal, quant means quantities iso-quants means that the quantities
throughout a given iso-quants are equal. Iso-quants also called, Iso-product curves or production
indifference curves.

An iso-quants curve shows various combinations of two input factors such as capital and
labour, which yield the same level of output.

Combinations Capital (C) No. of Labourers (L)

A 1 20

B 2 15

C 3 11

D 4 8

E 5 6

F 6 5
 A

B
Capital

D
E F

Labour

Type of Iso – Quants :

a) Linear Iso – Quant : Which iso-quants having

perfect substitutability of inputs such a iso-quants we
called as linear iso-quants
Oil
Ex: A power plant equipped to burn either Oil or Gas.

Gas
b) Right – Angle Iso – Quant : Where there is
complete non-substitutability between the inputs such
a iso-quants called as right – angel iso-qunats.

Ex : Exactly two wheels and one chassis are Chassis

required to produce a scoter and in no way can
wheels be substituted for chassis or vice-versa.

Wheels
c) Convex Iso – Quant : This from assumes
substitutability of inputs but the
substitutability is not perfect.
C1
Ex : A shirt can be made with relatively Q2
small amount of labour (L1) and large Cloth C2
amount of cloth (C1). The same shirt can be C3 Q1
as well made with less cloth (C2), if more
labour (L2) is use because the tailor will have

L1 L2 L3
Labour
to cut the cloth more carefully and reduce wastage.

Marginal Rate of Technical Substitution (MRTS) :

Marginal Rate of Technical Substitution (MRTS) refers to the rate at which one input factor is
substituted with the other attain a given level of output. In other words, the lesser units of one
input must be compensated by increasing amounts of another input to produce the same level of
output.

Change in one input , say , Capital

MRTS 
Change in another input , say , Labour

Combinations Capital (C) No. of Labourers (L) MRTS

A 1 20 -

B 2 15 5:1

C 3 11 4:1

D 4 8 3:1

E 5 6 2:1

F 6 5 1:1

Isocosts : Isocost refers to that cost curve that represents the combination of inputs that will cost
the producer the same amount of money. In other words, each isocost denotes a particular level
of total cost for a given level of production. If the level of production changes, the total cost
changes and thus the isocost curve moves upwards, and vice versa.

Isocosts curves showing

different volumes of output

Capital

Labour
Least – Cost Combination of Inputs: In order to gain maximum profit the cost of production
must be reduced. Isocost and Isoquants are used to determine input factors for minimizing cost
of production at maximum output. This is known as Least – Cost Combination of Inputs. To
explain how he can determine the least cost combination for given output, we need the price of
the factors of production. Let the price of labour (P L) be Rs.6 per unit and the price of capital
(Pk) Rs.9 per unit. Assume that any amount of labour and capital can be bought at these
respective fixed prices. Let our farmer wants to produce a certain amount of paddy. Assume
that the farmer has certain combinations of labour and capital (tractor) given in the table below.

Input in units
Combination Cost (Rs.)
K L

1 3 20 (3 x 9) + (20 x 6) = 147

2 4 13 (4 x 9) + (13 x 6) = 114

3 5 10 (5 x 9) + (10 x 6) = 105

4 6 8 (6 x 9) + ( 8 x 6) = 102

5 7 6 (7 x 9) + ( 6 x 6) = 99

6 8 5 (8 x 9) + ( 5 x 6) = 102

In our example, there are six alternative combinations of labour and capital to produce the 9
quintals. Combination 5 represents the least cost for producing the desired produce. The least
total cost producing various other quantities can be determined in a similar way

Graphically we can determine the least cost input combination or the maximum output for a
given cost, first we Iso – Quant 5 Quintal
have to draw iso-
quant map and than
iso-cost map as Iso – Quant 9 Quintal
shown below.
Iso – Quant 12 Quintal
As per above figure
the desired quantity Units of Capital
of output can be
produced at a least Iso – Cost Rs.99
cost Rs.99 by
E
having 6 units of Iso – Cost Rs.105
capital and 7 units
of labour. It is

Units of Labour
known by the point E where the iso-qunat curve is just tangent to the iso-cost curve (Rs.99). At
any other point of iso-quant the total cost is more than Rs.99. Similarly for a given cost, an
entrepreneur can select the best combination of two inputs which will give the maximum output
by way of selecting that iso-quant curve which is just tangent to a given iso-cost curve.

Cost Concepts : The kind of cost concept to be used in particular situation depends upon the
business to be made cost considerations enter into almost every business decision, and it is
important, though sometimes difficult, to use the right kind of cost. Hence an understanding of
the meaning of various concepts is essential for clear business thinking.

Different Type of Cost Concepts :

Actual cost & Opportunity Cost :

Actual cost means the actual expenditure incurred for acquiring or producing goods or
services Ex: Wages paid, Cost of material purchased.

Opportunity cost of a goods or service is measured in terms of revenue which could have
been earned by employing that goods or service in some other alternative uses. Opportunity cost
can be defined as the revenue foregone by not making the best alternative uses.

Ex: If start a business in the central locality area of the town we lease a shop after paying
some amount to the shop owner. The amount and interest on amount is opportunity cost.

Explicit and Implicit or Imputed cost :

Explicit cost are those expense that involve cash payments these are the actual or
business costs that appears in the books of accounts. Explicit cost is the payment made by the
employed for those factors of production hired by him from outsides. Ex: Wages, salaries, raw
material

Implicit costs are the costs of the factor units that are owned by the employer himself. It
does not involve cash payment and hence does not appear in the books of accounts. These costs
are not actually incurred but would have been incurred in the absence of employment of self-
owned factors.

Ex: Rent unclaimed on own building, Depreciation.

Historical and Replacement costs :

Historical cost valuation shows the cost of an asset as the original price paid for the asset
acquired in the past. Historical valuation is the basis for financial accounts.

Replacement cost is the price that would have to be paid currently to replace the same
asset.
 Ex: Price of a machine at the time of purchase was Rs.17,000 and the

present price of the machine is Rs.20,000

17,000 - Historical Cost

20,000 - Replacement Cost

Short – run and Long – run cost : 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 intensively. But in the long – run it is possible to change the
firms physical capacity as all the inputs are variable in the long – run. Short – run cost is that
varies with output when the plant and capital equipment remain constant.

Out – of Pocket and Book Cost :

Out of pocket costs, also know as explicit cost are those costs that involve current cost
payment Ex: wages, rent and interest etc.

Book costs also called implicit cost do not require current cash expenditure. Ex: Unpaid
salary of the owner manager, depreciation and unpaid interest.

Past cost and Future cost :

Past cost also called historical costs are the actual costs incurred and recorded in the
books of accounts.

Future costs are costs that are expected to be incurred in the future.

Traceable cost and Common cost :

Traceable cost otherwise called direct cost in one which can be identified with a
production process or product Ex: Raw material cost

Common costs are the ones that cannot be attributed to a particular process or product
Ex: Salaries paid.

Avoidable cost and Unavoidable cost:

Avoidable costs are those which will be eliminated. If a segment of the business with
which they are directly related, is discontinued.

Ex: Salary of clerks attached to the product or bad debts, traceable to the

product would be eliminated.

 Unavoidable costs are those which will not be eliminated with the segment. Such costs
are merely reallocated if the segment is discontinued.

Ex: In case a product discontinued, the salary of the factory manager or

factory rent can not be eliminated.

Controllable cost and Uncontrollable cost :

Controllable costs are those costs which can influenced by the action of specified
member of an undertaking. Costs which cannot be so influenced are termed as uncontrollable
costs.

Ex: The expenditure incurred by tool room is controlled by the Foreman –

In-charge of that section but the share of the tool room expenditure,

Which is apportioned to a machine shop can not be controlled by a

Machine shop-foreman.

Incremental cost and Sunk cost :

This additional cost due to a change in the level or nature of business activity, the
changes may be used by adding a new product, adding new machinery, replacing a machine by a
better one etc. Incremental or differential cost is not marginal cost. Marginal cost is the cost of
additional unit of output. Marginal costs involve only variable cost, where as incremental cost
includes both variable and fixed cost.

Sunk costs are those which are not altered by any change in the level or nature of
business activity, they are the costs incurred in the past. This cost is the result of past decision
and cannot be changed by future decisions.

Ex: Investment in fixed asset is sunk cost.

Fixed cost, Variable cost and Semi-variable cost :

Which cost is fixed up to certain level of output such a cost is called as fixed cost Ex:
Machinery cost

Which cost is vary with production such as cost is called as variable cost

Ex: Raw material cost

This cost neither fixed cost nor variable cost such a cost called as semi-variable cost. Ex:
Telephone bill
Total cost, Average cost and Marginal cost :

Total cost is the total cash payment made for the input needed for production. It is the
sum total of the fixed and variable costs.

Average cost is cost per unit of production.

AC = TC/Q

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

MC = ΔTC/ΔQ

Accounting cost and Economic Cost :

Accounting costs are the costs recorded for the purpose of preparing the balance sheet
and profit & loss statements to meet legal, financial and tax purposes of the company.

Economic concept considers future costs and future revenues which help future planning
and choices.

Abandonment cost : Abandonment costs are the cost of retiring altogether a plant from service,
abandonment arises when there is a complete cessation of activities and creates a problem as to
the disposal of assets.

Ex: The costs involved in the discontinuance of tram services in Mumbai and

Delhi.

Break – Even – Analysis : Break even analysis is defined as analysis of costs and their
possible impact on revenues and volume of the firm. Hence it is also called as Cost – Volume –
Profit (CVP) analysis. A firm is said to attain the break even point (BEP) when its total revenue
is equal to total cost.

Key Terms used in Break-even Analysis:

Fixed cost : Fixed costs remain fixed in the short-run, Examples are rent insurance, depreciation
factory supervisors’ salaries, and so on

Variable cost : The variable cost per unit vary with the volume of production. The variable
costs include cost of direct materials, direct labour, direct expenses, operating supplies such as
lubricating oil, and so on.

Total Cist : The total of fixed and variable costs

Total revenue: The sales proceeds (Selling price per unit x number of units sold) Contribution
margin: The contribution margin is the difference between the selling price per unit and the
variable cost per unit. It is also determined as (Fixed cost per unit + profit per unit)

Profit = Contribution – Fixed cost

Contribution margin ratio: It is the ratio between contribution per unit and the selling price per
unit.

Margin of safety in units: The excess of actual sales (in units) minus the break-even point (in
units)

Margin of safety in sales volume: The excess of actual sales (in rupees) minus the break-even
point (In rupees)

Angle of incidence: The angle formed where total cost curve cuts the total revenue curve

Break – even chart : The break-even analysis can be presented graphically too. The break-even
chart is the graphic presentation of the varying costs along with varying sales revenue. It
indicates the break-even point and also shows the estimated profit or loss at different levels of
production. A break-even char can be drawn with the data as per table below.

Output Fixed cost Variable cost Total cost Sales Proposed sales

0 200000 - 200000 - -

10000 200000 100000 300000 200000 180000

20000 200000 200000 400000 400000 360000

30000 200000 300000 500000 600000 540000

40000 200000 400000 600000 800000 720000

50000 200000 500000 700000 1000000 900000

60000 200000 600000 800000 1200000 1080000

The OX axis shows
the units of output and TR
OY axis shows the Profit Zone
TR1
cost and sales
TC
revenue. Fixed cost
line is parallel to OX Cost &
axis. This shows that Revenue
the fixed cost is same Loss Zone BEP1
TVC
Rs.200000 even when
the production is zero B (BEP)
unit or 10000 units.
The variable cost line
TFC
is drawn over the
fixed cost line in the
OY axis. As this is
drawn over the fixed
cost line this also the
total cost(TC) line.
Output
Sales (TR) line starts
from zero and goes
upwards showing increase in revenue with the increase in sales. The firm breaks even at the
point where TC line and TR line intersects the point B. At this point the firm is not making any
profit or loss. Any sales above the point B will bring in profit and sales below this point will
result only in loss.

Significance of Break-Even Analysis :

 To ascertain the profit on a particular level of sales volume or a given capacity of

production
 To calculate sales required to earn a particular desired level of profit
 To compare the product lines, sales area, method of sale for individual company
 To compare the efficiency of the different firm
 To decide whether to add a particular product to the existing product line or drop one
from it
 To decide to make or buy a given component or spare part
 To decide what promotion mix will yield optimum sales
 To assess the impact of changes in fixed cost, variable cost or selling price on BEP and
profits during a given period.

Break – Even Point : The break-even point is that junction where income and cost are exactly in
balance. Thus there is neither profit nor loss for that particular volume of production.
 Fixed Cost
BEP in Units 
Selling Pr ice per Unit  Varibale Cost per unit

Fixed Cost
BEP in Rupees   Selling Pr ice per unit
Selling Pr ice per Unit  Varibale Cost per unit

Fixed cos t  Desired Pr ofit

Sales required to earn a desired profit (in units) 
Selling Pr ice per Unit  Varibale Cost per unit

Profit – Volume Ratio (P/V) : P/V ratio measure the profitability in relation to sales and
contribution it also called contribution to sales (C/S) ratio. The contribution at given output is
defined to be the difference between total sales and total variable costs. It represents the
relationship between contribution and turn-over. So it is a measure to compare profitability of
different products. Higher the p/v ratio is preferable product.

Contribution
P / V Ratio   100
Sales

Fixed Cost  Pr ofit

P / V Ratio   100
Sales

Changes in profit
P / V Ratio   100
Changes in sales

Fixed Cost
P / V Ratio   100
P / V Ratio

Margin of Safety : The Margin of Safety (MOS) is the difference between the actual sales and
BEP sales. This is helps to know how much sales revenues can fall before a loss is incurred.

MOS = Actual Sales – Break-even sales

Actual Sales - Break even sales

MOS Ratio   100
Actual Sales
 Pr ofit
MOS Ratio 
P / V Ratio

Problems :

1. If sales are 10,000 units and selling price is Rs.20 per unit, variable cost Rs.10 per unit and
fixed cost is Rs.80, 000. Find out BEP in units and in sales revenue. What is profit earned?
What should be the sales for earning a profit of Rs.60,000.

Solution:

Quantity = 10,000 units

Selling Price = Rs. 20 per unit

Variable Cost = Rs.10 per unit

Fixed Cost = Rs.80,000

Profit = Rs.60,000

a) Break even points (in units) is given by

Fixed Cost
BEP in Units 
Selling Pr ice per Unit  Varibale Cost per unit

80,000
BEP in Unirs 
20  10

BEP in Units = 8000 units

b) Break-even point in rupees in given by

Fixed Cost
BEP in Rupees   Selling Pr ice per unit
Selling Pr ice per Unit  Varibale Cost per unit

80,000
BEP in Rupees   20
20  10

BEP in Rupees = 1,60,000/-

c) Profit earned is given by

Profit = Total Contribution – Fixed cost

 And contribution per unit = Selling price – Variable cost

Total Contribution = (Selling price – Variable cost) x Number of units sold.

= (20 – 10) x 10,000

= Rs.100000/-

Profit earned = Total contribution – Fixed cost

= 100000 – 80000

Profit = 20000/-

d) Sales for earning profit of Rs.60,000/-

Fixed cos t  Desired Pr ofit

Sales required to earn a desired profit (in units) 
Selling Pr ice per Unit  Varibale Cost per unit

80,000  60,000
Sales required to earn 60,000 Pr ofit 
20  10

= 14000 units.

2. The PV ratio of Matrix Books ltd. Is 40% and margin of safety is 30%. Your are required to
workout the BEP and Net profit of the sales volume is Rs,14000/-

Solution:

PV ratio = 40% = 0.4

Margin of safety = 30% = 0.3

Sales volume = Rs.14000

a) BEP is given by

BEP = Sales volume – Margin of Safety

BEP = 14,000 – (30% of 14000) = 14000 – 4200

BEP = Rs. 9800/-

b) Net profit is given by

Net Profit = Margin of safety x PV ratio

Net Profit = 4200 x 0.4

 Net Profit = Rs.1680/-

3. Sale of a product amounts to 20 units per month Rs.10 per unit fixed overheads are Rs. 400
per month and variable cost is Rs.6 per unit. There is a proposal to reduce prices by 10%.
Calculate present and future PV ratio.

Solution :

Sales = 20 units

Selling price = Rs.10 per unit

Fixed cost = Rs.400

Variable cost = Rs.6 per unit

Present PV ratio :

Contribution
P / V Ratio   100
Sales

10  6
P / V Ratio   100 = 40%
10

Future PV ratio:

Selling price is reduced by 10% hence future selling

Rs.10 – Rs.1 = Rs.9/-

Variable cost remains same i.e., Rs.6/- per unit

Contribution
P / V Ratio   100
Sales

96
P / V Ratio   100  33.33%
9

4. Sales of Rs.1,10,000 producing a profit of Rs.4000 in period – I. Sales of Rs.1,50,000

producing a profit of Rs.12,000 in period – II. Determine BEP and Fixed expenses.

Solution :
Period Sales Profit

I 1,10,000 4,000
II 1,50,000 12,000
BEP is given by

Changes in profit
P / V Ratio   100
Changes in sales

12000  4000
P / V Ratio   100
150000  110000

8000
P / V Ratio   100  20%
40000

Fixed Cost = (Sales x PV ratio) – Profits

= (110000 x 0.20) – 4000

= Rs.18,000/-

Fixed Cost
Now BEP =  100
P / V Ratio

18000
=  Rs.90,000
0.20

5. A gear manufacturing company sells gears at a selling price of Rs.250 per unit. The company
has fixed cost commitment at Rs.20 lakhs and variable cost of Rs.125/- per unit calculate.

a) Break-even sales quantity b) Break-even sales c) Contribution d) Margin of safety if actual

production quantity is 60,000 units.

Solution :

Selling price = Rs.250/- per unit

Variable cost = Rs.125/- per unit

Fixed cost = Rs.20,00,000/-

Fixed Cost
a) BEP in Units 
Selling Pr ice per Unit  Varibale Cost per unit

20,00,000
BEP in Units 
250  125

= 16,000 units
b) Break-even sales = BEP in Units x Selling price per unit

= 16,000 x 250

= 40,00,000/-

c) Contribution Margin = (Selling price – Variable cost)

= 250 – 125 = Rs.125/-

Since contribution margin per unit = Rs.125/-

Total contribution margin for 60,000 units = Rs.125 x 60,000

= Rs.75,00,000/-

d) Margin of Safety

Margin of Safety = Budgeted sales – sales at BEP

= (60,000 x 250) – (16000 x 250)

= 15000000 – 4000000

= 1100000/-