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Engineering Economics
Deals with the methods that enable one to take economics decision towards minimizing
costs and maximizing benefits to business organization.
Significance of economics
TECHNICAL
OUTPUT
100
INPUT
Technical efficiency:
ECONOMIC
Ratio of output to input of a physical system. Physical system may be diesel engine, machine
working on a floor.
Eg: Technical efficiency of a diesel engine :
Technical efficiency (%) =
It can never be more than 100%. Due to frictional loss and incomplete combustion of fuel which
is unavoidable in the working of diesel engine.
Economic efficiency:
Worth is the annual revenue generated by way of operating the business.
Cost is the total annual expenses incurred in carrying out the business
For survival and growth of the business, the economic efficiency should be more than 100%. It is
also called productivity.
DEMAND:
One of the basic objective of the firm is to make profit
No firm can survey without profit
A firm can make profit only when goods produced by them are been demanded or when
the firm is able to create demand for its goods
Definition:
Demand for a commodity refers to
Unless these 3 conditions are fulfilled the product is not set to have any demand
Example:
If a person wants a car and cannot pay for it, there is no demand.
If a person need a car & not available in the market, it is said to be demand
Types of Demand:
a single good.) If the price of the complement goes up the quantity demanded of
the other good goes down.] Mathematically, the variable representing the price of
the complementary good would have a negative coefficient in the demand
function.
The other main category of related goods is substitutes. Substitutes are goods that
can be used in place of the primary good. The mathematical relationship between
the price of the substitute and the demand for the good in question is positive. If
the price of the substitute goes down the demand for the good in question goes
down.
Expectation above the price in future:
If a consumer believes that the price of the good will be higher in the
future he is more likely to purchase the good now. If the consumer expects that
her income will be higher in the future the consumer may buy the good now. In
other words positive expectations about future income may encourage present
consumption.
Size of population:
It is the number of people in a household. As the number of people
increases, the consumption will also increase. It will lead to increased demand.
Advertising efforts:
A successful advertising campaign may affect the demand for a product or
services.
The Law of Demand:
The law of demand states that consumers will demand more of particular product at a lower
price, and less at a higher price.
The law of demand holds that other things equal, as the price of a good or service rises,
its quantity demanded falls.
The reverse is also true: as the price of a good or service falls, its quantity
demanded increases.
The typical demand curve slopes downwards from left to right, illustrating the same
Relationship between prices as stated in the law of demand.
Demand Curve:
Nature of demand:
Individual demand Vs market demand:
The product buy an individual at a given level of price is called individual demand.
The demand for a product by all buyers in a market is called market demand.
Eg: If there is no demand fro houses , there may be no demand fro steel, bricks, cement
etc. A demand for houses is autonomous whereas a demand for these inputs is derived.
Durable goods are those goods that give service for a relatively long period. Eg: Rice,
wheat etc.
The life of perishable goods is very small a few hours or days. Eg : Milk, vegetables
etc.
Products such as T.V, refrigerator and washing machines are useful for a longer period
and hence are classified as consumer durables.
Total market refers to the total demand for the product whereas segment implies a part of
it.
Ex: The total demand for sugar in the region is the total market demand. The demand for
sugar from the sweet industry from this region is the segment market demand.
4. Price Illusion
These different types of exceptions are described in brief explanation as follows:Inferior goods :
Some goods like potato, bread, vegetable oil etc. are called inferior goods. In the case of
these goods when their price falls, the real income or the purchasing power of the consumer
increases, this purchasing power is used to buy other superior goods. Such inferior goods are
named as 'Giffen goods'. An Irish economist Sir Robert Giffen observed this tendency of the
individuals in the 19th century.
Expectations and speculations:
When people expect a rise or fall in price in the near future, the law of demand does not
hold good. If a price rise is expected by next week, then they will buy more now itself though at
present the prices are quite high.
Prestige Goods:
Rich people like to show off their economic status. SO they buy prestige goods like
colour T.V., diamond etc. even at a higher price.
Price illusion:
There are certain consumers those who are always guided by the price of the commodity.
They always believe that higher the price, better the quality. Hence they purchase larger
quantities of high priced goods.
Demonstration effect:
It refers to a tendency of low income groups to imitate the consumption pattern of high
income groups. They will buy a commodity to imitate the consumption of their neighbors even if
they don't have the purchasing power.
Ignorance:
Sometimes due to ignorance of existing market price, and people buy more at a higher
price.
Quality and branded goods:
Commodities of good standard and quality give proper value for money. They last long
and give good service. So people prefer to buy them even at a higher price.
In the above exceptional cases, the demand graph curve slopes upward showing a positive
relationship between price and demand.
SUPPLY:
The total amount of a product (good or service) available for purchase at any specified
price.
FACTORS INFLUENCE SUPPLY:
The price of the good or service:
A rise in price will result in more of the commodity being supplied to the market
and vice versa.
The price of other products:
Any change in the prices of other products would influence the supply of a
product by substituting one product for another. If the market price of coffee rises, it
causes a reduction of the production and supply of tea as the producers withdraw some
resources from the production of tea and devote them for the production of wheat.
The state of technology:
A change in technology leads to a fall in the cost of production. If the
technologies followed by the firms are improved, the cost of production will decline so
that the firms would supply more than before. Thus the improvement in technology leads
to an increase in the supply of a commodity.
The law of supply holds that other things equal, as the price of a good rises, its quantity
supplied will rise, and vice versa.
Supply Curve:
Break-Even Analysis
Meaning:
Break-even analysis is a study of costs, revenues and sales of a firm and finding out the
volume of sales where the firms costs and revenues will be equal. The object of break-even
analysis is not merely to spot the Break-even point, but to create an understanding about the
relationship between costs, revenues and output that could be sold within the competence of the
firm. It is also known as CVP ( Cost,Volume,Profit)analysis. This analysis is an important bridge
between business behavior and the theory of the firm.Break even Analysis is useful for business
executives, but also for an entrepreneur who is on the threshold of setting up his own unit.
Fixed costs are costs that must be paid whether or not any units are produced. These costs are
"fixed" over a specified period of time or range of production.
Variable costs are costs that vary directly with the number of products produced. For instance,
the cost of the materials needed and the labour used to produce units isn't always the same.
Determination of Break-Even Point (BEP)
Break even point is that level of sales where the net income is equal to zero. The break-even
point is the zone of no-profit and no-loss as the costs equal revenues. According to this
definition, at break even point sales are equal to fixed cost plus variable cost
Key terms:
Selling price = Fixed cost+ Variable cost+ Profit
Profit = Selling price ( Fixed cost+ Variable cost)
BEP can be determined in 2 ways:
(i)
(Where, Contribution per unit = Selling price per unit - variable cost per unit)
(ii)
Contribution Ratio
Where,
BEP Chart:
will have this number. You are not alone in this, the vast majority of businesses sell more
than one item, and have to average for their Break even analysis.
2. Average per-unit cost:
This is the incremental cost, or variable cost, of each unit of sales. If you buy
goods for resale, this is what you paid, on average, for the goods you sell. If you sell a
service, this is what it costs you, per dollar of revenue or unit of service delivered, to
deliver that service. If you are using a Units-Based Sales Forecast table (for
manufacturing and mixed business types), you can project unit costs from the Sales
Forecast table. If you are using the basic Sales Forecast table for retail, service and
distribution businesses, use a percentage estimate, e.g., a retail store running a 50%
margin would have a per-unit cost of .5, and a per-unit revenue of 1.
3. Monthly fixed costs:
Technically, a break-even analysis defines fixed costs as costs that would continue
even if you went broke. Instead, we recommend that you use your regular running fixed
costs, including payroll and normal expenses (total monthly Operating Expenses). This
will give you a better insight on financial realities. If averaging and estimating is difficult,
use your Profit and Loss table to calculate a working fixed cost estimateit will be a
rough estimate, but it will provide a useful input for a conservative Break-even Analysis.
Limitations of Break Even Analysis:
It is best suited to the analysis of one product at a time. It may be difficult to classify a
cost as all variable or all fixed; and there may be a tendency to continue to use a break even
analysis after the cost and income functions have changed.
Application of BEP:
It is used for decision making in various areas as follows:
1.
2.
3.
4.
Pricing decisions
Make or buy decisions
Products mix
Utilization of limiting factors
5.
6.
7.
8.
Pricing Policies
Meaning:
Price, the amount of money that has to be paid to acquire a given product. Insofar as the amount
people are prepared to pay for a product represents its value, price is also a measure of value.
Pricing is a Method adopted by a firm to set its selling price. It usually depends on the firm's
average costs, and on the customer's perceived value of the product in comparison to his or her
perceived value of the competing products. Different pricing methods place varying degree of
emphasis on selection, estimation, and evaluation of costs, comparative analysis, and market
situation.
Pricing objectives:
Pricing objectives or goals give direction to the whole pricing process.
Primary objectives:
1)
2)
3)
4)
Secondary objectives:
1) Maximize long-run profit
2) maximize short-run profit
3) increase sales volume (quantity)
4) increase monetary sales
Internal Factors - When setting price, marketers must take into consideration several
factors which are the result of company decisions and actions. To a large extent these factors are
controllable by the company and, if necessary, can be altered. However, while the organization
may have control over these factors making a quick change is not always realistic. For instance,
product pricing may depend heavily on the productivity of a manufacturing facility (e.g., how
much can be produced within a certain period of time). The marketer knows that increasing
productivity can reduce the cost of producing each product and thus allow the marketer to
potentially lower the products price. But increasing productivity may require major changes at
the manufacturing facility that will take time (not to mention be costly) and will not translate into
lower price products for a considerable period of time.
External Factors - There are a number of influencing factors which are not controlled by
the company but will impact pricing decisions. Understanding these factors requires the marketer
conduct research to monitor what is happening in each market the company serves since the
effect of these factors can vary by market.
Internal Factors
1. Marketing Objectives
Marketing decisions are guided by the overall objectives of the company. While we will discuss
this in more detail when we cover marketing strategy in a later tutorial, for now it is important to
understand that all marketing decisions, including price, work to help achieve company
objectives.
Corporate objectives can be wide-ranging and include different objectives for different functional
areas (e.g., objectives for production, human resources, etc). While pricing decisions are
influenced by many types of objectives set up for the marketing functional area, there are four
key objectives in which price plays a central role. In most situations only one of these objectives
will be followed, though the marketer may have different objectives for different products. The
four main marketing objectives affecting price include:
Return on Investment (ROI) A firm may set as a marketing objective the requirement
that all products attain a certain percentage return on the organizations spending on marketing
the product. This level of return along with an estimate of sales will help determine appropriate
Cash Flow Firms may seek to set prices at a level that will insure that sales revenue will
at least cover product production and marketing costs. This is most likely to occur with new
products where the organizational objectives allow a new product to simply meet its expenses
while efforts are made to establish the product in the market. This objective allows the marketer
to worry less about product profitability and instead directs energies to building a market for the
product.
Market Share The pricing decision may be important when the firm has an objective of
gaining a hold in a new market or retaining a certain percent of an existing market. For new
products under this objective the price is set artificially low in order to capture a sizeable portion
of the market and will be increased as the product becomes more accepted by the target market
(we will discuss this marketing strategy in further detail in our next tutorial). For existing
products, firms may use price decisions to insure they retain market share in instances where
there is a high level of market competition and competitors who are willing to compete on price.
Maximize Profits Older products that appeal to a market that is no longer growing may
have a company objective requiring the price be set at a level that optimizes profits. This is often
the case when the marketer has little incentive to introduce improvements to the product (e.g.,
demand for product is declining) and will continue to sell the same product at a price premium
for as long as some in the market is willing to buy.
2. Marketing Strategy
Marketing strategy concerns the decisions marketers make to help the company satisfy its target
market and attain its business and marketing objectives. Price, of course, is one of the key
marketing mix decisions and since all marketing mix decisions must work together, the final
price will be impacted by how other marketing decisions are made. For instance, marketers
selling high quality products would be expected to price their products in a range that will add to
the perception of the product being at a high-level.
It should be noted that not all companies view price as a key selling feature. Some firms, for
example those seeking to be viewed as market leaders in product quality, will deemphasize price
and concentrate on a strategy that highlights non-price benefits (e.g., quality, durability, service,
etc.). Such non-price competition can help the company avoid potential price wars that often
break out between competitive firms that follow a market share objective and use price as a key
selling feature
3. Costs
For many for-profit companies, the starting point for setting a products price is to first determine
how much it will cost to get the product to their customers. Obviously, whatever price customers
pay must exceed the cost of producing a good or delivering a service otherwise the company will
lose money.
When analyzing cost, the marketer will consider all costs needed to get the product to market
including those associated with production, marketing, distribution and company administration
(e.g., office expense). These costs can be divided into two main categories:
Fixed Costs - Also referred to as overhead costs, these represent costs the marketing
organization incurs that are not affected by level of production or sales. For example, for a
manufacturer of writing instruments that has just built a new production facility, whether they
produce one pen or one million they will still need to pay the monthly mortgage for the building.
From the marketing side, fixed costs may also exist in the form of expenditure for fielding a sales
force, carrying out an advertising campaign and paying a service to host the companys website.
These costs are fixed because there is a level of commitment to spending that is largely not
affected by production or sales levels.
Variable Costs These costs are directly associated with the production and sales of
products and, consequently, may change as the level of production or sales changes. Typically
variable costs are evaluated on a per-unit basis since the cost is directly associated with
individual items. Most variable costs involve costs of items that are either components of the
product (e.g., parts, packaging) or are directly associated with creating the product (e.g.,
electricity to run an assembly line). However, there are also marketing variable costs such as
coupons, which are likely to cost the company more as sales increase (i.e., customers using the
coupon). Variable costs, especially for tangible products, tend to decline as more units are
produced. This is due to the producing companys ability to purchase product components for
lower prices since component suppliers often provide discounted pricing for large quantity
purchases.
Determining individual unit cost can be a complicated process. While variable costs are often
determined on a per-unit basis, applying fixed costs to individual products is less straightforward.
For example, if a company manufactures five different products in one manufacturing plant how
would it distribute the plants fixed costs (e.g., mortgage, production workers cost) over the five
products? In general, a company will assign fixed cost to individual products if the company can
clearly associate the cost with the product, such as assigning the cost of operating production
machines based on how much time it takes to produce each item. Alternatively, if it is too
difficult to associate to specific products the company may simply divide the total fixed cost by
production of each item and assign it on percentage basis.
External Factors
1. Elasticity of Demand
Marketers should never rest on their marketing decisions. They must continually use market
research and their own judgment to determine whether marketing decisions need to be adjusted.
When it comes to adjusting price, the marketer must understand what effect a change in price is
likely to have on target market demand for a product.
Understanding how price changes impact the market requires the marketer have a firm
understanding of the concept economists call elasticity of demand, which relates to how purchase
quantity changes as prices change. Elasticity is evaluated under the assumption that no other
changes are being made (i.e., all things being equal) and only price is adjusted. The logic is to
see how price by itself will affect overall demand. Obviously, the chance of nothing else
changing in the market but the price of one product is often unrealistic. For example, competitors
may react to the marketers price change by changing the price on their product. Despite this,
elasticity analysis does serve as a useful tool for estimating market reaction.
Elasticity deals with three types of demand scenarios:
Elastic Demand Products are considered to exist in a market that exhibits elastic
demand when a certain percentage change in price results in a larger and opposite percentage
change in demand. For example, if the price of a product increases (decreases) by 10%, the
demand for the product is likely to decline (rise) by greater than 10%.
Inelastic Demand Products are considered to exist in an inelastic market when a certain
percentage change in price results in a smaller and opposite percentage change in demand. For
example, if the price of a product increases (decreases) by 10%, the demand for the product is
likely to decline (rise) by less than 10%.
Unitary Demand This demand occurs when a percentage change in price results in an
equal and opposite percentage change in demand. For example, if the price of a product increases
(decreases) by 10%, the demand for the product is likely to decline (rise) by 10%.
For marketers the important issue with elasticity of demand is to understand how it impacts
company revenue. In general the following scenarios apply to making price changes for a given
type of market demand:
For elastic markets increasing price lowers total revenue while decreasing price
increases total revenue.
For inelastic markets increasing price raises total revenue while decreasing price lowers
total revenue.
Possibly the most obvious external factors that influence price settings are the expectations of
customers and channel partners. As we discussed, when it comes to making a purchase decision
customers assess the overall value of a product much more than they assess the price. When
deciding on a price marketers need to conduct customer research to determine what price
points are acceptable. Pricing beyond these price points could discourage customers from
purchasing.
Firms within the marketers channels of distribution also must be considered when determining
price. Distribution partners expect to receive financial compensation for their efforts, which
usually means they will receive a percentage of the final selling price. This percentage or margin
between what they pay the marketer to acquire the product and the price they charge their
customers must be sufficient for the distributor to cover their costs and also earn a desired profit.
3. Competitive and Other Products
Marketers will undoubtedly look to market competitors for indications of how price should be
set. For many marketers of consumer products researching competitive pricing is relatively easy,
particularly when Internet search tools are used. Price analysis can be somewhat more
complicated for products sold to the business market since final price may be affected by a
number of factors including if competitors allow customers to negotiate their final price.
Analysis of competition will include pricing by direct competitors, related products and primary
products.
Direct Competitor Pricing Almost all marketing decisions, including pricing, will
include an evaluation of competitors offerings. The impact of this information on the actual
setting of price will depend on the competitive nature of the market. For instance, products that
dominate markets and are viewed as market leaders may not be heavily influenced by competitor
pricing since they are in a commanding position to set prices as they see fit. On the other hand in
markets where a clear leader does not exist, the pricing of competitive products will be carefully
considered. Marketers must not only research competitive prices but must also pay close
attention to how these companies will respond to the marketers pricing decisions. For instance,
in highly competitive industries, such as gasoline or airline travel, competitors may respond
quickly to competitors price adjustments thus reducing the effect of such changes.
Related Product Pricing - Products that offer new ways for solving customer needs may
look to pricing of products that customers are currently using even though these other products
may not appear to be direct competitors. For example, a marketer of a new online golf instruction
service that allows customers to access golf instruction via their computer may look at prices
charged by local golf professionals for in-person instruction to gauge where to set their price.
While on the surface online golf instruction may not be a direct competitor to a golf instructor,
marketers for the online service can use the cost of in-person instruction as a reference point for
setting price.
be price floors (how low price may be set). Additional areas of potential regulation include:
deceptive pricing, price discrimination, predatory pricing and price fixing.
Finally, when selling beyond their home market, marketers must recognize that local regulations
may make pricing decisions different for each market. This is particularly a concern when selling
to international markets where failure to consider regulations can lead to severe penalties.
Consequently marketers must have a clear understanding of regulations in each market they
serve.
Pricing method whereby the selling price of a product is calculated to produce a particular rate of
return on investment for a specific volume of production. The target pricing method is used most
often by public utilities, like electric and gas companies, and companies whose capital
investment is high, like automobile manufacturers.
Target pricing is not useful for companies whose capital investment is low because, according to
this formula, the selling price will be understated. Also the target pricing method is not keyed to
the demand for the product, and if the entire volume is not sold, a company might sustain an
overall budgetary loss on the product.
16. Absorption pricing
Method of pricing in which all costs are recovered. The price of the product includes the variable
cost of each item plus a proportionate amount of the fixed costs. A form of cost plus pricing
17. High-low pricing
Method of pricing for an organization where the goods or services offered by the organization
are regularly priced higher than competitors, but through promotions, advertisements, and or
coupons, lower prices are offered on key items. The lower promotional prices are targeted to
bring customers to the organization where the customer is offered the promotional product as
well as the regular higher priced products.
18. Premium Decoy pricing
Method of pricing where an organization artificially sets one product price high, in order to boost
sales of a lower priced product.
19. Marginal-cost pricing
In business, the practice of setting the price of a product to equal the extra cost of producing an
extra unit of output. By this policy, a producer charges, for each product unit sold, only the
addition to total cost resulting from materials and direct labor. Businesses often set prices close
to marginal cost during periods of poor sales. If, for example, an item has a marginal cost of
$1.00 and a normal selling price is $2.00, the firm selling the item might wish to lower the price
to $1.10 if demand has waned. The business would choose this approach because the incremental
profit of 10 cents from the transaction is better than no sale at all.
20. Value Based pricing
Pricing a product based on the perceived value and not on any other factor. Pricing based on the
demand for a specific product would have a likely change in the market place.
Target pricing is not useful for companies whose capital investment is low because, according to
this formula, the selling price will be understated. Also the target pricing method is not keyed to
the demand for the product, and if the entire volume is not sold, a company might sustain an
overall budgetary loss on the product.